Lecture 1 Basics of Economics

1
Lecture 1 Basics of Economics Elasticity
Dr. Rajeev Dhawan Director
Given to the EMBA 8400 Class January 4, 2008
2
Course Objective Teaching Philosophy

• Practical Course to Comprehend the Economic
  Environment so that Managers can make their
  Decisions
• Philosophy is that Micro Sectors Add Up to a
  Macro Environment
• Optimal Blend of Economics and Real World
  Experience/Common Sense
• Train You to Critically Evaluate and Interpret
  Business Press Writings

3
Course Layout

• First Week (12) - Basic Microeconomics
• Second Week (34) Basics of Macroeconomics and
  Basic Workings of an Economy with the Help of a
  Basic Macromodel that can Perform Real-Life
  Fiscal And Monetary Experiments
• Third Week (56) Wrap up with Model Training
  and Group Project Presentations
• Field Trip to the Economic Forecasting Conference
  on Feb. 27th BONUS)

4
Background Articles

• My Economics
• Why Journalists Can't Add
• Where Presidents Have No Power
• Their Money Our Strength
• How to Stop Relatives from Bragging About their
  Big Profits in Real Estate
• Economic Hypochondria

5
Grading Policy

• 50 2 Quizzes in Class
• 25 Group Presentations on a Selected Industry
• 25 Take Home Final Exam
• Macroeconomic Model Exercise
• 25 Bonus - Economic Forecasting Conference

6
Group Presentations

• The objectives of this group project are
• To help you bridge the gap between the economic
  theory and models discussed in class and the
  real world
• To confront the problems of trying to find data
  which are appropriate for the questions under
  consideration and to deal with the problems of
  incomplete information
• To showcase your oral and written communication
  skills
• To identify how the problems faced and the
  decisions made by other firms are similar to your
  own.

7
Suggested Industries

• 1. Wireless Communication
• 2. Networking Security Systems
• 3. Oil Industry
• 4. Healthcare Industry
• 5. Hospitality Industry
• 6. Paper Pulp Industry
• 7. Utility Power Industry
• 8. Consumer Products
• 9. Insurance
• 10. REIT (Real Estate Investment Trust)

8
Macro Framework

• Households Consume Work
• Firms Production Investment
• Government Money Supply, Taxes, Expenditures
• Foreign Sector Exports, Imports Exchange Rate

9
Macroeconomic Model For Teaching

• Section 1 A Model Simulation Approach to
  Macroeconomics
• Section 2 Classification of Equations
• Section 3 Glossary of Variables
• Section 4 Listing of Equations in the Integrated
  Macro Model
• Section 5 Flow Diagram of Integrated Macro Model
• Section 6 Policy Experiments with Integrated
  Macro Model
• Section 7 Guidelines to Use the Model

