Econ Summary

1
Study Session # 4, Reading # 13
“Elasticity”
Elasticity Responsiveness of one variable to changes in
another variable.
Price elasticity of demand: ∆ in Qd due to ∆ in price.
Ed = % ∆ Qd
%∆P
Price Elasticity of Absolute

Causes Explanation
Demand value
% ∆ Qd > % ∆ P ; A small %age ∆ in P leads

Highly Elastic >1 Flatter
to a large %age ∆ in Qd.
% ∆ Qd < % ∆ P; A large %age ∆ in P leads to

Relatively Inelastic <1 Steeper
a small %age ∆ in Qd.
Flat
Perfectly Elastic ∞ As P, Qd approaches ‘0’.
(horizontal)
As P, Qd remains constant i.e., % ∆ in Qd is

Perfectly Inelastic 0 Vertical
‘0’.
Factors influencing Elasticity of Demand
Availability of Substitutes Relative Amount of Income Time Period

Spent on the Good
More Lesser More Small Proportion Long run Short run

Substitutes Substitutes Proportion Spent
⇓ ⇓
Available Spent
⇓ ⇓ ⇓ More Elastic. Less Elastic.
⇓
More Elastic Inelastic
e.g. Apples. e.g. Gasoline. More Elastic. Relatively Inelastic.
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2
Cross Elasticity of Income Elasticity of

Demand Demand
Where ‘y’ is a Where Y is income

substitute or
complement of ‘x’.
Inferior goods ⇒ Ey <0
Substitutes Complements
Cross Normal Goods
⇓ ⇓
Elasticity
+ ve Cross - ve Cross
Elasticity. Necessities Luxury Goods
Elasticity.
⇓ ⇓
0 < Ey < 1. Ey > 1

(Because of smaller
base of luxuries).
Total Revenue Test
As P⇒TR  ⇒ Inelastic demand
As P⇒ TR ⇒ Elastic demand
Unit elastic demand ⇒TR is max
CFA Level I Curriculum 2010, Volume II, Reading 13, Page15.

3
Elasticity of Supply: ∆ in Qs due to ∆ in price.
Price Elasticity of Supply Absolute Value Causes Explanation

A small %age ∆ in P leads to a large
Highly Elastic >1 Flatter
%age ∆ in Qs.
A large %age ∆ in P leads to a small
Relatively Inelastic <1 Steeper
%age ∆ in Qs.
Perfectly Elastic ∞ Flat As P↓, Qs approaches ‘0’.
As P, Qs remains constant
Perfectly Inelastic 0 Vertical
i.e. % ∆ Qs = 0.
Factors influencing Es
Available Resource Substitutions Supply Decision Time Frame
Inputs abundantly Unique or

available or easily rare inputs Elasticity of Elasticity of Elasticity of
substitutable Momentary < Short-term < Long-term
Supply Supply Supply
⇓ ⇓
Highly elastic, nearly Inelastic, nearly
horizontal supply vertical short run
curves. supply curves.

1
“Efficiency & Equity”

MC = Marginal Cost
MB = Marginal Benefit
Mkt = Market
Methods of Resource Allocation
Allocation by market Command Majority Based on personal Other methods, such as

price system rule characteristics e.g.  First-come-first-served.
race, religion,  Lotteries.
⇓ ⇓
ethnicity, sex etc.  Contests.
 Force i.e., extortion,
Most preferred Allocation
theft, or warfare.
method. determined by
central
authority.
Efficient Allocation of Resources

In a well-functioning mkt competition & allocation through market price
Leads to efficient allocation of resources, where MB = MC
Consumer Surplus (C.S) MC: Cost of producing one more

Difference b/w the price unit of a good or service.
that a consumer has to pay  It is considered an opportunity
& that he is willing to pay. cost.
At point A; C.S = 5-3 = $2. Supply curve: Sum of all producers’
upward sloping MC curve
Producer Surplus (P.S)
Difference b/w total cost of MB: Benefit derived from
producing the output & the consuming one additional unit of a
total amount producers good or service.
receive for it. Demand curve: Sum of all

At point B; P.S= 3-1 = $2 consumers’ downward sloping MB
Efficient Quantity or curve.
equilibrium quantity
Allocative Efficiency Over production: Producing more than

At point ‘E’ with equilibrium price (Pe) & quantity (Qe), efficient/equilibrium quantity
allocative efficiency is achieved because the quantities of all Underproduction: Producing less than
goods & services produced have the maximum total benefit to efficient/equilibrium quantity
the consumers. i.e, at equilibrium price total surplus is
maximized. Deadweight loss: Reduction in C.S & P.S due
to overproduction or underproduction.
Total Surplus = Consumer Surplus + Producers Surplus
Efficient allocation of resources maximizes sum of C.S & P.S.

2
Price controls Taxes & Trade Restrictions

Distort the incentives of supply & demand
Taxes Subsidies Quotas

Price Ceiling Price Floor
 Price paid by  Provided by  Govt-imposed
 Set below eq.  Set above
consumer. Govt. production
price. eq. price
 Price received  Price paid by limits.
 Creates excess  Excess
by seller. consumer.  Result in less
demand. Supply is
 Result in  Price received by than efficient
created.
under producer. qty.
production.  Results in
overproduction.
Monopoly External Costs External Benefits

 Single seller.  Costs imposed on others by the  Benefits of consumption enjoyed
 Chooses profit- production of goods which are not by people other than the buyers
maximizing qty that is taken into account in the production of the good that are not taken into
less than efficient level decision. account in buyers’ consumption
of production.  Results in an over-allocation of decisions.
resources.  Results in under allocation.
 MC to society > direct cost of  MB to society > MB to the firm.
production that producer bears.  Less than efficient qty is produced.
 More than efficient qty is produced.  Eq. qty produced < Efficient qty.
 Eq.qty. produced > Efficient qty
Public goods Vs Common Resources

 Used by everyone regardless of  May be used by everyone.
whether or not they paid for them.  Under competitive forces more
(Free Rider problem). than efficient qty is produced. i.e.,
 Under competitive forces less than they are over-used.
efficient qty produced.
Ideas about the Fairness Principles
Utilitarianism Symmetry Principle

 Equal benefits for all.
 Equality of opportunities.
 Greatest good occurs when wealth is
 Treating other people the way oneself wants
transferred from rich to poor because MB$poor >
to be treated.
MB$rich, hence more is gained than lost.
 People should get goods and services from the
Criticism:
economy equal to the value they contribute to
 Transfer of income through tax leads to less
the economy.
than efficient quantity of labor supplied.
 Fairness must be based on fairness of rules.
 Tax on capital earnings leads to reduced
 A competitive market allocates resources
savings and investments.
fairly as long as the same rules apply to all
 Administrative cost in taxation is also a source
participants.
of inefficiency.

