Macro midterm

Common misconceptions to avoid

"Investment" in reference to national income accounting has a very narrow definition: purchases of things like machines, factories, and houses. It refers only to the purchase of new items, not trades in financial instruments based on those items. We based statements about growth on GDP; but GDP has limitations, both as a measure of total production, and as a measure of well- being. In order to make useful comparisons, concentrate on real GDP rather than nominal GDP. In calculating real GDP, the choice of base year is largely arbitrary; there is no "correct" base year.

Rational:

-Using all available information to achieve your goals. -Economists generally assume that people are rational. -Rational consumers and firms weigh the benefits and costs of each action and try to make the best decision possible. -Example: Microsoft doesn't randomly choose the price of its Windows software; it chooses the price(s) that it thinks will be most profitable.

We can think about efficiency in a market in two ways:

1. A market is efficient if all trades take place where the marginal benefit exceeds the marginal cost, and no other trades take place. 2. A market is efficient if it maximizes the sum of consumer and producer surplus (i.e. the total net benefit to consumers and firms), known as the economic surplus.

Economists develop economic models to analyze real-world issues. Building an economic model often follows these steps:

1. Decide on the assumptions to use in developing the model. 2. Formulate a testable hypothesis. 3. Use economic data to test the hypothesis. 4. Revise the model if it fails to explain the economic data well. 5. Retain the revised model to help answer similar economic questions in the future.

Whenever you must use a formula, you should follow these steps:

1. Make sure you understand the economic concept the formula represents. 2. Make sure you are using the correct formula for the problem you are solving. 3. Make sure the number you calculate using the formula is economically reasonable. For example, if you are using a formula to calculate a firm's revenue and your answer is a negative number, you know you made a mistake somewhere.

Bonds

A bond is financial security that is essentially a loan. A firm sells a bond for its face value, say $1000, promising to repay this principal at the end of some term, say 30 years. The bond will also include a series of coupon payments, intermediate payments that will be made to the bond-holder; say, $40 every year. The interest rate, or cost of borrowing, can be expressed as the ratio of the coupon payment to the principal The higher the default risk, the higher the coupon payment (hence the interest rate) the firm will have to offer.

Increase and Decrease in Demand

A change in something other than price that affects demand causes the entire demand curve to shift.

Increase and Decrease in Supply

A change in something other than price that affects supply causes the entire supply curve to shift.

Change in Demand vs. Change in Quantity Demanded

A change in the price of the product being examined causes a movement along the demand curve. • This is a change in quantity demanded. Any other change affecting demand causes the entire demand curve to shift. • This is a change in demand.

Change in Supply vs. Change in Quantity Supplied

A change in the price of the product being examined causes a movement along the supply curve. • This is a change in quantity supplied. Any other change affecting supply causes the entire supply curve to shift. • This is a change in supply.

Demand curve:

A curve that shows the relationship between the price of a product and the quantity of the product demanded.

Supply curve:

A curve that shows the relationship between the price of a product and the quantity of the product supplied.

Final goods and services

A final good or service is a good or service purchased by a final user. These are what are used to calculate GDP. • Why? If we counted intermediate goods and services as well, ones that were inputs into another good or service, such as a tire on a truck, then we would end up double-counting. Example: if we counted the value of the ice cream bought by a store, and also counted the value of that ice cream when it was sold to a consumer, we would be double-counting the wholesale value of the ice cream.

Bonds

A financial security that represents a promise to repay a fixed amount of funds.

Stocks

A financial security that represents partial ownership of a firm.

Balance Sheet:

A financial statement that sums up a firm's financial position on a particular day, usually the end of a quarter or year. This summarizes the liabilities (anything owed by a person or firm) and assets of the firm. A firm's net worth is calculated as the amount of its assets minus the amount of its liabilities.

Technological Change

A firm may experience a positive or negative change in its ability to produce a given level of output with a given quantity of inputs. This is a technological change. Changes raise or lower firms' costs, hence their supply of the good. Examples: A new, more productive variety of wheat would increase the supply of wheat. Governmental restrictions on land use for agriculture might decrease the supply of wheat.

How Will the Goods Be Produced?

A firm might have several different methods for producing its goods and services. Example: A music producer can make a song sound good by • Hiring a great singer, and using standard production techniques; or • Hiring a mediocre singer, and using Auto-Tune to correct the inaccuracies. Example: As the cost of manufacturing labor changes, a firm might respond by • Changing its production technique to one that employs more machines and fewer workers; or even • Moving its factory to a location with cheaper labor

Sole proprietorship:

A firm owned by a single individual and not organized as a corporation.

Partnership:

A firm owned jointly by two or more persons and not organized as a corporation.

Accounting Profit

A firm's income statement is a financial statement that shows a firm's revenues, costs, and profit over a period of time. Profit on the income statement is referred to as net income, and is calculated as revenue minus operating expenses and taxes paid. Economists refer to this as accounting profit, and call the listed expenses explicit costs, costs that involve actually spending money. Accounting Profit=Revenue-explicit costs

Indirect finance:

A flow of funds from savers to borrowers through financial intermediaries such as banks. Intermediaries raise funds from savers to lend to firms (and other borrowers). Firms can borrow money from banks. As such, the banks are acting as financial intermediaries, permitting indirect finance of the firm by their savers.

Inferior good:

A good for which the demand decreases as income rises, and increases as income falls. Examples: Second-hand clothing Ramen noodles

Normal good:

A good for which the demand increases as income rises, and decreases as income falls. Examples: Clothing Restaurant meals Vacations

Market:

A group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade

Corporation:

A legal form of business that provides owners with protection from losing more than their investment should the business fail. their profits may be taxed twice: once as corporate profits and again when the profits are disbursed to investors.

Price ceiling:

A legally determined maximum price that sellers can charge.

Price floor:

A legally determined minimum price that sellers may receive.

Circular-flow diagram:

A model that illustrates how participants in markets are linked. Households provide factors of production to firms. Firms provide goods and services to households. Firms pay money to households for the factors of production. Households pay money to firms for the goods and services.

Slopes of Nonlinear Curves

A nonlinear curve has different slopes at different points. This curve shows the total cost of production for various quantities of iPhones. We can approximate its slope over a section by measuring the slope as if that section were linear. Between C and D, the slope is greater than between A and B; so we say the curve is steeper between C and D than between A and B. Another way to measure the slope of a nonlinear curve is to measure the slope of a line that is tangent to the point where we want to know the slope.

Principal-agent problem:

A problem caused by an agent pursuing his own interests rather than the interests of the principal who hired him. The conflict between the interests of shareholders and the interests of top management

Scarcity:

A situation in which unlimited wants exceed the limited resources available to fulfill those wants

Income Statement:

A summary of the firm's revenues, costs, and profit over a period of time—typically a 12-month fiscal year, which does not necessarily coincide with the calendar year.

Demand schedule:

A table that shows the relationship between the price of a product and the quantity of the product demanded.

Supply schedule:

A table that shows the relationship between the price of a product and the quantity of the product supplied.

The Importance of Accurate Financial Statements

Accurate and truthful financial statements are critical for investors to make investment decisions. Investments help guide resource allocation within the economy. Firms disclose financial statements in periodic filings to the federal government, and in annual reports to shareholders. If these financial statements are inaccurate, the whole economy suffers, as resources are allocated to less productive activities. This reduces economic growth directly, and reduces investor confidence which further erodes growth.

Stock and Bond Markets Provide Capital—and Information

After firms sell their stocks and/or bonds, these financial securities can be traded in stock and bond markets. The existence of these resale markets is beneficial for society, since without them, individuals could not invest in firms without tying up their money for a long time. The price at which a stock trades indicates the degree of confidence in the firm's ability to make future profits, since these profits are what is used to generate a return for investors. The price at which a bond trades is determined by its coupon payment, relative to other coupon payments available. But it also reflects the confidence of investors in the firm's ability to make those payments.

