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ECONOMICS what why

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Title: ECONOMICS what why


1
ECONOMICSwhat? why?
Social Science Efficiency
2
Frameworks of analysis within economics
  • MACRO-
  • Unit of analysis economy as a whole
  • Variables of interest include inflation,
    unemployment, output
  • MICRO-
  • Unit of analysis individual economic agents
    consumers, firms
  • Variables of interest include costs of
    production, individual demands, prices

3
  • Managerial economics and microeconomic analysis
  • Marketing
  • Cost analysis
  • Response to macroeconomic events and
    macroeconomic analysis
  • Strategic planning

4
Economic versus Accounting Cost
  • Opportunity cost (just how costly is this class
    to you or to me, or to the University?)
  • Does the benefit of taking this class outweigh
    the cost? (marginal analysis)

5
What is the value of a business?
  • Discounted stream of expected future profits
  • VF P1/(1i) P2/(1i)2 . Pn/(1i)n
  • Example (assume that the discount rate is 5)

VF 10 mill/1.05 10mill/1.1025
12mill/1.157625 28.96 mill
6
Changes in the value of the firm
  • Anything that changes future profits
  • Anything that changes the discount rate
  • Price to earning ratio as a measure of the
    markets expectation of future earnings

Maximization of the value of the firm requires
profit maximization
7
Do managers care about profit maximization?
  • Principle-agent problem conflicting interests of
    shareholders and managers.
  • Possible solutions include
  • payment in companys shares
  • borrowing instead of diluting shareholders
    equity
  • possibility of a takeover
  • Some other problems that can arise include
  • moral hazard
  • asymmetric information and self-selection

8
  • Markets Simple Overview

9
Markets
  • Defining a market
  • Product definition (and competition)
  • Geographical boundaries (internet, shipping cost
    reduction globalization and outsourcing)
  • Market forces Buyers (demand) versus Sellers
    (supply)
  • Price and quantity as the outcome

10
demand
  • Quantity f (price, other factors)
  • Price and the Law of Demand
  • Other factors
  • Income (normal versus inferior)
  • Related in consumption goods
  • Substitutes
  • Complements
  • Expectations about the future
  • OTHER FACTORS
  • Note that the demand is likely to be affected by
    both, macro and micro factors

11
Deriving demand and other factors
model
prediction
data
Data gathering issues (surveys) Models and
simplifications Regression analysis and
results Generalized demand function and inverse
demand function
12
supply
  • Quantity f ( price, other factors)
  • Price and the Law of Supply
  • Other factors
  • Costs of Production (MC, and price as MB)
  • Goods related in production
  • Substitutes (agricultural products)
  • Note, identical to costs of production since is
    based on opportunity cost concept
  • Complements (like gold and silver)
  • Producer expectations of future prices
  • Other factors

13
Market equilibrium
  • Quantity supplied quantity demanded
  • Demand Q a b P
  • Supply Q c d P
  • Equilibrium quantity (adbc)/(db)
  • Equilibrium price (a-c)/(db)
  • Who pays sales tax?

14
Same as before just with inverse functions
  • P a b Q demand
  • P c d Q supply
  • What if shipping cost of S is introduced? What
    impact will it have on the price? Can it be
    completely shifted to the consumer?

15
Who is more dependent on who? Elasticity of
demand Or, from Demand to Revenues
  • Elasticity of demand
  • D(Quantity
    demanded)/D(Price)
  • Elasticity as a measure of responsiveness of
    demand
  • Inelastic and elastic ranges marginal revenue
  • Elasticity and revenue maximization
  • Comparing demands in terms of their relative
    elasticities
  • What makes demand relatively less elastic?
    (Gasoline, Health care)
  • Availability of substitutes
  • Fraction of income spent
  • Time

16
Examples of elasticity at work
  • Health care insurance (co-payment structure)
  • Real estate commission of e-realty
  • Best Buy Reward zone
  • Selective discounts (in terms of products) by
    retailers

