Economic theory
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Economic Theory. Shashi Abeysinghe B.Sc(eng), CIMA. Micro-economics. What’s the difference between Microeconomics & Macroeconomics?. Microeconomics examines small economic units, the components of the economy. For example: individuals, households, firms, industries

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Economic theory

Economic Theory

Shashi Abeysinghe

B.Sc(eng), CIMA


Micro economics

Micro-economics


What s the difference between microeconomics macroeconomics

What’s the difference between Microeconomics & Macroeconomics?

  • Microeconomics examines small economic units, the components of the economy. For example: individuals, households, firms, industries

  • Macroeconomics looks at aggregates.

  • For example: national output, overall price level, aggregate unemployment


What is a market

What is a market?

  • The interaction of buyers & sellers of a good or service


Questions relevant to all economies market oriented or not

Questions relevant to all economies, market-oriented or not

  • What goods & services should be produced and how much?

  • How should the goods & services be produced?

  • Who gets the goods & services?

  • How do changes in the production & distribution mixes take place?


In a market economy these questions are handled by the market

In a market economy, these questions are handled by the market.

  • What & how much to produce:determined by demand & supply conditions, individual choices, & pursuit of profit.

  • How to produce:determined by technology & resource costs.

  • Distribution:based on ability & willingness to pay the price.

  • What if consumer wants or technology change?Those changes alter demand & supply, which changes prices, profits, & consequently output levels & distribution.


The circular flow

The Circular Flow

Product Markets

money to pay for goods & services

goods & services

Households & Resource Owners

Firms

labor & other resources

resource payments such as wages, rents, & interest

Resource or Factor Markets


The market is not the only way that the basic questions of economics can be answered

The market is not the only way that the basic questions of economics can be answered.

  • In some less developed nations, a traditional economic system is used.

  • Custom & tradition determine the answers.

  • Social arrangements & culture dictate the solutions.

  • Change occurs very gradually.


Historically the former soviet union had a command economy

Historically the former Soviet Union had a command economy.

  • Resources are government/publicly owned and centralized control is used to determine what is produced, how it is produced, and how it is distributed.


No country in the world has a purely market or purely command economy

No country in the world has a purely market or purely command economy.

  • They have mixed economies with both market and government sectors.

  • In this course, we will deal primarily with the market system.


The market supply and demand

The Market: Supply and Demand


What is the law of demand

What is the law of demand?

  • The lower the price of a good, the larger the quantity consumers will buy.

  • So the demand curve slopes downward from left to right.


What is the difference between demand quantity demanded

What is the difference between demand & quantity demanded?

  • Demand is the entire curve that shows the relation between price & quantity purchased.

  • Quantity demanded is one particular quantity on the demand curve.


Example apple market

Example: Apple Market

Price of apples(in dollars)

The demand for apples is the curve D.

The quantity demanded of apples when the price is 25 cents is 6 thousand bushels.

$ 0.25

D

6

Quantity of apples(in thousands of bushels)


What factors change demand that is shift the entire curve

What factors change demand (that is, shift the entire curve)?

  • Consumer income

  • Prices of substitutes and complements

  • Tastes

  • Consumer expectations


Example apple market1

Example: Apple Market

Price of apples(in dollars)

If income increases, people will buy more apples at every price & the entire curve will shift to the right.

D2

D1

Quantity of apples(in thousands of bushels)


What makes the quantity demanded of apples change

What makes the quantity demanded of apples change?

  • In other words, what causes a movement along the demand curve for apples?

  • A change in the price of apples.

  • That’s it, only a change in the price of apples.


Example apple market2

Example: Apple Market

Price of apples(in dollars)

Suppose the price of apples falls from 25 cents to 20 cents.

Then the quantity demanded of apples rises from 6 thousand bushels to 8 thousand bushels.

$ 0.25

$ 0.20

D

6

8

Quantity of apples(in thousands of bushels)


What is the law of supply

What is the law of supply?

  • The higher the price of a good, the larger the quantity firms will be willing to produce and sell.

  • So the supply curve slopes upward from left to right.


