Jake Does Econ 101

New Blogs For 2nd Year

2010-09-08T16:22:00.000-07:00

Hello anyone who reads these things!

Just thought I'd let you know, I'm starting some new subject blogs for the impending school year. I'm going to be making one for
-PSYC 207 (Contemporary Topics in Darwinian Approaches to Mental Health and Psychological Disorders with Dr. Wehr)
-PSYC 314 (Health Psychology with Dr. Perrino)
-PSYC 217 (Research Methods with Dr. Brenner)

If you're taking any of these classes, I encourage you to check out my subject blogs, as they may be a useful resource for studying and learning the material (it's always good to consider the same information from someone else's perspective). If you followed along with me for Econ or Sociology (two subjects which I enjoyed, but no longer have room for), I would definitely encourage you to start up your own subject blogs, either as an individual, or as a collective. I found these, personally, to be a great learning tool, as well as a great way to take on some academic leadership...

Feeling inspired?

Other than that, I just wanted to wish everyone best-of-luck for the fall session. Have an awesome year, everyone!

Exchange Rates and the BOP

2010-04-20T00:49:00.000-07:00

FINALLY: EXCHANGE RATES AND THE BALANCE OF PAYMENTS!!!!!!!!!!!!!!

Okay- final bit, and then we can all write our exams and promptly forget everything we ever needed to know about economics! =D

What is a balance of payments? It's a summary account of all the receipts and payments in and out of Canada (or any other country) in relation to the rest of the world (including payments made for both goods and investments). It clocks Canadian money moving back and forth across the border. Receipts are money going into Canada, and payments are money going out of Canada.

The balance of payments includes both current and capital accounts. Because these two accounts always balance out, the balance of payments will always be 0. You'll see why in a little bit.

SOME TERMS

A SURPLUS
-There is more money going in than out
-This is favorable
-We also call this "credit"
-More receipts than payments

A DEFICIT
-There is more money leaving than entering the country
-This is unfavorable
-We also call this a debit
-More payments than receipts

When foreign consumers buy Canadian exports, this creates a receipt (money enters Canada from the outside)
When domestic consumers buy foreign imports, this creates a payment (money leaves Canada)

OFFICIAL RESERVES
-These are holdings held by the BoC
-It includes gold, foreign exchange, and SDRs
-SDRs are special drawing rights, and they are the IMFs substitute for gold

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SO WHAT COMPOSES THE BALANCE OF PAYMENTS?

Basically, a bunch of different sub-accounts which measure trade flows

1: The Current Account (The BOP for goods)
-This encompasses exports, imports, and investment incomes
-The Trade Account is a subcategory of the current account, and it includes an account for merchandise, and an account for services. This account stacks up exports and imports and measures the difference difference
-The Capital Service Account measures the net investment income and unilateral money transfers. This measures the difference between Canadian interest and dividends on foreign bonds and investments, and Foreign interest and dividents on Canadian bonds and investments

2: The Capital Account
-This encompasses money spend on long and short term capital investments, including stocks, bonds, realty, factories and other investment devices
-Financial capital imports are A CREDIT (this may be confusing)! This is when foreigners bring money into Canada in order to purchase Canadian assets. Subsequently, financial capital exports are capital outflows: when Canadians bring money out of Canada in order to purchase foreign assets.
-Finally, the Capital account also includes the official financial account, which measures receipts and payments of Canadian dollars due to the selling and buying of foreign exchange. Selling foreign exchange constitutes a receipt of Canadian dollars, and thus counts as a receipt on the balance of payments. Essentially, the official financial account balances out the other two accounts: when Canadians buy a whole lot of foreign goods and investments, for instance, the BoC accommodates this by selling off foreign exchange for Canadian dollars (which thus counteracts the account deficit caused by other categories)
-An increase in official receipts means that the Bank of Canada is selling Canadian dollars in order to buy foreign exchange. This creates a negative balance effect (it counts as a debit on the balance sheet)
-An decrease in official receipts means that the BoC is selling foreign exchange in order to buy Canadian dollars. This creates a positive balance effect (it counts as a credit on the balance sheet)

IN SUMMARY

Current accounts = X - M + Returns to Investments
Capital Accounts = Capital in - Capital out, + Official Financing Account (which is Can$ in - Can$ out)

As you can see, the OFA always balances out all other payments and receipts, so the Balance of Payments is always 0! Sometimes, news media will talk about exchange deficits or credits, and when they are doing this, they are usually omitting the OFA.

So... if there are more exports than imports, foreigners are short of Canadian dollars, so the BoC will sell Canadian currency to foreigners (and in doing so, increase its holdings of foreign currency). This counts as a negative entry in the OFA: in this way, the BoC provides the excess Canadian money that foreigners require to buy Canadian exports.

Okay?

-The BOP always balances
-BOP balances or deficits are balanced out by the OFA
-There is nothing inherently good or bad about balances. A deficit is not necessarily bad, and a surplus is not necessarily good!

THE FLOATING EXCHANGE RATE ACTS AS AN ECONOMIC SHOCK ABSORBER!

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Okay- foreign exchange can be seen as a marketable good, just like anything else. As such, we have the FOREIGN EXCHANGE MARKET

External Value is how much domestic currency is worth in foreign terms (the foreign price of domestic currency)

Exchange Rate is how much foreign currency is worth in domestic terms (the domestic price of foreign currency)

ER = 1/EV & EV = 1/ER

Depreciation means that the external value is going down
Appreciation means that the external value is going up

What determines external value (and by association, exchange rates)???

SUPPLY AND DEMAND!!!

Remember: People supply currency in order to purchase imports or to facilitate capital exports (domestic investiture into foreign markets) and people demand currency in order to purchase domestic exports, or to facilitate capital imports (foreign investiture into domestic markets)...

Basically, supply of any currency increases as that currency becomes valued more (because high valued currencies can buy more imports, and translate into larger foreign investments), while demand for any currency shrinks as that currency appreciates (because this makes exports from that country more expensive, and capital in-flows less effective)

As such, currency prices tend to settle at an equilibrium value!

Remember, however, that demand and supply can shift here to affect the equilibrium price level!
Supply of currency will increase if
-There is heightened demand for imports
-There is heightened domestic demand for investment in foreign markets
-Domestic prices are higher than foreign prices

Demand for currency will increase if
-There is a heightened demand for exports
-There is a heightened foreign demand for investment in domestic markets
-Foreign prices are higher than domestic prices

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Surpluses, Deficits, and the EV

For surpluses, exports are higher, imports are low, demand for domestic currency is high, supply of it is low, and thus the currency appreciations

For deficits, exports are lower, imports are high, demand for domestic currency is low, supply of it is high, and this the currency depreciates

You can verify this by moving the supply and demand curves around!

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PRICES AND EXCHANGE RATES: Exchange rates facilitate the rule of one world price!

Domestic Prices = the exchange rate * Foreign Prices

And this translates into a stabilization mechanism- I'll show you!

When external value is higher, domestic prices become cheaper for international goods (due to the above formula), and as such, exports decrease, imports increase, and we are left with a BOT deficit (which brings the EV back down again)

The reverse is true for when the domestic value is lowered.

As such, the balance of trades and the exchange rate are interdependent and cyclical!

YOU SHOULD UNDERSTAND HOW THIS CYCLE WORKS

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Trade Policy

2010-04-18T12:24:00.000-07:00

This chapter looks at the policies which either facilitate or impede free trade in the world!

As economists, we usually are in favor of free trade. We recognize that free trade offers many benefits to different countries!

Why is free trade a good idea?
-The law of comparative advantage
-When there is regional specialization and trade, the world production of all products rises
-This maximizes the world's average standard of living (world GDP per capita)

On the other hand, some countries may attempt to instill protectionist policies (policies which counteract free trade in order to protect domestic firms from international competition). These can include both TARIFFS and NON TARIFF BARRIERS (NTBs, such as quotas, customs procedures, anti-dumping duties and countervailing duties).

Why might nation choose certain degrees of protectionism?

REASONS WHICH RELATE TO MAXIMIZING NATIONAL INCOME

1: To improve the terms of trade! If a country is large enough, it can force the world price downward for goods it imports by imposing a Tariff

2: Infant Industry Protection. Some countries may set up trade barriers in order to protect domestic firms from international competition, with the hopes that these industries will grow to the point where they can realize economies of scale. The idea here is that under protection, infant industries will eventually "grow up" to the point where they will be able to compete on the international market without need of protectionism. A problem with this is that not all industries develop to this level of competency while under protection. Canada's national policy of 1876 was an example of infant industry protection directed at improving Canadian manufacturing.

3: Learning by doing. This sort of goes along with infant industry protection, but along with protecting developing industries from international competitors, protectionism can also simply give those industries time to operate, which gives personnel time to gain mastery over certain procedures. In this way, countries can turn comparative disadvantages into comparative advantages.

PROBLEM! Not every industry which gets chosen for protection will ultimately grow up to be an international "winner", so each time the government placed an industry under protection, they are effectively gambling (as protectionism exacts economic costs) on their choice. If governments do this frequently, statistically, they are likely to choose more losers than winners, which would be quite costly.

=(

4: Protectionism can allow certain key industries to earn economic profits and thus innovate more. As such, Canada has strategic trade policy in place with regards to Bombardier (if you remember, they're the company which made the olympic torches)

OTHER REASONS

1: There are advantages from diversification. Countries which are only specialized in a narrow range of products may use protectionism in order to diversify their economies (which gives local firms a "safe space" to expand into new industries, thus increasing the range of products produced domestically). This can be useful in that it buffers the volatility and risk posed by price changes and new technologies by spreading production to several different sectors. The idea here is not to "put all of your eggs in one basket" (although, often, this is more of a political argument than an economic argument)

2: Protectionism lets governments protect favored groups! In Canada, competitive advantage favors skilled labour over unskilled labour, and as a result, free trade may lower the wages of unskilled laborers (who are now competing with wage slaves from overseas). Here, protectionism can redistribute income to certain productive groups, but at the expense of the collective standard of GDP. There is a deadweight loss!

USUALLY, HOWEVER, PROTECTIONISM IS FOR POLITICAL OR FALLACIOUS ECONOMIC REASONS!!!!!!!!! >=(

HERE ARE SOME FAULTY ARGUMENTS WHICH PEOPLE WILL OFTEN POSE IN ORDER TO SUPPORT PROTECTIONISM!

1: "We've got to keep our money at home"
The Premise: If I buy a domestic good, by country will have both the good AND the money used to buy that good
Why it's incorrect: Domestic money is only useful for buying domestic goods. If you are buying foreign products, the money you spend on those products eventually gets used to buy Canadian products- it flows between the two trading countries

2: "We've got to protect ourselves from low-cost foreign labour"
The Premise: Low wage foreign goods will eliminate domestic goods from the market, and thus lower the domestic standard of living.
Why it's incorrect: This goes against the law of comparative advantage. Even if a foreign country can produce all goods at a lower cost than Canada, it would still be advantageous to trade, as trade will lower the opportunity cost of having certain products.

3: "Exports are good, and imports are bad"
The Premise: Exports add to domestic GDP, while imports take away from domestic GDP
Why it's incorrect: Standard of living is dependent on consumption, not production. If a country exports a lot of goods, but derives its comparative advantage by paying its workers very low salaries, then those workers will not be able to consume very many products, on average, and thus that country's standard of living will probably be quite low.

4: "Protectionism creates local jobs"
The Premise: Protecting the domestic market can help save local jobs, and thus combat unemployment
Why it's incorrect: Protectionism reduces employment in other sectors which may have local comparative advantages, and thus, while it may increase employment in one sector, the overall economic effect is inefficient.

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METHODS OF PROTECTIONISM

TARIFFS: Import Duties- these are a tax on imports. They increase costs for domestic consumers, but benefit domestic producers (who can sell at higher than the world price) and the government (who receives tax revenue). Tariffs create a deadweight social loss for the economy as a whole.

Originally, at the world price, Canada will import 1500 units of this product, and domestic producers will supply the other 500 units needed to satisfy demand.

Once the tariff raises the prices, Canada only imports 500 units of the product, and domestic producers supply the other 1000 units needed to satisfy domestic demand (as you can see, demand has decreased due to the higher price).

Consumer lose surplus represented by sections C, D, E, & F due to the Tariff
Producers gain surplus represented by section C due to the Tariff (the increase in price times the increase in production, minus the costs incurred by increasing production)
The government gains section E due to the Tariff (the quantity of foreign imports at the Tariff price, multiplied by the amount of the Tariff)

SECTIONS D & F REPRESENT A DEADWEIGHT SOCIAL LOSS, HOWEVER! (tragic, isn't it!?)

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QUOTAS AND VOLUNTARY EXPORT RESTRICTIONS (VERs)
An import quota is like a quantity ceiling- it restricts the quantity of products which a country will import
With a voluntary export restriction, the exporter agrees to limit the amount of exports it will send to any one country.
This incurs costs for domestic consumers, but benefits domestic producers
The net result is a deadweight social loss which is greater than that which results from a Tariff!

At the world price, Canada will import Q4 - Q1, and domestic producers will supply Q1
Let's say that a quota restricts domestic imports to Q3 - Q2. If this happens, then the domestic price must rise to P1, where the quota exactly satisfies the excess demand which domestic producers cannot meet.

Consumers lose surplus equal to E, F, G, H, & I due to the quota,
Producers gain surplus equal to E due to the quota
Since there is no taxation here, the higher price on the quota goods causes foreign producers to gain surplus equal to G & H

THERE IS A DEADWEIGHT LOSS EQUAL TO SECTIONS F & I due to the quota! >=(

Usually, in trade barrier situations, exporters prefer a quota (so they can gain the extra revenue section) while importing governments prefer a tariff (so they can gain the extra revenue section).

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NON-TARIFF BARRIERS

1: Antidumping Duties
-Dumping is the practice of selling a good in a foreign country at a price below domestic prices at a reason other than costs
-This is like price discrimination (remember from micro) but on an international level
-Usually, it is only temporary, in order to sell off excess supply, or to weaken local industries and force reliance on foreign imports
-It is seen as anti-competitive, and many people believe that it is an unfair form of competition
-Antidumping duties (taxes to bring "dumped" imports back up to the domestic price level) are often used to compensate for this
-Recently, however, these have been abused and used as a non-trade barrier
-When Antidumping Duties are used, the domestic price becomes the price floor, regardless of the foreign price (which can lead to an inflexibility in domestic prices compared to the world price)
-As such, if the world price falls below the average costs for domestic producers, they are protected
-Often, the system requires foreign accusers to prove that dumping is occurring in order for antidumping duties to be instated

2: Countervailing duties: a tariff imposed as a trade remedy to counteract foreign governments subsidizing their industries
-Governments wishing to impose countervailing duties must prove that there is a foreign subsidy being used to bolster a certain foreign industry, and that it is significantly harming the prospects of domestic producers
-The U.S. is currently placing countervailing duties on Canadian softwood lumber.

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IMPORTANT ORGANIZATIONS AND TERMS

GATT- The general agreement on trades and tariffs: an effort to reduce international protectionism

The Uruguay Round- reduced tariffs by 40%, but failed to deal with European and Canadian agricultural subsidies (eventually, they ended quotas, but replaced them with Tariffs in a process called Tariffication)

WTO- World trade organization- it has 148 members, it is a global organization which deals with the rules of trade, and it endeavors to lower trade and non-trade barriers. It also includes a formal dispute settlement mechanism

Doha Round- tried to reduce agricultural subsidies

The Battle for Seattle- People protested that human, labour, and environmental rights were not being addressed by the WTO. Interestingly, 3rd world countries often argue against considering these in trade deals

MAI- Multilateral agreement on investment: similar to WTO, but for investments

Free trade Area- Goods and services may move freely among member countries, but each member nation still sets barriers against foreign imports on an individual basis (like NAFTA) PROBLEM: Certain Tariffs have grandfather clauses, and thus persist despite agreements.

Customs Union- A free trade area, but with a common set of barriers against foreign imports (like Mercosur: Brazil, Uruguay, Paraguay, and Argentina)

Common Market- A customs union in which factors of production (i.e., workers) may move freely among member nations (like the EU)

THAT'S ALMOST ALL!!!

Gains from International Trade

2010-04-17T16:26:00.000-07:00

OKAY! Let's talk turkey about international trade.

Over time, while world GDP had been increasing at a fairly constant rate, world trade has increased exponentially!

Canada is, itself, involved in quite a bit of international trade (we export and import quite a lot of goods)

David Rciardo was an economist of lore (1772-1823), and he was a major proponent of international trade. He wrote "Current comparative advantage is a major determinant of trade under free-market conditions."

Economists who advocated world trade often promoted teachings which led to real changes, such as England repealing its corn laws and moving towards a more open economy (an open economy is one which engages in international free trade, and realizes certain advantages from this, known as the gains from trade).

GAINS FROM TRADE: These are increases in total economic output due to efficiency advantages resulting from local economies engaging in specialization and trade of goods in which they have a comparative advantage.

COMPARATIVE ADVANTAGE: A situation where one local economy can produce a certain good at a lower opportunity cost than other economies (i.e., if it is less expensive for Canada to grow wheat than it is for Haiti to grow wheat, then we would state that Canada has a comparative advantage in wheat)

WHAT IS THE LOGIC BEHIND INTERNATIONAL TRADE? It's the same logic which states that interpersonal trade will be beneficial!
-When there is no trade on an interpersonal level, each individual has to be self-sufficient: they must provide for all of their own needs
-Trade allows individuals to specialize in providing goods and services which they can produce or provide efficiently, and then trade those for goods and services which they are less proficient at providing.

For an example, if I am a Doctor, I could be very very good at fixing coronary blockages, but terrible at fixing pipes. Trade means that I can simply make money by acting as a doctor, and then trade this money to "borrow" a trained plumber, thus saving me hours of frustration and reading complicated instructions. In this situation, both me and the plumber are providing the services which we are most efficient in, and because I don't have to waste time learning how to fix pipe and he doesn't have to waste time memorizing human anatomy, the overall economic output between the two of us is higher! We are more efficient when we can divide and conquer! =D

Well... interregional and international trade follows the same logic!

There are two different sources of gains from international trade:

1- The fact that different local economies have different resource endowments (and therefore can benefit from specializing in producing products which fit well with regional endowments, both natural and acquired)

2- The fact that international trade leads to a larger market for products means that local firms can realize reductions in production costs due to increased production (they are able to achieve economies of scale)

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ABSOLUTE ADVANTAGE: This is when one country (or economy), compared to another, can produce more of a good from the same inputs

So, lets say that given the same inputs...

Canada can produce 10 bushels of wheat or 6 lengths of cloth
England can produce 5 bushels of wheat or 10 lengths of cloth

Canada has an absolute advantage over England in terms of wheat, and England has an absolute advantage of Canada in terms of cloth. Here, we have a situation of reciprocal advantage (each country is more adept at producing a different good), and thus it will be advantageous for England and Canada to trade!

WHY?!

Because each unit of input which Canada switched from cloth production to wheat production leads to 6 fewer cloths, but 10 more wheat. Similarly, each unit of input which England switched from wheat production to cloth production leads to 5 fewer wheat and 10 more cloth. The net effect of this is that the world production of both wheat and cloth has increased if both the countries specialize in what they are best at producing: there are worldwide gains from specialization.

But English and Canadian consumers want to purchase both goods... so unless these countries are able to trade, this specialization would not be practical.

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THE LAW OF COMPARATIVE ADVANTAGE

Lets say that using one unit of input...

Canada can produce 100 bushels of wheat or 60 lengths of cloth
England can produce 5 units of wheat or 10 length of cloth

Here, Canada has can absolute advantage in both wheat and cloth (so Canada is more efficient at producing either of these products). Some people might think that Canada should thus not engage in trade... but they would be WRONG! Dead WRONG!

Canada can produce 20 times as much wheat at England, but only 6 times as much cloth using one unit of input. From this, we can surmise that Canada has a COMPARATIVE ADVANTAGE in wheat, while England has a comparative advantage in cloth.

Each country should trade goods in which it has a comparative advantage. Trade, in this case, increases the world's per-capita GDP. Comparative advantage is a necessary and sufficient condition for trade. Absolute advantages (in the absence of comparative advantages) do no lead to gains from trade.

How do we figure out which product a country has a comparative advantage in?

Easy! You just calculate the opportunity cost of producing any one good. Given the previous example, the OC of producing 100 bushels of wheat in Canada is 60 lengths of cloth, so the opportunity cost of each bushel of wheat is 0.6 lengths of cloth. Similarly, the OC of producing is length of cloth is 1.67 bushels of wheat for Canada. The opportunity cost for England of producing 1 length of cloth is 0.50 bushels of wheat, and the opportunity cost for England of producing 1 bushel of wheat is 2 lengths of cloth!

The opportunity cost of wheat is lower in Canada than in England, so Canada has a comparative advantage in wheat
The opportunity cost of cloth is lower in England than in Canada, so England has a comparative advantage in cloth

The point: opportunity cost depends on relative costs, no absolute costs!

WHENEVER OPPORTUNITY COSTS DIFFER, SPECIALIZATION AND TRADE CAN INCREASE THE WORLD PRODUCTION OF BOTH COMMODITIES, WHICH LEADS TO INCREASED CONSUMPTION POSSIBILITIES

*to note: increased production does not necessarily lead to increased consumption, and standard of living depends on consumption rather than production (so a country could produce a whole lot of products, but if its workers make very low factor incomes, and are hence unable to consume many goods, that country's standard of living may still be extremely low.)

ABSOLUTE ADVANTAGE DOES NOT LEAD TO GAINS FROM TRADE!

If Canada can produce 100 wheats or 60 cloths given one unit of input
and England can produce 10 wheats or 6 cloths given one unit of input

Canada has the same absolute advantage of England in terms of both products, but each country has the same opportunity costs in terms of producing each good. Because of this, specialization and trade will NOT lead to any gains for either country, nor will it increase world output of either product.

There are other reasons in addition to comparative advantage that can make it beneficial to engage in specialization and trade

Basically, whenever OC's differ for the same products between different countries, specialization (and subsequent trade) leads to an increase in net production of goods, and as a result, a decrease in costs, because of...

1: Economies of Scale- Trade creates a larger market for domestic producers (who, after international trade, provide products for consumers around the world instead of just domestically)

2: Product Differentiation- A large international market for any type of product leads to further specialization, or product differentiation. For an example, in Europe, each country specializes in intra-industry trade. Between Canada and the U.S., each country specializes in a different type of car.

3: Learning by doing- Larger international markets lead to specialization, which leads to "accumulated experience". For an example, the silicon valley area of the United States has gained a reputation for computerized innovation, and as a result of that specialization, people from that area gain experience over time, and become better-equiped to compete in that industry.

Economies of Scale = Production moves to the bottom of the LRAC
Learning by Doing = The entire LRAC shifts downward, so any level of production costs less

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SOURCES OF COMPARATIVE ADVANTAGE:

1: Natural Factor Endowments
-This is how traditional economists explained comparative advantages
-What each country is "born with"
-This includes both natural resources and climates, as well as social patterns and institutional set-ups
-This natural resource advantage translates into cost advantages (i.e., a very fertile country will not incur as many costs growing food as an arid country)

2: Acquired Comparative Advantages
-This is a newer idea: what each country DEVELOPS can lead to a comparative advantage in certain products
-For an example, social fixtures such as education, healthcare, and social services can create more productive workers
-Research and development can also lead to innovations and localized experience which gives certain nations comparative advantages in certain sectors (like Canada and aerospace engineering, or Korea and shipbuilding)

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PATTERNS OF INTERNATIONAL TRADE:

We know that countries should specialize and then trade in goods in which they have a comparative advantage.

So... do countries actually export those goods in which they have a comparative advantage? The answer is YESSSSSSS!

THE LAW OF ONE WORLD PRICE: Internationally traded goods sell at the same price, regardless of which country they are sold in, assuming
-zero transport costs
-it is actually the same good
-competitive markets
-the good is tradable

World price simply equates global supply and demand for any product to determine the equilibrium price

So.........

If one country has a comparative advantage in a certain product which would potentially lead to a lower domestic price for this product than the world price level, instead of simply selling the product at the domestic price level, that country will sell that product on the world market at the (higher) world price level: the domestic excess supply will get sold off on the international market.

THE THEORY OF COMPARATIVE ADVANTAGE IS STILL RELEVANT~!! Sources of those competitive advantages may have changed over the years, but the basic premise of this theory still holds true!

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TERMS OF TRADE: These determine how the gains from trade are shared- in other words, how will the gains in world per-capita GDP be shared among the trading nations.

The Terms of Trade = the ratio of (the price of exports / the price of imports)
OR
The relative international price of imports (how many imports can be purchased per unit of export)

If the terms of trade increase, this is favorable for the nation in question, because they are able to get more imports per export. The reverse is true if the terms of trade decrease.

Unfavorable terms of trade will not be conducive to trade! Basically, if the terms of trade make it so that the OC of obtaining imports is equal to or greater than the OC of producing a product domestically, the country in question will not trade for that product! There needs to be a win-win situation (terms of trade which allow for both countries to enjoy lowered OCs) in order to trade to occur.

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International Trade and the PPC:

When there is trade, consumption can differ from production! This means that trade can facilitate changes in production which allow for patterns of consumption which lie outside the PPC!

The slope of the dotted line = the terms of trade (tt)

Basically, given any point on the original PPC, international trade allows that country to trade products with another country at a rate which differs from that given on the PPC (which is usually convex). As you can see, if the country in the diagram specializes and trades, it can reach point B!

By specializing (changing production), countries can optimize their production in order to best take advantage of good terms of trade!

NOTE: Which country wins depends on the terms of trade (the slope of the line). Also, the consumption pattern (the point on the CPC) which each country settles into will depend on their preferences between the two products being compared.
Also, most countries have increasing OCs with increased specialization, and thus they have convex PPCs

That's all for now!

Unemployment

2010-04-14T21:55:00.000-07:00

Okay- I'm really behind in these online notes, but I'm going to catch up as much as I possibly can tonight.

Unemployment is scary stuff! Here we go!

CHANGES IN UNEMPLOYMENT:
-In the long run, increases in the labor force should be matched by changes in employment (so as the population grows, more people should get hired for more jobs)
-In the short run, changes in the labor force may not match population growth

In Canada, the supply of labour has increased because of increases in the population (probably due to immigration), an increased rate of labor force participation, and an increase in education. Demand for labor has also increased due to new technology and economic growth. In most years, new jobs are created to replace old jobs and provide new jobs for the growing labor force.

In a typical year in Canada, employment increases by 1/4 million jobs.

CHANGES IN UNEMPLOYMENT

-In Canada U was 12% in 1980, and 8% in 2008
-During booms, unemployment falls, and during recessions, unemployment rises. Doh
-In Canada, employment is rising, BUT the labor force is growing at a FASTER RATE, so in Canada, the unemployment rate has increased
-The proportion of employment in the service sector has increased (it is now about 75%)
-The proportion of employment in the goods sector has decreased

RECENT DEVELOPMENTS
-According to Naomi Klein, North America produces "brands, no products"
-A lot of labour is outsourced these days
-There is a rise in the amount of low-skill service labor these days (i.e., McJobs)
-There is greater transience in the workforce: people move from job to job more
-Schedules are crappier, and employees receive fewer benefits
-There is less company loyalty, so quality suffers (the Wal-mart greeter makes about $11,000 working full time, so you can bet your ass she's not really that happy to see you)
-The best way to operate here is to see yourself as a movable asset: "Me Inc." sell yourself and you will be happy- attach yourself to any one company and you will not be happy

What are some reasons for these negative changes?
-Low ability levels
-The entry level for better jobs has significantly increased
-Flexible hours are now the norm
-Part-time workers have less legal protection (and are thus preferred)

LABOR FLOWS
-The labor market can be seen in terms of flows in about of unemployment, rather than as a simple unemployment rate
-We should examine gross rather than net flows (because this gives us more information about the nature of the labor market)

THE EFFECTS OF UNEMPLOYMENT
-Voluntary vs. Involuntary: Technically, voluntary unemployment does not exist, as that individual has technically left the workforce.
-Not all unemployment is bad!

Unemployment: All individuals who are willing and able to work at the going rate, but are unable to find a job

When there is a great deal of involuntary unemployment, we end up with something like the great depression:
-On a small scale, this causes personal hardship and psychological suffering for those who lose their jobs
-On a large scale, this decreases national output per capita, and by association, the standard of living- there is a loss in potential output

GAP UNEMPLOYMENT

Why does it happen? It happens because there is a recessionary gap! (doh)

If Y = Y*, U =0
If Y < Y*, U > U*

Cyclical Unemployment is unemployment in exess of frictional and structural unemployment!

We could see the labour market as any other market where there is supply and demand for labour at different prices.
Demand = the willingness of firms to hire at any given wage rate
Supply = willingness of workers to work at any given wage rate
The price of labor is the real wage rate (w)

As the graph should demonstrate, labor markets are pretty flexible, because wages can shift upward and downward. With wage flexibility, real wages and employment change with economic cycles.

This graph shows that eventually, employment reaches an equilibrium! In other words, there should be no involuntary or cyclical unemployment in the long run...

There are two theories which examine gap unemployment

1: THE NEO-CLASSICAL THEORY OF LABOR MARKETS
2: THE NEO-KEYNESIAN THEORY OF LABOR MARKETS

NEO CLASSICAL LABOR MARKETS:
-We assume here that markets are flexible and that they will eventually clear
-This theory predicts that there will be no cyclical unemployment (but they're wrong! There is cyclical unemployment!)

Here's the logic: since wages are flexible, the labor market will always reach an equilibrium where the amount of labour supplied equals the labor demanded at the going wage rate. Here, no one is involuntarily unemployed, and thus, there is no cyclical unemployment. There are only people who are voluntarily unemployed (i.e., frictional and structural unemployment)

NAIRU, here, can occur due to

Exogenous demand shocks
-Changes in technology or tastes
-Changes in the demand for labour

Exogenous supply shocks
-Changes in the willingness to work
-Changes in the supply of labour

In this model, it is the NAIRU which fluctuates, since the unemployment rate is alwats the NAIRU

NOTE* Real wages ARE flexible and markets DO eventually clear, so this model isn't entirely wrong...

But there are PROBLEMS:
-According to this theory, real wages should change rapidly with the business cycle. This does not happen. Real wages remain relatively constant even as the economy fluctuates
-An unemployed person would be shocked to learn that economists veiw him or her as "voluntarily" unemployed
-This model seems to show that there is no need for stabilization policy, but in reality, we know that there IS!

thankfully, we have...

NEO-KEYNESIAN LABOUR MARKETS (aka, how they actually work)
-Here, labour markets are inflexible and do not clear... at least not in the short run
-This is because of STICKY WAGES! The wage rate does not change fast enough to equate the supply and demand of labour (because wages are not perfectly flexible), as a result, we get unemployment in slumps, and labour shortages in booms.
-Only when the supply and demand of labour are equal is there no involuntary unemployment: it is here that the market clears!

IN A SLUMP:
-Demand for labor decreases
-Wages want to fall to their new equilibrium level
-But wages stick at a higher level than the equilibrium
-So there is excess supply of labour, and thus unemployment

IN A BOOM:
-Demand for labor increases
-Wages want to rise to a new equilibrium level
-But wages will not immediately increase to that new equilibrium level: it takes time for that to happen
-In the meantime, there will be excess demand, and therefore a labor shortage

We know that wages are much more likely to be "sticky downward" (they take longer to fall than to rise). Why is this?

-Long-term employment contracts: workers and employers respond to other factors like job security by creating long term contracts: here, wages are planned over the long-term and are thus insulated from short term fluctuations. The fringe benefits of these contractual agreements can be mutually beneficial, as they give employees long term stability, and ensure employers that they will have trained employees invested in the company over a longer period of time

-Menu costs: Changing wages in any way invokes administrative costs

-Efficiency wages: this is when employers pay employees higher wages than the equilibrium wage necessary to hire them, because they believe that the higher wages will act as a motivator, and cause workers to become more efficient

-Unions: unions negotiate on behalf of workers who are already embedded in the workforce, and thus often make it difficult to negotiate for higher wages

-Psychological factors: people find it psychologically difficult to give up wages (even if the price level is dropping, so real wages are effectively still the same)

OKAY!

In summary, Neo-Keynesians assume that markets may not clear, and thus there CAN be involuntary unemployment

NOW LET'S BRING THESE TWO THEORIES TOGETHER!

In the short run, the Neo-Keynesian are correct: sticky wages can create excess supply or demand of labour... HOWEVER, all of the factors which contribute to sticky wages will not persist in the long run, so eventually, the labour market DOES clear, and wage flexibility eliminates involuntary unemployment. Thus, in the long run, both Classical and Keynesian theories predict that unemployment will be at U*

(The only differences is that for classical economists, there is no short run- that time frame is not taken into account)

LET'S COMPARE THESE TWO THEORIES ONE LAST TIME

NEO-CLASSICAL:
-Wages are flexible, so the labour market will always clear
-U is always at U* and there is no gap unemployment (no involuntary unemployment)
-Aggregate demand shocks will have no effect on unemployment, because aggregate supply reacts

NEO-KEYNESIAN:
-Wages are sticky, and markets will not clear immediately
-U is not always at U*, so there can be gap unemployment (involuntary unemployment)
-Aggregate supply and demand shocks cause gaps

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The Non-Accelerating-Inflationary-Rate of Unemployment (NAIRU)

There are 2 components to NAIRU: Frictional and Structural Unemployment

FRICTIONAL UNEMPLOYMENT (Job turnover, or search unemployment)
-This refers to the length of time it takes someone to either find their first job or a new job

STRUCTURAL UNEMPLOYMENT (Mismatching of supply and demand of labour)
-It can be supply-side (ie: a worker's skills are needed in an economy, but in a different city, persay)
-It can be demand-side (ie: there are jobs available, but they require more training than the current workforce has accumulated)

WHAT'S THE DIFFERENCE BETWEEN THE TWO?
-Structural Unemployment may just be long run frictional unemployment
-Both are similar in that the number of unfilled jobs is equal to the number of people looking for work

NAIRU = The Non-Accelerating-Inflationary-Rate of Unemployment
-This is the rate on unemployment when inflation does not accelerate
-In other words, this is the normal, or natural rate of unemployment
-Here, we only have frictional and structural unemployment
-There is no cyclical unemployment at U*
-But "there is always some unemployment at full employment"
-This is the rate of unemployment when the supply and demand of labour are equal
-This is the rate of unemployment at Y*, or Yfe

NEWSFLASH: NAIRU can change over time! How does this happen???

1: Demographic Changes
-Baby boomers and shadow baby boomers, for example, entered the labour market and created a larger flow of voluntary unemployment, thus increasing NAIRU
-Historically, increased female participation in the workforce (where females historically have had a higher unemployment rate than men) will increase NAIRU
-Immigration may affect this as well

2: Labour Market Flexibility
-The speed at which wages adjust to supply and demand changes is slowing down over time
-It is more costly for firms to hire new workers these days, and due to unions and legal issues, it often takes them a longer amount of time to commit to hiring or laying off workers
-Unions and the psychology of concessions also play a role here

3: Government Policy
-Any government policy that reduces labour market flexibility will increase the NAIRU
-EI decreases search costs (the opportunity cost of searching for a new job) and will therefore increase average job search times, thus contributing more to NAIRU
-Severance Pay increases the cost of firing a worker, but at the same time, also makes companies less willing to hire new workers in the first place (its a higher risk, so firms must be more discerning)

4: Globalization and Technological Changes
-Rightsizing, restructuring, retooling, and rationalizing, global competition, and freer trade have increased structural unemployment, many would argue (mature industrial nations such as Canada are expected to provide high level services and technology, while countries with cheaper labour are expected to provide lower level manufacturing and production, but this can often lead to a mismatch between available worker skills and desired potential employee assets)

5: Hysteresis (A lagged effect)
-This theory suggests that the future NAIRU is a function of the current actual rate of unemployment
-This is seen more in European countries with an insider-outsider model to the workforce: in these countries, people who are already employed use their insider power to keep outsiders out
-Recessions prevent on-the-job training and thus reduce the amount of "learning by doing" which can occur, and as a result, when a recession is over, the group of people who would otherwise have gained skills due to simply being employed are left without employable skills, and may thus continue to struggle to find employment

----------------------
MEASURING NAIRU

OKUN's LAW!!!!!!!!!!!!!!!!!!!!!!!!!!

