Economics Cram Kit

7/18/2019 Economics Cram Kit

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ECONOMICS

20 1 32 0 1 4E D I T I O N

Introduction to

Economics

Y E A R S

1 9 D O I N G O U R B E S T , S O Y O U C A N D O Y O

U R

the WorldScholar’s Cup®

®

ECONOMICSCRAM KIT

ALPA CA- IN-CH IEF

Daniel Berdichevsky

EDITOR

Tania Asnes





ECONOMICS CRAM KIT | 2

FUNDAMENTAL ECONOMIC CONCEPTSHow to Think like an Economist

ADMISSION TO THE CLUB THE RATIONAL HOMO ECONOMICUS

SO YOU WANT TO BE AN ECONOMIST?

Repeat after me…

1. There are no free lunches.

2. People have unlimited wants.

3. The cost of doing something includes its fulleconomic cost.

4. Humans behave rationally.

5. Humans benefit from voluntary exchange-----otherwise they wouldn’t trade.

WHY IS THERE SCARCITY?

Because wants are unlimited and resources are limited.

To cope, we must make choices and face trade-offs

MARGINAL ANALYSIS

Marginal analysis involves comparing the costs and benefitsof doing just a little more of something. The marginal benefit

of reading one more page of this Cram Kit is one more questionanswered correctly at competition.

THE COST OF MAKING A CHOICE

We have to pay for our choices. What's more, we give up achoice we don’t make for every choice we do make.

TYPES OF COSTS

Type Definition Example

Opportunitycost (implicit

cost)

Value of thenext-best

choice

Value of sleepyou lose whenyou choose to

cram

Accounting

cost (explicitcost)

What you

tangibly pay toget something

Cost in

dollars of thisCram Kit

Economiccost

Opportunitycost +

accountingcost

Sum of theabove

RATIONALITY CHECKLIST

Perform cost-benefit analysis

Maximize utility, or happiness

Think on the margin

Account for all economic costs

MAXIMIZING UTILITY

An economic agent maximizes utility when marginalutility equals marginal cost

DIMINISHING RETURNS

Economists assume that marginal benefit decreases aquantity increases. Eating your 42nd slice will not mak

you as happy as the first one did.

THE INVISIBLE HAND STRIKES BACK

In 1776, Adam Smith published An Inquiry into theNature and Causes of the Wealth of Nations,

establishing the field of economics and the idea of th“invisible hand” (the market regulates itself).

QUICK QUIZ

QUESTIONS

1. The full cost of a decision is its __________.

2. If Jolly Jeremy Joe is in a hot dog competition, thefact that his 100th hot dog gives him far less utilitythan his first is known as _____________.

3. There are no free lunches in our world because of__________ and _____________.

ANSWERS

1. economic cost

2. diminishing returns

3. limited resources, unlimited wants

Number of slices

Marginalbenefit

Marginalutility




FUNDAMENTAL ECONOMIC CONCEPTSCategorization

MODELING MICROECONOMICS VS. MACROECONOMICS

ECONOMIC ANALYSIS`

Theoretical models capture the basics of economic

interactions while stripping away extra details.

Most models look too simplistic. But it is this simplicitythat allows us to identify what assumptions andcharacteristics are important.

The true strength of a model is how well it captures andpredicts whatever we want to understand.

MODELING PARETO EFFICIENCY

Something is Pareto efficient when no one canhave more without someone else ending up

with less .

If you and your two friends split $100 so thateach of you has $33 and $1 is left on the table,the situation is not pareto efficient. You could

take one more dollar without hurting yourfriends.

But if you and your two friends split $100 sothat you have $100 and each of them has $0,the situation is pareto efficient. They can’t get

any money without taking away some of yours.

THREE FUNDAMENTAL QUESTIONS

Every market must answer three basic questions:

THE PYRAMID OF ECONOMICS

MICROECONOMICS

Microeconomics models individual behavior to analyzmarkets as a whole. Conclusions about markets are

then extended to the economy as a whole.Microeconomics works up the pyramid.

MACROECONOMICS

Macroeconomics is concerned with the entire economIt studies big changes and analyzes how societies-----anthe individuals within them-----can and do grow better oworse off. Macroeconomics works down the pyramid

POSITIVE VS. NORMATIVE ECONOMICS

POSITIVE NORMATIVE

‘‘What is?’’ ‘‘What should be?’’

Falsifiablestatements --- now or

with future data

Subjectivestatements

Conclusions of amodel

Judgments

POSITIVE OR NORMATIVE?

‘‘Academic Decathlon puts the Decathlete through10 different events’’ (positive)

‘‘Temperatures next year will cause a 10% decline crop yields.’’ (positive)

‘‘Economics is tough, but understanding it is useful understanding policy’’ (normative)

‘‘Alpacas are better than llamas’’ (normative)

Economies

Markets

Individuals

Careful observation Description

Measurement ofeconomic theory

Theory

EconomicAnalysis

1•How much should be produced?

2•Who should produce?

3•Who should receive what is produced?




FUNDAMENTAL ECONOMIC CONCEPTSThe Origin of Markets (Trade)

WHY TRADE? PRODUCTION POSSIBILITIES FRONTIER (PPF)

ABSOLUTE VS. COMPARATIVE ADVANTAGE

An agent can be terrible at producing every good and serviceand have no absolute advantages versus a second agent, but

he must have a comparative advantage in at least one good

AN EXAMPLE FROM OUTER SPACE

1. Say Laika is very good at producing both dogtreats and spacesuits. She can produce 80 dogtreats or 20 spacesuits in one month.

2. Neil is not very good at producing either good.He can produce 30 dog treats or 10 spacesuitsin one month.

3. Laika has absolute advantages for both goods,

while Neil has none.4. Laika gives up four dog treats for each spacesuit

produced, while Neil only gives up three.

a. Laika gives up 1/4 of a spacesuit per dogtreat, less than Neil’s 1/3 of an spacesuit

b. Neil gives up 3 dog treats per spacesuit,less than Laika’s 4 dog treats

5. This means Laika has a comparative advantagein producing dog treats, while Neil has acomparative advantage in producing spacesuits.

6. Therefore, Laika should specialize in producingdog treats, and Neil in producing spacesuits.

7. Trade benefits both because they are able tospecialize in their comparative advantages.

A country’s PPF represents all the combinations ofoutput (in this case, combinations of milk andmissiles) that are feasible

Any combination of milk and missiles inside or on curve is possible, but only points on the curve areefficient

Points outside the curve are impossible to producebut may be obtained through the benefits of trade

Producing more of one good requires a tradeoff in

the form of less production of the other good The curve bows out because of diminishing return

to scale: producing more milk increases theopportunity cost in terms of missiles

Different slopes (different opportunity costs) implcomparative advantages

A curve that is farther out indicates higherproduction and an absolute advantage

TRADE QUESTIONS FOR ANSWERS

QUESTIONS

1. If an agent can produce more of a good than anothagent with the same inputs, he has a(n) _____.

2. Comparative advantages arise from lower ___ ofproduction.

ANSWE

1. absolute advanta2. opportunity cos

Absolute advantage

An agent has an absoluteadvantage for producing

a good when he canproduce that good more

efficiently than otheragents.

Comparative

advantage

An agent has acomparative advantage

for producing a goodwhen he can producethat good at a loweropportunity cost than

other agents.




MICROECONOMICSIntroduction to Markets

PERFECT COMPETITON MARKET MODEL MARKETS

ASSUMING MAKES…

The perfectly competitive market model relies on several keyassumptions. These assumptions mark the boundarybetween perfect competition and other market types:

WE ALL COME TOGETHER

Markets occur when producers and consumersexchange a certain good or service voluntarily

Markets do not have to be explicitly created by acentral body (like a government)

Markets are not always highly organized

As long as the transactions are voluntary, everyoninvolved will be better off

THE PRICE IS RIGHT

A market price conveys the value of a good toproducers and consumers

In perfect competition, the price represents theopportunity cost of a good’s production

Price also signals the value of the good to allproducers and consumers

All buyers and sellers are price takers, not makers

AGGREGATION

Prices are good indicators of a product’s value in acompetitive market. Adding up prices allows us to

compare different goods. This process is calledaggregation and allows firms and consumers to make

good market decisions.

MARKET MENTALITY

QUESTIONS

1. What does “no agent has market power” mean incontext of a perfectly competitive market?

2. In a competitive market, market price reflects the______________.

3. Aggregation is the process of ____________.

ANSWE

1. No individual agent can affect the market price.economic agents must accept the market price as

determined by the market as a wh

2. value consumers and producers place on the go

3. comparing different goods using a common measurstick, such as market p

•No individual has marketpower

•No producer can set pricesother than the market price

All agents acceptprices as given

•All producers produce anidentical product or service

One

homogenousproduct

•Consuming more of aproduct eventually offersless utility to consumers

•Inputs eventually grow lessuseful as production rises

Diminishingreturns

•Entry costs are the costs ofstarting a certain business

•Exit costs are costs ofshutting down a business

Entry and exitcosts are zero

•The process of exchangedoes not add more costs

•The market price is thesame for all consumers

Transactioncosts are zero

•Consumers are aware of allproducers and vice versa

•Everyone has access to themarket price

Perfect

information

•Firms maximize profits

•Consumers maximizeutility

Rational behavior




MICROECONOMICSDemand

THEORY OF THE CONSUMER SHIFTING ALL OVER THE PLACE

THE LAW OF DEMAND

The quantity demanded of a good by consumers increases

when market price decreases and decreases when priceincreases-----price and quantity demandedare negatively correlated.

TERM DEFINITION

Quantity demanded

The amount of a goodconsumers will demand at agiven price; a specific value,

NOT the general relationshipgiven by demand

Demand The overall relationship givenby the law of demand, relatesprice to quantity demanded

Demand schedule

A table that represents thelaw of demand, maps values

of prices to quantitiesdemanded

Demand curve

Curve that represents the lawof demand, maps an interval

of prices to quantitiesdemanded

[

THE DEMAND CURVE

THE DEMAND SCHEDULE

Price $5 $10 $15 $20 $25

Quantity 20 15 10 5 0

CONSUMER INCOME

Normal goods Inferior goods

Computers, yachts,calculators

Dollar store goods,used textbooks

Increased incomehigher demand

Increased income lower demand

PRICES OF RELATED GOODS

Substitutes Complements

Goods that canreplace one another-----

7-Up and Sprite

Goods that combinefor consumption-----

peanut butter and jellyIncreased price of one higher demand for

substitute

Increased price of one lower demand for

complement

NUMBER OF CONSUMERS

Increased number of consumers higher demand

CONSUMER PREFERENCES AND EXPECTATIONS

Good becomes more desirable higher demand

Expectation of pay cut lower demand

Shifts in a curve are NOT the same aschanges in quantity or price

‘‘Demand increased’’ is a shift of thedemand curve; quantity demanded

has changed at every price

A change in quantity demanded or priceis a movement along the curve

I DEMAND A QUIZ

QUESTIONS

1. The law of demand states that when price increasequantity demanded ______.

2. A change in quantity demanded for every priceimplies a _______.

3. An increase in the price of a good will lead to a(n)______ in the demand for its complement.

ANSWE

1. decreases; 2. shift of the demand curve; 3. decrea

Price

Quantity Demanded

$25

$20

$15

$10

$5

5 10 15 20




MICROECONOMICSSupply

THEORY OF THE FIRM SHIFTY SUPPLY

THE LAW OF SUPPLY

The quantity of a good supplied by producers

increases when market price increases and decreaseswhen price decreases-----price and quantity supplied

are positively correlated.

TERM DEFINITION

Quantity supplied

The amount of a good firmswill supply at a given price; a

specific value, NOT thegeneral relationship given by

supply

Supply The overall relationship givenby the law of supply, relates

price to quantity supplied

Supply schedule A table that represents

supply, maps values of pricesto quantities supplied

Supply curve Curve that represents supply,maps an interval of prices to

quantities supplied

THE SUPPLY CURVE

THE SUPPLY SCHEDULE

Price $5 $10 $15 $20 $25

Quantity 0 5 10 15 20

FACTORS AFFECTING SUPPLY

Factor Impact SupplyIncreased costs ofproduction factors

Higher costsLower supply

Technologicaladvances

Lower costs

HighersupplyExpectations of

lower future pricesHigher

current prices

Increased number offirms

-

SHIFTS VS. MOVEMENTS

A HEALTHY SUPPLY OF QUIZZES

QUESTIONS

1. When price increases, quantity supplied ____.

2. If firms expect prices to rise, supply will ___ now.

ANSWE

1. increases; 2. decrea

Price

Quantity Supplied

$25

$20

$15

$10

$5

5 10 15 20




MICROECONOMICSElasticity

ELASTICITY BASICS CALCULATING ELASTICITY

PRICE ELASTICITY OF DEMAND

How much is quantity demanded

affected by changes in the good’s price?

PRICE ELASTICITY OF SUPPLY

How much is quantity suppliedaffected by changes in a good’s price?