What is the difference between supply quantity supplied

What is the difference between supply & quantity supplied?

  • Supply is the entire curve that shows the relation between price & quantity provided.

  • Quantity supplied is one particular quantity on the supply curve.


Example apple market3

Example: Apple Market

Price of apples(in dollars)

S

The supply of apples is the curve S.

The quantity supplied of apples when the price is 22 cents is 7 thousand bushels.

$ 0.22

Quantity of apples(in thousands of bushels)

7


What factors change supply that is shift the entire curve

What factors change supply (that is, shift the entire curve)?

  • Technology

  • Prices of inputs (for example: land, labor, machinery, raw materials)

  • Weather (in the case of agriculture)


Example apple market4

Example: Apple Market

Price of apples(in dollars)

S2

S1

If rainfall is low, the supply of apples will be reduced. At each price, there will be fewer apples provided.

Quantity of apples(in thousands of bushels)


What makes the quantity supplied of apples change

What makes the quantity supplied of apples change?

  • What causes a movement along the supply curve for apples?

  • Just a change in the price of apples.


Example apple market5

Example: Apple Market

Price of apples(in dollars)

S

$ 0.22

When the price of apples falls from 22 cents to 20 cents, the amount provided falls from 7 thousand bushels to 6 thousand bushels.

$ 0.20

Quantity of apples(in thousands of bushels)

6

7


What is equilibrium

What is equilibrium?

  • It is a state of balance, where there is no tendency for things to change.


Economic theory

Equilibrium occurs where the quantity demanded equals the quantity supplied, which is at the intersection of the supply and demand curves.


Example apple market6

Example: Apple Market

Price of apples(in dollars)

S

Here the equilibrium price is 22 cents & the equilibrium quantity is 7 thousand bushels.

$ 0.22

D

Quantity of apples(in thousands of bushels)

7


Economic theory

Suppose there is an increase in the price of pears (a substitute for apples).

Then the demand for apples will increase.

Equilibrium price increases & equilibrium quantity increases.

price

S

P2

P1

D2

D1

quantity

Q2

Q1


Economic theory

Suppose there is a long spell of bad weather for apple growing.

Then the supply of apples will decrease.

Equilibrium price increases & equilibrium quantity decreases.

S2

price

S1

P2

P1

D

Q2

quantity

Q1


Economic theory

Example: cigarette market

Suppose that the surgeon general comes out with stronger health warnings.

That will reduce the demand for cigarettes.

Simultaneously, there is a year of bad weather.

That decreases the supply of cigarettes.


Economic theory

So S & D both decrease.

The equilibrium quantity decreases. Equilibrium price may increase, decrease or stay the same. In this example, the price remained the same.

price

S2

S1

P2 =

P1

D1

D2

quantity

Q2

Q1


Economic theory

Resources are limited; wants are unlimited

Scarcity = not enough resources to produce the goods to satisfy

our wants.

Resources: Adam Smith in his Wealth of Nations (1776)

divided resources into land, labor and capital.

http://www.adamsmith.org/smith/won-intro.htm


Economic theory

Adam Smith’s 3 resources: Land, Labor and Capital

1. LAND: used as shorthand for any natural resource,

not simply for agricultural land.

2. LABOR: manual power + skill ("human capital")

3. CAPITAL: produced means of production

for example, hammers, drill presses, computers ...

.

Although money is used to BUY all the above,

money is not itself a productive resource.

Capital grows through investment –.


Scarcity means that choices are necessary

Scarcity means that choices are necessary.

  • When you can’t have all you want of everything, you must make choices.

  • Microeconomics is the study of how to make the best possible ( or the optimal) choice under the constraint of limited resources.


