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Economics
Economics is divided into three major fields
Microeconomics  examines behavior of individuals and firms
Macroeconomics  examines aggregate behavior of broad sectors of the
economy
Econometrics
 statistical analysis of economic and financial data
1
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
Accounting cost is the giving up of A in order to obtain B.
Opportunity cost is the failure to obtain C because you obtained B.
Economic cost is accounting cost plus opportunity cost.
Example
A firm hires a worker for $70,000 (including benefits). The firm’s weighted
average cost of capital is 15%.
 The explicit cost of the worker is $70,000 per year. This is what the firm gives
up in order to obtain the worker.
 The opportunity cost of the worker is ($70,000)(0.15) = $10,500. This is the
amount of money the firm could have earned, but failed to earn, had the firm
invested the $70,000 elsewhere.
 The economic cost of the worker is $70,000 + $10,500 = $80,500.
2
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
2.
People make decisions at-the-margin.
Example
A firm spends $100 million on building a new factory. The amortized cost of the
factory is $10 million annually. The new factory will cost $8 million to operate
annually. The factory is expected to bring in an additional $25 million in revenue
annually.
After the factory is completed, economic conditions change such that the
expected revenue to be generated by the factory drops to $5 million.
Should the firm operate or shut-down the factory (note: shutting down does not
recoup the $100 million cost of the factory)?
3
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
2.
People make decisions at-the-margin.
Example
Some managers will be tempted to operate the factory because of the $100
million invested. This is called the sunk cost fallacy. The sunk cost fallacy arises
when one fails to make decisions at-the-margin.
A decision at-the-margin looks only at changes given current conditions. In this
case, the given condition is that the factory exists. The choice to operate or not
is irrelevant to the $100 million investment.
Operate the factory
Annual profit = $5 million – $8 million – $10 million = – $13 million
Shutdown the factory
Annual profit = $0 million – $0 million – $10 million = – $10 million
4
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
2.
People make decisions at-the-margin.
3.
People respond to incentives.
Where people are concerned, we call this utility maximization. Where firms are
concerned, we call this profit maximization.
Example
Stockholders can mitigate portfolio risk by diversifying their stock holdings.
Therefore, they will want to hold individual stocks that have greater expected
returns and greater risks rather than individual stocks that have lesser expected
returns and lesser risks.
As a result, stockholders want CEO’s to take risks in pursuit of greater profits.
5
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
2.
People make decisions at-the-margin.
3.
People respond to incentives.
Problem
If a risk goes bad, the CEO will be fired  CEO has incentive not to take risks.
How can stockholders motivate CEO’s to take risks?
“Golden parachute” – guarantee the CEO that, in the event the CEO is fired, CEO
will receive a large lump-sum payment from the company.
6
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
2.
People make decisions at-the-margin.
3.
People respond to incentives.
Other Examples
• Soviet nail manufacturers produced huge, multi-ton nails.
• In Russia, dead light bulbs sold for more than live light bulbs.
• Traffic monitoring devices reduce side-impact, but cause rear-end collisions.
7
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
2.
People make decisions at-the-margin.
3.
People respond to incentives.
4.
Exchange is (usually) not a zero-sum game.
Zero-sum game: A situation in which what one person gains, the other loses.
In an exchange, both parties can end up better off than they were at the outset.
Example
Person A owns a car that he would like to sell. Person A has full knowledge of
the condition of the car. Given his need to drive, desire for style/comfort, etc.,
Person A places a subjective value of $10,000 on the car. This means that Person
A would accept nothing less than $10,000 in exchange for the car.
8
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
2.
People make decisions at-the-margin.
3.
People respond to incentives.
4.
Exchange is (usually) not a zero-sum game.
Example
Person B also has full knowledge of the condition of the car. Given her need to
drive, etc., Person B places a subjective value of $12,000 on the car. This means
that Person B would pay any price up to, but not more than, $12,000 in
exchange for the car.
9
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
2.
People make decisions at-the-margin.
3.
People respond to incentives.
4.
Exchange is (usually) not a zero-sum game.
Example
A reservation price is the minimum price the seller is willing to accept or the
maximum price the buyer is willing to pay.
Seller’s reservation price = $10,000
Buyer’s reservation price = $12,000
 If Person B pays $11,000 for the car, Person B gains $1,000 of value ($12,000
car value less $11,000 price), and Person A gains $1,000 of value ($11,000 price
less $10,000 car value).
10
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
2.
People make decisions at-the-margin.
3.
People respond to incentives.
4.
Exchange is (usually) not a zero-sum game.
5.
The world is non-linear.
Assuming that the world is linear results in erroneous expectations.
Example
A firm employs 100 workers who, together, produce 100,000 bottles of beer
daily.
Linear assumption: 200 workers will produce 200,000 bottles of beer daily.
Non-linear reality: Factory cannot accommodate 200 workers. Overcrowding puts
downward pressure on output  200 workers produce only 140,000 bottles.
11
Fundamental Principles of Economic Behavior
1.
Some choices involve accounting (“explicit”) costs, but all choices involve
opportunity costs.
2.
People make decisions at-the-margin.
3.
People respond to incentives.
4.
Exchange is (usually) not a zero-sum game.
5.
The world is non-linear.
Linear assumption: Double the workers and the factory size to produce 200,000
bottles of beer daily.
Non-linear reality: Managers are limited in the number of workers they can
manage. Without adding an extra layer of management, inefficiencies put
downward pressure on output  doubled workers and factory space produce
only 180,000 bottles.
12
Terminology
Product
A good or service.
Good
An object that is desirable.
Durable good
A good that is consumed over a long period of time.
Service
An action that is desirable.
Attributes
Color, taste, smell, size, price, durability, etc. Salient attributes are
attributes that are important to the consumer.
Brand
A variety of a product identified from other varieties by a commercial
name and/or other distinctive attributes.
Consumer
One who desires to purchase a product.
End-user
A consumer who will not resell a product.
Producer
One who offers a product for sale.
Manufacturer
One who creates a product.
Retailer
One who sells, but does not manufacture, a product.
Factor
Labor, materials, capital a producer uses to produce a product.
Capital
Buildings, land, machinery used in the production of a product. Also
called property, plant, and equipment (PP&E).
Market
Interaction of consumers and producers of a given product.
13
Markets
A market forms when consumers and producers of a product come together.
The behavior of the consumer is summarized by demand.
The behavior of the producer is summarized by supply.
Later, we will examine instances in which markets are influenced by government
intervention and foreign competition. For the moment, we will focus on the simple
case in which the only players in the market are the producers and consumers.
14
Demand
Demand
The relationship between the number of units of a product a consumer is willing to
buy and the price of the product.
Price per Unit
$20
$18
$16
Quantity Demanded
(per unit time)
100
120
150
Relationship between price and
quantity is demand.
Amount the consumer wants to buy
is quantity demanded.
Incorrect: “When the price of the product falls, demand rises.”
Correct:
“When the price of the product falls, the quantity demanded rises.”
15
Demand
Demand
The relationship between the number of units of a product a consumer is willing to
buy and the price of the product.
Price per Unit
$20
$18
$16
Quantity Demanded
(per unit time)
100
120
150
$21
$20
$19
Price per Unit
Figures from the table can be plotted
to form a graph of demand.
$18
$17
$16
$15
90
100
110
120
130
140
150
160
Quantity Demanded per Unit Time
16
Demand
Any event that alters the demand relationship is called a consumer shock.
A positive consumer shock causes consumers to want to purchase more units of the
product at all price levels.
A negative consumer shock causes consumers to want to purchase fewer units of the
product at all price levels.
$20
$18
$16
Quantity Demanded
(per unit time)
100
100
110
120
120
133
150
160
150
166
$21
Positive Consumer Shock
$20
$19
Price per Unit
Price per Unit
$18
$17
$16
$15
100
110
120
130
140
150
160
Quantity Demanded per Unit Time
17
Demand
A change in the price of a good is not a shock because the price change does not
alter the relationship between price and quantity demanded.
When the price falls, consumers want to buy more of the product, but they don’t
want to buy more of the product at all price levels.
$20
$18
$16
Quantity Demanded
(per unit time)
100
120
150
$21
If price had stayed at $20, consumers
would not want to buy more.
$20
$19
Price per Unit
Price per Unit
$18
$17
$16
$15
90
100
110
120
130
140
150
160
Quantity Demanded per Unit Time
18
Demand
Typical Consumer Shocks
1.
Change in consumers’ purchasing power.
Increase (decrease) in purchasing power is a positive (negative) shock.
2.
Change in price of a substitute product.
Increase (decrease) in price of a substitute is a positive (negative) shock. E.g.
increase in price of coffee increases demand for tea.
3.
Change in price of a complement product.
Increase (decrease) in price of a complement is a negative (positive) shock. E.g.
increase in price of charcoal decreases demand for lighter fluid.
4.
Change in consumer preferences.
Increase (decrease) in preferences is a positive (negative) shock.
5.
Change in number of consumers.
Increase (decrease) in number of consumers is a positive (negative) shock.
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Supply
Supply
The relationship between the number of units of a product a producer is willing to
offer and the price of the product.
Price per Unit
$20
$18
$16
Quantity Supplied
(per unit time)
140
120
100
Relationship between price and
quantity is supply.
Amount the producer wants to sell
is quantity supplied.
Incorrect: “When the price of the product falls, supply falls.”
Correct:
“When the price of the product falls, the quantity supplied falls.”
20
Supply
Supply
The relationship between the number of units of a product a producer is willing to
offer and the price of the product.
Price per Unit
$20
$18
$16
Quantity Supplied
(per unit time)
140
120
100
$21
$20
$19
Price per Unit
Figures from the table can be plotted
to form a graph of demand.
$18
$17
$16
$15
90
100
110
120
130
140
150
Quantity Supplied per Unit Time
21
Supply
Any event that alters the supply relationship is called a producer shock.
A positive producer shock causes producers to want to offer more units of the
product at all price levels.
A negative producer shock causes producers to want to offer fewer units of the
product at all price levels.
$20
$18
$16
Quantity Supplied
(per unit time)
140
140
160
120
120
133
100
100
110
$21
Positive Producer Shock
$20
$19
Price per Unit
Price per Unit
$18
$17
$16
$15
100
110
120
130
140
140
150
150
160
160
Quantity Supplied per Unit Time
22
Supply
A change in the price of a good is not a shock because the price change does not
alter the relationship between price and quantity supplied.
When the price falls, producers want to offer fewer units of the product, but they
don’t want to offer fewer units at all price levels.
$20
$18
$16
Quantity Supplied
(per unit time)
140
120
100
If price had stayed at $20, producers
would not want to offer fewer units.
$21
$20
$19
Price per Unit
Price per Unit
$18
$17
$16
$15
90
100
110
120
130
140
150
Quantity Supplied per Unit Time
23
Supply
Typical Producer Shocks
1.
Change in producers’ technology.
Increase (decrease) in technology is a positive (negative) shock.
2.
Change in prices of factors.
Increase (decrease) in price of a factor is a negative (positive) shock. E.g.
increase in price of steel decreases supply of cars.
3.
Change in the number of producers.
Increase (decrease) in number of producers is a positive (negative) shock.
24
Identifying Shocks
First
Identify the market under scrutiny, and the consumers/producers of the market’s
product.
Consumer Shocks vs. Producer Shocks
A shock is a consumer shock if it impacts consumers first and producers (if at all) only
as a result of the impact on consumers.
A shock is a producer shock if it impacts producers first and consumers (if at all) only
as a result of the impact on producers.
Positive Shocks vs. Negative Shocks
A shock is a positive shock if it makes it easier or more attractive for
producers/consumers to produce/consume.
A shock is a negative shock if it makes it harder or less attractive for
producers/consumers to produce/consume.
25
Identifying Shocks
Example
Refusing entry visas to Canadian loggers who, previously, cut trees in Maine for use as
pulpwood is what sort of shock to the American paper markets?
1.
Identify the market
Market for American-made paper
2.
Identify the producers
American paper manufacturers
3.
Identify the consumers
Those who buy American paper
4.
Identify the target of the shock (consumer shock or producer shock)
Producer shock
5.
Identify the direction of the shock (positive or negative)
Negative shock
6.
Identify the impact on demand/supply
Supply of paper decreases
26
Shortage, Surplus, and Equilibrium
Suppose the price of a product is $16.
According to the supply curve, producers will offer 100 units per day.
According to the demand curve, consumers will seek to purchase 150 units per day.
$21
$20
Price per Unit
$19
$18
$17
$16
$15
90
100
110
120
130
140
150
160
Quantity per Unit Time
A shortage is a situation in which QD > QS
Shortage = 50 units per day
27
Shortage, Surplus, and Equilibrium
Producers experience a shortage as a reduction in inventories (for goods producers)
or limited capacity (for service producers).
Competition by consumers for a limited quantity of product puts upward pressure on
price.
$21
$20
Price per Unit
$19
$18
$17
$16
$15
90
100
110
120
130
140
150
160
Quantity per Unit Time
As price rises, QS increases and QD
decreases, reducing the shortage.
28
Shortage, Surplus, and Equilibrium
Eventually, the price rises to a point such that the shortage is completely eliminated.
With the shortage gone, consumers no longer compete for a limited quantity of
product, and so the price stops rising.
$21
$20
Equilibrium price
Price per Unit
$19
Equilibrium point
$18
$17
$16
$15
90
100
110
120
130
140
150
160
Quantity per Unit Time
Equilibrium quantity
29
Shortage, Surplus, and Equilibrium
Suppose the price of a product is $20.
According to the demand curve, consumers will seek to purchase 100 units per day.
According to the supply curve, producers will offer 140 units per day.
$21
$20
Price per Unit
$19
$18
$17
$16
$15
90
100
110
120
130
140
150
160
Quantity per Unit Time
A surplus is a situation in which QD < QS
Surplus = 40 units per day
30
Shortage, Surplus, and Equilibrium
Producers experience a surplus as an increase in inventories (for goods producers) or
excess capacity (for service producers).
Competition by producers for a limited quantity of sales puts downward pressure on
price.
$21
$20
Price per Unit
$19
$18
$17
$16
$15
90
100
110
120
130
140
150
160
Quantity per Unit Time
As price falls, QD increases and QS
decreases, reducing the surplus.
31
Shortage, Surplus, and Equilibrium
Eventually, the price falls to a point such that the surplus is completely eliminated.
With the surplus gone, producers no longer compete for a limited quantity of sales,
and so the price stops falling.
$21
$20
Equilibrium price
Price per Unit
$19
Equilibrium point
$18
$17
$16
$15
90
100
110
120
130
140
150
160
Quantity per Unit Time
Equilibrium quantity
32
Shortage, Surplus, and Equilibrium
Shortage
QD > QS  Competition among consumers causes price to rise
Surplus
QD < QS  Competition among producers causes price to fall
Equilibrium
QD = QS  No competition and so no price change
33
Regression Analysis
In regression analysis, we look at how one variable (or a group of variables) can affect
another variable.
We use a technique called “ordinary least squares” or OLS. The OLS technique looks at a
sample of two (or more) variables and filters out random noise so as to find the underlying
deterministic relationship among the variables.
Example:
A retailer suspects that monthly sales follow unemployment rate announcements with a onemonth lag. When the Bureau of Labor Statistics announces that the unemployment rate is up,
one month later, sales appear to fall. When the BLS announces that the unemployment rate
is down, one month later, sales appear to rise.
The retailer wants to know if this relationship actually exists. If so, the retailer can use BLS
announcements to help predict future sales.
In linear regression analysis, we assume that the relationship between the two variables (in
this example, sales and unemployment rate) is linear and that any deviation from the linear
relationship must be due to noise (i.e. unaccounted randomness in the data).
34
Regression Analysis
Example:
The chart below shows data (see Data Set #4) on sales and the unemployment rate collected
over a 10 month period.
Date
Montly Sales
(current month) (current month)
January
$257,151
February
$219,202
March
$222,187
April
$267,041
May
$265,577
June
$192,566
July
$197,655
August
$200,370
September
$203,730
October
$181,303
Unemployment Rate
(previous month)
4.5%
4.7%
4.6%
4.4%
4.8%
4.9%
5.0%
4.9%
4.7%
4.8%
Notice that the relationship (if there is one)
between the unemployment rate and sales is
subject to some randomness.
Over some months (e.g. May to June), an increase
in the previous month’s unemployment rate
corresponds to a decrease in the current month’s
sales.
But, over other months (e.g. June to July), an
increase in the previous month’s unemployment
rate corresponds to an increase in the current
month’s sales.
35
Regression Analysis
Example:
It is easier to picture the relationship between unemployment and sales if we graph the data.
Since we are hypothesizing that changes in the unemployment rate cause changes in sales,
we put unemployment on the horizontal axis and sales on the vertical axis.
$280,000
Sales (current month)
$260,000
$240,000
$220,000
$200,000
$180,000
$160,000
4.3%
4.4%
4.5%
4.6%
4.7%
4.8%
4.9%
5.0%
5.1%
Unemployment Rate (previous month)
36
Regression Analysis
Example:
OLS finds the line that most closely fits the data. Because we have assumed that the
relationship is linear, two numbers describe the relationship: (1) the slope, and (2) the
vertical intercept.
$280,000
Sales (current month)
$260,000
$240,000
$220,000
$200,000
$180,000
^
y = -11,648,868x + 771,670
Sales  771,670  11,648, 868 (unemp rate)
$160,000
4.3%
4.4%
4.5%
4.6%
4.7%
4.8%
4.9%
5.0%
5.1%
Unemployment Rate (previous month)
Slope = –11,648,868
Vertical intercept = 771,670
37
Regression Analysis
The graph below shows two relationships:
1.
The regression model is the scattering of dots and represents the actual data.
2.
The estimated (or fitted) regression model is the line and represents the regression
model after random noise has been removed.
After eliminating noise, we estimate that sales should
have been 771,670 – (11,648,868)(0.045) = $247,471
Regression model
Salest     (unemp ratet 1 )  ut
…is observed with sales of $257,151
$280,000
True intercept and slope
$260,000
Estimated noise associated with this observation
^
Sales (current month)
 Sales  Sales  $257,151  $247, 471  $9, 680  uˆt
Noise (also called “error term”)
$240,000
Estimated regression model
$220,000
^
Salest  ˆ  ˆ(unemp ratet 1 )
$200,000
Estimated intercept, slope, and sales
after estimating and removing noise
$180,000
^
y = -11,648,868x + 771,670
Sales  771,670  11,648, 868 (unemp rate)
$160,000
4.3%
4.4%
4.5%
4.6%
4.7%
4.8%
4.9%
5.0%
5.1%
Unemployment Rate (previous month)
Unemp rate of 4.5%…
38
Regression Analysis
Terminology:
Variables on the right hand side of the regression equation are called exogenous, or
explanatory, or independent variables. They usually represent variables that are assumed to
influence the left hand side variable.
The variable on the left hand side of the regression equation is called the endogenous, or
outcome, or dependent variable. The dependent variable is the variable whose behavior you
are interested in analyzing.
The intercept and slopes of the regression model are called parameters. The intercept and
slopes of the estimated (or fitted) regression model are called estimated parameters.
The noise term in the regression model is called the error or noise. The estimated error is
called the residual, or estimated error.
Regression model
Fitted (estimated) model
Y    X u
Yˆ  ˆ  ˆX
Outcome variable
Fitted (estimated)
Error (noise)
outcome variable
Parameters
uˆ  Y Yˆ
Explanatory variable
Residual (estimated error)
Parameter estimates
39
Regression Analysis
OLS estimates the regression model parameters by selecting parameter values that minimize
the variance of the residuals.
= Residual  difference between actual and fitted values of the outcome variable.
$280,000
Sales (current month)
$260,000
$240,000
$220,000
$200,000
$180,000
y = -11,648,868x + 771,670
$160,000
4.3%
4.4%
4.5%
4.6%
4.7%
4.8%
4.9%
5.0%
5.1%
Unemployment Rate (previous month)
40
Regression Analysis
OLS estimates the regression model parameters by selecting parameter values that minimize
the variance of the residuals.
= Residual  difference between actual and fitted values of the outcome variable.
Choosing different
parameter values moves
the estimated regression
line away (on average)
from the data points. This
results in increased
variance in the residuals.
$280,000
Sales (current month)
$260,000
$240,000
$220,000
$200,000
$180,000
y = -11,648,868x + 771,670
$160,000
4.3%
4.4%
4.5%
4.6%
4.7%
4.8%
4.9%
5.0%
5.1%
Unemployment Rate (previous month)
41
Regression Analysis
To perform regression in Excel: (1) Select TOOLS, then DATA ANALYSIS
(2) Select REGRESSION
42
Regression Analysis
To perform regression in Excel: (3) Enter the range of cells containing outcome (“Y”) and
explanatory (“X”) variables
(4) Enter a range of cells for the output
Constant is zero
Check this box to force the vertical intercept to be
zero.
Confidence level
Excel automatically reports 95% confidence intervals.
Check this box and enter a level of confidence if you
want a different confidence interval.
Residuals
Check this box if you want Excel to report the
residuals.
Standardized residuals
Check this box if you want Excel to report the
residuals in terms of standard deviations from the
mean.
43
Regression Analysis
Regression results
Vertical intercept
estimate
Slope estimate
95% confidence interval around parameter estimate
Test statistic and p-value for H0: parameter = 0
Standard deviation of slope estimate
Standard deviation of vertical intercept estimate
44
Distribution of Regression Parameter Estimates
If we select a different sample of observations from a population and then perform OLS, we
will obtain slightly different parameter estimates.
Thus, regression parameter estimates are random variables.
Let ˆ be a regression parameter estimate.
The properties of a regression parameter estimates:
Population parameter  
Standard deviation of  varies depending on the regression mode
ˆ is distributed t N k , where k = number of parameters in the regression model
45
Distribution of Regression Parameter Estimates
Regression demo
Enter population values here.
Spreadsheet selects a sample from
the population and calculates
parameter estimates based on the
sample.
Press F9 to select a new sample.
46
Multiple Regression Analysis
In multiple regression analysis the OLS technique finds the linear relationship between an
outcome variable and a group of explanatory variables.
As in simple regression analysis, OLS filters out random noise so as to find the underlying
deterministic relationship. OLS also identifies the individual effects of each of the multiple
explanatory variables.
Simple regression
Yt  0  1 X t  u t
Multiple regression
Yt   0  1 X 1,t   2 X 2,t  ...  m X m ,t  u t
47
Multiple Regression Analysis
Example:
A trucking company wants to be able to predict the round-trip travel time of its trucks. Data
Set #6 contains historical information on miles traveled, number of deliveries per trip, and
total travel time. Use the information to predict a truck’s round-trip travel time.
Miles Traveled
500
250
500
500
250
400
375
325
450
450
Deliveries Travel Time (hours)
4
11.3
3
6.8
4
10.9
2
8.5
2
6.2
2
8.2
3
9.4
4
8
3
9.6
2
8.1
Approach #1: Calculate Average Time per Mile
Trucks in the data set required a total of 87 hours to
travel a total of 4,000 miles. Dividing hours by miles,
we find an average of 0.02 hours per mile journeyed.
Problem:
This approach ignores a possible fixed effect. For
example, if travel time is measured starting from the
time that out-bound goods begin loading, then there
will be some fixed time (the time it takes to load the
truck) tacked on to all of the trips. For longer trips this
fixed time will be “amortized” over more miles and will
have less of an impact on the time/mile ratio than for
shorter trips.
This approach also ignores the impact of the number
of deliveries.
48
Multiple Regression Analysis
Example:
A trucking company wants to be able to predict the round-trip travel time of its trucks. Data
Set #6 contains historical information on miles traveled, number of deliveries per trip, and
total travel time. Use the information to predict a truck’s round-trip travel time.
Approach #2: Calculate Average Time per Mile and Average Time per Delivery
Trucks in the data set averaged 87 / 4,000 = 0.02 hours per mile journeyed,
and 87 / 29 = 3 hours per delivery.
Problem:
Like the previous approach, this approach ignores a possible fixed effect.
This approach does account for the impact of both miles and deliveries, but the approach
ignores the possible interaction between miles and deliveries. For example, trucks that travel
more miles likely also make more deliveries. Therefore, when we combine the time/miles
and time/delivery measures, we may be double-counting time.
49
Multiple Regression Analysis
Example:
A trucking company wants to be able to predict the round-trip travel time of its trucks. Data
Set #6 contains historical information on miles traveled, number of deliveries per trip, and
total travel time. Use the information to predict a truck’s round-trip travel time.
Miles Traveled
500
250
500
500
250
400
375
325
450
450
Deliveries Travel Time (hours)
4
11.3
3
6.8
4
10.9
2
8.5
2
6.2
2
8.2
3
9.4
4
8
3
9.6
2
8.1
Timei  0  1 (milesi )  u i
Approach #3: Regress Time on Miles
The regression model will detect and isolate any fixed effect.
Problem:
The model ignores the impact of the number of deliveries. For example, a 500 mile journey
with 4 deliveries will take longer than a 500 mile journey with 1 delivery.
50
Multiple Regression Analysis
Example:
A trucking company wants to be able to predict the round-trip travel time of its trucks. Data
Set #6 contains historical information on miles traveled, number of deliveries per trip, and
total travel time. Use the information to predict a truck’s round-trip travel time.
Miles Traveled
500
250
500
500
250
400
375
325
450
450
Deliveries Travel Time (hours)
4
11.3
3
6.8
4
10.9
2
8.5
2
6.2
2
8.2
3
9.4
4
8
3
9.6
2
8.1
Timei  0  1 (deliveriesi )  u i
Approach #4: Regress Time on Deliveries
The regression model will detect and isolate any fixed effect and will account for the impact
of the number of deliveries.
Problem:
The model ignores the impact of miles traveled. For example, a 500 mile journey with 4
deliveries will take longer than a 200 mile journey with 4 deliveries.
51
Multiple Regression Analysis
Example:
A trucking company wants to be able to predict the round-trip travel time of its trucks. Data
Set #6 contains historical information on miles traveled, number of deliveries per trip, and
total travel time. Use the information to predict a truck’s round-trip travel time.
Miles Traveled
500
250
500
500
250
400
375
325
450
450
Deliveries Travel Time (hours)
4
11.3
3
6.8
4
10.9
2
8.5
2
6.2
2
8.2
3
9.4
4
8
3
9.6
2
8.1
Timei  0  1 (milesi )  2 (deliveriesi )  u i
Approach #5: Regress Time on Both Miles and Deliveries
The multiple regression model (1) will detect and isolate any fixed effect, (2) will account
for the impact of the number of deliveries, (3) will account for the impact of miles, and (4)
will eliminate out the overlapping effects of miles and deliveries.
52
Multiple Regression Analysis
Example:
A trucking company wants to be able to predict the round-trip travel time of its trucks. Data
Set #6 contains historical information on miles traveled, number of deliveries per trip, and
total travel time. Use the information to predict a truck’s round-trip travel time.
Regression model:
Timei   0  1 (milesi )   2 (deliveriesi )  u i
Estimated regression model:
^
Timei  ˆ0  ˆ1 (miles i )  ˆ2 (deliveries i )
SUMMARY OUTPUT
ˆ0  1.13 (0.952) [0.2732]
Regression Statistics
Multiple R
0.950678166
R Square
0.903788975
Adjusted R Square
0.876300111
Standard Error
0.573142152
Observations
10
ˆ1  0.01 (0.002) [0.0005]
ˆ2  0.92 (0.221) [0.0042]
R 2  0.90
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
X Variable 2
2
7
9
SS
MS
F
Significance F
21.60055651 10.80027826 32.87836743
0.00027624
2.299443486 0.328491927
23.9
Coefficients Standard Error
t Stat
P-value
1.131298533
0.951547725 1.188903619 0.273240329
0.01222692
0.001977699 6.182396959 0.000452961
0.923425367
0.221113461 4.176251251 0.004156622
Lower 95%
Upper 95%
-1.118752683 3.38134975
0.007550408 0.016903431
0.400575489 1.446275244
Standard deviations of
parameter estimates and pvalues are typically shown in
parentheses and brackets,
respectively, near the
parameter estimates.
53
Multiple Regression Analysis
Example:
A trucking company wants to be able to predict the round-trip travel time of its trucks. Data
Set #6 contains historical information on miles traveled, number of deliveries per trip, and
total travel time. Use the information to predict a truck’s round-trip travel time.
Estimated regression model:
^
Timei  ˆ0  ˆ1 (miles i )  ˆ2 (deliveries i )
ˆ0  1.13 (0.952) [0.2732]
ˆ1  0.01 (0.002) [0.0005]
ˆ2  0.92 (0.221) [0.0042]
R 2  0.90
Notes on results:
1. Constant is not significantly
different from zero.
2. Slope coefficients are significantly
different from zero.
3. Variation in miles and deliveries,
together, account for 90% of the
variation in time.
The parameter estimates are measures of
the marginal impact of the explanatory
variables on the outcome variable.
Marginal impact measures the impact of
one explanatory variable after the impacts
of all the other explanatory variables are
filtered out.
Marginal impacts of explanatory variables
0.01 = increase in time given increase of
1 mile traveled.
0.92 = increase in time given increase of
1 delivery.
54
Types of Analysis
A qualitative analysis attempts to determine the direction of changes in price and
quantity.
A quantitative analysis attempts to determine the magnitude of changes in price and
quantity.
55
Qualitative Analysis of Shocks
Example
In March 2005, crude oil rose to a then-record $56 per barrel. Crude oil is the main
component of gasoline. Using qualitative analysis, determine the impact of the rise in
oil prices on the market for gasoline.
Incorrect approach
The increase in the price of oil will cause an increase in the price of gas. As gas prices
rise, it becomes more profitable for retailers to sell gasoline, so the quantity of gas
offered for sale will rise. Because people won’t drive less, consumers will not buy less
gas, but will cut back on purchases of other things. In summary: The price of gas will
rise and the quantity of gas sold will rise.
Critique of Analysis
The analysis skips the impact of the price of oil on the demand and supply of gasoline,
and instead jumps right to the impact on the price of gas. While the analysis correctly
identifies the impact on the price of gas, by skipping the impact on demand and supply,
the analysis fails to identify why the price of gas is rising and, as a result, incorrectly
concludes that sales of gas will rise.
56
Qualitative Analysis of Shocks
Correct approach
1. The rise in the price of oil is a negative producer shock.
2.
3.
4.
5.
Negative producer shock causes supply of gasoline to decrease.
Decrease in supply of gasoline causes a shortage of gasoline.
Shortage of gasoline causes price of gasoline to rise.
Price rises until new equilibrium is attained.
Market for Gasoline
End result:
Market moves from equilibrium A to
equilibrium B
Price of gasoline rises and quantity sold
of gasoline falls.
S’
$/unit
S
B
P2
A
P1
D
QS
shortage
QD
Q/time
57
Qualitative Analysis of Shocks
Publicity surrounding the introduction of the new food pyramid has raised consumer
awareness of the health problems associated with eating fast food. Simultaneously,
Congress voted to increase the minimum wage effective immediately. Using qualitative
analysis, determine the combined impact of these shocks on the market for fast food.
1.
Identify the market
Market for fast food
2.
Identify the producers
Fast food retailers
3.
Identify the consumers
People who buy fast food
4.
Identify the target of the shock (consumer shock or producer shock)
Publicity: consumer shock
Minimum wage: producer shock
5.
Identify the direction of the shock (positive or negative)
Publicity: negative shock
Minimum wage: negative shock
6.
Identify the impact on demand/supply
Publicity: demand decreases
Minimum wage: supply decreases
58
Qualitative Analysis of Shocks
Perform qualitative analysis (skip intermediate steps – focus on change in equilibrium)
1. Market starts at equilibrium A  price is P1 and quantity sold per unit time is Q1.
2. Demand decreases and supply decreases.
3. New equilibrium at B  price rises to P2 and quantity sold falls to Q2.
End result:
Price of fast food rises and quantity sold
of fast food falls.
Market for Fast Food
S’
$/unit
Question:
What is wrong with this analysis?
Analysis assumes that the producer shock
was larger than the consumer shock.
P2
P1
S
B
A
D’
Q2
Q1
D
Q/time
59
Qualitative Analysis of Shocks
Perform qualitative analysis (skip intermediate steps – focus on change in equilibrium)
Assume now that the consumer shock is larger than the producer shock.
1. Market starts at equilibrium A  price is P1 and quantity sold per unit time is Q1.
2. Demand decreases and supply decreases (but, this time, demand shift is greater).
3. New equilibrium at B  price falls to P2 and quantity sold falls to Q2.
End result:
Price of fast food falls and quantity sold of fast
food falls.
We looked at two possibilities (1) consumer
shock is greater than producer shock, and (2)
producer shock is greater than consumer shock.
In both cases, quantity sold fell, but in case (1)
price rose while in case (2) price fell.
Market for Fast Food
S’
$/unit
P1
P2
B
A
Conclusion: Quantity sold will fall. Impact on
price is unknown.
D’
Q2
S
Q1
D
Q/time
60
Quantitative Analysis of Shocks
In a quantitative analysis, we apply regression techniques to data in an attempt to
estimate the parameters of the demand and supply functions.
Ordinary Least Squares
One might be tempted to use OLS to estimate the demand (or supply) function. One
problem with using OLS is that we don’t know if different observations are due to
shifts in demand or supply.
Data on P and Q show demand, but not supply.
S
••
•
S’
Data on P and Q show supply, but not demand.
S
S’’
S’’’
•
•
••
•
D
D D’ D’’
D’’’
61
Quantitative Analysis of Shocks
We employ a procedure called two-stage least squares in an attempt to account for
the fact that we don’t know whether the price and quantity data were generated by
changes in supply, demand, or both together.
Two-Stage Least Squares
1.
Identify factors that could cause shifts in demand and supply (over the sample
period represented in the data set). Example: Consumer Income, Prices of
Substitutes/Complements, Prices of Factors, Number of Producers, etc.
2.
Run an OLS regression of quantity on all of the factors that could cause shifts in
either demand or supply. This is stage #1 of the TSLS procedure.
3.
Using the parameter estimates from stage #1, calculate fitted values for quantity.
4.
Run an OLS regression of price on the fitted values for quantity and the factors
that could cause shifts in demand. The results from this regression comprise the
estimated demand function. This is stage #2 (as applied to demand).
5.
Run an OLS regression of price on the fitted values for quantity and the factors
that could cause shifts in supply. The results from this regression comprise the
estimated supply function. This is stage #2 (as applied to supply).
62
Quantitative Analysis of Shocks
Example
Using the following data, estimate the demand and supply functions.
Qt
Quantity (units) sold at time t
Pt
Price per unit at time t
It
Customers’ average incomes at time t
Ft
Average prices of factors at time t
St
Price of primary substitute at time t
Ct
Price of primary complement at time t
1. Factors that could cause a shift in demand or supply: I, F, S, C
2. Regress quantity sold on factors that could shift demand or supply.
Qt    1I t  2Ft  3S t   4C t  u t
63
Quantitative Analysis of Shocks
1. Factors that could cause a shift in demand or supply: I, F, S, C
2. Regress quantity sold on factors that could shift demand or supply.
Qt    1I t  2Ft  3S t   4C t  u t
3. Using parameter estimates, calculate fitted quantities.
Qˆt  ˆ  ˆ1I t  ˆ2Ft  ˆ3S t  ˆ4C t
4. Regress price on fitted quantity sold and factors that could shift demand. Regress
price on fitted quantity sold and factors that could shift supply.
Pt    1Qˆt   2I t   3S t   4C t  u t
Demand equation is: Pt  ˆ  ˆ1Qt  ˆ2I t  ˆ3S t  ˆ4C t
Pt    1Qˆt   2Ft  u t
Supply equation is: Pt  ˆ  ˆ1Qt  ˆ2Ft
64
Quantitative Analysis of Shocks
Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this
data, estimate the demand equation faced by the firm as a whole.
1. What factors could cause changes in demand or supply?
Household income (MAHI), Labor costs (LC), Competitor price per unit (CPPU),
Advertising budget (AB)
2. Regress output on these factors then calculate fitted output.
Qt    1MAHI t  2LC t  3CPPU t   4 ABt  ut
65
Quantitative Analysis of Shocks
Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this
data, estimate the demand equation faced by the firm as a whole.
2. Regress output on these factors then calculate fitted output.
66
Quantitative Analysis of Shocks
Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this
data, estimate the demand equation faced by the firm as a whole.
2. Regress output on these factors then calculate fitted output.
Dependent variable
Independent variable(s)
67
Quantitative Analysis of Shocks
Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this
data, estimate the demand equation faced by the firm as a whole.
2. Regress output on these factors then calculate fitted output.
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.999283462
R Square
0.998567438
Adjusted R Square
0.998403717
Standard Error
261.5251211
Observations
40
Qˆ  ˆ  ˆ1 MAHI   ˆ2 LC   ˆ3 CPPU   ˆ4  AB 
Qˆ  474.56   0.17 MAHI    0.07 LC 
  90.77 CPPU    0.46  AB 
ANOVA
df
Regression
Residual
Total
Intercept
Median Income
Labor Costs
Competitor Price
Advertising Budget
4
35
39
SS
MS
F
Significance F
1668625705 4.17E+08 6099.189
3.15186E-49
2393838.615 68395.39
1671019544
Coefficients Standard Error
-474.5638082
602.9004286
0.169918856
0.005828559
-0.067582498
0.003374014
90.76936788
53.69585291
0.462282487
0.003017196
t Stat
P-value
-0.787135 0.436501
29.15281 3.85E-26
-20.0303 9.34E-21
1.690435 0.099833
153.2159 4.48E-51
Lower 95%
Upper 95%
-1698.518244 749.3906274
0.158086238 0.181751475
-0.074432119 -0.060732878
-18.23914202 199.7778778
0.456157247 0.468407728
68
Quantitative Analysis of Shocks
Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this
data, estimate the demand equation faced by the firm as a whole.
2. Regress output on these factors then calculate fitted output.
Fitted Unit Sales
Qˆ  474.56   0.17 MAHI    0.07 LC 
  90.77 CPPU    0.46  AB 
Note: The figures shown in the equation are rounded
to two decimal places. The figures on the right are
calculated using the non-rounded coefficients.
9936
24765
13396
18889
23004
7317
15999
26254
19429
15518
8025
7521
22670
21715
26640
13372
25071
10543
8940
26480
8504
23914
11443
22341
12472
18385
13058
21925
11148
19742
11474
13264
5190
19488
15117
21320
12193
6466
15521
4865
69
Quantitative Analysis of Shocks
Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this
data, estimate the demand equation faced by the firm as a whole.
3. Regress price on fitted quantity and factors that could shift demand.
Pt    1Qˆt  2MAHI t  3CPPU t   4 ABt  u t
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.991419686
R Square
0.982912994
Adjusted R Square
0.980960194
Standard Error
2.952486265
Observations
40
Pˆt  0.4878   0.0013  Qˆt   0.0005  MAHI t
  0.0143  CPPU t   0.0021 AB t
ANOVA
df
Regression
Residual
Total
Intercept
Fitted Quantity Sold
Median Income
Competitor Price
Advertising Budget
4
35
39
SS
MS
17550.63891 4387.659727
305.10113 8.717175143
17855.74004
Coefficients Standard Error
t Stat
0.487756046
7.013101584 0.069549263
-0.001273075
0.000563621 -2.25874303
0.000501297
0.000119796 4.184601716
-0.0143109
0.609609764 -0.02347551
0.002112162
0.000262718 8.03964832
F
Significance F
503.3350432
2.14659E-30
P-value
0.944948276
0.030234817
0.000182421
0.981404306
1.83457E-09
Lower 95%
Upper 95%
-13.74961448 14.72512657
-0.002417287 -0.000128862
0.000258099 0.000744496
-1.251886027 1.223264226
0.001578815 0.002645509
70
Quantitative Analysis of Shocks
Data Set #1 contains monthly data relevant to a firm’s 40 retail locations. Using this
data, estimate the supply equation faced by the firm as a whole.
4. Regress price on fitted quantity and factors that could shift supply.
Pt    1Qˆt  2LC t  3 ABt  u t
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.991369183
R Square
0.982812858
Adjusted R Square
0.981380596
Standard Error
2.919708628
Observations
40
Pˆt  0.4085   0.0016  Qˆt   0.0002  LC t
  0.0008  AB t
ANOVA
df
Regression
Residual
Total
Intercept
Fitted Quantity Sold
Labor Cost
Advertising Budget
3
36
39
SS
MS
17548.8509 5849.616965
306.889145 8.524698471
17855.74004
Coefficients Standard Error
0.408493319
5.869001067
0.001590068
0.000332424
0.000193847
4.55408E-05
0.000787492
0.000153962
t Stat
0.069601848
4.783254098
4.256551323
5.114837906
F
Significance F
686.1963487
8.29996E-32
P-value
0.944895759
2.90824E-05
0.000141656
1.05727E-05
Lower 95%
-11.49437686
0.000915882
0.000101486
0.000475243
Upper 95%
12.3113635
0.002264255
0.000286208
0.001099742
71
Quantitative Analysis of Shocks
The firm is going to open a new retail store and is faced with a choice between two
locations. Location A is in a higher income area (median household income =
$80,000) while location B is in a lower income area (median household income =
$40,000). This means, in part, that the firm would have to pay a higher wage to its
workers if it located at A versus B. The firm is willing to spend, for labor costs plus
advertising combined, a total of $200,000 per month.
The firm estimates that its monthly labor costs at location A would be $150,000
while its monthly labor costs at location B would be $100,000.
Suppose the firm wants to sell 15,000 units per month. Using your estimate of the
demand curve, provide a recommendation as to which location the firm should
choose. Assume that the competition price is the average of the prices observed at
the firm’s 40 locations.
Pˆt  0.4878   0.0013  Qˆt   0.0005  MAHI t   0.0143  CPPU t   0.0021  AB t
Location A
Pˆt  0.4878   0.0013 15, 000    0.0005  $80, 000    0.0143  $7.58    0.0021 $50, 000 
 $125.88
72
Quantitative Analysis of Shocks
Suppose the firm wants to sell 15,000 units per month. Using your estimate of the
demand curve, provide a recommendation as to which location the firm should
choose. Assume that the competition price is the average of the prices observed at
the firm’s 40 locations.
Pˆt  0.4878   0.0013  Qˆt   0.0005  MAHI t   0.0143  CPPU t   0.0021  AB t
Location A
Pˆt  0.4878   0.0013 15, 000    0.0005  $80, 000    0.0143  $7.58    0.0021 $50, 000 
 $125.88
Location B
Pˆt  0.4878   0.0013 15, 000    0.0005  $40, 000    0.0143  $7.58    0.0021 $100, 000 
 $210.88
For the same cost and generating the same unit sales, the firm will be able to charge
more for its product at location B.
73
Elasticities
The information contained in the estimated demand and supply functions can be
summarized in elasticities. An elasticity is a number that indicates the sensitivity of
an outcome to a factor.
An elasticity is defined as the percentage change in quantity (either demanded or
supplied) divided by the percentage change in a factor.
%Q
%X
The elasticity can be rewritten as:
%Q  Q

