Rift Valley University

MBA Program
(BADM – 641)

Dagnachew Admasu Ayele (Dr.)

Chapter- Four: market structure
4.1 Competitive Market Structure
4.2 Monopoly
4.4 Oligopoly Models
Chapter Contents

Chapter- Five:
Strategies and Tactics in Game Theory
Dominant Strategy
Nash Equilibrium
Non –cooperative games
Cooperative games
Sequential games
Introduction
Definition:
• Game theory is a bag of analytical tools designed to help
us understand the phenomena that we observe when
decision-makers interact.

• Game theory is the study of how rivals make decisions in

situations involving strategic interaction (i.e., move and
countermove) to achieve an optimal outcome.
Dominant Strategy
• A strategy is a decision rule that indicates what action a player will
take when confronted with a decision.
• A dominant strategy is a sort of game plan. It is a decision rule that the
player will apply when decisions about the next move need to be
made.
• Knowledge of that player’s strategy allows us to predict what course of
action that player will take when confronted with choices.
• The collection of strategies for each player is called a strategy profile.
• Strategy profiles are often depicted within curly braces { }. Each
strategy profile defines the outcome of the game and the payoffs to
each player.
Dominant Strategy …
• A strictly dominant strategy results in the largest payoff to a player
regardless of the strategy adopted by any other player.
• A payoff represents the gain or loss to each player in a game.
• In many respects, running a business is like playing a game of football
or chess.
• The objective of the game is to achieve an optimal outcome.
• As we will see, the best outcome often results when the players
cooperate. When cooperation is not possible, or illegal, then the
objective is to win the game. But, victory does not always go to the
strongest, or the fastest, or the most talented. Very often, victory
belongs to the player who best understands the rules and has the
superior game plan.
Dominant Strategy …
• Strategic decisions are those in which each person, in deciding what
actions to take, must consider how others might respond to that action.
• In general, all games involve social and economic interactions in which
the decisions made by one player affect, and are affected by, the
decisions made by other players.
• In game theory, decision makers are called players. Players make
decisions based on strategies. Players with the best strategies very
often win the game, although this does not always happen.
The gams strategy can be:
a) Simultaneous-move game/ static games, and
b) Sequential-move game
Dominant Strategy …
a) simultaneous-move game/ static games
• In a simultaneous-move game the players effectively move at the
same time. The distinguishing characteristic of a simultaneous-move
game is that no player is aware of the decisions of any other player
until after the moves have been made.
• The players of simultaneous-move games are not actually required
to move at the same time. Could also be played, for example, by
isolating the players in separate rooms. Communication between the
players is prohibited.
• The essential element of this game is that each player must move
without prior knowledge of the move of the other player.
Dominant Strategy …
b) Sequential-move game
• In a sequential-move game the players take turns.
Sequential-move games are sometimes referred to as
multistage or dynamic games.
• In a two player game, player A moves first, followed
by player B, followed again by player A, and so on.
Moreover, player A’s next move will be based on the
knowledge of how player B moved in response to
player A’s last move, and so on.
Dominant Strategy …

• One-shot games are played only once.

• Repeated games are played more than once.

In many ways running a business is like playing a game. In a competitive

environment, the objective is to win the game.

• Game theory is the study of how rivals make decisions in situations

involving strategic interaction (move and countermove). In other words,
game theory refers to process by which the strategic behavior of the
players is modeled.
Non –cooperative games