Tradeoffs and the production possibility frontier

Tradeoffs and the Production Possibility Frontier

  • Economists would want to develop a more precise model of the tradeoffs involved –

  • And that model can be represented graphically by a “Production Possibility Frontier”, showing the choices which are

  • -- possible (on or within the frontier)

  • -- efficient (exactly on the frontier)

  • -- inefficient (within the frontier)

  • -- impossible (beyond the frontier)


Economic theory

Cadillacs ... 1944 and 1946

Opportunity cost of tank = 10 passenger autos

M5 Tank

Cadillac Coupe


Economic theory

M5 tanks

The tank-auto trade-off:

an economist's view using the

Production Possibility Frontier

500

Autos

5,000


Economic theory

M5 tanks

The tank-auto PPF:

one POSSIBLE point is

(2000 autos, 300 tanks)

another POSSIBLE point is

(4000 autos, 100 tanks)

500

300

Autos

5,000

2,000


Economic theory

M5 tanks

The tank-auto PPF:

an IMPOSSIBLE point is

(4000 autos, 300 tanks)

500

300

Autos

4,000

5,000


Economic theory

M5 tanks

500

200

an INEFFICIENT point is

(1000 autos, 200 tanks)

Autos

1,000

5,000


Economic theory

M5 tanks

The tank-auto equation:

TANKS = 500 – 0.1 AUTOS

Check out a few values:

AUTOSTANKS

0 500

1000 400

2000 300

2001 299.9

500

Autos

5,000


Economic theory

M5 tanks

  • Equation in general form:

  • TANKS = a + b AUTOS

  • How to find the equation from the graph:

  • a = Y-INTERCEPT = 500

  • b = SLOPE = rise over run = - 500 divided by 5000 = - 0.1

500

Autos

5,000


Economic theory

What the intercept means:

TANKS = 500 – 0.1 AUTOS

IF we produced zero autos, we could produce up to

500 tanks, since

TANKS = 500 – 0.1 (0) = 500

M5 tanks

500

Autos

5,000


Economic theory

What happens when the intercept changes:

TANKS = 600 – 0.1 AUTOS

IF we produced zero autos, we could produce up to

600 tanks, since

TANKS = 600 – 0.1 (0) = 600

The PPF would shift OUT and parallel to itself.

M5 tanks

600

500

This might be due to an increase in the resources available for production – for example, an increase in the labor force, and a new assembly line in the factory

Autos

5,000

6000


Economic theory

What the slope means:

TANKS = 500 – 0.1 AUTOS

IF we were producing 2000 autos and 300 tanks

and if we decided to produce one more auto, we would have to reduce tank production to 299.9

The OPPORTUNITY COST of an auto is

one-tenth of a tank.

M5 tanks

500

Autos

5,000


Economic theory

What happens when the slope changes:

TANKS = 500 – 0.05 AUTOS

If autos = 0, TANKS = 500

If autos = 5,000, TANKS = 250

If autos = 10,000, TANKS = 0

The possibility exists of producing more autos – perhaps some way of producing auto transmissions (but NOT tank transmissions) more rapidly has been discovered.

M5 tanks

500

Autos

5000

10,000


Economic theory

Introduction

to Macroeconomics


Macroeconomics

Macroeconomics?

  • A Study of aggregate behavior of

  • Macroeconomic variables

  • GDP

  • Price level

  • Employment

  • Interest rate

  • BOP


Let us look at the world economy today

Let us look at the world economy today

  • Some Statistics


The circular flow of income

The circular flow of income

The interdependence of

goods markets

and

factor markets


The interdependence of goods and factor markets

The interdependence of goods and factor markets

FIRMS

(suppliers of goods and services,

demanders of factor services)

HOUSEHOLDS

(demanders of goods and services,

suppliers of factor services)


Economic theory

Rs

Rs

Factor

services

Goods

S

S

PF2

P2

PF1

P1

D2

D2

D2

D1

D1

QF1

Q2

QF2

Q1

Factor

services

Goods

Rs

Rs

(2)

Producer

supply

(3)

Factor

demand

P

P

O

O

Q

Q

(4)

Factor

supply

(1)

Consumer

demand


The circular flow of income1

The circular flow of income

Consumption, injections, withdrawals and equilibrium


Economic theory

Consumption of

domestically

produced goods

and services (Cd)

Factor

payments

The circular flow of income

Firms

Households


Economic theory

Export

expenditure (X)

Investment (I)

Government

expenditure (G)

BANKS, etc

ABROAD

GOV.