A 1% Change in the cyclical unemployment rate is associated with a 2% change in the recessionary gap!

So... if the economy goes into a recession and is producing output at 12% below its potential level, than we know that cyclical unemployment has risen by 6%. Similarly, if cyclical unemployment were in increase by 3%, we could predict that output would decrease to 6% below Y*

HOW TO ESTIMATE NAIRU: You need to know Y*, the current output level, and the actual unemployment rate

1: Find Y* (potential output level)
2: Calculate the recessionary gap as a percentage of Y*: (Y-Y*)/Y* multiplied by 100
3: Take 1/2 of the recessionary gap you just calculated. This is the cyclical unemployment rate
4: Subtract the cyclical unemployment rate from the actual unemployment rate. The difference is the normal U-rate, or NAIRU!

=D

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WHAT ARE SOME WAYS THAT WE COULD REDUCE UNEMPLOYMENT?

Reducing Frictional Unemployment:
-Here, the goal is to decrease turnover time
-Governments could create giant posting boards to match potential employers with potential workers (i.e., Canada Manpower, workopolis, craigslist)

Reducing Structural Unemployment
-The goal here is to make the supply and demand of labour match
-Government initiatives to retrain and relocate workers can help here
-Eliminating resistance to change (i.e., tariffs and subsidies) can help, as these instruments perpetuate the status quo, and may deter people from getting the skills needed to operate in the new global labor market (i.e., if a tariff is supporting a failing industry, then that tariff is also going to deter people employed in that industry from getting the retraining they require to become employed once that industry inevitably topples)
-Aiding change is key here

Reducing Cyclical Unemployment
-The goal here is to bring Y back to Y* by increasing aggregate demand
-This accomplished using fiscal and monetary policy
-YAY! Gap-busting! =D =D

That's all for unemployment. I hope all of you who read this are successful at avoiding summer employment....

More Irritating Details About Inflation

2010-03-27T15:57:00.001-07:00

The Phillips Curve & Accelerating Inflation

-We know what the Phillips curve is. I'm not explaining it again.
-At Y* and U*, there is no gap inflation
-When the economy is in an inflationary gap, the BoC must validate for wage inflation
-In the 1960s, the level of wage and price adjustment began to rise for any level of output (the whole phillips curve shifted to the right)
-Why? Because the original phillips curve included only gap inflation and ignored expectation inflation (which impacts wage changes, obviously)
-This newly-shifted phillips curve is called the expectations-augmented phillips curve. There is still an inverse relation between the unemployment rate and the rate of changes of nominal wages, but with the effect of expectation inflation built into the model.
-Expectation inflation is graphically represented by the height of the phillips curve above the X axis at U*

Using this new phillips curve, we can see than when there is gap inflation, and when there are expectations adding to inflation, the curve shifts up at Y*: expected inflation increases for all levels of inflation, and thus, inflation can accelerate.

THERE IS NOT A STABLE TRADEOFF BETWEEN INFLATION AND OUTPUT. TO MAINTAIN Y @ LEVELS GREATER THAN Y*, INFLATION MUST ACCELERATE.

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Is inflation a monetary phenomenon? Was Milton Friedman correct when he said "Inflation is everywhere, and always a monetary problem"?

Does inflation have purely monetary consequences? What about its consequences- are they purely monetary?

Well... inflation on its own can be caused by either an increase in AD or a decrease in A. However, unless monetary validation is continuous, inflation will only be temporary. As such inflation is not necessarily caused by monetary issues, but continuous inflation IS.

The consequences of inflation:
1: Short run gap inflation caused by output being higher than Y*
2: Short run supply inflation caused by Y being less than Y*
3: In the long run, output will always eventually return to Y*, so inflation will only cause a change in the price level.

so... SUSTAINED inflation is everywhere, and is always a monetary problem.

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REDUCING INFLATION: The process of disinflation

Accelerating Inflation is inflation. There is a positive change in the price level.
Constant Inflation is inflation. There is a positive change in the price level.
Decelerating Inflation is disinflation. There is a positive change in the price level, but at a decreasing rate.
Stopped Inflation is zero inflation. There is no change in the price level.
Reverse Inflation is deflation. There is a negative change in the price level.

How do we reduce constant inflation from occurring at Y*??? by STOPPING EXPECTATIONS
How do we reduce accelerating inflation? By NO LONGER VALIDATING CHANGES IN THE ECONOMY

both of these measures may cause short-term economic pain (recessionary gaps cause unemployment, which is both depressing for individuals, and unproductive for economies in general). However, this will eliminate sustained accelerating inflation.

But is this a good thing?

There is often questions over whether the benefits of reducing inflation outweigh the costs.

How it works:
1: remove monetary validation to eliminate the inflationary gap (which allow the SRAS to return GDP to Y*)
2: stagflation: the SRAS decreases to the point where it actually overshoots Y* due to the intensity of wage momentum. As a result, there will be a period of rising unemployment accompanied by inflation
3: recovery: wage adjustments can bring SRAS back to Y* the slow way, or the BoC can use expansionary monetary policy to bring it there faster (at the cost in inflation)

The cost of disinflation:
-Disinflation is caused by a recessionary gap
-The cost of disinflation is equal to the loss of output caused by the required recessionary gap.

The SACRIFICE RATIO is the cumulative loss of output as a percentage of potential output divided by the percentage reduction in the inflation rate.

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THE COSTS OF INFLATION: Why is this bad, again?

1: Unanticipated Inflation
-Affected the distribution of income (redistributes income from creditors to debtors)
-Wage contracts: redistributes income from employers to employees if inflation is less than expected, and vice versa if inflation is higher than expected
-Pension contracts: redistributes income away from pensioners (although this can be solved by indexing pensions for inflation)

1970s: Trudeau indexed public pensions, and they have remained indexed as thus until..
1980s: Mulroney de-indexed tax brackets
2000: Chretian fully indexed tax brackets

Low versus Moderate Inflation: BC advocates low inflation
-The price signal distortion hypothesis suggests that inflation interferes with the information conveyed by price changes. As a result, market participants can have a difficult time distinguishing absolute prices from relative prices. This extra confusions created by inflation reduces market efficiency
-In PLANNING DISRUPTION, inflation interferes with retirement plans and long term contracts

With moderate inflation...
-The downward nominal wage rigidity hypothesis claims that low levels if inflation reduce economic efficiency, because real wage cuts will require nominal wage cuts, which will be resisted. Basically, if inflation is zero, a 2% cut in real wages required a 2% cut in nominal wages: workers will resist a drop in their nominal wages. However, if inflation were high enough, nominal wages could simply be maintained to the effect of reducing real wages, and this is met with much less resistance. In this way, this theory suggests that high inflation facilitates more efficient economies, because it makes it easier for employers to "trick" their employees into accepting real wage cuts.

The zero bound on nominal interest rates hypothesis claims that the BoC cannot run expansionary money policy.

AS A GENERAL RULE, healthy economies have moderate inflation (this is caused naturally by economic growth and increases in aggregate demand).

High and accelerating inflation leads to prediction problems, and arbitrary redistribution of income. It may also lead to hyperinflation. Politics, however, is usually the entity to blame for these problems.

HYPERINFLATION: This is associated with low economic growth. Why? Because hyperinflation increases transaction costs (ie: menus must be changed constantly, and holding money for transactions is risky, because that money's purchasing power can rapidly decrease)

DISINFLATION: Governments can try to use wage or price controls, but usually this doesn't work.
-Two recessions in Canada have been caused by the government of Canada attempting to slow the rate of disinflation. As such, the costs of disinflation probably outweigh the benefits unless inflation is getting seriously out of control.

DEFLATION: Like disinflation, is not a good idea.

THAT'S ALL

Demand Shocks and Accelerating Inflation

2010-03-27T14:27:00.000-07:00

INFLATIONARY DEMAND SHOCKS AND INFLATION
-An increase in consumption, investment, government expenditures, and net exports causes an increase in aggregate expenditure, a rightward shift in aggregate demand, and an increase in the equilibrium price level.

IF THE GOVERNMENT DOES NOT VALIDATE INFLATION CAUSED BY AN ISOLATED DEMAND SHOCK
Aggregate demand will shift to the right as a result of this demand shock. Y is now greater than Y*, and thus we have an inflationary gap. however, wages adjust: excess demand for labour increases wages, which in turn increases firm costs. As a result, short run aggregate supply shifts to the left, and output returns to its original level, but at a higher price level. This is one-shot inflation. The price level is now at a higher equilibrium level, but since the demand shock is isolated, inflation will not be sustained.

IF THE GOVERNMENT DOES VALIDATE INFLATION CAUSED BY ISOLATED DEMAND SHOCKS
Aggregate demand will shift to the right as a result of this supply shock. In response to this, SRAS shifts to the left due to wage adjustment. However, if the government tries to validate this change in supply by increasing the money supply (which lowers interest rates, and ultimately shifts AD to the right), this puts NEW INFLATIONARY PRESSURES on an economy: basically, the natural chain and anchor mechanism is fighting against government policy here, and the result is sustained inflation within an inflationary gap. The SRAS want to return output to Y*, but the government continues to artificially increase AD through monetary policy. As both AD and SRAS continue to shift right and left, respectively, the price level will continuously climb. =(

------------------------------------------------------------------------------

WHAT ABOUT ACCELERATING INFLATION?
-We know that in most cases, demand shocks cause wage adjustment, and that if governments are not crafty, they may follow this up with monetary validation. If we look at this graphically, we can say that the inflation rate (the change in the price level divided by the original price level) could be graphically represented by the vertical distance between the original price point and the new price point.
-When AD and AS both shift up, the inflationary gap will persist.
-Graphically, we know that inflation is accelerating if the arrow between the price points gets longer and longer.

SO... two questions we need to answer are:

1) What creates persistent inflation (what causes inflation to hang around, instead of being a one-off)?

The answer: Validation

and

2) When is the inflation at a constant rate, and when is it at an accelerating rate (what causes inflation to get worse and worse)?

The answer: Expectations

ACCELERATION HYPOTHESIS
-If the economy is running an inflationary gap caused by either increased aggregate demand (for an example, demand resulting from China's increased demand for raw materials) or increased aggregate supply (for an example, increase supply due to lower world prices of raw materials)...
-AND if the central bank wants to maintain the "good time" (aka: it uses monetary policy to validate this inflationary gap, and tries to keep the gap from being closed)...
-THEN, inflation will persist, and be accelerating.

In summary, if the BoC maintains a constant inflationary gap, then the actual inflation rate will persist and accelerate (the economy will continue to inflate at progressively larger rates over time).

WHY?

1) EXPECTATION EFFECTS (remember, actual inflation is a combined result of gap inflation, expectation inflation, and supply shock inflation)
-An increase in aggregate demand causes an inflationary gap, and as we know, this ultimately causes prices to rise due to the wage change mechanism
-As a result, expectations are formed: workers demand that their wages rise at a similar rate over the next year to account for predicted inflation (for an example, let's say that they expect inflation to be 2%, then they will demand a 2% wage increase).
-If the BoC adds inflationary pressures by maintaining the gap, then this will create extra gap inflation of 2%, which stacks on top of the expectation inflation for a combined actual 4% rate of inflation.
-This overall 4% rate of inflation informs new expectations for the next year: workers will demand 4% wage increases, and those new expectation pressures stack onto persistent gap inflation for a total of 6% total inflation over the next year
-This continues on for quite a while, generating an inflationary spiral.

AS LONG AS THE BoC VALIDATES THE GAP, EXPECTATIONS ARE ALWAYS BEING REVISED UPWARDS (worker expect higher and higher inflation, and demand higher and higher wage increases). People come to expect this inflation, and build it into their wage demands.

2) MORE RAPID MONETARY VALIDATION IS REQUIRED
-If the BoC wants to maintain output above Y*, it has to increase the rate of growth in the money supply.
-This is because the inflation rate is accelerating, and therefore, to accommodate for increase transaction demands due to higher prices, the BoC must accelerate the growth of money (basically, it must print a larger and larger quantity of money each year)
-This validation becomes more and more dramatic as time goes on

Let's summarize what we know!

We have an isolated shock ---> There will be no gap in the long run
We have have a repeated AS shock ---> There will be a persistent gap
We have a repeated AD shock ---> There will be a persistent gap

At Y*, persistent inflation will consist of only expectation inflation
With a Gap, there will be accelerating inflation, due to the gap inflation on top of expectation inflation

Cost push inflation from Y* lead to a recessionary gap
Demand pull inflation from Y* leads to an inflationary gap

AGAIN: Is monetary validation a good idea?
Yes, because monetary validation can eliminate recessions more quickly than simply letting "nature take its course"
No, because it causes inflation

Additionally, as we now know, monetary validation can create expected inflation to increase over time, creating a wage-price spiral. Some economists argue that the disadvantages of these increased expectations could be avoided if the BoC never validated gaps in the first place!

Inflation and Supply Shocks

2010-03-27T14:26:00.000-07:00

FROM WAGE CHANGES TO PRICE CHANGES
-If a change in money wages is positive (wages increase), short run aggregate supply will decrease (it shifts to the left due to increased costs). This causes prices to rise, and the overall effect is inflationary
-If an change in money wages is negative (wages decrease), short run aggregate supply will increase (it shifts to the right due to lowered costs). This causes prices to fall, and the overall effect is deflationary.

Wages up --> Costs up ---> SRAS shifts left --> Equilibrium price level rises

Okay... so so far, we've talked about two causes of inflation: gap effects and worker expectations. There is, however, a third cause of inflationary pressures: AN EXOGENOUS SUPPLY SHOCK (for an example, a change in the price of raw materials, such as oil, can increase the general price level, which is why vegetables can start to cost more when the price of oil goes up).

SOOO

ACTUAL INFLATION IS A COMBINATION OF:
1: GAP INFLATION
2: EXPECTATION INFLATION
3: SUPPLY SHCOK INFLATION (even though that's a bit of an afterthought)

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Next, we're going to talk about the difference between sustained/constant inflation and accelerating inflation.

CONSTANT/SUSTAINED INFLATION
-Here, we assume that there is no supply shock, and no output gaps
-As such, the ONLY cause for inflation when there is sustained inflation, is expectations
-This kind of inflation occurs when Y is equal to Y*

Let's summarize: constant inflation occurs when...
-There is no gap inflation
-There is no supply shock inflation
-Monetary growth is equal to the rate that wages increase at
-Actual inflation is equal to expected inflation

HOW IT WORKS:
1: Worker expectations trigger constant inflation (expectations cause workers to demand higher wages, which then causes SRAS to shift to the left)
2: The BoC validates the price increase by increase the money supply

SO.... let's say that we start off with expectation inflation at 2%. Workers anticipate future increases of 2% in the price level, so they demand higher wages, which causes SRAS to shift to the left as money wages rise. When the government validates this increase, they increase the money supply, which shifts SRAD to the right. Because of the way that this mechanism works, the price level will rise at the exact same rate as is predicted (because expectations are what catalyze the change). Actual inflation is equal to expected inflation, and output remains at Y*. THIS IS CONTINUOUS INFLATION AT A CONSTANT RATE.

NOTE* This isn't expansionary monetary policy- the BoC is not reducing the overnight target rate here- interest rates aren't affect by this. The BoC is merely accommodating for the growing demand for money by steadily increasing the nominal money supply. As such, the real money supply remains constant (so the ratio of money in the economy and the average price of products remains the same).

INFLATIONARY SUPPLY SHOCKS (negative supply shocks which temporarily inflate prices)
-Remember, in all cases of inflation, the price level rises to a new equilibrium level. In temporary inflationary situations, the price will simply remain at the new level, whereas in cases of persistent inflation, the equilibrium price level will continue to rise.

Inflationary supply shocks are caused by increased cost of productive inputs (for an example, an increase in the price of oil). This, in turn, causes costs to rise, which shifts SRAS to the left, and increases the price level while decreasing output.

BUT... as we know from previous chapters, this change is NOT permanent. Eventually, the higher unemployment which accompanies the supply-shock-recession puts downward pressures on wages, eventually causing them to fall. As a result of these wage-related cost savings to firms, the short run aggregate supply will shift back to its original level: costs will be the same as they once were, even though workers are being paid less. As SRAS shifts to the right, the price level and output level both shift back to what they were originally. SO, WE CAN CONCLUDE THAT INFLATIONARY SUPPLY SHOCKS ONLY CAUSE INFLATION IN THE SHORT RUN, AND THAT THERE IS NO SUSTAINED INFLATION HERE.

OKAY.. BUT WHAT HAPPENS WHEN WE HAVE AN ISOLATED SUPPLY SHOCK WHICH IS MONETARILY VALIDATED BY THE BoC?
Well, we start out at macroeconomic equilibrium, and then we shift SRAS to the left. This increases the price level and decreases the output level. After this, if the government tries to correct this recessionary gap by increasing the money supply (the money supply increases, which lowers interest rates, which increases investment and net exports, which drives aggregate expenditure up and shifts aggregate demand to the right), aggregate demand will shift to the right, which will bring output back to its equilibrium level, but at a higher general price level. As such, there will be more inflation than if the government does not intervene, but prices will still settle at the new equilibrium level, and inflation will not be persistant.

OKAY... BUT WHAT HAPPENS WHEN WE HAVE REPEATED SUPPLY SHOCKS WITHOUT MONETARY VALIDATION?
For an example, lets say we have cost push inflation, which occurs due to repeated increases in firms' costs. What happens then? Well, either the economy will stabilize at a higher price level and a smaller output level, OR persistent unemployment will erode the power of unions, causing monetary wages to fall, and bringing short run aggregate supply back to its original levels.

OKAY... BUT WHAT HAPPENS WHEN WE HAVE REPEATED SUPPLY SHOCKS WHICH ARE VALIDATED BY THE GOVERNMENT?
Well, then economies can enter into an inflationary spiral. For an example, if unions consistently negotiate to increase their monetary wages, and the government consistently validates this decrease in SRAS by printing more money, then an economy will experience consistent inflation (albeit, often the wage increases are very small, so inflation persists at a small but constant level). Basically, monetary validation reinforces price increases and offsets the natural tendency of Ye to return to Y* on its own, hence sustained inflation.

So.... is monetary validation of supply shocks desirable or undesirable? Yes and No!

No, because the BoC should allow for unemployment, which will eventually eliminate the output gap through the natural chain and anchor process.
Yes, because nations can avoid severe (albeit temporary) recessions by using monetary validation (although this comes at the cost of creating higher prices)

So its sort of a dilemma: governments must choose between long stretches of unemployment (no validating) or inflation (validating).

What is STAGFLATION? Stagflation is when supply shocks and monetary validating occur simultaneously, which leads to a NEGATIVE COMBINATION OF INFLATION AND UNEMPLOYMENT

Persistent Recessionary Gaps + Persistent Inflation: Continous SRAS shocks continue to push SRAS to the left, while continuous validation continues to push AD to the right. The overall effect on the output level is neutral, so the original recessionary gap is never closed. At the same time, both supply shocks and monetary validation continuously push up the price level, so the equilibrium price level will continuously rise while the economy remains in a recession. =(

The Gap Effect, and the Expectation Effect

2010-03-27T14:25:00.001-07:00

THE WONDERFUL WORLD OF INFLATION:

People talk about inflation a LOT, so its probably a good idea know what it is. If you've survived macroeconomics without knowing what inflation is up until this point, congratulations, you live a seriously charmed life.

For the rest of us, lets reiterate:

Inflation is any rise in the general price level (P)

Inflation can be temporary/transitory (the price level increases to a new equilibrium price level, where it stays put for a while) or it can be sustained/persistant (the price level rises continuously over time)

In classical economics, aggregate demand shocks and aggregate supply shocks cause TEMPORARY inflation (one-time jumps in the price level) as a side effect of gap inflation. In this chapter, we are more concerned with exploring the causes of sustained inflation (which, as we will learn, is affected by people's expectations). We're also going to look at what causes accelerating inflation.

On a very basic level, prices can rise for two different reasons
1) There is a decrease in supply (this is called cost-push inflation)
2) There is an increase in demand (this is called demand-pull inflation)

HERE IS A LIST OF TERRIBLY IMPORTANT DEFINITIONS WHICH WE SHOULD ALL PROBABLY LEARN IF WE WANT TO DO WELL IN MACROECONOMICS:
Inflation - A rise in the consumer price index
Inflation Rate - The percentage change in the consumer price index
Zero Inflation - A situation where there is no percentage change in the consumer price index
Stable Inflation - A situation where the inflation rate remains relatively constant over time (ie: inflation is 2% for seven years in a row)
Accelerating Inflation - The inflation rate increases over time (ie: inflation is 2% in 1991, 4% in 1992, 8% in 1993, and 13% in 1994)
Disinflation - The inflation rate decrease over time (ie: inflation is 16% in 1991, 9% in 1992, 5% in 1993, and 3% in 1994)
Deflation - A negative rate of inflation: the consumer price index goes down (so goods end up costing less)

Low inflation: 1-3%
Medium inflation: 3-6%
High inflation: Over 6%
Hyperinflation: Over 20%

Why are we concerned with inflation? Because too much inflation inflicts a bunch of costs on society. Here are some of them:
-It decreases the purchasing power of people who are on fixed incomes (both contractually and in terms of pensionary incomes)
-It can arbitrarily redistribute income
-It undermines the efficiency of the price system by distorting relative prices (so its harder for consumers to tell if they are getting a good deal or if they are getting ripped off if the general price level is continuously in flux)

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One last important concept is NAIRU, which is the non-accelerating inflationary rate of unemployment. Basically, this is the rate of unemployment present in an economy when there are no inflationary or recessionary gaps (when Y is at Y*). This does not mean that there is no unemployment- only that there is no GAP unemployment (there can still be frictional and structural unemployment). NAIRU is also sometimes called "full employment," or U*.

We're going to look at why NAIRU is called NAIRU in this chapter

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INFLATION AND WAGE CHANGES:

Okay... why do people's wages change?

There are two factors which can explain why people's wages change
1) The gap effect
2) The expectation effect

THE GAP EFFECT
-Basically, this is demand-pull inflation caused by excess demand in the labour market.
-In an inflationary gap, we get GAP INFLATION. Y is larger than Y*, U is smaller than U*, and there is an excess demand for labour. As a result, firms are forced to raise wages in order to keep employees. The result of this rise in wages is that average costs rise (which, in turn, causes the short run aggregate supply to shift to the left, correcting the inflationary gap).
-In a recessionary gap, we get GAP DEFLATION. Y is smaller than Y*, U is greater than U*, and there is an excess supply of labour. As a result, firms can safely lower employee wages without the risk of losing employees (its better to have a low-paying job than no job at all). This, in turn, causes average costs to fall, which shifts short run aggregate supply to the right, correcting the inflationary gap.
-When there is no gap, there is NO INFLATION. Y equals Y*, U equal U*, demand and supply of labour are equal, wages remain constant, average costs remain constant, and the short run aggregate supply remains constant (as do prices).

The Phillips Curve shows the inverse relation between the unemployment rate and the rate of changes in nominal wages.

Basically, as unemployment gets higher, wage increases get smaller and smaller, and eventually, turn into wage decreases (salary cuts).

Classical economists ONLY considered the gap effect to be a source of inflation, and believed that gaps would only create a temporary period of inflation. They also believed that if there was no gap, that there would be no increase in wages...

They were entirely correct... there is also...

THE EXPECTATION EFFECT
-Here, expected inflation is taken into account when employees are negotiating wage demands with their employers
-Here, inflation is like a "self fulfilling prophecy". If employees believe that there will be inflation of a certain level over the next year, they will negotiate for higher wages to account for that inflation. This, in turn, increases firms' average costs, which shifts the SRAD curve to the left, effecting CAUSING an increase in prices in-step with what employees predicted. In other words, preemptively adjusting wages for expected inflation can MANUFACTURE real inflation!

Causes of expectation inflation:
-Expectation inflation can be caused by backward-looking, where people assume that past rates in inflation will continue into the future (people believe that history repeats itself)
-At the same time, if an economy has an extremely volatile inflation rate, it may take time for people to develop a psychological trend to respond to inflation- it takes a while to figure out how the pattern works and predict accurately for the future.
-Expectation inflation can also be forward-looking. Workers could look at governments' macroeconomic policies to predict what future changes may be in store (they can prognosticate).
-The main thing to remember is that in economics, we assume that people are RATIONAL BEINGS with their own best interests at heart. People try to use all available information to the best of their ability, and for the most part, they are correct. People can adjust rapidly to changes.

The TOTAL EFFECT: Changes in money wages are a combination of the gap effect and the expectation effect
-In this way, we can decompose an increase in the rate of wage changes into the gap effect (excess demand for labour) and the expectation effect (psychology)
-We can think of the expectation effect as the "cake" and the gap effect as the "icing", which causes increased wages changes on top of expected changes
-The total effect can be either positive or negative.

Monetary Policy in Canada

2010-03-17T19:03:00.000-07:00

This is the last piece of the puzzle! This chapter is all about how the government of Canada uses policy instruments to change the money supply!

The central bank can set the money supply and let the market determine the interest rate

OR

The central bank can set the interest rate and the money supply will adjust to this interest rate

PROBLEMS WITH ADJUSTING THE MONEY SUPPLY DIRECTLY:
-The Bank of Canada (BoC) cannot directly control the money supply through the currency ratio and the reserve ratio (they can't control minds and make banks hold more or less assets and make people hold more or less money)
-Also, it's sometimes confusing as to which definition of the money supply should be used: H? M1? M2? Know know...

SO, the BoC sets the interest rate instead, and then accommodates for fluctuations and changes by using open market operations. (The US directly changes the money supply by printing more or less money, while Canada simply changes the bank rate)

There are 5 Different Policy Instruments The BoC Uses:
1: The Overnight Target Rate (Which is changes by changing the Bank Rate)
2: Buyback Operations (Specials and Reverses)
3: Shifting Government of Canada Accounts
4: Moral Suasion
5: The Announcement Effect

NOTE** It's important to know the difference between operational targets: usually, governments can only target one factor, so they have to choose between targeting

a) The Exchange Rate (from 1962-1970, Canada targeted the exchange rate and tried to keep its external value at 92.5)
b) The Interest Rate/Money Supply (from 1975-1982, the BoC would adjust interest rates to affect the money supply through the liquidity preference system. The problem was that interest rates became extremely volatile, and the government had no way of controlling the price level)
c) The Inflation Rate (the BoC uses interest rates and money supply as a policy instrument to affect the inflation rate, so the operational target is currently PRICES. The BoC tries to keep inflation at about 2%, because a little bit of inflation is healthy

Policy Variables: These are the ultimate targets for policy changes
Y - stable economic growth
U - low unemployment
P - Low Inflation !!! THIS IS THE PRESENT GOAL OF THE BoC

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THE 5 POLICY INSTRUMENTS

1: THE OVERNIGHT RATE

Note* the interest rates on borrowing increase as the term of the loan grows longer (as a compensation for leaving money inaccessible for a longer amount of time)

The Overnight Rate: This is the daily interest rate which chartered banks charge each other for borrowing money (or that investment dealers charge to banks for borrowing money) in cases where they have insufficient funds to clear cheques. These loans have a very short maturity (the term is extremely short) and the interest rates are MARKET DRIVEN

The BoC is the LENDER OF LAST RESORT

The Bank Rate is the rate which the BoC charges to lend to money to chartered banks. This is the upper limit of the overnight rate. Because the bank rate is so high, most chartered banks will not borrow from the bank of Canada unless all other sources refuse to loan them money

The Overnight Rate Operational Band: This is the difference between the highest overnight rate (the bank rate) and the lowest overnight rate (the rate the BoC pays to borrow for depoits)
-It is measured in basis points (each basis point is worth 0.01%, so an operational band of 50 basis points would mean a difference of 0.5% between the highest and lowest overnight rates)

Overnight Rate Target: the midpoint of the operational band for overnight rates, as set by the BoC
-THIS is the policy instrument used by the BoC to affect the interest rate
-There are fixed announcement dates: the BoC announces the overnight rate target 8 times per year

The USA uses a slightly different system...

OKAY: so basically, the bank rate is FIXED by the BoC
-Money's liquidity (the demand for money) is given
-The BoC accommodates the money supply to ensure equilibrium in the money market
-The money supply is thus endogenous, and becomes determined from the interest rates and the demand for money!

1: BoC increases the overnight rate (i goes up)
2: Banks increase their target reserves to buffer against this higher opportunity cost of borrowing from the BoC
3: The money supply decreases (because the reserve ratio is higher)
4: The market interest rate goes up!

This is a long-about way of showing how the market interest rate (which includes the prime rate, the 5-year mortgage rate, and commercial lines of credit) is related to the overnight interest rate!

NOTE* A change in the overnight rate target and other market interest rates usually happens very quickly BUT the demand for loans changes gradually (so the first step of the overall transmission mechanism is much faster than then subsequent steps)

As the demand for money changes, the BoC accommodates by using open market operations!

2: BUYBACK OPERATIONS (INCLUDING OPEN MARKET OPERATIONS)
-The BoC Uses Specials and Reverses to stabilize the overnight rate inside the operational band
-Buyback operations are used to fine-tune the overnight rate target within one basis point of the target

SPECIALS (Specials purchase and resale agreement):
-This is a transaction in which the BoC offers to purchase government of Canada securities from major financial players with an agreement to sell them back at a predetermined price the next business day
-This allows the BoC to put money into the system for one day
-This OFFSETS UPWARD PRESSURES on the overnight rate (by adding a bit to the money supply, the BoC decreases the interest rate a little bit)
-The BoC initiates SPRAs daily if overnight funds are generally trading above the target rate
-Differences between the purchase and the sale price determines the overnight rate

REVERSES (Sale and repurchase agreement)
-This is a transaction in which the BoC offers to SELL government securities to major financial parties with an agreement to buy them back at predetermined prices the next business day (this sale is called a reverse)
-Basically, this let's the BoC take cash out of the system for a day (by coaxing investors to temporarily store wealth in bonds instead of money)
-Reverses are used to offset downward pressures on the overnight rate
-The BoC initiates reverses daily if overnight funds are generally trading below the target rate

OPEN MARKET OPERATIONS (OMO): LONG RUN MONETARY ACCOMMODATION
-An OMO is the purchase/sale of government securities by the BoC in the open market for long run monetary accommodation
-Government securities are long run loans to the government
-Treasury bills are short term loans to the government
-These are auctioned off every Thursday, just like stocks, in a market

The BoC BUYS securities to increase excess reserves and attempt to increase the money supply
The BoC SELLS securities to decrease excess reserves and attempt to decrease the money supply

This analysis assumes that there are no cash drains, and that the reserve ratio remains constant in the long run (neither of which may be true)

3: SHIFTING GOVERNMENT OF CANADA DEPOSITS

Cash Management: The Bank of Canada shifts Government of Canada deposits to and from the Bank of Canada and the chartered banks. This is the major day-to-day instrument which the BoC uses to reinforce overnight rate targets within the operational band

Transferring money to a chartered bank increases their reserves, which allows the chartered bank to safely lend out more money, thus increasing the money supply
Transferring money from a chartered bank back to the BoC decreases chartered banks' reserves, which forces the chartered bank to lend out a smaller proportion of money, thus decreasing the money supply

4: MORAL SUASION

-The BoC enlists the cooperation of commercial banks
-This is possible because there is such a small number of banks in Canada
-Since there are not required reserves in Canada (required reserves are not legislated), this tool is more important
-For an example, the BoC may require an increase in settlement balances held at the BoC

5: THE ANNOUNCEMENT EFFECT

-There are fixed announcement dates where the BoC announces the bank rate (8 times per year)
-Like moral suasion, an increase in the bank rate sends a signal to the economy of the government's intentions, which can affect private investment (due to changed expectations)

CONCLUSION: The BoC fixes the overnight rate target, then uses buyback operations and shifting to reinforce it and open market operation to accommodate the demand for money in the long run

1: Policy instruments: The BoC sets the bank rate
2: The Money Market which defines reserves determines the money supply and the equilibrium interest rate
3: Transmission to real sector through the investment and net export effects

GAPBUSTING GUIDE

TO FIX A RECESSIONARY GAP (CREATE EASY MONEY)
-Decrease the target rate
-Increase the money supply
-Decrease interest rates
-Increase Investment and net exports
-Increase Aggregate Demand
-Y moves to the right, back to Y*

TO FIX AN INFLATIONARY GAP (TIGHTEN MONEY)
-Increase the target rate
-Decrease the money supply
-Increase interest
-Decrease investment and net exports
-Decrease aggregate demand
-Y moves left to Y*

The Transmission Mechanism

2010-03-17T18:11:00.000-07:00

So... what happens when the money supply changes? How does this affect things? That's what we're going to figure out today!

Remember the marginal efficiency of investment function?

There are two reasons why interest rates and desire for investment are negatively related
-lower interest rates mean that there is a lower opportunity cost for investing (it costs less to borrow money)
-when interest rates are lower, investing in capital becomes more attractive than keeping money in bonds (so if buying a new mixmaster will have a 4% yield, my friend the baker is much more likely to buy one when an equivalently-priced bond would only give him a 2% yield)
-Investment is determined by the REAL interest rate: for simplicity's sake, just assume that there is no inflation in this model for now

SO: There is an investment transmission mechanism

Let's do this in steps

1: The government changes the money supply (we'll learn how in the next little while)
2: The change in the money supply, thanks to the way the money market works, causes interest rates to fall (this is liquidity preference theory)
3: Lower interest rates cause investment to increase (this is marginal efficiency of investment theory)
4: Increased investment causes the family of aggregate expenditure curves for this economy to shift up
5: A shift up in aggregate expenditure causes aggregate demand to shift to the right, indicating an increasing in GDP, a decrease in unemployment, and an increase in the price level

BE SURE THAT YOU CAN REPRESENT EACH OF THESE STEPS GRAPHICALLY! If you have any questions about that, just send me an email and I will spell it out for you! =D

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THERE IS ALSO AN EXCHANGE RATE TRANSMISSION EFFECT:

In open economies, consumers are not restricted to buying domestic bonds- they can also buy bonds sold by foreign governments. Thus, when the interest rate falls for one country in comparison with other countries, this makes that particular country's bonds less attractive for investors (if China's interest rate is 25% and Canada's is 4%, why the hell would you put your money in Canadian bonds [assuming the Chinese bonds were relative risk-free]). As a result, when domestic interest rates fall, investors tend to pull money OUT of the domestic economy and into foreign economies. This DEVALUES domestic currencies.

We know that when domestic currencies are devalued, this makes it more attractive for foreign economies to import domestic goods, and less attractive for local consumers to import foreign goods (for price-related reasons). Thus, net exports increases. This leads to an increase in aggregate expenditure, and subsequently, an rightward shift in the aggregate demand curve!

