Course Lecture Notes For Cumulative Final Exam (Combined Weeks 1-10)

WEEK ONE
Instructor Lecture: Nature of Economics

Content Author: Dr. Basma Bekdache
This week we begin our introduction to the exciting world of

economics. By the end of this semester, you will be able to read
the daily economic news and understand what it means, how it
impacts you, and how to analyze it using the economic way of
thinking. You may even be able to make a prediction using one
or more of the economic models that you will learn in this
course!
The first thing we have to do before we study a new subject
matter is to introduce its language so that we are all on the same
page. The language of economics includes several terms that
you may also encounter in other disciplines, and some that will
be unique to economics. In this lecture, we will discuss and
define a number of concepts, which will be used throughout the
semester and that are central to the study of economics. First
and foremost let's define what economics is all about.
What is Economics?
Click here for answer.
Economics can be defined as the study of how we allocate scarce (or limited)
resources to satisfy unlimited wants. It is the study of how people make choices.
Resources are things that we use to make goods and services that people want.
Examples of resources are:
Labor
Time Materials Land Capital Oil
hours
Et
c.
Why do people have to make choices?

That's right, we have to make choices because resources are limited or scarce.
Think of the resource time. What kind of choices do you have to make everyday
to satisfy your wants given your limited time?
In making choices people respond to incentives, which are the rewards we receive
when we choose to engage in particular activities.
Macroeconomics and Microeconomics
We can think of economics as consisting of two major branches: Macroeconomics and
Microeconomics.
Macroeconomics (macro for short) is the study of the economy as a whole or
economic aggregate. Can you think of examples of topics that fall under the
subject of macroeconomics?
Correct. The unemployment rate, inflation, interest rates, the government
budget deficit or surplus, and GDP (Gross Domestic Product) are all
examples of topics that we study in macroeconomics.
Microeconomics (micro for short) is the study of specific markets, individuals,
and firms in the economy. A few examples of microeconomic topics are:
• What determines the demand and supply for cars or pizza?
• How does an individual decide how much time to spend working or taking
vacation?
• How does a business decide how much to produce?
We will see later as the semester progresses that often times, we need to blend Micro
and Macro analyses in order to answer some questions about the economy. For
example, to understand what determines the amount of jobs available in the economy,
or unemployment, we use a demand and supply model of the labor market along with
an aggregate demand and aggregate supply model of the aggregate economy's level of
production.
WEEK ONE
Instructor Lecture: How Do We Study
Economics?
Economics is often described as an empirical science. This is because we use

economic models and test them using the scientific method. However, since people's
behaviors determine outcomes in the economy, economics cannot be analyzed as an
exact science (such as physics or chemistry), therefore, we tend to describe economics
as a mix of science and art.
We have already used the term economic model. What is a model?
A model is a simplified representation of a reality.
Can you think of examples of models that you encounter in your daily life, not
necessarily related to economics?
I can think of these models: a map is a model of roads, a clock is a model of time,
and a small car prototype is a model of actual size car, etc.
Notice that in some cases (e.g., clock time, map) the model does not resemble the
reality. In economics, our models will take a variety of forms that don't resemble the
reality. They can be graphs (see lecture on graphs), tables, equations, and prose that
describe relationships among economic variables.
A variable is something that can change over time. We will refer to many of the
economic terms we use this semester as economic variables since their values may
change from period to period. For example prices, income or the interest rate you pay
on your credit card are all examples of variables. An example of an economic model
from macro is the relationship between household spending and income. An example
from micro is the relationship between the price of a good and the quantity demanded
and supplied for that good.
Each model is usually based on a set of assumptions. Assumptions are things that we
take to be true for the purpose of the model we are building. For example, let's say we
are trying to model the relationship between price and the quantity that people want to
purchase of a good or service. We might say that when the price of pizza decreases,
people will want to buy more pizzas. This statement is based on the assumption that
peoples' preference for pizza has not changed, and that their incomes are staying the
same. In other words, when we modeled the demand for pizza, we had to make the
assumption that income and tastes were held constant. This is referred to as the ceteris
parebus assumption, or "other things held constant".
Why do we use models?
Since the economy and its various sectors are complicated, we
use models to organize thoughts and narrow problems down
so they are manageable and easy to understand. Models are
used to analyze past situations, and understand relationships
among variables. Models are also used to forecast or predict
future values of economic variables.
When we are using models for forecasting, we often assume
that economic agents are rational. Rational economic agents
use all available information to update their models before they
make predictions. A rational economic forecast does not
repeat the same forecasting errors, as these should be taken
into account in updating the model. Bounded rationality is an
alternative assumption that states that people are not fully, but
nearly rational since it is impossible for people to examine
every choice available and know all information applicable to
models.
Economists often have theories about how economic variables are related. Theories
are statements or ideas about how things should be. However, since economics is an
empirical science, theories are not taken to be true unless the models are empirically
tested and supported by real-life data. Models and the corresponding theories are
useful only to the extent that they are representative of actual data on economic
variables. Empirical economics is the application of statistical methods to the testing
of economic models.
Finally, in talking about economics we distinguish between positive and normative
statements. A positive statement is one that describes "what is" and is a pure
description of the events or situation that are being studied. A normative statement is
one that introduces individuals' opinions or judgments about the situation. It is "what
ought to be" rather than "what is." As you may have guessed, economics as a science
is consistent with using positive statements to explain and describe economic models.
Please continue to the next section of the chapter by clicking on the next item in
this week's packet.
WEEK ONE
Course Lecture 1-1: Production Possibilities
Curve (Frontier) Lecture
Content Author: Dr. David Dieterle
"The World of Trade-offs"
This section is very important to an understanding of how "trade-offs" in economics
work in the real world. As the Production Possibilities Curve (PPC) suggests, it is a
graphical illustration of the trade-offs that occur, and the choices made in the production
of goods and services. A PPC helps us see what is being given up (opportunity costs)
as the trade-off in the production between two different goods or services. The PPC
represents the resource allocation for all the combinations of outputs between
two goods or services.
There are several assumptions that are crucial to the interpretation of A PPC. As an
essential understanding of this important theoretical concept is important, let's keep in
mind a few basic assumptions.
• All resources are fully employed.
• We take a static look-meaning we are looking at an economy in "a specific
moment in time"-a snapshot look.
○ The quantities of inputs (factors of production) are fixed for that moment in
time.
○ Technology does not change.
It is important to keep these assumptions front and center as we look at a PPC. These
assumptions provide the basis for the PPC current ("static") state. In a moment we will
see what happens when one, or several, of the assumptions change. But first, we need
to take a look at how we can use the PPC to determine whether an economy is being
efficient or inefficient with the allocation of its resources in the output determinations for
two goods.
The figure below provides a good example of the locations of three points relative to a
PPC. What story does each one of those points tell us about the resource allocation of
this two good economy? Well, let's take a look----
Point A: On the Point B: Inside the Point C: Outside
curve curve the curve
full production, full inefficient and impossible to achieve
use of resources incomplete use of
resources
An economy fully An economy falling To say an economy is

utilizing all of its short of full utilization at a point OUTSIDE
resources in an of the resources for the PPC (Point C) is bit
efficient manner will be producing the two tricky. It is because an
producing the two goods will be reflected economy cannot
goods at a point ON at a point INSIDE the function outside the
the PPC (Point A). PPC (Point B). This PPC, therefore Point C
While the market will less than full utilization is impossible. Here is
determine the relative could be for several where I like the term
combination between reasons associated "frontier." If you think
the two goods, by with our assumptions: about the term frontier,
producing on the poor economy, costs it means the far
curve, all of the associated with the reaches of ability. (i.e.,
resources available to fixed quantity of inputs, frontier of space,
the economy for the and less than fully frontier of the ocean,
production of the two employed resources historically our western
goods is being fully including technology. frontiers) It gives us
utilized. Whatever the reason, that vision of being on
an economy producing the edge of possibility -
the two goods inside economically being a
the curve has a "Production
significant problem with Possibilities Frontier."
under utilized capacity
of inputs.
Economic Growth and PPC

Finishing up with a description of a production point OUTSIDE the Curve (Point C),
leads us to a natural extension question. If Point C is impossible, given current set of
assumptions, is it possible to ever attain Point C?
And to that the answer is an emphatic YES.
As Miller states, "Over time it is possible to have more of everything." PPC can also be
used to exhibit the economic growth of an economy through the changing of the
assumptions; time becomes dynamic, technology changes, more resources employed,
or additional inputs efficiently added and used in the production of the two goods. The
figure below provides a good illustration of how a PPC can show the economic growth
of an economy.
So how does an economy decide which goods or services it will produce, and in what
combinations will the inputs be used?
Comparative and Absolute Advantage
This leads us to the concepts of absolute and comparative advantage. While we are
going to hold off on a more elaborate discussion of these for later in the course, let's
explore for the moment at least their definitions, and how they relate to our current
discussion of the PPC. In a common sense sort of way, absolute advantage plainly is,
"I can do something better than you" - period. Economically speaking, it just means I
can produce more outputs with the same inputs, or produce the same outputs with
fewer inputs.
With comparative advantage the rubber meets the road. With comparative advantage
you might hear, "I can do something with fewer opportunity costs than others." (i.e.,
comparatively) Comparative advantage focuses on the more efficient allocation of
inputs relative to the opportunity costs associated with how others allocate comparable
inputs. By focusing on our comparative advantages, for example, reducing our
opportunity costs, an economy becomes more efficient.
These concepts become especially applicable when discussing trade and the global
economy. That is why we will be returning to them when we discuss global trade and
globalization.
Specialization, Division of Labor, and Interdependence
The final concepts I want to present in this chapter are: specialization, division of
labor, and interdependence. These three concepts are very much related to each
other. For an economy to implement division of labor principles, the workers involved in
the economy will specialize in the production of a specific good or service. This
specialization by each worker means we are now interdependent with the other workers
to obtain all the goods and services we choose to possess or implement.
Please watch the following 3 minute presentation.
WEEK ONE
Instructor Lecture: More on Opportunity

Cost
In this lecture we revisit the concepts of scarcity and opportunity cost and learn how to
compute opportunity cost in various scenarios. We will also discuss the law of
increasing cost, which explains the shape of the Production Possibilities Curve (PPC).
Finally, we will use the PPC to illustrate the choices a society makes today regarding its
production of consumer and capital goods and discuss its implications on future
economic growth.
Recall from the previous lectures, that resources, also called Factors of Production
are things that we use to produce goods and services that the society wants. Factors of
production generally fall into one of the following categories (more on this subject in
week 7):
Labor: Capital: Human capital: Technology:
The human resource. The amount of physical The level of The society's level
Usually, the number of capital-plants, education and combined of
hours worked for machines, equipment to training of the knowledge.
production. be used in production labor input.
Since resources are scarce, there is an opportunity cost associated with using our
resources. Do you recall what we mean by scarcity?
Right, scarcity is the fact that resources are limited and are insufficient to
produce everything to satisfy the unlimited wants of society.
Since resources are scarce, when we choose to use a resource to produce good X, we
are giving up the option to use the same resource for the production of another good Y.
The value of good Y that could have been produced is the opportunity cost of the
choice we made to produce good X. In general, we can say that:
Opportunity cost is the highest valued, next best available alternative that must be
given up to obtain something or satisfy a want.
Let's consider a couple of examples. Suppose it takes you one hour to cut your grass. In
the same hour you can cook one meal and do a load of laundry. What is the opportunity
cost of cutting your grass?
Correct, the opportunity cost of cutting your grass is one meal and one load of
laundry because that is what you give up if you decide to spend your time cutting
grass.
Suppose that your hourly wage is $20/hour. You have a choice to pursue a college
degree but classes are only offered during the day when you can be working. If the
class takes up two hours a day, what is your the opportunity cost (per day) of making
the choice to take the class, everything else held constant?
You got it. The opportunity cost of taking the class is $40.
Think about how your answer would change if you can take classes after work. What
would be the opportunity cost of taking the class then?
The concept of opportunity cost is very important to economic analysis. You will see as
the semester progresses that it applies to almost everything we study, from the decision
of an individuals of how much to decision to consumer or save to a firm's decision of
how much to spend on capital good s to be used for production. We will discuss more
applications later, but for now let's review the PPC.
Law of Increasing Opportunity Cost
Let's return to the example of digital cameras and pocket PCs that you considered in the
last lecture to illustrate the PPC. In panel (a ) we can see the production possibilities
that are plotted in panel (b). The fact that the PPC is downward sloping shows that there
is a tradeoff or opportunity cost which occurs due to scarcity. If we want to produce
more pocket PC's (as in moving from combination B to C) we have to give up some
production of digital cameras.
(Reprinted from Roger LeRoy Miller, Economics Today, 14th edition)

Specifically, looking at the table or the graph, what is the opportunity cost of producing
the first 10 pocket PCs (going from 0 to 10)? What about the next 10 PCs (going from
10 to 20), and the next 10 etc? What is happening to the opportunity cost of producing
pocket PCs as we produce more and more pocket PC's?
The opportunity cost of the first 10 PC's is 2 digital cameras (50-48); the next 10 is
3 digital cameras (48-45); the next 10 is 5 digital cameras (45-40) etc. The
opportunity cost of producing more and more PCs, as measured by how many
digital cameras we have to give up producing, is increasing as we produce more
and more PCs. This is called the Law of increasing costs.
The law of increasing costs refers to the fact that the more we produce of a good, the
opportunity cost of that good generally increases. It is the reason why the PPC is bowed
out (decreasing slope) as illustrated in the graph below.
(Reprinted from Roger Le Roy Miller, Economics Today, 14th edition)
Why does this happen?
Using the goods in this example, as we produce more and more PC's, we have to use
to resources that were specialized in producing digital cameras and adapt them to the
production of PC's. This raise the opportunity cost of producing PC's. If resources are
easily adaptable to the production of any good, then the PPC will be less bowed out.
The more specialized the resources, the more bowed out the PPC (reflecting greater
increase in opportunity costs).
WEEK ONE
Instructor Lecture: More on Saving and

Economic Growth
This section illustrates the role of saving in economic growth. Consider the PPC for an
example where the society has to choose to produce from one of two categories of
goods: consumer goods and capital goods. Consumer goods are goods produced for
personal satisfaction while capital goods are goods that are used to produce other
goods.
If a society produces more capital goods today, it will have more capital available for
production in the future, which implies it can produce more of everything in the future.
We called this economic growth and it is shown as a shift to the right in the PPC.
We can see that if we choose to consume less today (or save) as in point C (and
compared to points A or point B), we can achieve greater economic growth since by
choosing more capital goods today, the capital stock will increase, allowing us to
produce more in the future.
WEEK ONE
Instructor Lecture: More on Comparative

Advantage and Specialization
Earlier in this week, we defined comparative advantage as being the ability to produce
a good or a service at lower opportunity cost. Let's see if we can apply this concept
to decide how one should spend their resources. Let's consider a simple example.
Suppose...
Who has the comparative advantage in the production of chairs?

To answer this question, we have to calculate and compare the opportunity cost of
producing a chair for both Bob and Ted individually.
To produce one chair, Bob has to give up the production a quarter of a table, which is
what Ted can produce in 1 hour if he does not make the chair. For Ted, making one
chair means giving up making two-thirds of a table. Who has the comparative
advantage in making chairs?
Suppose that Bob can make either four chairs or one table in an hour and Ted can
make either three chairs or two tables in an hour.
Who has the comparative advantage in the production of chairs?
Correct. Since Bob has the lower opportunity cost (2/3 > 1/4), he has the
comparative advantage in making chairs.
Using similar reasoning we can show that Ted has the comparative advantage in
producing tables.
So why do we care about who has the comparative advantage?
We do because we can show that if someone (or nations) specialize in the production of
the good in which they have a comparative advantage, total production will be greater
which benefits everyone.
Using the same example, let's compare the total number of
chairs and tables produced in one hour if Bob and Ted
specialize (i.e. they produce only the good in which they have a
comparative advantage) to the total production when Bob and
Ted split their time between the production of chairs and tables
(e.g. if they do not specialize). Let's assume they each spend a
half hour on each good.
In the case of specialization:
TOTAL PRODUCTION IS: 4 chairs, 2 tables.

In one hour Bob produces 4 chairs and Ted produces 2 tables.
In the case of no specialization:
In a half hour, Bob can produce 2 chairs.

In the second half hour, Bob can produce ½ table.
In a half hour, Ted can produce 1.5 chairs.

In the second half hour Ted can produce 1 table.
TOTAL PRODUCTION IS: 3.5 chairs and 1.5 tables.
This is less than the production that can be attained if

they specialize which is 4 chair and 2 tables.
The concept of comparative advantage is applicable to trade between nations.
When nations specialize in their comparative advantage and trade with the rest of the
world, economic output increases leading to a higher average standard of living.
WEEK ONE
Course Lecture 1-2: Consumer Choice

There are four critical concepts you will need to become familiar with for future
discussions:
1. Utility
2. Marginal analysis
3. Diminishing marginal utility
4. The difference between total and marginal
While "utility" is the term used in economics to define a consumer’s satisfaction, to
measure this utility it is important to understand the difference between what
economist’s mean by the term, "marginal", and "marginal analysis".
When economists study human behavior, they are most concerned with what happens
to the utility, or production (producer side which we will discuss later), when one more
unit is consumed (or produced). Therefore, the economists view of human action is to
study the results of adding one more unit; marginal analysis. Economists are always
interested in what happens "at the margin" (adding one more unit). Marginal utility can
be calculated by dividing the change in total utility by the change in number of units
consumed. The key to understanding marginal analysis is that we are studying behavior
or production changes with the addition of ONE ADDITIONAL UNIT. Contrary to
"normal" thinking, total utility is irrelevant in marginal analysis. We will look at the
relationship between marginal and average later on.
The last major concept of this chapter is diminishing
marginal utility (DMU). Take your time with this concept.
DMU is the idea that as utility increases with the continued
consumption of a good, a point will be reached when the utility
of the additional unit will be less then the one before it. For
most of us, a good example of this is eating pizza. The first
piece of pizza goes down well, tastes great, and satisfies
completely. So we have another. Again, complete total
satisfaction. So we have a third. Now, suddenly, we eat it a
little slower, the taste not have the zip it did with the first two,
and our satisfaction level is less. It can be said the third piece
was where we reached DMU; the total climbs, but we have
reached maximum satisfaction. Even if we go on and eat three
more pieces, for a total of six!
Conclude your initial introduction to marginal analysis and DMU with a review of DMU
and the diamond-water paradox of Adam Smith.
WEEK ONE
Course Lecture 1-3: Interpreting Graphs

Content Author: Dr. Linda Wiechowski
Please watch and listen to the following 7 minute VoiceOver PowerPoint for a
discussion of graphs. You will learn how to plot points on a graph, how to calculate the
slope of a line, as well as create a formula for the line.
For a printable version of this powerpoint, click Here.
You have two examples that you can work through. Both of the examples show you
step-by-step how to solve for the equation of a line.
Four more practice problems are shown that you can try. Only the answer is given for
these problems. You will need to work through the problems using the same steps as
the previous sample problems.
Click here for the answer.


