economic theory shashi abeysinghe b.sc(eng), cima

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


(in dollars)


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.


(in dollars)


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.


(in dollars)


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)


(in dollars)


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.


(in dollars)


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.


(in dollars)


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

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)



The circular flow of incomeThe circular flow of income

Firms

Households

Factorpayments

Factorpayments





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)

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)

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

economic theory shashi abeysinghe b.sc(eng), cima

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