SO! There are 2 different pathways through which changes in the money supply can affect aggregate demand in an economy (and by association, Y, U, and P)

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THE LONG RUN NEUTRALITY OF MONEY

Classical economists divided the economy into real and monetary sectors: they believed that changes in the money supply only affected the price level, but would not impact GDP in the long run
MV = PY where V and Y are constant (money has a constant velocity, and GDP tends to return to its potential leve in the long run)

Modern economist now understand that in the short run, changes in the money supply CAN impact GDP through the monetary transmission mechanism. At the same time, they state that in the long run, the "anchor and chain" mechanism will bring GDP back to its potential level (through wage adjustment)

Pretend this graph indicated that the increase in AD was due to an increase in the money supply. In the long run, inflationary pressures cause wages to increase, which effectively raises costs for firms. This shifts aggregate supply to the left until the real GDP is back at Y*, but at a higher price level

Hysteresis: some economists debate that Y* can be affected by short run trends in Y, not just factors and productivity (for an example, a long-lasting recessionary gap may cause worker skills to depreciate, thus bringing productivity down, and consequently lowering potential GDP as well)

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SOME OTHER COOL THINGS
-Changes in the money supply cause larger changes in the interest rate when the money-demand curve is STEEP
-Changes in the interest rate cause larger changes in investment when the MEI curve is very FLAT

MONETARISTS: believe that the LPF is steep and the MEI is flat- they think that monetary changes can cause LARGE changes in GDP and price levels
KEYNESIANS: believe that the LPF is very flat and that the MEI is very steep- they think that monetary changes are much less effective than fiscal changes in affecting GDP and the price level

That's all for now. Only one more bit to cover for the midterm! =D

The Demand & Supply for Money

2010-03-17T17:26:00.000-07:00

The Liquidity Preference Function: This shows people's preference to hold money (cash balances) rather than bonds (interest bearing assets)

-People have a choice between holding their wealth in one of two ways: bonds or money
-Money pays no returns, and bonds do pay a return
-The opportunity cost of holding money is the interest rate one earns on a bond
-People only want to hold money when it provides benefits which at least equal the cost of forgoing bond interest

3 REASONS WHY PEOPLE HOLD MONEY

1: TRANSACTION DEMANDS FOR MONEY
-People hold money so that they can make transactions

2: PRECAUTIONARY DEMAND FOR MONEY:
-People hold money in case they experience an emergency where money would is required
-There is uncertainty sometimes about the timing of receipts and payments, so it can be strategic to have a buffer of cash savings to "tide yourself over"

3: SPECULATIVE DEMAND FOR MONEY:
-People hold money because they believe it will be more strategic to buy bonds in the near future than in the immediate present (if the interest rate is really low, for interest, waiting for the interest raise to rise before buying bonds will be more financially strategic)

The transaction and precautionary demands for money account for the distance between the money demand curve and the Y-axis. When the demand for money shifts to the left or right, this is usually due to a change in transaction demands (for an example, if GDP increases or prices increase, consumers will have higher transaction demands)

The speculative demand for money explains why the liquidity preference curve is downward sloping: the opportunity cost of holding money increases as interest rates increase, so the higher the interest rates, the lower the demand for money (this is dependent on nominal interest rates, rather than real interest rates, as this is a PSYCHOLOGICAL, rather than an accounting effect)

Income, Prices, and The Nominal Interest Rate Affect Demand for Money!

The higher income is, the more transactions there are within an economy, so the higher demand for money will be
+ Positive Relation

The higher the nominal interest rate, the lower the demand for money will be, for reasons related to opportunity cost
- Negative Relation

The higher the price level is, the higher demand for money will be (this is called inflationary demand for money), because a greater monetary value of transaction will be required to facilitate the same amount of real spending: households need more money to carry out their transactions.
+ Positive Relation

Note* when interest rates are very very very high, the only demand for money is transaction demands (so this is the space between the liquidity preference function's asymptote and the Y axis)

THE SUPPLY OF MONEY

-The money multiplier is relatively constant
-The currency ration and and reserve ratio only change during times of uncertainty (usually, they both increase when the future is murky)
-The money supply is independent from the interest rate (although it affects the interest rate)
-In our model, we say that the money supply is a constant, and that it is perfectly inelastic: it is represented by a straight line on our graph
-The real money supply is M/P: this describes money's purchasing power in terms of goods and services

PUTTING SUPPLY AND DEMAND TOGETHER: MONETARY EQUILIBRIUM
(This is also called liquidity preference theory of interest, or the portfolio balance theory)
-This is a short run analysis of how interest rates are affected by the money supply- it is very different than the long run analysis we talked about earlier

Okay: So..
-The supply of money is perfectly inelastic (a vertical line)
-The demand for money varies inversely with the interest rate (it is a downward sloping curve)

Equilibrium occurs when demand and supply for money intersect: M = L

Notice that because the demand for money is downward sloping, the money supply affects equilibrium interest rates: a higher money supply renders lower interest rates, while a lower money supply renders higher interest rates

Monetary equilibrium is a stable equilibrium: if there is higher demand for money than money supplied, then a large number of people will begin to sell-off their bonds to generate some extra money. Because of an excess influx of bonds being sold on the market, the price of bonds will fall, while their relative yields will increase. This, in turn, causes the interest rate to rise, and it will rise until the money market is in equilibrium. A similar mechanism returns interest rates to an equilibrium level when there is an excess supply of money.

That's all for now!

Bonds!

2010-03-06T11:09:00.001-08:00

TODAY: WE ARE GOING TO LEARNING ABOUT THE MONEY MARKET: This basically let's us understand how the money supply determines the interest rate

BONDS: What are bonds...

Well... Wealth is accumulated purchasing power, and wealth can be held in assets, or "things which you own" -This includes both money and "interest bearing assets"

Any household's financial portfolio includes a combination of money and interest bearing assets- choosing a different investment plan is just a matter of deciding how much of your wealth you wish to hold as money, and how much of it you wish to hold as an asset

Money has no risk of lost value (other than inflation), but also does not give you any returns as an investment

Interest bearing assets include bonds (IOUs from companies or the government), stocks (shares of control of a company) and other things (like real estate). They contain an element of risk, in that they can decrease in value over time and cause you to lose money, but on the other hand, they can generate returns (so you can profit off of investing of interest bearing assets if they increase in value)

TO SIMPLIFY OUR MODEL (for now) WE'RE GOING TO ASSUME THAT THERE ARE ONLY TWO KINDS OF ASSETS: MONEY & BONDS!

So.... Here's a chart

Money: Cash in circulation, as well as deposits held in checking accounts: it has no risk, and generates no returns
Bonds: All other forms of interest bearing assets: it has risk, but can also generate returns
Debt: An interest-earning financial asset: this is a synonym for a bond: when you are a creditor, loaning money to a company, you are effectively buying a debt. There is some risk involved (because there is a chance that the company will go bankrupt and be unable to pay back the loan), but there is also a guaranteed rate of return, as determined by the bond agreement.
Equity: Claims on real capital: This describes stocks, which are a "gift" to companies. Companies may pay dividends to stockholders, but there is no guarantee of this.

BOND TERMINOLOGY: This is dense, awful stuff, so get ready

A BOND: A financial contract to pay fixed amounts at future specified dates, and to repay the principal (a loan agreement or a debt are both synonyms for bonds)
A DEBTOR: A borrower, or someone who sells bonds
A CREDITOR: A lender, or someone who buys bonds
THE INTIAL PRICE OF THE BOND: The original loan value or face value of the bond (ie: the principal)
A COUPON: The dollar value of the fixed returns on the bond
THE COUPON YIELD: Coupon / Initial Price (so, if the bond was valued at $100, and the coupon was $10 for a one-year loan, the coupon yield would be 10%, because 10/100 = 0.10

Initial Price * Coupon Yield = Coupon
100 * 10% = $10 Coupon!

PRICE OF THE BOND (Pb): Originally, this is the face value, or principal of the bond, BUT once the bond is sold, it is the present value of the bond in the market (so the price of the bond can change depending on market conditions)
PRESENT VALUE (PV): A discounted value of all future expected income streams using the MARKET RATE OF INTEREST (the discount rate). The price of the bond which a buyer is willing to pay to receive a future income stream provided by a bond
BOND YIELD: How much money you will make off of the bond- this is determined by a combination of the coupon, plus capital gain (as bonds are a form of asset, and can gain value depending on market conditions)
MARKET YIELD (i): The 'average' interest rate in all money-bearing assets currently in a market: the time-sensative value of money (in other words, the minimum rate on interest which you would impose on debtors to loan them money)
TERM (t): The time it takes to completely pay off a bond (principal and coupons)
JUNK BOND: A riskier, high-yield bond (BBB)

Basic ideas:
-The Present Value is equal to the Price of the Bond, which is equal to the face value of the bond at the time of issuance if the market rate of interest is equal to the coupon yield (which it usually is), because the present value, if you use the market rate, will be the face value
-The Present Value is equal to the Price of the Bond, which is equal to Face Value of the bond at maturity, because the bond has no return at that point: just principal
-As a lender, returns higher than those for the market rate are desirable

Note*

There are 3 yields (or rates of return, or interest rates)
-The coupon yield (which is guaranteed, according to the bond agreement)
-The bond yield (which can change depending on market conditions)
The market yield (which is the interest rate of money-bearing assets currently in a market): generally, coupon yields for bonds are set at the market rate for the time when they are issued

demand for money is a function of the NOMINAL rate of interest

Three cases where bonds are sold
Case 1: The bond is price "at par"
Case 2: The bond is sold at a discount (it is worth less in the market than it's face value, so it is sold for less than its face value
Case 3: The bond is sold at a premium (it is worth more in the market than it's face value, so it is sold for more than its face value)

Interest rates affect the present market value of bonds.

The price of bonds varies inversely with interest rates!
R = return one year hence
i = annual market rate of interest (sometimes called the discount rate)
PV = Present value

PV = R/(1 + i)

PV = R/(1 + i)-exponent t (where t is the number of years in the future)

So if the return on a bond one year hence is $110, and the interest rate is 3%, then
PV = 110/(1.03)
PV = $106.80

If the return on a bond is $120 in two years and the interest rate is 10%, then
PV = 120/(1.10)^2
PV = $99.17

The price of a bond is the present value of that future income stream
-The buyer will not pay more than PV for the bond, and the seller will not sell it for less than PV
-The higher the interest rate, the lower the present value of the bond, and vice versa, in order to keep the coupon yield equal to the market interest rate. Basically, we just always fiddle with the present value to make the bond yield equal to the market interest rate (or simply "the" interest rate)

Pb * Bond Yield = Coupon

On most bonds, only the coupon yield is constant.

So, with a given face value, or original bond price of $100, and an original market interest rate of 10%, the issuer of the bond (the borrower) will offer a coupon of $10, or a coupon rate of 10% to compete in the market. This means that the coupon will be $10

Coupon yield = Coupon/Face Value
10/100 = 0.10 = 10%
Bond Yield = The market rate of interest, so there is no capital gain initially...

BUT

let's say that the market interest rate jumps to 20%

The present value of the bond falls to around $60
The price of the bond falls to around $60
-The bond yield (including the present value of future payments + capital gain as the bond approaches maturity) rises to market interest rates of 20%

That's all for today!

MONEY MONEY MONEY

2010-03-04T14:57:00.000-08:00

Money Money Money!

THE NATURE OF MONEY

-Classical economists arbitrarily divided economies into the real sector, and the monetary sector.
-The REAL SECTOR describes the allocation of resources to produce different goods
-Resource allocation (use of factors) is dependent on relative prices
-Relative prices affect output (so if wood is cheaper than brick, an economy will produce more wood houses than brick houses

-The MONETARY SECTOR encompasses changes in the money supply (how much money is circulating in an economy)
-Most economists believe that a change in the money supply would just change the absolute price level in the long run
-If relative prices do not change (ie: the price of both wood and brick rises proportionately), then this will not change the allocation resources
-This shows the NEUTRALITY OF MONEY (A change in the money supply can change the macroeconomic price level, but it will not change relative prices, or GDP)
-The amount of money circulating in an economy affects ABSOLUTE prices, but not relative prices (so while the price of wood will go up, so will the price of bricks, and consequently, the price of houses)

-In modern economic theories, money supply has no long run effect on GDP (it only affects the price level)
-In the short run, however, money supply can affect both price level and GDP

This is the exchange identity: MV = PY : The velocity of money (the size of the money supply multiplied by the amount of times money is used in an economy) is equal to the general price level multiplied by real output. In other words, what you give up (the amount of many people spend to get things) is equal to what you get (the value of the real goods produced by an economy)

THE DEFINITION OF MONEY: 3 ESSENTIAL CHARACTERISTICS

1: Money is a medium of exchange
-Barter requires the "double coincidence of wants" (you have to want what I have, and I have to want what you have)
-Because such situations rarely occur, money is an excellent "in-between" medium-of-exchange for facilitating trade

There are stipulations, however!
1: Money only works as a medium of exchange if people expect that others will accept their money as a legitimate form of payment
2: Money should have a generally high value relative to its weight (or else it will be awkward to exchange: can you imagine if sand or dirt were money, for instance!)
3: It must be divisible (you can divide a dollar in half. You cannot divide a live cow in half)
4: It must not be counterfeit-able (which explains the elaborate construction of dollar-bills)

2: Money is a method of storing wealth
-Earning and spending are not synchronized (ie: you may work on a Monday, but not wish to buy anything until a Saturday)
-Money has stable value which does not diminish over time
-It is a method of deferred payment (this is sometimes cited as the 4th role of money)

3: Money is a unit of account, or financial measurement
-We use money as a unit of measurement: we measure different transactions using dollars, thus it is a sort of accounting unit which facilitates accounting.

NOTE* Demand deposits (aka: deposits into an easily-accessible checking account) count as money, as they satisfy all of these conditions!

THE ORIGINS OF MONEY

1: Commodity Money
-Money was originally precious metals, such as gold
-These were generally recognized as valuable and accepted as payment in most places- they did not wear away or lose value over time, and they had a stable value

Problems:
-Originally, these metals were carried in bulk, so they would have to be weighed, and then stamped by a ruler, guaranteeing the weight of "face value"
-Clipping and shaving
-debasement led to inflation and Quantity Theory of Money

Gresham's Law:
-Bad money forces good money out of the system
-People will hang on to money with high intrinsic value (because it is a very good method for storing wealth)

2: Token Money
-To overcome the problems associated with commodity money, would was deposited at a goldsmith's vault for safekeeping. The goldsmith would give owners a receipt, and this receipt of ownership of the gold was exchanged, rather than the gold itself. Eventually, banks replaced goldsmiths, performing a similar function
-Bank notes were paper money, which were FULLY BACKED by gold (ie: convertible on demand)
-A country whose money is fully backed by gold is on the gold standard

3: Fractionally Backed Money
-Banks discovered that while some customers withdraw gold, and some customers deposit gold, most of their customers are simply trading indirectly using bank notes
-Thus, banks could issue more notes convertible to gold than they actually have gold in their vaults as reserves, and then charge interest on this lent money to generate profits.
-The fraction of money held in reserve affects the money supply: the higher the amount held in reserve, the lower the money supply (because money held in banks cannot be in circulation)

4: Fiat Money: Legal Tender
-Here, the state promises that a certain form of paper or coin currency is legally money, so it becomes money
-Over time, central banks took control of the note issuance: while it was originally backed by gold, it is now only fractionally backed
-Ultimately most of the money we deal with on a day to day basis is not backed by gold at all (for instance, if we went to the neighborhood bank, deposited a cheque, and asked for gold, the teller would probably think we were very strange)
-Most countries abandoned the gold standard by 1940 (WW2)

Legal Tender: The law requires that this be accepted to repay debts- refusal discharges debt.
-Fiat money is backed by the productive capacity of an economy
-Fiat money is valuable because it can purchase goods and pay debts (today's money is fiat money)

5: Bank Deposits (Modern Money)
-Money held by the public in the form of deposits withdrawn on demand from banks (no notice is required)
-(Checks and debit cards, however, are not considered money)
-Bank deposits function on a fractional reserve system: banks create money by granting more loans than deposits to cover them (so if a run on the banks were to occur, the banks would not actually have enough money on hand to pay everyone back.

THE CANADIAN BANKING SYSTEM:

Canada (and many other countries) has a central bank which controls the money supply (the bank of Canada, which a run by a "governor" of the bank of Canada)
-Although the Bank is owned and operated by the government, it operates separately from the cabinet on a day to day basis: it is ultimately held responsible the cabinet, however.

In Canada, our current governor of the Bank of Canada is Mike Carney (Monetary Policy) and our current minister of finance is Jim Flaherty (Fiscal Policy)

THE FUNCTIONS OF THE BANK OF CANDA

1: It is the Bankers' Bank
-It is a lender of last resort to Chartered Banks (they can lend money from the BoC if they have to)
-Chartered Banks have their checking accounts at the Bank of Canada (reserves)
-As of 2002, about $1.2 billion was actually held in asset form at the bank of Canada

2: It is the government's bank
-The government has a chequing account at the BoC
-The government replenishes this account from larger accounts at Chartered Banks
-The BoC's monetary tool is "switching" the location of government accounts (between the BoC and Chartered Banks)

3: It regulates the money supply
-It prints money (this is only done as a reaction in Canada)

4: It regulates financial markets
-It prevents panic and bank failures
-Financial intermediaries (chartered and commercial banks) borrow short term and loan long term from the BoC, so increases in the bank rate squeezes them, and makes the "overnight market" less attractive: basically the higher the BoC sets the bank rate, the higher Chartered Banks will set their prime rate in order to continue to profit, and the more money they will hold in reserve to avoid getting "dinged" with interest for borrowing from the government should a customer seek to withdraw money
-The BoC is concerned about the exchange rate

So, the money supply involves the government, central banks, and chartered banks

The Canadian System

Canada- few banks with many branches (the banking sector is much more like an oligopoly)
USA- many banks with fewer branches (the banking sector is much more like monopolistic competition)
The systems are a bit different, but they essentially function the same way

COMMERCIAL BANKS: Includes chartered banks (formed prior to 1980), smaller banks trusts and credit unions, and foreign banks
A commercial bank is a profit-maximizing private corporation

Chartered Banks
-They hold deposits (trust companies also do this)
-They transfer deposits by cheque (the post office also does this)
-They make loans (credit unions also do this)
-They invest in government securities (insurance companies also do this)
-The government used to require the chartered banks to old money on reserve, but this is no longer required after reforms to the Bank Act (1980)

Interbank Cooperation
-Several Banks can make pooled loans to large companies (which they all benefit from due to the interest paid)
-Charted Banks must now compete against credit card companies
-Debit Cards
-Cheque clearing distinguishes chartered banks (they will turn cheques into money!)
-A clearing house settles interbanks debts: the net difference is accomplished by change in deposits at the bank of Canada

Chartered Banks are Profit-Maximizing Private Corporations:
-Their main asset is securities and loans
-Their main liability is deposits
-They make profits by borrowing money for less than they lend it for
-Competition is strong among different banks, which leads to competitive rates, which is good for consumers

The Big 5:
Royal
Toronto Dominion
Scotia
CIBC
BMO

Note* Our prof usually refers to chartered and commercial banks interchangeably

RESERVES
-Their purpose is to meet demands on deposits for chartered banks
-A RUN ON THE BANKS is when more depositors wish to withdraw more deposits than there are reserves

WAYS TO AVOID A RUN ON THE BANKS:

1: Reserves- the BoC can induce an INCREASE in reserves and avert a run on the banks by
-Loaning money directly to chartered banks
or
-Open Market Operations: buying securities from Chartered Banks

2: The Canadian Deposit Insurance Coporation
-A Federal Crown Corporation
-Insures deposits in any one account up to $100,000
-A problem is that this insurance is an incentive for banks to pursue riskier investment options "if this investment makes us money, the depositor wins- if it loses us money, then the taxpayer loses"

TYPES OF RESERVES:
1: A Reserve Ratio is the chartered bank's fraction of deposit liability held in Cash of BoC deposits

Actual reserves = reserves the Chartered Bank actually holds
Target reserves = reserves a Chartered Bank wishes to hold
Excess reserves = reserves a Charted Bank holds above target
Secondary reserves = liquid assets convertible to cash (ie: T-bills, and government bonds)

The old bank act required banks to hold reserves for stability and confidence in the system, and to regulate the money supply

Competition from intermediaries and international banks who were not required to hold reserves lead to the elimination of required reserves. Now, the BoC uses the "overnight target rate" (how much interest it charges target rates on overnight loans) to regulate reserves and control the money supply

Presently, actual reserves are about 0.5% of total Chartered Banks liabilities (so we are using a fractional reserve system)

THE FRACTIONAL RESERVE SYSTEM

The reserve ratio is much much less than 1, at about 0.5% of total liabilities. Chartered banks only hold a small portion of deposits on reserve, and the BoC will bail them out if reserves are too low to meet demands on deposits.

The Cost for chartered Banks of borrowing from the BoC (the Bank rate, or the "overnight rate") determines how much reserves banks will hold. An increase in the cost of borrowing will induce the Chartered Banks to hold more reserves

BANK RATE INCREASES ---> BANKS HOLD MORE IN RESERVES
BANK RATE DECREASES ---> BANKS HOLD LESS IN RESERVES

Target reserve ratios are now determined independently by Chartered Banks, but there is incentive for them to still hold some reserves on hand, in order to avoid losing money: the Bank rate determines the opportunity cost of the risk of loaning out more than is on reserve for Chartered Banks.

The Creation of Money!

Assume:
-There is a fixed reserve ratio
-There are no leakages or cash drains (this implies that a change in the money supply will manifest as a change in deposits)

2 Conditions are required for Banks to Make Money

1: The Public must be willing to use bank deposits as money

currency ratio = (public cash holdings/public bank deposits) or C/D

2: banks must be willing to use the fractional reserve system

reserve ratio = (reserve assets/deposit liabilities) or R/D

If the currency ratio is equal to 1, then there is no banking system
If the reserve ratio is equal to 1, there is no creation of money (there is just safety deposit boxes)

The Creation of Deposit Money

Assume:
-cr = 0 (all of the cash is deposited in banks)
-rr = 0.20 (banks loan out 80% of their deposits)

The creation of money is possible due to the fractional reserve system

Changes in the money supply are equal to deposits or withdrawals / The reserve ratio

The currency ratio acts as a cash drain, or leakage. The uncertainty of the banking system increases the currency ratio and decreases the multiple expansion of the money supply (the more cash people hold onto instead of converting into a bank deposit, the smaller the change in the money supply due to banks loaning out money)- we saw this sort of thing happen in 2008 with the US financial meltdown- people lost faith in the banks and wanted their money back, so the money supply in the United States suddenly decreased.

On the other hand, deposits are very convenient (thanks to debit cards), which decreases the currency ratio

High Powered Money (H) is "cash": a combination of cash held on reserve by banks, and cash in circulation within the public.
H = rr * D + cr * D

THE MONEY MULTIPLIER

Money Supply = M

M = D + C (bank deposits + money in circulation)

But, C = cr * D

so

M = (1 + cr)D

H = R + C

R = rr * D and C = cr * D

Therefore, H = (rr + cr)D

The money multiplier = Changes in M/Changes in H
= (1 + cr)/(rr + cr)

If the currency ratio = 0, then the money multiplier = 1/rr

If banks want to hold more money (the reserve ratio increases) or if the public wants to hold more cash (the currency ratio increases), then the money multiplier gets smaller: basically, the more loanable money which is held in banks, the higher the multiplier effect for money!

AN EXAMPLE OF THE MONEY MULTIPLIER

Assume:
-A constant reserve ration of 0.20
-cr = 0

Person 1 deposits $100 in the bank.
The bank loans out $80 to person 2
Person 2 deposits $80 in another bank
The bank loans out $64 to person 3
Etc...

With each transaction, the money supply increases by a decreasing amount (it works similarly to the expenditure multiplier effect)
So, let's do the math: 100 * the money multiplier = 100 *(1/0.20) = 500!

Monetary Base (H) = C + R - this is the amount of cash in an economy
Money Supply (M) = C + D - This is the amount of money in an economy (because not all money is cash!)

Variable reserve ratios make the the money multiplier equation complicated, but it still works

Cash Drains: Money creation is not automatic- it depends on public and bank behaviors
Public: Uncertainty causes the cr to increase, which makes it harder to create new money
Bank: Uncertainty causes the rr to increase, which makes it harder to create new money

TYPES OF DEPOSITS

Demand Deposit
-Can be withdrawn on demand (no notice required)
-Money can be transfered via cheque

Savings Deposit
-Notice of withdrawal required
-Non-transferable by cheque

Term Deposit
-Chequable savings accounts are now available, so the old distinction isn't as useful
-Today, "term deposit" distinguishes "notice accounts" from other accounts
-A deposit must be left in the account for a term: if withdrawn early, there is a reduced interest rate on that money (so the depositor gets less bang for their buck)

Definitions of the money supply
H = High Powered Money, or cash in public and cash in reserves
M1B = Cash in public + Demand Deposits (this emphasizes the exchange medium function of money)
M2 = M1B + savings deposits at chartered banks (emphasize money's wealth storage function)
M2+ = M2 + Deposits at other intermediaries, including credit unions, trust companies, insurance companies, and MMFs
M2++ = M2+ and all other mutual finds + Canada Savings Bonds

The BoC uses M2's to control inflation.

Near Money and Money Substitutes

There is debate over the definition of the money supply: if a medium of exchange is important, than M1B should define the money supply. If a storage of wealth is important, than deposits that pay higher returns but are not chequable (ie: the M2 series) should count as part of the money supply

Near Money is not a good medium of exchange, but it IS a good store of wealth (like Savings Bongs, Mutual Funds, and Money held in trust accounts)
Money Substitutes are good methods of exchange, but not good methods of storing wealth (like credit cards and debit cards)

Whew. That's all!

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GROWTH ACCOUNTING

It is generally believed that labour accounts for about 2/3 of all income generated, and that capital accounts for approximately 1/3 of national income

as such, percentage-growth in potential national income is = to the percentage change in the level of technology + 2/3 * the percentage change in labour + 1/3 * the percentage change in capital

MEASURING TECHNOLOGICAL CHANGE

-It is impossible to directly measure technological change. Solow tried, and got a Nobel Prize.

-The Solow growth model included only 3 independent varaibles: labour, capital, and "other"

-This "other" is the "Solow Residual" or "Total Factor Productivity" or "A" (in our model). It captures all growth in GDP which is not accounted for by changed in N (L and H) and K.

-BIG PROBLEM HERE: Solow's model included both the quantity and quality of labour and capital, and a great deal of technological change is EMBODIED with labour or capital (so technology factors into labour or capital, and cannot always be separated them from). For instance, if one of my shitty sweat-shop sewing machines breaks down and I decide to replace it with an uber-fast, ultra-modern sewing machine, the capital stock will remain the same for my sweatshop, but the technology level has increased.

-As such, the Solow residual underestimates true technical change (as it can only include disembodied technological changes)

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The Cobb-Douglas Aggregate Production Function is an example of an aggregate production function with 2 characteristics
-The law of diminishing marginal utility
-Constant returns to scale

For this APF, Y = A * N(2/3) * K(1/3)

Here, equal growth rates in labour and capital cause total GDP to grow at the same rate (as it would in a steady state)

y = A * k(1/3)

This is the per-capita APF, where y is per-capita GDP, and k is the capital-labour ratio
Equal growth rates in both labour and capital (ie: a constant k) cause y (per capita GDP) to remain constant

SO: BIG QUESTION: HOW DO WE ALLOW FOR GROWTH?

1: Increase savings (let per capita savings become larger)- in order for growth to occur, the economy requires sufficient savings to increase the capital stock faster than the population growth.

If you are in the Robert Gateman club of not-breeding, choosing NOT to personally contribute to population growth can also help economies grow here...

2: Increase technology: This requires infrastructural developments (health, education, law, physiological needs such as food and water taken care of), and many such developments are difficult for developing nations to set up.

WHY IS TECHNOLOGICAL CHANGE IMPORTANT?

Technological improvements lead to increased productivity, which increases the potential per-capita GDP

Embodied Technical Change = technical change intrinsic to the particular human or unit of physical capital in use: it is a change in the quality of the input (so a higher education, or a computer upgrade would both be examples of embodied technical changes)

Disembodied Technical Change = technical change that is NOT intrinsic to human or physical capital in use. This is a change other than to the quality of the capital (so if my sweat-shop fore-woman comes up with a fantastic new sewing procedure which halves the time it takes her to sew a sneakers, and then she teaches all of her sweat-shop buddies how to sew like this, that new technique would be an example of a disembodied technical change)

Usually, disembodied changes eventually become embodied, so the distinction becomes less important over the long run.

CONVERGENCE HYPOTHESIS: This an interesting theory, and there are 2 different facets of it

1: Absolute Convergence: the tendency for GDP AND Growth Rates in GDP to be equal across nations: each nation will have the same steady state values for y* and k*
-This assumes that different countries have the same marginal propensity to save, the same rate of population growth, and the same rate of technological improvement
-This theory states that if two countries have the same growth model, then even if one starts farther to the left, they will both end up with the same standard of living

2: Conditional Convergence: the tendency for Growth Rates in GDP to be equal across nations: each nation will have the same steady state values.
-This theory assumes different marginal propensities to save for different nations, different population growth rates, and different technological growth rates
-This theory acknowledges that different countries will have different per-capita GDP, but states that they will have THE SAME GROWTH RATES!

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NEW GROWTH MODELS

The Neoclassical Growth Model made growth dependent on exogenous variables such as population growth, the savings rate, and the rate of technological change.

Some new growth theories alter the 2 assumptions of the Neoclassical Model:
-Instead of technology as exogenous, they state that technological changes can be explained within the economic model
-Instead of having diminishing marginal returns, some new growth models suggest that the marginal product of capital is constant, or that there is even increasing marginal product of capital over time!

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ENDOGENOUS TECHNOLOGICAL CHANGE:
Endogenous growth is self-sustaining growth
In this theory, we assume constant marginal product of capital
For an example, if the price of an input rises, firms will develop a new technology rather than just switching to an existing alternative input (so market structures and competition can facilitate technological change)
-Some people believe that competition foster technological change: others believe, especially in the case of health technologies, that only monopolies can risk the large expenditure required to create new drugs

LEARNING BY DOING: In the 1940s, Shumpeter said that innovation was a one-way street- that research caused new developments, which led to new machines and new products. Today, things work different: it is more of a 2-way street. There is a feedback mechanism (ie: the Japanese method of building cars, where the mechanics and workers collaborate with the designer in order to streamline research and production in such a way that is productively efficient).

SHOCKS and INNOVATION:
-Different countries respond to economic shocks in different ways. Some will find different countries to produce goods in where costs are cheaper: others will change production methods and increase technology to make it more cost effective!

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INCREASING MARGINAL RETURNS TO INVESTMENT: Here, each new addition to the capital stock is more productive than the last.

There are 2 sources of increasing marginal returns to investment:

Market-Development Fixed Costs (Paul Romer)
-The original investment into new knowledge or technology has a large fixed cost
-Adopting or adapting this new technology once it has already been established is cheaper
-Also, consumers, wait to use new technologies
-In this way, the costs decrease as more and more people adopt new technologies, so the returns to scale increase with increasing investment

Knowledge
-It is a public good, so it is not subject to the law of diminishing marginal returns
-New ideas are non-excludable and non-rivalrous (as much as copyright laws try to prevent people from accessing them)
-New ideas are pure public goods
-New ideas may not suffer diminishing marginal returns
-SOOOO, because ideas play such a big role in economics, and ideas are practically unlimited, economics doesn't have to the be DISMAL SCIENCE! Yay!

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LIMITS TO GROWTH

-1970s, the club of Rome published a book called "Limits to Growth"
-This book predicted that increased growth would eventually destroy the earth's resources...

Here is their usual anti-growth argument: growth will look like more of what we witness today: production of mostly useless, impractical consumer goods with a short lifespan, which end up in the landfills in a couple of years.

This could be countered with the argument that growth can still occur, but under that condition that instead of producer large quantities of shitty goods, we focus on producing higher-quality, cleaner, longer-lasting, more efficient products.
-Growth permits societies to protect the environment and help the poor (if you haven't noticed, environmental protection legislation is more a by-product of mature industrial economies, and less-so of developing nations)
-The thought is that market participants will react to supply shortages, and innovate around them (ie: by the time oil runs out, productive processes will have innovated away from it)

RESOURCE EXHAUSTION
-Limits to growth are based on fixed technology and resources
-BUT, technology leads to more efficient resource use
-AND technology leads to the discovery of new resources
-Problem: THERE ARE TOO MANY PEOPLE: More people on the earth means that we will require more resource expenditure

POLLUTION:
-Economic growth creates pollution. Nuff said

Although many economists believe that growth creates opportunities for humankind to combat resource depletion and pollution through increased technologies, a lot of these beliefs are based on blind faith.

Like... we are basically relying on our ability to innovate away from these problems...

but what if we simply can't do that? Then what..............?

The Neoclassical Growth Model and Steady States

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THE NEOCLASSICAL GROWTH THEORY: This focuses on capital accumulation, and how it is affected by savings

One important function in the neoclassical growth theory is the AGGREGATE PRODUCTION FUNCTION. This function shows the relationship between total real output and total inputs (sort of like a "macro" version of the production function for individual firms we saw in microeconomics)

REMEMBER from the last leccture? There are three main determinants of economic growth: labour, capital, and technology. Well, with the aggregate production function, we say that output is technology times a function of labour and capital

Y = A x F(N,K) where A = total factor productivity (disembodied technology), N = Labour and Human Capital, and K = capital (both quantity and quality)

Now what happens if we divide through by N?

Well, we get

y = A x F(k) where y is the amount of GDP produced per worker, and k is the amount of physical capital available for each worker

Also, potential output is also representable here

Y* = A x F(Nfe, Kfc) where Nfe is full employment, and Kfc is full capacity. In other words, potential output is technology times a function of labour at its full employment level, and physical capital at its full- capacity level

Some important things to remember:
We assume in the long run that income is at its potential level (that there is no output gap)
L is labour quantity, H is labour quality, and N includes both the quality and quantity of labour.
K includes both the quality and quantity of physical capital
We omit land as a factor input for the sake of simplicity in this model
Technology includes entrepreneurship and savviness

PROPERTIES OF THE NEOCLASSICAL AGGREGATE PRODUCTION CURVE

1: In the short run, there are diminishing returns to scale: as more of a variable factor is added to a given amount of fixed factor, the additional output generated by the added factor (the "return") will get increasingly smaller and smaller: they will diminish... ceteris paribus (they will diminish if all other things are held constant) after a certain point (they will not begin to diminish immediately)
But, this is only true of the short run when one factor is increased, and all other factors are held constant!

2: In the long run, there are constant returns to scale: When all factors increase the same amount, output will also increase by that amount (so if I double the amount of workers and also the amount of sewing machines, my sweat shop should double its output of shitty sneakers!)

3: Technology is nuetral: A affects the productivity of K and N equally, so although technology is present, it will not disproportionately impact any one factor.

Image Plz! y = f(k)

4: Steady state equilibrium: Here, the per-capita capital (k) and the per capita output (y) remain constant over time, so /\y = /\k = 0

If the population is growing at n, then income and capital must also grow at the same rate in order to remain in a steady state equilibrium. In other words, in order to be in a stead state equilibrium, the percentage change in output must equal the percentage change in capital, which must = the percentage change in the workforce.

y* and k* are the steady state values (they don't change over time)

Investment required to provide capital for new workers and to replace machines that have worn out (depreciation) is just equal to the national savings in a steady state equilibrium, so New Capital + Replacement Capital = Investment = Savings

If savings is greater than investment, than capital per worker will increase, and thus output per worker will also increase

If savings is just equal to investment, then the capital per worker will be k* and thus output per worker will be y*

When savings is equal to required investment, the economy is in a steady state equilibrium, each worker will have access to k*, and will produce y*

MORE ON THE STEADY STATE

To maintain k at a constant rate, investment depends on both population growth and the depreciation rate. Some of investment will have to go to the new workers

WE ASSUME that the population growth rate is constant: thus, to keep capital per worker constant, you must grow capital by nk (the population growth rate times the amount of capital per worker)
WE ASSUME that the rate of depreciation is constant: thus to keep capital per worker constant, you must grow capital by dk as well (the depreciation rate times the amount of capital per worker)

The level of investment required to fund all of this capital growth to maintain a constant capital-worker ratio can be represented by
I = (n + d)k

THE SAVINGS FUNCTION
Here, we assume that we have a frugal economy (there is no government or international trade)
We also assume that the marginal propensity to save is constant
So:
S/N = sy = sf(k)
in other words, per capita savings are a function of per-capita output, which in turn, is a function of the labour-capital ratio

PUTTING IT ALL TOGETHER:
The net change in the capital-labour ratio is equal to the excess of actual savings over required investment
/\k = to per-capita savings - the capital-labour ratio multiplied by (the population growth rate + the rate of depreciation)

In a steady state, /\k = o, so per-capita savings must be equal to per-capita required investment
sy* = (n + d)k*

Image plz

If we graph the production function, the savings function, and the required investment function with money on the Y axis and the capital labour ratio on the X axis, the savings function and the required investment function will eventually intersect: this point is the steady state equilibrium, E
at E, actual investment is just equal to required investment
the capital-labour ratio k* and standard of living y* are constant
At capital labour ratios lower than k*, savings will be greater than required investment, so the capital labour ratio and the standard of living will both increase.

