1 Ten Principles of Economics

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 What Economics Is All About
▪ Scarcity refers to the limited nature of society’s
resources.
▪ Economics is the study of how society manages
its scarce resources, including
• how people decide how much to work, save,
and spend, and what to buy
• how firms decide how much to produce,
how many workers to hire
• how society decides how to divide its resources
between national defense, consumer goods,
protecting
CHAPTER the environment,
1 TEN PRINCIPLES OF ECONOMICSand other needs 1
 HOW PEOPLE MAKE DECISIONS

▪ Decision making is at
the heart of
economics.

▪ The first four

principles deal with
how people make
decisions.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 2

 HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs

All decisions involve tradeoffs. Examples:

▪ Going to a party the night before your midterm
leaves less time for studying.
▪ Having more money to buy stuff requires working
longer hours, which leaves less time for leisure.
▪ Protecting the environment requires resources
that might otherwise be used to produce
consumer goods.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 3
 HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
▪ Society faces an important tradeoff:
efficiency vs. equity
▪ efficiency: getting the most out of scarce
resources
▪ equity: distributing prosperity fairly among
society’s members
▪ Tradeoff: To increase equity, can redistribute
income from the well-off to the poor.
But this reduces the incentive to work and produce,
and shrinks the size of the economic “pie.”
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 4
 HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is What
You Give Up to Get It

▪ Making decisions requires comparing the costs

and benefits of alternative choices.
▪ The opportunity cost of any item is whatever
must be given up to obtain it.
▪ It is the relevant cost for decision making.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 5

 HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is What
You Give Up to Get It
Examples:
The opportunity cost of…
…going to college for a year is not just the tuition,
books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 6

 HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the
Margin

▪ A person is rational if she systematically and

purposefully does the best she can to achieve
her objectives.
▪ Many decisions are not “all or nothing,”
but involve marginal changes – incremental
adjustments to an existing plan.
▪ Evaluating the costs and benefits of marginal
changes is an important part of decision making.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 7
 HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the
Margin
Examples:
▪ A student considers whether to go to college
for an additional year, comparing the fees &
foregone wages to the extra income he could
earn with an extra year of education.
▪ A firm considers whether to increase output,
comparing the cost of the needed labor and
materials to the extra revenue.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 8
 HOW PEOPLE MAKE DECISIONS
Principle #4: People Respond to Incentives

▪ incentive: something that induces a person to

act, i.e. the prospect of a reward or punishment.
▪ Rational people respond to incentives because
they make decisions by comparing costs and
benefits. Examples:
• In response to higher cigarette taxes,
teen smoking falls.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 9

ACTIVE LEARNING 1:
Exercise
You are selling your 1996 Mustang. You have
already spent $1000 on repairs.
At the last minute, the transmission dies. You can
pay $600 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you have
the transmission repaired?
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
10
ACTIVE LEARNING 1:
Answers
Cost of fixing transmission = $600
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
Benefit of fixing the transmission = $800
($6500 – 5700).
It’s worthwhile to have the transmission fixed.
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
Benefit of fixing the transmission is only $500.
Paying $600 to fix transmission is not worthwhile.
11
ACTIVE LEARNING 1:
Answers
Observations:
▪ The $1000 you previously spent on repairs is
irrelevant. What matters is the cost and benefit
of the marginal repair (the transmission).
▪ The change in incentives from scenario A
to scenario B caused your decision to change.

12
 HOW PEOPLE INTERACT

▪ An “economy” is just
a group of people
interacting with
each other.

▪ The next
three principles
deal with how people
interact.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 13

 HOW PEOPLE INTERACT
Principle #5: Trade Can Make Everyone Better
Off
▪ Rather than being self-sufficient, people can
specialize in producing one good or service
and exchange it for other goods.
▪ Countries also benefit from trade & specialization:
• get a better price abroad for goods they
produce
• buy other goods more cheaply from abroad
than could be produced at home
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 14
 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity

▪ A market is a group of buyers and sellers.

(They need not be in a single location.)
▪ “Organize economic activity” means determining
• what goods to produce
• how to produce them
• how much of each to produce
• who gets them
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 15
 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity

▪ In a market economy, these decisions result from

the interactions of many households and firms.
▪ Famous insight by Adam Smith in
The Wealth of Nations (1776):
Each of these households and firms
acts as if “led by an invisible hand”
to promote general economic well-being.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 16

 HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity

▪ The invisible hand works through the price system:

• The interaction of buyers and sellers
determines prices of goods and services.
• Each price reflects the good’s value to buyers
and the cost of producing the good.
• Prices guide self-interested households and
firms to make decisions that, in many cases,
maximize society’s economic well-being.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 17
 HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes

▪ Important role for govt: enforce property rights

(with police, courts)
▪ People are less inclined to work, produce, invest, or
purchase if large risk of their property being stolen.
• A restaurant won’t serve meals if customers
do not pay before they leave.
• A music company won’t produce CDs if too many
people avoid paying by making illegal copies.
CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 18
 HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes

▪ Govt may alter market outcome to promote efficiency

▪ In such cases, public policy may increase efficiency.
▪ Govt may alter market outcome to promote equity
▪ If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can change
how the economic “pie” is divided

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 19

A C T I V E L E A R N I N G 2:
Discussion Questions
In each of the following situations, what is the
government’s role? Does the government’s
intervention improve the outcome?
a. Public schools for K-12
b. Workplace safety regulations
c. Public highways
d. Patent laws, which allow drug companies to
charge high prices for life-saving drugs

20
HOW THE ECONOMY AS A WHOLE WORKS

▪ The last three

principles deal with
the economy as a
whole.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 21

 HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living
depends on its ability to produce goods &
services.

▪ Huge variation in living standards across

countries and over time:
• Average income in rich countries is more than
ten times average income in poor countries.
• The U.S. standard of living today is about
eight times larger than 100 years ago.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 22

 HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living
depends on its ability to produce goods &
services.
▪ The most important determinant of living standards:
productivity, the amount of goods and services
produced per unit of labor.
▪ Productivity depends on the equipment, skills, and
technology available to workers.
▪ Other factors (e.g., labor unions, competition from
abroad) have far less impact on living standards.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 23

 HOW THE ECONOMY AS A WHOLE WORKS
Principle #9: Prices rise when the government
prints too much money.

▪ Inflation: increases in the general level of prices.

▪ In the long run, inflation is almost always caused
by excessive growth in the quantity of money,
which causes the value of money to fall.
▪ The faster the govt creates money,
the greater the inflation rate.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 24

 HOW THE ECONOMY AS A WHOLE WORKS
Principle #10: Society faces a short-run
tradeoff between inflation and unemployment

▪ In the short-run (1 – 2 years),

many economic policies push inflation and
unemployment in opposite directions.
▪ Other factors can make this tradeoff more or less
favorable, but the tradeoff is always present.

CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 25

 The Market Forces of Supply and
4 Demand

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 Markets and Competition
▪ A market is a group of buyers and sellers of a
particular product.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 1

 Demand
▪ Demand comes from the behavior of buyers.
▪ The quantity demanded of any good is the
amount of the good that buyers are willing and
able to purchase.
▪ Law of demand: the claim that the quantity
demanded of a good falls when the price of the
good rises, other things equal

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 2

 The Demand Schedule
Price Quantity
▪ Demand schedule: of of Bread
A table that shows the Bread demanded
relationship between the $0.00 16
price of a good and the 1.00 14
quantity demanded. 2.00 12
3.00 10
▪ Example: 4.00 8
Helen’s demand for Bread.
5.00 6
▪ Notice that Helen’s 6.00 4
preferences obey the
Law of Demand.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 3
 Helen’s Demand Schedule & Curve
Price of Price Quantity
Bread of of Bread
Bread demanded
$0.00 16
1.00 14
2.00 12
3.00 10
4.00 8
5.00 6
6.00 4
Quantity
of Bread
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 4
 Market Demand versus Individual Demand
▪ The quantity demanded in the market is the sum of
the quantities demanded by all buyers at each price.
▪ Suppose Helen and Ken are the only two buyers in
the Bread market. (Qd = quantity demanded)
Price Helen’s Qd Ken’s Qd Market Qd
$0.00 16 + 8 = 24
1.00 14 + 7 = 21
2.00 12 + 6 = 18
3.00 10 + 5 = 15
4.00 8 + 4 = 12
5.00 6 + 3 = 9
6.00 4 + 2 = 6
 The Market Demand Curve for Bread

Qd
P P
(Market)
$0.00 24
1.00 21
2.00 18
3.00 15
4.00 12
5.00 9
6.00 6
Q

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 6

 Demand Curve Shifters
▪ The demand curve shows how price affects
quantity demanded, other things being equal.
▪ These “other things” are non-price determinants
of demand (i.e., things that determine buyers’
demand for a good, other than the good’s price).
▪ Changes in them shift the D curve…

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 7

Demand Curve Shifters: # of buyers
▪ An increase in the number of buyers causes
an increase in quantity demanded at each price,
which shifts the demand curve to the right.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 8

Demand Curve Shifters: # of buyers

P Suppose the number

of buyers increases.
Then, at each price,
quantity demanded
will increase
(by 5 in this example).

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 9

Demand Curve Shifters: income

▪ Demand for a normal good is positively related

to income.
• An increase in income causes increase
in quantity demanded at each price, shifting
the D curve to the right.
(Demand for an inferior good is negatively
related to income. An increase in income shifts
D curves for inferior goods to the left.)

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 10

Demand Curve Shifters: prices of
related goods
▪ Two goods are substitutes if
an increase in the price of one causes
an increase in demand for the other.
▪ Example: pizza and hamburgers.
An increase in the price of pizza
increases demand for hamburgers,
shifting hamburger demand curve to the right.
▪ Other examples: Coke and Pepsi,
laptops and desktop computers,
compact discs and music downloads
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 11
Demand Curve Shifters: prices of
related goods
▪ Two goods are complements if
an increase in the price of one causes
a fall in demand for the other.
▪ Example: computers and software.
If price of computers rises, people buy fewer
computers, and therefore less software.
Software demand curve shifts left.
▪ Other examples: college tuition and textbooks,
bagels and cream cheese, eggs and bacon

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 12

Demand Curve Shifters: tastes

▪ Anything that causes a shift in tastes toward a

good will increase demand for that good
and shift its D curve to the right.

▪ Example:
The Atkins diet became popular in the ’90s,
caused an increase in demand for eggs,
shifted the egg demand curve to the right.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 13

Demand Curve Shifters: expectations
▪ Expectations affect consumers’ buying
decisions.
▪ Examples:
• If people expect their incomes to rise,
their demand for meals at expensive
restaurants may increase now.
• If the economy turns bad and people worry
about their future job security, demand for
new autos may fall now.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 14

 Summary: Variables That Affect Demand

Variable A change in this variable…

Price …causes a movement

along the D curve
No. of buyers …shifts the D curve
Income …shifts the D curve
Price of
related goods …shifts the D curve
Tastes …shifts the D curve
Expectations …shifts the D curve

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 15

ACTIVE LEARNING 1:
Demand curve
Draw a demand curve for music downloads.
What happens to it in each of the following
scenarios? Why?
A. The price of iPods
falls
B. The price of music
downloads falls
C. The price of
compact discs falls

16
 ACTIVE LEARNING 1:
A. price of iPods falls
Music downloads
Price of
music
and iPods are
down-loa complements.
ds A fall in price of
iPods shifts the
P1
demand curve for
music downloads
to the right.
D1 D2

Q1 Q2 Quantity of
music downloads
17
ACTIVE LEARNING 1:
B. price of music downloads falls

Price of
music
down-lo The D curve
ads does not shift.
Move down along
P1
curve to a point with
P2 lower P, higher Q.

D1

Q1 Q2 Quantity of
music downloads
18
ACTIVE LEARNING 1:
C. price of CDs falls

Price of CDs and

music music downloads
down-lo are substitutes.
ads
A fall in price of CDs
P1 shifts demand for
music downloads
to the left.

D2 D1

Q2 Q1 Quantity of
music downloads
19
 Supply
▪ Supply comes from the behavior of sellers.
▪ The quantity supplied of any good is the
amount that sellers are willing and able to sell.
▪ Law of supply: the claim that the quantity
supplied of a good rises when the price of the
good rises, other things equal

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 20

 The Supply Schedule

▪ Supply schedule: Price

of
Quantity
of Bread
A table that shows the Bread supplied
relationship between the $0.00 0
price of a good and the 1.00 3
quantity supplied. 2.00 6
Example: 3.00 9
Starbucks’ supply of Bread 4.00 12
5.00 15
▪ Notice that Starbucks’ 6.00 18
supply schedule obeys the
Law of Supply.
CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 21
 Starbucks’ Supply Schedule & Curve
Price Quantity
P of ofBreadsu
Bread pplied
$0.00 0
1.00 3
2.00 6
3.00 9
4.00 12
5.00 15
6.00 18
Q

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 22

 Market Supply versus Individual Supply
▪ The quantity supplied in the market is the sum of
the quantities supplied by all sellers at each price.
▪ Suppose Starbucks and Jitters are the only two
sellers in this market. (Qs = quantity supplied)
Price Starbucks Jitters Market Qs
$0.00 0 + 0 = 0
1.00 3 + 2 = 5
2.00 6 + 4 = 10
3.00 9 + 6 = 15
4.00 12 + 8 = 20
5.00 15 + 10 = 25
6.00 18 + 12 = 30
The Market Supply Curve
QS
P
(Market)
P
$0.00 0
1.00 5
2.00 10
3.00 15
4.00 20
5.00 25
6.00 30

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 24

 Supply Curve Shifters
▪ The supply curve shows how price affects
quantity supplied, other things being equal.
▪ These “other things” are non-price determinants
of supply.
▪ Changes in them shift the S curve…

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 25

Supply Curve Shifters: input prices
▪ Examples of input prices:
wages, prices of raw materials.