1
“Markets in Action”
P.S = Producer Surplus
C.S = Consumer Surplus
Market Equilibrium Impact of an outside shock on the equilibrium

Occurs at the price
where Qs = Qd. In S.R In L.R
Short run Outside shocks Producers

A period in which reduce supply Equilibrium increase Equilibrium
producers can’t adjust price  output due to price 
their capacity. higher prices.
Equilibrium
quantity  Equilibrium
quantity 
Price Ceiling Price Floor Black Market

 Upper limit on the price a  Minimum price that a Economic activity that takes place illegally.
seller can charge. buyer must pay.
 Below equilibrium price.  Set above equilibrium Reasons of inefficiencies in black market
 It has no impact if it is set price.
above equilibrium price.  It has no impact if it is set Contracts Risk of prosecution Quality 
 Reduction > Reduction below equilibrium price. are not increases the price control
in P.S in C.S  Reduction > Reduction enforceable. required by suppliers. ⇓
 Hence C.S > P.S in C.S in P.S Defective
Example  Hence P.S > C.S products 
Rent ceiling or rent control Example
in house market. Minimum wage rate in labor
Inefficiencies market. Subsidies Quotas
 Consumers have to wait Inefficiencies  Overproduction.  Underproduction.
in long lines (opportunity  Suppliers will not be able to  Produce more than  Produce less than
cost has to be paid). sell all they produce. equilibrium quantity. equilibrium quantity.
 Suppliers may engage in  Consumers will go  Lower prices.  Higher prices.
discrimination. towards less costly
 Suppliers may take bribes substitutes.
to sell at the ceiling price.
 Suppliers may reduce the
quality.
Illegal Goods
Demand & Equilibrium

Supply curves quantities
shift to the left ⇒ fall as compared
due to expected to equilibrium
penalties. quantities of
Legal goods.

2
Taxes
Difference b/w what buyers pay & what sellers get.
Consequences of Taxes
 Equilibrium price 
 Equilibrium quantity
 Deadweight loss.
Statutory Incidence of tax Actual Incidence

Incidence Allocation of tax Who actually
Who is b/w buyers & bears the cost
legally sellers. of tax by paying
responsible a higher price or
for paying by receiving a
the tax. lower price.
Impact of Elasticities
Condition More burden on
Ed<Es Consumers
Ed>Es Producers

1
“Organizing Production”
Opportunity Cost for a Firm Explicit Costs Implicit Costs
Value of the firm’s resources in = Measurable expenses + Not explicitly observable.
their next most valuable use. e.g, cost of production.
Two categories
Implicit Rental Normal Profit

Economic It is the sum of Rate Opportunity cost of the
Depreciation Opportunity cost time & financial
Decrease in value of firm for using resources &
of firm’s assets Foregone
it’s own capital entrepreneurship
over time. Interest.
expertise of the owner.
Economic = Total Explicit

Constraints on Profit Revenue - +
Implicit
Profit maximization costs
Technology Information Market

Output & revenue can be increased by At times there is lack of Prices and availability of
employing additional technological information or even if resources that a firm uses &
resources, but they in fact are limited by information is available, the willingness of people to invest
the cost of adopting new technology. cost of obtaining it is in the firm constraints the
greater than it’s value. firm’s growth.
Command Ways of Organizing Incentive

System Production System
Technologically ⇒ producing with
efficient lesser inputs.
 Hierarchical system.  Performance based system.
Economically ⇒ producing at  Organizing production  System of rewards intended to
efficient lower costs. according to chain of motivate workers to perform
command. in a way that maximizes
 Used when it is easy to profits.
monitor employee’s  Used when it is difficult or
performance. costly to monitor.

2
Reducing Principal – Agent Problem
Principal – Agent problem

 It arises when incentives &
motivations of agents Ownership interest Incentive pay Long-term employment
(employees) are not the same as of employees in the Pay and Contracts
those of principals (firm owners). firm. promotions For CFOs to develop
 The essence of the problem is that Used more for based on strategies that will
it is difficult or costly to monitor managers, less for performance. maximize profits over a
agents. workers. reactively long period.
Four Market Types
Perfect competition Monopolistic Oligopoly Monopoly

 Identical products. competition  Small no. of producers.  Single seller.
 Large no. of  Slightly differentiated  Similar or  Specific, well
independent firms. products. differentiated defined product
 Large no. of buyers  Product differentiation products. with no good
& sellers, each gives a degree of  Decisions made by one substitutes.
knows the price market power to firm affect the demand,  High barriers to
but are too small to firms. price & profit of other. entry.
affect price.  Large no. of firms.  Significant barriers to
 No barriers to  Downward sloping entry, including large
entry or exit. demand curve. economies of scale.
Type of Business Organizations
Proprietors Partnership Corporation
 Single owner.  Two or more owners.  Many shareholders.

 Unlimited liability.  Unlimited liability of each  Liability is limited to the capital
 Simple decision process. partner. contributed to firm.
 Easy to start.  Difficult to reach consensus  Decision process is slow & costly due
 Decisions are not reviewed. decision. to complex management structure.
 Business may cease if owner  Easy to start.  Unlimited life.
dies.  Decisions are reviewed by  Double taxation of corporate earnings,
 Profits are taxed only once. partners. when;
 Access to capital is limited to  Business can survive if a partner (a) earned
debt incurred by owner. leaves or dies. (b) distributed to shareholders
 Taxable income is allocated  Can raise large amount of capital.
among partners.  Managerial expertise are not limited
 Access to capital is limited as to owners.
compared to corporate
structure.

3
Four Firm Concentration Ratio Herfindahl – Hirschman Index Limitations on the

 Sum of %age of four largest (HHI) Usefulness of Concentration
firm’s market share.  Sum of squared %age market Measures
 Highly shares of 50 largest firms in an  Geographical scope of the market; difficult
Competitive ⇒ 0% Industry. industry. to define.
 Competitive ⇒Below 40%.  Moderately Competitive ⇒  It does not account for barriers to early &
 Oligopoly ⇒ greater than 60%. 100<HHI<1800 firm turnover.
 Monopoly ⇒ 100%.  Not Competitive ⇒ HHI>1800.  Weak relationship b/w markets & the
 Monopoly ⇒ 10,000. definitions of industries.
Firm Co-ordination
 Company/firm tries to do everything itself. Market Co-ordination

 Firms can coordinate market activity more
efficiently than markets can because of Specializing in what we are
achieving: good at as a company.
 Lower transactions cost.
 Economies of Scale.
 Economies of Scope.
 Economies of team production.