NONCOOPERATIVE, SIMULTANEOUS-MOVE, ONE-SHOT GAMES

• In a non-cooperative game the two players do not engage in
collusive behavior. In other words, the two players do not
conspire/collaborate to “rig” the final outcome.
• The Prisoners’ Dilemma is an example of a two-person, non-
cooperative, simultaneous-move, one-shot game in which both
players have a strictly dominant strategy, that is, one that
results in the largest payoff regardless of the strategies
adopted by any other player.
 Non –cooperative games …
• An example of a simultaneous-move game would be the children’s game rock–
paper–scissors. In this game, both players are required to recite in unison the words
“rock, paper, scissors.” When they say the word “scissors” both are required to
simultaneously show a rock (fist), a paper (open hand), or a scissors (index and middle
finger separated).
• The winner of the game depends on what each player shows. If one player shows
rock and the other player shows scissors, then rock wins because rock breaks
scissors. If one player shows rock and the other player shows paper, then paper
wins because paper covers rock. If one player shows scissors and the other player
shows paper, then scissors wins because scissors cut paper.
• Strictly speaking, it is not absolutely necessary that both players actually move at
the same time. The important thing is that neither player knows what the other
player plans to show until both have moved. It is only necessary that neither player
be aware of the decision of the other player until after both have moved.
Non –cooperative games …
What the one player gains, the other player loses

0, 0 -1, 1 1, -1

1, -1 0, 0 -1, 1

-1, 1 1, -1 0, 0
Non –cooperative games …
• The Prisoners’ Dilemma is a two-person, simultaneous-move, non-cooperative,
one-shot game in which each player adopts the strategy that yields the largest
payoff, regardless of the strategy adopted by the other player.
• Two individuals are taken into custody by the police following the robbery of a
store, but after of the treasure has been disposed of. Although the police
believe the suspects to be guilty, they do not have enough evidence to convict
them. In an effort to extract a confession, the suspects are taken to separate
rooms and interrogated/questioned. If neither individual confesses, the most that
either one can be convicted of is loitering at the scene of the crime, which carries
a penalty of 2 years in jail. On the other hand, if one confesses and turns state’s
evidence against the other, the person who talks will be in jail for only 1 year,
while the other will receive 10 years in prison. Finally, if both suspects confess,
both will be convicted, but because of a lack of evidence (the stolen items
having been disposed of prior to their arrest) the penalty is 6 years on the
lesser charge of breaking and entering.
• Payoff matrix for the Prisoners’ Dilemma bellow
Example 1: Payoff matrix for the Prisoners’ Dilemma
(Normal Form of Simultaneous Move Game)
Martha’s options

Don’t Confess Confess

Peter’s Don’t Confess M: 2 years M: 1 year

Options P: 2 years P: 10 years
Confess M: 10 years M: 6 years
P: 1 year P: 6 years

What is Peter’s best option if Martha doesn’t confess? Confess (1<2)

What is Peter’s best option if Martha confess? Confess (6<10)
Example 1: Payoff matrix for the Prisoners’ Dilemma

Martha’s options

Don’t Confess Confess

Peter’s Don’t Confess M: 2 years M: 1 year

Options P: 2 years P: 10 years
Confess M: 10 years M: 6 years
P: 1 year P: 6 years

What is Martha’s best option if Peter doesn’t confess? Confess (1<2)

What is Martha’s best option if Peter Confesses? Confess (6<10)
Example 1: Payoff matrix for the Prisoners’ Dilemma

First Payoff in each “Box” Martha’s options

is Row Player’s Payoff .
Don’t Confess Confess

Peter’s Don’t Confess 2 years , 2 10 years , 1 year

Options years
Confess 1 year , 10 6 years , 6 years
years
Dominant Strategy – A strategy that results in the highest payoff to a
player regardless of the opponent’s action.
Example 2: Price Setting Game

Firm B’s options

Low Price High Price

Firm A’s Low Price 0,0 50 , -10

Options
High Price -10 , 50 10 , 10

Is there a dominant strategy for Firm B? Low Price

Is there a dominant strategy for Firm A? Low Price
Nash Equilibrium
• John Forbes Nash Jr. who, along with John Harsanyi and Reinhard
Selten, received the 1994 Nobel Prize in economic science for
pioneering work in game theory.
• Nash created quite a stir in the economics profession in 1950, when
he first proposed his now famous solution to non-cooperative games,
which he called a “fixed-point equilibrium.”
• A Nash equilibrium occurs in a non-cooperative game when each
player adopts a strategy that is the best response to what is believed
to be the strategy adopted by the other players. When a game is in
Nash equilibrium, neither player can improve the payoff by
unilaterally changing strategies.
Nash Equilibrium
• A Nash equilibrium is a condition describing a set of strategies in
which no player can improve her payoff by unilaterally
changing her own strategy, given the other player’s strategy.
(Every player is doing the best they possibly can given the other
player’s strategy.)

