University of Nizwa

ECON 101: Introduction to EconomicsCourse Notes

TEACHING & ASSESSMENT PLAN

1. College : CEMIS

2. Department : Economics

3. Semester : Spring 2012-2013

4. Course Code : ECON 101

5. Course Name : Introduction to Economics

6. Time Table Sections: 2, 3 & 6

Day Section – 2 Time venue Day Section – 6

Time

Venue

Sat 08:00 – 08.50 31-3 Sat 12.00 –

12.50

34/12

Mon 08:00 – 08.50 31-3 Mon 12.00 – 12.50

34/12

Wed 08:00 – 08.50 31-3 Wed 12.00 – 12.50

34/12

Section – 3 Time venue

Sun 12.30 – 01.45 31-3

Tue 12.30 – 01.45 31-3

7. Faculty Name : Mr. James Devassy Puthussery

8. Office No. : 11H-19

9. Telephone Ext. : 812

10. E-mail : jamespd@unizwa.edu.om

11. Office hours :

Day Time

Sat. to Wed. 10:00 – 11:00

Doc. Ref. No. Issue Version DateUoN-STC-T&A 1 June 2009

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12. Text Book & References :

Text Book References

Principles of Macro Economics, 3rd EditionN. Gregory Mankiv, Thomson

Introductory Books-available in the library &

through the university’s e-library system.

13. Course Description

Economics is concerned with how society determines what goods to produce, how to produce these goods, and who will get to consume these goods. This course will introduce students to how market economies work in answering these three basic questions. We begin by considering the fact that economics involves cooperation between the members of society. We then consider how this cooperation can be accomplished by individuals trading in markets. The demand for and supply of goods, then the determination of prices and market equilibrium .The next part of the course is concerned with macro economics. Macroeconomics is concerned with the overall performance of the economy. After defining the key macroeconomic variables, study the financial markets, investment, interest rates, the role of money, inflation, and business cycles.

13. Learning Outcomes

After course acquirement students should be able:

1. To understand the basic economic problems & to define Economics.

2 Know how market economies work in answering the three basic questions.

3

To understand the demand for, the supply of goods & the determination of

prices.

4 To calculate the gain from trade, the role of intermediaries in trade.

5 To understand the market equilibrium & application of the market model

6 Define the key macro economic variables.

7 Define the key macro economic variables.

14. Assessment Policy

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Assessment process takes direct and indirect measurements to ensure that learning

outcomes and program objectives have been achieved. The assessment includes quizzes,

tests, and discussions. The type of assessment is indicated in the weekly plan table and

the assessment details are as follows:

Assessment Details:

Assessment Percentage % Due / week

Quiz - 1 5 3rd

Quiz - 2 5 9th

Class Participation &

Attendance

5 1st To 16th

Mid exam -1 20 5th

Mid Exam -2 25 11th

Final Exams 40

Total

100

15. Plagiarism Policy:

As per the University Policy UoN-STC-CR-1-2009, the following actions (not limited to),

without proper attribution (quoting and/or referencing), will attract stringent penalties:

1. To copy the work of another student;

2. To directly copy any part of another person’s work;

3. To summarize another person’s work;

4. To use or develop an idea or thesis derived from another person’s work;

5. To use experimental results or data obtained or gathered by another person;

6. To demonstrate academic misconduct during an exam.

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16. Attendance Policy

As per the University Absentee Regulations Uon-RR-AP-1-2009, Absentee warning

notice will be issued to the student according to:

1. “Absentee Warning 1” has to be issued to a student who has missed 5% of course

contact hours.

2. “Absentee Warning 2” has to be issued to a student who has missed 10% of

course contact hours.

3. “Drop one Grade” has to be issued to a student who has missed 15% of course

contact hours.

4. “Barred from Examination” has to be issued to a student who has missed 25%

of course contact hours.

17. Weekly Teaching & Assessment Plan

Week No Topic Course Outcome Assessment of Outcomes

1&2

Introduction: Economics as the Study of Social Cooperation. Social Cooperation and the Questions of Economics. The Three questions.Opportunity Cost, Scarcity The Benefits of Specialization, Social Cooperation Need to Answer the Questions. Social Cooperation vs. Personal Cooperation. Cooperation by Command& Voluntary Cooperation Through Trade.

Key terms

&Definitions of

Economics. Able to

understand the basic

problems of the

economy. Know

how market

economies work in

answering the three

basic questions.

Discussion/Participation. Quiz,Mid Exams & Final Exam

3&4

Trade and Specialization, Gains from Trade, Voluntary Trade and Wealth Creation. Private Property as a Requirement for Trade.Transaction Costs and TradeTrade, Trust, Contract Enforcement and the Rules of the GameThe Role of Intermediaries.

Able to understand

how to calculate the

gain from trade &

the role of

intermediaries in

trade.

Discussion, Quiz,Mid Exams & Final Exam

5&6 Discussion,

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FACULTYMr James Devassy Puthussery

___________________________Signature

Date : January 27, 2013

HEAD OF DEPARTMENT

Dr Dennis Powers

____________________________Signature

Date : January 27, 2013

Microeconomics: Markets as a Method of Social Cooperation. Supply and Demand Model of a Market. Opportunity Costs and Supply. Substitutes and Demand. The Market Equilibrium and Social Cooperation

To understand the

demand for goods. To

understand the supply

of goods and the

determination f prices

Quiz,Mid Exams&Final Exam

8&9

Applications of the Market Model. Shifts in Demand & Shifts in Supply

To understand the

market equilibrium

&application of the

market model

Discussion, QuizMid Exam & Final Exam

10&11

Macroeconomics &Social cooperation Understanding Macroeconomic Data. Gross Domestic Product. .Price Indices. National income Identity.

Able to define the

key macro economic

variables.

Discussion, Quiz, Mid exam & Final Exam

12&13

Financial Markets and Interest Rates. The Role of Financial Institutions and Markets.

To provide information about the financial markets, investment.

Discussion/Participation & Final Exam

14,15&16

Loanable Funds Model and the Interest Rate. Money and Prices. The Role of Money. Money Market Model. Price and Inflation in the Long-Run .Interest Rates in the Short-Run. Economic growth &Business cycle

The role of money, interest rates, inflation, Economic growth&Business cycles.

Discussion,

Presentation&

Final Exam

17&18 Final Examination Week

Part I - Basic Concepts- Chapter 1

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Dean’s Endorsement.................................................................. Date................................

Origin of the word “Economics”

The word Economics is derived from the Greek word: “Oekov Nomia” which means ‘principles (norms) of household management’. In the modern sense, it refers to the management of the economy’s (country’s) resources.

What is Economics? Definitions of Economics

1) Wealth Definition of Adam Smith: (Father of Economics)

"Economics is the science which studies the nature and cause of the wealth of nations". His book: “Wealth of Nations”, Published in 1776

2) Welfare Definition -Alfred Marshall: ‘Principles of Economics’ published in 1890.

For the well being or welfare of people

3. Scarcity definition of EconomicsProf. Lionel Robbins of the London School of Economics in his challenging book "An Essay on the Nature and Significance of Economic Science" published in 1932 introduces his scarcity definition of Economics. According to him "Economics is the science which studies human behavior as a relationship between ends and scarce means which alternative uses.'' 1. 'Ends' refer to wants. Human wants are unlimited in number.

2. The means at the disposal of every individual arc limited or scarce compared to

his wants

3. The limited means have alternative uses. It means that it can he put to different

uses.

4. Owing to the multiplicity of wants, the scarcity of resources and the alternative uses

of the scarce resources one is compelled to choose the most urgent wants for

immediate satisfaction.

The Basic Economic Problem(Based on Lionel Robbins’ definition)

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Wants (demands) Resources (means) Unlimited & recurring (repeated) Limited (scarce) Differ in importance (priorities) Alternative (other) uses

Algebra of ChoiceThe Four Factors of Production with their rewards

LAND (Rent)

(Entrepreneurship) Labor (Wages) ORGANIZATION (Profit / Loss)

CAPITAL (Interest)

Define Factors of Production.Resources or inputs used to produce goods & services such as land, labor, capital and

organization.

What are the four basic factors (agents) of production?

1) Land, Labor ,Capital, Entrepreneurship:

Micro Economics and Macro Economics

Economic Problem

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Production(Factory)

The two approaches to economic problems ie, micro and macro approaches have become

so common and meaningful that economic theory is divided into –Micro economics and

Macro economics .The words Micro and Macro Economics were coined by the

economist Ragner Frisch in 1933.The words Micro and Macro are derived from the

Greek word ‘mikros’ meaning small and ‘makros’ meaning large.

Micro economics is the study of particular firms, particular house holds,

individual prices, wages, incomes, individual industries, particular commodities etc. It

explains how a consumer derives maximum satisfaction out of his expenditure, how a

firm maximizes its profits, how the national out put is distributed among the owners of

the factors of production etc. In short it is a study of the individual units in the whole

system.

Macro Economics is a study of the economic system as a whole, it deals with the

aggregates and averages of the system and examines how they are related and determined.

Naturally, it is a study of the great variables or aggregates such as national income,

national output, total production, total consumption, total investment, the volume of

employment, the general price level, government expenditure etc.

Micro Economics Macro Economics

It is centered on "prices and markets". It is concerned with the fluctuations in the

national income, output and employment.

It takes a worm’s eye view of a specific

component of the entire economic system.

It takes a bird's eye view of the

entire economic system

A particular study. A general study

It aims at the optimum allocation of

resources

It wants the fuller employment and growth

of resources.

Depends on Macro Economics analysis Depends on Micro Economics analysis

Micro Economics deals with “parts” of the

economy.

Study of the economy as a whole.

Economics can be defined as:

The study of how society satisfies unlimited desires with limited resources.

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The above definition of economics shows that there are limits to what we can produce, but our desires have no limits. This implies we, as society, must make choices on how we use our scarce resources. In a sense, this is no different from any individual. If a person earns OR 1,000 per month, they must make choices on how to spend this money. In the same way, society must choose how to use its resources (land, labor, natural resources) to meet the desires of its people.

One word that keeps appearing is the word choice, or choose. That is, economics is about the study of how choices are made. At one level we are interested in the choices individuals make, but ultimately we are interested in the choices society makes.

The Three Big QuestionsWhen we talk about making choices on how to use resource to meet people’s desires, we can break it into three separate choices, or questions.

1. What to Produce?2. How to Produce?3. For Whom to Produce?

1. What to Produce?The choice of what to produce is the choice of how much of each good to produce. For instance, do we want more food or more automobiles or more housing, and so on? The most important thing to realize though is that we cannot have more of everything. In fact, if we want more of one good we must take resources away from other goods, which means we will have less of other goods. So if we decide we want more housing, this means we will have less food, automobiles, etc. This is the choice we have in mind when we ask the question of “What to Produce?”.

2. How to Produce?The choice of how to produce is based on realizing that there are different ways to accomplish the same thing. For instance, suppose we decide we want five houses built. How much labor should be used to produce these houses? How much machinery should be used to produce these houses? What land should these houses be placed on? Thus when we ask “How to Produce?” we are asking how to combine resources to produce those goods we desire.

3. For Whom to Produce?The choice of for whom to produce relates to who will get to consume the goods once produced. For example, we may decide to build five houses, we may decide how to build these houses, but then we have to decide who will live in those five houses. This is the question of for whom to produce.

An Aside on Two TermsOpportunity CostWith the concept of choice comes the concept of opportunity cost. Opportunity cost is defined as the best alternative sacrificed when a choice is made. Every decision one makes involves an opportunity cost. For instance, if you decide to buy a car then you cannot spend that money on something else. Whatever else you would have spent the money on is your opportunity cost. Just like choices apply to both individuals and society, so also opportunity cost applies to both individuals and society. If we, as society, decide to expand the housing production by ten percent, then the opportunity cost of the new housing is whatever the next best alternative we could have produced with the resources that were used to produce the new housing. Whenever we use the term cost in economics, we always mean opportunity cost; what did society sacrifice when a choice was made.

Scarcity

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Associated with the concept of cost is the concept of scarcity. Scarcity, or its root word scarce, is used to describe a situation in which little of a good is available. But, one could ask, little relative to what. And one answer is relative to how much people value the good. That is, those goods that people value a great deal will be relatively scarce. However, those goods that people place a low value on are relatively less scarce. Little of a good is available also the resources required are not easily available (either because they are physically less available or because there is much competition over their use). Hence we see scarcity of a good depends on the value people place on the good, and on the cost of producing the good.

Benefits of Specialization When we consider the three big questions all societies must answer, a question that arises is why are these societal questions? Why cannot everyone just answer these questions for themselves? That is, why can I not decide for myself exactly how much of each good I will produce for myself, how to produce these goods, and then I consume them all. In this case, every individual is simply produces for themselves; there is no societal aspect to this economic problem. The reason these questions are at the societal level is because of the benefits of specialization. Specialization is when everybody produces just one thing; the thing at which they are best producing. If everyone specializes in production, the total amount of goods and services will be increased. Hence all modern economies have specialization.

To understand this better suppose that no one specialized in production. That means everyone must produce the goods that they consume. So you must build your own home, grow your own food, make your own clothes, etc. While you may be good at building homes, you may also be terrible at making clothes. So you must take time away from what you are good at to do something you are not good at.

Now if people specialize in what they are best at, total production will rise. For instance, if you specialize in building homes while those who are best at producing clothes specialize in making clothes, then there will be more homes and clothes for everyone. For this reason all modern economies rely on specialization in production.

It is clear that once we specialize social cooperation is necessary. This is for two reasons. First, after all the goods are produced there must be some system by which we decide who gets to consume the various goods. This takes cooperation between the members of society. Second, how can we say who is best a producing a particular good unless we compare that person to another person in society. In an economy of millions of people, knowing who should specialize in what becomes a crucial question for society.

The Need for Social CooperationAs stated above, the three questions are societal questions because it is benefit to have specialization. But the very fact that these are questions for society implies the people in a society must cooperate with each other to answer these questions. That is, there must be some system in which millions of people cooperate in the production and consumption of goods. Hence the desire for specialization necessarily implies there must be social cooperation.

