Introduction to Macroeconomics and a Brief Review of Microeconomics

Section 01: Introduction to Macroeconomics

Macroeconomics is the study of the economy as a whole, as opposed to microeconomics which is the study of individual firms and consumers.

In this course we will study total output, total levels of employment, total income, aggregate expenditures, the general price level, etc. Do you see the difference between that and studying the output of an individual firm, spending on a single product, or individual price or wage determination?

During our study of macroeconomics we will employ three different levels of analysis: Descriptive Economics, Economic Theory, and Economic Policy. This course relies heavily on data relevant to economy. Descriptive Economics involves the gathering of facts and data that describe the state of the economy. Labor market data, output data, price data, and others will help us understand what is happening in the economy as a whole. Much of this data will allow us to make positive statements about the economy. A positive statement is defined to be a statement of fact. If we gather data on the number of people in the labor force who are unemployed and calculate the unemployment rate to be 8.6%, then the statement, “The unemployment rate is 8.6%” is a positive statement because it is a simple statement of fact.

Economic policy is used to try to manipulate the economy to achieve desired outcomes. Policies are generally designed to meet some goal or target. Typical goals are such things as low employment, price level stability, economic growth, or balanced trade. Since not everyone would agree what are the most important economic goals to achieve, economic policy almost always involves some value judgment and results in the formulation of normative statements. A normative statement is a statement of what “should be,” or a statement of opinion. Therefore, “An unemployment rate of 8.6% is too high, and we should pursue policies to lower the unemployment rate,” would be a normative statement.

To a much larger degree than microeconomics, macroeconomics will involve discussions of policies and normative issues about which we may not all agree. Make sure you understand Descriptive Economics and can properly analyze and calculate the various measures that this course will require of you. Also, make sure that you understand the different Economic Theories that are presented in this course. When it comes to Economic Policy, you will have to understand the impact on the economy of various fiscal, monetary, and trade policies, but that will not mean that you have to agree with the Instructor or your fellow students about which of the policies would be best to peruse.

 

Section 02: A Brief Review of Microeconomics

The Economic Perspective

Economics is a Social Science. We study how people and institutions behave given certain constraints. Our behavior is generally directed toward satisfying some want. In fact, we have unlimited wants. The constraint we all face is scarcity. For example, the factors of production are scarce. Land, Labor, Capital, and Entrepreneurship are the factors of production. The payments to these factors are rent, wages, interest, and profit, respectively.

The one fact that none of us can avoid is: to have more of one thing, you’ll have to settle for less of another. We are all faced with choices. Every time you make a choice, you incur a cost. The opportunity cost of any action is the best alternative foregone. For example, let’s say that you have $50.00 and that you would really like to buy the domain name for an idea that you have. If you do not purchase it right away, there is a danger that someone else will grab it up. The domain name purchase would cost exactly fifty dollars, but there is a problem: you need to fill your gas tank on your car, and the gas will also cost $50.00. Since your resources are scarce (you only have $50.00) what would you choose to buy?

Let’s say that you decide to buy the gas. What did the gas cost you? An accountant might say that it cost you $50.00, but an economist would say that it cost you $50.00 and the domain name. The domain name was the opportunity cost of buying the gas. Many choices entail both opportunity costs and explicit or out-of-pocket costs. For example, attending college requires out of pocket costs like tuition, books and fees, but the opportunity costs, your foregone earnings, are probably much greater!

The Assumption of Rationality

We always assume that individuals and all economic entities make decisions based on rational self-interest. Of course, this does not imply that everyone makes the same decision, because different people have different preferences. A perfectly rational person could choose vanilla ice cream even when chocolate is available, even though someone who likes chocolate may think that decision is irrational! Rationality does not require that we all make the same decisions. Rational self-interest also does not require us to be selfish. The fact that people will behave rationally to advance their self-interests does not preclude altruism or charity. It may be that many, or even most, people have a preference to help those in need when they can. If I feel better when I am being of service to others, then it is in my self-interest to use part of my resources to help others. This helps to explain why members of the church give so freely to the fast offering funds and to humanitarian causes.

