Introduction to Macroeconomics Econ 1011

Introduction to Introduction to MacroeconomicsMacroeconomics

Econ 1011Econ 1011

A multi-lecture presentation for Air University – Sp-08

This presentation can be used freely for non commercial purposes.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.

The Economic ProblemThe Economic Problem

Unlimited Unlimited WantsWants

Scarce Scarce Resources – Resources – Land, Labour, Land, Labour, CapitalCapital

Resource UseResource Use ChoicesChoices

The Economic ProblemThe Economic Problem

What goods and services should an What goods and services should an economy produce?economy produce? – should the emphasis – should the emphasis be on agriculture, manufacturing or be on agriculture, manufacturing or services, should it be on sport and leisure services, should it be on sport and leisure or housing?or housing?

How should goods and services be How should goods and services be produced?produced? – labour intensive, land – labour intensive, land intensive, capital intensive? Efficiency?intensive, capital intensive? Efficiency?

Who should get the goods and services Who should get the goods and services produced?produced? – even distribution? more for – even distribution? more for the rich? for those who work hard?the rich? for those who work hard?

Opportunity CostOpportunity Cost

Definition – the cost expressed in terms Definition – the cost expressed in terms of the next best alternative sacrificedof the next best alternative sacrificed

Helps us view the true cost of decision Helps us view the true cost of decision makingmaking

Implies valuing different choicesImplies valuing different choices

QUIZQUIZ

What is PPF?What is PPF? Where are the following zones Where are the following zones

located in PPF?located in PPF? OptimumOptimum InefficientInefficient ImpossibleImpossible

REMEMBER TO ADD THE REMEMBER TO ADD THE UNDERTAKINGUNDERTAKING

Choice in ScarcityChoice in Scarcity

Scarcity PrincipleScarcity Principle Although we have boundless needs, Although we have boundless needs,

resources available to us are unlimited. resources available to us are unlimited. So, having more of one good means So, having more of one good means having less of anotherhaving less of another

Cost-Benefit PrincipleCost-Benefit Principle An action should be taken if and only if, An action should be taken if and only if,

the extra benefits from taking the actions the extra benefits from taking the actions are at-least as great as the extra costsare at-least as great as the extra costs

Example of Cost-Benefit Example of Cost-Benefit PrinciplePrinciple

How many fellow students will you like How many fellow students will you like to have in your class?to have in your class? 100, 50, 20 or 10 ?100, 50, 20 or 10 ?

Professors Pay: Rs. 150,000/semesterProfessors Pay: Rs. 150,000/semester Class Charges: Rs. 800/hrClass Charges: Rs. 800/hr All other charges: Rs. 2500/student-All other charges: Rs. 2500/student-

monthmonth Fixed Charges: 5700,000. (Assume 1000 Fixed Charges: 5700,000. (Assume 1000

students)students)

Professors Pays: 10 x 150,000 = 1500,000Professors Pays: 10 x 150,000 = 1500,000 Class Charges: 3hrs x 16 weeks x 800 = 38,400Class Charges: 3hrs x 16 weeks x 800 = 38,400

Fees Per SemesterFees Per SemesterIf 100 Students in a classIf 100 Students in a class15,38,400/100 = Rs. 15384 + 2500x4 = 25384 + 5700 =15,38,400/100 = Rs. 15384 + 2500x4 = 25384 + 5700 = 3108431084If 50 Students in a classIf 50 Students in a class = 40768 + 5700 == 40768 + 5700 = 464684646820 Students in a class20 Students in a class = 86920 + 5700 == 86920 + 5700 = 926209262010 Students in a class10 Students in a class = = 169540169540 How many fellow students will you How many fellow students will you

like NOW to have in your class?like NOW to have in your class?

Mental AuctionsMental Auctions Ironing Your ShirtIroning Your Shirt

How much (max) can you pay someone to iron How much (max) can you pay someone to iron your shirt?your shirt?