Total production = Total income

All production must be rewarded with income; so in theory, we could count either in order to calculate GDP. • In practice, data limitations make us unlikely to come up with the same number; there will always be some statistical discrepancy.

Labor-force participation and employment-population

Also important are the labor-force participation rate (the percentage of the working-age population in the labor force)... Labor force/ Working - age population ×100 = Labor force participation rate

Business cycle:

Alternating periods of economic expansion and economic recession.

Efficiency wage:

An above-market wage that a firm pays to increase workers' productivity. Firms want to get the best performance they can out of their workers. Sometimes monitoring workers is difficult or costly; an alternative is to pay them a relatively high wage, making them motivated to perform well in order to keep their job. These above-market wages are probably another reason why unemployment exists even when cyclical unemployment is zero.

Measuring GDP using the value-added method

An alternative method to measure GDP is to measure the value added: the market value a firm adds to a product. The final selling price of a product must equal the sum of the values added to the product at each stage of production.

trade-off

An increase in the production of one good requires the reduction in the production of some other good. resulting from the scarcity of productive resources.

Asset:

Anything of value owned by a person or a firm.

Raising Funds as Your Firm Grows: Indirect Finance

As firms get larger, the need to obtain external funds tends to grow. The economy's financial system facilitates the transfer of funds from savers to borrowers.

People Respond to Economic Incentives

As incentives change, so do the actions that people will take. Example: Changes in several factors have resulted in increased obesity in Americans over the last couple of decades, including: • Decreases in the price of fast food relative to healthful food • Improved non-active entertainment options • Increased availability of health care and insurance, protecting people against the consequences of their actions

Economic Growth on the PPF

As more economic resources become available, the economy can move from point A to point B, producing more tanks and more automobiles. Shifts in the production possibilities frontier represent economic growth.

Shifts of the Demand Curve

As the demand curve shifts, the quantity demanded will change, even if the price doesn't change. The quantity demanded changes at every possible price.

Shifts of the Supply Curve

As the supply curve shifts, the quantity supplied will change, even if the price doesn't change. The quantity supplied changes at every possible price.

A Shortage in the Market for Smartphones

At a price of $100, • consumers want to buy 12 million smartphones, while • producers want to sell 8 million. This gives a shortage of 4 million smartphones: a situation in which quantity demanded is greater than quantity supplied. Prediction: sellers will realize they can increase the price and still sell as many smartphones, so the price will rise.

Market Equilibrium

At a price of $200, • consumers want to buy 10 million smartphones, and • producers want to sell 10 million smartphones. This is a market equilibrium: a situation in which quantity demanded equals quantity supplied. A market equilibrium with many buyers and sellers is a competitive market equilibrium.

A Surplus in the Market for Smartphones

At a price of $250, • consumers want to buy 9 million smartphones, while • producers want to sell 11 million. This gives a surplus of 2 million smartphones: a situation in which quantity supplied is greater than quantity demanded. Prediction: sellers will compete amongst themselves, driving

The efficiency of competitive equilibrium—surplus

At the competitive equilibrium quantity, the economic surplus is maximized.

Unemployment rate

Based on the CPS estimates, we calculate several important macroeconomic indicators. • The most-watched is the unemployment rate: Number of unemployed/labor force ×100 = Unemployment rate This most-common measure of unemployment is known formally as BLS series U-3.

The Financial Crisis of 2007-2009

Beginning in 2007 and lasting into 2009, the U.S. economy suffered the worst financial crisis since the Great Depression. At its heart were financial instruments based on home mortgage loans: mortgage-backed securities. These instruments appeared to be much like bonds, and though many of the underlying mortgages were risky (made to "subprime" borrowers), the securities were incorrectly perceived to be low-risk. When prices fell in many housing markets, the underlying mortgages went into default, and the value of the securities plunged. The mortgage-backed securities had become popular with many investors, including large investment banks and insurance companies. These companies suffered heavy losses, and several were able to remain in business only through federal government aid.

Common Misconceptions to Avoid

Believing economics is only about money. Confusing positive and normative analysis. Assuming familiar meanings for economic terms.

Using Present Value to Calculate Bond Prices

Bond price=Coupon1/(1+ i) +Coupon2/(1+ i)2 +...+Couponn/(1+ i)n +Face value/(1+ i)n

Direct finance generally takes the form of one of two financial securities:

Bonds Stocks

Time-Series Graphs

Both panels present time-series graphs of Ford Motor Company's worldwide sales during each year from 2001 to 2012. Panel (b) has a truncated scale on the vertical axis, while panel (a) does not. As a result, the fluctuations in Ford's sales appear smaller in panel (b) than in panel (a).

When drawing the demand curve, we assume ceteris paribus.

Ceteris paribus ("all else equal") condition: The requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant.

Change in Expectations about Future Prices

Consumers decide which products to buy and when to buy them. • Future products are substitutes for current products • An expected increase in the price tomorrow increases demand today. Effect on today's gasoline demand, if price will rise tomorrow • An expected decrease in the price tomorrow decreases demand today. Example: If you found out the price of gasoline would go up tomorrow, you would increase your demand today.

Substitution bias:

Consumers may change their purchasing habits away from goods that have increased in price.

Components of GDP in 2012

Consumption is the largest component of GDP; within that, services are the largest component—almost half of GDP. American net exports are negative, since the value of our imports exceeds the value of our exports.

Analyzing Balance Sheets

Corporations list their assets on the left of their balance sheets and their liabilities on the right. The difference between the value of the firm's assets and the value of its liabilities equals the net worth of the firm, or stockholders' equity. Stockholders' equity is listed by tradition as a liability, so the balance sheet must logically balance.

What's so bad about falling prices?

Deflation is much more dangerous for an economy than inflation. Why? Suppose you are considering buying a car. You know the car will be cheaper next year, so you delay purchasing. But if everyone does the same, then many purchases are postponed, firms stop producing, people become unemployed, etc. This can create a dangerous downward-spiral, delaying economic recovery. Economists believe this occurred after the Great Depression of the 1930s, and also in Japan in the 1990s. There were concerns that significant periods of deflation might have followed the recession of 2007-2009. but fortunately that did not occur.

The household survey

Each month, the U.S. Bureau of the Census conducts the Current Population Survey (a.k.a. the household survey). • ~60,000 households selected to be "representative" • Household members of "working age" (16+ years old) • Asked about employment during "reference week" • Also asked about recent job-search activities

The GDP deflator

Economists and policy-makers are interested in the price level: a measure of the average prices of goods and services in the economy. • Why? Stable prices are desirable because they allow households and firms to plan for the future appropriately. In order to know whether we are achieving price stability, we need to measure the price level. • One way to do this is using the GDP deflator: a measure of the price level, calculated by dividing nominal GDP by real GDP and multiplying by 100: GDP deflator = Nominal GDP/Real GDP x 100 Since nominal and real GDP will be the same in the base year, the GDP deflator will be 100 in the base year.

Economic Profit

Economists differ from accountants when calculating profit, because economists and accountants have different intents: • Accountants present financial information in order to allow people to make judgments on investments. • Economists are interested in decision-making; whether investing in the firm is wise, and whether the firm should continue to operate. So it is important for economists to consider the whole opportunity cost of the firm's activities, including both explicit and implicit costs: opportunity costs that do not require an outlay of money; for example, a firm owner's time, or the next-best use for their invested funds. Economic profit is a firm's revenues minus all of its implicit and explicit costs.

marginal analysis

Economists think about decisions like this in terms of the marginal cost and benefit (MC and MB): the additional cost or benefit associated with a small amount extra of some action. Comparing MC and MB is known as marginal analysis

The Scientific Nature of Economics

Economists try to mimic natural scientists by using the scientific method. But economics is a social science; studying the behavior of people is often tricky.

and the employment-population ratio (the percentage of the working- age population that is employed):

Employment /Working - age population ×100 = Employment - population ratio

Problems with anticipated inflation

Even if inflation is anticipated, it still causes problems: • People and firms have increased real costs of holding cash. • Firms have menu costs: the cost to firms of changing prices. Frequently changing prices cause are inconvenient for firms (and consumers too!) to deal with. • Investors are taxed on nominal returns, rather than real returns; so this can increase the tax due.