▪ A fall in input prices makes production

more profitable at each output price,
so firms supply a larger quantity at each price,
and the S curve shifts to the right.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 26

Supply Curve Shifters: input prices

P Suppose the
price of milk falls.
At each price,
the quantity of
Lattes supplied
will increase
(by 5 in this
example).

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 27

Supply Curve Shifters: technology
▪ Technology determines how much inputs are
required to produce a unit of output.
▪ A cost-saving technological improvement has
same effect as a fall in input prices,
shifts the S curve to the right.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 28

Supply Curve Shifters: # of sellers

▪ An increase in the number of sellers increases

the quantity supplied at each price,
shifts the S curve to the right.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 29

Supply Curve Shifters: expectations

▪ Suppose a firm expects the price of the good it

sells to rise in the future.
▪ The firm may reduce supply now, to save some
of its inventory to sell later at the higher price.
▪ This would shift the S curve leftward.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 30

Summary: Variables That Affect Supply

Variable A change in this variable…

Price …causes a movement
along the S curve
Input prices …shifts the S curve
Technology …shifts the S curve
No. of sellers …shifts the S curve
Expectations …shifts the S curve

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 31

ACTIVE LEARNING 2:
Supply curve
Draw a supply curve for tax
return preparation software.
What happens to it in each
of the following scenarios?
A. Retailers cut the price of
the software.
B. A technological advance
allows the software to be
produced at lower cost.
C. Professional tax return preparers raise the
price of the services they provide.
32
ACTIVE LEARNING 2:
A. fall in price of tax return software
Price of
tax return The S curve
S1
software does not shift.
P1 Move down
along the curve
P2 to a lower P
and lower Q.

Q2 Q1 Quantity of tax
return software
33
ACTIVE LEARNING 2:
B. fall in cost of producing the software
Price of
tax return The S curve
S1 S2
software shifts to the
right:
P1
at each price,
Q increases.

Q1 Q 2 Quantity of tax
return software
34
ACTIVE LEARNING 2:
C. professional preparers raise their price
Price of
tax return
S1 This shifts the
software
demand curve for
tax preparation
software, not the
supply curve.

Quantity of tax
return software
35
 Supply and Demand Together

P Equilibrium:
D S
P has reached
the level where
quantity supplied
equals
quantity demanded

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 36

 Equilibrium price:
The price that equates quantity supplied
with quantity demanded
P
D S D
P Q QS
$0 24 0
1 21 5
2 18 10
3 15 15
4 12 20
5 9 25
Q 6 6 30

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 37

 Equilibrium quantity:
The quantity supplied and quantity demanded
at the equilibrium price
P
D S D S
P Q Q
$0 24 0
1 21 5
2 18 10
3 15 15
4 12 20
5 9 25
Q 6 6 30

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 38

 Surplus:
when quantity supplied is greater than
quantity demanded
P
D Surplus S Example:
If P = $5,
then
QD = 9 lattes
and
QS = 25 lattes
resulting in a surplus
of 16 lattes
Q

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 39

 Surplus:
when quantity supplied is greater than
quantity demanded
P
D Surplus S Facing a surplus,
sellers try to increase
sales by cutting the price.
This causes
QD to rise and QS to fall…
…which reduces the
surplus.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 40

 Surplus:
when quantity supplied is greater than
quantity demanded
P
D Surplus S Facing a surplus,
sellers try to increase
sales by cutting the price.
Falling prices cause
QD to rise and QS to fall.
Prices continue to fall until
market reaches equilibrium.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 41

 Shortage:
when quantity demanded is greater than
quantity supplied
P
D S Example:
If P = $1,
then
QD = 21 lattes
and
QS = 5 lattes
resulting in a
shortage of 16 lattes
Shortage Q

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 42

 Shortage:
when quantity demanded is greater than
quantity supplied
P
D S Facing a shortage,
sellers raise the price,
causing QD to fall
and QS to rise,
…which reduces the
shortage.

Shortage
Q

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 43

 Shortage:
when quantity demanded is greater than
quantity supplied
P
D S Facing a shortage,
sellers raise the price,
causing QD to fall
and QS to rise.
Prices continue to rise
until market reaches
equilibrium.
Shortage
Q

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 44

Three Steps to Analyzing Changes in Eq’m

To determine the effects of any event,

1. Decide whether event shifts S curve,
D curve, or both.
2. Decide in which direction curve shifts.
3. Use supply-demand diagram to see
how the shift changes eq’m P and Q.

CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 45

 Elasticity
▪ Basic idea: Elasticity measures how much
one variable responds to changes in another
variable.
• One type of elasticity measures how much
demand for your websites will fall if you raise
your price.
▪ Definition:
Elasticity is a numerical measure of the
responsiveness of Qd or Qs to one of its
determinants.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 0

 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P

▪ Price elasticity of demand measures how

much Qd responds to a change in P.
▪ Loosely speaking, it measures the
price-sensitivity of buyers’ demand.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 1

 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Example:
P rises
Price P2
by 10%
elasticity P1
of demand D
equals
Q
15% Q2 Q1
= 1.5 Q falls
10%
by 15%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 2
 Price Elasticity of Demand
Price elasticity Percentage change in Qd
=
of demand Percentage change in P
P
Along a D curve, P and Q
move in opposite directions, P2
which would make price
elasticity negative. P1

We will drop the minus sign D

and report Q
all price elasticities Q2 Q1
as positive numbers.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 3

 Calculating Percentage Changes
Standard method
of computing the
Demand for percentage (%) change:
your websites
P end value – start value
x 100%
start value
B
$250
A Going from A to B,
$200
the % change in P equals
D
($250–$200)/$200 = 25%
Q
8 12

CHAPTER 5 ELASTICITY AND ITS APPLICATION 4

 Calculating Percentage Changes
Problem:
The standard method gives
Demand for different answers depending
your websites on where you start.
P
From A to B,
B P rises 25%, Q falls 33%,
$250
A elasticity = 33/25 = 1.33
$200
From B to A,
D
P falls 20%, Q rises 50%,
Q elasticity = 50/20 = 2.50
8 12

CHAPTER 5 ELASTICITY AND ITS APPLICATION 5

 Calculating Percentage Changes
▪ So, we instead use the midpoint method:
end value – start value
x 100%
midpoint

▪ The midpoint is the number halfway between

the start & end values, also the average of
those values.
▪ It doesn’t matter which value you use as the
“start” and which as the “end” – you get the
same answer either way!