Import

expenditure (M)

Net

taxes (T)

Net

saving (S)

The circular flow of income

In an opened economy

INJECTIONS

Consumption of

domestically

produced goods

and services (Cd)

Factor

payments

WITHDRAWALS


Economic theory

Macroeconomics policiesMicroeconomic policies are intended to influence or control macroeconomics variables in order to achieve macroeconomics relationships and outcomes.

  • Fiscal policy-

  • The government’s decision over taxation and public spending, which are incorporate in the government’s budget, is referred to as fiscal policy.

  • Monetary policy-

  • Central bank’s control over money supply affecting interest rate is known as monetary policy.

  • Trade policy-

  • The government’s actions influencing international trade constitute trade policy.

  • Eg: - Tariffs,

  • Quantitative restrictions on import trade,

  • Subsidies on export trade,

  • Controls over the payments of foreign exchange


Macroeconomics policies cont

Macroeconomics policies cont..

  • Exchange Rate policy-

  • The system of exchange rate maintained in the economy is the exchange rate policy. This includes different systems such as fixed, floating or managed floating exchange rate systems.

  • Redistributive policy-

  • The governments usually design policy measures to redistribute income for the benefit of low-income groups. Income distribution through taxation and welfare are important components of the redistributive policy, included in the government budget.


Economic theory

EconomicGrowth


Economic theory

Economic growth

- An increase in an economy's ability to produce goods and services

- Sustainable increase in real output or real income of an economy

  • Therefore increasing economic output, is possible under two conditions:

  • More resources are used in the economy.

  • Existing resources are used more efficiently.


Economic theory

Measurement of Economic Growth

1. Current Real GDP

2. National Output

3. PPF


Current real gdp

Current Real GDP

Rate of GDP growth in yeart=

[Real GDPt - Real GDPt-1]/Real GDPt-1

Calculate GDP Growth


Economic theory

  • Controversies in economic growth

  • GDP is not regarded as a good way of indicating the standard of living of individuals and households in an economy.

  • The current measure of GDP is not good at reflecting the damage to the environment caused by much economic activity.

  • Ignores unpaid, voluntary work

  • How has an economy developed?

  • Which industries does it depend on?

  • How sustainable are the routes that a country has chosen to follow towards the goal of growth?

  • How can we measure human happiness?


National output

National Output

  • Relationship between total national outputs (Y) to inputs:

  • Output = Level of technology in the economy+ (productive services of capital + Labour input + Natural resource input) 

  • Y = A+ (K+L+R)

Output Grows due to:

-An increase in productive factors (K, L or R)

-An improvement in Technology (A)


Contribution to the economic growth

Contribution to the economic Growth

  • 1. Human Resources

  • Increase in number of workers

  • Increase in working time

  • Improvement in quality of work force

    • Education, Training, Experience, Positive working attitudes

  • Use of technology

    • Computers, automated equipments

  • Improve working conditions

    • Rewards, pleasant working environment

Employment Rise

Increase in Contribution


Economic theory

  • 2. Natural resources

  • Resources availability within the country

  • 3. Capital Formation

  • Machines, equipments, buildings and inventories

  • Depreciated when used in production

  • Grows due to investment


Economic theory

  • 4. Technology change and Innovation

  • R & D is an economic activity aimed at producing technology

  • Invention – Discovery of New knowledge

  • Innovation – Incorporate new knowledge into production techniques

  • New tools and machines

  • Training and Experience

  • New Management practices & new ways of organizing activities


Economic theory

  • Sources of Growth - Where does it come from?