1
“Output & Costs”

K = capital
Short Run (S.R) Long Run (L.R) Total Product of Labor (TRL) Increasing Marginal
A time period for which; Firm can adjust its No. of units of output produced Returns
 qtys of some inputs  Inputs. for a given amount of labor input. Keeping ‘K’ constant as
are fixed.  Production methods. labor is increased, MPL
 Production method is  Plant & equipment. Average Product of Labor (APL) rises.
fixed. TPL divided by units of labor used. Decreasing Marginal
 Plant size is fixed. Marginal Product of Labor (MPL) Returns
Increase in the total product of Keeping ‘K’ constant,
A firm’s S.R decisions are easier to increasing labor units
labor from using one additional
reverse than its L.R decisions. beyond a certain point,
unit of labor, holding the
quantities of other inputs fixed. decreases MPL.
(Source: “Output and Important relationships b/w

Cost”, Michael Parkin MC & AC curves
2010 Modular Level 1,  AFC curve slopes downwards.
Vol.2, p.144  AFC is the vertical distance b/w ATC & AVC.
Study Session 4-17-d)  MC declines initially, then increases.
 MC intersects AVC & ATC at their minimum
points.
 ATC & AVC curves are U-shaped.
A firm’s marginal product curve is linked to its marginal cost curve. If

the firm hires more labor its marginal product rises, its marginal cost
falls. If marginal product is maximum, marginal cost is minimum.If the
firm hires more labor its marginal product diminishes, its marginal cost
rises.
A firm’s average product curve is linked to its average variable cost
curve. If the firm hires more labor its average product rises, its average
variable cost falls. If average product is maximum, average variable cost
is minimum.If the firm hires more labor its average product diminishes,
its average variable cost rises.

2
Total Cost (TC) Total Fixed Cost (TFC) Total Variable Cost (TVC)
Sum of all costs associated  Cost of fixed inputs plus normal  Cost of all variable inputs.
with the generation of = profit i.e. value of +  It increases with an
output. entrepreneurial ability of firm’s increase in output.
owners.
 It is independent of the level of
firm’s output in short-run.
Average Total Cost (ATC) Average Fixed Cost (AFC) Average Variable Cost (AVC)
TC per unit of output i.e., = TFC per unit of output i.e., + TVC per unit of output i.e.,
Marginal Cost (MC)

Increase in total cost for one
additional unit of output.
Production Function Law of Diminishing Marginal Product of Diminishing Marginal

Relationship b/w a Returns Capital (MPK) Product of Capital
firm’s labor & capital Holding the quantity of Increase in output from Keeping labor constant
inputs & its quantity of other inputs constant, using an additional unit beyond some point,
output. adding more & more of of capital, holding the adding one more unit
a resource beyond a quantity of labor of capital increases the
point, continues to constant. output at a decreasing
increase the output but rate.
at a decreasing rate.

3
Short Run Cost Curves Long Run Cost Curves Three reasons of a
Specific to a given plant  Costs are industry decline in unit cost
size. specific. due to an increase in
 LR cost curves are output or plant size
known as planning
curves.
Savings Specialization Experience

due to mass of labor &
production machinery
Avg
unit
Economies of Scale Constant Diseconomies of Scale
Cost
As firm Return to As size (scale)
size (scale)⇒ Avg. unit cost Scale of firm ⇒ Avg. unit cost 
Q* Output
Minimum
efficient scale

1
“Perfect Competition”
MR = Marginal Revenue
MC = Marginal Cost
P = Price
Characteristics of Perfect Competition Price Takers

 Large number of independent firms. Producers in perfect competition are price-
 Large number of buyers. takers, because they face horizontal (perfectly
 Identical products. elastic) demand curve. P
 Buyers & sellers can’t influence market Producers can’t sell their
price. output above market price.
D
No barrier to entry or exit.

0
 Q
Profit Maximizing Output for Price Takers Short Run Supply Curve of a Firm
 In the short-run, economic profit is maximized The MC line of a firm above its AVC curve is short run supply
where; MR=MC =P. curve for a firm.
 If MR < MC ⇒ Economic losses ⇒ P< ATC Short Run Market Supply Curve
 Economic Profit is zero in the long run. It is the horizontal summation of all the MC curves for all firms
in the industry.
Equilibrium in a Perfectly Competitive Market
 In equilibrium, each firm is producing the Short Run Adjustment to an Increase in Demand
quantity for which P = MR = MC = ATC.  As demand curve shifts up, equilibrium output & price rises,
 Long-run equilibrium output level for perfectly firms earn +ve economic profits in short run.
competitive firms MR = MC = ATC, where ATC is  Because of new higher Price (MR), new firms enter the
at a minimum. market.
 At this point economic profit is ‘zero’, and only a  Similarly as market demand falls, price falls, output falls &
normal return is realized. firms exit the industry due to economic losses.
 If, temporarily, AVC < Price < ATC, then Long Run Adjustment to Shift in Demand &
continue to operate. Change in Price is
 If, temporarily, Price < AVC, then temporarily 1. To alter the size of its plant to minimize ATC
shutdown. at new profit maximizing level of output.
 If, Price is always less than ATC, than go out OR
of business. 2. To leave the market entirely.

2
Effects of a Permanent Change in Demand Effect of Technological Change on Price,

Permanent change in demand leads to a Output & Economic Profit
change in market prices resulting in new
entrants or exits in the industry because of Cost-reducing technology expands output
the economic profits or economic losses & earns economic profit for a period of
respectively. time till it becomes common practice
throughout the industry. As the technology
  is adopted by other firms, equilibrium
External Economies of Scale External Diseconomies of supply & quantity will both be greater.
 Increased demand of Scale Equilibrium price will be lower & equal to
inputs results in a  Increased demand of inputs both the MC & minimum ATC. Hence
decrease in their prices. result in an increase in their economic profit returns to zero.
 With external economies price.
of scale, the long run  With external diseconomies
effect is of a permanent of scale, the long run effect
increase in demand, of a permanent increase in
increase in the output & a demand is an increase in the
decrease in equilibrium output and an increase in
market price. the equilibrium market
price.

1
“Monopoly”
Barriers to entry
Characteristics of Monopoly Factors that make it
 Only one seller. difficult for competing
 Specific, well defined product. firms to enter a market.
 No good substitutes.
 High barriers to entry. Legal barriers Natural barriers
Two types of
 Monopolists are price  Govt. licensing. Economics of scale
barriers
searchers.  Patents. i.e., Avg cost of
 Monopolists have imperfect  Copyrights. production decreases
information about demand.  Govt. granted franchises. as a single firm
produces greater &
greater output.
Monopoly price setting strategies Price discrimination

 Practice of charging different consumers, different
1) 2)
prices.
Charge a single Price  Motivation: To capture more consumer surplus as
profit-maximizing Discrimination. economic profit than in single price strategy.
price.
⇓
Charging different Seller must face Conditions for price

prices to different a downward discrimination to work
groups. sloping demand
curve.
Profit maximizing output
 Monopoly faces a downward sloping demand curve. At least two identifiable Ability to prevent resale
i.e., there is a trade-off between price and quantity groups of customers of products form low
sold. with different price price paying customer
 Monopolists have imperfect info. about demand. elasticities of demand. to high price payer.
 They search a price that maximizes their profit.
 Profit – maximizing output ⇒ MR = MC Perfect price discrimination Imperfect price
 At the optimal quantity ⇒ demand curve lies above discrimination
the firm’s ATC curve i.e., P>ATC  Charging the max-price  Less than efficient qty is
 Optimal quantity will be in the elastic range of the each consumer world pay. produced.
demand curve.  Efficient qty is produced Because MB ≠ MC.
because MB society = MC  Consumer surplus > 0.
society.
 All consumer surplus is
captured by monopolist i.e.,
Consumer Surplus =0.