ELASTICITY AND GOODS

DEMAND

Elastic Inelastic

Goods with closesubstitutes | Example:

baseball caps

Luxury goods that we cando without | Example:

Porsches

Necessities that peoplemust buy regardless ofprice | Example: insulin

SUPPLY

Elastic Inelastic

In the long run, firms can

reallocate resources

In the short run, firmscannot reallocate

resourcesExtremely scarce goods

FACTORS THAT AFFECT PRICE ELASTICITY

Demand

Degree of substitution (goods withclose substitutes have high elasticityof demand)

Degree of necessity (necessities aremore inelastic)

Time frame (in the short run, goodstend to be more inelastic)

Scope of the market (a larger marketis more inelastic since fewersubstitutes are available)

Supply

Scarcity of inputs (scarcity of inputsmeans more inelastic supply)

Time frame (in the short run, supplyis inelastic)

Presence of barriers to entry (lowerbarriers to entry means more elasticsupply)

THE FORMULA

E is the elasticity of A with respect to B

AF is the final value of A, AI is the initial value

BF is the final value of B, B I is the initial value

DEFINITIONS

E = 0: Perfectly inelastic , vertical line; change invariable B does not affect variable A at all

0 < E < 1: Inelastic ; steep line; change in variable B

causes a smaller change in variable A E = 1: Unit elastic ; convex curve; change in variabl

B causes an equal change in variable A

E > 1: Elastic ; shallow line, change in variable Bcauses a larger change in variable A

E =∞: Perfectly elastic ; horizontal line; changing

variable B infinitely affects variable A

AN EXAMPLE

E is the price elasticity of demand (elasticity ofdemand with respect to price)

m is a good’s price; pF and pI are final and initialprice, respectively

q is the quantity demanded; qF and qI are final andinitial quantities, respectively

REVENUE | THE ELASTICITY SHORTCUT

Revenue = price of good x quantity

IIF

IIF

B÷)B-(B

A÷)A-(A

Binchange%

Ainchange%

=E ≈

IIF

IIF

p÷)p-(p

q÷)q-(q

pinchange%

qinchange%=E ≈

Price elasticgood

•Increase inprice ®

decrease inrevenue

Price inelasticgood


increase inrevenue

Unit elasticgood


no change inrevenue




MICROECONOMICSEquilibrium

MEET ME AT THE INTERSECTION MARKET SURPLUS

THE INVISIBLE HAND

The laws of supply and demand meet at the marketequilibrium point, where their forces areequal and opposite.

Triangle A is consumer surplus, or the differencebetween how much consumers are willing to payand the market price

Triangle B is producer surplus, or the differencebetween the price at which firms are willing to selltheir product and the market price

Market equilibrium maximizes market surplus, orthe sum of producer and consumer surplus; the goof social planners is to maximize this surplus

SHIFTING SUPPLY AND DEMAND

Shift Result

Supply Demand Price Quantity Producer surplus Consumer surplus Total surplus

- N/A ¯ - ambiguous - -

¯ N/A - ¯ ambiguous ¯ ¯

N/A - - - - ambiguous -

N/A ¯ ¯ ¯ ¯ ambiguous ¯

- - ambiguous - - - -

¯ ¯ ambiguous ¯ ¯ ¯ ¯

- ¯ ¯ ambiguous ambiguous ambiguous ambiguous

¯ - - ambiguous ambiguous ambiguous ambiguous

An- means an increase, not a shift upward. Likewise, ¯ means a decrease, not a shift downward.

A

B

Price

Quantity




MICROECONOMICSGovernment Policies

PRICE CONTROLS TAXATION

PRICE CEILINGS

Price ceilings set a maximum legal price on a good. If this

price is below the equilibrium price, the ceiling is binding andthe market price is changed.

Trapezoid A is the new consumer surplus Triangle B is the new producer surplus

Triangle C is the deadweight loss caused by the policybecause the market is not in equilibrium

The width of the shaded rectangle is the differencebetween quantity demanded and quantity supplied, orthe shortage in the market

Note that A + B + C = equilibrium market surplus

PRICE FLOOR

Triangle A is the new consumer surplus

Trapezoid B is the new producer surplus

Triangle C is the policy’s deadweight loss

The width of the shaded rectangle is the differencebetween quantity supplied and quantity demanded-----in other words, the surplus in the market

THE LESSON TO BE LEARNED

Applying a price ceiling below equilibrium or a

price floor above equilibrium is inefficient andleads to deadweight losses.

ONLY ON THE MARGIN

Marginal taxes (taxes per unit) make consumers pay

different price than what producers receive. Thegovernment steps in between consumers andproducers. Since marginal taxes distort how prices

signal value, they lead to inefficiency.

Triangle A is the new consumer surplus

Triangle B is the new producer surplus

Triangle C is the deadweight loss caused by taxatiobecause quantity is contracted (mutually beneficiatransactions are not taking place)

Rectangle D is tax revenue, which is equal to mark

quantity times revenueNote that marginal taxation is equivalent to holdingquantity at a fixed value (like a quantity ceiling)

ELASTICITY AND TAXATION

Flatter curves increase the size of the deadweightloss triangle and make the revenue rectanglesmaller

Therefore, markets with elastic demand and supplcurves suffer the most from taxation and providethe least revenue

The incidence of taxation determines whetherconsumers or producers bear the majority of the ta

If supply is more inelastic than demand, demand cadjust more easily and firms bear more of the tax

Similarly, if demand is more inelastic, consumerswill bear the brunt of the taxation

A

PriceB

PriceFloor

Quantity

C

APrice

B

C

PriceCeiling

Quantity

A

Price

B

Producer

price

Quantity

Consumerprice

Tax D C




MICROECONOMICSTariffs and Exports

TRADE IN A SMALL ECONOMY TRADE TAXATION

OVERPOWERED BY THE WORLD

We assume the domestic economy is small relative to the

world economy and cannot influence the world price.Therefore, the world price is fixed for the domestic market,

making international trade equivalent to a price control. Thedifference is that the world market either buys the surplus or

supplies the shortage.

DIAGRAM OF AN IMPORTING ECONOMY

The big triangle A is consumer surplus

The small triangle B is producer surplus

Triangle C represents the gains from trade Rectangle D is the value of the goods imported

AN EXPORTING ECONOMY

The small triangle A is consumer surplus

The big triangle B is producer surplus

Triangle C represents the gains from trade

Rectangle D is the value of the goods exported

TARIFFS, IMPORT DUTIES, AND OTHER NASTIES

A tariff is a tax on imports.

Triangle A represents the gains from trade with theimport tax in place

Triangle B is the revenue collected by thegovernment from the tax

The two triangles marked by C are the deadweightlosses associated with the tax

If the tax were removed, the gains from trade woube A + B + C

Applying an import tariff increases producer surpluat the expense of consumer surplus and efficiency

TRADE AND TARIFFS TRIVIA

QUESTIONS

1. An export tax benefits domestic _______ at theexpense of domestic _______.

2. An import tax benefits international _______ at theexpense of international _______.

3. For a small open economy, international trade isequivalent to a binding _______ _______.

4. If voluntary trade is always beneficial, why do somoppose it?

ANSWE

1. consumers; produce

2. consumers; produce

3. price cont

4. While the economy as a whobenefits, not everyone do

A

Price B

WorldPrice

Quantity

D

C

APrice

B

WorldPrice

Quantity

C

D

A

Price

World Price+ Tariff

Quantity

World PriceB

C

C C




MICROECONOMICSBehavior of Firms

FIRM DECISION-MAKING COST CURVES

TYPES OF COSTS

Fixed costs: Incurred even when quantity produced is

zero, independent of output Variable costs: Change with quantity produced,

contribute to marginal cost

Total costs: Sum of fixed costs and variable costs

MARGINAL COST & MARGINAL REVENUE

Marginalcost

Cost of producing ‘‘just onemore’’ of a good

Marginalrevenue

Revenue from producing ‘‘justone more’’ of a good. For a

perfectly competitive market,fixed at market price

TYPES OF PROFIT

1. Accounting profit: Total revenue minus accountingcosts; producers attempt to maximize this

2. Economic profit: Total revenue minus full economiccosts (including opportunity costs)

3. Normal profit: Zero economic profit; means accountingprofit equals opportunity cost of production; in a

competitive market firms can expect normal profits in thelong run

THE GOLDEN RULE: MC = MR

All firms are assumed to seek to maximize profits.

Profit maximization in any market occurs where marginalrevenue equals marginal cost (MC=MR).

All firms will produce up to this point of profit-maximization.

In graphical terms, find where the marginal cost and marginalrevenue curves intersect. Then, look at the quantity wherethat occurs.

In a perfectly competitive market, the marginal revenue curveis the same as the demand curve, which is perfectly elastic at

the market price.

In a perfectly competitive market, therefore, profit-maximization occurs where the demand curve intersects the

MC curve.

AVERAGE COST CURVES

AverageFixed Cost

Fixed costs divided by quantityproduced

Decreases as quantity increases

Averagevariable

cost (AVC)

Variable costs divided by quantityproduced

Decreases and then increase

Averagetotal cost

(ATC)

Sum of average fixed cost and averagvariable cost

ATC =Total fixed costs + Total variable costs

Total number of units produced

DIMINISHING RETURNS TO SCALE

Marginal costs first decrease and then increase. Thisphenomenon is the result of diminishing returns to scal

Firms will spread fixed costs over multiple units ofoutput. Variable costs, however, will drag average cos

upward after a certain point.

Consider a restaurant kitchen. After a certain point,adding too many cooks will cause inefficiency-----they wget in one another’s way, and one may faceplant into th

soup.

MULTIPLE INPUTS

Inputs: labor and capital

Prices: wage rate and price of capital

Increasing the price of an input makes a firmsubstitute away from it

Quantity Produced

Averagefixed cost

Marginal cost

AFC Averagevariable cost

Averagetotal cost

$




MICROECONOMICSFailures of Perfect Competition

IMPERFECT MARKETS: MONOPOLY I HAVE THE POWER

FAILURES OF PERFECT COMPETITION

Removing any assumptions of perfect competition creates a

new market type. All of these market types are inefficientand create deadweight loss. All firms face downward sloping

demand curves.

MONOPOLY BASICS

Only one firm supplies (example: De Beers diamonds)

This firm has full market power to set prices

Arise from barriers to entry or economies of scale (aftera certain point, producing more of a good will increasecosts due to increasing inefficiency)

Faces a downward sloping demand curve (for the entiremarket)

DEALING WITH MONOPOLIES

The United States government has devised severalmethods of dealing with monopolies.

RegulationLegislation (Sherman

Anti-Trust Act)Public

Ownership

MARKET POWER

Market power is the ability of an individual to influenc

market price. Perfect competitors have no marketpower and must accept the market price.

CAUSES OF MARKET POWER

PRICE DISCRIMINATION

Price discrimination involves sellingthe same product to different consumers at different

prices-----such as airline seats or movie tickets.

This practice increases producer surplus at the expenseconsumer surplus. Monopolies price discriminate tocapture new consumers without losing current ones

BARRIERS TO ENTRY

Monopolies arise due to barriers that keep competitorsfrom entering the market. Barriers include:

Ownership of a key resource

Government-created barriers (patents, copyrightsand other property protections)

Natural monopolies: emerge when it is practical foonly one seller to operate in a given market

YOU SHALL NOT MATCH

1. Market power2. Economies of scale

3. Sherman Anti-Trust Act

4. Barriers to entry

5. Only one supplier

A. After a certain pointproducing more gooincreases costs

B. Monopoly

C. Ability to influencemarket price

D. Legislation that dealwith monopolies

E. Prevent more firmsfrom entering

Answers: 1. C; 2. A; 3. D; 4. E; 5

•Monopolies can produce less than what isdemanded to increase profits

•This leaves some consumer demand unmet,decreasing general welfare

•Some consumer surplus becomes producersurplus, but part of it vanishes as deadweightloss

Deliberate scarcity

•Monopolists are sometimes lazy, incompetent,or just lack incentive to raise standards due tono competition

•This inefficiency can result in wasted resources,higher production costs, and higher prices

Inefficiency

•A monopoly will set price and quantity suppliedwhere marginal revenue equals marginal cost

•Unlike a perfectly competitive firm, increasingsupply to reach that point increases economicprofits

Positive economic profit

High entrycosts

Policies thatrestrict entry

Economies ofscale

Control ofnatural

resources

Rent seeking(see later)




Harm others

They are the costs

of an action thatare not passedalong to the agenttaking that action

Since the agentdoes not face thecost, he willperform more ofthe action than isoptimal

Negativeexternalities

Benefit others

They are the

benefits of anaction not felt bythe agent takingthat action

Since the agentdoes not enjoy thbenefit, he willperform less of taction than isoptimal

Positiveexternalities

MICROECONOMICSFailures of Perfect Competition

IMPERFECT MARKETS CONTINUED MARKET FAILURES

OLIGOPOLY

Only a few firms (suppliers) exist

Each firm has some degree of market power

Goods are either homogenous or differentiated

Firms primarily face non-price competition

Producers often collude and form cartels

Examples: Market for mobile phone service, OPEC

Collusion occurs when firms in an oligopoly cooperate toraise market prices artificially. A group of firms that colludesto control prices is a cartel, which is illegal under U.S. anti-

trust law.

The incentive to cheat in a cartel is strong, so cartels tend to

break down even without government intervention.

THE BOTTOM LINE

An oligopoly will be more efficient and benefitmore people than a monopoly, but will be less

efficient and benefit fewer people than aperfectly competitive market.

MONOPOLISTIC COMPETITION

Goods no longer homogenous

Large number of firms, just like perfect competition

Firms compete by differentiating their products, oftenartificially

Producers often engage in non-price competition (forexample, through advertising)

Firms face a downward sloping demand curve

Examples: Blue jeans, restaurants, toothbrushes

The diversification of products in a monopolisticallycompetitive market gives consumers more choices than in a

perfectly competitive market, where all products arehomogenous.

However, since market price is greater than marginal cost, themarkets will experience some social inefficiency.

THE BOTTOM LINE

You can spot a monopolistically competitivemarket whenever multiple companies are using

ads to convince you that their products aredifferent when they are actually pretty similar.

Market failures occur when competitive markets fail tproduce socially desirable outcomes.

The two main forms of market failures are linked toexternalities and public goods.

Externalities are costs or benefits associatedwith a decision not factored into the decision-making

process. They do not affectthe decision maker directly.