But how does society (i.e. millions of people) make choices? How do millions of people come to agree on what to produce, who will produce which goods, and who will consume the goods? How does such social cooperation occur?

Social vs. Personal CooperationWe are all familiar with the concept of cooperation. For instance, you cooperate with friends when you decide what to do. Or perhaps you cooperate with your family in making decisions. In these cases you are cooperating with few people, and with people you know quite well. This

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cooperation we can call personal cooperation. This is not what we mean when we say social cooperation. Social cooperation differs in two ways. First, you are cooperating with all members of society; millions of people. Second, you do not know them at all. These differences make social cooperation much more difficult to achieve.

Methods of Social CooperationThere are two primary methods of social cooperation as applied to economics. The first is cooperation by command. Cooperation by command means a central organizer instructs everyone as to what they must do, or not do, to cooperate. The central organizer would tell people what goods to produce, what to consume, etc.

The other method is voluntary cooperation through trade. A trade is simply an exchange of goods between a buyer and seller. Notice the very nature of trade makes it voluntary. That is, you do not have to sell a good if you do not want to. Similarly, a buyer does not have to buy a good if they do not want to. Voluntary social cooperation simply means that people only agree to this cooperation if they choose to. Hence people individually decide what trades to enter into. The fact that they decide for themselves makes this appear that there is no cooperation at all. But this is not so. It just means that the cooperation is not intentional. That is, their individual decisions are not made with the intention of social cooperation, but nevertheless that is what happens.

The primary question in economics is which method of social cooperation is better at answering the three basic questions in economics; or under what conditions is one system better than the other.

Sample Questions for Section I.AFill in the Blank

1. Economics is the study of how man satisfies _______________ desires, with _____________

resources.

2. Anything that is used to help satisfy a desire, or produce a good, is a _______________.

3. The fact that resources are limited, but desires are unlimited, implies that society must make

______________ regarding how to best use resources.

4. The choices society must make can be expressed as three big questions any society must answer.

These are

(i) _____________ to Produce?

(ii) _____________ to Produce?

(iii) _____________ to Produce?

5. Whenever a choice is made, we must sacrifice the most highest valued alternative. This is known

as _______________ cost.

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6. A good is more scarce if it is physically ______ available, or if the desire for the good is

_________.

7. The best answer to the question of “For Whom to Produce” is we should give the good to those

who ________ the good the most.

8. The best answer to the question of “How to Produce” is we should produce the good in the

__________ opportunity cost manner possible.

9. The best answer to the question of “What to Produce” is we should produce goods that have

________ value, but also have ____ cost.

10. When each person produces the one good they are best at producing this is known as

____________________.

11. Specialization requires ____________ cooperation because society must decide ____ will

specialize in each good, and then society must decide how the goods will be _________.

12. Cooperation by _______________ is when one person is in charge deciding who will specialize in

what, and how the goods will be shared.

13. ________________ cooperation through __________ is when each person decides for themselves

what to produce and what goods to consume.

CIRCLE THE CORRECT ANSWER

1. Economics is the study of how a. to run a successful businessb. to invest in the stock marketc. society uses limited resources to meet unlimited desiresd. All the above

2. Which of the following is not one of the three big questions every economy must answer?a. Why to Produce

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b. What to Producec. How to Produced. For Whom to Produce

3. The most highly value alternative sacrificed when a choice is made is known asa. scarcityb. the definition of economicsc. opportunity costd. none of the above

4. The greater the desire for the good, then the more scarce is that good.a. Trueb. False

5. Specialization is when each person produces the one thing they are best at producing.a. Trueb. False

6. If people in society specialize, thena. We must decide who will produce which goods.b. We must decide who will consume which goods.c. Social cooperation becomes necessary.d. All the above

7. Social cooperation by command is when people are told what to produce, how to produce and what to consume by a single person.

a. Trueb. False

8. Social cooperation through voluntary trade is when people decide for themselves what to produce, and then trade goods for the things they choose to consume.

a. Trueb. False

9. Under which system of social cooperation is someone in charge, deciding how to answer the three basic questions every economy must answer?

a. Social cooperation by commandb. Social cooperation through voluntary trade

Answers1. c 4. a 7. a2. a 5. a 8. a3. c 6. d 9. a

Short-Answer/Problem Solving Questions10. Suppose there is an increase in the number of hotels produced.

I. What resources are used to produce these extra hotels? II. What other goods could have been produced with these resources? III. What is the opportunity cost of these extra hotels?

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IntroductionB. Voluntary Trade and Wealth Creation

i. Gains from Tradeii. Trade and Specialization

Gains from TradeSuppose Person A owns a car that he values at 4,000. Person B values the same car at 5,500. There is then a 1,500 gain from trade. That is, if I take the car from A and give it to B, there would be a net 1,500 gain. That is, person A loses something worth 4,000 and person B gains something worth 5,500. Together, the net gain is 5,500 - 4,000 = 1,500.

Now will such a trade occur voluntarily? The trade occurs only if both A and B agree to trade at some price. And they will only do so if they are both better off. So the question is, can we find a price such both A and B are better off? The answer is yes.

To see this, note that Person A would accept any price greater than 4,000. Person B will pay any price less than 5,500. Hence trade will occur at some price between 4,000 and 5,500.

While the trade occurs at some price between 4,000 and 5,500, the gains from trade will always be 1,500, but the price determines how the 1,500 is split between A and B. Below are two possible prices showing the gains to A and B, and the total gain of 1,500.

Price = 4,500 Price = 5,000Person A’s Gain 4,500 – 4,000 = 500 5,000 – 4,000 = 1,000Person B’s Gain 5,500 - 4,500 = 1,000 5,500 – 5,000 = 500Total Gain 1,500 1,500

This demonstrates that trade creates gains by transferring goods to those that value the goods the most. We now turn our attention to how trade creates gains by increasing production in an economy.

Trade and Specialization

The Gains of SpecializationConsider a simple economy of two goods and two people. The two goods are food and clothing, and call the two people A and B. Now suppose that these two people can only consumer what they produce for themselves. Such a situation is referred to as autarky.

Is autarky a good situation? It is not if people differ in terms of talents, or productive abilities. To demonstrate consider the following example. Suppose person A is superior at producing clothing and person B is superior at producing food. In particular let us consider the following production possibilities for both people.

A’s Production Possibilities B’s Production PossibilitiesFood Clothing Food Clothing

50 0 0 5040 20 20 4030 40 40 3020 60 60 2010 80 80 100 100 100 0

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Consider first person A, if he specializes in food he produces 50 food, and 0 clothing. If he specializes in clothing, he produces 100 clothing and zero food. Let us compare him to person B. If B specializes in food he produces 100 food, and 0 clothing. If he specializes in clothing, he produces 50 clothing and zero food. So clearly, comparing A and B, we must conclude that A should specialize in clothing and B in food.

To see the benefits of this, let us compare to a situation of autarky; that is, in which no specialization occurs. Without specialization, both A and B must produce food and clothing if they are to consume both. Let us assume A produces 30 food and 40 clothing (the point bolded in the above table), while B produces 40 food and 30 clothing (also the point bolded in the above table). Hence total production is given below

Food ClothingA 30 40B 40 30Total 70 70

Thus without specialization, total food produced is only 70, and total clothing is only 70. With A specialized in clothing and B specialized in food, total production is 100 of each. The reason production is lower is that A is wasting his time producing good, when B is better at food production. And B is wasting his time producing clothing, when A is better at clothing production.

We need a system in which each produces what they are best at. However, they will only do this if they can share the goods afterward, since each want to consume both goods; that is, there must be a system of social cooperation in which each person specializes and then shares the goods with each other. This could be accomplished by central command, or by voluntary trade. Our focus is on how this sharing of goods is accomplished by voluntary trade, and how this leads to specialization.

With voluntary trade, no one trades unless it makes them better off. Hence a trade never occurs unless it makes both people better off. It would seem that it should be possible to make both A and B better off if they specialize. After all, production of each good will rise from 70 to 100. To show that they will indeed be better off through voluntary trade we need to first find prices of food for clothing so that both A and B will want to trade.

Sample Questions for Section I.BFill in the Blank

1. For trade to be voluntary, both the buyer and seller must ________.

2. Suppose person A owns a TV. He values it at 200. In this case he would be willing to sell the TV

for any price greater than ____.

3. Suppose person B likes person A’s TV and values it at 300. He would be willing to buy the TV for

any price less than _____.

4. In this case, a price that both A and B would agree to trade at any price between ____ and ____.

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5. Suppose A and B agree to trade at the price of 230. Then A’s gain from trade is ____, B’s gain

from trade is ____, and the total gain from trade is ____.

6. Consider another scenario in which person C owns a car which he values at 10,000. Person B

values the same car at 10,500. Is there a price such that trade occurs? ____.

7. In the above question, if trade occurs the total gains from trade is _____.

Consider the following when answering questions 8 – 13

A’s Production Possibilities B’s Production PossibilitiesDates Fish Dates Fish

0 75 75 010 60 60 1020 45 45 2030 30 30 3040 15 15 4050 0 0 50

8. If each person consumes only what they produce, and they do not trade, this is called __________.

9. Suppose in autarky each person produces 30 dates and 30 fish, as in bold above. Then total

production of dates is _______ and total production of fish is ______.

10. If person A specializes in fish and person B specializes in dates, then total production of dates is

_______ and total production of fish is ______.

11. If A specializes in fish his opportunity cost is ____ dates, and if B specializes in dates, his

opportunity cost is ____ fish.

12. Assuming A wants to eat both dates and fish, then he will specialize in fish only if the 75 fish he

produces can be traded for more than ____ dates (his opportunity cost).

13. Assuming B wants to eat both dates and fish, then he will specialize in dates only if the 75 he

produces can be traded for more than ____ fish (his opportunity cost).

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CIRCLE THE CORRECT ANSWER

Gains from Trade1. Voluntary trade implies no one is forcing another person to trade.a. Trueb. False

2. If trade is voluntary then a. both the buyer and seller must believe they are better off as a result of the trade.b. both the buyer and seller cannot be better offc. the buyer is better off, while the seller is worse offd. the seller is better off, while the buyer is worse off

3. Suppose Person A owns a computer that he values at OMR 400 and Person B values the computer at OMR 550. The total gains from trading this computer from A to B is

a. OMR 550b. OMR 150c. OMR 950d. OMR 400

4. In the example of question 3, which of the following is a price at which trade might occur?

a. 150b. 300c. 500d. 650

Gains from Trade and Specialization5. A person will only specialize in production of a good if he can trade it for the other

goods that he wants.a. Trueb. Falsec.

Consider the following production possibilities when answering questions 6-9.A’s Production Possibilities B’s Production PossiblitiesApples Oranges Apples Oranges

20 0 0 2015 10 10 1510 20 20 105 30 30 50 40 40 0

6. Person A should specialize in ________, and Person B should specialize in ______.a. Apples, Orangesb. Apples, Applesc. Oranges, Applesd. Oranges, Oran

ANSWERS1. a2. a3. b4. c5. a

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IntroductionC. Private Property as a Requirement for TradeD. Transaction Costs and Trade

i. Trade, Trust, Contract Enforcement and the Rules of the Gameii. Role of Intermediaries

Property RightsProperty Rights and TradeThere are three aspects of property rights:

1. The right to own a good or resource2. The right to transfer ownership of the good or resource3. The transfer of ownership (i.e. contracts) must be enforceable

Without property rights it is impossible to trade. That is, if no one owns a good, how can the good be sold or bought. Or even if ownership is established, if it is not possible to transfer ownership, then there can be no selling or buying of goods. So the first two aspects of property rights are required for trade to occur.

The third says that any transfer of ownership (i.e. trade) must be such that it is enforceable. This applies particularly to trades that occur over a period of time.

Many trades are accomplished over time as part of a long-term trading relationship. For example, a wholesaler of textile goods signs a contract to deliver a particular amount of textiles to a retailer for the next year. Because it takes place over time one party to the contract may find it advantageous to break the contract. For instance the retailer receives the good then does not make payment.

The wholesaler must have some method to enforce the contract. The reason for this is that if you cannot enforce a contract with someone else, that other person can break the contract. For instance the textile company delivers the textiles, but the retailer does not make payment. If this is likely the textile company would never agree to the contract in the first place, and hence the trade does not occur. In this case the economy does not experience the gains from trade because one cannot enforce contracts.

More generally we could say if contracts are costly to enforce, there will be less trades occurring, and we will not experience all the gains from trade. Hence contract enforcement is necessary for economic growth and development.

Transaction Costs

Importance of Transaction CostsTransaction costs are costs associated with making a trade occur. While there are many types of transaction costs, let us leave that issue behind so that we can focus on understanding the effect of transaction costs. Consider a simple trade to illustrate the problem created by transaction costs. Suppose A owns a car that he values at 3,000; this is his opportunity cost of selling the car. B values the car at 3,800. So we can see immediately there is a gain of 800 if the car is transferred from A to B. Now to see if this trade takes place we establish that we can find a price that both A and B will trade at. This is established below:

A’s Condition to Sell: Price > 3000B’s Condition to Buy: Price < 3800

Clearly, any price between 3000 and 3800 will result in a trade. For example, suppose the price is 3500. Below are the gains from trade to both A and B

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A’s Gain = 3500 – 3000 = 500B’s Gain = 3800 – 3500 = 300Total Gain = 800

Now let us introduce transaction costs. We will consider two cases. Case 1 will be a transaction cost of 300. Case 2 will be a transaction cost of 900.

Case 1: Transaction Cost = 300I have not said who actually pays the transaction cost, but to illustrate the effect of a transaction cost suppose person A must pay the cost of 300. In this case when he sells the car he has an opportunity cost of 3000 plus a transaction cost of 300, for a total cost of 3300. So in comparing A and B’s condition to trade we now have

A’s Condition to Sell: Price > 3300B’s Condition to Buy: Price < 3800

We can see any price between 3300 and 3800 will still result in trade. However notice the gains from trade are smaller; only 500. The reason is that the 300 transaction cost has “eaten up” 300 of the gains from trade. So the gains from trade fall from 800 to 500.

