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MICROECONOMICS

Economics:
Thestudyofhowgroupsallocatescareresourcestosatisfyunlimitedwantsandneeds
OpportunityCost:
Thevalueofthenextbestalternativeforgone
FactorsofProduction:
Allinputsusedtoproducegoodsandservices
CCapital(equipment)
EEntrepreneurship(management)
LLand(naturalresources)
LLabor(workforce)
NormativeStatement:
Astatementthatisamatterofopinion
PositiveStatement:
Astatementthatcanbeprovenordisproven
PPF(ProductionPossibilitiesFrontier):
Representsallcombinationsofthemaximumamountsthattwogoodscanbeproducedinan
economywhenthereisafullemploymentofresourcesandefficiency.ThePPFmodel
demonstratesconceptssuchasscarcityandopportunitycost.
PointA=theeconomyisoperatinglessthanfull
efficiency
PointB=theeconomyisoperatingatfullefficiency
howevertheopportunitycosttoproducemoregunsisa
lotofbread
PointC=theeconomyisoperatingatfullefficiency
howevertheopportunitycosttoproductmorebreadisa
lotofguns
PointX=theeconomycannotoperateatthisefficiency
astheydonothavethefactorsofproductiontodoso
EconomicGrowth:
ThemeasureofachangeincountriesGDP,orrealnationalincomesuchthatanincreasein
nationalincomeisclassifiedaseconomicgrowth
EconomicDevelopment:

Themeasureofwelfareandwellbeing,insteadofbeingmeasuredinmonetaryindicators,itis
measuredintermsofindicatorssuchaseducation,healthandsocialindicators

Demand
DemandandtheLawofDemand
Demandisthequantityofagoodthatconsumersarewillingandabletopurchaseatagivenprice
inagiventimeperiod.
Thelawofdemandstatesthatasthepriceofaproductfalls,thequantitydemandedincreases.
Ceterisparibus.

Shifts in the Demand Curve


Income
NormalGoods:asaconsumersincomerises,thedemandfortheproductwillalsorise,shifting
thedemandcurvetotheright
InferiorGoods:asaconsumersincomerises,thedemandfortheproductwillfall,shiftingthe
demandcurvetotheleft
Substitutes
Ifproductsaresubstitutes,thenachangeinthepriceofoneoftheproductswillleadtoachange
inthedemandfortheotherproduct.Forexample,ifthereisafallinthepriceforGoodA
(movementalongthedemandcurve),thenthedemandforGoodBwilldecrease(demandshifts
left).
Complements
Ifproductsarecomplementstoeachother,thenachangeinthepriceofonegoodwillleadtoa
changeinthedemandfortheotherproduct.Forexample,ifthereisafallinthepriceforGoodA
(movementalongthedemandcurve),thenthedemandforGoodBwillincrease(demandshifts
right).

Calculating the Demand Curve (HL)


Qd=abP

A=wherethegraphmeetsthexaxisandwheredemandwouldbeifthepricewaszero.IfA
changes,therewillbeaparallelshiftinthedemandcurve.
B=setstheslopeforthedemandcurve(rise/run).IfBchanges,therewillbeachangeinthe
steepnessofthecurvethereforeachangeintheelasticity.

Supply
SupplyandtheLawofSupply
Supplyisthewillingnessandabilityofproductstoproduceaquantityofagoodorserveata
givenpriceinagiventimeperiod.
Thelawofsupplystatesthatasthepriceofaproductrises,thequantitysuppliedoftheproduct
willincrease.CeterisParibus.

Shifts in the Supply Curve


CostofFactorsofProduction
Ifthereisanincreaseinthecostsofthefactorsofproduction,suchasawageincrease,thswill
increasethefirmscostsmeaningthattheycansupplyless(shifttotheleft)
PriceofOtherProducts
Producersoftenhaveachoiceofwhattheywouldliketoproducesuchthatifthereisaraisein
thepriceofGoodA,theymayproducelessofGoodB(shifttotheleft)tomaximizerevenue
Technology
Improvesinthestateofteachnologyinafirmshouldleadtoanincreaseinsupplythusashiftof
thesupplycurvetotheright

Calculating the Supply Curve (HL)


Qs=c+ dP
C=thequanititythatwouldbesuppliedifthepricewaszero.IfCchanges,therewillbea
parallelshiftinthesupplycurve
D=setstheslopeofthecurve.IfDchanges,therewillbeachangeintheslopethereforethe
elasticity.