CHAPTER 5 ELASTICITY AND ITS APPLICATION 6

 Calculating Percentage Changes
▪ Using the midpoint method, the % change
in P equals
$250 – $200
x 100% = 22.2%
$225
▪ The % change in Q equals
12 – 8
x 100% = 40.0%
10

▪ The price elasticity of demand equals

40/22.2 = 1.8

CHAPTER 5 ELASTICITY AND ITS APPLICATION 7

ACTIVE LEARNING 1:
Calculate an elasticity
Use the following
information to
calculate the
price elasticity
of demand
for hotel rooms:
if P = $70, Qd = 5000
if P = $90, Qd = 3000

8
ACTIVE LEARNING 1:
Answers
Use midpoint method to calculate
% change in Qd
(5000 – 3000)/4000 = 50%
% change in P
($90 – $70)/$80 = 25%
The price elasticity of demand equals

50%
= 2.0
25%

9
 The Determinants of Price Elasticity:
A Summary

The price elasticity of demand depends on:

▪ the extent to which close substitutes are
available
▪ whether the good is a necessity or a luxury
▪ how broadly or narrowly the good is defined
▪ the time horizon: elasticity is higher in the
long run than the short run.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 10

 The Variety of Demand Curves
▪ Economists classify demand curves according to
their elasticity.

▪ The price elasticity of demand is closely related

to the slope of the demand curve.

▪ Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.

▪ The next 5 slides present the different

classifications, from least to most elastic.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 11
“Perfectly inelastic demand” (one extreme case)
Price elasticity % change in Q 0%
= = =0
of demand % change in P 10%

D curve: P
D
vertical
P1
Consumers’
price sensitivity: P2
0
P falls Q
Elasticity: by 10% Q1
0 Q changes
by 0%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 12
“Inelastic demand”
Price elasticity % change in Q < 10%
= = <1
of demand % change in P 10%

D curve: P
relatively steep
P1
Consumers’
price sensitivity: P2
relatively low D
P falls Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 13
“Unit elastic demand”
Price elasticity % change in Q 10%
= = =1
of demand % change in P 10%

D curve: P
intermediate slope
P1
Consumers’
price sensitivity: P2
intermediate D

P falls Q
Elasticity: by 10% Q1 Q2
1
Q rises by 10%

CHAPTER 5 ELASTICITY AND ITS APPLICATION 14

“Elastic demand”
Price elasticity % change in Q > 10%
= = >1
of demand % change in P 10%

D curve: P
relatively flat
P1
Consumers’
price sensitivity: P2 D
relatively high
P falls Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 15
“Perfectly elastic demand” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of demand % change in P 0%

D curve: P
horizontal
P2 = P1 D
Consumers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
CHAPTER 5 ELASTICITY AND ITS APPLICATION 16
Elasticity of a Linear Demand Curve

P The slope
200% of a linear
$30 E = = 5.0
40% demand
67% curve is
20 E = = 1.0 constant,
67%
but its
40%
10 E = = 0.2 elasticity
200%
is not.
$0 Q
0 20 40 60

CHAPTER 5 ELASTICITY AND ITS APPLICATION 17

 Price Elasticity and Total Revenue
▪ Continuing our scenario, if you raise your price
from $200 to $250, would your revenue rise or fall?
Revenue = P x Q
▪ A price increase has two effects on revenue:
• Higher P means more revenue on each unit
you sell.
• But you sell fewer units (lower Q), due to
Law of Demand.
▪ Which of these two effects is bigger?
It depends on the price elasticity of demand.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 18
 Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q

▪ If demand is elastic, then

price elast. of demand > 1
% change in Q > % change in P

▪ The fall in revenue from lower Q is greater

than the increase in revenue from higher P,
so revenue falls.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 19
 Price Elasticity and Total Revenue
Elastic demand increased
Demand for
(elasticity = 1.8) P revenue due
your websiteslost
to higher P
revenue
If P = $200,
due to
Q = 12 and $250 lower Q
revenue = $2400.
$200
If P = $250, D
Q = 8 and
revenue = $2000.
When D is elastic, Q
8 12
a price increase
causes revenue to fall.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 20
 Price Elasticity and Total Revenue
Price elasticity Percentage change in Q
=
of demand Percentage change in P

Revenue = P x Q
▪ If demand is inelastic, then
price elast. of demand < 1
% change in Q < % change in P
▪ The fall in revenue from lower Q is smaller
than the increase in revenue from higher P,
so revenue rises.
▪ In our example, suppose that Q only falls to 10
(instead of 8) when you raise your price to $250.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 21
 Price Elasticity and Total Revenue
Now, demand is
increased
Demand for
inelastic:
revenue due
your websites
elasticity = 0.82 P to higher P lost
If P = $200, revenue
due to
Q = 12 and
$250 lower Q
revenue = $2400.
$200
If P = $250,
Q = 10 and D
revenue = $2500.
When D is inelastic, Q
a price increase 10 12
causes revenue to rise.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 22
ACTIVE LEARNING 2:
Elasticity and expenditure/revenue
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
B. As a result of a fare war, the price of a luxury
cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?

23
ACTIVE LEARNING 2:
Answers
A. Pharmacies raise the price of insulin by 10%.
Does total expenditure on insulin rise or fall?
Expenditure = P x Q
Since demand is inelastic, Q will fall less
than 10%, so expenditure rises.

24
ACTIVE LEARNING 2:
Answers
B. As a result of a fare war, the price of a luxury
cruise falls 20%.
Does luxury cruise companies’ total revenue
rise or fall?
Revenue = P x Q
The fall in P reduces revenue,
but Q increases, which increases revenue.
Which effect is bigger?
Since demand is elastic, Q will increase more
than 20%, so revenue rises.
25
APPLICATION: Does Drug Interdiction
Increase or Decrease Drug-Related Crime?
▪ One side effect of illegal drug use is crime:
Users often turn to crime to finance their habit.
▪ We examine two policies designed to reduce
illegal drug use and see what effects they have
on drug-related crime.
▪ For simplicity, we assume the total dollar value
of drug-related crime equals total expenditure
on drugs.
▪ Demand for illegal drugs is inelastic, due to
addiction issues.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 26
 Policy 1: Interdiction
Interdiction new value of
reduces the Price of drug-related crime
supply of Drugs S2
D1
drugs. S1
Since demand P2
for drugs is
inelastic, initial value
P1
P rises of
propor-tionally drug-relate
more than Q d crime
falls.
Result: an increase in Q2 Q1 Quantity
total spending on drugs, of Drugs
and in drug-related crime
CHAPTER 5 ELASTICITY AND ITS APPLICATION 27
 Policy 2: Education
new value of
Education Price of drug-related crime
reduces the Drugs
demand for D2 D1
drugs. S