2
Natural monopoly Monopoly vs. perfect competition

 Monopoly firm produces lesser output.
Economies of scale are so pronounced that:  It charges a higher price.
 ATC is falling over the entire relevant output  Profit maximizing qty does not maximize the sum of
range. consumer surplus & producer surplus.
 MC < ATC.  It creates a dead weight loss.(DWL)
 ATC of the industry is minimized when there
is only one firm in the industry.
Regulation of Natural Monopoly
Economies of Scope
By expanding the range of the goods it
produces, the ATC of a firm is reduced. Avg. Cost pricing Marginal Cost pricing
 Most common form of  Efficient Regulation.

regulation.  Price = MC
 Price = ATC Consequences
Consequences  Output 
 Output  Price 
 Price   It requires a govt.
 Social welfare  subsidiary for the
(Allocative efficiency) monopolist to stay in
 Monopolist earns a business. Because
normal profit since Price = MC < ATC.
P = ATC.
Reasons for the regulators to go astray when dealing with

markets with high barriers to entry.
Lack of Info. Cost Shifting Quality Regulations Special Interest Effect

Regulators may not know If the firm allows cost to If the firm faces falling Firm may try to influence
the firm’s ATC, MC & rise, the regulators will profits, it may reduce the the composition &
demand schedule. allow prices to rise. quality of goods or decisions of regulatory
services and quality is board.
difficult to regulate.

1
“Monopolistic Competition & Oligopoly”

S.R = Short Run Min = Minimum
L.R = Long Run Qty = Quantity
Characteristics of Monopolistic
Competition
1) Larger no. of independent 2) Product 3) Low barriers to 4) Firms compete

sellers differentiation entry & exit on price quality
 No firm has power over Product produced by & marketing as
price. each firm is slightly a result of
 There are two many firms different from others product
of collusion to be possible. & ax close differentiation.
substitutes.
Profit Maximizing or loss Minimizing Perfect Competition Vs Monopolistic Competition

Output for Monopolistic Competition  Price = MC.  Price > MC (inefficient
 Firm maximizes Economic profit by  ATC is min. for the allocation) of resources.
producing at MR = MC. qty produced.  ATC is not min. for the qty
 At this point, P> ATC, hence +ve produced (Inefficient scale of
Economic profit is earned in S.R. production).
 In L.R, new firms enter the market, &  Price is slightly higher than
zero economic profit is earned. under perfect competition.
 Firms face down ward sloping demand
curve i.e., they are price searchers.
Efficiency of Monopolistic Competition
 Demand curve is highly elastic because
To judge the efficiency, costs of product innovation,
of the availability of close substitutes.
development, advertisement & branding should be
weighted against the benefits they produce for the
consumers.
Important Elements for Monopolistic Competition
Product Innovation Advertising Expenses Brand Names

It enables price increase &  These are incurred to inform Provides info. to consumers
helps earn economic consumers about the unique about the quality of the
profits which are then features of the product. branded product.
eroded by new entrants  These are higher in
Hence firms continually Monopolistic Competition &
look for innovative Monopolies.
product features.

2
Characteristics of Oligopoly Kinked Demand Curve Model Dominant firm model

 Small no. of seller.  Each firm face a demand curve  The firm with the cost advantage
 Interdependence among that is more elastic (flatter) is the dominant firm.
competitors. above a given price (the kink),  Dominant firm produces a
 Significant barriers to entry than it is below the given price. relatively large proportion of the
including economies of scale. Assumption: industry output & thus sets the
 Similar or differentiated product. ⇒ Price declined is matched by price.
the competitor.  Other firms act as price takers.
⇒ Price rise is not be matched.
Game Theory Prisoner’s Dilemma

Used to examine A simple game that may be used to
Strategic behavior describe decisions faced by firms’
in an oligopoly. competing under oligopoly
conditions.
Firm B honors Firm B cheats
 Total Economic profit is  Total Economic Profit is less than

Firm A honors maximized. that of the monopoly.
 Both firms share it equally.  Cheating firm earns greater
economic profit.
 Total economic profit is less than  Both firms produce the qty at
Firm A cheats that of the monopoly. which their P = MC = ATC.
 Cheating firm earns greater  Both earn zero economic profits.
economic profit.
Nash Equilibrium Collusion is more effective if

Firms make their best  Fewer oligopoly firms in the market.
decision, given the  Cheating is easy to detect.
decision of the other  Threat of new entrants is less.
firms.  Enforcement of anti-collusion laws is weaker.
 Penalties for colluding are weaker.

1
“Markets for Factors of Production”
Ptvty = Productivity F.O.P = Factor of Production

K = Capital D2 = Demand for labor
MRPk = Marginal Revenue Product of Capital S2 = Supply of labor
Demand for F.O.P Marginal Product Marginal Revenue Marginal Revenue Product
It is a derived demand Additional output of a Addition to total  Addition to the total revenue
i.e., it is derived from the final product produced revenue from selling gained by selling the marginal
demand for the by using one more unit one more unit of product from employing one
consumer goods they are of a productive input, output. more unit of a productive
used to produce. holding other inputs resource.
constant.  MRP is downward sloping in
any range of output for which
diminishing marginal returns
are realized from using
additional units of f.o.p.
 Downward-sloping MRP Curve
is firm’s short-run demand
curve for that f.o.p.
Profit Maximizing Units of Determinants of Demand for Labor

Labor
 Continue to add units of Firm’s Substitute Complementary
labor until MRPL = PriceL Product Price Resources Price Resource’s Price
 Add units of labor as long as It firm’s if If price of If price of
MRPL > wage rate product price substitute complementary
⇒ Note: Pricel is the wage ⇒ DL  resource ⇒ DL resource
rate. (vice versa)  (vice versa) ⇒DL
 Hence, MRPL = wage rate is (vice versa).
profit maximizing units of
labor. Factors affecting supply of labor (SL) Supply Shifters
 Size of the adult
Elasticity of DL
Substitutions Effect Income Effect (I.E) population.
 Long run ⇒ greater
(S.E)  As income rises, demand  Capital accumulation.
elasticity.
Higher the wage for leisure rises. i.e, As W
 Greater proportion of labor
rate workers ⇒ SL 
in production process ⇒
substitute labor hrs  Income effect limits the
greater elasticity.
for leisure and amount of labor a worker
 Greater degree of
work more horse is willing to substitute for
substitution ⇒ greater
i.e, As WL ⇒ SL  leisure.
elasticity.

