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Economic Theory
Shashi AbeysingheB.Sc(eng), CIMA
Micro-economics
What’s the difference between Microeconomics & Macroeconomics?
Microeconomics examines small economic units, the components of the economy. For example: individuals, households, firms, industries
Macroeconomics looks at aggregates.
For example: national output, overall price level, aggregate unemployment
What is a market?
The interaction of buyers & sellers of a good or service
Questions relevant to all economies, market-oriented or not
1. What goods & services should be produced and how much?
2. How should the goods & services be produced?
3. Who gets the goods & services?
4. How do changes in the production & distribution mixes take place?
In a market economy, these questions are handled by the market.
What & how much to produce:determined by demand & supply conditions, individual choices, & pursuit of profit.
How to produce:determined by technology & resource costs.
Distribution:based on ability & willingness to pay the price.
What if consumer wants or technology change?Those changes alter demand & supply, which changes prices, profits, & consequently output levels & distribution.
The Circular Flow
Households & Resource Owners
Firms
Product Markets
Resource or Factor Markets
money to pay for goods & services
goods & services
labor & other resources
resource payments such as wages, rents, & interest
The market is not the only way that the basic questions of economics can be answered.
In some less developed nations, a traditional economic system is used.
Custom & tradition determine the answers.
Social arrangements & culture dictate the solutions.
Change occurs very gradually.
Historically the former Soviet Union had a command economy.
Resources are government/publicly owned and centralized control is used to determine what is produced, how it is produced, and how it is distributed.
No country in the world has a purely market or purely command economy.
They have mixed economies with both market and government sectors.
In this course, we will deal primarily with the market system.
The Market: Supply and
Demand
What is the law of demand?
The lower the price of a good, the larger the quantity consumers will buy.
So the demand curve slopes downward from left to right.
What is the difference between demand & quantity demanded?
Demand is the entire curve that shows the relation between price & quantity purchased.
Quantity demanded is one particular quantity on the demand curve.
Example: Apple MarketPrice of apples
(in dollars)
Quantity of apples(in thousands of bushels)
D
$ 0.25
6
The demand for apples is the curve D.
The quantity demanded of apples when the price is 25 cents is 6 thousand bushels.
What factors change demand (that is, shift the entire curve)?
1. Consumer income
2. Prices of substitutes and complements
3. Tastes
4. Consumer expectations
Example: Apple MarketPrice of apples
(in dollars)
Quantity of apples(in thousands of bushels)
D1
If income increases, people will buy more apples at every price & the entire curve will shift to the right.
D2
What makes the quantity demanded of apples change?
In other words, what causes a movement along the demand curve for apples?
A change in the price of apples.
That’s it, only a change in the price of apples.
Example: Apple MarketPrice of apples
(in dollars)
Quantity of apples(in thousands of bushels)
D
$ 0.25
6
Suppose the price of apples falls from 25 cents to 20 cents.
Then the quantity demanded of apples rises from 6 thousand bushels to 8 thousand bushels.
8
$ 0.20
What is the law of supply?
The higher the price of a good, the larger the quantity firms will be willing to produce and sell.
So the supply curve slopes upward from left to right.
What is the difference between supply & quantity supplied?
Supply is the entire curve that shows the relation between price & quantity provided.
Quantity supplied is one particular quantity on the supply curve.
Example: Apple MarketPrice of apples
(in dollars)
Quantity of apples(in thousands of bushels)
S
$ 0.22
7
The supply of apples is the curve S.
The quantity supplied of apples when the price is 22 cents is 7 thousand bushels.
What factors change supply (that is, shift the entire curve)?
1. Technology
2. Prices of inputs (for example: land, labor, machinery, raw materials)
3. Weather (in the case of agriculture)
Example: Apple MarketPrice of apples
(in dollars)
Quantity of apples(in thousands of bushels)
S1
If rainfall is low, the supply of apples will be reduced. At each price, there will be fewer apples provided.
S2
What makes the quantity supplied of apples change?
What causes a movement along the supply curve for apples?
Just a change in the price of apples.
Example: Apple MarketPrice of apples
(in dollars)
Quantity of apples(in thousands of bushels)
S
$ 0.22
7
When the price of apples falls from 22 cents to 20 cents, the amount provided falls from 7 thousand bushels to 6 thousand bushels.
$ 0.20
6
What is equilibrium?
It is a state of balance, where there is no tendency for things to change.
P QD QS conditionprice
pressure
0.25 6 8excess supply
0.22 7 7 QD = QS 0
0.20 8 6excess demand
Equilibrium occurs where the quantity demanded equals the quantity supplied, which is at the intersection of the supply and demand curves.