P and Q fall.
P1 initial value
Result: of
A decrease in P2 drug-relate
total spending d crime
on drugs, and
in drug-related Q2 Q1 Quantity
crime. of Drugs

CHAPTER 5 ELASTICITY AND ITS APPLICATION 28

 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P

▪ Price elasticity of supply measures how much

Qs responds to a change in P.
▪ Loosely speaking, it measures the
price-sensitivity of sellers’ supply.
▪ Again, use the midpoint method to compute the
percentage changes.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 29

 Price Elasticity of Supply
Price elasticity Percentage change in Qs
=
of supply Percentage change in P
P
Example: S
P rises
Price P2
by 8%
elasticity P1
of supply
equals
Q
16% Q1 Q2
= 2.0
8% Q rises
by 16%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 30
 The Variety of Supply Curves
▪ Economists classify supply curves according to
their elasticity.
▪ The slope of the supply curve is closely related
to price elasticity of supply.
▪ Rule of thumb:
The flatter the curve, the bigger the elasticity.
The steeper the curve, the smaller the elasticity.
▪ The next 5 slides present the different
classifications, from least to most elastic.

CHAPTER 5 ELASTICITY AND ITS APPLICATION 31

“Perfectly inelastic” (one extreme)
Price elasticity % change in Q 0%
= = =0
of supply % change in P 10%

S curve: P
S
vertical
P2
Sellers’
price sensitivity: P1
0
P rises Q
Elasticity: by 10% Q1
0
Q changes
by 0%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 32
“Inelastic”
Price elasticity % change in Q < 10%
= = <1
of supply % change in P 10%

S curve: P
S
relatively steep
P2
Sellers’
price sensitivity: P1
relatively low
P rises Q
Elasticity: by 10% Q1 Q2
<1
Q rises less
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 33
“Unit elastic”
Price elasticity % change in Q 10%
= = =1
of supply % change in P 10%

S curve: P
intermediate slope S
P2
Sellers’
price sensitivity: P1
intermediate
P rises Q
Elasticity: by 10% Q1 Q2
=1
Q rises
by 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 34
“Elastic”
Price elasticity % change in Q > 10%
= = >1
of supply % change in P 10%

S curve: P
relatively flat S
P2
Sellers’
price sensitivity: P1
relatively high
P rises Q
Elasticity: by 10% Q1 Q2
>1
Q rises more
than 10%
CHAPTER 5 ELASTICITY AND ITS APPLICATION 35
“Perfectly elastic” (the other extreme)
Price elasticity % change in Q any %
= = = infinity
of supply % change in P 0%

S curve: P
horizontal
P2 = P1 S
Sellers’
price sensitivity:
extreme
P changes Q
Elasticity: by 0% Q1 Q2
infinity
Q changes
by any %
CHAPTER 5 ELASTICITY AND ITS APPLICATION 36
 The Determinants of Supply Elasticity
▪ The more easily sellers can change the quantity
they produce, the greater the price elasticity of
supply.
▪ Example: Supply of beachfront property is
harder to vary and thus less elastic than
supply of new cars.
▪ For many goods, price elasticity of supply is
greater in the long run than in the short run,
because firms can build new factories, or
new firms may be able to enter the market.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 37
 Other Elasticities
▪ The income elasticity of demand measures the
response of Qd to a change in consumer income.

Income elasticity Percent change in Qd

=
of demand Percent change in income

▪ Recall from chap.4: An increase in income causes

an increase in demand for a normal good.
▪ Hence, for normal goods, income elasticity > 0.
▪ For inferior goods, income elasticity < 0.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 38
 Other Elasticities
▪ The cross-price elasticity of demand measures
the response of demand for one good to changes
in the price of another good.
Cross-price elast. % change in Qd for good 1
=
of demand % change in price of good 2

▪ For substitutes, cross-price elasticity > 0

E.g., an increase in price of beef causes an
increase in demand for chicken.
▪ For complements, cross-price elasticity < 0
E.g., an increase in price of computers causes
decrease in demand for software.
CHAPTER 5 ELASTICITY AND ITS APPLICATION 39
13 The Costs of Production

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 Total Revenue, Total Cost, Profit
▪ We assume that the firm’s goal is to maximize
profit.

Profit = Total revenue – Total cost

the amount a the market

firm receives value of the
from the sale inputs a firm
of its output uses in
production

CHAPTER 13 THE COSTS OF PRODUCTION 1

 Costs: Explicit vs. Implicit
▪ Explicit costs – require an outlay of money,
e.g. paying wages to workers
▪ Implicit costs – do not require a cash outlay,
e.g. the opportunity cost of the owner’s time
▪ Remember one of the Ten Principles:
The cost of something is
what you give up to get it.
▪ This is true whether the costs are implicit or
explicit. Both matter for firms’ decisions.

CHAPTER 13 THE COSTS OF PRODUCTION 2

 Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business.
The interest rate is 5%.
▪ Case 1: borrow $100,000
• explicit cost = $5000 interest on loan
▪ Case 2: use $40,000 of your savings,
borrow the other $60,000
• explicit cost = $3000 (5%) interest on the loan
• implicit cost = $2000 (5%) foregone interest you
could have earned on your $40,000.
In both cases, total (exp + imp) costs are $5000.
CHAPTER 13 THE COSTS OF PRODUCTION 3
Economic Profit vs. Accounting Profit
▪ Accounting profit
= total revenue minus total explicit costs
▪ Economic profit
= total revenue minus total costs (including
explicit and implicit costs)
▪ Accounting profit ignores implicit costs,
so it’s higher than economic profit.

CHAPTER 13 THE COSTS OF PRODUCTION 4

 Types of Cost
▪ Fixed Cost
▪ Variable Cost
▪ Total Cost
▪ Average Fixed Cost
▪ Average Variable Cost
▪ Average Total Cost
▪ Marginal Cost

CHAPTER 13 THE COSTS OF PRODUCTION 5

 Marginal Cost
▪ Marginal Cost (MC)
is the increase in Total Cost from
producing one more unit:
∆TC
MC =
∆Q

CHAPTER 13 THE COSTS OF PRODUCTION 6

 Fixed and Variable Costs
▪ Fixed costs (FC) – do not vary with the quantity of
output produced.
• For Farmer Jack, FC = $1000 for his land
• Other examples:
cost of equipment, loan payments, rent
▪ Variable costs (VC) – vary with the quantity
produced.
• For Farmer Jack, VC = wages he pays workers
• Other example: cost of materials
▪ Total cost
CHAPTER 13
(TC) = FC + VC
THE COSTS OF PRODUCTION 7
 EXAMPLE 1
▪ Our example is more general,
applies to any type of firm,
producing any good with any types of inputs.