Economic Growth: Savings and Investments

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The Very Long Run: Economic Growth Models

We can measure long run economic as the annual percentage change in per-capita real potential GDP.
Ecoonomic growth causes Y* to move to the right.

The standard of living is measured by the per capita real actual GDP: The average income generated by each individual within an economy

Although a small difference in growth rates may not seem to make a huge difference, compounded over time, smaller changes in growth rates can have a huge impact on economic growth!
-1% growth rate increases GDP by 10% in 10 years
-7% growth rate increases GDP by 100% in 10 years

Even a small change in the growth rate can cause major long term changes in terms of living standards- much more than gap-busting can, anyways...

Malthus thought that output would not be able to grow at a fast enough rate to keep up with population growth

In this unit, we're going to be studying the depressing, Neoclassical growth model, and then we'll be looking at some more optimistic modern growth models.

(As a general note, most asian countries have a much larger growth rate than the rest of the world, currently. This is because they are developing rather rapidly!)

THE PROS AND CONS OF GROWTH

What are some benefits of economic growth?
-Growth may increase the standard of living, as long as the economy is growing more quickly than the population. This means that people are able to buy more crap!
-Economic growth may help governments to alleviate poverty- the more national wealth a country has access to, the greater their ability to redistribute that wealth to those who are worse off.

What are the costs of economic growth?

1: Opportunity Cost: In order to allow for economic growth, individuals need to divert resources away from present consumption and into investment (ie: savings). For an example, a government has the option of spending 100 million dollars on new parks and public spaces now, OR it can spend that money on educating it's citizens, which won't generate any immediate benefit, but will create better workers and a stronger tax base 20 years into the future

2: Personal hardships to those who can't adapt to change (ie: the poor old blacksmith who goes out of business and doesn't want to retrain for a new job more befitting of the information age)

3: NEGATIVE EXTERNALITIES
-Pollution
-Resource Depletion
-Global Warming
-Financial Meltdown
-Congestion
-Stress
-Disease
-Reduced Happiness (if you want to see this sort of thing in action, check out Carl Honore's "In Praise of Slowness"

SOURCES OF ECONOMIC GROWTH
Well, as we learned in the last chapter, in the long run, output is a function of the supply of factors (usually capital and labour, and this includes embodied increases in quality, not just quantity), and productivity (which can also by thought of as technological change)

In this chapter, we flip this idea around and reconfigure it, to state that we have four determinants of growth

1: Supply of labour: the quantity of labour
2: Human capital: the quality of labour (this is acquired through on-the-job training and education)
3: Physical capital: both the quantity and quality of plant, equipment, inventories, and residential construction
4: Technological change: This is sort of a catch-all category for all sorts of different changes, including changes in the productive process, innovation and invention (creative new ideas), new products, new organizations and many other things!

THE NEOCLASSICAL GROWTH MODEL
-Economic growth occurs in the long run, and related to increasing Y*, not output gaps

Long run growth is determined, largely, by investment and savings. In a nutshell, savings allows for more investment, and greater investment in productive capital increases potential output in the long run

In the short run, we assume that the interest rate is constant, so we use the equilibrium condition savings must = investments and use this to determine output
In the long run, we assume that potential GDP is constant, We also see that both savings and investment are a function of the interest rate, so we use the equilibrium condition S = I to determine what the equilibrium interest rate will be.

In this model of savings, we focus on public savings, which is a combination of private savings (Y* - C - T) and public savings (G - T)

NS = (Y* - C - T) + (T - G)
NS = Y* - C - G

When the interest rate increases, we know that consumption will decrease (because the opportunity cost of borrowing money has risen). When consumption decreases while income remains the same, national savings increases. As a result, high interest rates encourage more people to save money, and as a result, this creates a larger "pot" of loanable funds which accumulates in banks. Basically national savings as a function of interest rates is positively sloped.

What about investment????? Well, we use the marginal efficiency of investment curve to measure the degree of investment as a function of interest rates: this curve basically shows the demand for investment at each interest rate
This curve is negatively sloped. As interest rates rise, the opportunity cost of borrowing money to fund new investments also increases, which leads to decreased desired investment.

SO... what happens when we graph both desired national savings and desired investment together? We get two criss-crossing curves! The point where the two curves intersect is where NS = I: this is the equilibrium point- it does not change over time. If there is an excess supply of funds, this will mean that banks do not need to charge as much interest to prospective borrowers, so the interest rates will naturally fall, which drives up investment until it is equal to savings. Likewise, if there is excess demand for loanable funds, banks will know that that loaning out money when there are not many hard assets to cover their asses should the loan go unpaid is RISKY BUSINESS, so they will charge higher interest rates to compensate for this risk. Higher interest rates, likewise, discourages excess investment and encourages national savings until the economy is in equilibrium once again!

An increase in either public savings OR in the marginal efficiency of investment causes the level of equilibrium savings and investment to increase. This increased investment leads to long term increases in potential national income (because investment allows for the accumulation of new capital production factors). As such, although savings can be bad for an economy in the short run (because increased savings puts recessionary pressure on an economy), they are good in the long run, because they create opportunities for new growth! Woooooooooooo!

Macroeconomic Timespans

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Macroeconomic Time Spans: Changes can have different effects over the long run than they do in the short run! This is just going to be a brief comparison exercise between the long run and the short run.

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IN THE SHORT RUN:
-Changes in national income are a function of factor utilization rate: for an example, the rate of employment. When more people are employed, more factors are being utilized, so national income increases
-National income is demand-induced: aggregate demand determines what the national income is going to be. The higher demand is, the higher the factor utilization rate will have to be in order to sate demand.
-Actual GDP, or Y determines national income: this means that there can be recessionary or inflationary output gaps
-Fiscal and monetary policy can affect both aggregate demand and actual national income
-Policies focus on shifting aggregate demand
-Gapbusting is the political objective
-Policies affect utilization rates
-Policies are focused on stabilizing real GDP at it's potential

IN THE LONG RUN
-Changes in national income are a function of both the supply of factors (ie: the size of the labour force), and factor productivity (ie: how productive and useful, on average, each worker is). The larger the workforce, and the more productive that workforce is, the higher national income will be
-National income is supply-induced: even if demand increases, wages will simply adjust and price will change, but producers will still produce the same amount in the long run UNLESS their production capabilities change. The supply and productivity of factors affects supply, and therefore, can change production in the long run.
-Potential GDP (Y* or Yfe) is a better determinant of what the national income will be. While understanding that output gaps do occur thanks to the business cycle, it is long run aggregate supply which basically determines what GDP will be
-Fiscal and monetary policy have a neutral effect (or even a negative effect: if expansionary policies increase consumption at the expense of savings, then there will be a smaller "pot" for investors to borrow from, so investment will be lower in the long run, causing a lower long run GDP)
-Policies are aimed at affecting potential GDP
-Technological change is key
-Policies attempt to affect factor supply and productivity
-Growth is the political goal

Cool?

Cool! =D

Honestly, just read the chapter for this one: it's short, and it makes more sense than the class notes...

Supply and Demand-Side Economics

2010-02-17T21:24:00.000-08:00

Long-run aggregate supply, however, can shift if the potential national income shifts. When potential national income increases, this brings the equilibrium price level down, and the equilibrium level of GDP up in the long run. Neoclassical economists believe that policies which intend to bring real economic growth and betterment should focus on shifting potential national income to the right (increasing it): they believe that policies which only focus on increasing aggregate demand merely cause price-inflation in the long run.

So, for a classical economist, instead of using short term fiscal policy "gap-busting" to correct short term deviations from potential national income (boosting or reducing government expenditures to correct recessionary and inflationary gaps), policies should focus on brining potential national income forward, and closing the gap through increased potential economic growth! We call this SUPPLY-SIDE ECONOMICS

SO... let's say that an economy is in an inflationary state... there are a few things which policy-makers can do to fix this

1: They can do nothing. The chain and anchor system of long term economic adjustment will make wages higher, which shifts AS to the left and brings the economy back to Y*, but with a higher price level
2: The government could engage in some "gap-busting" policies (ie: they could raise taxes and decrease expenditures to kick aggregate demand back to the left, which would bring equilibrium GDP back to its potential levels)
3: The government could focus on increasing long run aggregate supply. This is also called Reaganomics: some policies in with vein include cutting personal income taxes (which increases incentives to work), cutting corporate income taxes (which increases production and investment). This shifts LRAS to the right to close the gap, and arguably, there is no negative effect on overall tax revenues, despite these cuts (because the increased long run equilibrium national income creates a larger tax base, so the government is still able to generate the same amount of revenue, despite taxing at lower rates).

CRITICISMS of SUPPLY SIDE ECONOMICS

Although these sorts of policies may increase LRAS, critics note that decreases in personal income tax also increase disposable income, which drives consumption upward. Also, decreases in corporate income tax are likely to cause corporations to increase their levels of investment. Thus, while LRAS will shift to the right, aggregate demand will also shift to the right, and the inflationary gap will persist, even if the economy's productive potential grows. This means that economies where supply side economic policies are instated will experience EVEN LARGER price inflation.

FISCAL POLICY

There are two different models we use for the economy: the short run model and the long run model. These two models are very different.

Fiscal policies which are based on the long run model is focused on increasing economic growth by increasing either labour, capital, or technology. These are factors which cause the potential national income to shift, and thus, they create long-run changes in economic potential.

The short run model, on the other hand, deals with temporary fluctuations in the economy which causes GDP to fall above or below potential: this is the economy model which is centered around the business cycle. Most policies in this vein are based around gap-busting, or eliminating recessionary and inflationary gaps.

It is not particularly difficult to determine the direction of the shift which must be kickstarted by fiscal policies: rather, it is the mixture and the magnitude which is hard to determine (for an example, if lowering taxes is likely to eliminate a recessionary gap, the question which the government must ask is how much of a tax cut should be given, how long should these cuts persist for, and which taxes should be affected by the cut).

STABILIZATION POLICY
-This is meant to damped the fluctuations caused by the business cycle
-This reduces the amplitude of the fluctuations (so recessionary and inflationary gaps are less extreme)
-This is GAPBUSTING!

While the automatic economic adjustment which occurs thanks to natural wages shifts WILL bring economies back to potential GDP, one problem is that the natural adjustment process can take a very long time, and while the economy is adjusting to reduce a recessionary gap, unemployment will be high, and the economy will remain unproductive for a long while. Government stabilization policies can fix recessionary gaps a lot more quickly by increasing government expenditures and decreasing taxation. This boosts aggregate demand, and shifts equilibrium GDP back to Y* a lot more quickly than the natural AS shift to the right would have.

Contractionary fiscal policy works in a very similar way: if there is an inflationary gap, the government increases taxation and decreases government expenditure to shift aggregate demand to the right, thus bringing equilibrium GDP back to Y* much faster than the natural AS shift to the left would have.

THE PARADOX OF THRIFT!

In a recession, the natural tendency is for individuals to increase savings: while such prudent actions may benefit individuals, on a larger aggregate level, frugality decreases consumption, and therefore, it also reduces aggregate expenditures, aggregate demand, and GDP as a whole. As a result, this psychological tendency towards thriftiness in a recession can exacerbate recessionary gaps. A historical example of this occurred in the great depression when governments actually RASIED taxes as a response to the hard economic times.

Note* this negative economic result of savings only really applies to the short run: in the short run, increased savings means decreased consumption, and therefore decreased aggregate demand. In the long run, however (as we will learn in the next chapter), an increase in savings facilitates an increase in investment, which leads to a higher aggregate demand.

AUTOMATIC FISCAL STABILIZATION: This refers to built-in tax and expenditure rates which automatically stabilize the business cycle without the government having to specifically set up any policies
-Basically, tax 'n spend systems decrease the simple multiplier, so injections and withdrawals from the economy create smaller shifts in GDP.
-Automatic stabilization can be represented by the slope of the budget function (as GDP increases, there are more withdrawals from the economy)
-Discretionary stabilization (ie: expansionary and contractionary policies) can be represented by a shift in the budget function (so governments are taxing and spending at different rates for the same national income rate)
-Taxes aren't the only automatic stabilizer: other ones include employment insurance and welfare payments (which are forms of withdrawals or expenditures)

ONE FINAL IMPORTANT THOUGHT: WHY ARE ECONOMISTS SO LEERY ABOUT FISCAL STABILIZATION POLICY???
Why not just increase expenditures and lower taxes to fight unemployment???

Wellll....

There can be policy lags- so by the time a budgetary policy gets through the political process and takes effect, it may already be obsolete, or even counter-productive (remember, stabilization policy is extremely time-sensitive)

Also, economists recognize that many households are not "fooled" by short term changes in tax structures. Many households base their spending on what they believe their long term incomes are going to be (as Milton Friedman predicted), so short term changes in taxation which temporarily boosts income may not cause changes in spending habits.

Finally, most economists believe that fiscal policy creates too broad and general a change in the economic environment to fine tune an economy for optimal performance. While stabilization policy may be useful when large, sweeping economic changes are required, many economists believe that it is unnecessary overkill for small economic imbalances which will correct themselves.

THE LONG TERM EFFECTS OF FISCAL POLICY

While increased government purchases lead to increased AE, AD, and GDP in the short run, in the long run, they may "crowd out" private-sector consumption and investment
Similarly, while decreased taxes may increase AE, AD, and GDP in the short run, the long run effect is less clear. On the one hand, some economists believe that decreased taxes may increase investment and incentive to work in the long run, thus drumming up GDP. On the other hand, some economists believe that decreased taxes may crowd out public spending on public goods (case and point, check out Alberta's decaying public infrastructure)

Supply Shocks and Other Important Things!

2010-02-12T17:05:00.000-08:00

SUPPLY SHOCKS: These also correct themselves in the long-run, but unlike demand shocks, these do not cause any net changes in the price level.

NEGATIVE SUPPLY SHOCK
-Let's say that the cost of oil rises: this shifts AS to the left, which decreases overall economic output and increases the price level.
-There is now a recessionary gap in the economy, and this will cause unemployment to rise
-As unemployment rises, firms can get away with paying their workers less, so wages fall
-Because wages are a cost, production costs fall, and this shifts aggregate supply to the right, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE

POSITIVE SUPPLY SHOCK
-Let's say that a new technology emerges which lowers the price of electricity: this shifts AS to the right, which increases overall economic output and decreases the price level
-There is now an inflationary gap in the economy, and this will cause unemployment to fall below its natural level
-As unemployment falls wages rise (overtime and worker retention)
-Because wages are a cost, production costs rise, and this shifts aggregate supply to the left, back to equilibrium
-Ultimately, the economy is right back where it started at: there is NO NET CHANGE

BUT, just because the economy is the same, this doesn't mean that wealth doesn't shift. In the event of a negative supply shock wealth tends to shift from the workers to the capital owners (so workers are paid less, and company owners make more money)

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SHOCKS AND THE BUSINESS CYCLE

Positive supply and demand shocks cause GDP to rise above it's potential level for a period of time, and then to fall back to potential (because inflationary gaps cause decreased unemployment, higher wages, and increased factor prices)

THESE SHOCKS ARE RANDOM...

SO:

The economy's adjustment system accounts for these random shocks, and basicaly incorporates them into business cycles (short term fluctuations of the economy)

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LONG RUN AGGREGATE SUPPLY: This is the relationship between price and GDP after changes in input prices have been taken into account. LRAS is the result of automatic adjustments which bring GDP back to its potential level. LRAS is also called classical aggregate supply, because classical economists assumed that the economy has an automatic tendency to return to Y*

LRAS, graphically, is a vertical line at Y*, because the amount of goods produced at the normal utilization rate is Y*

The only thing which this can be used to demonstrate is price changes: as long as factor prices rise by the same proportion as output prices, then Y*remains constant

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SHIFTING Y*

Factor Prices and the Output Gap!

2010-02-12T15:18:00.000-08:00

Oh dear god, am I ever behind schedule for these notes...

Okay, today, we're going to have a look at what happens to our economic model when we allow factor prices (this usually refers to wages) to vary. Up until this point, we've been assuming that factor prices remain constant, but in real life, that isn't necessarily the case.

Here are some things you'll probably need to know about wages and the economy, and how they relate to demand shocks:

If the economy is in a recessionary gap (think post-2008)
-Actual income is lower than potential income
-There is an excess supply of labour (there are a lot more people going around trying to find jobs in a recession than firms are willing to hire)
-This excess supply of labour means that companies can lower wages without having to worry about losing workers
-By lowering wages, producers effectively decrease their average costs
-As a result, the short run aggregate supply curve will shift to the right (remember, decreased costs allow firms to increase production at every output price level)
-IMPORTANT: This adjustment happens relatively slowly, because it takes longer to lower wages than to raise wages (firms have to fight with unions, and it takes a while to agree on a lower wage rate: people don't like to be paid less)
-So... given some time, recessionary gaps will correct themselves, and unemployment will fall back to normal levels. Also, this kind of an adjustment causes the price level to decrease

If the economy is in an inflationary gap (for an example, Alberta circa 2007)
-Actual income is greater than potential income
-There is an excess demand of labour (there are not enough workers to supply firms' increasing demands, which is why you have fifteen year olds working in restaurants and making $12/hour during economic boom-times... it's ridiculous!)
-This excess demand of labour means that firms have to pay higher wages to entice new workers to stay on, or alternately, to reward current workers for working overtime
-This means that average costs increase for firms
-This increase in costs shifts short run aggregate supply to the left (increased costs force firms to decrease production at every output price level)
-IMPORTANT: This is a fast change: wages rise relatively quickly in good times, so this natural return to economic equilibrium is relatively quick.
-So... in the long run, the price level increases, and production decreases, bringing us back to equilibrium... yah!

AS YOU CAN SEE, we have ADJUSTMENT ASYMMETRY:
-Booms cause wages to rise quickly
-Recessions cause wages to fall slowly

ALSO, you should probably know about the Phillips curve!

Basically, the phillips curve shows us that as employment increases, rate of wages become lower. In other words, in times were there is lots of unemployment (read: recessions), the wage rates will fall. Conversely in times when unemployment is high (booms), the wage rates will increase!

Basically, a good way to think about long run economic adjustment is to imagine that Y* (potential GDP) is like an anchor, and that short run aggregate supply is a chain. We have have demand shocks which shift the economy around for a little while, but because these demand shocks affect wage rates, which in turn, affects supplier costs, the short run aggregate supply will always eventually bring the economy back to it's potential level!

We can practice figuring out what happens with supply and demand shocks in the long run, but basically, all you need to know is what I've already told you.
-Inflationary gaps cause increases in prices in the long run
-Recessionary gaps cause decreases in prices in the long run
-Production will eventually shift back to its potential levels
-Also, for economies where wages are "stickier" (less flexible), recessions are likely to last longer, because the wage adjustment does not occur as quickly
-Recessionary and inflationary gaps WILL disappear on their own, but but discretionary fiscal policy can speed up the process a LOT!

MACROECONOMIC EQUILIBRIUM: Putting it all Together

2010-01-30T11:47:00.000-08:00

So, we have the aggregate supply curve and we have the aggregate demand curve.
AD measures levels of production which won't change over time as a function of price
AS measures levels of production which suppliers will actually produce at as a function of price.
SO... what happens when you put both of them together?

Answer: You get a real level of output which doesn't change over time (at the intersection point). Here, GDP is at an equilibrium, which means that output is equal to expenditures. Also GDP is an actual achievable level of output, which firms are willing to produce at, given the price level, to maximize profits: The actual output is in equilibrium!

The general price level is the y-axis, and we can use it to determine inflation (increases in the general price level)
GDP is the x-axis, and we can use actual GDP in relation to potential GDP to determine unemployment

This is also a stable equilibrium! If the price level is too low, then aggregate demand will overwhelm what producers are actually willing to produce. As production increases to meet the needs of the consumers, however, the accompanying rise in the price level reduces consumer demand until the two meet in the middle. Whenever the economy is not at macroeconomic equilibrium, there are pressures which ultimately bring it back to a state of equilibrium

Aggregate Demand Shocks and Macroeconomic Equilibrium:

These are a bit more tricky. If a change in autonomous expenditure shifts the family of aggregate expenditure functions, then in turn the Aggregate Demand function will shift (to the left in expenditure is lower, and to the right if it is higher). However, in macroeconomic equilibrium, an increase in aggregate demand predicts an accompanying increase in prices, while lower aggregate demand predicts an accompanying drop in prices (remember, firms will only produce more if prices increase to stabilize profit margins). This change in the price level changes aggregate expenditure, causing it to shift up or down due to a new price!

As a general rule, both price and output move in the same direction as a demand shock (increased demand = more output at higher prices. Decreased = less output at lower prices)

You may have noticed, but the simple multiplier, due to the change in price, can no longer predict the change in output caused by changes in expenditure. Instead, we use the multiplier (not simple, just multiplier) to determine output changes which result from expenditure changes. The multiplier is smaller than the simple multiplier. It represents the change in GDP divided by the change in aggregate expenditure.

The severity of a demand shock depends on the state of the economy: in other words, where an economy lies on the Aggregate Supply Curve.

When the economy has excess capacity (constant costs of production), it is called Keynesian short run aggregate supply (this is the flat part of the AS curve). Increases in AE cause Y to rise and Price to remain the same.

When the economy has increasing costs (the middle of this graph where the AS curve is about diagonally sloped), this is intermediate short run aggregate supply. Here, increases in aggregate expenditure cause increases in both price and output.

When the economy has rapidly increasing costs, this is classical short run supply (the vertical part of the AS curve). Here, increases in aggregate expenditure lead to increases in price, and no change in output.

Basically, the steeper AS is, the more a demand shock will affect price, and the less it will affect output.

We can have supply shocks too! The new intersection point is the new stable macroeconomic equilibrium.

Be careful- in some cases, both AS and AD will shift in response to a single event! (for an example, let's say the price level in China rises. This increases domestic AD (because of increased net exports). However, if domestic producers buy a lot of intermediate products from China, then their costs of production just rose, so aggregate supply shifts to the left. The net effect could be either positive or negative: it depends how invest producers are in chinese intermediate goods, and how much of the domestic economy is trade-determined.

Okay- that's all you'll need for the test. Good luck!

Aggregate Supply

2010-01-30T01:39:00.000-08:00

In the short run, we're going to assume that factor prices remain constant (but later on, this can change, as we look at the long run)

The short run aggregate supply curve shows the amount which firms are willing to produce at any given price level.

Aggregate Supply is positively sloped!

Why?

Well, as firms increase output and input prices are constant, the law of diminishing marginal returns causes marginal output per factor to fall, and the short run average cost to rise. THUS, in order to retain expected profit margins, the only way for producers to feasibly increase production is to increase the price of goods: as such, as price rises, the actual GDP/output which firms will produce increases- there is a positive relationship here.

What about the slope? Why is it increasing?

Well... at low levels of output, firms have excess capacity, so they are capable of increasing output without making a huge investment, and the law of diminishing marginal returns hasn't really kicked in yet. Production can be increased at a relatively low cost (this corresponds to the flatter part of the curve)

At higher levels of output, however, there is no excess capacity, and great costs must be incurred to increase production.

Aggregate supply can shift (we call this an aggregate supply shock!). Basically, anything which would cause the cost of inputs (wages, intermediate goods, machinery, etc.) to rise OR anything which lowers the productivity of those factor inputs (like a rainy day on a farm) will shift the aggregate supply curve to the left (and consequently, lower input costs shifts AS to the right)

Aggregate Demand

2010-01-30T01:36:00.001-08:00

ECON 101 HELL WEEK BLOG REVIEW:

PART 1: DEMAND SIDE EXPENDITURE
PART 2: SUPPLY SIDE EXPENDITURE
PART 3: EQUILIBRIUM: PUTTING IT TOGETHER

----------------------------------------------------
PART 1: DEMAND SIDE EXPENDITURE

We know that National Income is a function of Aggregate Expenditure. Thus far, we have been assuming that prices remain constant...

Newsflash! In real life, prices change (unless the firms contributing to GDP are monopolies, or they have excess capacity). We need to look at how this affects aggregate expenditure, and subsequently, national income.

We assume that output is demand-determined: that is, GDP will rise if general consumer demand rises, and it will fall with decreases in demand

OKAY: How does price affect aggregate demand? Well, it affects it in an inverse relationship. When the price level increases, aggregate expenditures shift down. When the price level decreases, aggregate expenditures shift up! Why?

2 Reasons:

1: A Decline in Wealth
An increase in price levels causes people's wealth to decrease (unless they have invested into price-variable assets, which most people have not)- inflation decreases the purchasing power of money. Wealth is a ceteris paribus variable for consumption When wealth goes down, peoples' desire to spend (their MPC) also decreases.

2: A Decline in Net Exports
An increase in domestic price levels implies that relatively speaking, foreign products will be cheaper than domestic products. The increases the incentive for domestic consumers to import foreign goods, and it also decreases the incentive for foreign consumers to buy domestic goods. As a result, imports increase (cutting into MPSpend) and exports decrease (lowering autonomous expenditures)

The overall effect is that AE and Prices are negatively related...

SO, what happens when we take the same Aggregate Expenditure curve, and then change the price several times? Well, the equilibrium level of national income will be different for each curve (higher price levels lead to lower expenditures, and therefore lower national income)

When you put together ALL of the different equilibrium income levels for AE, and then graph them in relation to price, you have the Aggregate Demand function!

The Aggregate Demand function is a family of equilibrium national income levels for different price levels! Every point on the AD function is a different equilibrium level.
-The Y-axis is price, and the X-axis is equilibrium national income
-It is downward sloping (As price decreases, equilibrium national income increases)
-Generally speaking, points which are not directly ON the AD function tend to gravitate towards it (because it is a stable equilibrium)
-If income for a certain price level is to the left of the AD curve, it means that for that price level, there is not enough production to satisfy expenditure demands. There are two solutions: firms can make more product (and horizontally move towards the AD curve) or they can raise prices (and vertically move towards the AD curve). More likely, it will be a combination of the two

Shifts in AD are called aggregate demand shocks, and are caused by changes in exogenous, autonomous expenditure (which consequently shifts the whole family of aggregate expenditure curves which we use to derive aggregate demand). If the family of expenditure curves increases, aggregate demand shifts to the right. If the family of expenditure curves decreases, aggregate demand shifts to the left.

The simple multiplier can be used to determine the horizontal shift in AD caused by a demand shock- you just multiply the shock by the simple multiplier, and the AD graph will shift out by that amount for that specific prices level

That's all for this section

Putting it ALL together! Building and fiddling with aggregate expenditures!

2010-01-20T17:44:00.001-08:00

EQUILIBRIUM NATIONAL INCOME AND THE AGGREGATE EXPENDITURE FUNCTION:

REMEMEBER:
Consumption is a function of disposable income (income minus net taxes) and net taxes are taxes minus transfer payments.
So, when you add the government to the economy, you have to substitute (income minus net taxes) into the consumption equation!
As such, consumption is a function of income: C = f(Y) (the disposable part is now implicit with the addition of the government)

Taxes and transfer payments are thus subtly incorporated into the consumption function

DESIRED AGGREGATE EXPENDITURE is a function of actual income! E = f(Y)
AE = C + I + G +NetX

The marginal propensity to spend is the slope of the aggregate expenditure function: This is the portion of each additional added dollar of national income which is spent.

(Don't confuse this with MPS, which is the marginal propensity to save)

THE FORMULA for MPSpend:
MPSpend = z = Marginal Propensity to consume multiplied by (one minus the marginal propensity to tax) minus the marginal propensity to import.
MPSpend = z = MPC(1-MPT) - MPM

C = 10+0.8Yd
I = 25
G = 17
NX = 24-0.1Y
T=0.1Y

Let's put it together to make our formula for aggregate expenditure as a function of national income

AE = (Autonomous C + I + G + X) + MPSpendY
AE = (10+25+17+24) + (0.8(1-0.1) - 0.1)Y
AE = 76 + 0.62Y

Hooray!

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EQUILIBRIUM IN THE GOVERNED (CLOSED) ECONOMY: This involves Households, firms, and governments as economic actors (banks just act as instruments for investments and savings). We assume that the household uses the bank to save money, and that firms loan from banks to fund investments. We also assume that the government taxes and spends.

In the garden hose theory, then, equilibrium happens when National Income is equal to Expenditures (C + I + G). On a graph, this happens when the AE function intersects the 45 degree line. Algebraically, you can find this point by multiplying autonomous expenditures by the simple multiplier (1/(1 - the MPSpend))

In the bathtub theory, equilibrium is when total injections of money into the economy is equal to total withdrawals of money from the economy (S + T = I + G)
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EQUILIBRIUM IN THE OPEN ECONOMY: This involves Households, firms, the government, and the world as economic actors. This is similar to the open economy, but with the world added, domestic consumers can purchase imports, and foreign consumers can purchase exports.

In the garden hose theory, equilibrium happens when National Income is equal to Expenditures (C + I + G + NetX). On a graph, this happens when the AE function intersects the 45 degree line. Algebraically, you can find this point by multiplying autonomous expenditures by the simple multiplier (1/(1 - the MPSpend))

In the bathtub theory, this is when total injections of money into the economy is equal to total withdrawals of money from the economy (S + T + M= I + G + X)
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MORE ON THE SIMPLE MULTIPLIER!

(1/(1 - the MPSpend)) is the simple multiplier!
Taxes and imports reduce the value of the simple multiplier (which makes sense mathematically, because they reduce the value of MPSpend): This is because taxes and imports are directly linked to national income, so as the national income increases, the withdraws or leakages from the economy causes by taxes and imports also increase!
-The simple multiplier causes injections into the economy to lead to an increase in equilibrium expenditure/income which is larger than the injection itself: the value of this equilibrium difference is the sum of the injection multiplied by the simple multiplier
-The simple multiplier in Canada, however, is only 1.2 =(
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MORE ON NET EXPORTS
-Net exports is affected by both foreign, autonomous effects on exports and domestic, induced effects on imports
-The marginal propensity to import is subtracted from MPSpend
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FISCAL POLICY

Fiscal policy is changes in government purchases or spending administered to affect the national income
Stabilization Policy is policy where the government tries to maintain the national income at a given level (usually potential GDP) , and to reduce the extreme effects of business cycles
Expansionary fiscal policy is where the government increases purchases and reduces taxation in order to increase the national income
Contractionary fiscal policy is where the government decreases purchases and increases taxation in order to decrease the national income

IMPORTANT: Balanced budgets actually are expansionary in nature! Why is this??
Well, simple multiplier for balanced budgets is 1, so when we have a balanced budget, the equilibrium value for national income actually has a net increase equal to government purchases (or taxation, seeing as purchases and taxation are equal)
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SO FAR, prices are constant in our model. This will change once we start to fiddle with interest and exchange rates...
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Remember** the budget function is the opposite of the government's withdrawal and injections in terms of the circular flow economy
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USUALLY

Withdrawals as a function of Y are upward sloping lines

Injections as a function of Y are flat lines

Net Additions to AE as a function of Y are downward sloping lines

AND

All injections are autonomous, while all withdrawals are a function of national income!
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Remember the CETERIS PARIBUS VARIABLES!

CONSUMPTION:
-Wealth - Direct Effect
-Expectations - Direct Effect
-Interest Rates - Inverse Effect

INVESTMENT:
-Interest Rates - Inverse Effect
-Change In Sales - Direct Effect
-Business Confidence - Direct Effect

GOVERNMENT:
-Elections/Political Agendas - Direct Effect

NET EXPORTS:
-Foreign Income (affects exports)
-Relative Canadian Prices (affects exports)
-Canadian National Income (affects imports)
-Relative Canadian Prices (affects imports)

IN THE NEXT LITTLE WHILE, PRICES, EXCHANGE RATES, AND INTEREST RATES ARE GOING TO COME IN AND MESS THINGS UP!

Adding Government and Net Exports to the expenditure function

2010-01-19T13:29:00.000-08:00

IMPORTANT: We spent a lot of time determining equilibrium values in this course, but it's important to remember that equilibrium is NOT NECESSARILY A GOOD THING: You could have an equilibrium level of national income which is abysmal and leads to unprecedented unemployment. The only thing we can state about the equilibrium level is that it does not change over time! Ye = the National Income at equilibrium

THE GOVERNMENT

Government purchases are added as a separate category to aggregate expenditure, but transfer payments are not (don't worry, they get factored in later)
-Remember, we are still assuming a constant price level
-Fiscal policy directs government purchases (which increase aggregate expenditure) and taxation (which decreases aggregate expenditure) to effect the equilibrium level of national income
-Government purchases affect aggregate expenditure DIRECTLY
-Taxes affect aggregate expenditure INDIRECTLY (they affect disposable income and consumption)
-Government SPENDING includes transfer payments AND government purchases. We don't include transfer payments in government purchases, however.

Government purchases are usually a function of election promises, not national income!

THEREFORE: Government purchases are a constant in the functional relationship with national income (not unlike investments, government spending as a function of national income is a flat line)

NET TAXES:
-Taxes DECREASE disposable income, while transfer payments increase disposable income
-Disposable income = Income minus net taxes
-Net taxes = Taxes minus transfer payments
-Usually, taxes are a function of income, and change with income: T = f(Y)
-We could say that T = tY, where t = the net tax rate (also called the marginal propensity to tax, or the marginal rate of taxation)
-If t is constant, then that is a flat tax rate
-Taxes include income tax, corporate tax, sales taxes, excise taxes, property taxes, and others!

THE BUDGET FUNCTION!

The government's budget is net taxation minus government purchases (money in minus money out): It's important to remember that this is withdrawals and injections for the GOVERNMENT, not for the circular flow economy (in terms of the economy, it's the opposite: taxes are withdrawals and government purchases are injections)

There are 3 types of budgets which a government can ring up:
-A budget surplus, where net taxes are higher than purchases, and therefore government revenues outweigh government expenditures
-A budget defecit, where net taxes are lower than purchases, and therefore government expenditures outweigh government revenues
-A balanced budget, where net taxes are equal to government purchases, and therefore government expenditure is equal to government revenue

THE PUBLIC SAVINGS FUNCTION is the budget surplus function: This is derived by graphing both government purchases and net taxes as functions of national income. While taxes increase with income (and thus form an upward-sloping line), purchases are flat. The point where taxes and purchases intersect is a balanced budget. The area where government purchases are greater than the level of net taxation represents budget deficits, while the area where net taxes are higher than government purchases represents budget surpluses.

The public savings function combines these two into one function to represent budget savings!
It is equal to Net Taxes minus Government Purchases as a function of national income
(T - G) = f(Y)

This shows that the budget changes as GDP changes. REMEMEBER: This budget represents money inflows and outflows for the government: while a government budget deficit is bad for the government in that they are losing money, it is good for the economy, in that the economy receives a monetary injection.

THE FEDERAL GOVERNMENT taxes about equal to provincial and municipal taxes, but federal government purchases are less than provincial municipal purchases. As a result, the feds spend more on transfer payments to the provinces. We include spending and taxing on all levels in our national income and expenditure accounts.