  • The sources of growth include:

  • Natural resources

  • Labour

  • Capital

  • Technology

    • The pace of technological change will depend on:

      • Scientific skills of the country

      • Quality of education

      • Amount of GDP devoted to research and development


The four wheels of progress

The four Wheels of Progress


Total factor productivity

Total Factor Productivity

  • Increase in output given the productive factors

  • Total Factor Productivity measured by change in Technology

  • A = Y - (K+L+R)

  • -Labour Productivity output per unit of Labour input

  • Y/L

  • -Labour productivity can improve due to :

  • Technology improvements

  • Capital accumulation – Capital Labour ratio


Actual and potential economic growth economic growth and the production possibility curve

(Actual and potential economic growth)

Economic Growth and the Production Possibility Curve


Economic theory

Growth through making a fuller use of resources

x

Production inside

the production

possibility curve

y

v

Food

O

Clothing


Economic theory

Growth in potential output

Now

Food

O

Clothing


Economic theory

Growth in potential output

5 years’ time

Food

Now

O

Clothing


Cost of economic growth

Cost of Economic Growth

  • Inequality of income

  • Pollution and other negative externalities

  • Loss of non-renewable resources

  • Lifestyle changes


Growth and the business cycle

Growth and the business cycle

The business cycle


The business cycle

Potential output

3

4

2

Actual

output

1

The business cycle

National output

3

4

2

1

O

Time


The business cycle1

Trend

output

The business cycle

Potential output

National output

Actual

output

O

Time


Growth and the business cycle1

Growth and the business cycle

The business cycle

in practice


Economic theory

Annual GDP growth rate (%)


Growth rates in selected industrial countries

Growth rates in selected industrial countries

Germany

UK

Japan

USA

France

Annual growth rate (%)


Causes to the booms and recession

Causes to the booms and Recession

  • Random shocks

  • Policy-induced

  • Imported cycles

  • Expectations


Economic theory

Barriers to economic growth

  • Insufficient or contaminated land

  • Substandard labor supply

  • Poor technical infrastructure

  • Poor social infrastructure

  • Poor industrial infrastructure


International trade

International Trade


Why international trade is essential

Why international trade is essential ?

  • Every Country lack some vital resources that it can get only by trading with others

  • Each country’s climate, labour force, & other endowments make it a relatively efficient producer of some goods & efficient producer of other goods

  • Specialization permits larger outputs & offer economies of large-scale production


Modern governments use three main devices when seeking to control trade

Modern Governments use three main devices when seeking to control trade

  • Tariff

    • Tax on imports

  • Quota

    • Legal limit on amount of goods import

  • Export Subsidy

    • Payment by the government to exporters to permit them to reduce the selling price


Foreign exchange market

Foreign Exchange Market

  • Foreign currencies are bought and sold for local currencies

Exchange Rate

  • The price of foreign currency that has to be paid by the buyers of and, received by the suppliers of foreign exchange


Participants in the market

Participants in the Market

  • Bank customers

  • Commercial Banks

  • Central Bank


Balance of payment

Balance of Payment

  • Statistical Records of foreign exchange transactions of a country

  • Two main accounts

    • Inflow

    • outflow


The balance of payments account

The Balance of Payments Account

  • The current account

    • International Trade in goods and services

    • Net Factor income flows

    • Net transfers


Balance of payments rs millions

Balance of payments: (Rs millions)


Balance of payments rs millions1

Balance of payments: (Rs millions)


Balance of payments rs millions2

Balance of payments: (Rs millions)


Balance of payments rs millions3

Balance of payments: (Rs millions)


Balance of payments rs millions4

Balance of payments: (Rs millions)


Balance of payments rs millions5

Balance of payments: (Rs millions)


The balance of payments account1

The Balance of Payments Account

  • The capital account

  • The financial account

    • investment

    • flows to and from reserves


Balance of payments rs millions6

Balance of payments (Rs millions)


Balance of payments rs millions7

Balance of payments: (Rs millions)


Balance of payments rs millions8

Balance of payments: (Rs millions)


Balance of payments rs millions9

Balance of payments: (Rs millions)


Balance of payments rs millions10

Balance of payments: (Rs millions)


Balance of payments rs millions11

Balance of payments (Rs millions)


Uk balance of payments 2001 millions

UK balance of payments: 2001 (£ millions)


Exchange rate

Exchange Rate

  • The domestic price of a foreign currency unit or the foreign price of a domestic currency unit