%X  X
 X 
Q 
 
The ratio of the change in Q to a change in X can be derived from the coefficients in
the demand and supply equations.
74
Elasticities
A different elasticity can be constructed corresponding to each factor in the demand
and supply equations. Typical elasticities include:
From the demand equation
Price elasticity of demand
Cross-price elasticity of demand
Income elasticity of demand
Advertising elasticity of demand
%Qd
%Price
%Qd
%Price of Other Product
%Qd
%Income
%Qd
%Advertising
From the supply equation
Price elasticity of supply
Labor cost elasticity of supply
%Qs
%Price
%Qs
%Labor Cost
75
Elasticities
Continuing with the demand equation derived from Data Set #1, calculate the price
elasticity of demand for Store Location #10.
Price Elasticity of Demand 
%Qd
 Qd   P 

%Price  P   Q 
Demand Equation
Pˆt  0.4878   0.0013  Qˆt   0.0005  MAHI t   0.0143  CPPU t  0.0021 AB t
P
 0.0013
Qd
Use “appropriate” values for P and Q.
Examples: most current values, average values
76
Elasticities
Continuing with the demand equation derived from Data Set #1, calculate the price
elasticity of demand for Store Location #10.
For Store Location #10
P  $78.33
Qd  15, 931
“At current price and unit sales levels, every
1% rise (fall) in price results in a 3.8% fall
(rise) in unit sales.”
Price Elasticity of Demand

 1
 Qd   P  
 P   Q    
P

 d 
 
  Qd


1
  78.33 
 P   
 3.8

 




  Qd   0.0013   15, 931 
 

We say, “at current price…” because, as price and quantity change, the elasticity
changes.
77
Elasticities
Continuing with the demand equation derived from Data Set #1, calculate the
advertising elasticity of demand for Store Location #10.
Advertising Elasticity of Demand 

  Advertising 
%Qd
Qd



%Advertising  Advertising  
Q

Demand Equation
Pˆt  0.4878   0.0013  Qˆt   0.0005  MAHI t   0.0143  CPPU t  0.0021 AB t
1. Calculate ΔQd/ΔAdvertising
Qd  P

AB  AB
 1

  P
  Q
d


1
 
  1  0.0021 

 1  1.615

 0.0013 

Multiply by  1 because we are multiplying
two effects together.
Qd
 1.615
Advertising
78
Elasticities
Continuing with the demand equation derived from Data Set #1, calculate the
advertising elasticity of demand for Store Location #10.
Advertising Elasticity of Demand 

  Advertising 
%Qd
Qd



%Advertising  Advertising  
Q

2. Select “appropriate” values for Q and Advertising.
For Store Location #10
Qd  15, 931
Advertising  $35,552
3. Calculate advertising elasticity of demand.
Advertising Elasticity of Demand

  Advertising 
Qd
 35,552 

1.6154
 3.6

 



Qd
 15, 931 
 Advertising  

79
Elasticities
Continuing with the demand equation derived from Data Set #1, calculate the
advertising elasticity of demand for Store Location #10.
Advertising Elasticity of Demand

  Advertising 
Qd
 35,552 

1.6154





 15, 931   3.6

Advertising
Q




d

4. Interpret the elasticity.
“At current unit sales and advertising levels, every 1% increase (decrease) in
advertising increases (decreases) unit sales by 3.6%.”
80
Inelastic vs. Elastic
Elasticity measures that are less than one (in absolute value) are called inelastic or
insensitive. Elasticity measures that are greater than one (in absolute value) are
called elastic or sensitive.
Example
Suppose that the labor cost elasticity of supply for a product is –0.1. We say that
unit sales of the product are “labor cost inelastic” or “labor cost insensitive.”
This means that a given change in labor cost causes a proportionally smaller change
in quantity supplied.
Suppose that the advertising elasticity of demand for a product is 5. We say that
unit sales of the product are “advertising elastic” or “advertising sensitive.”
This means that a given change in advertising causes a proportionally larger change
in quantity demanded.
81
Price Elasticity of Demand
The price elasticity of demand indicates a product is a luxury or a necessity.
Price Elasticity of Demand 
%Qd
%Price
If the elasticity is greater than one in absolute value, then unit sales of this product
move proportionally more than the change in price  the product is a luxury.
If the elasticity is less than one in absolute value, then unit sales of this product
move proportionally less than the change in price  the product is a necessity.
strong luxury
-
weak luxury
weak necessity
-1
strong necessity
0
82
Price Elasticity of Demand
Using Data Set #1, find the average price price elasticity for your product across the
40 retail locations.
Demand Equation
Pˆt  0.4878   0.0013  Qˆt   0.0005  MAHI t   0.0143  CPPU t  0.0021 AB t
Price Elasticity of Demand
P
Qd

 1



Q
P

d 

 P   Q    
P

 d 
 
  Qd


1
 P 
 P   




   Qd   0.0013   Qd 
 

83
Price Elasticity of Demand
Using Data Set #1, find the average price price elasticity for your product across the
Store
Price per
40 retail locations.
P/Q
(1 / -0.0013) (P / Q
Unit Sales
Location
Unit
d
Average price elasticity of demand
across the 40 stores = -4.23
Interpretation:
Consumers consider the product a
luxury.
Consumers shopping at location
#40 regard the product as a strong
luxury (relative to other store
locations).
Consumers shopping at location
#34 regard the product as a weak
luxury (relative to other store
locations).
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
10414
24677
13723
18889
22978
7198
15777
25963
19084
15931
8278
7379
22630
21377
26836
12886
25199
10660
8897
26351
8353
23814
11627
22842
12688
18522
12759
22015
10812
19522
11511
13611
4889
19688
14937
21522
12292
6706
15418
4658
$65.23
$111.16
$64.25
$90.05
$100.32
$58.16
$82.91
$112.89
$93.65
$78.33
$56.66
$53.42
$104.35
$101.14
$112.05
$64.76
$111.46
$64.39
$62.15
$108.29
$61.07
$105.85
$69.58
$104.43
$55.82
$82.38
$57.25
$110.43
$59.93
$90.95
$65.71
$63.76
$47.62
$80.12
$78.66
$100.87
$61.92
$56.91
$77.18
$46.02
0.0063
0.0045
0.0047
0.0048
0.0044
0.0081
0.0053
0.0043
0.0049
0.0049
0.0068
0.0072
0.0046
0.0047
0.0042
0.0050
0.0044
0.0060
0.0070
0.0041
0.0073
0.0044
0.0060
0.0046
0.0044
0.0044
0.0045
0.0050
0.0055
0.0047
0.0057
0.0047
0.0097
0.0041
0.0053
0.0047
0.0050
0.0085
0.0050
0.0099
d)
-4.82
-3.47
-3.60
-3.67
-3.36
-6.22
-4.04
-3.34
-3.77
-3.78
-5.27
-5.57
-3.55
-3.64
-3.21
-3.87
-3.40
-4.65
-5.37
-3.16
-5.62
-3.42
-4.60
-3.52
-3.38
-3.42
-3.45
-3.86
-4.26
-3.58
-4.39
-3.60
-7.49
-3.13
-4.05
-3.61
-3.87
-6.53
-3.85
-7.60
84
Cross-Price Elasticity of Demand
The cross-price elasticity of demand indicates whether two products are
complements, substitutes, or unrelated.
Cross-Price Elasticity of Demand 
%Qd of this product
%Price of a different product
If the elasticity is positive, then unit sales of this product move in the same direction
as the price of the different product  the different product is a substitute for this
product.
If the elasticity is negative, then unit sales of this product move in the opposite
direction of the price of the different product  the different product is a
complement for this product.
strong complements
-
weak complements
weak substitutes
0
strong substitutes
+
85
Cross-Price Elasticity of Demand
Using Data Set #1, find the average cross-price price elasticity between your
product and your competitor’s product.
Demand Equation
Pˆt  0.4878   0.0013  Qˆt   0.0005  MAHI t   0.0143  CPPU t  0.0021 AB t
Find Qd / CPPU
Qd
 P

CPPU  CPPU
 1

  P
 Q
d

1
  

 


1


0.0143

 1  11

 0.0013 


Cross-Price Elasticity of Demand
 Qd

 CPPU
 CPPU 
  CPPU 


11






Q
  Qd 
 d 
86
Cross-Price Elasticity of Demand
Using Data Set #1, find the average cross-price price elasticity between your
product and your competitor’s product.
Average cross-price elasticity
of demand across the 40
stores = -0.003
Interpretation:
Consumers consider our product to
be virtually unrelated (competitionwise) to our competitors.
If anything, consumers perceive
that the products are slight
complements.
Store
Location
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
Unit Sales
10414
24677
13723
18889
22978
7198
15777
25963
19084
15931
8278
7379
22630
21377
26836
12886
25199
10660
8897
26351
8353
23814
11627
22842
12688
18522
12759
22015
10812
19522
11511
13611
4889
19688
14937
21522
12292
6706
15418
4658
Competitor Price per P competitor / Qd (-11) (P competitor / Qd
Unit
our product)
our product
$7.40
0.0007
-0.0078
$6.96
0.0003
-0.0031
$8.23
0.0006
-0.0066
$8.31
0.0004
-0.0048
$6.23
0.0003
-0.0030
$6.21
0.0009
-0.0095
$6.50
0.0004
-0.0045
$8.82
0.0003
-0.0037
$8.56
0.0004
-0.0049
$7.38
0.0005
-0.0051
$7.95
0.0010
-0.0106
$8.51
0.0012
-0.0127
$7.93
0.0004
-0.0039
$7.65
0.0004
-0.0039
$7.54
0.0003
-0.0031
$7.97
0.0006
-0.0068
$6.35
0.0003
-0.0028
$8.40
0.0008
-0.0087
$8.55
0.0010
-0.0106
$9.12
0.0003
-0.0038
$6.15
0.0007
-0.0081
$8.43
0.0004
-0.0039
$8.40
0.0007
-0.0079
$7.96
0.0003
-0.0038
$7.91
0.0006
-0.0069
$8.52
0.0005
-0.0051
$7.91
0.0006
-0.0068
$7.47
0.0003
-0.0037
$8.39
0.0008
-0.0085
$8.03
0.0004
-0.0045
$6.80
0.0006
-0.0065
$8.66
0.0006
-0.0070
$7.29
0.0015
-0.0164
$7.32
0.0004
-0.0041
$6.09
0.0004
-0.0045
$6.27
0.0003
-0.0032
$7.07
0.0006
-0.0063
$7.06
0.0011
-0.0116
$6.41
0.0004
-0.0046
$6.55
0.0014
-0.0155
87
Income Elasticity of Demand
The income elasticity of demand indicates whether a product is superior, inferior, or
normal.
Income Elasticity of Demand 
%Qd
%Income
If the elasticity is greater than one, then unit sales of this product rise faster than
income rises  the product is superior.
If the elasticity is less than one, then unit sales of this product rise slower than
income rises  the product is inferior.
If the elasticity equals one, then unit sales of this product rise at the same rate as 
the product is normal.
strongly inferior
-
weakly inferior
normal
1
weakly superior
strongly superior
+
88
Income Elasticity of Demand
Using Data Set #1, find the average income elasticity of demand for your product.
Demand Equation
Pˆt  0.4878   0.0013  Qˆt   0.0005  MAHI t   0.0143  CPPU t  0.0021 AB t
Solve Demand Equation for Qˆt
Qˆt  375   769  Pˆt   0.385  MAHI t  11 CPPU t  1.615  AB t
Qd
Income
Income Elasticity of Demand
 Qd
 Income

  Income
 Q

d

 Income 
   0.385  

Q
d



89
Income Elasticity of Demand
Using Data Set #1, find the average income elasticity of demand for your product.
Average income elasticity of
demand across the 40 stores
= 2.76
Interpretation:
Overall, consumers consider our
product to be strongly superior.
However, at 16 of the 40 stores,
consumers consider our product to
be inferior.
As consumers’ incomes rise, we
should shift resources away from
those 16 stores toward the
remaining stores.
Store
Location
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
Unit Sales
10414
24677
13723
18889
22978
7198
15777
25963
19084
15931
8278
7379
22630
21377
26836
12886
25199
10660
8897
26351
8353
23814
11627
22842
12688
18522
12759
22015
10812
19522
11511
13611
4889
19688
14937
21522
12292
6706
15418
4658
Median Annual
Household Income
$38,622
$30,728
$50,925
$48,711
$50,117
$38,209
$30,679
$51,498
$51,605
$39,350
$46,427
$52,875
$44,961
$33,875
$52,175
$54,211
$43,784
$46,371
$47,715
$44,580
$37,946
$49,120
$50,268
$46,223
$54,909
$52,460
$48,502
$30,915
$50,492
$31,803
$39,607
$40,861
$31,655
$52,210
$48,131
$31,616
$32,856
$33,823
$52,968
$32,273
Income / Qd
(0.385) (Income / Qd)
3.7087
1.2452
3.7109
2.5788
2.1811
5.3083
1.9445
1.9835
2.7041
2.4700
5.6085
7.1656
1.9868
1.5846
1.9442
4.2070
1.7375
4.3500
5.3630
1.6918
4.5428
2.0627
4.3234
2.0236
4.3276
2.8323
3.8014
1.4043
4.6700
1.6291
3.4408
3.0021
6.4747
2.6519
3.2223
1.4690
2.6730
5.0437
3.4355
6.9285
1.4278
0.4794
1.4287
0.9928
0.8397
2.0437
0.7486
0.7637
1.0411
0.9510
2.1593
2.7588
0.7649
0.6101
0.7485
1.6197
0.6689
1.6748
2.0648
0.6513
1.7490
0.7941
1.6645
0.7791
1.6661
1.0904
1.4635
0.5406
1.7979
0.6272
1.3247
1.1558
2.4928
1.0210
1.2406
0.5656
1.0291
1.9418
1.3227
2.6675
90
Elasticities and Sales
Sales (“total revenue”) is calculated as:
Total Revenue = (Price per unit) (Unit sales)
By extension, %Δ Total Revenue = %Δ Price per unit + %Δ Unit sales
Example
Suppose that the price of a product rises by 12% and the unit sales drop by 8%.
Sales (total revenue) of the product change by 12% – 8% = 4%.
91
Applying Elasticities
US Air’s market researchers estimate that, were US Air to decrease the price of its
coach fairs by 10%, then the number of coach tickets sold would increase by 20%.
To increase US Air’s sales, should US Air increase or decrease its coach fairs?
Price Elasticity of Demand 
%Qd
0.2

 2
%Price 0.1
A 1% increase in price will be accompanied by a 2% decrease in Qd. Similarly, a
1% decrease in price will be accompanied by a 2% increase in Qd.
A 1% increase in price will result in a 1% – 2% = –1% change in sales.
A 1% decrease in price will result in a –1% + 2% = +1% change in sales.
92
Applying Elasticities
The May Company owns Filenes and Hechts. May is going to open two new stores
(one Filenes and one Hechts) in New York and Philadelphia. The populations in each
area (adjusted for the difficulty of getting to the stores) are comparable, and unit
sales are initially equivalent in the two markets. Research shows that the income
elasticity for major selling items at Filenes is approximately 1.1 while the income
elasticity for major selling items at Hechts is approximately 0.9. Demographers
predict that the average income level in New York will rise by 30% over the next
twenty years (the expected life of the store) while the average income level in
Philadelphia will rise by 20% over the same period. Assume that price at Filenes and
Hechts are roughly equivalent and that unit sales at the two stores are also roughtly
equivalent. Based on this information, given that May is going to open one of each
store, which should it locate in New York and which in Philadelphia?
%Qd
 1.1
%Income
%Qd
Income Elasticity of Demand for Hechts 
 0.9
%Income
Income Elasticity of Demand for Filenes 
%IncomeNew York  0.3
%IncomePhiladelphia  0.2
93
Applying Elasticities
Filenes
 %Qd 
%Qd  
  %IncomeNew York   1.1 0.3   0.33
%

