2010 Pearson Addison-Wesley

! At the end of this chapter you should be able to

answer the following questions:
! Will the global economy remain weak through the next year or will
it begin to expand more rapidly?
! To assess the state of the economy and to make big decisions
about business expansion, firms use forecasts of GDP.
! What exactly is GDP?
! How do we use GDP to tell us whether our economy is in a
recession or how rapidly our economy is expanding?
! How do we take the effects of inflation out of GDP to reveal the
growth rate of our economic well-being?
! And how to we compare economic well-being across countries?
2010 Pearson Addison-Wesley
! GDP Defined
! GDP or gross domestic product is the market value
of all final goods and services produced in a
country in a given time period.
! This definition has four parts:
! Market value
! Final goods and services
! Produced within a country
! In a given time period
2010 Pearson Addison-Wesley
! Market Value
! GDP is a market valuegoods and services are
valued at their market prices.
! To add apples and oranges, computers and
popcorn, we add the market values so we have a
total value of output in dollars.
2010 Pearson Addison-Wesley
! Final Goods and Services
! GDP is the value of the final goods and services
produced.
! A final good (or service) is an item bought by its
final user during a specified time period.
! A final good contrasts with an intermediate good,
which is an item that is produced by one firm,
bought by another firm, and used as a component
of a final good or service.
! Excluding intermediate goods and services avoids
double counting.
2010 Pearson Addison-Wesley
! Produced Within a Country
! GDP measures production within a country
domestic production.
! In a Given Time Period
! GDP measures production during a specific time
period, normally a year or a quarter of a year.
2010 Pearson Addison-Wesley
! GDP and the Circular Flow of Expenditure and
Income
! GDP measures the value of production, which also
equals total expenditure on final goods and total
income.
! The equality of income and value of production
shows the link between productivity and living
standards.
! The circular flow diagram illustrates the equality of
income and expenditure.
2010 Pearson Addison-Wesley
! The circular flow diagram shows the transactions among
households, firms, governments, and the rest of the world.
2010 Pearson Addison-Wesley
2010 Pearson Addison-Wesley
! Households and Firms
! Households sell and firms buy the services of
labor, capital, and land in factor markets.
! For these factor services, firms pay income to
households: wages for labor services, interest for
the use of capital, and rent for the use of land. A
fourth factor of production, entrepreneurship,
receives profit.
! In the figure, the blue flow, Y, shows total income
paid by firms to households.
2010 Pearson Addison-Wesley
2010 Pearson Addison-Wesley
! Firms sell and households buy consumer goods
and services in the goods market.
! Consumption expenditure is the total payment for
consumer goods and services, shown by the red
flow labeled C .
! Firms buy and sell new capital equipment in the
goods market and put unsold output into inventory.
! The purchase of new plant, equipment, and
buildings and the additions to inventories are
investment, shown by the red flow labeled I.
2010 Pearson Addison-Wesley
2010 Pearson Addison-Wesley
! Governments
! Governments buy goods and services from firms
and their expenditure on goods and services is
called government expenditure.
! Government expenditure is shown as the red flow
G.
! Governments finance their expenditure with taxes
and pay financial transfers to households, such as
unemployment benefits, and pay subsidies to firms.
! These financial transfers are not part of the circular
flow of expenditure and income.
2010 Pearson Addison-Wesley
2010 Pearson Addison-Wesley
! Rest of the World
! Firms in Spain sell goods and services to the rest of
the worldexportsand buy goods and services
from the rest of the worldimports.
! The value of exports (X ) minus the value of imports
(M) is called net exports, the red flow X M.
! If net exports are positive, the net flow of goods and
services is from Spanish firms to the rest of the
world.
! If net exports are negative, the net flow of goods
and services is from the rest of the world to Spanish
firms.
2010 Pearson Addison-Wesley
2010 Pearson Addison-Wesley
! The blue and red flows are the circular flow of
expenditure and income.
2010 Pearson Addison-Wesley
! The sum of the red flows equals the blue flow.
2010 Pearson Addison-Wesley
! That is: Y = C + I + G + X M
2010 Pearson Addison-Wesley
! The circular flow shows two ways of measuring GDP.
! GDP Equals Expenditure Equals Income
! Total expenditure on final goods and services
equals GDP.
! GDP = C + I + G + X M.
! Aggregate income equals the total amount paid for
the use of factors of production: wages, interest,
rent, and profit.