CHAPTER 13 THE COSTS OF PRODUCTION 8

EXAMPLE 2: Costs
$800 FC
Q FC VC TC $700 VC
TC
0 $100 $0 $100 $600
1 100 70 170 $500

Costs
2 100 120 220
$400
3 100 160 260
$300
4 100 210 310
$200
5 100 280 380
$100
6 100 380 480
$0
7 100 520 620 0 1 2 3 4 5 6 7
Q
CHAPTER 13 THE COSTS OF PRODUCTION 9
EXAMPLE 2: Marginal Cost

Q TC MC Recall, Marginal Cost (MC)

is the change in total cost from
0 $100
$70 producing one more unit:
1 170
50 ∆TC
2 220 MC =
∆Q
40
3 260 Usually, MC rises as Q rises, due
50 to diminishing marginal product.
4 310
70 Sometimes (as here), MC falls
5 380
100 before rising.
6 480
140 (In other examples, MC may be
7 620 constant.)
CHAPTER 13 THE COSTS OF PRODUCTION 10
EXAMPLE 2: Average Fixed Cost

Q FC AFC Average fixed cost (AFC)

is fixed cost divided by the
0 $100 n.a.
quantity of output:
1 100 $100
AFC = FC/Q
2 100 50
3 100 33.33
Notice that AFC falls as Q rises:
4 100 25 The firm is spreading its fixed
5 100 20 costs over a larger and larger
number of units.
6 100 16.67
7 100 14.29

CHAPTER 13 THE COSTS OF PRODUCTION 11

EXAMPLE 2: Average Variable Cost

Q VC AVC Average variable cost (AVC)

is variable cost divided by the
0 $0 n.a.
quantity of output:
1 70 $70
AVC = VC/Q
2 120 60
3 160 53.33 As Q rises, AVC may fall initially.
4 210 52.50 In most cases, AVC will
eventually rise as output rises.
5 280 56.00
6 380 63.33
7 520 74.29

CHAPTER 13 THE COSTS OF PRODUCTION 12

EXAMPLE 2: Average Total Cost

Q TC ATC AFC AVC Average total cost

(ATC) equals total
0 $100 n.a. n.a. n.a.
cost divided by the
1 170 $170 $100 $70 quantity of output:
2 220 110 50 60 ATC = TC/Q
3 260 86.67 33.33 53.33
Also,
4 310 77.50 25 52.50
ATC = AFC + AVC
5 380 76 20 56.00
6 480 80 16.67 63.33
7 620 88.57 14.29 74.29

CHAPTER 13 THE COSTS OF PRODUCTION 13

EXAMPLE 2: Average Total Cost

Q TC ATC $200
Usually,
$175
as in this example,
0 $100 n.a.
the ATC curve is U-shaped.
$150
1 170 $170
$125

Costs
2 220 110
$100
3 260 86.67
$75
4 310 77.50 $50
5 380 76 $25
6 480 80 $0
0 1 2 3 4 5 6 7
7 620 88.57
Q
CHAPTER 13 THE COSTS OF PRODUCTION 14
EXAMPLE 2: The Various Cost Curves Together

$200
$175
$150
ATC
$125

Costs
AVC
$100
AF
C
MC $75
$50
$25
$0
0 1 2 3 4 5 6 7
Q
CHAPTER 13 THE COSTS OF PRODUCTION 15
ACTIVE LEARNING 3:
Costs
Fill in the blank spaces of this table.
Q VC TC AFC AVC ATC MC
0 $50 n.a. n.a. n.a.
$10
1 10 $10 $60.00
2 30 80
30
3 16.67 20 36.67
4 100 150 12.50 37.50
5 150 30
60
6 210 260 8.33 35 43.33
16
ACTIVE LEARNING 3:
Answers
Use AFC
ATC
AVC
deduce FC/Q
= TC/Q
First,relationship
FCbetween
VC/Q MC
= $50 and and
use FCTC
+ VC = TC.

Q VC TC AFC AVC ATC MC

0 $0 $50 n.a. n.a. n.a.
$10
1 10 60 $50.00 $10 $60.00
20
2 30 80 25.00 15 40.00
30
3 60 110 16.67 20 36.67
40
4 100 150 12.50 25 37.50
50
5 150 200 10.00 30 40.00
60
6 210 260 8.33 35 43.33
17
EXAMPLE 2: Why ATC Is Usually
U-Shaped(Behaviour of cost in Short Run)
As Q rises: $200
Initially, $175
falling AFC $150
pulls ATC down.
$125

Costs
Eventually, $100
rising AVC
$75
pulls ATC up.
$50
$25
$0
0 1 2 3 4 5 6 7
Q
CHAPTER 13 THE COSTS OF PRODUCTION 18
 Costs in the Short Run & Long Run
▪ Short run:
Some inputs are fixed (e.g., factories, land).
The costs of these inputs are FC.
▪ Long run:
All inputs are variable
(e.g., firms can build more factories,
or sell existing ones)
▪ In the long run, ATC at any Q is cost per unit
using the most efficient mix of inputs for that Q
(e.g., the factory size with the lowest ATC).
CHAPTER 13 THE COSTS OF PRODUCTION 19
 EXAMPLE 3: LRATC with 3 factory Sizes
Firm can choose
from 3 factory Avg
sizes: S, M, L. Total
Cost ATCS ATCM
Each size has its ATCL
own SRATC curve.
The firm can
change to a
different factory
size in the long
run, but not in the Q
short run.

CHAPTER 13 THE COSTS OF PRODUCTION 20

 EXAMPLE 3: LRATC with 3 factory
Sizes(Behaviour of cost in Long Run)
To produce less
than QA, firm will Avg
choose size S Total
in the long run. Cost ATCS ATCM
ATCL
To produce
between QA
and QB, firm will LRATC
choose size M
in the long run.
To produce more Q
than QB, firm will QA QB
choose size L
in the long run.
CHAPTER 13 THE COSTS OF PRODUCTION 21
 A Typical LRATC Curve
In the real world,
factories come in ATC
many sizes,
each with its own LRATC
SRATC curve.
So a typical
LRATC curve
looks like this:

CHAPTER 13 THE COSTS OF PRODUCTION 22

 How ATC Changes As
the Scale of Production Changes
Economies of ATC
scale: ATC falls
as Q increases.
LRATC
Constant returns
to scale: ATC
stays the same
as Q increases.
Diseconomies of
scale: ATC rises Q
as Q increases.