Example: Apple MarketPrice of apples
(in dollars)
Quantity of apples(in thousands of bushels)
D
Here the equilibrium price is 22 cents & the equilibrium quantity is 7 thousand bushels.
7
$ 0.22
S
quantity
D1
Suppose there is an increase in the price of pears (a substitute for apples). Then the demand for apples will increase.Equilibrium price increases & equilibrium quantity increases.
price
S
Q1
Q2
P2
P1
D2
quantity
D
price
S1
Q1
Q2
P2
P1
S2
Suppose there is a long spell of bad weather for apple growing. Then the supply of apples will decrease.Equilibrium price increases & equilibrium quantity decreases.
Suppose that the surgeon general comes out with stronger health warnings.
That will reduce the demand for cigarettes.
Simultaneously, there is a year of bad weather.
That decreases the supply of cigarettes.
Example: cigarette market
price
quantity
D1
S2
S1
Q1
D2
So S & D both decrease. The equilibrium quantity decreases. Equilibrium price may increase, decrease or stay the same. In this example, the price remained the same.
P1
P2 =
Q2
Resources are limited; wants are unlimited
Scarcity = not enough resources to produce the goods to satisfy our wants.
Resources: Adam Smith in his Wealth of Nations (1776) divided resources into land, labor and capital.
http://www.adamsmith.org/smith/won-intro.htm
Adam Smith’s 3 resources: Land, Labor and Capital
1. LAND: used as shorthand for any natural resource,not simply for agricultural land.
2. LABOR: manual power + skill ("human capital")
3. CAPITAL: produced means of production for example, hammers, drill presses, computers ...
.
Although money is used to BUY all the above, money is not itself a productive resource.
Capital grows through investment –.
Scarcity means that choices are necessary.
When you can’t have all you want of everything, you must make choices.
Microeconomics is the study of how to make the best possible ( or the optimal) choice under the constraint of limited resources.
Tradeoffs and the Production Possibility Frontier
Economists would want to develop a more precise model of the tradeoffs involved –
And that model can be represented graphically by a “Production Possibility Frontier”, showing the choices which are-- possible (on or within the frontier)
-- efficient (exactly on the frontier) -- inefficient (within the frontier) -- impossible (beyond the frontier)
Cadillacs ... 1944 and 1946
M5 Tank Cadillac Coupe
Opportunity cost of tank = 10 passenger autos
500
M5 tanks
Autos
5,000
The tank-auto trade-off:an economist's view using the
Production Possibility Frontier
500
M5 tanks
Autos
5,000
The tank-auto PPF:one POSSIBLE point is(2000 autos, 300 tanks)
another POSSIBLE point is
(4000 autos, 100 tanks)300
2,000
500
M5 tanks
Autos
5,000
The tank-auto PPF:
an IMPOSSIBLE point is(4000 autos, 300 tanks)
300
4,000
500
M5 tanks
Autos
5,000
an INEFFICIENT point is(1000 autos, 200 tanks)
200
1,000
500
M5 tanks
Autos
5,000
The tank-auto equation:TANKS = 500 – 0.1 AUTOSCheck out a few values:
AUTOS TANKS 0 500 1000 400 2000 300 2001 299.9
500
M5 tanks
Autos
5,000
Equation in general form:
TANKS = a + b AUTOS
How to find the equation from the graph:
1. a = Y-INTERCEPT = 500
2. b = SLOPE = rise over run = - 500 divided by 5000 = - 0.1
500
M5 tanks
Autos
5,000
What the intercept means:
TANKS = 500 – 0.1 AUTOS
IF we produced zero autos, we could produce up to 500 tanks, since
TANKS = 500 – 0.1 (0) = 500
500
M5 tanks
Autos
5,000
What happens when the intercept changes:TANKS = 600 – 0.1 AUTOS
IF we produced zero autos, we could produce up to 600 tanks, sinceTANKS = 600 – 0.1 (0) = 600
The PPF would shift OUT and parallel to itself.
600
6000
This might be due to an increase in the resources available for production – for example, an increase in the labor force, and a new assembly line in the factory
500
M5 tanks
Autos
5,000
What the slope means:TANKS = 500 – 0.1 AUTOS
IF we were producing 2000 autos and 300 tanksand if we decided to produce one more auto, we would
have to reduce tank production to 299.9 The OPPORTUNITY COST of an auto is
one-tenth of a tank.