WEEK TWO
Course Lecture 2-1: Demand and Supply

This week you are going to learn about the key concepts that make up
microeconomics; supply, demand, price, and elasticity. Don't fall behind. These
concepts are so vital to your overall understanding of economics role in our life and a
thorough understanding here is critical to your future success in this course.
The title of this lecture is arguably the most popular phrase in all of Economics. The
media, political pundits, and just about anyone who wants to make one think they
understand the world of economics can quote this phrase and make people think they
know what they are talking about regarding almost any economics topic or issue.
Yet, if we surveyed 100 people asking them to define "supply and demand," the great
majority of them would get it wrong.
Why?
Most of them would have received their definition from the media, who get it
wrong 95% (if not more) of the time.
We are going to spend our time "getting it right." At the conclusion of this lecture, you
will have the "right" definition and understanding of both supply and demand. And you
will understand why most everyone gets it wrong.
Before we dive into supply and demand as concepts, let's review (for at least most of
you I presume) the notion of a "market."
A market is anytime there is a voluntary interaction between a buyer and a seller. Think
back to the last 24 or 48 hours - have you bought something; anything? You, as the
buyer, made your purchase from the seller. So just remember when it comes to
identifying a "market." if someone is buying from someone who is selling, you have a
market of voluntary exchange.
You now understand a market is the abstract concept economists use to present the
"environment" to discuss and analyze how producers and consumers (buyers and
sellers) interact with each other. A "marketplace" is defined by the laws of supply and
demand.
The Laws of Demand and Supply
The Law of Demand focuses on the relationship between price and the quantity
demanded of a good or service by a consumer.
There are a couple of characteristics of the consumer that are important for you to
understand:
1. A consumer must be willing to purchase the good or service at each price
2. A consumer must be able to purchase the good or service at each price
You might be quite "willing" to purchase a Rolls Royce Pierce Arrow automobile (most
of us would!). However, you are probably not "able" (And if you are, call me
immediately!). In the reverse, you might be quite "able" to purchase a Yugo, but have a
good understanding of quality and are not "willing" to do so. As we move along in this
chapter and the course, it is important to remember that markets are made up of
consumers (demand) and producers (supply) who are both "willing" and "able"
participants.
Now back to this relationship idea . . .
The Laws of Demand and Supply are laws that describe the relationship between the
price of a good and service, and the quantity that will be demanded or supplied. These
can both be best understood if you think about them intuitively and remembering one of
the core principles of economics, "people respond to incentives in predictable ways."
First, let's look at demand and supply intuitively.
As a consumer, what is your reaction when a good or service you often purchase rises
in price?
At first, you may not do anything. But if the price rise continues, at some price
you will stop buying it. You begin to search out alternatives. Well, that's the Law
of Demand. As the price of a good of service goes up, consumers will buy less of
it. The relationship between price and quantity demanded is INVERSE. As one
goes up, the other goes down . . . and vice versa. Intuitively, does that make
sense? You exhibited this relationship with the Chocolate Chip Cookie Survey.
Regarding Supply, just the opposite applies. As a producer, if the price of the
good or service you provide goes up, your incentive and intuition tells you to do
what? That's right, produce more it. The Law of Supply states the relationship
between price and quantity supplied is a direct relationship.
Both of these relationship ideas should become clearer to you as we explore these
graphically as demand and supply schedules and curves.
Demand Schedules
Let's return to the Cookie Survey for a moment. Last week you completed a survey
based on your willingness and ability to purchase chocolate chip cookies. As you and
each of your classmates completed the survey and the results were tabulated, in the
aggregate all of you began to illustrate a picture on your total willingness to purchase
the cookies at the various prices. This "story" was reflected in the chart. If you want, go
back and take a look at the chocolate chip cookie "story" the class created. What you
created was a Demand Schedule. It is similar to the one illustrated below:
Demand Curves
Demand curves, by extension, are demand schedules in graph form. If we use
Quantity(Q) for the vertical axis, and Price(P) for the horizontal axis, then a demand
curve becomes nothing more than the "picture" of the demand schedule "story". Our
story is now a picture:
Supply Schedules and Supply Curves
What we just discussed about the demand schedule and demand curve applies for the
supply schedule and supply curve but for one major exception; we have to apply the
Law of Supply which changes the relationship between quantity supplied and price.
Remember, the Law of Supply states a DIRECT relationship between quantity and
price. So a supply schedule "story" would look something like the supply schedule
below:
The Supply Curve, consequently, will be upward to the right reflecting the story that as
prices increase, a producer is willing and able to produce more of the good or service.
The Supply Schedule below reflects this direct relationship:
One additional point needs to be emphasized here. If you look at the definitions they
both have a very important phrase, "other things being equal". The only relationship
being considered is the relationship between price and quantity-nothing else. This is
important because it will help us distinguish between changes along the curve (change
in quantity demanded) and the creation of a new curve (change in demand).
NOTE: We will cover shifts in demand and supply further in the lecture.
There are two more key issues we need to address: shifts in demand (supply) curves
versus quantity demanded (supplied).
When a curve (demand or supply) shifts, it is because something has created an entire
change in overall preferences for the good or service in question. The "story" has
changed. It is now more than a change in price. Let me repeat that. It is now more
than a change in price.
By now you should realize a demand (supply) curve, (the picture), represents a set of
prices and quantities that one is able and willing to purchase (produce) at every price
on the curve, other things being equal.
But what happens when "other things" are not equal, and the "other things" change?
That's our next task.
Determinants of Demand
When the "other things" change, the story and picture regarding our relationship
between quantity demanded and price changes. Before we go there, let's take a look at
what are some of these "other things" that could change the demand picture. What are
the determinants of demand?
Income
As one's income changes, the willingness and ability to purchase a good or service also
changes. Are there items you buy more or less of now than at a different time in your
life? I suspect we all have a few of those. Well, one of the reasons for our change in
consumer behavior could be our income level. While economists call this the "income
effect", if the change in income is significant as an economy, it will change the demand
"picture" of a good or service.
Tastes and preferences
It may be a news article has announced research that drinking wine will add 40 years to
your life! What do you suppose will happen to the demand for wine? Or the reverse, the
research announces wine will deduct 40 years from your life. Again, what do you
suppose will happen to the demand for wine? As a society we are a pretty fickle lot
when it comes to the latest fads in food, clothing, toys and gadgets, and most goods.
These tastes and preference fads change the demand "picture" for goods and services.
Prices of substitutes and complement goods and services
If the price of coffee suddenly quadrupled, many of us may switch to tea, thus
increasing the demand for tea. Coffee and tea are considered by many to be substitute
goods. The price of the substitute (coffee) changes the demand of the good (tea).
Having grown up on peanut butter and jelly sandwiches, if the price of jelly quadrupled,
my mom may have resorted to bologna sandwiches (Yuck!!). If many moms did the
same, the demand for the good, peanut butter, would change because of a price
change in a complement good, jelly.
Expectations of buyers
Going back to the wine research, if as a result of the good news buyers now have
expectations of living longer because of drinking wine, demand for wine will definitely
change. Buyers' expectations (whether founded or not) will change the demand story
and picture of a good or service.
Number of buyers
Finally, a change in the number of buyers for a good or service will change the demand
story and picture. We are seeing this today in the demand for health care of senior
citizens as the baby boomer generation reaches senior status. Since I "are one," I am
also anticipating an increase in the supply and quality of that health care! But that's
another story. . .
Determinants of Supply
Some of the "other things" that would change the supply story and picture include
determinants that influence the production of/and providing of goods and services.
Costs of Inputs
The costs of the inputs (land, labor, capital) is one of the key determinants of supply. As
costs of the inputs decline, for example, production costs decline, it allows the producer
to produce more at each price. The opposite is also true decreasing supply when the
costs of the inputs increase.
Changes in technology
As technology changes, a producers willingness and ability to provide goods and
services changes. Technology has been the number one change in the manufacturers
ability to provide goods and services to the marketplace.
Taxes and subsidies
Government tax policies or incentives through subsidies certainly change a producers
willingness and ability to provide goods and services to the marketplace. This would
also include a country's protectionist policies like tariffs, which are taxes on imported
goods.
Price expectations
Like consumers, if producers expect a change in the price for the good or service they
provide, their willingness and ability to provide the marketplace will change.
Number of companies in an industry
As the number of companies increases, or decreases, the competitive environment
changes. This change can also impact a producers willingness and ability to provide
goods and services to the marketplace.
IMPORTANT MESSAGE FROM THE SPONSOR!
Changes Along a Curve (changes in quantity demanded) vs. a New Curve
(changes in demand)
To best understand changes along the curve we have to understand two characteristics:
one, the demand schedule ("story") has not changed, and two, since the story hasn't
changed, the "picture" hasn't changed. All that has changed is the price (P) which by
extension changes the quantity demanded (Qd) as you will see below.
Now that we have identified the "other things" that can influence the demand of a good
or service, these determinants change the demand schedule (story) and by extension
the demand curve (picture). A changed schedule means that the consumer has
changed their willingness and ability to purchase the good or service at all prices. When
the schedule changes the curve changes, i.e. we now have a new demand curve as
shown below.
Please view the following 6 minute presentation.

Likewise, just as with demand, if these "other things" change the story, the picture
changes and we have new supply curves, as shown below.
Normal goods vs. Inferior Goods
One more distinction we should make before moving on. When one talks about the law
of demand and the relationship between price (P) and quantity demanded (Qd), one is
also making an assumption on the type of good or service. When income increases,
and the change in demand obeys the law of demand, we identify that good or service as
a normal good. So if income rises, and this change creates a normal movement of the
new demand curve, we are dealing with a normal good. Most goods and services are
normal goods obeying the law of demand.
Now let's change the response of an increase in income. If one's income increases, yet
the demand response is in the direction opposite the law of demand, then we say the
good is an inferior good. That is to say as our income changes, the demand for that
good or service actually goes in the opposite direction. The good graphs below reflect
the response of an inferior good.
I warned you this is an extremely important section. It is one of the most important we
will cover during our tour of microeconomics. But we are almost through it . . . two more
topics.
WEEK TWO
Course Lecture 2-2: Putting Demand and
Supply Together
The key point to get across here is that when one "crosses the curves" a very
exciting, enlightening occurrence happens; we suddenly are provided crucial
information on the market place interactions between buyers and sellers. This
information helps both parties make decisions regarding their participation in the market
place.
That information is in the form of a price. Not just any price, but a price at which buyers
and sellers will be able to buy all they are willing and able to purchase, and producers
will sell all they are willing and able to produce; a market equilibrium price or market
clearing price. At the market clearing price there will be no shortages and no
surpluses. Economic life is beautiful and everything is right with the world!
However, as you can see from the graph above, if the price is not at market clearing
price, there will be a consequence. If the price of a good or service is ABOVE market
clearing price too much will be produced and a surplus will occur.
If the price of a good or service is BELOW market clearing price more will be demanded
for purchase then will be produced and a shortage will result.
Finally, be sure you understand the significance and difference between the three
"states" of a market:
1. Market clearing or equilibrium price; Qd = Qs
2. Surplus; Qd < Qs
3. Shortage; Qd > Qs
WEEK TWO
Analysis
There are several key elements you will need to be sure to familiarize yourself with
regarding the concepts of demand and supply.
Microeconomics is made up of many "signals" in the marketplace. The key signal is the
price system. The price system provides both the consumer and producer significant
information for them to determine what action to take in the marketplace that will best
serve their self-interest. Also here, jump over to the section on rationing function of
prices.
The price system evolves around and is totally dependent on the idea of voluntary
exchange. Voluntary exchange is the action between individuals where both feel they
will be better off after the exchange. We began practicing voluntary exchange as young
children, trading with our siblings or friends everything from dolls to cards to even bikes
- which I had to give back! For me, it was baseball cards. When I opened up my bubble
gum pack and found Mickey Mantle inside, it was like winning the lottery. Yet, it wasn't
too long after that I found myself trading Mickey for my favorite Cincinnati Red, Ted
Kluzewski. I was convinced I was better off with Ted than Mickey - and now you know
your instructor is a very old man.
Every one of us has a story of voluntary exchange. Voluntary exchange makes the
economic world go round, as we will see later in the course. It is voluntary exchange
and the decisions of consumers and producers that create changes in our willingness
and ability to buy or produce goods and services.
Finally, government controlled price controls in the form of price ceilings and price
floors distort markets creating shortages and surpluses respectively. Both actions
restrict the marketplace.
Price ceilings create shortages
Price ceilings restrict the supply of goods because they don't permit prices to reach
equilibrium. Rent controls for example. While certainly well intentioned, they create
disincentives for landlords and property owners to maintain their property or for others
to buy property and add to the rental housing market.
Price floors create surpluses
Price floors subsidize over production of a good or service, resulting in a surplus.
Agricultural price floors create over production of food stuffs. Minimum wage is a price
floor on what employers can pay their employees, regardless of the market conditions at
the time.
WEEK TWO
Instructor Lecture: Shortages and
Surpluses: Application and Analysis
In previous lectures you learned about the three potential states of a market:
Equilibrium, shortage, and surplus. Let's consider some situations and practice
determining the state of the market from the graphs. We can then discuss adjustment to
equilibrium when the price is allowed to change and the situations that arise when the
price is not allowed to change to clear the market as in the case of price floors and price
ceilings.
Consider the market for gasoline shown in the figure below:
What is the equilibrium price and quantity in this market?

Click here for an answer.
Quantity demanded equals quantity supplied at 30 million gallons per day and a
price of $2 per gallon. Recall that $2 is also called the market clearing price.
What is the state of the market if the price was $4? What about 1$?
At a price of $4, there is a surplus (or excess supply). The amount of the surplus
is equal to 50-10 = 40 millions of gallons per day. At a price of $1, there is a
shortage or excess demand. The amount of the shortage is equal to 40-20 = 20
million gallons per day.
Assuming no price controls, how do you think the market adjusts if the price is too high
and there is a surplus? Or when the price is too low and there is a shortage?
Your intuition is right. When there is a surplus, the price will decrease as firms
there is an excess of goods at the high price. This will continue until the excess
supply is eliminated and the market price is reaches the equilibrium price.
Similarly, in a shortage, the price is bid up" by the excess demand. The price will
stop increasing when the quantity demand and supplied are again equal at the
market clearing price.
What happens when the price market is not allowed to change to clear the market (or
equate quantity supplied and quantity demanded? Let's revisit the price controls defined
in the previous lecture. As you can see in the graph below, when the government
imposes a price ceiling to keep the price low, it is set below the equilibrium price, since
the equilibrium price is believed to be too high.
What do you think happens in this situation?

There is shortage. Since the shortage cannot be eliminated with the price
increasing, usually a black (or illegal) market will develop to satisfy the excess
demand.
Below we can see a typical example of price floor, the minimum wage. A price floor is
regulation that is meant to keep the price above equilibrium, when the equilibrium is
believed to be too low.
At the wage, Wm, there is an excess supply of labor (the surplus is QS - Qd), which is
equivalent to unemployment since not everyone available for work is working at that
wage. The impact of the minimum wage is to reduce employment in that market from Qe
to Qd
WEEK TWO

Elasticity
You are about to enter the world of truly exciting economics. No, that is not an
oxymoron! You will understand why demand and supply curves look differently - why
some are flat, others almost vertical. You will understand what that means to our
economic decisions as consumers and producers. Probably most of all, you will see this
"economic stuff" really does have relevance in the real world.
Elasticity is the concept that reveals the responsiveness of changes in quantity
demanded to changes in price. An important mathematical point is to remember the
change is measured as a percent change in quantity demanded divided by a percent
change in price as noted in the equations below.
Price elasticity of demand really provides explanations on why many economic actions
are either valid or not valid. Why does government like to tax gas, cigarettes, and
alcohol? Why can't some retailers just raise prices any time they wish?
When a good's elasticity is elastic, like a rubber band, as prices change the consumers'
responsiveness is greater than the change in price. Conversely, if a good's elasticity is
inelastic, like a wall, as prices change the consumers' responsiveness is smaller than
the change in price. This distinction will be made clearer in the following discussions.
Hopefully, this will give you a mental picture of what to look for as we now discuss
consumers behavior when prices of goods and services change.
Price elasticity of demand identifies the percentage change in Quantity Demanded to
percentage change in Price. Couple of key points:
1. Focus is on percentage change, not absolute changes.
2. Mathematically, the ratio will always be negative. Don't be concerned.
Remember these three scales:
Ratio < 1 INELASTIC Elasticity of Demand - % change of Qd is less than % change of
price
= 1 UNITARY ELASTIC Elasticity of Demand - % change of Qd is equal to %
change of price
> 1 ELASTIC Elasticity of Demand - % change of Qd is greater than % change of
price
Price Elasticity of Demand
A measure of the sensitivity of quantity demanded to changes in price. The percentage
change in quantity demanded divided by the percentage change in price (absolute
value)
(The following formulas and graphs provided by Dr. Linda Wiechowski)
The formula for the price elasticity of demand is:
Price Elasticity of Demand: Examples

Price Elasticity Ranges
The price elasticity of demand results in a value that falls within one of five ranges:
Elasticity and Total Revenues
The final aspect for price elasticity of demand is another way in which to measure the
relationship between price and Qd is to look at price increases and what it does to Total
Revenue (TR). The following is a helpful guide:
If p increases (decreases), and TR increases (decreases), price elasticity of demand is
inelastic.
If p increases (decreases), and TR remains the same, price elasticity of demand is
unitary.
If p increases (decreases), and TR decreases (increases), price elasticity of demand is
elastic.
Please see the following information about the relationships between the types of price
elasticity and total revenue. This panel shows the table of data:
Determinants of the Price Elasticity of Demand
Just as there are determinants that changed demand and supply, there are also several
determinants that can change the price elasticity from elastic to inelastic, or vice versa.
Existence of substitutes - The more substitutes available, the larger the elasticity of
demand. While gasoline may have few substitutes, producing a small elasticity,
chocolate bars can have many leading to a much larger elasticity.
Percentage of budget - The larger percentage of one's budget, the larger elasticity of
demand. As prices change of those items absorbing more of our budget, we are more
inclined to search out substitute goods.
Time - The more time one has for adjusting to price changes, the larger the elasticity of
demand.
Elasticity of Supply
Elasticity of supply measures the responsiveness of quantity supplied (Qs) to changes
in price (P). Again like elasticity of demand, it is measured as a percentage change in
quantity supplied (Qs) divided by the price (P).
WEEK THREE
Course Lecture 3-1: Public Spending and
Public Choice
This week you are going to discuss reasons and purposes for government's role in the
economy. Yes, we live and operate in an economic system where individual choice and
decisions by both producers and consumers reign as key methods of choice making in
the market place. Yet, there are times when we need a third party, for example the
government, to help provide goods and services (mostly services) we deem especially
important as a society to be available to all citizens. How and why society makes those
decisions is what we will explore in Chapter 5.
In Chapter 5 we are going to look at why government sometimes needs to get involved
in the economy. There are times when the market leaves us with consequences we do
not like, does not provide a good or service to the quantity we as a society would like, or
does not provide the good or service due to costs or other reasons. Economists refer to
these situations as market failures even though many economists grimace at the use
of that term.
One area in which a market failure can occur is when a market action has a
consequence whose cost is actually borne by a third party. These third party costs are
called externalities. Externalities can be both positive and negative, or both dependent
on the recipient. The key point to understand with an externality is that the economic
activity has a benefit or cost to a third party independent of the market transaction.
Let me illustrate externality that can be both

positive and negative with a story.
When I was a young boy growing up in Kettering,

Ohio, our back yard was the neighborhood
baseball field. I also lived in a neighborhood with
close neighbors, one being a very nice elderly
couple, Mr. and Mrs. Peters.
One summer the local utility company came

through and put up new utility poles and hung
large lights for nighttime security. One of these
poles was on the fence line between the Peters'
yard and our yard. While the light certainly
achieved its purpose of providing security for the
neighborhood, the Peters had another view. The
new light was shining directly into the Peters'
bedroom, a situation not conducive to good sleep.
This was definitely a negative externality. Yet, for
a group of neighborhood ten year olds it was
exactly what we wanted- night baseball!! For us, it
was definitely a positive externality.
In both situations the new light provided an

externality to a third party. In one instance, it was
positive, in another negative.
Why does government get involved with externalities in the first place? Often,
externalities become a problem because the externality influences non-property, such
as air with air pollution. Since no one owns the air, there is no property right allotted to
an owner. A property owner has certain rights relative to use, exchange, and condition.
If you are a property owner you expect to have certain rights as to what you can do with
your property. These rights will often negate the true costs associated with an
externality action. A key role of government in an economy is providing a legal system
to protect and enforce an owner's property rights. You expect government to uphold
those rights for you in your actions and dealings with others, consistently and regardless
of whom the action is for or against. This consistency is the rule of law for a society.
Well, if those rights are not present because there is no owner, then the Government
intervenes to serve as a "referee" between the party creating the externality and the
party affected by their actions.
How does government correct externalities?
Generally we think of government getting involved in the correcting of negative
externalities such as all forms of pollution. As we know, people respond to
incentives and disincentives. Government actions can create either incentives or
disincentives to correct externality situations. It is sort of deciding whether to use
the carrot or the stick as an incentive for an action to happen, or a disincentive
for an action not to happen.
So what does the government do?
When it comes to negative externalities, government has mainly two sticks,
special taxes or regulation. Regarding pollution, government can charge taxes for
over polluting, or charge a tax to allow pollution. Or, they may place regulations
to either prevent polluting, force reduced polluting, or create an environment or
market for pollution. Regardless, remember from earlier discussions all choices
have consequences that lie in the future. It is important for governments to
identify future consequences before implementing taxes or regulations.
What about positive externalities?
Sometimes, government wants to encourage positive externalities. They may
accomplish this by producing and/or financing the production of the good or
service providing the positive externality as they do with higher education,
subsidizing (negative tax) the good or service such as subsidies for public
education, or could establish regulations creating incentives for the positive
externality to occur, such as vaccinations for school age children.
Another function of government, often as a result of externalities, is to provide certain
goods and services. These are called public goods. Public goods are, as their name
suggest, for consumption and use by the general public and can be consumed by many
individuals simultaneously. This is in contrast to goods that are consumed or used by
only one individual at a time, generally the individual who paid for the good or service.
These are private goods.
So how do we distinguish between public goods and private goods?
Public goods satisfy two conditions or characteristics. One, as stated previously,
a public good can be used by many people at the same time without interfering
with each other's utility of the good. This can called shared consumptionm. Two,
a public good or service is one in which consumers cannot be excluded from its
use, regardless of such things as where they live, where they are from, or if they
paid taxes to support the good or service. This is called the exclusion principle.
This exclusion principle creates what economists like to call the free rider
problem. We will take up the free rider problem a bit later.
How can we tell if a good or service is a public or private good?
Good question, glad you asked.
Instructions: Below is a chart that will help us differentiate between a public good and
a private good. Build the chart by dragging and dropping each of the goods listed on the
outer edges of the chart to their respective quadrants based on the vertical and
horizontal labels displayed.
Now that you have had a minute to review the chart, let's take a look at each of the
cells.
In the top left cell are goods and services that exclude individuals and there is not
shared consumption. If you don't pay for it, you don't get it! The goods and services that
fit into this cell are definitely private goods.
Let's jump down to the lower right cell where individuals are not excluded and shared
consumption exists. So, regardless of what you did, who you are, or where you are
from, you share in the consumption of this good or service and we all share it together!
Ah, togetherness!! This is clearly a cell for all public goods.
The two cells with the question marks, "?", are the fun ones. Let's explore each of these,
starting with the upper right cell. In this cell we have both shared consumption yet one
can be excluded-Hmmmm?? How does that work? What is a good or service where
many of us can participate or consume at the same time, yet can also be excluded for
some reason, like not paying the fee or price? Answers might be restaurants, golf
courses, theaters, parks, libraries, schools to name just a few. Now, can you think of
restaurants that are private and ones that are public? What golf courses? Parks?
Libraries? Schools? If you think about it, all these "categories" of goods and services
have both public and private entities. Regarding our discussion, this cell actually
contains both public and private goods and services.
What about the other question mark cell in the lower left? The goods and services that
fit into this cell do not exclude one from use, yet can only be consumed by one
individual at a time. Defining goods and services in this group can get a bit muddled.
What good or service is consumed by only one person, but cannot be excluded? What
about a drinking fountain? How about a Porta-John? Or a public restroom for that
matter? Hey, let's not get carried away with the shared consumption thing!! Seriously,
as you can see this group of goods and services is a bit tricky.
Back to the public goods for a moment. By definition and extension all public goods
have one thing in common, the free rider problem. So before we leave this topic of
public goods, it is important to briefly introduce a concept applicable to all of us. Yes, we
have all been free riders no matter how much you have paid in taxes. First, let us set
the record straight; being a free rider is not a bad thing. Being a free loader, yes that's a
problem! But a free rider is anyone who has used a public service and not been party of
paying the costs for the production and/or operation of the good or service. At some
time in our life we have all taken advantage of a public good or service when the cost of
the good or service was paid for by others. Now I know you are reading this
thinking-"Prof, you're wrong; not me, I have never done that!" So let me ask you this.
Have you ever driven on a road in another state in which you live? Or have you ever
enjoyed a city or county park in a city or county where you don't live? The challenge for
any government at any level that offers public goods or services is how to reduce the
free rider problem.
The free rider problem can take on a very different perspective when we extend this
concept to national and international issues pertaining to national defense, international
cooperation, and international alliances. But we will save that discussion for later...
WEEK THREE
Instructor Lecture: Externalities