Now in the above, I said A pays the cost. Does it matter if B pays the cost? The answer is no. To see this suppose the buyer must pay the 300 in transaction cost. Since B values the car at 3800 he will not pay more than 3800 in total for the car. But his total payment for the car is Price + 300. So B’s condition to buy is

Price + 300 < 3800 → Price < 3800 – 300 → Price < 3500

Comparing A and B we have

A’s Condition to Sell: Price > 3000B’s Condition to Buy: Price < 3500Again we can see that the trade will occur. Any price between 3000 and 3500 will result in trade. Also, the gains from trade are still 500, since transaction costs have “eaten up” 300 of the gains from trade.

Case 2: Transaction Cost = 900Again, suppose A pays all the transaction cost. That means his total cost of selling the car is 3000 in opportunity cost plus 900 in transaction costs, for a total cost of 3900. Hence A needs a price greater than 3900. So in comparing A and B’s condition to trade we now have

A’s Condition to Sell: Price > 3900B’s Condition to Buy: Price < 3800

It is impossible to have a price larger than 3900, but still less than 3800. Hence in this case there is no price at which trade can exist. The reason is simply that the transaction cost (900) exceeds the gains from trade (800), so if the transaction occurs there would be a net loss from trade, not a gain.

One important thing to notice is that even though A pays the cost, both A and B bears the cost. That is since trade does not occur, it is both A and B that are negatively effected.

As above, we can show that if B pays the cost we will reach the same conclusion; no trade. If B pays the cost the most he is willing to pay for the car is 3800 – 900 = 2900.

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So in comparing A and B’s condition to trade we now have

A’s Condition to Sell: Price > 3000B’s Condition to Buy: Price < 2900

It is impossible to find a price greater than 3000, but less than 2900. Hence no trade occurs. And again, even though B pays the cost, both A and B are negatively effected since the trade does not occur.

The general conclusion is that if the transaction cost exceeds the gain from trade, then trade will not occur. Hence anything that reduces transaction costs will allow for more trade, and thus allow for more wealth creation. Not surprising much of economic activity is devoted to the reduction of transaction costs. In what follows we will focus on different types of transaction costs are how they are reduced.

Types of Transaction CostsBelow are listed some types of transaction costs. We will identify them now and return to them in more detail later.

Transportation Costs…As it sounds, these are costs associated with delivering the good from the producer to the consumer.

Search Costs…This refers to the costs of finding a trading partner. That is, if you have a car to sell, there are some costs involved in finding a buyer. Hence this is a transaction cost.

Information Costs…This refers to the costs one faces because they do not have complete information about their trading partner, or the good being sold. For instance, if you are buying a used car, the seller may not tell you all the information regarding the quality of the car. So you face some risks when you buy the car. In this case, the fact that you face risk when buying is like a transaction costs.

Trade, Trust, Contract Enforcement and the Rules of the GameMany trades extend over a period of time. Such trades call for individuals to do different things at different times. For instance, a producer may have an order for supplies from a supplier in which the supplier delivers the good on demand for a particular price. Such arrangements are common. In fact the vast majority of production of goods occurs by such trades. That is, only sales of final goods do not have a time element. The trades that are part of the production process generally occur over time. The fundamental nature of these trades is that since they occur over time I must trust the other party of the trade to do what they have agreed to. That is, if I cannot trust the other person, then it may cost me considerably. For example, suppose I need parts delivered so that I can produce a good. The supplier knows this and decides to increase the price he charges. He has broken his agreement. As a result I have to pay a high price and may lose money. The problem this creates is that I am less willing to enter any trade in which I cannot be certain I can trust the other party. Hence trade will occur only if I can first trust.

How to Establish Trust Close knowledge of the other party to the trade…in this case I know the other party so

well, I know he is trustworthy. The problem with this solution is that if I limit my trades with those I know well, I may be missing out on significant gains from trade with those I do not know as well. Hence for an economy to realize large gains from trade it needs to find some ways to establish trust between trading partners that do not know each other very well.

Long-term, mutually beneficial relationship…In a long-term trading relationship, as long as both parties are willing to end the relationship if the other person does not keep their

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promises, then trust can be established. The reason is, since trade is mutually beneficial, the threat that one party will end the relationship may be enough to make the other person behave in a trustworthy manner.

While the above can help establish trust necessary for trade, there are times when they are not sufficient. There must be other rules to enforce agreements, and such rules work together with the above to reinforce trust.

Official Rules of EnforcementBelow are some “official” means of enforcement:

Trade Associations…These are associations of people who tend to interact on a regular basis. For example, there may be an association of cotton traders, or diamond traders. Such associations have rules that govern their members, including rules for the enforcement of contracts between their members. So if one party does not abide by their contract, the other party can take the case to the association. The association will assign someone to judge the case. If the first party is found guilty, they must do whatever the judge says or else they are kicked out of the association. Because the association is an important way of doing business, it is very damaging to be kicked out of the association, so people tend to abide by the rulings.

Government Court Systems…In situations where there is no trade association, where the threat of ending the relationship is not enough to make all people abide by their agreements you can take one to a government court. For this reason, the government court system is a crucial part of the economic system.

Informal Rules of EnforcementSocial structure, networks, etc. play an important role in forcing people to behave per agreement. Bad reputations can be gained (good ones lost) in such situation, or other forms of punishment (such as ostracism) can be given out. Indeed these informal rules usually form the basis of the formal rules established in law.

The Role of Intermediaries

An intermediary is someone that reduces transactions cost. The reduction in transactions cost allows more trades to occur. From the increase in wealth created by these trades the intermediaries make their profit.

To see this let us consider a simple example of an intermediary. Suppose a seller sells a good that costs 60. The buyer values the good at 100. Absent any transaction cost there is a 40 gain from trade. However suppose there is a transaction cost of 50. Since the transaction cost is greater than the gain from trade, trade will not occur. For example, suppose the seller must pay the transaction cost of 50. Hence the total cost of selling is 110. So the seller needs a price greater than 110, but the buyer would only pay a price less than 100. So trade cannot occur.

Now suppose a third party comes along and can reduce the transaction cost. Suppose if he organizes the transaction he will only face a transaction cost of 20. Since this is less than the gains from trade of 60, we know trade can still occur. To see this let us suppose the way the trade is now organized is the third party buys the good from the seller and then sells it to the buyer. For the sake of argument, suppose the intermediary pays the transaction cost of 20. In this case we have the following:

Now let us first consider the transaction between the buyer and the intermediary. The buyer will buy at any price less than 100. The intermediary will sell at any price greater than the price he paid to the seller plus the transaction cost. Or,

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Intermediary: Buyer Price > Seller Price + 20

Buyer: Buyer Price < 100

So the intermediary will sell to the buyer if

Seller Price + 20 < 100Or

Seller Price < 80

Now, consider the trade between the intermediary and the seller.

Seller: Seller Price > 60

Intermediary: Seller Price < 80

Clearly trade will occur at a price between 60 and 100. As an example, suppose the seller price is 70. Now suppose the intermediary sells the good to the buyer at a price of 95 (for the intermediary he needs the buyer price to be at least 20 greater than the seller price). Then

Seller’s Gain: 70 – 60 = 10Intermediary’s Gain: 95 – 70 - 20 = 5Buyer’s Gain: 100 – 95 = 5 Net Gain 20

Notice the total gain is simply the original 40 in gains from trade minus the 20 in transaction costs paid by the intermediary.

In the above example, the intermediary pays the transaction costs. It does not really matter who pays the transaction costs as long as the transaction costs are reduced to something lower than the gains from trade. Sometimes the intermediary does pay the cost, sometimes the seller, sometimes the buyer, or sometimes some combination of the three.

Types of Intermediaries and the Transaction Costs Reduced Retail Stores…reduces search costs Wholesalers…reduces transportation costs Car Dealers…reduce transportation costs and search costs Real Estate Agents…Reduce search costs and information costs Banks…Reduce information costs Stock/Bond Broker…Reduces information costs Websites…Reduce Search Costs

It is estimated that approximately 50% of the price paid at a retail store goes to the intermediaries needed to get the good from the producer to the consumer. Hence the existence of an intermediary is a crucial institution that society has created that allows more wealth to be created through trade.

Sample Questions for Section I.C and I.DFill in the Blank

1. Trade is not possible without _______________ rights.2. There are three aspects of property rights.

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a. The right to ____ a good or resource.b. The right ______________ ownership of a good.c. The ability to ____________ a contract that transfers ownership of a good.

3. The more costly are contracts to enforce, the ____ likely is trade to occur.

4. The cost of making a trade is called a _________________ cost.

Use the following information to answer questions 5-8. Suppose person A owns a TV he values at RO 80, and further suppose person B values the same TV at RO 100.

5. Suppose there is a transaction cost of RO10, paid by person A. Then trade will occur at a price between ___ and ____.

6. With the transaction cost of RO 10, the gains from trade is ____.

7. Suppose there is a transaction cost of R025 paid by person A. Then person A must have a price greater than _____ for trade to occur.

8. If the transaction cost is greater than ____ trade will not occur.

9. The cost of delivering the good from the producer to consumer is known as ___________ cost.

10. The cost of finding someone to trade with is known as _____________ cost.

11. If you face some risk because you are not sure about the quality of the good you are buying, this creates a cost known as ________________ cost.

TRADE,TRUST,CONTRACT ENFORVEMENT AND THE RULES OF THE GAME.CIRCLE THE CORRECT ANSWER

1. Suppose a trade between buyer and seller extends over time. Once the trade begins a buyer or seller may want to break the trade agreement. Hence, if trade extends over a period of time, the buyer and seller must establish _______ that they will not break the agreement in order for trade to exist.

2. Trust can be established by close _____________ of your trading partner.

3. Trust can also be established by if there is a ____________ relationship between the buyer and seller.

4. A long-run relationship that is mutually ____________ can establish trust because each person knows the other person will not want to end the relationship.

5. Trust can also be established by punishment when a person breaks a contract. Such official punishments can come from _____ __________________ or ________________ ________.

6. Another type of punishment that can help establish trust is when an informal social network leads to a bad _______________ when a person breaks their agreement.

7. An intermediary exists to _______________ transaction costs, thereby causing more ______ to occur.

8. Suppose person A has a car and values it at 600, and that person B values the car at 1000. Also suppose there is a transaction cost of 500, implying trade will not occur. Now suppose there is an intermediary who can perform the transaction at a cost of only 100. In this case trade ____ occur, and the gains from trade will be equal to __________.

9. If the intermediary buys the car from person A for 700 and sells the car to person B for 900, then person A’s gain from trade is _____, person B’s gain from trade is ______, and the intermediary’s gain from trade is _____, for a total gain of 300.

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Property Rights and Trade1. Property Rights refer to the rights to own and use property, transfer ownership of

property, and enforce contracts regarding the use of property.a. Trueb. False

2. All trade involves the transfer of property. Hence in the absence of a system of property rights trade could not occur.a. Trueb. False

Transaction Costs3. Suppose Person A owns a computer that he values at OMR 400 and Person B values the

computer at OMR 550. Now suppose there is a transaction cost of OMR 75 paid by Person A. Thena. Person A will accept no price less than 475.b. Person B will pay no more than 550.c. Trade will occur.d. All the above

4. Suppose Person A owns a computer that he values at OMR 400 and Person B values the computer at OMR 550. Now suppose there is a transaction cost of OMR 200 paid by Person A. Will trade occur?a. Yesb. No

5. Suppose a potential trade between A and B might occur. However a transaction cost is paid by person A and this causes trade to not occur. In this casea. Only person A is harmed by the transaction cost.b. Only person B is harmed by the transaction cost.c. Both A and B are harmed by the transaction cost.d. None of the above

6. Which of the following is not a type of transaction cost?a. The cost of delivering goods to a retail store.b. The cost paid to workers to produce goods.c. The cost verifying the quality of goods to a potential buyer of goods.d. The cost of finding a buyer for the goods.

Trust7. When a trade extends over a period of time, the trade is less likely to occur if trust cannot

be established between the buyer and seller.a. Trueb. False

8. Which of the following are means to establish trust?a. Close knowledge of your trading partner.b. Trade Associationsc. Government Court Systemsd. All the above

Role of Intermediaries9. Suppose Person A owns a computer that he values at OMR 400 and Person B values the

computer at OMR 550. Also suppose there is a transaction cost of OMR 200 paid by person A. In this case trade will not occur. However, suppose an intermediary can

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perform the same transaction for only OMR 100. Will trade occur through the intermediary?a. Yesb. No

10. Suppose you want to sell a used car, but you live in a small village and there is no one there that wants to buy a used car. You then decide to sell you car by advertising it on a website, where must pay a small fee. What transaction cost has been reduced by the website?a. Transportation costsb. Search costsc. Information costsd. None of the above

ANSWERS1. a 6. b2. a 7. a3. d 8. d4. b 9. a5. c 10. b

II. Microeconomics: Markets as a Method of Social CooperationA. Supply and Demand Model of a Market

1.Opportunity Costs and Supply 2. Substitutes and Demand

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b. The Market Equilibrium and Social Cooperation

SupplySupply refers to the amount of goods offered for sale at various prices. To understand supply we must first understand the condition under which a seller would offer any unit for sale.

Recalling our self-interest assumption, a seller will only sell a good if the price received exceeds the marginal cost of producing that unit. For instance, if the marginal cost of a unit is R.O. 5, then the seller must receive a price greater than or equal to R.O. 5 to be willing to sell the good. In general we can say that for a seller to sell a particular unit it must be the price of the good is greater than or equal to the marginal cost of that unit. We can write this condition mathematically as

P ≥ MC.

Alternatively we can show it using the bar graph as we used earlier. Let the height of the bar represent the marginal cost of a good, expressed in OMR, and then we can say for any price line higher than the bar, the good will be sold.

