Lecture 1 Basics of Economics & Elasticity

Given to theGiven to theEMBA 8400 ClassEMBA 8400 ClassBuckhead CenterBuckhead Center

March 7, 2009March 7, 2009

Dr. Rajeev Dr. Rajeev DhawanDhawanDirectorDirector

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

Course Layout First Part (Lectures 1 & 2) - Basic Micro

Economic Concepts Second Part (Lectures 3 & 4) – Basics of

Macroeconomics Third Part (Lectures 5 & 6) Basic Workings

of an Economy with the Help of a “Basic” Macromodel that can Perform Real-Life Fiscal And Monetary Experiments

Wrap up Project Presentations (Lecture 7)

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

Grading Policy

40% Midterm30% Group Presentations on a

Selected Industry30% Take Home Final Exam

–Macroeconomic Model Exercise

Group PresentationsThe objectives of this group project are :

1. To help you bridge the gap between the economic theory and

models discussed in class and the “real world”

2. 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

3. To showcase your oral and written communication skills

4. To identify how the problems faced and the decisions made by

other firms are similar to your own.

Suggested Industries1. Wireless Communications

2. Networking & Security Systems

3. Aerospace Industry

4. Healthcare Industry

5. Hospitality Industry

6. Heavy Equipment

7. Banking

8. Consumer Products

9. Online / E-commerce

10. Real Estate (any topic)

11. Entertainment Industry

12. Shipping Industry

Macro Framework

Households: Consume & WorkFirms: Production & InvestmentGovernment: Money Supply,