INTERNALIZE IT!

One way to address externalities is to internalize themby incorporating the cost of the externality into the

market. For instance, if companies are taxed for eachpound of pollution they emit-----and the tax is set to equ

the cost of that pollution to society-----companies wilmake choices based on true social cost.

THE COASE THEOREM

As long as the parties involved in a dispute cannegotiate and property rights are clearly defined, the

private market can settle any disputes.

PLEASE DON’T FAIL THIS TRUTH TEST

TRUE/FALSE

1. Oligopolies are more efficient than monopolies

2. Externalities are the only area of market failure

ANSWE

1. Tr

2. False; public goods are alassociated with market failu




MICROECONOMICSInstitutions

PROPERTY RIGHTS ENTREPRENEURS & CREATIVE DESTRUCTION

INSTITUTIONS AND ORGANIZATIONS

Institutions Organizations

Formal or informal rulesthat structure human

interaction

Examples: Codes ofconduct, social norms,

most markets, laws

More formal thaninstitutions

Examples: Stockexchanges, organizedreligions, corporations

MINE, NOT YOURS

Property rights dictate who can and can’t use a good.

The rivalry of a good is how much one person’s use of agood prevents another person from using it.

The excludability of a good is the ease of preventingsomeone from using it.

TYPES OF GOODS

EXCLUDABLE NON-EXCLUDABLE

RIVALPrivate Goods

(food, clothes, cars)

Collective goods (sidewalks, fishing

ponds)

NON-

RIVAL

Common goods

(electricity, cabletelevision)

Public Goods

(national defense,air)

INTELLECTUAL PROPERTY

Copyright: protection given to the creators of literature,art, or music

Patent: rights awarded to inventors so that no one elsecan copy their inventions for a period of time

FINANCIAL INTERMEDIARIES

These institutions link savers and borrowers. Banks, stockexchanges, and bond markets are financial intermediaries.

INNOVATION

Entrepreneurs can earn economic profits by taking riskto be the first to sell a product or to provide a new orbetter service. While innovation can create new barrier

to entry in the form of patents and copyrights, it alsodestroys existing market imperfections and therefore

betters society.

CREATIVE DESTRUCTION

Economist Joseph Schumpeter described the impact oentrepreneurs as creative destruction----- replacing the o

and inefficient with the new and improved.

THE GOVERNMENT

POWERS OF THE GOVERNMENT

Ability to tax citizens

Legitimate use of force

The use of force gives power to the court system,which ensures contracts are upheld. Without therule of law, market economies cannot function.

DEMOCRATIC INEFFICIENCIES

Pork barrel politics : The tendency of elected officiato steer money to their home communities toincrease their chances of being reelected

Logrolling : Vote trading among elected officials,usually to get support for pet projects

Rent seeking : Socially unproductive activities thatredirect, rather than create, economic benefits(lobbying, for example)

AN EFFICIENT LITTLE QUIZ

1. Non-excludable and rival2. Excludable and rival

3. Non-excludable and non-rival

4. Excludable and non-rival

A. PrivateB. Public

C. Common

D. Collective

Answers:

1. D; 2. A; 3. B; 4. C

Savingsdeposited

BanksLoans

borrowed




MACROECONOMICSBasics of Macroeconomics

MACROECONOMICS ISSUES THE STATE OF THE ECONOMY

Macroeconomics is concerned with two main issues:

Factors that affect things in the long run (the size of

economies, standard of living, and price level) The causes and consequences of short-run economic

fluctuations (especially unemployment and inflation)

REAL GDP

Real Gross Domestic Product (GDP) measures the totalquantity of goods and services produced in an economy in agiven year, adjusted for the effects of inflation.

REAL GDP PER CAPITA

‘‘Per capita’’ is a Latin phrase meaning ‘‘per head.’’ GDP per

capita is the GDP per person in the economy; it indicates whatthe average person is able to consume in an economy.

If the population were suddenly to double, GDP per capitawould be cut in half. (Technically, the same would be true ifevery person in the economy were to grow a second head.)

AVERAGE LABOR PRODUCTIVITY

Average labor productivity measures how much the typicalworker can produce.

Divide the economy’s total output (GDP) by the total number

of workers employed.

Average labor productivity =Economy's output (GDP)

Total number of workers

Greater levels of production and average labor productivityenable consumption that improves the standard of living.

HUMAN HAPPINESS

Human happiness depends on more than just material levelsof consumption. Other important factors:

A long, healthy life

Access to education

Clean environment

Possession of alpacas

THE BUSINESS CYCLE

Real output fluctuates cyclically, alternating between

periods of growth and decline. Note that even thoughthe economy fluctuates, the general trend is upwards

TERM DEFINITION

ExpansionIncrease in real GDP;occurs until a peak

DownturnDecrease in real GDP;occurs until a trough

RecessionDownturn that lasts at least twoquarters (six months)

DepressionNo official definition; a verysteep and prolonged recession

A QUIZ FOR A DEPRESSION

QUESTIONS

1. A period of increase in real GDP is a(n) _______.

2. What were the years of the Great Depression?

3. When was World War II?

4. How do most nations moderate the business cycle

ANSWE

1. expansi

2. 1929 to 19

3. 1941 to 194

4. through countercyclical monetaand fiscal poli

Peak

Trough

Expansion

Downturn

Realoutput

Time




MACROECONOMICSUnemployment

EMPLOYMENT TYPES OF UNEMPLOYMENT

THE LABOR FORCE

The labor force includes all members of the populationwho have a job (employed) or are actively seekingemployment (unemployed).

To be in the labor force, you cannot be:

Younger than 16 or retired

In jail, in the military, or a homemaker

A discouraged worker : you must have worked in the pastweek or looked for work in the past four weeks

TERM DEFINITION

Employmentrate

Percentage of the labor force thathas a job; number of persons

employed divided by the laborforce; never 100%

Unemploymentrate

Percentage of the labor force thatlacks a job but is searching for one.

The Bureau of Labor Statisticsmeasures unemployment.

Participationrate

Percentage of the population inthe labor force-----about 66%

Employed Worked for pay in the past week,or on vacation or sick leave

UnemployedDid not work during the past

week but did look for paid worksometime in the past four weeks

Discouragedworker / out ofthe labor force

Did not work in the past week orlook for work in the past four

weeks

THE NATURAL RATE OF UNEMPLOYMENT

Key fact: Full employment is NOT 0% unemployment.

There is always unemployment-----some people arealways between jobs, or just joining the labor force

The unemployment rate of an economy at full output isthe natural rate of unemployment

Okun’s law relates unemployment to GDP; every 1%increase in unemployment above the natural rate resultsin a 2% drop in real GDP

No one knows exactly what the natural rate is in 21st

century America-----it might be higher than it used to be

d

QUIZ FOR EMPLOYMENT

QUESTIONS

1. Unemployed workers must be _______, but nothave a _______.

2. Unemployment due to a mismatch between skillsdemanded and skills supplied is _______.

3. No one knows the ____ rate of unemployment.

4. The percentage of the population that is in the laboforce is known as the _______.

ANSWE

1. looking for work; j

2. structural unemployme

3. natu

4. labor participation ra

•Mismatch between skills demanded and skillssupplied

•Spurred by changes in technology or consumerpreferences

•Would be zero if retraining was instant wasinstant and free

•Factors into the natural rate of unemployment

Structural

•Unemployment resulting from movement alongthe business cycle

•Increases with recessions and decreases withexpansions

•Does not factor into the natural rate ofunemployment

Cyclical

•Caused by time-lag between jobs

•Inevitable

•Factors into the natural rate of unemployment

Frictional




MACROECONOMICSGross Domestic Product

THE ‘‘BIG’’ PART OF MACRO HISTORY OF GDP

GROSS DOMESTIC PRODUCT (GDP)

GDP is the market value of all final goods and services

produced within a country in a given period of time.

WHAT’S NOT INCLUDED IN GDP

Intermediate goods: goods used for the production ofother goods, value is reflected in its final good

Example: bolts

Goods not sold on the open market: illegal ‘‘blackmarket’’ goods, as well as goods produced for personalconsumption

Example: home-knit sweaters

Used goods: the value of the good was already counted

in GDP when the good was sold newExample: a used car

Transfer payments: moving money between thegovernment and people

Example: a Social Security check

LIMITATIONS OF GDP

HEY, YOU MISSED ME!

GDP misses out on a lot of economic activity.

It can be difficult to determine what is a ‘‘final’’ goo GDP excludes goods and services not bought or so

in ‘official’ markets (such as work done by stay-at-home spouses)

GDP usually ignores the fact that certain activitiesdeplete natural resources , pollute, or have othercostly externalities

•The total value of differentgoods (add up dollar values)

“the marketvalue”

•Only final goods are counted

•Capital goods (made to makeother goods) are counted theyear they are produced

“of all finalgoods andservices”

•All goods produced within acountry’s borders, even if aforeigner owns the factory

“producedwithin acountry"

•Typically a specific quarter oryear

“in a givenperiod of

time”

Development of GDP

In the mid-17th century, Sir William Petty wasassigned by the British government to assess

the Irish people’s ability to pay taxes.

In 1932, the U.S. Department of Commercecommissioned Simon Kuznets to develop a

system to measure national output.

Kuznets presented his findings in 1934 to theU.S. Senate.

When the U.S. entered World War II (whicheffectively ended the Great Depression) it

continued to refine techniques for measuringoutput.

For his efforts, Kuznets received the NobelPrize in Economic Science in 1971.




MACROECONOMICSMeasuring GDP

MEASURING GDP, PART A MEASURING GDP, PART B

THREE WAYS TO MEASURE IT

CONSUMPTION/EXPENDITURES APPROACH

GDP = production = expenditures = Y = C + I + G + NX

TRICKY BITS

The value of homes purchased is considered personal

investment, NOT consumption If a good does not sell in the given time period, it enters a

firm’s inventory and is counted as investment

A good in inventory sold in a later year does NOT enterthat year’s GDP, as it was already counted as aninvestment in inventory

Government transfer payments, such as Social Security,are not payments for a good or service and thus are notconsidered government expenditures

INCOME APPROACH

GDP = production = expenditures = income

REAL VS. NOMINAL

REAL NOMINAL

In terms of a baseperiod’s price level

Can be comparedacross years

In terms of themeasurement year’sprice level

Includes inflation

Real measurements like real GDP are used tomeasure economic growth

Economists need a way to separate the effects ofchanges in price from changes in quantity produce(and production equals GDP)

Prices do not change consistently-----the price of ongood may increase while the price of anotherdecreases by a different magnitude

SURPLUS AND DEFICIT

NX = net exports = exports --- imports

Trade surplus: Exports exceed imports; GDP increases

Trade deficit: Imports exceed exports; GDP decreases

In the long run, imports and exports will move in similardirections, both either decreasing or increasing.

CAUTION

Don’t confuse trade surpluses and deficits withbudget surpluses and deficits

Budget surpluses and deficits refer to the

difference between how much a government takein (mostly as tax revenue) and how much it spend

Trade surpluses and deficits refer to how much aneconomy exports versus how much it imports

Consumption (C): value of all purchases of finalgoods designed for consumption by consumers

•Consumer durables: long-lived consumer goods

•Consumer nondurables: used up more quickly thandurable goods

•Services: intangible goods

Investment (I): what firms spend on capital,technologies, and real estate

•Business fixed investment: purchase of capital equipment

•Residential fixed investment: purchase of new homes andapartment buildings

•Inventories: unsold goods placed in storage for later sale

Government spending (G): everything thegovernment pays for labor, goods, and services

Net exports (NX): exports minus imports

Calculating GDP

ProductionApproach: Measure

total value ofeconomic output

ExpendituresApproach: Counteverything spenton consumption

Income Approach:Follow the money




MACROECONOMICSMeasuring Inflation

INFLATION AND THE CONSUMER PRICE INDEX GDP DEFLATOR

WHAT IS INFLATION?

Inflation is an increase in the aggregate price level or,

equivalently, a decrease in the value of money

THE CONSUMER PRICE INDEX (CPI)

In the United States, the Bureau of Labor Statistics calculatesthe CPI each month by comparing the prices of a given basketof goods between the current year and a base year.

This basket includes the sorts of goods that an averagehousehold would buy regularly (housing is the maincomponent), and varies by income and region.

The CPI in the base year is always 100.

A CPI of 120 = prices are 20% higher than in the base year.A CPI of 75 = prices went down 25% since the base year.

THE FORMULA: CPIYEAR T=COST OF BASKETYEAR T

COST OF BASKETBASE YEAR X 100

ADVANTAGES DISADVANTAGES

Used to reflect changesin cost of living (so as to

adjust Social Securitybenefits and other

‘‘COLA’’ accounts)

New goods andservices are introduced all

of the time. Example: Kenyaadded mobile phone airtime

to its CPI basket in 2010.

Captures changes inprice for basic consumer

goods

Does not account forsubstitution bias

(consumers may switch to agood not in the basket if one

gets too expensive)

Makes inflation rateeasy to calculate

Does not account forchanges in quality

THE BOSKIN COMMISSION

In 1996, economist Michael Boskin was appointed to head acommission to evaluate CPI. His group found that the CPI

overstated the rate of price inflation by 1.3% a year.

The GDP deflator also measures inflation.

The deflator corrects for price increases in

nominal GDP.THE FORMULA

GDP deflator=nominal GDP

real GDP x 100

VOLATILITY

Compared to the CPI, the GDP deflator is much lessvolatile.

It increases less at peaks and declines less at troug

DIFFERENCES

The GDP deflator is differentfrom the CPI in two main ways.

The GDP deflator reflects only the prices ofdomestically produced goods.