Marginalism: Benefits and Costs

Most of our analysis in economics is marginal analysis. The word “marginal” means incremental or additional. Most decision-making in economics is done on the margin. For example, let’s say that Rexburg City is trying to decide whether they should widen a currently two-lane road into a four-lane road. What process will they employ to determine if it is a wise decision? An economist would suggest that the proper criterion would be to compare the marginal benefit and the marginal cost. The marginal benefit would take into account the benefit to the community of having the extra lane going each way. The two lanes that already exist, therefore, are not included in the marginal benefit. The marginal cost would look at the cost of constructing the additional lanes, the additional maintenance costs for maintaining two extra lanes, and the opportunity cost of using the land for a wider road compared to its best alternative use. If the marginal benefit is greater than the marginal cost then the project makes sense. If the marginal cost is greater than the marginal benefit then the city should forgo the project.

Marginal analysis is widely used in many fields of economics and is a concept with which the student of economics should become very familiar.

Economic Models

What is a model? A model is a simplified representation of a complex idea or entity. A model airplane is a scaled version of a real airplane, but the model is not necessarily an exact replica of a real airplane. The model gives us a good idea of reality without all of the complexity. Economic models are similar in that they are generally a simplified version of a complex reality. This idea of simplification gives us the primary reason for why economists use models.

Consider the example of a map. Think of a road map as a model. If you were unfamiliar with Los Angeles and were planning to go there on a trip, how would you feel if I gave you a map of Los Angeles exactly the size of Los Angeles? Would it be helpful to you? No, it would not. If you do not know LA, a map the size of the city would be just as confusing for you as having no map at all. You need the map to be scaled down. The actual economy is much too grand to be studied in detail. We must model the economy to be able to make sense of it. As we study various economic models, it is not helpful for you to think, “But that isn’t the way it is in real life!” Generally, economists recognize that they are making simplifying assumptions that are not always true to life, but studying a model that is scaled down is infinitely easier than studying the real thing.

The Circular Flow

The first model that we will consider is called the Circular Flow Model of the Economy. In its simplest form we will assume that the economy is composed of only two markets: a factor or resource market and a product market. The key result of this model is the fact that the flow of income is equal to the expenditures on goods and services (the output of the economy). Income flows through the Factor Market and is represented on the top of the Circular Flow Model. Households supply the factors of production in exchange for income. The factors of production are Land, Labor, Capital, and Entrepreneurship. These factors of production are purchased (or rented in the case of labor) by businesses through a factor market. But households do not provide these factors for free. Households are paid for the factors of production and the payments to Land, Labor, Capital, and Entrepreneurship are called Rent, Wages, Interest, and Profit, respectively.

What do businesses do with these factors, and what do households do with these incomes? That is represented by the bottom half of the circular flow. Businesses use the factors or resources to produce an output, generally described as goods and services, to be sold in product markets. Households use their income to make expenditures in these product markets as they purchase goods and services. These expenditures become the source of revenue for businesses that allow them to employ the resources necessary to produce their output. As the name of the model suggests, the income generated on the top of the circular flow is exactly sufficient to produce the expenditures necessary to buy all of the output of goods and services on the bottom of the circular flow.

Students will often note that the model does not account for the banking sector, the government, foreign trade, etc., suggesting that the model is too simplistic to represent the real economy. Each of these objections could be handled by the circular flow model, but the model would just get more complicated. Remember the more the model resembles the true economy, the more you are trying to navigate an unfamiliar city with an enormously detailed map!

Production Possibility Curves

Another useful model is the model of production. This model helps us explain several important economic concepts, involving trade-offs, that firms face in deciding among production alternatives. There are four simplifying assumptions that we will make in this model:

1. Full Employment—We assume that all of the factors of production are fully employed. We will explore later what would happen in the model if there were unemployed resources.

2. Fixed Resources that are Allocated Efficiently—We assume that at any given point in time, the amount of resources available to the economy is fixed and that these resources are being employed in such a way that there is no way to reallocate the resources and achieve a higher output. In other words, this is an assumption that we are at our maximum output.

3. Fixed Technology—We assume that at any given point in time the technology available to the economy is fixed and that we are using all of our technology to its full potential.

4. Only two Products are Being Produced—In order to easily represent this model in a two-dimensional plane, we will assume that only two products are being produced in our economy. Given our previous assumptions, this will require that to produce more of one good we must give up production of the other good. The cost of one good in terms of the other good will represent the opportunity cost of production.