Market Equilibrium
Equilibrium
Thepointinwhichthedemandandsupplycurveintersectandtheeconomyisinastateofrest
suchthatthereisnooutsidedisturbance

ChangesinEquilibrium
Ifthereisachangeinoneofthedeterminantsofdemandorsupplytherewillbeashiftinoneof
thecurvesresultinginanewequilibrium.
SurplusesandShortages
Ifthepriceisraisedabovetheequilibrium,supplierswillhavemoreincentivetoproduce
howeverdemandwilldecreaseresultinginasurplus(excesssupply)
Ifthepriceislowered,demandwillincreasewhilesupplywilldecreaseresultinginashortage
(excessdemand)

ConsumerandProducerSurplus
Consumersurplus:thehighestpriceconsumersarewillingtopayminusthepricetheyactually
pay.Consumerswhoarewillingtopayforaproductatahigherprice,butonlyhavetopayat
equilibriumpriceareexperiencingagain.
Producersurplus:thepricereceivedbyfirmsforsellingtheirgoodsminusthelowestpricethey
arewillingtoaccept.Producerswhoarewillingtosupplyaproductatalowerprice,butinstead
cansupplyatequilibriumareexperiencingagain.

EconomicEfficiency
Whenallocativeandproductiveefficiencyareachievedandmarginalcost=marginalbenefit
(MC=MB)ineverymarket
AllocativeEfficiency
Whenaneconomyproducesthecombinationofgoodsmostdesiredbysocietywherethe
consumersurplusisequaltoproducersurplusthuscommunitysurplusisachievedandwhere
marginalcostisequaltomarginalbenefit

Calculating Market Equilibrium


1.SetQsandQdequaltooneanotherandsolveforPtogettheequilibriumprice
2.SubstitutePintoeitheroftheequationstogettheequilibriumquantity

Elasticitys
Elasticvs.Inelastic
Elastic:respondssubstantiallytoprice(e.g.luxuries,goodswithclosesubstitutes),suchthatif
thepricegoesdownthechangeinQd/Qsisgreater
Inelastic:doesnotrespondtoprice(e.g.necessities,addictiveness),suchthatifthepricegoes
downthechangeinQd/Qsissmaller

Price Elasticity of Demand (PED)


PriceElasticityofDemand
Themeasureofhowmuchthedemandforagoodchangeswhenthereisachangeinthepriceof
theproduct

PED=

change quanitity demanded


change price

*Percentagechangeiscalculatedbytaking(NewOld)/Old
ValuesofPED
PED<1inelastic
PED>1elastic
PED=1unitelastic
PED=0perfectlyinelastic
PED=Pperfectlyelastic
InelasticDemand
Ifaproducthasinelasticdemand,thenachangeinthepriceofaproductleadstoaproportionally
smallerchangeinthequantitydemandedofit.Thereforeraisingthepriceofaninelasticproduct
leadstoalargertotalrevenue.
P TR
P TR
ElasticDemand
Ifaproducthaselasticdemand,thenachangeinthepriceleadstoagreaterthanproportionate
changeinthequantitydemandedofit.
P TR
P TR

DeterminantsofPED
Thenumberofsubstitutes:Ifaproducthasmoresubstitutesthenlikelythedemandwillbeelastic
Thenecessityoftheproduct:Ifaproductisanecessity,thenlikelyitwillhaveinelasticdemand

Cross Elasticity of Demand (XED)


CrossElasticityofDemand
Themeasureofhowmuchthedemandforaproductchangeswhenthereisachangeintheprice
ofanotherproduct

XED=

changedemand of product X
change price of product Y

ValuesofXED
XED>0substitutes
XED<0complements
Largenumberclosesubstitutes/complements
Smallnumberremotesubstitutes/complements

Income Elasticity of Demand (YED)


IncomeElasticityofDemand
Themeasureofhowmuchthedemandforaproductchangeswhenthereisachangeinthe
consumersincome

YED=

changedemand for the product


changeincome

ValuesofYED
YED>0normalgood
YED<0inferiorgood
0<YED<1incomeinelastic(necessity)
YED>1incomeelastic(superiorgood)

Price Elasticity of Supply (PES)


PriceElasticityofSupply
Themeasureofhowmuchthesupplyofaproductchangeswhenthereisachangeintheprice

PES=

changesupply of product
change price of the product

ValuesofPES
PES=0perfectlyinelastic
PES=Pperfectlyelastic
0<PES<1inelasticsupply
PES>1elasticsupply
PES=1unitelasticsupply
DeterminantsofPES
Mobilityoffactorsofproduction:theabilityforthefactorsofproductiontobeswitched,ifitis
easilyswitchedthenPESiselasticbutiftheycannotbeeasilyswitchedthenPESisinelastic
TimePeriod:thetimeinwhichelapsesforsupplierstochangetheirsupply,intheshortrunPES
isinelasticwhileinthelongrunPESiselastic
SpareCapacityAvailable:thehigherthesparecapacitythemoreelasticPESis

Taxation
IndirectTax
Ataximposeduponexpenditure.Itisplaceduponthesellingpriceofaproductsoitraisesthe
firmscostsandshiftsthesupplycurvefortheproductverticallyupwardsbytheamountofthe
tax.