• The Prisoners’ Dilemma provides some very important insights into

the strategic behavior of oligopolists. Suppose that firm A and
firm B are confronted with the decision to charge a “high” price
or a “low” price for their product.
Example 1: Nash?
Martha’s options

Don’t Confess Confess

Peter’s Don’t 2 years , 2 10 years , 1

Options Confess years year
Confess 1 year , 10 6 years , 6
years years

Nash Equilibrium: (Confess, Confess) 21

Example 2: Nash?

Firm B’s options

Low Price High Price

Firm A’s Low Price 0,0 50 , -10

Options
High Price -10 , 50 10 , 10

Nash Equilibrium: (Low Price, Low Price) 22

Mixed Strategies
Cooperative games
• Instead of playing purely Up or Down, Player A selects a
probability distribution (pU,1-pU), meaning that with
probability pU Player A will play Up and with probability 1-
pU will play Down.

• Player A is mixing over the pure strategies Up and Down.

• The probability distribution (pU,1-pU) is a mixed strategy for

Player A.
Mixed Strategies

• Similarly, Player B selects a probability distribution (pL,1-

pL), meaning that with probability pL Player B will play
Left and with probability 1-pL will play Right.

• Player B is mixing over the pure strategies Left and

Right.

• The probability distribution (pL,1-pL) is a mixed strategy

for Player B.
Mixed Strategies

Player B
L R
U (1,2) (0,4)
Player A
D (0,5) (3,2)

This game has no pure strategy Nash equilibria but it

does have a Nash equilibrium in mixed strategies.
How is it computed?
Mixed Strategies

Player B
L,pL R,1-pL

U,pU (1,2) (0,4)

Player A
D,1-pU (0,5) (3,2)
Mixed Strategies
Player B
L,pL R,1-pL
U,pU (1,2) (0,4)
Player A
D,1-pU (0,5) (3,2)

If B plays Left her expected payoff is 2pU  5(1  pU )

Mixed Strategies
Player B
L,pL R,1-pL

U,pU (1,2) (0,4)

Player A
D,1-pU (0,5) (3,2)

If B plays Left her expected payoff is 2pU  5(1  pU ).

If B plays Right her expected payoff is 4pU  2(1  pU ).
Mixed Strategies
Player B
L,pL R,1-pL
U,pU (1,2) (0,4)
Player A
D,1-pU (0,5) (3,2)
If 2pU  5(1  pU )  4pU  2(1  pU ) then

B would play only Left. But there are no

Nash equilibria in which B plays only Left.
Mixed Strategies
Player B
L,pL R,1-pL
U,pU (1,2) (0,4)
Player A
D,1-pU (0,5) (3,2)

If 2pU  5(1  pU )  4pU  2(1  pU ) then

B would play only Right. But there are no
Nash equilibria in which B plays only Right.
Mixed Strategies
Player B
L,pL R,1-pL
U,pU (1,2) (0,4)
Player A
D,1-pU (0,5) (3,2)

So for there to exist a Nash equilibrium, B

must be indifferent between playing Left or
Right; i.e. 2pU  5(1  pU )  4pU  2(1  pU )
Mixed Strategies
Player B
L,pL R,1-pL
U,pU (1,2) (0,4)
Player A
D,1-pU (0,5) (3,2)

So for there to exist a Nash equilibrium, B

must be indifferent between playing Left or
Right; i.e. 2p U  5(1  p U )  4 p U  2(1  p U )
 p U  3 / 5.
Mixed Strategies
Player B
L,pL R,1-pL
3
U, 5 (1,2) (0,4)
Player A 2
D, (0,5) (3,2)
5
So for there to exist a Nash equilibrium, B
must be indifferent between playing Left or
Right; i.e. 2p U  5(1  p U )  4 p U  2(1  p U )
 p U  3 / 5.
Mixed Strategies
Player B
L,pL R,1-pL