Production in a Two-Good Economy

We will begin by defining a Production Possibility Curve (PPC) as the boundary between production levels which can and cannot be obtained. In the diagram below points A, B, and C all represent different combinations of machines and food that can be produced. All four of our assumptions are true at each of these points. Point D represents a production level that is below full production and must have resulted from a violation of one or more of our assumptions. This could be because of unemployment, misallocation of resources, improper use of technology, etc. Point E, a point outside our PPC represents a production combination that is beyond the current capabilities of our economy. It can be easily demonstrated that point E represents the same amount of Machines as point A but more food. That is not a possibility, however, since we assumed that the only way to produce more of one good was to produce less of the other good. This final assumption will guarantee that the PPC is always downward sloping.

An Example with Tractors and Food

Assume that you have an economy that produces only food and tractors and that the various combinations of food and tractors that can be produced are provided in the table below:

Possibility	Food	Tractors
A	0	15
B	2	14
C	4	12
D	6	10
E	8	7
F	10	4
G	12	0

Graphically this PPC is illustrated below:

This explanation of the non-adaptability of economic resources is also called the Law of Increasing Opportunity Costs. The fact that there is an increasing opportunity cost is the explanation for why the PPC is concave to the original or bowed out away from the origin. The tradeoff between the two goods becoming larger and larger is illustrated in the graph below by the slope of the curve becoming steeper and steeper as more of good B is produced. Notice a relatively flat slope at point A and a much steeper slope at point C.

If you could devise an example where the resources used to produce the two goods were perfectly adaptable (maybe if the two goods were volleyballs and soccer balls and the materials, labors, and machines were perfectly suited to the production of both) then the PPC would not be concave to the origin but would be a straight downward sloping line. This, of course, would be a rare exception to the Law of Increasing Opportunity Costs, and you would have a case of Constant Opportunity Costs, which is illustrated below.

Economic Growth

There are several ways to cause economic growth in an economy which is illustrated by an outward shift in the PPC. The ways that economic growth can be achieved involve relaxing our assumptions: increasing the amount of resources available to the economy, increasing the efficiency of our resources, or improving technology. Each of these changes would result in a shift to the right of the PPC.

Demand

The market demand curve shows the amount of the commodity buyers are willing and able to purchase at various prices. For example, let’s consider the following information on the quantity demanded for a particular CD at various prices:

Price ($/CD)	Quantity (1000s)
$30	40
$25	50
$20	70
$15	100

This data can be graphed as follows:

The demand curve is downward sloping to the right. The inverse relationship between price and the quantity demanded is called The Law of Demand. It should make intuitive sense to you that at lower prices consumers demand higher quantities. There are several economic reasons for why the demand curve slopes downward.

Rationales for the Law of Demand

Below are listed four rationales for why the demand curve has a downward slope. The first is what might be called the  man on the street explanation. It is just the logical description of how most people behave. The other three rationales rely on economic principles.

1. People buy more of a given product at lower prices than they do at higher prices.

2. In any given time period, a buyer of a product will derive less utility from each successive unit of a product he consumes. This is called diminishing marginal utility. Since a consumer is receiving less utility from each additional unit of a good consumed, he will only buy successive units at lower prices.

3. Income Effect of a Price Change—At lower prices, one can afford to buy more of all goods, because one’s income stretches further. Thus, at lower prices higher quantities are demanded. The reverse is also true.

4. Substitution Effect of a Price Change—As the price of a good falls you tend to substitute away from higher priced good and buy more of this relatively cheaper good. As the price of good “A” falls the quantity demanded for good “A” goes up because it is relatively cheaper than other goods for which prices remained constant.

Determinants of Demand

There are other factors that influence the demand for a good other than the price. Since these other factors are not measured on either the horizontal or vertical axes, when there is a change in one of these factors it is represented by a shift in the demand curve. For this reason they are sometimes called “demand shifters,” although we will refer to them by the more traditional name of the “determinants of demand.” In this section it will be useful to understand the terminology that economists employ in referring to shifts in the demand curve. A shift to the right of the demand curve is called an increase in demand and a shift to the left of the demand curve is called a decrease in demand. The position of the demand curve is determined by the following factors:

1. Consumer Tastes—When a product becomes more popular, the demand for this product increases and the demand curve shifts to the right. If a product loses favor with consumers, there is a decrease in demand and the demand curve shifts to the left.