The CPI can include imports like oil.

The GDP deflator and CPI place different weights ogoods.

Since the deflator weights prices by production, itadjusts to changing consumption patterns.

DEFLATING THE DEFLATOR: SHORTCOMINGS

Unfortunately, the GDP deflator is difficult to calculateaccurately and therefore is only published once per yea

That means the deflator cannot track inflation veryquickly. As a result, it is not very useful for guiding

government policy, despite its accuracy.

Like the CPI, the GDP deflator fails to take into accounchanges in product quality.




MACROECONOMICSMoney

IT’S A… THE MONEY SUPPLY

DEFINITION

Money is something accepted as payment for goods

and for the settlement of debts.

FUNCTIONS OF MONEY

Medium of exchange: Eliminates the need to barter forgoods, which requires both parties to want what theother has (double coincidence of wants)

Unit of account: Establishes the value of goods relativeto one another

Store of value: Allows individuals to store wealth over aperiod of time

For something to be money, it must satisfy these threefunctions.

TYPES OF MONEY

Commodity money

Money with value outside of justbeing money, such as gold, orcigarettes in prison

Fiat money Money only valuable because thegovernment says it is and we believeit to be so

WHAT IS NOT MONEY

Credit cards are NOT money. They just provide a convenientway to accumulate debt.

The use of credit cards reduces the economy’s need formoney, since credit cards are convenient.

THE QUANTITY THEORY OF MONEY

MV = PQ

M = the money supply

V = velocity (how often a dollar is spent in a year)

P = the aggregate price level

Q = total output

V and Q are generally held constant,meaning an increase in M (money supply)

will lead to an increase in P (inflation).

DEFINITION

The money supply is the stock of all liquid assets in a

economy that can be exchanged for goods.

MONETARY AGGREGATES

Monetary aggregates classify money by its liquidityhow easily it can be converted into currency. M0 is th

most liquid, M1 more liquid, M2 the most liquid.

M2 is widely considered the most useful measure of thmoney supply.

MONEY QUIZ (WITH A WORD BANK)

medium of exchange | unit of account | store of valueliquid | commodity money | fiat money

1. Currency is the most ____ form of money.

2. Money’s role as a ____ allows people to store weaover time.

3. ____ is money with intrinsic value.

4. Money’s role as a _____ removes the need to barte

5. Most money today is ____.

6. Money’s role as a ____ provides a way to comparethe value of goods.

Answe1. liquid; 2. store of value; 3. commodity mon

4. medium of exchange; 5. fiat money; 6. unit of accou

M0• Cash and coins• Most liquid categ

M1• M0

• Demand/checkindeposits

• Other checkabledeposits

• Nonbank travelerschecks

M2

• M1

• Savings deposit

•CDs

• money market f




MACROECONOMICSThe Financial System

SAVING AND INVESTMENT FINANCIAL INTERMEDIARIES

DEFINITIONS

Saving: Difference between what is earned and spent

Investment: Purchase of new capital equipment Financial institutions: Coordinate the saving and

investment decisions in the economy

Financial markets: Institutions in which people withmoney to save supply their funds to those who wish toborrow for investment

BONDS AND STOCKS

BONDS STOCKS

DEFINITION

Certificate that

specifies how muchthe borrower owesthe bond holder

Share of ownershipin a firm

SELLING Debt finance Equity finance

PROFITING

The bondpurchaser receivesboth the principalback and interest

on the loan

Shareholders hopeto have their stockincrease in value(and may receive

dividends)

RISKS

Market interestrates can fluctuate

The borrower maydefault by declaring

bankruptcy

Riskier than bond(bondholders are

paid beforeshareholders) but

rewards are greater

OTHER

The date ofmaturity is the dateon which the loan

will be repaid

Often sold to thepublic on stock

exchanges, such asthe NASDAQ orNew York Stock

Exchange

A financial intermediary links two other parties in afinancial transaction. Banks and mutual funds are the

most common.

BANKS

Most businesses turn to banks for the funds they needsince most small businesses do not have the resources

sell bonds or stocks.

Banks draw their funds from deposits made by peoplewho wish to save money. Banks pay their depositors a

rate of interest and charge borrowers an even higher raof interest for taking loans.

MUTUAL FUNDS

Mutual funds allow investors to buy into a diverse pool stocks and bonds in a single investment vehicle.

Diversification means mutual funds are less riskyand volatile than individual stocks

Mutual funds are managed by experts

Even someone with only a small amount of savingscan invest in a mutual fund and effectively have adiverse portfolio

INTRODUCING THE FEDERAL RESERVE

The Federal Reserve is often called the Fed

It serves as the central bank of the United States

It is a lender of last resort to other banks, to helpmaintain the stability of the banking system

Control of the money supply falls to the FederalOpen Market Committee (FOMC)

The FOMC is made up of the seven governors of thFederal Reserve and five regional bank presidents

The amount of money in the economy results fromthe interaction of the public, commercial banks, anthe Federal Reserve system

Stock

•shares of ownership

•more risk

•more potential profit

Bonds

•loans

•less risk

•less potential profit

FederalReserve

Helpscontrolmoneysupply

Monesupplyaffects

econom




MACROECONOMICSMonetary Policy

SHOW ME THE MONEY THE FED IN SLIGHTLY MORE DETAIL

WHAT IS MONETARY POLICY?

The Federal Reserve can use monetary policy to stimulate orslow down the economy.

Monetary policy has three goals: price stability, full employment, and economic growth.

Policy makers cannot achieve all three goals simultaneously

WAYS TO IMPLEMENT MONETARY POLICY

OPEN MARKET OPERATIONS

FOMC trades securities onthe open market

Open market operationsare performed daily

Buying securities injectsmoney into the economy

Selling securities takesmoney out of the economy

DISCOUNT RATE AND FEDERAL FUNDS RATE

Discount rate Federal funds rate

Interest rate the Fedcharges banks for loans

Overnight rate charged onloans between banks

Changed infrequently andby the board of governors

Not directly set by the Fed,but strongly influenced

Increasing the interest rate decreases the money supply

RESERVE REQUIREMENT

Dictates how much of itsdeposits a bank must hold

in reserve

Set by the board ofgovernors

Increasing the reserverequirement decreases the

money supply

Money Multiplier=1

RR

(RR = reserve requirement)

AMERICA’S CENTRAL BANK

The Federal Reserve is the central bankingsystem of the United States.

Created by the Federal Reserve Act (1913)

It contains 12 district banks.

It sets monetary policy, manages banks, and serveas lender of last resort

FEDERAL RESERVE BOARD OF GOVERNORS

Located in Washington, D.C.

Directed by a presidentially-appointed chairman---as of 2012, Ben Bernanke.

Members appointed by the President, approved bySenate and serve 14 year terms

FEDERAL OPEN MARKET COMMITTEE (FOMC)

Manages open market operations

Made up of

Seven rotating governors of the Fed

President of the New York district bank

Presidents of four other district banks

Day-to-day operations run by New York bank

Meets every six weeks in Washington, D.C.

MONETARY POLICY: PROS AND CONS

THE POSITIVE

Monetary policy can be enacted immediately, unlikmost fiscal policy, which must be legislated

Central banks are relatively free of politicalinterference; thus, they can pursue unpopular butimportant policies

Central banks are staffed by professionals, notpoliticians

THE BAD

Monetary policy does not affect the economyquickly

Central banks are hard to hold accountable

Increasing the money supply may not boost theeconomy as well as traditional fiscal policy would

Expansionary monetary policy

•Increases the money supply

•Increases aggregate demand in theshort run (at the risk of inflation)

Contractionary monetarypolicy

•Decreases the money supply

•Lower aggregate demand in the shortrun




MACROECONOMICSMore on Saving and Investment

SAVING AND INVESTMENT IN AGGREGATE COORDINATING SAVING AND INVESTMENT

IDENTITY

An identity will always be true, just like the equality of GDP,

production, income, and expenditures.

CLOSED TO TRADE

Assume the economy in question is closed to trade.

GDP = Y = C + I + G

I = Y --- C --- G = national savings = S

By subtracting net taxes (T) from each side:

S = (Y --- C --- T) + (T --- G) = I

Savings is equal to investment and to the sum of privatesavings (Y --- C --- T) and government saving (T --- G).

GOVERNMENT SAVINGS

If government savings are positive, thegovernment is running a budget surplus.

If government savings are negative, thegovernment is running a budget deficit.

This implies that when the government runs a deficit,investment decreases.

INTERNATIONAL CAPITAL FLOWS

In an open economy, domestic savings do not need to equaldomestic investment.

There are two kinds of international capital flows.

Foreign direct investment: A company or individualacquires and actively manages assets in a foreigncountry-----such as an airport in Belgium run by the British

Portfolio investment: An individual or companypurchases stock or bonds issued by a foreign corporationbut does not play a direct role in managing it

Net capital output (NCO) equals the purchase of foreign

capital or financial assets by domestic residents minus foreignpurchase of domestic assets.

In an open economy, NCO = NX

Remember: Y = C + I + G + NX, so:

Y --- C --- G = S = I + NX

Therefore, S = I + NCO

In an open economy, savings can differ from investment onlyas much as the difference is offset by net capital outflow.

The financial market features the supply of savings andthe demand for savings (or investment).

The supply and demand for savings are equalizedthrough adjustments of the real interest rate.

The real interest rate acts as the price of a loan. It ihow much borrowers pay for a loan and how muchsavers earn for giving up their money so that it canbe loaned.

Effect of interest rate

Resulting curve

Supply of

savings

the higher the realinterest rate, themore people willsave

the supply ofsavings slopesupward

Demand for

savings

the lower the realinterest, the moreinvestingbusinesses will do

the demand forsavings slopesdownward

BANK RUNS

A bank run occurs when depositors rush to a bank towithdraw their deposits before other depositors.

Banks only hold reserves equal to a fraction of theirliabilities-----so even solvent banks will be unable to pay aof their depositors right away.

The FDIC (a government institution) now insuresdeposits at federal banks for up to $250,000, so, even ia bank collapses in a bank run, accountholders canrecover up to $250,000 of their money from the FDIC.

Quantity of Money

FINANCIAL MARKETS

Real

InterestRate

SavingsDemand

Supply of

Savings




MACROECONOMICSMoney Market in the Long Run

PRICES AND THE LONG RUN BACK TO THE NEUTRALITY OF MONEY

The aggregate price level is the level of prices for the entireeconomy. It rises and falls over time.

If P is the price level, then it also measures the cost of abasket of goods.

Therefore, the amount of goods and service that can bebought with $1 is 1/P. 1/P is also the value of money

measured in terms of goods and services.

PRICES IN THE LONG RUN: MONEY MARKET

Just like in any other market, the value of money isdetermined by the interaction of supply and demand.

MONEY SUPPLY MONEY DEMAND

Depends on thedecisions of the

Federal Reserve andthe banking system

Depends on how muchwealth people want to hold

as money

Inelastic in the short-run since it is set bythe Federal Reserve

Relates to the volume andprices of the transactions

that take place

If the real level of economicactivity stays the same,doubling prices should

double demand for money

The long run is the time period it takes for the price level toequate demand for money with the money supply.

THE GRAPH

Money demand slopes downward. As the price level falls,people need less money to purchase goods. In other words,the value of money increases.

The long-run neutrality of money means that changes inthe money supply have no bearing on real quantities in

the economy.Recall the quantity theory of money: MV = PY.

M is the money supply

V is the velocity of money (how often moneychanges hands each year)

P is the average current price level

Y is real output of goods and services at a givenpoint in time

This equation is also called the equation of exchange.

Of the variables, P is dependent. Since V and Y are

usually fixed for the long run, changes in P depend onchanges in M, the money supply.

This equation says that the amount of money spentequals the amount of money used.

Also note that PY = nominal GDP = MV.

EFFECTS OF INFLATION

While in the long-run, inflation has no effect on theeconomy, it has powerful short-term effects.

Inflation reduces the value of money, and ‘‘taxes’’those that choose to hold it

Inflation distorts prices: not all firms adjust theirprices at the same time (so relative prices do notalways reflect costs of production)

Inflation introduces confusion about the value ofgoods and services in the future

TRUE/FALSE FLASH QUIZ

1. In the quantity equation, Y is nominal output2. Money supply is inelastic in the short-run

3. 1/price level is the value of money

4. In the quantity equation, M and Y are usuallyconstant

5. Inflation reduces the value of money

ANSWE

1. False (real output); 2. True; 3. Tru4. False (V and Y are constant); 5. Tr

Quantity of Money

Market for Money

Value ofmoney

(1/P)

MoneyDemand

MoneySupply




MACROECONOMICSModeling the Economy

THE CIRCULAR FLOW MODEL FLOWS

GOODS AND SERVICES (CLOCKWISE)

MONEY (COUNTER-CLOCKWISE)

THE ACTORS

FIRMSProduce goods and services usingthe factors of production ownedby households

HOUSEHOLDS

Rent the factors of production(land, labor, capital,entrepreneurship) to firms

Consume goods produced by firms

GOVERNMENT

Ability to tax to earn income

Can borrow from financial marketsto produce goods for society

GDP AS FLOW

GDP is equal to the flow around the model at any

given point The expenditure approach is the sum of consumpt

and government purchases (since investment andexports are not counted in this model)

The income approach uses the flow of income tohouseholds

Totaling the flow in the money diagram yieldsnominal GDP

Totaling the flow in the goods and services diagramyields real GDP

ENTERING THE CIRCULAR FLOW MODELNew wealth enters the cycle through households.

Households provide the human labor used to work. Eveinputs such as land belong to individuals, which in turnbelong to households. These land-owning individuals retheir land to businesses.