Adding the financial system to the circular flow

Finally, there are firms that deal specifically in flows of money; we label these firms the financial system. • Households elect not to spend some of their income, and instead save it with financial system firms like banks. • These financial system firms lend money to other firms and the government.

Using graphs to draw conclusions about cause and effect is dangerous.

For example, in panel (a), as the number of fires in fireplaces increases, the number of leaves on trees falls; but the fires don't cause the leaves to fall. In panel (b), as the number of lawn mowers being used increases, so does the rate at which grass grows.

Should Medical School Be Free?

Forecasts indicate a significant shortage of doctors, especially primary care physicians, by 2020. High costs of medical school may: • Prevent some people from becoming doctors • Lead people to pursue lucrative specialties instead of primary care Would more people become primary care physicians if medical school were free? And if so, would it be worth the cost? Economic models can find answers to the positive aspects of this debate.

Shortcomings of GDP

GDP can be a useful tool to measure total output in an economy. Many people go further than this, interpreting GDP as a measure of the well-being of citizens. However GDP has shortcomings, both in its measure of total production, and in its usefulness as a measure of well-being.

National Income

GDP minus the consumption of fixed capital; i.e. GDP minus depreciation

Shortcomings of GDP as a measure of well-being

GDP per capita (i.e. GDP divided by population) is often used to represent differences in standards of living from country to country. However, even if it accurately measured total production, it would not reflect: • The value of leisure • Pollution and other negative effects of production • Crime and other social problems • The distribution of income In fact, improvements in many of these will result in lower GDP per capita. Example: Lower crime would allow lower spending on police, prisons, and private security. This would decrease GDP, but surely result in improvements in economic well-being.

Complements:

Goods and services that are used together. Examples: Big Mac and McDonald's fries Hot dogs and hot dog buns Left shoes and right shoes

Substitutes:

Goods and services that can be used for the same purpose. Examples: Big Mac and Whopper Ford F-150 and Dodge Ram Jeans and Khakis

Government policies and the unemployment rate

Governments often attempt to directly influence unemployment. Example: The federal government's Trade Adjustment Assistance program offers training to workers whose firms laid them off as a result of competition from foreign firms. This would reduce structural unemployment. Other policies try to reduce frictional unemployment, for example by subsidizing new hires. However some other government policies probably increase unemployment, like • Unemployment insurance, and • Minimum wage laws We will examine the effects of each of these on unemployment.

Two key groups participate in the modern economy

Households

Scarcity:

Households, firms and governments continually face decisions about how best to use their scarce resources. -a situation in which unlimited wants exceed the limited resources available to fulfill those wants. Scarcity requires trade-offs. Economics teaches us tools to help make good trade-offs. Example: When deciding how to use its scarce workers and machinery, if Tesla wants to produce more Model X SUVs, those resources will not be available to produce Model S sedans.

Change in Expected Future Prices

If a firm anticipates that the price of its product will be higher in the future, it might decrease its supply today in order to increase it in the future. What types of products could be "stored" like this? Perishable products, or Non-perishable products

Tastes

If consumers' tastes change, they may buy more or less of the product. Example: If consumers become more concerned about eating healthily, they might decrease their demand for fast food. Effect on demand for fast food, if consumers want to eat healthy

The efficiency of competitive equilibrium

If the quantity is too low, the value to consumers of the next unit exceeds the cost to producers. If the quantity is too high, the cost to producers of the last unit is greater than the value consumers derive from it. Only at the competitive equilibrium is the last unit valued by consumers and producers equally—economic efficiency.

How important are these shortcomings?

If we are comparing GDP from year to year, the size of household production and the underground economy is probably about the same from year to year, so GDP growth is a reasonable measure of the growth in total production. However over long periods of time, these shortcomings might be more serious. Example: As women have entered the workforce in larger numbers, some household production has been replaced by paid childcare and restaurant meals. So increases in GDP may exaggerate the increase in actual total production.

How should we categorize unemployment at Caterpillar?

In 2013, Caterpillar announced layoffs at its South Milwaukee plant. • Did this increase frictional, structural, or cyclical unemployment? This is generally a hard question to answer; we need to look closely at this specific plant: • The South Milwaukee plant manufactured mining equipment. • Prices for mining products were in decline, decreasing demand for Caterpillar's mining machinery. But sales of other equipment remained strong. • The laid-off workers were likely specialists at making mining equipment; so they are probably structurally unemployed.

The Legal Basis of a Successful Market System

In a free market, government does not restrict how firms produce and sell goods, or how they employ factors of production. However governments must provide a sound legal environment that will allow the market system to succeed, including:

the circular flow and the measurement of GDP

In a very simple model of the economy, we could start with households and firms. To measure overall economic activity, we could measure the amount of money that households spend on goods and services. Or we could measure income to households.

The establishment survey

In addition to the household survey, the BLS also uses the establishment survey, (a.k.a. the payroll survey). This survey samples ~300,000 establishments, or places of employment, about their employees. Disadvantages include: • Self-employed people not surveyed (not on a company payroll) • Newly-opened firms often omitted • Information on employment only, not unemployment • Numbers fluctuate depending on establishments included, often requiring large revisions However, a big advantage is that the data are determined by real payrolls, not self-reporting like the household survey.

Underground economies in developing countries

In developing countries, the underground economy is often referred to as the informal sector, as opposed to the formal sector, in which output of goods and services is measured. • In many developing countries, the informal sector is very large; often above 50% of total output. Economists studying economic development say this often reflects poor government policies: high taxes and regulations, and low confidence in the security of private property from government seizure.

The Accounting Scandals of the Early 2000s

In the early 2000s, top managers at Enron and WorldCom were shown to have falsified their firms' financial statements. Some of these managers served jail time, but the damage done to many investors was severe. The government creates regulations to try to minimize the chance of such deception. The accounting scandals prompted the Sarbanes- Oxley Act (2002), requiring that CEOs personally certify financial statements, and requiring disclosure of conflicts of interest from auditors, the accountants charged with checking the accuracy of financial statements.

Market Equilibrium Price and Quantity

In this market: • The equilibrium price of a smartphone is $200, and • The equilibrium quantity of a smartphone is 10 million smartphones per week. Since buyers and sellers want to trade the same quantity at the price of $200, we do not expect the price to change.

What Factors Influence Market Demand?

Income of consumers Prices of related goods Tastes Population and demographics Expected future prices

Personal Income

Income received by households; includes transfer payments, but excluded firms' retained earnings

Income of consumers

Increase in income increases demand if product is normal, decreases demand if product is inferior.

Prices of related goods

Increase in price of related good increases demand if products are substitutes, decreases demand if products are complements

Outlet bias:

Increases in purchases from discount stores like Sam's Club and Costco or the internet are not incorporated into the CPI; it still uses full-retail price.

Population and demographics

Increases in the number of people buying something will increase the amount demanded. Example: An increase in the elderly population increases the demand for medical care.

What Goods and Services Will Be Produced?

Individuals, firms, and governments must decide on the goods and services that should be produced.

Principal-Agent Problems and the Financial Crisis

Investment banks (financial institutions that, among other things, aided corporations in stock- and bond-issuance) were traditionally organized as partnerships. By 2000, they had all converted to corporations. The managers now had short-term perspectives, and less incentive to avoid risk: "No investment bank owned by its employees would have ... bought and held $50 billion in [exotic mortgage-backed securities]. ... or even allow [these securities] to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit." - Michael Lewis, former Wall Street bond salesman

Which Firm(s) Should You Invest In?