-------------------------------

NET EXPORTS AND THE NET EXPORT FUNCTION

Net exports = imports minus exports (another name for this is the balance of trade)

-A balance of trade surplus occurs when there is more foreign money spent on exports than domestic money spent on imports (money in is higher than money out)
-A balance of trade deficit occurs when there is more domestic money spent on imports than foreign money spent on exports (money out is higher than money in)
-A balance of trade occurs when there are equal exports and imports, and money in is equal to money out

Exports are autonomous, since they depend on foreign economies, so we see than as a constant (flat line graph) in a functional relationship with national income
Imports, however, increase with national income, so we could say that:
Imports = m(Y) (where m is the marginal propensity to import [the slope of the import function], and Y is national income, not disposable income)

We can graph both imports and exports as functions of national income, and then find the difference between the value of exports and the value of imports to determine net exports.

Net exports = (imports minus exports) as a function in national income
fY = X-M

This appears as a downward sloping line. When the national income is very low, there will not be a lot of imports, but there will be a constant amount of exports, so the value of the exports will outweigh the value of the imports, leading to a positive value for net exports. When national income is high, however, imports outweigh exports, leading to a negative value for net exports.

SHIFTS IN THE NET EXPORT FUNCTION
-Two things affect net exports as ceteris paribus variables
1) Foreign income (which affects domestic export levels)
2) Relative prices of goods (aka: the exchange rate)
-Domestic prices rise if domestic inflation rises or if the external value of domestic currencies rise
-Foreign prices rise if foreign inflation rates rise, or if the exchange rate of foreign currencies rise.
-Foreigners like to buy things that are CHEAPER, so the higher the exchange rate of their currencies, and the lower the external value of domestic currencies, the more they will want to import!

Generally, an increase in exports causes the net export function to shift up (and a decrease would cause it to shift down)
Meanwhile. an increase in the marginal propensity to import (the slope of the import function) causes net exports to rotate down (so net exports fall more steeply as a function of national income if MPM is higher)

Examples:
If a foreign country's national income decreases, then exports will decrease, and the net export function will shift downward
If relative canadian prices increase, this will lead to a reduction in exports, so the net export function will shift downward. However, this will ALSO lead to an increase in domestic consumers importing products (an increase in the marginal propensity to import), so the net export function will also rotate downward.
-An increase in external value (appreciation of domestic currencies) causes the same affect as an increase in the general domestic price level (fewer exports, and an increase in the MPS)

That's all for today

Adding Investment to the Consumption Function, and then Finding Equilibrium

2010-01-15T11:37:00.000-08:00

Before we move on to investment, it's important to understand the difference between shifts in consumption and movement along the consumption function.

Movement along the consumption function occurs whenever the national income changes- if it increases, then we move up and to the right along the consumption function. If the national income decreases, we move left and downwards along the consumption function. The graph itself, however, doesn't move in response to changes in national income.

Changes in the ceteris paribus variables (wealth, expectations, and interest rates), however CAN shift the consumption function up and down. This constitutes a SHIFT in consumption!

When consumption increases, the graph shifts up. When consumption decreases, the graft shifts down.

WEALTH causes direct shifts: an increase in wealth causes an upward shift of consumption
EXPECTATIONS cause direct shifts: optimism causes upward consumption shifts, while pessimism causes downward consumption shifts
INTEREST RATES cause inverse shifts: as interest rates rise, consumption decreases and vice versa.

Most of these variables tend to remain stable in the short run, however, so economists suspect that changes in consumption are not the root cause of the fluctuations we witness in business cycles.

There are other theories about consumption other than the one we have just learned about!
Modigliani and Friedman both came up with similar theories that suggest that consumption is a function of someone's average lifelong income, rather than current disposable income. This accounts for consumption which continues to remain high after retirement- current disposable income is very low for retirees, but they are able to live off of some stockpiled income from their income throughout the rest of their lives.

Okay.. time to factor in INVESTMENT!

Remember, investment involves Plant and Equipment, Inventories, and Residential Construction. Of all of these subfactors of investment, inventories tend to fluctuate the most.

There at 3 BIG factors which affect investment, so you could think of all of these at the ceteris paribus variables for investment
-The Real Interest Rate
-Changes in Sales
-Business Confidence

(Technology improvements, a decline in the price of new capital goods, and higher relative output prices may also affect investment, but we don't have to worry about that right now)

Interest Rates have a reverse relation to investment: the higher the interest rates, the higher the opportunity cost of borrowing money for investment, so overall investment decreases as interest rates rise

Sales have a direct relationship with investment. As sales increase, businesses need to have a larger inventory to buffer possible stock depletion, and also sales requires greater production, which facilitates investment in more plant an equipment.

Business Confidence has a direct relationship with investment. If business are confident that their economic futures are promising, then they will invest in more plants, equipment, buildings, and inventories. If the prospects appear grim, however, and businesses are uncertain if they will make profits in the near future, they are far less likely to invest.

SOOO: Investment is related and affected by these three factors... BUUUUUUUUUTTTTTTTTTTTTT
INVESTMENT IS NOT RELATED TO NATIONAL INCOME! IT IS AUTONOMOUS

In other words, if we were to graph investment as a function of national income, it would be a constant, flat-line graph!

Investment stays the same even as national income change, as long as the ceteris paribus variables remain constant.
Changes in the ceteris paribus variables can shift investment up or down, however!

OKAY: That's all we need to know about investment. Now, we just have to put the two together: This is called aggregate expenditure, and we graph it as a function of national income, so AE = f(Y)
In a frugal economy (with only a bank added to the economic flow system), desired Aggregate Expenditure = Consumption + Investment
SO, AE = C + I = f(Y)
AE = autonomous consumption + mpc(national income) + Investment
AE = a +b(Y) + I

This is the aggregate expenditure function! The slope of the aggregate expenditure function is called the Marginal Propensity to Spend (The change in expenditure divided by the change in national income)
***Important: You do not want to consume MPSpend with MPS, as MPS is the marginal propensity to save (which is how much money is saved per dollar of income, or the slope of the savings function)

So, now we know what the aggregated expenditure function looks like. Now, the only thing left to do is to figure out where equilibrium is.

SO, where is equilibrium?
It's any point where Income stays constant over time!

Well, there are two ways of thinking about equilibrium in macroeconomics:
-The Garden Hose Theory suggests that equilibrium is when Income is equal to expenditures. If you think about this in terms of the circular flow diagram, this means that the incomes that household receive from firms are equal to the expenditures that firms receive from households. Here, the condition for equilibrium is that the national income must equal expenditures!

-The Bathtub theory suggests that equilibrium is when the amount of monetary injections into an economy are equal to the amount of monetary withdrawal from an economy. Think of it like a bathtub with the tap adding water to the tub, while the drain removes water from the tub. If the tap adds water to the tub at the same rate that the drain removes water from the tub, then the water level in the tub remains the same, so we could say that the tub is in equilibrium! Using our current frugal economic model, equilibrium is when savings (withdrawals) are equal to investment (injections).

You will find that the point where Y = AE and where J (Injections) = W (Withdrawals) is the same!

This is also a stable equilibrium! There are pressures which return both expenditure and investments to equilibrium levels in the event of disequilibrium!

Let's say that desired expenditure is lower than GDP: This means that people want to consume more than an economy is effectively producing. In response to this increase in demand, producers will increase their level of production to make more products to satisfy that demand. That increase in production causes gross domestic product to raise, and eventually align with expenditure!

On the other hand, if GDP is greater than expenditure, this means that more products are being produced by an economy than are being consumed by households. Businesses will notice the drop in sales, and respond by producing fewer products. This reduction in output causes the GDP to fall until it aligns with expenditure.

The savings function works similarly, BECAUSE IT IS DERIVED FROM THE CONSUMPTION FUNCTION!

We can then shift around all of these different graphs by changing ceteris paribus variables, and then try and predict where new equilibriums will be! Expect this sort of thing on your typical, Gateman-style examination! Practice this sort of activity in your precious spare time, and you'll be a macroeconomic whiz-kid!

I bet you're EXCITED!

The Importance of Consumption! The consumption function, and other wonderful things!

2010-01-13T17:59:00.000-08:00

Quick review:
We have 5 basic macro-economic variables: Y,U,P,i, and e
Y is the bull's eye, which we try to control using fiscal and monetary policy
There are 4 stages to developing our economic model
1) Spendthrift (where there is just the firm and the household)
2) Frugal (which allows for spending and investment through banks)
3) Governed (which factors in taxation and government expenditure)
4) Open (which factors in imports and exports)

Our end-goal is to find the relationship between the general price level and the national income!

Here are some basic assumptions we have to make in building our macroeconomic model right now:
-Demand determines output
-The price level is constant (we pretend there is no inflation)
-In a basic economy, the interest and exchange rates remain constant
-We assume that potential national income is constant

Autonomous versus Induced Variables:
-Autonomous variables do not depend on national income, and thus are external to our model: this includes things like exports, which are determined by foreign economies, not domestic economies

Induced Variables DO depend on national income, and are thus found within our model: imports for an example tend to increase as Canada's national income grows, thus this an induced variable.

Today, we are going to learn about consumption, which is a very important part of national expenditure (the other parts being investment, government expenditure and net exports).

First: DESIRED versus ACTUAL EXPENDITURE:
-This is similar to microeconomics where we talked about willingness to buy (quantity demanded) at a given price. In Macro, we talk about the willingness to expend at a given income- it's a similar concept
-Actual aggregated expenditure is measured by NIEA (national income and expenditure accounts), which is denoted by an "a" subscript
-Desired expenditure is planned or intended expenditure
-It is a combination of consumption, investment, government expenditure, and net exports
-It is a function of national income (so national income effects expenditure)

THE CONSUMPTION FUNCTION: As a general rule, if people have more money, they spend more. Who'd have thunk...
-Consumption is a function of disposable national income! (Yd = current disposable income, which is national income minus taxes). However, in a spendthrift economy, we don't have to worry about taxation! =D

The ceteris paribus variable for the consumption function are
-Wealth (accumulated income: higher wealth generally leads to more consumption)
-Expectations (if prices are expected to rise in the future, this increases current consumption; if prices are expected to fall in the future, this decreases current consumption)
-Interest Rates (higher interest rates decreases consumption)

DESIRED CONSUMPTION IS A FUNCTION OF NATIONAL INCOME! John Meynard Keynes figured this out!

Here are some basic assumptions of the consumption function:
1) There is a break-even level of consumption (where consumption is exactly equal to disposable income)
2) as disposable income increases, consumption increases, but by less and less (in other words, the higher disposable income, the larger the portion of that income which will go into savings)
3) DESIRED CONSUMPTION IS A FUNCTION OF CURRENT DISPOSABLE INCOME!

*On a graph you can see this visually: consumption has risen with national income over the years in Canada.

Okay, so let's see one of these consumption functions!

-First off, this is a simplified version of the consumption function: most real ones would look more like curves, but we don't like to solve quadratics in this class
-The 45 degree line is where consumption is equal to disposable income- any point on this line is the break even point!
-As Y increases, so does C
-Here, Y = Yd (because this is a frugal economy)

-The slope of the consumption like is denoted by the variable 'b', and the actual term for it is the Marginal Propensity to Consume (MPC)
-The Y intercept is autonomous/exogenous expenditure which occurs even when there is no income: this is denoted by the variable 'a'
-Desired Consumption is 'C'
-Any point where consumption is higher than income has dissavings, or borrowed money, while any point where income is higher than consumption has savings

C = a + b(Yd)

for example: Consumption = 100 + 9/10(Disposable Income)

Basically
-Income is either spend (so it goes into consumption) or not spent (so it goes into savings)
-Savings are non-consumption
-Disposable income is then equal to consumption + savings
-Negative savings are dissavings, or loans
-Savings are Disposable income minus consumption
-At the break even point, income is equal to consumption, and savings is equal to zero

It is possible to build a savings function from the consumption function!

The savings function is derived from C = a + b(Yd)
S = Yd - C
if C is a straight linear function, then...
S = -a + (1-b)Yd
S = the vertical distance between C and the break even line (45 degrees)

SOME OTHER TERMS WHICH ARE IMPORTANT TO REMEMBER:
Average Propensity to Consume (APC): This is consumption divided by disposable income- this is the slope of the ray from the origin to the point being considered
Marginal Propensity to Consume (MPC): This is a change in consumption divided by a change in disposable income- this is the slope of the tangent to the curve being considered (so, for this very simplified, linear graph, it is equal to the slope of the consumption function)
Average Propensity to Save (APS): This is savings divided by disposable income- this is the slope of the ray from the origin to the point being considered on the savings function
Marginal Propensity to Save (MPS): This is a change in savings divided by a change in disposable income- this is the slope of the tangent to the curve being considered on the savings function (so for this linear savings curve, it's just equal to the slope of the savings function)

SOME MATHEMATICAL RELATIONSHIPS WHICH WILL MAKE PERFECT SENSE
Income = Consumption + Savings
Income/Income = Consumption/Income + Savings/Income, so 1 = APC + APS
/\Income//\Income = /\Consumption//\Income + /\Savings//\Income, so 1 = MPC + MPS
MPC is a value between 0 and 1
C = a + b(Yd) where a = the vertical intercept and b = MPC

THAT'S ALL FOR TODAY

Calculating National Income

2010-01-11T22:11:00.000-08:00

There are three different approaches which we can use to determine the national income. We're going to review all of them in a big, boring, and utterly painful lecture.

1) GDP from Value Added Approach- a measure of the value of all goods and services produced in a fiscal year
2) GDP from Expenditures Side- a measurement of the flow of expenditure
3) GDP from Income Side- a measurement of the flow of income

THE VALUE ADDED APPROACH

Problem: Why not just add the value of each producer's individual output?
Answer: Because production occurs in stages, so in order to avoid counting inputs twice (ie: counting the steel used to build a car, and then the car as well), we must either include only final products in our math, OR only count the value added to products at each stage of production.

Definitions:
Double Counting: Adding the value added more than once to the final value of a good or service
Intermediate Good: output which is used as an input for another good (ie: steel used to build a car)
Final Good: Output NOT used again as an input- output used for final consumption in the time period being considered
Value Added: The value which is added to a product at each stage of production. Revenue minus the cost of intermediate goods from other firms (ie: if a car sells for $2000, and the parts used to make it cost $1000, the added value is $1000). Value added is equal to factor income (WRiP) for any stage of production.
Revenue: Factor Income (WRiP) + The cost of intermediate goods from other firms.

NOTE: Value added does not factor in the costs of factors of production from other firms (so it does not matter how much it costs a steel manufacturer to produce car-steel: this is not factored into the final value of the car)

SO...

GDP (A measure of national income) is the FINAL (not intermediate) MARKET VALUE (determined by the price system of supply and demand) of all GOODS AND SERVICES (goods are tangible, like watermelons. Services are intangible, like haircuts) PRODUCED (so only actual output is measured- flipped assets like stocks or resold real estate does not factor into GDP) in a GIVEN PERIOD (A fiscal year is April to April)

THE EXPENDITURE SIDE APPROACH:

GDP is also equal to the total amount of expenditure required to produce all of the outputs which GDP encompasses.

There are 4 different players in the economy, and thus there are 4 different types of expenditure

CONSUMPTION- Expenditure by the household. This is the 'using up' of a product by a final user. Expenditure can be on durable and non durable goods, as well as services

INVESTMENT- Expenditure by the firm. Investment refers to a change in Capital (Plant, Equipment, Inventory, or Residential Construct). Most of the time, investiture is on goods which are NOT intended for present or immediate consumption. Also, investment is for goods which are used to produce other goods (ie: sewing machines)

Plant and Equipment are "business fixed investment"
Equipment includes machinery and equipment
Inventories are used to buffer fluctuations in production and sales.
Inventories may be outputs or inputs, and they are valued at fair market value
Inventories can be considered investment because they are expenditure on goods not for current consumption, and because we assume that the firm has paid for these goods themselves
Divestment is decumulation, or the reduction of inventory- in other words, a decrease in the stock of fixed goods available to be sold
Residential Construction is investment because a house or building is consumption over a long period of time, and thus not for present consumption
-This only applies to newly built houses or buildings- not purchases from a builder or used homes

GROSS INVESTMENT = NET INVESTMENT + DEPRECIATION! REMEMBER THIS!
Depreciation is the wearing out of capital, and also the cost of replacement capital: it is forced investiture which is not earned by any factor of production

Captial Cost Allowance (CCA) is an income tax act approximation for depreciation

we use GROSS INVESTMENT to calculate GDP (gross investment for gross domestic product- it makes sense). Why? Because all investment, even on broken equipment, creates an income flow and therefore contributes to GDP.

GOVERNMENT EXPENDITURE: This includes all government purchases of goods and services
-These are valued at cost to the government, not at their market value (because it is difficult to assign a market value to certain services which are provided at cost by the government, such as courts)
-Government expenditure also includes government investment!

-TRANSFER PAYMENTS are expenditures not in return for a service. Some examples include expenditure on the Canada Pension Plan, Employment Insurance, and Welfare payments (basically, situations where the government 'gives away' money in some form or another)
-This shows that "expenditure" is not always a "purchase"
-we EXCLUDE transfer payments from our calculation of the government''s expenditures when accounting for GDP

NET EXPORTS:

Exports = X = Goods leaving the country and money entering the country. This adds to our GDP
Imports = M = Goods entering the country and money leaving the country. This lowers our GDP

Net Exports = X - M (it can be positive or negative)

TOTAL EXPENDITURES = GDP

SO...

GDP = Consumption + Investment + Government Expenditure + Net Exports
Y = C+I+G+NetX

Wooooooooooo!
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THE INCOME SIDE APPROACH TO GDP
Here, we use income claims from different factors and non-factors of production to calculate the national income. To put it simply we say that the national income is equal to factor payments plus non-factor payments

FACTOR PAYMENTS (WRiP): Another word for these is Net Domestic Product at Factor Costs
"Net" means that we do not take depreciation into account
"Domestic" means that these are domestic factors (ie: we can't add Saudi oil production incomes to Canada's GDP)
"Factor Cost" means the value of output which can be accredited to factors minus the net taxes paid by the firm

DIFFERENT TYPES OF FACTOR PAYMENTS
Wages & Salaries: A return to labour- it can include gross wages, cpp, other pensions, and extra benefits (like dental)
Economic Rent: A return to land- this can include stumpage fees, or oil royalties
Interest: A return to capital- This is the rate of return of capital
Profits: A return to Entrepreneurship and Technology- This includes dividends (distributed profits) and retained earnings (undistributed profits)

NON FACTOR PAYMENTS: Indirect Business Taxes minus Subsidies plus Depreciation
Non factor payments are money which is paid to firms which are not for income claims by factors
In other words, output by firms can generate income NOT accruing to those four factors. These are non-factor payments, and there are 2 types:

1) Indirect Business Taxes less Subsidies: Tax on production collected indirectly by third parties (like excise taxes, provincial sales taxes, and government sales taxes). This is a claim by the government on production which was NOT included in the net domestic product at factor costs. We add this to income to get the MARKET VALUE of goods.
Subsidies are benefits on production contributed indirectly by third parties (like the government subsidizing BC translink)- in other words, these are goods and services whose market value is artificially lowered due to government intervention. As a result, we subtract subsidies from income to get the market value of the good.

To make this easy, let's just say we want to calculate national income using what people ACTUALLY PAY for things: people actually pay indirect business taxes, so we add those, but people don't pay for subsidized portions of things, so we subtract those! Simple enough, right? =D

WriP + (IBT - Subsidies) = Net Domestic Product (NDP)

DEPRECIATION:
-This was not included in the NET domestic product at factor costs
-This is required reinvestment for simply maintaining capital stock
-It is not earned by any factor

NDP + Depreciation = GROSS DOMESTIC PRODUCT! YAY!

SOME EQUATIONS TO REMEMBER:
GDP = Factor Payments (WRiP) + Non Factor Payments ([IBT - Sub] + Dep)
NDP = GDP - Dep
NDPFC = NDP - (IBT - Sub)
WriP = NDPFC
NDPFC + (IBT - Sub) = NDP
NDP + Dep = GDP
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OTHER THINGS TO WORRY ABOUT

Gross Domestic Product versus Gross National Product

GDP: Income produced in Canada - domestic (it could be made in Canada by non-citizens and still count)
GNP: Income received by Canadians - nationals (it could be made by Canadians working outside of the country)

Calculating Gross National Product:
-GNP = GDP minus factor income produced in Canada but received by foreigners (non-Canadians) plus factor income received by Canadians from abroad

Generally, the value of Canadian based assets owned by foreigners is much greater than the value of foreign assets owned by Canadians (we do have a relatively small population in Canada), so the GDP is much higher than the GNP

Personal Income:
Personal Income is GDP minus any part NOT received by households (Depreciation, retained earnings, etc.)m plus transfer payments received by households: PI = GDP + Net Transfer Payments

Disposable Personal Income: Personal Income minus Personal Income Tax

Real Versus Nominal

Nominal values are related to money values, and change according to prices and current values. Nominal values reflect price changes and quantity changes
Real values stay constant over time. Real values only reflect quantity changes

REAL = Nominal/Price Index

For an example, real GDP = Nominal GDP/implicit GDP deflator (an implied raise in the price index, or inflation, in other words)

HOW TO DETERMINE THE IMPLICIT GDP DEFLATOR:
1: Set base year prices
2: Calculate current output at base year prices
3: Compare using ratios

GDP DEFLATOR = Current Q X Current P/Current Q X Base-year P
GDP DEFLATOR = GDP at current prices/GDP at base year prices
GDP DEFLATOR = Nominal GDP/Real GDP

Some things are omitted from GDP, for example...
-Illegal Activities (such as drug sales), because they are difficult to measure or ascertain
-Non-market Activities (such as housework, do it yourself repairs, and volunteer work), because these are not traded as services in a market
-Unreported Activities (such as bartered services or agreements), because they are difficult to measure or ascertain
-Economic "Bads" or negative externalities (such as pollution, stress, congestion, etc.)- these should be deducted from national income, but they are not traded in markets

Definitions for output
Production: Total output (GDP): This describes the size of the economy
Per Capita GDP: GDP divided by population- this is used to measure the standard of living
Productivity: GDP divided by employment, or GDP divided by # of hours worked- this is used to measure the rate of technological change and worker efficiency

Economics, however, is not involved in measuring happiness or quality of life. We leave that to other organizations!

That's all for now....

Basic Macroeconomic Concepts Continued

2010-01-08T15:21:00.000-08:00

UNEMPLOYMENT (U):
-News publications will often toss around unemployment rates, but very few people actually know what the unemployment rate means, or what a 'good' rate for employment or unemployment is

Increases in output are either caused by
1) more works being utilized (aka an increase in employment) OR
2) each worker being more productive

In the SHORT RUN, changes in productivity usually don't happen (they take a longer time to come to be realized), so only changes in employment affect output

In the LONG RUN, changes in both productivity and employment can affect output (so the Canadian economy could raise it's GDP either by putting more people to work, or by implementing more efficient production processes [like switching to machine-centric production processes which allow each worker to produce more in a shorter amount of time])

Definitions and Terms Surrounding Employment and Unemployment:
LABOUR FORCE: The total number of people who wish to work at any given time (Unemployment + Employment) ***Note: The size of the labour force can grow and shrink depending on how motivated the general populace is to work. Often, higher wages motivate more people to work, so in times where wages are higher, the labour force is also larger
EMPLOYMENT: The total number of workers ages 15 and older who have any kind of job (including part time work, full time work, and self-employment)
UNEMPLOYMENT: The total number of workers ages 15 and older who are willing and able to work, but have NO job
UNEMPLOYMENT RATE (U): UNEMPLOYMENT/LABOUR FORCE
EMPLOYMENT RATE: EMPLOYMENT/POPULATION

NOTICE how unemployment rate and employment rates are calculated differently? Pretty tricky, huh?

TYPES OF UNEMPOYMENT:
Frictional- turnover unemployment (people who are unemployed because their still trying to find a job that works for them, like recent college graduates)
Structural- unemployment due to mismatching (like when there are 20 positions for teachers and 20 unemployed plumbers- there are enough jobs, but they are the wrong kind of jobs for those who are unemployed)
Cyclical- unemployment that results from recessionary gaps

NAIRU = Non-Accelerating-Inflationary-Rate of -Unemployment: The rate of unemployment that exists at full employment

THE HISTORY OF UNEMPLOYMENT:
-Employment tends to increase fairly constantly in line with growth in the labour force
-Unemployment rates peak during recessions. In Canada, they fluctuate from 12% to 4%, but usually average at around 7%

WHY DOES UNEMPLOYMENT MATTER? Unemployment causes stress and unhappiness on an individual level, and creates economic waste on a macro-level. Overall, it's a very bad sort of thing
---------------------------------
PRODUCTIVITY: Real output per unit of input (all five different kinds of inputs)
LABOUR PRODUCTIVITY: Real output per unit of labour input- this can be measured either per worker or per hour worked

HISTORY OF PRODUCTIVITY IN CANADA:
Real GDP per worker has increased at 1.3% per year
Real GDP per hour has increased at 1.1% per year
Per hour is probably the better measure because the number of hours worked per worker can contribute to per-worker productivity (in other words, we aren't necessarily becoming more productive in Canada as much as we are simply working more hours)

Why does productivity increase? Usually because of increases in human and physical capital.

The trend is that both per hour and per worker GDP have been rising gradually in Canada over time.
------------------------------------
INFLATION (P) OR GENERAL PRICE LEVEL: The average price of all goods in the economy (usually expressed at CPI)
Inflation is defined as an increase in P (an increase in the average cost of all products)

CPI is the consumer price index. This is weighted average of all goods and services in a representative basket of goods (where each good is weighted depending on what percentage of their income the average consumer would spend on it). This is used to measure the cost of living.

Problems with CPI:
-It doesn't adjust for quality changes (ie: situations where you would pay the same amount of money but for a much better product)
-It also doesn't adjust for changes in consumption patterns over time

4 steps to construct an index:
1) Determine the goods in the index
2) Find the base year quantity of goods times the base year price of goods
3) Find the current year quantity of goods times the current price of goods
4) The price index: the ratio of current year/base year

Purchasing power = the number of goods that can be purchased per dollar

HISTORICAL TREND: Inflation has caused the general price level to increase to over 6 times its 1960 level. The rate of inflation can fluctuate wildly

WHY INFLATION MATTERS: Inflation diminishes the purchasing power of money, it reduced the value of fixed assets. If inflation is unanticipated, it can have serious macro effects.
------------------------------
INTEREST RATES (i): The cost of borrowing money
-"The" interest rate is the mean of all of the different interest rates
-The prime rate is the rate which chartered banks charge to preferred customers
-The bank rate is the rate which the bank of Canada charges to chartered banks

The nominal interest rate is the current rate of borrowing (the real interest rate + inflation)
The real interest rate is the nominal interest rate corrected for changes in purchasing power (so if the current interest rate is 5% and inflation is currently 5%, then the real interest rate is 0% [nominal minus inflation])
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EXCHANGE RATES (e): These are the same as they were in micro
Foreign Exchange = Actual Foreign currency
Foreign Exchange Market = The Market for Foreign Currency
External Value = The price of domestic currency
Exchange Rate = The price of foreign currency
Appreciation = rise in external value and fall in the exchange rate (when domestic currency becomes worth more relative to foreign currencies)
Depreciation = fall in external value and rise in exchange rate (when domestic currency becomes worth less relative to foreign currencies)

BALANCE OF PAYMENTS (BOP) = a measure of the money going in and out of any country
BALANCE OF TRADE = Exports minus Imports = net exports = NX

Historically, our imports and exports have both increased over time, but our net exports are positive (The US's net exports are negative right now).

Our exchange rate has fluctuated greatly over time. It's reached parity with the US a few times (like in 2008).

Growth and Fluctuations (Business cycles) are different!

Introduction to Macroeconomics

2010-01-06T14:01:00.000-08:00

Here we go!

MACROECONOMIC MODELING: There are two different ways to model the economy.

-Bottom up modeling uses all of the principles of microeconomics (such as profit and utility maximization) and analyzes the choices made by workers, firms, consumers, and others to create a model of the economy. A bottom-up model assumes that the economy works, and thus wages and prices are flexible within a bottom-up model.

-Top down modeling is a macroeconomic aggregation (summation) which analyzes the collective behavior of larger groups (as opposed to individual actors). Thus, top down modeling focuses on total demand and supply within an economy, and also assumes wage and price rigidity.

OUR course follows the Top Down approach to macroeconomic modeling. We do not explicitly rely on microeconomic foundations here, and we are initially assuming wage and price rigidity.

REMEMEBER:
-Macroeconomics is concerned with the 'big picture'
-Macroeconomics studies aggregates and how government policy affects them (ie: the government can manipulate the economy)
-The concepts of price and quantity which we learned in Microeconomics now become the general price level (P) and the national income or production or Gross Domestic Product (Y)
-Two issues of major importance are BUSINESS CYCLES and GROWTH of Y

BUSINESS CYCLES: The cycles of the national income in the medium term
GROWTH of Y: The long term trend of national income

Macroeconomics studies FISCAL and MONETARY policy

FISCAL POLICY: Government policies regarding taxation and spending
MONETARY POLICY: Government policies regarding interest rates and the money supply

There are 5 different variables which we have to learn for macroeconomics. Y, U, P, i, & e (we call these the YUPie varaibles in Gateman's class). For each of these different variables, we will be learning what exactly the variable refers to, what historical trends have we observed regarding the variable, and why the variable is important.
-----------------------------------------------
Y: OUTPUT AND INCOME
****REMEMBER: Output generates income!
DEFINITION OF Y: Final market value of all goods and services produced in the economy during a defined period of time (usually a fiscal year).

Final- refers to the fact that intermediate goods do not count towards GPD (so you cannot count both a car and the steel needed to produce that car both as contributors to national income)
Market Value- This refers to the value of products as determined by supply and demand
Good and Services- Both concrete goods (like tomatoes) and immaterial goods (like economics classes) contribute to GDP
Produced in the economy- this refers to the fact that 'flipping' products does not add to the GDP, so a stock broker who makes a small fortune from buying and selling stocks is not technically contributing to the GDP. On the other hand, if this broker were were to create a financial brokerage service for others, this WOULD contribute to the GDP (because the broker could be seen as offering a service to others for money)
A fiscal year in Canada is usually from April of one year until April of the next year, because that is when the government unveils the budget (their plan regarding spending and taxation)

Nation Income (Y) is the 'target' at which we aim the economy- in other words, it is the variable which we seek to manipulate directly in order to make changes to the economy. The government uses fiscal and monetary policy to accomplish this task. Unemployment (U) is inversely related to growth in Y, so as national income grows, unemployment shrinks. Conversely, as the national economy shrinks, unemployment rises. Inflaction (P) is directly related to growth in Y, so as the national income grows, the general price index (aka inflation, aka P) will increase.

Just REMEMEBER THIS:
National income (Y) is the primary target of attempts to manipulate the economy
Unemployment (U) and Inflation (P) are secondary
Interest Rates (i) and Exchange Rates (e) are tertiary

So, in other words, every macroeconomic variable we deal with in this course is affected by national income.
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THE CIRCULAR FLOW DIAGRAM

The red arrow flowing from households to producers represents flow of factors (workers provide factors to producers so that consumers may produce products)
The black arrow flowing from producers to households represents flow of income (producers give workers wages in return for providing labour as a factor of production)
The red arrow flowing from producers to households represents flow of output or goods (households buy products from producers)
The black arrow flowing from households to producers represents flow of expenditures (households pay producers money in order to purchase goods)

The red arrows here show real flows (flows of real goods, services, and factors), while the black arrows should money flows. There are two systems represented here: the output-expenditure flow (also known as the products market) and the factor income flow (also known as the factor market)

IMPORTANT*** GDP(Y) = GDP(E) (income = expenditures)
Also, OUTPUT GENERATES INCOME (so the higher our output, the higher out income)

This basic circular flow structure is called a spendthrift economy.

If we add a bank to the system, we can call it a frugal economy. Here, actors can put money into the bank (this is called savings) and the bank can lend money out to different actors (this is called investment). If the level of savings is equal to the level of investment, then the flow of money doesn't change, and the national income remains at equilibrium (so it is constant over time)

If we add government to the system in addition to a bank, we can call it a governed economy. There difference between a government and a bank is that with a bank, withdrawal and injections of money are voluntary, where as with the government, they are imposed. Taxation is like an imposed version of savings- it takes money out of the economy, while government spending is equivalent to investment, it injects money back into the economy.

If we also add the rest of the world to our economic system, we have an open economy. Here, we can have imports, where domestic consumers purchase foreign goods, and effectively move money out of the economy, and exports where foreign consumers purchase domestic goods and effectively inject money into the economy.

JUST REMEMEBER: for any of these added institutions, as long as all money withdrawals are equal to money injections the GDP is in equilibrium!
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GDP - Income
W, R, i, & P all refer to different flows of income- they are the returns for factors of production

W = wages- a return on labour (N)
R = economic rent - a return on land (L)
i = interest - a return on capital (K)
P = economic profits - a return on technology and entrepreneurship (T & E)

GDP - Expenditures
C, I, G, & netX all refer to different flows of expenditure- they are returns for output products (ie: payments for goods and services)

There are four plays in an economy, all of whom must accumulate expenditures

C = Consumption, or expenditures by households
I = Investment, or expenditures by firms
G = Government Expenditure, which is obviously expenditure accumulated by the government
netX = Net exports: in other words, the total number of exports minus the total number of inputs. This is foreign expenditure on domestic goods minus domestic expenditure on foreign goods (X-M).

Y has many many different synonyms. It can refer to:
-national income
-national expenditure
-output
-production
-GDP
-the real thing
-it is a measure of material wealth (the standard of living is the per-capita GDP): this is basically a measure of the material wealth of a nation)

It is NOT, however, a measure of quality of life (money can't necessarily buy happiness).
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REAL VS. NOMINAL VALUES

Nominal: Actual, current, money, refers to changeable prices and quantities
Real: Constant dollar- here, there are only changes in quantity, while holding the price constant to base year values.

REAL = NOMINAL/PRICE (so real could be the number of cars produced, nominal would be the value of cars produced in 2009, and price would be the price of each car in 2009)

***IN OUR COURSE, WE WILL ALWAYS ASSUME THAT Y IS REAL UNLESS OTHERWISE STATED.
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OUTPUT GAPS

Potential National Income (Y*) is the maximum achievable output level if all inputs are used at their NORMAL UTILIZATION RATE

Output gap = Y - Y* (actual output level minus potential output level)

If the output gap is negative, then it is a recessionary gap, and the economy is producing at less than its potential
If the output gap is positive, the it is an inflationary gap, and the economy is producing at more than its potential.
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THE BUSINESS CYCLE: Changes in Y over real time

4 Stages:
1- Trough (recession/depression)
2- Expansion (boom/recovery)
3- Peak
4- Contraction (slump)

Recessions are downturns in economic growth: two quarters (6 months) of negative growth
Depressions are periods of persistent low growth, high unemployment, and excess capacity

HISTORICALLY, potential output has tripled since 1970, and the output gap is very cyclical (hence business cycles)
Growth varies, but average growth over the last 40 years had been 3.5% per year. Sometimes growth is negative (hence a recession)

WHY DOES NATIONAL INCOME MATTER?
Output gaps concern politicians, because inflation causes high prices which voters do not like, and unemployment also makes voters unhappy. As a result, politicians try to focus on eliminating output gaps.
Economists are more concerned by the potential output. Economic growth is a long term trend we are witnessing: per capita GDP or the standard of living is increasing over time (although this may be deceptive, as standard of living applies only to the average person. In reality, the standard of living may seen reasonable for a country when in reality, there is an enormous wealth gap between the poor and the wealthy).

That's all for today

And So It Begins

2010-01-06T00:25:00.000-08:00

I have no notes for macroeconomics as of yet. I'm not making a new blog for macro- just keep reading this one and pretend that the title says 102, and not 101. =)

Good luck to all of us...