500
M5 tanks
Autos
10,000
What happens when the slope changes:TANKS = 500 – 0.05 AUTOS
If autos = 0, TANKS = 500If autos = 5,000, TANKS = 250If autos = 10,000, TANKS = 0
The possibility exists of producing more autos – perhaps some way of producing auto transmissions (but NOT tank transmissions) more rapidly has been discovered.
5000
Introduction Introduction to to
MacroeconomicsMacroeconomics
Introduction Introduction to to
MacroeconomicsMacroeconomics
Macroeconomics?
A Study of aggregate behavior of
Macroeconomic variables
- GDP
- Price level
- Employment
- Interest rate
- BOP
Let us look at the world economy today
Some Statistics
Share of World GDP in 2005 (US$ billion)
I taly 4%
Japan 9%
Rest of the World21%
Germany 6%
India 2%
Korea2%
Russian Federation
2%
Spain 3%
Mexico 2%
France 5%
China 5%
Australia 2%
Canada 3%
Brazil 2%
UK 5%
United States 27%
GDP growth rates in selected regions, 1995-2005
-4
-2
0
2
4
6
8
10
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Year
GD
P g
row
th r
ate
(%)
Africa: Sub-Sahara European Union
Newly industrialized Asian economies World (All WEO countries)
The circular flow of income
The interdependence of goods markets
and factor markets
FIRMS(suppliers of goods and services,
demanders of factor services)
HOUSEHOLDS(demanders of goods and services,
suppliers of factor services)
The interdependence of goods and factor markets
The interdependence of goods and factor markets
Q1
P1
QF2
PF2
Q2
P2PF1
QF1
D2D2
P
Q
P
Q
RsRs RsRs
RsRsRsRs
Factorservices
Goods
GoodsFactor
services
S S
D1 D1
(1)Consumer
demand
(1)Consumer
demand
(4)Factor supply
(4)Factor supply
(3)Factor
demand
(3)Factor
demand
(2)Producer
supply
(2)Producer
supply
OO
D2
The circular flow of income
Consumption, injections, withdrawals and equilibrium
Factorpayments
Factorpayments
Consumption ofdomestically
produced goodsand services (Cd)
Consumption ofdomestically
produced goodsand services (Cd)
The circular flow of incomeThe circular flow of income
Firms
Households
Factorpayments
Factorpayments
Consumption ofdomestically
produced goodsand services (Cd)
Consumption ofdomestically
produced goodsand services (Cd)
Investment (I)Investment (I)
Governmentexpenditure (G)
Governmentexpenditure (G)
Exportexpenditure (X)
Exportexpenditure (X)
BANKS, etc
Netsaving (S)
Netsaving (S)
GOV.
Nettaxes (T)
Nettaxes (T)
ABROAD
Importexpenditure (M)
Importexpenditure (M)
The circular flow of incomeIn an opened economy
The circular flow of incomeIn an opened economy
WITHDRAWALS
INJECTIONS
Macroeconomics policiesMicroeconomic policies are intended to influence or control macroeconomics variables in
order to achieve macroeconomics relationships and outcomes.
Fiscal policy- The government’s decision over taxation and public spending, which are incorporate in
the government’s budget, is referred to as fiscal policy.
Monetary policy-Central bank’s control over money supply affecting interest rate is known as monetary
policy.
Trade policy-The government’s actions influencing international trade constitute trade policy.
Eg: - Tariffs,
Quantitative restrictions on import trade,
Subsidies on export trade,
Controls over the payments of foreign exchange
Macroeconomics policies cont..
Exchange Rate policy-The system of exchange rate maintained in the economy is the exchange rate policy.
This includes different systems such as fixed, floating or managed floating exchange rate systems.
Redistributive policy-The governments usually design policy measures to redistribute income for the benefit of
low-income groups. Income distribution through taxation and welfare are important components of the redistributive policy, included in the government budget.
Economic Growth
Economic Growth
Therefore increasing economic output, is possible under two conditions:
•More resources are used in the economy.
•Existing resources are used more efficiently.
Economic growth- An increase in an economy's ability to produce goods and services- Sustainable increase in real output or real income of an economy
Measurement of Economic Growth
1. Current Real GDP
2. National Output
3. PPF
Current Real GDP
Rate of GDP growth in yeart =
[Real GDPt - Real GDPt-1]/Real GDPt-1
Country 2002 2003 2004 2005 2006 2007 2008 2009 2010
GDP in Sri Lanka (billion)
62.70 73.70 80.58 86.07 95.55 82.02 91.87 96.74 106.5
Calculate GDP Growth
Controversies in economic growth
GDP is not regarded as a good way of indicating the standard of living of individuals and households in an economy.