Investment decisions are relatively complicated, but can be made more intelligently with information from a firm's financial statements. In the U.S., publicly owned firms are required to release regular financial statements prepared using standard accounting methods known as generally accepted accounting principles. Ideally, such statements would present information in an unbiased manner, reducing information costs for investors. Firms specializing in information sell their services in verifying and investigating these reports.

The Beauty of the Market Mechanism

It is not immediately obvious that markets will do better than centrally- planned systems for satisfying human desires. After all, individuals are acting only in their own rational self-interest. But markets with flexible prices allow the collective actions of households and firms to signal the relative worth of goods and services. In this way, the "invisible hand" allows individual responses to collectively end up satisfying the wants of consumers.

Job creation and destruction

Jobs are continually being created and destroyed in the U.S. economy. In 2012, about 27.8 million jobs were created, while about 25.5 million jobs were destroyed. This is a natural and normal process for the economy. The table shows jobs created and destroyed over a three-month period from September to December 2012.

Labor unions

Labor unions are organizations of workers that bargain with employers for higher wages and better working conditions. Unions are probably not a significant cause of unemployment in the United States. While they raise the wage, only about 9% of private- sector workers are unionized, limiting the effect that unions have on the wider economy.

Measuring unemployment and inflation

Last chapter, we learned about how to measure total output—a critical first step in understanding the economy. In this chapter, we continue along these lines, learning about how to measure unemployment and inflation. These are very important and commonly-used macroeconomic concepts; we want to solidify what they mean, so that we can talk intelligently about them.

Adding government to the circular flow

Let's add in some more layers. We'll start with government. How does the government affect economic activity? • It takes in taxes from households and firms. • It uses those taxes to buy goods and services, and to make transfer payments—payments to households for which the government does not receive a good or service in return.

How long are people typically unemployed?

Long periods of unemployment are bad for workers, as their skills decay and they risk becoming discouraged and depressed. • During the Great Depression of the 1930s, some people were unemployed for years at a time. Since World War II, average lengths of unemployment have been relatively low; but that changed dramatically with the 2007-2009 recession.

Common misconceptions to avoid

Many economic indicators like the unemployment rate are only created from sample data, so they are not exact measures of economic well-being. The BLS does not estimate separately the causes of unemployment; but these are still useful to understand. The price level compares prices in a given year to those in a base year; inflation represents changes in price levels. Do not confuse the two.

Efficiency of Economies

Market economies tend to be more efficient than centrally-planned economies.

Minimum wage laws

Minimum wage laws are designed to help low-income workers; but raising the wage that firms have to pay will likely result in them hiring fewer workers. Relatively few full-time adults earn minimum wage. The group most likely to receive minimum wage is teenagers. How much unemployment does the minimum wage really cause? Economists are uncertain, but believe it to be relatively small. • Studies suggest a 10% increase in the minimum wage would reduce teenage employment by about 2%.

Common Misconceptions to Avoid

Mixing up terminology: movement along the curve (caused by price change) vs. shifting the curve (caused by other changes). Not moving curves far enough to be able to illustrate a change. Exaggerating curve shifts is okay. Incompletely labeling diagrams. Use your arrows! Being certain of both price and quantity changes when both demand and supply curves move. Only one of these effects will be certain.

The Importance of Small Business

Most economists argue that small firms are vital to the health • In a typical year, new small firms create 3.3 million jobs—40% of all new jobs created. Similarly, while large firms may be good at improving existing products, small firms are often better at creating new and innovative products and services. Also, small firms are less likely to lay off workers during a recession (red bars on the graph).

Proportions of Business Organizations

Nearly 3⁄4 of firms are sole proprietorships, and just one in six is a corporation. But since larger firms tend to be corporations, most economic activity takes place through them.

Health Insurance and Obesity

Obesity is rising in America, for various reasons. Is one of those reasons health insurance? People with health insurance have less incentive to stay healthy than people without health insurance. Holding constant other factors like age, gender, and income, research shows people with health insurance are more likely to be obese. They are responding to economic incentives.

Increasing Marginal Opportunity Costs

On the previous slide, opportunity costs were constant. But opportunity costs are often increasing. Why? Some resources are better suited to one task than another. The first resources to "switch" are the one best suited to switching. The more resources already devoted to an activity, the smaller the payoff to devoting additional resources to that activity.

Formula for a Percentage Change

One important formula is the percentage change, which is the change in some economic variable, usually from one period to the next, expressed as a percentage. Percentage change = Value in the second period − Value in the first period/Value in the first period ×100

Shifts in Demand and Supply over Time

Over time, it is likely that both demand and supply will change. For example, as new firms enter the market for smartphones and incomes increase, we expect • The supply of smartphones will shift to the right, and • The demand for smartphones will shift to the right.

Revisions to employment numbers

Over time, the BLS adjusts its estimates of employment and unemployment for previous months. Revisions sometimes take place years later. The large negative revisions were because the BLS underestimated the severity of the 2007-2009 recession.

Graphs of One Variable

Panel (a) shows a bar graph of market share data for the U.S. automobile industry; market share is represented by the height of the bar. Panel (b) shows a pie chart of the same data; market share is represented by the size of the "slice of the pie".

choices

People make choices as they try to attain their goals. Choices are necessary because we live in a world of scarcity.

Discouraged workers:

People who are available for work, but have not looked for a job during the previous four weeks because they believe no jobs are available for them

Disposable Personal Income

Personal income minus personal tax payments; this measures the amount that households are able to spend or save

Is falling labor force participation bad?

Politicians often like to point to a "falling labor-force participation rate" as a strongly negative sign for the economy. • Is this necessarily true? The two major reasons why the LFPR for men has fallen over the last several decades are: • Men have been going to school for longer and retiring earlier than before (why?) • Increases in Social Security Disability Insurance availability have allowed people with disabilities to stop work Whether these are good or bad is a value judgment.

The Usefulness of the Demand and Supply Model

Predictions about price and quantity in our model require us to know supply and demand curves. Typically, we know price and quantity, but do not know the curves that generate them. The power of the demand and supply model is in its ability to predict directional changes in price and quantity traded.

Demand and Supply Both Count

Price is determined by the interaction of buyers and sellers. Neither group can dictate price in a competitive market (i.e. one with many buyers and sellers). However changes in supply and/or demand will affect the price and quantity traded.

Prices of Substitutes, and Number of Firms

Prices of Substitutes, and Number of Firms Many firms can produce and sell more than one product. Example: An Illinois farmer can plant corn or soybeans. If the price of soybeans rises, he will plant (supply) less corn. More firms in the market will result in more product available at a given price (greater supply). Fewer firms → supply decreases.

Variables that Shift Market Supply

Prices of inputs Technological change Prices of substitutes in production Number of firms in the market Expected future prices

Producer surplus

Producer surplus can be thought of in much the same way as consumer surplus. It is the difference between the lowest price a firm would accept for a good or service and the price it actually receives.

Gross National Product (GNP)

Production performed by citizens of a nation, including overseas production (as opposed to GDP, which is performed within national borders)

Market economies promote:

Productive efficiency Allocative efficiency These efficiencies come about because all transactions result from voluntary exchange: transactions that make both the buyer and seller better off.

Increase in quality bias:

Products like cars and computers have become more durable and better quality over time. It is hard to isolate the pure-inflation part of price increases.

Common Misconceptions to Avoid

Profit in economics tends to refer to economic profit, which takes into account all opportunity costs. This can be substantially different from accounting profit, which only considers explicit costs. When a firm makes shares available, it receives the money from the sale. Subsequent trades of those shares do not result in any profit or loss for the firm, however. The principal-agent problem can occur on various levels: between a firm's owners and managers, and between managers and workers.