! Firms pay out all their receipts from the sale of final
goods, so income equals expenditure,
! Y = C + I + G + (X M).
2010 Pearson Addison-Wesley
! Why Is Domestic Product Gross?
! Gross means before deducting the depreciation
of capital.
! The opposite of gross is net.
! Net means after deducting the depreciation of
capital.
2010 Pearson Addison-Wesley
! Depreciation is the decrease in the value of a firms
capital that results from wear and tear and
obsolescence.
! Gross investment is the total amount spent on
purchases of new capital and on replacing
depreciated capital.
! Net investment is the increase in the value of the
firms capital.
! Net investment = Gross investment - Depreciation.
2010 Pearson Addison-Wesley
! Gross investment is one of the expenditures
included in the expenditure approach to measuring
GDP.
! So total product is a gross measure.
! Gross profit, which is a firms profit before
subtracting depreciation, is one of the incomes
included in the income approach to measuring GDP.
! So total product is a gross measure.
2010 Pearson Addison-Wesley
! There are two approaches to measure GDP:
! The expenditure approach
! The income approach
2010 Pearson Addison-Wesley
! The Expenditure Approach
! The expenditure approach measures GDP as the sum
of consumption expenditure, investment, government
expenditure on goods and services, and net exports.
! GDP = C + I + G + (X - M)
! On next slide, there is a table that shows the
expenditure approach with data (in billions) for 2008.
! GDP = $10,003 + $2,056 + $2,798 - $706
! = $14,151 billion
2010 Pearson Addison-Wesley
2010 Pearson Addison-Wesley
! The Income Approach
! The income approach measures GDP by summing
the incomes that firms pay households for the
factors of production they hire.
2010 Pearson Addison-Wesley
! The National Income and Expenditure Accounts
divide incomes into five categories:
1. Compensation of employees
2. Net interest
3. Rental income
4. Corporate profits
5. Proprietors income
! These five income components sum to net
domestic income at factor cost.
2010 Pearson Addison-Wesley
! Two adjustments must be made to get GDP:
! 1. Indirect taxes minus subsidies are added to
get from factor cost to market prices.
! 2. Depreciation (or capital consumption) is added
to get from net domestic product to gross
domestic product.
! Table 4.2 on the next slide shows the income
approach with data for 2008.
2010 Pearson Addison-Wesley
2010 Pearson Addison-Wesley
! Nominal GDP and Real GDP
! Real GDP is the value of final goods and services
produced in a given year when valued at valued at
the prices of a reference base year.
! Currently, the reference base year is 2000 and we
describe real GDP as measured in 2000 dollars.
! Nominal GDP is the value of goods and services
produced during a given year valued at the prices
that prevailed in that same year.
! Nominal GDP is just a more precise name for GDP.
2010 Pearson Addison-Wesley
! Calculating Real GDP
! Table shows the
quantities produced
and the prices in 2000
(the base year).
! Nominal GDP in 2000
is $100 million.
! Because 2000 is the
base year, real GDP and
nominal GDP both are
$100 million.
2010 Pearson Addison-Wesley
! The second table (b)
shows the quantities
produced and the
prices in 2009.
! Nominal GDP in 2009
is $300 million.
! Nominal GDP in 2009
is three times its value
in 2000.
2010 Pearson Addison-Wesley
! The third Table (c), we
calculate real GDP in
2009.
! The quantities are
those of 2009, as in
part (b).
! The prices are those in
the base year (2000) as
in part (a).
! The sum of these
expenditures is real
GDP in 2009, which is
$160 million.
2010 Pearson Addison-Wesley
! Economists use estimates of real GDP for two main
purposes:
! To compare the standard of living over time
! To compare the standard of living across
countries
2010 Pearson Addison-Wesley
! The Standard of Living Over Time
! Real GDP per person is real GDP divided by the
population.
! Real GDP per person tells us the value of goods and
services that the average person can enjoy.
! By using real GDP, we remove any influence that
rising prices and a rising cost of living might have
had on our comparison.
2010 Pearson Addison-Wesley
! Long-Term Trend
! A handy way of comparing real GDP per person
over time is to express it as a ratio of some
reference year.
! For example, in 1958, real GDP per person was
$12,883 and in 2008, it was $38,422.
! So real GDP per person in 2008 was 3 times its
1958 levelthat is, $38,422 $12,883 = 3.