SpecificTax
Thisisafixedamountoftaxthatisimposeduponaproductlike$1,thusshiftingthesupply
curveverticallyupwardsbytheamountofthetax.
AdValoremTax
Thisisapercentagetaxonthesellingpricesothesupplycurvewillshiftsuchthatasprices
increase,thetaxcurvewillbecomeincreasinglylarger.

EffectofTaxation

RevenueBeforeTax:
Qx$5.00
RevenueAfterTax:
Q1x$4.50
GovernmentRevenue:
Consumerburden+producerburden
DeadweightLoss:
Thetriangleformedbythelossin
producerandconsumersurplus

IncidenceofTaxation
Referstothegroupthatsharesthegreatestburdenofthetax,sincetheelasticgroupismore
affectedbythetax,themoreinelasticpartyhasthegreatestburden
Whenthegovernmenttaxesaninelasticproduct,theygeneratelargerevenuewhereaswhenthey
taxelasticproducts,theygeneratemuchsmallerrevenue

Subsidization
Subsidies
Anamountofmoneypaidbythegovernmenttoafirmperunitofoutputthusshiftingthesupply
curveverticallydownwards.Thegovernmentmaydothisfortworeasons:
1. Thelowerthepriceofessentialgoodstoconsumers
2. Toguaranteethesupplyofproductsthatthegovernmentthinksarenecessaryforthe
economy
EffectofaSubsidy

Consumers:
Pdecreases(P1)
Quantityincreases(Q1)
Producers:
Priceincreases(P0)
Quantityincreases(Q1)
TRincreases
TaxPayers:
Paymoretaxestocoversubsidies

Price Control and Government Intervention


PriceControls
Pricecontrolsareimposedwhenpolicymakersbelievethemarketpriceisunfairtoeither
producersorconsumers
PriceCeiling
Apriceceilingisthelegalmaximumatwhichagoodcanbesold.Ifitisabovetheequilibrium,it
isnotbindingbecausetheequilibriumcanbeobtained.Howeverifitisbelowtheequilibrium,
thenitisbindingbecausetheequilibriumcannotbeobtained

Consequencesofapriceceiling
1.Smallerquantitysuppliesandsold
2.Qualitydecreases
3.Failuretomeetallocativeefficiency(shortage)

PriceFloor
Apriceflooristhelegalminimumatwhichagoodcanbesold.Ifitisbelowtheequilibriumisit
notbindingbecauseequilibriumcanbereachedhoweverifisitaboveequilibrium,thenitis
bindingbecauseequilibriumcannotbeobtained.
Consequencesofapricefloor
1.Failuretoreachallocativeefficiency(surplus)
2.Smallerquantitydemandedandpurchased
3.Illegalsalesbelowthepricefloor

Market Failure
MarketFailure
Asituationinwhichthefreemarketleadstoamisallocationofsocietiesresourcesleadingto
eitheranoverproductionorunderproductionofagood

Private(MPC)vs.Social(MSC)Cost
PrivateCost:internalmonetarycostssuchaswages,rawmaterialsandheating/lighting
SocialCost:realcosttosocietysuchthatitreflectstheprivatecostsplusthenegativeexternality
Private(MPB)vs.Social(MSB)Benefit
PrivateBenefit:themonetaryvalueofthebenefitsuchassalesrevenue
SocialBenefit:thebenefittosocietysuchthatisreflectstheprivatebenefitplusthepositive
externality
PositiveExternality
Abenefitnotreflectedinthefreemarketpricethatthegeneratoroftheexternalityimposes
benefitsonotherswhoarenotresponsibleforinitiatingit.
PositiveExternalityofConsumption
Occurswhenmarginalsocialbenefitexceedsmarginalprivatebenefitinrelationtomarginal
socialcost.

PositiveExternalityofProduction
Occurswhenmarginalprivatecostisgreaterthanmarginalsocialcostinrelationtomarginal
socialbenefit.ThereispotentialwelfaregainbecausequantitycouldbeincreasedtoQs.

NegativeExternality
Acostnotreflectedinthefreemarketpricesuchthatthegeneratoroftheexternalityimposesthe
costnotthosewhoarenotresponsibleforit.
NegativeExternalityofProduction
Occurswhenmarginalsocialcostislargerthanmarginalprivatecostinrelationtomarginal
privatebenefit.Thereiswelfarelossbecausethereisanoverproduction.