Free ECON 101 Tutoring

2009-12-10T00:50:00.001-08:00

I blog this, I can help you out if you need.
Just come down to vanier commonsblock thursday or friday afternoon, or if that doesn't work for you, just send me an email- jsussman@telus.net

Cases Against Government Intervention!

2009-12-04T17:17:00.000-08:00

Not every case where the government intervenes in the economy is optimal. There are many cases where intervention is probably not the best idea: for an example, should the government go crazy with spending on new infrastructure and facilities just because vancouver won the bid for the olympics?

So, what determines whether governments should intervene or provide public goods? Well, it depends on whether the social costs outweigh the social benefits (the total social costs and total social benefits- this is includes both private costs and benefits, and externalities). The social costs are the total opportunity costs of a government intervention (eg: should there be marginal cost pricing for vancouver translink? Well, the social costs are the taxpayer dollars which could have been spent in other ways: ie, to lower UBC tuition). The social benefit of an intervention is the cost of the market failure which the intervention prevents. Sometimes, by intervening and attempting to correct a market failure, a government incurs an even larger social cost than the market failure would have caused.

So is there a social benefit to a new skating oval in richmond? Absolutely not! There was no social demand for this skating oval prior to the olympics, and the money could have been spent on much more important things (eg: social housing)

PROBLEMS WITH COST-BENEFIT ANALYSIS?
-How do you quantify subjective costs and benefits to society (eg: the happiness something will bring, the future problems pollution could cause, etc)?
-It can be difficult to forecast the future, and many economic predictions rely on predictable futures (case example: many provincial governments went WAY over budget in 2009, because they did not anticipate the economic meltdown).
-Governments often discount future costs in order to benefit the present (the olympics is a perfect example: vancouver and the BC government are spending billions of dollars on a small party, which we will have to pay off, with interest, for years and years in the future)

METHODS OF GOVERNMENT INTERVENTION:
-Public provision versus user-pay: is it better for the government to own and provide a particular service, or is it better for the government to contract that service out to the private sector, and then just pay the private sector for their work? **Note: check out the handi-dart strike in Vancouver if you want a really cool look at some of the problems that can result from contracting out public work to the private sector. This goes against the right-wing principles of Gatemanism, but its definitely worth a look.
-Regulation (some problems are that there are costs to enforcing regulations, and most firms can find some kind of legal loophole to get around enforcement)
-Redistribution of income (Taking money from the rich and giving some to the poor through different social programs. socialism! Yay!)

COSTS OF INTERVENTION:
-Direct costs: The government uses real resources (ie: steel to make military vehicles)
-Indirect costs/externalities: ie, extra costs of production due to safety standards and environmental control (eg: safety goggles and pollution filters cost money), costs of compliance (eg: Red tape and pay equity), and the cost of Rent seeking (where companies pay for lobby groups to lobby the government for economic advantage).

WHY DOES THE GOVERNMENT OFTEN FAIL WHEN INTERVENING IN MARKETS? Most of the causes of government failure are systemic- they occur naturally within the system of government intervention.

Public Choice Theory:
-There are three different stakeholders for government policy
Politicians: They want to maximize their political power
Bureaucrats: Want to maximize authority and salary
Electorate: Want to maximize utility
The electorate want to maximize their total utility, and often, this is achieved when private citizens choose to IGNORE political-economic policy issues. This is called RATIONAL IGNORANCE: There is no incentive for the electorate to become informed when they only have one vote each. As a result, government can get policies which hurt the electorate passed because we don't have the information to stop them.

Rent Seeking: Special Interest Groups have an inordinate ability to lobby the government and get policies created which benefit them at the expense of everybody else.

Democratic Inefficiency and public Choice:
-One vote fails to account for preferences (so people have, in reality, very little control over the decisions the government makes)
-There is a TRADEOFF between democratic processes and efficiency (so the more democratic something is, the longer it takes to get anything done. Key examples of this include governments like Weimar Germany, which were socially democratic, but incredibly inefficient. In Weimar germany, the merits of everything had to be weighed and voted on, so it took them ages to actually get anything accomplished. Fascism, although often terrible, is much more efficient than democracy).

Government Monopolies: In industries in which there are government monopolies, there are no market forces to create innovation and further efficiencies, which can lead to stagnation. This is not good! Think of Canada Post, and how inefficient it is!

OKAY, so what is the optimum level of government intervention? Well, to decided that, you have to compare the market with government performance. Usually, this involves making value judgements, which is why so many different countries have different levels of government intervention in their economies: they have made different value judgements!

THAT'S THE END OF ECON 101!

HERE IS THE TAKE HOME MESSAGE:

1: Assume nothing. Why? Well, economics is all about putting together arguments. In order to make a good argument, you need to get rid of your assumptions, don't jump to conclusions, and evaluate the evidence clearly for yourself. Make sure your arguments are based on observable, provable facts, and not sound-bites which you've picked up from different sources.

2: Rational Wisdom: Using your smarts with a broader perspective!
-You're at least as smart as the next person. There's even the chance that you might be smarter.
-There are benefits to this: we probably get to become important people.
-On the other hand, you must use your smarts with humility and responsibility. Don't be arrogant- instead use your powers for good.

Congratulations on finishing Econ. It's study time. If you read these notes at all, share them with your friends. I'm probably going to be organizing some small scale, not-for-profit review sessions for anyone who's interested over the next couple of weeks. I'll be making a post here as soon as I've got times and dates figured out for that.

Government Intervention: When Markets Fail

2009-12-02T10:21:00.000-08:00

WHAT IS THE BASIC FUNCTION OF THE GOVERNMENT?
-The government has a monopoly on violence, in order to keep society from dissolving into violent anarchy (in countries where the government does not have a monopoly on violence, anarchy and civil unrest make like very difficult- just think of Somalia, or Afghanistan)
-Because the government has this monopoly on violence, they can enforce property rights laws, and prevent people for stealing other people's property
-The government's main job from an economist's perspective, then, is to enforce property rights
-By enforcing property rights and maintaining stability, governments allow for economic activity and prosperity.

OKAY!

So, for most of this course, we have been focusing on how the market works. In most of the cases we have explored, an economy regulated by the invisible hand of the market leads to the best possible outcome for society. This chapter will examine certain situations where markets fail to provide the best possible outcome for society, and how the government can intervene to correct this. We're also going to look at some inherent problems with government intervention.

Basically, when looking at any economic situation, we should ask ourselves:
-"Is the market working or failing"
-"If the market is failing, what is the optimal level of government

Markets are working best when they are allocatively efficient. Competitive markets are allocatively efficient:
-Competitive Markets use marginal cost pricing, so the price is set at the marginal cost of producing the last unit
-Competitive Markets minimize price and maximize the quantity produced
-Competitive Markets maximize economic surplus

If all markets were perfectly competitive, then the economy would be allocatively efficient. This is a pareto optimum, and neither producers not consumers would be able to add to their own surplus without causing the other to lose surplus.

PROBLEM: Most markets aren't perfectly competitive!

Here is an informal defense of natural market forces- why governments should usually just let the economy run itself.
-Free markets are automatic, flexible, and decentralized
-The price system acts like an invisible hand, regulating the market: demand affects price, which in turn, affects supply.
-There is no need for inefficient, centralized planning
-The pursuit of profits stimulates innovation and economic growth
-Power is naturally challenged through competition and innovation, so it is ultimately difficult for monopolies to exist indefinitely.
-Milton Friedman argued that economic freedom is essential to political freedom (which makes sense: if you don't have enough money to afford a house or fixed address, then you can't vote).

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INSTANCES OF MARKET FAILURES: Sometimes we do need the government to intervene. Sometimes, intervention is a waste of public funds. Many of the services which the government provides are, according to our prof, unnecessary and wasteful.
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MONOPOLIES:
-Monopolies and monopolistic competition have downward-sloping demand, so they are allocatively inefficient.
-This is due to barriers to entry
-The government usually does not obliquely try to eliminate monopolies. Instead, they either punish monopolies with regulation, or they try to create a level playing field with competition policy
-Governments can intervene in monopolies to make things more allocatively efficient

EXTERNALITIES: Non-priced costs or benefits which affect third parties
-This refers to the results of economic functioning which effect people other than the buyer and the seller (for an example, if you buy a coat of paint for your house, and then paint the ugly front of your house to make it look nicer, this creates an external benefit for your neighbor, whose property values probably will increase as a result).
-EXTERNAL ECONOMIES are external benefits, such as the added benefit your neighbor receives when you paint your house
-EXTERNAL DISECONOMIES are external costs, such as pollution or second-hand smoke.
-PRIVATE COSTS are the costs to the buyer or seller (this includes opportunity cost)
-SOCIAL COSTS are the combined external costs and private costs of any economic decision. This is the opportunity cost to society.

Externalities create unrecorded discrepancies between private costs and social costs, and result in allocative inefficiencies on a societal level

Negative externalities can be treated like an extra cost, and thus shift supply to the left!
This means that when there are negative externalities which are not taken into account, usually an economy is overproducing at too low a price. By raising prices and scaling back production, these economies can become allocatively efficient

Positive externalities can be treated like an addition to demand, and this they shift demand to the right!
This means that when there are positive externalities which are not taken into account, usually an economy is underproducing at too low a price. By increasing production and raising prices, these economies can become allocatively efficient.

Governments can correct externalities by forcing corporations to pay for negative externalities as an added cost.

APPLICATIONS OF EXTERNALITIES:
Here are some negative externalities which are fairly well known
-Nuisance externalities (pollution is considered a nuisance in legal terms)
-Open access resources (eg: fish in the Fraser river. There is a negative externality, in that catching the fish depletes fish stocks and reduces the availability of fish in the future).
-Congestion of highways (The fact that cars take up space on the highway is not taken into account, so even though it doesn't cost to use the highway, a negative externality is created from the frustration and irritation of having to deal with too many extra drivers)
-A famous example is the tragedy of the commons. In olden days when peasants still had commons land where they could let their animals graze, many peasants failed to take into account the cost of maintaining the grass and animal food supply of the commons. As a result, they overused the commons, and eventually all of the natural animal food become depleted, so the livestock died of starvation. This is an example of overproduction (overuse of the commons) due to a failure to factor external diseconomies into social costs.

PUBLIC GOODS: Sometimes, governments must intervene in order to provide society with a specific kind of good which markets cannot provide. Here are the characteristic of a pure public good:

1: It must be non rivalrous- in other words, consuming this good will not reduce the ability of others to consume this good (a good example of this is information-- gathering information from a sources does not hinder anyone else from gathering that information (unless you are stealing library books or something stupid like that)

2: Non excludability- If this good is produced, it must be a product which can be consumed equally by all- there are no restrictions in who is allowed and not allowed to use the good (so within the context of Gateman's class, the lecture itself is non-excludable. Everyone in the class is equally able to listen to the lecture and learn about economics from it). Example here include a lighthouse, or national defence.

Normal Goods: Rivalrous and Excludable-- This includes most goods which are sold on a market, such as chocolate bars, legal advice, plane tickets, etc. Governments can let markets take care of the distribution of normal goods. The market works here!

Common Property Goods: Rivalrous and Non Excludable-- This includes goods which anybody can access, despite their being a limited supply of the good. Examples include camping sites, or fish stocks. Often, common property goods suffer from the tragedy of the commons, and are overused because negative externalities are not factored into private costs. The market fails due to external diseconomies here!

Psuedo Public Goods: Non-Rivalrous and Excludable-- This includes goods which do not deppreciate when consumed, but which are distributed in such a way that some people are excluded from using them. Examples include art galleries, day care, roads, public parks, education, and others. The fact that these are non-rivalrous implies that supply is always greater than demand, so this excess supply will often push the price of a quasi public good down to zero. Often, the government provides these as merit goods. The market fails due to $0 price demanded, here!

Pure Public Goods: Non-Rivalrous and Non Excludable-- These are goods which do not deppreciate with use, and which are accessible to everyone. This includes things like national defence, a ligthouse signal, public information, and public protection. The free rider problem means than consumers usually will not reveal their price preferences, because they would rather someone else pay for the pure public good (everyone wants a free ride). As such, the government must use taxation to force everybody to pay for this good, or else, the good will not be produced. As such, we need the government to intervene. The market fails due to the free rider effect here!

So we need the government to intervene!

ASYMMETRY OF INFORMATION: This is where the buyer and the seller have different levels of knowledge about a particular good

a MORAL HAZARD, is an example of assymetry of information where one party has the ability and incentive to shift costs onto the other party due to some special knowledge which they posess (for example, a car mechanic could trick you into getting expensive work done on your car which you don't need). Another example is a used car salesman inflating the price of a used car.

ADVERSE SELECTION is an example of assymetry of information where "self selection" adverse affects the group. Because people who are poor drivers are more likely to purchase insurance, and isurance companies often have no way of evaluating each customer's driving abilities, poor drivers increase the overall cost of insurance at the expense of good drivers. Similarly, people who are unhealthy pay the same medical premiums as everyone else, yet cost the medical system much more money. Here, there are negative externalities created by adverse selection. The private cost to a smoker for using the hospital is less than the social cost of that hospital visit.

THE PRINCIPLE AGENT PROBLEM: Where top employees for a company seek to maximize revenues (and their own salaries) at the expense of net profits. Here, marginal social benefits and marginal social costs are not equated, so the firm is inefficient.

THUS WE HAVE A CASE FOR GOVERNMENT INTERVENTION

OTHER SOCIAL GOALS: Sometimes, governments seek to intervene for reasons other than market failures! Here are some of them

-Income redistribution (many people think this a fairer way of allocating wealth. Professor Gateman thinks its just a throwback to communism)

-Merit Goods: The government provides goods which are not pure public goods based on their Merit to society (eg: Healthcare and education). They cold technically also be provided by private groups.

-Social obligations (eg: jury duty, conscription, voting, etc.)

-Economic Growth (research and developement)

That's all for now!

The Government and Economic Policy

2009-11-26T10:50:00.000-08:00

Governments have two different options in terms of economic policy.
-They can enforce economic regulation (and punish firms who misbehave)
-They can draft competition policy (and create an economic environment conducive to competition)

The big issue here is market power versus rivalry. Generally, market structures closer to perfect competition are seen as preferable, but this must be qualified- perfect competition and efficiency are not always the best outcomes for society.
-Efficiency is not always the only goal for society. For instance, an industry may be the most cost efficient if it outsources labour to a Malaysian sweatshop, but but many people see wage slavery as unethical, and would rather pay a higher price for FAIR TRADE goods than inexpensive but guilt-inducing free-trade products
-Private Costs to Industries do not include social costs, such as environmental damage. A highly economically efficient production process may incur a high external cost to society through the accumulation of dangerous pollution, etc.
-Costs are not independent of market structure. If there are economies of scale inherent in the market, perfect competition may divide up market shares to the point where the minimum efficiency scale would provide for more products than is suitable for each firm to maximize profit. As such, a shift to a monopoly structure may be more efficient (as in the power industry, landline telephones, and other tentacle industries)
-Monopolies may be necessary for innovation. Generally, the size and profits of monopolies give them more economic freedom to invest in research and development (for an example, drug companies receive patents which grant them the exclusive right to sell new drugs they develop because this monopoly profit incentive drives new research)
-Also a competitive desire from external firms hoping to enter an industry may drive innovation (as seen in cell phones, email, solar panels, and other new technologies which de-emphasize monopoly power in certain sectors.
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Economic Regulation to Promote Efficiency!

Controlling Natural Monopolies (Industries where scale economies and high fixed costs permit only one firm to operate at minimum efficiency scale, and discourage other firms from entering the industry- tentacle industries like electric companies): There are two options
-Buy up the monopoly and turn it into a state-owned Crown Corporation
-Allow private ownership to continue, but regulate the monopoly firm (using bodies like the Canadian Radio and Television Commission, for instance)

If the government chooses to regulate, or if it chooses to buy up a tentacle it must dictate the pricing policy for that industry:
-It can induce marginal cost pricing, and sell where the demand-determined price is equal to the marginal cost of producing the final unit
-It can induce average cost pricing, and sell where the demand-determined price is equal to the average cost of producing the final unit
-It can induce a "rate of return" legislation, where regulated firms are allowed to a small percentage of returns (eg: 5% profit)

MARGINAL COST PRICING:

Here, demand = supply, and price = marginal cost. The major benefit of this pricing model is that it allows for allocative efficiency (so there is no deadweight social loss). However, this is not the profit maximizing output where marginal revenue is equal to marginal costs, so there is an inherent conflict between the governments desire for allocative efficiency, and the firm's desire for profit.

As is shown be the green box in the diagram, when a natural monopoly with falling average costs uses marginal cost pricing, it incurs an economic loss (the price is lower than the average cost here, thus a loss is generated by producing at this output level). Usually, this loss must be offset with government subsidies (aka: taxpayer money)

REMEMBER: TR (Price at output level X output produced) - TC (average cost at output level X output produced) = A LOSS IN THIS CASE
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AVERAGE COST PRICING

Here, monopolies are forced to produce an output where demanded determined prices are equal to the average cost of producing at that output level. This means that total costs will = total revenues, so the firms here will make normal profits, and there will be no need for a subsidy. On the other hand, this pricing model is less allocatively efficient, as Price is not equal to the marginal cost of production here, and the quantity produced is less than what is required for maximum total economic surplus (so a deadweight loss is generated).

Which is better? Well, that's a value judgement. Marginal Cost Pricing is allocatively efficient, but requires costly subsidies. Average cost pricing is not allocatively efficient, but will not require subsidies.

Rate of Return pricing lets monopolies keep a "fair" profit. Here, allocative efficiency is ignored. A big problem with this pricing model is determining what is "fair".
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DIRECT CONTROL OF OLIGOPOLIES

-Historically, the government has controlled entry into certain industries (such as postal services and air travel) in order to protect crown corporations from competition.
-Recently, however, government intervention has become less popular. Crown corporations are increasingly becoming privatized, while regulated industries are becoming deregulated. An example of this is the open skies policy for airlines. Originally, Air Canada operated as a monopoly in Canadian air travel, and would often cross-subsidize airfare (so flyers traveling from Calgary to Toronto would pay extra so that travelers going from Vancouver from Nunavut would not have to pay as much [The UBC bookstore also does this to find student activities]). Now, Westjet has broken up that monopoly, but there is still legislation in place to prevent non-Canadian airlines from carrying passengers from one Canadian city to another.

Why is the government moving out of direct control for oligopoly markets?
-Oligopolies are a good source of innovation
-Cross subsidization which was used by crown corporations in the past is now not seen as economically sound
-There has been a great deal of corruption and cross fertilization between regulators and the industries they supposedly regulate (often, because employees at regulatory agencies later wish to seek employment in the industries they have previously regulated in order to make more money and help firms find regulatory loopholes)
-As such, regulators often favor producers over consumers
-Crown corporations do not improve labour relations and efficiency (just take Canada Post, and disgruntled postal unions for an example)
-International competition makes subsidies inefficient

The government strives to "maintain and encourage competition in Canada" - section 2 of the competition act
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CANADIAN COMPETITION POLICY (The carrot approach)
-Using this, the government tries to create a good balance between market power and efficiency.

In the combines investigation act (1889), the government created explicit restrictions in terms on non-competitive behavior under the larger legal umbrella of criminal law. There were four basic areas.
a) Conspiracy (this forbade explicit collusion)
b) Merger (this forbade companies from joining together or buying their competitors. Amusingly, this was originally intended to break unions apart, as unions were seen as creating a monopoly in labour markets and restricting trade and efficiency)
c) Monopoly-abuse of dominant position (Although this was seen as hypocritical by many firms, as the government favored competition, yet would penalize firms who were successful in negotiating markets and eliminating their competitors)
d) unfair trade practices

In 1986, this was replaced with the Competition Act, and the competition tribunal (a special economic court with economists acting as judges). Its purpose is to "maintain and encourage competition in Canada".

INDICTABLE OFFENSES (Things you can go to jail for doing)
-Conspiracy (explicit collusion)
-Bid Rigging (for firms who do contract work, bid rigging is a method of collusion)
-Illegal Trade Practices (such as giving certain buyers preferential discounts
-Misrepresentation (lying about costs or profits for instance)
-Telemarketing
-Double ticketing (having two sticker prices for a particular good)
-Pyramid Selling

Matters Reviewable by Tribunal (slightly less bad, but still suspicious)
Abuse of dominant position
-squeezing
-fighting brands (like the 'life' brand)
-Pre-emption (preventing entry)
-Predation (predatory pricing to eliminate competition over the long run)
-Mergers (Which cause a significant loss of competitive behavior) *** unless the raised consumer prices faced due to decreased competition can be offset by the productivity gains and lowered production costs brought about by the merger

THATS ALL!

Productive and Allocative Efficiency for different market structure

2009-11-25T12:11:00.000-08:00

We know that there are 4 different market structures in economics.

Now we're going to explore the idea of efficiency

PRODUCTIVE EFFICIENCY:
-This is when firms minimize the cost of inputs required to produce a given number of outputs
-This is also when firms maximize the quantity of outputs given a set combination of inputs (or set amount of money to spend on inputs)
-This is maximizing the input/output ratio (the greatest bang for your buck)
-Either hold output constant and minimize inputs (in other words, get on the LRAC curve, because the LRAC shows the combination of inputs which will cost the least in order to produce any quantity of output): This is the condition needed to reach productive efficiency for individual firms

OR

-Hold inputs constant and maximize outputs (get on the Production Possibilities Boundary)

In order for the industry to reach productive efficiency, each individual firm must have the same marginal costs because if one firm has lower marginal costs, then it is more efficient for that industry to switch to favor the lower cost producer.

CONCLUSION: In order to reach the production possibilities boundary for any one industry, both individual firms and entire industries must be productively efficient

ALLOCATIVE EFFICIENCY:
-The Allocative Concept is build around the idea of Pareto Optimality: a scenario where we cannot make someone better off without making someone else worse off. The allocative concept states that it is good to reach Pareto Optimality, because there, the mix of commodities which are produced match the mix of commodities which are desired by consumers. Allocative efficiency refers to a quality of an entire industry- not just an individual firm. While there can be many productively efficient points on a production possibilities boundary, only ONE of these is allocatively efficient.
-Allocative efficiency is one definition for "the best society can do"

CONDITIONS FOR ALLOCATIVE EFFICIENCY:
-We know that consumers will buy any one product up until the marginal benefit equals the marginal cost of that product
-The marginal benefit is the marginal value of any unit of a product minus the price
-THEREFORE, consumers buy units of a product until the price is equal to the marginal cost
-Perfect competition uses MARGINAL COST PRICING
-If the marginal benefit to the consumer outweighs the marginal cost to the producer, too little is being produced from society's viewpoint
-If the marginal benefit to the consumer is smaller than the marginal cost to the producer, then too much is being produced from society's viewpoint
ALL INDUSTRIES MUST EQUATE PRICE TO MARGINAL COSTS in order to that industry to be allocatively efficient

ECONOMIC SURPLUS MAXIMIZATION:
-Economic surplus maximization is allocatively efficient because it maximizes total surplus for all members of society
-This occurs when the price is equal to the point where demand equals supply (as it will in perfect competition). Here, total economic surplus is maximized and there is no dead weight social loss

-With free markets (where demand and supply naturally reach an equilibrium), it is impossible to make either the producers or the consumers better off without hurting the other: THIS IS PARETO OPTIMUM! This is the best scenario for society!

To test for allocative efficiency, we must ensure that:
-Price is equal to marginal cost
-Total economic surplus is maximized- there is no dead weight social loss!
--------------------------
PRODUCTIVE AND ALLOCATIVE EFFICIENCY WITH A PPC Curve

ANY POINT ON THE PPC IS PRODUCTIVELY EFFICIENT, because by definition, the PPC is the maximum level of output where all inputs are fully employed and productively efficient

ONLY ONE POINT ON THE PPC IS ALLOCATIVELY EFFICIENT, because only one combination of outputs will exactly match consumer's demands. On any other point, a tradeoff could be made in order to better one group of consumers without making anyone worse off. At the one point of allocative efficiency, no one can be made better off.

It is possible to produce too much or too little of either product.

REMEMBER: If the price is lower than the marginal cost, the producer is getting ripped off. Meanwhile, if the price is higher than the marginal cost, then the consumer is getting ripped off.
-----------------
EFFICIENCY IN PERFECT COMPETITION AND MONOPOLIES

PERFECT COMPETITION

CONDITION ONE: Is each firm producing on the LRAC in the long run? YES, because in the long run, all firms in perfect competition will produce at minimum efficiency scale.
CONDITION TWO: Is the marginal cost equal for all firms? Yes, because all firms in perfect competition face the same prices, and at the MES output level, marginal cost will = the price for all firms!

As a result, no reallocation among firms can lower industry costs: Firms in perfect competition are productive efficient!

In perfect competition, firms maximize their profits by producing where the price is equal to the marginal cost (marginal cost pricing). This will guarantee Pareto Optimality if all firms are in perfect competition: Why? Because here, there is no deadweight social loss, so both consumer and producer surpluses are maximized

Any output greater than or less than QE will reduce the total sum of producer and consumer surplus

IN SUMMARY: For perfect competition,
-Firms will produce at the minimum efficiency scale, so individual firms are productively efficient
-Marginal costs are equal for all firms, so the industry is productively efficient
-Price is equal to the average cost minimum, so in the long run, firms only make normal profits
-Price = marginal cost, so this market structure is allocatively efficient

MONOPOLIES AND EFFICIENCY

Monopolies are productively efficient!
-In the long run, the monopolist will be on the long run average cost curve (although not necessarily at MES). Why? Because monopolies want to maximize their profits by minimizing costs.
-This is productively efficient
-NOTE: The long run average cost for monopolies may be abnormally high (due to high fixed costs and excess capacity)

Monopolies are not allocatively efficient in the long run!
-To maximize profits, monopolies produce where marginal revenue equals marginal costs
-BUT, marginal revenue falls much more quickly than average revenue (price) as output increases, and thus, price will be greater than the monopolist's marginal costs at the monopoly's selected output level
-Because MC < P, the consumer is getting ripped off in a monopoly, and as such, monopolies are allocatively ineffienct

P > MC
Price is higher and quantity produced is lower than it would be if that same industry was in perfect competition
There is a deadweight social loss

WHEN INDUSTRIES CARTELIZE, THERE IS A DEADWEIGHT SOCIAL LOSS

See?

Game Theory Pt. 2

2009-11-22T10:50:00.000-08:00

In Oligopolies, and in game theory, there are also sequential games. Chess is a good example of a sequential game. In sequential games, there is time-sensitive sequencing, OR simultaneous knowledge of the other player's decision by both players. As such, we use decision trees to mark off the outcomes of sequential games.

DIFFERENT PATHS: The first player to move can use BACKWARDS INDUCTION to predict which moves their opponent will make given their move. The first mover here can predict all of the outcomes, and will probably choose the "large" strategy, because they will receive 30 points in every outcome for the large scenario. Given that the first player will always choose the "large" strategy, the second mover will always choose the large strategy as well, because they prefer having 3 points to having 0.3 points. AS SUCH, we know that there is a NASH EQUILIBRIUM, because both players are playing their best strategy given the strategy of the other play. Additionally, this is Pareto, as we cannot make either player better off.

ULTIMATUM BARGAINING GAME: In an ultimatum, the first player imposes a "take it or leave it offer". For an example, lets say that my mom gives my sister a dollar. My mom tells my sister that she must take that dollar and share some of it with me, or else she will take it away. In other words, my sister will offer me a portion of the money she has received, and I can accept it, or decline it. If I reject the offer, then neither me nor my sister will get a dollar. This is the payoff tree:

SISTER will propose $X for herself, and $(1-X) for me. If I accept this offer, I will get $(1-X), and my sister gets $X. If I reject this offer, we both get nothing.

Nash Equilibrium Occurs where I accept my sister's offer (regardless of the offer). This is because I would rather get a little bit of money than no money. Neither me nor my sister has any incentive to use any strategy other than this.

WHAT SHOULD MY SISTER'S STRATEGY BE? She should offer me the smallest amount as possible, because it is to my advantage to accept ANY offer. SO...

If my sister offers me 1 cent, it is still in my best interest to accept it, because 1 cent is better than nothing. In this scenario, my sister will get to keep 99 cents, and I will get 1 cent!

ULTIMATUM BARGAINING WITH AN ACCEPTANCE THRESHOLD: This is a version of ultimatum bargaining, but here, the second mover (me) can declare a minimum acceptance threshold (Y) in advance. This changes the payoff tree.

My sister can either propose an offer greater or equal to my minimum acceptance threshold (100-X > or = Y), or lower than it (100-X < Y). If she offers me an amount equal to or greater than my minimum acceptance threshold, then I will get $1-X, and she will get $X. If she offers me an amount lower than my minimum acceptance threshold, then I will reject the offer, and we will both get nothing.

Here, Nash Equilibrium occurs where my sister accepts my minimum acceptance threshold. This is because she would rather have a little bit of money than no money. Given my minimum acceptance threshold, it is always in my sister's best interests to offer an amount which complies with it.

SO WHAT IS MY BEST STRATEGY? Well, because it is always in my sister's best interest to accept my threshold, I stand to make the most money by setting my threshold as high as possible (99 cents). If I do this, then I will make 99 cents, and my sister will only make one cent.

KIDNAPPER GAMES ARE ALSO IMPORTANT, AS ARE COMPETITIVE MARKETS, but my internet just died and deleted all of the previous crap I typed up, and I am NOT spending another hour and typing it all up again. FORGET IT!

Oligopolies and Game Theory

2009-11-19T14:18:00.000-08:00

Today, we begin game theory, which is interesting and exciting- probably one of the neatest things you will learn in Microeconomics.

Oligopolies use game theory, because decision-making is strategic- it hinges on the decisions of other firms.

OLIGOPOLY CHARACTERISTICS
-Several Sellers (but not many: 2 or 3 is most common)
-They must sell a similar, but differentiated good (ie: coke and pepsi both sell soda, but they are well-differentiated. GM and Ford both sell cars, but the brands are different, as are the cars).
-Entry and exit from the industry is possible, but very very difficult
-All of the firms can act as price setters within a reasonable limit.

REASONS FOR OLIGOPOLY

1: STRATEGIC BEHAVIOR (It benefits the firms in the oligopoly industry, so firms will actively vie to maintain oligopoly conditions)
-Merger and acquisitions (bigger companies buy up smaller companies, so that in the long run, in major industries, there are only a few large companies competing)
-With fewer rivals, the remaining players reap larger profits
-This can only occur if there are substantial barriers to entry

2: NATURAL CAUSES
-Economies of Scale: Bigger, well established companies have bigger cost savings, and are more able to approach the minimum efficiency scale than newer entrants
-Economies of Scope: It is cheaper for a company to produce two products together
-Oil and gad had both economies of scale and scope working in favor of established companies, because larger firms have an advantage over smaller firms (especially in unstable economic times, when many smaller firms go under)

3: ARTIFICIAL CAUSES
-Oligopolies due to government policies
-------------------------------
GAME THEORY/STRATEGIC BEHAVIOR: Decisions that are based on what other people do. (This section will HURT your brain)

Game: A decision making process of two or more players who are interdependent. There are two different kinds of games:
a) Simultaneous Game: Where both players make their decisions are the same time (or alternately, they don't know what the other player is going to do). An example of this would be rock-paper-scissors.
b) Sequential Game: One player makes a decision, then the other player reacts (sort of like a game of chess).

Player: The decision maker/strategist. In economics, this usually refers to the firm

Strategy: An interdependent decision (for example, choosing to move a pawn or a bishop could be two different strategies: choosing to cooperate with other firms and form a cartel or or choosing to compete and try to make more profit than other firms could be two different strategies)

Payoff: The outcome of a game: profits!

TODAY: WE ARE LEARNING ABOUT SIMULTANEOUS GAMES

Here are a few different important terms:

NASH EQUILIBRIUM: When each player's best strategy is to maintain its present behavior, given the present behavior of the rival. Given the behavior of the other, both players are simultaneously playing their best strategy. Both players have a best strategy, and "my best strategy is to keep doing what I'm doing as long as you keep doing what you're doing
-Nash EQ is stable, because both firms end up in a Nash Equilibrium scenario (both players want to play their best strategy)
-Nash EQ is an equilibrium, because neither firm will benefit from departing from it (in this way, equilibrium could have nothing to do with maintaining supply and demand)
-Nash EQ is self-policing, because there is no need for group behavior to enforce it (players will naturally adopt their best strategies)
-Stable equilibrium is reached by rational non-cooperation (if both players pursue self-interests, they will reach a Nash Equilibrium)
-THE DOMINANT STRATEGY is the strategy that yields a higher payoff, regardless of the strategy of the other player!
-THE DOMINATED STRATEGY is the strategy that yields a lower payoff than an alternate strategy, regardless of the strategy of the other player. This is the strategy, which logically should never be played because it will always lead to a lower payoff than different strategies.

NOTES:

-If two players are in a game, and both are playing their dominant strategy, then there is a Nash Equilibrium
-BUT a Nash equilibrium can be reached when not ALL parties have a dominant strategy

THE PRISONER'S DILEMMA: A dilemma which faces some players in a Nash Equilibrium (so this is still a type of Nash Equilibrium). In a prisoner's dilemma scenario, both players have a dominant strategy, but if they both play their dominant strategy, the resulting payoff is lower than if they had both played their dominated strategy.
-An example of this is studying. In order to get good marks in a class, each student's dominant strategy is to study. Interestingly, if none of the students in a particular class studied and they all go abysmally low marks, then the prof would have no choice but to scale their marks up, so that the average would end up being the same as it would if all of the students had studied. In this case, each student would have gotten the same mark-payoff, but for a minimal effort.
-The prisoner's dilemma highlights the difference between the narrow self interest of individual players, and the broad collective interest of a group.
-Other examples? -Advertising, Cellphones, Everyone Standing at a concert, everyone shouting at a party, CARTELS

CARTELS ARE AN EXAMPLE OF THE PRISONER'S DILEMMA SCENARIO: If all of the firms abide by the rules set by the cartel and actually restrict their outputs as agreed, all of the firm can generate economic profit (their collective payoff is higher than if they compete)
-If one member of a cartel cheats, however, they can potentially earn even GREATER profits than if they acted according to the restrictions of the Cartel
-If all members of a Cartel cheat, however, the Cartel will break apart and all of the firms will be in competition.

YUP! difficult decisions to make for Cartel participants...

FINAL DEFINITION: PARETO OPTIMUM- "You cannot make someone better off without making someone else worse off"
-This is one concept of "the best"
-Synonyms? Allocative efficiency; Pareto Optimality; Pareto Efficiency
-EXAMPLE: I have a chocolate ice cream cone, and my friend Genya has a butterscotch ice cream cone. My favorite flavor of ice cream is butterscotch, and her favorite flavor is chocolate. Is this a scenario of Pareto Optimality?

NO!

This may be productively efficiency, but it is not allocatively efficient. We can trade our ice cream cones and BOTH of us will be better off. Let's say me and Genya trade ice cream cones. This is an example of a PARETO IMPROVEMENT

PARETO IMPROVEMENT: An action which causes someone to be better off without making someone else worse off. The opposite of a Pareto Improvement is a Pareto Dis-improvement, which is an action which makes someone worse off without causing someone else to be better off (so if a garbage truck came by and threw rotten garbage on me and Genya's ice cream cones, that would be a Pareto Disimprovement).

Pareto Optimum is ONE defition of a best-case scenario. There can also be many different Pareto optimums (for an example, if both me and Genya have rye crackers, and we both love rye crackers, that can also be a pareto optimum)

Here are some different scenarios!