Now, let us assume there are many possible sellers of this good, but they all have different marginal costs. In particular, suppose there are six possible sellers of this good, A, B, C, D, E, and F. Let us suppose there marginal costs are as follows:

Producer Marginal Cost

A 3B 4C 5D 6E 7F 8

Now recall, any given producer sells a unit if P ≥ MC. Hence we can summarize the decisions to produce in the following table:

If the Price is

Who Produces

Amount Supplied

3 A 14 A-B 2

OMR

Any price greater than 5 and the unit is sold.

5

27

5 A-C 36 A-D 47 A-E 58 A-F 6

If the price is 3, only person A has a MC less than or equal to price. Hence only one unit is produced. If the price is 4, then both A and B have a MC less than or equal to the price. Hence two units are produced. If the price is 5, then A, B, and C have MC less than or equal to the price, thus 3 units are produced. Etc.

In the above table, the first and third columns make up what is known as the supply schedule. It tells one at alternative prices what will be the amount offered for sale.

This same information can be displayed in graphically. The graph below shows the various units produced by A-F and their associated marginal costs.

As in the table above, and remembering that no one sells a unit unless P ≥ MC, we can graphically find the amount of goods produced for any given price. For instance suppose the price is 5. Then the only ones producing are those that have a marginal cost less than or equal to 5. The graph below shows this is the units produced by A, B, and C.

A B C D E F

OMR

8 7 6 5 4 3

A B C D E F

OMR

8 7 6 5 4 3

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Clearly A, B, and C are produce the three units that have a marginal cost less than or equal to the price of 5. Or one could say, the bars representing the marginal cost of the units is less than the price line. So at the price of 5, the amount supplied will be 3.

Similarly, if the price is 6, the amount supplied is 4. This is shown in the graph below, where persons A, B, C, and D produce their unit.

Since A produces the first unit, B produces the second unit, etc., we can write the above graph as

Now what we have is the supply curve. Notice it is simply the graph of our supply schedule. It tells one at alternative prices the total amount supplied.

From the Bar Graph to a Continuously Upward Sloping Supply CurveThe bar graphs above are useful for explaining the relationship between costs and supply. However, we now want to transition to a graph that is continuously upward sloping. The reason for this is though the above graph is useful for introducing the concept of supply it is not very realistic to have cost of each additional unit jumping up, instead of going up gradually.

To accomplish this let us replace the above bars with dots at the top of the bars. The height of the dots represents the height of the bars.

A B C D E F

OMR

8 7 6 5 4 3

1 2 3 4 5 6

OMR

8 7 6 5 4 3

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Notice the same information is contained. For example, in the graph below we see when the price is 5, units 1, 2, and 3 will be produced (i.e. their costs are below, or equal to, the price line).

Now, if we filled in for many other units, and pushed all the dots closer together, and connect the dots with a line we have the following graph.

1 2 3 4 5 6

OMR

8 7 6 5 4 3

1 2 3 4 5 6

OMR

8 7 6 5 4 3

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Notice, then our line becomes nothing more than the collection of points (or dots) that represent the cost of a particular unit. And again, we have ordered the units lowest cost to highest cost. Notice then this one can read from the above line the quantity of goods supplied at different prices. As in the above, graph at the price of 5, we see 3 units are supplied. In general, of course, we do not explicitly include the dots, as in the above graph. We simply draw a line, knowing that it is the line that orders lowest cost to highest cost units. Since we can read the quantity supplied off of this line it is called the supply curve. An example is given below. At the price of 5, 3 units are supplied. As the price rises to 8, 6 units are supplied.

Prices as SignalsNotice that as the price rises (falls), more (fewer) goods are produced. But consider this increase in goods produced. When the price rises causing producers to produce more of a good, where do the resources to produce these extra units come from? They must be taken away from other goods. Hence more of one good necessarily means less of other goods. Thus a price increase (decrease) causes a reorganization of the economy. The first of the three big questions (What to Produce?) is ultimately decided by this signaling role of prices.

The Second Big QuestionThe second big question is “How to Produce?”. The answer we gave to this question was to produce in the lowest cost manner possible. From the supply curve we can see that this is

3 Quantity

OMR

5

Quantity

Price

S

3 6

8

5

31

precisely what happens. That is, for any price a unit is produced only if its cost is less than the price received. Hence for any number of units being produced we can be assured that they are being produced in the lowest cost manner possible.

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DemandDemand refers to the amount of goods consumers want to purchase at various prices. To understand demand we must first understand the condition under which a consumer would buy a unit.

Recalling our self-interest assumption, a buyer will only buy a good if the value of the good to the consumer exceeds the price of the good. For instance, if the value of the good is R.O. 10, then the buyer will buy at any price less than or equal to R.O. 10. In general we can say that for a buyer to buy a particular unit it must be the value of the good is greater than or equal to price of the good. We can write this condition mathematically as

Value ≥ P.

Alternatively we can show it using the bar graph as we used earlier. Let the height of the bar represent the value of the good, expressed in OMR, and then we can say for any price line below the bar, the good will be purchased by the consumer.

Now, let us assume there are many possible buyers of this good, but they all have different values placed on the good. In particular, suppose there are six possible buyers of this good, A, B, C, D, E, and F, and all buy at most one unit. Let us suppose the value they place on the good is as follows:

Buyer ValueA 10B 9C 8D 7E 6F 5

Now recall, any given consumer buys a unit if Value ≥ P. Hence we can summarize the decisions to consume in the following table:

If the Price is

Who Consumes

Amount Demanded

11 - 010 A 19 A-B 28 A-C 37 A-D 46 A-E 55 A-F 6

OMR

10

Good is purchased at any price less than 10

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Hence the above table tells us at various prices the amount consumers wish to purchase; that is, it summarized the demand for this good. In fact, the first and third columns are referred to as the demand schedule. To understand this, note that if the price is 9, the both A and B value the good more than or equal to 9. Hence the amount demanded is 2. If the price falls to 7, the A, B, C, and D value the good more than or equal to 7, so four units is the amount demanded.

We can get a graphical representation of this by putting these values on a bar graph, as below. Note that in this graph the height of the bar represents the value of the good to the consumer.

Now let us suppose the price is 8. We see in the graph below that persons A, B, and C have a value that is greater than or equal to 8. Thus three units are demanded, as in our table above.

Similarly, as the price is lowered, to say 6, we see that persons A-E have a value above the price and buy the good, so that the quantity demanded is 5. This pictured in the graph below.

A B C D E F

10 9 8 7 6 5

A B C D E F

8

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Since A buys the first unit, B the second, and so forth, we can replace A, B, C, etc. with the numbers 1, 2, 3, and so forth. Furthermore, I can replace the bar graph with a dot to represent the value of the unit to the consumer. These two changes are pictured in the graph below.

Though we now use dots to represent the value of the unit to the consumer the information is the same. For instance, in the graph below at the price of 8 the first three units have a value greater than or equal to 8, and so 3 is the number of units demanded.

A B C D E F

8 6

1 2 3 4 5 6

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Now, if we filled in for many other units, and pushed all the dots closer together, and connect the dots with a line we have the following graph.

Notice, then our line becomes nothing more than the collection of points (or dots) that represent the value of a particular unit. And again, we have ordered the units highest valued to lowest valued units. Notice then one can read from the above line the quantity of goods demanded at different prices. As in the above graph at the price of 8, we see 3 units are demanded. In general, of course, we do not explicitly include the dots, as in the above graph. We simply draw a line, knowing that it is the line that orders highest valued to lowest valued units. Since we can read the quantity demanded off of this line it is called the demand curve. An example is given below. At the price of 8, 3 units are demanded. As the price falls to 6, 5 units are demanded.

1 2 3 4 5 6

8

Price

Quantity

8

36

3

Prices as SignalsNotice that as the price rises (falls), fewer (more) goods are demanded. But consider this fall in goods demanded. Suppose the good in question is chicken. When the price of chicken rises, causing consumers to purchase less chicken does that mean they stop eating meat; of course not. It means they switch from chicken to some substitute good. Thus the fall in the quantity of chicken demanded is met by an increase in the quantity of some other meat demanded. Thus a price increase (decrease) causes a reorganization of consumption in the economy.

The Third Big QuestionThe third big question is “For Whom to Produce?”. The answer we gave to this question was to give the goods to those that value the goods the most. From the demand curve we can see that this is precisely what happens. That is, for any price a unit is purchased only if its value is greater than the price paid. Hence for any number of units being purchased we can be assured that they are being purchased by those that value the good the most.

Price

Quantity

8

6

3 5

D

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EquilibriumWhile we showed how the quantity supplied and the quantity demanded depends on the price, we have yet to show what that price will be. We now look at that question.

Suppose prices change in the following way:

If at the current price the quantity supplied exceeds quantity demanded, then the price will fall. This is because sellers are producing more than what is being purchased. Sellers, desiring to get rid of the excess supply, bid the prices down. Hence the price must fall.

If at the current price the quantity demanded exceeds quantity supplied, then the price will increase. This is because the buyers are competing for the same good. These buyers bid the prices up; hence the price increases.

Now consider the following table to illustrate how the equilibrium may come to be.

Price Quantity Supplied

Quantity Demanded

Effect on Price

Signals to Sellers and Consumers

7 16 4 Price Falls Sellers: Produce less; use fewer resources for this good Consumers: Buy more of this good, less of others

6 14 6 Price Falls Sellers: Produce less; use fewer resources for this good Consumers: Buy more of this good, less of others

5 12 8 Price Falls Sellers: Produce less; use fewer resources for this good Consumers: Buy more of this good, less of others

4 10 10 Price Same

Sellers: Keep producing same amountConsumers: Keep buying the same amount

3 8 12 Price Rises Sellers: Produce more; shift resources to this goodConsumers: Buy less of this good, more of others

2 6 14 Price Rises Sellers: Produce more; shift resources to this goodConsumers: Buy less of this good, more of others

1 4 16 Price Rises Sellers: Produce more; shift resources to this goodConsumers: Buy less of this good, more of others

If the price were 7, the quantity supplied exceeds quantity demanded, and so the price falls. This signals sellers to produce fewer units and signals consumers to buy more units. And so perhaps the price falls to 6. But still the quantity supplied exceeds quantity demanded, and so the price falls. This again signals sellers to produce fewer units and signals consumers to buy more units. And so perhaps the price falls to 5. Again the same process continues and the price falls to 4. At the price of 4, quantity supplied equals quantity demanded. There is no longer any reason for the price to change.

Now if the price were 1, the quantity demanded exceeds quantity supplied, and so the price rises. This signals sellers to produce more, and consumers to purchase less. And so the price rises to 2, but still the quantity demanded exceeds quantity supplied. And so the price rises again to 3. But still the quantity demanded exceeds quantity supplied. And so the price rises to 4. At this price quantity supplied equals quantity demanded. There is no longer any reason for the price to change.

Hence we see that at the price of 4, where quantity supplied equals quantity demanded, there is no longer any reason for the price to change. Therefore we say that 4 is the equilibrium price and 10 is the equilibrium quantity. That is, the equilibrium is a situation where both buyers and sellers are satisfied given the current price; no one has a reason to change their behavior.

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TerminologyWhen quantity supplied exceeds quantity demanded it is called a surplus. Hence a surplus causes the price to fall. When quantity demanded exceeds quantity supplied it is called a shortage. Hence a shortage causes the price to increase.

Graphical Representation of EquilibriumWe now want to show the equilibrium in a graph that combines the supply and demand curves. This is demonstrated in the graph below. Notice at the price of 7, quantity supplied exceeds quantity demanded, implying the price falls towards equilibrium. At the price of 1, quantity demanded exceeds quantity supplied; implying the price rises towards equilibrium.

More generally, we can draw the following graph to depict the equilibrium. Note that Pe and Qe refer to the equilibrium price and quantity.

Market Prices and Social CoordinationRecall that in this course we are interested in understanding how social coordination is accomplished in the economy. We see now that market prices are able to accomplish this coordination. That is, the prices adjust until the plans of the sellers match the plans of the buyers (i.e. until quantity supplied equals quantity demanded).

D

S 7

4

1

4 10 16

Surplus of Goods

Shortage of Goods

Q

P

D

S

Qe

Pe

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The First Big QuestionThe second big question is answered along the supply curve. The third big question is answered along the demand curve. Putting supply and demand together to find the equilibrium quantity provides the answer to the first big question of What to Produce.

We now turn our attention to determining whether this question is answered in the best way possible or not. In what sense can we say whether the quantity produced in the market is the “right” amount? Recall that market is nothing more than a collection of trades in the same good. Wealth is created in the economy as people trade. Hence the right amount of goods produced is the amount that maximizes the gains from all possible trades in this good. So to show that the equilibrium quantity is the best amount, we must show that it is the quantity that maximizes gains from trade. The way we do this is to show that any other quantity has lower gains from trade. To begin we must first find how the gains from trade.

Gains from Trade at the Market EquilibriumRecall how we calculated the gains from trade when there are just two people; a buyer and a seller. Suppose the buyer values the good at 10 and the seller has a cost of 1. Then the gain from trade is simply 10 – 1 = 9. Graphically we can display this as follows, where the yellow bar is the value of the good and the red is the cost of the good:

We will do precisely the same thing with the market equilibrium. We just have more trades to keep track of. To begin, consider the following demand and supply schedule and the resulting demand and supply curves. The table below provides both a demand and supply schedule. We can see that at the price of 5 the market is at equilibrium with 4 units traded the gains from trade on those units is found by

Price Quantity Supplied Quantity Demanded

2 1 73 2 64 3 55 4 46 5 37 6 28 7 1

The equilibrium occurs at the price of 5, where the equilibrium quantity is 4. Let us display the supply and demand curves using the bar graphs.

Gain from trade = 9

1

10

40

The yellow bars represent the demand curve. The height of each bar (i.e. the height of the demand curve at that unit) tells one the value of that unit to the consumer. The blue bars represent the supply curve. The height of each bar (i.e. the height of the supply curve at that unit) tells one the cost of that unit to the producer. The difference between the yellow and blue bars represents the gain from trade on that unit (i.e. value minus cost). So as we can see in the graph, the total gains from trade is simply 5 + 3 + 1 = 9.