In this lecture we review market failures and illustrate the impact of government
intervention on the market equilibrium price and quantity.
Let's check to see if you recall what we mean by a market failure. So - What is a market
failure?
A market failure is a situation where the market equilibrium quantity is either too
much or too little as compared to what would be optimal for society.
Market failures generally arise when there are positive or negative externalities. An
externality occurs when a third party (someone not involved in the activity) is affected by
someone's action.
A typical example of a negative externality is the pollution that results from a firm or an
industry's production process. Consider the following example of a steel mill depicted in
the demand and supply graph below. The supply curve for steel is given by S1 and the
demand curve is D, so that the equilibrium quantity exchanged is 110 million tons of
steel and the price is $500 per ton (point E).
Assume that currently the government does not regulate pollution and that this steel
mill's production emits spoke (pollution) which causes diseases and dirties the
environment for the people living in that area. This is an example of a negative
externality. Therefore, it is desirable that less steel is produced in order to reduce the
negative effects of this production process. Here we say that the market over allocates
resources to the production of steel when the negative externality is not taken into
account (as shown in the market equilibrium at point E). If the negative externality is
taken into account, for example by imposing environmental regulations on the steel mill,
then the supply curve for steel would shift to the left (S2) to reflect the increase in cost
due to complying with regulations. This would take the market equilibrium to E1 thus
reducing the amount of steel produced and reducing the pollution.
The example above shows that in this case, there is a role for the government to help
the market achieve the optimal outcome. By forcing the polluting firms to bear some of
the cost of the negative externality, the market ends up producing less of the good that
is causing the negative consequences on the third parties.
Using similar reasoning, let's work through an example of the opposite situation from the
one discussed above. Suppose we would like to see more resources allocated to the
production of a good or service because it has positive consequences on society.
Consider the graph below, which shows the market for inoculations (or flu shots as an
example). The demand for shots is given by D1 and the supply by S. The market
equilibrium at point E (150 million inoculations per year) is considered to be insufficient,
so that we say, the market under allocates resources to the production of this good.
Why do you think the activity of taking shots is considered to have a positive
externality?
Right, the more people take flu shots, the less people get the flu which should
result in everyone being healthier-which should ultimately lower the cot of
healthcare and minimize the number of lost work days.
The optimal scenario is for the number of shots taken to increase. What can the
government do to increase the number of inoculations?
One way is to raise the demand for inoculations, taking the demand curve to D2,
say to 200 million per year as shown in equilibrium E2. Another way is to raise
demand is to subsidize the cost of shots made available through employers, thus
encouraging more people to get them since they are free. Another way is to
educate the public on the benefits of taking inoculations thus raising awareness
and potentially raising demand.
Can you think of other examples of positive or negative externalities?
WEEK THREE
Course Lecture 3-2: Rents, Profits, and the
Financial Environment of Business
Over the next several weeks we are going to explore an area of microeconomics known
as the theory of the firm. We are going look at how economists use a different prism to
view the business environment and business structures as compared to a business
person and/or an accountant. At the conclusion, you will have a much better
understanding of the "microeconomics" side of the economics world.
Economic Rent
Economic rent takes on several forms, economic rent of land or economic rent of labor.
First, let's make sure you are comfortable with the definition. "Economic rent" is the
value of the land or labor above its opportunity cost (i.e., its next best alternative).
Let's look at two examples of how, "Economic rent allocates resources to their highest-
valued use."
Land example - The Empire State Building
Real estate in mid-town Manhattan in New York City has been considered some of the
most valuable real estate in the world. Yet, it is only land, just like central Iowa farmland
or upper Michigan forests. If as good economists we want to allocate our resources
most efficiently, i.e., their highest valued use, we want to minimize the opportunity cost
of their use. This is where economic rent comes in. What would be the next best
alternative for use of the land that the Empire State Building sits upon? Maybe a smaller
office building, or retail, or maybe even farmland would occupy the real estate.
Whichever its opportunity cost use, would it have the same value? Of course not. Any
value above its opportunity cost value is considered economic rent.
You can see from the graph below, at any point in time supply (S) of land is perfectly
inelastic. As a result, as the demand for the land increases so does the economic rent
for the land (D1 to D2) which raises the land's price (P1 to P2).
Source: Miller, Roger; Economics Today, 14th Edition
Labor example - Ben Wallace
For those of you not familiar with Ben, "Big Ben" was a professional basketball player
with the Detroit Pistons. He left the Pistons for the Chicago Bulls, and since landed in
Cleveland. He has been an all-star and was named best defensive player for several
years. He is very good, and he makes a lot of money as a professional athlete. As an
economist, I am more interested in what his next best alternative for a profession might
be. For example, his opportunity cost of playing professional basketball. Without
knowing Ben, or his personal situation, I can still say with a very high degree of
confidence if he was not playing professional basketball, his next best alternative would
not be valuing him at the millions of dollars he currently receives as a professional
basketball player. As a result, what he receives above the value of his next best
alternative profession is Ben's economic rent.
Like "Big Ben", most "superstars" whether in sports, films, or entertainment such as the
"Stars" in the chart below are receiving economic rent for their current earnings. What is
your economic rent?

Profits of a Firm
"The Profits of a Firm" is a very important concept for you to become very familiar and
comfortable with. It also may be a little difficult, especially for those of you who have
accounting backgrounds, and for those of you who have business backgrounds and
careers. There is a very significant difference between how an economist views the idea
of "profit" to that of a business person (with accounting), which you will see.
Accountants' view of a business operation is very concrete, and direct. They identify the
costs of production, the expenses of a business. These are called explicit costs, as
they are paid costs and accurately known. Then they identify the business's revenue
through the selling of the good or service. Subtracting the costs from the revenue, an
accountant will provide the business owner a picture of the business health of the
business.
An accountant's view of profits:
Accounting profit = total revenue - explicit costs
(expenses paid)
However, an economist takes a different view of

profits. While an economist also takes into account the
revenue and expenses of the business, they have one
more item in their bag of numbers. Remembering
economics is about trade-offs and opportunity costs,
the economist also wants to know what the business
owner could have earned had they not allocated their
available resources to the production of the business's
good or service, but say invested the "expenses" in a
money market account. Isn't that lost savings a cost to
the business owner? Absolutely it is, and the
economist wants to count it as a cost of doing
business. These are the implicit costs of doing
business. Implicit costs are the opportunity costs of
the productive resources used in the creation of the
good or service of the business. As a result, the
economist formula for profit has an additional cost,
implicit costs, as shown below:
An economist's view of profits:

Economic profits = total revenue- (explicit costs +
implicit costs)
Economic profits are much harder to achieve. They

are also much more descriptive in illustrating the
efficient allocation of resources for the business
owner.
Course Lecture 4-1: The Firm: Cost and
Output Determination
Economic Pairs
If you remember in week one you were introduced to several - what I described as
economic pairs. Well, there are several more of these "pairs" as we explore
microeconomics and the theory of the firm. By taking a few moments at the beginning,
we will have a head start on the important concepts of this lecture.
This lecture is chock full of the critically important concepts the micro-economist uses in
assisting companies to be more effective and efficient. At the conclusion of this lecture,
you will have a better understanding of how an economist can help businesses be more
efficient and maximize their profits in the allocation of the factors of production they own
and use to produce goods and/or services for their business.
Let's begin with a quick introduction to several economic pairs:
Variable vs. fixed
•
An input whose quantity used in the
Variable
production process is determined by the
input
quantity of goods and/services produced.
An input whose quantity used in the
production process is not a set amount in the
Fixed input
production process regardless of how many
goods and/or services are produced.
Average vs. marginal
•
Average The total divided by the quantity.
The difference in the total when one more
Marginal
unit is added.
Before we attack the average product, marginal product relationship let's take a moment
and do a short exercise to prove a point:
Please add up the following numbers:
30, 24, 33, 36, 45, 35, 30, 35, 44, and 33
1. What is your answer? Have it -- good!

2. How many numbers did you add? What is the average?
Now, add 32.
1. What is the new total? What is the new average?

2. What is the marginal quantity in this new set of numbers?
Click here.
If you answered 32 as the marginal quantity, you are correct.
Now, add 40.
What is the new total? What is the new average?

What is the marginal quantity in this new set of numbers?
Click here.
Again, if you answered 40 as marginal quantity, you are correct.
Remember: Marginal value is the value of the LAST unit added.

Can you see the relationship between the marginal number and the average?
When we add one more number (marginal), in what direction does the average go?
Inputs vs. outputs
•
The capital (K) and labor (L) factors of
Inputs production used by a business to produce
goods and/or services.
Outputs (Q) The goods and/services produced.
•
A second important relationship is an understanding of the relationship between inputs
and outputs. This relationship is how a business defines its productivity. It is how we
define productivity at the macroeconomic level as well which we will cover later in the
course. Be absolutely sure you understand the definition of production.
Increasing productivity, using the input/output relationship, is defined as a resulting
increase in output using additional inputs or in a more efficient manner. Another way of
increasing productivity is by maintaining output level with a decreasing level of inputs.
This relationship leads to what many consider the defining definition of economics;
diminishing marginal product (returns).
Course Lecture 4-2: Diminishing Marginal

Product
Before we define diminished marginal product, it's important to remember that marginal
product is the change in total product that occurs when a variable input is increased and
all other inputs are held constant.
Now we can go ahead and define Diminishing Marginal Product (DMP). DMP is an
understanding that at some point, as equal additional units of input are added, the
increase in marginal output will decrease. This decrease will continue, lowering average
product until marginal product becomes negative and total product actually decreases.
The charts below exemplify this relationship between marginal, average, and total
product.
Source: Miller, Roger, Economics Today, 14th Edition

Remember, you have actually already been introduced to this notion through
diminishing marginal utility. That is, the idea that as utility increases with the continued
consumption of a good, a point will be reached when the utility of the additional unit will
be less than the one before it. DMP is exactly the same concept, only now we are using
it in the production process. Another way of looking at it is that DMU was measuring the
consumer's satisfaction with goods and services from the Product Market; DMR is
measuring the producer's use of the factors of production from the Resource Market.
As we look at DMP, remember a couple of cues:
1. The point of DMP is not the same as a decrease in Total Product (TP). If you
look at the charts above, DMP (panel c) is reached at two units of labor. Yet, if
you scan up to panel b Total Product continues to rise. That's because DMP,
even though descending, it is still positive which means additional labor will
continue to add to the Total Product.
2. So if DMP is not where TP declines, where does it decline? Let's turn the
question, where does MP go negative? At about 7.5 units of labor, MP goes
negative signifying that TP will now decrease.
Understanding these cues and the MP - TP relationship hinges on your understanding
of the marginal-average, and marginal- total relationships discussed earlier. If you are
not comfortable here yet, I strongly suggest you return to the earlier section; Average
vs. Marginal.
Instructor Lecture: More on Marginal

Product and Marginal Cost
Content Author: Basma Bekdache
Earlier this week you learned how to define production and marginal product. You also
learned about the law of diminishing marginal product (also referred to as diminishing
marginal returns). What happens to marginal product has important implications on the
cost structure of the firm, which is a key determinant of its production level. In this
lecture, we'll review and calculate marginal product, explain why it's diminishing and
explain its relationship to marginal cost.
Do you recall the general definition of the marginal product of an input?
The marginal product of an input is defined as the change in total production
(output) per unit increase in the input (equal to change output/change in input). If
the input in question is labor, we can say that the marginal product of labor (MP)
is the extra (or marginal) units of output we get when we you add an extra unit of
labor.
Before we get to an example, let's remember that our analysis assumes that the firm is
operating in the short-run. How do we define the short-run?
The short-run is a time period where at least one input is fixed (or cannot be changed).
The input that is usually assumed to be fixed in the short-run is the capital stock, such
as plant size. In the long-run, all inputs to the production process can change.
Suppose that the production function of snowboards is as described in the following
table:
Total production
Quantity of Labor
of
(workers per
snowboards
week)
(per week)
1 22
2 52
3 81
4 100
5 115
6 126
What is the marginal product of the 1st unit of labor? How about the 2nd, 3rd, 4th, etc?
When does diminishing marginal product set in?
The marginal product of:
• The 1st unit of labor is 22 snowboards,
• The 2nd is 30 snowboards (= 52-22),
• The 3rd is 29 (=81-52),
• The 4th is 19 (=100-81),
• The 5thth is 15m, and
• The 6th is 11 snowboards.
• Diminishing product starts after the 2nd unit of labor.
Why does diminishing marginal product occur? That is, why is it that every extra unit of
labor gives us less and less additional output?
Diminishing marginal product occurs because the other inputs, specifically,
capital is fixed since the firm is operating in the short-run. In this example, with a
given plant size (and a given set of tools and machines to be used for
production), adding more workers will yield less and less additional output since
the additional labor has to share the existing machines and tools.
Therefore, we know that diminishing marginal product occurs in the short-run
when some of the other inputs are fixed. In the long-run, if we add labor and
expand plant size (and get more machines and tools) at the same time,
diminishing returns does not occur as quickly, especially if technology is
improving as well, allowing the Labor input to be more productive at using the
capital.
So why should marginal product be important to the firm? To answer this question we
need to explain the relationship between marginal product and marginal cost. We will
see next week that marginal cost is a key determinant of the production level of the firm.
Relationship between Marginal Product and Marginal cost:
Consider the definition of Marginal Cost (MC) that you learned in the previous lecture:
In the short-run, the labor input is the only variable input. Assuming (with no loss of
generality) that the cost of labor is the same for all units of labor, meaning hiring the 1st
unit of labor costs the same as the second and 3rd etc. and is equal to the wage, $W.
We can see that the change in total cost (numerator in MC formula) is the same as the
wage rate W. That is, when we add an extra unit of labor on the margin, we are adding
$W to total cost. What about the change in output (the denominator in the formula for
MC)? What is the change in output that results from adding that extra unit of labor?
The extra unit of labor is adding its marginal product! So the change in output is
equal to the MP of that extra unit of labor.
Given this, MC can be rewritten as:
As we can see from the MC formula in (2), as the marginal product of labor
increases, the marginal cost of labor decreases, given W!
Intuitively, given the wage that the firm pays an additional worker, the more this
extra worker produces (the higher his/her marginal product), the lower this extra
worker is effectively costing the firm, (i.e., its marginal cost decreases, which is
what we are seeing in the relationship above.
Let's have a look at the table below to work through a numerical example of
this relationship:
Columns 1 and 2 show the production function while column 4 shows the
marginal product of labor.
Suppose that each unit of labor costs $W = $1,000. We can calculate the
marginal cost using the relationship in (2) and get the results shown in
column 6.
For example, for the 5th unit of labor MP = 50 internet accounts serviced
(290-240), given W = $1,000, MC = 1,000/50 = 20. Similarly for the 6th unit,
MC = 1,000/40 = 25.00. Since we have diminishing marginal product, the MC
of the 6th unit of labor is greater than that of the 5th unit.
Therefore, MC will rise when MP starts to diminish! We can see this in the
graphs below as well. Note that MP and MC are almost like mirror images of
each other. MC declines when MP is rising. MC starts to increase when MP
declines or at the point where diminishing marginal product sets in, which is
after the 3rd unit in this example.
What's the implication of this relationship on a firm's cost structure?
A firm can reduce it's marginal cost if the marginal product of its labor increases!
Can you think of ways to increase marginal product of labor?
Course Lecture 4-3: Short-Run Costs to the

Firm
In some ways, and at the chagrin of some educators, one way to begin to remember
and ultimately understand the use and application of these formulas is to first,
memorize them; second, see their relationship to each other, and third, see their
relationship to the production process.
First, let's take a look at the popular short-run cost curves:
Second, spending time with the definitions.
Before we move on and look at the curves as curves, let us take a moment and make
sure we have an understanding, mathematically speaking, and we are comfortable with
each of these:
In the beginning we differentiated between variable costs and fixed costs, remember?
So our first equation for Total Costs should make very logical sense:
TC = TFC + TVC
Now as we move on to the average cost curves, beginning with average total cost
(ATC). For all the average costs curves, just remember how we arrive at an average.
We have been doing it since fourth grade!
Divide the total (T--) by the quantity (Q)

The results for each of the totals then are logical extensions of fourth grade math:
ATC=TC/Q AVC=TVC/Q AFC=TFC/Q

Remembering our definition of marginal, identifying marginal cost (MC) becomes an
extension of the definition, or the change in total cost by adding one more unit (change
Q).
MC = change in TC/change in Q
Now that we have seen the mathematical look to these cost curves what do they look
like as curves?
Third, let's spend a minute taking a look at the production curves. While studying the
cost curves, pay special attention to the graphing of these cost curves in the figure
above. While you may not be asked to directly recreate these cost curves, you will be
responsible for their relationship to each other. Then again, maybe you will.
Notice the relationship between marginal cost (MC) and average total cost (ATC). As
MC is decreasing, notice ATC decreasing as well to between 3 and 4 units. As the MC
begins its climb upward, what is ATC doing? Hint: Go to the discussion earlier about the
marginal-average relationship.
As MC intersects ATC, how does the MC-ATC relationship change again?
Finally, as MC>ATC, the ATC begins to increase.
Another relationship exemplified in the figure above is the Total Cost (TC), Total Fixed
Cost (TFC), and Total Variable Cost (AVC). If you add the AFC and AVC curves, you
can determine Total Cost (TC) curve. Also, if you observe the three curves, you will also
notice the cost between 0 and AFC is equal to the amount between the AVC and TC
Instructor Lecture: Long-Run Cost Curves

The previous lectures focused on the cost structure of the firm in the short-run. Let's
consider some issues that apply when we extend the analysis to the long-run. Do you
recall how we define the long-run?
The long-run is a time period when all inputs (or factors of production) can
change.
The plant size (or the amount of physical capital) was fixed in the short-run. When we
vary the plant size, we can envision the long-run average total cost curve of the firm as
consisting of the minimum points of the various short-run average total cost curves that
apply for different plant sizes. We can see this is the graphs below:
In the example shown above, SAC1 represents the Short-run Average total cost curve if
the firm is operating under plant size 1. If the firm expands to plant size 2, the short-run
average total cost is SAC2 and so on. Panel (b) shows the long run average total cost
curve as the locus of points representing the minimum unit cost of producing any given
rate of output, given current technology and resource prices.
In panel (a), what do you notice is happening to the SAC curves as the firm's plant size
increases?
Think about this before clicking here for the answer.
In panel (a), the SAC curves are decreasing as the firm expands production
capacity. When a firm can achieve lower average total costs when it expands its
size, we call it Economies of Scale.
In panel (b), we can see that the Long-run Average cost curve is U shaped. What does
this mean? Up to a certain output level, average total costs decrease as the firm
expands plant size. Then its average costs stay about the same and after a certain
output level (at SAC5 in this example), average costs tend to increase with a bigger
plant size. We can think of three separate portions of this curve and define them as
follows:
1. Economies of scale refers to decreases in long-run average total costs resulting
from increases in output panel (a) below.
2. Constant returns to scale shown in panel (b) below is a situation where
average costs do not change with the size of the output.
3. Diseconomies of scale refers to increases in long-run average total costs
resulting from increases in output (panel c).
What can explain economies of scale or diseconomies of scale?