2
i = Interest rates = Expected future Income SK = Supply of capital

Y = Current Income S = savings DK = Demand of capital
Collective Bargaining Labor Unions attempt to increase DL by:

Monopsony
 A process in which workers  Instituting training programs to increase
 Only one buyer. i.e., only one
organize themselves as a group ptvty of union members.
employer of labor.
to bargain for wages & other  Encouraging the purchase of union-made
 Hires additional workers units.
aspects of employment. or domestically produced good.
MCL= MRPL.
 Labor unions are also called as  Getting import restrictions enacted.
 Result in less than efficient
bargaining agents.  Limiting the supply of immigrant labor.
quantity of labor demanded.
 Collective bargaining does not  Increasing the minimum wage for
 Result in less than efficient
attempt to increase DL – rather unskilled workers.
output of final good or service.
it attempts to restrict SL.
Physical Capital Financial Capital Profit- Maximizing units of capital

Physical assets of Funds necessary to Firms invest in more physical capital if
firm e.g., PP&E, purchase the PV of future MRPK > Cost of financial capital required.
inventory of physical capital
finished goods & Demand for Physical Capital
goods in process  Downward sloping MRP curve.
 Optimal units of capital: PV of MRPK = i
As demand for physical capital ⇒
Demand for Financial capital 
Supply of Financial Capital
Savers supply financial capital.
Demand for Financial Capital
 Derived from MRP of physical capital. ⇓
 Downward sloping function of interest rate.
 As i⇒ Dk (both physical & financial). Factors influencing savings &
 As i ⇒Dk (both physical & financial). supply of financial capital:
Equilibrium Interest Rate Interest Rates (i) Current Income (Y) Expected Income
Qty of Sk = Qty of Dk As y⇒Sk
As i⇒Sk As ⇒ S⇒ Sk
i⇒Sk y⇒ savings⇒Sk As ⇒S⇒Sk

3
Known Stock of Resource Renewable Natural Non-Renewable Natural

The qty of a non-renewable Resources Resources
natural resource that has already Supply is perfectly inelastic Supply is perfectly elastic at
been discovered is called the at the sustainable qty of the PV of expected future
known stock. production. price.
Opportunity Cost (O.C) VS Economic Rent
 Next highest  Difference b/w what a

paying alternative. f.o.p is earning & his
opportunity cost.
 Income is determined by  Skill in limited supply can
MPR & O.C. also be rewarded through
economic rent.

1
“Monitoring Jobs & The Price Level”

CPI: Consumer Price Index
Unemployed person Unemployment rate Labor force

A person available to  %age of unemployed labor People who are employed or are
work who is not working force. actively seeking employment.
and:
 Has actively searched
for work in the last 4  It decreases during
weeks. expansion.
 Has been laid off from  Increases during recessions.
Labor Force Participation rate
a job & is waiting to be
%age of the working age population who are either
recalled.
Working-age population employed or actively seeking employment
 Will start a new job in
the next 30 days. All people 16 year of age or
elder who are not living in
Discouraged workers institutions. It increase in expansion & decreases in recession.
 Available for work but
are neither employed Employment-to-Population ratio
nor actively seeking  %age of working age population who
employment. are employed.
 Changes in no. of
discouraged workers
 It rises during expansion & destines
can cause short term
during recession.
fluctuations in labor-
force participation
rate.
Avg. work week Real wage rates Particulars Expansion Recession

 Weekly hours worked per  Money wage rates adjusted
person. for changes in overall price Unemployment
 
 These have been declining level. rate
over time.  Payment to an hour’s labor
Labor force
in terms of goods & services
Aggregate hours participation  
 It fluctuates with the
 Total no. of hours worked rate
productive of labor.
in a year by all employed  Calculated using total labor Employment to
people. compensation which population  
 These have been includes wages, salaries, & ratio
increasing over time. employer-paid benefits.
 It allows us to estimate Aggregate
 
the productivity of labor. hours
 More productivity ⇒
higher wage rate. Avg work week  

2
Three types of unemployment
Frictional unemployment Structural unemployment Cyclical unemployment

 Results from job search  Caused by structural changes.  Caused by changes in general
activity.  Unemployed workers don’t level of economic output.
 It can never be eliminated currently have the skills  Economy working at less than
i.e., it is never zero. needed to perform the newly full capacity.
created jobs.
Full employment level & Potential GDP

Natural rate of unemployment Level of output the economy
(NRU) can produce when
 Zero cyclical unemployment. unemployment is at the natural
 Sum of frictional & structural rate.
unemployment is called NRU.
CPI Bias
 CPI has an upward bias
 It overstates inflation, estimated to about 1%
per year.
New goods Quality changes Commodity Outlet substitution Measures being taken to
Though they Price changes substitution Reduction in cost of reduce bias
provide same due to quality Due to availability living because of 1. Surveying consumers
function but they changes is not of substitutes, a shift of purchases more frequently.
are expansive inflation but still fixed basket of towards discount
than old goods. impacts the price goods is a less outlets is not 2. Re-evaluating the
index. accurate measure. captured in CPI. weighting method.
CPI Three stages of constructing

Measures the avg. price CPI
for a defined basket of
goods & services that
represents the 1. 2. 3.
purchasing patterns of Select the CPI Conduct a Calculate CPI
a typical urban basket. monthly price
household. survey.
Inflation rate
%age changes in the prices level from a year ago.

1
“Aggregate Supply & Aggregate Demand”
AD = Aggregate Demand
C = Consumption
LAS = Long run Aggregate Supply Y = Income I = Investment
SAS = Short run Aggregate Supply MP = Monetary Policy i = interest rate G = Govt. Spending
AS = Aggregate Supply FP = Fiscal Policy P= price level Nx = Net exports
SAS curve LAS curve

 Short-run refers to a period over
which worker’s wage demands are  LAS is the potential (full employment) real output of the economy.
constant.  LAS represents the supply of goods & services at each price level when;
 SAS refers to amount of goods & Worker’s inflation expectations = Actual inflation
services produced by an economy
holding money wage (not real wage)  LAS curve is a vertical line.
constant.  LAS is not affected by the price level.
 It is increasing function of price level
& hence SAS curve is upward sloping. Changes in A.S (L.R & S.R)
 Money wages depend directly on are caused by:
worker’s expectations about future  Changes in labor force.
rate of inflation.  Changes in amount of capital.
 Changes in technology. Factors Influencing the Change in
Money Wage Rates
Unemployment Inflation Expectation

As unemployment,  Expected increase in inflation ⇒
there is a downward money wage rate
pressure on the money wage  Expected decrease in inflation ⇒
rates. increase in money wage rate
slows.

2
AD Shifters
Future Income & Exchange Expected rate of MP & FP

Profit rate inflation AD because
As Y ⇒ AD As E.R ⇒ A.D As it  ⇒ ADT of expansionary
M.P & F.P
Macroeconomic Inflationary GAP Aggregate demand (AD) curve

Equilibrium Difference b/w real GDP &  AD = C+I+G+Nx
LAS = AD at full full employment GDP in an  AD is inversely related to price level.
employment level above full-employment S.R  AD curve is downward sloping because of:
equilibrium (L.R
disequilibrium) Wealth effect Intertemporal
Substitution effect
Recessionary gap or
Output gap P ⇒ Real AS P ⇒ I
Difference b/w real Wealth
GDP & full ⇓ ⇓
employment GDP in a AD  Current consumption
below full &I
employment
equilibrium. ⇓
AD
Influence of economic growth inflation & change in AD & As on equilibrium

From an Initial L.R
Equilibrium S.R price Workers
level & adjust
As AD () ⇒ ⇒
output () inflation
expectations
⇓
Full-
Price Money
employment ⇐ SAS() ⇐ wages()
⇐ level
L.R
()
equilibrium
restored.