How much (min) will you accept as payment for How much (min) will you accept as payment for ironing someone’s shirt?ironing someone’s shirt?

Reservation Price: Reservation Price: Highest price someone is willing to pay to Highest price someone is willing to pay to

obtain any good or service;obtain any good or service; Or, the lowest payment someone would accept Or, the lowest payment someone would accept

for giving up a good or performing a servicefor giving up a good or performing a service Economic SurplusEconomic Surplus

The benefit of taking action minus its costsThe benefit of taking action minus its costs

Production Possibility Production Possibility FrontiersFrontiers

Show the different combinations of goods Show the different combinations of goods and services that can be produced with a and services that can be produced with a given amount of resourcesgiven amount of resources

No ‘ideal’ point on the curveNo ‘ideal’ point on the curve Any point inside the curve – suggests Any point inside the curve – suggests

resources are not being utilised efficientlyresources are not being utilised efficiently Any point outside the curve – not attainable Any point outside the curve – not attainable

with the current level of resourceswith the current level of resources Useful to demonstrate economic growth Useful to demonstrate economic growth

and opportunity costand opportunity cost

Production Possibility Production Possibility FrontiersFrontiers

Cap

ital G

ood

s

Consumer Goods

Yo

Xo

A

BY1

X1

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

Ym

Xm

If the country is at point A on the PPF It can produce the combination of Yo capital goods and Xo consumer goods

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.

Production Possibility Frontiers

Cap

ital G

ood

s

Consumer Goods

Yo

Xo

A

.B

CY1

X1

Production inside the PPF – e.g. point B means the country is not using all its resources

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.

Positive and Normative Positive and Normative EconomicsEconomics

Health care can be Health care can be improved with more improved with more tax fundingtax funding

Pollution control is Pollution control is effective through a effective through a system of finessystem of fines

Society ought to Society ought to provide homes for allprovide homes for all

Any strategy aimed Any strategy aimed at reducing factory at reducing factory closures in deprived closures in deprived areas would be areas would be helpfulhelpful

Positive Statements: Positive Statements: Capable of being Capable of being

verified or refuted by verified or refuted by resorting to fact or resorting to fact or further investigationfurther investigation

Normative Normative Statements:Statements: Contains a value Contains a value

judgement which judgement which cannot be verified by cannot be verified by resort to investigation resort to investigation or researchor research

The Production The Production Possibilities FrontierPossibilities Frontier

Let’s introduce the Production Let’s introduce the Production Possibilities FrontierPossibilities Frontier better known as the PPF.better known as the PPF.

The PPF is a basic workhorse in The PPF is a basic workhorse in economics.economics.

Often introduced in the first Often introduced in the first couple of lectures in both micro couple of lectures in both micro and macro intro courses.and macro intro courses.

The PPFThe PPF Important for understanding some basic Important for understanding some basic

issues in economics and... more issues in economics and... more importantly….in international trade importantly….in international trade theory.theory.

Helps one understand opportunity cost Helps one understand opportunity cost and distinguish between comparative and distinguish between comparative advantage and absolute advantage.advantage and absolute advantage.

An important historical figure in all this An important historical figure in all this is David Ricardo.is David Ricardo.

David RicardoDavid Ricardo Famous 19th century British economist.Famous 19th century British economist. Some consider him the grandfather of Some consider him the grandfather of

international trade theory.international trade theory. Very influential in pioneering the theory Very influential in pioneering the theory

of comparative advantage, of comparative advantage, inter aliainter alia.. Very interesting, Very interesting, veryvery bright guy. bright guy. Had a lot of say about the “corn laws” in Had a lot of say about the “corn laws” in

England.England.

The Production The Production Possibility Frontier - Possibility Frontier -

What Is It?What Is It? The description of the best possible The description of the best possible

combinations of two goods to combinations of two goods to produce using all of the available produce using all of the available resources.resources.

Shows the trade-off between more of Shows the trade-off between more of one good in terms of the other.one good in terms of the other.