U,
3 (1,2) (0,4)
Player A 5
D, 2 (0,5) (3,2)
5
Mixed Strategies
Player B
L,pL R,1-pL
3
U, 5 (1,2) (0,4)
Player A 2
D, (0,5) (3,2)
5

If A plays Up his expected payoff is

1  pL  0  (1  pL )  pL .
Mixed Strategies
Player B
L,pL R,1-pL
3
U, (1,2) (0,4)
5
Player A 2
D, (0,5) (3,2)
5

If A plays Up his expected payoff is

1  pL  0  (1  pL )  pL .
If A plays Down his expected payoff is
0  pL  3  (1  pL )  3(1  pL ).
Mixed Strategies
Player B
L,pL R,1-pL
3
U, 5 (1,2) (0,4)
Player A 2
D, (0,5) (3,2)
5
If p L  3(1  p L ) then A would play only Up.
But there are no Nash equilibria in which A
plays only Up.
Mixed Strategies
Player B
L,pL R,1-pL
3
U, 5 (1,2) (0,4)
Player A 2
D, (0,5) (3,2)
5
If p L  3(1  p L ) then A would play only
Down. But there are no Nash equilibria in
which A plays only Down.
Mixed Strategies
Player B

L,pL R,1-pL
3
U, 5 (1,2) (0,4)
Player A 2
D, (0,5) (3,2)
5
So for there to exist a Nash equilibrium, A
must be indifferent between playing Up or
Down; i.e. p L  3(1  p L )
Mixed Strategies
Player B
L,pL R,1-pL
3
U, 5 (1,2) (0,4)
Player A 2
D, (0,5) (3,2)
5
So for there to exist a Nash equilibrium, A
must be indifferent between playing Up or
Down; i.e. pL  3(1  pL )  pL  3 / 4.
Mixed Strategies
Player B
3 1
L, 4 R, 4
3
U, 5 (1,2) (0,4)
Player A 2
D, (0,5) (3,2)
5
So for there to exist a Nash equilibrium, A
must be indifferent between playing Up or
Down; i.e. pL  3(1  pL )  pL  3 / 4.
Mixed Strategies
Player B
3 1
L, 4 R, 4
3
U, 5 (1,2) (0,4)
Player A 2
D, (0,5) (3,2)
5

So the game’s only Nash equilibrium has A

playing the mixed strategy (3/5, 2/5) and has
B playing the mixed strategy (3/4, 1/4).
Mixed Strategies
Player B
3 1
L, 4 R, 4
3
U, 5 (1,2) (0,4)
Player A 9/20
2
D, (0,5) (3,2)
5

The payoffs will be (1,2) with probability

3 3 9
 
5 4 20
Mixed Strategies
Player B
3 1
L, 4 R, 4
U,
3 (1,2) (0,4)
Player A
5 9/20 3/20
2
D, (0,5) (3,2)
5

The payoffs will be (0,4) with probability

3 1 3
 
5 4 20
Mixed Strategies
Player B
3 1
L, 4 R, 4
U,
3 (1,2) (0,4)
Player A
5 9/20 3/20
D,
2 (0,5) (3,2)
5 6/20
The payoffs will be (0,5) with probability
2 3 6
 
5 4 20
Mixed Strategies
Player B
3 1
L, 4 R, 4
U,
3 (1,2) (0,4)
Player A
5 9/20 3/20
D,
2 (0,5) (3,2)
5 6/20 2/20
The payoffs will be (3,2) with probability
2 1 2
 