2010 Pearson Addison-Wesley
! Two features of our expanding living standard
are
! ! The growth of potential GDP per person
! ! Fluctuations of real GDP around potential GDP
! The value of real GDP when all the economys
labor, capital, land, and entrepreneurial ability are
fully employed is called potential GDP.
2010 Pearson Addison-Wesley
! Real GDP Fluctuations
! A business cycle is a periodic but irregular up-
and-down movement of total production and other
measures of economic activity.
! Every cycle has two phases:
1. Expansion
2. Recession
! and two turning points:
1. Peak
2. Trough
2010 Pearson Addison-Wesley
! An expansion is a
period during which
real GDP increases.
! Recession is a period
during which real GDP
decreasesits growth
rate is negativefor at
least two successive
quarters.
2010 Pearson Addison-Wesley
2010 Pearson Addison-Wesley
! Standard of Living Across Countries
! Two problems arise in using real GDP to compare
living standards across countries:
! 1. The real GDP of one country must be converted
into the same currency units as the real GDP of
the other country.
! 2. The goods and services in both countries must
be valued at the same prices.
2010 Pearson Addison-Wesley
! Limitations of Real GDP
! Real GDP measures the value of goods and services
that are bought in markets. Some of the factors that
influence the standard of living and that are not part
of GDP are
! Household production
! Underground economic activity
! Health and life expectancy
! Leisure time
! Environmental quality
! Political freedom and social justice
2010 Pearson Addison-Wesley
! The price level is the average level of prices and
the value of money.
! The inflation rate is the annual percentage change
in the price level.
! We are interested in the price level because we
want to
! Measure the inflation rate
! Distinguish between real and nominal values of
economic variables.
2010 Pearson Addison-Wesley
! Why Inflation Is a Problem
! Inflation is a problem for many reasons, but the
main one is that once it takes hold, it is
unpredictable.
! Unpredictable inflation is a problem because it
! Redistributes income and wealth
! Diverts resources from production
2010 Pearson Addison-Wesley
! Unpredictable changes in the inflation rate
redistribute income in arbitrary ways between
employers and workers and between borrowers and
lenders.
! A high inflation rate is a problem because it diverts
resources from productive activities to inflation
forecasting.
! From a social perspective, this waste of resources
is a cost of inflation.
! At its worse, inflation becomes hyperinflationan
inflation rate that is so rapid that workers are paid
twice a day because money loses its value so
quickly.
2010 Pearson Addison-Wesley
! The Consumer Price Index
! The Consumer Price Index, or CPI, measures the
average of the prices paid by urban consumers for a
fixed basket of consumer goods and services.
2010 Pearson Addison-Wesley
! Reading the CPI Numbers
! The CPI is defined to equal 100 for the reference
base period.
! Currently, the reference base period is 1982-1984.
! That is, for the average of the 36 months from
January 1982 through December 1984, the CPI
equals 100.
! In July 2008, the CPI was 220.
! This number tells us that the average of the prices
paid by urban consumers for a fixed basket of
goods was 120 percent higher in 2008 than it was
during 1982-1984.
2010 Pearson Addison-Wesley
! Constructing the CPI
! Constructing the CPI involves three stages:
! Selecting the CPI basket
! Conducting a monthly price survey
! Calculating the CPI
2010 Pearson Addison-Wesley
! The CPI Basket
! The CPI basket is based on a Consumer
Expenditure Survey, which is undertaken
infrequently.
! The CPI basket today is based on data collected in
the Consumer Expenditure Survey of 2001-2002.
! The CPI basket contains 80,000 goods.
2010 Pearson Addison-Wesley
! Figure illustrates the
CPI basket.
! Housing is the largest
component.
! Transportation and
food and beverages
are the next largest
components.
! The remaining
components account
for 25 percent of the
basket.
2010 Pearson Addison-Wesley
2010 Pearson Addison-Wesley
! The Monthly Price Survey
! Every month, BLS employees check the prices of
80,000 goods on 30 metropolitan areas.
! Calculating the CPI
! 1. Find the cost of the CPI basket at base-period
prices.
! 2. Find the cost of the CPI basket at current-period
prices.
! 3. Calculate the CPI for the current period.
2010 Pearson Addison-Wesley
! Lets work an example
of the CPI calculation.
! In a simple economy,
people consume only
oranges and haircuts.
! The CPI basket is 10
oranges and 5 haircuts.
! The table also shows
the prices in the base
period.
! The cost of the CPI
basket in the base
period was $50.