17
Point elasticity (requires knowledge of demands
functional form) Q a b P (DQ/Q)/(DP/P)
(DQ/DP)(P/Q) E - b (P/Q) If demand variables
are written in log form then ln Q a b ln
P Then differential leads to dQ/Q -b dP/P
18
Price elasticity of demand
  • TRPQ

Elastic range, E1
P
Unit elastic, E1
Inelastic range E
D
Q
Elastic E1, DQDP, dont
increase P Inelastic E increase P
19
TR, MR and Demand
  • TR PQ, MRD(TR)/DQ

E1
D
MR
20
  • Macro Side Reading Economic Activity

21
Evaluating Economic Activity
  • Output GDP
  • Labor Market Unemployment
  • Prices Inflation indicators
  • International aspects
  • Trade
  • Investment Flow
  • Currency Fluctuations

22
Output
  • Gross Domestic Product - the total market value
    of all final goods and services produced by
    factors of production located within a nations
    borders over a period of time
  • Gross National Product - the total market value
    of all final goods and services produced by
    factors of production owned by a nation over a
    period of time
  • Source for these statistics for the US is
    www.bea.gov (Table 1.7.6)

23
GDP and GNP in chained dollarssource BEA
24
International Comparison source WB
25
Evaluating Economic Activity
  • Employment
  • Labor Force
  • Labor Force Participation Rate
  • Unemployment Rate - CPS
  • Structural versus cyclical unemployment

Historical unemployment rate http//data.bls.gov/
servlet/SurveyOutputServlet?series_idLNS14000000
data_tool"EaG http//data.bls.gov/servlet/Survey
OutputServlet?data_toollatest_numbersseries_idC
ES0000000001output_viewnet_1mth
Statistics for the US economy For March-July 2003
(seasonally adjusted). Source BLS
Discouraged Worker Phenomenon
26
Historical unemployment rate in the US
27
Evaluating Economic Activity
  • Inflation
  • cost of inflation (menu, redistribution of
    wealth, forward looking financial arrangements,
  • standard of living, and for a later topic the
    impact on the exchange rate)
  • measures of Inflation CPI, PPI (for US
    available through BLS)

Real versus Nominal measures
US Real and Nominal GDP. Source BEA
28
Business cycle and the role of the government
Different Sectors of the Economy, GDP identity by
expenditures on final GS (US 2000 shares) GDP
Consumption (70) Investment(15) Govt
Spending (20) Exp Imp(Net Exports 5)
  • Business cycle

Real GDP (per capita)
time
Definition of Recession Supply versus Demand
driven recession
29
More detailed look at the components of the GDP
  • Personal Consumption
  • Goods
  • Durable
  • Non-durable
  • Services
  • Gross Private Domestic Investment
  • Fixed Investment
  • Non-residential
  • Structure
  • Equipment and software
  • Residential
  • Business
  • Government Spending (all levels)
  • Exports of goods and services
  • Imports of goods and services

30
Business Cycle and Inflation
  • Relationship between unemployment (natural
    unemployment) and inflation (there are other
    causes of inflation monetary policy, currency
    depreciation, decreases in the supply of
    resources oil)
  • Costs of inflation
  • Menu costs
  • High inflation tends to be more volatile
    inflation uncertainty and forward looking
    contracts.
  • Nominal interest rate real rate of return
    rate of inflation
  • The more uncertain the future inflation is the
    less likely borrowers and lenders are to agree on
    the interest rate and the volume of loans suffers
    as a result.
  • If anticipated inflation is different from actual
    inflation, wealth may be redistributed in the
    society between borrowers and lenders (different
    generations)
  • Inflation and relative prices