Income


 %Qd 
%Qd  
%IncomePhiladelphia   1.1 0.2   0.22


 %Income 
Hechts
 %Qd 
%Qd  
  %IncomeNew York    0.9  0.3   0.27
%

Income


 %Qd 
%Qd  
%IncomePhiladelphia    0.9  0.2   0.18


 %Income 
94
Applying Elasticities
The May Company owns Filenes and Hechts. May is going to open two new stores
(one Filenes and one Hechts) in New York and Philadelphia. The populations in each
area (adjusted for the difficulty of getting to the stores) are comparable, and unit
sales are initially equivalent in the two markets. Research shows that the income
elasticity for major selling items at Filenes is approximately 1.1 while the income
elasticity for major selling items at Hechts is approximately 0.9. Demographers
predict that the average income level in New York will rise by 30% over the next
twenty years (the expected life of the store) while the average income level in
Philadelphia will rise by 20% over the same period. Assume that price at Filenes and
Hechts are roughly equivalent and that unit sales at the two stores are also roughtly
equivalent. Based on this information, given that May is going to open one of each
store, which should it locate in New York and which in Philadelphia?
Filenes
Hechts
New York
0.33
0.27
Philadelphia
0.22
0.18
27% + 22% = 49% change in unit
sales
33% + 18% = 51% change in unit
sales
Mays should locate the Filenes store in New York and the Hechts store in Philadelphia.
95
Applying Elasticities
Bayer markets a prescription migraine drug and a heart medication. Because of
interactions, patients cannot take both the migraine drug and the heart medication.
Market research indicates that the price elasticity for the migraine drug is –0.7, the
price elasticity for the heart medication is –0.5, and the cross-elasticity for the heart
medication and the migraine drug is 0.1. The unit contributions for the migraine and
heart drugs are, respectively, $0.75 and $0.52. Bayer sells 10 million units of each
quarterly. Should Bayer alter the price of either product, and if so in what
direction(s)?
Price Elasticity of Demand for Migraine 
Price Elasticity of Demand for Heart 
Cross-price Elasticity of Demand 
%Qd Migraine
 0.7
%Price
%Qd Heart
 0.5
%Price
%Qd Heart
%Qd Migraine

 0.1
%Price Migraine
%Price Heart
96
Applying Elasticities
Suppose Bayer increases the price of the migraine drug by 15%
%SalesMigraine  %PMigraine  %QMigraine
%SalesHeart  %PHeart  %QHeart
 %QMigraine 
%QMigraine  
  %PMigraine    0.7  0.15   0.105
 %P
Migraine 

 %QHeart 
%QHeart  
  %PMigraine    0.1 0.15   0.015
 %P
Migraine 

%SalesMigraine  0.15   0.105   0.045  4.5%
%SalesHeart  0  0.015  0.015  1.5%
ContributionMigraine   4.5% 10 million $0.75   $337,500
ContributionHeart  1.5% 10 million $0.52   $78,000
ContributionTotal  $337,500  $78,000  $415,500
97
Applying Elasticities
Suppose Bayer increases the price of the heart medication by 15%
%SalesMigraine  %PMigraine  %QMigraine
%SalesHeart  %PHeart  %QHeart
 %QMigraine 
%QMigraine  
  %PHeart    0.1 0.15   0.015
 %PHeart 
 %QHeart 
%QHeart  
  %PHeart    0.5  0.15   0.075
%

P
Heart 

%SalesMigraine  0  0.015  0.015  1.5%
%SalesHeart  0.15   0.075   0.075  7.5%
ContributionMigraine  1.5% 10 million $0.75   $112,500
ContributionHeart   7.5% 10 million $0.52   $39,000
ContributionTotal  $112,500  $39,000  $151,500
98
Applying Elasticities
Compare the 15% increase in the price of the migraine drug to the 15% increase in
the price of the heart drug.
Increase Price of Migraine Drug by 15%
ContributionMigraine   4.5% 10 million $0.75   $337,500
ContributionHeart  1.5% 10 million $0.52   $78,000
ContributionTotal  $337,500  $78,000  $415,500
Increase Price of Heart Drug by 15%
Firm obtains greater profit
from increasing the price of
the migraine drug.
ContributionMigraine  1.5% 10 million $0.75   $112,500
ContributionHeart   7.5% 10 million $0.52   $39,000
Contribution Total  $112,500  $39,000  $151,500
99
Analysis of the Firm
The firm’s goal is to maximize shareholder value. Specifically, the firm seeks to
maximize the present discounted value of future cash flows. In economics, we call
this “profit maximization.”
Business Terminology
Economics Terminology
Sales
Total Revenue
COGS, SG&A, R&D
Variable Costs
D&A
Fixed Costs
Contribution
Producer Surplus
Net Income
Accounting Profit
“Normal Profit”
Zero Economic Profit
“Excess Profit”
Economic Profit
100
Analysis of the Firm
Long-run vs. Short-run Costs
Long-run (or “fixed”) costs are costs that remain even if the firm produces no
output. These costs include things like rent on office space, depreciation on
buildings and equipment, and casualty insurance.
Fixed costs can be eliminated, but only by selling off the firm’s assets and
discharging its debt. Because this cannot be done quickly, we call these fixed costs
“long-run” costs.
Short-run (or “variable”) costs are costs that are change as the firm’s level of output
changes. These costs include things like materials used in production, electricity,
fuel, and labor.
Variable costs can be eliminated virtually immediately by ceasing operations.
Note that both variable and fixed costs include both explicit and opportunity costs.
101
Analysis of the Firm
Average and Marginal Cost Measures
Total Cost  Variable Cost  Fixed Cost
Average Total Cost 
Total Cost
Units Output
Average Variable Cost 
Average Fixed Cost 
Marginal Cost 
Variable Cost
Units Output
Fixed Cost
Units Output
Average cost measures are useful for
analyzing costs that the firm has incurred
up to the present.
Marginal cost measures are useful
analyzing costs that the firm will incur in
the future.
 Total Cost
 Units Output
102
Analysis of the Firm
Economies and diseconomies of scale arise from the non-linear relationship between
inputs and output.
Production Stage I
As inputs rise, output rises proportionally more. Example: Double inputs and output
more than doubles.
Cause: Adding inputs presents opportunities for specialization.
Production Stage II
As inputs rise, output rises proportionally less. Example: Double inputs and output
less than doubles.
Cause: Adding inputs creates physical and/or managerial congestion.
103
Analysis of the Firm
Stages of production give rise to economies and diseconomies of scale
Economies of scale: Average cost as decreases as output increases.
Diseconomies of scale: Average cost increases as output increases.
Units Output
Total Cost
Average Total Cost
10,000
$1.0 million
$1.0 million / 10,000 = $100
15,000
$1.4 million
$1.4 million / 15,000 = $93
20,000
$1.9 million
$1.9 million / 20,000 = $95
Economies
of scale
Diseconomies
of scale
104
Analysis of the Firm
$
ATC
AVC
MC
Economies of Scale
Diseconomies of Scale
AFC
Units output
Specialization
Increasing Returns to Variable Factors
Decreasing Returns to Variable Factors
Congestion
105
Analysis of the Firm
$
ATC
AVC
MC
Economies of Scale
AFC
Units output
Specialization
Over this range, the firm continues to experience economies
of scale despite the fact that congestion has set in  the
congestion is not yet severe enough to have overcome the
cumulative positive effect of specialization
106
Analysis of the Firm
Your firm can produce 10,000 units of product at a total cost of $1 million, or 11,000
units of product at a total cost of $1.2 million. Your firm can sell, at a fixed price of
$120 per unit, as much product as it can produce.
Should your firm produce 10,000 units or 11,000 units?
Average cost analysis
Average cost @ 10,000 units = $1 million / 10,000 = $100 per unit
Average cost @ 11,000 units = $1.2 million / 11,000 = $109 per unit
 At a price of $120 per unit, price exceeds per-unit cost.
 Produce the extra 1,000 units.
Marginal cost analysis
Marginal cost of additional 1,000 units = Δ Total Cost / Δ Units Output
= ($1.2 m. – $1 m.) / (11,000 – 10,000)
= $200 per unit
 At a price of $120 per unit, price is less than marginal cost.
 Do not produce the extra 1,000 units.
107
Analysis of the Firm
Output rule for profit maximization
Produce the output level at which MR = MC.
Suppose MR > MC
If the firm increases its output level, what it gains in sales (MR) exceeds what it
loses in increased costs (MC).
As the firm increases its output level, MC rises thereby resulting in MR = MC.
Suppose MR < MC
If the firm decreases its output level, what it loses in sales (MR) is less than what it
saves in decreased costs (MC).
As the firm decreases its output level, MC falls thereby resulting in MR = MC.
108
Analysis of the Firm
Consider a simple case wherein the firm can sell as many units as it wants at a
fixed price.
Example
The market price is $100 per unit.
If the firm sells 50 units, its TR = ($100)(50) = $5,000
If the firm sells 51 units, its TR = ($100)(51) = $5,100
MR = ΔTR / ΔQ = ($5,100 – $5,000) / (51 – 50) = $100
When MR = Price, we say that the firm is a price taker.
When would MR not be the same as price?
 If, in altering the quantity of output produced, the firm caused a change in the
market price. We say that the firm is a price setter.
109
Analysis of the Firm
A Price Taking Firm  Firm’s output level has no impact on market price  MR = Price
$
MC
ATC
AVC
P = $15
P = $10
AFC
Q = 150
When P=$10, MR = MC at an output of
150 units  firm will produce 150 units
Q = 200
Units output
When P=$15, MR = MC at an output of
200 units  firm will produce 200 units
110
Analysis of the Firm
$
MC
ATC
AVC
Breakeven price
Shutdown price
AFC
Units output
111
Analysis of the Firm
Three Pricing Scenarios
Price is above breakeven price: Price > ATC
Firm is making an economic profit
Price is below breakeven price but above shutdown price: ATC > Price > AVC
Firm is incurring a loss and should continue producing in the short run. In the long
run, the firm must either shutdown or reorganize.
Price is below shutdown price: AVC > Price
Firm is incurring a loss and should shutdown in the short run.
112
Analysis of the Firm
Example
A firm’s profit maximizing output level is 1,000 units per day. The firm’s fixed costs
are $50,000 per day. At 1,000 units per day, the firm’s variable costs are $80,000
per day.
What are the firm’s AVC and ATC?
AVC 
$80,000 per day
 $80 per unit
1,000 units per day
AFC 
$50,000 per day
 $50 per unit
1,000 units per day
ATC  AVC  AFC  $80 per unit  $50 per unit  $130 per unit
113
Analysis of the Firm
Example
A firm’s profit maximizing output level is 1,000 units per day. The firm’s fixed costs
are $50,000 per day. At 1,000 units per day, the firm’s variable costs are $80,000
per day.
The market price of the firm’s product is $100 per unit. How much profit would the
firm make (a) if it continued to produce and (b) if it shutdown?
Continue to produce
VC   $80 per unit per day 1, 000 units per day   $80, 000 per day
FC  $50, 000 per day
TC  VC  FC  $80, 000 per day  $50, 000 per day  $130, 000 per day
TR  Price per unit Units per day   $100 1, 000   $100, 000 per day
Profit  TR  TC  $100, 000 per day  $130, 000 per day  $30, 000 per day
114
Analysis of the Firm
Example
A firm’s profit maximizing output level is 1,000 units per day. The firm’s fixed costs
are $50,000 per day. At 1,000 units per day, the firm’s variable costs are $80,000
per day.
The market price of the firm’s product is $100 per unit. How much profit would the
firm make (a) if it continued to produce and (b) if it shutdown?
Shutdown
VC   $80 per unit per day  0 units per day   $0 per day
FC  $50, 000 per day
TC  VC  FC  $0 per day  $50, 000 per day  $50, 000 per day
TR  Price per unit Units per day   $100  0   $0 per day
Profit  TR  TC  $0 per day  $50, 000 per day  $50, 000 per day
Firm is better off producing at a loss than shutting down.
115
Quantitative Analysis of a Firm
We have already seen how to estimate a demand function.
If the unit sales data we use to estimate demand are unit sales for a single firm,
then the demand function we obtain is the firm demand function.
If the unit sales data we use to estimate demand are unit sales for the industry,
then the demand function we obtain is the industry demand function.
To estimate the firm’s total cost function, we employ data on the firm’s unit sales,
the firm’s accounting costs, and the firm’s opportunity costs.
116
Quantitative Analysis of a Firm
Data Set #2 contains monthly unit sales and cost figures for a firm.
1. For each month, calculate the firm’s total accounting cost, opportunity cost, total
(economic) cost, and ATC.
Total accounting cost  COGS  SG&A  D&A
 0.08 
Opportunity cost   Total accounting cost  

12


Total (economic) cost  Total accounting cost  Opportunity cost
ATC 
Total cost
Units output
117
Quantitative Analysis of a Firm
Data Set #2 contains monthly unit sales and cost figures for a firm.
2. Using the unit sales data, the total (economic) cost data, and knowledge of the
expected shape of the total cost function, estimate the ATC function.
We expect ATC to be parabolic  ATC should be a function of both Q and Q 2.
Because AFC = FC / Q, we also expect ATC to be a function of 1/Q.
Use OLS to estimate the ATC function.
ATC    1Q   2Q 2   3
1
Q
u
ATC
$0.2710
$0.2742
$0.3152
$0.2593
$0.3514
$0.2668
$0.3268
$0.2867
$0.2662
$0.2988
$0.2622
$0.3040
$0.2657
Q
169,344
242,431
110,871
211,975
91,596
171,039
246,864
247,696
171,600
128,896
224,079
249,964
180,304
Q^2
28,677,390,336
58,772,789,761
12,292,378,641
44,933,400,625
8,389,827,216
29,254,339,521
60,941,834,496
61,353,308,416
29,446,560,000
16,614,178,816
50,211,398,241
62,482,001,296
32,509,532,416
1/Q
5.90514E-06
4.12489E-06
9.01949E-06
4.71754E-06
1.09175E-05
5.84662E-06
4.05081E-06
4.03721E-06
5.82751E-06
7.75819E-06
4.46271E-06
4.00058E-06
5.54619E-06
118
Quantitative Analysis of a Firm
2. Using the unit sales data, the total (economic) cost data, and knowledge of the
expected shape of the total cost function, estimate the ATC function.
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.889690194
R Square
0.791548642
Adjusted R Square
0.777651885
Standard Error
0.013371982
Observations
49
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
X Variable 2
X Variable 3
3
45
48
SS
0.030554626
0.008046446
0.038601072
MS
F
Significance F
0.010184875 56.95923371
2.31706E-15
0.00017881
Coefficients Standard Error
t Stat
P-value
0.970926175
0.300855057 3.227222387 0.002333554
-6.00076E-06
1.86697E-06 -3.214177278 0.002421263
1.43492E-11
3.66995E-12 3.909921027 0.000308356
-17505.55997
15232.04504 -1.149258679 0.256521162
Lower 95%
Upper 95%
0.364972994 1.576879356
-9.76103E-06 -2.2405E-06
6.95755E-12 2.17409E-11
-48184.47307 13173.35312
ATC = 0.9709 – (0.000006) Q + (0.00000000001) Q2 – 17505 / Q
119
Quantitative Analysis of a Firm
3. Find the firm’s efficient output level.
Minimize the ATC function with respect to Q.
ATC = 0.9709 – (0.000006) Q + (0.00000000001) Q2 – 17505 / Q
ATC is minimum when Q = 192,665.
4. Find the firm’s breakeven price.
Breakeven price is the minimum attainable ATC.
ATC = 0.9709 – (0.000006)(192,665)+ (0.00000000001)(192,665)
– 17505 / 192,665
= $0.26
120
Quantitative Analysis of a Firm
5. Looking at the data, at what output level was the firm’s ATC minimum?
ATC was minimum ($0.2593) at 211,975 output.
6. Explain why this figure differs from the figure we calculated in step #3.
Step #3 gave us the best estimate of the efficient output level. Step #5 gave
the output level that, possibly by random chance, produced the historically
lowest ATC.
121
Quantitative Analysis of a Firm
Using Data Set #2, find the firm’s shutdown price.
The shutdown price is the minimum attainable AVC.
AVC = α + β1 Q + β2 Q
2
SUMMARY OUTPUT
Regression Statistics
Multiple R
0.917876354
R Square
0.842497001
Adjusted R Square
0.835649045
Standard Error
0.014106472
Observations
49
ATC
$0.1476
$0.1904
$0.1345
$0.1639
$0.1314
$0.1480
$0.2452
$0.2025
$0.1482
$0.1379
$0.1713
$0.2224
$0.1509
Q
169,344
242,431
110,871
211,975
91,596
171,039
246,864
247,696
171,600
128,896
224,079
249,964
180,304
Q^2
28,677,390,336
58,772,789,761
12,292,378,641
44,933,400,625
8,389,827,216
29,254,339,521
60,941,834,496
61,353,308,416
29,446,560,000
16,614,178,816
50,211,398,241
62,482,001,296
32,509,532,416
ANOVA
df
Regression
Residual
Total
Intercept
X Variable 1
X Variable 2
2
46
48
SS
0.048963697
0.009153658
0.058117355
MS
F
Significance F
0.024481849 123.0289656
3.4486E-19
0.000198993
Coefficients Standard Error
t Stat
P-value
0.222387617
0.02876938
7.73001074 7.41553E-10
-1.41482E-06
3.53371E-07 -4.003778415 0.000225205
5.5078E-12
9.90754E-13 5.559200359 1.31852E-06
Lower 95%
0.164477859
-2.12612E-06
3.51352E-12
Upper 95%
0.280297375
-7.03521E-07
7.50209E-12
122
Quantitative Analysis of a Firm
Using Data Set #2, find the firm’s shutdown price.
AVC = 0.2239 – (0.0000014) Q + (0.00000000006) Q2
Minimum AVC is $0.13 (at Q = 128,438)  this is the shutdown price.
123
Industry Structures
Industry structure refers to the market power that individual firms in an industry
have.
Individual firms have less
influence over the market price
Perfect/Pure
Competition
Monopolistic
Competition
Individual firms have greater
influence over the market price
Oligopoly
Monopoly
124
Industry Structures
Perfect/Pure Competition
1. Many firms
2. Individual firm’s output is small relative to the market
3. Firms produce a homogeneous product
4. Free entry/exit to/from the industry
5. All market participants have full information (perfect competition)
Monopolistic Competition
1. Many firms
2. Individual firm’s output is small relative to the market
3. Firms produce a heterogeneous product
4. Free entry/exit to/from the industry
Oligopoly
1. Few, but more than one, firms
2. Individual firm’s output is large relative to the market
3. May or may not be free entry/exit to/from the industry
Monopoly
1. (Usually) one firm
2. Individual firm’s output is virtually the entirety of the market
3. May or may not be free entry/exit to/from the industry
125
Perfect/Pure Competition
$
Cost curves depict a single firm in the
industry
Equilibrium price is determined
by the market
S
$
MC
ATC
AVC
D
Q
AFC
Q
All firms in the industry charge the market price
(firms are “price takers”)  MR = Price
126
Perfect/Pure Competition
A Single Firm in the Industry
$
MC
3. Firm’s ATC is here
ATC
AVC MR
1. Equilibrium price is here
AFC
Q
4. Area is economic loss
2. Profit max output is here
127
Perfect/Pure Competition
Firm is incurring an economic loss
 The accounting profit the firm is
making is less than the
accounting profit earned by firms
in other industries that are
exposed to comparable risk.
A Single Firm in the Industry
$
MC
ATC
AVC MR
AFC
Q
The economic loss provides
incentive (1) for firms to exit to
similar industries (e.g. due to low
margins in the PC market, HewlettPackard will likely sell off its PC
division and focus on its printer
division), and (2) for firms to shut
down entirely (e.g. due to on-going
losses, Eastern Airlines shut down in
1991).
128
Perfect/Pure Competition
$
1. Departure of firms from the
industry is a negative producer
shock  Supply decreases
S’ S $
A Single Firm in the Industry
MC
ATC
AVC
D
AFC
2. Decrease in supply causes market
price to rise
Q
4. When economic profit reaches zero, there is
no longer incentive for firms to leave the
industry and so price stabilizes.
3. As market price rises, profit maximizing output level and economic profit
increase
Q
129
Perfect/Pure Competition
Equilibrium price is determined
by the market
$
$
S
MC
MR
ATC
AVC
D
AFC
Q
Q
All firms in the industry charge the market price
(firms are “price takers”)  MR = Price
130
Perfect/Pure Competition
A Single Firm in the Industry
$
1. Equilibrium price is here
MC
MR
ATC
AVC
3. Firm’s ATC is here
AFC
Q
4. Area is economic profit
2. Profit max output is here
131
Perfect/Pure Competition
Firm is incurring an economic profit
 The accounting profit the firm is
making is more than the
accounting profit earned by firms
in other industries that are
exposed to comparable risk.
A Single Firm in the Industry
$
MC
MR ATC
AVC
AFC
Q
The economic profit provides
incentive (1) for firms in similar
industries to enter this industry (e.g.
in the 1980’s Hewlett-Packard,
which made mainframe computers,
entered the PC industry), and (2)
for entrepreneurs to create new
firms in this industry (e.g. in the
1990’s Dell computer was launched
as a PC manufacturer/retailer).
132
Perfect/Pure Competition
1. Entrance of firms to the
industry is a positive producer
$
shock  Supply increases
$
S
A Single Firm in the Industry
MC
S’
ATC
AVC
D
AFC
2. Increase in supply causes
market price to rise
Q
4. When economic profit reaches zero, there is
no longer incentive for firms to enter the
industry and so price stabilizes.
3. As market price falls, profit maximizing output level and economic profit
decrease
Q
133
Perfect/Pure Competition
A firm that produces at the
minimum attainable ATC is called
“efficient.”
$
MC
ATC
Efficient firms utilize the
minimum possible resources to
produce their product.
From an economy-wide
perspective, efficient firms are
good because they waste little or
no resources.
AVC
AFC
Q
Efficient output is the output
level at which ATC is minimum.
134
Perfect/Pure Competition
Conclusions
1.
In the short-run, firms in perfect/pure competition may make an economic profit
or incur an economic loss.
2.
In the long-run, firms in perfect/pure competition will make zero economic profit.
3.
Firms in perfect/pure competition are efficient in the long-run.
135
Monopoly
In a monopoly industry there is (usually) one firm. The firm represents (virtually)
the entirety of market supply.
There are instances in which an industry may contain a single very large firm and
some (perhaps many) very small firms (e.g. long distance service prior to AT&T’s
breakup). In such an industry, the large firm behaves as if it were the only firm
and the small firms behave as if they were in perfect competition.
136
Monopoly
A firm that can influence the market price does so by altering output. When the firm
increases output, a surplus results and the market price falls. When the firm
decreases output, a shortage results and the market price rises.
When a firm can alter the market price by altering output, MR is no longer equal to
price.
Example
• A large firm produce 100 units per day.
• The resulting market price is $10 per unit.
• TR = ($10 per unit)(100 units per day) = $1,000 per day
If the firm increases its output to 110 units per day, a surplus results.
 The market price falls to $9.95 per unit.
TR = ($9.95 per unit)(110 units per day) = $1,094.50 per day
MR = ΔTR/ΔQ = ($1,094.50 – $1,000) / (110 – 100) = $9.45.
 MR is less than price because the increase in output lowers the price for all units.
137
Monopoly
$
A Monopoly Firm
…the resulting price is $10…
D
…but the MR is $9.45.
MR
Q
When the firm produces 100 units…
138
Monopoly
$
A Monopoly Firm
MC
2. Resulting price is determined by D
ATC
4. Economic profit is profit-per-unit
multiplied by units sold.
3. Cost per unit is determined by ATC
D
MR
Q
1. Firm produces where MR = MC
139
Monopoly
$
A Monopoly Firm
MC
ATC
Notice that the firm’s efficient
output level is different from its
profit maximizing output level.
D
MR
Q
Efficient output level
Profit maximizing output level
140
Monopoly
$
Produce at Profit Max Output
$
MC
Produce at Efficient Output
MC
ATC
ATC
D
MR
D
MR
Q
If the firm were to produce at the efficient output level, gains in cost savings due to
lower per-unit costs would be more than offset by losses in revenue due to
decreased price.
141
Monopoly
Suppose a monopoly firm faces the following demand and average total cost functions
P  6, 354  4.5Q
ATC  3, 021  4.9Q  0.002Q 2 
100
Q
1. Find the firm’s profit maximizing output level. Hint: Use Excel’s SOLVER to
maximize profit with respect to output.
Q
ATC  3, 021  4.9Q  0.002Q 2 
P  6, 354  4.5Q
TR  P Q 
Profit  TR  TC
100
Q
TC   ATC Q 
Q = 815 maximizes profit
142
Monopoly
Suppose a monopoly firm faces the following demand and average total cost functions
P  6, 354  4.5Q
ATC  3, 021  4.9Q  0.002Q 2 
100
Q
2. Find the market price that results when the firm produces at its profit maximizing
output level
P = 6,354 – (4.5)(815) – 100/Q = $2,686.68
3. Find the firm’s ATC when it produces at the profit maximizing output level.
ATC = 3,021 – 4.9Q + 0.002Q 2 – 100/Q = $356.14
4. Find the firm’s economic profit when it produces at the profit maximizing output
level.
Profit = TR – TC = (P)(Q) – (ATC)(Q) = ($2,686.68)(815) – ($356.14)(815)
= $1.9 million
143
Monopoly
Suppose a monopoly firm faces the following demand and average total cost functions
P  6, 354  4.5Q
ATC  3, 021  4.9Q  0.002Q 2 
100
Q
5. Find the efficient output level. Hint: Use SOLVER to minimize ATC with respect to
output.
Q = 1,225
6. Find the firm’s ATC when it produces at the efficient output level.
ATC = 3,021 – 4.9Q + 0.002Q 2 – 100/Q = $19.83
7. Find the market price that would result if the firm produced at the efficient output
level.
P = 6,354 – (4.5)(1,225) = $841.43
144
Monopoly
Suppose a monopoly firm faces the following demand and average total cost functions
P  6, 354  4.5Q
ATC  3, 021  4.9Q  0.002Q 2 
100
Q
8. Find the firm’s economic profit when it produces at the efficient output level.
Profit = TR – TC = (P)(Q) – (ATC)(Q) = ($841.43)(1,225) – ($19.83)(1,225)
= $1.0 million
145
Monopoly
$
$2,686.68
$356.14
$19.83
MC
ATC
$1.9 million
D
MR
815
1,225
Q
146
Monopoly
Conclusions
1.
The monopoly firm makes an economic profit.
2.
The monopoly firm is inefficient.
147
Oligopoly
In an oligopoly industry, there are several firms. Each of the firms is large enough
(relative to the market) to cause an impact on the market price via altering output.
An oligopoly exists in one of three states
1. Competitive oligopoly  Firms do not coordinate their production levels.
2. Cartel oligopoly  Firms coordinate their production levels effectively acting as a
single firm.
3. Chiseling oligopoly  One or more firms renege on a cartel agreement while
other firms adhere to the cartel agreement.
148
Oligopoly
Suppose an oligopoly industry is comprised of two firms (a two-firm oligopoly is
sometimes called a duopoly). The firms face the following demand and average total
cost functions:
P  6,354  4.5 Q1  Q 2 
ATC1  3,021  4.9Q1  0.002Q12
ATC2  3,021  4.9Q 2  0.002Q 22
Notice that the two firms face the same market price, P, and that the market price is
determined by the combined output of the two firms.
149
Oligopoly
P  6,354  4.5 Q1  Q 2 
ATC1  3,021  4.9Q1  0.002Q12
ATC2  3,021  4.9Q 2  0.002Q 22
1. Assume that the industry is a competitive oligopoly. Find the profit maximizing
output levels, ATC, and profits for the two firms.
Follow an iterative procedure in which you set the output level for one firm, then
find the profit maximizing output for the other firm.
Example: Set both the output of each firm to 400 units.
Firm #1
Firm #2
Q
400
400
P
$2,754
$2,754
ATC
$1,381
$1,381
TR
$1,101,600
$1,101,600
TC
$552,400
$552,400
Profit
$549,200
$549,200
150
Oligopoly
P  6,354  4.5 Q1  Q 2 
ATC1  3,021  4.9Q1  0.002Q12
ATC2  3,021  4.9Q 2  0.002Q 22
1. Assume that the industry is a competitive oligopoly. Find the profit maximizing
output levels, ATC, and profits for the two firms.
Example: Given that Firm #2 is producing 400 units, adjust Firm #1’s output so as
to maximize the profit for Firm #1.
Firm #1
Firm #2
Q
577
400
P
$1,960
$1,960
ATC
$861
$1,381
TR
$1,129,787
$783,875
TC
$496,274
$552,400
Profit
$633,513
$231,475
151
Oligopoly
P  6,354  4.5 Q1  Q 2 
ATC1  3,021  4.9Q1  0.002Q12
ATC2  3,021  4.9Q 2  0.002Q 22
1. Assume that the industry is a competitive oligopoly. Find the profit maximizing
output levels, ATC, and profits for the two firms.
Example: Now, given Firm #1’s profit maximizing output, adjust Firm #2’s output
so as to maximize the profit for Firm #2.
Firm #1
Firm #2
Q
577
424
P
$1,852
$1,852
ATC
$861
$1,304
TR
$1,067,989
$785,125
TC
$496,274
$552,462
Profit
$571,715
$232,663
152
Oligopoly
P  6,354  4.5 Q1  Q 2 
ATC1  3,021  4.9Q1  0.002Q12
ATC2  3,021  4.9Q 2  0.002Q 22
1. Assume that the industry is a competitive oligopoly. Find the profit maximizing
output levels, ATC, and profits for the two firms.
Example: Given Firm #2’s profit maximizing, adjust Firm #1’s output so as to
maximize the Firm #1’s profit.
Firm #1
Firm #2
Q
559
424
P
$1,933
$1,933
ATC
$908
$1,304
TR
$1,079,786
$819,134
TC
$507,121
$552,462
Profit
$572,666
$266,673
153
Oligopoly
P  6,354  4.5 Q1  Q 2 
ATC1  3,021  4.9Q1  0.002Q12
ATC2  3,021  4.9Q 2  0.002Q 22
1. Assume that the industry is a competitive oligopoly. Find the profit maximizing
output levels, ATC, and profits for the two firms.
Continue iteratively until the two profit maximizing output levels converge.
Firm #1
Firm #2
Q
498
498
P
$1,870
$1,870
ATC
$1,076
$1,076
TR
$931,613
$931,613
TC
$536,159
$536,159
Profit
$395,454
$395,454
154
Oligopoly
P  6,354  4.5 Q1  Q 2 
ATC1  3,021  4.9Q1  0.002Q12
ATC2  3,021  4.9Q 2  0.002Q 22
2. Assume that the industry is a cartel oligopoly. Find the profit maximizing output
levels, ATC, and profits for the two firms.
Maximize the combined profits of the two firms with respect to the two firm’s
output levels.
Firm #1
Firm #2
Q
328
328
P
$3,404
$3,404
ATC
$1,630
$1,630
TR
$1,115,778
$1,115,778
TC
$534,223
$534,223
Profit
$581,555
$581,555
155
Oligopoly
P  6,354  4.5 Q1  Q 2 
ATC1  3,021  4.9Q1  0.002Q12
ATC2  3,021  4.9Q 2  0.002Q 22
3. Assume that Firm #1 adheres to the cartel profit maximizing output level, but that
Firm #2 chisels. Find the profit maximizing output levels, ATC, and profits for the
two firms.
Set Firm #1’s output at the cartel profit max level and maximize Firm #2’s profit
with respect to Firm #2’s output.
Firm #1
Firm #2
Q
328
627
P
$2,057
$2,057
ATC
$1,630
$735
TR
$674,298
$1,289,846
TC
$534,223
$460,750
Profit
$140,075
$829,096
156
Oligopoly
Compare the results from the three cartel scenarios
Competitive Oligopoly
Q
P
Firm #1
498
$1,870
Firm #2
498
$1,870
ATC
$1,076
$1,076
TR
$931,613
$931,613
TC
$536,159
$536,159
Profit
$395,454
$395,454
Cartel Oligopoly
Q
Firm #1
328
Firm #2
328
P
$3,404
$3,404
ATC
$1,630
$1,630
TR
$1,115,778
$1,115,778
TC
$534,223
$534,223
Profit
$581,555
$581,555
Chiseling Oligopoly
Q
Firm #1
328
Firm #2
627
P
$2,057
$2,057
ATC
$1,630
$735
TR
$674,298
$1,289,846
TC
$534,223
$460,750
Profit
$140,075
$829,096
157
Oligopoly
Cartel Instability and the Cyclicality of Oligopoly Structure
1. Starting from a competitive oligopoly, firms have incentive to form a cartel thereby
increasing their profits at the expense of consumers.
2. Once a cartel is formed, individual firms have incentive to chisel on the cartel
agreement thus garnering even more profit, though at the expense of the other
oligopolists and to the benefit of consumers.
3. Firms remaining in the cartel now have even more incentive to chisel. As the cartel
agreement falls apart, firms are now acting independently  return to competitive
oligopoly.
158
Oligopoly
Conclusions
1.
In a competitive oligopoly, firms make an economic profit and are inefficient.
2.
In a cartel oligopoly, firms make greater economic profit and are more inefficient
than in a competitive oligopoly.
3.
In a chiseling oligopoly, the chiseling firms make greater economic profit and are
less inefficient than in a cartel oligopoly, while the non-chiseling firms make less
economic profit and are as inefficient as in a cartel oligopoly.
159
Monopolistic Competition
In a monopolistically competitive industry, there are many firms. Individual firms are
too small to impact the market price for the brand category, but, via product
differentiation, can influence the market prices of their individual brands.
To the extent that the consumer focuses on the brand category, the individual firm
acts like a firm in perfect competition. To the extent that the consumer focuses on
the individual brand, the individual firm acts like a monopoly (i.e. the individual firm
is the only producer of a given brand).
Whereas oligopoly and monopoly firms rely more on their abilities to impact market
price via changes in their output levels, monopolistically competitive firms rely more
on their abilities to impact the prices of their individual brands via shifts in the firm
demand curves due to product differentiation and marketing.
160
Monopolistic Competition
Monopolistic Competition and the Consumer Information Problem
Consumer information problem  Consumers must acquire enough information to
make an informed purchase decision, but information gathering is costly (both
explicitly and cognitively).
Monopoly Industry  Lack of competing brands makes information gathering
negligible.
Oligopoly Industry  Few competing brands makes information gathering low cost.
Perfect Competition  Intense competition causes competing brands to be identical
making information gathering negligible.
Monopolistic Competition  Many different brands makes information gathering
very costly.
161
Monopolistic Competition
The iterative choice process and consumer information
External Uncertainty
 Partial Information
 Measurement Error
 Obsolete Information
True Brand
Universe
Brand information mitigates external uncertainty
Estimated Brand
Universes
Perceived
Brand Universe
Perceived Product-Market
Characteristics
Characteristics