5 4 20
Mixed Strategies
Player B

L,
3 R,
1
4 4
3 (1,2) (0,4)
U,
9/20 3/20
Player A 5
2 (0,5) (3,2)
D,
6/20 2/20
5
Mixed Strategies
Player B
3 1
L, 4 R, 4
U,
3 (1,2) (0,4)
Player A
5 9/20 3/20
D,
2 (0,5) (3,2)
5 6/20 2/20
A’s expected Nash equilibrium payoff is
9 3 6 2 3
1  0  0  3  .
20 20 20 20 4
Mixed Strategies
Player B
3 1
L, 4 R, 4
3 (1,2) (0,4)
U, 5
Player A 9/20 3/20
2 (0,5) (3,2)
D,
5 6/20 2/20
A’s expected Nash equilibrium payoff is
9 3 6 2 3
1  0  0  3  .
20 20 20 20 4
B’s expected Nash equilibrium payoff is
9 3 6 2 16
2  4  5  2  .
20 20 20 20 5
How Many Nash Equilibria?
• A game with a finite number of players, each
with a finite number of pure strategies, has at
least one Nash equilibrium.

• So if the game has no pure strategy Nash

equilibrium then it must have at least one mixed
strategy Nash equilibrium.
 Chapter-6
National Income Accounting;
Balance of Payments Accounting
Income, Product, and Expenditure
Three Approaches to Measuring National Economic Activity
■ The expenditure approach : it examines how much is spent on
demand for final goods and services. The key measure is GNE.
■ The product approach : it measures the value of all goods and
services produced as output minus the value of goods used as
inputs in production. The key measure is GDP.
■ The income approach focuses : it tracks the amount of income they
receive. The key measures are gross national income GNI and
gross national disposable income GNDI.
Income, Product, and Expenditure
From GNE to GDP: Accounting for Trade in Goods and Services
■ Personal consumption expenditures (usually called “consumption”)
equal total spending by private households on final goods and
services, including nondurable goods such as food, durable goods,
and services.
■ Gross private domestic investment (usually called “investment”)
equals total spending by firms or households on final goods and
services to make additions to the stock of capital.
Investment includes construction of a new house or a new factory,
the purchase of new equipment, and net increases in inventories of
goods held by firms (i.e., unsold output).
Income, Product, and Expenditure
From GNE to GDP: Accounting for Trade in Goods and Services
■ Government consumption expenditures (often called
“government consumption”) (G) equal spending by the public
sector on final goods and services, including spending on public
works, national defense, the police, and the civil service.
Government consumption does not include any transfer payments
or income redistributions, such as Social Security or
unemployment insurance payments—these are not purchases of
goods or services, just rearrangements of private spending
power.
Measuring Macroeconomic Activity
The Flow of Payments in a Closed Economy:
Introducing the National Income and Product Accounts
• Gross national expenditure (GNE) is the total expenditure
on final goods and services by home entities in any given
period (C + I + G).
• A country’s gross domestic product (GDP) is the value of
all (intermediate and final ) goods and services produced
as output by firms, minus the value of all goods and
services purchased as inputs by firms.
• Intermediate products are used as inputs in the production of some other product.
• Final output – goods and services purchased for final use.
Measuring Macroeconomic Activity
The Flow of Payments in a Closed Economy:
Introducing the National Income and Product Accounts

• GDP is a product measure, in contrast to GNI, which is

an income measure.
• In a closed economy, income is paid to domestic
entities. It thus equals the total income resources of the
economy, also known as gross national income (GNI).
Measuring Macroeconomic Activity

The Closed Economy

Measurements of national
expenditure, product, and
income are recorded in the
national income and product
accounts, with the major
categories shown. The purple
line shows the circular flow of
all transactions in a closed
economy.
Income, Product, and Expenditure
From GNE to GDP: Accounting for Trade in Goods and Services
 
 
GDP
  C

I 
G   EX  IM
 
Gross Gross  finalAll exports, All imports, 
domestic
product
national  & intermedia te final