31
business cycle, unemployment and inflation
This slide merely provides you with
some definitions and a basic discussion (for your
reading)
  • Inflation and unemployment are related. Inflation
    will decline, and even deflation may begin when
    unemployment rate is above the natural rate of
    unemployment. In fact, the natural rate of
    unemployment is defined as the rate of
    unemployment at which the inflation rate remains
    constant. Another way of defining the natural
    rate of unemployment is to simply tie it to the
    level of real GDP. Natural rate of unemployment
    is the rate of unemployment that occurs when the
    real GDP is at its long term trend. Note that at
    the start of a recession the unemployment rate
    may still be above the natural rate of
    unemployment and hence the rate of inflation may
    continue to increase. Similarly, early in the
    recovery, unemployment rate remains higher than
    the natural rate of unemployment which may
    further reduce inflation.
  • Inflation is dependent on unemployment. If
    unemployment is high then there is little
    pressure on prices to go up, but if unemployment
    is low, then people can bid up prices because
    they have disposable incomes. There are some
    additional factors that can change inflation,
    including currency fluctuations, but that topic
    will be covered later in the semester when we get
    to the international finance section.

32
Macro Picture of the US economy Stunning Growth
of the 1990s and now
33
1994 Mexican currency crisis
1997 - Asian financial crisis
1998 Russian currency
crisis Recession in Japan Slow Growth in Europe
34
(No Transcript)
35
Real GDP growth in 2003-2004 Source BEA Table
1.5.1
36
Growth in components of Real GDP,
2000-2003 Seasonally adjusted at annual rates
37
Jobless Recovery
Seasonally adjusted US unemployment rate Source
BEA
38
A side-note Job recovery in Atlanta
39
Predicting the Future
  • The magical art of forecasting

40
predictor
  • Correlated with the variable of interest
  • Easily observable and measured

41
Predictors (indicators) - examples
  • Lagging to the variable of interest
  • Employment indicators to GDP (unemployment rate)
  • Coincident to the variable of interest
  • Tax revenues to GDP
  • Corporate income tax receipts to GDP
  • Some employment indicators (total hours worked to
    GDP)

42
More predictors
  • Leading indicators to GDP
  • Average work hours in manufacturing
  • Average weekly claims for unemployment insurance
  • Business inventories
  • New orders for non-defense capital goods
  • Sales tax receipts
  • Stock index (index futures)
  • Construction Employment
  • Residential permits

43
Even more on predictors
  • Lading indicators on inflation
  • Growth in wage rate
  • Productivity growth
  • Money supply (velocity)
  • Interest rate spread (10 year bond federal
    funds rate) or (10 year bond 1 year bond)

44
Production SideTheory of the Firm
45
Production FunctionOutput f (inputs,
technology)
  • Input substitutability
  • Perfect substitutes
  • Q a L b K
  • Imperfect substitutes
  • Perfect complements
  • Q min a L, b K
  • Production technology is captured in the form of
    the function and in the coefficients

46
Time framework
  • Long-run
  • Choice of the production process
  • Choice of combination of inputs
  • Planning horizon
  • Short-run
  • Constrained production
  • Capital level is fixed
  • production is subject to constraint due to
    previous planning
  • Operating framework

47
Time framework costs of production
  • Short-run
  • Fixed costs
  • Capital
  • User cost of capital
  • Economic depreciation
  • Interest rate
  • Variable costs
  • Labor
  • Wage rate
  • Benefits
  • Sunk costs
  • Long-run
  • Variable costs
  • Labor
  • Capital (choice of production process, facility
    size)

48
Constrained production short-run
  • Marginal product of labor
  • The law of diminishing MPL
  • Over-use of fixed inputs
  • Exhaustion of gains from specialization
  • From MPL to MC
  • TC(Q) TVC(Q) TFC(Q) ? MC Wage/MPL
  • MC depends on the cost of variable inputs (wage)
    and the productivity of those inputs on the
    margin
  • From APL to AVC

49
Profit maximization in the short-run
  • MARGINAL REVENUE MARGINAL COST
  • Estimation of marginal cost
  • Hiring decision and profit maximization
  • Marginal cost of labor
  • Wage rate
  • Marginal revenue from hiring a worker
  • Output produced by that worker MPL
  • Change in total revenues from a sale of an
    additional unit of output
  • Marginal revenue
  • Price in the case of highly competitive markets
  • MRMCw/MPL ? wMRMPLvalue of MPL