Assumes: input endowments given, Assumes: input endowments given, technology given, time given and technology given, time given and efficient production.efficient production.

Opportunity CostOpportunity Cost The opportunity cost of an activity is The opportunity cost of an activity is

the value of the resources used in the value of the resources used in that activity when they are used in that activity when they are used in their next best alternative.their next best alternative.

The slope of the Production The slope of the Production Possibility Frontier measures the Possibility Frontier measures the opportunity cost of producing one opportunity cost of producing one good in terms of the amount of the good in terms of the amount of the other good foregone.other good foregone.

Exercise – Productivity Exercise – Productivity Advantage for Paula and Advantage for Paula and

BethBethTime to update Time to update a web pagea web page

Time to repair a Time to repair a bi-cyclebi-cycle

PaulPaulaa

20 Minutes20 Minutes 10 Minutes10 Minutes

BethBeth 30 Minutes30 Minutes 30 Minutes30 Minutes

Total Working hours per day: 6

Draw “Web-Page vs Bike Repair” PPF for Paula and BethWho is more Productive?What should Paula do as a business?What should Beth do as a business?

QU

ES

TIO

NS

web pages a dayweb pages a day Bike repairs a Bike repairs a dayday

PaulPaulaa

60/20 x 6 = 60/20 x 6 = 1818 60/10 x 6 = 60/10 x 6 = 3636

BethBeth 60/30 x 6 = 60/30 x 6 = 1212 60/30 x 6 = 60/30 x 6 = 1212

PPF of Paula and BethPPF of Paula and Beth

0 5 10 15 20 25 30 35 40

0

5

10

15

20

Bike Repairs

We p

ag

es

deve

lop

men

t

PaulaBeth

What is Paula’s Opportunity What is Paula’s Opportunity Cost of Updating a Web Cost of Updating a Web

Page?Page?

0 5 10 15 20 25 30 35 40

0

5

10

15

20

Bike Repairs

We p

ag

es

deve

lop

men

t

PaulaBeth

36/20 = 1.8 Bike Repair

Opportunity CostsOpportunity Costs

0 5 10 15 20 25 30 35 40

0

5

10

15

20

Bike Repairs

We p

ag

es

deve

lop

men

t

PaulaBeth

Paula Repairs a Bike20/36 = .55 Web Pages

Paula Develops a Web Page36/20 = 1.8 Bike Repair

Beth Repairs a Bike12/12 = 1 Web Page

Beth Develops a Web Page12/12 = 1 Bike Repair

Production Possibility Production Possibility ScheduleSchedule

Paula BethBR/day WP/Day BR/day WP/Day

36 0 12 0

32 2 10.64 1.33

28 4 9.31 2.66

24 6 7.98 3.99

20 8 6.65 5.32

16 10 5.32 6.65

12 12 3.99 7.98

8 14 2.66 9.31

4 16 1.33 10.64

0 18 0 12

PPF of Paula + BethPPF of Paula + Beth

0 5 10 15 20 25 30 35 40 45 50

5

10

15

20

2

5

3

0

We p

ag

es

deve

lop

men

t

Paula + Beth

Bike Repairs

PaulaBeth

Kink added with

addition of worker in economy

PPF of Paula + Beth + 3PPF of Paula + Beth + 3rdrd WorkerWorker

0 5 10 15 20 25 30 35 40 45 50

5

10

15

20

2

5

3

0

We p

ag

es

deve

lop

men

t

Bike Repairs

Kinks increase

with increase

in workers

Comparative and Absolute Comparative and Absolute AdvantagesAdvantages

Paula has Absolute Advantage in both Paula has Absolute Advantage in both Bike Repairing and Web Page Bike Repairing and Web Page DevelopingDeveloping

Beth Has Absolute Advantage in none.Beth Has Absolute Advantage in none.