&

intermediate
expenditure
GNE Trade balance
TB

This important formula for GDP says that gross domestic product is equal
to gross national expenditure (GNE) plus the trade balance (TB).
The trade balance, TB, is also often referred to as net exports. Because
it is the net value of exports minus imports, it may be positive or
negative.
If TB > 0, exports are greater than imports and we say a country has a trade surplus.
If TB < 0, imports are greater than exports and we say a country has a trade deficit.
Measuring Macroeconomic Activity
The Flow of Payments in an Open Economy: Incorporating the
Balance of Payments Accounts
• The difference between payments made for imports and payments received for
exports is called the trade balance (TB), and it equals net payments to domestic
firms due to trade. GNE plus TB equals GDP, the total value of production in the
home economy.
Income, Product, and Expenditure
From GDP to GNI: Accounting for Trade in Factor Services
• Gross national income equals gross domestic product (GDP)
plus net factor income from abroad (NFIA).

GNI  C  I G  ( EX  IM )  ( EX FS  IM FS )
     
Gross national expenditure Trade balance Net factor income from abroad
GNE TB NFIA

GDP
Measuring Macroeconomic Activity
The Flow of Payments in an Open Economy: Incorporating the
Balance of Payments Accounts
• The value of factor service exports minus factor service imports is known
as net factor income from abroad (NFIA), and thus GDP plus NFIA
equal GNI, the total income earned by domestic entities from all
sources, domestic and foreign.
Measuring Macroeconomic Activity
The Flow of Payments in an Open Economy: Incorporating the
Balance of Payments Accounts
• Gifts may take the form of income transfers or “in
kind” transfers of goods and services. They are
considered nonmarket transactions, and are
referred to as unilateral transfers.
• Net unilateral transfers (NUT) equals the value of
unilateral transfers the country receives from the rest
of the world minus those it gives to the rest of the
world.
Income, Product, and Expenditure
From GNI to GNDI: Accounting for Transfers of Income
If a country receives transfers worth UTIN and gives transfers worth UTOUT, then
its net unilateral transfers, NUT, are NUT = UTIN − UTOUT. Because this is a net
amount, it may be positive or negative.
Adding the impact of net unilateral transfers to gross national Income, we
obtain a full measure of national income in an open economy, known as gross
national disposable income (GNDI), henceforth denoted Y:

Y  C  I  G   ( EX  IM )  ( EX FS  IM FS )  (UT  UT )
GNDI
      
 
         
GNE Trade Net factor income
balance from abroad Net unilateral
(TB ) ( NFIA) transfers


 (NUT )
GNI
Measuring Macroeconomic Activity
The Flow of Payments in an Open Economy: Incorporating the
Balance of Payments Accounts
• These net transfers have to be added to GNI to calculate gross national
disposable income (GNDI). Thus, GNI plus NUT equals GNDI, which represents
the total income resources available to the home country.
Income, Product, and Expenditure
From GNI to GNDI: Accounting for Transfers of Income
Major Transfer Recipients The chart
shows average figures for 2000 to
2008 for all countries in which net
unilateral transfers exceeded 15% of
GNI. Many of the countries shown
were heavily reliant on foreign aid,
including some of the poorest countries
in the world such as Liberia, Burundi,
Eritrea, and Nepal. Some countries
with higher incomes also have large
transfers because of substantial
migrant remittances from a large
number of emigrant workers overseas,
for example, Tonga, Jordan, El
Salvador, and Cape Verde.
Measuring Macroeconomic Activity
The Flow of Payments in an Open Economy: Incorporating the Balance of
Payments Accounts
The current account
(CA) is a tally of all
international
transactions in goods,
services, and income
(occurring through
market transactions
or transfers).
Income, Product, and Expenditure
Understanding the Data for the National Economic Aggregates
U.S. Economic Aggregates in 2016 The table shows the computation of GDP, GNI, and
GNDI in 2016 in billions of dollars using the components of gross national expenditure,
the trade balance, international income payments, and unilateral transfers.
Income, Product, and Expenditure
What the Current Account Tells Us