10
GLOSSARY OF VARIABLES
11
Typical Macro-Model
price level lag 1
world interest rate
IMPORTS
world GDP
inflation lag 1
world price
EXPORTS
EXCHANGE RATE
PRICE LEVEL
NET EXPORTS
money
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
EXPECTED INFLATION
UNEMPLOYMENT
CONSUMPTION
DISPOSABLE INCOME
tax rate
TAX REVENUES
POTENTIAL GDP
capital stock lag 1
investment lag 1
CAPITAL STOCK
labor force
12
Typical Macro-Model
price level lag 1
world interest rate
IMPORTS
world GDP
inflation lag 1
world price
EXPORTS
EXCHANGE RATE
PRICE LEVEL
NET EXPORTS
money
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
EXPECTED INFLATION
UNEMPLOYMENT
CONSUMPTION
DISPOSABLE INCOME
tax rate
TAX REVENUES
POTENTIAL GDP
capital stock lag 1
investment lag 1
CAPITAL STOCK
labor force
13
Typical Macro-Model
price level lag 1
world interest rate
IMPORTS
world GDP
inflation lag 1
world price
EXPORTS
EXCHANGE RATE
PRICE LEVEL
NET EXPORTS
money
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
EXPECTED INFLATION
UNEMPLOYMENT
CONSUMPTION
DISPOSABLE INCOME
tax rate
TAX REVENUES
POTENTIAL GDP
capital stock lag 1
investment lag 1
CAPITAL STOCK
labor force
14
Typical Macro-Model
price level lag 1
world interest rate
IMPORTS
world GDP
inflation lag 1
world price
EXPORTS
EXCHANGE RATE
PRICE LEVEL
NET EXPORTS
money
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
EXPECTED INFLATION
UNEMPLOYMENT
CONSUMPTION
DISPOSABLE INCOME
tax rate
TAX REVENUES
POTENTIAL GDP
capital stock lag 1
investment lag 1
CAPITAL STOCK
labor force
15
New Economy Macro-Model
price level lag 1
world interest rate
IMPORTS
world GDP
inflation lag 1
world price
EXPORTS
EXCHANGE RATE
PRICE LEVEL
NET EXPORTS
money
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
EXPECTED INFLATION
Tech/Profit Opportunities
STOCK MARKET
UNEMPLOYMENT
CONSUMPTION
CONSUMPTION
DISPOSABLE INCOME
tax rate
TAX REVENUES
POTENTIAL GDP
capital stock lag 1
investment lag 1
CAPITAL STOCK
labor force
16
New Economy Macro-Model
price level lag 1
world interest rate
IMPORTS
world GDP
inflation lag 1
world price
EXPORTS
EXCHANGE RATE
PRICE LEVEL
NET EXPORTS
money
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
EXPECTED INFLATION
Tech/Profit Opportunities
STOCK MARKET
UNEMPLOYMENT
CONSUMPTION
EUPHORIA
DISPOSABLE INCOME
tax rate
TAX REVENUES
POTENTIAL GDP
capital stock lag 1
investment lag 1
CAPITAL STOCK
labor force
17
New Economy Macro-Model
price level lag 1
world interest rate
IMPORTS
world GDP
inflation lag 1
world price
EXPORTS
EXCHANGE RATE
PRICE LEVEL
NET EXPORTS
money
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
EXPECTED INFLATION
Tech/Profit Opportunities
STOCK MARKET
EUPHORIA
UNEMPLOYMENT
CONSUMPTION
EUPHORIA
DISPOSABLE INCOME
tax rate
TAX REVENUES
POTENTIAL GDP
capital stock lag 1
investment lag 1
CAPITAL STOCK
labor force
18
New Economy Macro-Model
price level lag 1
world interest rate
IMPORTS
world GDP
inflation lag 1
world price
EXPORTS
EXCHANGE RATE
PRICE LEVEL
NET EXPORTS
money
INTEREST RATE
INFLATION
government
INVESTMENT
REAL GDP
EXPECTED INFLATION
Tech/Profit Opportunities
STOCK MARKET
EUPHORIA
UNEMPLOYMENT
CONSUMPTION
DISPOSABLE INCOME
tax rate
TAX REVENUES
POTENTIAL GDP
capital stock lag 1
investment lag 1
CAPITAL STOCK
labor force
19

• Field Trip to the Forecasting Centers
  Quarterly Forecast Conference on Feb. 27th!

20
The Economic Forecasting Center at Georgia
State University collects and analyzes
macroeconomic data and develops procedures to
forecast the national, regional and local
economies.
http//robinson.gsu.edu/efc/index.html
21
What Products Do We Offer?

• The Center offers
• Forecast Reports
• Georgia and Atlanta (Quarterly)
• Nation (Quarterly)
• Southeast Indicators (Bi-Annual)
• Quarterly Conferences
• Sponsorships
• Custom Consulting Services

22
Quarterly Conferences

• Consortium of GSU Experts and Business Executives
• My Forecast Talk!
• 4 Industry Speakers
• Forecast Reports
• Networking Breakfast, Refreshments and Lunch

23
How to Attend Our Conferences?

• It Costs Money!
• 150 per Person
• Institutional Discounts Available.
• BUT MY STUDENTS ARE IN FOR FREE!
• Check Our Website for Latest Program
  www.robinson.gsu.edu/efc

24
Introduction

• The 10 Principles of Economics

25
What is Economics?

• Economics is the study of how we use our scarce
  productive resources for consumption, now or in
  future.
• Paul Samuelson
• Resources are scarce
• Society has limited resources and therefore
  cannot produce all the goods and services people
  wish to have
• Example clean air water
• Scarcity is not poverty

26
Basic Questions

• What to produce in what quantity?
• How to produce them?
• When and where to produce?
• For whom?
• Who makes economic decisions and by what process?

27
Basic Concepts

• Opportunity Cost Things are Scarce
• Next Best Alternative
• Ex Party on Friday night vs. study for exams
• Cost of Time
• Ex 1 hour wait time at the dentist

28
Basic Concepts

• Marginal Concept At the Margin

• Utility Level of Satisfaction (here, drunkenness)

29
Basic Concepts

• Sunk/Fixed Costs Expenditures Made that Cannot
  be Recovered
• Example
• You bought a computer laptop for 1500
• A newer, upgraded model costs 1200
• The dealer will accept a trade in 400
• What do you do?

30
Winnicks Voyage to the Bottom of the Sea WSJ
by Andy Kessler

• First Mover, FCC regulated fixed costs
• Regulated utility
• Price protection
• You cant lose
• Traffic / use was of low economic value or
  cashless
• Global Crossing couldn't cut prices without
  running the risk of either failing to cover its
  debt or being unable to raise more capital
• Accounting Tricks.

