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Introduction to Macroeconomics Econ 1011

Introduction to Macroeconomics Econ 1011. A multi-lecture presentation for Air University – Sp-08 This presentation can be used freely for non commercial purposes. Students MUST note that lecture slides are for reference only and the exam will rely

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Introduction to Macroeconomics Econ 1011

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  1. Introduction to MacroeconomicsEcon 1011 A multi-lecture presentation for Air University – Sp-08 This presentation can be used freely for non commercial purposes. Students MUST note that lecture slides are for reference only and the exam will rely mostly on class discussions rather than slides.

  2. The Economic Problem • Unlimited Wants • Scarce Resources – Land, Labour, Capital • Resource Use • Choices

  3. The Economic Problem • What goods and services should an economy produce? – should the emphasis be on agriculture, manufacturing or services, should it be on sport and leisure or housing? • How should goods and services be produced? – labour intensive, land intensive, capital intensive? Efficiency? • Who should get the goods and services produced? – even distribution? more for the rich? for those who work hard?

  4. Opportunity Cost • Definition – the cost expressed in terms of the next best alternative sacrificed • Helps us view the true cost of decision making • Implies valuing different choices

  5. QUIZ • What is PPF? • Where are the following zones located in PPF? • Optimum • Inefficient • Impossible • REMEMBER TO ADD THE UNDERTAKING

  6. Choice in Scarcity • Scarcity Principle • Although we have boundless needs, resources available to us are unlimited. So, having more of one good means having less of another • Cost-Benefit Principle • An action should be taken if and only if, the extra benefits from taking the actions are at-least as great as the extra costs

  7. Example of Cost-Benefit Principle • How many fellow students will you like to have in your class? • 100, 50, 20 or 10 ? • Professors Pay: Rs. 150,000/semester • Class Charges: Rs. 800/hr • All other charges: Rs. 2500/student-month • Fixed Charges: 5700,000. (Assume 1000 students)

  8. Professors Pays: 10 x 150,000 = 1500,000 • Class Charges: 3hrs x 16 weeks x 800 = 38,400 Fees Per Semester If 100 Students in a class 15,38,400/100 = Rs. 15384 + 2500x4 = 25384 + 5700 =31084 If 50 Students in a class= 40768 + 5700 =46468 20 Students in a class= 86920 + 5700 =92620 10 Students in a class= 169540 • How many fellow students will you like NOW to have in your class?

  9. Mental Auctions • Ironing Your Shirt • How much (max) can you pay someone to iron your shirt? • How much (min) will you accept as payment for ironing someone’s shirt? • Reservation Price: • Highest price someone is willing to pay to obtain any good or service; • Or, the lowest payment someone would accept for giving up a good or performing a service • Economic Surplus • The benefit of taking action minus its costs

  10. Production Possibility Frontiers • Show the different combinations of goods and services that can be produced with a given amount of resources • No ‘ideal’ point on the curve • Any point inside the curve – suggests resources are not being utilised efficiently • Any point outside the curve – not attainable with the current level of resources • Useful to demonstrate economic growth and opportunity cost

  11. Production Possibility Frontiers Assume a country can produce two types of goods with its resources – capital goods and consumer goods If it devotes all resources to capital goods it could produce a maximum of Ym. If it devotes all its resources to consumer goods it could produce a maximum of Xm If the country is at point A on the PPF It can produce the combination of Yo capital goods and Xo consumer goods Ym A Yo If it reallocates its resources (moving round the PPF from A to B) it can produce more consumer goods but only at the expense of fewer capital goods. The opportunity cost of producing an extra Xo – X1 consumer goods is Yo – Y1 capital goods. Capital Goods B Y1 Consumer Goods Xo X1 Xm

  12. Production Possibility Frontiers Production inside the PPF – e.g. point B means the country is not using all its resources C Y1 A .B Yo It can only produce at points outside the PPF if it finds a way of expanding its resources or improves the productivity of those resources it already has. This will push the PPF further outwards. Capital Goods Xo X1 Consumer Goods

  13. Positive Statements: Capable of being verified or refuted by resorting to fact or further investigation Normative Statements: Contains a value judgement which cannot be verified by resort to investigation or research Positive and Normative Economics • Health care can be improved with more tax funding • Pollution control is effective through a system of fines • Society ought to provide homes for all • Any strategy aimed at reducing factory closures in deprived areas would be helpful

  14. The Production Possibilities Frontier • Let’s introduce the Production Possibilities Frontier • better known as the PPF. • The PPF is a basic workhorse in economics. • Often introduced in the first couple of lectures in both micro and macro intro courses.

  15. The PPF • Important for understanding some basic issues in economics and... more importantly….in international trade theory. • Helps one understand opportunity cost and distinguish between comparative advantage and absolute advantage. • An important historical figure in all this is David Ricardo.