1: NASH EQUILIBRIUM - BOTH DOMINANT - PARETO

HERE, Actor one's best strategy is C1, regardless of what Actor 2 does, and Actor 2's best strategy is C2, regardless of what actor one does. As such, both actor one and Actor 2 have a Dominant Strategy (C1 and C2 respectively).
This is Nash equilibrium, given the action of the other player, both players are simultaneously playing their best strategy. The Pareto Optimum here is the same as the Nash Equilibrium, as both actors get "8" points in Nash Equilibrium. You can't make either actor better off than they already are, so this is Pareto Optimum!

2: NASH EQUILIBRIUM - ONE DOMINANT -PARETO

Here, businessman M's dominant strategy is to sell meat. No matter what the other businessman does, M will have a bigger payoff is she sells meat.
Businessman P, on the other hand has no Dominant Strategy. If M sells meat, it is better for P to sell Potatoes. If M sells Potatos, P will have a bigger payoff selling meat.

NASH EQUILIBRIUM, therefore, is when M is selling meat, and P is selling potatoes. In this scenario, given the actions of either player, both players are simultaneously playing their best strategy.
Pareto Optimum is the same scenario as Nash Equilibrium here. Both players are receiving the must payoff they can receive give the situation, so there is no way to make either player better off.

3: BATTLE OF THE SEXES- DOUBLE NASH EQUILIBRIUM, NO DOMINANT STRATEGY, & PARETO
Let's say we have a nice, normal heterosexual couple. The man likes baseball, and the woman likes ballet (they follow typical gendered behavior, which is the sort of thing that nice normal heterosexual couples do). However, the man and the woman both love each other SO MUCH that they would rather be with each other and at an activity which isn't their favorite than go to their favorite activity alone.

If the man goes to the baseball game, the woman's best strategy is to go to the baseball game too. If the man goes to the ballet game, however, the lady's best strategy is to go to the ballet game, so she HAS NO DOMINANT STRATEGY.
If the woman goes to the ballet, the man's best strategy is to go with her to the ballet. If the woman goes to the baseball game, however, the man's best strategy is to choose baseball, so he HAS NO DOMINANT STRATEGY!

There are two different Nash Equilibrium Scenarios here- both the man and the lady go to a baseball game, or they both see the ballet. In either situation, each player is playing their best strategy given the actions of the other player. Here, there are two different Pareto Optimums. If the couple are at the baseball game, it IS possible to make the woman happier, but not without making the man worse off. Conversely, if the couple is at the ballet, it IS possible to make the man happier, but not without making the woman worse off. Because we cannot make either player better off without making the other one worse off, there are two Pareto Optimums.

4: CARTELS: A PRISONERS DILEMMA NASH EQUILIBRIUM: BOTH DOMINANT, BUT NOT PARETO
In Oligopolies, firms behave interdependently, so decision-making is strategic (it depends on the actions of other players). As such, firms must take the actions of their rivals into account.

The basic dilemma: Should firms cooperate and form a Cartel, or compete with one another?
If firms cooperate, the collective profits for all of the firms will be higher
If a firm decides to compete with rivals, that firm's individual profit will be higher.

Here, both player A and player B's dominant strategy is to compete! As a result, Nash equilibrium occurs when both players are competing. This is NOT pareto optimum, however, as a change to a cooperative strategy for both players would result in a Pareto Improvement (in other words, the players are in Nash Equilibrium, they can both better off without making somebody else worse off).

This is why cartels often collapse: because their dominant strategy is to cheat!

That's all

Introduction to Imperfect Competition

2009-11-16T12:10:00.000-08:00

Monopolies and Perfect Competition are both fairly extreme market structures. In reality, most firms operate in conditions known as imperfect competition. There are two different kinds of imperfect competition: Monopolistic Competition and Oligopoly

THERE IS A SPECTRUM OF DIFFERENT MARKET STRUCTURES:

Monopoly---Duopoly---Oligopoly---Monopolistic Competition---Perfect Competition
Competition increases as we go to the right (with the exception of perfect competition, in which there is no competitive behavior)
Market power increases as we go to the left (remember, market power is the ability of a single firm to control the price of a good).

CANADA: A large country with a small population (but it's getting bigger).
-The large geographic area of Canada creates higher transportation costs and natural barriers to entry (for an example, atlantic fishers cannot enter the pacific fishing market, because the costs of transporting their goods to BC for sale are too high).
-Our small population causes excess capacity (in other words, most Canadian firms which only operate domestically do not get to reap the benefits of a minimum efficiency scale because demand in Canada is not high enough to warrant such a large scale of output. This is why Canada is a big proponent of free trade- Because Canadian industries must sell their goods on the international market in order to maximize profits- domestic demand is not high enough).

MONOPOLISTIC COMPETITION: A large number of small firms. (Ie: the canadian wine market, grocery stores, night clubs, restaurants)

OLIGOPOLY: A small number of large firms (Ie: banks, insurance industries, power companies)

THE INDUSTRIAL CONCENTRATION RATIO: This lets us know what fraction of total market sales (or shipments or orders or anything really) are controlled by a given number of an industries largest firms. For an example, CR4 could be the fraction of total market sales controlled by the top 4 firms of any industry.

The industrial concentration ratio is ONE indicator of market power and competition in any industry, and can help us decide whether a market is an Oligopoly, or Monopolistic Competition. AS A GENERAL RULE, HIGHER LEVELS OF MARKET CONCENTRATION IMPLY HIGHER LEVELS OF MARKET POWER. There are, however, some issues which arise when only using industrial concentration ratios as a barometer for a market.

1: It is difficult to define a relative market for any good- are we talking about domestic markets? International markets? Is a coke part of the pop market, or is it a part of the 'junk food' market, or is it part of the much larger food and beverage market?

2: Tying the degree of competitiveness in any market to the number of firms within that market can be deceptive. For an example, a market in which the CR4 = 100%, and the top four firms each control 25% of the market could still involve fierce competition between these 4 markets. In contrast, a different market's CR4 could be only 33%, but if one of those 4 largest firms controls 30% of the market, and the rest only control 1% if the market, the firm which controls 30% of the industry will be the market leader, and will effectively set the price of goods within that market, with the other firms acting as price takers. This market has a lower industrial concentration ratio, but involves much less competition.

3: The standard concentration ratio in Canada overstates the degree of industrial concentration in Canada due to the openness of the Canadian economy (because we lack trade barriers).

IMPERFECT COMPETITION: Rivalrous behavior with some market power to set a price within a range (a combination of perfect competition and monopoly). Basically, any intermediate market structure

There are 2 types of imperfect competition:
-Monopolistic Competition (involves non-strategic behavior)
-Oligopoly (involves strategic behavior)

In Imperfect Competition There Are:
-Many Sellers
-Selling a differentiated product
-Entry and exit are possible, but not easy
-Each firm acts as a price setter within a range

MARKET CHARACTERISTICS FOR IMPERFECT COMPETITION:

1: Firms select their products (each firm decides what sort of a product they are going to produce. Often this involves product differentiation, in which the producers must somehow distinguish their product from competitor products in the eyes of the consumer. This involves associating certain products with happiness, beauty or sex appeal through clever advertising. This also ensures that different products from different producers are not PERFECT substitutes for each other. For this reason, crest toothpaste is considered a different good than oral-b toothpaste).

2: Firms select their prices (The individual firms decide what price to sell their goods at... within a reasonable range with reference to supply and demand. For instance, a sock firm knows better than to try and charge consumers $400 for a pair of socks. Firms then, act as price setters and let demand determine sales. If demand changes, firms can gage this through increased or declining sales for their goods.

3: Prices are sticky in the short run (In perfect competition, prices change in response to supply and demand. In imperfect competition, however, it is much easier for firms to directly alter their output in response to changes in demand than it is to change the price of a product (ie: for vending machines, this would take considerable effort). Price DO change in the long run, but in the short run, they tend to remain the same, regardless of demand (ie: a dairy queen blizzard costs the same in winter as it does in summer).

4: Non-price competition versus price competition.
Traditionally, people believe that firms can compete in ways other than lowering the price of a good. For instance, they can
-Create funny advertisements which entice consumers to purchase their product
-Cash in on their brand appeal
-Offer additional services (real people on the help lines)
-Guarantee Quality
-Have various warrantees of guarantees
-Have contests

According to Gateman, these are all just different forms of price competition- consumers are just getting more goods (ie: a telephone line, and nice, even-tempered technicians to help with troubleshooting) for the same price. This is economically similar to lowering the price of the good- consumers can still get more for less.

5: Barriers to entry. Unlike in markets of monopolies, these are not insurmountable.

MONOPOLISTIC COMPETITION:
-Many Sellers (so sellers will ignore each others actions, and engage in non-strategic behavior)
-Differentiated Goods (So different firms try and sell their BRANDS)
-Entry and exit CAN and DO occur (like in perfect competition)
-The firms set prices within a range (prices are sticky- they tend to stay put for a while, but firms can change them if they have to [usually, in the short run, it isn't worth their trouble])
-It is different from perfect competition because of differentiated brands (thus, demand curve is downward sloping for each firm, as they each have a slightly different product)
-Different from monopolies because of entry and exit (so demand can shift!)

PROFIT MAXIMIZATION FOR MONOPOLISTIC COMPETITION: In the short run, this is similar to monopoly profits.

-In the short run, firms can enjoy economic profits.
-These profits signal other firms to enter the industry
-As more firms enter the industry, set industry demand is divided further and further amongst competing firms. The demand for each individual firm will thus DECREASE
-Once each firm is only making normal profit (when the price is tangent to average total costs--see graph above), no new firms will enter the industry.

EXCESS CAPACITY: The difference between the minimum efficiency scale and the quantity actually produced in long run equilibrium.

In perfect competition, there is no excess capacity for individual firms in the long run.
In imperfect competition, there is excess capacity for individual firms in the long run. This means that compared to perfect competition, firms in imperfect competition will produce fewer goods at higher prices. In this way, brands (what differentiates perfectly competitive markets from imperfectly competitive markets) create a deadweight social loss (when production is limited, deadweight social loss occurs).

That's all

Barriers to Entry and Multi-Price Monopolists

2009-11-16T00:28:00.000-08:00

REVIEW: Difference between perfect competition and monopolies

PERFECT COMPETITION:
-Horizontal Demand Curve for Individual Firms
-Marginal Revenue = Average Revenue
-Price = Marginal Cost at the profit maximizing output level
-Perfectly elastic firm demand, while market demand elasticity can be anything
-In the long run, firms will only make normal profits

MONOPOLIES
-Downward Sloping Demand for the Firm
-Marginal Revenue is less than Average Revenue
-Price is greater than Marginal Cost at the profit maximizing level
-Elasticity is greater than 1, or the firm will not produce
-In the long run, monopolies can make economic profits

In a monopoly, there is no 'market supply curve', because the monopoly IS the market. Also, there is no difference between the long run and the short run, due to barriers to entry, which prevent other firms from entering the monopolist's industry.
---------------------------------------------
BARRIERS TO ENTRY: These can be natural or artificial

Profits still act as a signal for other firms to enter a monopolist's industry. Various BTEs (Barriers to Entry) prevent new firms from entering this market, however. As a result, market supply remains stable, and thus, a monopoly can still make economic profits over the long run.

Natural Barriers to Entry:

Economies of Scale and Scope- larger, well established firms are more able to access the cost-cutting benefits which are part and parcel to economies of scale. In a natural monopoly, one firm can remain in business because demand conditions prevent smaller, less efficient firms from competing and selling their products at a comparable price. EG: It's much less expensive to buy electricity from a pre-existing power company which already has a large, efficient power grid in place than it is to purchase electricity from a tiny solar farm which does not have the same economies of scale. Consumers choose the cheaper product, hence a natural monopoly.

Startup Costs- For larger industries, this can make entry impossible for all but the wealthiest of firms. EG: a nuclear reactor can cost billions in startup costs.

Artificial Barriers to Entry (Most of these are created or perpetuated by the government)
-Patents (These are prevalent in the pharmaceuticals industry, and they create legal monopolies on certain drugs for 20 years)
-Franchises (If you want to make big macs, then you need to buy a Mickie-Dee's franchise)
-Charters (These required for professionals like lawyers)
-Licenses (Eg: for farming or hunting or busking)
-Environmental Regulations (These force products to be up to certain environmental standards in order for them to be sold in a certain place. California is notorious for having very high environmental regulations, thus preventing the sale of many automobiles in the state of California)
-Red Tape (Aka: administrative forms which take a while for competing foreign firms to fill out before they can sell their product in a certain country)
-Government Procurement Policies (ie: Obama urges everybody to "buy American")
-Predatory Pricing (Safeway lowers its prices to the point where competing 'mom and pop' grocers can no longer compete. The rest of the safeway empire effectively subsidizes that one store, and the once the competition goes out of business, they raise their prices even higher than the competitions was in order to recap losses)
-Product Differentiation (This is psychological, and creates an artificial monopoly for stupid things like shampoo and toothpaste, which by all accounts, accomplish the same task regardless of brand).
-Etc.

In monopolies, barriers to entry prevent other firms from entering an industry in reaction to perceived profits, so monopolies CAN reap long run economic profits.

CARTELS: Voluntary Associations of producers who agree to act as a monopoly to maximize joint profits (ie: OPEC and DeBeers (a diamond wholesaler famous for paying hollywood to use expensive diamonds in movies to somehow ingrain the idea of diamonds symbolizing love into our public consciousness). When a cartel forms, all of the firms within the cartel are able to enjoy monopoly profit maximization (aka, they can sell less of their product for more money)

Problems:
-Enforcement Issues: Firms within a cartel have a large incentive to "cheat" and increase their own profits at the expense of everyone else in the cartel (backstabbing and cheating often cause cartels to collapse).
-Restrictive Entry: The profits create incentive for new entry.

MONOPOLIES and CARTELS USUALLY DO NOT LAST FOREVER! Why? CREATIVE DESTRUCTION (Schumpeter 1883-1950)!
-Creative new ideas destroy old ideas and structures, thus creating economic growth
-In the very long run, new products or processes ultimately circumvent barriers to entry (for an example, the explosion in online media distribution has caused many recording artists to completely cut out the middle man [record labels] and start selling their music directly to their fans through their own websites).
-Because of this, monopolies don't tend to stick around for very long unless they are protected by the government.

PRICE DISCRIMINATION & MULTI-PRICE MONOPOLISTS

Price Discrimination is when the same producer charges different prices for different units of the same good for reasons other than costs. There are a few ways of doing price discrimination:

1: You can charge the same buyer two different prices for the same good (ie: quantity discounts, wholesale versus retail, or the fact the certain goods are much cheaper in different locations [Buying textbooks in India will maybe set you back $50- not $500])
2: You can charge different buyers different prices for the same good

EG:
-Wholesale food products versus retail food products (same product, but it is cheaper to buy it wholesale)
-Telephone (residential phones are less expensive than business phones, even though it is the same service)
-Hydroelectric (After you have used up a certain amount of power, often, power becomes cheaper by the Kilowatt-hour)
-Airlines
-Seniors/Students/Children's Discounts (like for translink)
-Dumping
-Hurdle Pricing (new technology is often extremely expensive initially, because many people are willing to buy new technology at a much higher price. After a few months, the price decreases).

CONDITIONS FOR PRICE DISCRIMINATION TO OCCUR:
-Monopoly Power must be Established (price takers cannot offer different prices, and firms must be able to 'segment' up the market in order to utilize price discrimination)
-Consumers must value different units of the same product differently (this means that demand must be negatively sloped for the firm. This means either than each individual consumer values a product less as they increase consumption, or that different groups of consumers are willing to purchase the same good at different prices)
-No Arbitrage/Resale Market (Price discriminating monopolies must avoid pricing a product so low for one market segment that a third party could buy their product at the lower price and then resell it at a higher price. This would effectively destroy their monopoly power).

ADVANTAGES OF PRICE DISCRIMINATION:
-Multiprice monopolists effectively cut into consumer surplus and take is as profit. By selling at many different prices for different quantities, they are able to raise the price closer to what the consumers value the product at for each level of output. Profits increase, and consumer surplus decreases.
-In a perfect price discrimination scenario, the monopolist charges the demand curve price (the reservation price) for each quantity of a good. As a result, the marginal revenue becomes the price line. Output is the same as it would be for perfect competition, and all consumer surplus has been converted into profits.

RESULTS OF PRICE DISCRIMINATION:
-Higher Profits (for each output, profits will be higher for a multi-price monopolist than for a single-price monopolist)
-Higher Output (Output can be higher for multi-price monopolists than for single-price monopolists because a multi-price monopolist can continue to produce until price = marginal cost)
-The Market is very efficient this way- consumers may hate it, but it allows for much higher productivity than other systems.
-The total economic surplus from economic exchange is much greater due to this increase productivity.
-The firms, however, see all of the surplus, while the consumers get no surplus
-Different people with different opinions will judge this as "right or wrong" based on value judgements

RECAP:

Things to ask when looking at a graph

1- Is this for the individual firm, or for the entire industry
2- Is this the short run, or the long run?
3- Is this perfect competition, monopoly, or a different market structure?

That's all

Monopolies! OH NO!

2009-11-14T23:58:00.000-08:00

Making money is so fun, we've even made a game out of it. And then we made money by selling that game to consumers. Coincidence? I think not!

TODAY: Monopolies! We already have a pretty good idea about how markets work in perfect competition. Not all markets are perfectly competitive though: ENTER THE MONOPOLY!

Most Important: There is no competition, and no competitive behavior in monopolies, because in a monopoly market structure, one firm has absolute market power (power to raise and lower the price of a product without losing buyers to competitors).

CHARACTERISTICS OF MONOPOLIES:

1: There is only one seller, so THE FIRM IS THE INDUSTRY

2: This firm is selling a unique, exclusive good which other firms cannot sell (ie: exclusive pharmaceutical drugs which cannot be copied by non-name brand drug companies due to patent restrictions)

3: Entry and Exit into and out of the industry is impossible. In other words, there are insurmountable barriers to entry (and they are often created by the government).

MONOPOLIES ARE PRICE SETTERS! They choose which price to sell their product at.

Let's just do a quick recap for comparison's sake.

PERFECT COMPETITION
-Many Firms
-Selling a Homogenous Good
-Entry and Exit is Easy
-Firms are Price Takers

MONOPOLIES
-Single Firm
-Selling a Unique Good
-Entry and Exit is Impossible
-The Firm is the Price Setter

So, for the most part, a monopoly is the total opposite of perfect competition. The only similarity they share is a total lack of competitive behavior within the market.
----------------------------
THE DEMAND CURVE FOR THE FIRM IN A MONOPOLY

Well: In a monopoly, the firms is the industry. Logically then, the industry demand is the same as the demand curve for the firm. This means that the demand curve for firms is DOWNWARD SLOPING in monopolies.

We know that monopolists have the freedom to set the price at any level. We know that in a situation of downward sloping demand, consumer demand for a particular good decreases as the price increases. We also know that monopolists, like all producers, will seek to maximize their profits. The question we have to answer then is this:

AT WHAT PRICE WILL MONOPOLISTS SELL TO MAXIMIZE PROFITS?

In order to answer this question, we first need to understand how revenue curves for monopolies work.
First, a chart for revenues with downward sloping demand in effect.

Quantity Demanded--Price--Total Revenue---Average Revenue---Marginal Revenue
0----------------100---0------------------------------------------
1----------------90----90-------------90-----------------90-------
2----------------80----160------------80-----------------70-------
3----------------70----210------------70-----------------50-------
4----------------60----240------------60-----------------30-------
5----------------50----250------------50-----------------10-------
6----------------40----240------------40----------------(-10)------
7----------------30----210------------30----------------(-30)------
8----------------20----160------------20----------------(-50)------
9----------------10----90-------------10----------------(-70)------
10---------------0-----0--------------0-----------------(-90)------

Things you should notice: The average revenue for each of these different potential prices is still equal to the price (just like it was in perfect competition). Marginal revenue, on the other hand, falls twice as quickly as average revenue.

NOTE: As long as marginal revenue is positive, elasticity of demand is greater than one. When marginal revenue = zero, elasticity of demand = 1. When marginal revenue is negative, elasticity of demand is a fraction smaller than 1.

So, why is the marginal revenue always lower than the price (average revenue) for monopolists? Well, in order to sell one more unit of their good, monopolists have to lower the price of that good. This increases demand, so more units will be sold, but at the same time, that lower price will apply to the entire quantity of products sold, including the additional unit which required a lower price in order to sell. As such, the marginal revenue for the 20,323rd iphone sold by apple will be slightly less than the marginal revenue for the 20,322nd iphone.

Monopolists will never produce when the elasticity of demand is negative and marginal revenue is less than zero. Why? because this implies that the firm's total revenue is falling. Firms will not produce extra units if the price adjustment required to sell those extra units creates negative marginal revenue. Firms like profits. Monopolists do not like producing extra units which cost more to produce, and lower total revenue when sold.

When drawing marginal revenue lines, just draw the x-intercept of the marginal revenue line at the midway point between the x intercept of demand and the origin (just trust me, it works)

---------------------------------------
SHORT RUN PROFIT MAXIMIZATION: AT WHAT PRICE WILL MONOPOLISTS SELL TO MAXIMIZE PROFITS?

There are three rules which monopolists must follow to maximize profits.

Rule 1: Monopolists will not produce when elasticity of demand is less than 1. They can only produce when elasticity is equal to or greater than one, or where marginal revenue is equal to or greater than zero (when total revenue is rising). Why? Because for every level of output with elasticity lower than 1, there is another, lower level of output with higher elasticity which will yield the same total revenue, but for a much lower cost (remember, it costs firms to produce units of a good).

Rule 2: A profit maximizing monopolist will produce output where it covers day-to-day expenses (in other words, the price must be higher than the average variable cost)

Rule 3: A profit maximizing monopolist will produce output where marginal revenue equals marginal costs.

SUMMARY:
1: e > or = 1
2: P > or = AVC
3: MR = MC
---------------------------
DIFFERENT SHORT RUN REVENUE SCENARIOS: Here, we're going to look at different revenue scenarios which an affect firms in the short run.

First- we we find the point where MC = MR to determine the profit-maximizing quantity
Then, we find total revenue (price X quantity sold)
Then, we find total costs (average costs X quantity sold)
Finally, we subtract total costs from total revenues to find total profit

SCENARIO 1: Economic Profit!

Here, total revenue is greater than total costs, so economic profit is positive

SCENARIO 2: Normal Profit!

Here, total revenue is equal to total costs, so economic profit is zero

SCENARIO 3: Economic Loss!

Here, total revenue is less than total costs, so economic profit is negative

NOTE: Although there is only one output level which will completely maximize profits, any output quantity where the price (demand) is greater than average costs will render positive economic profits. This gives monopolies some flexibility- they can adjust output to comply with various regulations (ie: lower their output due to environmental legislation) and still reap positive profits.

That's all!

Perfect Competition and Long Run Production

2009-11-14T14:27:00.000-08:00

OVER THE LONG RUN, FIRMS CAN ENTER AND EXIT DIFFERENT PERFECTLY COMPETITIVE INDUSTRIES (This is one of the defining traits of a perfectly competitive market structure. Remember, we assume in perfectly competitive markets that there are no barriers to entry, and that startup costs are relatively inexpensive).

The difference between the long run and the short run in perfect competition is the free entry and exit of different firms. There are three different short run scenarios which can predict the long-run movement of firms into and out of industries.

1: Economic Profits- New firms and capital enter the industry
2: Normal Profits- Firms neither exit nor enter the industry
3: Economic Loss- Firms and capital exit the industry

ENTRY INDUCING PRICE:

1: Firms could be making economic profit at the equilibrium price for S0.
2: This economic profit signals other firms to enter the industry to try and take some of that industry-profit for themselves. This increases the industry supply from S0 to S1
3: Due to supply shifting to the right, the industry equilibrium price decreases.
4: This decrease in price lowers the economic profits of each individual firm, and each individual firm must produce less in order for marginal costs to equal marginal revenue (the price). As industry output rises, individual firm output falls
5: This cycle continues until each firm is only making normal profit. After this point, no new firms will enter the industry, because there is no profit-incentive for them to do so.

Let's go over this again:
FIRST- In the short run, an industry sees economic profits
THEN- In the long run, this will adjust to only normal profits. Why?
-In the long run, economic profits act as a signal for new firms to enter the industry
-As new firms enter the industry, industry supply increases
-As such, the price for each individual firm is pushed down to the short-run-average-cost minimum (the lowest price each firm can charge without making an economic loss)
BUT REMEMBER- The Long Run Average Cost for any quantity of production is even lower than the minimum short run average cost for firms. So:
-Firms can lower their costs even further by changing their amount of capital (ie: office space or factory size)
-Economic profits would thus rise, due to decreased costs over the long run
-These economic profits signal more firms to enter the industry, and the cycle repeats itself

THE MORAL OF THE STORY: Firms will continue to increase output, and change their capital investment until they reach the minimum efficiency scale (the minimum quantity of production where the long run average cost is minimized). THIS IS LONG RUN EQUILIBRIUM IN PERFECT COMPETITION

EQUILIBRIUM:

There are 3 conditions for long run equilibrium in a perfectly competitive market.
1: Price must equal marginal costs for each firm (so each firm must be maximizing profits)
2: Price must be equal to minimum short run average cost. This ensures the each firm is only making normal profits.
3: Price must be equal to the minimum long run average cost. This ensures that firms cannot make further economic profits by increasing scale.

If this condition is met, no firms will enter or exit the industry in the long run (due to stable, normal economic profit), so industry supply will not change (STABILITY = EQUILIBRIUM).

LONG RUN SUPPLY: This is the supply curve when firms are no longer entering or exiting the industry (the supply when individual firms are making zero economic profits)
-This is caused by shifts in the long run average cost as the industry size changes
-DO NOT confuse this with short run supply
-"Decreasing cost industry" refers to an industry in which costs are decreasing over the long run
-"Decreasing costs" just refers an an individual firm facing decreasing costs over the short run

THIS IS HOW WE DERIVE LONG RUN SUPPLY:

-Start off with an autonomous increase in industry demand.
-This increases the price of the good over the short run
-Individual firms will make higher economic profits due to this increased price
-Economic profits signals more firms to enter
-Supply increases in the long run due to more firms entering
-LONG RUN SUPPLY IS A LINE CONNECTING ALL POINTS OF DEMAND-INDUCED SHIFTS IN SHORT RUN SUPPLY (so it only includes supply over the log run at points when there is no net entry or exit into firms)

AN INCREASING COST INDUSTRY: This is where long run supply is rising
-Division of labour, bulk discounts and the spreading of overhead occur in these industries
-Input prices rise as quantity increases
-This causes the cost curves to shift up
-The increases the price at which all firms will make zero economic profits

A CONSTANT COST INDUSTRY: This is where long run supply is constant, and horizontal
-Input prices are constant, and the long run average cost for firms does not rise or fall

A DECREASING COST INDUSTRY: This is where long run supply is falling
-Alienation of labour and middle management mush occur in these industries
-New entrants to the industry make it cost effective for suppliers
-Input prices fall as quantity increases

--------------------------------
LONG RUN MISCONCEPTIONS:

TECHNOLOGICAL CHANGE: We assume the technologies change and improve continuously for all firms. One might assume from this that all firms in perfect competition have the same cost curves. In reality, new firms can enter the industry with lower cost curves due to improved technology (ie: a new wool sweater factory will have more efficient equipment, and therefore lower long run average costs than an existing, older factory)

THERE ARE THREE CHARACTERISTICS FOR INDUSTRIES WITH CONTINUOUS TECHNOLOGICAL IMPROVEMENTS

1: Older firms with higher cost will continue to exist... for a while anyways
-As witnessed, new firms usually enter with improved technologies and lower average costs
-These new firms increase industry supply and push price down to a new average cost minimum
-Preexisting firms are stuck with higher production costs, and must produce at a lower marginal revenue rate (think GM after the more advanced Japanese car manufacturers entered the market)
-This may cause older firms to make an economic loss on production
-The older firms should continue to operate at an economic loss, however, as long as the price remains higher than their average variable costs (so they can cover their daily costs). Although this may not be the most efficient use of capital, this will still generate some accounting profits.

MISCONCEPTION: We should eliminate the use of older, higher cost plants as new technology exists.
THE TRUTH: Many different plants with different cost and different levels of technological advancement can exist in any industry and still continue to produce.

2: Price is eventually determined by the minimum average cost of production for new plants
-New firms with the latest technology have lower average costs than pre-existing firms, and will make comparative economic profits
-As more firms enter the industry due to economic profits, the price is bid down to the minimum average cost for the new firms (so at equilibrium, even the new firms are only making economic profit)

3: Old plants are shut down when they become economically obsolete
-Once price is lower than average variable costs for older firms, the plant should be shut down, because continuing production costs more than the product will sell for
MISCONCEPTION: Plants that can still produce products should not be shut down until they are physically obsolete (until the equipment no longer works)
THE TRUTH: Some plants are perfectly well equipped to continue to production, but it would be illogical for any firm to continue to produce goods with these plants, because the goods they could produce would sell for a price lower than the cost of making them.

DECLINING INDUSTRIES: Industries where the long run equilibrium is disturbed to a trend of decreasing consumer demand (think horseshoes and buggy whip industries, or the decline in demand for glass beverage containers following the rise of plastic)

The Response of Firms: Firms generally try to cut costs by forgoing necessary upgrades and equipment maintenance. This leads to further long run economic losses, which leads to further cost cutting measures (it's a slow and vicious cycle).

Government's role in failing industries:
MISCONCEPTION: The government should subsidize failing industries in order to save people's jobs (voters prefer to be employed than unemployed).
THE TRUTH: By subsidizing failing industries, the government is just delaying the inevitable (the industry will eventually become obsolete, and involved firms will go under). A better approach would be for the government to encourage workers to find new jobs with subsidized retraining and temporary income support.

THAT'S ALL!!!!!! =D

Short Run Decisions in Perfect Competition

2009-11-14T11:20:00.000-08:00

REMEMBER:
-Demand in perfect competition is constant for individual firms (it does not change with quantity produced), and demand is equal to price, average revenue, and marginal revenue.
-Supply is equal to the marginal cost curve above the average variable cost curve.

We're going to look at some different scenarios for firms in perfect competition in the short run. For each of these, we try to calculate economic profit. Here's how:

-First, we find out which quantity will allow Marginal Revenues is equal to Marginal Costs
-Next we calculate total revenue, which is the price X the quantity exchanged
-Next we calculate the total cost, which is the average cost for this quantity X the quantity exchanged
-Finally we determine economic profit by subtracting the total costs from the total revenue. The remaining money is economic profit!

SCENARIO ONE: ECONOMIC PROFIT

Here, marginal revenue = marginal costs at a point where the average revenue (price) is greater than the average costs. Because of this, revenue will exceed costs, thus creating positive economic profit in the short run. NOTE: This usually signals firms to enter the industry, which occurs over the long run.

SCENARIO TWO: NORMAL PROFIT

Here, marginal revenue = marginal costs at a point where the average revenue (price) is just equal to average costs. Because of this, revenue will equal costs, thus creating zero economic profit (aka: normal profit). In a normal profit scenario, firms are making the same amount of accounting profits in this industry that they would anywhere else. There is no incentive for firms to enter or leave the industry.

SCENARIO THREE: ECONOMIC LOSS

Here. marginal revenue = marginal costs at a point where the average revenue (price) is lower than average costs. As a result, firms in this scenario will take an economic loss on production (they could still be making accounting profits on their business, but that money would make more profits if invested elsewhere). In the long run, economic losses act as a signal for firms to leave a business. However, firms which are operating at an economic loss should not necessarily exit the industry. As long as they continue to cover daily operating costs, they are 'breaking even' in an accounting sense, and should continue to produce.

SCENARIO FOUR: SHUT DOWN POINT

Here, total revenue is much lower than total costs (negative economic profit). Average revenue JUST equal average variable costs, which means that this firm can JUST cover daily expenses (zero accounting profit). Any point below this, and the firm will be operating at a loss, and should shut down.

-----------------------

SHORT RUN SUPPLY CURVES:
-a supply curve shows a firm's willingness to produce at any given price.

remember:
-a demand curve is derived using the principles of total utility maximization, so when price increases, quantity demanded decreases
-a supply curve is derived using the principles of profit maximization, so when the price increases, quantity supplied increases.

THE MARGINAL COST ABOVE THE AVERAGE VARIABLE COST CURVE IS THE SHORT RUN SUPPLY CURVE FOR FIRMS IN PERFECT COMPETITION! As the price increases, marginal costs will = marginal revenue at a greater quantity of production.

INDUSTRY SUPPLY IN THE SHORT RUN FOR PERFECT COMPETITION
Industry supply for the short run is just the horizontal sum of each individual firm's supply curves (aka their marginal cost curve above average variable cost)
-It is the short run, because the cost curves are holding capital constant (so individual firms cannot change their scale of production)

CONDITIONS FOR SHORT RUN INDUSTRY EQUILIBRIUM:
1-The demand and supply must be equal for the industry
2-Each firms must be maximizing profits (minimizing losses)
3-This does not necessarily mean that all of the firms will be making economic profit. If there are too many firms in the industry, in the short run, all of the firms may be making economic losses while operating at maximum profit

THATS ALL FOR NOW

Introduction to Revenue Curves: Perfect Competition

2009-11-02T11:41:00.000-08:00

We're done learning about cost curves now! Unfortunately, cost is only one of the factors which determines profit. The other factor which determines profit is REVENUE, so for the next three weeks we're going to learning about different types of markets, and different kinds of revenue curves inherent in each of them.

What is a market structure? A market structure is the 'genetic' features of a market that affect firm behavior including:
-The numbers and sizes of the firms involved in the market (are there a whole bunch of firms, like the BC cafe/coffee market, or is there only one firm, like the BC hydroelectric market)
-The types of goods sold in the market (What does the good do? Is it unique to each firm (like artwork) or the same no matter where you buy it from (like coca cola)
-Freedom of firms to enter and exit the market (Can firms enter the market freely, or are their market barriers like licenses or qualification restrictions)

Different Market Structures disperse MARKET POWER in different ways

Market Power: The ability of a single firm to affect the market price. In other words, firms which have a large share of Market power can jack up prices and get away with it.

RIVALRY is the antidote to too much market power. Rivalry (competitive behavior, or competition) deflates the market power of any one firm, so rivalry is inverse related to market power. This is because rival companies can "steal" a firm's customers if that firm tries to jack up the price, so the market power of that firm is lessened.

THIS WEEK: We are learning about perfect competition!

In perfect competition, there is NO MARKET POWER!
Ironically, in markets which are perfectly competitive, there is no competitive behavior. As we will learn, in order for there to be competitive behavior, there needs to be SOME market power.

Here are ALL of the different market types:

Perfect Competition --> No Market Power
Imperfect Competition-> Some Market Power
Oligopoly-----------> Substantial Market Power
Monopoly-----------> Total Market Power

REMEMBER: The each of these market structures, the COST side of the analysis looks IDENTICAL. Only the revenue side changes. Each week, we will study revenues for each structure.

PERFECT COMPETITION: What assumptions can we make about this market structure?

1: Many Sellers (So one firm does not affect the industry's supply curve. In other words, the industry's supply curve is fairly constant. As such, each seller's minimum efficiency scale is quite small relative to the industry's level of output. An example of this would be gasoline stations in Vancouver, or coffee shops in the lower mainland)

2: Each seller is selling a homogenous (identical) product (this is what allows for 'perfect' competition. If one seller raises the price of an IDENTICAL product, consumers will simply obtain that product for a lower price elsewhere. If two gas stations are selling gas for different prices, you're probably going to buy gas from the cheaper station, because THE GAS IS THE SAME PRODUCT NO MATTER WHERE YOU BUY IT FROM)
NOTE: Identical products are very rare (ie: even coffee is not the same at every coffee shop), so perfect competition is very rare. Even arbitrary consumer preferences can turn an identical product into a non-identical product (eg: prefering Husky gas to Shell gas for ethical reasons).
This also gives markets of perfect competition a Horizontal Demand line (perfect elasticity), since an increase in price will simply cause consumers to cease buying the offered product from that firm.