31
10 Principles of Economics

• People face tradeoffs
• No such thing as free lunch
• Give up one thing to get another Opportunity
  Cost (OC)
• Everything has an OC whatever must be given up
  to get that item
• People make decisions at the margins increments
  matter
• People respond to incentives e.g. cigarette
  laws, communism
• Free Trade is good (for everybody)

32
10 Principles of Economics

• Markets organize economic activity
• - Adam Smith Invisible Hand
• Governments can sometimes improve market outcome
• A countrys standard of living depends upon its
  production power (productivity)
• Prices rise when government prints too much money
• Phillips curve short run tradeoff between
  inflation and unemployment

33
Branches of Economics

• Micro The Study of One Entity (firm,
  business, people)
• Macro The Study of a Collection of Things
  (national, aggregate)

34
How are Theories Developed?

• Decision-Makers
• Firms, governments
• Markets
• Place where exchange takes place

35
Who REALLY Owns that WineryTIME Magazine by
Terry McCarthy

• Consolidation is the Norm
• 60 of U.S. wine is produced by the top five
  companies
• Consolidation among distributors is squeezing out
  the medium-sized producers, who make from 100,000
  to 1 million cases a year
• Market is not growing
• Only 10 of adults drink 86 of the wine
• Fixed Costs
• Some wineries do not have enough volume to get a
  priority from distributors

36
Who REALLY Owns that Winery TIME Magazine by
Terry McCarthy

• Reshuffling to scarce resources
• He can make lots of money just by shifting more
  of his production - and more of his customers
  from 1.5L jugs of generic red that sell for less
  than 5 retail to smaller bottles of 7 Merlot
• The Future
• The higher end is where the profits and the
  growth are to be found
• The Italians have figured it out how to create
  tastes that suit the American palate

37
Chapter 4

• Demand Supply

38
Some Basic Definitions

• Market a group of buyers and sellers of a
  particular good or service
• E.g. Warren Buffet has been buying up junk
  bonds
• E.g. Bars, parties informal market
• Stock market organized market

39
Example of Supply Demand

• Hong Kong chicken flu scare? Price of chicken ?
• Mad cow disease in US? Price of beef ?
• Oprah bad mouths beef? Price of beef ?
• Amarillo farmers sue her.
• SARS? (Macro issue)

40
Demand
Quantity demanded (Q) the amount of a good that
buyers are willing and able to purchase at a
given price (P).

• Pints of Beer
• P QD
• 10.00 0
• 7.00 1
• 5.00 3
• 4.00 6
• 2.00 11
• 0.00 19

41
Market Demand versus Individual Demand

• Market demand refers to the sum of all individual
  demands for a particular good or service.
• Graphically, individual demand curves are summed
  horizontally to obtain the market demand curve.

42
The Market Demand Curve
The market demand curve is the horizontal sum of
the individual demand curves!
When the price is 5.00, Catherine will demand 3
beers.
The market demand at 5.00 will be 7 beers.
When the price is 5.00, Nicholas will demand 4
beers.


Nicholass Demand
Catherines Demand
Market Demand
Price of Beers
Price of Beers
Price of Beers
5.00
5.00
5.00
4.00
4.00
4.00
13
7
4
7
3
6
Quantity of Beers
Quantity of Beers
Quantity of Beers
When the price is 4.00, Catherine will demand 6
beers.
The market demand at 4.00, will be 13 beers.
When the price is 4.00, Nicholas will demand 7
beers.
43
Graph Results

• Demand curve/schedule is downward sloping and
  shows the relationship between price of a good
  and the quantity demanded
• Why downward sloping?
• Law of demand Ceteris Paribus (all other things
  being equal) the quantity demanded falls when
  price rises

44
Other Determinants of Demand

• Income (I)
• I ? , D ? ? Normal Goods car, Ferrari
• I ? , D ? ? Inferior goods bus rides, potatoes
• Price of related goods
• Substitutes (inversely correlated)
• Compliments (directly correlated)

45
Other Determinants of Demand

• Tastes taken as above
• You get old and prefer Lincoln Town cars to
  sports cars
• Expectations about future
• Income potential with EMBA degree ?
• Loss of jobs, layoffs prospects
• Market Demand
• More players ? Increase in demand
• Buy IPOs in 90s

46
Shifts in Demand Curve

• Variables that shift the demand curve

47
Shifts in the Demand Curve
Price of
Beer
Quantity of
0
Beer
48
Supply
Quantity supplied (Q) the amount of a good that
sellers are willing and able to sell at a given
price (P).
Pints of Beer P QS
10.00 12 7.00 7 5.00 4 4.00 3 2.00 1
0.00 0
49
Supply