Supply Curve Unchanged Demand Curve Shifts to the Left

Q decreases P decreases

Supply Curve Shifts to the Left Demand Curve Unchanged

Q decreases P increases

Supply Curve Shifts to the Left Demand Curve Shifts to the Left

Q decreases P increases or decreases

Supply Curve Shifts to the Right Demand Curve Unchanged

Q increases P decreases

Supply Curve Unchanged Demand Curve Shifts to the Right

Q increases P increases

Supply Curve Shifts to the Right Demand Curve Shifts to the Right

Q increases P increases or decreases

Supply Curve Shifts to the Right Demand Curve Shifts to the Left

Q increases or decreases P decreases

Supply Curve Shifts to the Left Demand Curve Shifts to the Right

Q increases or decreases P increases

Should the government control apartment rents?

Rent control puts a legal limit on the rent that landlords can charge for an apartment. Since rent-controlled rents are usually far below market rents, it seems clear that this doesn't make landlords better off. Does it make tenants better off? Would you prefer to look for an apartment in a city with or without rent control?

Small business owners have three principal methods of raising funds:

Retained earnings • Profits reinvested in the firm, instead of paid to firm owners. Recruit additional owners • Such an arrangement would increase the firm's financial capital. Borrow • From financial institutions, or from friends or family.

Common misconceptions to avoid

Scarcity and shortage both have technical meanings. There is no shortage of most scarce goods. Price ceilings are only effective if they are placed below the equilibrium price. Similarly, price floors are effective only when above the equilibrium price. When showing a tax, if sellers are legally obligated to pay the tax, move the supply curve up by the amount of the tax; if buyers are obligated to pay the tax, move the demand curve down by the amount of the tax. The legal obligation to pay a tax is not the same as the tax burden.

Frictional unemployment:

Short-term unemployment that arises from the process of matching workers with jobs. Frictional unemployment occurs mostly because of job search: entering or re-entering the labor force, or being between jobs. It also occurs because of seasonal unemployment: some jobs fluctuate in availability due to seasonal demand, like ski-instructor or farm-work. • To control for this, the BLS releases raw and seasonally-adjusted employment figures. Some frictional unemployment actually increases economic efficiency by allowing for better job matches.

Calculating real GDP

Since GDP is measured in "value" terms, we might have problems interpreting changes over time if prices change. Is an increase in GDP due to production increasing, or due to prices increasing?

why Do Stock Prices Fluctuate So Much?

Since a stock represents a claim to a share of future profits of a firm, changes in expectations about those profits get reflected in the stock's price. When the overall economy performs well, a "rising tide lifts all boats", and the price of a stock rises, reflecting investor confidence. The opposite happens in a recession, of course. The values shown are stock market index numbers, created as weighted averages of the underlying stock prices. By convention, the index is set to a value of 100 in some base year; but since the year and initial value are arbitrary, it is changes in the index number that are relevant for determining market performance.

Adding the rest of the world to the circular flow

Some economic activity takes place between households, firms, and the rest of the world. • Households buy goods and services from firms in other countries; these are known as imports. • Firms sell goods and services to households in other countries; these are known as exports.

Alternative measures of unemployment: U-6

Some people suggest that we should include discouraged workers and underemployed workers in the unemployment statistics, to create a broader measure of unemployment. • The BLS measures this, calling it BLS series U-6.

• Unemployed:

Someone who is not currently at work but who is available for work and who has actively looked for work during the previous month

Surplus (noun):

Something that remains above what is used or needed Economists use the idea of "surplus" to refer to the benefit that people derive from engaging in market transactions.

Is inflation a problem?

Sometimes inflation seems unimportant. After all, if all prices doubled overnight, it seems like nothing much would change: the prices of goods and services would have doubled, but so would your wage; so you could afford exactly as much as before. But there are some less obvious problems with inflation. For example, inflation affects the distribution of income and wealth • It is unlikely that everyone's wages would increase at the same rate. Many people have long-term contracts specifying their wage in nominal terms, for example. • Also, nominal assets like cash decrease in value when there is significant inflation. If you hold much of your wealth in cash, then inflation causes a significant decrease in real wealth for you.

Some potential problems with the CPI include:

Substitution bias Increase in quality bias New product bias Outlet bias For these reasons, economists believe the CPI overstates true inflation by 0.5 to 1 percentage point.

Unemployment insurance

Suppose you have just lost your job. You want to find another, and have two main options: • Take a new low-paying job immediately, or • Search for a better job If unemployment insurance payments are available to you, you will probably be more likely to choose the second option. In the U.S., unemployment insurance payments are typically not very generous, compared with other high-income countries; and there are relatively short time-limits. • Many economists believe that the more generous unemployment insurance benefits available in other high-income countries like Germany and France have contributed to higher unemployment rates in those countries.

Taxes

Taxes are the most important method by which governments fund their activities. We will concentrate on per-unit taxes: taxes assessed as a particular dollar amount on the sale of a good or service, as opposed to a percentage tax. Example: The US Federal government imposes a 18.4 cents per gallon tax on gasoline sales, as of 2013.

How much benefit do the potential tea consumers derive from this market?

That depends on the price and their marginal benefit, the additional benefit to a consumer from consuming one more unit of a good or service. If the price is low, many of the consumers benefit. If the price is high, few (if any) of the consumers benefit.

Adding more of Lady Gaga to GDP

The BEA continually studies ways to improve its measurement of GDP. In 2013, the BEA started counting R&D as investment, rather than an intermediate good, so as to emphasize the importance of intellectual property. • A consequence is that money spent on development of, say, entertainment products, now gets counted as investment. • So the money spent by Lady Gaga and her record company of writing and recording her songs is now included in the investment component of GDP.

Economic growth:

The ability of an economy to produce increasing quantities of goods and services

Comparative advantage:

The ability of an individual, a firm, or a country to produce a good or service at a lower opportunity cost than competitors. Individuals, firms, and countries are better off if they specialize in producing goods and services for which they have a comparative advantage and obtain the other goods and services they need by trading.

Absolute advantage:

The ability of an individual, a firm, or a country to produce more of a good or service than competitors, using the same amount of resources.

Trade:

The act of buying and selling. Could your neighbor benefit from trade? She is better at picking both apples and cherries... Both of you can benefit from trade, by specializing in what you are relatively good at.

Quantity demanded:

The amount of a good or service that a consumer is willing and able to purchase at a given price.

Quantity supplied:

The amount of a good or service that a firm is willing and able to supply at a given price.

The Area of a Rectangle

The area of a rectangle is equal to its base multiplied by its height; total revenue is equal to quantity multiplied by price. Area of a rectangle = Base × Height Here, total revenue is equal to the quantity of 125,000 bottles times the price of $2.00 per bottle, or $250,000. The area of the green- shaded rectangle shows the firm's total revenue

The Area of a Triangle

The area of a triangle is equal to 1⁄2 multiplied by its base multiplied by its height. Area of a triangle = 1 × Base × Height 2 The area of the blue-shaded triangle has a base equal to 150,000 - 125,000, or 25,000, and a height equal to $2.00 - $1.50, or $0.50. Therefore, its area equals 1⁄2 × 25,000 × $0.50, or $6,250.

New product bias:

The basket of goods changes only every 10 years. There is a delay to including new goods like cell phones.

Substitution effect:

The change in the quantity demanded of a good that results from a change in price making the good more or less expensive relative to other goods that are substitutes.

Income effect:

The change in the quantity demanded of a good that results from the effect of a change in the good's price on consumers' purchasing power.

U.S. nominal and real interest rates

The chart shows the interest rate on three-month treasury-bills, a good measure of the nominal interest rate. The real interest rate adjusts them for changes in the CPI. Notice that in 2009, the real interest rate was above the nominal interest rate. This was because the change in the CPI was negative then, indicating a rare deflation, or decrease in the price level.