  16. David Ricardo • Famous 19th century British economist. • Some consider him the grandfather of international trade theory. • Very influential in pioneering the theory of comparative advantage, inter alia. • Very interesting, very bright guy. • Had a lot of say about the “corn laws” in England.

  17. The Production Possibility Frontier - What Is It? • The description of the best possible combinations of two goods to produce using all of the available resources. • Shows the trade-off between more of one good in terms of the other. • Assumes: input endowments given, technology given, time given and efficient production.

  18. Opportunity Cost • The opportunity cost of an activity is the value of the resources used in that activity when they are used in their next best alternative. • The slope of the Production Possibility Frontier measures the opportunity cost of producing one good in terms of the amount of the other good foregone.

  19. Exercise – Productivity Advantage for Paula and Beth Total Working hours per day: 6 Draw “Web-Page vs Bike Repair” PPF for Paula and Beth Who is more Productive? What should Paula do as a business? What should Beth do as a business? QUESTIONS

  20. PPF of Paula and Beth We pages development Paula 0 5 10 15 20 Beth 0 5 10 15 20 25 30 35 40 Bike Repairs

  21. What is Paula’s Opportunity Cost of Updating a Web Page? 36/20 = 1.8 Bike Repair We pages development Paula 0 5 10 15 20 Beth 0 5 10 15 20 25 30 35 40 Bike Repairs

  22. Opportunity Costs Paula Repairs a Bike 20/36 = .55 Web Pages Paula Develops a Web Page 36/20 = 1.8 Bike Repair Beth Repairs a Bike 12/12 = 1 Web Page Beth Develops a Web Page 12/12 = 1 Bike Repair We pages development Paula 0 5 10 15 20 Beth 0 5 10 15 20 25 30 35 40 Bike Repairs

  23. Production Possibility Schedule

  24. PPF of Paula + Beth Kink added with addition of worker in economy We pages development Paula + Beth 5 10 15 20 25 30 Paula Beth 0 5 10 15 20 25 30 35 40 45 50 Bike Repairs

  25. PPF of Paula + Beth + 3rd Worker Kinks increase with increase in workers We pages development 5 10 15 20 25 30 0 5 10 15 20 25 30 35 40 45 50 Bike Repairs

  26. Comparative and Absolute Advantages • Paula has Absolute Advantage in both Bike Repairing and Web Page Developing • Beth Has Absolute Advantage in none. • Paula has Comparative Advantage in Bike Repairing • Beth has Comparative Advantage in Web Development

  27. Comparative Advantage • The person with the lower opportunity cost of an activity has the comparative advantage at that activity. • This means that the person with the comparative advantage can produce the activity by giving up the smallest amount of the alternative activity.

  28. The Idea of Comparative Advantage and Trade • Specialization and free trade will benefit all trading parties, even when some are “absolutely” more efficient producers than others. • Need to understand absolute vs. comparative advantage.

  29. Absolute vs. Comparative Advantage Applied to Trade • Absolute advantage: If your country uses fewer resources to produce a given unit of output than the other country. • Comparative advantage: if your country can produce the output at a lower opportunity cost than the other country. • Every country (or person, or economy) has a comparative advantage at some activity. • Absolute advantage is not important and may not always happen. Sometimes people or countries have the absolute advantage in nothing! Yet trade possibilities still exist. • It’s all about comparative advantage.

  30. Concepts Affecting Trade • Absolute advantage – exists when one nation can produce goods more cheaply than another nation. • Comparative advantage – ability of a nation to specialize in the production of the good for which it has the greatest comparative advantage or lowest opportunity cost. • Competitive advantage – economic competitive of a nation reflected in the absolute cost of a given good in a given market at a particular point in time.

  31. Sunk Costs • The costs that are beyond recovery at the moment a decision is to be made

  32. Discussion Examples • Should you drive 100 kms through a snow storm to watch a football game? • Ticket purchased in own city for $ 30. • Your friend had decided to buy the ticket on the ground, where it is $ 25, but seat choice may not be available. • If you and your friend are both rational, is one of you more likely to attend the game than the other?

  33. Since you have paid $ 30, it is a sunk cost. It cannot be recovered whether you watch the gamer or not. So in deciding whether to go to the game, you should compare benefits of going to the game (your reservation price, the largest dollar amount you will be willing to pay to watch it) to the additional costs you must incur to see the game (OC of your time, costs you assign to driving through the storm). You should not include the ticket cost, that $ 30 is gone, you will never see it again, whether you watch the game or not. • Your friend, must however include the cost of ticket since he/she has not paid yet, and it is not a sunk cost. • Suppose your friend got a ticket as gift form anther friend before going. What will happen now?