2. Income Levels—For normal goods, when your income increases the demand curve shifts to the right and when your income falls, the demand curve shifts to the left. There are goods that are called inferior goods for which the opposite is true. When your income goes up, you have a decrease in your demand for an inferior good, and when your income goes down, you actually have an increase in demand for an inferior good. Can you think of some examples of goods that would be classified as normal and others that would be classified as inferior?

3. Number of Consumers in the Market—When the number of consumers in a market rises, the demand for products in that market shifts to the right. For example, as our population gets older we would expect the demand for hearing aids to shift to the right. When the number of consumers in a market falls, the demand curve shifts to the left. If the number of babies being born goes down, the demand for disposable diapers should decrease.

4. Level of other Prices—When two goods are substitutes for each other (goods that can be consumed in place of each other such as Sprite and Seven-Up), then if the price of one of the goods goes up, the demand for the other good increases and its demand curve shifts to the right. The opposite would also be true. When two goods are complements to each other (goods that are used together such as tennis balls and tennis rackets), then when the price of one of the goods goes up, the demand for the other good decreases and its demand curve shifts to the left. The opposite is also true.

5. Price Expectations—We have indicated already that when the price of a good changes it causes movement along a given demand curve because of the law of demand. But what it a price does not actually change but consumers think it is going to change. This expectation of a price change in the future will shift the demand curve in the current period. For example, if you think the price of gasoline is going to go up this weekend you might increase your demand for gasoline today. This increase in the demand for gasoline in the face of constant prices is represented by a shift to the right of the demand curve. The opposite would also be true. If you think the price of gasoline is going to go down this weekend, you might delay buying gas today and today’s demand curve for gasoline would shift to the left.

Each of the changes in the determinants of demand can be illustrated in the graph below either by a shift in the demand curve from Dó to D’ (in the cases of an increase in demand) or to D” (in the cases of a decrease in demand).

Quantity Demanded versus Demand

Now here’s a bit of information that you are just going to have to memorize and know, even if it does not make any sense to you. Movement along a demand curve for a given product is referred to as a change in the quantity demanded and is the result of a change in the own price of the product. Shifts in the demand curve for a product are referred to as changes in the demand for the product and can result from changes in any of the determinants of demand. You have to keep these two terminologies in your mind and use them correctly or you will incorrectly identify the impact of things such as an increase in income or a decrease in the price. Even though the concepts are similar, to an economist, a change in demand is very different from a change in quantity demanded, and they evoke completely different images: one is a shift in the demand curve and the other is movement along a single demand curve.

Supply

The market supply curve shows the amount of the commodity sellers would offer at various prices. The supply curve slopes upward and to the right since the quantity supplied increases as price increases. For example, let’s consider the following data on the quantity supplied of a particular CD at various prices and the graph that would correspond to this data:

Price ($/CD)	Quantity (1000s)
$30	125
$25	100
$20	70
$15	50
$10	25

 

The Determinants of Supply

There are other factors that influence the supply for a good other than the price. Since these other factors are not measured on either the horizontal or vertical axes, when there is a change in one of these factors it is represented by a shift in the supply curve. For this reason they are sometimes called “supply shifters” although we will refer to them by the more traditional name of the “determinants of supply.” In this section it will be useful to understand the terminology that economists employ in referring to shifts in the supply curve. A shift downward and to the right of the supply curve is called an increase in supply and a shift upward and to the left of the supply curve is called a decrease in supply. The position of the supply curve is determined by the following factors:

1. Technology—Technological advances will shift the supply curve to the right. Generally speaking, improvements in technology decrease the per unit costs of production, and therefore increase the supply of the good.

2. Resource Prices—When there is a decrease in the price of a resource or factor of production the cost of producing the good falls and there is a corresponding increase in supply the supply curve shifts to the right. When resources prices rise the supply curve shifts to the left.

3. Prices of Related Goods—When the price one substitute in production (such as cars versus trucks for Ford) falls, the supply of the other substitute will rise. Ford will produce more trucks if the price of cars is falling relative to trucks.

4. Number of Sellers—When the number of sellers in a market increases there is an increase in the supply of the good and the supply curve shifts to the right. When there is a decrease in the number of sellers the supply curve shifts to the left.

5. Taxes and Subsidies—Taxes increase the costs of production and shift the supply curve to the left and subsidies decrease the costs of production and cause an increase in supply.

Each of the changes in the determinants of supply can be illustrated in the graph below either by a shift in the supply curve from Só to S’ (in the cases of an increase in supply) or to S” (in the cases of a decrease in supply).