True Utilities
Internal Uncertainty
 Absolute Error Utility
 Relative Error Utility
Cluster Sizes
Cluster Variances
Cluster Frontiers
Brand Variances
Granularity
Consideration
Choice-GivenConsideration
Estimated Utilities
Consumption experience mitigates internal uncertainty
162
Monopolistic Competition
Affordability
A Consumer’s Perceived Brand Universe
Affordability cluster
Budweiser
MGD
Coors
Genesee
Cluster frontier combines the
best attributes of the observed
brands within the cluster
Taste cluster
Samuel Adams
Heineken
Fosters
Guinness
Taste
163
Monopolistic Competition
Affordability
Characteristics of the Perceived Brand Universe
Cluster frontier: How
far away are brands
from the frontier
Budweiser
Cluster size: How many brands are in a cluster
MGD
Coors
Genesee
Granularity: How distinct are
the clusters from each other
Cluster variance: How “spread out”
are brands within a cluster
Samuel Adams
Heineken
Brand variance: How uncertain is
the consumer about a brand’s true
attributes
Fosters
Guinness
Taste
164
Monopolistic Competition
Compensatory vs. Non-Compensatory Decision-Making
Compensatory Decision-Making: Levels of one attribute are traded-off for levels of
another attribute. Example: A car buyer chooses a less powerful engine in exchange
for greater fuel efficiency.
Non-Compensatory Decision-Making: Levels of an attribute must surpass some
minimal boundary independent of other attribute levels. Example: A home buyer
requires a minimum of three bedrooms regardless of location, number of
bathrooms, garage, etc.
Pros and Cons:
Compensatory decision-making
• Cognitively costly
• Unlikely to erroneously reject brands
Non-compensatory decision-making
• Cognitively inexpensive
• Likely to erroneously reject brands
165
Monopolistic Competition
Affordability
A Consumer’s Perceived Brand Universe
Consideration Phase: Consumer
selects a single cluster of brands via
non-compensatory decision-making
Budweiser
MGD
Coors
Genesee
Choice Phase: Consumer selects a
single brand from within the
consideration cluster via compensatory
decision-making
Samuel Adams
Heineken
Fosters
Guinness
Taste
166
Monopolistic Competition
Pr  Choice   Pr  Consideration Pr  Choice | Consideration
Behavioral Propositions
1. An increase in cluster size increases the consumer’s probability of consideration
for the cluster.
2. An increase in cluster variance decreases the consumer’s probability of
consideration for the cluster.
3. An increase in the distance of a brand to its cluster frontier decreases the
probability of choice-given-consideration for the brand.
4. An increase in brand variance decreases the effect of a brand’s distance-tofrontier on the probability of choice-given-consideration.
5. An increase in granularity increases the effect of cluster size on the probability of
consideration, and decreases the effect of cluster variance on the probability of
consideration.
167
Monopolistic Competition
Red Dog’s introduction
increased the size of the
cluster.
Because Red Dog was
positioned close to MGD,
there was minimal impact
on the cluster variance.
Net result: Red Dog’s
introduction increased
Pr(Consideration) for the
cluster
Conclusion: Pr(Choice) for
MGD (and, in fact, all
brands within the cluster)
increased
 MGD gained market
share at the expense of
“imports.”
Affordability
Case Study: Miller’s Red Dog Brand
Red Dog’s introduction did not move
the cluster frontier  no impact on
Pr(Choice|Consideration)
Budweiser
Red Dog
MGD
Coors
Genesee
Miller introduces a new brand, Red Dog.
Miller positions Red Dog to be close, but
strictly inferior to its flagship brand MGD.
Samuel Adams
Heineken
Fosters
Guinness
Taste
168
Monopolistic Competition
Ad campaign reduces the
perceived distance
between Ben & Jerry’s and
the cluster frontier.
Result: Campaign
increased Pr(Choice-givenConsideration) for Ben &
Jerry’s.
Conclusion: Pr(Choice) for
Ben & Jerry’s increased
 Ben & Jerry’s gained
market share at the
expense of other premium
ice-creams.
Calories (reverse scale)
Case Study: Ben & Jerry’s Ice Cream
Ben & Jerry’s launches an ad
campaign around the phrase, “High
calories are the price of great taste.”
Weight Watchers
Carnival
Edys
Campaign causes consumers to
believe that the previously-perceived
frontier is unattainable. Consumers
perceive a new frontier that reflects
the tradeoff of taste with calories.
Haagen-Dazs
Ben & Jerry
Breyers
Taste
169
Monopolistic Competition
Pr  Choice   Pr  Consideration Pr  Choice | Consideration
The firm’s goal is to increase the Pr(Choice) for its brand. Whether the firm should
focus on increasing Pr(Consideration) or increasing Pr(Choice|Consideration)
depends on the probabilities.
Example
Pr(Choice) = 1.0 and Pr(Choice|Consideration) = 0.1  Pr(Choice) = 0.1
Marketing effort aimed at increasing Pr(Consideration) is wasted. Firm should focus
on increasing Pr(Choice|Consideration).
Example
Pr(Choice) = 0.1 and Pr(Choice|Consideration) = 1.0  Pr(Choice) = 0.1
Marketing effort aimed at increasing Pr(Choice|Consideration) is wasted. Firm
should focus on increasing Pr(Consideration).
170
Monopolistic Competition
A Monopolistically Competitive Firm in the Long Run
$
2. Resulting price
MC
ATC
D
3. Cost per unit
4. Zero economic profit
MR
Q
5. Efficient output level
1. Profit maximizing output level
171
Monopolistic Competition
A Monopolistically Competitive Firm in the Short Run
$
MC
D’
ATC
MR’
D
MR
Q
Firm increases Pr(Choice) for its brand via
increase in Pr(Consideration) and/or
increase in Pr(Choice | Consideration)
 Demand (and MR) increases
172
Monopolistic Competition
A Monopolistically Competitive Firm in the Short Run
$
4. Economic profit
MC
2. Resulting price
D’
ATC
MR’
3. Cost per unit
Q
5. Efficient output level
1. Profit maximizing output level
173
Monopolistic Competition
A Monopolistically Competitive Firm Returning to the Long Run State
$
MC
D’
ATC
MR’
D’’
MR’’
Q
In the long run, either (a) competitors duplicate the firm’s brand innovation (e.g.
cruise control), or (b) consumers realize that the supposed innovation has no real
value (e.g. “ice” beers). Either way, demand (and MR) for the firm’s brand declines.
174
Monopolistic Competition
A Monopolistically Competitive Firm in the Short Run
$
MC
ATC
D
MR’
MR
D’
Q
A competing firm causes an increase in
Pr(Choice) for its brand. If that increase
comes at the expense of this brand’s
market share, then this firm’s demand
decreases.
175
Monopolistic Competition
A Monopolistically Competitive Firm in the Short Run
$
3. Cost per unit
MC
4. Economic loss
ATC
2. Resulting price
MR’
D’
Q
1. Profit maximizing output level
5. Efficient output level
176
Monopolistic Competition
A Monopolistically Competitive Firm in the Short Run
$
MC
ATC
D’’
MR’
MR’’
D’
Q
In the long run, either (a) this firm duplicates the competitor’s brand innovation, or
(b) consumers realize that the competitor’s supposed innovation has no real value.
Either way, demand (and MR) for this firm’s brand increases.
177
Monopolistic Competition
Conclusions
1.
Firms can make an economic profit or incur an economic loss in the short-run.
2.
Firms make zero economic profit in the long run.
3.
Firms are usually inefficient in both the short and long runs.
Monopolistic Competition or Perfect Competition?
If the summed expected present values of the economic profits due to marketing
exceed the sum of the present values of the costs of marketing campaigns plus the
summed expected present values of the economic losses due to competitors’
marketing campaigns, then a given industry will be monopolistically competitive rather
than perfectly competitive.
Firms will continue to advertise in an attempt to garner short-run “bursts” of economic
profit (e.g. Budweiser advertises during every Super Bowl).
178
Long Run vs. Short Run ATC
Long Run vs. Short Run ATC
Thus far, the ATC curve we have seen has been constructed holding long run costs
fixed. In the long run, all costs (including “fixed” costs) become variable.
We can now distinguish between short run ATC and long run ATC. The short run ATC
(i.e. the ATC curve we have so far been using) assumes that long run costs are fixed.
The long run ATC allows for long run costs to be variable.
179
Long Run vs. Short Run ATC
SRATC’s – each corresponds to a different level of fixed costs
$
LRATC
Q
180
Long Run vs. Short Run ATC
1. Suppose the firm’s fixed costs are
$100,000 per week. This is the firm’s
SRATC function.
$
3. If, in the long run, the firm acquires
more PP&E, its fixed costs will
increase to $150,000 per week and
the firm’s SRATC will move here.
LRATC
2. With fixed costs
of $100,000 per
week, the firm’s
efficient output
level is 20,000
units per week.
Q
4. With the additional PP&E, the
firm’s efficient output level is
25,000 units per week.
181
Long Run vs. Short Run ATC
This is the lowest
ATC that can be
attained in the
long run. If the
firm were to
produce any
more or any less
output, or have
any more or any
less PP&E, the
firm’s cost per
unit would rise
above this point.
$
In the long run, the firm acquires
still more PP&E and so the firm’s
SRATC again shifts.
LRATC
We call this the long run
efficient output level. To
achieve long run efficiency,
the firm would have to
produce this much output
and have the long run
efficient quantity of PP&E.
Q
With the additional PP&E, this is the firm’s
new efficient output level.
182
Determinants of Industry Structure
Whether an industry will develop more to the extreme of monopoly or more to the
extreme of perfect competition depends on two factors:
1. Firms’ LRATC functions, and
2. Market demand.
The LRATC function is determined by technology and the prices of factors. Market
demand is determined by consumers.
The implication is that the factors that determine the degree of competition within
an industry are independent of the skills of the managers involved. If market
forces are such that a particular industry will evolve toward perfect competition,
then it will be impossible for any single firm to successfully establish itself as a
monopoly within that industry.
183
Determinants of Industry Structure
1. Suppose all firms in the industry
have LRATC’s that look like this.
$
LRATC
$10
3. Without incurring
a loss, the
lowest price a
firm could
possibly charge
is $10.
2. Suppose market demand
is positioned here.
5. If all the firms in the
industry charge $10,
the quantity market
demanded will be
500,000 units per
day.
6. In equilibrium, there
must be 1,000 firms.
500,000 / 500 = 1,000 firms
500
D
500,000 Q
4. To charge a price of $10 and not incur a
loss, the firm must produce 500 units of
output per day using the long run
efficient quantity of fixed factors.
184
Determinants of Industry Structure
1. Suppose all firms in the industry
have LRATC’s that look like this.
2. Suppose market demand
is positioned here.
$
LRATC
$10
3. Without incurring
a loss, the
lowest price a
firm could
possibly charge
is $10.
6. In equilibrium, there
can be only 1 firm.
10,000
D
5. If all the firms in the
industry charge $10,
the market quantity
demanded will be
10,000 units per day.
Q
4. To charge a price of $10 and not incur a
loss, the firm must produce 10,000 units
of output per day using the long run
efficient quantity of fixed factors.
185
Government Intervention
Government intervention takes the following typical forms:
Price controls
By law, certain products cannot be sold below a price floor (e.g. workers are
prohibited from selling their labor for less than the minimum wage) or above a price
ceiling (e.g. state laws prohibit credit card companies from charging more than (in
some states) 40% interest, rent control limits the rent landlords can charge in NYC).
Quotas
By law, producers may not sell more than a certain quantity of product per time
period. Quotas are most often imposed on imports and infrequently imposed on
domestically produced products.
Technical Regulations
By law, producers must produce products to a certain standard or via a certain
method. Example: Cars sold in the U.S. must adhere to EPA regulations. Employers
must adhere to OSHA safety regulations in the workplace.
186
Government Intervention
Taxes
Types of taxes:
•
•
•
•
•
•
Income tax (tax on wages and salaries, and interest and dividend income)
Sales tax (tax on the value of products sold – e.g. 6% of the sale)
Excise tax (tax on the quantity of products sold – e.g. 35 cents per gallon of gas)
Capital gains tax (tax on the difference between the sale and purchase prices)
Property tax (periodic tax on owned assets)
Tariff (tax on imports)
Classifications of taxes:
•
•
•
•
Flat (called “poll” in the media; tax is same dollar amount for all)
Proportional (called “flat” in the media; tax is same percentage of income for all)
Progressive (tax is a greater percentage of income for higher income people)
Regressive (tax is a lesser percentage of income for higher income people)
187
Who Pays Federal Personal Income Taxes?
100%
90%
Proportion of Tax Revenues
80%
70%
60%
50%
40%
30%
20%
10%
0%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Proportion of Taxpayers (by AGI)
Federal Taxes 2004
Perfect Equity
188
Who Pays Wage Taxes?
100%
90%
Proportion of Tax Revenues
80%
70%
60%
50%
40%
30%
20%
10%
0%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Proportion of Taxpayers (by AGI)
Federal Taxes 2004
Perfect Equity
Social Security Taxes
Medicare Taxes
189
Who Pays Wage and Capital Gains Taxes?
100%
Proportion of Tax Revenues
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Proportion of Taxpayers (by AGI)
Perfect Equity
Federal Income Taxes
Medicare Taxes
Capital Gains Taxes
Social Security Taxes
190
What is the Expected Return on Social Security Taxes?
Age
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40
41
42
43
44
45
46
47
48
49
50
51
52
53
54
55
Wage
Prob(Alive) SS Tax
$57,000
100.0%
$7,068
$59,679
99.9%
$7,400
$62,484
99.7%
$7,748
$65,421
99.6%
$8,112
$68,495
99.4%
$8,493
$71,715
99.3%
$8,893
$75,085
99.2%
$9,311
$78,614
99.0%
$9,748
$82,309
98.8%
$10,206
$86,178
98.7%
$10,686
$90,228
98.5%
$11,188
$94,469
98.3%
$11,714
$98,909
98.1%
$12,265
$103,558
97.9%
$12,841
$108,425
97.7%
$13,445
$113,521
97.4%
$14,077
$118,856
97.2%
$14,738
$124,442
97.0%
$15,431
$130,291
96.7%
$16,156
$136,415
96.4%
$16,915
$142,826
96.2%
$17,710
$149,539
95.9%
$18,543
$156,568
95.6%
$19,414
$163,926
95.3%
$20,327
$171,631
94.9%
$21,282
$179,697
94.6%
$22,282
$188,143
94.2%
$23,330
$196,986
93.8%
$24,426
$206,244
93.4%
$25,574
$215,938
92.9%
$26,776
$226,087
92.4%
$28,035
$236,713
91.9%
$29,352
$247,838
91.3%
$30,732
$259,487
90.6%
$32,176
$271,683
89.9%
$33,689
SS Benefit
Expected SS Tax/Benefit
($7,068)
($7,390)
($7,727)
($8,079)
($8,447)
($8,831)
($9,233)
($9,652)
($10,089)
($10,544)
($11,019)
($11,514)
($12,030)
($12,569)
($13,130)
($13,715)
($14,325)
($14,961)
($15,623)
($16,313)
($17,031)
($17,778)
($18,555)
($19,363)
($20,203)
($21,075)
($21,979)
($22,915)
($23,882)
($24,881)
($25,909)
($26,967)
($28,052)
($29,164)
($30,301)
Age
56
57
58
59
60
61
62
63
64
65
66
67
68
69
70
71
72
73
74
75
76
77
78
79
80
81
82
83
84
85
86
87
88
89
90
Wage
$284,452
$297,821
$311,819
$326,474
$341,818
$357,884
$374,704
$392,316
$410,754
$430,060
$450,273
$471,435
Prob(Alive)
89.2%
88.4%
87.5%
86.5%
85.5%
84.4%
83.2%
82.0%
80.7%
79.3%
77.8%
76.3%
74.7%
73.1%
71.5%
69.8%
68.1%
66.3%
64.5%
62.7%
60.9%
59.2%
57.4%
55.6%
53.9%
49.9%
44.2%
37.3%
29.9%
22.7%
18.2%
13.6%
9.1%
4.5%
2.0%
SS Tax
$35,272
$36,930
$38,666
$40,483
$42,385
$44,378
$46,463
$48,647
$50,934
$53,327
$55,834
$58,458
SS Benefit
$119,580
$125,200
$131,085
$137,246
$143,696
$150,450
$157,521
$164,925
$172,676
$180,792
$189,289
$198,186
$207,500
$217,253
$227,464
$238,154
$249,348
$261,067
$273,337
$286,184
$299,635
$313,718
$328,462
Expected SS Tax/Benefit
($31,460)
($32,638)
($33,831)
($35,033)
($36,243)
($37,456)
($38,669)
($39,878)
($41,079)
($42,268)
($43,444)
($44,604)
$89,375
$91,563
$93,702
$95,786
$97,809
$99,767
$101,652
$103,459
$105,224
$106,943
$108,613
$110,231
$111,794
$108,500
$100,568
$88,828
$74,582
$59,366
$49,725
$39,046
$27,254
$14,268
$6,569
Assumptions: Age 21 income is average for Economics majors. Wages grow by inflation (3.5%) plus average growth in real wages
for college graduates (1.2%). Burden is based on both halves of SS tax. Benefit at retirement is estimated by SSA and is assumed
to grow by 4.7% annually. Mortality figures are for white males.
191
What is the Expected Return on Social Security Taxes?
$120,000
Internal rate of return = 2.2%
$100,000
$80,000
SS benefits average $82,000
annually for 23 years.
$60,000
$40,000
$20,000
$0
21 24 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 81 84 87 90
($20,000)
($40,000)
($60,000)
192
What is the Return on Social Security Taxes?
$2,500,000
$2,000,000
$1,500,000
Investing both halves of the SS taxes at
12% expected return yields $18.5 million
at retirement.
This sum can generate a stream of $2.4
million annual payments for the
following 23 years.
$1,000,000
$500,000
$0
21 24 27 30 33 36 39 42 45 48 51 54 57 60 63 66 69 72 75 78 81 84 87 90
($500,000)
193
Government Intervention
Modeling Government Interventions
Shocks are modeled according to which group, consumers or producers, are
impacted first by the shock. For example, an increase in income impacts consumers
first and producers second (through the change in consumer behavior).
A single government intervention that impacts consumers and producers
simultaneously is not modeled as a shock at all, but as the presence of a “third party”
to the market. For example, a price ceiling impacts both consumers and producers at
the same time as producers are not allowed to ask prices above the ceiling and
consumers are not allowed to offer prices above the ceiling. However, technical
regulations impact producers first because the regulations apply to the production
process.
Interventions modeled as shocks: Technical regulations
Interventions not modeled as shocks: Price controls, quotas, taxes
194
Price Controls
Market for Labor
Government
imposed price floor
$
Workers
supply labor
S
Free market
equilibrium
wage rate
D
Employers
demand labor
Q
Labor employed
with price floor
Labor employed in free market
equilibrium
195
Price Controls
Market for Labor
$
Workers
supply labor
S
Unemployment is not
“people out of work.” It is
“people who want work
being out of work.”
Prior to the minimum
wage, there was no
unemployment (everyone
who wanted a job at the
prevailing wage had one).
The minimum wage
causes unemployment by
simultaneously enticing
more people to offer their
labor and fewer firms to
desire labor.
D
Qd
Qs
Employers
demand labor
Q
Unemployment = surplus of labor
196
Price Controls
Money to pay for increased wages comes from one (or more) of three sources:
• Unemployed workers whose former earnings are now used to pay higher wages to those
who are still employed
Workers who add less value per hour than the minimum wage are laid off. The workers
who are retained are those who would have (via competition among employers) ended up
earning above minimum wage anyway. Either the work they performed is eliminated (e.g.
full-service gas stations, fast food drink dispensers), or they are replaced by machines (e.g.
telephone operators, toll collectors, elevator operators), or the work load is placed on
remaining higher productive employees (e.g. formerly hourly jobs becoming “salaried”).
• Consumers who now pay higher prices for the employers’ products
Higher prices for products that utilize minimum wage workers cause consumers to buy less,
further reducing employment for these workers.
• Investors who now earn less return on firm’s stocks and bonds
Lower rate of return causes investors to invest in other firms, reducing the number of startups that employ low-skilled workers.
197
Price Controls
From which of these three sources, money required to pay the increased wage
comes depends on elasticities:
• The more price-elastic (i.e. the more of a luxury) are low-skilled workers, the
more of the increased wage will come from layoffs.
• The more price-inelastic (i.e. the more of a necessity) is a product, the more of
the increased wage will come from consumers paying higher prices for the firm’s
product.
• The more interest-rate-inelastic (i.e. the less risky) are a firm’s stocks and bonds,
the more of the increased wage will come from investors receiving less return on
their investments in the firm.
198
Price Controls
Market for Apartments in NYC
$
S
Price ceiling on rent
causes more people to
want to rent than there
are apartments available.
This results in a chronic
housing shortage.
The lowered rental price
also reduces incentive for
investors to build more
housing units.
D
Qs
Qd
Q
Housing shortage
199
Minimum Wage
Prices Ration Goods
All things are scarce. Scarce resources will be rationed. The
question is, by what mechanism? Who will be excluded?
 Cap on interest rates?
Rationed by risk. Higher risk borrowers excluded.
 Cap on tuition?
Rationed by talent. Less talented students excluded.
 Minimum wage?
Rationed by skill. Less skilled workers excluded.
Minimum Wage
Minimum Wage
When we force an employer to pay a worker more than the
job is worth, the job disappears.
40 years ago:
30 years ago:
10 years ago:
Last year:
Telephone operators
Gas station attendants
Fast food servers
Pizza deliverers
What happens to workers whose jobs are eliminated?
 Those whose labor is worth more than minimum wage?
 Those whose labor is worth less than minimum wage?
College Education (1984-2004)
4.0%
3.5%
y = 0.003x + 0.02
R2 = 0.0002
p = 0.95
Unemployment Rate
3.0%
2.5%
2.0%
1.5%
1.0%
0.5%
0.0%
0.3
0.32
0.34
0.36
0.38
0.4
Min Wage as Fraction of Avg Hourly Wage
Source: Statistical Abstract of the United States, and Bureau of Labor Statistics
0.42
0.44
HS Education (1984-2004)
9.0%
8.0%
y = 0.23x - 0.03
R2 = 0.18
p = 0.05
Unemployment Rate
7.0%
6.0%
5.0%
4.0%
3.0%
2.0%
1.0%
0.0%
0.3
0.32
0.34
0.36
0.38
0.4
Min Wage as Fraction of Avg Hourly Wage
Source: Statistical Abstract of the United States, and Bureau of Labor Statistics
0.42
0.44
Less than HS Education (1984-2004)
16.0%
14.0%
y = 0.46x - 0.07
R2 = 0.26
p = 0.02
Unemployment Rate
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
0.0%
0.3
0.32
0.34
0.36
0.38
0.4
Min Wage as Fraction of Avg Hourly Wage
Source: Statistical Abstract of the United States, and Bureau of Labor Statistics
0.42
0.44
Minimum Wage
What percentage of workers earn minimum wage?
% of Hourly Workers Earning Minimum Wage or Less
8%
7%
6%
5%
4%
3%
2%
1%
0%
16 - 19
20 - 24
Worker Age
Source: Bureau of Labor Statistics, 2008
25 +
% of Hourly Workers Earning Minimum Wage or Less
8%
7%
6%
5%
4%
3%
2%
1%
0%
Part time
Full time
Worker Status
Source: Bureau of Labor Statistics, 2008
% of Hourly Workers Earning Minimum Wage or Less
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
Service
Occupations
Sales and Office
Occupations
Production,
Transportation
Industry
Source: Bureau of Labor Statistics, 2008
Management,
Professional
Occupations
Construction,
Maintenance,
Natural Resources
Occupations
Unemployment for Teenagers Relative to Adults (1964-2004)
Unemployment Population Ratio for 16-19 Year Olds as Percentage of 20-64 Year
Olds
Unemployment Population Ratio for 16-19 Year
Olds as a Percentage of Ratio for 20-64 Year Olds
3.3
3.1
2.9
2.7
2.5
2.3
2.1
1.9
1.7
1.5
0.3
0.32
0.34
0.36
0.38
0.4
0.42
0.44
Minim umas
Wage
as Percentage ofof
Average
Hourly Earnings
Minimum Wage
Percentage
Average
Hourly Wage
Source: Bureau of Labor Statistics
0.46
0.48
Minority vs. Non-Minority Household Income (1970-2001)
Ratio of Median Household Incomes
(Black/White)
69%
67%
65%
63%
y = -0.33x + 0.73
R2 = 0.15
61%
59%
57%
55%
32%
34%
36%
38%
40%
42%
44%
46%
Minimum Wage as Fraction of Average Hourly Earnings
Source: Bureau of Labor Statistics
48%
Minimum Wage
How to Pay for a Minimum Wage
There are three ways in which a firm can find additional
money to pay workers.
1. Layoff some workers and shift their wages to the
remaining workers.
2. Keep all the workers and pay for the additional wages
out of profits.
3. Keep all the workers and pay for the additional wages
by raising prices.
Comparison of Minimum Wage to CA Inflation (1970-2004)
16%
14%
y = 0.44x - 0.14
R2 = 0.28
p = 0.001
CA Inflation
12%
10%
8%
6%
4%
2%
0%
35%
37%
39%
41%
43%
45%
47%
49%
Real CA Min Wage as % of Real US Avg Hourly Wage
Source: Bureau of Labor Statistics, California Department of Finance
51%
53%
Minimum Wage
But, we have to do something about the
distribution of income.
The rich are getting richer while the poor get
poorer!
% of Households in Each Income Bracket (2006$)
Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2009, Table 668.
% of Households in Each Income Bracket (2006$)
From 1980 to 1990, the number of households with purchasing power of at least $75,000
grew while the number with purchasing power less than $75,000 declined.
Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2009, Table 668.
% of Households in Each Income Bracket (2006$)
From 1990 to 2006, the number of households with purchasing power of at least $75,000
grew while the number with purchasing power less than $75,000 declined.
Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2009, Table 668.
Minimum Wage
1980
The top 20% of households earned 44%
of all income.
2003
The top 20% of households earned 50%
of all income.
Source: Statistical Abstract of the United States, U.S. Bureau of the Census, 2008, Table 675.
Minimum Wage
In which world would each person rather live?
Person 1
Person 2
Person 3
Person 4
Person 5
Person 6
Person 7
Person 8
Person 9
Person 10
Household Income in World #1
$32,000
$33,500
$35,000
$36,500
$38,000
$39,500
$41,000
$42,500
$44,000
$45,500
Household Income in World #2
$40,000
$41,875
$43,750
$45,625
$47,500
$49,375
$51,250
$53,125
$77,000
$79,625
In world #1, Person 10 earns 10% of all income.
In world #2, Person 10 earns 15% of all income.
(prices are the same in the two worlds)
Quotas
At the quota limit,
consumers are
willing to pay this
price for foreign
cars.
U.S. Market for Foreign Cars
$
Foreign car
supply (from
foreign
producers)
S
Free market
equilibrium
price
D
Foreign car
demand (by
American
consumers)
Q
Government imposed
quota on unit sales
Free market
equilibrium quantity
At the price consumers are
willing to pay, foreign
producers want to offer this
many cars, but can’t because
of the quota.
219
Technical Regulations
The federal government
requires all gasoline sold in
major urban areas to contain a
certain quantity of ethanol.
Market for Gasoline
$
S’
S
This regulation
increases the cost
of production for
gasoline, shifting
supply to the left.
Free market
equilibrium
price
The market price of gasoline
rises and the quantity sold
falls.
Ethanol is more expensive to
produce than gasoline
(ironically, the production of 1
gallon of ethanol requires the
burning of 1.2 gallons of
gasoline).
D
Q
Free market
equilibrium quantity
220
Taxes
All taxes can be treated as sales taxes
 A wage tax is a tax on the sales of labor.
 A property tax is a tax that is paid every year on the past sale of a physical asset.
 Interest and dividend taxes are property taxes on financial assets.
 A capital gains tax is a sales tax on a re-sold asset.
The one from whom a tax is collected is not the same as the one who pays the tax
While the law states from whom a tax is collected, the government is powerless to
determine who pays the tax. Who pays the tax is determined by market forces and is
found by comparing the price of the taxed item before and after imposition of the
tax.
The split in the tax between the consumer and producer is called the tax burden.
221
Taxes
When the government imposes a tax, two prices result:
1. The price the consumer pays (the price of the product plus the tax)
2. The price the producer receives (the price the consumer pays less the tax)
For an excise tax, the relationship between the two prices is:
Pc = Pp + Tax per unit
For a sales tax, the relationship between the two prices is:
Pc = Pp (1 + Tax Rate)
222
Taxes
2. The government imposes
a $0.50 per gallon tax.
3. The resulting
consumer price
is $1.90 and the
resulting
producer price is
$1.40
Market for Gasoline
$
1. Prior to the tax, the
equilibrium price is
$1.50 per gallon, and
the equilibrium
S quantity is 380
million gallons per
day.
The steep demand
curve reflects the fact
that consumers
regard gasoline as a
necessity.
$1.90
$1.50
$1.40
$0.50 separation between Pc and Pp
This distance
is $1.50
D
370 m. 380 m.
Gallons/day
This distance
is $0.50
4. The market is in equilibrium
because both Qs and Qd are 370 m.
223
Taxes
Market for Gasoline
Consumers pay $0.40 of the $0.50 tax,
for a total tax payment of
($0.40)(370 m.) = $148 million per day
$
S
$1.90
$1.50
$1.40
Producers pay $0.10 of the $0.50 tax,
for a total tax payment of
($0.10)(370 m.) = $37 million per day
D
370 m.
Gallons/day
224
Taxes
2. The government imposes
a $5,000 per car tax.
Market for Luxury Cars
3. The resulting
$
consumer price
is $40,500 and
the resulting
producer price is
$35,500
$40,500
$40,000
1. Prior to the tax, the
equilibrium price is
$40,000 per car, and
the equilibrium
S quantity is 100,000
cars per year.
D
The flat demand
curve reflects the fact
that consumers
regard these cars as
luxuries
$35,500
$5,000 separation between Pc and Pp
This distance
is $40,000
70,000 100,000
Cars/year
This distance
is $5,000
4. The market is in equilibrium
because both Qs and Qd are 70,000.
225
Taxes
Market for Luxury Cars
Consumers pay $500 of the $5,000 tax,
for a total tax payment of
($500)(70,000) = $35 million per year
$
S
$40,500
$40,000
D
$35,500
Producers pay $4,500 of the $5,000 tax,
for a total tax payment of
($4,500)(70,000) = $315 million per year
70,000
Cars/year
226
Taxes
Conclusion:
From whom the tax is collected is irrelevant. What is important is who pays the tax.
The law can only specify from whom the tax is collected. Market forces determine
who pays the tax.
Example:
Social Security wage tax. The law specifies that the employer “pays” half of the tax
(7.5%) and that the worker “pays” the other half (7.5%). In fact, the law is stating
from whom the tax is collected. Who really bears the burden of the tax depends on
the elasticities of labor demand and labor supply.
Data indicate that the supply of labor tends to be inelastic (i.e. as wages fall a given
percentage, a proportionally smaller percentage of people drop out of the
workforce), and that the demand for labor tends to be more elastic the less skilled is
the labor (i.e. the less skilled the labor is, the more the firm regards the labor as a
luxury).
227
Taxes
Market for Higher Skilled Labor
Market for Lower Skilled Labor
$
$
S
S
D
D
Worker-hours/year
Worker-hours/year
Portion of Social Security wage
tax paid by the employer
Portion of Social Security wage
tax paid by the employee
228
Quantitative Analysis of a Price Control
You have analyzed industry data for the market for gasoline and estimated the
following demand and supply functions (where Q is millions of gallons per day).
Demand: Pˆ  1187.08   3.12  Qˆd
Supply: Pˆ  302.52   0.80  Qˆs
1. Find the estimated free market price and equilibrium quantity of gasoline.
P = $1.48 per gallon, Q = 380 million gallons
2. The government is debating imposing a $1.25 per gallon price ceiling on gasoline.
Estimate the impact of the price ceiling on the market.
1187.08  1.25
1.25  1187.08   3.12  Qˆd  Qˆd 
 380.07
3.12
302.52  1.25
1.25  302.52   0.80  Qˆs  Qˆs 
 379.71
0.80
Shortage of 360,000
gallons per day.
229
Quantitative Analysis of a Tax
3. An alternate proposal calls for the imposition of a $0.40 per gallon tax on
gasoline. Estimate the impact of the tax on the market and also estimate the
burden of the tax on consumers and on producers.
Two conditions for equilibrium
Qd  Q s
Pc  Pp  Tax per gallon
1187.08  Pc
Pc  1187.08   3.12  Qˆd  Qˆd 
Pp  302.52   0.80  Qˆs  Qˆs 
3.12
302.52  Pp
0.80
1187.08  Pc 302.52  Pp