Taxes, ExpendituresForeign Sector: Exports,

Imports & Exchange Rate

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

Variable Meaning Units

C Consumption Billions of $

EX Exports Billions of $

EXCH Exchange Rate Index

G Government Purchases Billions of $

GDP Gross Domestic Product Billions of $

GDP@FULL

GDP @ Full Employment Billions of $

GDP@ROW

GDP in Rest of the World Billions of $

I Investment Billions of $

IM Imports Billions of $

M Money supply Billions of $

NETEX Net Exports Billions of $

P Price Level Index

P% Inflation Percent

P@ROW Price Level, Rest of the World Index

R Real Interest Rate Percent

R@ROW Real Interest Rate, Rest of the World Percent

T Tax Revenues Billions of $

TAX% Tax Rate Fraction

YDP Disposable Income Billions of $

GLOSSARY OF VARIABLES

world interest

rateworld GDP

IMPORTS

price level lag 1

worldprice

money

government

tax rate

capital stock lag 1

EXCHANGE RATE

INTEREST RATE

INVESTMENT

TAX REVENUES

investmentlag 1

EXPORTS

NETEXPORTS

REAL GDP

CONSUMPTION

DISPOSABLE INCOME

CAPITAL STOCK

inflationlag 1

PRICE LEVEL

INFLATION

EXPECTED INFLATION

UNEMPLOYMENT

POTENTIAL GDP

labor force

~~Typical Macro-ModelTypical Macro-Model~~

world interest

rateworld GDP

IMPORTS

price level lag 1

worldprice

government

tax rate

capital stock lag 1

EXCHANGE RATE

INTEREST RATE

INVESTMENT

TAX REVENUES

investmentlag 1

EXPORTS

NETEXPORTS

REAL GDP

CONSUMPTION

DISPOSABLE INCOME

CAPITAL STOCK

inflationlag 1

PRICE LEVEL

INFLATION

EXPECTED INFLATION

UNEMPLOYMENT

POTENTIAL GDP

labor force

~~Typical Macro-ModelTypical Macro-Model~~

money

world interest

rateworld GDP

IMPORTS

price level lag 1

worldprice

government

tax rate

capital stock lag 1

EXCHANGE RATE

INTEREST RATE

INVESTMENT

TAX REVENUES

investmentlag 1

EXPORTS

NETEXPORTS

REAL GDP

CONSUMPTION

DISPOSABLE INCOME

CAPITAL STOCK

inflationlag 1

PRICE LEVEL

INFLATION

EXPECTED INFLATION

UNEMPLOYMENT

POTENTIAL GDP

labor force

~~Typical Macro-ModelTypical Macro-Model~~

money

world interest

rateworld GDP

IMPORTS

price level lag 1

worldprice

government

tax rate

capital stock lag 1

EXCHANGE RATE

INTEREST RATE

INVESTMENT

TAX REVENUES

investmentlag 1

EXPORTS

NETEXPORTS

REAL GDP

CONSUMPTION

DISPOSABLE INCOME

CAPITAL STOCK

inflationlag 1

PRICE LEVEL

INFLATION

EXPECTED INFLATION

UNEMPLOYMENT

POTENTIAL GDP

labor force

~~Typical Macro-ModelTypical Macro-Model~~

money

world interest

rateworld GDP

IMPORTS

price level lag 1

worldprice

government

tax rate

capital stock lag 1

EXCHANGE RATE

INTEREST RATE

INVESTMENT

TAX REVENUES

investmentlag 1

EXPORTS

NETEXPORTS

REAL GDP

CONSUMPTION

DISPOSABLE INCOME

CAPITAL STOCK

inflationlag 1

PRICE LEVEL

INFLATION

EXPECTED INFLATION

UNEMPLOYMENT

POTENTIAL GDP

labor force

~~”New Economy” Macro-Model”New Economy” Macro-Model~~

money

Tech/ProfitOpportunities

STOCK MARKET

CONSUMPTION

world interest

rateworld GDP

IMPORTS

price level lag 1

worldprice

government

tax rate

capital stock lag 1

EXCHANGE RATE

INTEREST RATE

INVESTMENT

TAX REVENUES

investmentlag 1

EXPORTS

NETEXPORTS

REAL GDP

CONSUMPTION

DISPOSABLE INCOME

CAPITAL STOCK

inflationlag 1

PRICE LEVEL

INFLATION

EXPECTED INFLATION

UNEMPLOYMENT

POTENTIAL GDP

labor force

~~”New Economy” Macro-Model”New Economy” Macro-Model~~

money

Tech/ProfitOpportunities

EUPHORIA

STOCK MARKET

world interest

rateworld GDP

IMPORTS

price level lag 1

worldprice

government

tax rate

capital stock lag 1

EXCHANGE RATE

INTEREST RATE

INVESTMENT

TAX REVENUES

investmentlag 1

EXPORTS

NETEXPORTS

REAL GDP

CONSUMPTION

DISPOSABLE INCOME

CAPITAL STOCK

inflationlag 1

PRICE LEVEL

INFLATION

EXPECTED INFLATION

UNEMPLOYMENT

POTENTIAL GDP

labor force

~~”New Economy” Macro-Model”New Economy” Macro-Model~~

money

Tech/ProfitOpportunities

EUPHORIA

STOCK MARKET

EUPHORIA

world interest

rateworld GDP

IMPORTS

price level lag 1

worldprice

government

tax rate

capital stock lag 1

EXCHANGE RATE

INTEREST RATE

INVESTMENT

TAX REVENUES

investmentlag 1

EXPORTS

NETEXPORTS

REAL GDP

CONSUMPTION

DISPOSABLE INCOME

CAPITAL STOCK

inflationlag 1

PRICE LEVEL

INFLATION

EXPECTED INFLATION

UNEMPLOYMENT

POTENTIAL GDP

labor force

~~””New Economy” Macro-ModelNew Economy” Macro-Model~~

money

Tech/ProfitOpportunities

STOCK MARKET

EUPHORIA

Introduction

The 10 Principles of Economics

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

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?

Basic Concepts

Opportunity Cost: Things are Scarce

– Next Best Alternative Ex: Party on Friday night vs. study for examsEx: Party on Friday night vs. study for exams

– Cost of Time Ex: 1 hour wait time at the dentistEx: 1 hour wait time at the dentist

Basic Concepts Marginal Concept: At the Margin

Shot SatisfactionMarginal

Satisfaction1 50

202 70

103 80

54 85

15 86

06 86

Shots of Wild Turkey

Utility: Level of Satisfaction (here, drunkenness)

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?