•The current measure of GDP is not good at reflecting the damage to the environment caused by much economic activity. • Ignores unpaid, voluntary work•How has an economy developed? •Which industries does it depend on?• How sustainable are the routes that a country has chosen to follow towards the goal of growth? •How can we measure human happiness?
National OutputRelationship between total national outputs (Y) to inputs:
Output = Level of technology in the economy+ (productive services of capital + Labour input + Natural resource input)
Y = A+ (K+L+R)
Output Grows due to:
-An increase in productive factors (K, L or R)
-An improvement in Technology (A)
Contribution to the economic Growth
1. Human Resources- Increase in number of workers- Increase in working time- Improvement in quality of work force
- Education, Training, Experience, Positive working attitudes
- Use of technology- Computers, automated equipments
- Improve working conditions- Rewards, pleasant working environment
Employment Rise
Increase in Contribution
2. Natural resources
- Resources availability within the country
3. Capital Formation
- Machines, equipments, buildings and inventories
- Depreciated when used in production
- Grows due to investment
4. Technology change and InnovationR & D is an economic activity aimed at producing
technology
Invention – Discovery of New knowledge
Innovation – Incorporate new knowledge into production techniques
New tools and machines
Training and Experience
New Management practices & new ways of organizing activities
Sources of Growth - Where does it come from?
The sources of growth include:•Natural resources •Labour•Capital•Technology
The pace of technological change will depend on: 1.Scientific skills of the country 2.Quality of education 3.Amount of GDP devoted to research and development
The four Wheels of Progress Factor Income Growth Examples
Human Resources Size of the labour forceQuality of Labors (Education, skills, discipline)
Natural Resources Oil and gasSoils and climate
Capital Formation Equipment and factoriesSocial overhead capital
Technology change and Innovation
Quality of scientific and engineering knowledgeManagerial know-howRewards and innovation
Total Factor Productivity
Increase in output given the productive factors-Total Factor Productivity measured by change in Technology
A = Y - (K+L+R)
-Labour Productivity output per unit of Labour input
Y/L
-Labour productivity can improve due to :
Technology improvements
Capital accumulation – Capital Labour ratio
(Actual and potential economic growth)
Economic Growth and the Production Possibility Curve
v
x
y
O
Growth through making a fuller use of resourcesGrowth through making a fuller use of resourcesF
oo
d
Clothing
Production insidethe production
possibility curve
O
Growth in potential outputGrowth in potential outputF
oo
d
Clothing
Now
O
Fo
od
Clothing
Now
Growth in potential outputGrowth in potential output
5 years’ time
Cost of Economic Growth
Inequality of income
Pollution and other negative externalities
Loss of non-renewable resources
Lifestyle changes
Growth and the business cycle
The business cycle
O
Nat
iona
l out
put
Time
Potential output
1
2
3
4
1
2
34Actualoutput
The business cycle
O
Nat
iona
l out
put
Time
Potential output
Actualoutput
Trendoutput
The business cycle
Growth and the business cycle
The business cycle
in practice
Ann
ual G
DP
gro
wth
rat
e (%
)
Ann
ual g
row
th r
ate
(%)
UK
France USA
GermanyJapan
-3
-2
-1
0
1
2
3
4
5
6
7
8
9
10
1970 1975 1980 1985 1990 1995 2000
Growth rates in selected industrial countries
Causes to the booms and Recession
Random shocks
Policy-induced
Imported cycles
Expectations
•Insufficient or contaminated land
•Substandard labor supply
•Poor technical infrastructure
•Poor social infrastructure
•Poor industrial infrastructure
Barriers to economic growth
International Trade
Why international trade is essential ?