Now, to make the transition to a normal supply and demand graph, let us push the bars closer together. This gives the following graph. Again the difference between the height of the yellow bars (value of a unit) and the height of the blue bars (cost of the unit) is the gains from trade on that unit. However by pushing the bars together one can see that this gain from trade is simply the difference between the height of the demand curve and the height of the supply curve. This, of course, follows immediately from the fact that the height of the demand curve is the value, and the height of the supply curve is the cost. Notice also that since the gain from trade on a unit is simply the difference between the height of demand and height of supply, the total gains from trade is simply the area between the demand and supply curves; 5 + 3 + 1 = 9.

Price

8

7

6

5

4

3

2

1 2 3 4 5 6 7 Quantity

5 3 1

D

S

1 2 3 4 5 6 7 Quantity

Price

53

1

8

7

6

5

4

3

2

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The fact that the gains from trade is simply the area between the demand and supply curves means we can show it in our normal graph of supply and demand, as below, where the green area represents the gains from trade in the market.

Now that we have established how to find the gains from trade, all we must now do to establish this is the best amount to produce is show that if the quantity is anything other than Qe then the gains from trade are lower. This is actually quite simple to show.

Suppose the quantity is something less than Qe; say QL in the graph below. In this case, we know the gains from trade are lower than at Qe because the gains from trade on the units between QL and Qe are not occurring. In fact the part of the triangle shaded below is the gains from trade not occurring because the quantity as at QL.

Now we consider quantities greater than Qe; such as QH in the graph below. If the quantity is above the equilibrium quantity, then there are still the gains from trade on the Qe units. But units from Qe to QH would have losses. The reason is, for these units, the value of the good to the consumer (the height of the demand curve) is lower than the cost of the good to the producer (the height of the supply curve). Hence on these units there are losses to trade, not gains. Thus our total gains from trade on QH units would be the gains on Qe units minus the losses on the units between Qe and QH, which is obviously lower than the gains on just the Qe units.

D

S

Qe Quantity

Price

Pe

Gains from Trade

D

S

QL Qe Quantity

Price

Pe

Gains from Trade Not Occurring

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Thus we conclude the following:

The gains from trade on anything less than Qe is less than the gains from trade on Qe. The gains from trade on anything more than Qe is less than the gains from trade on Qe.

Hence the gains from trade are maximized at Qe.

Thus we see that the market system results in arriving at the best answer to the first of the three big questions; What to Produce. Hence the social coordination necessary to answer the three big questions in the best way possible is achieved by markets and voluntary trade, even though no one is trying to achieve these results.

Sample Questions for Section II.A and II.BFill in the Blank

1. A _______ curve shows the amount of goods produced and offered for sale at alternative prices.

2. A seller will produce a unit of a good if the price exceeds the ___________ ____ of that unit.

3. When the price of a good rises, the quantity supplied of the good will _______.

4. A price increase ________ producers to devote more resources to the production of the good.

5. At any price/quantity combination along a supply curve, only the units with a marginal cost less than the ______, are produced. Hence the units produced are produced in the ________ cost manner possible.

Short-Answer/Problem Solving Questions1. Draw a graph of a supply curve.

DEMANDFill in the Blank

6. A _______ curve shows the amount of goods consumers would like to buy at alternative prices.

7. A consumer will buy a unit of a good if the price is less than the ___________ _______ of that unit.

8. When the price of a good rises, the quantity demanded of the good will _______.

9. A price increase ________ consumers to switch to an alternative good.

10. At any price/quantity combination along a demand curve, only the units with a marginal benefit greater than the ______, are purchased. Hence the units consumed always go to the consumers who _____ the good the most.

D

S

Qe QH Quantity

Price

Pe

Losses on Units Qe to QH

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Short-Answer/Problem Solving Questions1. Draw a graph of a demand curve.

EQUILIBRIUMFill in the Blank

1. A shortage occurs when quantity _____________ exceeds quantity _____________.

2. A surplus occurs when quantity _____________ exceeds quantity _____________.

3. If there is a shortage, we would expect the price to ________.

4. If there is a surplus, we would expect the price to _________.

5. If quantity demanded equals quantity supply we would expect the price to ______________.

6. The equilibrium price is the price such that quantity demand ______ quantity supplied.

7. If someone values a good at OMR10, but it can be produce at a cost of OMR10, then the gain from trade is _______.

8. If the equilibrium price is OMR10 and the equilibrium quantity is 50, then the area between the demand and supply curve represents the ___________________.

Short Answer/Problem Solving Questions1. Draw a graph of supply and demand with the price above the equilibrium price. Show on

the graph the amount of the surplus. What will happen to the price in this situation? Explain how this leads to a the equilibrium.

2. Draw a graph of supply and demand with the price below the equilibrium price. Show on the graph the amount of the shortage. What will happen to the price in this situation? Explain how this leads to the equilibrium

3. In the graph below, identify the equilibrium and the gains from trade at the equilibrium. Explain why any quantity other than the equilibrium quantity must have lower gains from trade.

Q

P

D

S

44

1. A shortage is when quantity demanded exceeds quantity supplied.a. Trueb. False

2. A surplus is when quantity supplied exceeds quantity demanded.a. Trueb. False

3. The price will ___________ if there is a shortage.a. riseb. fallc. stay constant

4. The price will __________ if there is a surplus.a. riseb. fallc. stay constant

5. If the economy is in equilibriuma. there is no shortageb. plans of the sellers match the plans of the buyersc. the price remains the samed. all the above

6. The gains from trade are maximized at the equilibrium.a. Trueb. False

7. Social cooperation in answering the three big questions is achieved by the market.a. Trueb. False

ANSWERS1. a 5. a 9. a 13. a2. c 6. b 10. a 14. a3. d 7. a 11. b4. c 8. a 12. d

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II. Microeconomics: Markets as a Method of Social CooperationC. Applications of the Market Model

Extension and Contraction of Demand

The change in quantity demand due to change in price when other factors remain constant is

known as extension and contraction of demand. Contraction of demand means decline in demand

due to a rise in price and extension of demand means increase in demand due to a fall in price.

Extension and contraction of demand results in a movement in the same demand curve. The Fig

shows that when the price is OP1 the quantity demand is OQ1 and when the price comes down to

OP, the quantity demand is OQ, and when the price is increased to OP2, the quantity demanded is

OQ2. .These three price levels make three points a, b and c on the same demand curve DD.

Extension of demand makes downward movement along the demand curve and contraction of

demand brings an upward movement on the demand curve. Thus extension and contraction of

demand cause movement in the same demand curve whereas shift in demand results in a

new demand curve

Extension and Contraction of SupplyWhen quantity supplied changes as a result of the change in price alone, it is known as change in

quantity supplied. When quantity supplied increases due to increase in its price, it is called rise in

quantity supplied or extension of supply. When the supply falls due to full in its price it is called

fall in quantity supplied or contraction of supply.

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A change in quantity supplied causes movement in the same supply curve. An increase in price

causes an upward movement and a fall in price causes a downward movement and a same supply

curve SS. In the fig. the points A, B and C represents the different quantities supplied at prices

OP.OP1 and OP2, respectively plotted in the same supply curve SS.

Changes in Market Equilibrium: Shift in Demand/Change in Demand

(Increase and Decrease in Demand)The demand of a product depends not only on its price but also on many other factors like

consumers' income, their tastes and preferences, prices of the substitutes etc. An increase or

decrease in demand due to any of the factors other than price is known as shift in demand. A

change in demand shifts the demand curve either upwards or downwards. An upward shift in

demand curve is known as increase in demand and vice-versa. In fig DD is the original demand

curve. When the demand increases the curve is D2D2 When the demand decreases the curve will

shift to D1D1.

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Change in Supply---- Shift in Supply(Increase and Decrease in Supply)

When the supply of a commodity increases or decreases due to change in factors other than the

price of the commodity, it if called change in supply. Change R supply causes a shift in the whole

supply curve. The change in supply results in a new supply curve, which is shown in fig.

The normal quantity supplied at a price OP is OQ units and its respective supply curve is SS.

When the supply increases due to a change in a factor or factors other than price a new supply

curve S2 S2 is formed. When the supply decreases it leads to a new supply curve S1 S1.

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This section discusses applying the market model to consider changes in the market equilibrium. The market equilibrium will change whenever there is a shift in the demand curve or supply curve. Let us first discuss these shifts in the curves.

Demand CurvesIncrease (decrease) in demand is when more (less) is demanded at any given price.

Graph of an Increase

Notice at the price of 14 the amount demanded increased from 25 to 40. This is captured by a rightward shift of the demand curve.

Graph of a Decrease

Notice at the price of 20 the amount demanded decreased from 350 to 250. This is captured by a leftward shift of the demand curve.

Changes in Market EquilibriumWe will now show the effects of a shift in either supply or demand on the market equilibrium. There are four cases to consider; demand increase, demand decrease, supply increase, and supply decrease.

Quantity

Price

D0

D1

14

25 40

Quantity

Price

D1

D0

20

250 350

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These four cases are graphed below, where Graph A depicts a demand increase, Graph B a demand decrease, Graph C a supply increase, and Graph D a supply decrease.

Graph A: Demand IncreaseNotice that when demand increases, at the initial price P0 quantity demand is greater than quantity supplied; that is, a shortage is created. The shortage puts upward pressure on prices. The higher prices cause producers to increase the quantity supplied, and consumers reduce quantity demanded along the new demand curve D1. The market is returned to a new equilibrium with a higher price and quantity, as in the graph below.

Graph B: Decrease in DemandA decrease in demand is just the reverse of the above. Below when demand decreases, at the initial price P0 quantity supplied is greater than quantity demanded; that is, a surplus is created. The surplus puts downward pressure on prices. The lower prices cause producers to decrease the quantity supplied, and consumers increase quantity demanded along the new demand curve D1. The market is returned to a new equilibrium with a lower price and quantity.

Graph C: Increase in SupplyInitially, before the price has changed, the increase in supply causes a surplus. This creates downward pressure on prices. As a result, quantity demanded increases, moving down the demand curve, and quantity supplied decreases along the new supply curve S1. This continues until the new equilibrium is reached, as in the graph below.

Graph D: Decrease in SupplyInitially, before the price has changed, the decrease in supply causes a shortage. This creates upward pressure on prices. As a result, quantity demanded decreases, moving up the demand curve, and quantity supplied increases along the new supply curve S1. This continues until the new equilibrium is reached.

Price

Price

Price

Price

Quantity

Quantity

Quantity

Quantity

Graph A

Graph C Graph D

S

D0

D1

P1

P0

Q0 Q1

D1

D0

S

P0

P1

Q1 Q0

D

S0

S1

P0

P1

Q0 Q1

D

S1

S0

P1

P0

Q1 Q2

50

Graph B

These results can be summarized in the following table:

Type of Change Equilibrium Price … Equilibrium Quantity…Demand RisesDemand FallsSupply RisesSupply Falls

Price Reflect ScarcityRecall the scarcity of a good depends on both the physical amount of the good, and the desire for the good. Or, scarcity depends on supply and demand. If supply falls a good becomes more scarce. If demand rises a good becomes more scarce. Hence scarcity has to do with the amount of the good relative to how much people desire the good. As you can see in our above table, prices rise when the good has become more scarce (demand rises or supply falls) and prices fall when the good becomes less scarce (demand falls or supply rises). Hence we can say prices reflect scarcity, but do not cause scarcity.

Sample Questions for Section II.CFill in the Blank

1. An increase in demand is when ______ is demanded at every price.

2. A decrease in demand is when ______ is demanded at every price.

3. An increase in supply is when ______ is supplied at every price.

4. A decrease in supply is when _____ is supplied at every price.

5. A change in _________ ____________ is a movement along a demand curve, and a change in ________ is a shift of the entire demand curve.

6. A change in _________ ____________ is a movement along a supply curve, and a change in ________ is a shift of the entire supply curve.

7. An increase in demand will cause the price to _______ and the equilibrium quantity to _________.

8. A decrease in demand will cause the price to ________, and the equilibrium quantity to ___________.

9. An increase in supply will cause the price to _______ and the equilibrium quantity to ______.

10. A decrease in supply will cause the price to _______ and the equilibrium quantity to ______.

11. If the demand for a good increases, the price will _____, which will cause ______ resources to be devoted to the production of the good.

12. If the supply of a good decreases, the price will ______, which will cause consumers to buy _____ of the good.

CIRCLE THE CORRECT ANSWER1. If the demand for a good rises, then one would expect

a. the equilibrium price to rise, and the equilibrium quantity to fall.

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b. the equilibrium price to rise, and the equilibrium quantity to rise.c. the equilibrium price to fall, and the equilibrium quantity to fall.d. the equilibrium price to fall, and the equilibrium quantity to rise.

2. If the supply of a good rises, then one would expecta. the equilibrium price to rise, and the equilibrium quantity to fall.b. the equilibrium price to rise, and the equilibrium quantity to rise.c. the equilibrium price to fall, and the equilibrium quantity to fall.d. the equilibrium price to fall, and the equilibrium quantity to rise.

3. If the demand for a good falls, then one would expecta. the equilibrium price to rise, and the equilibrium quantity to fall.b. the equilibrium price to rise, and the equilibrium quantity to rise.c. the equilibrium price to fall, and the equilibrium quantity to fall.d. the equilibrium price to fall, and the equilibrium quantity to rise.

4. If the supply of a good falls, then one would expecta. the equilibrium price to rise, and the equilibrium quantity to fall.b. the equilibrium price to rise, and the equilibrium quantity to rise.c. the equilibrium price to fall, and the equilibrium quantity to fall.d. the equilibrium price to fall, and the equilibrium quantity to rise.

5. A good becomes more scarce because its price rises.a. trueb. false

6. If a good becomes more scarce its price will rise.a. trueb. false

7. If the demand for a good increases, then more resources will be devoted to producing this good. This is because

a. the price will rise.b. the supply curve will shift to the right.c. the government will force producers to produce more.d. None of the above

8. If the supply of a good falls, thena. the price will rise.b. consumers will be signaled to switch to other goods.c. less of the good will be produced.d. All the above

ANSWERS1. b 5. b2. d 6. a3. c 7. a4. a 8. d

III. Macroeconomics and Social Cooperation

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A. Understanding Macroeconomic Datai. Gross Domestic Product

ii. Price Indicesiii. National Income Identity

In macroeconomics, we are concerned with the overall performance of the economy. To evaluate the overall performance of the economy we need a measurement of the production of goods and services in the economy. This section will consider how we construct and interpret the measurement of production; Gross Domestic Product.