Paula has Comparative Advantage in Paula has Comparative Advantage in Bike RepairingBike Repairing

Beth has Comparative Advantage in Web Beth has Comparative Advantage in Web DevelopmentDevelopment

Comparative AdvantageComparative Advantage The person with the lower The person with the lower

opportunity cost of an activity has opportunity cost of an activity has the comparative advantage at that the comparative advantage at that activity.activity.

This means that the person with the This means that the person with the comparative advantage can produce comparative advantage can produce the activity by giving up the smallest the activity by giving up the smallest amount of the alternative activity.amount of the alternative activity.

The Idea of The Idea of Comparative Advantage Comparative Advantage

and Tradeand Trade

Specialization and free trade will Specialization and free trade will benefit all trading parties, even benefit all trading parties, even when some are “absolutely” more when some are “absolutely” more efficient producers than others.efficient producers than others.

Need to understand absolute vs. Need to understand absolute vs. comparative advantage.comparative advantage.

Absolute vs. Absolute vs. Comparative Advantage Comparative Advantage

Applied to TradeApplied to Trade Absolute advantageAbsolute advantage: If your country uses fewer : If your country uses fewer

resources to produce a given unit of output than the resources to produce a given unit of output than the other country.other country.

Comparative advantageComparative advantage: if your country can : if your country can produce the output at a lower opportunity cost than produce the output at a lower opportunity cost than the other country.the other country.

Every country (or person, or economy) has a Every country (or person, or economy) has a comparative advantage at some activity.comparative advantage at some activity.

Absolute advantage is not important and may not Absolute advantage is not important and may not always happen. Sometimes people or countries have always happen. Sometimes people or countries have the absolute advantage in nothing! Yet trade the absolute advantage in nothing! Yet trade possibilities still exist.possibilities still exist.

It’s all about comparative advantage.It’s all about comparative advantage.

Concepts Affecting Concepts Affecting TradeTrade

Absolute advantageAbsolute advantage – exists when one – exists when one nation can produce goods more nation can produce goods more cheaply than another nation.cheaply than another nation.

Comparative advantageComparative advantage – ability of a – ability of a nation to specialize in the production nation to specialize in the production of the good for which it has the of the good for which it has the greatest comparative advantage or greatest comparative advantage or lowest opportunity cost.lowest opportunity cost.

Competitive advantageCompetitive advantage – economic – economic competitive of a nation reflected in competitive of a nation reflected in the absolute cost of a given good in a the absolute cost of a given good in a given market at a particular point in given market at a particular point in time.time.

Sunk CostsSunk Costs

The costs that are beyond recovery The costs that are beyond recovery at the moment a decision is to be at the moment a decision is to be mademade

Discussion ExamplesDiscussion Examples

Should you drive 100 kms through a Should you drive 100 kms through a snow storm to watch a football game?snow storm to watch a football game? Ticket purchased in own city for $ 30.Ticket purchased in own city for $ 30. Your friend had decided to buy the ticket Your friend had decided to buy the ticket

on the ground, where it is $ 25, but seat on the ground, where it is $ 25, but seat choice may not be available.choice may not be available.

If you and your friend are both rational, If you and your friend are both rational, is one of you more likely to attend the is one of you more likely to attend the game than the other?game than the other?

Since you have paid $ 30, it is a sunk cost. It cannot be Since you have paid $ 30, it is a sunk cost. It cannot be recovered whether you watch the gamer or not. So in recovered whether you watch the gamer or not. So in deciding whether to go to the game, you should deciding whether to go to the game, you should compare benefits of going to the game (your compare benefits of going to the game (your reservation price, the largest dollar amount you will be reservation price, the largest dollar amount you will be willing to pay to watch it) to the additional costs you willing to pay to watch it) to the additional costs you must incur to see the game (OC of your time, costs you must incur to see the game (OC of your time, costs you assign to driving through the storm). You should not assign to driving through the storm). You should not include the ticket cost, that $ 30 is gone, you will never include the ticket cost, that $ 30 is gone, you will never see it again, whether you watch the game or not.see it again, whether you watch the game or not.