Economies of scale can result from many factors. In most cases, large fixed costs, such
as those associated with a big car factory, are spread out over more units of output
which decreases the average unit costs. Operational efficiencies and specialization also
contribute to economies of scale. Bulk buying and spreading overhead are additional
factors as well as financial considerations factors that sometimes enable large firms to
obtain better financing and thus reduce their average costs of production. Diseconomies
of scale start to occur when firms get too large to the point where they become
inefficient. The firm can reach a certain size where coordination and communication
problems start to limit the efficiency of management, thus increasing its average costs
of production.
A related measure to long-run average costs is the minimum efficient scale.
Minimum Efficient Scale (MES) is the lowest possible output for which the firm
reaches its lowest long-run average total cost.
Given this definition, what is the MES in the example shown in the graph above?
The MES in this example is 10 units of output. This the smallest output this firm
can produce to achieve its minimum long-run average total cost.
Economists use MES as a measure of how competitive a market can become. If the
output that it takes to reach minimum long-run average costs is small, then given total
market size, there is room for many firms to enter and produce in this type of market. If
MES is large then only a few companies will be able to exist in the same market, given
the total market size. Therefore, MES can be used as a measure to predict the likely
market structure of a particular market.
Course Lecture 5-1: Perfect Competition
Businesses come in all shapes and sizes. They compete in the marketplace every day
against businesses similar in how they conduct business on a daily basis. This week
you will be introduced to the characteristics of four market structures in which
businesses compete: perfect competition, monopolistic competition, oligopoly, and
monopoly. In economics, we call this the theory of the firm. You will see how and why
some businesses operate the same, how and why some businesses operate differently,
and why their knowledge of these similarities and differences can help them compete in
the marketplace.
Let's ask ourselves a few questions about each industry structure:
1. What are the characteristics of each market structure?
2. How is demand determined?
3. How are profits maximized?
4. What signals do profits provide producers?
We can view each market characteristics by asking a few key questions:
Answering these questions provides us enough information to classify every company
into a market structure and gain a better understanding of the "why" they conduct
business the way they do. Let's set the stage to compare the four market structures by
looking at the most "pure" market structure; perfectly competitive market structure.
The Perfectly Competitive Market Structure
Of the four structures, perfect competition creates the most "pure" structure since no
one buyer or seller can have an effect on the market price. The characteristics of a
perfectly competitive market structure include:
• Large number of sellers and large number of buyers.
• Product sold is homogenous. A homogenous product is one that is exactly the
same, regardless of who makes it, sells it, or buys it. Each product is a perfect
substitute for another. Agricultural product such as wheat is considered
homogenous.
• Both buyers (consumers) and sellers (producers) have access to the same
information.
• There are no barriers to entry. Both producers and consumers can enter and exit
the industry with relative ease. The factors of production used can be transferred
to another industry quite easily.
• Producers are price takers. As price takers, the producers have no ability to set
price but must take the price established by the market.
At the end of the lecture we will take a look at each of these characteristics and how
they differ (or are similar) for each of the four market structures. But for now, let's keep
our focus on the perfectly competitive firm.
How is Demand Determined?
The demand curve for a firm in a perfectly competitive industry is a horizontal line. Of
course the obvious question is "why?"
Think about this for a moment and then click here for the answer.
If we look at the graphs below we see Panel (a) representing the industry and
Panel (b) the Individual Firm within the industry. The industry demand curve
looks very much like what we studied earlier on supply and demand, markets and
prices. Yet when broken down to the individual firms of the market, the demand
curve becomes a horizontal line and tells a very different story. This story can be
explained by returning to the characteristics of the market structure: many
buyers and sellers, full information, homogeneous product, no barriers to entry.
With all these characteristics at play, the individual firm has absolutely no
influence on the market price of the product (i.e., a price taker). Consequently, the
firm has only one price it can charge. In our example, the price for pen drives is
$5. As a result, the firm has a demand curve that is horizontal representing only
the one price it can charge. Any other price cannot be charged because the
demand curve represents a market of consumers who are willing and able (sound
familiar?) to only purchase pen drives at $5.
The Demand Curve for a Producer of Flash

Memory Pen Drives
(Source: Economics Today, Miller, 14th Edition)
So if the firm can only charge $5, how can it make a profit? Ah, the next big question...
How are profits maximized in each of the market structures?
For every firm, total revenue (TR) is the price per unit times quantity sold (TR=PQ).
Yet, there is one point at which profits can be maximized by a firm. Look at the graph
below:
Profit Maximization, Panel (b)

Profit Maximization, Panel (c)

Think about what we just viewed. For our purposes, let's momentarily pay special
attention to the bottom Panel (c). First, look at the demand curve (d). With a horizontal
demand curve, at the margin adding one more unit (margin) the price does not change.
As a result the marginal revenue (MR) is the same as price (P) which is the demand
curve (D). In essence, in a perfectly competitive industry P, MR, and D are equal, and
therefore interchangeable. If you know one, you know the other.
Regarding marginal cost (MC) and the MC curve, you were introduced to this curve in
previous lectures. Now imagine as if you are standing on your head looking at it! What
other curve does it replicate? (Hint: Think about our pizza eating.). If you return to the
lecture on diminishing marginal returns you will find some interesting similarities
between DMR and the MC curve. Cool!!
There is a second way to look at the MC curve. On the MC curve, diminishing marginal
returns sets in at 3 units. Beyond 3 units, the MC curve is moving upward - yet, MC <
AVC and below MR. We are definitely making short run profits at the margin; MC < MR!
So let's continue producing additional units (Q). Are we still making profits (i.e., is MC <
MR)? Keeping our focus on panel (c) above, what interesting things happen beyond
point E?
YES, beyond point E MC is now more than MR! We are no longer making a profit,
but now experiencing a loss. Since we do not want to suffer losses we can then
determine we are best at Point E where MC=MR. We have, in economics jargon,
obtained the point of profit maximization!
Profits are maximized at the point at which marginal cost (MC) is equal to
marginal revenue (MR). This is true for every firm of every industry.
Another interesting "point" about our MC curve. If you remember the marginal-average
relationship we discussed earlier, when MC > AVC something interesting happens. The
point where MC > AVC the curve becomes a firm's short run supply curve (s). Look at
the figure below and you will see what I mean.
The Individual Firm's Short-Run Supply

Curve
Before we move on, remember as we stated earlier, MC = MR is the profit maximizing
point for every firm in every industry. Profit maximizing will always occur where MR =
MC. It just may not be quite as obvious in the other market structures of monopolistic
competition, oligopoly, and monopoly.
Pretty cool stuff, huh? Notice as we move through the course, the concepts and topics
discussed in earlier lectures are beginning to come together and bring our economic
world to life! And ... we are just getting started!
Short Run Profits
Profits come in several sizes. There are normal profits, economic profits, and of course
no profits. Each provides firms information and signals on how a specific market is
postured for growth, decline, or stability. Now it is time to see how these signals are
exhibited. We will wrap up this lecture by looking at how businesses can use the
information and respond to certain business climates.
Measuring Total Profits

The above graph gives us our first look at Total Profits. Notice that MC = MR (profits are
maximized) is below average revenue (AR). Remembering our marginal- average
relationship, with a horizontal d curve, MR = AR. Observe it is above average total cost
(ATC= TC/Q). That means for every unit sold, where MC = MR, AR > ATC.
In this scenario the profits are considered economic profits because they exceed the
normal profits. Normal profits are "built in" to the explicit costs of doing business.
Economic profits, however, return not only explicit costs, but implicit costs as well.
When economic profits are present, it is a signal to others firms that entry to the market
is a good thing and profits can be earned.
The other side of the business coin is the graph below where AR < ATC at MC=MR.
Minimization of Short-Run Losses

When at MC = MR and P < ATC, the firm will experience short run losses as shown in
the graph. This information becomes signals for businesses to not allocate resources to
the market, or exit the market.
When a firm is in this situation, does it continue to operate or shut down? Does it exit
the industry or hang in there? The answer is a definite MAYBE. Seriously, the rule for
continuing to operate or shut down has a contingent "IF" attached.
In the short run, if price (P) exceeds average variable costs (AVC) per unit, stay open.
Obviously a business cannot stay open in the long run if it continues losing money. But,
if a firm can cover its variable costs, it might survive.
Why cover variable costs instead of fix costs? Good question - glad you asked.
Remember our definitions of the two costs. A firm will have to cover fix costs (FC)
whether it produces 0 units or a million. Variable costs (VC), on the other hand, are per
unit of production sensitive. So if VC costs can be covered, it is reasonable to continue
producing. In the long run, eventually FC will become VC. Then the decision-making
process begins again.
The graph below shows the break even price where MC = ATC = AR = P = d; i.e. all the
economic stars are in alignment. Remember, a "normal profit" (return on investment) is
built into the cost structure of a firm. So if the firm achieves this break even point, a
normal return on investment will be realized. This is the point of zero economic profits.
Short-Run Shut Down and Break-Even

Prices
(Source: Economics Today, Miller, 14th Edition
Instructor Lecture: More on Perfect

Competition - The Firm's Short-Run Supply
Curve
In this lecture we're going to derive a firm's supply curve using the information we
learned in the previous lecture. Let's begin with a quick review of the most important
points that were made in the previous lecture.
First: Since firms in a perfectly competitive market are faced with a perfectly
elastic (horizontal) demand curve, marginal revenue is equal to the output
price (MR=P). Recall that price equals average revenue (P=AR) for all types
of firms, but only for perfect competition can we say that MR=P.
Second: To maximize total profits, firms must choose output such as MR =
MC. For the perfectly competitive firm this implies that profit maximization
occurs at P = MC (since MR= P). Firms break even if price is equal to
average total cost at the profit maximizing output level (P = MC = ATC).
Finally, firms can be incurring economic losses and still operate in the short-
run if price is greater than average variable cost (P > AVC). Firms should
shut down (stop producing) in the short-run if output price is less than
average variable cost (P < AVC). The graph below, which appeared in the
previous lecture, shows the break-even and shut down prices of the perfectly
competitive firm.
As we can see in the figure above, when demand is at d1 (price = 4.5) the firm is
breaking even. We can see this since P = ATC at the profit maximizing output (E1).
When demand falls to d2, the profit maximizing (loss minimizing) output becomes point
E2 (quantity produced falls from 7 to 5 and the firm is now making a loss since P <
ATC).
Short-run Supply Curve

In week 2 we learned that a supply curve shows a positive relationship between the
quantity supplied and the price of output. Now that we know how a perfectly competitive
firm decides how much to produce, we can see how the supply curve is derived from
the MC curve. When the firm is faced with a given price, it produces the amount that is
consistent with P=MC. As P changes, the quantity produced changes along the MC
curve. Therefore, the MC curve represents the supply curve of the firm, since it gives us
the quantity supplied for various prices. The firm stops producing when the output price
drops below the minimum AVC, therefore only the portion of MC above AVC represents
the supply curve of the firm. This is shown in the graphs below for one firm and for the
industry as a whole in panel (c):
Source: Miller, Economics Today, 14th Edition
Understanding that the supply curve of a business is their marginal cost curve sheds
light on the reasoning behind the determinants of supply we learned about in week 2.
Recall we stated that an increase in the cost of inputs such as the wage rate would shift
the supply curve to the left. Can you explain why this happens using the MC curve?
Study the graphs above before clicking here for the answer.
If the wage paid by the firm increases their MC increases. Therefore, the MC curve
shifts up and to the left. Since the supply curve is the same as MC, the supply
curve would shift left, consistent with a decrease in supply.
We can also see how an increase in productivity leads to an increase supply as we said
in week 2. An increase in productivity raises marginal product. An increase in MP
decreases MC (see lecture from week 4 on the relationship between MP and MC).
When MC decreases, the MC curve shifts down and to the right. This shifts the firm's
supply curve to the right consistent with an increase in supply.
Instructor Lecture: More on Perfect

Competition - Industry in the Long-run
We are now ready to discuss what happens to the perfectly competitive industry in the
long-run. Recall that one of the features of a perfectly competitive structure is that there
are no barriers to entry (i.e., firms can enter and exit the industry at very little cost). Also
recall that the firm can be in either one of three situations:
1. Making economic profits,
2. Breaking even, or
3. Incurring economic losses.
This is summarized in the graph below:
Firms in the same industry are all faced with the same price (remember they are price
takers), but they don't necessarily have the same cost structure. But suppose many
firms in this market have the average cost curve AC3 so that they are making economic
profits. What do you think will happen in this industry?
In this industry, new businesses will be attracted to this industry since there are
economic profits.
Profits and losses act as signals for resources to enter an industry or to leave an
industry. When we have economic profits, it signals resources to enter the market.
Similarly, economic losses signal resources to exit the market. At break-even, resources
will not enter or exit the market. Let's suppose we are in a constant cost industry (an
industry whose total output can be increased without an increase in long-run per-unit
costs). As firms enter an industry with economic profits, the supply curve in that industry
will shift to the right (since the number of sellers increased). This drives the industry
equilibrium price down, everything else held constant. As each firm is faced with a lower
price (the horizontal demand curve shifts down), their economic profits decrease and
are eventually down to zero as more firms continue to enter the industry. Conversely, as
firms exit an industry that is incurring persistent economic losses, the industry supply
curve shifts to the left (because the number of sellers decreased). This drives the
industry equilibrium price up, everything else held constant. This means that the firms
that remain receive a higher price and eventually reverse their economic losses. This
adjustment process continuously takes place, leading to a competitive long-run
equilibrium where firms make zero economic profits. The firm's long-run situation is
shown in the graph below, where the price is exactly equal to average short-run and
long-run cost and the firm is making zero economic profit, which is equal to the normal
rate of return.
Marginal Cost Pricing

A final point to make about perfect competition (in the short-run and long-run) is
perhaps one of the most important. Firms in competitive markets are always
producing at a point where the output price is equal to marginal cost (recall that
profit maximization occurs at MR=MC and since P=MR for perfectly competitive firms,
P=MC as well). The fact that P=MC is referred to as Marginal cost pricing. Marginal
Cost Pricing refers to a system of pricing in which the price charged is equal to the
opportunity cost to society of producing one more unit of the good or service in
question. The opportunity cost to society of using a particular resource for production is
its marginal cost. This result is important since it indicates that resources are being used
most efficiently since the price of the output exactly reflects the cost of the resource.
Therefore, competitive markets are considered to be the most efficient for resource
allocation.
Course Lecture 6-1: The Data of

Macroeconomics - Unemployment
In this lecture we begin our study of the Macreconomy! We first introduced the
difference between micro and macroeconomics at the beginning of the semester. Do
you recall the definition of Macroeconomics?
Macroeconomics is the study of the behavior of the economy as a whole.
Given that you have been exposed to several microeconomic models at this point in the
semester (i.e., demand and supply, the profit maximizing model of the firms, etc.), you
probably feel quite comfortable with using models and variables to analyze economic
problems and answer economic questions. Recall that an economic model is:
Click on the option that best completes this sentence.
Correct! An economic model is a simplified representation of a reality and must be

based on a set of assumptions.
Incorrect. An economic model is a simplified representation of a reality and must be
based on a set of assumptions.
Before we can begin modeling the economy as a whole, we have to spend some time
defining and measuring the most important macroeconomic variables. Therefore, the
next couple of lectures will be quite descriptive, as we will learn how to measure the
variables that tell us how the whole economy is performing. These measures are
commonly referred to as Macroeconomic Aggregates. Once we are done with this,
then we can start developing the aggregate demand/aggregate supply model which will
help us analyze the economy and answer a number of interesting policy questions.
Examples of such questions are:

1. What happens when the government lowers taxes,
or increases government spending?
2. Why does the Fed sometimes raise or lower
interest rates?
3. Should policy be used to try to influence the
economy?
So how do we decide how the economy as a whole is performing? From your own
experience and reading the daily news, you probably have heard of a few terms that are
always mentioned about the economy.
Can you think of any?
The most commonly mentioned measures are: GDP (Gross Domestic Product),
Inflation, and Unemployment! If this was your answer, you are right!
We are interested in learning how much the economy produced in a given year, what
happened to the general price level in a given month or year, and finally, we are
interested in the proportion of people who are looking for a job and are not working.
Does that mean that these are the only variables we study about the economy? You
probably guessed no. There are many other important variables that we can study.
However, the aforementioned three variables are indicators that can flag problems and
tell us whether we need to explore more variables. It’s similar to when you go visit your
doctor for your annual check up. They take your temperature, blood pressure, and a few
others things. If one of these measures turn up abnormal, then they investigate further.
Perhaps the economic variable that people can relate to the most is unemployment.
Let’s start with that and learn how to calculate and interpret the Unemployment Rate
(UR).
The unemployment rate is defined as the proportion of the labor force that is
unemployed. The labor force is the part of the population that is eligible to work and is
looking for a job. More specifically:
Source: Reprinted from Roger LeRoy Miller, Economics Today, 14th edition.
The labor force is defined as individuals 16 or older who are either currently working or
are actively looking for a job.
According to these figures for 2007, the UR was 4.8 percent. That is, 4.8 percent of the
people who were eligible to work and were actively looking for work but are not working.
Let’s see if we can look at the UR with more recent figures. We can visit the Web site of
the Bureau of Labor Statistics (BLS) to view the current statistics on unemployment.
This week’s packet also contains a link to a presentation that will help you to navigate
the BLS Web site.
We can see on the top left under Latest numbers that the UR for December 2008 is
7.2%! Obviously larger than the 4.8% we got for 2007. We will learn soon that a major
type of unemployment (called cyclical) occurs when the economy is in a downturn and
firms are laying off workers because they are producing less. How does that compare to
other years for the U.S? We can take a look back over the last Century by going to a
time series graph for the UR.

Macroeconomics: Inflation
You probably already know something about inflation from your own experience! When
you start paying more for gasoline or food and/or other items that you regularly
purchase, you notice a difference in how much you can afford to buy with your current
income. If this happens then you are experiencing a decrease in your "purchasing
power" due to inflation. The opposite can also occur. If overall prices go down
(deflation), then you can buy more goods and services with the same income, which is
an increase in your purchasing power. Based on this, how do you think we define
inflation and deflation?
Inflation is defined as a sustained increase in the general or overall price level.
Deflation is a decrease in the overall price level.
Before we learn how to calculate inflation figures, let's pause for a moment on the
definition above. The key word in this definition is overall or general price level (we can
also say the average price level). If the price of one or two items we buy increases that
does not necessarily mean that there is economy-wide inflation. Recall that
Macroeconomics deals with aggregates or totals. Here too we have to define an
aggregate price level that represents almost all of the goods in the economy. Let's
denote this price level by P. Then we see that P is rising, so then we can say that there
is inflation. You're probably wondering how we can define one number that represents
all of the prices in the economy. For that, economists turn to prices indices. There are
several price indices that we can use to calculate inflation:
1. The Consumer Price Index (CPI)
2. The Gross Domestic Product (GDP) deflator
3. The Producer Price Index (PPI)
4. The Personal Consumption Expenditures (PCE) Index
The most commonly used indices are the first two listed above. A little bit later we will
learn how to compute the CPI, an index which is based on a representative bundle of
goods and service.
For now, let's assume we have the price index, denoted by P, and let's learn how we
can use this index to calculate an inflation rate. The inflation rate is given by the
percentage change in the price index from one period to another - say from one
year to another).
The Bureau of Labor Statistics computes (among many other statistics) the CPI and
inflation for our whole economy as well as various regions and cities. Let's check the
BLS Web site for some data on the CPI and use it to illustrate how we can compute
inflation using a price index.
Navigating the BLS Web site, we can find the CPI for 2000 and 2001 to be 172.2 and
177.1 respectively. To calculate the inflation rate let's apply the percentage change
formula we discussed earlier in the lecture. Do you recall how to calculate a percentage
change in a variable? Take a moment to try to calculate this for yourself.
When you are ready click here.
That's right. The percentage change in a variable, X, is given by the [(new value -
old value)/old value ] * 100) or [(X2 -X1)/X1]*100)
Do you think an inflation rate of 2.8% is high or low for the U.S economy?
Also, how do you think inflation moves with the state of the economy? For example,
when should we see it increase or decrease?
To try to answer these questions, let's have a look at historical data for inflation in the
U.S.
Click here for the answer to the questions above.

