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Chapter 1 Economics and the Market Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–1 Chapter 1: Economics and the Market • • • • • • Studying choice in a world of scarcity Implications of rationality for good decision making Supply and demand Simple rules Markets and social welfare Microeconomics and macroeconomics Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–2 Economics: Studying Choice in a World of Scarcity • The Scarcity Principle – Boundless wants cannot be satisfied with limited resources – Therefore, having more of one thing usually means having less of another – Because of scarcity we must make choices Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–3 Economics: Studying Choice in a World of Scarcity (cont.) • Economics is the study of how people make choices under conditions of scarcity and of the results of those choices for society • Economists assume that people make choices rationally, with a view to maximising the difference between the cost and benefit for them (their net benefit) Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–4 Applying the Cost–Benefit Principle • Rational Persons – Have well-defined goals who try to meet those goals as best they can – Seek to maximise their net benefit from the course of action arising from any decision – When benefits and costs can be measured, net benefit is called Economic Surplus – the difference between total benefit and cost Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–5 Economics: Studying Choice in a World of Scarcity • The Cost–Benefit Principle – An individual (or a firm or a society) should take an action if, and only if, the extra benefits from taking the action are at least as great as the extra costs – The emphasis is on the EXTRA or MARGINAL benefits and costs – Following this rule maximises total net benefit Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–6 How Do We Define Cost? • Opportunity Cost – The value of the next-best alternative that must be forgone to undertake an activity – So if you value an additional hour of pleasurable leisure time at $20, this is the opportunity cost of an additional hour of burdensome work or study – Conversely, if you can earn $20 per hour, this is the opportunity cost of leisure Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–7 Applying the Cost–Benefit Principle • Should you walk downtown for a half hour to save $10 on a $25 computer game? • The marginal benefit of the walk is $10 • If your time is worth $18 per hour, the marginal cost of the half hour walk is $9 • The marginal benefit ($10) exceeds the marginal cost ($9) of buying the game downtown Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–8 Cost–Benefit Analysis is a Model or Simplification of How People Think • C/B analysis assumes that people make decisions consciously and rationally • What if their decisions are unconscious? • This does not matter as long as their decisions are consistent with the C/B model • Models are abstract constructs (simplified descriptions) that allow us to analyse situations in a logical way Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–9 Other Abstract Models • • • • A computer model of climate change A road map or building plans Simulated crash tests using dummies Analyses of the economy which divide the community into only three parties: – households (consumers) – firms (producers) – the government Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–10 Four Implications of Rationality • Cost and benefits are absolute, not proportional • Example which is more valuable: – saving $100 or 5% on a $2000 international air fare or – saving $90 or 50% on a $180 domestic bus fare? Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–11 Four Implications of Rationality (cont.) • Take Account of Opportunity Costs Example: Do frequent flyer points mean that your trip to destination X is costless? – No, because there may be accommodation costs in excess of those at home – No, because going to destination X may preclude you from going to destination Y Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–12 Four Implications of Rationality (cont.) • Costs already incurred or ‘sunk’ are not relevant to your decisions • The only costs that should influence a decision about whether or not to take an action are those that we can avoid by not taking that action Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–13 Sunk Costs are Irrelevant • The entry fee to an ‘all you can eat’ restaurant is irrelevant to how much we should eat, once we have entered and paid • Since the marginal cost is zero, we should eat up to the point where the marginal benefit of eating is zero • Failure to observe this rule will lead to indigestion and regret (negative marginal benefit) through overeating! Emotion of greed has overcome rational thought! Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–14 Four Implications of Rationality • The cost of a course of action is what it adds to our total costs, that is its marginal cost • Marginal, not average, costs are relevant Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–15 Example of the Average–Marginal Distinction • Should NASA expand the space shuttle program from three launches per year to four? • Assume average benefit = marginal benefit = $6 billion • Assume marginal cost exceeds average cost Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–16 The Optimal Number of Launches Total Cost No. of Launches ($ billion) Average Cost ($ billion/launch) Marginal Cost 0 0 0 0 1 3 3 3 2 7 3.5 4 3 12 4 5 4 20 5 8 5 32 6.4 12 What is the optimal number of launches? Assume: Average Benefit = Marginal Benefit = $6 billion Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–17 Supply and Demand: An Introduction Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–18 What, How, and for Whom? Central Planning Versus the Market • Given limited resources and unlimited wants, there are three problems facing all economic systems – What should be produced? – How should it be produced? – For whom will it be produced? Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–19 Free Markets vs Central Plans • In market or capitalist economies these decisions are made by individual households (consumers and owners of factors of production) and firms (producers) who participate in markets as buyers and sellers of factor services and finished goods • In centrally planned economies these decisions are made by the authorities • In mixed economies, households, firms and government all play a role in decisions Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–20 Market Demand As price falls, the quantity demanded rises because: • Substitutes become less attractive • There is a rise in the purchasing power of buyers’ incomes • So existing consumers buy more and new consumers enter the market Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–21 The Daily Demand Curve for Pizza Price ($ per slice) 4 3 Demand 2 8 12 16 Quantity (1000s of slices per day) 1–22 Market Supply • As prices rise, the quantity supplied increases • This is because the benefit to suppliers rises relative to their costs of production • These costs include their opportunity costs – the revenue they get from alternative products Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–23 The Daily Supply Curve for Pizza Price ($ per slice) Supply 4 3 2 8 12 16 Quantity (1000s of slices per day) 1–24 Market Equilibrium • Occurs where the demand curve intersects the supply curve: the quantity demanded = the quantity supplied and no pressure for price to change • At prices above this point the quantity supplied exceeds the quantity demanded (there is excess supply) and prices fall • At prices below this point there is excess demand and prices rise Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–25 The Equilibrium Price and Quantity of Pizza Price ($ per slice) Supply Equilibrium at $3 Quantity Demanded = Quantity Supplied 4 3 2 Demand 8 12 16 Quantity (1000s of slices per day) 1–26 Excess Supply: Prices Fall Price ($ per slice) Excess supply = 8000 slices/day Supply 4 3 2 Demand 8 12 16 Quantity (1000s of slices per day) 1–27 Excess Demand: Prices Rise Price ($ per slice) Supply 4 Excess demand = 8000 slices per day 3 2 Demand 8 16 Quantity (1000s of slices per day) 1–28 Graphing Supply and Demand and Finding the Equilibrium Price and Quantity Price ($ per slice) Supply 5 4 The Equilibrium Price = $2.50 The Equilibrium Quantity = 5 3 2.50 2 1 0 Demand 2 4 6 5 8 10 Quantity (1000s of slices per day) 1–29 Predicting and Explaining Changes in Prices and Quantities • Distinguishing Between – A change in the quantity demanded (a movement along the demand curve that occurs in response to a change in price) and – A change in demand (a shift of the entire demand curve) Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–30 An Increase in Quantity Demanded vs an Increase in Demand Price ($/can) 6 D Increase in quantity demanded 5 4 3 2 1 0 D 2 4 12 Quantity (1000s of cans/day) 1–31 An Increase in Quantity Demanded vs an Increase in Demand Price ($/can) 6 D’ D 5 4 Increase in demand 3 2 D’ 1 0 D 12 Quantity (1000s of cans/day) 1–32 Predicting and Explaining Changes in Prices and Quantities • Change in the quantity supplied – A movement along the supply curve that occurs in response to a change in price • Change in supply – A shift of the entire supply curve Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–33 An Increase in Quantity Supplied vs an Increase in Supply Price ($/can) S 6 5 Increase in quantity supplied 4 3 2 S 1 0 2 4 6 8 10 Quantity (1000s of cans/day) 1–34 An Increase in Quantity Supplied vs an Increase in Supply Price ($/can) 6 S S’ 5 4 3 Increase in supply 2 1 S’ S 0 2 4 6 8 10 Quantity (1000s of cans/day) 1–35 Factors Changing Demand • • • • • Change in price of complement Change in price of substitute Change in income Change in population of potential buyers Change in expectations of future prices Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–36 Factors Changing Supply • • • • • Change in cost of inputs Change in technology Change in number of suppliers Change in expectations of future prices Change in profitability of other industries competing for resources Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–37 Markets and Social Welfare • If prices reflect marginal benefits (MB) to buyers and marginal costs (MC) to society, free market equilibrium is good for the community • This is because Price = MB = MC and consumers are getting as much of the commodity as they are willing to pay for • Price controls prevent this Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–38 Price Controls in the Pizza Market Price ($ per slice) Supply 4 Excess demand = 8000 slices per day 3 Price ceiling = 2 Demand 8 12 16 Quantity (1000s of slices per day) 1–39 Price Ceilings • Price ceiling causes production to fall from 12 to 8, a reduction of 4 units • On average, these 4 units cost $2.50 each to make, or $10 in total (4 x 2.5) • On average, consumers value these 4 units at $3.50 each or $14 in total (4 x 3.5) • So the price ceilings have caused a loss of economic surplus to the community of $4: we saved $10 by not making them, but lost $14! Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–40 Cash on the Table: Buyers • In the absence of price ceilings, the price is $3 and the quantity is 12 units • Price ceilings deprive consumers of 4 units, which they value at $3.50 each or $14 • Without price ceilings, consumers would have paid $12 ($3 x 4) for them • So price ceilings have deprived consumers of a surplus (cash on the table) of $2, or $0.50 per unit Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–41 Cash on the Table: Sellers • Sellers have also lost profits on 4 units • Without price ceilings they received $3 per unit on 4 units which, on average, cost $2.50 to make, a profit of $0.50 per unit • They have lost profits (cash on the table) of $2 (4 x $0.50) • So the price ceilings have imposed a social loss of $4, $2 on buyers and $2 on sellers Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–42 When is the Market Efficient? • When all of the costs of producing the good or service are borne directly by the seller, so that costs to producers reflect costs to the community • When all benefits from the good or service accrue directly to buyers, so that benefits to buyers reflect benefits to the community Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–43 When is the Market Inefficient? • Smart For One, Dumb For All – When some costs of production fall on people other than those who produce the commodity – When some of the benefits of the commodity fall on people other than those who consume the commodity Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–44 Inefficient Markets • Example: Environmental Pollution – The market is in equilibrium: Sellers’ MC = MB – However, sellers’ MC underestimates the cost to society of producing the good – Therefore, the market produces more than the efficient amount and there is no incentive for producers and consumers to alter their behaviour Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–45 Inefficient Markets • Example: Vaccinations – The market is in equilibrium: Buyers’ MB = MC – Buyers’ MB underestimates the benefits to society of consuming the vaccinations – The market produces less than the efficient amount of vaccinations and there is no incentive for producers and consumers to alter their behaviour Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 1–46