3
Comparisons of Macroeconomic
schools of thoughts
Classical Economists Keynesian Economists Monetarists

 Shifts in AD & AS are due to changes in  Business cycles are  Business cycles are caused
technology over time. caused by shifts in AD by inappropriate M.P.
 Economy has a strong tendency towards full- due to changes in  Recessions are caused by
employment equilibrium. expectations. inappropriate decrease in
 L.R adjustments of money wages happen  Economy may not return the money supply.
rapidly to restore full-employment rapidly from recession to  Recessions can be
equilibrium. full- employment real persistent because money
 Taxes are the primary impediments to L.R GDP because wages are wages are downward
equilibrium. downwards sticky. sticky.
 As labor force  Policy: Policy:
L.R equilibrium
accumulated capital Increase AD by ⇒ Steady & predictable
real output.
technology  ⇒ Increasing Money increase in money supply.
supply. ⇒Low taxes (similar to
⇒ Increasing Govt. classical).
Spending.

1
“Money, the Price Level and Inflation”

= Change
Md= Demand for Money
Bd= Demand for Bond (securities) Ms= Money Supply
Checks & credit cards
Bp= Price of Bond D.R = Discount Rate
are not part of MS.
I = Equilibrium Interest Rate. OMO = Open Mkt Operations
Three basic functions of Money Primary measures of Ms in U.S
Medium of Unit of account Store of value M1 M2

Exchange Price of all goods Money  Currency not held at  M1.
 Accepted as & services are preserves banks.  Time deposits.
payment for expressed in unit value better  Traveler’s checks.  Savings deposits.
goods & services. of money. when inflation  Checking accounts of  Money market
 Means of is low. firms & individuals but mutual fund
payment. not of govt. balances.
Depository Institutions Money Market Four main economic functions

Financial Intermediaries Debt securities of depository institutions
with maturities
 To create liquidity.
⇓ of one year or
 To act as financial intermediary.
Three primary types less.
 To monitor the risk of loans.
 To pool the default risks of individual loans.
Commercial Thrift Institutions Money Market
Banks  Savings banks. Mutual Funds Regulation of banks with Financial Innovation (ATMs &
Intermediaries  Credit unions. An investment respect to balance sheet Internet Banking)
b/w savers &  Savings & loan company that  Maintaining minimum  Better serves customer
borrowers associations. manages amount of equity needs .
pooled funds. capital.  Decreases borrowing cost.
 Reserve requirements.  Increases profits.
 Restrictions on types  Increase earnings from
of deposits. lending.
 Rules about the ⇒ These are driven by
proportions of various changes in the economic
types of loans. environment, technology &
regulation.

2
Policy Tools of Fed
Goals of U.S Fed D.R Bank Reserve OMO To Increase Ms, Fed:
The rate at Requirements Buying or selling  Buys treasury securities.
Managing MS to keep inflation which banks %age of of Treasury  Decreases discount rates.
low while promoting can borrow deposits that securities in the  Decreases required
economic growth & full reserves from banks must open market. reserve ratios.
employment. the Fed. retain.
Fed’s Balance sheet

Assets Liabilities
 U.S treasury securities (90%  Currency notes (over 90%
of assets) of liabilities)
 Gold.  Bank’s reserve deposits.
 IMF special drawing rights.
 Loans to banks.
Fractional Reserve Banking Monetary Base consists Currency Drain Money Multiplier
System of: Effect of people  Printing more money gives a
 Hold required reserves.  Currency notes issued holding part of  n monetary base.
 Lend out excess reserves. by Fed. the increase in  in monetary base result in a in qty
 New reserves increase MS  Coins issued by U.S MS as currency & of money with multiplier effect
by multiple of new Treasury. not depositing it 
reserves.  Bank’s reserve to create more
 This multiple is reciprocal deposits at the Fed. loans.  Multiplier is a function of req. reserve
of the required reserve
ratio & currency drain i.e.,
ratio.
Md MS Equilibrium MS()⇒ Excess supply People buy

 It is a decreasing  Determined by Interest Rates (excess demand)⇒ (sell)securities
function of interest Fed. Determined by the to reduce
rate.  It is independent intersection of MS (increase)
 As of interest rates. & Md. money
Real GDP⇒Md  Vertical balances.
P⇒ Md (perfectly ⇓
 Md has reduced due inelastic) Supply
Curve. Conclusion i()⇐ Bp()⇐Bd()
to innovations
As MS ⇒i
(ATMS, credit &
debit cards)
 In short run ⇒ MS⇒i⇒AD Real GDP

P
 In long run ⇒ MS has no effect on Real GDP.

3
Equation of Exchange
An identity that breaks GDP into price level & its real output
components
MV = PY
Qty Theory of Money

 An increase in MS will cause a proportional
increase in prices.
 QTM is based on
⇒ Equation of Exchange
⇒ Assumption that V & Y are relatively constant,
because they are not determined by MS and are
rather determined by institutional factors.
 In L.R. QTM describes the results of MS growth in
excess of the growth rate of real output.

1
“U.S Inflation, Unemployment & Business Cycles”

L.F = Labor Force
LRAS = Long Run Aggregate Supply MS = Money Supply  = Increase
C.O.P = Cost of Production AD = Aggregate Demand = Decrease
NRU = Natural Rate of Unemployment AS = Aggregate Supply Ptvty= productivity
Inflation Two types of

 Persistent increase in the general Inflation
price level.
 Not a one-time increase. Demand-Pull Inflation Cost-Push Inflation
 Not simply an increase in the prices Results from persistent  in Results from a  in AS due to  in
of some goods or resources. AD (due to  in Ms or in Govt. cost of an important factor of
spending.) production.
Inflation Correctly Anticipated
Consequences Consequences
 Expected inflation = Actual inflation
 Price level.  Output 
 Output grows at growth rate of LRAS
 Economic output  above  Unemployment
without cyclical behavior
potential (full-employment) ⇒ If MS  in reaction to rising
  in AD is matched by  in AS.
level. unemployment & declining output,
 Economy remains at full-
then C.O.P further rises & inflation 
employment GDP.
further.
Impact of high inflation even when well-articulated
 Reduces real after-tax returns on investment.
 Increases transaction costs.
 Decreases productive activity.
Conclusion
Reduces the level & growth rate of GDP.
Philips curve
Short run Long run
“Movements along the Philips curve (S.R.)”
 Downward  Vertical at NRU.
sloping.  Shifts because of Actual Inflation >
⇒ Unanticipated  in A.D ()
 Size of L.F. Expected Inflation (<)
 Illustrates –ve  Makeup of L.F. ⇓
relationship b/w  Mobility of L.F.
unexpected GDP() ⇒ Unemployment ()
 Advances in
inflation & technology. ⇓
unemployment.
 Expected Upward (downward)

inflation & NRU movement along S.R
are constant. Philips curve

2
NRU = Frictional unemployment + Structural unemployment Nominal Real Premium

interest = interest + for
⇓ ⇓ rate rate expected
inflation
Affected by Affected by
 Mobility of L.F. technology ⇓
 Composition of L.F. It depends
 Size of L.F. on rate of
growth of
MS in the
L.R.
Two phases of
⇒ Fluctuations in economic activity Two turning points Business cycle
⇒ Real GDP & rate of unemployment
are key variables used to determine
the current phase of the cycle Expansion Contraction
Peak Trough
+ve -ve Eco.growth
Increasing Decreasing Real GDP
Decreasing Increasing Unemployment
Inflationary
Increasing Decreasing
pressure
Business Cycle Theories
Mainstream Real Business Cycle