Quantity Supplied versus Supply

Movement along a supply curve for a good is called a change in the quantity supplied and is caused by a change in the own price of the good. A shift in the supply curve is called a change in supply and can be caused by a change in any of the determinants of supply. The same warning about not confusing these two terms is as valid for supply as it was for demand.

Equilibrium Price and Quantity

An equilibrium in economics is a state from which there is no tendency to change. If you move away from equilibrium there is a tendency to return to it. Therefore, an equilibrium price or quantity is one from which there is no tendency to deviate, and to which you tend to return if you move away from it. The equilibrium price and quantity for a product is determined by the intersection of supply and demand. It is easy to demonstrate that the intersection constitutes an equilibrium by considering what would happen if you were not at the intersection. Consider the graph below where the equilibrium price and quantity are labeled P* and Q* respectively.

What if price is below equilibrium?

Our graph shows what happens if the price is set at a price below the equilibrium, say P1. At P1 the quantity demanded (B) will be larger than the quantity supplied (A) and a shortage will occur. Market forces will automatically exert pressure which causes the price to rise to equilibrium. Consider a case where you open a t-shirt shop in Rexburg and are not certain what the equilibrium price of t-shirts should be so you set a price of $2 per t-shirt. On opening day, you quickly run out of t-shirts. You have to close your doors early because more people want to buy a t-shirt at $2 each than you were willing to supply at that price. The market itself has signaled to you that you should raise the price of your t-shirts and the price will rise towards P*.

What if price is set above equilibrium?

These same market forces will cause price to fall if the price is set above P*, say at P2, because the quantity supplied will be larger than the quantity demanded and there will be a surplus. In our example, consider if you raise the price of your t-shirts on your second day of operations to $30 per t-shirt. On the second day you bring in lots of t-shirts to sell at this much higher price, but the quantity demanded is far below what you were willing to supply and almost nobody is willing to pay $30 for your t-shirts. The market is signaling to you that you need to lower your price. As prices fall toward P* you approach equilibrium.

Only in equilibrium is there no tendency for the price to rise or fall because this is where quantity demanded equals quantity supplied. Let’s say on your third day of operations you lower the price of you t-shirts to $15 and the number that you were willing to sell at this price exactly equals the number that your customers are willing to buy. Quantity supplied equals quantity demanded and you have no incentive to change the price going forward. You have found the equilibrium price for t-shirts in Rexburg, Idaho!

Price Controls and Disequilibrium

If, for some reason, the government or some other entity were to impose a price on a market that was not the equilibrium price, the resulting shortages (if the price is set below equilibrium) or surpluses (if the price is set above equilibrium) could persist and equilibrium might not be achieved. When prices are set below equilibrium, they are called price ceilings (such as rent controls in New York City) and when prices are set above equilibrium, they are called price floors (such as a minimum wage or a price floor on an agricultural commodity). You might want to think about why the government would do such a thing when it interferes with the market equilibrium.

Shifts in Demand and Supply

A decrease in demand (shifting the demand curve to the left) results in a decrease in price and a decrease in the quantity supplied. An increase in demand (shifting the demand curve to the right) results in an increase in price and an increase in the quantity supplied. Both of these cases are illustrated below. What would be the impact on the price and quantity of automobiles in Washington, D.C. if the price of the D.C. subway ticket were to go down? What would be the impact on equilibrium price and quantity in the market for landscaping in Rexburg if there were an increase in income levels in Rexburg? What would happen to the price and quantity of peaches in the U.S. if scientists were to discover that peaches cause cancer? These are the types of questions you should be prepared to answer related to shifts in the demand curve.

A decrease in supply (shifting the supply curve to the left) results in an increase in price and a decrease in the quantity demanded. An increase in supply (shifting the supply curve to the right) results in a decrease in price and an increase in the quantity demanded. Both of these cases are illustrated below. What would be the impact on price and quantity of automobiles in Washington, D.C. if auto workers were to get an increase in their pay? What would be the impact on equilibrium price and quantity in the market for landscaping in Rexburg if there were an increase in the number of landscape companies in Rexburg? What would happen to the price and quantity of peaches in the U.S. if scientists were to discover a new technology that increase yields of peaches per tree? These are the types of questions you should be prepared to answer related to shifts in the supply curve.