Review Im planning just a Q&A on 12/9. Here are last PPF Macro - PDF document

12/3/2019 3:09 PM OUTLINE — December 5, 2018 Review  I’m planning just a Q&A on 12/9. Here are last  PPF  Macro definitions: GDP, year’s review slides as an FYI Unemployment, Inflation  Economic Growth  Gains from Trade  Keynesian Model  Supply & Demand  Y = C + I + G + EX - IM  Elasticity  Review of Material  Spending Multipliers  Consumer & Producer  Investment  Order of file is Surplus  Fiscal Policy • Micro (pp. 3 - 34)  Profit-Maximization  International finance • Then macro (pp. 35 – end)  Market Failure  Phillips Curve  More slides here than we can cover in 50 minutes  Externalities  Inflation & the Fed  Monopoly & Monopolistic  Monetary policy Competition  Asymmetric Information  Distribution Overarching Concepts Production Possibilities Frontier  Counterfactual  General characteristics of  To properly evaluate effect of policy, don’t compare the possible combinations of policy’s results across time because factors other than the output that an economy can policy could have changed, too. produce  Compare the policy’s results ( eg , today’s economy) with  Simplification: 2 types of what the same time period would have hypothetically have output been like without the policy in effect (eg, today without the  Key assumption: No policy, which is “the counterfactual”) deliberate waste  Implication: no unemployment when on PPF  “On PPF” is equivalent to full employment economy  Related to “potential output” 1

12/3/2019 3:09 PM How can we consume beyond PPF? Long-run economic growth  Productivity increases with improvements in [1] Economic [2] Specialization [3] Aid  Education Growth & Trade  Allows  Research and Development  Sources of growth  Comparative consumption  Financial Institutions • advantage beyond PPF but more resources • greater productivity doesn’t shift PPF  Transportation Networks  Allows  Shifts out PPF  Political Institutions consumption beyond PPF but  Property Rights doesn’t shift PPF  Judicial System Movements Along vs Shifts Demand & Supply Model  Question: What determines  Δ price Y MOVE  Supply shifters the price & quantity of a ALONG curve  input costs product?  Δ anything else Y  technology  Assumptions:  prices of related products SHIFT OF curve  Homogeneous product  Lots of buyers & sellers  # of sellers  Demand shifters  No barriers to entry / exit  income of buyers  Full information  wealth of buyers  Everyone is maximizing something:  all other prices • Buyers maximize utility  buyer preferences • Sellers maximize profit  buyer expectations  Note this model is for perfect competition (but results generalize) 2

12/3/2019 3:09 PM Consumer & Producer Surplus Price Ceilings & Floors  Ceiling  Consumer Surplus  Producer Surplus  max price allowed compares compares  Binds if p* > p ceiling  What we are willing to pay  Minimum price sellers are  What we actually pay willing to accept  Floor  Price sellers actually receive  Min price allowed  Binds if p* < p floor  When price is determined by the market, surplus is maximized  Need non-price  Loss of surplus when there’s a market intervention called mechanism to “deadweight loss” determine buyers  Occurs with price ceilings, price floors, excise taxes (ceiling) or sellers (floor) Burden of a Tax Elasticity  Elasticity of A with respect to B  Sales or excise tax on an item increases its price  How much does A change when B changes?  But not by the full amount of percent change of A the tax elasticity   Who “bears the burden” of percent change of B the tax?  Burden = (  price paid or  Price-Elasticity of Demand retained) / tax  Income Elasticity of Demand  Buyers ’ Burden (P 2 – P 1 )/T = % of tax buyers pay  Cross-Price Elasticity of Demand  Sellers’ Burden  Price-Elasticity of Supply (P 1 – (P 2 – T))/T = % of tax sellers pay 3