CIRCULAR FLOW FLASH QUIZ

QUESTIONS

1. The three actors in the circular flow model are_______, _______, and _______.

2. The two markets in the circular flow model are themarkets for _______ and _______.

3. All factors of production are owned by _______.

4. With regard to the circular flow, nominal GDP isequal to the _______.

5. ______ sits between households and the goods andservices market.

ANSWERS

1. households; firms; government

2. goods and services; factors of production

3. households

4. flow around the money diagram

5. government

FactorMarkets

Firms

Goods andServicesMarkets

Households

FactorMarkets

Households

Goods andServicesMarkets

FirmsGovernment

Governmentpurchases

Income Wages andrent

RevenueConsumption

Taxes

Government

Goods andservices

Land, capitallabor

Factors ofproduction

Goods andservices

Goods andservices

Transfers




MACROECONOMICSLiving Standards

AVERAGE LABOR PRODUCTIVITY GDP PER CAPITA

Five factors affect averagelabor productivity.

All else equal, large economies should produce morethan smaller economies.

Real GDP per capita is equal to real GDP per workermultiplied by the fraction of the population employed.

GDP

POP =

GDP

N x

N

POP

POP is the country’s total population

N is the labor force

Most differences in GDP per capita can be explained bydifferences in average labor productivity, since theproportion of the population engaged in productionremains remarkably consistent in the long run.

SHORT-RUN FLUCTATIONS

The most important correlates of fluctuations in theeconomy’s growth are unemployment and inflation.

During recessions, unemployment increases. Businesseincrease hiring slowly in the early phases of anexpansion. Increased employment lags behind the nextstage of economic growth.

When the economy expands, inflation accelerates.Recessions are linked to slowing inflation.

A SHORT RUN QUIZ

QUESTIONS

1. What is the most important factor in raisingaverage labor productivity?

2. What is real GDP per capita equal to?

ANSWERS

1. Technological knowledge

2. Real GDP per worker multiplied by the fraction ofpopulation employed

Physical capital

•Tools, machinery, even computers andInternet access: the stuff that helps peoplemake stuff

•Making capital for future poductionrequires giving up current consumption

Human capital

•Skills and experienced acquired througheducation, training, and on-the-jobexperience

•By spending time learning and training, wesacrifice current earning and consumption

Natural resources

•The wealth of many nations depends ontheir natural resources• Example: Saudi Arabia

•On the other hand, in a global economy,natural resources are not essential for aneconomy to succeed•Example: Singapore

Technological knowledge

•Transforms inputs into the goods andservices households desire

•Single most important factor in raisingaverage labor productivity

•Patents help encourage and publicize

innovations

Political and legal environment

•Broken political and legal systems stopmany countries from building effectiveeconomies

•Investors and workers alike must feelconfident in a country's stability, privateproperty laws, and supply of an educatedworkforce

Economy's output depends on the quantity

of goods and services a firm can produce

Total quantity of goods and servicesdepends on the quantity of factor inputs

households supply and the ability of firms toturn inputs into outputs




MACROECONOMICSThe Output Gap and the Short Run

OUTPUT GAP SHORT RUN FLUCTATIONS AGAIN

TWO PART STRUCTURE

Think of the actual level of GDP as having two parts.

POTENTIAL OUTPUT

Potential output is the quantity of goods and services that theeconomy could produce when using all its resources atnormal rates.

Over time, the level of potential output can increase over timeas technology improves and the country obtains moreresources.

Y symbolizes actual output

Y* symbolizes potential output

OUTPUT GAPThe output gap is the difference between actual and potentialoutput.

Output gap = Y --- Y*

When an output gap exists, the economy’s resources are notbeing fully utilized.

When the economy is in recession, an output gap exists.Unemployment rises beyond the natural rate ofunemployment.

During the presence of an output gap, Okun’s Law (that for

every 1% the unemployment rate differs from the natural rateof unemployment, the output gap deviates by 2%) applies.

JOHN MAYNARD KEYNES

British economist John Maynard Keynes (1883-1946)developed the model to explain short-run fluctuations.

His theory was first published in the 1936 book, TheGeneral Theory of Employment, Interest, and Money .

Keynes believed known economic models were

inadequate to account for the Great Depression.His view of the business cycle—and how to manage it by

adjusting taxation and government spending—wouldbecome known as Keynesian economics.

In the short run, the pace of economic growth is mostlydue to the divergence between actual and potentialoutput (that is, the presence of an output gap).

In the long run, variations are due to changes in thegrowth rate of potential output. This, in turn, depends othe growth of the population, the rate at which capitalstock increases, and changes in the pace of technologicadvances.

In a world in which prices adjust immediately to balancesupply and demand, the economy’s actual output wouldnever deviate from potential output.

However, firms do not constantly adjust prices torespond to changes in market demand-----they set pricesand sell as much as is demanded. Only after a while wilthey change prices.

Therefore, in the short run, firms respond to variations idemand by changing production rather than prices;short-run output is determined by the level of aggregatedemand.

Variations in rate ofgrowth of output

LONG RUNChanges in growth

rate of potentialoutput

Growth rate of thepopulation

Rate of increase ofcapital stock

Changes in pace oftechnological

advances

SHORT RUNThe level of actualoutput relative topotential output




MACROECONOMICSAggregate Demand

INTRODUCING THE AD/AS MODEL AGGREGATE SHIFTS RESULT FROM…

WHAT IS AGGREGATE DEMAND?

Aggregate demand is the sum of all expenditures in aneconomy, or the country’s output for a period. Aggregate

demand describes how expenditures change in response tochanges in the aggregate price level.

C = consumer spending

I = investment

G = government spending and purchases

NX = net exports

THE SHAPE

Just like the microeconomic demand curve,the AD curve slopes downward. It slopes downward for

different reasons, however.

1. Wealth effect: Decreases in the price level lead toincreases in consumption because consumers’ realincome has increased.

2. Interest effect: Decreases in the price level lead todecreases in the interest rate, which increasesinvestment by decreasing its opportunity cost.

3. Foreign exchange effect: Decreases in the price levelmake domestically produced goods cheaper in theinternational market, increasing net exports.

GRAPH IT!

CHANGES IN CONSUMPTION

Tax cuts, transfer payments from the government

Changes in consumer sentiment (such as after 9/1and the Enron scandal)

Changes in wealth due to the stock market

Expectations about the price level in the future

CHANGES IN INVESTMENT

Changes in the interest rate

Changed expectations about the future

CHANGES IN GOVERNMENT SPENDING

Only direct government spending

Transfer payments are not included

CHANGES IN NET EXPORTS

Changes in the income of foreign entities

Changes in the exchange rate

CAUTION

Just as with microeconomics, shifts are NOTchanges in output or the price level

Changes in the price level lead to movements along the aggregate demand curve

Changes in any of the factors above cause shifts

AD QUIZ

QUESTIONS

1. An increase in the price level leads to a decrease inoutput due to the _______, which denotes that_______.

2. Expectations of a higher future price level shift theAD curve outward because _______.

ANSWERS

1. wealth effect; consumers' real wealth has decrease

2. consumers wish to spend now, when prices arelower

NX+G+I+C=Y=AD

PriceLevel

Real Level of Output




MACROECONOMICSAggregate Supply

LOTS OF SUPPLIES SHORT RUN AGGREGATE SUPPLY (SRAS)

WHAT IS AGGREGATE SUPPLY?

Aggregate supply is the potential supply of all the goods and

services an economy can produce at different price levels.Aggregate supply behaves very differently in the short term

and long term.

LONG RUN VS. SHORT RUN

Economists define the long run as the period when themarket is in equilibrium

All prices have adjusted to their equilibrium values andall markets clear

The short run is the period in which other effects, such asprice stickiness, can prevent long run equilibrium

LONG RUN AGGREGATE SUPPLY (LRAS)

Long run aggregate supply is a vertical line fixed at thefull employment level of output

LRAS is not affected by changes in the price level(monetary neutrality)

Output must be the full employment level in the long run

YOU’RE SHIFTING ME!

Changes in the expected aggregate price level are themost common cause of shifts in the position of SRAS; atthe expected level SRAS is equal to Y*

Aggregate supply shocks also shift the aggregate supplycurve (example: the 1973 OPEC oil embargo)

Over time, technological progress can cause LRAS toincrease; this increase accounts for the long-run growthof real GDP

WHY DOES THE SRAS SLOPE UPWARDS?

At the microeconomic level, the supply curve slopeupwards because higher prices attracted resourcefrom the production of other products

The aggregate supply curve slopes upward to reflethe relationship between price adjustments and thsize of anticipated sales; firms fix prices for a while

and only over time do they adjust prices

SHORT-RUN CRAMMING

QUESTIONS

1. Markets always clear in the _______.

2. What does the position of the SRAS depend on?

3. What is the short run defined as?

4. What accounts for the long-run growth of real GD

ANSWERS1. long run

2. The economy’s long-run potential output (Y*) andexpectations for the price level

3. The period when the market is in equilibrium (theeconomy produces at full, potential output)

4. The steady increase of the LRAS over time due totechnological progress

PriceLevel

Level of Output

LRAS

Short-Run Aggregate Supply

Price Level

Level of Output




MACROECONOMICSEquilibrium

BALANCING ACT LONG-RUN EQUILIBRIUM

EQUILIBRIUM OVER TIME

The behavior of the economy in the short run is given by the

intersection of SRAS and AD. This point of intersection iscalled short-run equilibrium. Long-run equilibrium is given by

the intersection of LRAS and AD.

FLUCTUATIONS

Short term departures of the economy from equilibrium canbe modeled in terms of short-run equilibriums.

Inflationary gap: Short-run equilibrium output exceedslong-run output; the economy is ‘‘overheated’’

Deflationary gap: Short-run equilibrium output is less

than long-run output; the economy is inefficient andperhaps in a recession

EFFECTS OF SHIFTS: AN EXAMPLE

In the long run, both curves shift to restore long-runequilibrium and changes in either curve only affect the price

level.

An increase in aggregate demand will lead to a higherprice level and output in the short run.

In the long run, aggregate supply will shift inwards aspeople adjust their perceptions and expectations torestore equilibrium.

LONG-RUN EQUILIBRIUM

Long-run equilibrium is obtained when SRAS, LRAS, aall intersect at a common point

INCREASING LONG-RUN OUTPUT (GROWTH)

Increasing long-run output MUST involve anoutward shift of the LRAS curve

LRAS does NOT shift outward from changes due to

monetary policy as money is neutral in the long run Simple government spending does not cause grow

as spending only temporarily increases aggregatedemand

Growth can only result from improvements in labocapital, natural resources, or productivity

AGGREGATE QUIZ

QUESTIONS

1. An economy is experiencing an inflationary gapwhen _______ exceeds _______.

2. What adjusts to restore long-run equilibrium whenthe government stimulates aggregate demand bypassing a stimulus?

ANSWERS

1. short-run output; long-run output

2. short-run aggregate supply

Price Level

RealLevel ofOut ut

AD

SRASLRAS

Y = Y*

Price

Level

Real Levelof Out ut

AD1

SRAS

LRAS

AD2

PriceLevel

Real Levelof Out ut

AD1

SRAS1

LRAS

AD2

SRAS

Newequilibrium




MACROECONOMICSFiscal Policy

SPEND, SPEND, SPEND PROBLEMS WITH FISCAL POLICY

WHAT IS FISCAL POLICY?

Fiscal policy is the use of government spending and taxation

to intervene in the economy. Government spending directlyand indirectly increases aggregate demand and,

consequently, GDP.

A government stimulus package----- hiring workers to builddams, reducing taxes on small businesses, and offering more

student loans----- is an example of fiscal policy.

FLAVORS OF FISCAL POLICY

Type Contractionary Expansionary

Main goal Decrease aggregatedemand to curbinflation

Increase aggregatedemand in arecession

Examples Tax increases;governmentspending cuts

Tax cuts;governmentspending increases

The government can employ fiscal policy either directly, bydirect spending (or spending less) or indirectly, through

changes in taxes and subsidies.

ASSESSING FISCAL POLICY

Fiscal policy is an important tool to moderate the businesscycle.

The economy will not always return quickly to long-runequilibrium

With changes in spending, the government can make upfor some of the failings of the free market in the short-term

However, fiscal policy faces two major problems: crowdingout and debt creation.

DEBTS AND DEFICITS

The government’s debt is all the money it owes; it is theaccumulation of all its annual deficits

Since the government must pay interest on its debt,more debt means less future spending and lessinvestment

The United States has not run a surplus since the Clintonadministration

CROWDING OUT

Fiscal policy usually is needed at the time when the

ecoomy generates low tax revenues

The government has to finance expansionary fiscapolicy by borrowing money or increasing taxes

Increasing taxes decreases consumer wealth,directly decreasing consumption

Borrowing money drives interest rates up, makinginvestment less desirable

Such spending thus crowds out private investmen

ASSESSING GOVERNMENT INTERVENTION

FORDeviations from potential output are costly:

When resources are not fully employed, teconomy forever loses what it could haproduced-----even if it recovers on its own later

Unemployment imposes hardships on those wlose their jobs

Inflation results from overemploying resources

AGAINST

It is difficult to identify the correct type and degree o

intervention.

GDP estimates can take about three months calculate and are imprecise

Almost all information about the economy lags, policy makers must act on incomplete information

Effects of policy take time to be felt-----businesswill not invest right away

When Congress approves spending on neprojects, it can take many months until the projecare undertaken

The economy may overshoot full employme

resulting in inflation




ECONOMIC HISTORY OF WWIAmerican Entry into the War

BRIEF OVERVIEW MOBILIZATION IN EUROPE

THE COURSE OF WWI

WWI was the product of long-term European tensions,

caused by rising nationalism and German competitionwith Great Britain and France for imperial power. Thewar was sparked off by the assassination of Austria-Hungary’s Archduke Franz Ferdinand by a Bosnian-

Serb student on June 28, 1914.