We can see that, generally, inflation tends to increase when economic activity is
increasing and vice versa.
There are however, a few periods of time where the economy is in a downturn, and we
still experience inflation. We will see later in our model that this occurs when we have a
decrease in aggregate supply or what we call a supply shock. On the other hand,
when aggregate demand is increasing leaving to more economic activity, inflation tends
to increase as well. We will call that a demand shock.
We can go back to the BLS Web site and check the latest data on inflation:
What is happening to overall prices according to the latest data?
Why do you think prices are now (increasing or decreasing)?
In December 2008 the economy experienced deflation. The price of oil, and food
fell leading to a drop in the general price level. This is consistent with the
weakening demand conditions that are occurring now due to the credit tightening
and drop in consumer confidence.
We still have not discussed why rising inflation is a problem for the economy. In fact,
one of the two main goals of the Federal Reserve, the nation's central bank-a lot more
on this later, is to maintain price stability! Why is price stability so important?
High and unstable prices can generate uncertainly in the economy, which can
lead to erratic economic behavior and creates inefficiencies. In addition, inflation
leads to high interest rates and redistributes the income in the economy between
creditors and debtors.
We will show how this occurs shortly. But first, let's turn our attention back to calculating
inflation and return to the subject of the price index!
How to calculate the Price Index
The formula for the price index is given by:
Let's focus on the CPI. The basic idea is to track the dollar value (or dollar price) of a
typical market basket of goods and services relative to a reference point in time we call
a base year. The choice of the base year is not important as long as it is not a year
where prices are not unusually high or low. In the example we consider next, the market
basket consists of two goods, for simplicity sake. In reality, the BLS defines the market
basket using hundreds of goods and services that a typical average consumer might
purchase.
Macroeconomics: Business Fluctuations
By now, you know how to compute and interpret the unemployment and inflation rates.
You also know a little bit about how these two economic indicators move when
economic activity is changing. In the next lecture we will also learn details on how we
measure the output (income) or production level of the economy and its growth rate,
using real Gross Domestic Product (GDP). Before we dive into the details of National
Income Accounting, let's sketch a picture of how economic activity, as measured by real
GDP, might look over time and then ask ourselves what we expect to see happen to
unemployment and inflation over that period of time.
Real Gross Domestic Product: Level and Growth Rate
Reprinted from the Federal Reserve Bank of San Francisco Educational Resources
Web site
Looking at the blue line in the chart above, what do you notice is happening to the
production level of the economy over the last 40 years or so? What do you notice if
instead you zoom in only a few years, say from 1975 to 1980 or 1990 to 1992?
And to that the answer is an emphatic YES.The economy's production level is
trending up over a long period of time. However, it fluctuates around the trend in
different years. For example, in 1975, real GDP decreased and again in 1990 and
1991, whereas it increased in 1978 and 1992.
Next week we will study the determinants of the long-term upward trend in GDP or the
long-term economic growth trend. Focusing on the economic fluctuations for now,
economists often speak of these fluctuations occurring in cyclical fashion sometimes
termed the business cycle. We can envision economic activity changing as in the chart
below:
Source: Economics Today, Roger Miller, 14th edition

As you can see, when real GDP is increasing above the trend, we say the economy is
an expansion phase, whereas real GDP decreasing and falling below the trend is
termed a contraction (or recession - a lot more to say about that later).
The model we will develop in the next two lectures will enable to analyze and
understand the factors that lead the economy through these fluctuations. Economists
have found over the years that it is very difficult to predict exactly when the economy will
transition from one phase of the cycle to another. Obviously, everyone would be
interested in avoiding a recession since it causes unemployment and implies loss of
income and a lower standard of living. Later on we will discuss the role of government
and Federal Reserve policy in trying to predict and influence the business cycle to
minimize fluctuations.
Course Lecture 6-4: Gross Domestic
Product: Definition and Measurement
We've been talking about Gross Domestic Product (GDP), for a quite a while now, as
being a measure of the economy's output or production level. In this lecture we
learn how to compute and interpret GDP and real GDP figures. We also learn about
what GDP does not tell us about the economy. We will have a look at the definition
shortly. But first, let's ask ourselves this question:
Why is the economy's output or production level a measure of how well it's performing?
In other words why do we care about the output of the economy?
Click here to answer these questions.
If you thought the economy's total production level is tied to the total income in
the economy, you are right!
When an individual or a business in the economy produces a good or service it creates
income to the inputs (or factors of production) that were involved in the creation of this
good or service. Therefore, an increase in aggregate output is the same as an
increase in aggregate income and vice versa.
As an example:
When I purchase a cup of coffee at Starbucks for $3.00, the

value of the production of this cup of coffee is $3.00, and
this amount is also income to the owner of the Starbucks
store. Part of it goes to wages to the workers there, another
part to the cost of materials, rent, etc.
So the value of the output is also the value of the income to

the inputs that helped produce the coffee cup.
Economists often represent this relationship between aggregate income and

aggregate output using the following circular flow diagram:
Source: Economics Today, Roger Miller, 14th edition
Gross Domestic Product (GDP) is defined as the total market (dollar) value of all final
goods and services produced in a given period (year or quarter) within the nations' domestic
borders.
Important things to note about this definition:
Market value:
We need to use the dollar value
(instead of quantities) as a weight to
add up all the different goods in the
economy. Can you imagine how hard
it would be to express total
production in terms of quantities
instead?
As an example, you would have to
say: this year the economy produced
1,000 bushels of corn, 10,000 cars,
500 computers etc. We can't really
add things up if they are not the
same units! Therefore, we use a
common denominator, their market
(dollar) value. When all items are
expressed in dollars they can be
summed up into one number
representing the value of total
production in the economy.
Final goods:
These are goods that require no
further processing and are ready to
be consumed, such as a car or a loaf
of bread. Intermediate goods on the
other hand go back in the production
process. Examples are wheat used
in bread production, steel used in
cars, tires on a car etc.
Why do we only include final goods?

If we count both, intermediate goods causes us to overstate production as we
end up double counting some items. So if we count the value of the tire and then
also the value of the car which includes the tire, we would be double counting the
tire!
In a given year: GDP is a flow not a stock measure. Do you recall the difference
between a stock and a flow?
A flow variable is one that is defined over a specified period of time, such as a
year or a quarter. A stock variable accumulates over time and is measured at a
specific point in time. For example, your savings per year or per month is a flow
whereas the level of your wealth at the end of the year (or month) is a stock.
Now let's turn to how we calculate GDP. There are two main methods for computing
GDP:
1. The expenditure approach.
2. The income approach.
In the expenditure approach, GDP is found by adding up the value of all the spending
that takes place in the economy. We can think of the whole economy as consisting of
the following sectors (or economic agents) and their corresponding spending:
Total spending by households on durable and non durable goods
1. Households
is called Consumption (denoted by C)
Total spending by businesses on plants, equipment, machinery

2. Firms
and inventories is called Investment (denoted by I)
Total state and federal spending by the government, excluding

3. Government
transfers, is called Government spending (denoted by G)
Goods produced here and sold overseas are called Exports (EX).
Good we buy from the rest of the world are called Imports (IM).
4. The Rest of the
World
In net, total spending on good produced here by foreigners is
called:
We can summarize the expenditure approach using the following relationship:
Notice that IM or Imports are being subtracted out of the GDP calculation? Why are we
subtracting imports?
Click here to answer these questions.
Imports are goods that were not produced in the domestic economy. Therefore,
they should not be included in our production level. They are subtracted because
they are already included in other spending the components C, I and G!
The economy's national income accounts are kept at the Bureau if Economic Analysis
(BEA). Let's visit the BEA Web site to check the latest figures on the spending
components and compute GDP using the expenditure approach
Let's go to the Bureau of Economic Analysis (BEA (http://www.bea.gov), and follow the
appropriate links to find real GDP tables.
Or link directly to the National Income and Product Accounts Table:
Let's apply this to 2006 data from the BEA. In billions of
dollars, the spending components values are:
C = 8,029, I = 1,912.5, G = 1,917.2, X = - 615.7

What is GDP?
GDP = C + I + G + X = 8,029 + 1912.5 + 1917.2 - 615.7 = 11,

243 billion
We will revisit these figures again shortly to learn about the shares of each of the
spending component in GDP. But first, let's learn about the income approach.
Recall the circular flow concept described above. Each dollar that is spent in the
economy represents a dollar of income to one or more of the factors of production. In
the Income approach, the value of GDP is computed by adding the total income of all
the factors of production. Specifically: we add wages (income to labor), interest (income
to capital), Rent (income to land) and Profits (income to entrepreneurs). The following
table shows a calculation of GDP using the Income and expenditure approaches:
Given these figures, which spending category do you think represents the largest
portion of GDP?
Consumption is the largest portion of GDP. Let's have a look at a times series
graph of the GDP components to see how the spending shares change over time
We have learned how to measure the economy's output using the GDP measure
obtained from the expenditure and income approaches. What are some items that may
not reflected in the GDP measure?
• GDP does not reflect any home production that takes place in the economy. For
example if I cut my own grass, this production does not enter the GDP
calculation. But If I hire a company to cut my grass, then it is reflected in GDP.
Illegal activity is also excluded from GDP.
• GDP does not (and should not) include any financial transactions or transfers.
That is because a transfer of wealth does not involve new production. For
example, if a stock is bought or sold, it does not enter GDP since this transaction
does not produce a new good or service.
• Finally, GDP is not a measure of the well being of an economy since it does not
reflect the quality of life of people living in that society.
Course Lecture 6-5: Nominal and Real GDP
We first learned about the distinction between nominal and real values in our
discussion on inflation and interest rates. Do you recall what is a real value?
That's right! A variable is in expressed in real terms if it is adjusted for price
changes or inflation.
When we calculate GDP as described before using the expenditure or income
approach, we are computing nominal GDP since we use the current market value of
goods and services which is determined by current year price.
So why do we need to adjust for inflation?
Nominal GDP can overstate the production level of the economy.
Looking at GDP from year to year, we are interested in whether the economy's
production level and income grew in real terms. Since nominal GDP figures are
obtained using current year prices, nominal GDP from year to year can increase even if
the quantities produced did not increase but only their market value or prices rose.
Therefore, if there is inflation, nominal GDP overstates the growth rate of the economy.
In order to avoid misrepresenting the growth rate of the economy due to changes in
prices, economists base their growth rate calculations on real GDP, which is nominal
GDP adjusted for inflation.
Real GDP is found by computing the dollar value of current year production using base
year prices. Recall that the base year is a reference year where we hold the price level
constant. Real GDP can also be computed using the GDP deflator as follows:
Real GDP - [Nominal GDP / GDP

Deflator] * 100
Per Capita Real GDP

To adjust for population growth over time we compute Real GDP per capita or Real
GDP per person as follows:
Per capita real GDP = Real GDP/
Population
This measure also allows for comparison of standard of living over different countries
with different populations.
WEEK SEVEN
Course Lecture 7-1: Economic Growth
Earlier in the semester, we discussed the production possibilities frontier as a model
that represents the economy's tradeoffs and output choices given its existing resources,
at a point in time. Using the PPC, we showed how a society can expand its production
possibilities (i.e. produce more of everything) if it increases one or more of its factors of
production. For example, if the economy has more capital (i.e., machines, equipment,
and factories), its PPC shifts to the right, indicating that the economy's potential has
grown.
Do you recall what we call an increase in the economy's potential output?
We called this Economic Growth.
In this lecture, we revisit the concept of economic growth and focus on its determinants.
Understanding what determines an economy's potential production level will set the
stage for the next lecture where we show the Long-run Aggregate Supply Curve
(LRAS). The LRAS is a key component of the Aggregate Demand /Aggregate
supply model which we will continue to build throughout this week's lecture. The LRAS
will represent the level of output, which the economy can reach if it's fully utilizing its
resources. It can be thought of as a goal for where the economy should be. After we are
finished building the entire model, we will use it to analyze why and how the economy
may produce at above or below that level in the short run. We will also analyze the
consequences of each situation on the economy and whether and how, if any, policy
can be used to steer the economy to its potential level.
Before we describe the factors that lead to economic growth, let's revisit the data on
output that we learned about in last week's lecture. Recall that to allow for population
changes over long periods of time, we look at a variable that is derived from Real GDP,
the measure of the economy's output. Do you recall this variable?
That's right. It's real GDP Per Capita or real GDP/Population.
Let's have a look at a time series graph for data on Real GDP per capita for the U.S
economy:
Looking at this graph, how would you describe the trend in Real GDP per capita?
We can see that output per person trends upwards over the whole period, but it
also fluctuates up and down and around the trend over various years.
In this lecture, we focus on the long-term upward trend in per capita Real GDP. We will
shift our focus to short term fluctuations in Real GDP (or the business cycle) next week.
We can be more specific and compute the growth rate in per capita Real GDP from year
to year. The average growth rate for the U.S for the period 1990-2007 is about 3%.
What do you think accounts for this average positive growth rate? To answer this
question, we have to ask ourselves what factors determine how much an economy is
capable of producing at a point in time. What do you think an economy needs to
produce?
You probably thought of the human resource or Labor, and the physical
resources, or Capital.
Other important factors of production (or resources) are the level of education (or
human capital), natural resources (or Land), and Entrepreneurship (the ability to
create and manage businesses). How much an economy has of all of these resources
determines its long term ability to produce.
As an example, what do you think would happen to the economy's growth rate if
business spending on plants and equipment increases (i.e., using last week's definition -
if Investment (I) increases)?
The economy's growth rate should expand! Business Investment leads to an
increase in the physical resources or capital of the economy which enables it to
produce more of everything.
In a similar reasoning, an increase in any of the aforementioned resources helps the
economy grow more over time and vice versa. Any permanent decrease in one or more
of the factors of production can hinder economic growth.
There is one last very important determinant of growth that we did not discuss yet. Can
you guess what it is? I'll give you a hint: This important determinant of growth is the
result of research and development, new ideas, and innovations. It represents society's
pool of knowledge!
Yes, it's technology! One of the most important factors of production, technology
cannot be measured directly. Instead we observe its effects on production levels
and quality of products. Technological improvements enable us to produce the
same level of output more efficiently (or cheaper). Equivalently, we can say,
technology enables us to produce more with the same amount of the other
inputs. (i.e., labor, capital etc.).
This leads us to another concept intimately related to technology and economic growth:
Productivity! What is productivity? At some point or another, we've all used this term in
our daily lives. What does it mean when we say that we are being more productive at a
certain activity?
Labor Productivity is measured as output per hour of work. We say we are more
productive if we can produce more with the same resources.
For example, if I could cut my grass in 2 hours and now I can cut my grass and trim the
bushes in 2 hours, then I can say I became more productive at yard work. This is
because I can accomplish (or produce) more with the same resource, which is 2 hours
of my time.
What do you think could have helped me become more productive at doing yard work?
Click on each of the options below to see if and how that effort could have
helped.
1.
Yes,
technology
raises
productivity.
Buying a new faster

mower.
2.
Yes, an
increase in
physical
capital raises
labor
productivity.
Buying an electric
trimmer.
3.
Yes, an
increase in
human capital
helps too!
Learning new
techniques for doing
yard work.
4.
No, I should
have been
working as
hard as I could
from the
beginning
since I have
my self-
interest
incentive to
cut my cost,
I decided to work which is my
harder. time!
Productivity is important to economic growth. An increase in productivity leads to lower
costs of production or more efficiency, which in the long-run enables the economy to
produce more.
To continue please click on the next link in the navigation bar on the left.
WEEK SEVEN
Course Lecture 7-2: Long-Run Aggregate
Supply
We are now finally ready to start our model of the macro economy! In this lecture we
work on the Long-Run Aggregate Supply curve (LRAS) piece of the model. Next lecture,
we develop Aggregate Demand, and then we put them together! As we are building the
model, the material is quite theoretical at times. But bear with it and before you know it,
you'll be able to put on your economist hat to analyze real life economic scenarios and
make predictions using this model. Recall that one reason we use models is to simplify
a complicated reality (such as the economy) and visualize it in order to understand it,
analyze it, and make predictions.
The two macroeconomic variables that the model will explain are Real GDP (output)
and inflation (as derived from changes in the price index). Since unemployment is
inversely related to output, we can also make predictions on unemployment indirectly
through our predictions on output. Given this, the graphical depiction of the model will
have Real GDP on the horizontal axis and the price level on the vertical axis. Let's start
with some definitions:
Aggregate Supply: the total of all planned
production for the economy.
Long-run: A period of time where all inputs are

variable and prices are flexible.
Long-run Aggregate Supply (LRAS) - A vertical

line that represents the level of Real GDP when
the economy is fully utilizing its resources and
producing at potential (full employment output,
which is equivalent to being on the frontier of the
PPC), as shown in the graph below:
According to panel (b) in the graph above, what is the level of potential GDP?
In this example, potential Real GDP is 12 trillion. We can see this since the LRAS
is placed at that level on the horizontal axis.
Since the economy is at full employment output (potential) at 12 trillion, what is the
unemployment rate at this level of production? Hint: Recall definitions of unemployment
from last week's lecture.
Since at potential output (where LRAS is placed), there is no cyclical
unemployment, the unemployment rate will be equal to the Natural Rate of
Unemployment.
Why is the LRAS a vertical line in the model graph? To answer this, it helps to ask
yourself, is the level of real GDP at potential (or full employment) related to the price
level?
The answer to his question is No! The price level does not determine how much
the economy can produce at potential.
As we learned in the previous lecture, potential real GDP is determined by the factors of
production (or the amount of resources-also called endowments) in the economy.
Given this, let's work on an exercise to see if you recall these factors and how they
affect the economy's potential. In addition, let's also show how a change in a factor of
production affects the placement of the LRAS in our model.
To continue please click on the next link in the navigation bar on the left.
WEEK SEVEN
Course Lecture 7-3: Aggregate Demand
We have already represented the production side of the economy in the long-run using
the LRAS curve. Now let's represent the demand side of the economy, starting with this
definition:
Aggregate Demand: the total of all planned expenditures in the economy.
Aggregate Demand Curve (AD): a line showing the relationship between total
expenditures and the aggregate price level (or GDP deflator).
We already know a great deal about the total expenditures of the entire economy from
last week's lecture. Hint: Review section on expenditure approach to computing GDP.
Do you recall what makes up aggregate spending or total expenditures in the economy?
You remembered! Total expenditures are the sum of household spending or
Consumption (C), Business spending or Investment (I), Government Spending
(G), and foreigners' spending or Net Exports (X).
Clarification Note:
Last week, in the expenditure approach to measuring GDP, we showed how to compute
GDP as the sum of all expenditures in the economy. Here we just defined Aggregate
Demand to be equal total planned expenditures, and in the previous lecture we defined
Aggregate supply to be total planned production. Is there any inconsistency in these
definitions? Actually, no. When we are computing output using the GDP measure, we
assume that we are observing the economy in a short-run equilibrium where Aggregate
demand is equal to aggregate supply. Therefore we can compute total production /
output as equaling total spending. In the model we have here, we start by discussing
the demand and supply (production) sides of the economy separately and then show
how we reach the short-run and long-run equilibriums.
To draw the Aggregate Demand curve in our model, we need to determine how these
components relate to the price level. That is, we need to understand what happens to
either one or more of C, I, G or X when the aggregate price level changes, all other
things held constant.
When the price level rises, the total spending in the economy falls and when the price
level falls, total spending rises, that is the AD curve is downward sloping as shown
below:
Source: Roger Le Roy Miller, Economics Today, 14th edition

Does this make sense? Why do you think total spending would decrease if the price
level increases and total spending would increase if the price level decreases?
I am guessing you thought of at least one reason, which is that an increase in the
price level decreases the real value of our money balances which makes us feel
less wealthy and leads us to want to spend less on goods and services. This is
called the real-balance or wealth effect.
In addition to the real-balance effect, there are two other channels through which we
can find an inverse (or negative) relationship between total expenditures and the price
level. These are:
1. The interest rate effect:
As we learned in last week's lecture, nominal interest rates are directly related to
inflation. When prices increase, interest rates tend to increase which in turn
discourage spending by consumers and businesses, thereby reducing total
spending.
2. The open economy:
When domestic prices rise relative to those in the rest of the world, everything
else held constant, our goods and services become more expensive to
foreigners, which reduces out exports. At the same time, we buy more from
foreigners since their goods are cheaper, which increases our imports. The
decrease in export (Ex) and the rise in imports (IM) reduces exports (X), which
reduces total spending.
Now that we know why the AD curve slopes downward, we are ready to discuss shifts in
the AD curve. Do you recall what it means when a curve shifts to the right or to the left?
In this particular case for AD, what can we tell is happening if we see the curve shift to
the right as shown below?
When the AD curve shifts to the right, we say AD increased. This means at any
value for the aggregate price level, total spending increased. Recall that this is
different from a movement along the curve which indicates that total spending is
changing due to a change in the price level.