 Pc  7.25  3.9Pp
3.12
0.80
Pc  Pp  Tax per gallon  7.25  3.9Pp  Pp  0.40
Qˆd  Qˆs 
 Pp  $1.40, Pc  $1.80, Q  379.90
Consumers pay $1.80 – $1.48 = $0.32 of the tax.
Producers pay $1.48 – $1.40 = $0.08 of the tax.
230
Quantitative Analysis of a Subsidy
You have analyzed industry data for the market for higher education and estimated
the following demand and supply functions (where Q is full-time equivalent students
per semester in millions, and P is tuition, fees, room and board).
Demand: Pˆ  32796.8  1781 Qˆd
Supply: Pˆ  2595.2   984  Qˆs
1. Find the estimated free market price and equilibrium quantity.
P = $10,000 per semester, Q = 12.8 million FTE students
2. To ease the burden of tuition, the government is debating providing grants to all
full-time students equal to 10% of their semester tuition. State the two conditions
required for equilibrium.
Two conditions for equilibrium
Qd  Q s
Pc  Pp 1  Tax Rate   Pc  0.9Pp
231
Quantitative Analysis of a Subsidy
3. Estimate the impact of the subsidy on the market and also estimate the share of
the subsidy for consumers and for producers.
Two conditions for equilibrium
Qd  Q s
Pc 1  Tax Rate   Pp 
0.9  Pc
 Pp
32796.8  Pc
Pc  32796.8  1781 Qˆd  Qˆd 
Pp  2595.2   984  Qˆs  Qˆs 
1781
2595.2  Pp
984
32796.8  Pc 2595.2  Pp

 Pp  15525  0.55Pc
1781
984
 Pc   0.9 15525  0.55Pc 
Qˆd  Qˆs 
Pc  0.9Pp
 Pc  $9,332, Pp  $10,369, Q  13.175
Students receive $10,000 – $9,332 = $668 of the subsidy.
Colleges absorb $10,369 – $10,000 = $369 of the subsidy.
232
Macroeconomics
Macroeconomic analysis looks at economic phenomena that impact broad sectors of
the economy.
Microeconomics focuses on individual firms, consumers, and industries, and analyzes
the markets for particular products.
Macroeconomics treats all consumers as a single group, all producers as a single
group, and analyzes production in general.
233
In the following slides, you will be asked a series of questions.
Answer honestly – only your opinion matters.
You will not be asked to share your results.
Answer by writing the number corresponding to your answer.
Military service should be voluntary – no draft.
=1
Yes = 2 Maybe
No = 0
Government should not control radio, TV, the press,
or the Internet.
0
Yes = 2Maybe = 1 No =
Repeal regulations on sex by consenting adults.
0
Yes = 2Maybe = 1 No =
Drug laws do more harm than good. Repeal them.
0
Yes = 2Maybe = 1 No =
Let peaceful people cross borders freely.
0
Yes = 2Maybe = 1 No =
Businesses and farms should operate without government subsidies.
0
Yes = 2Maybe = 1 No =
People are better off with free trade than with tariffs.
0
Yes = 2Maybe = 1 No =
Minimum wage laws cause unemployment. Repeal them.
0
Yes = 2Maybe = 1 No =
End taxes. Pay for services with user fees.
0
Yes = 2Maybe = 1 No =
All foreign aid should be privately funded.
0
Yes = 2Maybe = 1 No =
What are “Liberalism” and “Conservatism”?
Team up with the person next to you. Between the two of you, come up with
a definition for “liberalism” and a definition for “conservatism.”
Each definition should be no more than one or two sentences.
Formal Definitions: “Liberalism” and “Conservatism”
Webster’s Collegiate Dictionary
Liberalism is “a political philosophy based on belief in…the essential goodness
of the human race, and on the autonomy of the individual, and (stands) for
the protection of political and civil liberties.”
Conservatism is “a political philosophy based on tradition and social stability,
stressing established institutions, and preferring gradual development to
abrupt change.”
Contradictions
Webster’s Collegiate Dictionary
Liberalism is “a political philosophy based on belief in…the essential goodness
of the human race, and on the autonomy of the individual, and (stands) for
the protection of political and civil liberties.”
Representative Ted Weiss (D, NY)
“Liberals believe (that) government has an obligation to provide equal
educational and job opportunities for all. To those whose survival requires
economic assistance, government should extend a helping hand. Individual
liberties and human rights must be safeguarded from and by government.”
Contradictions
Webster’s Collegiate Dictionary
Conservatism is “a political philosophy based tradition and social stability,
stressing established institutions, and preferring gradual development to
abrupt change.”
Senator John Tower (R, TX)
“Conservatives have more faith in people than in government institutions, and
would keep government out of issues that can be handled in the private
sector.”
What Issues are “Liberal” versus “Conservative”?
Mandatory
Prohibit
Universal
Minimum
Reduced
Prayer
Gay
Prayer
Free
Drug
Marriage
Health
Trade
inWar
in
Taxes
Wage
Public
Public
Care
School
School
“Conservative”
“Liberal”
What Issues are “Liberal” versus “Conservative”?
Free Trade
Prohibit Prayer in Public School
Drug War
Gay Marriage
Mandatory Prayer in Public School
Minimum Wage
Reduced Taxes
“Conservative”
Universal Health Care
“Liberal”
Rather than thinking in terms of “liberal” and
“conservative”, think in terms of “more individual
freedom” vs. “less individual freedom”.
Less Individual Freedom vs. More Individual Freedom
Two
spheres
which ahumans
Choice
to inmarry
goat =exercise
socialfreedoms:
choice
Social
sphere
where goods
they choose
how to Prayer
behave
Prohibit
in Public School
Free
Tradeto
Choice
buy 
foreign
= economic
choice
Economic sphere  where they enter into contracts with others
Drug WarChoice
to do drugs = social choice
Gay Marriage
Choice
to buyare
drugs
= economic
choice
The
two spheres
not necessarily
independent.
Mandatory Prayer in Public School
Reduced Taxes
Less Freedom
Minimum Wage
Universal Health Care
More Freedom
The terms “liberal” and “conservative” are ambiguous.
Better terms are:
Making
Control vs.
Freedom
Centralized Decision Making
Power from Above
vs.
Slavery vs.
Liberty
vs.
Decentralized Decision
Power from Below
Less Individual Freedom vs. More Individual Freedom
More Economic Freedom
Less Social Freedom
More Social Freedom
Drug War
Free Trade
Minimum Wage
Gay Marriage
Universal Health Care
Reduced Taxes
Prohibit Prayer in Public School
Mandatory Prayer in Public School
Less Economic Freedom
Who is “Liberal” and Who is “Conservative”?
“Conservative”
“Liberal”
Who is “Liberal” and Who is “Conservative”?
Economically “Conservative”
Socially “Liberal”
Socially “Conservative”
Economically “Liberal”
Economic“Conservative”
Freedom
Economically
Personal
Socially Freedom
“Liberal”
Socially “Conservative”
Economically “Liberal”
Economic Freedom
10
Classical Liberal
“Republican”
Centrist
5
Authoritarian
0
0
“Democrat”
5
10
Personal Freedom
What kind of society do we want to live in?
Take a few minutes to list what you want from a well-functioning
social order.
Keep the list abstract.
“Prosperity” not “adequate per-capita income”
What is more important?
Copy the list and identify the four items of highest priority (in your opinion).
Write a #1 next to the highest priority item, #2 next to the second highest
priority item, etc.
Does the importance change?
You have identified the four most important goals/features of a society.
Will these goals/features always be the most important?
Consider: Crime vs. Car Pollution
Indicate the four most important goals/features of a society when considering
each of these two problems.
Indicate the four least important goals/features of a society when considering
each of these two problems.
Consensus
Divide into groups.
Discuss your rankings and come to a consensus.
Note main areas of agreement and disagreement.
Market Systems
Market systems are categorized according to the degree of separation between the
ones who make decisions and the ones who must endure the consequences of the
decisions.
Capitalism
Market socialism
Planned socialism
Free markets
Command markets
Less separation
between decisions
and consequences
Greater separation
between decisions
and consequences
Communism
262
Market Systems
Capitalism
No government intervention. No transactions are illegal. Not anarchy – government
is necessary to protect property rights. Individuals are motivated to maximize profit.
Called “capitalism” because individuals, not government, own the means of
production (i.e. capital – buildings, land, machinery).
Market Socialism
Significant government intervention. Some transactions are illegal. Output levels and
prices are determined by market forces of demand and supply. Individuals are
motivated to maximize profit. Government owns means of production, but people
own all other property. Government seizes profits for use for “good of society.”
Planned Socialism
Significant government intervention. Many transactions are illegal. Output levels and
prices are set by the government. Individuals are motivated to hit production
targets. Government owns means of production and virtually all other property.
Government directs production and spending for “good of society.”
263
Market Systems
Communism
Total government intervention. Transactions do not exist. Money does not exist.
Government owns everything. No personal property. People work for “free” and
receive what they need for “free” from the government.
What we call “communism” in the common usage of the word is really economic
planned socialism mixed with political totalitarianism. Communism in the economic
sense is more akin to the common usage of the word “commune.”
264
Political Systems
Political systems can also be categorized according to the degree of separation
between the ones who make decisions and the ones who must endure the
consequences of the decisions.
Anarchy
Democracy
Republic
Political Freedom
Political Oppression
Less separation
between decisions
and consequences
Greater separation
between decisions
and consequences
Dictatorship
265
Political Systems
The choice of political system hinges on whether one believes that
1.
Government derives its power from the people, or
2.
People are granted power by the government.
For example, one can argue tax policy from one of two starting points. Either:
1.
Income belongs to the people and the government confiscates part of that
income (in the form of taxes) to be used for the public good, or
2.
Income belongs to the government and the government allows people to keep
part of that income (in the form of tax relief) to be used for their own purposes.
For example, one can argue patents from one of two starting points. Either:
1.
Intellectual property belongs to the inventor and the government protects the
inventor’s IP through the use of patents, or
2.
Intellectual property belongs to the government and the government allows the
inventor to earn a profit off of the IP through the use of patents.
266
Political Systems
Political Classifications According to the Origin and Application of the Power of
Decision Making
When making social decisions, power derives
from…
When making economic
decisions, power derives
from…
the Individual
the Government
the Individual
Libertarianism
(“Classical Liberalism”)
“Conservatism”
the Government
“Liberalism”
Populism
267
Political Systems
A vote in the political arena is the equivalent of a purchase in the economic arena.
Political vote
1 person = 1 vote
Vote does not reflect the intensity of the voter’s desire
There is no opportunity cost to the vote  vote is not a “real” measure
There is one winner  up to 50% of the voters are left with a decision they did not
want
Economic vote
1 person = multiple votes (depending on person’s abilities)
Vote reflects the intensity of the voter’s desire
There is an opportunity cost to the vote  vote is a “real” measure
There are multiple winners  potentially every voter is left with a decision he wants
268
Market Systems
Index of Economic Freedom (2005 Scores)
Free market system
Command market system
1.0
5.0
Hong Kong (1.4)
Singapore (1.6)
Italy (2.3)
Spain (2.3)
United Kingdom (1.8)
United States (1.9)
Canada (1.9)
Sweden (1.9)
China (3.5)
India (3.5)
Russia (3.6)
Poland (2.5)
Japan (2.5)
France (2.6)
Germany (2.0)
Iran (4.2)
North Korea (5.0)
Saudi Arabia (3.0)
Mexico (2.9)
269
Market Systems
270
Market Systems
$45,000
Per-Capita Income (US$, PPP Equivalent)
Luxembourg
$40,000
$35,000
U.S.
$30,000
$25,000
$20,000
$15,000
$10,000
$5,000
$0
1
2
3
4
5
Index of Economic Freedom (1=Free, 5=Repressed)
271
Market Systems
Income vs. Equity
Historically, individuals have tended to “rate” economic systems according to their
subjective assessments of both income and equity.
Formally, income is measured as “income per capita,” or “GDP per capita,” and
equity is measured via the Gini coefficient.
Gini coefficient
Scale is 0 to 100.
0 indicates perfect equality  All people earn same income.
100 indicates perfect inequality  One person earns all the income, everyone else
earns nothing.
Gini coefficient ignores income level and looks only at income distribution.
272
Market Systems
$45,000
Per-Capita Income (US$, PPP Equivalent)
Luxembourg
$40,000
$35,000
U.S.
$30,000
$25,000
Finland
$20,000
$15,000
South Africa
Cyprus
$10,000
Brazil
$5,000
$0
10.0
20.0
30.0
40.0
50.0
60.0
70.0
Gini Coefficient (0=Equitable, 1=Inequitable)
273
Production Possibilities Frontier
Because an economy has limited resources (land, energy, labor, technology, raw
materials), the amount of output the economy can produce is limited.
Further, because of economies and diseconomies of scale, the tradeoffs between
production of different types of products is limited.
We represent these limits on production by the production possibilities frontier. The
PPF shows all combinations of products an economy is capable of producing.
The PPF does not represent desires only possibilities.
274
Production Possibilities Frontier
Non-durables
Consider an economy that produces two types of goods: durables and non-durables
Economy has enough resources
to produce any combination of
products along the PPF line.
Combinations of
products outside the
PPF are unattainable.
Combinations of
products within the PPF
represent
unemployment.
Durables
275
Production Possibilities Frontier
Non-durables
PPF is non-linear due to specialization and congestion.
4. The economy was producing so few non-durables that there
were many opportunities for specialization in the non-durables
industry  moving resources into non-durables production
caused a relatively large increase in non-durables output.
3. The economy was producing so many
durables that there was a lot of congestion in
the durables industry  moving resources
out of durables production caused a relatively
small decline in durables output.
2. If the economy reduces production of
durables, the freed-up resources can
be employed in the production of nondurables.
Durables
1. Suppose the economy is producing this
combination of durables and non-durables. 276
Production Possibilities Frontier
Non-durables
Technological and resource changes move the PPF.
Over time, improvements in technology and the
discovery/creation of new resources causes the
PPF to shift out.
The economy can now produce combinations of
products that were previously unattainable.
Levels of productivity that used to represent full
employment now represent unemployment.
Durables
277
Measures of Productivity: GDP and GNP
The two major measures of productivity are GDP and GNP.
Gross Domestic Product (GDP)
The value of all final goods and services produced by firms within a country in a
given year.
Gross National Product (GNP)
The value of all final goods and services produced by a country’s firms in a given
year.
Residence of Firm
Nationality of Firm
Domestic
Foreign
Domestic
Domestic GDP
Domestic GDP
Foreign GNP
Foreign
Domestic GNP
Foreign GDP
Foreign GDP
278
Measures of Productivity: GDP and GNP
279
Measures of Productivity: GDP and GNP
280
Measures of Productivity: GDP and GNP
281
Measures of Productivity: GDP and GNP
282
Luxembourg
Connecticut
Wyoming
New York
Alaska
Minnesota
Illinois
Rhode Island
Hawaii
North Dakota
Texas
Nebraska
Wisconsin
Iowa
Louisiana
Australia
United Kingdom
Missouri
Tennessee
Belgium
France
Idaho
South Carolina
West Virginia
Mississippi
South Korea
New Zealand
Saudi Arabia
Seychelles
Hungary
Poland
Russia
Mexico
Malaysia
Turkey
Uruguay
Belarus
Lebanon
Costa Rica
South Africa
Saint Vincent and the Grenadines
Dominica
Bosnia and Herzegovina
Ecuador
Jamaica
Ukraine
Turkmenistan
China
Egypt
Georgia
Paraguay
Syria
Bolivia
Honduras
Mongolia
India
Vietnam
Pakistan
Kiribati
Papua New Guinea
Djibouti
Tajikistan
São Tomé and Príncipe
Lesotho
Ghana
Bangladesh
Haiti
Burkina Faso
Madagascar
Mozambique
Timor-Leste
Niger
Liberia
Measures of Productivity: GDP and GNP
$80,000
$70,000
$60,000
$50,000
$40,000
$30,000
$20,000
$10,000
$0
283
Dominican Republic
Congo
Chad
Venezuela
Mozambique
Turkey
Iran
Uzbekistan
Zambia
Tajikistan
Equatorial Guinea
Malawi
Turkmenistan
Ghana
Afghanistan
400%
Belarus
Haiti
Burma
Angola
Zimbabwe
Measures of Productivity: GDP and GNP
GDP Growth Rate (2003 to 2004)
350%
300%
250%
200%
150%
100%
50%
0%
284
Russia
San Marino
India
Botswana
Bhutan
Argentina
Ukraine
Qatar
Kazakhstan
China
Tajikistan
Azerbaijan
Armenia
Faroe Islands
Liechtenstein
Man, Isle of
Chad
Equatorial Guinea
Turkmenistan
Afghanistan
Measures of Productivity: GDP and GNP
30%
RGDP Growth Rate (2003 to 2004)
25%
20%
15%
10%
5%
0%
285
Measures of Productivity: GDP and GNP
2008 Figures
GDP (trillions, US$,
PPP)
Per-Capita GDP Growth RGDP
Inflation
Public Debt Share
Unemployment
of GDP
World
$69.60
$10,400
3.1%
1% to 20%
30.0%
United States
$14.26
$46,900
1.1%
3.8%
61%
7.2%
China
$7.97
$6,000
9.0%
5.9%
16%
4.0%
Japan
$4.33
$34,000
-0.7%
1.4%
173%
4.0%
Germany
$3.67
$35,400
1.0%
2.7%
64%
7.8%
United Kingdom
$2.26
$36,500
0.7%
3.6%
52%
5.6%
France
$2.13
$33,200
0.3%
2.8%
68%
7.4%
Canada
$1.30
$39,100
0.4%
2.4%
64%
6.2%
Mexico
$1.56
$14,200
1.3%
5.1%
19%
4.0%
286
Measures of Productivity: GDP and GNP
Final Goods and Services
By measuring the value of final goods and services, we automatically include the
values of the intermediate goods and services.
Economic Costs of Processes
Extract Iron Ore  Smelt Steel  Stamp Parts  Assemble Refrigerator
$175
$225
$125
$200
Sale Prices
Iron Ore  Smelted Steel 
$175
$175 + $225
Stamped parts
$175 + $225 + $125