NegativeExternalityofConsumption
Occurswhenmarginalprivatebenefitislargerthanmarginalsocialbenefitinrelationtomarginal
socialcost.

Meritvs.DemeritGoods
MeritGoods:goodsthataredeemedsociallydesirablebutarelikelytobeunderproducedand
underconsumed(e.g.education,healthcareandpublicparks).Meritgoodsareoftenassociated
withpositiveexternalities.
DemeritGoods:goodsthataredeemedsociallyundesirableandarelikelytobeoverproduced
andoverconsumers(e.g.alcohol,cigarettesandillegaldrugs).Demeritgoodsareoften
associatedwithnegativeexternalities.
RemediesforExternalities

Taxation:thegovernmentcouldtaxanegativeexternalityofproduction,whichwouldresultin
MPCshiftingupwardstowardsMSC.Iftheytaxanegativeexternalityofconsumption,theMSC
willshiftupwardsthereforedecreasingquantitybecauseofanincreaseinprice.
CapandTrade:thegovernmentcouldissuetradableemissionpermitstogivefirmsthelicenseto
createpollutionuptoasetlevel,thiswouldsolvenegativeexternalitiesofproduction.
Subsidization:thegovernmentcouldsubsidizefirmswhogeneratepositiveexternalities,which
woulddecreasethemarginalsocialcostcurve
Advertising:thegovernmentcouldadvertisetheconsequencesofnegativeexternalitiesof
consumptiontoreduceconsumption,orcouldincreasetheadvertisingofthebenefitsofpositive
externalitiesofconsumption

Tragedy of the Commons


TragedyoftheCommons
Theoverconsumptionofresourcesintheinterestofselfworthandareabletodosobecausethe
goodsarecommonorunknown
PublicGoods
Publicgoodshavetwoqualitiesthatmakethemapartofthetragedyofthecommons.
1. Nonrivalry:onepersonsconsumptionofthepublicgooddoesnotdepriveanothers
abilitytoconsumerthatgoods
2. Nonexcludability:oncethegoodisprovidedforonepersonitisnotpossibletoprevent
othersfromconsumingit
PublicGoodsandMarketFailure
Publicgoodsarelikelytobeunderproducedornotproducedatallbecausetheirpropertiesmake
themincapableofprovidingprivateprofitability.
Thefreeriderproblemarisesbecausethosewhoenjoythebenefitsofapublicgooddonothave
topay.

Costs, Revenues and Profits


ShortRunvs.LongRun
Shortrun:theperiodoftimeinwhichatleastonefactorofproductionisfixed.
Longrun:theperiodoftimeinwhichallfactorsofproductionarevariable
Fixedvs.VariableCosts
FixedCosts:coststhatdonotchangeasproductionisincreasedordecreased
VariableCosts:coststhatvaryindirectproportiontooutput
TotalProduct(TP)
Thetotaloutputthatafirmproducesusingitsfixedandvariablefactorsinagiventimeperiod

AverageProduct(AP)
Averageproductistheoutputthatisproduced,onaverage,byeachunitofthevariablefactor.

AP=

total product
number of units of variable factor employed

MarginalProduct(MP)
Thechangeinoutputresultingfromoneadditionalunitofthevariableinput

AP=

total product
units of variable factor

LawofDiminishingReturns
Asmoreunitsofvariableinputareaddedtofixedinputs,themarginalproductatfirstincreases
butthendecreases
EconomicsCosts
Acombinationofexplicitandimplicitcosts
Explicitcosts:firmsuseresourcestheydonotownandmakespaymentsofmoneytotheresource
suppliers
ImplicitCosts:thecostistheopportunitycostofthesacrificeofincomethatwouldhavebeen
earnediftheresourcehadbeenemployedinitsbestalternativeuse
EconomicsofScale
Advantagesthatafirmgainsduetoanincreaseinsize.
1. ConstantReturnstoScale:changeininputisequaltochangeinoutput
2. IncreasingReturnstoScale:asinputchanges,outputincreasinglychanges
3. DecreasingReturnstoScale:asinputchanges,outputdecreasinglychanges
CostCurves
AverageFixedCost(AFC):Thefixedcostperunitofoutput.Calculatedbydividingtotalfixed
costbyquantity.Sincetotalfixedcostisconstant,AFCfallsasoutputincreases.
AverageVariableCosts(AVC):Thevariablecostpetunitofoutput.Calculatedbydividingtotal
variablecostbyquantity.AVCtendstofallasoutputincreasesbutthenincreasesagain.
AverageTotalCost(ATC):Thetotalcostperunitofoutput.Calculatedbydividingtotalcostby
quantity.ATCtendstofallasoutputincreasesandthenriseagainastheoutputcontinuesto
increase.
MarginalCost(MC):Theincreaseintotalcostofproducingandextraunitofoutput.Calculated
bydividingthechangeintotalcostbythechangeinquantity.MCtendstofallasoutputincreases
andthenstarttorisebecauseasmorevariablefactorsareaddedtofixedfactors,thecostperunit
ofoutputeventuallybeginstorise
GraphicalRepresentationofCostCurves