Gross Domestic Product (GDP) is a measurement of all final goods and services produced within in a country in a given period of time. Notice a few things about this definition.

First, only final goods are included; that is, intermediate goods used in the production of final goods are not included. For example, paper is produced to be used for the production of textbooks. The textbook is a final good, and counts towards GDP while the paper is an intermediate good and does not count toward GDP. Why is this? It is because the value of the paper contributes to the book. Hence the paper’s contribution to GDP is included when we include the book. If we included the book and the paper, we would essentially be counting the paper twice.

Second, it only includes production in the current period. Sales of previously produced goods (for example, the sale of a used car) will not be included.

Third, it includes only goods produced inside the borders of the country. Hence if a domestic firm produces goods elsewhere, those goods will not be included. In the same way, if a foreign firm produces in the domestic country, it will count toward GDP.

Fourth, GDP is measured either for a given year or for a quarter of a year.

Measuring Output: GDP

Suppose there are only two goods; food and clothing. Let us suppose the economy currently produces 10 units of food and 5 units of clothing. How can we measure GDP? Obviously we cannot add food to clothing; so how do we get a meaningful number? We do it by converting the units of food and clothing into their monetary equivalents. This is accomplished by multiplying 10 units of food by the RO price of a unit of food and multiplying the 5 units of clothing by the RO price of clothing. Since these are now expressed in terms of the same thing (i.e. RO) we can add them together. For example, suppose one unit of food costs RO 2 and one unit of clothing costs 4 RO, then

GDP06 = (10F)*(RO2/1F) + (5C)*(RO4/1C) = RO 20 + RO 20 = RO 40.Now a single number by itself means little. To know if this number is meaningful let us change the number of goods produced and see if the number for GDP changes in the same way. Suppose next year the amount of production doubles so that the economy currently produces 20 units of food and 10 units of clothing, with no change in prices. For ease of presentation let us put this information in the table below:

Food Clothing GDPYear Qt

F PtF Qt

C PtC Qt

F*PtF + Qt

C*PtC

2006 10 RO2 5 RO4 RO2*10 + RO4*5 = RO 402007 20 RO 2 10 RO 4 RO2*20 + RO4*10 = RO 80

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Since the quantity of each item doubles, it should be that the measure of GDP will double as well, and indeed we see this in the last column of the above table.

GDP07 = (20F)*(RO2/1F) + (10C)*(RO4/1C) = RO 40 + RO 40 = RO 80.

Notice that our measure of GDP has also doubled. Thus it would seem this is a good measurement.

However, there is a problem. Suppose that GDP next year stays constant at 10 units of food and 5 units of clothing. So our measure of GDP should be constant. However, suppose the prices of each good doubles next year, so that one unit of food costs RO 4 and one unit of clothing costs 8 RO. Putting this into a table form we have

Food Clothing GDPYear Qt

F PtF Qt

C PtC Qt

F*PtF + Qt

C*PtC

2006 10 RO2 5 RO4 RO2*10 + RO4*5 = RO 402007 10 RO 4 5 RO 8 RO4*10 + RO8*5 = RO 80

Notice that GDP doubles even though production has not doubled. This implies that when GDP changes we do not know if it is because actual production has changes or because the prices have changed. We need some way of correcting GDP to give us a more accurate measurement of production, and the changes in production.

Base Year PricesOne way to correct for the problem of changing prices is to not let the prices change in our calculation. In this case we pick a particular year, called the “base year”, and use these prices to calculate GDP in every year. It is easy to see why this works. In our above example, GDP doubled between 2006 and 2007 because prices doubled between 2006 and 2007. However, if we calculate GDP in 2007 using 2006 prices we will not have this problem. Instead the measurement of GDP for 2007 will be

gdp07 = (10F)*(RO2/1F) + (5C)*(RO4/1C) = RO 20 + RO 20 = RO 40.

By not letting prices change, the only thing that can change GDP is a change in actual production.

Real vs. Nominal GDPWe can generalize this as follows:

Nominal GDP07 = F07PF07 + C07PC

07

Real gdp07 = F07PFB + C07PC

B

where the subscript B refers to the base year price.

The term “nominal GDP” means that it is in “name only”. That is, the measurement of production is not terribly useful because it can be influenced by rising prices, and thus the “increase” in GDP is not real, it is in name only. Generally nominal GDP is denoted with uppercase letters; GDP.

The term “real gdp” means that the changes we observe are not due to changing prices, but to real changes in production. Generally real gdp is denoted with lowercase letters; gdp. Obviously real gdp is the one of interest to us.

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GDP and Well-BeingIt is important to realize what GDP tells us and what it does not tell us. At best, it is a measure of stuff that gets produced in the market. It does not tell us about well-being, though it may be related to well-being.

Why Higher GDP may lead to Greater well-being1. Higher GDP allows more leisure time; time for friends, family, etc.2. Higher GDP allows more resources for health care and improved diet; which means lower

infant mortality rates, longer life spans, higher quality of life while alive.3. Higher GDP allows more resources for education beyond the “productive” education; for

example, fine arts, literature, philosophy, etc.

Why GDP may not reflect well-being1. An increase in crime increases security systems. The security system show up as GDP but

we are clearly not better off. 2. If a manufacturer produces a good, that good is part of GDP. But if the production causes

pollution, GDP is not reduced because of the pollution.3. As said before, GDP does not include “home” produced goods/services.4. GDP includes ALL goods. Some may think some people make immoral choices that are

bad for them and society. Some such choices involve the purchase of an item that shows up in GDP, though in fact well-being would be lower.

Price Index and GDP DeflatorThe GDP deflator uses nominal and real gdp to construct a measure of how much prices have changed. Consider again the example in which production is constant and prices double. That is,

Food Clothing GDPYear Qt

F PtF Qt

C PtC Qt

F*PtF + Qt

C*PtC

2006 10 RO2 5 RO4 RO2*10 + RO4*5 = RO 402007 10 RO 4 5 RO 8 RO4*10 + RO8*5 = RO 80

Using 2006 as the base year calculate nominal and real gdp in 2007.

Nominal GDP07 = F07PF07 + C07PC

07 = RO 80

Real GDP07 = F07PFB + C07PC

B = RO 40

Now we know the reason for the difference is the difference in prices between 2006 and 2007. Since the only difference between the two is due to price changes, we should be able to use this information to determine the amount by which prices have increased. Indeed we can. All we have to do is take the ratio of nominal to real gdp for a given year. This is called the GDP Deflator.

The answer 2 is to be read “prices in 2007 are 2 times as high as they were in 2006”. Most often this is put into percentage terms by multiplying by 100. That is,

In this case it is read “prices in 2007 are 200% of what they were in 2006”.

55

One may wonder why this is called the GDP “Deflator”. To deflate is to make smaller, as in making a balloon smaller by letting the air out. To understand this term again note that

.

Notice we can rearrange this to get

.

Hence real gdp takes nominal gdp and divides it by a measurement of the average price level in the economy. To understand this let us take a simpler example. Suppose you have RO10. Suppose also that a unit of food costs RO 2. Then what is the real value of your RO 10. It is five units of food. This can be calculated as

Real Value of RO 10 = RO 10/RO2 = 5

More generally,

Real Value of a Monetary Amount = Monetary Amount/Price Level

This is precisely what one can do with nominal GDP. Since it is measured in units of money, we divide by the measurement of prices to ðeflate” it into real goods and services.

National Income Identity

Let me write the identity then explain it.

Y = C + I + G + NX

Y = Real gdp…goods produced. But for the entire country all goods produced corresponds to income. Hence we can also call this national income.

The r.h.s. of the equation tells us the various ways the goods produced can be used. Or stated differently, it is the different ways in which income can be spent. It is put into four broad categories.

C = Consumption…refers to the expenditures on consumption in a given period of time. These are goods that are final goods for consumers, such as food, clothing, entertainment, energy, etc.

I = Investment…refers to expenditures by business firms on investment goods. Investment goods are not final goods for consumers, but are goods business buy to help them produce other goods. For example, machinery, equipment, raw materials, etc. all fall into the category of investment.

G= Government Spending…refers to expenditures by the government on national defense, roads, police, courts, etc.

NX = Net Exports = Exports – Imports…refers to net exports, or what is sometimes called the trade balance. Some of our goods produced can be sent overseas as exports. Why then do we not count all exports? Why subtract the imports? The reason is the imports (which are produced

56

elsewhere) are already counted in consumption and investment. That is, some of consumption and investment spending is on goods produced by foreign countries, hence they must be subtracted.

So in building a model of the macro-economy, we must account for these four major sources of spending, or demand, in the macro-economy.

Sample Questions for Section III.A

Fill in the Blank1. Gross Domestic Product (GDP) is a measurement of all _____ goods and services

produced within in a _____ in a given period of _______.

2. Goods that are used to produce other goods are called _______________ goods. These goods should ____ be included in GDP.

3. Goods produced at home are ___ part of GDP.

4. Nominal GDP is calculated by adding together the ________ value of all goods and services sold.

5. If the price level rises, nominal GDP will _____.

6. Nominal GDP may rise because _______ rise, or because _______ rises.

7. Real gdp measures production using ________ prices.

8. If real gdp rises it is only because _____ rises.

9. By comparing nominal ___ to real ____, we can measure how much ______ have changed. This measurement of prices is known as the ___ Deflator.

.CIRCLE THE CORRECT ANSWER

1. Gross domestic product (gdp) is a measure ofa. how much prices have changed over the yearb. goods produced inside the borders of a country in a year.c. the PPF.d. None of the above

2. If someone made their own clothes, would those clothes be included in part of gdp?a. Yesb. No

3. Why is gdp an inaccurate measurement of the goods produced in the economy?a. Home produced goods are not included.b. Only goods, and not services sold, are included in gdp.c. Intermediate goods are not included.d. None of the above

4. Real gdp is not a perfect measure of the well-being of an economy becausea. some goods may actually have a bad effect on people.b. some goods have negative externalities.

57

c. some goods exist simply exist as a response to something bad happening in the economy.

d. All the above

5. Home produced goods (i.e. those not sold in the market) are not included in gdp. This makes comparison of the gdp numbers more difficult when comparing two countries, rather than comparing one country in two different years.

a. Trueb. False

6. If nominal GDP changes over time it could be becausea. prices have changed.b. quantity of goods produced have changed.c. Both a and b

7. If real GDP changes over time it could be becausea. prices have changed.b. quantity of goods produced have changed.c. Both a and b

8. Which of the following is NOT a true statement about the national income identity; Y = C + I + G + NX?

a. The term Y refers to real gdp, or total income, in the economy.b. The term C refers to consumption in the economy.c. The national income identity only is true in equilibrium.d. All the above are true statements.

9. The term I in the national income identity stands for investment. Investment means the purchase of capital goods; that is, those goods that firms use to produce final goods for consumption.

a. Trueb. False

Answers1. b 5. a 9. a2. b 6. c3. a 7. b4. d 8. c

Short-Answer/Problem Solving Questions1. Consider the following table of information:

Food ClothingYear Qt

F PtF Qt

C PtC

2006 20 RO 3 10 RO 62007 20 RO 6 10 RO 122008 40 RO 6 20 RO 12

a. Compute Nominal GDP in all years, and compute the growth rate in all years.b. Compute Real gdp in all years, and compute the growth rate in all years.

c.Using 2006 as the base year, compute the GDP deflator in all years, and compute the the growth rate(ie.inflation) in all years.

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III. Macroeconomics and Social CooperationB. Financial Markets and Interest Rates1. The Role of Financial Institutions and Markets2. Loanable Funds Model and the Interest Rate

Financial Markets and InvestmentInvestment represents an important part of the macroeconomy and is connected to both economic growth and business cycles.

One factor that influences economic growth and development is the level of investment. Investment in productive inputs provides the ability to produce at a higher level in the future. Hence anything that interferes with investment will necessarily result in stagnation instead of growth and development.

Investment is also important for business cycles in that the majority of movement in gdp during a business cycles is owing to movements in investment. Indeed, economists have identified that it is changes in investment that is primarily responsible for business cycles.

Hence a proper understanding of how investment occurs is essential to understanding macroeconomics. Investment occurs through financial markets. Generally speaking, savers (individuals with excess money they wish to save) provide the money to business firms with investment projects (but without their own money to put into the project). For reasons to be discussed later, most of this transfer of funds from savers to firms occur within financial markets.

Broadly speaking there are two types of finance that occurs in markets.

1. Direct Finance: With direct finance there is a direct relationship between the saver and the firm.

2. Indirect Finance: With indirect finance there is an intermediary between the saver and the firm.

There are also two types methods of financing that occurs:1. Financing with Equity…selling ownership in your firm. The buyer then gets a share of

the profits.2. Financing with Borrowing…Taking out a loan and repaying with interest.

Putting these together we have really four types/methods of financing.

1. Direct Finance and Equity…directly participating in the purchase of stocks, or becoming a silent partner with a firm.

2. Direct Finance and Borrowing…directly participating in the purchase of a corporate bond, of lending money directly to someone you may know.

3. Indirect Finance and Equity…When financial intermediaries buy equity in firms for their clients/depositors. Examples are mutual funds, insurance companies, etc.

4. Indirect Finance and Borrowing…When financial intermediaries make loans to firms. Examples are banks.

By far the most prevalent of the above is number 5; indirect finance by borrowing. At least 90% of all investment occurs with funds that firms have borrowed from financial intermediaries. Hence understanding financial intermediation is fundamental to understanding investment in the economy.