Consumer price index

The consumer price index is a measure of the average change over time in the prices a typical urban family of four pays for the goods and services they purchase. The chart shows the composition of the basket of goods used to create the CPI. This basket of goods derives from a survey of 14,000 households by the BLS.

Nominal and real values

The current standard base "year" for the CPI is an average of 1982- 1984 prices. Values like wages in current-year dollars are called nominal variables. When we adjust them for inflation, by dividing by the current year's price index and multiplying by 100, we convert them to real variables.

Analyzing Income Statements

The difference between revenue ($5,089 million) and operating expenses ($4,551 million) is operating income ($538 million). Most corporations also have investments, such as government or corporate bonds, that generate some income for them. • The sum of these incomes is the firm's (before-tax) accounting profit.

The employment situation following the 2007-2009 recession

The fall of the employment-population ratio may give an even better indication of how weak the U.S. labor market was during and after the 2007-2009 recession. • Explaining these changes is a top priority for labor economists.

Graphs of Two Variables

The figure shows a two- dimensional grid on which we measure the price of pizza along the vertical axis (or y- axis) and the quantity of pizza sold per week along the horizontal axis (or x-axis). Each point on the grid represents one of the price and quantity combinations listed in the table. By connecting the points with a line, we can better illustrate the relationship between the two variables.

opportunity cost

The highest-valued alternative given up in order to engage in some activity Example: the opportunity cost of increased funding for space exploration might be giving up the opportunity to fund cancer research.

What does determine the tax incidence?

The incidence of the tax is determined by the relative slopes of the demand and supply curves. A steep demand curve means that buyers do not change how much they buy when the price changes; this results in them taking on much of the burden of the tax. If the demand curve were shallower, buyers would change how much they bought a lot in response to a price change. Then they could not be forced to accept as much of the burden of the tax. • Similar analysis applies for sellers.

Trends in labor force participation

The labor force participation rate of adult men has declined gradually since 1948... ... but it has increased significantly for adult women, making the overall rate higher today than it was then

What is the lowest price a firm would accept for a good or service?

The marginal cost of producing that good or service.

natural rate of unemployment:

The normal rate of unemployment, consisting of frictional unemployment and structural unemployment. When all unemployment is due to frictional and structural factors, we say that the economy is at full employment. This means there will always be some unemployment in the economy. • The general consensus of economists is that the U.S. natural rate of unemployment is somewhere between 5 and 6 percent.

Inflation rate:

The percentage increase in the price level from one year to the next

Expansion:

The period of a business cycle during which the total production and total employment are increasing

Recession:

The period of a business cycle during which total production and total employment are decreasing

Can the Principal-Agent Problem Be Resolved?

The principal-agent problem derives from economic incentives being improperly aligned. A remedy for the problem must be based on aligning the interests. This is why many top managers are paid a large part of the salary in stock or stock options: their salary becomes tied to the performance of the firm. However since the CEO owns only a fraction of the firm, incentives can never be 100% aligned.

Producer price index (PPI)

The producer price index is an average of the prices received by producers of goods and services at all stages of the production process. It is conceptually similar to the CPI, in that it uses a basket of goods, but the goods are those used by producers. The PPI can give early warning of future movements in consumer prices.

Common Misconceptions to Avoid

The production possibilities frontier should never bow inward (why?). The PPF tells us what can be produced, not what should be produced. Just because someone is better or worse at everything, doesn't mean trade with them cannot be beneficial. • The basis for trade is comparative advantage, not absolute advantage! Free markets raise the standard of living; but that doesn't mean there is no role for governments. • Governments must provide a sound legal environment to allow the market system to succeed

Deadweight loss

The reduction in economic surplus resulting from a market not being in competitive equilibrium is known as deadweight loss. Deadweight loss can be thought of as the amount of inefficiency in a market. In competitive equilibrium, deadweight loss is zero.

Are Graphs of Economic Relationships Always Straight Lines?

The relationship between two variables is linear when it can be represented by a straight line. Few economic relationships are actually linear. However linear approximations are simpler to use, and are often "good enough" in modeling.

The law of supply:

The rule that, holding everything else constant, increases in price cause increases in the quantity supplied, and decreases in price cause decreases in the quantity supplied.

Law of demand:

The rule that, holding everything else constant, when the price of a product falls, the quantity demanded of the product will increase, and when the price of a product rises, the quantity demanded of the product will decrease. Implication: Demand curve slopes downward

Labor force:

The sum of employed and unemployed workers in the economy.

NIPA measurements

The table and graph show the various measures of the national income accounts for the United States in 2012. • National income must be smaller than GDP, since it is just GDP minus depreciation. Similarly, disposable personal income must be less than personal income, since it is just personal income minus taxes. • Each measure is useful in different contexts.

Comparing the household and establishment surveys

The table below gives the data from the July and August 2013 household and establishment surveys: Even if all surveys are truthfully and accurately answered, we do not expect the numbers to be identical between the two surveys: • Different groups are measured • All surveys have measurement errors But we get a more complete picture by considering both surveys.

Conflicts of Interest in Credit-Rating Agencies

The three main credit-rating agencies (Moody's, Standard and Poor's, and Fitch) assign ratings to bonds. This service helps investors to determine which bonds are safe and which at risk of default (non-payment). However, payment for the ratings comes from the firms and governments issuing the bonds, creating the potential for a conflict of interest. Such a conflict of interest may explain why the mortgage-backed bonds issued in the mid-2000s continued to score the highest ratings, even as housing prices began to decline, raising the risk of mortgage default.

Problems with measuring the unemployment rate

The unemployment rate measured by the BLS is not a perfect measure of joblessness. Why? It may understate unemployment: • Distinguishing between people who are unemployed and not in the labor force requires judgment (should we exclude "discouraged workers"?) • Only measures employment, not intensity of employment (full-time vs. part-time; some people are underemployed) It may overstate unemployment: • People might claim falsely to be actively looking for work • May claim not to be working to evade taxes or keep criminal activity unnoticed

corporate governance.

The way in which a corporation is structured and the effect that structure has on the corporation's behavior While the board of directors and top management are, in theory, representing the interests of the firm owners, they may sometimes pursue their own agendas. • Example: Managers may procure for themselves very high salaries, or perks such as corporate private jets.

Who Will Receive the Goods and Services?

The way we are most familiar with in the United States is that people with higher incomes obtain more goods and services. Changes in tax and welfare policies change the distribution of income; though people often disagree about the extent to which this "redistribution" is desirable.

Measuring unemployment

There are more than 300 million people in the United States, and monitoring and reporting on their activities regularly would be very difficult and costly. Instead, the U.S. Department of Labor reports estimates of employment, unemployment, and other statistics related to the labor force each month.

Production and income

There are two main conceptual ways to measure the total economic activity in an economy: total production or total income. When we measure one, we are also measuring the other. • Why? Everything that is produced and sold constitutes income for someone; so we have the choice of measuring the value of products produced and sold, or the value of incomes, and each is a valid way of measuring economic activity.

Technological Change in One Industry

This panel shows technological improvement in the automobile industry. The quantity of tanks that can be produced remains unchanged. As in the previous slide, many previously unattainable combinations are now attainable.

Calculating the CPI

To calculate the CPI in a given year, we need: • A basket of goods • The cost to purchase the basket of goods in a base year • The prices in the current year The CPI in the current year is the cost to purchase the basket of goods this year, divided by the cost in the base year. By convention, we multiply this by 100, so that the CPI in the base year is 100. CPI= Expenditures in the current year/Expenditures in the base year ×100 Since the CPI measures consumer prices, it is often referred to as the cost of living index. CPI-inflation is sometimes used to generate "fair" increases in wages for workers, and government benefits.