Perfect Competition
PerfectCompetition
TypeofProduct:identical
MarketPower:pricetakers
Numberofsellers:many
Roleofadvertising:negligible
Barrierstoentry:low
CostCurves

Thepriceoftheindustrydeterminesthepricethatfirmsmustsellat.Theshadedregion
representsnormalprofitsuchthatitshowsboththecostandtherevenueofthefirm.

ShortRunvs.LongRun

Supernormalprofitscanbeearnedintheshortrunifthedemandintheindustryshiftsright,
thereforeincreasingprice.Howeverinthelongrun,theentryofnewfirmswillresultinsupplyin
theindustryshiftingrightandthereforepricedecreasingbacktoitsoriginal.
AllocativeandProductiveEfficiency
Allocative:whenP=MC,inthismarketP=MR
Productive:whenP=minAC,inthismarketP=minAC

Monopoly
Monopoly
TypeofProduct:thesame
MarketPower:pricemarket
Numberofsellers:oneortwofirms
RoleofAdvertising:possiblyhigh
Barrierstoentry:veryhigh
CostCurves

Thelightgreyboxrepresentsthefirmscosts,whilethedarkgreyboxrepresentssupernormal
profits.
ShortRunvs.LongRun
Intheshortrunandthelongrun,themonopolistexperiencessupernormalprofitsasthereare
highbarrierstoentryandexit.
AllocativeandProductiveEfficiency
Allocative:whenP=MC,inthismarketP>MCbecausethereisanunderallocationofresources
Productive:whenP=minac,inthismarketP>minACbecausethemonopolistisproducingat
higherthanminimumaveragecost

Monopolistic Competition
MonopolisticCompetition
TypeofProduct:differentbutservethesamepurpose
MarketPower:nonpricedeterminants
Numberofsellers:many
RoleofAdvertising:high
Barrierstoentry:moderate
MonopolisticCompetitivefirmsaimtoachievethebenefitsthatmonopoliesenjoy,thereforeby
usingproductdifferentiationandadvertising,theycanexperiencesimilarcharacteristics
CostCurves

Thelightgreyboxrepresentsthefirmscosts,whilethedarkgreyboxrepresentssupernormal
profits.
ShortRunvs.LongRun
Intheshortrun,monopolisticcompetitivefirmscanexperiencesupernormalprofitshoweverin
thelongrun,morefirmsareattractedbythesupernormalprofitsandthereforeaveragerevenue
shiftsdownwards,erasingsupernormalprofits.
AllocativeandProductiveEfficiency
Allocative:whenP=MC,inthismarketP>MCindicatingthereisanunderallocationofresources
Productive:whenP=minAC,inthismarketP>minACthereforeaveragecostishigherthan
whatisoptimal,ifexcesscapacityisloweredthanitcanbecomeproductivelyefficient

Oligopolies
Oligopoly
TypeofProduct:similar
MarketPower:competeonstrategynotprice
NumberofSellers:few
RoleofAdvertising:high
BarrierstoEntry:veryhigh
Collusion
Oligopolisticfirmsareverycompetitiveandbecauseofthat,theytrytolimitcompetitionon
priceasmuchaspossible.Acartelisanagreementbetweenfirmstolimitcompetition,orwhatis
referredtoascollusion.
CostCurveswhenfirmsCollude

Thelightgreyboxrepresentsthefirmscosts,whilethedarkgreyboxrepresentssupernormal
profits.
CostCurveswhenfirmsdonotcollude

TheKinkedDemandCurveexplainspriceinflexibilityofoligopolisticfirmsthatdonotcollude.
FirmsalsomaximizeprofitswhereMC=MR,thereforefirmswillalwaysproduceatQ,whichis
thepointthatreflectsthedashedpartoftheMRcurve.