50
From profit maximization to demand for labor
  • Demand for labor
  • Derived from output market
  • Wage (price of output)(MPL)

wage
An increase in output price Or improvement in
marginal productivity
DL
labor
51
Profit maximization
P

MC
Pprofit
Prevenues
MRMC
D
Q rev-max
Q prof-max
Q
MR
Elastic range
52
Example for those familiar with basic calculus
  • Consider the following scenario
  • Demand is estimated to be
  • Q 10000 50 P
  • Production function is estimated to be
  • Q L1/2K1/2
  • Profit maximization in the short-run
  • Marginal revenue
  • TR PQ (200-Q/50)Q200Q-Q2/50
  • Thus, MRdTR/dQ200-Q/25
  • Marginal cost
  • TC(Q)TVC(Q)TFC(Q)wLrK
  • Note, from the production function we can solve
    for LQ2/K, simplifying TC(Q)wQ2/KrK,
    marginal cost is
  • MCdTC/dQ2wQ/K
  • Profit maximization MRMC
  • 200-Q/252wQ/K ? Q200/((50wK)/K)
  • If we assume that K20, and W10, then
    Q200/267.7

53
Planning for the long-run
  • All inputs are variable
  • Long-run average cost structure
  • Choice of the optimal size of capital stock
  • Envelope of short-run average cost functions


LRAC
Diseconomies of scale
Economies of scale
Constant economies Of scale
Q
Min eff. scale
54
Economies of scale
  • Efficiency with size horizontal expansion
  • Sources
  • Sharing of Indivisible inputs (i.e. fixed costs)
  • Management costs
  • Production technology and capital inputs (A380)
  • Transaction costs shipping, processing.
    (economies of scale in retail)
  • Specialization of variable inputs
  • Division of labor
  • Complementarities of skills
  • Horizontal expansion will also affect demand by
    reducing competition, but this is not a component
    in the discussion of production costs

55
Diseconomies of Scale
  • Inefficiencies with size
  • Rise in Average Cost of production
  • Sources
  • Increased overhead costs (additional layers of
    management)
  • Principal-Agent problem
  • Increased labor costs (unionization of labor)

56
Economies of Scope
  • Combined production reduces costs
  • TC(X, Y)
  • Gains from vertical integration
  • Note economies of scope do not require vertical
    production. For instance, AMD is in the business
    of processors and flash memory, yet memory is not
    a component in the manufacturing of a processor
  • Sources
  • Sharing of fixed input costs
  • Infrastructure
  • Management

57
Profit maximization rule in planning
  • The last dollar spent on capital brings the same
    increase in the output as the last dollar spent
    on labor
  • MPK/r MPL/w
  • Note that both marginal products exhibit
    diminishing property

58
market structure

oligopoly
mc
monopoly
Perfect competition
59
Perfect competition
  • Assumptions
  • number of firms
  • Ease of entry and exit
  • Perfect information
  • Identical transaction costs
  • Homogeneous good
  • Possible Examples
  • Commodity markets
  • Online commerce (retail)

60
Perfect Competition
  • Implications of the model
  • Price taking behavior and perfectly elastic
    demand
  • Zero long-term profits

61
monopoly
  • Market power MR
  • What is Monopoly and why do they exist?
  • natural monopoly
  • barriers to entry (legal, brand loyalty.)
  • is Microsoft a monopoly?
  • Measures of monopoly power
  • elasticity approach
  • Learner index (P-MC)/P

62
Market Power and Price Discrimination
  • Price discrimination charging different
    consumers different prices for the same good or
    service (retail end, for wholesale end price
    differentiation)
  • First degree price discrimination (car
    dealerships)
  • Second degree price discrimination (airlines)
  • Third degree price discrimination (volume
    discounts)

63
Oligopoly
  • Strategic interdependence
  • Theoretical approaches
  • Competitive models
  • Cournot
  • Bertrand
  • Strategic interaction
  • Discontinuous MR model and price leadership
  • Game Theory
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