Follow the spending to measure GDP

To measure GDP, the Bureau of Economic Analysis (BEA) in the Department of Commerce measures four major categories of expenditures: • Personal Consumption Expenditures, or Consumption (C) • Gross Private Domestic Investment, or Investment (I) • Government Consumption and Gross Investment, or Government Purchases (G) • Net Exports of Goods and Services, or Net Exports (NX) GDP can be expressed as the sum of these: Y=C+I+G+NX

During a period of time

To measure total output in a given year, we measure the goods and services produced only in that given year. • Again, this avoids double-counting: if you buy a DVD in 2011, that DVD counts in 2011's GDP. If you resell it in 2012, it will not count again in 2012. • So GDP counts only new goods and services. Used items were previously produced and counted, so don't need to be counted again.

Measuring producer surplus (entire market)

Total producer surplus is equal to the area above the supply curve and below the market price

Cyclical unemployment:

Unemployment causes by a business cycle recession. In normal recoveries after a recession, unemployment due to cyclical factors will fall.

U.S. annual unemployment rate over time

Unemployment rates rise when the economy is faltering, and fall when the economy is doing well. But they never fall to zero. • To understand why, we will examine the types of unemployment.

Unemployment rates for different groups

Unemployment rates vary by ethnic group... ... and by education level. Unemployment rates in the United States, August 2013 • These two observations are statistically related.

Structural unemployment:

Unemployment that arises from a persistent mismatch between the skills and attributes of workers and the requirements of jobs. Structural unemployment is associated with longer unemployment spells. Workers who are structurally unemployed may require retraining in order to obtain "modern" jobs.

Stocks

Unlike bonds, stocks are financial securities that represent partial ownership of the firm. A corporation that sells a stock acts similarly to a partnership taking on a new partner; though the new shareholder typically owns a tiny fraction of the firm. When the corporation makes profits, these are either reinvested in the firm—causing a capital gain, or increase in value of the stock—or paid out to the firm's shareholders as dividends. By law, corporations must repay bondholders before shareholders. This helps to ensure that bonds are substantially less risky financial securities to hold than stocks.

Going Deeper into Financial Statements

Using the income statements and balance sheets of a firm, we can learn a lot about the firm's profitability and financial positions. Recall that an income statement gives a record of the firm's revenues and costs over a period of time, while a balance sheet gives a "snapshot" of the firm's financial position at a particular point in time. On the next slides, we will see Facebook's income statement from 2012, and its balance sheet as of December 31, 2012.

Using Present Value to Calculate Stock Prices

Valuing a stock is a little trickier, since there is no end-date on a stock—you own a share of the firm forever. The value of a stock derives from the expected dividend payments of the stock. Stockprice=Dividend1/(1+i) +Dividend2/(1+i)2 +...

Calculating the Slope of a Line

We can calculate the slope of a line as the change in the value of the variable on the y- axis divided by the change in the value of the variable on the x- axis. Because the slope of a straight line is constant, we can use any two points in the figure to calculate the slope of the line. Slope = Change in value on the vertical axis/ Change in value on the horizontal axis = ∆y/∆x = Rise/Run

Having access to a broadband internet connection is beneficial for consumers.

We can measure just how beneficial it is by estimating the consumer surplus derived in the market. What would we need to know in order to do this? • The demand curve for broadband internet service • The price of broadband internet service

Market values

We cannot add together the number of cars, melons, haircuts, and all other goods and services without agreeing on a common way to measure them. The best practical way is to value each good and service in monetary terms; and the best measure of this that we have is the price that each good or service is sold for.

Present Value of a Series of Payments

When calculating the present value of a series of payments, we add the present values of each individual payment.

Problems with unanticipated inflation

When people cannot predict the rate of inflation, they find it hard to make good borrowing and lending decisions. • For example, in 1980 banks were charging 18% or more on home loans because the rate of inflation was very high. People who bought homes were locked into high rates even when inflation subsided. On the other hand, if banks lend money at a low rate and then high inflation takes place, the real interest rate they receive may be zero or negative; thus the risk of inflation makes banks wary of lending. Unpredictable inflation makes borrowing and lending risky.

Present Value

When people lend money, they expect to receive back more than they lend. $1000 today is worth more than $1000 a year from now; and that in turn is worth less than $1000 two years from now. How much are funds in the future worth to you? Economists refer to this amount as the present value of those funds: the value in today's dollars of funds to be paid or received in the future. The general formula is: Present value = Future valuen/ (1+i)^n where Future valuen represents funds that will be received in n years, and i is the rate of interest.

What Explains the Law of Demand?

When the price of a product falls, two effects cause consumers to purchase more of it: • The product has become cheaper relative to other goods, so consumers substitute toward it. This is the substitution effect. • The consumer now has greater purchasing power, and elects to purchase more goods overall. This is income effect.

Inflation and interest rates

When you lend money to someone, they typically agree to pay you back with interest. If the interest rate is 6%, for example, then a $1,000 loan paid back in a year will be paid back with $1,060.

Optimal Decisions Are Made at the Margin

While some decisions are all-or-nothing, most decisions involve doing a little more or a little less of something. Example: Should you watch an extra hour of TV, or study instead?

Employed:

Worked 1+ hours in reference week (or were temporarily away from their jobs).

Did World War II bring prosperity?

World War II was a period of extraordinary sacrifice and achievement by the "greatest generation." But statistics on GDP may give a misleading indication of whether it was also a period of prosperity: • Production was very high, but much of the production was on military goods—so people weren't becoming more well-off. • After the war, GDP fell; but the production of consumption goods rose rapidly.

Consumption

Y = C + I + G + NX Consumption is spending by households in goods and services, not including spending on new houses (which are counted instead in investment). In BEA statistics, consumption is further divided into expenditure on services, durable goods, and nondurable goods.

Investment

Y = C + I + G + NX Investment is spending by firms on new factories, office buildings, and additions to inventories, plus spending by households and firms on new houses. The BEA measures the following categories of investment: business fixed investment, residential investment, and changes in business inventories. • This last category includes goods that have been produced but not yet sold.

Net exports

Y = C + I + G + NX Net exports are defined as the value of exports minus the value of imports. This difference might be positive or negative; in recent years, this has been negative in the United States. Since we want to count domestic production (production in the United States), we add up the value of the goods and services sold to foreigners, and subtract off the value of the goods and services sold to Americans by foreigners.

Government purchases

Y = C + I + G + NX These are spending by federal, state, and local governments on goods and services, such as teachers' salaries, highways, and aircraft carriers. This does not include transfer payments, since those do not result in immediate production of new goods and services.

limited liability

a legal provision shielding owners of the corporation from losing more than they have invested in the firm. The owners of corporations have limited liability, Limited liability makes raising funds easier for a firm; it also makes investing in firms easier for individuals.

black market -

a market in which buying and selling take place at prices that violate government price regulations.

perfectly competitive market:

a market with (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market.

price level:

a measure of the average prices of goods and services in the economy.

Separation of ownership from control:

a situation in a corporation in which the top management, rather than the shareholders, controls day-to-day operations. Owners designate a board of directors, who appoint a chief executive officer (CEO) to oversee day-to-day operations, perhaps along with other members of top management.

Inputs

are things used in the production of a good or service. Examples of inputs for smartphones: Computer processor Plastic housing Labor

In a negative relationship,

as one variable increases, the other decreases.

positive relationship between two variables

as one variable increases, the other variable also increases.

Households

consist of individuals who provide the factors of production: labor, capital, natural resources, and entrepreneurial ability. Households receive payments for these factors by selling them to firms in factor markets.

An increase in the price of an input

decreases the profitability of selling the good, causing a decrease in supply.

Real interest rate,

equal to the nominal interest rate minus the inflation rate. (Note: this is an approximation, but it is quite accurate for low interest and inflation rates.) If prices rise by 2% from this year to next, then your real interest rate on the loan is only 4%. This more accurately reflects the cost of borrowing and lending money.