MACROECONOMICS
ExpenditureComponentsofGDP
Consumers(C)=consumerexpenditure
Investment(I)=investmentbyfirmsincapital
Government(G)=governmentexpenditure
NetExports(XM)=exportsminusimports
AggregateDemand(AD)
Thetotalquantityofgoodsandservicesthatallsectorsoftheeconomy(GDP)arewillingand
abletobuyatallpossiblepricelevels
ChangesinConsumerSpending
Changesinwealth
Changesininterestrates
Changesinexpectations
Changesinpersonalincometaxes
ChangesinInvestmentSpending
Changesininterestrates
Changesinbusinesstaxes
Changesinexpectations
ImprovementsinTechnology
ChangesinGovernmentSpending
Changesinpoliticalpriorities
DeliberateeffortstoinfluenceAD
ShortRuninMacroeconomics
Theperiodoftimeduringwhichthenominalpricesofresourcesdonotchangeinresponseto
changesinthepricelevel
LongRuninMacroeconomics
Periodoftimeinwhichthenominalpricesofallfactorsandresourceschangesoastoreflctfully
anychangesinpricelevel
AggregateSupply(SAS)
Thetotalquantityofgoodsandservicesproducedinaneconomyatdifferentpricelevels
ShiftsinSAS
Wages:ifwagesincrease,SASshiftsleft.Ifwagesdecrease,SASshiftsright.

ResourcePrices:ifpricesincrease,SASshiftsleft.Ifthepricedecreases,SASshiftsright.
Taxes:Ifbusinesstaxesincrease,SASshiftsleft.Ifbusinesstaxesdecrease,SASshiftsright.
Subsidies:ifsubsidiesincrease,SASshiftsright.Ifsubsidiesdecrease,SASshiftsleft.
LongRunAggregateSupply(LAS)
RepresentspotentialGDPwhereresourcesarebeingusedefficientlyandwhereunemploymentis
atitsnaturalrate.LASrepresentpotentialGDP.
ShortRunEquilibrium
OccurswhereADintersectsSAS,thispointdeterminesthepricelevel,thelevelofoutputandthe
levelofunemployment

Changes in the Equilibrium


InflationaryGap
WhenrealGDPislargerthanpotentialGDPandoccurswhenADshiftsright
Outputincreases
Unemploymentdecreases
Priceincreases
RecessionaryGap
WhenrealGDPislessthanpotentialGDPandoccurswhenADshiftsleft
Outputdecreases
Unemploymentincreases
Pricedecreases

Stagflation
OccurswhenthereishighunemploymentandhighinflationandoccurswhenSASshiftsleft
Outputdecreases
Unemploymentincreases
Priceincreases
Givesrisetoaneconomiccontraction

Neoclassical Perspective
NeoclassicalPerspective
Inthelongrunallresourcepriceschangesoastomatchchangesinpricelevels.TheLAScurve
isverticalatpotentialGDPbecauseinflationaryanddeflationarygapsareonlyintheshortrun.
Thisisbecauseifunemploymentisincreasedinshortrunthereisadownwardpressureonwages.
ShiftofLAS
AshiftintheLAScurveindicatesadecreaseorincreaseinpotentialoutputandtherefore
economicsgrowth.
TheLAScurvemayshiftduetoimprovementsinthefactorsofproduction,improvementsin
technologyoranincreaseinefficiency.
GovernmentIntervention
Governmentinterventionmayintensitythebusinesscycleandonlyresultinpricechanges
thereforegovernmentsshouldencouragecompetitiontostimulateeconomicgrowthratherthan
intervenethemselves

Keynesian Perspective
KeynesianPerspective
Theeconomycanstaystagnantforalongtimethusitisimperativeforgovernmentintervention.
AstheeconomyapproachespotentialGDP,allfactorsofproductionareemployed

GovernmentIntervention
Governmentpoliciesareimperativetodealwithshorttermfluctuationsthereforetheyshould
intervenewithpolicesthatwillincreaseADuntilitintersectsLASatpotentialGDP

Demand Side Policies


DemandSidePolicies
TheseaimtochangeADtomeetmacroeconomicobjectives.Therearetwotypesofdemandside
policies,fiscalandmonetarypolicies
WeaknessesinDemandSidePolicies
Fiscalandmonetarypoliciesareunabletofixbothinflationandunemploymentatthesametime
becauseinflationworsensunemploymentandunemploymentworsensinflation

Fiscal Policy
FiscalPolicy
WhengovernmentsusegovernmentexpenditureandtaxationtoinfluenceAD.Fiscalpoliciescan
affectconsumptionwithpersonaltaxes,investmentwithbusinesstaxesandgovernment
expenditurewithgovernmentspending.
ExpansionaryFiscalPolicy
Thisisusedwhentheeconomyisexperiencingadeflationarygap.Itmayconsistof:
1. Governmentspendingincreased
2. Personaltaxesdecreasing
3. Businesstaxesdecreasing
ContractionaryFiscalPolicy
Thisisusedwhentheeconomyisexperiencinganinflationarygap.Itmayconsistof:
1. Governmentsspendingdecreased