Y  C  I  G  CA
• This equation is the open-economy national income identity. It tells us that
the current account represents the difference between national income Y
(or GNDI) and gross national expenditure GNE (or C + I + G ). Hence:
• GNDI is greater than GNE if and only if CA is positive, or in
surplus.
• GNDI is less than GNE if and only if CA is negative, or in
deficit.
Income, Product, and Expenditure
What the Current Account Tells Us
• The current account is also the difference between national
saving (S = Y − C − G) and investment:

S
  I  CA
Y C G

• This equation is called the current account identity even though it

is just a rearrangement of the national income identity. Thus,
• S is greater than I if and only if CA is positive, or in surplus.
• S is less than I if and only if CA is negative, or in deficit.
APPLICATION
Global Imbalances
• We define private saving Sp as that part of after-tax private sector
disposable income Y that is not devoted to private consumption C. Hence,
private saving Sp is
Sp  Y  T  C
• We define government saving as the difference between tax revenue T
received by the government and government purchases G. Hence,
government saving Sg equals
S T G
g

• Private saving plus government saving equals total national saving, since
S  Y  C  G  (Y  T  C )  (T  G )  S p  Sg
 
Private saving Government saving
APPLICATION
Global Imbalances
Do government deficits cause current account deficits? Sometimes they do go
together, but these “twin deficits” are not inextricably linked, as is sometimes
believed. We can use the equation just given and the current account identity
to write
CA  S p  Sg  I
The theory of Ricardian equivalence asserts that a fall in public saving is fully
offset by a contemporaneous rise in private saving. However, empirical studies
do not support this theory: private saving does not fully offset government
saving in practice.

APPLICATION
Global Imbalances
Global Imbalances
The charts show saving
(blue), investment (red),
and the current account
(beige) as a percent of
GDP.

© 2014 Worth Publishers International

Economics, 3e | Feenstra/Taylor
APPLICATION
Global Imbalances
Global Imbalances (continued)

In the 1990s,
emerging markets
moved into current
account surplus
and thus financed
the overall trend
toward current
account deficit of
the industrial
countries.
Note: Oil producers
include Norway.
APPLICATION
Global Imbalances
Global Imbalances (continued)

For the world as a

whole since the
1970s, global
investment and
saving rates have
declined as a
percent of GDP,
falling from a high
of near 26% to low
near 20%.
The Balance of Payments
Accounting for Asset Transactions: the Financial Account
• The financial account records transactions between residents and
nonresidents that involve financial assets.
• This definition covers all types of assets: real assets such as land or
structures, and financial assets such as debt (bonds, loans) or equity,
issued by any entity.
• Subtracting asset imports from asset exports yields the home country’s
net overall balance on asset transactions, which is known as the
financial account, where FA = EXA − IMA.
• The financial account therefore measures how the country accumulates
or deacumulates assets through international transactions.
The Balance of Payments
Accounting for Asset Transactions: the Capital Account

• The capital account (KA) covers two remaining areas of asset

movement of minor quantitative significance.
• One is the acquisition and disposal of nonfinancial, non-produced
asets (e.g., patents, copyrights, trade-marks, franchises, etc.).
• The other important item in the capital account is capital transfers
(i.e., gifts of assets), an example of which is the forgiveness of debts.
• We denote capital transfers received by the home country as KAIN
and capital transfers given by the home country as KAOUT. The capital
account, KA = KAIN − KAOUT, denotes net capital transfers received.
The Balance of Payments
Accounting for Home and Foreign Assets

• From the home perspective, a foreign asset is a claim on a

foreign country. When a home entity holds such an asset, it
is called an external asset of the home country.