Assumes stable growth Emphasizes effect of
rate for potential real real economic
GDP. variables.
Variations in growth
Cause of Business Cycle Variations in AD rate of potential real
GDP.
Rapid  in labor ptvty
Cause of Expansion Increase in AD
as technology changes.
Slow in labor ptvty as
Cause of Contraction Decrease in AD
technology changes
School of Thought Cause of Economic Cycles

New classical Unexpected changes in AD.
Both expected & unexpected
New Keynesians
changes in AD.
Due to variability of growth rate of
Monetarists
MS.

1
“Fiscal Policy”
LRAS = Long Run Aggregate Supply I = Investment
F.P = Fiscal Policy Fed.Govt. = Federal i = Investment Rate
T.R = Tax Revenue Government. K = Capital
G.E = Fed. Govt. Expenditure  = Rise or Increase ∝ = Directly Proportional To
Inflationary  Taxes  Balanced

periods  Govt spending  budget: T.R = G.E
F.P
To smooth
Fed.Govt’s use of
economic Budget
spending & taxation to  Taxes
cycles in Recessionary surplus: T.R > G.E
meet macroeconomic  Govt spending 
periods
goals.
Budget
deficit: T.R < G.E
Supply Side Effects: Influence of F.P (taxation) on LRAS or potential real GDP.
Income Taxes Incentive Qty of labor Potential

As ⇒ ⇒ ⇒
or to work supply  real
Consumption below full GDP
Taxes employment
Laffer Curve
Investment
 As tax rate, tax revenuetill a
point after which increase in  ‘I’ is defined as expenditures for fixed
taxes per $ earned will be more productive assets & inventory.
than offset by the decrease in  ‘I’ is a major component of GDP.
total numbers of $ earned.  I ∝ Real GDP growth.
Laffer curve begins & ends at ‘0’  If I  ⇒ K ⇒ Real GDP growth rate
tax revenue.  If I  ⇒ K ⇒ Real GDP growth rate
Tax Potential Taxes
rate GDP collected Sources of Financing for
0% Max. 0 Investments
100% 0 0
National Borrowing Govt.
Crowding-out Effect savings from foreigners savings
 Budget deficits reduce qty of savings,
& govt. starts borrowing. ⇓
 As a result real interest rate & the Private
cost of money for private sector  & sources T.R –G.E > 0
they go out of business.
 Private Investment is replaced by Govt. Budget Sources of
⇒
Govt. Investment & no new demand Surplus total Investment 
is created.
Govt. Budget Sources of
⇒
Deficit total Investment 

2
Ricardo – Barro Effect Ricardo – Barro Equivalence

Increase in the current fiscal deficit Reduction in current consumption &
means greater taxes in the future & ⇒ increase in current saving would be
hence fiscal deficit indirectly leads to just enough to buy the bonds the
increased savings so that people can govt.will issue to fund the increased
offset higher future taxes. deficit.
Generational Effects of F.P Generational Accounting Generational Imbalance

Effects of postponing fiscal  It measures taxes owed by & PV of govt. benefits to
imbalances, shifting the burden of benefits owed to each generation. current generation is not
increased taxes or decreased govt.  It shows that over half of the fiscal fully paid by taxes levied on
spending on next generation. imbalances will be paid by future the current generation.
generations.
Discretionary Fiscal Policy Automatic F.P

Spending & taxing decisions of national govt,  Govt. spending changes that occur when
intended to stabilize the economy, such as; economic growth slows or accelerates.
 Increased Govt. spending and/or decreased  No action required by policy makers.
taxes to increase aggregate demand during
Automatic Stabilizers
recessions.
 Built-in fiscal devices triggered by the state of
 Decreased Govt. spending and/or increased
the economy.
taxes during inflationary economic
 They minimize timing or lag problems in
expansions.
discretionary F.P stabilizers.
Problems in Discretionary F.P Categories of Automatic
1. Economic forecast may be wrong, leading Stabilizers
to incorrect policy decisions.
2. Lags or delays in implementation & Induced Taxes Needs-tested Spending
resulting effect of changes in F.P.
 Recognition Delay  Amount of taxes collected as  Govt. spends on programs
Time is required to recognize the extent of %age of income. that pass a “needs” test.
economic problems.  As income rises in boom, tax  Govt. automatically pays
 Administrative or Law Making Delay revenue rises & hence economy out more in unemployment
Time is required to make legal changes & slows down. compensation during
pass the law.  As income falls during recession to stimulate
 Impact Delay recession, tax revenue falls & economy.
Time is required for implementation & hence stimulates the economy.  Unemployment
impact to take place. compensation falls during
expansion & hence economy
dampens.
Induced taxes & needs- Needs-

Induced
tested spending are Tested
Taxes
countercyclical & Spending
together provide
automatic stability. Expansion  
Contraction  

3
Govt. Expenditure Multiplier Actual surplus or Cyclical Structural

Magnitude of impact of change in govt. = +
deficit surplus or surplus or
spending on aggregate demand. deficit deficit
Autonomous Tax Multiplier ⇓

Magnitude of impact of change in taxes on
Exists even at full
aggregate demand.
employment.
Balanced Budget Multiplier
Cyclical ⇒ Producing above full-employment GDP.
As Govt. expenditure multiplier is greater than
Surplus
Tax multiplier, an increase in Govt. expenditure
accompanied by an equal increase in taxes will Cyclical ⇒ Producing below full-employment GDP.
lead to increase in aggregate demand. Deficit
Zero cyclical
Surplus or ⇒ Producing at full-employment GDP.
deficit

1
“Monetary Policy”
Ms = Money Supply
FFR = Federal Fund rate S = Supply
QTM = Quantity theory of Money D = Demand
Goal of U.S Fed (M.P) Fed’s means of achieving the goals Fed operationalizes these goals
Max. employment. Keeping the long-term growth of by focusing on:
Stable prices. monetary aggregates consistent 1. Core inflation.
Moderate long-term interest with the potential long-term growth 2. Output gap i.e, the
rates. rate of GDP. difference b/w potential &
actual real GDP.
+ve output Inflationary Actual > Potential Reduction in monetary

⇒ ⇒ ⇒
gap pressures GDP GDP aggregates is the recommended
policy.
-ve output Recessionary Actual < Potential Increase in monetary aggregates

⇒ ⇒ ⇒
gap gap GDP GDP is the recommended policy.
Primary way that Fed conducts M.P Rules used to adjust FFR
Federal Funds rate (FFR) 1. Instrument rules
 Interest rate that banks charge each Basing target FFR on the current performance of the economy.
other for overnight loans. Taylor rule
 To increase, Ms ⇒ reduce FFR. Instrument rule based on rate of inflation & output gap.
 To decrease,
Ms growth ⇒ increase FFR. 2. Targeting rule
Based on a forecast of future inflation & requires that the FFR be set so that
Open Market Operation (OMO) the forecast of inflation equals the target inflation rate, typically 2%.
 Buying & Selling of Treasury
securities in open market by the Fed.
 FFR is determined by S & D for
interbank loans of reserves
& can be influenced by OMO.