• Supply graph for another bar

Pints of Beer P QS
10.00 8 7.00 5 5.00 4 4.00 3 2.00 1 0
.00 0
50
Determinants of Supply

• Your own Price
• Input Prices
• Cost of bottle of beer labor, capital, rent
• Technology
• Smoking laws ? separation of smoking drinking
• Expectations
• Future outlook

51
Shifts in The Supply Curve

• Variables that shift the supply curve

52
Shifts In Supply Curve
Price of
Beer
Quantity of
0
Beer
53
Equilibrium

• Equilibrium the price where quantity supplied is
  equal to quantity demanded

Equilibrium
6
54
Markets Not In Equilibrium
Excess Supply
Price of
Beer
0
Quantity of
Beer
55
Markets Not In Equilibrium
Excess Demand
Price of
Beer
0
0
Quantity of
Beer
56
Changes in Equilibrium

• Decide whether the event shifts the supply or
  demand curve (or both).
• Decide whether the curve(s) shift(s) to the left
  or to the right.
• Use the supply-and-demand diagram to see how the
  shift affects equilibrium price and quantity.

57
Changes in Equilibrium
Price of
Price of
Beer
Beer
Initial equilibrium
Pints of Beer
0
Pints of Beer
0
58
One bar closes?
New Equilibrium
5.00
4
59
Article Too Many Cars, WSJ by Paul Ingrassia

• Overcapacity is the biggest problem for any
  automobile company in the world
• GM buys Daewoo Motor, Fiat Auto, Saab
• Ford motor owns Mazda, Land Rover
• Daimler Chrysler is riding to rescue Mitsubishi
• Oldsmobile and Chryslers Plymouth, are the first
  major automobile companies in 40 years
• Why do ailing automobile companies who decry
  overcapacity keep ailing car companies?
• National pride plays a big role
• More brands mean more dealerships mean more
  sales.
• But this also means more costs and complexity in
  business operations.
• In reality, overcapacity is not really a problem.
• One mans overcapacity is others bargain.
• Thus, lower priced leases and generous rebates
  abound in todays car market.

60
Chapter 5

• Elasticity

61
Elasticity Its Application

• Evaluating questions like-
• Banana Republic store manager/headquarters needs
  to decide on sale on jeans vs. sale on shirts
• Rain destroys strawberry crop, prices go ?. Does
  it benefit growers ?
• Why dont you ever see sale or discounts on pure
  milk but see it on orange juice ?
• These can be answered with the concept of
  elasticity (or responsiveness of buyers sellers
  to changes in market conditions)

62
Elasticity

• Price elasticity of demand a measure of how much
  the quantity demanded of a good responds to a
  change in the price of that good

63
Continued..

• Two types of demand
• Elastic responds a lot e.g. luxury cars (
  luxuries)
• Inelastic not much change e.g. milk, certain
  food items, gasoline ( necessities)
• Preferences Luxuries vs. Necessities
• Availability of close substitutes Elastic
• Butter margarine cars, booze
• Time horizon
• Gasoline necessity in short run
• Substitute long run (electric cars, walk, bike)

64
Elasticity

• Inelastic Demand
• Quantity demanded does not respond strongly to
  price changes.
• Price elasticity of demand is lt one.
• Elastic Demand
• Quantity demanded responds strongly to changes in
  price.
• Price elasticity of demand is gt one.

65
Demand Curves

• Question Can I tell from the graphical shape of
  the demand curve what kind of elasticity the
  curve has?
• Answer Yes, but not all the time.

66
Perfectly Inelastic Demand
Elasticity 0
Price
Quantity
0
3. . . . revenue goes from 4 x 100 to 5 x 100
67
Inelastic Demand
Elasticity lt 1
Price
Quantity
0
3. . . . revenue goes from 4 x 100 to 5 x 90
68
Unit Elastic Demand
Elasticity 1
Price
Quantity
0
3. . . . revenue goes from 4 x 100 to 5 x 80
69
Elastic Demand
Elasticity gt 1
Price
Quantity
0
3. . . . revenue goes from 4 x 100 to 5 x 50
70
Perfectly Elastic Demand
Elasticity Infinity
Price
Quantity
0
71
Relationship Between Total Revenue (Sales)
Elasticity

• Total Revenue Price x Qty Sold P x Qty
• If demand is elastic, then a price decrease
  increases revenue
• If demand is inelastic, then a price increase
  increases revenue
• Example ? class to contribute

72
Box Shows the 50 Drop of New Paying Customers
for the May August 2004 Conference Caused by
the Latest Price Hike
1st Price Hike
2nd Price Hike
73
Applications of Supply, Demand Elasticity

• Can good news for farmers be bad news for
  farmers?
• Wheat is inelastic Bumper crop ? bad news

74
Increase In Supply In Market For Wheat
Price of
Wheat

Quantity of
0
Wheat