Your friend, must however include the cost of ticket Your friend, must however include the cost of ticket since he/she has not paid yet, and it is not a sunk cost.since he/she has not paid yet, and it is not a sunk cost.

Suppose your friend got a ticket as gift form anther Suppose your friend got a ticket as gift form anther friend before going. What will happen now?friend before going. What will happen now?

Example 2Example 2

How much should you eat at an all How much should you eat at an all you can eat restaurant, if the buffet you can eat restaurant, if the buffet price is $ 10?price is $ 10?

How much should you eat at an all How much should you eat at an all you can eat restaurant, if the buffet you can eat restaurant, if the buffet price is $ 5?price is $ 5?

How much if you are a lucky winner How much if you are a lucky winner of a free meal at the same of a free meal at the same restaurant?restaurant?

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

Example of Absolute Example of Absolute AdvantageAdvantage

Units of Output/Unit of LaborUnits of Output/Unit of Labor

64Coffee

210Wheat

MexicoTons/man hour

United StatesTons/man hour

The U.S. is the most efficient producer of wheat while Mexico is themost efficient producer of coffee. With trade, the U.S. would specializein wheat and exchange part of its surplus for coffee. Mexico would specialize in coffee and trade part of the surplus for wheat

The U.S. is the most efficient producer of wheat while Mexico is themost efficient producer of coffee. With trade, the U.S. would specializein wheat and exchange part of its surplus for coffee. Mexico would specialize in coffee and trade part of the surplus for wheat

Example of Comparative Example of Comparative AdvantageAdvantage

Units of Output/Unit of LaborUnits of Output/Unit of Labor

34Coffee

210Wheat

MexicoTons/man hour

United StatesTons/man hour

Mexico has the absolute disadvantage in producing both goods becauseits 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.

Mexico has the absolute disadvantage in producing both goods becauseits 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.

Factors Affecting Factors Affecting Comparative Advantage….Comparative Advantage….

National differences in opportunity National differences in opportunity costscosts

Costs affected by availability of Costs affected by availability of resourcesresources

Costs affected by production Costs affected by production requirements for goods and requirements for goods and services producedservices produced

Costs affected by resource Costs affected by resource combinationscombinations

Costs affected by resource mobility Costs affected by resource mobility

Production Possibilities Production Possibilities ScheduleSchedule

600800

4886440

36164880

302040100

242432120

123216160

0400200

Coffee

Tons/year

Wheat

Tons/year

Coffee

Tons/year

Wheat

Tons/year

MexicoMexicoU.S.U.S.

Based upon assumption that both countries fully employ all resources, technology and specific amounts of labor per year.

Based upon assumption that both countries fully employ all resources, technology and specific amounts of labor per year.

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




Mexico produces 32tons of wheat and 12 tons of coffee

Mexico produces 32tons of wheat and 12 tons of coffee

Through trade, the U.S. specializes in wheat at point B, trades 50 tons of wheat to Mexico for 45 tonsof coffee, and consumesmore of both goods atpoint C (45 tons of coffeeand 150 tons of wheat).

By comparing point C withpoint A, we see that theU.S. has gained from trade.

Through trade, the U.S. specializes in wheat at point B, trades 50 tons of wheat to Mexico for 45 tonsof coffee, and consumesmore of both goods atpoint C (45 tons of coffeeand 150 tons of wheat).

By comparing point C withpoint A, we see that theU.S. has gained from trade.

Mexico will specialize incoffee, producing 60 tonsat point B’ and no wheat.

They would trade 45 tonsof coffee for 50 tons ofwheat, and consumer moreof both goods (50 tons ofwheat and 15 tons ofcoffee at point C’) than itcould at point A’.

Mexico will specialize incoffee, producing 60 tonsat point B’ and no wheat.

They would trade 45 tonsof coffee for 50 tons ofwheat, and consumer moreof both goods (50 tons ofwheat and 15 tons ofcoffee at point C’) than itcould at point A’.