2
Transmission Mechanism
Fed buys (sells) ⇒ Bank reserves Supply of loanable FFR falls Equilibrium rate for
⇒ ⇒ ⇒
Treasury increase (decrease). funds rises (falls). (rises). loans falls (rises).
securities.
⇓
Foreign demand US $ depreciates Long term Other short term
⇐ ⇐ ⇐
for U.S exports (appreciate) because of a rates fall rates fall (rise).
rises (falls).i.e., net decline (rise) in demand for (rise).
exports (Nx) rise US $.
(fall). ⇓
b) c)
a) Business Consumption of
investment goods, houses,
The link b/w changes in FFR & changes in rises (falls). autos rises (falls).
long-term interest rates is actually loose &
M.P changes affect economy with a time
lag, hence policy decisions don’t always a), b) & c) together increase (decrease)
have their intended affects at appropriate aggregate demand which in turn increases
times. (decreases) inflation, employment & real GDP.
Alternative M.P Strategies Drawbacks
1) McCallum Rule Fluctuations in demand for money can

⇒ cause variations in interest rates that lead
 Focuses on the rate of growth of to fluctuations in aggregate demand.
monetary base, based on QTM, (MV = PY).
 Growth rate of = long-term growth
monetary base rate of real GDP.
2) Milton Friedman Rule Fluctuations in money demand & velocity of

⇒ money can cause volatility in interest rates
Growth rate of = Rate of increase of & aggregate demand.
Ms potential real GDP.
3) Exchange Rate Rule In the long-run, the resulting inflation rate is

Keeping exchange rate fixed with an index ⇒ that of other countries over which Fed has
of foreign currencies. no control.
4) Inflation Targeting Performance of inflation targeting vs

⇒
Central Bank makes its inflation targeting based on some variant of the
expectations explicit & uses OMO & Taylor rule is still subject to debate.
manages overnight rate to bring expected
inflation into line with the target rate,
typically 2%, (with the acceptable range of
1% -3%). It is used by many countries with
exceptions of Japan & U.S.

1
“An Overview of Central Banks”

Max =Maximum
C.B = Central Bank OMO = Open Market Operations
MS = Money Supply FFR = Federal Funds Target Rate
D.R = Discount rate M.P = Monetary Policy
R.R = Reserve Requiremant %age = Percentage
i = Interest rate
Primary function of Goals of C.B  These goals are compatible in Difference in the
C.B 1. Price level stability. the long run. mandate of C.Bs of
to control a 2. Max. sustainable growth  In short run, actions taken to different countries is
country’s Ms. of real GDP. reduce inflationary pressures due to the difference
may slow down the economy in emphasis on
or even lead to a recession. promoting economic
growth.
Policy tools of the Fed
Discount rate Banks reserve requirement OMO

 The rate at which banks can borrow reserves from  %age of deposits that the  Buying or selling
the Fed. banks must retain. of Treasury
 R.R⇒ Available  ⇒ i  Securities.
Reserves Bank
 D.R ⇒ ⇒ lending is ⇒ i Funds  Fed’s most
are less
 RR ⇒ Available ⇒ i  commonly used
costly encouraged
Funds tool.
⇒ This tool works only if banks  Important in
Reserves Bank
are willing to lend & their achieving FFR.
are more lending is
 D.R ⇒ ⇒ ⇒ i customers are willing to borrow
costly discouraged
the additional funds.
Name for Interbank Inflation targeting Dual mandate of U.S. Fed

Country Overnight Loan Rate  Most common M.P goal.  U.S. Fed does not target
U.K. ⇒ Repo rate or  Usually the target is 2% annual inflation rates.
repurchase rate. inflation with an acceptable  U.S. Fed has a dual mandate
Australia ⇒ Cash rate. range of 1% to 3%. of
Canada ⇒ Overnight rate. - Full Employment.
Measures of Core Inflation - Stable Prices.
Constructed by taking some of
the most volatile components of
overall prices, such as food &
energy, out of the CPI
calculation.

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1

Study Session # 4, Reading # 13

Price elasticity of demand: ∆ in Qd due to ∆ in price.

Price Elasticity of Absolute

% ∆ Qd > % ∆ P ; A small %age ∆ in P leads

% ∆ Qd < % ∆ P; A large %age ∆ in P leads to

As P, Qd remains constant i.e., % ∆ in Qd is

Factors influencing Elasticity of Demand

Availability of Substitutes Relative Amount of Income Time Period

More Lesser More Small Proportion Long run Short run

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Cross Elasticity of Income Elasticity of

Where ‘y’ is a Where Y is income

0 < Ey < 1. Ey > 1

Total Revenue Test

As P⇒TR  ⇒ Inelastic demand

As P⇒ TR ⇒ Elastic demand

Unit elastic demand ⇒TR is max

CFA Level I Curriculum 2010, Volume II, Reading 13, Page15.

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Elasticity of Supply: ∆ in Qs due to ∆ in price.

Price Elasticity of Supply Absolute Value Causes Explanation

Available Resource Substitutions Supply Decision Time Frame

Inputs abundantly Unique or

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“Efficiency & Equity”

Methods of Resource Allocation

Allocation by market Command Majority Based on personal Other methods, such as

Efficient Allocation of Resources

Consumer Surplus (C.S) MC: Cost of producing one more

Allocative Efficiency Over production: Producing more than

Efficient allocation of resources maximizes sum of C.S & P.S.

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Price controls Taxes & Trade Restrictions

Taxes Subsidies Quotas

Monopoly External Costs External Benefits

Public goods Vs Common Resources

Ideas about the Fairness Principles

Utilitarianism Symmetry Principle

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Market Equilibrium Impact of an outside shock on the equilibrium

Short run Outside shocks Producers

Price Ceiling Price Floor Black Market

Demand & Equilibrium

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Statutory Incidence of tax Actual Incidence

Condition More burden on

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Implicit Rental Normal Profit

Economic = Total Explicit

Technology Information Market

Command Ways of Organizing Incentive

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Reducing Principal – Agent Problem

Principal – Agent problem

Four Market Types

Perfect competition Monopolistic Oligopoly Monopoly

Type of Business Organizations

Proprietors Partnership Corporation

 Single owner.  Two or more owners.  Many shareholders.

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Four Firm Concentration Ratio Herfindahl – Hirschman Index Limitations on the

 Company/firm tries to do everything itself. Market Co-ordination