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Principles of Macroeconomics Prof. Jeffrey Nilsen. Fundamentals Chapters 1 - 3. Chapter 1 Thinking Like an Economist. Scarcity Principle Cost-Benefit Principle Incentive Principle Appendix: Graphing and Equations. Khan .

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chapter 1 thinking like an economist
Chapter 1Thinking Like an Economist
  • Scarcity Principle
  • Cost-Benefit Principle
  • Incentive Principle
  • Appendix: Graphing and Equations
scarcity principle
Scarcity Principle
  • We have boundless needs & wants but our resources are limited
  • Thus, to gain more of something usually means getting less of something else
    • Taking winter vacation in Antalya => can’t take trip to Sicily
  • Everyone faces trade-offs: buying text => fewer restaurant meals
    • Trade-off: a compromise between competing interests
cost benefit principle
Cost-Benefit Principle
  • Take taxi to Sofia (vs. bus) only if benefits (time saved, comfort) outweigh costs (higher fare)
  • Scarcity => without budget limit always prefer taxi
    • Constraints exist: may not choose fastest transport since consider also cost
  • Valuation of time saved may differ:
    • Usually take bus, but if early morning flight, benefit of taxi (avoid hotel) outweighs cost
economic surplus
Economic Surplus
  • Surplus = Benefit (of taking taxi) – cost (of taxi)
    • If positive surplus, take taxi
    • If negative, DON’T take taxi
    • People choose to do those actions giving the largest economic surplus
taxi for trip to sofia
Taxi for trip to Sofia?

Taxi benefits (comfort & time) 30

Taxi extra cost (90 – 11) = 79

=> negative surplus, do not take taxi

taxi for emergency trip to sofia
Taxi for emergency trip to Sofia?

If need transport late at night, time cost of bus may be infinite

(since they do not run at night)

Taxi benefits (comfort & time) 100

Taxi extra cost (90 – 11) = 79

=> positive surplus, take taxi

opportunity cost
Opportunity Cost
  • Opportunity cost of an activity is the value of everything you must sacrifice to engage in it
  • Opportunity cost of attending AUBG is cost of tuition + salary could have earned if working
    • Includes all costs (explicit as well as implicit)
economic model
Economic Model
  • Skeletal (essential parts only) explanation of phenomenon
    • May be in mathematical terms (or simple prose)
    • Allows logical analysis
  • Cost-Benefit is economist’s model of individual behavior (i.e., economists assume individuals rational [if weigh benefits against costs])
frequent cost benefit mistake 1
Frequent Cost/Benefit Mistake 1
  • Measure economic surplus as absolute amount, not as percentage of cost
  • Travel to Sofia if opportunity cost 40$ (bus fare + loss of time)
    • Travel to Sofia if save 50$ on $500 camera
    • Don’t travel to save 50% on 10$ bottle of wine
frequent cost benefit mistake 2
Frequent Cost/Benefit Mistake 2
  • Include both explicit and implicit costs
  • Some students missing class consider only percentage loss in grade, ignore lost intuition from class
frequent cost benefit mistake 3
Frequent Cost/Benefit Mistake 3
  • Sunk costs are irrelevant to a decision
    • Sunk costs: those incurred whether or not action is taken.
  • More precisely, execute action if marginal benefit > marginal cost (ignores sunk costs)
  • Example: Should you include cost of insurance in choice to drive your own car to Sofia ?
drive or taxi to sofia
Drive or Taxi to Sofia?

Counting insurance & registration you would take taxi,

but I & R must be paid if drive to Sofia or not,

they are sunk costs to be ignored

Marginal Costs are those incurred if choose to drive (35)

(marginal costs of taxi are 90)

incentive principle
Incentive Principle
  • Rational person chooses to ACT if economic surplus positive (benefits > costs)
  • Incentive principle is that action likelier if benefits rise
    • Action less likely if costs rise
positive vs normative
Positive vs. Normative
  • Incentive principle: “positive” (describes how people actually behave)
  • Cost/benefit principle: normative (describes how people should behave)
appendix equations of straight lines
Appendix: Equations of Straight Lines
  • Suppose Cinemax offered a plan
    • 120 leva for unlimited movies during year
    • At 5 leva per movie, how many movies must you view per year to buy plan?
  • Algebraic Solution
    • TMCP = 120
    • TMCNo = 5X where X number of movies seen
    • Find where equal cost (more movies makes plan more attractive): 120 = 5X or X = 24
graphical solution
Graphical Solution

Slope for plan ?

