ECONOMICS what why

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ECONOMICSwhat? why?
Social Science Efficiency
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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

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• Managerial economics and microeconomic analysis
• Marketing
• Cost analysis
• Productivity analysis
• Optimization and profit maximization
• Response to macroeconomic events and
  macroeconomic analysis
• Strategic planning

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Economic versus Accounting Cost

• Opportunity cost (just how costly is this class
  to you or to me, or to the University?)
• Measuring the user cost of capital
• Does the benefit of taking this class outweigh
  the cost? (marginal analysis)

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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
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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
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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

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• Markets Simple Overview

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Markets

• Defining a market
• Product definition and market segmentation (and
  competition)
• Retail sector grouping the product with warranty
• Manufacturing sector different features of the
  product/warranty.
• Geographical boundaries
• Adaptation of the internet for commercial
  purposes
• Cross-border shopping and tax revenues
• Globalization of the labor market in some
  occupation
• --------------------------------------------------
  ----------------------------
• Consumer view of the substitutability of the
  products
• --------------------------------------------------
  ----------------------------
• Market forces Buyers (demand) versus Sellers
  (supply)
• Price and quantity as the outcome

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Demand

• Quantity demanded function (price, all other
  relevant factors)
• Low of demand relationship between the price and
  Q-demanded
• Importance of other relevant factors (shift
  parameters)
• Income (normal versus inferior)
• Micro implications
• Targeted consumer group
• Business location
• Advertising
• Macro implications
• Business cycle and changes in the demand
• New cars versus antidepressants
• Expectation about future prices
• Demand driven price increases
• Substitutes versus complements
• Micro cost of the product
• Macro Inflation and relative prices
• Preferences and advertising
• Market size

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Demand versus Inverse demand

• Demand
• Determining the price at which a given level of
  output will clear the market
• A car manufacturer targeting a given level of
  output and determining a pricing strategy that
  would allow the output to clear the market and
  generate the greatest possible profits
• Inverse Demand
• Determining willingness to pay
• Single product sale and the determination of the
  price
• Auctions eBay auctions
• New car purchase and dealer-consumer negotiations

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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
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Demand and The Revenue Functions

• Total Revenue
• Marginal Revenue
• Price discrimination

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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

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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?

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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?

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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

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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

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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
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Price elasticity of demand

• TRPQ

Elastic range, Egt1
P
Unit elastic, E1
Inelastic range Elt1
D
Q
Elastic Egt1, DQgtDP, dont
increase P Inelastic Elt1, ------ lt ------,
increase P
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TR, MR and Demand

• TR PQ, MRD(TR)/DQ

E1
D
MR
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Production SideTheory of the Firm
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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

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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

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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)

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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

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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

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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
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Profit maximization
P

MC
Pprofit
Prevenues
MRMC
D
Q rev-max
Q prof-max
Q
MR
Elastic range
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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

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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
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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

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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)

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Economies of Scope

• Combined production reduces costs
• TC(X, Y)ltTC(X)TC(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

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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

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market structure

oligopoly
mc
monopoly
Perfect competition
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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)

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Perfect Competition

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

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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

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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)

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Oligopoly

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

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• Macro Side Reading Economic Activity

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Evaluating Economic Activity

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

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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)

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GDP and GNP in chained dollarssource BEA
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International Comparison source WB
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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
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Historical unemployment rate in the US
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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
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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
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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

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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

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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.

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

• The magical art of forecasting

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predictor

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

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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)

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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

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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)