2010 Pearson Addison-Wesley
! Table (a) shows the
fixed CPI basket of
goods.
! It also shows (b) the
prices in the current
period.
! The cost of the CPI
basket at current-
period prices is $70.
2010 Pearson Addison-Wesley
! The CPI is calculated using the formula:
! CPI = (Cost of basket at current-period prices
Cost of basket at base-period prices) ! 100.
! Using the numbers for the simple example,
! CPI = ($70 $50) ! 100 = 140.
! The CPI is 40 percent higher in the current period
than it was in the base period.
2010 Pearson Addison-Wesley
! Measuring the Inflation Rate
! The major purpose of the CPI is to measure
inflation.
! The inflation rate is the percentage change in the
price level from one year to the next.
! The inflation formula is:
! Inflation rate = [(CPI this year CPI last year) CPI
last year] ! 100.
2010 Pearson Addison-Wesley
! The figure shows the relationship between the
price level and inflation.
! Figure (a) shows the CPI from1972 to 2008.
2010 Pearson Addison-Wesley
! Figure (b) shows that the inflation rate is
! High when the price level is rising rapidly and
! Low when the price level is rising slowly.
2010 Pearson Addison-Wesley
2010 Pearson Addison-Wesley
! The Biased CPI
! The CPI might overstate the true inflation for four
reasons:
! New goods bias
! Quality change bias
! Commodity substitution bias
! Outlet substitution bias
2010 Pearson Addison-Wesley
! New Goods Bias
! New goods that were not available in the base year
appear and, if they are more expensive than the
goods they replace, they put an upward bias into
the CPI.
! Quality Change Bias
! Quality improvements occur every year. Part of the
rise in the price is payment for improved quality
and is not inflation.
! The CPI counts all the price rise as inflation.
2010 Pearson Addison-Wesley
! Commodity Substitution Bias
! The market basket of goods used in calculating the
CPI is fixed and does not take into account
consumers substitutions away from goods whose
relative prices increase.
! Outlet Substitution Bias
! As the structure of retailing changes, people switch
to buying from cheaper sources, but the CPI, as
measured, does not take account of this outlet
substitution.
2010 Pearson Addison-Wesley
! Some Consequences of the Bias
! The bias in the CPI
! Distorts private contracts.
! Increases government outlays (close to a third of
federal government outlays are linked to the CPI).
! Biases estimates of real earnings.
! A bias of 1 percent is small but over a decade adds
up to almost $1 trillion of additional expenditure.
2010 Pearson Addison-Wesley
! Alternative Price Indexes
! Alternative measures of the price level are
! CPI
! GPD deflator
2010 Pearson Addison-Wesley
! The Real Variables in Macroeconomics
! We can use the GPD deflator to deflate nominal
variables to find their real values.
! For example,
! Real wage rate = (Nominal wage rate GDP deflator)
!100
! But not the real interest rate! It is different.
2010 Pearson Addison-Wesley
1he ConcepL of 8uslness and roL
8uslness
An organlzauon LhaL provldes (sells) goods or servlces Lo
earn proLs.
roLs
1he dlerence beLween a buslness's revenues and lLs
expenses.
Consumer Cholce and uemand
Consumers choose how Lo sausfy Lhelr wanLs and needs.
CpporLunlLy and LnLerprlse
ldenufy needs and caplLallze on Lhe opporLunlLy.
1-68
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1he ConcepL of 8uslness and roL (conL.)
1he 8eneLs of 8uslness
rovlde goods and servlces
Lmploy workers whlch resulLs ln lncreased quallLy of llfe
and sLandard of llvlng
lnnovauon and opporLunlues
Lnhanced personal lncomes of owners and sLockholders
SupporL for charlues and communlLy leadershlp
1-69
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1he LxLernal LnvlronmenLs of 8uslness
LxLernal LnvlronmenL
LveryLhlng ouLslde an organlzauon's boundarles
LhaL mlghL aecL lL
Slx areas: domesuc buslness, global buslness,
Lechnologlcal, pollucal-legal, socloculLural, and economlc
envlronmenLs
1-70
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1he LxLernal LnvlronmenLs of 8uslness (conL.)
uomesuc 8uslness LnvlronmenL
1he envlronmenL ln whlch a rm conducLs lLs
operauons and derlves lLs revenues by:
Seeklng Lo be close Lo cusLomers
8ulldlng relauonshlps wlLh suppllers
ulsungulshlng lLself from compeuLors
1-71
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1he LxLernal LnvlronmenLs of 8uslness (conL.)