• When a foreign entity holds such an asset, it is called an

external liability of the home country because it represents
an obligation owed by the home country to the rest of the
world.
Measuring Macroeconomic Activity
The Flow of Payments in an Open Economy: Incorporating the Balance
of Payments Accounts
• The value of asset exports minus asset imports is called the financial
account (FA). These net asset exports are added to home GNDI when
calculating the total resources available for expenditure in the home
country.
Measuring Macroeconomic Activity
The Flow of Payments in an Open Economy: Incorporating the Balance
of Payments Accounts
• A country may not only buy and sell assets but also transfer assets
as gifts. Such asset transfers are measured by the capital account
(KA), which is the value of capital transfers from the rest of the
world minus those to the rest of the world.
Measuring Macroeconomic Activity

The Open Economy Measurements of

national expenditure, product, and income
are recorded in the national income and
product accounts, with the major categories
shown on the left.
Measurements of international transactions
are recorded in the balance of payments
accounts, with the major categories shown
on the right.
The purple line shows the flow of
transactions within the home economy.
The green lines show all cross-border
transactions.
The Balance of Payments
Accounting for Home and Foreign Assets
• If we use superscripts “H” and “F” to denote home and foreign assets, we
can break down the financial account as the sum of the net exports of each
type of asset:

FA  ( EX  IM )  ( EX  IM )  ( EX  IM )  ( IM  EX )
H H F F H H F F
 A
  A
   
A A
 A A A A
Net export of home assets Net export of foreign assets Net export of home assets Net import of foreign assets
= =
Net additions to Net additions to
external liabilities external assets

• FA equals the additions to external liabilities (the home-owned assets moving

into foreign ownership, net) minus the additions to external assets (the foreign-
owned assets moving into home ownership, net).
The Balance of Payments
How the Balance of Payments Accounts Work: A Macroeconomic View
• Recall that gross national disposable income is

Y  GNDI  GNE  TB  NFIA  NUT  

GNE CA

Resources available
to home country from income
• In addition, the home economy can free up (or use up) resources in another
way: by engaging in net sales (or purchases) of assets. We can calculate
these extra resources using our previous definitions:
[ EX A  KAOUT ]  [ IM A  KAIN ]  EX A  IM A  KAIN  KAOUT  FA

KA

   
Value of Value of Value of Value of Extra resources available
all assets all assets all assets all assets to the home country
exported exported imported imported due to asset trades
as gifts
 as gifts


Value of Value of
all assets exported via sales all assets imported via purchases
The Balance of Payments
How the Balance of Payments Accounts Work:
A Macroeconomic View
• Adding the last two expressions, we arrive at the value of the total
resources available to the home country for expenditure purposes. This
total value must equal the total value of home expenditure on final
goods and services, GNE:

GNE CA
  FA

KA
  GNE
Resources available Extra resources available
to home country due to income to the home country
due to asset trades
• We can cancel GNE from both sides of this expression to obtain the
important result known as the balance of payments identity or BOP
identity:
CA
 + KA
 + FA
 = 0
Current account Capital account Financial account
The Balance of Payments
How the Balance of Payments Accounts Work: A Microeconomic View

• The components of the BOP identity allow us to see the details

behind why the accounts must balance.

CA  (EX  IM )  (EX FS  IM FS )  (UT UT )

KA  (KA  KA )
FA  (EX  IM )  (EX  IM )
H
A
H
A
F
A
F
A

• If an item has a plus sign, it is called a balance of payments

credit or BOP credit.
• If an item has a minus sign, it is called a balance of payments

debit or BOP debit.
The Balance of Payments
How the Balance of Payments Accounts Work: A Microeconomic
View
• We have to understand one simple principle: every
market transaction (whether for goods, services, factor
services, or assets) has two parts. If party A engages in a
transaction with a counterparty B, then A receives from B
an item of a given value, and in return B receives from A
an item of equal value.
The Balance of Payments
What the Balance of Payments Account Tells Us
• The balance of payments accounts consist of the current account,
which measures external imbalances in goods, services, factor
services, and unilateral transfers. The financial and capital
accounts measure asset trades.
• Surpluses on the current account side must be offset by deficits on
the asset side. Similarly, deficits on the current account must be
offset by surpluses on the asset side. By telling us how current
account imbalances are financed, the balance of payments makes
the connection between a country’s income and spending decisions
and the evolution of that country’s wealth.