The war ended on November 11, 1918, when the Alliessigned a ceasefire with Germany.

TWO IMPORTANT FIGURES

70 million military personnel fought in WWI

9.4 million soldiers died from battle or disease

BREAKING DOWN AMERICAN PARTICIPATION

ECONOMIC WARFARE

Each country’s ability to sustain the war effortdepended heavily on the strength of its economy. The

British established a naval blockade on the CentralPowers. This action angered American merchants whowanted to trade with Germany. In return, the Germans

imposed a U-boat (submarine) blockade on GreatBritain.

THE EUROPEAN ECONOMIES

The major WWI combatants possessed economies at very

different levels of development and readiness for war.

QUICK QUIZ

QUESTIONS

1. World War I began when ___ was assassinated.

2. Of the major powers involved, ___ suffered the greatest

cost of war.3. Russia was considered to be economically ___ at the

start of war.

4. ___ facilitated British munitions production.

ANSWERS

1. Archduke Franz Ferdinand

2. France

3. backward

4. The Ministry of Munitions

July 28: Austria-Hungary declares war on Serbia

Russia mobilizes to defend Serbia

August 1: Germany declares war on Russia

August 4: England declares war on Germany

2 million went to France

1.39 million fought on the front lines

114,000 died

Great Britain

•Devoted 40% of GDP to war effort•1913 to 1917: upped steel output 25%

•Ministry of Munitions facilitatedmunitions production

France

•Suffered worst damage in the war•Government spending increased to53.5% of GDP by 1918

Italy

•Relatively underdeveloped; had fewerresources to mobilize

•Supreme Committee of Ministers andUnder-Secretariat for Arms andMunitions coordinated wartimeproduction

Russia

•Considered economically "backward"

•Unable to organize and mobilize itsvast resources




ECONOMIC HISTORY OF WWIAmerican Entry into the War

AMERICAN ENTRY INTO THE WAR AMERICAN WAR PRODUCTION

REASONS FOR AMERICAN ENTRY

Germany’s U-boat blockade caused American

indignation at attacks on neutral ships and passengers.

MOBILIZATION

4 million men served in the U.S. Army

800,000 men served in the U.S. Navy and othermilitary services

24.2 million men between the ages of 18 and 45registered under the selective service law; 2.8million were inducted

Men chosen for service trained for 6 months in theUnited States and another 2 months in Europe

DEPLOYMENT

American soldiers had to be shipped across theAtlantic to France

Great Britain provided half the ships required

The American Emergency Fleet Corporationprovided another million tons of new ships

Germany only sank about 200,000 tons of trans-Atlantic cargo out of a total of 7.5 million tons

GOVERNMENT PLANNING

President Wilson established several government bodies to

ensure the production and procurement of strategicwartime goods.

‘‘VOLUNTARY’’ COOPERATION

The Food Administration did not directly setprices, but could threaten to revoke food

providers’ distribution licenses if they refused tocooperate.

PRICE-SETTING DURING WAR

BULK-LINE PRICING

The Price Fixing Committee of the War Industry Boardset prices on war-related materials

The main problem they faced was that suppliers haddiffering costs of production

The Committee used bulk-line pricing

It set prices at a level (the bulk-line) just high enough toproduce the amount that the government required

•Ship torpedoed and sunk on itsway from New York to Liverpool

•159 American passengers killed

RMSLusitania

•French ferry mistaken for amine-laying vessel

•25 Americans injured provokedU.S. to threaten to sever

relations with Germany

Sussex

•Germans promise after theSussex to leave non-militaryships alone

•Broken in March 1917; Germanysank 5 American merchant ships

SussexPledge

•German effort to entice Mexicoto declare war on the UnitedStates

•Immediate cause for American

entry into the war

Zimmer-man

Telegram

•Procured war products for the government andset prices

•Used "bulk-line pricing"

War Industries Board

•Created by the Lever Food and Fuel Act

•Led by future president Herbert Hoover•Relied on voluntary cooperation

Food Administration

•Nationalized railroads to deal with railroadcongestion

•Transported 616,000 troops over 800 milesevery month

Railroad Administration

•Set the price of coal•Worked with Railroad Administration tofacilitate coal delivery

Fuel Administration




ECONOMIC HISTORY OF WWICosts of War

CALCULATING THE COST OF WWI CALCULATING THE COST OF WWI (II)

CALCULATING DIRECT COSTS

Net Cost = Gross Cost - Loans The gross cost of war is the sum of total

expenditures of all countries involved

Loans (or ‘‘advances’’) between countries arefactored into both countries’ total expenditures

To avoid double-counting, loans must besubtracted from the gross cost to yield the net costof war

AVERAGE NET COSTS PER PERSON

Country Cost ($)

Great Britain 766

France 613

Germany 557

United States 229

INDIRECT COSTS OF WAR

Most of the indirect costs of war were opportunity costs-----what the country could have produced with theresources directed towards the war effort.

Just because spending increases does not necessarilymean that well-being increases.

PHYSICAL COSTS OF WAR

Property loss

Shipping and cargo loss

Production loss

War relief

HUMAN COST OF WAR

The enormous number of deaths in WWI represents a

further indirect cost. The alliances lost a significantproportion of their total populations:

The value of lost lives includes their human capital, theskills and knowledge that they would have used tocontribute to the economy

Calculating this lost potential earnings provides thecapitalized value of war deaths

PAYING ATTENTION?

QUESTIONS

1. The most immediate cause of American entry intoWWI was ___.

2. The United States’ main obstacle to mobilization notfaced by Europeans was ___.

3. The United States shipped ________ tons of cargo toEurope during WWI.

4. The American government created threeadministrations to coordinate the ___, ____, and ___industries.

5. The total cost of the war was ___.

6. Of the major powers, ___ had the greatest net cost perperson.

ANSWERS

1. the Zimmerman Telegram

2. the Atlantic Ocean

3. 7.5 million tons

4. food; fuel; rail

5. $337.85 billion

6. Great Britain

Total direct net cost of the war:$186 billion

Money spent onbullets, guns, andtanks

cannot be spent onfood, clothing, orhealthcare

Total: 1%

CentralPowers:

2.6%

AlliedPowers:

0.7%

Total Direct and Indirect Cost of War:$337.85 billion




ECONOMIC HISTORY OF WWIWar Financing

METHODS OF WAR FINANCING EUROPEAN WAR FINANCING

POCKETBOOK ISSUE(S)

Combatant states had three main ways of raising

funds: Borrowing

Taxation

Printing money

UNITED STATES FINANCING

The United States relied mostly on borrowing, or debt financing, to finance the war.

In total, the United States borrowed $19 billion

The United States undertook a series of four loans(called Liberty Loans) with interest rates ranging

from 3.5% to 4.25%

Most lenders to the United States were individualswho bought Liberty Bonds from the government

Taxation covered nearly a quarter of war expenditures.

The war marked the first widespread use of theincome tax, which had just been added to theConstitution (16th Amendment, 1913)

The United States government also created a significantquantity of new money.

The Federal Reserve purchased government bonds

on the open market It paid for the bonds by creating new deposits,

effectively increasing the money supply

TO SUMMARIZE:

Amount Percent

Taxes $7.6 billion 24.5%

Borrowing $19.0 billion 61.4%

New money $4.4 billion 14.1%

Total $31.0 billion 100%

GREAT BRITAIN

*Excise taxes were taxes on specific goods, as opposed tosales taxes, which taxed all goods.

FRANCE

GERMANY

Germany relied more on debt financing than any othercountry throughout the war, borrowing 81% of its spending.

The money supply rose 500%

Prices doubled over the course of the war

Post-war hyperinflation helped fuel the Nazis’ rise

Debt Financing

Issued three war loans

Borrowed heavily fromthe United States

Caused debt levels toreach 127.5% of GDPby 1918

Taxation

Raised about a quarterof total war

expenditures

Gradually increasedthroughout the war

Excise taxes on

tobacco, tea, alcohol,cars, and musical

instruments

Debt Financing

Raised most ofFrance's war funds

Debt was already highbefore the war, at 65%

of GDP

After the war, debtrose to 124% of GDP

Taxation

Not used much due towidespread public

opposition

ineffective 1916 taxon "extraordinary

war profits"

"Inflation tax" oncitizens: rising pricescut purchasing power




ECONOMIC HISTORY OF WWIEconomic Performance Throughout WWI

THE WAR’S ECONOMIC IMPACT THE WAR’S ECONOMIC IMPACT (II)

MEASURING GDP

The economic prosperity of a country is most often

measured by calculating GDP, a measure of the totalvalue of production in the country. GDP can be

calculated according to either the total expenditures orthe total income of a country.

ECONOMIC PERFORMANCE DURING THE WAR

Only the United States and Great Britain saw economicgrowth over the course of WWI.

THE PROBLEM WITH GDP

Measuring countries’ economic performance during WWI

through GDP alone is problematic for several reasons.

The ‘‘value’’ of a product is its market price, rather thanits contribution to consumer wellbeing

Thus, increased production of guns, munitions, andmilitary aircraft can cause GDP to rise significantly,but…

This rise does not improve living standards

Meawnwhile, other sectors receive fewer resourcesduring wartime

THE UPSHOT:

NAME THAT COUNTRY!

QUESTIONS

Which country…

1. Imposed an indirect “inflation tax” on its citizens?

2. Issued excise taxes on many goods to finance the war?

3. Experienced hyper-inflation during and after the war?

4. Withdrew from the war in 1917?

5. Suffered the largest decline in GDP during the war?

6. Enjoyed the greatest increase in GDP during the war?

7. Had a debt level of 127.5% of GDP in 1918?

8. Experienced an economic boom when the war began?

ANSWER

1. Franc

2. Great Britai

3. German

4. Russi5. Franc

6. Great Britai

7. Great Britai

8. United State

•In a recession before war began•Experienced an economic boom when warbroke out in Europe

•Rate of growth slowed significantly after joining the war•Majority of economic growth during the waroccured while it was neutral

•Overall GDP increase of 13.2% from 1913 to1918

United States

•Economic contraction in 1914 and 1915•Total production peaked in 1916

•Overall, experienced an increase of 14.8% inreal GDP throughout the war

Great Britain

•Germany: real GDP in 1918 was 81.8% of its1913 GDP

•Austria-Hungary: real GDP in 1918 was73.3% of its 1913 GDP

•Russia: real GDP fell to 67.7% of 1913 valueby 1917, when it withdrew from the war

•France: real GDP fell to 63.9% of 1913 valueby the end of the war

Other major powers

Increased in GDP does not always meanincreased economic prosperity




ECONOMIC HISTORY OF WWIEconomic Consequences of Peace

DEMOBILIZATION LONG-RUN EFFECTS

HOMECOMING

Soldiers began demobilizing after the war ended in

November 1918. By mid-1920, 4 million soldiers hadreturned to the American labor force.

Soon after the war, the United States experienced a

major economic expansion, fueled by several factors:

MEANWHILE, ACROSS THE ATLANTIC…

With help from the United States, most Europeancountries slowly recovered after the war. However,Germany continued to experience severe declines.

It suffered heavy losses in human capital

By 1919, its real GDP had fallen between 52 and72% of its 1913 level

War-related industries recovered, but labor-intensive industries like agriculture suffered

GOVERNMENT SPENDING

Robert Higgs cited the high levels of government spending

during the New Deal as evidence for the ratchet effect. Heproposed that increases in government spending duringWWI led to permanently higher expenditure even after thewar ended.

Other scholars disagreed:

Lindberg argued government spending was high evenbefore the war

Broadberry and Harrison argued the government had tospend more on its debt service payments (repaymentof its loans); other government spending only increasedalong with other types of spending

DON’T MAKE ME

The United States became a reluctant world leader afterthe war.

American entry into the war had broken the stalematand allowed the Allies to win

American loans to its allies funded their war effort

European economies relied on American loans torecover

THE TREATY OF VERSAILES

George Clemenceau of France, David Lloyd George ofGreat Britain, and Woodrow Wilson of the United States

drafted the Treaty of Versailles. Germany’s newgovernment signed it on June 28, 1919.

Germany accepted all of the blame for the war Germany would pay $33 billion in reparations back to

the Allies

Labor-market shock caused by suddenreturn of soldiers

Brief economic downturn while labor-market adjusted itself

Economic boom as all aspects of GDPincreased (see below)

•The government paid transportcosts and a $60 bonus for eachdischarged soldier

•The United States loaned $2billion to its allies

GovernmentSpending

•Businesses spent more onplants and equipment (capital)

to make more consumerdurable goods, such as cars•This, in turn, led to an increasein consumer demand

BusinessInvestment

•As European economiesrecovered, they demandedmore American imports

•The increase in foreign demandcaused net exports to rise

Net Exports

France:2.7 bn

GreatBritain:4.0 bn

Italy: 1.6bn

Russia:0.2 bn

Others:0.7 bn




ECONOMIC HISTORY OF WWIEconomic Consequences of Peace

THE TREATY OF VERSAILLES (II) CONCLUSION

REPARATIONS TERMS

The Treaty of Versailles imposed a heavy payment

burden on Germany.

They made their final reparations payment in October2010, proving that some things do take longer than

college loans to pay back.

CRITICISM OF THE TREATY

John Maynard Keynes, a British economist, criticizedthe Treaty of Versailles in his 1919 book The Economic

Consequences of the Peace .