10 Principles of Economics1. People face tradeoffs :

• “No such thing as free lunch”• Give up one thing to get another –

Opportunity Cost (OC)2. Everything has an OC – whatever must be given

up to get that item3. People make decisions at the margins –

increments matter4. People respond to incentives – e.g. cigarette

laws, communism5. Free Trade is good (for everybody)

10 Principles of Economics6. Markets organize economic activity

- Adam Smith “Invisible Hand”

7. Governments can sometimes improve market outcome

8. A country’s standard of living depends upon its production power (productivity)

9. Prices rise when government prints too much money

10. Phillips curve – short run tradeoff between inflation and unemployment

Branches of Economics

Micro: The Study of One Entity (firm, business, people)

Macro: The Study of a Collection of Things (national, aggregate)

How are Theories Developed?

Decision-Makers– Firms, governments

Markets– Place where exchange takes place

Winnick’s Voyage to the Bottom of the Sea WSJ; by Andy Kessler

First Mover, FCC regulated + fixed costsRegulated utilityPrice protection

You can’t lose Traffic / use was of low economic value or

cashlessGlobal 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…….

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

Who REALLY Owns that Winery TIME Magazine; by Terry McCarthy

Chapter 4

Demand & Supply

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

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…)

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

Pints of BeerPints of Beer

P QD

$10.00 07.00 15.00 34.00 62.00 110.00 19

Demand for Beer

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

0 5 10 15 20Quantity (Pints)

Pri

ce

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.

The Market Demand Curve

Price of Beers

Price of Beers

Price of Beers

5.00 5.00 5.00

3 4 7

4.00 4.004.00

6 7 13

Quantity of Beers Quantity of Beers Quantity of Beers

Catherine’s Demand Nicholas’s Demand Market Demand+ =

When the price is $5.00, Catherine will demand 3 beers.

When the price is $5.00, Nicholas will demand 4 beers.

The market demand at $5.00 will be 7 beers.

When the price is $4.00, Catherine will demand 6 beers.

When the price is $4.00, Nicholas will demand 7 beers.

The market demand at $4.00, will be 13 beers.

The market demand curve is the horizontal sum of the individual demand curves!

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

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)

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 IPO’s in 90’s

Shifts in Demand Curve

Variables that shift the demand curve:

Shifts in the Demand CurvePrice of

Beer

Quantity ofBeer

Increasein demand

Decreasein demand

Demand curve, D3

Demandcurve, D1

Demandcurve, D2

0

SupplyQuantity supplied (Q): the amount of a good that sellers are willing and able to sell at a given price (P).

Pints of BeerPints of Beer

P QS

$10.00 127.00 75.00 44.00 32.00 10.00 0

Supply of Beer - Neighbors

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

0 2 4 6 8 10 12Quantity (Pints)

Pri

ce

Supply

Supply graph for another bar

Supply of Beer - Hand in Hand

$0.00$1.00$2.00$3.00$4.00$5.00$6.00$7.00$8.00$9.00

$10.00

0 2 4 6 8 10 12Quantity (Pints)

Pri

ce Pints of BeerPints of Beer

P QS

$10.00 87.00 55.00 44.00 32.00 10.00 0

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

Shifts in The Supply Curve

Variables that shift the supply curve:

Shifts In Supply CurvePrice of

Beer

Quantity ofBeer0

Increasein supply

Decreasein supply

Supply curve, S3

curve, Supply

S1Supply

curve, S2

Equilibrium

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

Market for Beer

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

0 5 10 15 20Quantity (Pints)

Pri

ce

Equilibrium

6

Markets Not In Equilibrium

Price ofBeer

0

Supply

Demand

Excess Supply

Quantitydemanded

Quantitysupplied

Surplus

Quantity ofBeer

2

$6.50

10

4.00

6

Markets Not In EquilibriumPrice of

0

Supply

Demand

Excess Demand

Quantity ofBeer

Beer

0Quantitysupplied

Quantitydemanded

2.50

10

$4.00

62

Shortage

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.