Slope for individual ?

plan alteration
Plan Alteration
  • Cinemax alters plan 120 leva + 1 per show…
chapter 2 comparative advantage
Chapter 2: Comparative Advantage
  • Comparative Advantage Principle
  • Increasing Opportunity Cost Principle
  • Production Possibilities Curve
comparative advantage
Comparative Advantage
  • Basis for trade between individuals (also countries!!)
  • Shows why specialization (with trade) is good
  • Distinct from “competitive advantage” !!
comparative advantage1
Comparative Advantage
  • Key: individual can do some things better than others
    • So may specialize in doing what he/she is good at
    • AND then trade with neighbor (who does better other things and specializes in them).
  • In economic terms: one should produce the thing with the lowest opportunity cost
village economy
Village Economy
  • Neighbors Adelia and Georgi
  • Adelia can make both bread & beer faster than Georgi (she has “absolute [or competitive] advantage” in both goods)
opportunity cost of bread
Opportunity Cost of Bread
  • To make another bread, Adelia can make less beer; her opportunity cost of bread = 1 beer
  • To make another bread, Georgi’s opportunity cost is 2 beer
opportunity cost of beer
Opportunity Cost of Beer
  • Adelia’s opportunity cost of beer is 1 bread
  • Georgi’s opportunity cost of beer is ½ bread (to make a beer, give up ½ bread)
claim greater total output if each specializes in good with lowest o c
Claim: Greater total output if each specializes in good with lowest O.C.
  • “Autarky” (no specialization, no trade):
    • Adelia spends ½ day making bread & ½ day beer
    • Georgi spends ½ day making bread & ½ day beer

Total output 12 + 4 bread and 12 + 8 beer

specialization in good with lowest o c
Specialization in good with lowest O.C.
    • Georgi specializes in beer 8 hours * 2 beer per hour = 16
  • Adelia specializes in bread
  • Assume need 16 bread to survive (same as autarky)
    • Adelia makes bread 16 * 1/3 = 5.3 hours since Georgi makes 0 bread
    • Adelia makes beer with rest of her time (2.7 hrs)

(Adelia has same O.C. in beer and could specialize in beer with another trader)

re cap
Re-cap !!
  • Adelia has absolute advantage producing both beer & bread
  • Georgi had comparative advantage in producing beer (lowest opportunity cost)
  • Both Adelia & Georgi can be better off if specialize & trade with each other
ppc production possibility curve
PPCProduction Possibility Curve
  • PPC describes all possible quantities of goods individual/nation can produce
  • If Adelia uses all 8 hrs to make Bread, her output is 24 BR, 0 BE
  • If she uses all 8 hours to make Beer, her output is 0 BR, 24 BE
  • She can make different combinations, e.g. 12 BR and 12 BE
ppc shows possible numbers to produce
PPC shows possible numbers to produce
  • If Georgi uses all time to make Bread, output is 8 BR, 0 BE
  • If Georgi uses all time to make Beer, output is 0 BR, 16 BE
  • Or in-between quantities, e.g. 4 BR, 8 BE
ppc increased productivity
PPC: increased productivity
  • If Georgi learns to produce beer faster, his PPC shifts out in the beer direction
    • If learns only about beer, his max quantity bread stays unchanged
ppc characteristics 1
PPC Characteristics 1
  • Zones on graph:
    • Infeasible need greater resources to produce these outputs
    • Inefficient: can produce more of each good with current resources
ppc characteristics 2
PPC Characteristics 2
  • Slope of line (“rise/run”)
    • Make either 8 BR or 16 BEER so 8/16 = 1/2
  • Slope:opportunity cost of good on horizontal axis (beer)
    • To make 16 beer, Georgi must give up 8 bread
    • For 1 more beer, Georgi must give up ½ bread
  • Scarcity: to produce another 1 beer, Georgi must give up ½ loaf of bread
ppc recap
PPC Recap
  • Opportunity cost of beer = slope
  • Opportunity cost of bread = inverse of slope
shows spec trade better than isolation using ppc
Shows Spec+Trade better than Isolation using PPC
  • If both Karl & Will spend ½ time in each crop
    • Karl output k: 10 C + 5 W
    • Will output w: 5 C + 10 W
  • If specialize in goods with lowest O.C.:
    • Karl output: 20 C + 0 W
    • Will output: 0 C + 20 W
  • Greater total production is shared (specialize + trade)
aggregate ppc rising opportunity cost
Aggregate PPC(rising opportunity cost)
  • If make little wine, lots of bread (at A), low
  • When making lots of wine, little bread (at B), high O.C. wine
  • At A, using for wheat the best wine land
  • At B, using for wine the best bread land