It prevented European economic integration

It was inconsistent with President Wilson’sproposed ‘‘Fourteen Points’’, especially on thesubject of reparations

Fourteen Points Treaty of Versailles

German paymentonly for damage

to invadedterritory

Inclusion of losses at seaby submarine,

bombardments from sea,and damage from air raids

Its terms were too vague: Germany had to pay forall ‘damage done to the civilian population of theAllies… by land, by sea, and from the air’

It was guided by political, not economic concerns

It did not follow through on its promise that people

could determine their own governmentsKeynes believed that $10 billion would have been amore appropriate sum.

WAS KEYNES RIGHT?

Other scholars have criticized Keynes’ arguments:

They say Germany had the ability to pay; it wasmerely unwilling to pay

The reparations were less severe than thoseimposed on France by Germany after the Franco-Prussian War

UNLIKE ANY THAT CAME BEFORE

The First World War was the first war that depended on

large-scale industrialized warfare. Many technologicaladvances were introduced in:

Machine guns

Tanks

Attack aircraft

Poison gas

Furthermore, it was the first war that depended onlarge-scale industrialized warfare.

THE IMPORTANCE OF ECONOMICS

Economics determined the result of the war.

Competing blockades were more effective than armiesin draining the enemy’s resources

The Allies ultimately won because they wereeconomically superior

They mobilized more effectively and were able todevote more resources to producing weapons andother war goods

FINAL RECAP

QUESTIONS

1. Why did the United States experience a brief economicdownturn at the end of the war?

2. In what type of goods’ production did Americanbusinesses invest after the war?

3. What type of government spending did Broadberry andHarrison argue that the ratchet effect reflected?

4. When was the Versailles Treaty signed?

5. How much did Keynes believe was an appropriateamount for German reparations?

ANSWERS

1. Labor market adjustment

2. Consumer durable goods

3. Debt service payments

4. June 28, 1919

5. $10 billion

Total:

$33 billion

Before 1925:

$375 million

After 1925:

$900 million




CRUNCH KITEconomics in Four Pages (Page 1)

BASICS OF ECONOMICS

Human wants are unlimited, but goods are scarce

There are no free lunches; you can never get something trulyfree (due to the cost of time, and other costs)

To get one thing, we must give up another Humans behave rationally in economics

Economic cost includes opportunity and accounting costs

Accounting cost: tangible cost

Opportunity cost: value of the next-best alternative

RATIONALITY

Marginal cost: cost of producing/consuming ‘‘one more’’

Marginal benefit: benefit of producing/consuming ‘‘onemore’’

Diminishing returns: marginal benefit decreases as quantityincreases

Rational agents will produce or consume a good untilmarginal cost = marginal benefit/revenue (MC = MR)

Rational consumers maximize their utility, or satisfaction;rational firms maximize their profits

POSITIVE VS. NORMATIVE

Positive: ‘‘What is’’ (taxes are 20%)

Normative: ‘‘What should be’’ (taxes should be lower)

MICRO VS. MACRO

Microeconomics: focuses on individual decision making;works its way up from individuals to markets to economies

Macroeconomics: focuses on the economy as a whole;

tracks economy wide variables; takes a top-down approachCOMPARATIVE ADVANTAGE

Comparative advantage: being able to produce a good at alower opportunity cost than anyone else

Absolute advantage: being able to produce a good moreefficiently than everyone else

An individual can have an absolute advantage in everything,but NOT a comparative advantage in everything

Agents should specialize in what they have a comparativeadvantage for, and then everyone will benefit from trade

THE PRODUCTION POSSIBILITIES FRONTIER (PPF)

A PPF shows all of the ways an economy can produce goods Each axis features a good; the PPF measure trade-offs

between these two goods

All points outside the curve are impossible to produce at

Points inside the curve are possible but inefficient and do notuse all available resources

PARETO EFFICIENCY

Something is Pareto efficient if it is impossible to improvewell-being without hurting someone else

Pareto efficiency provides no way to judge the superiority ofone distribution versus another

THREE FUNDAMENTAL QUESTIONS OF ECONOMICS

How much should be produced?

Who should produce the good?

Who should receive the good?

PERFECTLY COMPETITIVE MARKETS

The good being sold must be highly standardized

Large number of buyers and sellers

Everyone is well informed about the market price

No barriers to entry exist; firms enter and exit easily

Everyone is a price taker

The market price represents the opportunity cost of agood’s production

DEMAND

Law of demand: the quantity demanded of a gooddecreases when the price increases and vice versa

Demand: this relationship between prices and quantitiesfor a particular market

Quantity demanded: amount demanded at each price

Demand can shift due to consumer income, substitutesand complements, the number of consumers, andconsumer preferences and expectations

SUPPLY

Law of supply: the quantity supplied of a good increaseswhen the price increases and vice versa

Supply: relationship between prices and quantities for aparticular market

Quantity supplied: the amount supplied at a given price Supply can shift due to changes in factor costs,

technology, expectations of future prices, number ofproducers, and government regulations

Changes in demand or supply cause a shift of the curve;quantity changes at every price

Change in quantity demanded or supplied causes amovement along the curve

MICROECONOMIC EQUILIBRIUM

Equilibrium: intersection of supply and demand

Consumer surplus: difference between how muchconsumers are willing to pay and the market price

Producer surplus: difference between the price at whichfirms are willing to sell and the market price

Market equilibrium maximizes consumer and producersurplus

ELASTICITY

Percent change in quantity over percentage change inprice

Price elastic demand: goods with close substitutes,luxuries

Price inelastic demand: necessities

Price elastic supply: long run




CRUNCH KITEconomics in Four Pages (Page 2)

ELASTICITY

Price inelastic supply: short run, scarce good

Factors affecting demand elasticity: substitutes, necessities,scope of market, time horizon

Factors affecting supply elasticity: scarcity of inputs,presence of barriers to entry, time horizon

Elasticity= 0: perfectly inelastic

0 < Elasticity < 1: price inelastic

Elasticity = 1: unit elastic

Elasticity > 1: elastic

Elasticity =∞: perfectly inelastic

ECONOMIC AND ACCOUNTING PROFIT

Total revenue: amount a firm receives from selling its goods

Total cost: costs of a firm supplying its goods

Accounting cost: actual monetary cost Accounting profit: straight monetary profit earned

Economic cost: both monetary (accounting) cost and theopportunity cost of the resources used

Economic profit: monetary profit minus opportunity cost;always equal to zero in the long run

FIRMS AND COSTS

Fixed costs: costs that a firm must pay regardless of howmuch it produces (rent, utilities); only fixed in short run

Variable costs: costs that change with the amount produced

Average cost: the sum of fixed costs and total variable costs,divided by the total number of units produced

After a certain point, marginal costs stop decreasing andbegin increasing-----this is called diminishing returns to scale

In the long run, all costs are variable

PRICE CONTROLS

Price ceilings set a maximum; price floors set a minimum

Deadweight loss: lost efficiency due the market not being inequilibrium

Binding price controls ALWAYS have deadweight losses

Price controls transfer surplus from consumers to producersor vice versa

Taxes distort the market, transferring surplus from the

market to the government at the expense of efficiency

The more inelastic party always bears more of the tax

Revenue equals price times quantity

MARKET FAILURES

A market failure is when competitive markets fail to producesocially desirable outcomes

Two types discussed here are externalities and public goods

EXTERNALITIES

Externalities are costs or benefits that affect a third partyuninvolved in the activity or transaction in question

EXTERNALITIES

Individuals do not factor externalities into their decisions

Negative externalities harm third parties; the tendency isto overproduce them

Positive externalities benefit third parties; there are notenough of them

Coase Theorem: private parties can resolve theinefficiencies created by externalities as long as propertyrights are clearly defined and all parties can negotiatewith each other

PUBLIC GOODS

A rival good, when it is consumed, can no longer beconsumed by anyone else

People have limited access to excludable goods

Private goods are both rival and excludable

Public goods are neither

Collective goods are non-rival and excludable

Common resources are non-excludable and rival

The tragedy of the commons occurs when peopleoveruse a resource because no one owns it

MARKET POWER

A firm with a downward sloping demand curve hasmarket power; they can choose their price

The combinations of price and quantity available tochoose from are determined by the market demand

MONOPOLY

Market with only one firm Produce less than what consumers demand, and sell it at

higher than the market price

Arise due to the presence of barriers to entry

Price discrimination: charging different customersdifferent prices; a monopoly can capture more of theconsumer surplus for the firm

OLIGOPOLY

Market with only a few firms

Collusion: when firms cooperate to artificially raisemarket prices by restricting supply

Cartel: group of firms that collude

Cartels often break up due to an incentive to cheat

MONOPOLISTIC COMPETITION

Firms compete through product differentiation, not pricecompetition

Few barriers to entry exist

INSTITUTIONS, ORGANIZATIONS, AND GOVERNMENT

Institutions: formal or informal rules that guide humaninteractions

Organizations are like institutions but more formal

Governments can tax their citizens and use force




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Economics in Four Pages (Page 3)

INSTITUTIONS, ORGANIZATIONS, AND GOVERNMENT

Pork barrel politics: elected officials tend to steer money totheir constituents by introducing projects

Logrolling: vote trading among elected officials

Rent seeking: socially unproductive activities that simplydirect economic benefits

GROSS DOMESTIC PRODUCT (GDP)

Market value of all final goods and services produced withina country in a given period of time; four components

GDP = Y = C + I + G + NX

Consumption: consumer spending on final goods

Investment: value of all money spent on capital ortechnology

Government expenditures

Net exports: exports minus imports

Business cycle: fluctuations in GDP over recessions andexpansions

Average labor productivity: GDP divided by the total numberof workers employed

MACROECONOMIC MODELLING

Circular flow model: households own factors of production;firms rent factors and produce goods, which households buy;two markets: goods market and factor market

Aggregate demand (AD): quantity of goods demanded by aneconomy at different price levels, slopes downward

Aggregate supply (AS): potential supply of goods andservices in an economy at different price levels

Short run aggregate supply (SRAS): slopes upwards

Long run aggregate supply (LRAS); fixed at full employmentoutput; vertical line; independent of price level

Short run equilibrium: intersection of SRAS and AD; long runequilibrium is at the intersection of all three curves

UNEMPLOYMENT

Labor force: all individuals 16 or over, not in prison or armedforces, and actively looking for work or has a job

Employment rate: percentage of labor force with a job

Participation rate: percentage of population in the labor force

Structural unemployment: unemployment due to large shifts

in economy; mismatch between skills demanded and skillssupplied

Cyclical unemployment: caused by the business cycle

Frictional unemployment: natural unemployment due totime-lag between jobs

Unemployment rate calculated every month by the BLS

Natural rate of unemployment: never 100%; structural +frictional unemployment

Okun’s Law: for every 1% increase in unemployment, GDPdrops by 2%

MONEY

A medium of exchange, unit of account, and store ofvalue

Commodity money: money with intrinsic value

Fiat money: intrinsically worthless; declared valuable bygovernment

Inflation: rise in price level; decrease in purchasing poweof money; measured by the CPI and GDP deflator

Liquidity: how easily an asset can be converted intocurrency

THE FINANCIAL SYSTEM

Savings: income that is not spent

Investment: purchase of new capital equipment

Bond: a certificate of indebtedness

Stock: ownership of a portion of a company

Net capital outflow: domestic purchase of foreign capitaminus foreign purchase of domestic assets

FISCAL POLICY

Government spending or taxes to influence AD

Contractionary: increasing taxes, decreasing spending

Expansionary: decreasing taxes, increasing spending

MONETARY POLICY

Open market operations: buying or selling securities,done by the FOMC

Reserve ratio: fraction of deposits banks must keep inreserve; adjusted by Board of Governors

Discount rate: interest rate the Fed charges to memberbanks; adjusted by Board of Governors

Contractionary: selling securities, increasing reserveratio, increasing discount rate

Expansionary: buying securities, decreasing reserve ratiodecreasing discount rate

Quantity theory of money: MV = PY

ECONOMIC HISTORY OF WWI

Great Britain and Germany carried out economic warfarethrough blockades

The Allies used central government planning tocoordinate war output

Great Britain’s wealth allowed it to devote a highproportion of its economy to war output

France suffered the greatest economic losses as mostbattles were fought on its territory

Italy was economically underdeveloped and Russiaeconomically backward at the start of the war

Russia withdrew from WWI in 1917




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Economics in Four Pages (Page 4)

AMERICAN ENTRY INTO THE WAR

Germany’s unrestricted submarine warfare and theZimmerman telegram prompted American entry into the war

The United States’ contribution tipped the balance to the

Allies

4.8 million Americans served in the military during WWI

The Emergency Fleet Corporation and the British providedtroop transport vessels to ship American soldiers to France

Losses to German U-boat attacks after 1917 were small

AMERICAN WARTIME PRODUCTION

The War Industries Board obtained war products for thegovernment

The Board’s Price Fixing Committee used bulk-line pricing toset prices for such products

Bulk-line pricing involved setting prices at a level that would

obtain the corresponding output desired The Food Administration licensed food producers and

controlled food production through voluntary cooperation

The Railroad Administration was formed after the railroadswere nationalized

It organized troop transports and worked with the FuelAdministration to ensure coal deliveries

COST OF THE WAR

WWI’s direct net cost was $186 billion

Great Britain had the highest per capita spending of $766 perperson

The United States spent $229 per capita

WWI had additional indirect costs, including the opportunitycost of resources diverted to wartime output

The combatant states also suffered from the destruction ofhuman and physical capital

Peoples’ deaths represented a loss of their future potentialearnings

WWI’s total cost was $337.85 billion

WAR FINANCING IN THE UNITED STATES

The United States spent $31 billion on the war effort

The United States borrowed $19 billion through public LibertyBonds to fund the war effort

Income taxes were raised during the war and contributed$7.6 billion of the war budget