• Every Country lack some vital resources that it can get only by trading with others
• Each country’s climate, labour force, & other endowments make it a relatively efficient producer of some goods & efficient producer of other goods
• Specialization permits larger outputs & offer economies of large-scale production
Modern Governments use three main devices when seeking to control trade
• Tariff Tax on imports
• Quota Legal limit on amount of goods import
• Export Subsidy Payment by the government to exporters to
permit them to reduce the selling price
Foreign Exchange Market
Foreign currencies are bought and sold for local currencies
Exchange Rate
• The price of foreign currency that has to be paid by the buyers of and, received by the suppliers of foreign exchange
Participants in the Market
Bank customers
Commercial Banks
Central Bank
Balance of Payment
Statistical Records of foreign exchange transactions of a country
Two main accounts
Inflow
outflow
The Balance of Payments Account
The current account
International Trade in goods and services
Net Factor income flows
Net transfers
Balance of payments: (Rs millions)Balance of payments: (Rs millions)
Balance of payments: (Rs millions)Balance of payments: (Rs millions)
Balance of payments: (Rs millions)Balance of payments: (Rs millions)
Balance of payments: (Rs millions)Balance of payments: (Rs millions)
Balance of payments: (Rs millions)Balance of payments: (Rs millions)
Balance of payments: (Rs millions)Balance of payments: (Rs millions)
The Balance of Payments Account
The capital account
The financial account
investment
flows to and from reserves
Balance of payments (Rs millions)Balance of payments (Rs millions)
Balance of payments: (Rs millions)Balance of payments: (Rs millions)
Balance of payments: (Rs millions)Balance of payments: (Rs millions)
Balance of payments: (Rs millions)Balance of payments: (Rs millions)
Balance of payments: (Rs millions)Balance of payments: (Rs millions)
Balance of payments (Rs millions)Balance of payments (Rs millions)
UK balance of payments: 2001 (£ millions)UK balance of payments: 2001 (£ millions)
Exchange Rate
The domestic price of a foreign currency unit or the foreign price of a domestic currency unitLKR 100=US$ 1US$ 0.01=LKR 1
Spot Exchange Rate – Current exchange rate quoted for immediate delivery
Forward Exchange Rate – Future exchange rate quoted for today for delivery after a time lag
Depreciation – Reduction the value of domestic currency against foreign currency
Appreciation – Increase in value in domestic currency against foreign currency
Appreciation or depreciation occur in the foreign exchange market due to BoP imbalances
Exchange Rate System
Floating exchange rate SystemER is determined in the foreign exchange
Market demand for and supply of foreign exchange
Fixed exchange systemDetermined by the central Bank
Where do the Supply & Demand come of Foreign Exchange?
International Trade in Good & Services
International trade in financial instruments (Stocks & Bonds)
Purchase of physical assets
Determination of exchange rates
The equilibrium exchange rateBoP equals zeroDemand – Inversely related to the ERSupply – Positively related to ER
Pric
e of
£ in
$/E
xcha
nge
Rat
e
S by UK
Q of £ /Foreign Exchange
Determination of the rate of exchangeDetermination of the rate of exchange
D by USA
$ pr
ice
of £
QS
S by USA
Q of $
Determination of the rate of exchangeDetermination of the rate of exchange
D by UK
QD
b a
QS QD
d$ pr
ice
of £
Determination of the rate of exchangeDetermination of the rate of exchangeS by USA
Q of £
c
D by UK
Fixed versus Floating Exchange Rates
Advantages of fixed exchange rates• certainty• no speculation (if rate is absolutely fixed)• prevents 'irresponsible' government policies
Disadvantages of fixed exchange rates• conflicts with other macro objectives• danger of competitive deflations• problems of international liquidity• difficulties in adjusting to shocks• speculation
Fixed versus Floating Exchange Rates
Advantages of free-floating rates• automatic correction• no problem of international liquidity• insulation from external events• less constraint on domestic macro policy
Disadvantages of free-floating rates• possibly unstable exchange rates• speculation• uncertainty for business
• but use of forward markets• lack of discipline on economy
How to Boost Economic Growth - How can we grow more
The policies to boost growth split into two types:
Demand-side policies ( fiscal policy and monetary policy)
Supply-side policies
Demand-side policies
To boost the level of aggregate demand and therefore growth, the government needs to use deflationary policies. These are policies that help to generate more demand. They include:
• Fiscal policy• Cutting tax rates to boost people's disposable income • Increasing the level of government expenditure• Monetary policy • Cutting interest rates to encourage more borrowing and
spending
Supply-side policies
These are policies that aim to boost the potential for the economy to grow - in other words to supply more. They are policies that should make the economy more productive and more responsive to change. Examples include:
Cutting tax rates - this gives people the incentive to work harder and be more productive
Cutting benefits - this gives the unemployed a bigger incentive to find a job; a harsh policy (but a fair one???).
Promoting education and training - this should make the workforce more skilled and therefore more productive.
Promoting research and development (R & D) - spending on R & D will help find new more efficient ways to produce and should lead to better and more varied products.
Promoting mobility - if the economy is to be as flexible as possible, people need to retrain where necessary and they need to move to where the jobs are. The government has to help encourage this.
The Causes of Economic GrowthEconomic Growth is caused by improvements in the quantity and quality of
the factors of production that a country has available i.e. land, labour, capital and enterprise. Conversely economic decline may occur if the quantity and quality of any of the factors of production falls.
• Improving the Quantity and Quality of Land Resources
• Improving the Quantity and Quality of Human Resources
• Improving the Quantity and Quality of Capital Resources
Thank you