CHAPTER 13 THE COSTS OF PRODUCTION 23

 The Complete Data for Example 2
Q FC VC TC AFC AVC ATC MC
0 $100 $0 $100 n.a. n.a. n.a.
$70
1 100 70 170 $100 $70 $170
50
2 100 120 220 50 60 110
40
3 100 160 260 33.33 53.33 86.67
50
4 100 210 310 25 52.50 77.50
70
5 100 280 380 20 56.00 76
100
6 100 380 480 16.67 63.33 80
140
7 100 520 620 14.29 74.29 88.57
200
8 100 720 820 12.50 90 102.50

CHAPTER 13 THE COSTS OF PRODUCTION 24

14 Firms in Competitive Markets

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 Characteristics of Perfect Competition

1. Many buyers and many sellers

2. The goods offered for sale are largely the same.

3. Firms can freely enter or exit the market.

▪ Because of 1 & 2, each buyer and seller is a

“price taker” – takes the price as given.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 1

 The Revenue of a Competitive Firm

▪ Total revenue (TR) TR = P x Q

TR
▪ Average revenue (AR) AR =
Q
=P

▪ Marginal Revenue (MR): ∆TR

The change in TR from MR =
∆Q
selling one more unit.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 2

ACTIVE LEARNING 1:
Exercise
Fill in the empty spaces of the table.

Q P TR AR MR

0 $10 n.a.

1 $10 $10

2 $10

3 $10

4 $10 $40
$10
5 $10 $50
3
ACTIVE LEARNING 1:
Answers
Fill in the empty spaces of the table.
TR ∆TR
Q P TR = P x Q AR = MR =
Q ∆Q
0 $10 $0 n.a.
$10
1 $10 $10 $10
Notice that $10
2 $10 $20 $10
MR = P $10
3 $10 $30 $10
$10
4 $10 $40 $10
$10
5 $10 $50 $10
4
 MR = P for a Competitive Firm
▪ A competitive firm can keep increasing its output
without affecting the market price.
▪ So, each one-unit increase in Q causes revenue
to rise by P, i.e., MR = P.

MR = P is only true for

firms in competitive markets.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 5

 Profit Maximization
▪ What Q maximizes the firm’s profit?
▪ To find the answer,
“Think at the margin.”
If increase Q by one unit,
revenue rises by MR,
cost rises by MC.
▪ If MR > MC, then increase Q to raise profit.
▪ If MR < MC, then reduce Q to raise profit.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 6

 Profit Maximization
(continued from earlier exercise)

Q TR TC Profit MR MC
Δ Profit =
At any Q with
MR – MC
MR > MC,
increasing Q 0 $0 $5 –$5
$10 $4 $6
raises profit. 1 10 9 1
10 6 4
2 20 15 5
At any Q with 10 8 2
MR < MC, 3 30 23 7
10 10 0
reducing Q 4 40 33 7
raises profit. 10 12 –2
5 50 45 5

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 7

 MC and the Firm’s Supply Decision
Rule: MR = MC at the profit-maximizing Q.
At Qa, MC < MR. Costs
So, increase Q
MC
to raise profit.
At Qb, MC > MR.
So, reduce Q
to raise profit. P1 MR
At Q1, MC = MR.
Changing Q
would lower profit. Q
Qa Q1 Qb

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 8

 MC and the Firm’s Supply Decision

If price rises to P2,

then the Costs
profit-maximizing
MC
quantity rises to Q2.
P2 MR2
The MC curve
determines the
firm’s Q at any price. P1 MR
Hence,
the MC curve is the
firm’s supply curve. Q
Q1 Q2

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 9

 Shutdown vs. Exit
▪ Shutdown:
A short-run decision not to produce anything
because of market conditions.
▪ Exit:
A long-run decision to leave the market.
▪ A firm that shuts down temporarily must still pay
its fixed costs. A firm that exits the market does
not have to pay any costs at all, fixed or variable.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 10

A Firm’s Short-run Decision to Shut Down
▪ If firm shuts down temporarily,
• revenue falls by TR
• costs fall by VC
▪ So, the firm should shut down if TR < VC.
▪ Divide both sides by Q: TR/Q < VC/Q
▪ So we can write the firm’s decision as:
Shut down if P < AVC

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 11

 The Irrelevance of Sunk Costs
▪ Sunk cost: a cost that has already been
committed and cannot be recovered
▪ Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
▪ FC is a sunk cost: The firm must pay its fixed
costs whether it produces or shuts down.
▪ So, FC should not matter in the decision to shut
down.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 12

 A Firm’s Long-Run Decision to Exit
▪ If firm exits the market,
• revenue falls by TR
• costs fall by TC
▪ So, the firm should exit if TR < TC.
▪ Divide both sides by Q to rewrite the firm’s
decision as:
Exit if P < ATC

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 13

 A New Firm’s Decision to Enter Market
▪ In the long run, a new firm will enter the market if
it is profitable to do so: if TR > TC.

▪ Divide both sides by Q to express the firm’s

entry decision as:
Enter if P > ATC

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 14

 The Competitive Firm’s Supply Curve

The firm’s
Costs
LR supply curve
is the portion of MC
its MC curve
above LRATC. LRATC

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 15

ACTIVE LEARNING 2 A:
Identifying a firm’s profit
A competitive firm
Determine Costs, P
this firm’s
MC
total profit.
P = $10 MR
Identify the
ATC
area on the
graph that $6
represents
the firm’s
profit.
Q
50

16
ACTIVE LEARNING 2 A:
Answers
A competitive firm
Costs, P
profit per unit MC
= P – ATC
P = $10 MR
= $10 – 6
profit ATC
= $4
$6

Total profit
= (P – ATC) x Q
= $4 x 50 Q
= $200 50

17
ACTIVE LEARNING 2B:
Identifying a firm’s loss
A competitive firm
Determine Costs, P
this firm’s
MC
total loss.
Identify the
ATC
area on the
graph that $5
represents
the firm’s P = $3 MR
loss.
Q
30

18
ACTIVE LEARNING 2B:
Answers
A competitive firm
Costs, P
MC
Total loss
= (ATC – P) x Q
= $2 x 30 ATC
= $60
$5
loss loss per unit = $2
P = $3 MR

Q
30

19
 Market Supply: Assumptions
1) All existing firms and potential entrants have
identical costs.
2) Each firm’s costs do not change as other firms
enter or exit the market.
3) The number of firms in the market is
• fixed in the short run
(due to fixed costs)
• variable in the long run
(due to free entry and exit)

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 20

 The SR Market Supply Curve
▪ As long as P ≥ AVC, each firm will produce its
profit-maximizing quantity, where MR = MC.
▪ Recall from Chapter 4:
At each price, the market quantity supplied is the
sum of quantity supplied by each firm.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 21

 The SR Market Supply Curve
Example: 1000 identical firms.
At each P, market Qs = 1000 x (one firm’s Qs)

One firm Market

P MC P S
P3 P3

P2 P2
AVC
P1 P1
Q Q
10 20 30 (firm) (market)

10,000 20,000 30,000

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 22
 Entry & Exit in the Long Run
▪ In the LR, the number of firms can change due
to entry & exit.
▪ If existing firms earn positive economic profit,
• New firms enter.
• SR market supply curve shifts right.
• P falls, reducing firms’ profits.
• Entry stops when firms’ economic profits have
been driven to zero.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 23

 Entry & Exit in the Long Run
▪ In the LR, the number of firms can change due
to entry & exit.
▪ If existing firms incur losses,
• Some will exit the market.
• SR market supply curve shifts left.
• P rises, reducing remaining firms’ losses.
• Exit stops when firms’ economic losses have
been driven to zero.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 24

 The Zero-Profit Condition
▪ Long-run equilibrium:
The process of entry or exit is complete –
remaining firms earn zero economic profit.