The Federal Reserve also issued $4.4 billion of money

WAR FINANCING IN GREAT BRITAIN

Great Britain borrowed heavily during WWI, domesticallyand from the United States

Its debt level was 127.5% of GDP

Taxes contributed 24.5% of war expenditure

Great Britain increased its excise, property, and income taxesover the course of the war

WAR FINANCING IN FRANCE

France took on long-term debt from 1915 onwards, andhad debt amounting to 124% of GDP by 1916

Public opposition limited the government’s ability to

raise taxes

However, inflation caused by a growth in the moneysupply imposed an implicit tax by reducing consumers’purchasing power

WAR FINANCING IN GERMANY

Germany used debt financing to supply 80% of its warexpenditures

Its money supply increased fivefold during WWI andprices doubled

Germany’s heavy debt contributed to hyperinflationafter the war

ECONOMIC PERFORMANCE DURING THE WAR European demand for American goods pulled the

American economy out of recession

American entry into the war slowed its growth, but itsGDP still grew by 13.2% overall

Great Britain’s economy grew after 1916, with an overal14.8% increase in GDP

Germany’s GDP dropped by 19.2%, and Austria-Hungary’s by 26.7%

France’s GDP declined by 34.1% and Russia’s GDP in1917 was 67.7% of its 1913 level

ECONOMIC IMPACT OF THE WAR

Demobilization caused a sudden expansion in the laborforce and a brief recession in the United States

However, American government spending remainedhigh, fuelling economic growth

The United States loaned money to its allies

Europe relied on American goods during itsreconstruction

American businesses invested in plants and equipmentto produce consumer durable goods

Some scholars believe that WWI permanentlyincreased government spending

Others argue that spending only increased to repaydebt, or that it had already increased before the war

ECONOMIC CONSEQUENCES OF THE PEACE

The United States’ allies owed it a combined $9.2 billion

Germany had to pay $33 billion in reparations under theTreaty of Versailles

It would have to pay $375 million per year until 1925and $900 million in yearly interest payments after 1925

British economist Keynes believed this unduly harshand unrealistic

German resentment of the Treaty helped fuel the Nazisrise to power and hence the Second World War.




CRUNCH KIT

List of Lists (1 of 3)

8 ECONOMISTS 8 EQUATIONS

Michael Boskin In 1996, assigned to head a committee toreview the methods used to calculate CPI

Michael Edelstein Constructed the ‘‘marginal’’ and ‘‘strong’’

set of standards to gauge the effect ofempire on the British economy

Stanley Engerman Estimated profitability of the slave trade

Milton Friedman Most famous advocate of monetarypolicy (instead of Kenyesian policy)

John MaynardKeynes

Proposed fiscal policy as a way to smoothout the business cycle; his theories put tothe test in the Great Depression; wrote1936 book The General Theory of

Employment, Interest, and Money

Simon Kuznets Commissioned by the U.S. Department ofCommerce to develop a system to

measure national outputJosephSchumpeter

Described the impact of entrepreneurs as‘‘creative destruction’’

Adam Smith Father of classical economics; wrote the1776 book An Inquiry into the Nature

and Causes of the Wealth of Nations

Average totalcost

CPI

Elasticity E =

GDP deflator GDP deflator =

Grossdomesticproduct

General profitmaximizing

condition

Marginal revenue = marginal cost

Moneymultiplier

Quantityequation

MV = PY

6 UNEMPLOYMENT TERMS 12 FISCAL AND MONETARY POLICY TERMS

Frictionalunemployment

Results from the time lag betweenworkers leaving one job and findinganother; exists even in the healthiest andwealthiest of economies

Labor force Total number of persons aged 16 and overeither working or actively seekingemployment (excluding those in prison orin the military)

Okun’s law Sugests every 1% rise in unemploymentabove the natural rate of unemploymentresults in a 2% drop in GDP

Participation rate Percentage of the total population eligiblefor the labor force that is currently in thelabor force (employed or actively seekingemployment)

Structural

unemployment

Results from fundamental changes in the

economy, such as improving technologyor shifting consumer preferences-----leading to a mismatch of skills offered bylabor and skills desired by firms

Underemployment When someone is working at a job thatdoes not use the full extent of theireducation or human capital

Cyclicalunemployment

Unemployment that occurs alongside thebusiness cycle, increasing duringcontractions and decreasing duringexpansions

Contractionarypolicy

Policy meant to fight inflation anddecrease aggregate demand

Discount rate Interest rate the Federal Reserve chargesfor loans to its member banks

Expansionarypolicy

Policy meant to fight recession andincrease aggregate demand

Federal funds rate Interest rates banks charge on loans toeach other; based on the discount ratebut not set by the Federal Reserve

Federal AdvisoryCouncil

Advisory body with bankers representingeach district in the Federal Reserve

Federal Reserve(the Fed)

The central banking system of the UnitedStates; sets monetary policy

Federal OpenMarket Committee

Controls the money supply and conductsday-to-day monetary policy

Board ofGovernors Ruling council of the Federal Reserve;consists of seven governors

Fiscal policy Government taxation and spending policchoices meant to influence the economy

Monetary policy Central bank policies affecting theeconomy by altering the money supply

Open marketoperations

Trading of securities by the FederalReserve to adjust the the money supply

Reserve ratio The amount of each deposit banks musthold in reserve

ProducedUnitsofNumberTotal

CostVariableTotal+CostsFixedTotal=ATC

100•yearbaseinpriceBasket

tyearinpriceBasket=CPI

price%

quantity%

100•GDPalRe

GDPalminNo

NX+G+I+C=Y

RR

1=MM




CRUNCH KIT

List of Lists (2 of 3)

12 COMPETITION TERMS 13 FUNDAMENTAL CONCEPTS

Price elasticity ofdemand

A measurement of the sensitivity of quantitydemanded to a change in market price

Complements Related goods, such that when the price ofone good falls, demand for the other rises

Substitutes Related goods, such that when the price ofone good falls, demand for the other falls

Normal good A good the demand for which increases asthe income of its consumers increases

Inferior good A good the demand for which decreases asthe income of its consumers increases

Firm An organization that produces a good orservice for sale to the market

Monopoly A market that has only one producer, withhigh barriers to entry

Natural monopoly A special monopoly that arises when two ormore producers cannot coexist profitably;often regulated or run by the government

Oligopoly A market with only a few producers and highbarriers to entry; firms in an oligopolysometimes collude

Monopolisticcompetition

A market with many producers each aimingto differentiate its product, hoping to obtaina small amount of monopoly power

Perfectcompetition

A market with many producers andconsumers, perfect information, and nobarriers

Benefit-costanalysis

Rational decision-making process,weighing pros and cons

Margin A small incremental change

Marginal benefit The benefit of an incremental change

Marginal cost The cost of an incremental change

Utility Satisfaction gained from doing orconsuming something

Marginal utility Satisfaction gained from an incrementalchange

Total utility The total satisfaction (or dissatisfaction!Gained from doing or consumingsomething

Optimization Act of maximizing total utility

Free marketeconomy

An economic system in which marketforces allocate goods and services

Commandeconomy

Economic system in which a centralauthority makes all economic decisions

Laissez-faire The notion that government should notinterfere with the economy

Absoluteadvantage

When one country is able to producemore of a good than another country

Comparativeadvantage

When one party has a lower opportunitycost of producing a good than anotherparty

MICROVOCABULARY MACROVOCABULARY

Price The amount in exchange for which sellersgive buyers a good or service

Quantitysupplied

The total of a good or service that, at agiven price level, producers will be willingto sell

Quantitydemanded

The total of a good or service that, at agiven price level, consumers will bewilling to buy

Supply The relationship between price quantitysupplied by producers

Demand The relationship between price andquantity demanded by consumers

Law of supply As price increases, producers will supplygreater quantities of goods and services

Law ofdemand

As price increases, consumers willdemand smaller quantities of goods andservices

Demandschedule

A table showing quantity demanded atvarious prices

Supply

schedule

A table showing quantity supplied at

various prices

Economics The study of decision-making

Microeconomics Study of economics on the micro-scale:households, firms, specific regions of aneconomy

Macroeconomics Study of economics at a broad level:national and international issues

Scarcity Not having the resources to satisfy allwants

Opportunitycost

The value of the next-best alternative to achoice

Trade-off The act of giving something up to getsomething else

Factors ofproduction

Resources used to produce goods andservices

Land Factor of production-----includes all naturalresources

Capital Factor of production; includes buildingsand equipment

Labor Factor of production; includes workers




CRUNCH KITList of Lists (3 of 3)

12 HIGH-PRIORITY FIGURES 8 ECONOMIC CONCEPTS

13.2% Total growth in the United State’s GDP from1913 to 1918

14.8% Total growth in Great Britain’s GDP from 1913

to 191818.2% Total decline in Germany's GDP from 1913 to

1918

32.3% Total decline in Russia’s GDP from 1913 to1917

36.1% Total decline in France's GDP from 1913 to1918

24% Proportion of Russia’s economy devoted towar output during WWI

53.5% Proportion of France’s economy devoted towar spending in 1918

1.39 million Number of American soldiers serving inthe front line during WWI

9.4 million Number of deaths in WWI

$375 million Yearly reparations to be paid by Germanyuntil 1925 under the Treaty of Versailles

$33 billion Amount of reparations imposed on Germanyin the Treaty of Versailles

$186 billion Direct net cost of WWI

$337.85 billion Total cost of WWI

Bulk-line pricing Pricing method used by the Americangovernment during WWI for war-related goods; involved setting a price

level that would obtain for it thedesired output

Debt financing Method of borrowing money tofinance the war effort, relied uponheavily by Germany

Debt servicepayments

Payments over a period of time on theprincipal and interest of a loan, e.g.Allied WWI loans from the UnitedStates

Durable goods Products that last at least three yearson average, e.g. cars and householdappliances

Excise taxes Direct taxes on specific products used

by Great Britain to fund its war effort

Human capital A person’s skills, knowledge, andexperience, all of which contribute tohis or her productivity

Inflation tax Phenomenon whereby price risesimpose an implicit tax on consumerpurchasing power

10 WAR AGENCIES 17 MEDIUM-PRIORITY FIGURES

Emergency FleetCorporation

American body that procured half of theUnited States' troop transport vessels to shipsoldiers to France

Federal Reserve American central bank; helped to finance thewar effort through Liberty Bond issues andissuing money

FoodAdministration

Agency created in August 1917 to overseefood output and license food businesses

FuelAdministration

American agency created in August 1917 toset coal prices and ensure coal deliveries

Ministry ofMunitions

British ministry overseeing key war industriesafter 1915

Price FixingCommittee

American agency established to determineprices of strategically important products;adopted the bulk-line pricing strategy

RailroadAdministration

American agency created in 1917 to run thenationalized railroad system and coordinatetroop transports

SupremeCommittee ofMinisters

Italian government body responsible foreconomic central planning in WWI

Under-Secretariatfor Arms andMunitions

Italian agency directly overseeing wartimeproduction decisions in WWI

War IndustriesBoard

American agency established in July 1917 andrestructured in March 1918; procured warproducts and set prices

$229 American per capita spending in WWI

$557 German per capita spending in WWI

$613 French per capita spending in WWI$766 British per capita spending in WWI

200,000 Deadweight tons of American shippinglost to German attacks

616,000 Number of troops transported byAmerican railroads monthly after 1917

2.8 million Number of Americans inducted intothe military under selective service

7.5 million Tons of cargo shipped from the UnitedStates to Europe during WWI

$900 million Yearly interest payment on Germanreparations after 1925

$0.2 billion Russian debt to United States in 1918

$1.6 billion Italian debt to United States in 1918

$2.7 bi llion French debt to United States in 1918

$4.0 billion British debt to United States in 1918

$4.4 billion Amount of money issued by theFederal Reserve for WWI spending

$7.6 billion Amount raised by income tax for theAmerican WWI spending

$10 billion Amount proposed by Keynes forGerman reparations after WWI

$19 billion Sum raised by American Liberty Bonds




FINAL TIPS AND ABOUT THE AUTHOR

FINAL TIPS ABOUT THE AUTHORS

Don’t just learn definitions by rote; rephrasethem in ways that make sense to you

Repeat after me: shifts in demand are notthe same as shifts in quantiy demanded

Come prepared to draw out supply anddemand diagrams

Draw out supply and demand diagrams

The marginal utility of eliminating wronganswers before answering is very high

When short on time, memorize key factsfrom Section IV by leader, reform, and year

Make a study playlist that gets you pumpedfor brain workouts

Catherine Tran is a studentof philosophy and religiousstudies at the University ofTexas. When she isn’t

studying, her next-bestalternatives include writingabout morality, attendinglive concerts, and shoppingfor second-hand clothing.The previous sentencemakes her appear a lot hipper than she actually is. JacquelineKhor (unpictured) was the 2010 Global Round champion in theWorld Scholar’s Cup, and lives in an ambiguous land calledSingapore where top-scoring students often wear green.

ABOUT THE EDITORSROBB DOOLING DANIEL BERDICHEVSKY SOPHY LEE

Robb Dooling first became aDemiDec factor of production in2009-----namely, a beta tester. Inaddition to beta testers, DemiDecfactors of production includewriters, editors, and frequently-misplaced laptops.

Daniel Berdichevsky is conducting alifelong experiment to determinewhether the law of diminishingmarginal utility applies to theconsumption of tea. He is picturedhere speaking at a school in Indiaafter drinking four cups.

Sophy Lee rides her bike the wayshe pursues everything in life, fromAcademic Decathlon, Harvard, anDemiDec, to her recent appearancon Million Second Quiz : withdetermination, focus, and a diet ofberries, yogurt, and self-appraisal

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Economics Cram Kit