12/3/2019 3:09 PM Marginal benefit vs marginal cost Price Elasticity of Demand  Compare marginal benefit & marginal cost Determinants Total Revenue Effect  Ignore “sunk costs”  Availability of Substitutes  What happens to TR  Share of Total Spending when price rises?  MB > MC: do it  Time Horizon  Price-Elastic  MB < MC: don’t do it  MB = MC: that’s the best you can do  Price-Inelastic  Unitary Price Elasticity  Profit Max: choose q where MR=MC Profit (  ) Long Run Short Run  Economic Profit =  Technique is fixed  Technique can be Accounting Profit – Opportunity Cost  Entry & exit are changed  Entry & exit are impossible  Accounting Profit =  Opportunity Cost = possible Produce Total Revenue – Total what could owner(s) Exit  Decision Accounting Costs earn elsewhere with  Decision (if planning their time plus what to exit) Shut could owner(s) earn Stay in Down elsewhere with the Industry  Decision (if planning to stay, assets ($) they sunk or if not shutting down): how into the company much to produce? 4

12/3/2019 3:09 PM Law of Diminishing Returns Profit Max: choose q where MR=MC  As quantity of variable input (labor) increases, all else  Rule is always true constant, marginal product decreases (=diminishes)  Market structure determines firm’s  Implication demand and MR  To increase output by constant amount requires ever more curves variable input (labor)  How much profit?  And implication of that . . .  π = TR – TC  Marginal cost increases as amount of output increases = p*q – ATC*q Long-run & Short-run & profit Free Entry Drives Profit to 0  Short- run π > 0 ? Firms enter industry in the long run Market Firm  Short- run π < 0 ? Some firms exit industry in the long run  If π < 0 & firm will exit in the long run, what about short run?  If revenue > variable costs, then produce in SR • Firm is covering all its variable costs, and more  If revenue < variable costs, then shut down in SR • Firm loses less by just paying fixed costs  Supply curve is MC curve above minimum Average Variable Cost 5

12/3/2019 3:09 PM Definitions of Wealth & Income Distribution of Income  Gini Coefficient: A  Income = what we earn Wealth (or, Net Worth) Income measure of evenness of  What you receive annually = Assets – Liabilities distribution  Evaluated over a period  Includes labor income &  Assets: what you own  Gini = 0 means perfectly of time (e.g., per year) property income • Real Assets equal distribution  Sources of Income  Income inequality is as • Financial Assets  Gini = 1 means perfectly • Labor income  Liabilities: what you high (bad) today as in un equal distribution • Property income owe to others 1920s • Transfer payments  Evaluated as of a  Somewhat due to particular date (e.g., as property income of today)  But largely due to inequality in labor income 6

12/3/2019 3:09 PM “Market Failure” Monopoly  If any of these assumptions isn’t satisfied…  One firm  perfect competition  No close substitutes  profit maximization  Barriers to entry  utility maximization  Patents  private property rights  Government franchises  full information  Owning scarce resource  Economies of scale  …then markets “fail” . . .  Illegal means  . . . to produce q* where p = MC  Max profit when choose q so that MR = MC  Long run: π can be > 0 Monopolistic Competition Comparing Industry Forms  Lots of firms Short Run Transition Long Run  No barriers to entry/exit  > 0  = 0 Entry (  S) Perfect  = 0  = 0 No change  Heterogeneous product Competition  < 0  = 0 Exit (  S)  > 0 Entry (  D)  = 0 Monopolistic  Max profit when choose  = 0  = 0 No change Competition  < 0 Exit (  D)  = 0 q so that MR = MC  > 0  > 0 No change  = 0  = 0 Monopoly No change  Long Run: profit = 0  < 0 Exit 7

12/3/2019 3:09 PM Externalities Internalizing Externalities  Your activity affects  Coase Theorem:  People have no incentive to  But if government can someone else  Government intervention take external benefit or cost change the private costs so required to move market to into account that they include the social optimum unless external cost (or benefit),  Negative externality  So private optimum differs • Well-defined property rights then the private optimum  Cost borne by someone else from social optimum • No costs to bargaining can become equal to the • Only a few people social optimum  Positive externality  Benefit received by someone  Otherwise: government If government implements a tax equal to marginal damage else intervention cost, then private market produces socially optimal quantity Tax too small  market equilibrium quantity > socially optimal quantity Tax too big  market equilibrium quantity < socially optimal quantity (Pos externality): If government implements a subsidy equal to marginal external benefit, then private market produces socially optimal quantity Negative Externality: A Tax Positive Externality: A Subsidy 8