2. Personaltaxesincreased
3. Businesstaxesincreased
StrengthsofaFiscalPolicy
CombatInflation:contractionarypolicyhelpsbringproblemundercontrol
Recession:expansionarypolicycanpullaneconomyoutofarecession
WeaknessesofaFiscalPolicy
TimeLags:lagssuchasrecognition,decisionorimplementationlags
Politicalconstraints:taxincreasescouldbeinappropriatelyenacted
Crowdingouteffect:whenthegovernmentborrowstopursueanexpansionarypolicy,ineffectit
increasesthedemandformoneyandinterestratesgettoohigh

Monetary Policy
MonetaryPolicy
Thesepoliciesarecarriedoutbycentralbank,whichisagovernmentfinancialinstitutionto
changemoneysupplyandinterestratestoaffectconsumptionandinvestment
ExpansionaryMonetaryPolicy
Theobjectiveistoexpandaggregatedemand.Itmayconsistof:
1. Increasingthesupplyofmoney
2. Decreasinginterestrates
ContractingMonetaryPolicy
Theobjectiveistoincreasethecostsofborrowingthereforereducingaggregatedemand.Itmay
consistof:
1. Decreasingthesupplyofmoney
2. Increasinginterestrates
StrengthsofaMonetaryPolicy
QuickImplementation:doesnothavetogothroughpoliticalprocesses
Nopoliticalconstraints:greaterfreedomtopursue
Nocrowdingouteffect
WeaknessesofaMonetaryPolicy
TimeLags:lagsinrecognitionorimplementation
Ineffectiveinrecession:expansionarypolicyaimstoincreaseADbyencouragingspending
howeverthisisundertheassumptionthatconsumerswillincreasespending

Supply Side Policies


SupplySidePolicies

AimtoshifttheLAScurvetotherightinordertoachievelongtermeconomicgrowth.The
objectsaretoincreaseefficiency,decreasethenaturalrateofunemploymentandincrease
productionpossibilities.Therearetwotypes,marketorientedorinterventionist.

Market Oriented Supply Policies


ReducingthesizeoftheGovernmentSector
Largegovernmentsectorsmaybeinefficient.Themethodstoreducemayincludeprivatization,
restrictingmonopolypowerorprivatefundinghoweverprivatizationmaymakeproductsless
affordable.
IncentivesbyLoweringTaxes
Lowerpersonaltaxes=incentivesforpeopletoworkandspendmore
Lowerinvestmenttaxes=moremotivatedtosave
Lowerbusinesstaxes=increaseprofitsthereforeinvestmentspending
Theweaknesseshoweveristhatthismayworsenincomedistributionorhavealargerimpacton
ADthanAS
MakeLaborMarketMoreResponsive
Abolishminimumwagelegislation
Weakenlaborunions
Reduceunemploymentbenefits
Theweaknesseshoweverarethatitmayincreaseincomeinequalitiesandhaveadownward
pressureonconsumerspending

Interventionist Supply Policies


InterventionistSupplySidePolicies
Presupposethattheeconomycannotbyitselfachievedesiredresultsthereforegovernment
interventionisrequired.Examplesmayinclude:
1. Trainingandeducation(moreskillsinworkforce)
2. Improvedhealthcare(moreproductive)
3. Researchanddevelopment
4. Supportforsmallbusinessesandinfantindustries

Money Multiplier
MoneyMultiplier
Achangeinaninjectionofexpenditurewillleadtoaproportionallylargerchangeinthelevelof
nationalincome

multiplier=
Leakages

changeGDP
changeleakages

Sizeofsavingsratio(mps)
Amountspentonimports(mpm)
Leveloftaxation(mrt)
Thegreatertheseleakagesare,thesmallerthemultiplieris

multiplier

1
1
=
mps+mpm+mrt mpw

MarginalPropensitytoConsume
MPCistheproportionofeachextradollarthathouseholdswillspendintheeconomy,thehigher
thevaluethelargerthemultiplier.

multiplier=

1
1mpc

Consumer Price Index


ConsumerPriceIndex
TheCPIistheoverallcostofthegoodsandservicesboughtbyatypicalurbanconsumer.Itis
usedtomonitorthecostoflivingovertimebymonitoringabasketofgoodsandservices.As
theCIPrises,thetypicalfamilyhastospendmoretomaintainthesamestandardofliving

CPI=

price of basket year


x 100
price of basketbase year

CategoryWeighting
Differentcategoriesofconsumptionhavedifferentimpactsonconsumersthereforeweightingis
usedtocalculateindicesbasedontherelativeexpenditureoneachcategory

CPI with weighting=

index for year


weighting

ProblemswithMeasuringCPI
Substitutionbias:doesnotconsiderconsumersubstitution
Newgoods:doesnotreflectchangeinvalueofdollarasnewproductsareintroduced
Unmeasuredqualitychanges:ifqualitychangesandthevalueofthedollarchanges,thepriceof
thegoodremainsthesame