Clobal 8uslness LnvlronmenL
1he lnLernauonal forces LhaL aecL a buslness:
lnLernauonal Lrade agreemenLs
lnLernauonal economlc condluons
ollucal unresL
lnLernauonal markeL opporLunlues
Suppllers
CulLures
CompeuLors
Currency values
1-72
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1he LxLernal LnvlronmenLs of 8uslness (conL.)
1echnologlcal LnvlronmenL
All Lhe ways by whlch rms creaLe value for
Lhelr consuLuenLs:
Puman knowledge
Work meLhods
hyslcal equlpmenL
LlecLronlcs and Lelecommunlcauons
varlous buslness acuvlLy processlng sysLems
1-73
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1he LxLernal LnvlronmenLs of 8uslness (conL.)
ollucal-Legal LnvlronmenL
1he relauonshlp beLween buslness and Lhe
governmenL, laws regulaLe whaL an organlzauon can
and cannoL do ln many areas lncludlng:
roducLs
Adveruslng pracuces
SafeLy and healLh conslderauons
1-74
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1he LxLernal LnvlronmenLs of 8uslness (conL.)
SocloculLural LnvlronmenL
1he cusLoms, mores, values, and demographlc
characLerlsucs of Lhe socleLy
1he sLandards of buslness conducL a socleLy ls
llkely Lo accepL
1-73
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1he LxLernal LnvlronmenLs of 8uslness (conL.)
Lconomlc LnvlronmenL
1he relevanL condluons LhaL exlsL ln Lhe economlc sysLem
ln whlch a company operaLes
ln a sLrong economy where many people have [obs, a
growlng company may nd lL necessary Lo pay hlgher
wages and oer more beneLs ln order Lo auracL
workers.
ln a weaker economy where people are looklng for [obs,
a rm may be able Lo pay less and oer fewer beneLs.
1-76
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
Lconomlc SysLems
Lconomlc SysLem
A nauon's sysLem for allocaung lLs resources among lLs
cluzens, boLh lndlvlduals and organlzauons
lacLors of roducuon
Labor
CaplLal
LnLrepreneurs
hyslcal resources
lnformauon resources
1-77
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1wo 1ypes of Lconomlc SysLems
lanned Lconomy
A cenLrallzed governmenL conLrols all or mosL facLors of
producuon and makes all or mosL producuon and
allocauon declslons for Lhe economy.
MarkeL Lconomy
lndlvldual producers and consumers conLrol producuon
and allocauon by creaung comblnauons of supply and
demand.
1-78
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1ypes of Lconomlc SysLems
lanned Lconomy
- Communlsm - lndlvlduals conLrlbuLe accordlng
Lo Lhelr ablllues and recelve beneLs accordlng Lo
Lhelr needs.
1he governmenL owns and operaLes all facLors of
producuon.
1he governmenL asslgns people Lo [obs and owns all
buslnesses and conLrols buslness declslons.
1-79
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1ypes of Lconomlc SysLems (conL.)
MarkeL Lconomlcs
CaplLallsm
1he governmenL supporLs prlvaLe ownershlp and encourages
enLrepreneurshlp.
lndlvlduals choose where Lo work, whaL Lo buy, and how much Lo pay.
roducers choose who Lo hlre, whaL Lo produce, and how much Lo
charge.
MarkeL
A mechanlsm of exchange beLween buyers and sellers of a
good or servlce.
1-80
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
1ypes of Lconomlc SysLems (conL.)
MarkeL Lconomlcs
Mlxed MarkeL Lconomy
leaLures characLerlsucs of boLh planned and markeL
economles.
!"#$%&'%&()* 1he process of converung governmenL
enLerprlses lnLo prlvaLely owned companles.
,(-#%.#/0: 1he governmenL owns and operaLes selecL
ma[or lndusLrles such as banklng and LransporLauon.
Smaller buslnesses are prlvaLely owned.
1-81
CopyrlghL 2011 earson Lducauon, lnc. publlshlng as renuce Pall
2010 Pearson Addison-Wesley
By size: micro, small, medium and corporations (according to the turnover,
number of employees)
By the capital ownership: Privates, Publics, Mix
By the legal form: sole proprietorship, general partnership: Limited partnership or
limited Liability company, Corporation, Cooperative
By activity: primary , secondary, third sector