Refrigerator
$175 + $225 + $125 + $200
The price of the refrigerator includes the values of all the intermediate goods that
went into the production of the refrigerator.
287
Circular Flow of Income and Spending
Labor market
Wages and Salaries
Labor
Savings
Households
Financial markets
Financial
Institutions
Safe return
Lending
Risky return
Financial
intermediation
Firms
Financial
disintermediation
Savings
Risky return
Products
Payments for Products
Goods market
Foreign
Markets
288
Circular Flow of Income and Spending
The circular flow model implies that there are two methods for accounting for all
economic activity within a country.
1. Add up all the spending on final goods and services (the expenditures approach).
2. Add up all the income earned (the income approach).
289
Expenditure Approach to GDP
GDP = C + I + G + X – M
C = Personal Consumption Expenditures
= Consumption of Durable Goods
+ Consumption of Non-durable Goods
+ Consumption of Services
I = Gross Private Domestic Investment
= Non-Residential Fixed Investment
+ Residential Fixed Investment
+ Changes in Private Inventories
290
Expenditure Approach to GDP
GDP = C + I + G + X – M
G = Government Consumption and Investment
= Federal Government Spending on Defense
+ Federal Government Spending on Non-defense
+ State and Local Government Spending
X = Exports
= Exports of Goods
+ Exports of Services
M = Imports
= Imports of Goods
+ Imports of Services
291
Expenditure Approach to GDP
Trillions
Expenditures Components of GDP (2004)
$10.0
$8.0
$6.0
$4.0
$2.0
$0.0
C
I
G
X
M
-$2.0
-$4.0
292
$0.0
M (services)
M (goods)
X (services)
X (goods)
G (state & local)
G (non-defense)
G (defense)
I (Δ inventories)
I (residential)
I (non-residential)
C (services)
C (non-durables)
C (durables)
Trillions
Expenditure Approach to GDP
Expenditures Components of GDP (2004)
$6.0
$5.0
$4.0
$3.0
$2.0
$1.0
293
Expenditure Approach to GDP
Expenditure Components of GDP (2004)
NX (services)
NX (goods)
(negative)
C (durables)
G (state & local)
G (non-defense)
C (non-durables)
G (defense)
I (Δ inventories)
I (residential)
I (non-residential)
C (services)
294
Economic Activity vs. Transactional Activity
The intent of GDP is to measure economic activity. Economic activity is not the same
as transactional activity.
Transactional activity includes all activity in which dollars change hands.
Economic activity includes only those activities in which production takes place.
Economists are concerned with economic activity because it is the production of new
goods and services, not the transfer of existing goods and services that benefits
people.
Note: You might argue that “moving a car from a seller’s home in Maine to the buyer’s
home in Florida” represents economic value. It is the physical moving that has value,
not the transfer of ownership.
295
Transactions Excluded from GDP
With the intent of measuring production, not transactions, certain transactions are
excluded from GDP calculations.
Things not included in GDP
1. Spending in the current year on products produced in prior years.
Example:
Buy a new book on Amazon that was printed this year.
 This transaction counts as GDP (Consumption) because the book was produced
in the current year.
Buy a new book on Amazon that was printed last year.
 This transaction does not count as GDP because the book was counted last year
when it was produced (as Changes in Inventory)
Buy a used book on Amazon that was printed last year.
 This transaction does not count as GDP because the book was counted last year
(as Consumption) when the original owner purchased it.
296
Transactions Excluded from GDP
Things not included in GDP
2. Spending on “used” products that are re-sold.
Example:
Buy a new book on Amazon that was printed this year.
 This transaction counts as GDP (Consumption) because the book was produced
in the current year.
Buy a used book on Amazon that was printed this year.
 This transaction does not count as GDP because the book was counted earlier in
the year (as Consumption) when the original owner purchased it.
297
Transactions Excluded from GDP
Things not included in GDP
3. Spending on intermediate products.
Example:
Buy new tires from a car dealer that were produced this year.
 The value of the tires counts as GDP (Consumption) because the tires were
produced in the current year.
Car dealer buys new tires that were produced this year, puts them on a car and
offers the car for sale.
 The value of the tires on the car does not count as GDP because the value will
be counted, as part of the value of the car, when the car is sold.
298
Transactions Excluded from GDP
Things not included in GDP
4. Spending on financial assets.
Example:
Buy a share of stock.
 The stock is neither a good nor a service, but a financial asset; the purchase of
the stock is the transformation of a safe, liquid asset that yields no return (cash)
into a risky, less liquid asset that yields an expected return (stock).
299
Transactions Excluded from GDP
Things not included in GDP
5. Full value of government services.
Example:
Government provides interstate road system.
 The cost of building and maintaining the system is included in GDP, but, because
drivers are not charged to use the roads, the value of the road system (which is
likely more than the cost) is not included in GDP.
 If the road system were private and drivers paid a market-determined price to
use the roads, then the full value of the roads would be included in GDP.
 Note: If drivers were charged to use the road system, they would have less
money to spend on other things, so much of the “increase” in GDP due to proper
accounting of roads would be offset due to decreased consumption of other goods
and services.
300
Invisible Transactions That Should Be Included in GDP
Some transactions represent economic activity and should be included in GDP but are
not because the transactions are “invisible.”
Things not included in GDP that should be included
1. “Under-the-table” spending on labor.
Example:
Hire a babysitter.
 This transaction should count as GDP (Consumption) because babysitting is a
service. But, because the babysitter does not declare the money as income and
because the parents do not claim the money as a child-care tax deduction, the
government has no way of knowing the transaction occurred.
301
Invisible Transactions That Should Be Included in GDP
Things not included in GDP that should be included
2. Spending on illegal goods and services.
Example:
Buy illegal drugs.
 This transaction should count as GDP (Consumption) because the drugs were
produced in the current year. But, because neither the dealer nor the buyer want
the government to know the transaction occurred, the transaction is not counted as
part of GDP.
302
Invisible Transactions That Should Be Included in GDP
Things not included in GDP that should be included
3. Home labor.
Example:
Mow your lawn.
 There is no transaction associated with this activity because you do not pay
yourself to mow your lawn. However, the mowing of the lawn is the production of a
service. That service should be included in GDP but isn’t because there is no
transaction and hence no record of a transaction.
303
Invisible Transactions That Should Be Included in GDP
Things not included in GDP that should be included
4. Barter.
Example:
Trade lawn mowing for babysitting.
 There is no transaction associated with this activity because you agree to trade
services with your neighbor. However, the mowing of the lawn and the babysitting
are the productions of services. Those services should be included in GDP but
aren’t because there is no transaction and hence no record of a transaction.
304
Income Approach to GDP
Employee
compensation
Corporate
profits
Personal Income
Rental
income
Interest income less
interest expense
Proprietors
income
Indirect taxes (sales, excise, business
property taxes) and transfers less subsidies
National Income
Statistical discrepancy
Net National Product
Depreciation
(“capital consumption”)
Gross National Product
Income to foreigners in the US less
income to Americans abroad
Gross Domestic Product
305
Income Approach to GDP
Income Components of GDP (2004)
Net Income from
Abroad
Capital
Consumption
Statistical
Discrepancy
Indirect Taxes
Net Interest
Income
Proprietors
Income
Employee
Compensation
Rental Income
Corporate Profits
306
National vs. Domestic Measures
Net Domestic Income at
Factor Cost
National Income
Net National Product
Gross National Product
+ Income to foreigners
in the US
– Income to Americans
abroad
Net Domestic Product
Gross Domestic Product
307
Nominal vs. Real Measures
A dollar measure is relevant only to the extent that the person reading the measure
understands the implied value of the dollar.
Example
In 2006, one gallon of gasoline cost (on average) $2.59, while in 1967, one gallon of
gasoline cost $0.26.
These two figures imply that the cost of gasoline has risen 896% over 40 years.
However, in 2006, per-capita disposable income (income after taxes) was $31,240,
while in 1967, per-capita disposable income was $2,895.
These two figures imply per-capita disposable income rose 979% over 40 years.
Comparing gasoline to income, we see that the price of gasoline has risen less than
per-capita income.
Conclusion: Relative to our incomes, gasoline is cheaper now than it was 40 years ago.
308
Purchasing Power
Stripping away what economists call, “money illusion,” we see that what
ultimately matters to people is how hard they have to work to obtain goods.
The following slides show the number of minutes the average American had to
work to afford various goods from the 1920’s to the present.
Note that there are many goods that cannot be represented because the goods
did not exist in the past. For example, in 1950 it would have taken an infinite
amount of time to earn enough money to buy a DVD player because DVD
players did not exist.
Source: Working for Sears Goods, Donald Boudreaux
(cafehayek.typepad.com/hayek/2006/01/working_for_sea.html)
Purchasing Power
Milk (1 gallon)
Minutes of Work to Afford
80
70
60
50
40
30
20
10
0
1920 - 1930
1950
1980
1997
Purchasing Power
Gas (1 gallon)
Minutes of Work to Afford
35
30
25
20
15
10
5
0
1920 - 1930
1950
1980
1997
Purchasing Power
Electricity (1 kWh)
Minutes of Work to Afford
900
800
700
600
500
400
300
200
100
0
1920 - 1930
1950
1980
1997
Purchasing Power
Air Travel (100 miles)
Minutes of Work to Afford
900
800
700
600
500
400
300
200
100
0
1920 - 1930
1950
1980
1997
Purchasing Power
Levis Jeans (1 pair)
Minutes of Work to Afford
700
600
500
400
300
200
100
0
1920 - 1930
1950
1980
1997
Purchasing Power
The following slides show prices taken from the Sears catalogues for 1975 and
2006. The goods are selected so as to have the same (or very similar) qualities
across the two years.
Source: Working for Sears Goods, Donald Boudreaux
(cafehayek.typepad.com/hayek/2006/01/working_for_sea.html)
Purchasing Power
Freezer
Minutes of Work to Afford
5000
4500
4000
3500
3000
2500
2000
1500
1000
500
0
1975
2006
Purchasing Power
Garage Door Opener
Minutes of Work to Afford
1400
1200
1000
800
600
400
200
0
1975
2006
Purchasing Power
Car Tire
Minutes of Work to Afford
600
500
400
300
200
100
0
1975
2006
Purchasing Power
Lawn Mower
Minutes of Work to Afford
900
800
700
600
500
400
300
200
100
0
1975
2006
Purchasing Power
Table Saw
Minutes of Work to Afford
3500
3000
2500
2000
1500
1000
500
0
1975
2006
Purchasing Power
Garbage Disposal
Minutes of Work to Afford
1400
1200
1000
800
600
400
200
0
1975
2006
Purchasing Power
Interior Latex Paint (1 gallon)
Minutes of Work to Afford
160
140
120
100
80
60
40
20
0
1975
2006
Nominal vs. Real Measures
A nominal dollar measure (or “current dollar measure”) is the actual dollar measure
that was taken at a point in time – e.g. the average price of gas in 1967 was $0.26 per
gallon in 1967 dollars.
A real dollar measure (or “constant dollar measure”) is the dollar measure taken at a
point in time and then adjusted for the overall rate of inflation that has occurred since
that point in time – e.g. the average price of gas in 1967 was $2.80 in 2006 dollars.
To compare dollar measures from two different points in time, we first must convert
the dollar measures to the same base year. The conversion is achieved using price
indices.
323
Price Indices
Major types of price indices
CPI (consumer price index)
Measures prices of things consumers typically buy
PPI (producer price index)
Measures prices of things producers typically buy
IPD (implicit price deflator)
Measures prices of all things produced in the economy
Some variations on the price indices
CPI-U
CPI for all urban consumers
CPI-W
CPI for urban wage earners and clerical workers
C-CPI
Chain weighted CPI
324
Price Indices
Using Economy.com’s database, find the following consumer price indices for 1974 and
2004.
CPI-U (all items)
1974: 49.32
2004: 188.89
CPI-U (energy)
1974: 38.04
2004: 151.33
CPI-U (medical care)
1974: 42.37
2004: 310.14
CPI-U (transportation)
1974: 45.76
2004: 163.06
On average, the prices of all items purchased by urban consumers in 2004 was
188.89% of the prices in the base year.
On average, the prices of all items purchased by urban consumers in 1974 was
49.32% of the prices in the base year.
325
Price Indices
Calculation of a (Simple) Price Index
1.
Establish a representative basket of goods and services for the base year.
2.
Find the average prices of the goods/services during the base year, and the average prices
of the goods/services during the current year.
3.
Calculate the total cost of the base-year basket using the base year’s prices and the
current year’s prices.
4.
The (simple) price index is the ratio of the current year’s total cost to the base year’s total
cost (multiplied by 100).
326
Price Indices
Example
Let 2000 be the base year. In 2000, the average consumer purchased the following
quantities of goods/services.
Beer
Car
House
2000
30 units
0.1 units
0.02 units
The average prices of these goods over three years were:
Beer
Car
House
2000
$20
$28,000
$100,000
2001
$21
$30,000
$98,000
2002
$20
$31,000
$102,000
327
Price Indices
Example
Multiplying the quantities of goods in the basket by the prices in each year gives the
cost of the base year’s basket in each year.
2000
$5,400 = (30 units)($20) + (0.1 units)($28,000) + (0.02 units)($100,000)
2001
$5,590 = (30 units)($21) + (0.1 units)($30,000) + (0.02 units)($98,000)
2002
$5,740 = (30 units)($20) + (0.1 units)($31,000) + (0.02 units)($102,000)
Basket
2000
2000
$5,400
Prices
2001
$5,590
2002
$5,740
328
Price Indices
Example
The price index for a year is the total cost of the basket in that year divided by the
total cost of the basket in the base year multiplied by 100.
 Basket Cost X 
Price Index for Year X using Year Y as the Base Year  
 100 
Basket
Cost

Y 
Basket
2000
2000
$5,400
Prices
2001
$5,590
2002
$5,740
 Basket Cost 2002 
 $5,740 
100





 $5,400  100   106.3
Basket
Cost


2000 

 Basket Cost 2001 
 $5,590 
100

 
100   103.5



 $5,400 
 Basket Cost 2000 
329
Chain Weighted Price Indices
Calculation of a Chain-Weighted Price Index
1.
Establish a representative basket of goods and services for the base year, and a
representative basket of goods and services for the current year.
2.
Find the average prices of the goods/services during the base year, and the average prices
of the goods/services during the current year.
3.
Calculate the total cost of the base-year basket and the current-year basket using the base
year’s prices.
4.
The first simple price index is the ratio of the current year’s total cost to the base year’s
total cost.
5.
Calculate the total cost of the base-year basket and the current-year basket using the
current year’s prices.
6.
The second simple price index is the ratio of the current year’s total cost to the base year’s
total cost.
7.
The chain-weighted price index is the geometric mean of the two simple price indices
(multiplied by 100).
330
Chain Weighted Price Indices
Chain weighted price indices are an attempt to correct the inflation biases
Over three years, the average consumer purchased the following quantities of
goods/services.
Beer
Car
House
2000
30 units
0.10 units
0.02 units
2001
28 units
0.09 units
0.03 units
2002
33 units
0.08 units
0.01 units
The average prices of these goods over three years were:
Beer
Car
House
2000
$20
$28,000
$100,000
2001
$21
$30,000
$98,000
2002
$20
$31,000
$102,000
331
Chain Weighted Price Indices
Let 2000 be the base year
2001 Index Calculations
2002 Index Calculations
Prices
2000
2001
2000
$5,400
$5,590
2001
$6,080
$6,228
Basket
Basket
Prices
2000
2002
2000
$5,400
$5,740
2002
$3,900
$4,160
$6,080
 1.126
$5,400
$3,900
 0.722
$5,400
$6,228
 1.114
$5,590
C-CPI2001 

1.1261.114  100  112.0
$4,160
 0.725
$5,740
C-CPI2002 

0.9360.934  100  72.3
332
Inflation
Price indices are expressed in terms of a base year. The index for the base year is
defined as 100. Indices for other years give prices relative to the base year.
Example
Suppose 2002 is the base year and the CPI for 2003 is 102.5. This means that, on
average, prices in 2003 were 102.5 / 100 = 102.5% times the prices in 2002.
Inflation is calculated as the growth rate in a price index
Total inflation from year X to year Y  ln Price IndexY   ln Price Index X 
Effective annual inflation from year X to year Y 
ln Price IndexY   ln Price Index X 
YX
333
Inflation
Using the price indices, calculate the following effective annual inflation rates from
1974 to 2004.
CPI-U (all items)
CPI-U (energy)
CPI-U (medical care)
CPI-U (transportation)
ln 188.89   ln  49.32 
2004  1974
ln 151.33   ln  38.04 
2004  1974
ln  310.14   ln  42.37 
2004  1974
ln 163.06   ln  45.76 
2004  1974
 4.5%
 4.6%
 6.6%
 4.2%
334
Inflation
There does not appear to be much difference between a 4.2% inflation rate (for
transportation) and a 4.5% inflation rate (for all items). However, compounded over 30
years, the 0.3% difference can become significant.
Using the price indices, calculate the following total inflation rates for all items and for
transportation alone.
CPI-U (all items)
ln 188.89  ln  49.32  134%
CPI-U (transportation)
ln 163.06  ln  45.76  127%
Total inflation for all items is 7% more than for transportation alone.
335
Inflation
On which price index the inflation measure is based alters the definition of inflation.
Example
Inflation calculated from the CPI-U is called “consumer inflation.”
Inflation calculated from the PPI is called “producer inflation.”
Inflation calculated from the IPD is called “(overall) inflation.”
336
Inflation
Biases in inflation measures
1.
New Goods Bias
Newly invented goods are more expensive, but usually more desirable.
Example: If people stop buying $50 VHS players and start buying $100 DVD
players, we will see an increase in inflation measures. However, the extra
happiness people get from DVD players exceeds the additional cost of the players
(vs. VHS players) – otherwise people would buy the VHS players instead.
Conclusion: Inflation measure can mask the fact that people are happier buying
the more expensive product.
337
Inflation
Biases in inflation measures
2.
Quality Change Bias
Inflation measures imperfectly account for quality changes.
Example: As computers become more powerful, even though their retail prices do
not change, for the purpose of price index calculations computers are recorded as
being less expensive. The purpose of this is to account for the fact that, one
computer today is the equivalent of several computers from five years ago.
Conclusion: Depending on how statisticians interpret quality changes, the official
inflation measures can erroneously account for changes in product quality.
338
Inflation
September 1977
4 MHz
Disk storage extra
Monitor extra
RAM extra
$1,000 (assembled)
339
Inflation
October 1981
32K RAM
1 180K Disk drive
Monitor extra
$1,275
340
Inflation
October 1984
64K RAM
Monochrome monitor
2 360K Disk drives
$1,300
341
Inflation
March 1986
10 MB HD
Monochrome monitor
256K RAM
360K Disk Drive
Mouse
$1,700
342
Inflation
July 1996
75 MHz
510 MB hard drive
Color monitor
8 MB RAM
16 bit audio
$2,900
343
Inflation
August 2006
2.8 GHz
250 GB hard drive
19” Flat panel monitor
1 GB RAM
$990
344
Inflation
Biases in inflation measures
3.
Commodity and Outlet Substitution
As prices change, consumers’ buying habits change.
Example: As the price of shoes rises, people will alter what they buy (fewer shoes
and more of other things) and where they buy (buy shoes at discount retailers
rather than high-end retailers).
Conclusion: As people change what they buy, the official basket will no longer
reflect people’s true purchase decisions. As people change where they buy, official
price measures will no longer reflect the prices people are actually paying.
345
Inflation
Consequences of erroneously measuring inflation
Wage increases, Social Security benefits, and variable interest rates are tied to official
inflation measures.
Many economists believe that the simple CPI-U overstates annual inflation by as much
as 1%.
Because Social Security retirement benefits are indexed to inflation, these benefits will
increase faster than intended.
346
Inflation
Example
In 1970, the law intended (1) that a retiree receive $4,000 annually in Social Security
retirement benefits, and (2) that the retirement benefits be increased each year to
adjust for inflation.
Suppose the actual annual inflation rate is 2.9%.
By 2004, retirees should receive $10,573 annually. This sum will buy the same quantity
of goods and services that $4,000 bought in 1970.
Suppose that the official inflation rate is 3.9%.
By 2004, retirees are actually receiving $14,689 annually. The overstating of inflation
has caused retirement benefits to grow in real terms.
Current debate about indexing Social Security benefits to the chain-weighted CPI is an
attempt to correct this real growth.
347
Effects of Unanticipated Inflation
Anticipated inflation is not a problem because people will incorporate their (correct) expectations
about inflation into their decisions.
Unanticipated inflation creates a problem because, had people known what inflation was going to
be, they would have made different decisions.
Losers: Lenders
When lenders receive back the monies they loaned, the monies have less purchasing power than
the lenders anticipated.
Winners: Borrowers
The dollars that borrowers pay back to lenders have less value (i.e. purchasing power) than the
borrowers had anticipated.
Losers: Workers and those on fixed incomes
Until workers’ contracts expire, they cannot negotiate higher wages to compensate for the
unexpectedly higher inflation. Similarly, people on fixed incomes have less purchasing power than
they anticipated.
Winners: Employers
Until workers’ contracts expire, the cost of wages to employers is less (in real terms) than the
employers anticipated.
348
Nominal vs. Real Return
Nominal return is the dollar return on an investment.
Real return is the purchasing power return on an investment.
As with GDP and RGDP, what matters to the investor is the real return, not the nominal
return.
Example
A lender is willing to loan $100,000 for one year in exchange for an annual interest
rate of 6%. The 6% rate is called the nominal interest rate and represents the dollar
return on the loan  Each year, the lender receives ($100,000)(0.06) = $6,000 in
interest.
The 6% loan compensates the lender for three costs:
1. Credit risk  risk of loan default (e.g. 1%)
2. Opportunity risk  risk of not investing money in a better opportunity (e.g. 3%)
3. Inflation risk  risk of purchasing power of loaned money eroding (e.g. 2%)
349
Nominal vs. Real Return
As long as inflation remains at 2%, the lender is exactly compensated for the risks
from lending  the lender makes “zero economic return.”
At the end of one year, the lender will receive $106,000. Meanwhile, inflation will have
reduced the purchasing power of the $106,000 to $106,000 / 1.02 = $103,922. Thus,
the lender’s expected nominal return on the loan is $6,000 while the expected real
return on the loan is $3,922.
Suppose that, the day after the loan is made, inflation increases to 3%. The lender
still receives $106,000 at the end of the year. But, the purchasing power of the
$106,000 is only $106,000 / 1.03 = $102,913. Thus, the lender’s nominal return is
$106,000, but the real return is $2,913 – or $1,009 less than the lender had
expected.
350
Nominal vs. Real Return
The real rate of return is given by the formula:
r 
1 R
1
1 
r  real interest rate
R  nominal interest rate
  inflation rate
Example
At 6% nominal interest and a 2% inflation rate, the real rate of return is:
1  0.06
 1  0.039  3.9%
1  0.02
An increase in inflation to 3% reduces the real rate of return to:
1  0.06
 1  0.029  2.9%
1  0.03
351
Nominal vs. Real GDP
Nominal GDP measures productivity in terms of the dollar value generated.
Real GDP measures productivity in terms of the purchasing power generated.
Productivity in 2001
Cars produced
Average price per unit
Contribution to GDP
1,000,000
$28,000
$28.0 billion
Contribution to GDP
Contribution to GDP rose 9.9%
But, production of cars only
increased 3.0%
Productivity in 2002
Cars produced
Average price per unit
From 2001 to 2002
1,030,000
$30,000
 Discrepancy of 6.9% is due to
the price of cars rising.
$30.9 billion
 We say that GDP rose 9.9%,
but RGDP rose 3.0%.
352
Nominal vs. Real GDP
We can use price indices to convert GDP to RGDP.
The price index used to convert is called (generically) the GDP deflator. We can use
either the IPD (to obtain RGDP) or the chain-weighted IPD (to get chain-weighted
RGDP).


GDP for year X
Real GDP for year X in terms of year Y prices  
  GDP deflator for year Y 
GDP
deflator
for
year
X


2001: GDP = $10.0 trillion, IPD = 109.8
2002: GDP = $10.4 trillion, IPD = 111.3
What is the growth rate in nominal and real GDP from 2001 to 2002?
Growth rate of nominal GDP = ln(10.4) – ln(10.0) = 3.9%
Real GDP for 2002 in 2001 prices = ($10.4 trillion / 111.3) (109.8) = $10.26 trillion
Growth rate of real GDP = ln(10.26) – ln(10.0) = 2.6%
353
2009Q1
2008Q3
2008Q1
2007Q3
2007Q1
2006Q3
2006Q1
2005Q3
2005Q1
2004Q3
2004Q1
2003Q3
2003Q1
2002Q3
2002Q1
2001Q3
2001Q1
2000Q3
2000Q1
1999Q3
1999Q1
1998Q3
1998Q1
1997Q3
1997Q1
1996Q3
1996Q1
1995Q3
1995Q1
1994Q3
1994Q1
1993Q3
1993Q1
1992Q3
1992Q1
1991Q3
1991Q1
Business Cycles
16000
GDP (trillions)
14000
12000
10000
8000
RGDP (1991.1 trillions)
6000
4000
354
Business Cycles
Business cycles are the natural
fluctuations in economic output around
“full employment output.”
Full employment RGDP is the maximum
sustainable output level.
For short periods, the economy can
operate above full employment GDP.
This is achieved by, for example,
significant numbers of workers working
more than 40-hour weeks, factories
being run around the clock, etc.
In the long-run, the economy cannot
sustain such overproduction because
workers and machinery “burnout” –
workers move to less stressful jobs,
machines breakdown due to lack of
maintenance due, in turn, to a lack of
down-time.
355
2009Q1
2008Q3
2008Q1
2007Q3
2007Q1
2006Q3
2006Q1
2005Q3
2005Q1
2004Q3
1992.1: Start of Clinton’s first term
2004Q1
2003Q3
2003Q1
2002Q3
2002Q1
2001Q3
2001Q1
7
2000Q3
2000Q1
1999Q3
1999Q1
1998Q3
1998Q1
1997Q3
1997Q1
1996Q3
1996Q1
1995Q3
1995Q1
1994Q3
9
1994Q1
1993Q3
1993Q1
1992Q3
1992Q1
1991Q3
1991Q1
Trillions
Business Cycles
11
2005.4: Hurricane Katrina
10
2001.1: Dot-com crash
8
2008.2: Housing Crash
2003.1: Iraq War begins
6
2001.3: 9/11 and Enron
5
1996.1: End of Clinton’s first term
4
356
1947Q1
1948Q1
1949Q1
1950Q1
1951Q1
1952Q1
1953Q1
1954Q1
1955Q1
1956Q1
1957Q1
1958Q1
1959Q1
1960Q1
1961Q1
1962Q1
1963Q1
1964Q1
1965Q1
1966Q1
1967Q1
1968Q1
1969Q1
1970Q1
1971Q1
1972Q1
1973Q1
1974Q1
1975Q1
1976Q1
1977Q1
1978Q1
1979Q1
1980Q1
1981Q1
1982Q1
1983Q1
1984Q1
1985Q1
1986Q1
1987Q1
1988Q1
1989Q1
1990Q1
1991Q1
1992Q1
1993Q1
1994Q1
1995Q1
1996Q1
1997Q1
1998Q1
1999Q1
2000Q1
2001Q1
2002Q1
2003Q1
2004Q1
2005Q1
2006Q1
2007Q1
2008Q1
2009Q1
Trillions
Business Cycles
14
12
10
8
6
4
2
0
357
Employment
Participation Rate 
Population
Institutionalized
Labor Force
Civilians
Non-institutionalized
Military
Civilians
Non-participating
Labor Force
Unemployed
Employed
Unemployment Rate 
Unemployed
Labor Force
358
1948
1949
1950
1951
1952
1953
1954
1955
1956
1957
1958
1959
1960
1961
1962
1963
1964
1965
1966
1967
1968
1969
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
Percent of Civilian Labor Force
Employment
Unemployment Rate
12
10
8
6
4
2
0
359
Employment
Unemployment Rates by Educational Attainment
12.0%
10.0%
8.0%
6.0%
4.0%
2.0%
MBA
BS/BA
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
0.0%
Total
360
Employment
Official unemployment figures understate true unemployment
1.
Excludes people who have been unemployed for a long time.
People who have been unemployed for 12 months or longer are no longer counted as part
of the labor force and are classified as non-employed.
2.
Does not account for overqualified workers.
People who are overqualified for their positions are not being used to their full capacity.
While, in reality, these people are underemployed, they are counted as fully employed.
Example: Someone who qualifies for a $100,000 job but currently holds a $40,000 job
should be counted as only 40% employed, but is actually counted as fully employed.
3.
Does not account for part-time work.
People who work work full-time and people who only work part-time are both considered
“employed” to the same extent. In reality, those who are employed part-time are
underemployed.
Example: Someone who works 20 hours per week should be counted as 50% employed,
but is actually counted as fully employed.
361
Employment
Components of Unemployment
1.
Cyclical unemployment  unemployment because job was temporarily
eliminated due to business cycle downturn.
2.
Structural unemployment  unemployment because job was permanently
eliminated due to market changes.
3.
Frictional unemployment  unemployment due to a job change.
Natural unemployment = Structural unemployment plus Frictional unemployment
Natural unemployment remains in the long-run as “background” unemployment.
362
Employment
Relationship between RGDP and Unemployment
Because RGDP measures the production of
goods and services, and because labor is
required for all production, business cycles and
unemployment tend to move in opposite
directions.
Frictional unemployment is estimated to be 1%
to 2%.
 This is the lowest attainable unemployment
rate.
 Occurs when structural and cyclical
unemployment rates are both zero.
363
Employment
10
Relationship between RGDP and Unemployment (1991.1 to 2009.2)
9
Percent Unemployed
8
2003.2
7
2001.1: Dot-com crash
2007.3
6
5
4
3
5000
6000
7000
8000
9000
10000
11000
12000
13000
14000
15000
RGDP (billions 2005$)
364
Employment
Structural Unemployment and Economic Development
While structural unemployment is the most painful (jobs disappear permanently), it is
often necessary for even greater future employment.
Example
Foreign competition in the steel industry causes a permanent loss of manufacturing
jobs in the U.S. But, resources shift from manufacturing to other sectors resulting in
unforeseen employment gains.
Example
When the automobile replaced the horse, there was tremendous structural
unemployment among horse breeders, stables, tack, buggy, wagon manufacturers,
and blacksmiths.
What no one at the time could have foreseen was the massive creation of jobs in
automobile manufacturing, service, sales, tire manufacturing, gasoline production,
distribution, retailing, automotive sound systems production, car detailing, etc.
365
Employment
Economic, social, and political factors contribute to cross-country differences in unemployment
Economic factors
Less infrastructure (e.g. roads, electricity, water) in Central America results in higher
unemployment because it is too costly for many modern firms to locate there.
Social factors
As a matter of tradition, Japanese employers do not fire or layoff workers. This results is higher
unemployment as less productive employees cannot be replaced with more productive
employees. The tradition extends to banks continuing to provide credit to firms that are
insolvent. As with the workers, this results in an inability of the economy to replace unprofitable
firms with profitable firms.
Political factors
German law makes it extremely difficult to fire workers. As a result, firms are reluctant to hire
workers and so the unemployment rate in Germany is consistently above 10%.
366
China
Venezuela
Mexico
Brazil
Germany
Spain
France
European
Union
Italy
Chile
Canada
United States
United
Kingdom
Employment
Unemployment Rates (2004)
25%
20%
15%
10%
5%
0%
367
Aggregate Demand and Aggregate Supply
As with microeconomic analysis, we can summarize the behaviors of producers and
consumers with demand and supply.
The behavior of all consumers as a whole is summarized by aggregate demand.
The behavior of all producers as a whole is summarized by aggregate supply.
The equilibrium formed by aggregate demand and aggregate supply is called the
macroequilibrium.
368
Price Index
Aggregate Demand
Typical Aggregate Demand Shocks
1.
Change in consumers’ spending
that is independent of price
changes.
2.
Change in investment spending
that is independent of price
changes.
3.
Change in government spending
that is independent of price
changes.
4.
Change in net export spending that
is independent of (domestic) price
changes.
Increase in AD
AD’
Decrease in AD
AD’’
AD
RGDP
369
Aggregate Demand
Price Index
Aggregate demand is the relationship
between the average price level and
aggregate expenditures.
Aggregate expenditures is the amount
of purchasing power the economy
spends at a given price level.
Average
price
level
AD
RGDP
AD in macro is analogous to D in micro.
AE in macro is analogous to Qd in micro.
Aggregate
Expenditures
370
Price Index
Aggregate Supply
Short-Run Aggregate Supply Shock
LRAS
SRAS
1.
Change in resource prices.
Long-Run Aggregate Supply Shock
1.
Change in quantity of
resources.
2.
Change in technology.
RGDP
Full employment RGDP
371
Aggregate Supply
SRAS’
SRAS
Decrease in SRAS
Price Index
Price Index
A change in resource prices without a change in the quantity of resources impacts
SRAS, but does not impact LRAS because the maximum attainable production level
(i.e. full employment RGDP) has not changed.
SRAS
SRAS’
Increase in SRAS
RGDP
RGDP
372
Aggregate Supply
LRAS
LRAS’
Increase in full employment RGDP
Price Index
Price Index
A change in the quantity of resources impacts LRAS because the maximum attainable
production level (i.e. full employment RGDP) has changed.
LRAS’
LRAS
Decrease in full employment RGDP
373
Aggegate Supply
LRAS
LRAS’
Non-durables
Price Index
An increase in LRAS and an increase in the PPF are the same thing. The PPF shows
how the increase in production can be broken down into two types of goods. The
LRAS shows production of all goods combined into a single measure.
Increase in PPF
Durables
374
Aggegate Supply
SRAS
SRAS’
Factor intensive products
Price Index
An increase in SRAS is caused by a reduction in the prices of factors. This will cause
the economy to shift production toward products that intensively use factors. Because
the quantity of factors has not changed, the PPF does not change.
Movement along the PPF
Factor non-intensive products
375
Price Index
Aggregate Supply
SRAS
SR aggregate supply is the relationship
between the average price level and
aggregate output in the short run.
Aggregate output is the amount of real
output the economy generates at a
given price level.
Average price level
AS in macro is analogous to S in micro.
RGDP
RGDP in macro is analogous to Qs in micro.
Aggregate output = RGDP
376
Price Index
Short Run Macroequilibrium
Short-Run Equilibrium
LRAS
SRAS
112
Equilibrium Point A is a short-run
macroequilibrium because (a) at Point A,
aggregate expenditures equal aggregate
output, and (b) at Point A, aggregate
output does not equal full employment
output.
A
AD
$8 t.
RGDP
Full employment RGDP
377
124
Price Index
Long Run Macroequilibrium
Long-Run Equilibrium
LRAS
SRAS
A
AD
$8.2 t.
Equilibrium Point A is a long-run
macroequilibrium because (a) at Point A,
aggregate expenditures equal aggregate
output, and (b) at Point A, aggregate
output equals full employment output.
RGDP
378
Price Index
Short Run to Long Run Transition
1. At Point A, equilibrium output is less
than full employment output. This
means that there is unemployment.
LRAS
2. In the long run, competition among
the unemployed leads to a reduction
in the prices of factors. This results in
an increase in SRAS.
SRAS
112
110
SRAS’
A
B
AD
$8 t.
$8.2 t.
RGDP
3. The increase in SRAS causes a
reduction in the average price level
and an increase in output. The
economy moves to Point B.
4. Point B is a long-run equilibrium
because (a) aggregate expenditures
equal aggregate output, and (b)
aggregate output equals full
employment output.
379
Macroeconomic Shocks
124
Price Index
1. The economy starts at long-run
equilibrium Point A.
LRAS
SRAS
A
AD
118
B
SRAS’
C
116
$8.1 t.
3. The economy moves to equilibrium
Point B. SR impact of shock: Prices
fall, RGDP falls.
4. Because there is unemployment at
Point B, the equilibrium is only a
short-run equilibrium.
AD’
$8.2 t.
2. A decrease in consumer confidence
causes consumption to fall. This is a
negative shock to AD  AD
decreases.
RGDP
5. In the long run, unemployment puts
downward pressure on the prices of
factors causing SRAS to increase.
6. The economy moves to equilibrium
Point C. LR impact of shock: Prices
fall, RGDP unchanged.
380
Macroeconomic Shocks
120
Price Index
1. The economy starts at long-run
equilibrium Point A.
LRAS
C
SRAS
A
2. The government increases its
spending. This is a positive shock to
AD  AD increases.
AD’
3. The economy moves to equilibrium
Point B. SR impact of shock: Prices
rise, RGDP rises.
AD
4. Because there is over employment at
Point B, the equilibrium is only a
short-run equilibrium.
B
118
115
SRAS’
$8.2 t. $8.3 t. RGDP
5. In the long run, over employment
puts upward pressure on the prices of
factors causing SRAS to decrease.
6. The economy moves to equilibrium
Point C. LR impact of shock: Prices
rise, RGDP unchanged.
381
Macroeconomic Shocks: Creation of the Internet
1. In 1997, real GDP was $8.7 trillion and the IPD was 109.0 (Point A).
Price Index
2. The creation and growth of the Internet represents a new resource. LRAS
increases over the period 1997 through 2002.
LRAS LRAS’
SRAS
SRAS’
A
3. Increase in quantity of resources
causes a reduction in the prices of
resources. SRAS increases.
4. Economy moves to Point B. Prices are
lower and RGDP is higher.
109
B
AD
$8.7 t. $10.1 t.
RGDP
382
Macroeconomic Shocks: Creation of the Internet
What really happened
116
Price Index
From 1997 to 2002, AD was increasing also, so the economy moved from Point A
to Point C.
LRAS LRAS’
SRAS
As a result, by 2002, the IPD had risen
to 116 instead of falling.
C
A
109
AD’
AD
$8.7 t. $10.1 t.
RGDP
383
Macroeconomic Shocks: Creation of the Internet
Price Index
However, if the Internet had not been created, the same increase in AD would have
increased the prices of resources and pushed the IPD higher than 116 to Point D.
LRAS
D
SRAS’
SRAS
A
109
AD’
AD
$8.7 t.
RGDP
384
Macroeconomic Shocks: War Disrupts Oil Markets
1. In 2002, real GDP was $10.1 trillion and the IPD was 116 (Point A).
Price Index
2. The Iraq War causes a disruption in oil markets resulting in an increase in the
price of oil. The market does not react as if the quantity of oil available has
declined because the market believes the disruption to be temporary.
LRAS
SRAS’
SRAS
3. Increase in the price of oil causes the
SRAS to decrease.
4. Economy moves to Point B (for the
short run). RGDP declines and prices
rise.
B
A
116
AD
$10.1 t.
RGDP
385
Macroeconomic Shocks: War Disrupts Oil Markets
5. In the long run, oil production will return to normal and oil prices will fall.
Price Index
6. This will result in an increase in the SRAS to its original level. The economy
will return to Point A.
LRAS
SRAS’
SRAS
7. In the long run, RGDP returns to full
employment and prices return to their
original level.
B
A
116
AD
$10.1 t.
RGDP
386
Macroeconomic Shocks: War Disrupts Oil Markets
What really happened
Price Index
At the same time that oil markets were disrupted, the Federal government increased
spending to pay for the war and Homeland Security.
LRAS
C
SRAS’
SRAS
1. Increase in the price of oil causes the
SRAS to decrease.
2. Almost simultaneously, AD increases
due to the increase in government
spending.
A
116
AD’
3. Economy moves to Point C. Prices
rise, but RGDP remains at full
employment.
AD
$10.1 t.
RGDP
387
Macroeconomic Shocks: Housing Bubble Bursts
1. In 2008, real GDP was $13 trillion and the IPD was 108 (Point A).
Price Index
2. When the housing bubble burst, AD fell because people perceived themselves
to be less wealthy (decline in consumption), and banks cut back on lending
(decline in investment). This would have moved the economy to point B.
LRAS
SRAS
3. Over time, unemployment would have
caused prices to fall and the economy
would have moved to point C.
SRAS’
A
108
B
C
AD’
$13 t.
AD
RGDP
388
Macroeconomic Shocks: Housing Bubble Bursts
What really happened
Price Index
2. When the housing bubble burst, AD fell because people perceived themselves
to be less wealthy (decline in consumption), and banks cut back on lending
(decline in investment). This would have moved the economy to point B.
LRAS
SRAS
SRAS’ 4. Unemployment causes prices to drop
and the economy begins to heal itself.
Then, as increased government
spending kicks in, we will find the
economy being pushed above full
employment RGDP (point C).
A
108
C
B
AD’
$13 t.
3. The government passed legislation to
dramatically increase spending in an
attempt to increase AD.
AD
RGDP
389
Deflationary and Inflationary Gaps
When the short run equilibrium output is less than full employment output, we say that there
exists a deflationary gap. In the long run, SRAS will increase causing the economy to achieve
full employment along with a fall in the average price level.
LRAS
SRAS
Deflationary gap
Price Index
Price Index
When the short run equilibrium output is greater than full employment output, we say that
there exists an inflationary gap. In the long run, SRAS will decrease causing the economy to
achieve full employment along with an increase in the average price level.
LRAS
SRAS
Inflationary gap
AD
AD
RGDP
RGDP
390
Expenditure Multiplier
From the expenditures approach to calculating GDP, we have:
Y  C  I G  X  M
Let consumption be comprised of two components: autonomous and induced
consumption.
C  C0  bYd
Induced consumption
Autonomous consumption
Autonomous consumption  An amount of money that (on average) consumers will
spend regardless of their incomes.
Induced consumption 
An amount of money that (on average) consumers will
spend as a function of their disposable incomes.
391
Expenditure Multiplier
Disposable income is income net of income taxes.
Yd  Y 1 t   T  R
t = marginal tax rate (e.g. 20% of income)
T = flat tax (e.g. $5,000)
R = government transfers (e.g. $2,000)
Induced consumption is:
bYd  b Y 1  t   T  R 
where b is the marginal propensity to consume (MPC).
MPC is the amount of money out of every $1 of disposable income that consumers
will spend on consumption.
392
Expenditure Multiplier
Example
Suppose C0 = $12,000, Y = $50,000, t = 0.2, T = $1,000, R = $0, and b = 0.8.
Disposable Income: Yd  Y 1 t   T  R  $50,000 1 0.2  $1,000  $39,000
Consumption: C  C0  bYd  $12,000  0.8$39,000  $43,200
Savings: S  Yd  C  $39,000  $43,200  $4,200
In this example, households breakeven at (on average) an income level of $76,250.
Disposable Income: Yd  Y 1 t   T  R  $76,250 1  0.2   $1,000  $60,000
Consumption: C  C0  bYd  $12,000  0.8$60,000  $60,000
Savings: S  Yd  C  $60,000  $60,000  $0
393
Expenditure Multiplier
Similarly, let imports be comprised of autonomous and induced components.
M  M0  mYd
Induced imports
Autonomous imports
Note that savings (S ) is Y – C, not Y – C – M, because consumption includes
purchases of both domestic products and imports. Because imports should not be
counted toward the domestic country’s GDP, we subtract M from Y in the GDP
equation.
394
Expenditure Multiplier
Autonomous Expenditures
I
Investment
G
Government spending
C0
Autonomous consumption
M0
X
Autonomous imports
Exports
Induced Expenditures
bYd
Induced consumption
mYd
Induced imports
Parameters
b
Marginal propensity to consume
m
Marginal propensity to import
t
Marginal tax rate
T
Flat tax
R
Transfers
Note that exports (X ) do not include an
induced component. While it is the case
that spending on exports is a function of
income, the spending is a function of
foreign consumers’ incomes. As such
exports are autonomous with respect to
domestic income.
395
Expenditure Multiplier
We now have a set of equations that describe spending.
Y  C I G  X M
C  C0  bYd
M  M0  mYd
Yd  Y (1  t )  T  R
We can solve these equations for Y to obtain GDP as a function of autonomous
spending:
Y
1
C0  I  G  X  M0   b  m T  R  