Inflation

InflationRate

Inflation Rate=

index for year ( x +1 )index for year (x )


x 100
index for year (x )

Realvs.NominalInterestRates
Nominalinterestrates:interestratenotcorrectedforinflation
Realinterestrates:Correctedforinflation
Anticipatedvs.UnanticipatedInflation
AnticipatedInflation:firmswillconstantlychangepricesandpeoplewillbelesslikelytohold
cash,asitwilllosevalue
UnanticipatedInflation:itisdifficulttopredictifinvestmentswillbeprofitable,wagedistortions
suchthatsomeprofessionscanadjustwageseasierthanothersandassetsareworthmorewhile
loanisthesame
DemandPullInflation
Aggregatedemandincrease
Causesinclude:
1. Decreaseininterestrates
2. Decreaseintaxation
3. Increaseingovernmentspending
CostPullInflation
CostsincreaseindependentlyofAD(SASdecreases)
Typesinclude:
1. Wagesincreaseduetopowerofunions
2. Monopoliesdriveupprices
3. Taxes
4. Expectations

Unemployment
PPFModelofFullEmployment
Fullemploymentoccurswhenthereisamaximumuseofallresourcesintheeconomytoproduct
themaximumcombinationoftwogoods(i.e.alongthePPFcurve)
AD/ADModelofFullEmployment
Occurswheretheeconomyisproducingatpotentialoutput(i.e.attheLAScurve)
UnemploymentandUnderemployment
Unemployment:peopleofworkingagewhoarewithoutwork,availableforworkandactively
seekingemployment
Underemployment:referstothosehowonlymanageparttimeworkorthosewhoareover
qualifiedfortheirjobs

DifficultiesMeasuringUnemployment
Theunemploymentratedoesnotincludediscouragesworkers,doesnotcapture
underemploymentandmaybeoverestimatedasitdoesnotincludeworksintheinformal
economy
CostsofUnemployment
Fortheunemployed,itisalossofincome
Forsociety,thereisanincreaseincrimerates,divorce,healthcostsandthereisanunequal
distributionofincome
Fortheeconomy,thereisadecreaseinproduction/consumption

Structural Unemployment
StructuralUnemployment
Whenindustriesarenolongercapableofcompetingduetochangingdemandornewtechnology
thereisstructuralunemployment.Therearemismatchesbetweenthelaborskillsdemandedand
suppliedandbetweenthephysicallocationofworksandemployers
MarketOrientedapproach
Letwagesfallsonewfirmsmayarise
Lowerunemploymentbenefitssoworksmustacceptlowerpay
Lowerincometaxes,increasedincentiveforworkstoacceptworsejobs
DISADVANTAGES
Theremaybeanincreaseinincomeinequalities
Interventionistapproach
Settinguptrainingprogramsandassistyouthtopursueeducationandtraining
Providegrantsandsubsidiestohelpwithrelocation
Establishgovernmentprojects
DISADVANTAGES
Requiresgovernmentfundingwithhighopportunitycosts

Frictional and Seasonal Unemployment


FrictionalUnemployment
Atimelagbetweensomeonelosing/changingjobandstartinganother.Itmaybetheresultof
geographicalimmobilityorlackofknowledgeregardingavailablejobopportunities
MarketOrientedapproach
Lowerunemploymentbenefitstoincreaseincentivestoacceptwork
Lowerincometaxesincreaseincentives
Interventionistapproach
Establishjobcenterstoimproveinformation
Establishemploymentagencies
Improveinformationbetweenemployersandjobseekers

SeasonalUnemployment
Occurswhenthedemandforlaborincertainindustrieschangesastoreflectinreasons
CorrectingSeasonalUnemployment
Provinginformationonjobsavailableduringoffpeakseasonsinotherindustries

Cyclical Unemployment
CyclicalUnemployment
Cyclicalordemanddeficientunemploymentiswhenthecyclicalnatureofthemacroeconomic
economygoesintoarecessionarygap(ADshiftsleft)
MonetarySolutions
Interestratesdecrease
Supplyofmoneyincrease
FiscalSolutions
Taxationdecreased
GovernmentSpendingincreased

Disequilibrium/Equilibrium Unemployment
Disequilibrium/EquilibriumUnemployment

Ifthewageraterisesabovetheequilibriumthensomeunemploymentwillarise.Thisis
alsoknownasrealwageunemployment

Solutions

Eliminateminimumwagelegislation
Reducethepoweroflaborunions
Thiswillresultinthecostsofproductiondecreasing,wagesdecreasingandSASshifting
totheright

Calculating Employment
CalculatingUnemploymentRate

unemployment rate=

number of unemployed
x 100
numberlabour force