The Role of Financial IntermediariesThe role of financial intermediaries is the same as that of other intermediaries; to reduce transaction costs and thereby increase wealth. The transactions are somewhat different from other

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transactions. Instead of trading a good, in a financial transaction a person trades the use of their money for future repayment, which for a loan is the interest rate applied to the loan. If done correctly, financial transactions will transfer funds to those firms that have the highest return investment projects in the economy.

Types of Transaction Costs Search Costs: need to find someone willing to borrow what you have to lend Costs of Writing Contract Costs of Determining Risk Cost of Monitoring the Borrower, particularly when he says he cannot pay

How a Bank Reduces These Costs A bank accepts many deposits from small savers and pools their money to make any size

loans, including large loans. A bank develops expertise in lending and writing contracts. Instead of each saver trying

to write a contract, the bank can write a single contract and use it for all loans. A bank can develop expertise in determining good and bad risks. Individual savers cannot

develop the expertise. A bank can develop plans/strategies for dealing with bad loans, apart from going to court.

Determination of Interest RatesThe interest rate is like a price. As the price is the benefit a seller gets from supplying goods, the interest rate is the benefit the lender gets from supplying loans. Hence as the interest rate rises, loan supply rises. This relationship is pictured in the following graph. Note that loan supply represents funds made available for lending; that is, the savings of the people in the economy.

The interest rate is also a price to borrowers. Just like a price is the cost a buyer pays when demanding goods, the interest rate is the cost a borrower pays when demanding loans. Hence as the interest rate rises, loan demand falls. This relationship is pictured in the following graph. Note that loan demand represents desired borrowing. So most firms borrow funds for investment purposes, loan demand is ultimately determined by the returns on investment.

Loans

Interest Rate

LS

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Equilibrium in the Loanable funds market occurs at the interest rate where loan supply equals loan demand. This is pictured in the graph below.

As with a price, the interest rate will change if loan demand changes (perhaps because returns on investment changes), or if loan supply changes (perhaps because savings changes). These possibilities are pictured below:

Loans

Interest Rate

LD

LD

LS i

ie

LLe

i

i

i

i

Quantity

Quantity

Quantity

Quantity

Ld increase

LS IncreaseLS Decrease

Ls

Ld0

Ld1

i1

i0

L0 L1

Ld1

Ld0

LS

i0

i1

L1 L0

Ld

LS0

LS1

i0

i1

L0 L1

S1

S0

i1

i0

L1 L2

Ld decrease

Ld

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Hence we see the interest rate is determined by the same things that determine any other price; changes in supply and demand conditions.

Sample Questions for Section III.B

1. A financial systems transfers funds from ________________ to ________________.

2. The funds for investment comes from __________________.

3. When a business raises funds for investment by selling shares of ownership this is known as __________ financing

4. When a business raises funds for investment by receiving funds with a promise to pay them back with interest this is known as financing by _________________.

5. If there is no intermediary between investors and savers this is known as ____________ finance.

6. If there is an intermediary between investors and savers this is known as ____________ finance.

7. Most investment in the economy is __________ finance by ___________.

8. Financial intermediaries exist to __________ transaction costs.

9. Financial intermediareis help promote economic growth by __________ transaction costs, and thereby increasing ____________.

10. An increase in loan demand will cause the interest rate to ______ and the quantity of lending to ______.

11. A decrease in loan demand will cause the interest rate to ______ and the quantity of lending to ______.

12. An increase in loan supply will cause the interest rate to ______ and the quantity of lending to ______.

13. A decrease in loan supply will cause the interest rate to ______ and the quantity of lending to ______.

.Circle the correct answer1. Investment in the economy is financed (paid for) by the savings of individuals in the

economy. Direct finance of investment refers toa. when there is no intermediary between savers and the firm that is investing.b. when there is an intermediary between savers and the firm that is investing.c. when the savers invest in the firm by buying part ownership of the firm (i.e.

equity)d. All the above

2. Which is more common in the economy; indirect finance or direct finance?a. Indirectb. Direct

3. Which is more common in the economy; financing by borrowing or financing with equity.

a. Financing by borrowing.b. Financing with equity.

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4. Financial transactions take funds from those with low return investment opportunities and transfer them to those with high return investment opportunities.

a. Trueb. False

5. Financial Transaction Costs includea. search costsb. costs of gathering information on the quality of loan applicants.c. costs of writing a loan contract.d. All the above

6. Suppose person A has an investment opportunity that pays a return of 12%, but has no money to invest. Also suppose person B has an investment opportunity that pays a return of 5%, and he has money to invest. Then

a. it is optimal for person B to transfer his money to A and let A make the investment.

b. an interest rate that makes them both better off is 9%.c. this transaction will not occur if the transaction cost if more than 7%.d. All the above

7. Financial intermediaries (such as banks) exist to reduce transaction costs, thereby increasing investment in the economy.

a. Trueb. False

8. Suppose the returns on investment increases, causing the demand for loans to increase. Then one would expect the interest rate to

a. riseb. fall

9. Suppose there is a tax on investment, causing the returns to investment to fall. In this case the demand for loans will fall. This will

a. reduce the amount of lending in the economy.b. increase the interest rate in the economy.c. decrease the interest rate in the economy.d. A and Be. A and C

10. Suppose there is an economic expansion, causing savings to rise. Then one would expecta. the interest rate to rise.b. the interest rate to fall.c. lending to increase.d. A and Ce. B and C

Answers1. a 5. d 9. e2. a 6. d 10. e3. a 7. a4. a 8. a

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III. Macroeconomics and Social CooperationC. Money and Prices

1. The Role of Money2. Money Market Model

1. Price and Inflation in the Long-Run2. Interest Rates in the Short-Run

The Role of MoneyLet us begin with a definition:

Money is a medium of exchange; it is the good that is accepted as payment for all other goods and services. One accepts money as payment not to consume the money, but to use it to buy the goods they wish to consume.

To understand how money reduces transaction costs let us begin with a simple model without money. If money is not used then a situation of barter exists. Barter means that you trade a good you have directly for a good you want to consume. So if you have clothing and you want food, you trade clothing directly for food. The problem with this is in terms of finding a trading partner, because you must find someone that not only has food he wants to sell, but who also happens to want the clothing you have. That is, there must be a double coincidence of wants. Such a situation is presented schematically below:

While this may seem plausible in our two person model of trade, it is highly unlikely in the real world where there are thousands of goods and millions of potential trading partners. For example, how difficult would it be for me to buy food if I needed to find a grocer who happened to want an economics lesson? That is to say, the search costs of finding a trading partner may be so high that you decide not to trade. And as we learned earlier, without trade there is no specialization. Hence reducing these search costs is crucial for any economy.

To show how money can reduce the search costs let us take a simple case of three people (A, B, and C) and three goods (clothing, food, and housing). I will assume each person has one of the three goods, but wants a different good. To capture the idea of high search costs I will assume there is no double coincidence of wants; that is, barter is impossible (which is like saying it is very, very costly). The following illustrates the situation.

Person B(Has Food, Wants Clothing)

Person A(Has Clothing, Wants Food)

Clothing

Food

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As you can see there is no double coincidence of wants. Thus trade cannot occur with barter. However, we could “force” trade as depicted above. In some sense, though, this seems to violate the idea that one only trades if it makes them better off. The reason is person B accepts something in trade that he does not want (clothing). But notice that he can then immediately trade the clothing for what he ultimately wants (housing). So while B does not value clothing, he does value the fact that the clothing can be traded for housing. So actually, B would be willing to accept clothing in exchange if he believes he can trade it for the good he ultimately wants. But notice this is precisely the definition of money: A good accepted in exchange, not because you want to consume it, but because you want to use it to buy other goods. Thus in our example, clothing is being used as money.

However, money does not have to be a real good in order to solve the double coincidence of wants problem. Suppose there are pieces of paper (called M). People will accept these in exchange their good as long as they believe other people will accept them when they want to buy something. Such a situation is depicted below, where I have started person A out with M pieces of paper.

In this case everyone accepts M not because they ultimately want it to consume, but because they can use it to get the good they want to consume.

In a system of barter, finding a double coincidence of wants is so unlikely that trade is very costly. Hence there will be little specialization and wealth will be greatly reduced. A system using money removes the double coincidence of wants problem so that trade is much less costly. Thus more trade, and specialization, will occur. Hence the use of money increases the wealth in the economy.

Person A(Has Clothing, Wants Food)

Person B(Has Food, Wants Housing)

Person C(Has Housing, Wants Clothing)

C

F

C

H

Person A(Has Clothing and M, Wants Food)

Person B(Has Food, Wants Housing)

Person C(Has Housing, Wants Clothing)

M F

M

HC

M

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The Quantity of Money and the Determination of PricesTo understand the relationship between money and prices, let us first define total spending in an economy; or sometimes referred to as nominal GDP. Nominal GDP is real gdp expressed in current dollars. It is simply real output multiplied by the price level in the economy. For example, if we let Y stand for real output of the economy, and let P stand for the price level in the economy, then total spending is given byTotal Spending = P*Y

As a numerical example, if there are 100 goods produced and the price level is R0 5 per good, then

Total Spending = P*Y = RO5 *100 = RO 500

This is the most obvious way to compute spending. And it is clear how the price level is linked to spending in the economy. However there is another way to compute spending that links the money supply in the economy to spending. This follows from the fact that when we buy things, we are spending money.

It is tempting to think that all spending must be equal to the money supply. That is, if there is 100 million rials in the economy, then spending must be equal to 100 million rials. But actually spending is more. The reason is spending is measured over a period of time, while the money supply is measured at a point in time. So the same money can be spent multiple times during a period of time.

The number of times one rial is spent during a year is called the velocity of money (velocity means speed; for example 1 rial may be spent twenty times in one year). What this means then is that the total amount of spending supported by 1 rial is actually 1*V. So if V = 20, one rial supports RO 20 of spending. More generally, if there are a total of M rials in the economy, total spending is M*V. For example, if there are 50 rials in the economy, and velocity is 10, then

M*V = RO 50*10 = RO 500.

Since we have two ways of calculating spending, we can equate them to get what is called the equation of exchange.

PY = MV.

We can use the equation of exchange to determine the price level. Dividing by Y we have

P = MV/Y.

The relationship between money and prices is now clear. As the money supply rises, the price level rises proportionally. For example, suppose V = 20, Y = 1000, and M = 200. Then

P = 200*20/1000 = 4000/1000 = RO 4

Now suppose V = 20 and Y = 1000, but M = 400. That is the money supply doubles. Then the price level is given by

P = 400*20/1000 = 8000/1000 = RO 8…the price level also doubles.

This is called the quantity theory of money. An increase in the money supply causes a proportionate change in the price level.

Other Effects on Price Level

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* If Y increases then P falls. For example, suppose again that V = 20, Y = 1000, and M = 200. Then

P = 200*20/1000 = 4000/1000 = RO 4

Then suppose that Y rises to 2000. Then we have

P = 200*20/2000 = 4000/2000 = RO 2.

* If V increases, the price level rises. For example, suppose again that V = 20, Y = 1000, and M = 200. Then

P = 200*20/1000 = 4000/1000 = RO 4

Then suppose that V rises to 40. Then we have

P = 200*40/1000 = 8000/1000 = RO 8.

What Causes Changes in Velocity(1) Technology…how easy is it for money to change hands depends on the ease of

converting other assets into money. Hence ATMs, checks, etc. allows for quick change of money, implying velocity rises, implying the price level rises.

(2) Interest Rates…the higher the interest rate, the greater the cost of holding money (instead of other assets), hence the quicker will people get rid of their money. Thus velocity is higher at higher interest rates, implying a price level increase.

Neutrality of MoneyWe established above that an increase in the money supply causes the price level to rise proportionately. A further statement says this the only impact an increase in the money supply has. This is known as the neutrality of money proposition. It states that a one time increase in the quantity of money causes a proportionate change in the price level, but leaves all real variables unchanged.

The idea is that production of goods and services depends on technology, resources, labor force, etc…Not the quantity of pieces of paper called money. And in fact there is much evidence for the neutrality of money. As the money supply rises, the price level rises proportionally, but other things are left unaffected.

Long-Run vs. Short-runBut this results holds only in the long-run (e.g. 30 years). In the short-run, changes in the money supply do not affect prices in such a simple way, and output may vary with the money supply.

InflationInflation is defined as the percentage change in the price level over a period of time. While prices may rise or fall due to various factors identified above, we are interested in the situation in which prices are continuously rising over a long period of time. Understanding this to be a situation of inflation, our question is what could cause inflation. In general, anything that causes the price level to rise could cause inflation if that continues to occur. Below we consider the possible explanations for inflation.

Possible Explanation for Inflation1. Decrease in Y (i.e. real gdp):We saw above that a decrease in Y would cause the price level to increase. But for this to be the cause of inflation (i.e. continual increases in the price level) it would have to be the case

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that Y continually decreases. However we observe just the opposite to be true. Y tends to grow through time. Hence its effect would be to cause prices to go down, not up, hence this cannot explain inflation.

2. Increases in V (velocity):If velocity increases over time, the price level would increase over time. There are two possible reasons velocity may increase.A. Velocity may increase because of an increase in the interest rate. But for this to be the

explanation for inflation it would have to be the case that the interest rate is always increasing. This is simply not the case. In fact, over the long-run the interest rate is fairly constant. In the short-run it is just as likely to fall as rise, hence this cannot explain inflation.

B. Velocity may also increase if technology related to banking increases. Technology does increase over time, hence this can be an explanation for inflation. But technology changes very slowly, and could only be responsible for a very small inflation (less than 1% per year), whereas much of the world has experienced very large inflation (over 100% per year). So while this explains some inflation, it cannot be the only explanation.

3. Increases in M (Money Supply):As shown above an increase in the money supply will cause an increase in the price level. For this to explain inflation it must be it is possible for the money supply to continually increase. In fact, there is nothing restricting the supply of money. The government can print as much as they like. Hence this is the only possible explanation for inflation.

The above demonstrates that inflation is caused only by continual increases in the money supply.

Sample Questions on Section III.CFill in the Blank

1. Suppose Person A has fish and want rice, while Person B has rice and wants fish. If A trades the fish to B, and B trades the rice to A, then this is known as _______.