When AD shifts to the left (as shown below), we say AD decreased. This means that
total spending decreased at any price level.
The factors that cause AD to increase (or decrease) are called non-price determinants
of AD. Non-price determinants of AD are economic variables or events that influence
any of the spending components. The following table summarizes a number of these
determinants:

To understand how each of the changes listed above affect AD, let's have a closer look
at each of the rows in the table and determine which of the spending components are
affected in each case. Let's work together on some of these changes using the following
presentation (before you watch , try to predict which of C, I , G or X are affected in each
case). When you are done, you can check your thinking by working on the remaining
items in the table using similar reasoning.
Please watch the following 6-minute presentation.
WEEK SEVEN
Course Lecture 7-4: Long-Run Equilibrium

and the Price Level
By now, you should be familiar with the determinants of long-run aggregate supply
(LRAS) and the determinants of aggregate demand (AD), our representation of the
production and spending sides of the economy as a whole, in the long-run. We are now
ready to put them together to discuss long-run equilibrium. You first used the concept
of equilibrium at the beginning of the semester, in week 2's micro demand and supply
model. Do you recall how we defined equilibrium?
Equilibrium is a state of no change or a state of balance. In the market for a
particular good or service, equilibrium price and quantity are those that occur
when quantity demanded equals quantity supplied, such that there is no need for
the price to adjust. If quantity demanded is not equal to quantity supplied, we
have a disequilibrium (either a surplus or shortage) and the price of the good
adjusts to eliminate the shortage or surplus.
For the economy as a whole, long-run equilibrium occurs at the price level where AD
intersects LRAS as shown below:
According to the figure above, what is the equilibrium price level in this economy?
Given potential real GDP of 12 trillion and the level of aggregate demand (AD
curve), the equilibrium price level is 120. This is the price level at which total
aggregate spending equals total long-run planned production.
How does the economy end up at this equilibrium price level of 120?
Let's consider alternative price levels and explain the adjustment to equilibrium.
If the GDP deflator or the price index was at

140, then AD would be too low as compared
to total planned production.
AD = 11 trillion, potential output = 12 trillion.
In this situation of excess supply, the excess

capacity in the economy eventually drives
prices down towards the equilibrium.
Remember that prices are completely
flexible in the long-run!
Similarly, if the GDP deflator was equal to
100, AD is too high as compared to potential
output.
AD= 13 trillion, supply is 12 trillion
The excess demand in the economy puts

upward pressure on prices and takes the
price level towards its equilibrium level of
120.
Note that since the economy's output in the long-run is determined by the factors of
production or the endowments that determine potential output, AD does not play a role
in determining how much the economy produces in the long run. AD does however
determine the price level! We will see next week that AD plays a very important role
in determining the economic fluctuations around potential real GDP or the
economy's production level in the short-run.
Inflation and Deflation in the Long-Run
At this point, we should be able to use our model to explain trends in prices and output.
Looking at the equilibrium graph above, what can cause an increase in the equilibrium
price level (or inflation)?
That's right. There are two situations that can result in inflation:
1. A decrease in LRAS, and
2. An increase in AD, as shown in panels (a) and (b) below.
What about deflation? When does that occur? One situation that can result in the price
level decreasing over time is if we have economic growth (LRAS shifting right) without
matching increases in AD as follows:
Can you think of another scenario where we can also experience deflation?
That's right if LRAS is stable and AD decreases, that can also cause deflation.
Draw the graph to show yourself that this situation leads to a lower equilibrium
price level.
Applying the Model to U.S Data
Let's apply our model to explaining observations or trends in real GDP and prices in our
economy. In last week's lecture, we examined time series data on inflation and real
GDP (i.e., we examined inflation and real GDP individually over time). The following
chart plots U.S. data on the price index and real GDP for the period 1970 to 2007 using
the model graph set up, with the GDP deflator measured on the vertical axis and real
GDP measured on the horizontal axis. This allows us to see the relationship between
the price level and real GDP as it evolves over time. You can envision each of these
data points as an equilibrium point in our model or the intersection of AD and LRAS.
Looking at this graph, how do you see the price level and real GDP changing together
over time? How can we explain this trend using our long-run model?
Let's listen to the following 5-minute presentation to practice using the model to answer
these questions.
WEEK EIGHT
Course Lecture 8-1: Short-Run Aggregate
Supply and the Short Run Equilibrium
Last week we developed the long-run model of the economy. The long-run model allows
us to explain and analyze the long-term trend in Real GDP and inflation. Although it is
very important to understand factors that lead to long-term economic growth and
contribute to long-term price stability, it is equally important to understand economic
fluctuations around the trend. In fact, most of us can only relate to short-run changes
into the economy, as that is what affects our daily livelihood. Specifically, we are all
interested in learning what can cause downturns in economic activity or recessions.
This is important to us as recessions are coupled with layoffs and unemployment. We
also want to find out if and how government or central bank policy can alleviate or
reverse recessions. Alternatively, if economic activity is really strong, we can face
inflation, which has its detrimental effects on the economy in the short run as well. In
this situation, central bank policy may be used to slow down the inflationary effects by
raising interest rates to reduce aggregate demand. This week we develop the short-run
version of our model of the economy, which is the tool we use to analyze economic
fluctuations and economic policy.
Note that this model is the same as the long-run model with the exception of aggregate
supply. This is because in the long-run, aggregate supply is determined by the
availability of endowments or factors of production (which determine potential or full
employment GDP). In the short-run the behavior of firms in the economy determines
aggregate supply.
Let's start by stating what we mean by the words short-run. Perhaps it helps to revisit
the definition of the long-run, do you recall what defines the long-run?
Yes, the long-run is a period of time where all inputs are variable and all prices
are flexible or can change.
Given this, what would you say defines the short-run?
Right again! The short run is a period of time where some inputs are fixed and
some prices are inflexible or fixed.
So what does it mean for some inputs to be fixed?
Example:
Suppose a small business is facing more demand
for its product and it determines that it needs to
expand its production to meet the growing
demand. In the short-run, the business can hire
more labor (variable input) to increase production
but it needs time to buy a new plant or expand its
physical space. In the short-run, the capital (plant
or physical capacity) is a fixed input.
Given that firms face constraints on production capabilities in the short-run, how do they
vary their production levels (real GDP) in response to changes in the price level? In
other words, what is the shape of the aggregate supply curve for the whole economy in
the short run? Recall that in our model, the price level is on the vertical axis and real
GDP appears on the horizontal axis.
If you guessed that the short-run aggregate supply curve (SRAS) is upward
sloping, reflecting that firms would produce more in response to higher prices,
you were at least partially right! Why aren't you completely right? Because as we
will soon see, the slope of the SRAS changes depending on where the economy's
output is relative to its potential.
The following graph shows the widely accepted modern Keynesian SRAS with a
positive slope, placed relative to the LRAS or potential real GDP. As we will see a little
later, there are other versions of the SRAS that can result when we change our
assumptions about price flexibility in the economy. The modern Keynesian SRAS is
consistent with empirical data reflecting the behavior of firms in the economy.
There are two important things to note about the graph above:
1. The intersection of AD and SRAS represents the equilibrium of the economy in
the short-run. In this example, the economy is producing at potential since AD
intersects LRAS as well. Recall that LRAS represents real GDP at full
employment or potential.
2. The slope of the SRAS is flatter at levels of real GDP that are below potential (to
the left of LRAS) and gets steeper as the economy's output surpasses potential
output (to the right of LRAS).
Why do you think the SRAS gets steeper as the economy produces more and more?
Keep in mind that when the SRAS is flat, a change in AD leads to a bigger change in
Real GDP than a change in price. When the SRAS is steeper, a change in AD leads to
a bigger change in the price level than the change in Real GDP.
You're on the right track. When real GDP is below potential, firms have excess
capacity. At that time, when faced with higher demand, a business responds by
meeting the extra demand and raising production without raising prices too
much. On the other hand, when real GDP is above potential, firms are over
utilizing their resources (hiring extra labor, overworking their equipment). In this
situation, an increase in demand will lead to higher prices ad firms need to
compensate for the higher costs they incur to increase production when they are
operating over capacity.
Recessionary gap and Inflationary gap
In the situation depicted in the graph above, the economy's short-run equilibrium is such
that the economy is also on its long-run growth path or at full employment. We can see
this because the short -run equilibrium (intersection of SRAS and AD) is the same as
the long-run equilibrium (intersection of AD and LRAS). We already know from previous
weeks' lectures that real GDP fluctuates around its trend (recall the idea of the business
cycle?). For now, let's assume Aggregate Supply is stable and that there are changes in
AD (we will discuss shifts in Aggregate Supply in the next couple of lectures).
In the following presentation, we will look at graphs depicting two other possible short-
run equilibria for the economy that would result when there are changes in AD, creating
economic fluctuations.
WEEK EIGHT
Course Lecture 8-2: Classical and
Keynesian Models
The modern Keynesian SRAS discussed in the previous lecture has not always been a
common way for economists to depict the supply side of the economy in
macroeconomic models. In this lecture we will present two other points of view about
how the economy might operate in the short-run: the Classical and Keynesian models.
As you will see soon, these two models have completely different assumptions about
prices and yield completely different policy implications for the economy in the short-run.
In that sense, they represent extreme cases. As you may have guessed given the name
of the SRAS from the previous lecture, modern Keynesian, the commonly used
upward sloping SRAS has more in common with the Keynesian model. After we're done
with this lecture you will be able to understand why this is the case and why most (but
not all) economists tend to view the modern SRAS as the one that is the closest to
reality.
The Classical Model:
The most important assumption in the classical model is that all prices in the economy
are completely flexible in the short-run as they are in the long-run. This assumption
leads to the result that all markets always clear since the price is able to adjust to
eliminate any disequilibrium immediately. Take as an example the labor market, where
the wage rate is the price of labor. If there is a change in demand that prompts firms to
reduce production and lay off workers, the unemployment rate will tend to increase.
Under the classical model, the unemployment will not persist since the wage rate (an
input price) is completely flexible and will decrease as firms hire less labor. The lower
wage rate will then prompt firms to produce more again and the economy will return to
its potential. The same thing can occur for other prices in the economy (price of
materials, interest paid on a loan etc.). If there is lower demand for an input, its price will
decrease and the economy will return to its initial production level due to the lower input
prices. Similarly, if there is an increase in demand for an input (say labor), then its price
will increase (wage will increase) again bringing the economy back to its potential level.
The following graph depicts the economy in the classical model:
Following the reasoning we gave above, if AD increases from AD1 to AD2, real GDP
increases above its potential (point A). This raises the wage rate and other input prices,
which decreases output back to its initial level due to the higher input prices (the
economy returns to E1). Conversely, if AD decreases from AD1 to AD3, real GDP falls
below potential (point B), higher unemployment lowers wages and other input prices,
taking the economy back to E1.
The following schematic summarizes the basic adjustment mechanism underlying the
classical model in the case of a decrease in AD.

Therefore, in the classical model, since the SRAS and LRAS are the same (vertical and
placed at potential GDP), what do you think happens if there are changes in aggregate
demand?
That's right, given a vertical aggregate supply, AD cannot influence the level of
real GDP in the short run. Any changes in AD will only cause a change in
inflation. If AD increases, the price level rises (inflation) and if AD decreases, the
price level decreases (deflation). This has the implication that policy should not
be used to manage real GDP in the short-run as it would be ineffective!
The Keynesian Model:
In this model, the central assumption is that wages and other inputs prices are
almost completely fixed or inflexible (or sticky) in the short-run, leading to a
horizontal SRAS as shown below:
As you can see, this is the exact opposite of the assumption in the classical model. The
assumption that prices are "sticky" in the Keynesian model was based on data
observation from the 1930's and 1940's where the price level was not changing in
response to a period of high unemployment (or lower aggregate demand). If prices are
completely fixed as shown by the horizontal Keynesian SRAS above, what will happen
in this model if there are changes in aggregate demand?
Correct, the implication here is that AD changes do not influence the price level,
but rather only affect output in the short-run. Therefore, if AD increases, real GDP
increases and there is no inflation. Conversely, if AD decreases, real GDP
decreases and there is no deflation.) Here we can see that the implications from
the Keynesian model are opposite to those from the classical model.
Back the Modern Keynesian SRAS:
For the history of the U.S. data, we know that there are periods of inflation and low
unemployment, and periods of high unemployment and low inflation. The classical
model does not allow for any unemployment (since it is assumed that wages adjust
immediately to eliminate the excess supply of labor) or for real GDP to go below
potential. The Keynesian model (with horizontal SRAS) does not allow for any inflation
to occur even in periods of high AD. Given this analysis, these models are considered to
be extreme cases which are not representative of the whole period of data for the U.S
and most other countries. The modern Keynesian model detailed in the previous lecture
(graph shown again below) allows for some price stickiness by showing the SRAS to be
flat or nearly horizontal when the economy is below potential and letting prices
becoming more flexible (or adjust upwards and downwards faster) as the economy gets
closer to its potential. Therefore, we will use the modern Keynesian model in our future
analysis of economic policy which we will cover over the next couple of weeks.
this week's packet.
WEEK EIGHT
Course Lecture 8-3: Shifts in Aggregate

Supply
In the previous lectures we learned how to use our model to depict economic
fluctuations (changes in real GDP away from potential) that result in recessions or
expansions. The situations we have considered were due to changes in Aggregate
Demand, which can happen if any of the spending components change.
Can you recall from last week's lecture a factor that increases (or decreases) AD?
Yes, a decrease in taxes can raise AD (shift right). Also, an increase in consumer
confidence can raise AD. Revisit last week's lecture to remind yourself of some
other events that can happen to increase or decrease AD.
Changes in aggregate supply can also cause economic fluctuations and changes in
inflation. We learned last week about what can cause a shift in long-run aggregate
supply (LRAS), but what about shifts in short-run aggregate supply (SRAS)?
Before we talk about the consequences of shifts in supply, let's review how the graphs
change when there is a shift in supply and consider what can happen in the economy to
cause such shifts. We will also see that some of the factors that may cause a change in
SRAS also cause a change in LRAS.
The following table summarizes changes that cause an increase or decrease in supply.
An increase in SRAS in shown as a shift to the right in the SRAS, whereas a decrease
in shown as a shift to the left in SRAS. The graphs below the table show how we depict
the changes in SRAS only and changes in both SRAS and LRAS.

To understand how each of the changes listed above affect Aggregate Supply, let's
have a closer look at each of the rows in the table and determine why SRAS changes
and whether the change also affects LRAS. Let's consider some of these events in the
following presentation. After you are done watching, you can work by yourself on the
remaining items in the table to check your understanding.
Consequences of changes in short-run aggregate supply
As we saw earlier in the presentation, SRAS can decrease due to a variety of events
which raise firms' costs of production, leading to lower aggregate supply (SRAS shifts
left). We can see this situation and how it affects the short-run equilibrium in the figure
below:

Initially the economy is at the equilibrium E1. When aggregate supply decreases the
short-run equilibrium shifts to E2. How is the equilibrium E2 different from E1?
Yes, the price level increased (from 120 to 125) causing inflation, and real GDP
decreased, causing a recession.
Since the inflation was caused by a decrease in aggregate supply, it is termed cost-
push inflation (recall that demand pull inflation occurs when the price level rises due
to an increase in aggregate demand).
Economists sometimes use the term stagflation to refer to the situation when real GDP
decreases along with inflation. This is a term that combines the words stagnation (since
real GDP is decreasing) with inflation (since the price level is rising). This is also
referred to as a negative (or adverse) supply shock. This is because there was a
change in aggregate supply that adversely affects the economy. As we will see next
week when we discuss economic policy, stagflation is a very difficult situation for the
economy since it is difficult to correct using policy. Just to preview the weeks ahead,
you can see from the graph above that if policy makers try to raise AD to increase GDP
back to potential and reduce unemployment, they will cause even higher inflation.
What do you think happens to real GDP and prices in the short-run when we have a
positive (or good) aggregate supply shock or an increase in supply?
That's right, an increase in aggregate supply leads to lower prices (deflation) and
raises real GDP as shown in the figure below:
this week's packet.
WEEK NINE
Course Lecture 9-1: Aggregate Expenditures

This week we begin our section on economic policy. In the next lecture, we will define
government policy (Fiscal policy) and explain its impact on the economy using the
macroeconomic model (Aggregate Demand /Aggregate supply), which we developed
over the last 2 weeks. Next week we focus on defining and explaining the role of the
Federal Reserve (Monetary policy) and using the model to analyze its policy effects on
the economy.
We have already touched on the subject of economic policy when we discussed factors
that shift aggregate demand. Do you recall some policy changes we previously
discussed as determinants of aggregate expenditures and aggregate demand?
If you thought of taxes, interest rates or the money supply, you remembered
correctly! We previously mentioned that lower taxes encourage households to
spend more (consumption increases), which leads to an increase in aggregate
demand. We also talked about lower interest rates (or an increase in the money
supply) achieving the same effect on Investment as well. To refresh your memory
on this material, you can return to lecture 7-3 in week 7.
Although we have an idea of how policy affects aggregate demand and real GDP, we
are now ready to dig deeper into this subject and consider the question of how much is
real GDP changing when taxes or the interest rate are changed? In answering this
question, we will explain the transmission mechanism of policy in the economy and how
different macroeconomic variables interact to achieve the full effect on GDP and
unemployment.
Let's begin by revisiting each of the spending components that make up aggregate
expenditures.
• Consumption (C),
• Investment (I),
• Government Expenditures (G), and
• Net Exports (X).
We will refer to an expenditure that does not vary with the level of real GDP or real
income as autonomous, that is as independent of the level of real income. As we will
see in the next lecture, the amount of government spending (G) is determined by the
government budget as set by congress and the administration. It does not
systematically depend on the level of income in the economy. Therefore, we will take G
as given and consider it to be an autonomous variable. This means that G will increase
or decrease when we are analyzing a scenario where the government decided to raise
or lower their spending, but it will not automatically change when real GDP changes.
Similarly Net Exports (X), or (Exports - Imports), is also an autonomous variable. This is
because Exports depend on foreign real GDP (foreign real income) not our real GDP.
We will also for now make the simplifying assumption that Imports do not vary with the
level of real income. Therefore, changes in X will affect our real GDP but X will not
automatically change when real GDP changes.
Investment
How about Investment? Recall from week 6 that this variable represents business
spending on plants and equipment, machines and inventories to be used for production.
Can you think of some factors that influence the decisions of businesses of how much
to spend on Investment projects?
Yes, future sales or expected future real GDP is one of the important variables to
consider. Firms will spend to increase their capacity (Investment increases) when
they expect economic activity to increase and the demand for their product or
service to increase.
Other economic variables that influence the level of business investment (I) are:
The interest rate:

Firms either borrow or use retained earning (cash
leftover) to finance projects. In either case, the
interest rate represents the cost of Investment. If
the firm borrows, an increase (decrease) in the
interest rate raises (lowers) the cost of the
project. If the firm uses internal funds, an
increase (decrease) in the interest rate implies
that the opportunity cost of using the funds
elsewhere has increased (decreased). Given this,
how would you describe the relationship between
Investment and the interest rate?
Correct. When the interest rate increases (decreases), Investment projects are
more (less) expensive and Investment decreases (increases).
Incorrect. When the interest rate increases (decreases), Investment projects are
more (less) expensive and Investment decreases (increases).
So far, we've discussed two determinants of Investment, the interest rate and
expectations of future real GDP. Investment is not systematically affected by current
real GDP as firms usually plan Investment projects in advance as part of their strategic
or long-term planning. Therefore, Investment is also autonomous, since it does not
respond to on current changes in real GDP or real Income. Another important
determinant of Investment is firms' existing capacity utilization rate. The capacity
utilization rate is to the proportion of existing physical capital that is currently being used
for production. Why do you think this is an important variable?
Right. If firms have excess capacity or too much slack, then Investment will not
increase when the interest rate is lower since businesses already have the ability
to increase production without adding to their capital stock. Similarly if firms are
running low on capacity, they might increase Investment even when interest rates
are not too low.
Therefore, when we state that Investment is inversely related to the interest rate, we
have to remember that this is true only when we hold everything else constant.
Consumption
The last, and perhaps the most important, of the expenditures to discuss is household
spending or Consumption. This spending category is important because it makes up a
large portion of real GDP (recall from week 6 that C is about 2/3 of real GDP). In
addition, we will see shortly that Consumption is a variable that does depend on current
real GDP (or real income). This dependency will be a key factor determining the
multiplier effect that results from a change in any of the autonomous spending
categories. What are some factors that determine the level of household spending?
Yes, definitely, current after tax or disposable income! This is the most important
determinant of Consumption, simply because current disposable income is what
we have available for spending or saving. On the aggregate, disposable income is
measured using real GDP minus taxes.
Intuitively, we expect that when disposable income increases, consumption increases,
and vice versa. That is, spending by households is positively related to real GDP or real
Income. Let's be more specific about this relationship. Suppose that your after-tax
income increases by $100. By how much do you think your consumption would
increase?
Yes, the answer will vary for different individuals. If someone was liquidity
constrained, then they might spend all of the extra income. Another individual
may decide to spend a portion and save the rest.
On the aggregate (for the whole economy), we find that on average, when disposable
income increases by $100, consumptions increases by less than $100. If we express
this per dollar, then we can say for every dollar increase in aggregate income,
consumption increases by less than $1. The fraction by which consumption increases
for every dollar increase in disposable income is called the Marginal Propensity to
Consume (MPC). The MPC is defined as:
In the example we gave above, suppose when income increases by $100, consumption
increases by $90, what is the MPC?
The MPC is $90/$100 = 0.9. That is, when income increases by $1, spending
increases by 90 cents.
What happens to the rest of the $100? That's right, it is saved. So in this example, 10
cents out of every extra dollar of income is saved.
We will come back to the MPC shortly in the next section in our discussion of the
multiplier. Let's review other factors that also influence the level of household spending.
The following are non-income determinants of consumption:
Wealth:
Accumulated savings and various assets
that we own are all part of our wealth
(house, cars, retirement accounts, etc).
Consumption and wealth are positively
related. If the value of our assets
increases, we feel wealthier, and we could
spend more.
Expectations about future income:
Households tend to act to even out their
consumption patterns over time. If we
anticipate an increase in income, we may
increase consumption today based on the
expected increase in future income.
Similarly, if future income is expected to
decrease, consumption could decrease
today to save for the future.
Interest rates:
The interest rate represents the
opportunity cost of consuming today.
Every dollar that we spend today on goods
and services can be saved, earning the
market interest rate. Given this, an
increase in the interest rate should
discourage consumption and a decrease
in the interest rate should make it easier to
spend. In addition, if we borrow to
consume, then the interest rate is part of
the direct cost of spending. This also
contributes to the negative relationship
between the interest rate and
consumption.
WEEK NINE
Course Lecture 9-2: The Multiplier Effect