Changes in Equilibrium

Price ofBeer

0 Pints of Beer

Supply

Initialequilibrium

An increase in wealth

increases demand for beer

0

Demand

Newequilibrium

Initial equilibrium

S1

S2

An increase in the

price of hops reduces

the supply of beer

4.00

6

$6.50

2

D1

Price ofBeer

D2

Pints of Beer

4.00

6

New equilibrium

$6.50

10

Market for Beer

$0.00

$2.00

$4.00

$6.00

$8.00

$10.00

0 5 10 15 20Quantity (Pints)

Pri

ce

S2

S1

One bar closes…New

Equilibrium

4

$5.00

Chapter 5

Elasticity

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 don’t 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)

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

P rice e las tic ity o f d em an d =P ercen tag e ch an g e in q u an tity d em an d ed

P ercen tag e ch an g e in p rice

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)

Elasticity

Inelastic Demand– Quantity demanded does not respond strongly

to price changes.– Price elasticity of demand is < one.

Elastic Demand– Quantity demanded responds strongly to

changes in price.– Price elasticity of demand is > one.

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.

Perfectly Inelastic Demand

Elasticity = 0

$5

4

Quantity

Demand

1000

1. Anincreasein price . . .

2. . . . leaves the quantity demanded unchanged.

Price

3. . . . revenue goes from $4 x 100 to $5 x 100

Inelastic Demand

Elasticity < 1

Quantity0

$5

90

Demand1. A 22%increasein price . . .

Price

2. . . . leads to an 11% decrease in quantity demanded.

4

100

3. . . . revenue goes from $4 x 100 to $5 x 90

Unit Elastic Demand

Elasticity = 1

Quantity0

$5

80

1. A 22%increasein price . . .

Price

2. . . . leads to a 22% decrease in quantity demanded.

4

100

Demand

3. . . . revenue goes from $4 x 100 to $5 x 80

Elastic Demand

Elasticity > 1

Quantity0

$5

50

1. A 22%increasein price . . .

Price

2. . . . leads to a 67% decrease in quantity demanded.

4

100

Demand

3. . . . revenue goes from $4 x 100 to $5 x 50

Perfectly Elastic Demand

Elasticity = Infinity

Quantity0

Price

$4 Demand

2. At exactly $4,consumers willbuy any quantity.

1. At any priceabove $4, quantitydemanded is zero.

3. At a price below $4,quantity demanded is infinite.

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 revenueExample class to contribute

Box Shows the 50% Drop of New Paying Customers for the May & August 2004 Conference Caused by the Latest Price Hike

Conference Date Attendance New Paying % of Total

Feb’ 01 72 6 8%

May’ 01 66 10 15%

Aug’ 01 101 31 31%

Nov’ 01 163 49 30%

Feb’ 02 189 28 15%

May’ 02 160 42 26%

Aug’ 02 195 62 32%

Nov’ 02 169 44 26%

Feb’ 03 260 55 21%

May’ 03 196 37 19%

Aug’ 03 220 43 20%

Nov’ 03 222 40 18%

Feb’ 04 238 48 20%

May’ 04 201 25 12%

Aug’ 04 211 23 11%

1st Price Hike

2nd Price Hike

Applications of Supply, Demand & Elasticity

Can good news for farmers be bad news for farmers?

Wheat is inelastic: Bumper crop bad news

Increase In Supply In Market For Wheat

Quantity ofWheat

0

Price ofWheat

3. . . . and a proportionately smallerincrease in quantity sold. As a result,revenue falls from $300 to $220.

Demand

S1 S2

2. . . . leadsto a large fallin price . . .

1. When demand is inelastic,an increase in supply . . .

2

110

$3

100