2. For barter to work requires a double _______________ of _______.

3. Barter is costly because the ____________ costs of finding a double coincidence of wants is very high.

4. A medium of ____________ is when a good is accepted as payment not because one will consume the good, but because they can use it to buy other goods.

5. Without money (i.e. medium of exchange) search costs are so high people may not trade. Hence money allows for more_____, thus allowing for ______________to occur, which creates wealth.

6. ____________ is the number of times a unit of money changes hands in a given period of time.

7. According to the equation of exchange Price*Total Production = ______ * _______.

8. According to the equation of exchange P = ____/__.

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9. If M rises, P will _____. If Y rises, P will _____. If V rises, P will _____.

10. If V and Y are not determined by M, then an increase in M will cause a proportional change in the price, but have no impact on production. This is known as the __________ of money ___________.

1. Moneya. reduces search costs, thereby allowing for more trade.b. is the good accepted as payment for other goods.c. removes the need for a double coincidence of wants in a transaction.d. All the above

2. All money must be backed by gold to be used as the medium of exchange.c. Trued. False

3. The equation MV = PY is known asa. the equation of exchange.b. real gdpc. nominal GDPd. none of the above4. According to the equation of exchange, if M = 800, V = 50, and Y = 400, then the price

level, P, is equal toe. 20f. 50g. 100h. 200

5. The price level will rise ifa. the money supply risesb. velocity fallsc. gdp risesd. All the above6. Inflation (i.e. a long-run, continual increase in the price level) can only be explained bya. a continual fall in gdp.b. a continual rise in the interest rate.c. a continual rise in the money supply.d. None of the above

ANSWERS1. d2. b3. a4. c5. a6. c

Short-Answer/Problem Solving1. Explain how money creates wealth, compared to a barter economy. 2. Suppose M = RO 1000, Y = 20, and V = 10.

a. Compute the price level, according to the equation of exchange.b. Compute the price level, assuming M = RO 2000, Y = 20, and V = 10.c. Compute the price level, assuming M = RO 1000, Y = 40, and V = 10.

Compute the price level, assuming M = RO 1000, Y = 20, and V = 20

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III. Macroeconomics and Social Cooperationc. Economic Growth

i. The Cause of Long-Run Economic Growthii. Why Poor Countries Do Not Catch Up to Rich Countries

iii. Government Policy and Economic Growthd. Economic Fluctuations

i. The Dataii. Theories of Economic Fluctuations

1. Real Business Cycles2. Coordination Failure3. Money Supply Changes

When we discus the movements of gdp over time, there are two macroeconomic issues. One is the long-run tendency for gdp to increase over time, and the other is the fluctuations in gdp over relatively short time periods. These two happen, of course, simultaneously. Hence the actual changes in gdp may appear as follows (where gdp is on the vertical axis and time is on the horizontal axis):

In this graph, the dashed line is the actual gdp (or national income). The solid line shows the general, long-run tendency for the economy to grow. It is called the Trend line. Movements away from this trend line are the short-run fluctuations in the economy. For our purposes we have two issues then: Long-Run Economic Growth and Short-Run Fluctuations.

Questions of Economic Economic GrowthThere are two big questions related to economic growth:

1. What causes the kind of steady economic growth that we have experienced for the past 200 years?

2. Why do large gaps in national incomes exist…that is, why don’t poor countries catch up to the rich countries?

These two questions can be explained using the graph below. In the graph below, national income (Y) is on the vertical axis and time is on the horizontal axis. The graph on the left hand side shows the rich country growing at some particular rate. The poor country is also growing at the same rate, but because it starts out poorer it does not catch up to the rich country; that is, large gaps in

Trend National Income

Actual National IncomeExpansion

Recession

Real gdp

time

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national income persist through time. In this case we say the national income of the poor country does not converge to that of the rich country; or that convergence does not occur. In the graph on the right, the rich country grows at some rate. The poor country starts out growing at the same rate, but at some particular time starts growing at a faster rate. Eventually the national incomes are the same and they both grow at the same rate. In this case we say convergence does occur.

So our questions are why the rich countries continually grow, as pictured in the graphs below. Second, why don’t all countries converge? While the answers to the questions are not perfectly known, we will provide seems plausible answers to these questions and give you an understanding of what are the issues that might drive the answers to these questions, and also what government policy might be most conducive to economic growth.

Productivity: The Key to Economic GrowthProductivity measures how much a typical worker producers in one hour. Hence it is the ability to produce that ultimately determines a country’s level of output. Thus the growth of output is determined, ultimately, by changes in productivity…i.e. productivity growth.

But this just restates the question. What determines productivity? We can identify four primary determinants of productivity. These are as follows:

Determinants of Productivity1. Physical Capital2. Human Capital3. Natural Resources4. Technological Knowledge

Let us discuss each of these in turn.

Physical Capital: Machinery, equipment, buildings, etc…the things used by firms to produce goods and services.

Human Capital: Education and skills acquired by people…Like physical capital human capital is useful in producing goods and services. Also like physical capital, people must abstain from current consumption in order to acquire human capital.

time time

Y YYrich

YPoor

Yrich

YPoor

Growth: No Convergence Growth: Convergence

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Natural Resources: Land, non-renewable resources, etc.

State of Technology: The scientific and practical knowledge that has been acquired up to a particular point in time.

So Growth in gdp comes from growth in these key determinants. The changes in these determinants are referred to as

1. Investment…change in physical capital2. Education…change in human capital3. If we use natural resources, the amount of natural resources must be falling4. Research and Development Spending…change in technology

Potential Determinants of Long-Run Economic Growth InvestmentLet us first consider investment as a source of long-run growth. That is, could investment in physical capital be the reason for sustained long-run economic growth? This seems highly unlikely. The reason is, for given technology, the returns to capital may be very high when capital is low, but as capital is increased through investment the returns to capital will become very low. So investment can only explain, short-run temporary growth; not long-run permanent growth.

Human Capital and EducationAs with physical capital, human capital has diminishing returns. This means that it also cannot explain long-run economic growth. There would come a point where it no longer pays to invest in human capital and we come to a steady state level of human capital.

Natural ResourcesSince natural resources are either constant (e.g. land) or falling (e.g. oil), this would tend to decrease productivity and cause negative economic growth. So clearly this cannot explain long-run economic growth.

Technology and KnowledgeThis leaves us with technological changes as the source of economic growth. To understand this let us consider what an improvement in technology looks like. The graph below starts with a production function as we used above. It also shows a shift in the production function so that the new production function allows more output for a given amount of capital. This captures the improvement in technology.

What determines the amount of technology that gets created? It is the individual return to investing in research and development. The problem is that R&D creates a positive externality. If that externality is severe then no one would want to invest in R&D. Thus solving the problem of the externality is important to promoting world economic growth. There are basically two ways to solve the externality;The first is to create and enforce patent laws. The second is to subsidize R&D spending.

Explaining ConvergenceThe Role of Investment in ConvergenceFor poor countries, investment in capital has a very high return, allowing them to increase the level of their income to that of the rich countries. Hence investment is critical to economic growth and development. However, the savings of poor countries will be very low, and hence investment will be low, so while investment will occur, it will be very low, and growth will be very slow. However, if foreign investment is allowed, the level of investment is not limited by the income in the country, but only by the willingness of foreigners to invest. Hence foreign investment can allow a poor country to grow very fast.

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Based on the above, we can say government policy created to attract foreign investment can allow poorer countries to grow very fast. Similarly bad government policy can cause foreign investors to look elsewhere to invest. The following list some things that would reduce foreign investment:

Lack of Protection of Property Rights: That is, one will not invest unless they are guaranteed that they get to benefit from that investment. So if the property in which they invested is taken by another, they will not invest. For example, a foreign investor will not build a new factory if he fears another can seize the property on which that factory is located. Such a lack of property rights could come from a poor legal system. With a poor legal systems, one may not be able to enforce contracts, recover money owed to them, etc. Hence one cannot do business in that country, making it difficult to attract foreign investment. Also, a lack of property rights could come from an unstable government. For instance, if a new government can comes to power and seizes property in which you invested, you receive no return on your investment. Hence, countries with poor legal systems and unstable political situations find it difficult to attract investment.

Health and EducationThe health and education of the workers determines the productivity of investment. If workers are of low education and poor health, they will not use the capital goods well, and the returns on investment will be low. Hence government policy aimed to improving health and education may have an effect, eventually, of attracting more foreign investment.

Inefficient Financial InstitutionsIt may also be that foreign investment comes from foreigners in the form of deposits in banks. In that case foreigners are less inclined to invest in the economy if banks, and other financial institutions, are inefficient. For example, if banks make risky loans, or have high operating costs giving rise to low interest rates to depositors, then foreigners are less likely to want to invest.

Short-Run Economic FluctuationsAnother important topic in macroeconomics is business cycles, or economic fluctuations. One way to think about business cycles is as a deviation from the long-run growth path. The earlier graph in this section shows a solid line reflecting long-run “trend” growth. The actual values of national income at each and every point may deviate from that. These deviations from the trend are business cycles. When above the trend, it is called an expansion in the economy. When below the trend it is called a recession.

Before turning to explanations of business cycles there is one fact that one must know to explain business cycles. This is the fact that most of the movement in gdp over the course of the business cycles is due to changes in investment spending. That is, during economic expansions most of the increase in gdp is due to increases in investment. During economic recessions most of the decrease in gdp is due to decreases in investment.Explanation 1: Real Business CyclesSuppose there is a technological improvement that increases productivity. Assuming investment takes time, this starts a period of prolonged investment, giving rise to an economic expansion.

If productivity falls, firms will reduce investment. Given it takes time to sell of capital, there will be a period of disinvestment, giving rise to an economic recession.

Note in these cases there is nothing wrong with the economy. The economy is simply responding to changes in productivity. But because there is nothing wrong with the economy, economic

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fluctuations are not a cause of concern, and thus the government need not be concerned with them. So the optimal government policy is to do nothing.

Explanation 2: Malfunctioning in the EconomyAnother theory of business cycles suggests that economic fluctuations are due to the malfunctioning of the economy. We could imagine there are two types of malfunctions in the economy. First we do not use all our resources efficiently. This would correspond to a recession. Second, we are over-using our resources.. This would correspond to an expansion.

What could cause such a malfunction in the economy? Below are some possible answers.

1. Money Supply ChangesOne theory of economic fluctuations is that they are tied to changes in the money supply. For instance, suppose the money supply unexpectedly increases. People tend to spend this extra money by putting it in banks, and the banks make loans. This increase in loans causes interest rates to fall. As a result, more firms take out loans and investment by these firms increase. The increase in the money supply thus causes an economic expansion. However, this is not permanent since the increase in lending is not based on people’s desire to increase savings. Once the economy adjusts to the increase in money supply (meaning price level rises), firms will realize they have overinvested, and investment falls. This returns the economy to its normal growth path.

In the same way a decrease in the money supply causes a recession. As the money supply falls, lending falls, interest rates rise, and investment falls. Eventually, once the economy has adjusted to the decrease in money supply, investment rises returning the economy to its normal growth path.2. Coordination FailureCoordination failure shows up in many settings, so it is best to get an understanding of this concept before applying it to economic fluctuations. Coordination failure can occur whenever there is joint production of a good; that is, when two or more people are involved in production of a good. In this case the outcome depends both on your action (which you can control) and the actions of another (which you cannot control). This leads to two possible results. In one case, if person A feels person B will not work hard, then person A will not work hard. In this case, production is low. However, if person A believes person B will work hard, then person A will work hard. In this case production is high. The fact that they must coordination their behavior means sometimes they may fail to coordinate, leaving us with a low level of production; hence the term coordination failure.

Now let us apply this to economic fluctuations. In a highly specialized economy, it is only worthwhile working hard if others in the economy work hard. So if we ever come to believe others will not work hard (or that production will be low), we will not work hard. If everyone thinks this way, no one works and production is indeed low. So anything that alters our optimism about the future can actually cause a recession.

In the same way it would be possible to show that over optimism can make people believe there are rewards to very hard work, when in fact there are not. In this case, every one works very hard, uses all resources intensely, and a temporary expansion occurs.Government PolicyNotice since both of the above explanations occur due to malfunctions in the economy, there may be a role for government policy. If money supply changes are responsible for economic fluctuations, then this implies the government should attempt to have a very stable money supply and be very predictable in their policy.If coordination failure is the explanation it is more complicated. We would have to know what triggers such waves of optimism or pessimism. Even then it is not obvious what can be done about it.

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Sample Questions on Section III.D and III.EEconomic Growth

1. Which of the following is one of the two questions of economic growth?a. Does investment contribute to growth?b. What causes long-run economic growth?c. Why don’t poor countries catch up to rich countries?d. A and Be. B and C2. The best explanation for what causes permanent long-run economic growth isa. investmentb. educationc. changes in natural resourcesd. improvement in technology3. Foreign investmenta. is when foreigners invest in a country.b. is very important for economic developmentc. will occur if the returns on investment are high.d. All the above4. Some poor countries grow fast enough to catch up to rich countries, while other poor

countries never catch up to rich countries. Which of the following helps explain why some poor countries never catch up to rich countries?

a. The returns on investment when capital is low (like in poor countries) must be very low.b. Poor protection of property rights discourages foreign investment.c. Lack of education and low quality of health makes workers less productive, discouraging

foreign investment.d. A and Be. B and C

Short-Run Fluctuations5. A recession is when gdp falls.a. Trueb. False6. According to one theory of business cycles, an unexpected increase in the money supply

will cause gdp to rise.a. Trueb. False7. Suppose Persons A and B together produces a good for their consumption. If one person

does not work hard because they believe other will not work hard, then it may be that no one works hard and production and consumption will be low. Using this as a theory to explain business cycles, this is known as real business cycle theory

a. Trueb. False8. Which of the following theories of business cycles implies there is no role for the

government in reducing business cycles?a. Real Business Cyclesb. Coordination Failurec. Money Supply Changesd. All the above have a role for government.

ANSWERS1. e 5. a 2. d 6. a 3. d 7. b4. e 8. a

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