3: Firms can freely enter and exit the market (there are no barriers to entry [BTEs], and startup costs required to enter the industry are reasonable)

In a market of perfect competition, the larger market is composed of MANY MANY small firms, creating the entire market

THE DEMAND CURVE FOR A FIRM in PERFECT COMPETITION
-In perfect competition, firms are 'price takers' (they simply sell products at the market prices as a result of there being many firms which all sell identical products)
-The firm's demand is horizontal
-One firm more or less does not affect industry supply
SO: because demand is horizontal, a firm can sell all it wants to at the going price. If a firm raises prices, however, it loses all of its buyers. If it lowers it prices, and starts a price war, ALL of the other firms in the industry will eventually lower their prices as well, simply creating less profit for all firms within the industry. For this reason, price wars do not usually last very long in perfect competition (because they are bad for ALL firms within that market).

FOR THIS REASON, there is no competitive behavior in perfectly competitive markets: firms cannot raise prices for fear of either losing customers or profit.

As you can see, the industry sets the price, and each firm simply TAKES that price.

SO: Demanded Price = The Firm's selling price = The Average Revenue = The Marginal Revenue

HOW DOES REVENUE WORK?

Revenue is the amount of money firms receive from the sale of goods. In perfect competition, total revenue is a basic function of units sold

TOTAL REVENUE
TR = Quantity of Products sold X fixed price of sold Products
This is the total income of firms
In perfect competition, this is represented graphically by a straight line out from the origin (so it is a linear function)

AVERAGE REVENUE
AR = The total revenue/The quantity of products sold
In other words, this is the 'per unit' income of firms
This is represented graphically as the slope of the ray from the origin to total revenue (so it remains constant throughout the perfect competition revenue function)

MARGINAL REVENUE
MR = Change in total revenue / Change in quantity of products sold
In other words, this is the additional income the firm makes from the last output.
Graphically, this is the slope of the tangent to the total revenue function (so it remains the same throughout the perfect competition revenue function, and is equal to the average revenue)

Seeeee:

Quantity Price TR AR MR
1 $1 $1 $1 $1
2 $1 $2 $1 $1
3 $1 $3 $1 $1
4 $1 $4 $1 $1

Demand = Price = Average Revenue = Marginal Revenue!

Remember: Demand for the ENTIRE industry is downward-sloping, but demand for the INDIVIDUAL FIRM during the short run in a perfectly competitive market is HORIZONTAL!

SO... in a situation of perfect competition, how do firms maximize profits??
Well... there are two rules to follow:

Rule #1: The firms should be breaking even (in other words, the firm must be making more revenue on a daily basis than their average variable costs on a daily basis, or else the firm will LOSE MONEY) (Total fixed costs on the other hand can be paid off slowly over time, so it is not necessary to cover them on a daily basis).

In short: TR must > or = TVC
OR
P must > or = AVC
"You must cover day-to-day costs"

Rule #2: Firms should produce goods up until the point where marginal revenue = marginal costs. In other words, any extra average revenue above the cost of producing each unit gets added to the the total profits for that firm. If you sell cups of coffee for one dollar, as a firm, you'll be making total profits AS LONG AS YOU CAN SELL COFFEE FOR LESS THAN IT COSTS TO MAKE IT. SO, you sell until revenue = costs, and this MAXIMIZES PROFIT. Selling less than this leaves potential total profits unrealized, while selling more than this incurs unnecessary extra costs.

Profit = Total Revenue - Total Costs
Profit Maximization Occurs when the slope of total revenue (aka: the marginal revenue) equals the slope of the total costs (marginal costs)
SO: Profit is maximized when MR = MC

Another way of looking at this is seeing total profits as a bank account. As long as marginal revenues are greater than marginal costs, the bank account is growing. The instant marginal costs become greater than marginal revenues, the bank account starts to shrink.
That's all for today!

Isoquant and Isocost and The Very Long Run

2009-11-01T11:34:00.000-08:00

Short Run:
-Fixed Factor
-Fixed Input Prices
-Fixed Technology
Grahpically: Short-run-average-cost

Long Run:
-All factors vary
-Price of inputs can be fixed, or can vary
-Technology is fixed
Graphically: Long -run-average-cost-curve (or shifts in the long-run-average-cost curve for the case of changes in factor prices)

THE VERY LONG RUN:
-Technology can vary
-Price of inputs can vary
Graphically: Shown by shifts in the long run average cost curve (generally, downward shifts)

3 types of changes in technology:
-Change in process (for an example, robotic assembly lines instead of human assembly lines. Bull dozers and forklifts instead of pickaxes and brute strength)
-Improved inputs (aluminum bikes instead of iron bikes)
-New Products (Ipods instead of portable walkmen)

Usually, a change in technology changes the productive process, and therefore, would change the production function (the functional relationship between inputs and outputs). Remember, productivity is output per input.

There are 2 theories about technological innovation. The second one is more correct.

Old Theory: Technological Changes were seen as exogenous, or independent variables unaffected by changes in the economy (think crazy old scientists sitting around in the their labs and coming up with new technologies "just because they want to").

New Theory: Technology Changes are endogenous, or dependent on the economy. A production-side want to innovate away from costly inputs often drives firms to finance new technological changes. It is a FEEDBACK MECHANISM (for instance, many oil producers are now looking into unconventional drilling methods which use water pressure to release the oil from rocks. This turns land which was previously unproductive and cheap into a great asset, and helps companies move away from pricier traditional drilling sites) .

GENERALLY, TECHNOLOGICAL CHANGES SHIFT THE DEMAND CURVE DOWNWARD!

So... in the very long run, firms can both substitute away from costly inputs, or innovate away from them.

OKAY! Isoquants and Isocosts! These are very similar to indifference curves and budget lines from chapter six!

Isocost Lines:

The isocost line reflects two things
-The total cost of inputs
-The factor prices of inputs

Each isocost line shows all possible combinations of factors available for a given cost (sort of like a budget line, except with inputs, not products)

For an example, an isocost line could show the amount of cooks and ingredients a restaurant can utilize for a set cost.

The formula: Total Cost = (Px X Qx) + (Py X Qy)
The slope: -Px/Py (I'm doing this by axes so not to confuse people, because technically, you could graph labour or capitol on either axis).

As your total costs increase, the isocost line moves out from the origin. Changes in input factor prices will cause the isocost line to tilt.

Isoquant Lines

Each isoquant line shows all possible combinations of the factors of production that yield a given level of output. (Sort of like an indifference curve, except with productive output held constant instead of total utility)
In other words, total product is constant: the /\TP = 0
The formula: /\x*MPx + /\y*MPy = 0
The slope: -MPx/MPy

Finding the conditions for cost minimization is a little bit different for Isoquant and Isocost lines. Instead of finding the optimal quantity level for a given budget (like we do for indifference curves), we figure out which level of production we need to meet (for example, how many teddy bears we want to produce in a day). We first draw the Isoquant line which corresponds to that level of production (so we would draw the isoquant line showing the combination of inputs needs to produce 100 bears in a day). After that, whichever isocost line is JUST tangent to the desired isoquant line will represent the minimum cost for that level of output, and the point of tangency will show the exact quantity of inputs required to achieve this minimum cost.

If an isocost line is not quite touching the isoquant line, then expenditure is not high enough to meet those production goals. Meanwhile, if an isocost line bisects the isoquant line, that production goal can be met, but efficiency is not being maximized, as that same level of production could be facilitated with a less-costly combination of inputs.

At the point of tangency, the slope of the isoquant line = the slope of the isocost line!
MPx/MPy = Px/Py
which is the same condition for marginal productivity maximization! (again, this parallels indifference curves in a BIG way)

REMEMBER, EFFICIENCY IS IMPORTANT!

SO... if you were to study efficiently, you should know that anything after this point will NOT be on the big, evil Gateman-style midterm this Friday!

It's hard to believe it's already November...

The relationship between the short run and the long run

2009-10-29T09:42:00.000-07:00

First off, we're going to talk about tangency.

LEFT OF TANGENCY: This is when there is too much capital to efficiently produce a specific quantity of output. In other words, the SRAC > LRAC. This can be corrected by subletting capital (hence moving us into the long run)

Eg: You want to produce 20 letters. You have 3 meters of office space, and two secrataries who each produce 10 letters. Each secratary only requires 1 meter of office space though, so there is an extra meter of office space which is adding an unecessary burden to your overhead costs.

AT TANGENCY: This is when there is exactly the right amount of capital to efficiently produce a given quantity of product. In other words, the SRAC = LRAC. You don't need to change anything, because production is already the most efficient it can be for that level of output.

Eg: You want to produce 20 lettters. You have 2 meters of office space, and two secrataries who each produce 10 letters. Each secratary only requires 1 meter of office space, so this is perfect. There is just the right amount of secrataries and office space to produce 20 letters.

RIGHT OF TANGENCY: This is when there is too little capital to efficiently produce a specific quantity of output. In other words, the SRAC > LRAC. This can be corrected by purchasing capital (hence moving us into the long run)

Eg: You want to produce 30 letters. You have 2 meters of office space, and 3 secrataries who each produce 10 letters. Each secratary requires 1 meter of office space though, so there isn't enough office space for each secratary to do her job most efficiently.

What we can see here is that LRAC is an 'envelope' of all SRAC curves. Each point on the LRAC curve represents a tangency point with a short run cost curve for a different amount of capital. This tangency point is the OPTIMAL level of fixed factor of each output level.

So basically, each different short run cost curve tangent to the long run cost curve represents a different level of capital.

NOTE there is only one point of the entire LRAC curve where the SRAC curve is tangent to the LRAC at it's minimum.

IT IS ALWAYS MORE EFFICIENT FOR FIRMS TO HAVE LOWER COSTS. USUALLY, THIS MEANS BEING TANGENT TO THE LRAC CURVE!

--------------------
Deriving the supply curve:

SR:
-One Fixed Factor
-Fixed Prices

LR:
-All Factors Can Vary
-Prices Can Also Vary

Demand can increase independently from supply. As we know, an increase in demand leads to an increase in the price. An increased unit price for products will generate positive economic profits for producers in high-demand industries. This acts as a signal for other firms to enter this industry. As a result, the overall supply for this product will increase.

The long run supply is a conjoined trail of all the points on intersection caused by demand induced shifts in short run supply (thus, the long run supply is not always necessarily upward-sloping).

Long run supply may increase, remain constant, or decease depending factor price changes and the conditions of entry into that particular industry.

The long run average costs for each firm SHIFTS as the industry expands.

Economies of scale determine the shape of the long run average cost curve
Shifts in the long run average cost determine the shape of long run supply

Cost Curves-Econ 101

2009-10-24T10:20:00.000-07:00

Econ 101- The introduction of the cost curve!

Last lecture, we studied the production curve, and learned about the law of diminishing marginal productivity- basically, that after a certain point (the inflection point), adding more variable factor (ie labour) will causes the marginal productivity to decrease.

Today, we're going to look at full cost curves, and discover how to derive them from the product curve.

It includes several factors:
Total Costs
Total Fixed Costs (overhead costs like rent, licenses and insurance: these do not change with quantity produced)
Total Variable Costs (costs like wages, supplies, etc. which change with the quantity produced)

Average Variable Costs: TVC/Q
Average Fixed Costs: TFC/Q
Average Total Costs: TC/Q
Remeber: Average costs are always a ray from the origin on the total cost curve.

Marginal Fixed Costs (Always zero)
Marginal Variable Costs: /\Total Variable Costs / /\Quantity Supplied
Total Variable Costs: /\Total Costs / /\Quantity Supplied
Remember: Marginal costs are always the slope of the derivative of the same point on the total cost curve.

Cost curves use the following formulas:

Total Costs = f(Q produced)

Total Costs = Total Variable Costs + Total Fixed Costs

Average Total Costs = Average Fixed Costs + Average Variable Costs.

TOTAL FIXED COSTS

These don't change as production increases, so the cost is constant throughout production

AVERAGE FIXED COSTS

These fall as production increases. This is called spreading overhead costs. Each additional unit produced has to cover a smaller and smaller portion of the original overhead costs.

TOTAL VARIABLE COSTS

The shape is due to specialization and saturation. Basically, remembering the production curve, we know that production initially increases at an increasing rate due to specialization and division of labour. This means that due to increased efficiency, the variable costs will not rise significantly for a particular range of output (because no new workers will be required to meet these production targets, so no extra wages will have to be paid).

As saturation occurs, we require more and more workers to be working to produce higher quantities of product. This causes our costs to rise, because each additional worker must be paid wages. Basically, we can infer that all of the cost changes seen on the variable cost curve are the result of production changes seen on the short run production curve.

AVERAGE VARIABLE COSTS

Similar to average production, only flipped upside down!

TOTAL COSTS-combining the two

As you can see, the average cost curve and the marginal cost curve are the rays and derivatives from the total cost curve.

The average cost and marginal cost curves are valley-shaped for the same reason that the average and marginal production curves are hill-shaped. When a firm is at capacity, it's average cost valley is at its lower point, and it's average producttion hill is at it's highet point.

Marginal costs intersects both the average costs and the average variable costs at their minimums.

AC is cup shaped
AVC is saucer shaped (they are lower than average costs because average costs also include average fixed costs)
MC is spoon shaped

PRODUCTION AND COST CURVES ARE VERY CLOSELY LINKED- costs are closely linked to production realities

There are two things which can shift the cost curve:

1: a change in input prices (varies directly with the cost curve. For an example, if I run a furniture factory, and the price of lumber goes up, my costs will all rise)

2: a change in fixed factor (this is a long-run planning decision), which can benefit or harm a firm, depending on production realities. Will a bigger lumber factory decrease average costs? It depends on how production goes- all we need to know is that it DOES change things!

Introduction to cost curves!

2009-10-21T22:41:00.001-07:00

Okay! Last lecture was all about firms. Now today, we're gonna talk about how we derive the Short-run supply curve. We must examine the theoretical link between price and quantity produced!

Price --------> [?]----> Quantity Supplied

What is the missing link???
PROFITS!!!!

We assume, as economists that producers (like consumers) want to be as happy as possible. Instead of maximizing utility, however, consumers are made the most happy by maximizing total profits!

Total profits = total revenue - total costs

TOTAL REVENUE
-total revenue = price X quantity
-Total revenue is changes based on different kinds of markets (there are different revenue curves for markets with perfect competition, imperfect competition, and monopolies. We talk about all of these in the upcoming chapters!)

TOTAL COSTS on the other hand are the same for each market structure. We're gonna talk about total costs in this chapter!

OKAY! Let's think about production! What is production?

Well... production is the transformation of various inputs into outputs, which is performed by a firm. For an example, when joe the employee, rent for a smoothie shop, electricity, a blender, yoghurt, mangoes, and bananas are used together to create a mango-banana smoothie, THAT is production.

INPUTS are the factors of production (factors)
OUTPUTS are goods and services (commodities)

There are 5 factors of production

Capital- (Plant or Factory, Equipment, Inventory, and Residential Inputs)
Land- Natural Resources
Labour- Human Resources (Employees)
Technology- Changes and innovations in the production process
Entrepreneurship- Innovation, Invention, Research and Development (new and exciting ideas)

THE PRODUCTION FUNCTION: Maximum output is a function of inputs

For the sake of simplicity, we focus on the relationship between 2 inputs: Capital and Labour.
TP = f (Labour, Capitol)

Let's say we've got an office where we produce written letters using secrataries. The number of letters written is a function of the office infrastructure and the number of secrataries employed.

COSTS: The value of the factor used up in production (the value of inputs)
REMEMBER: Opportunity costs determine decision-making in the firm (inputs are valued depending on their next best allocation, not their sticker-price). We call the costs with ppportunity cost factored in the IMPUTED OR IMPLIED COST (OR IN GATEMAN'S LECTURES, THE OPPORTUNITY COST).

The Accounting Cost is not something we look at in Economics. It is used in business school, and merely includes the explicit invoice prices of factors. It does not take the owner's time and money, for example, into consideration.

SUNK COSTS, however, are not factored in to opportunity cost, because they have no alternative use (or salvage value). In other words, they have No 'next best' allocation. An example of a sunk cost would be a computer program which is designed and purhcased specifically for your business. This input cannot be used any other way, so Opportunity cost is 0, and it is a sunk cost!

PROFITS!

ACCOUNTING PROFIT = total revenue - Accounting costs (the sticker prices of inputs). This does not include opportunity costs.

ECONOMIC PROFIT = Total Revenue - Total Costs (and includes opportunity costs). This is also known as pure profit, supra-normal profit, or in an econmics class, simply 'profit'. It basically measures profit compared to other opportunities. In order to understand economic profit, it is important to understand the idea of normal profit.

NORMAL PROFIT is actually a cost. It is the cost of technology and entreprenuership, or the implicit cost of risk taking. It is the cost of choosing to devote time and money into a certain business instead of simply putting money in the bank or working at the next-most-profitable business. For an example, if I can make 5% returns on my money in the bank, then those 5% returns are considered normal profit, and should be added to my economic costs. In the long run, the profit level of surviving firms (after a business trend has come and gone) can be seen as the normal profit.

When a firm is making no economic profit, we say that it is allocatively efficient.

Firms can make accounting profts, but no economic profits. If this is the case, we know that the firm would be better off using their resources in a different way to make more profit.

Economic profit in a particular sector acts as a sugnal for firms to enter that sector. Conversely, economic loss is a signal for firms to exit the market for that sector! Pretty cool, hey?

NOW.. let's try and get into the idea of cost curves.

We know that profit is total revenue minus total costs. We don't know how to determine revenue quite yet, but we're going to learn how to determine costs. Now, we're going to have a closer looks at how total costs relate to quantity. Cost theory is similar for all firms, no matter what the revenue market is.

OKAY: There are 3 different cost scenarios:

THE SHORT RUN (Operating Decisions): at least one of the input factors is fixed. Q = f (variable factor, fixed factor)

THE LONG RUN (Planning Decisions): all factors are variable except technology. Q = f (variable factor, variable factor)

THE LONG RUN (Growth Decisions): all factors are variable including technology. Q = f (variable factor, variable factor, with variable technology)

In other words, time isn't actually a factor- it just depends on whether facors are variable or not. The short run could extend for years in some industries, while the long run may only last a few weeks in other industries.

NOW FOR THE COST CURVE:

from 0-3 is specialization
from 3-7 is saturation
from 7-8 is congestion

Usually, when you initially add more people (labour), division of labour and specialization can happen! As a result, efficiency increases, so the total product (grapgically represented as a lazy S) rises at an increasing rate.

Since production is a function of labour, it looks like the additional unit of labour (extra worker) added after the first worker can produce 2 extra products. In real life, the extra worker allows both the new worker and the old worker to produce 1.5 products (for a total of 3). The average product (total output per worker, represented as a slope of a ray from the origin on the total product curve) is 1.5, and the marginal product (extra productivity added by the last hired worker represented as the slope of the tangent of the product curve) is 2.

AP = quantity produced/number of workers = 3/2 = 1.5

MP = change in quantity/change in number of workers = 2/1 = 2

The marginal production rate always intersects the average production rate at it's maximum. This is because the average rate will continue to logically rise until an additional worker will no longer cause an increase in productivity. If a worker is added whose added productivity is exactly the same as the present level of productivity, then the average productivity will be equal to the marginal productivity. Any point after this in which another worker's marginal productivity will be lower than the average productivity, and will therefore cause the average to decrease.

After a certain point (the inflection point), each additional worker still adds to total productivity, but at a decreasing rate. Here, total productivity is rising, and marginal productivity is positive, but falling. This is called saturation.

Eventually, due to overcrowding and other inefficiencies (400 people in a tiny office for example), addional workers will actually cause a decrease in total productivity. Here, margical productivity is negative, and falling, and total productivity is decreasing.

This is for situations when Output is a function of Capital and Labour.

WE CAN USE THIS TO FIND THE COST CURVE!

There is a law of diminshing marginal product, which states that after a certain point (the inflection point), adding more of the variable factor will dimish the additional output generated by that extra variable factor.

Why?
-Because the variable factor has less of the fixed factor to work with (EG: 12 secratories sharing 4 computers). This is the reason for the shape of the product curve

Econ 101: An introduction to FIRMS

2009-10-19T22:58:00.001-07:00

We have been studying consumer and consumer behavior a LOT lately... well not anymore! It's time for us to turn our attention to the strange and wonderful world of PRODUCERS!

Scary stuff, right?

First-off: The role of the firm.

In economics, we define a firm as any self-contained, profit maximizing entity that produces and sells goods or services (or both)

A firm is an economic construct, and may not necessarily be exactly the same as a "business". There are three main kinds of firms in the economic universe: Single Proprietorships, Partnerships, and Corporations.

Single (Sole) Proprietorship:
In this type of firm, the owner IS the business. For an example, Mr. Wong owns Mr. Wong's Confectionary, so Mr. Wong IS Mr. Wong's Confectionary! What this means is that Mr. Wong is personally liable for all damage done by his business, and will be accordingly held responsible. For an example, if I ate a pie from Mr. Wong's Confectionary and it made me sick, I could sue Mr. Wong's Confectionary for damages and uncleanliness. If I won, Mr. Wong would have to pay me out of his own pocket.
Some other characteristics of proprietorships:
-There is only one owner
-Unlimited liability
-There are obvious incentives for the owner to get the firm to generate profit
-They can be difficult to finance (because the burden of financing proprietorships falls on one individual)
-Transfering ownership is difficult (selling your business can be hard)
-Owners are taxed at the personal rate

Partnership:
In this type of firm, two or more individuals who perform the same kind of work (for an exampple, two laser hair removal specialists) join together under a contract in order to make PROFIT! This partnership is legal and binding. What it entails is that all of the individuals who have entered the partnership are jointly liable for all damage their business causes. For an example if I get laser hair removal from doctor A, and the procedures somehow gives me skin cancer, I can sue A & B hair removal and force Doctor B to pay me for damages out of his own pocket, even though he had nothing to do with me contracting skin cancer. For this reason, it is important to REALLY TRUST anyone you enter a partnership with.
Some other characteristics of partnerships:
-2 or more owners
-Unlimited shared liability
-They can be difficult to finance (because the burden of financing proprietorships falls on only a few individual)
-Transfering ownership is difficult (selling your small business can be hard, especially if you are a group of specialized professionals and there is no one with a similar skill set who is willing to take over your business)
-Owners are taxed at the personal rate

Both of these types of firms can be very risky to own, due to the unlimited liability imposed on all owners. SO, laws were invented to pave the way for...

THE CORPORATION:
These have lots of different names (company, ltd, inc)
http://en.wikipedia.org/wiki/Salomon_v_A_Salomon_&_Co_Ltd
Basically, the corporation is treated as a separate legal entity. Each shareholder (owner) has limited liability equal only to the dollar amount of the company which they own as shares
-Corporations are easier to finance (many different people can become part owners and finance corporations as shareholders without having to assume liability)
-Shareholders can easily buy and sell their partial ownership (this is what trading stocks and selling shares is all about)
-Usually, the shareholders elect a board of directors, who in turn hire the top-ranking employees (the CEO, CFO, and VPs)
-Corporations are taxed twice: once for corporate profits and once for shareholder dividends.

There are also a few hybrid firms, which combine aspects of several different kinds of firms.

A limited partnership is a cross-breed between a partnership and a company. In a limited partnership, there is at least one general partner with unlimited liability. There can be other limited partners, however, who own limited shares of the business, but aren't involved in running it (kind of like shareholders). Limited partnerships are used to get around security legislation and gives limited partners the chance to invest in riskier operations without being held liable for shortcomings

A limited liability partnership is only available for professionals. It is very similar to a limited partnership, but the limited partners can be involved in the business.

A crown corporation is a company in which the controlling shareholder is the government. The business may function as an entity independent from the government, but often they act as a sounding board for government policy (ie CBC).

Not For Profit Corporations try to just break even, not making any excess profit.

TransNational Corporations (TNGs) are the big boys. THINK McDonalds and Wal-Mart

Proprietorship Partnership Corp
Ownership Easy Easy Easy
Liability Unlimited Unlimited Limited (but with conditions)
Transfer Difficult P-ship Agmnt Easy
Finance Difficult Difficult Easier
Mgmt Easy Tough Separate
Taxes Tough Tough Excruciating

3 problems which small businesses face:
- Government Regulation and payroll taxes (Canada Pension Plan, Unemployment Insurance, Workers Compensation Board)
-Financing Problems
-A lack of Qualified Labor

Canadian Federation of Independent Business is a lobby group for small businesses.

A shelf company is just a piece of paper created by company lawyers. After it is created, a firm needs to raise financial capital (money) to carry on their business.

There are 2 ways most firms do this:

1: Equity Financing: Firms grant others a share of control of their company in return for a gift of money. Investor, however, expect a divident- a return on their investment. It should be noted that this return is completely DISCRETIONARY (firms can withhold it). Capital gain is an increase in the market value of the share (the share becomes more valuable, eg: a stock goes from $12 to $16). If a company pumps profits back into the company instead of distributing them to the shareholders, this is called undistributed profit.

2: Debt Financing: Firms borrow money from external lenders (usually banks)
Debtor = Borrower
Creditor = Lender
Principal = Originally Borrowed Amount
Interest = Extra money paid as a return on the loan
Redemption Date = The date the loan must be repaid
Term = The period between the date of the loan and the redemption date.

There are 3 Kinds of debt instruments!

1: Loans
-Short Terms
-Principal must be repaid
-Interest must be paid

2: Bill and Notes (ie you loan $90 and expect $100 back)
-Short Term
-Principal Guaranteed
-No interest, but sold by debtors to creditors for less than their real worth

3: Bonds and Debentures
-Long term
-Principal must be paid
-Interest payments must be made

Debentures:
If they are unsecured, there is no charge on specific assets
If they are secured all assets which are no specifically secured can be charged
Assets are taken by the creditor in the case of bankruptcies
This lets you use your assets as a credit (ie- you can use your house as a line of credit if it is paid for)

BIG IDEA: We assume that firms want to maximize profit!

This may not happen in corporations where management is hired by the owners. Management may be more focused on increasing their own salaries in this case. Here, they will maximize sales sometimes at the expense of profit.

There IS a range of profit which companies can work within which can be adjusted for different situations while still keeping the owners reasonably happy.

In the end, the companies that make profits are the one which survive. it's evolutionary.

Econ 101: Income, and Substituion with Indifference curves

2009-10-16T15:02:00.000-07:00

HEY, Before anything else happens, we should all ask our TAs why indifference curves are convex to the origin (I think it has something to do with diminishing marginal rates of substitution- basically, a combination of goods with a major defficiency in one product requires a LOT of compensation in terms of the other product in order to get the same total utility as you would with a balanced combination of goods).

Alright: It's a shorter lecture today.

We know that we can use the budget line and the indifference curves for any two products to predict a different quantiy which will be purchased at each price.

Now we're going to look at how to graphically represent the substitution and income effects using budget lines and marginal utility analysis.

Remember: whenever the price of one good drops, our real income (purchasing power) rises. For theory's sake, in order to isolate the substitution effect, we must change the budget line to reflect changing price ratios while keeping real income constant. In order to do this, we take the budget line and rotate it around the point where it originally intersects with it's original indifference curve.

We look at where this new, streched budget line is tangent to a greater indifference curve. The change in the quantity of product A is caused by the substituion effect: consumers substituting into the cheaper good to maximize total utility (reach a greater indifference curve).

Now let's look at income effect: If total income increases when the price of a NORMAL GOOD decreases, that will also cause us to purchase more of that good. In order to look at the income effect, we take the restricted budget line (with the new price ratio) and shift it up and to the right to reflect the increase in real income.

The point where this new, inflated budget line is tangent to the highest indifference curve represents the new quantity purchased as a result of both substitution AND income effect.

Remember:
-The total effect is the substitution effect + the income effect
-The substitution is a change in quantity purchased due to a change in relative prices. It is always negative (except for conspicious consumption goods), which means that price and quantity purchased change in opposite directions
-Income effect is a change in quantity purchased due to a change in purchasing power.
It can be positive (for normal goods) or negative (for inferior goods)

If the income effect is greater than the substitution effect, the product in question is a Giffen Good

NOW: let's put it all together!

Indifference curve analysis yields the same conditions for total utility maximization as marginal utility analysis!

We know that for Utility to be maximized in indifference curve analysis, the budget line must be tangent to the indifference curve.

BUDGET LINE EQUATION: PxQx +PyQy = Income
BUDGET LINE SLOPE: -Px/Py (Marginal rate of tranformation)

INDIFFERENCE CURVE EQUATION: /\Qx(MUx) + /\Qy(MUy) = 0
INDIFFERENCE CURVE SLOPE: -MUx/MUy (Marginal rate of substitution)

Maximazation condition: The budget line must be tangent to the indifference curve

or

the slope of the budget line must equal the slope of the indifference curve

or

-Px/Py must = -MUx/MUy

or

MUx/Px = MUy/Py WHICH IS MARGINAL UTILITY ANALYSIS

Brilliant, non?

Econ 101 Indifference Curves:

2009-10-14T17:54:00.000-07:00

Indifference curves are graphs which incorporate the idea of tastes or preferences.

We assume that consumers are rational thinkers, and that they can rank their preferences. There are three parts to this 'rationality':

1- COMPLETE the consumer must either prefer good A to good B, good B to good A, or be indifferent
2- REFLEXIVE A is always as good as A. Preferences don't change based on exogenous variables
3- TRANSITIVE If A > B and B > C, then A > C

THESE SUBJECTIVE PREFERENCES ARE INDEPENDANT (EXOGENOUS).
-We cannot make comparisons between different people (because you can't compare my happiness to yours)
-We cannot make comparisons between different times
-This shows us that psychology is the basis of microeconomics!

HOKAY! Now that the background stuff is out of the way, let's actually look at one of these again.

FUNCTION OF A UTILITY CURVE: U = U(x,y) higher number = higher utility...

All of the different points on one indifference curve show different combined quantities of 2 goods (x and y) which yield a constant total utility.
Because the utility derived from any product is different for different people, the indifference curve shows PERSONAL PREFERENCES.

CHARACTERISTICS:
For any two products, there are an infinite number of indifference curves expanding outward. The total utility for each progressive curve is higher than the last one, because each progressive curve represents a greater combined quantity of goods x and y, and in most cases, we prefer to have MORE (more goods = greater total utility).

Two indifference curves for the same product cannot cross, because that would suggest that we can achieve the same total utility with a set combination of x and y as we could with the same quantity of x, but fewer of y. Also the point of intersection would imply two different total utilities for the same combination of goods. That's illogical.

EQUATION: Change in X (Marginal utility of X) + Change in Y (Marginal utility of Y) = 0

Why? Because if two points are on the same indifference curve, the utility lost on one axis is gained on the other axis.

utility lost = Change in X (Marginal utility of X)
utility gained = Change in Y (Marginal utility of Y)

The slope of the indifference curve = change in X/change in Y

OR

negative marginal utility of X/marginal utility of Y

OR

the marginal rate of substitution!

COMBINING BUDGET LINES AND INDIFFERENCE CURVES:
both budget lines and indifference curves have the same axes: quantities of different products. Budget lines show us possible combinations of different products, and indifference curve show us desired combinations of different products!

REMEMBER, price changes are represented as rotations or stretches of the budget line. SO, if the price of soda falls, the budget line for soda stretches out further along the x-axis, and the possible quantity of soda increases. Consumers want to maximize total utility, so places where the indifference line meets the budget line represent the demanded combinations of goods, given the prices of both products. As the prices of a good falls, consumers substitute into that good in order to reach higher indifference curves with the stretched budget line.
.
In this way, we can see the formation of a demand curve- consumers buy greater quantities of a product as the price decreases in order to maximize total utility (intersect with the highest indifference curve). This results in a negatively sloped demand curve.

-------------

Econ 101: More on deriving supply curves!

2009-10-09T11:59:00.000-07:00

UBC is pretty awesome according to the Globe and Mail.

OKAY:

Conspicuous Consumption Goods
Veblen coined this term in 1900 with "The Theory of the Leisure Class"
Basically, he asserted that certain goods have "snob appeal" and can be seen as "status symbols"
Things like designer clothes and big expensive cars.
Here, the substitution effect is POSITIVE! So, as relative prices of conspicuous consumption goods rise, consumers buy more of them. What this shows is that:
-Happiness is relative (we often derive our happiness by comparing what we have with what other people have. As such, exclusive products (made exclusive through high prices) often make us very very very happy.
-There is a great deal of passive consumption which occurs. Advertisements brainwash us into buying certain products, and we never really question whether we really like them, or if we are just buying them because we feel we have to.

Conspicuous Consumption Goods:
-The demand would probably be negatively sloped if consumers could buy the good without anyone knowing the prices (in other words, the public knowledge of the exclusivity of the product is what causes this positive substitution effect). It isn't as simple as we'd like to think- sometimes dropping the price will sell more.
-These goods may exist for the individual, but not for the entire market

BEWARE: A positive substitution effect may look like an overly positive income effect... but these two situations are very different.

Giffen Good: Negative substitution effect over shadowed by price effect
Conspicuous Consumption Good: The Substitution Effect is positive.

CONSUMER SURPLUS:

We can arrange the maximized total utility formula like so:
The marginal utility of product X = (The Price of Product X / The Price of Y) X The Marginal Utility of Y

Let Y be money.
Let the price of 1$ be 1
Let the marginal utility of money remain constant.

Then..
The marginal utility of a product is the price of that product times the marginal utility of money! Thus, demand is a marginal utility curve.

So...

The marginal utility gained from an extra unit of product X is the utility of the money spent to purchase that good.
WE KNOW that marginal utility diminishes as consumption increases
WE KNOW that the marginal utility of a product is the price of that product times the marginal utility of money.... so

Consumer surplus is the difference between what the consumer is willing to pay, and what the consumer must pay for a product.
The demand curve price is the price the consumer is willing to pay for each additional unit of a good (notice, it goes down as more and more of the good is consumed)
The market price is the price consumers actually pay to receive this good.

The total utility lost is the boxed area.
The total utility gained is the entire pencil-shaped area
The consumer surplus is the difference between what the consumer is willing to pay and what the consumer must pay. It's FREE HAPPINESS!

The producer surplus is the difference between the cost of producing each unit and the market price.

THE PARADOX OF VALUE:
People value water very highly, and yet they pay a very low price for it. Why? Because the MARGINAL UTILITY of water is very low compared to other products (1 glass of water is not worth as much to us as one glass of coke). The important point is not to mistake total utility for marginal utility.

HOKAY
Now onto the next part of this unit:
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Indifference Curve Analysis:

Decision Theory or Choice Theory:
-There are three factors at work when we choose how to allocate our incomes: How large are incomes are, the prices of the products we want to purchase, and our personal tastes.

A BUDGET LINE shows all possible combinations of two goods given your income (Y) and the price of the two goods (sort of like a PPC, but for consumers).

A budget line incorporates two of the three factors: income and prices.
So let's say tacos cost $1 and burgers cost $3. I have a $30 income, so this is my budget line:

The maximum quantity of tacos I can buy is 30
The maximum quantity of burgers I can buy is 10

We can play with the prices and incomes to change the shape of the budget line.

THE EQUATION OF A BUDGET LINE:
(Price of Product A X Quantity of Product A) + (Price of Product B X Quantity of Product B) = Income

The slope = -(price of product on X axis/price of product on Y axis)
or... -(maximum quantity of product on Y axis/maximum quantity of product on X axis)
or -(income/price of the product on the Y axis)/(income/price of the product on the x axis)

The slope is the ratio of the relative prices
The slope is also the opportunity cost.

If income changes, the budget line moves parallel to it's previous position. It's a positive relation. If income increases, it shifts out and vice versa.

If relative price change, then the budget line will rotate and the slope will change. As price increases on one axis, the quantity decreases for that product, so there is a negative relation.

A proportional change in both price is like an income change (ie a price effect)
If both prices and your income change proportionally, the budget line will not change.

THATS ALL!