Important Features of Economic Models Assumptions and simplifications:

every model needs them in order to be useful.

equity,

fairer distribution of economic benefits. Economically efficient outcomes may not be the most desirable. Markets result in high inequality; some people prefer more equity

Testability:

good models generate testable predictions, which can be verified or disproven using data.

Mixed economies

have features of both of the above. Most economic decisions result from the interaction of buyers and sellers, but governments play a significant role in the allocation of resources.

• Not in the labor force,

if neither of the above apply

A decrease in the price of an input

increases the profitability of selling the good, causing an increase in supply.

coupon payments,

intermediate payments that will be made to the bond-holder

A production possibilities frontier (PPF)

is a curve showing the maximum attainable combinations of two products that may be purchases with available resources and current technology. Question: Is the PPF a positive or normative tool? Answer: Positive; it shows "what is", not "what should be".

A shift to the left

is a decrease in demand.

• A shift to the left

is a decrease in supply.

A shift to the right

is an increase in demand.

• A shift to the right

is an increase in supply.

A free market

is one with few government restrictions on how a good or service can be produced or sold, or on how a factor of production can be employed. Countries that come closest to the free market benchmark have been more successful than those with centrally planned economies in providing their people with rising living standards. This concept is not new: Adam Smith argued for free markets in his 1776 treatise, An Inquiry into the Nature and Causes of the Wealth of Nations.

An entrepreneur

is someone who brings together the factors of production—land, labor, and capital—to produce goods and services. The best entrepreneurs create products that consumers never even knew they wanted. "If I had asked my customers what they wanted, they would have said a faster horse." - Henry Ford Entrepreneurs make a vital contribution to economic growth, often with considerable personal risk and sacrifice.

Consumer surplus

is the difference between the highest price a consumer is willing to pay for a good or service and the actual price the consumer receives. the area below the demand curve, above price.

Producer surplus

is the difference between the lowest price a firm would be willing to accept for a good or service and the price it actually receives.

Microeconomics

is the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices.

Macroeconomics

is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth.

macroeconomics

is the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth. • When we want to study the overall economy-level actions of people and governments, the models and tools of macroeconomics become very useful.

Economics

is the study of these choices.

Capital:

manufactured goods that are used to produce other goods and services

In sole proprietorships and partnerships,

no legal distinction is made between the assets of the firm and the assets of its owner(s).Limited liability makes raising funds easier for a firm; it also makes investing in firms easier for individuals.

interest rate,

or cost of borrowing, can be expressed as the ratio of the coupon payment to the principal

Centrally planned economies

result when governments decide what to produce, how to produce it, and who received the goods and services.

Market economies

result when the decisions of households and firms determine what is produced, how it is produced, and who receives the goods and services.

economic models

simplified versions of reality used to analyze real-world economic situations.

Economic variables:

something measurable that can have different values, such as the incomes of doctors.

Firms

supply goods and services to product markets; households buy these products from the firms.

Economic growth:

the ability of the economy to increase the production of goods and services.

tax incidence:

the actual division of the burden of a tax between buyers and sellers in a market.

Marginal cost:

the additional cost to a firm of producing one more unit of a good or service.

menu costs:

the cost to firms of changing prices.

direct finance:

the flow of funds from savers to firms through financial markets, such as the New York Stock Exchange. firms can appeal directly to potential investors for funds.

Gross Domestic Product:

the market value of all final goods and services produced in a country during a period of time, typically one year. The most common measure used by economists of overall economic activity in an economy

producer surplus measures

the net benefit received by producers from participating in a market.

Consumer surplus measures

the net benefit to consumers from participating in a market rather than the total benefit.

the inflation rate.

the percentage increase in the price level from one year to the next

unemployment rate:

the percentage of the labor force that is unemployed. Of these statistics, the most watched

Technology:

the processes a firm uses for turning inputs into outputs of goods and services

• Property rights—

the rights individuals or firms have to the exclusive use of their property, including the right to buy or sell it— are essential here.

nominal interest rate:

the stated interest rate on a loan. But in that year's time, prices will have risen; so the $1,060 next year is not worth the same as $1,060 this year.

• Positive analysis:

the study of "what is?"

• Normative analysis:

the study of "what ought to be?"

Producer surplus in a market is equal to

the total amount firms receive from consumers minus the cost of producing the good or service.

Consumer surplus in a market is equal to

the total benefit received by consumers minus the total amount they must pay to buy the good or service.

Real GDP—

the value of final goods and services evaluated at base-year prices. The choice of a base-year is arbitrary; we might use any year's prices to compare real GDP in each year. The current standard is 2009. • Unfortunately, the relative prices also change from year to year, distorting real GDP calculations. Since 1996, the BEA has overcome this problem by using chain-weighted prices, using previous-year prices to adjust current-year production measure.

Nominal GDP—

the value of final goods and services evaluated at current- year prices

Productive efficiency,

where goods or services are produced at the lowest possible cost; and

Allocative efficiency,

where production is consistent with consumer preferences: the marginal benefit of production is equal to its marginal cost

The crisis prompted the Wall Street Reform and Consumer Protection Act (2010), an act intended to reform financial regulation.

• Also known as the Dodd-Frank Act. • Created Consumer Financial Protection Bureau, intended to protect consumers in their borrowing and investing activities. • Established Financial Stability Oversight Council, intended to identify and act on risks in the financial system. • Overall effect on likelihood of future financial crises: unknown.

The Underground Economy

• Buying and selling of goods and services might be concealed from the government to avoid taxes or regulations, or because the goods and services are illegal. This constitutes the underground economy. • This may be 10% or more of the economy in America, and substantially more in low-income households.

Suppose an increase in supply occurs. We now know:

• Equilibrium quantity will increase, and • Equilibrium price will decrease

The three types of unemployment are:

• Frictional unemployment • Structural unemployment • Cyclical unemployment

Borrow

• From financial institutions, or from friends or family.

Household Production

• Household production such as childcare, cleaning, and cooking is not typically paid for with money. However such contributions are real—if they were performed by a non-household-member, they would be paid for and counted in GDP.

Supply of smartphones

• How many smart phones are producers willing to sell? • Affected by price of the smartphones • Affected by other factors, including prices of other goods

Demand for smartphones

• How many smart phones do consumers want to buy? • Affected by price of the smartphones • Affected by other factors, including prices of other goods

Enforcement of contracts and property rights

• Important for transactions across time to occur. • An independent court system is critical here.

Price ceilings and floors in the USA are uncommon, but include:

• Minimum wages • Rent controls • Agricultural price controls

Markets may not result in fully efficient outcomes. For example:

• People might not immediately do things in the most efficient way • Governments might interfere with market outcomes • Market outcomes might ignore the desires of people who are not involved in transactions - ex: pollution

When analyzing human behavior, we can perform:

• Positive analysis • Normative analysis Economists generally perform positive analysis.

Retained earnings

• Profits reinvested in the firm, instead of paid to firm owners.

It is clear that when a government imposes price controls,

• Some people are made better off, • Some people are made worse off, and • The economy generally suffers, as deadweight loss will generally occur.

Recruit additional owners

• Such an arrangement would increase the firm's financial capital.

It is tempting to believe the decrease in price will cause an increase in demand. But this is incorrect.

• The decrease in price will cause a movement along with demand curve, but not an increase in demand. • Why? The demand curve already describes how much of the good consumers want to buy, at any given price. • When the price change occurs, we just look at the demand curve to see what happens to how much consumers want to buy.

Protection of private property

• When criminals can take your wages or profits, households and firms have little incentive to work hard.

Microeconomics is the study of

• how households and firms make choices, • how they interact in markets, and • how the government attempts to influence their choices

Economists seldom recommend price controls, with the possible exception of minimum wage laws. Why minimum wage laws?

•Price controls might be justified if there are strong equity effects to override the efficiency loss. •The people benefitting from minimum wage laws are generally poor.