Suppose that Government spending increase by 100 billion. We know that this should
raise real GDP since this is an increase in aggregate demand leading to an increase
production or real GDP Recall that when aggregate demand increases, firms notice a
decrease in their planned inventories which signals that they should increase production
to meet the increased demand. Do you think the increase in real GDP will be more or
less than the 100 billion rise in G?
Correct! Real GDP will increase by more than 100. This is due to the multiplier
process, which occurs since consumption responds to changes in real GDP.
Incorrect. Real GDP will increase by more than 100. This is due to the multiplier
process, which occurs since consumption responds to changes in real GDP.)
Why does real GDP increase by more than the change in G? Let's think of this process
for a one dollar increase in G.
When G increases by $1, this raises real income

by $1 Think of this as the first round of the
process. The increase in real income by $1 raises
consumption by the amount of the MPC.
If the MPC is 0.9, this means people spend 90
cents out of every extra dollar of income. When
consumption increases by 90 cents, this raises real
GDP and real income by another 90 cents,
bringing the total to $1+$0.9 = $1.90. This is the
second round of the process.
The 90 cents increase in income leads to an
increase in Consumption of (0.9 x 90) cents or 81
cents. This is the third round of the process. Now
real GDP has increased by ($1+ $0.9+ $0.81 =
$2.71).
This process continues until the $1 increase in G
turns into a $10 increase in real GDP, or the $100
billion increase in G turns into a $1 trillion increase
in real GDP.
We know this because the process described above leads to the following expression
for the multiplier:
The following table shows another example of the multiplier process for a case where
Investment (I) increases 100 billion and the MPC is 0.8.
(Reprinted from Roger LeRoy Miller, Economics Today, 14th Edition)
What is the multiplier in the example shown in the table?
Right! The multiplier is: (1/1-MPC) = 1/(1-0.8) = 5, which is also equal to500/100 =
5. This means real GDP increases by $5 for every dollar increase in I.
What do you think happens to the multiplier if the MPC increases?
Yes, the multiplier increases as the MPC increases. If we spend more out of every
extra dollar earned MPC increases. A given increase in any of the autonomous
expenditures (I, G, or C) will flow through the economy faster and generate a
bigger impact on real GDP and real income.
this week's packet.
WEEK NINE
Course Lecture 9-3: Fiscal Policy

So far we have learned how the various sectors of the economy interact to influence the
level of production (income) and inflation. In this lecture, we discuss Fiscal policy and its
potential impact on output, unemployment, and inflation. Let’s begin with a general
description of economic policy.
There are two types of economic policy:
1. Fiscal Policy
Policy that is conducted by the administration and

congress (the government) and consists of changes in
taxes (T) and/or government spending (G).
2. Monetary Policy
Policy that is conducted by the Central Bank (the

Federal Reserve or the Fed) and consists of changes
in the money supply and interest rates.
Fiscal and Monetary policies are implemented by separate policy makers (note that the
Federal reserve is independent from the government – more on this next week).
Depending on the circumstances, sometimes we have a mix of fiscal and monetary
policies, and other times only one type of policy is used at a time. In either case, the
goals of economic policy are the same and are usually stated to be:
• Promoting economic growth (low unemployment), and
• Maintaining price stability.
We will see a little later that these goals can conflict at times and create dilemmas for
policy makers.
Discretionary Fiscal Policy refers to the discretionary changes in government
expenditures and/or taxes in order to achieve the national economic goals. Notice we
added the word discretionary in this definition. What does it mean to say that the policy
is discretionary?
That’s right. Discretionary policy is policy that is made at the discretion or choice
of the policy maker and generally is decided upon based on the circumstances.
This is in contrast to a rule that the policy maker has to follow.
Let’s take a look at how Fiscal policy affects the economy. Using the Aggregate
Demand/Aggregate supply model from last week, how do you think a change in taxes
affects real GDP, unemployment and inflation, everything else held constant? This
should be review of concepts we learned over the last two weeks but now placed in the
context of policy making.
Good job. If the government lowers taxes (T decreases), Consumption increases
leading to an increase in AD. This raises real GDP and the price level (leading to
inflation). Unemployment decreases since firms hire more as production
increases. Similarly, higher taxes decrease consumption and AD causing real
GDP and the price level to decrease (leading to deflation). Unemployment rises
since firms lay off workers as output decreases.
Now let’s ask the same question but assume the government wants change spending
(G) instead of changing taxes.
Correct again. If the government increases spending (G increases), AD increases.
This raises real GDP and the price level (leading to inflation). Unemployment
decreases since firms hire more as output increases. Conversely, a decrease in
government spending lowers AD, causing real GDP and the price level to decline
(leading to deflation). Unemployment rises since firms lay off workers as output
decreases.
These results are summarized in the two graphs below:
When economic policy (in this case fiscal) is used to stimulate the economy, resulting in
an increase in real GDP, we refer to it as Expansionary policy. When policy is aimed at
reducing real GDP, it is called Contractionary Policy.
Given what we just reviewed about how fiscal policy affects the economy, let’s consider
two different scenarios about the economy. Let’s first identify the state of the economy,
and then let’s put our policy hats on and pretend we‘re the government and make policy
recommendations aimed at keeping output at the full employment level.
WEEK NINE
Course Lecture 9-4: Crowding Out
In the previous lecture, we showed how the government can influence the level of real
GDP or income in the economy by changing taxes and/or changing government
spending. Particularly, the government could lower taxes or raise government spending
to increase aggregate demand when the economy is in a recession in order to steer the
economy back to full employment. Does this mean that it is always desirable for the
government to increase spending (or lower taxes) in a recession to stimulate the
economy? You might be tempted to say yes since it is obviously optimal for the
economy to be at full employment, but the question is whether Fiscal policy (instead of
monetary policy as an alternative) is always a good policy choice. The answer is No! Do
you know why?
You’re on the right track. Stimulating the economy with Fiscal policy is not
always desirable since lowering taxes and/or raising government spending raises
the government budget deficit. This can have negative consequences on the
economy.
The government budget is defined as the difference between government spending (G)
and government revenues or net taxes (T). We will spend more time on this subject in
the next lecture, but for now, let’s just think about this by making an analogy to an
individual’s budget.
Let’s take me as an example. If I spend less on goods and services than my after tax
income, then I have leftover income or savings. If my spending exceeds my income,
then I have to come up with the difference—either by borrowing or by using previous
period savings (or wealth). For the government, if G is less than T, the government has
a budget surplus (akin to the leftover income), and if G exceeds T, we say the
government has a budget deficit (akin to my spending more than my income). As we
will see in the next lecture, for most of the recent history of the U.S. economy, the
government has experienced budget deficits. Given this, any time the government
increases spending or lowers taxes, government borrowing increases to finance the
new deficits. The accumulation of government borrowing is also called the public debt.
The government borrows by issuing securities (Treasury bonds, notes etc.—more on
this later), which individuals and firms with excess funds or savings can purchase to
earn interest. An increase in government borrowing increases the demand for these
loanable funds, which everything else held constant raises the interest rate. As we know
from week 7, an increase in the interest rate causes Investment (business spending on
plants and equipment) and Consumption to decrease. Therefore, we say that the
increase in government spending crowds out private spending.
The Crowding out effect refers to the fact that an increase in government spending
leads to a decrease in Investment and Consumption due to higher interest rates that
result from more government borrowing.
The following chart summarizes the process that leads to the crowding out effect:

The decrease in private spending offsets some of the increase in Aggregate Demand
due to the increase in G. This can be seen in the graph below by the AD shifting back to
the left due to the crowding out effect.
(Reprinted from Roger LeRoy Miller, Economics Today, 14th edition)
Crowding out is undesirable since the positive impact of increased government
spending is partially offset by less private spending as shown in the figure above.
However, most economists are concerned about crowding out not only due to its short-
term offset on Aggregate Demand but mainly due to its impact on Investment Spending.
Can you think of why it is particularly important for Investment not to decrease due to
crowding out? (You may need to revisit week’s 6-8 lectures to refresh your memory on
the special role of Investment in aggregate expenditures).
You reviewed well! Investment is a special spending component since it is
through business spending on plants and equipment that the capital stock is
maintained and increased. The capital stock is a key determinant of long-term
economic growth. Therefore, a decrease in Investment could hinder the
economy’s growth potential and could lead to a decrease in potential GDP (LRAS
shifts left).
We will see next week when we study monetary policy that the Federal Reserve can
accommodate Fiscal policy by raising the money supply and trying to keep the interest
rate from rising due to increased government borrowing. This policy mix is sometimes
optimal when it is necessary for Government spending to increase to stimulate the
economy.
WEEK NINE
Course Lecture 9-5: Policy Lags
So far, we’ve talked about how Fiscal policy affects the economy and about when the
government should conduct expansionary or contractionary policies. In this lecture we
discuss the timing of policy in light of the existence of time lags. The discussion of
time lags leads us to the debate about whether policy should be used to try to manage
the economy, especially in the presence of automatic stabilizers. This debate applies to
monetary policy as well. Let’s start with policy lags and end with explaining the concept
of automatic stabilizers.
There are three types of time lags associated with economic policy:
Recognition lag:
Refers to the time it takes to
gather information about the
current state of the economy.
As we learned in week 6,
economists look to several
economic variables to measure
the economy’s performance.
Economic data is gathered with
some delay. For example, GDP
is available on a quarterly
basis, unemployment and
some jobs indicators on a
monthly basis. To shorten the
recognition lag policy makers
look for leading indicators to
predict changes in the
economy’s cycles. Leading
indicators are events that have
been found to occur before
changes in business activity.
For example, decreases in real
GDP are often preceded by
decreases in the money supply
and increases in weekly
unemployment insurance
claims. Nevertheless, there is a
time lag between when the
state of the economy changes,
and when that change is
revealed in the data.
Action lag:
Refers to the time between
recognizing there is a problem
in the economy and taking
policy action.
The action lag is quite long for
Fiscal policy since legislation is
required for any changes in
government spending or taxes
to be put into effect. Monetary
policy on the other hand has a
very short action time lag. As
we will see next week, the
Fed’s interest rate setting body,
the Federal Open Market
Committee (FOMC), decides
on interest rates in a two-day
meeting, and the policy is put
into effect immediately after the
meeting.
Effect lag:
The time from when policy is
implemented and when it
affects the economy.
This effect or impact lag can be
quite long depending on the
response of the various sectors
of the economy to the policy.
Take for example the policy of
lowering taxes to reverse a
recessionary gap. Depending
on the type of tax cut
(temporary or permanent) and
how consumers react, they
may or may not choose to
spend part or all of the increase
in their after tax income. If the
tax cut is spent, economic
activity increases faster than if
household spending is
unresponsive to the policy.
Similarly with monetary policy,
lower interest can take up to
two years to generate their full
impact on GDP. This is
because GDP will start to
increase when consumers and
businesses spend more in
response to the lower interest
rates. Whether, when and how
much consumption and
Investment react to lower
interest rates and how fast that
flows through the economy
(recall the multiplier process
from earlier this week) depends
on may other variables which
are highly uncertain from the
point of view of policy makers.
Now that we’ve learned about the various time lags associated with Fiscal policy, how
do you think this affects its effectiveness in reaching the policy’s economic goals?
Click on the option that best completes this sentence.
Incorrect. Since policy lags are long and variable, they make it more difficult for
Fiscal policy to fine-tune the economy. For example, expansionary policy may not
produce the desired results until the economy is already experiencing inflation.
Correct! Since policy lags are long and variable, they make it more difficult for
Fiscal policy to fine-tune the economy. For example, expansionary policy may not
produce the desired results until the economy is already experiencing inflation.
This discussion leads us to a point of view that suggests that it is best not try to manage
the economy’s output. The argument rests on the idea that the presence of time lags
makes it hard to predict when policies will achieve their intended results, which at times
can lead to even greater fluctuations in output. Proponents of this argument will point to
the existence of automatic stabilizers as alternatives to actively managing the economy
through discretionary changes in government spending and taxes.
Automatic (or built-in) stabilizers refer to the changes in government spending and
taxation that occur automatically without deliberate action of Congress. These are the
tax system, unemployment compensation and welfare spending.
Since we have a progressive tax system where the amount of taxes we pay and the tax
rate both depend on the level of income, tax revenues increase when the economy is
expanding (as real GDP and income increase) and tax revenues decrease when the
economy experiences a recession (as real GDP and income decrease). At the same
time, government spending on unemployment compensation and welfare payments
increase during recessions (as real GDP decreases) and decrease during expansions.
These changes combined lead to an “automatic” relationship between the government
budget and economic activity. The budget deficit (G - T) increases during recessions
and decreases during expansion. Since a surplus is the opposite of a deficit (defined as
T - G), we can say that if an economy had a surplus, the surplus would decrease during
a recession and increase during expansions. The following chart illustrates this
relationship:
(Reprinted from Roger Le Roy Miller, Economics today, 14th edition)As we can see
from the figure above, tax revenues are positively related to real GDP while
unemployment compensation and transfer payments are negatively related to real GDP.
The figure and the discussion above explain the automatic or built in relationship
between the government budget and real GDP. Recall that we referred to these as
“automatic stabilizers.” So how is this relationship between GDP and the budget
stabilizing, or how does it minimize the fluctuations in real GDP?
Right. Changes that occur automatically in G and T tend to pull real GDP in the
opposite direction taking it back to full employment. Let’s think about how this
works.
When the economy is in a recession, G increases (because unemployment
compensation and welfare increase) and taxes decrease (because real GDP
decreased). These two changes cause an increase in aggregate demand (or at least
reverse the decrease in aggregate demand), which partially reverses the decrease in
real GDP. Similarly, when the economy is expanding, G decreases and T increase. This
causes a decrease in aggregate demand and reverses some of the increase in real
GDP. Therefore, automatic changes in G and T tend to stabilize the fluctuations in real
GDP.
WEEK NINE
The Deficit and the Debt
We've briefly talked about the government budget in the previous lecture as part of our
discussion on crowding out. In this lecture, we examine the government budget in more
detail and relate it to the public debt. We also look at historical data for the deficit and
the debt.
The government budget is defined as the difference between government spending and
taxes. The budget can be in one of three possible situations:
Take the following hypothetical example. If in 2003 government spending (G) was $600
billion and tax revenues (T) were $700 billion, how would you describe the government
budget for 2003? How would your answer change if the government increases spending
by $150 billion for 2004, but tax revenues remain the same?
Correct! For 2003 the government has a budget surplus of $100 billion, given by
T-G = 700-600 = $100 billion. In 2004, G = $750 billion (600+150 = $750 billion).
There is now a budget deficit = G-T = 750-700 = $50 billion.
Now that you are comfortable calculating the government budget deficit (or surplus), do
you think the deficit is a flow or stock measure? (You may need to revisit week 6
lectures to remind yourself of the definition of a flow.)
Good job. It is a flow measure. That is, it is defined over a specific period of time,
usually a year. A stock measure is one that accumulates over time and is
measured as of a specific point in time.
Therefore, when we say, as in the example above, that the deficit for 2004 is $50 billion,
this figure represents the government budget for the year 2004 only. No other period is
reflected in this figure. This distinction between flow and stock measures is relevant
here because people often confuse the deficit with the public debt, which is a stock
measure. Let's define the public debt and explain the difference.
The government issues securities or bonds in order to finance the deficit. They are debt
instruments called Treasury securities, named as such since the Treasury department
issues them on behalf of the government. They consist of Treasury Bonds, Notes and
Bills, depending on the securities maturity or due date. The public debt is defined as
the total value of all outstanding government securities.
The public debt is a stock variable that is related to the deficit in a specific way.
Whenever the government budget is in deficit, the public debt increases since more
debt is issued to finance the deficit in that year. Therefore, the debt generally increases.
The public debt can only decrease if the government budget is in surplus and the
surplus is used to pay off the existing debt.
Now that we know the difference between the deficit and the debt, let's have a look at
the historical data for the U.S economy in the following presentation.
In the preceding presentation, we examined historical data on the government budget
and public debt, as of 2007. Let's update these data.
According to the Congressional Budget Office (CBO), the following figures apply for
2008:
Government spending = $2,983 billion, Tax revenues = $2,524

billion. What was the government budget deficit for 2008?
The deficit for 2008 is equal to G – T = $2,983 - $2,524 = $459

billion, which is 3.2% of GDP.
As of 2008, the public debt is equal to 5,803 billion, which is

about 40% of GDP.
For the most recent information and additional details on the U.S. government budget,
you can visit the following links:
• CBO Web site: http://www.cbo.gov/
• White House Office of Management and Budget:
http://www.whitehouse.gov/omb/budget/
WEEK TEN
Course Lecture 10-1: Definition of Money

This week we discuss money, the Fed, and monetary policy! Money is a word we often
use in our daily lives. We hear people say, "I need more money... " or "...if I make more
money..." We are accustomed to using the word money to refer to our income, which is
what we earn in return for our work. On the aggregate (for the whole economy), income
and money are intimately related and have a predictable relationship. However, they are
not the same thing. So let's begin this week by defining money, explaining how it's
different from income and learning how to measure the quantity of money in circulation.
Money Defined
What would you say if someone asked you to explain what money is? I am guessing
you would start to describe what you can do with money. For example, "Money is what I
use to pay for goods and service," or "Money is how prices are quoted in the economy."
Our money is called the U.S. dollar, which is also the name of our currency. In other
countries, currencies have different names, such as the Mexican peso or the Canadian
dollar.
Functions of Money
Notice that to define money, we had to think of its functions (or what it can do for us).
These are necessary for an item, something to be called money, and can be
summarized as follows:
Medium of exchange:
Money is anything that is accepted
as a means of payment for goods or
services. The U.S. dollar is paper or
fiat money. Fiat money does not
have intrinsic value, or value in and
of itself. Commodity money such as
gold has intrinsic value since it can
be used to make jewelry or other
things. Over time paper money
replaced barter and commodity
money since it facilitates exchange
and is the most efficient form of
payment. Barter is a situation where
goods are exchanged for other
goods. This requires what
economists refer to as the double
coincidence of wants. That is, I can
only trade with someone that has
what I want, and I happen to have
what they want! Therefore, barter is
obviously inefficient and limits trade
and specialization. Why does the
system of fiat money work - that is,
why do people accept the U.S. dollar
as a means of payment?
I accept the U.S. dollar as
payment since I know everyone
else in the economy accepts it as
well! Everyone accepts it since it
is the legal tender and is backed
by the full faith of the U.S.
government.
Unit of Accounting:
Money is used to express prices in
the economy. When I see a price tag
on a car of $25,000, money is
serving its function as a unit of
account. It serves as a common
denominator of the price system in
the economy.
Store of Value:
Money allows us to transfer value or
wealth into the future. This means
that money that is not spent today
can be spent in the future since it will
still be accepted as a means of
payment. Let's be careful here not to
misinterpret what we mean by
"holding value." We do not mean
that purchasing power will stay the
same since that will depend on
inflation. If prices are rising fast
(there is high inflation), then the
purchasing power of the dollar will
decrease.
Standard of Deferred Payment:
Another essential property of money
is that we can use it to pay back
debts maturing in the future. This
property of money is similar to the
store of value function because if
money does not retain its value,
people in the economy will not
accept it for future payments of debt.
Money and Income

To understand the difference between income and money, let's consider a simple
example where our class represents the whole economy. To make it easy let's start with
zero income and one unit of money or $1. You can assume that one person in the class
inherited the $1 and other stuff. Suppose this classmate asks you to help them copy
notes in return for a one dollar. What is the amount of money (or the money supply) in
this fictional economy? What is the income in this economy?
Yes, money is $1 and income is $1.
Now assume that you buy a notebook from a classmate for $1. Now what is the amount
of money in the economy? What is the total income in the economy?
Right, the quantity if money is still $1, but total income is $2!
As we can see, money and income are not exactly the same but they are intimately
related. If the amount of transactions (exchanges) in the economy increases, then the
amount of money in circulation has to increase to support the added transactions.
Otherwise, as we will see later the interest rate will increase if money supply is too low.
Alternatively, an increase in the amount of money available can raise the amount of
transactions in the economy and hence raises income. We will see in the next few
lectures that the Federal Reserve (Fed), as part of monetary policy, often adjusts the
money supply in order to align aggregate demand with full employment output.
Liquidity
In our discussion of money, we will often refer to the word liquidity. What do we mean
when we say an asset is liquid? Another definition is needed for this question. What is
an asset?
An asset is something we own that has value. This is the opposite of a liability,
which is something we owe that has value.
What is liquidity?
Liquidity is how easily (or quickly) we can turn an asset into cash without much
loss of value.
Note that the most important part of this definition is the last piece of the definition which
is, "without much loss of value." Obviously any asset can be turned into cash if the
owner is willing to take any price offered to them even if that does not reflect the asset's
value. A liquid asset is one that can be easily converted into cash without loss of value.
We can think of liquidity as a spectrum with various assets ranging from highly liquid to
highly illiquid. How do you think money fits in this spectrum of liquidity?
That's right. Money is the most liquid asset.
The following chart gives examples of various assets in relation to degree of liquidity.
this week's packet.
WEEK TEN
Course Lecture 10-2: Measurement of

Money
How we measure money?
The central bank of the U.S. or The Federal Reserve (Fed) measures the money supply
for our economy. They define two monetary aggregates (or money stock measures), M1
and M2, with M1 being the narrow definition of money, consisting of the most liquid
forms of money. M2 is defined as a broader monetary aggregate, adding savings and
other types of accounts to M1. Specifically,
Checkable deposits (also called demand deposits) are basically checking account
balances. Traveler's checks issued by depository institutions (commercial banks, credit
unions etc.) are already included in demand deposits, therefore only traveler's checks
not issued by banks are added to M1. The composition of M1 for 2007 is shown in the
pie chart below.
The following definitions apply.

