Title: ECONOMICS what why
1ECONOMICSwhat? why?
Social Science Efficiency
2Frameworks 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
-
4Economic 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)
5What 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
6Changes 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
7Do 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 9Markets
- 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
10demand
- 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
11Deriving 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
12supply
- 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
13Market 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?
14Same 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?
15Who 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
16Examples 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
17Point 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
18Price elasticity of demand
Elastic range, E1
P
Unit elastic, E1
Inelastic range E
D
Q
Elastic E1, DQDP, dont
increase P Inelastic E increase P
19TR, MR and Demand
E1
D
MR
20- Macro Side Reading Economic Activity
21Evaluating Economic Activity
- Output GDP
- Labor Market Unemployment
- Prices Inflation indicators
- International aspects
- Trade
- Investment Flow
- Currency Fluctuations
22Output
- 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)
23GDP and GNP in chained dollarssource BEA
24International Comparison source WB
25Evaluating 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
26Historical unemployment rate in the US
27Evaluating 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
28Business 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)
Real GDP (per capita)
time
Definition of Recession Supply versus Demand
driven recession
29More 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
30Business 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
31business 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.
32Macro Picture of the US economy Stunning Growth
of the 1990s and now
331994 Mexican currency crisis
1997 - Asian financial crisis
1998 Russian currency
crisis Recession in Japan Slow Growth in Europe
34(No Transcript)
35Real GDP growth in 2003-2004 Source BEA Table
1.5.1
36Growth in components of Real GDP,
2000-2003 Seasonally adjusted at annual rates
37Jobless Recovery
Seasonally adjusted US unemployment rate Source
BEA
38A side-note Job recovery in Atlanta
39Predicting the Future
- The magical art of forecasting
40predictor
- Correlated with the variable of interest
- Easily observable and measured
41Predictors (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)
42More 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
43Even 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)
44Production SideTheory of the Firm
45Production 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
46Time 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
47Time 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)
48Constrained 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
49Profit 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
50From 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
51Profit maximization
P
MC
Pprofit
Prevenues
MRMC
D
Q rev-max
Q prof-max
Q
MR
Elastic range
52Example 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
53Planning 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
54Economies 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
55Diseconomies 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)
56Economies 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
57Profit 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
58market structure
oligopoly
mc
monopoly
Perfect competition
59Perfect competition
- Assumptions
- number of firms
- Ease of entry and exit
- Perfect information
- Identical transaction costs
- Homogeneous good
- Possible Examples
- Commodity markets
- Online commerce (retail)
60Perfect Competition
- Implications of the model
- Price taking behavior and perfectly elastic
demand - Zero long-term profits
61monopoly
- 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
62Market 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)
63Oligopoly
- Strategic interdependence
- Theoretical approaches
- Competitive models
- Cournot
- Bertrand
- Strategic interaction
- Discontinuous MR model and price leadership
- Game Theory