OC (wine) = slope

OC (bread) = inverse slope

ppc shifting
PPC Shifting
  • Economic Growth: over time, can produce more of everything
  • Arises from
    • Technological improvements
    • Population rise
needed for specialization
Needed for Specialization
  • Population density
  • But, mind-numbingness??
chapter 3 supply demand
Chapter 3Supply & Demand
  • Seemingly chaotic market organization can better allocate resources than e.g. government agency.
the market
“The” Market
  • Market system: individuals (not bureaucrats) make the production and distribution decisions.
    • Decentralized decisions
    • They meet & trade in markets
  • The market: consists of all buyers and sellers of specific good
  • Prevailing market price influenced both by cost of production and value that buyers put on product
mixed economy
Mixed Economy
  • Most believe market is best way to organize economic activity
  • But some individuals pollute and behave irresponsibly so government regulates
demand curve is down sloping
Demand Curve is Down-sloping
  • As Beer Price rises
    • Drinkers switch into Wine (substitution effect)
    • Drinkers can’t afford to buy as much Beer (income effect)
  • With Price rise, beer passes cost/benefit test for fewer consumers, so buy fewer bottles (incentive principle)
  • Buyer’s reservation price: highest amount buyer is willing to pay for good
law of demand
Law of Demand
  • People buy less of good as cost of duying it rises
    • If PGAS rises, Anton saves by using substitutes (walk or take bus) => buy less since offered price exceeds reservation price
  • Demand reaction to price depends on whether good is a need (shelter) or a want (dream house)
  • Demand may be biological but also influenced by peers
working with demand supply graphs
Working with Demand & Supply Graphs
  • Convention: always
    • Q on horizontal axis
    • P on vertical axis
  • Read vertically (start with Q, find associated P)
  • Read horizontally (start with P, find associated Q)
demand aggregation
Demand Aggregation
  • Construct market curve by horizontal addition
    • At P = 1.50: A wants 20, B wants 10 => (market) demand 30
    • At P = 2.00: A wants 15, B wants 0 => demand 15
    • At P = 2.50: A wants 10, B wants 0 => demand 10
supply curve
Supply Curve
  • For each P, how many bushels would farmers sell at that P?
  • Upsloping: as price rises, firms willing to sell more
    • Increasing opportunity cost principle: use first those resources with lowest opportunity cost. With higher production, use resources with higher opportunity cost
    • Point on curve represents marginal cost of production at that P or Q (the lowest P that the supplier is willing to accept for that unit)
  • Seller’s reservation price: smallest dollar amount seller is willing to accept for marginal unit (usually seller’s reservation price equals marginal cost)
wheat supply
Wheat Supply
  • Vlado has 3 equal-sized fields, equal output 10 bu. from each field, but:
    • Flat: easy to work the land, cost $2 per bushel
    • Rocky: tougher, breaks tractor plow etc, cost $3 per bushel
    • Rocky and Hilly: cost $4 per bushel
  • Assume no other use for land or for Vlado, so seller’s reservation price $2 (below $2, Vlado stays home, supplies 0)
market supply horizontal additon
Market Supply (horizontal additon)
  • Dimitri’s different costs (at 3, 15; at 4, 20; at 5, 25)
  • Horizontal addition to calculate Market supply:
    • At Price 2, Vlado 10, Dimitri 0 => supply 10
    • At Price 3, Vlado 20, Dimitri 15 => supply 35
    • At Price 4, Vlado 30, Dimitri 20 => supply 50
    • At Price 5, Vlado 30, Dimitri 25 => supply 55
market equilibrium eqbm
Market Equilibrium (eqbm)
  • Eqbm occurs when all forces within system are cancelled by others, resulting in balance.
    • No tendency for Q or P to change
    • Find eqbm at intersection of S & D Curves
  • At eqbm
    • As group, buyers satisfied: buy all offered in market at P*
    • As group, sellers satisfied: sell all put on market at P*
away from eqbm
Away from Eqbm
  • P too high: excess supply (at high P, firms willing to supply more than what consumers want to buy)
    • Competition => firms bid down P to make sales
  • P too low: excess demand (at this P, consumers want to buy more than what firms willing to supply)
    • Competition: consumers bid up P to obtain good
blocked market mechanisms
Blocked Market Mechanisms
  • Government may interfere in market “mechanism” bringing P to eqbm
  • But blocking P has impact on Q !!
Rent control (price ceiling): government prohibits
  • landlords from raising rent above certain amount
Farm support (e.g. common agricultural policy): to ensure farmers’ incomes, government requires minimum price on e.g. butter
subtle terminology difference
Subtle Terminology Difference
  • “Change in supply or demand”: Q changes at each P
  • “Change in quantity demanded or supplied”: Q changes due to P change)
demand shifts
Demand Shifts
  • Complement: PPIZZA falling causes rise in demand for beer
  • Substitute: PWINE falling causes falling demand for beer
  • Income: higher income raises demand for beer (if normal good)
    • Inferior good: e.g. potatoes: higher income cuts demand for potatoes (people eat more meat)
supply shifts
Supply Shifts
  • Technology
  • Input prices
  • Number of sellers
  • Expectations
  • Changes in other good’s Price (higher price for gold => stop looking for silver)
eqbm changes due to change in demand or supply
Eqbm changes due to change in demand or supply
  • Gold: Higher expected future P gold
    • Miners withhold gold from today’s market
    • S shifts in, today’s P rises, Q falls
  • Gasoline: trend towards electric cars
    • Demand smaller at each price
    • D shifts in, P falls and Q falls
other principles
Other Principles
  • Efficiency principle: waste not, want not (wasting is bad)
  • Equilibrium principle: a market in equilibrium leaves no unexploited opportunities for individuals
    • (but externalities may exist)
  • Yoram Bauman