    • LKR 100=US$ 1

    • US$ 0.01=LKR 1

  • Spot Exchange Rate – Current exchange rate quoted for immediate delivery

  • Forward Exchange Rate – Future exchange rate quoted for today for delivery after a time lag


Economic theory

  • Depreciation – Reduction the value of domestic currency against foreign currency

  • Appreciation – Increase in value in domestic currency against foreign currency

  • Appreciation or depreciation occur in the foreign exchange market due to BoP imbalances


Exchange rate system

Exchange Rate System

  • Floating exchange rate System

    • ER is determined in the foreign exchange Market demand for and supply of foreign exchange

  • Fixed exchange system

    • Determined by the central Bank


Where do the supply demand come of foreign exchange

Where do the Supply & Demand come of Foreign Exchange?

  • International Trade in Good & Services

  • International trade in financial instruments (Stocks & Bonds)

  • Purchase of physical assets


Determination of exchange rates

Determination of exchange rates

  • The equilibrium exchange rate

    • BoP equals zero

    • Demand – Inversely related to the ER

    • Supply – Positively related to ER


Determination of the rate of exchange

Determination of the rate of exchange

S by UK

Price of £ in $/Exchange Rate

D by USA

Q of £ /Foreign Exchange


Determination of the rate of exchange1

b

a

QS

QD

Determination of the rate of exchange

S by USA

$ price of £

D by UK

Q of $


Determination of the rate of exchange2

c

d

QD

QS

Determination of the rate of exchange

S by USA

$ price of £

D by UK

Q of £


Fixed versus floating exchange rates

Fixed versus Floating Exchange Rates

  • Advantages of fixed exchange rates

    • certainty

    • no speculation (if rate is absolutely fixed)

    • prevents 'irresponsible' government policies

  • Disadvantages of fixed exchange rates

    • conflicts with other macro objectives

    • danger of competitive deflations

    • problems of international liquidity

    • difficulties in adjusting to shocks

    • speculation


Fixed versus floating exchange rates1

Fixed versus Floating Exchange Rates

  • Advantages of free-floating rates

    • automatic correction

    • no problem of international liquidity

    • insulation from external events

    • less constraint on domestic macro policy

  • Disadvantages of free-floating rates

    • possibly unstable exchange rates

    • speculation

    • uncertainty for business

      • but use of forward markets

    • lack of discipline on economy


How to boost economic growth how can we grow more

How to Boost Economic Growth - How can we grow more

  • The policies to boost growth split into two types:

  • Demand-side policies ( fiscal policy and monetary policy)

  • Supply-side policies


Demand side policies

Demand-side policies

  • To boost the level of aggregate demand and therefore growth, the government needs to use deflationary policies. These are policies that help to generate more demand. They include:

  • Fiscal policy

  • Cutting tax rates to boost people's disposable income

  • Increasing the level of government expenditure

  • Monetary policy

  • Cutting interest rates to encourage more borrowing and spending


Supply side policies

Supply-side policies

  • These are policies that aim to boost the potential for the economy to grow - in other words to supply more. They are policies that should make the economy more productive and more responsive to change. Examples include:

  • Cutting tax rates - this gives people the incentive to work harder and be more productive

  • Cutting benefits - this gives the unemployed a bigger incentive to find a job; a harsh policy (but a fair one???).

  • Promoting education and training - this should make the workforce more skilled and therefore more productive.

  • Promoting research and development (R & D) - spending on R & D will help find new more efficient ways to produce and should lead to better and more varied products.

  • Promoting mobility - if the economy is to be as flexible as possible, people need to retrain where necessary and they need to move to where the jobs are. The government has to help encourage this.


The causes of economic growth

The Causes of Economic Growth

  • Economic Growth is caused by improvements in the quantity and quality of the factors of production that a country has available i.e. land, labour, capital and enterprise. Conversely economic decline may occur if the quantity and quality of any of the factors of production falls.

  • Improving the Quantity and Quality of Land Resources

  • Improving the Quantity and Quality of Human Resources

  • Improving the Quantity and Quality of Capital Resources


Economic theory

  • Thank you


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