Home AssignmentHome AssignmentDue on Monday 21 Apr 08Due on Monday 21 Apr 08

Consider a society whose only worker is Consider a society whose only worker is Helen, who allocated her production time Helen, who allocated her production time between cutting hair and baking bread. Each between cutting hair and baking bread. Each hour she devotes to cutting hair yields 4 hair hour she devotes to cutting hair yields 4 hair cuts, and each hour she devotes to baking cuts, and each hour she devotes to baking bread yields 8 loaves of bread. bread yields 8 loaves of bread.

Q No 1-A.Q No 1-A. If Helen Works a total of 8 hours If Helen Works a total of 8 hours per day, graph her Production Possibility per day, graph her Production Possibility Curve.Curve.

Q No 1-B.Q No 1-B. Which of the points listed below is Which of the points listed below is efficient? Which is unattainable?efficient? Which is unattainable? 28 Haircuts/day, 16 loaves/day28 Haircuts/day, 16 loaves/day 16 Haircuts/day, 32 loaves/day16 Haircuts/day, 32 loaves/day 18 Haircuts/day, 24 loaves/day18 Haircuts/day, 24 loaves/day

Question No 2Question No 2 Determine whether the following statements Determine whether the following statements

are True or False, and Briefly Explain Why?are True or False, and Briefly Explain Why?

A.A. Toby can produce 5 gallons of apple cider Toby can produce 5 gallons of apple cider or 2.5 ounces of feta cheese per hour. Kyle can or 2.5 ounces of feta cheese per hour. Kyle can produce 3 gallons of apple cider or 1.5 ounces of produce 3 gallons of apple cider or 1.5 ounces of feta cheese per hour. Therefore Toby and Kyle feta cheese per hour. Therefore Toby and Kyle cannot benefit from specialization from trade.cannot benefit from specialization from trade.

B.B. A doctor who can vacuum her office faster and A doctor who can vacuum her office faster and more thoroughly than commercial cleaners more thoroughly than commercial cleaners should clean her office herself.should clean her office herself.


Larry and Harry are stranded together on a desert Larry and Harry are stranded together on a desert island. The raw material on the island are only suitable island. The raw material on the island are only suitable for making beer and pizza, but their quantities are for making beer and pizza, but their quantities are unlimited. What is scarce is labor. Harry and Larry unlimited. What is scarce is labor. Harry and Larry each spend 10 hours a day making beer or pizza. The each spend 10 hours a day making beer or pizza. The following table specifies how much beer and pizza following table specifies how much beer and pizza Harry and Larry can produce each hour.Harry and Larry can produce each hour.

Question No 3Question No 3A.A. Draw the Daily PPC for Harry and Larry.Draw the Daily PPC for Harry and Larry.

B.B. Who has absolute advantage in making pizza? In Who has absolute advantage in making pizza? In brewing beer?brewing beer?

C.C. Who has comparative advantage in making pizza? In Who has comparative advantage in making pizza? In brewing beer?brewing beer?



Now suppose their preferences are as follows: Now suppose their preferences are as follows: Harry wants 2 beers and as much pizza as he Harry wants 2 beers and as much pizza as he can eat each day; Larry wants 2 pizzas and as can eat each day; Larry wants 2 pizzas and as much beer as he can consume each day.much beer as he can consume each day.

Question No 3Question No 3D.D. If each man is self reliant, how much pizza and If each man is self reliant, how much pizza and

beer will Harry and Larry eat and drink, each day?beer will Harry and Larry eat and drink, each day?

E.E. Suppose the two men decide to trade with each Suppose the two men decide to trade with each other. Draw their joint PPC, and give an example of a other. Draw their joint PPC, and give an example of a trade that will make each of them better off.trade that will make each of them better off.

Beer/hrBeer/hr Pizza/hrPizza/hr

HarryHarry 1 bottle1 bottle 0.20.2

LarryLarry 0.5 bottle0.5 bottle 1.51.5

Documents

Introduction to Macroeconomics Econ 1011