1   b  m  (1  t )
396
Expenditure Multiplier
Retrieve nominal quarterly data on consumption and disposable personal income
from Economy.com’s database (1959.1 to 2005.1). Via OLS, find estimates for
autonomous consumption and the marginal propensity to consume and construct
the estimated consumption equation.
1. State the model we are attempting to estimate.
C  C0  bYd
2. Run the regression.
Intercept
Disposable Income
Coefficients
-67.55519062
0.931256974
3. State the estimated regression model.
C  67.56  0.93Yd
397
Expenditure Multiplier
Retrieve nominal quarterly data on imports and disposable personal income from
Economy.com’s database (1959.1 to 2005.1). Via OLS, find estimates for
autonomous imports and the marginal propensity to import and construct the
estimated imports equation.
1. State the model we are attempting to estimate.
M  M0  mYd
2. Run the regression.
Intercept
Disposable Income
Coefficients
-104.9787082
0.192439729
3. State the estimated regression model.
M  104.98   0.19Yd
398
Expenditure Multiplier
Retrieve nominal quarterly data on GDP and disposable personal income from
Economy.com’s database (1959.1 to 2005.1). Via OLS, find estimates for flat
taxes less transfers and the marginal tax rate and construct the estimated
disposable income equation.
1. State the model we are attempting to estimate.
Yd  Y 1 t   T  R
2. Run the regression.
Intercept
GDP
Coefficients
-56.33440016
0.74648681
3. State the estimated regression model.
Yd  Y  0.75  56.33  1 t  0.75  t  0.25
  T  R  56.33  T  R  56.33
399
Expenditure Multiplier
Retrieve nominal quarterly data on the remaining autonomous expenditures for
2005.1.
Remaining Autonomous Expenditures
I
G
X
Investment
Government spending
Exports
$2,130.7 billion
$2,316.5 billion
$1,262.4 billion
400
Expenditure Multiplier
Combine these figures into a single equation that expresses GDP as a function of
autonomous spending.
Y
1
C0  I  G  X  M0   b  m T  R  

1   b  m  (1  t )
Autonomous Expenditures
I
$2,130.7 b.
G
$2,316.5 b.
C0
–$67.56 b.
Parameters
b
0.93
m
0.19
t
0.25
M0
X
T – R $56.33 b.
Y
–$104.98 b.
$1,262.4 b.

1
67.56  2130.7  2316.5  1262.4   104.98   0.93  0.19 56.33  
1   0.93  0.19  (1  0.25)
Y  2.25 5683.93  $12,773 billion

 Estimate of GDP as of 2005.1
401
Expenditure Multiplier
1
 b  m
We call the fraction 1   b  m  (1  t ) the expenditures multiplier and 1  b  m (1 t )