  34. Example 2 • How much should you eat at an all you can eat restaurant, if the buffet price is $ 10? • How much should you eat at an all you can eat restaurant, if the buffet price is $ 5? • How much if you are a lucky winner of a free meal at the same restaurant?

  35. Psychologists and economists have found experimental evidence that people in these groups do not eat similar amounts on average. In particular, the lucky winner tend to eat substantially less than those who paid $ 10. People in the paid group somehow seem determined to “get their money’s worth”. Their apparent goal is to minimize the average cost of the per bite food they eat.

  36. United States Tons/man hour Mexico Tons/man hour Wheat 10 2 Coffee 4 6 Example of Absolute AdvantageUnits of Output/Unit of Labor The U.S. is the most efficient producer of wheat while Mexico is the most efficient producer of coffee. With trade, the U.S. would specialize in wheat and exchange part of its surplus for coffee. Mexico would specialize in coffee and trade part of the surplus for wheat

  37. United States Tons/man hour Mexico Tons/man hour Wheat 10 2 Coffee 4 3 Example of Comparative AdvantageUnits of Output/Unit of Labor Mexico has the absolute disadvantage in producing both goods because its productivity fell by 50% from the previous example). While the U.S. is more productive in both goods, its relative advantage is greatest in wheat (5.0>1.33). The U.S. therefore has a comparative advantage in wheat while Mexico has the least comparative disadvantage in coffee, or comparative advantage in coffee.

  38. Factors Affecting Comparative Advantage…. • National differences in opportunity costs • Costs affected by availability of resources • Costs affected by production requirements for goods and services produced • Costs affected by resource combinations • Costs affected by resource mobility

  39. U.S. U.S. Mexico Mexico Wheat Tons/year Coffee Tons/year Wheat Tons/year Coffee Tons/year 200 0 40 0 160 16 32 12 120 32 24 24 100 40 20 30 80 48 16 36 40 64 8 48 0 80 0 60 Production Possibilities Schedule Based upon assumption that both countries fully employ all resources, technology and specific amounts of labor per year.

  40. U.S produces 100 tons of wheat and 40 tons of coffee.

  41. U.S produces 100 tons of wheat and 40 tons of coffee. Mexico produces 32 tons of wheat and 12 tons of coffee

  42. Through trade, the U.S. specializes in wheat at point B, trades 50 tons of wheat to Mexico for 45 tons of coffee, and consumes more of both goods at point C (45 tons of coffee and 150 tons of wheat). By comparing point C with point A, we see that the U.S. has gained from trade.

  43. Mexico will specialize in coffee, producing 60 tons at point B’ and no wheat. They would trade 45 tons of coffee for 50 tons of wheat, and consumer more of both goods (50 tons of wheat and 15 tons of coffee at point C’) than it could at point A’.

  44. Home AssignmentDue on Monday 21 Apr 08 • Consider a society whose only worker is Helen, who allocated her production time between cutting hair and baking bread. Each hour she devotes to cutting hair yields 4 hair cuts, and each hour she devotes to baking bread yields 8 loaves of bread. • Q No 1-A. If Helen Works a total of 8 hours per day, graph her Production Possibility Curve. • Q No 1-B. Which of the points listed below is efficient? Which is unattainable? • 28 Haircuts/day, 16 loaves/day • 16 Haircuts/day, 32 loaves/day • 18 Haircuts/day, 24 loaves/day

  45. Home AssignmentDue on Monday 21 Apr 08 • Question No 2 • Determine whether the following statements are True or False, and Briefly Explain Why? A. Toby can produce 5 gallons of apple cider or 2.5 ounces of feta cheese per hour. Kyle can produce 3 gallons of apple cider or 1.5 ounces of feta cheese per hour. Therefore Toby and Kyle cannot benefit from specialization from trade. B. A doctor who can vacuum her office faster and more thoroughly than commercial cleaners should clean her office herself.

  46. Home AssignmentDue on Monday 21 Apr 08 • Larry and Harry are stranded together on a desert island. The raw material on the island are only suitable for making beer and pizza, but their quantities are unlimited. What is scarce is labor. Harry and Larry each spend 10 hours a day making beer or pizza. The following table specifies how much beer and pizza Harry and Larry can produce each hour. • Question No 3 A.Draw the Daily PPC for Harry and Larry. B. Who has absolute advantage in making pizza? In brewing beer? C. Who has comparative advantage in making pizza? In brewing beer?

  47. Home AssignmentDue on Monday 21 Apr 08 • Now suppose their preferences are as follows: Harry wants 2 beers and as much pizza as he can eat each day; Larry wants 2 pizzas and as much beer as he can consume each day. • Question No 3 D. If each man is self reliant, how much pizza and beer will Harry and Larry eat and drink, each day? E. Suppose the two men decide to trade with each other. Draw their joint PPC, and give an example of a trade that will make each of them better off.

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