Savings Deposits are interest-earning funds that can be withdrawn at any time
without payment of a penalty.
Money Market Deposit Accounts (MMDAs) are accounts issued by banks
yielding a market rate of interest with a minimum balance requirement, a limit on
transactions, and having no minimum maturity.
Time Deposit is a deposit in a financial institution that requires notice of intent to
withdraw or must be left for an agreed period. Early withdrawal may result in a
penalty.
Certificate of Deposit (CD) is a time deposit with fixed maturity.
Money Market Mutual Funds are funds obtained from the public that investment
companies hold in common. Funds are used to acquire short-maturity credit
instruments such as CDs and U.S. government securities.
As you can see from these definitions, M2 adds to M1 assets that are almost money
called Near monies, are highly liquid, and are easily converted to cash.
The composition of M2 for 2007 is shown in the pie chart below:

The Fed tracks the money stock measures and studies their relationship with economic
activity and spending. The broad money definition of M2 is found to be more stable over
long periods of time and correlates better with overall economic activity.
Let's test our understanding of M1 and M2 and see why it is a more stable aggregate
than M1. ATM's were introduced in the late 1960's and became widely used in the early
1970's. What do you think happened to M1 and M2 balances as a result of the
introduction of ATM's?
Think about this for a moment or two and then click here for an answer.
Correct. M1 balances decreased as a result of ATM's. Since ATM's made it more
convenient to transfer funds from savings and other interest earning accounts,
less cash and checking account balances were held in favor of interest earning
type accounts or near monies. Therefore, M1 declined. M2 stayed about the same.
Remember that M2 includes M1. The funds that shifted from M1 to accounts in M2
left M2 unchanged (since the M1 portion of M2 decreased by the same amount as
the increase in the near monies portion of M2.
For the most recent information and additional details on the money stock measures,
you can visit the following link:
Federal Reserve Board web site-Statistical Releases:
http://www.federalreserve.gov/releases/h6/current/h6.htm
WEEK TEN
Course Lecture 10-3: Federal Reserve

System
In this lecture we discuss the Federal Reserve System (Fed for short), which is the
Central bank of the U.S. A central bank is usually an official institution that has a
primary function of regulating the banking system and performing banking functions for
their nation's governments. In the U.S. and other major industrialized countries, the
central bank is independent from the government and has a key role to conduct
monetary policy in a manner consistent with the nation's economic goals. We will
discuss what it means for the Fed to be independent shortly. Let's first learn about its
organizational structure.
The Fed was created on December 23, 1913 by an Act of Congress, The Federal
Reserve Act. The system consists of the following 3 important parts:
Board of Governors (BOG) has seven members that are appointed by the
President and confirmed by the Senate. Each member serves a 14-year term.
One of the members is designated by the president and confirmed by the Senate
to serve as the Chairman of the Board for a four year term. Do you know who the
current chairman of the BOG of the Fed is?
Think about this for a moment, and then click here.
That's right, you've heard about him in the news, Dr. Ben Bernanke is the
current chairman of the Fed's BOG. He has been in this position since
February of 2006.
Reserve Banks (12 District banks) are the operating arms carrying the day to
day operations of the Federal Reserve System. There are 12 District banks and
25 branches that serve the whole nation.
The chart below shows the various districts and the areas they serve.

Which District bank serves the Detroit area?
Correct! The Federal Reserve Bank of Chicago serves our area. There is
also a Detroit branch in downtown Detroit.
Federal Open Market Committee (FOMC) consists of the seven members of
the BOG and five district bank presidents. The FOMC is the most important part
of the Fed, as it is responsible for formulating monetary policy in order to achieve
the stated economic goals of promoting economic growth and price stability. It
controls a key interest rate, the Federal funds Rate, by manipulating the amount
of Reserves that banks hold with the Fed.
Functions of the Fed
The Federal Reserve System as a whole has many important functions. The Fed:
• Supplies the economy with fiduciary currency
• Provides a payment-clearing system
• Holds depository institutions' reserves
• Acts as the government's fiscal agent
• Supervises depository institutions
• Acts as a "lender of last resort"
• Regulates the money supply
The following chart summarizes the organizational structure of the Fed and lists the
functions of each of its organizational parts.

There are several terms that are in the chart above that we need to define: the discount
rate, reserves, and reserve requirements. We will defer defining these until the next
lecture since they are part of the discussion on the Fed's Monetary policy tools.
Central bank Independence
At the beginning of this lecture we mentioned that the Fed is independent from the
government. But the Fed was created by an Act of Congress and thus is bound by the
Articles of the Federal Reserve Act of 1913. It is accountable to the government
accordingly. So what do we mean when we say it's independent within this structure?
The Fed is independent in that its policy decisions are not directly affected by
anyone in the government (congress and the administration). It is not officially part of
the government and is not paid by the government- Fed pays its employees from
interest earned on loans and Treasury securities. The fed policy making body, the
FOMC, does not check with anyone in Congress or the administration before making
decisions on interest rates. The founders of the Fed intended it to be structured this way
so that it is not directly part of the political process. Do you know why it may be good for
the economy if the central bank is not part of the government?
By focusing on the goal of low inflation without political pressure, independent
central banks can help avoid a political business cycle. This is a situation where
the economy gets into an inflationary equilibrium due to the incumbents
stimulating the economy in times of elections. Studies show that countries with
independent central bank have lower average inflation rates than those whose
central banks are part of the government.
Central bank independence does not imply that the Fed and the government do not
work together to achieve common economic goals. In fact they are doing this now,
coordinating Fiscal and Monetary policies in order to stimulate the economy out of a
recession.
For more information on the organizational structure of the Fed, you can visit the
following link:
Federal Reserve Web site - About the Fed:
http://www.federalreserve.gov/aboutthefed/default.htm
this week's packet.
WEEK TEN
Course Lecture 10-4: Monetary Policy Tools

Content Author: Dr. Basma Beckdache
As we learned in the previous lecture, one of the main functions of the Fed is to regulate
the money supply. We also learned how to measure the money supply using the
monetary aggregates M1 and M2. There are still several unanswered interesting
questions:
• First, how does the Fed influence the money supply?
• Second, how do changes in the money supply (or interest rates) influence the
state of the economy?
• Finally, we always hear in the news about the Fed changing interest rates, not
the money supply. What is the relationship between interest rates and the money
supply?
We will answer the first question in this lecture. In the next two lectures, we will explain
the impact of monetary policy on the economy and explore the relationship between the
money stock and interest rates using a model of the money market.
The Fed traditionally uses three primary tools to conduct monetary policy:
1. Reserve Requirements:
The Fed sets the reserve requirements for all depository institutions. A depository
institution is one that accepts funds in the form of deposits and lends them out to
borrowers, such as commercial banks, credit unions, and savings banks. Reserves are
deposits held at Federal Reserve banks and vault cash. Depository institutions are
operating in a fractional reserves system, where a fraction of the deposits made by
savers are loaned out.
There are two types of reserves:
a. Required reserves: The parts of deposits that are required to be held in
reserves (i.e., the portion of deposits that cannot be loaned out). The reserve
requirement ratio (RR) set by the Fed is the percentage of deposits that
have to be kept on reserve. As an example, suppose RR is 10% (or .10) and
Bank ANC has $150,000 in deposits. What is the bank's required reserves?
In this case, required reserves = $15,000. Since the bank has to hold 10% of
its deposits on reserves, we find required reserves as follows:
b. Excess reserves: If the bank chooses to hold more than the required reserves,
that is if their actual (or legal) reserves exceed required reserves, we say the
bank has excess reserves, consistent with the following definitions:
Legal reserves = Actual amount of reserves being held by the bank.
Excess reserves = Legal (or actual) Reserves - Required Reserves.
When the banks have no excess reserves, we say they are "loaned up".
Continuing with the example of Bank ANC. Suppose the bank's legal reserves
are equal to $25,000. How can we describe Bank ANC's reserves situation?
Bank ANC has excess reserves in the amount of $10,000. This is found
using the following:
Recall that the money supply aggregates M1 and M2 are mainly deposits and cash.
Therefore, when deposits increase, the money supply increases and vice versa. For
simplicity, let's assume for now that when banks make loans, those loans ultimately get
deposited back in the banking system, creating more deposits. If some of the loans are
not deposited in the system (i.e., people keep their cash at home instead), a process
called currency drain, the amount of deposits would not rise as much when loans are
made leading to a smaller increase in the money supply. Given this, how can the Fed
use reserve requirements to increase the money supply?
Think about this question and then click on the button of your choice.
Correct! Lowering reserve requirements enables depository institutions to

increase loans, which raises the amount of deposits and the money supply.
Incorrect. Increasing reserve requirements leads to less loans and a decrease in
the money supply. Lowering reserve requirements enables depository
institutions to increase loans, which raises the amount of deposits and the
money supply.
In summary, an increase (decrease) in the required reserve ratio makes it more (less)
expensive for banks to meet reserve requirements thus reduces (expanding) bank
lending. Although changing reserve requirements is one of the tools available to the
Fed to control the money supply, it is not often used to conduct monetary policy. The
reserve requirements ratio for large institutions was lowered from 12 to 10 percent in
1992 and has not changed since. Why do you think the Fed does not often change the
required reserves ratio?
Correct. Depository institutions channel funds from savers to borrowers by
making loans based on their deposits. If the reserve requirement ratio was not
stable and predictable, it would be very difficult for banks to plan their loans and
conduct business.
Because of this, the Fed focuses on other tools to conduct monetary policy. As we will
see soon, the Fed does seek to change the amount of reserves to alter the money
supply but not by changing the reserve requirement ratio.
For more information on reserve requirements, you can visit the following section of the
Federal Reserve Web site:
http://www.federalreserve.gov/monetarypolicy/reservereq.htm
2. The Discount Rate:

The discount rate is the interest rate charged to depository institutions on loans
that they receive from the Fed - made through the discount window at their regional
Federal Reserve bank. The discount rate is generally set slightly above the usual level
of another short-term market interest rate, the Fed funds rate. The rate varies
depending on whether the borrowing institution qualifies under the primary, secondary
or seasonal credit programs (see Federal Reserve Web site link to discount rate
programs below for more details). Loans made through the discount widow, are
generally made overnight for the purpose of managing reserve requirements. Other
short-term loans are also sometimes extended under the secondary program to meet
depository institutions other short-term liquidity needs. Generally, banks and other
depository institutions prefer to borrow from other banks when they are short on
reserves. When banks borrow from each other they pay the Federal Funds rate - more
on this in a minute. This preference appears to stem from a perception that since the
Fed is a "lender of last resort," banks should only go to the discount window when they
have already exhausted other channels.
How can the Fed use the discount rate to influence the money supply? What do you
think the Fed should do to the discount rate if the aim was to lower the money supply -
say because the economy is overheating and they are trying to reduce aggregate
demand?
Think about this question and then click on the button of your choice.
Incorrect. Lowering the discount rate enables banks to make more loans, which
raises the amount of deposits and the money supply. The Fed should increase
the discount rate if they want to money supply to decrease.
Correct! Raising the discount rate reduces the ability of banks to make loans
which lowers the amount of deposits and the money supply.
The discount rate as of March 2009 is 0.5% and 1.0% for the primary and secondary
credit programs respectively.
For more information on the discount window programs and current rates, you can visit
the following section of the Federal Reserve Web site:
http://www.federalreserve.gov/monetarypolicy/discountrate.htm
3. Open Market Operations:

Open Market Operations (or OMOs for short) are the principal tool used by the Fed
for implementing monetary policy. OMOs refer to the buying and selling of
Treasury Securities and other government agency securities in the open
market. The objective of OMOs is specified by the policy directive of the Federal
Open Market Committee (FOMC) in terms of a target level for the Federal funds rate
or the quantity of reserves. The Federal Funds rate (Fed funds rate for short) is the
interest rate paid by banks to borrow funds kept at the Federal Reserve (reserves)
from other banks overnight. The Fed funds rate is basically the price of reserves.
Banks that have excess reserves charge this rate when they lend to banks that are
short on reserves.
The Federal Funds rate is a key interest rate in the economy since it represents a
base interest rate for all lending institutions. If the Fed funds rate increases, all other
interest rates in the economy tend to increase as depository institutions pass on the
higher cost of funds to their customers. Given this, the Fed targets this key interest
rate to influence aggregate demand. If the Fed wants to raise the money supply and
stimulate economic activity, they act to lower the Fed funds rate. Conversely, if the
Fed is trying to reduce aggregate demand to contain inflation, they act to increase the
Fed funds rate and increase the cost of funds causing the money supply to decrease.
Let's talk about how OMOs or the buying and selling of securities influence the Fed
funds rate.
Recall that the Federal funds rate is the rate charged by banks to other banks for
borrowing reserves. If we think of the market for reserves in terms of the demand and
supply model from week 2, we can see how an increase in the supply of reserves
would decrease the Fed funds rate and vice versa. That is, if there are more (less)
reserves in the banking system the price of borrowing reserves, which is the Fed
funds rate would decrease (increase).
• Open Market Purchase:
When the Fed acts to lower the Fed funds rate they buy Treasury securities
from depository institutions (basically giving cash to the banks and taking away
treasury securities. This raises the level of reserves (since banks now have
cash that can be loaned out that they did not have prior to the Fed's purchase
of securities) and lowers the Fed funds rate.
• Open Market Sale: When the Fed acts to raise the Fed funds rate they sell
securities to the banks. This lowers the amount of reserves, as banks
exchange their cash for securities. This lowers the amount of reserves (akin to
a decrease in the supply of reserves) and puts upward pressure on the Fed
funds rate.
As of December 2008, the Fed funds target has been set at 0 -.25%, which is
historically extremely low.
For more details and current information on the Fed's open market operations, you
can visit the following link: http://www.federalreserve.gov/fomc/fundsrate.htm
this week's packet.
WEEK TEN
Course Lecture 10-5: The Money Market

In the previous lecture, we learned how the Fed influences the money supply using
reserve requirements, the discount rate, and open market operations (the Fed funds
rate). To gain a better understanding of how the actions of the Fed influence other
market interest rates, we make use of a simple model of the money market. Let's start
building the model by defining money demand and deriving the demand for money
curve. We will then interact this with money supply and derive the equilibrium interest
rate.
The Demand for Money
What do we mean by "the demand for money?" We surely don't mean wanting more
money! If we group assets into two main categories: interest earning and non-interest
earning, and use the M1 definition of money, we can see that money is the non-interest
earning asset. Without much loss of generality, we can call the interest earning asset
"bonds." The demand for money refers to the willingness to hold part of our income (or
wealth) in the non-interest earning asset, money. Given that bonds earn interest and
money doesn't, what motivates people to hold money as an asset, other things held
constant?
Think about this question for a moment and then click here.
Right. We need the liquidity of money to conduct many transactions. Therefore, one of
the main motives for holding money is the transactions demand for money. We can
summarize the motives for holding money as follows:
Transactions demand:
Refers to holding money as
a medium of exchange to
conduct transactions. The
amount of money (or money
balances) that people hold for
this purpose varies directly
with the level of income and
economic activity. When
aggregate income increases
in the economy, the number of
transactions tends to increase
leading to a higher demand
for money and vice versa.
Precautionary demand:
Refers to holding money to
meet unplanned
expenditures and
emergencies. The greater the
uncertainty about income and
expenditures the greater the
money balances that people
will hold for this purpose.
Asset Demand:
Sometimes we hold money
simply as an asset that
holds value over time. We
might also hold it for
speculative reasons, to have
the liquidity to purchase other
assets (stocks, bonds, real
estate) that we speculate will
increase or decrease in price
depending on market
conditions. Speculating refers
to making predictions on
changes in the price of certain
assets and acting on that
prediction.
How should the demand for money be related to the interest rate? That is, given their
income, what should happen to the amount of money that people hold as the interest
rate increases or decreases?
Hint: Think of the opportunity cost of holding money.
Once you've done that, click here for the answer.
The interest rate represents the opportunity cost of holding the non-interest
earning asset money. It is what we give up when choose money over bonds.
Therefore, the demand for money is negatively related to the interest rate that can
be earned on the other type of assets.
In the money market graph, with the quantity of money on the horizontal axis, and the
interest rate on the vertical axis (representing the price of money), the demand for
money curve has a negative slope as shown in the graph below.
(Roger Le Roy Miller, Economic Today,

14th edition)
Equilibrium in the money market:

Recall that money supply is the actual amount of money in circulation or M1. We know
from the previous lectures that the money supply can be increased or decreased if the
Fed uses any of the three monetary policy tools. However, the money supply itself is not
dependent on the market interest rate. Since money supply is a constant with respect to
the interest rate, it is a vertical line in the money market model graph, as shown below.
14th edition)
The money market is in equilibrium at the interest rate r1, where the quantity of money
demanded is equal to money supply. Let's reason through how the market reaches the
equilibrium interest rate r1.
At any interest rate greater than r1, money supply (or the actual amount of money being
held-shown by the red curve) is greater than money demand (the amount that people
are willing to hold at that interest rate - shown by the blue curve). In that situation we
have an excess supply of money. That is people are holding more money than they
would like at that interest rate. To reduce money balances, they buy bonds (or interest
earning assets). This raises the amount of loanable funds in the market and lowers the
interest rate, towards r1.
Conversely, at any interest rate less than r1, money supply is less than money demand.
We have an excess demand for money or people would like to hold more money at that
interest rate. To increase money balances, they sell bonds. This lowers the amount of
loanable funds in the market and raises the interest rate, towards r1.
Given the adjustment mechanism we just described above, what do you think the Fed
should do if they want to lower the equilibrium market interest rate?
The fed should increase money supply. This creates an excess supply of money,
which drives down the market interest rate. This is illustrated in the money
market graph below.
14th edition)
To increase interest rates, the Fed can decrease the money supply to cause an excess
demand for money pulling the interest rate to a higher equilibrium. Can you illustrate this
situation with your own sketch of the money market graph? Please take a moment to
sketch this out.
In choosing how to express their policy targets, the Fed focuses on a target interest
level that is deemed consistent with the ultimate economic goals. The money market
graph is useful in illustrating the fact that when the Fed chooses a target level for the
interest rate, they cannot control the money supply at the same time, as shown in the
graph below:
14th edition)
this week's packet.
WEEK TEN
Course Lecture 10-6: Effects of Monetary

Policy on the Economy
So far, we spent quite some time discussing the Fed, monetary policy tools, and the
money market. The interest rate and the money supply are intermediate goals that the
Fed sets in order to reach the ultimate goals of their policy. Do you recall what the
ultimate goals of economic policy are?
Click here.
As discussed in previous lectures, the goals of monetary policy are economic
growth and price stability.
So how does the Fed go about achieving these goals?
The Fed can influence Aggregate Demand (AD) through the interest rate. Specifically,
the transmission mechanism for monetary policy can be summarized in the following
schematic.
(Reprinted from Roger LeRoy Miller,

Economic Today, 14th edition.)
As shown in the graphs below, expansionary monetary policy is aimed at increasing

AD in order to increase real GDP and reduce unemployment. Conversely,
contractionary monetary policy is aimed at decreasing AD in order to reduce
economic activity to prevent inflation. Recall from prior weeks that when AD increases
real GDP increases, but prices increase as well causing inflation. Since price stability is
a goal that can conflict with economic growth (if the economy is already at potential), the
Fed sometimes undertakes a contractionary policy to promote price stability.
Similar to what we did last week with Fiscal policy, let's consider two different scenarios
about the economy. Then, let's pretend we're in an FOMC meeting and make policy
recommendations aimed at keeping output at the full employment level.

Course Lecture Notes For Cumulative Final Exam (Combined Weeks 1-10)

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Course Lecture Notes For Cumulative Final Exam (Combined Weeks 1-10)

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WEEK ONE

Instructor Lecture: Nature of Economics

This week we begin our introduction to the exciting world of

Why do people have to make choices?

Economics is often described as an empirical science. This is because we use

An economy fully An economy falling To say an economy is

Economic Growth and PPC

Instructor Lecture: More on Opportunity

Labor: Capital: Human capital: Technology:

(Reprinted from Roger LeRoy Miller, Economics Today, 14th edition)

Instructor Lecture: More on Saving and

Instructor Lecture: More on Comparative

Who has the comparative advantage in the production of chairs?

In the case of specialization:

TOTAL PRODUCTION IS: 4 chairs, 2 tables.

In the case of no specialization:

In a half hour, Bob can produce 2 chairs.

In a half hour, Ted can produce 1.5 chairs.

TOTAL PRODUCTION IS: 3.5 chairs and 1.5 tables.

This is less than the production that can be attained if

Course Lecture 1-2: Consumer Choice

Course Lecture 1-3: Interpreting Graphs

Click here for the answer.

Click here for the answer.

Click here for the answer.

Course Lecture 2-1: Demand and Supply

Please view the following 6 minute presentation.

What is the equilibrium price and quantity in this market?

What do you think happens in this situation?

Course Lecture 2-4: Demand and Supply

Price Elasticity of Demand: Examples

Let me illustrate externality that can be both

When I was a young boy growing up in Kettering,

One summer the local utility company came

In both situations the new light provided an

Instructor Lecture: Externalities

Source: Miller, Roger; Economics Today, 14th Edition

However, an economist takes a different view of

An economist's view of profits:

Economic profits are much harder to achieve. They

1. What is your answer? Have it -- good!

Now, add 32.

1. What is the new total? What is the new average?

Now, add 40.

What is the new total? What is the new average?

Remember: Marginal value is the value of the LAST unit added.

Course Lecture 4-2: Diminishing Marginal

Source: Miller, Roger, Economics Today, 14th Edition

Instructor Lecture: More on Marginal

Course Lecture 4-3: Short-Run Costs to the

Divide the total (T--) by the quantity (Q)

ATC=TC/Q AVC=TVC/Q AFC=TFC/Q

Instructor Lecture: Long-Run Cost Curves

What can explain economies of scale or diseconomies of scale?

The Demand Curve for a Producer of Flash

Profit Maximization, Panel (b)

Profit Maximization, Panel (c)

The Individual Firm's Short-Run Supply

Measuring Total Profits

Minimization of Short-Run Losses

Short-Run Shut Down and Break-Even

Instructor Lecture: More on Perfect