the flat tax and transfer multiplier
We can use the multipliers to estimate the impact of a change in autonomous
spending on GDP.
For A  C0 , I, G, X , or M0
Y 
1
 A 
1   b  m  (1  t )
For A  T  R
Y 
 b  m
1   b  m  (1  t )
 A 
402
Fiscal Policy
Example
Suppose the expenditures multiplier is 2.21. What is the impact on GDP of the
government increasing spending by $200 billion?
For A  C0 , I, G, X , or M0
Y  2.21 A 
A  200  Y   2.21 200   $442 billion
Suppose the flat tax and transfers multiplier is expenditures multiplier is –2.52.
What is the impact on GDP of the government reducing transfer payments by
$200 billion?
For A  T  R
Y  2.52  A 
R  200  A   T  R   200
A  200  Y   2.52  200   $504 billion
403
Fiscal Policy
Republicans have proposed cutting marginal tax rates from 25% to 23% and
leaving government spending unchanged. Democrats have proposed increasing
marginal tax rates from 25% to 32% and increasing government spending by $1
trillion.
Using current expenditure values and the previously derived parameter estimates,
estimate the impact of each plan on GDP.
I
G
C0
M0
X
Current
2130.7
2316.5
-67.6
-105.0
1262.4
Republican Plan
2130.7
2316.5
-67.6
-105.0
1262.4
Democrat Plan
2130.7
3316.5
-67.6
-105.0
1262.4
b
m
t
T-R
0.93
0.19
0.25
56.3
0.93
0.19
0.23
56.3
0.93
0.19
0.32
56.3
multiplier
autonomous expenditures
2.25
5683.9
2.32
5683.9
2.01
6683.9
Predicted GDP
12773
13212
13454
404
Fiscal Policy
Estimate the impact on the total government surplus of the two plans.
Government surplus  Tax Revenues  Government Spending
 T  R   tY  G
I
G
C0
M0
X
Current
2130.7
2316.5
-67.6
-105.0
1262.4
Republican Plan
2130.7
2316.5
-67.6
-105.0
1262.4
Democrat Plan
2130.7
3316.5
-67.6
-105.0
1262.4
b
m
t
T-R
0.93
0.19
0.25
56.3
0.93
0.19
0.23
56.3
0.93
0.19
0.32
56.3
multiplier
autonomous expenditures
2.25
5683.9
2.32
5683.9
2.01
6683.9
Predicted GDP
12773
13212
13454
Tax Revenue
Spending
3249.5
2316.5
3095.2
2316.5
4361.6
3316.5
Surplus (Deficit)
-933.0
-778.7
-1045.1
405
Fiscal Policy
1. The economy starts at short run equilibrium Point A. The autonomous
expenditures multiplier is 2.5. There is a $200 billion deflationary gap.
Price Index
2. In an attempt to close the deflationary gap, the government increases spending
by $80 billion. This will increase GDP by (2.5)($80 billion) = $200 billion.
LRAS
SRAS
$200 b. shift
101.3
100.0
3. The increase in government spending
is a shock to AD. AD increases by
$200 billion.
B
4. Economy moves to Point B.
5. If prices had remained constant,
RGDP would have increased by $200
billion to $7.8 t. Instead, prices rise
AD’
by 1.3%.
A
AD
$7.6 t. $7.7 t.
$7.8 t. RGDP
6. GDP increased by (2.5)($80 b.) =
$200 billion to $7.8 trillion.
RGDP only increased by $100 billion
to $7.7 trillion.
$7.7 t. = ($7.8 t.)(100.0)/(101.3)
406
Economic Policy
Any organized attempt to influence the economy is called economic policy.
There are three major types of economic policy:
1.
Fiscal policy  Any attempt by the Federal government to influence either
inflation or RGDP. Government enacts fiscal policy via alterations in government
spending and taxation.
2.
Monetary policy  Any attempt by the Central Bank to influence either inflation
or RGDP. Central Bank enacts monetary policy via alterations in the money
supply.
3.
Trade policy  Any attempt by either the Federal government or the Central
Bank to influence trade. Trade policy is enacted via alterations in tariffs, the
exchange rate, and the money supply.
In the United States, the fiscal policy is almost always aimed at influencing RGDP,
monetary policy is usually (though not always) aimed at influencing inflation. Trade
policy is almost always conducted by the Federal government.
407
1983Q1
1984Q2
1985Q3
1986Q4
1988Q1
1989Q2
1990Q3
1991Q4
1993Q1
1994Q2
1995Q3
1996Q4
1998Q1
1999Q2
2000Q3
2001Q4
2003Q1
2004Q2
2005Q3
2006Q4
2008Q1
2009Q2
Economic Policy
Government Spending (including transfers) as Fraction of GDP
21%
20%
19%
18%
17%
16%
15%
408
Economic Policy
Federal Government Revenue (all sources) as Fraction of GDP
25%
20%
15%
10%
5%
2008
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1960
1957
1954
0%
409
Economic Policy
Federal Government Revenue (all sources, billions 2008$)
$3,000
$2,500
$2,000
$1,500
$1,000
$500
2008
2005
2002
1999
1996
1993
1990
1987
1984
1981
1978
1975
1972
1969
1966
1963
1960
1957
1954
$0
410
Policy Lags
Policy lags are time intervals that pass between the need for economic policy and the
realization of the effects of economic policy.
Major types of policy lags:
1.
Recognition lag  The time interval between when economic policy is needed
and the realization that economic policy is needed. Often, several months will
pass between a turning point in the business cycle and the realization that a
turning point has been reached.
2.
Decision lag  The time interval between the realization that economic policy is
needed and the determination of the details of what policy to enact.
The Federal Reserve’s decision lag tends to be extremely short because (a) the
Board of Governors is small (7 people), (b) the BOG is comprised entirely of
professional economists, bankers, and accountants, and (c) the BOG is insulated
from political pressures. The Federal government’s decision lag tends to be
extremely long for the opposite reasons.
3.
Implementation lag  The time interval between the decision as to what policy
to employ and the full impact of the policy on the economy. Implementation lags
can be moderately to extremely long.
411
Policy Lags
Because the economy is self-correcting (i.e. the
economy naturally returns to full employment on
its own), and because policy lags cannot be
avoided, most economic policy is destabilizing.
Example
The economy starts into recession in January. It
takes until March before people become aware
that the economy is in recession. The Federal
government debates enacting tax cuts to help
bolster the economy. It takes until June for the
Congress and President to agree on a course of
action. Tax cuts are enacted in June, but the full
impact of the tax cuts doesn’t filter through the
economy until October. However, by October, the
economy had naturally turned around on its
own.
Result: The expansionary policy reinforces the
expansion that is naturally taking place resulting
in the economy overshooting full employment
and so generating inflation.
412
Attributes of Money
Any object that fulfills the following three criteria is considered money.
1. Medium of exchange
 Object is readily accepted in exchange for goods and services.
2. Store of value
 Object maintains its value over time.
3. Standard of value
 Values of other objects are measured relative to this object.
Notice that it is not necessary for the object to have an inherent value (i.e. value
beyond being a medium of exchange).
Objects used for money that have inherent value are called commodity money (e.g.
gold coins).
Objects used for money that have no inherent value are called fiat money (e.g. paper
bills).
413
Benefits of Money
An economy based on money (rather than barter) achieves greater productivity.
1. Money eliminates double incidence of wants.
Without money, every exchange must involve two transactions  Suppose the a person
seeks to buy product A and has product B to offer in exchange. For exchange to occur, the
person must find someone who (1) seeks to buy product B, and (2) has product A to offer in
exchange. In every exchange, each party is both a buyer and a seller.
With money, every exchange involves one transaction only  A person seeks to buy product
A. The person must find someone who offers product A. In the exchange, one person is a
buyer only and the other person is a seller only.
2. Money makes intertemporal substitution of consumption possible.
Without money, people must consume products as they are produced because most
products will degrade over time.
With money, people can forego current consumption for future consumption via saving, and
can forego future consumption for current consumption via borrowing.
3. Money makes investment possible.
Because money allows for intertemporal substitution of purchasing power, people can
borrow from their future selves to invest (in human or physical capital) so as to create
greater future income.
414
Benefits of Money
Example
A person requires $90,000 to pay for a college education. Without the education, the person
earns $30,000 annually. With the education, the person earns $60,000 annually. The person
incurs $15,000 in annual living expenses regardless of his education.
Option #1: Save to pay for college
Ages 18 – 27
Earn $30,000 per year and save $15,000 per year
Ages 28 – 31
Attend college at a total cost of $150,000
Ages 32 – 65
Earn $60,000 per year
Lifetime earnings = $2,340,000
Option #2: Borrow $150,000 to pay for college and living expenses
Ages 18 – 21
Attend college at a total cost of $150,000
Ages 22 – 31
Earn $60,000 per year and pay back $15,000 per year
Ages 32 – 65
Earn $60,000 per year
Lifetime earnings = $2,640,000
Borrowing to invest in education increased lifetime earnings by $300,000
415
Federal Reserve
The entity responsible for maintaining a country’s money supply is the central bank.
In the U.S., the central bank is called the Federal Reserve (or the “Fed”).
The Fed prints money, establishes rules under which banks operate, and aids in the
check clearing process.
The Fed is comprised of 12 District Banks. Monetary policy decisions are made by the
Board of Governors – a panel of seven people appointed to 14-year terms.
416
Liquidity Classifications
Financial assets are classified according to liquidity.
Liquidity is the ability to turn an asset into cash quickly and without incurring a loss.
MB
M0 + bank deposits at the Federal Reserve
M1
Notes + coins + checkable deposits + travelers checks + other
deposits against which checks can be written without penalty.
M2
M1 + savings deposits + retail money market mutual fund deposits
+ small certificates of deposit (CD’s) (small = under $100,000)
M3
M2 + institutional money market fund deposits + large certificates of
deposit (large = over $100,000) + repurchase agreements (short
term loan collateralized, typically, by an M2 asset) + Eurodollars
(dollar denominated deposits in foreign branches of U.S. banks).
M4
M3 + U.S. government savings bonds + short-term treasury
securities + commercial paper + bankers acceptance.
Less liquid
Notes + coins
More liquid
M0
Financial assets = M4 + other publicly traded financial assets + privately
traded financial assets
417
Liquidity Classifications
Assets
Financial Assets
L
M4
M3
M2
M1
MB
MS
Monetary
M0
Base
418
1959Q1
1961Q1
1963Q1
1965Q1
1967Q1
1969Q1
1971Q1
1973Q1
1975Q1
1977Q1
1979Q1
1981Q1
1983Q1
1985Q1
1987Q1
1989Q1
1991Q1
1993Q1
1995Q1
1997Q1
1999Q1
2001Q1
2003Q1
2005Q1
2007Q1
Economic Policy
Total Reserves Divided by RGDP
0.008
0.007
0.006
0.005
0.004
0.003
0.002
0.001
0
419
1959Q1
1961Q1
1963Q1
1965Q1
1967Q1
1969Q1
1971Q1
1973Q1
1975Q1
1977Q1
1979Q1
1981Q1
1983Q1
1985Q1
1987Q1
1989Q1
1991Q1
1993Q1
1995Q1
1997Q1
1999Q1
2001Q1
2003Q1
2005Q1
2007Q1
2009Q1
Economic Policy
Total Reserves Divided by RGDP
0.07
0.06
0.05
0.04
0.03
0.02
0.01
0
420
1959Q1
1961Q2
1963Q3
1965Q4
1968Q1
1970Q2
1972Q3
1974Q4
1977Q1
1979Q2
1981Q3
1983Q4
1986Q1
1988Q2
1990Q3
1992Q4
1995Q1
1997Q2
1999Q3
2001Q4
2004Q1
2006Q2
2008Q3
Economic Policy
M2 Divided by Total Reserves
200
180
160
140
120
100
80
60
40
20
0
421
Financial Intermediaries
Transfer of money across time is facilitated by financial markets.
Financial intermediation  ultimate lender lends indirectly to ultimate borrower via a
financial intermediary (e.g. an individual puts money in a bank; the bank buys a
corporate bond).
Pro: Individual is not exposed to default risk.
Con: Individual earns a lower rate of return.
Financial disintermediation  ultimate lender lends directly to ultimate borrower
(e.g. an individual buys a corporate bond).
Pro: Individual gains a higher rate of return.
Con: Individual is exposed to default risk.
422
Financial Intermediaries
Major types of financial intermediaries
Commercial banks
Savings and Loans
Credit Unions
Money market mutual funds
Insurance companies
Finance companies
423
Banking Crisis of 2008
MORTGAGE A
MORTGAGE B
MORTGAGE C
MBS #1
Payment $800
Payment $1,000
Payment $1,200
Payment $3,000
Life
30 yrs
Life
30 yrs
Life
30 yrs
Life
30 yrs
Risk
5%
Risk
1%
Risk
4%
Risk
3.3%
MORTGAGE D
MORTGAGE E
MORTGAGE F
MBS #2
Payment $1,500
Payment $300
Payment $1,200
Payment $3,000
Life
30 yrs
Life
30 yrs
Life
30 yrs
Life
30 yrs
Risk
10%
Risk
15%
Risk
20%
Risk
14.5%
424
Fractional Reserves
When an individual deposits cash into a bank, the bank creates a deposit account in
the person’s name that contains the value of the cash deposited. The deposit account
is a liability to the bank. The corresponding asset is the cash the bank received.
Cash
$100 Joe Smith’s Deposit Account
$100
When a bank loans money to an individual, the bank creates a deposit account in the
person’s name that contains the value of the loan. The deposit account is a liability to
the bank. The corresponding asset is the loan.
Loan to Susan Jones
$100 Susan Jones’ Deposit Account
$100
425
Fractional Reserves
When a bank loans money, the bank does not give the borrower cash, but creates a
deposit account against which the borrower can write checks. As a result, it is
possible for a bank to give loans without having cash to “backup” the loans.
Example
Suppose Smith deposits $100 in the bank, and then the bank gives a loan to Jones
for $300. The bank’s accounts would look like the following.
Cash
$100 Joe Smith’s Deposit Account
$100
Loan to Susan Jones
$300 Susan Jones’ Deposit Account
$300
Notice that, together, Smith and Jones can write checks for a total of $400 despite
the fact that the bank only has $100 cash.
We call this fractional reserves because the bank is required to only maintain a
fraction of its deposits in the form of cash.
426
Fractional Reserve Accounting
Deposits (D)
The total value held by the bank’s customers in accounts at the bank. Deposits
include checking deposits, savings deposits, loan deposits, certificates of deposit, etc.
Total Reserves (TR)
The value of cash on hand plus the value of the bank’s deposits at the Federal
Reserve.
Reserve Requirement Ratio (rrr)
The percentage of deposits held by the bank’s customers for which the bank is
required to hold reserves. The reserve requirement ratio is set by the Fed.
Required Reserves (RR)
The minimum amount of reserves the bank is required to have.
RR = (D)(rrr)
Excess Reserves (ER)
An additional amount of reserves the bank has beyond what is required by law.
ER = TR – RR
427
Fractional Reserve Accounting
Example
Using the bank’s accounts below and assuming the reserve requirement ratio is 4%,
calculate the bank’s TR, RR, and ER.
Cash
Deposits at the Fed
Loans
Treasury Bills
$100,000 Customer Deposit Accounts $25,100,000
$1,300,000
$23,000,000
$700,000
Customer Deposits = D = $25,100,000
TR = Vault cash + Deposits at the Fed = $100,000 + $1,300,000 = $1,400,000
RR = (D)(rrr) = ($25,100,000)(0.04) = $1,004,000
ER = TR – RR = $1,400,000 – $1,004,000 = $396,000
Assuming that this is the only bank in the economy and the only person holding cash
is Smith (who keeps $10,000 under his mattress), what is the money supply?
$25,110,000
428
Fractional Reserve Accounting
Example
Continuing with the previous question, suppose Smith deposits his $10,000 cash in
the bank. What is the impact on the bank’s accounts?
Cash
Deposits at the Fed
Loans
Treasury Bills
$110,000 Customer Deposit Accounts $25,100,000
$1,300,000 Smith Deposit Account
$10,000
$23,000,000
$700,000
Calculate the bank’s TR, RR, and ER, and the money supply.
Customer Deposits = D = $25,110,000
TR = Vault cash + Deposits at the Fed = $110,000 + $1,300,000 = $1,410,000
RR = (D)(rrr) = ($25,110,000)(0.04) = $1,004,400
ER = TR – RR = $1,410,000 – $1,004,400 = $405,600
MS = $25,110,000
429
Fractional Reserve Accounting
Example
Continuing with the previous question, suppose the bank gives Jones a home loan for
$275,000. Prior to Jones spending the money on the home, what is the impact on
the bank’s accounts?
Cash
Deposits at the Fed
Loans
Treasury Bills
$110,000 Customer Deposit Accounts $25,100,000
$1,300,000 Smith Deposit Account
$10,000
$23,275,000 Jones Deposit Account
$275,000
$700,000
Calculate the bank’s TR, RR, and ER, and the money supply.
Customer Deposits = D = $25,385,000
TR = Vault cash + Deposits at the Fed = $110,000 + $1,300,000 = $1,410,000
RR = (D)(rrr) = ($25,385,000)(0.04) = $1,015,400
ER = TR – RR = $1,410,000 – $1,015,400 = $394,600
MS = $25,385,000
430
Fractional Reserve Accounting
Example
Continuing with the previous question, what is the impact on the bank’s accounts
when ABC Construction deposits Jones’ check for $275,000 for building her house?
Cash
Deposits at the Fed
Loans
Treasury Bills
$110,000 Customer Deposit Accounts $25,100,000
$1,300,000 Smith Deposit Account
$10,000
$23,275,000 Jones Deposit Account
$0
$700,000 ABC Const. Deposit Account
$275,000
Calculate the bank’s TR, RR, and ER, and the money supply.
Customer Deposits = D = $25,385,000
TR = Vault cash + Deposits at the Fed = $110,000 + $1,300,000 = $1,410,000
RR = (D)(rrr) = ($25,385,000)(0.04) = $1,015,400
ER = TR – RR = $1,410,000 – $1,015,400 = $394,600
MS = $25,385,000
431
Money Creation
Notice that, when Smith deposited the $10,000 cash in the bank, the money supply
did not change.
All that happened was that the components of the money supply shifted  $10,000
cash in Smith’s hands became Smith’s $10,000 checking deposits. Remember: The
cash is the bank’s hands does not count toward the money supply.
Notice that, when Jones obtained the loan for the house, the money supply
increased.
When the bank gave Jones a loan, the bank created a loan deposit account for
Jones. This deposit account counts toward the money supply just like a checking
account because Jones can write checks on the account to pay for her house.
Yes, Jones owes the bank $275,000, but this does not change the fact that Jones
now can spend up to $275,000 on a house  the increased ability to spend is the
cause of the increase in the money supply.
432
Money Creation
Banks create money when they create loans. Because the bank is required to
maintain some minimum quantity of reserves, there is a limit to how much money a
bank can create.
Start with an economy that has a single bank with $100 in the vault. There is no
other cash and the reserve requirement ratio is 10%.
Cash
$100 Smith Deposit Account
$100
The bank’s reserve calculations and the money supply are
Customer Deposits = D = $100
TR = Vault cash + Deposits at the Fed = $100
RR = (D)(rrr) = ($100)(0.10) = $10
ER = TR – RR = $100 – $10 = $90
MS = $100
433
Money Creation
Suppose the bank makes a loan for $100 to Jones. The bank’s accounts are
Cash
$100 Smith Deposit Account
$100
Loan to Jones
$100 Jones Deposit Account
$100
The bank’s reserve calculations and the money supply are
Customer Deposits = D = $200
TR = Vault cash + Deposits at the Fed = $100
RR = (D)(rrr) = ($200)(0.10) = $20
ER = TR – RR = $100 – $20 = $80
MS = $200
434
Money Creation
Suppose the bank makes a loan for $100 to Smith. The bank’s accounts are
Cash
$100 Smith Deposit Account
$200
Loan to Jones
$100 Jones Deposit Account
$100
Loan to Smith
$100
The bank’s reserve calculations and the money supply are
Customer Deposits = D = $300
TR = Vault cash + Deposits at the Fed = $100
RR = (D)(rrr) = ($300)(0.10) = $30
ER = TR – RR = $100 – $20 = $70
MS = $300
435
Money Creation
The bank can continue making loans until its excess reserves fall to zero. When this
happens, the bank looks like this
Cash
$100 Smith Deposit Account
$200
Loan to Jones
$100 Jones Deposit Account
$100
Loan to Smith
$100 Other Deposit Accounts
$700
Loans to Others
$700
The bank’s reserve calculations and the money supply are
Customer Deposits = D = $1,000
TR = Vault cash + Deposits at the Fed = $100
RR = (D)(rrr) = ($1,000)(0.10) = $100
ER = TR – RR = $100 – $100 = $0
MS = $1,000
436
Money Creation
Notice that the maximum size of the money supply is a function of two things:
1.
2.
Cash
Bank deposits at the Fed
Together, we call these two things the monetary base (or “high powered money”).
The money supply reaches its maximum possible size when:
1.
People hold no cash (i.e. all of the economy’s cash is deposited in banks).
2.
Banks maintain zero excess reserves.
Maximum size of the money supply 
Monetary Base
rrr
Money multiplier = 1 / rrr
437
Check Clearing Process
Suppose Jones’ account is at Bank A while Smith’s account is at Bank B. The two
banks’ accounts are as follows:
Bank A
Cash
$100 Jones Deposit Account
$100
Deposits at Bank B
$500 Bank B Deposit Account
$800
$1,000 Other Deposit Accounts
$700
Deposits at Fed
Bank B
Cash
$750 Smith Deposit Account
$300
Deposits at Bank A
$800 Bank B Deposit Account
$500
Deposits at Fed
$700 Other Deposit Accounts
$1,450
438
Check Clearing Process
Smith writes Jones a check for $175 drawn on his account at Bank B. Jones deposits the check
in her account at Bank A.
Because the check is drawn on Bank B, Bank A transfers $175 from Bank B’s account to Jones’
account.
Bank A
Cash
$100 Jones Deposit Account $100+$175=$275
Deposits at Bank B
$500 Bank B Deposit Account $800–$175=$625
Deposits at Fed
$1,000 Other Deposit Accounts
$700
Bank B registers that its deposits at Bank A have declined by $175 and reduces Smith’s account
by the same amount.
Bank B
Cash
Deposits at Bank A
Deposits at Fed
$750 Smith Deposit Account $300–$175=$125
$800–$175=$625 Bank B Deposit Account
$500
$700 Other Deposit Accounts
$1,450
Neither bank’s equity changed because the
transaction did not involve the banks’ money.
439
Check Clearing Process
If two banks do not maintain mutual deposits, then the Fed aids the check clearing process.
Suppose the two banks begin as follows:
Bank A
Cash
$100 Jones Deposit Account
$100
Deposits at Fed
$700 Other Deposit Accounts
$700
Bank B
Cash
Deposits at Fed
$750 Smith Deposit Account
$1,000 Other Deposit Accounts
$300
$1,450
Smith writes Jones a check for $175 drawn on his account at Bank B. Jones deposits the check
in her account at Bank A.
440
Check Clearing Process
Bank A
Cash
Deposits at Fed
$100 Jones Deposit Account $100+$175=$275
$700+$175=$875 Other Deposit Accounts
$700
Fed
Treasury Bills
$2,550 Cash outstanding
$850
Bank A Deposits
$700+$175=$875
Bank B Deposits
$1,000–$175=$825
Bank B
Cash
Deposits at Fed
$750 Smith Deposit Account $300–$175=$125
$1,000–$175=$825 Other Deposit Accounts
$1,450
441
Monetary Policy
The Fed has three tools it uses to conduct monetary policy.
1.
2.
3.
Reserve requirement ratio
Discount rate
Open market operations
Reserve requirement ratio
By decreasing (increasing) the reserve requirement ratio, banks are better (less) able
to create money.
In practice, the Fed alters the reserve requirement ratio infrequently. Frequent
changes will cause banks to hold a lot of excess reserves (to guard against increases
in the rrr). As a result, changes in the rrr will end up having little impact.
Discount rate
In practice, the Fed discourages banks from borrowing except when most necessary
(e.g. during the Christmas season when there are significant cash withdrawals,
reducing bank reserves). Over borrowing is an indication of a bank extended more
loans than (on average) it has reserves to back.
442
Monetary Policy
The Fed has three tools it uses to conduct monetary policy.
1.
2.
3.
Reserve requirement ratio
Discount rate
Open market operations
Open market operations
The most widely used tool of the Fed is open market operations. With OMO, the Fed
buys or sells securities (usually government bonds) on the open market. When the
Fed purchases bonds from banks, it increases the banks’ deposits at the Fed, thereby
increasing the banks’ reserves. When the Fed sells bonds to banks, it decreases the
banks’ deposits at the Fed, thereby decreasing bank reserves.
443
Monetary Policy
By altering the money supply, the Fed can influence two economic measures:
inflation and interest rates.
Quantity Theory of Money: How money supply changes affect prices
The quantity theory of money holds that the money supply is related to prices by the
following formula.
Mv  PY
M = money supply
v = velocity of money (number of times a dollar changes hands over a year)
P = IPD
Y = full-employment RGDP
If velocity is constant (which it tends to be, at least over the short run), and the
economy is at full employment, an increase in the money supply causes inflation
only.
444
Money Demand
Money demand is not the demand for “money” – it is the demand for holding one’s
wealth in the form of money rather than in an illiquid form.
Cost to holding wealth in form of money  money yields a low (sometimes negative,
often zero) return.
Components of money demand
1.
Transactions demand  desire to hold wealth in liquid form for purpose of
conducting transactions.
2.
Speculative demand  desire to hold wealth in liquid form for purpose of
taking advantage of investment opportunities.
3.
Precautionary demand  desire to hold wealth in liquid form for purpose of
protecting against unforeseen events.
445
Money Demand
Holding wealth in the form of money makes it easier to conduct transactions, but
yields a low return.
MD is downward sloping because, as interest rates rise, the opportunity cost of
holding wealth in the form of money rises.
R
M/P
“real money” (i.e. purchasing
power)
R
nominal interest rate
MD
M/P
446
Money Supply
Because the money supply is determined by the Fed, it is constant with respect to
interest rates.
R
MS
Equilibrium interest rate
MD
M/P
447
Money Supply
By increasing the money supply (via one of the three policy tools), the Fed causes
interest rates to decline.
R
MS
MS’
5.0%
4.9%
MD
M/P
448
Money Supply
In practice, the Fed uses the Federal Funds Rate (the interest rates that banks
charge each other for loans) as a target for monetary policy. The Fed will select a
level for the Federal Funds Rate (e.g. 4.9%) and then continually adjust the money
supply so as to maintain the Federal Funds Rate at the target level.
This is why the media refer to the Fed “lowering the interest rate” when, in fact, the
interest rate is determined by market forces. Technically, the Fed increases the
money supply.
MS
MS’
R
5.0%
4.9%
MD
M/P
449
Monetary and Fiscal Policies
When the interest rate falls, it becomes less expensive to borrow. As a result,
investment rises. As investment rises, AD rises. As AD rises, RGDP and prices rise.
Expansionary Monetary Policy
MS   R   I   AD   RGDP 
 P
Contractionary Monetary Policy
MS   R   I   AD   RGDP 
 P
Expansionary Fiscal Policy
G   AD   RGDP 
 P
T   C   AD   RGDP 
 P
Contractionary Fiscal Policy
G   AD   RGDP 
 P
T   C   AD   RGDP 
 P
450
Monetary Policy
R  I
MS’
Price Index
MS
R
MS 
LRAS
SRAS
5.0%
I   AD 
MS   R 
4.9%
AD’
MD
AD
M/P
AD   RGDP 
RGDP
451
Monetary Policy
Notice that expansionary policy (either fiscal or monetary) has the desired effect only if the
economy is operating below full employment.
Economy starts at Point A. Increase in MS causes interest rates to fall, investment to rise, and
AD to rise. Economy moves to Point B. Economy is now in over employment. Increases in
resource prices decrease SRAS. Economy moves to Point C.
MS’
Price Index
MS
R
MS 
LRAS
R  I  AD 
C
SRAS’
SRAS
5.0%
B
MS   R 
4.9%
AD’
A
Over employment
MD
M/P
causes SRAS 
AD
RGDP
452
Absolute vs. Relative Advantage
A nation is said to have an absolute advantage in the production of a product if it can
produce that product at a lower cost than another nation.
Cost to produce 1 car (US$, PPP)
Cost to produce 1 computer (US$, PPP)
US
$10,000
$2,000
Japan
$12,000
$4,000
In this example, we say that the US has an absolute advantage in the production of
both cars and computers.
One might argue that these two countries will not trade because the US can produce
both products more cheaply than Japan.
This argument is erroneous because it focuses on the dollar (or “nominal”) cost of
production rather than the opportunity cost (or “real cost”) of production.
453
Absolute vs. Relative Advantage
Cost to produce 1 car (US$, PPP)
Cost to produce 1 computer (US$, PPP)
US
$10,000
$2,000
Japan
$12,000
$4,000
Example
In the US, to produce one additional car requires moving $10,000 worth of resources
out of the production of computers and into the production of cars. Because each
computer requires $2,000 worth of resources, the cost of producing one additional
car is a loss of 5 computers.
In Japan, to produce one additional car requires moving $12,000 worth of resources
out of the production of computers and into the production of cars. Because each
computer requires $4,000 worth of resources, the cost of producing one additional
car is a loss of 3 computers.
We say that Japan has a relative advantage in the production of cars because the
opportunity cost of producing a car in Japan is less than the opportunity cost of
producing a car in the US.
454
Absolute vs. Relative Advantage
Cost to produce 1 car (US$, PPP)
Cost to produce 1 computer (US$, PPP)
US
$10,000
$2,000
Japan
$12,000
$4,000
Example
Similarly, in the US, to produce one additional computer requires moving $2,000
worth of resources out of the production of cars and into the production of
computers. Because each car requires $10,000 worth of resources, the cost of
producing one additional computer is a loss of 0.20 cars.
In Japan, to produce one additional computer requires moving $4,000 worth of
resources out of the production of cars and into the production of computers.
Because each car requires $12,000 worth of resources, the cost of producing one
additional computer is a loss of 0.33 cars.
We say that the US has a relative advantage in the production of computers because
the opportunity cost of producing a computer in the US is less than the opportunity
cost of producing a computer in Japan.
455
Absolute vs. Relative Advantage
Example
Suppose that Mexican and American labor is equally productive. The chart below
shows productivity figures for the two countries’ workers.
Pairs of sneakers 1 worker can produce per hour
Shirts 1 worker can produce per hour
US
10
20
Mexico
20
10
Suppose also that Mexican labor is cheaper than American labor. The chart below
shows wages in the two countries.
US
Mexico
Labor Cost per Hour (US$, PPP)
$9.00
$2.00
Intuition would suggest that Mexico will produce both sneakers and shirts and that
the US will produce nothing. This argument is incorrect because it is based on
absolute, not relative advantage.
456
Absolute vs. Relative Advantage
Pairs of sneakers 1 worker can produce per hour
Shirts 1 worker can produce per hour
US
Mexico
US
10
20
Mexico
20
10
Labor Cost per Hour (US$, PPP)
$9.00
$2.00
Combining these two charts, we find the cost to produce shirts and sneakers in each
country.
Cost to produce 1 pair of sneakers (US$, PPP)
Cost to produce 1 shirt (US$, PPP)
US
$0.90
$0.45
Mexico
$0.10
$0.20
In Mexico, the opportunity cost of producing 1 more shirt is 2 pairs of sneakers. In
the US, the opportunity cost of producing 1 more shirt is ½ of a pair of sneakers.
Mexico has a relative advantage in the production of sneakers and the US has a
relative advantage in the production of shirts.
457
Absolute vs. Relative Advantage
Cost to produce 1 pair of sneakers (US$, PPP)
Cost to produce 1 shirt (US$, PPP)
US
$0.90
$0.45
Mexico
$0.10
$0.20
Relative advantage suggests that Mexico will produce only sneakers and the US will
produce only shirts – despite the fact that Mexican labor is significantly cheaper than
US labor.
Suppose Mexico and the US can exchange shirts for sneakers at a rate of 1-for-1.
Mexico produces only sneakers but wants more shirts. There are two alternatives:
1. Mexico diverts resources out of the production of sneakers and into the
production of shirts. Result: Mexico gains 1 shirt at a loss of 2 sneakers.
2. Mexico trades sneakers to the US in exchange for shirts. Result: Mexico gains 1
shirt at a loss of 1 sneaker.
 It is better for Mexico to trade its shirts to the US for sneakers rather than to
produce sneakers itself.
458
Absolute vs. Relative Advantage
Cost to produce 1 pair of sneakers (US$, PPP)
Cost to produce 1 shirt (US$, PPP)
US
$0.90
$0.45
Mexico
$0.10
$0.20
Suppose Mexico and the US can exchange shirts for sneakers at a rate of 1-for-1.
The US produces only shirts but wants more sneakers. There are two alternatives:
1. The US diverts resources out of the production of shirts and into the production of
sneakers. Result: US gains 1 sneaker at a loss of 2 shirts.
2. The US trades shirts to Mexico in exchange for sneakers. Result: US gains 1
sneaker at a loss of 1 shirt.
 It is better for the US to trade its sneakers to Mexico for shirts rather than to
produce shirts itself.
459
Absolute vs. Relative Advantage
Conclusion:
Trade does not occur because of the cost of domestic labor vs. foreign labor.
Trade does not occur because of the productivity of domestic labor vs. foreign labor.
Trade occurs because of the cost and productivity of domestic labor employed in the
production of one good vs. the cost and productivity of domestic labor employed in
the production of another good.
Example
Because the US has a relative advantage in the production of agricultural products
and a relative disadvantage in the production of automobiles, you support American
car manufacturers when you buy American cars. But, you support American farmers
when you buy foreign cars.
460
Trade
Trade is the combination of specialization and exchange. Countries specialize in the
production of those products in which they have competitive advantages, and then
exchange some of those products for products in which they do not have
competitive advantages.
In practice, countries do not perfectly specialize because of the production
phenomena of specialization and congestion. The more a country focuses on the
production of one product, the more congestion occurs in the firms producing that
product and the more opportunities for specialization arise in firms producing other
products. This results in countries partially specializing.
Warning: Unfortunately, the word “specialization” occurs here with two different
meanings. In reference to a country, “specialization” means “to focus resources on
the production of a specific product.” In reference to a firm, “specialization” means
“an increase in factors employed by the firm causes a proportionally greater increase
in units produced.”
461
Trade
Misconceptions about trade
1.
Trade exploits foreign workers.
Reality: US firms that employ foreign labor overseas do pay foreigners less than
what American workers earn, but more than the foreigners would have earned
from native firms.
Example: In 2000, Nike paid its Indonesian workers $720 per year. This is far
less than the average US worker earns ($32,000 per year), but far more than
the average Indonesian worker earns ($240 per year).
Example: Mexican firms that produce exportable products pay their workers
10% to 70% more than Mexican firms that do not produce exportable products.
462
Trade
Misconceptions about trade
2.
Trade eliminates US jobs.
Reality: US jobs that compete with foreign-made imports are reduced. However,
US jobs that provide foreign-purchased exports are gained. Also, US jobs that
use foreign-made imports are gained.
Example: Inflow of cheaper foreign steel hurts US steelworkers, but helps US
automobile and US tire workers. Countries that gain income from selling steel to
the US are better able to afford American exports. This helps US farmers.
3.
Trade leads to a reduction in competition and a consolidation of power in the
hands of a few large multi-national firms.
Reality: Trade increases the number of consumers and producers and so
increases competition. Increased competition decentralizes economic power.
Example: There are currently 40,000 multi-national firms. This number is far too
large to allow for collusion. Also, the number of multi-national firms is growing
faster than the world economy. This means that, on average, the economic
power of individual multi-national firms is declining.
463
Trade
Using Economy.com’s database, download quarterly data on exports, imports, and
GDP (in current dollars), and the unemployment rate over the period 1980.1 through
the present.
Calculate “relative trade” as (Exports + Imports) / GDP.
Create a graph of unemployment compared to relative trade.
12
Unemployment Rate (%)
10
8
6
4
2
0
0.15
0.17
0.19
0.21
0.23
0.25
0.27
0.29
Relative Trade
464
Exchange Rates
Think of a currency as a product. The exchange rate is the price of that product. The
demand for a currency is determined by foreigners who want to buy products and
investments denominated in that currency.
The demand for pounds is determined
by foreigners who want to purchase
pounds either (1) as an investment, (2)
for the purpose of purchasing British
products, or (3) for the purpose of
purchasing British investments.
E
The exchange rate (E = $/£) is the price
(in US dollars) of a pound.
When E rises, it becomes more
expensive for Americans to buy pounds,
so the quantity of pounds demanded (by
Americans) falls.
D
£
When E falls, it becomes cheaper for
Americans to buy pounds, so the
quantity of pounds demanded (by
Americans) rises.
465
Exchange Rates
The supply of pounds is determined by British who want to sell pounds (for foreign
currency) either (1) as an investment, (2) for the purpose of purchasing foreign
products, or (3) for the purpose of purchasing foreign financial instruments.
E
The exchange rate (E = $/£) is the price
(in US dollars) of a pound.
S
When E rises, it becomes more
profitable for the British to sell pounds
(to the Americans), so the quantity of
pounds supplied (by the British) rises.
When E falls, it becomes less profitable
for the British to sell pounds (to the
Americans), so the quantity of pounds
supplied (by the British) falls.
£
466
Exchange Rates
The equilibrium exchange rate is the price of pounds that causes quantity demanded
of pounds to equal quantity supplied of pounds.
E
S
Equilibrium exchange rate ($/ £)
D
£
Equilibrium quantity of
pounds bought/sold daily
467
Exchange Rates
A change in the exchange rate implies a change in the relative values of the two
currencies.
Exchange rates are typically expressed as Domestic/Foreign. However, because the
definition of “domestic” and “foreign” changes depending on one’s perspective, you
should always verify which currency is in the numerator and which is in the
denominator.
Suppose the exchange rate starts at $2.00/£. This is the same as £0.50/$.
An increase in the exchange rate to $2.10/£ implies that the pound has become more
valuable relative to the dollar.
Because $2.10/£ is the same as £0.48/$, the dollar has become less valuable relative
to the pound.
If the exchange rate is expressed as Domestic/Foreign, then an increase in the
exchange rate means that the domestic currency has become less valuable and a
decrease in the exchange rate means that the domestic currency has become more
valuable.
468
Exchange Rates
Notice that, like in any market, the exchange rate (i.e. the price) changes when
there is a change in either the demand or supply of pounds.
E
1. The exchange rate starts at $1.82
per pound.
S
2. An increase in real interest rates in
the US causes US financial
instruments to be more attractive to
British investors. This is a positive
shock to the supply of pounds.
S’
$1.82
$1.75
3. Supply of pounds increases causing
a decline in the exchange rate.
D
£
A decline in the exchange rate
means that dollars have become
more valuable.
469
Exchange Rates
Notice that, like in any market, the exchange rate (i.e. the price) changes when
there is a change in either the demand or supply of pounds.
E
1. The exchange rate starts at $1.82
per pound.
S
2. Americans demand more British
goods. This is a positive shock to
the demand for pounds.
$1.87
$1.82
D’
D
£
3. Demand for pounds increases
causing an increase in the
exchange rate.
An increase in the exchange rate
means that dollars have become less
valuable.
470
Exchange Rate Regimes
An exchange rate regime is a method for determining the exchange rate.
Exchange rates are usually determined by one of three methods.
1.
Floating rate  Exchange rate is determined by forces of demand and supply.
This is also called the “free market rate.”
2.
Fixed rate  Exchange rate is set by a government. Example: The exchange
rate of the Bahamian dollar with the US dollar is fixed by the Bahamian
government at 1.
3.
Dirty float  A government will allow the exchange rate to be determined by
market forces provided that the rate stays within some bounds set by the
government. If the rate moves outside those bounds, the government will
intervene to hold the rate at the bound until such time as market forces act to
move the rate back within the bounds. This is also called a “managed float.”
Example: The Hong Kong monetary authority will not allow the exchange rate to
fall below $HK7.8/$US
471
Exchange Rate Regimes
A fixed rate or dirty float regime is like a price ceiling and price floor together.
The major difference is that, whereas price controls can be enforced by law, a
government cannot legally enforce fixed rates because many (if not most) of the
exchange rate transactions involving its currency occur outside the country’s
borders.
To maintain a fixed rate or dirty float, a government must intervene in the market
place by buying up its currency to lower the exchange rate and selling its currency
to raise the exchange rate.
Example
The Russian government wants to hold the exchange rate at $0.04/RUB. Because of
a decline in the demand for rubles, the exchange rate starts to fall. To counteract
the decline in the exchange rate, the Russian government begins buying rubles on
the market. The Russian government’s purchases constitute an increase in demand.
The government continues to purchase until the market rate rises back to
$0.04/RUB.
472
Exchange Rate Regimes
Question
What does the Russian government use to buy up rubles on the open market? The
government must use its stock of foreign currencies (e.g. dollars, pounds, etc.) that
it has acquired over time.
Problem
The Russian government can’t print foreign currency. Once it runs out of foreign
currency, it is no longer able to buy up rubles and so can no longer support a falling
exchange rate.
This happened in August 1998 when Russia was forced to devalue the ruble because
Russia had run out of foreign currency with which to buy up rubles.
Result: In the course of 24 hours, the ruble fell by an amount that it otherwise
would have fallen over the course of a year or more.
473
Exchange Rate Regimes
Ruble-Dollar Exchange Rate (1/1/98 - 12/31/98)
0.18
0.16
0.14
$/RUB
0.12
0.1
0.08
0.06
0.04
0.02
0
474
Exchange Rate Regimes
Ruble-Dollar Exchange Rate (1/1/98 - 12/31/98)
25
20
RUB/$
15
10
5
0
475
Exchange Rate Regimes
Dollar-Euro Exchange Rate (1/1/01 - 6/9/05)
1.6
2001
2002
2003
2004
1.4
1.2
$/ECU
1
0.8
0.6
0.4
0.2
0
476
Exchange Rate Regimes
Terminology
In a floating exchange rate regime, when a currency becomes more valuable, it is
said to appreciate. When a currency becomes less valuable it is said to depreciate.
In a fixed exchange rate regime, when a currency is made more valuable, it is said
to be revalued. When a currency is made less valuable, it is said to be devalued.
477
Impact of Exchange Rate Fluctuations
Example
Suppose exchange rate is floating and is currently RUB 4 / $.
Russia exports caviar at a price of RUB 2 each. The US exports Coke at a price of
$0.50 each.
Russian Bank
RUB 4
$1
Russian Importer
2 Cokes
$1
US Exporter
US Bank
$1
RUB 4
Flows of currency
Russia: +RUB 4 –$1
US:
–RUB 4 +$1
US Importer
2 caviar
RUB 4
Russian Exporter
Flows after banks exchange surplus currency
US Bank
RUB 4
$1
Russian Bank
Russia: +RUB 0 –$0
US:
–RUB 0 +$0
478
Impact of Exchange Rate Fluctuations
Now, suppose Russia fixes the exchange rate at RUB 2 / $.
Russia exports caviar at a price of RUB 2 each. The US exports Coke at a price of
$0.50 each.
Russian Bank
RUB 4
$2
Russian Importer
4 Cokes
$2
US Exporter
US Bank
$1
RUB 2
Flows of currency
Russia: +RUB 2 –$2
US:
–RUB 2 +$2
US Importer
1 caviar
RUB 2
Russian Exporter
Flows after banks exchange surplus currency
US Bank
RUB 2
$1
Russian Bank
Russia: +RUB 0 –$1
US:
–RUB 0 +$1
479
Impact of Exchange Rate Fluctuations
Impact of fixing the exchange rate at an artificially low level.
Some People are Better Off
1.
The Russian importer buys more Coke at the same price.
2.
The US exporter sells more Coke at the same price.
Some People are Worse Off
1.
The Russian exporter sells less caviar at the same price.
2.
The US importer buys less caviar at the same price.
Russia is Bleeding US Dollars
When the Russian bank attempts to buy back the dollars that left the country, it
finds that it does not have enough rubles to buy back all of the dollars. The
government bought the remainder in an effort to maintain the artificially low
exchange rate.
480
Impact of Exchange Rate Fluctuations
The alteration in the exchange rate impacts not only exporters and importers, but
also Russian investors investing in US securities and US investors investing in
Russian securities.
Suppose the exchange rate is $0.50/RUB.
US Bank
$10
RUB 20
US Investor
Bond @ FV
RUB 30
US Bank
RUB 20
Russian Firm
RUB 30
Time
$15
US Investor
RUB 30
Bond
Russian Firm
The US investor made a 50% return on the investment, but
incurred (in addition to default risk) exchange rate risk.
481
Impact of Exchange Rate Fluctuations
Suppose the exchange rate is $0.50/RUB initially. But, after the US investor
purchases the bond, Russia devalues its currency to $0.25/RUB.
US Bank
$10
RUB 20
US Investor
Bond @ FV
RUB 30
US Bank
RUB 20
Russian Firm
RUB 30
Time
$7.50
US Investor
RUB 30
Bond
Russian Firm
The US investor incurred a 25% loss on the investment
due to the alteration in the exchange rate.
482
Impact of Exchange Rate Fluctuations
Impact of depreciation or devaluing of a currency.
Some People are Better Off
1.
Russian investors who had invested in US firms prior to the exchange rate
change receive back currency (dollars) that is worth more than the currency
they invested.
2.
US firms that had borrowed from Russian investors prior to the exchange rate
change pay back currency (rubles) that is worth less than the currency they
borrowed.
Some People are Worse Off
1.
US investors who had invested in Russian firms prior to the exchange rate
change receive back currency (rubles) that is worth less than the currency they
invested.
2.
Russian firms who had borrowed from US investors prior to the exchange rate
change pay back currency (dollars) that is worth more than the currency they
borrowed.
483
Hedging Exchange Rate Risk
Exchange rate risk can be hedged via currency options and futures.
A futures contract is a bilateral agreement to buy/sell a quantity of foreign currency
at a specified future date and at a specified price.
An options contract is a unilateral agreement in which the holder of the option has
the right (but not the obligation) to buy or sell a quantity of foreign currency at any
time up to a specified future date and at a specified price (the “strike price”).
A call option gives the contract holder the right to buy the currency. A put option
gives the contract holder the right to sell the currency.
The holder of the contract pays the issuer of the contract a contract premium which
the issuer keeps regardless of whether or not the holder executes the contract.
484
Hedging Exchange Rate Risk
Suppose the exchange rate is $0.50/RUB initially. But, after the US investor
purchases the bond, Russia devalues its currency to $0.25/RUB.
US Bank
$10
RUB 20
The US investor makes the
expected 50% return less the
premium paid for the futures
contract.
premium
US Investor
Bond @ FV
RUB 30
RUB 20
Futures Market
Contract
to sell
RUB 30
for $15
Russian Firm
RUB 30
US Investor
Futures Market
$15
RUB 30
Bond
Russian Firm
485