▪ Zero economic profit occurs when P = ATC.

▪ Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.

▪ Recall that MC intersects ATC at minimum ATC.

▪ Hence, in the long run, P = minimum ATC.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 25

 The LR Market Supply Curve

In the long run, The LR market supply

the typical firm curve is horizontal at
earns zero profit. P = minimum ATC.

One firm Market

P MC P

LRATC
P=
long-run
min.
supply
ATC

Q Q
(firm) (market)
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 26
Why Do Firms Stay in Business if Profit = 0?
▪ Recall, economic profit is revenue minus all
costs – including implicit costs, like the
opportunity cost of the owner’s time and money.
▪ In the zero-profit equilibrium, firms earn enough
revenue to cover these costs.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 27

 SR & LR Effects of an Increase in Demand
A firm begins in …but then an increase
long-run to…driving
…leadingeq’m… SR profits to zero
Over time, profits
in demandinduce entry,
raises P,…
andfirm.
profits for the restoring long-run
shifting eq’m.
S to the right, reducing P…

P One firm P Market

MC S1

S2
Profit ATC B
P2 P2
A C long-run
P1 P1 supply
D2
D1
Q Q
(firm) Q1 Q2 Q3 (market)
CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 28
Why the LR Supply Curve Might Slope Upward
▪ The LR market supply curve is horizontal if
1) all firms have identical costs, and
2) costs do not change as other firms enter or
exit the market.

▪ If either of these assumptions is not true,

then LR supply curve slopes upward.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 29

 1) Firms Have Different Costs
▪ As P rises, firms with lower costs enter the market
before those with higher costs.
▪ Further increases in P make it worthwhile
for higher-cost firms to enter the market,
which increases market quantity supplied.
▪ Hence, LR market supply curve slopes upward.
▪ At any P,
• For the marginal firm,
P = minimum ATC and profit = 0.
• For lower-cost
CHAPTER 14
firms, profit > 0.
FIRMS IN COMPETITIVE MARKETS 30
 2) Costs Rise as Firms Enter the Market
▪ In some industries, the supply of a key input is
limited (e.g., there’s a fixed amount of land
suitable for farming).
▪ The entry of new firms increases demand for this
input, causing its price to rise.
▪ This increases all firms’ costs.
▪ Hence, an increase in P is required to increase
the market quantity supplied, so the supply curve
is upward-sloping.

CHAPTER 14 FIRMS IN COMPETITIVE MARKETS 31

15 Monopoly

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 Introduction
▪ A monopoly is a firm that is the sole seller of a
product without close substitutes.
▪ In this chapter, we study monopoly and contrast
it with perfect competition.
▪ The key difference:
A monopoly firm has market power, the ability
to influence the market price of the product it
sells. A competitive firm has no market power.

CHAPTER 15 MONOPOLY 1
 Why Monopolies Arise
The main cause of monopolies is barriers
to entry – other firms cannot enter the market.
Three sources of barriers to entry:
1. A single firm owns a key resource.
E.g., DeBeers owns most of the world’s
diamond mines
2. The govt gives a single firm the exclusive right
to produce the good.
E.g., patents, copyright laws

CHAPTER 15 MONOPOLY 2
 Why Monopolies Arise
3. Natural monopoly: a single firm can produce
the entire market Q at lower ATC than could
several firms.
Example: 1000 homes
need electricity. Cost Electricity
Economies of
ATC is lower if scale due to
one firm services huge FC
all 1000 homes $80
than if two firms $50 ATC
each service
Q
500 homes. 500 1000
CHAPTER 15 MONOPOLY 3
Monopoly vs. Competition: Demand Curves
In a competitive market,
the market demand curve
slopes downward.
A competitive firm’s
but the demand curve demand curve
for any individual firm’s P
product is horizontal
at the market price.
The firm can increase Q D
without lowering P,
so MR = P for the
competitive firm.
Q

CHAPTER 15 MONOPOLY 4
Monopoly vs. Competition: Demand Curves

A monopolist is the only

seller, so it faces the
market demand curve.
A monopolist’s
To sell a larger Q, demand curve
P
the firm must reduce P.
Thus, MR ≠ P.

D
Q

CHAPTER 15 MONOPOLY 5
ACTIVE LEARNING 1:
A monopoly’s revenue
Moonbucks is
Q P TR AR MR
the only seller of
cappuccinos in town. 0 $4.50 n.a.
The table shows the 1 4.00
market demand for
2 3.50
cappuccinos.
Fill in the missing 3 3.00
spaces of the table. 4 2.50
What is the relation 5 2.00
between P and AR?
Between P and MR? 6 1.50

6
ACTIVE LEARNING 1:
Answers

Q P TR AR MR
Here, P = AR,
same as for a 0 $4.50 $0 n.a.
competitive firm. $4
1 4.00 4 $4.00
Here, MR < P, 3
2 3.50 7 3.50
whereas MR = P 2
for a competitive 3 3.00 9 3.00
1
firm. 4 2.50 10 2.50
0
5 2.00 10 2.00
–1
6 1.50 9 1.50

7
 Moonbuck’s D and MR Curves

P, MR
$5
4
Demand curve (P)
3
2
1
0
-1 MR
-2
-3
0 1 2 3 4 5 6 7 Q

CHAPTER 15 MONOPOLY 8
 Understanding the Monopolist’s MR
▪ Increasing Q has two effects on revenue:
• The output effect:
More output is sold, which raises revenue
• The price effect:
The price falls, which lowers revenue
▪ To sell a larger Q, the monopolist must reduce the
price on all the units it sells.
▪ Hence, MR < P
▪ MR could even be negative if the price effect
exceeds the output effect
(e.g.,15when
CHAPTER Moonbucks increases Q from 5 to 6).
MONOPOLY 9
 Profit-Maximization
▪ Like a competitive firm, a monopolist maximizes
profit by producing the quantity where MR = MC.
▪ Once the monopolist identifies this quantity,
it sets the highest price consumers are willing to
pay for that quantity.
▪ It finds this price from the D curve.

CHAPTER 15 MONOPOLY 10
 Profit-Maximization

Costs and
1. The Revenue MC
profit-maximizing
Q P
is where
MR = MC.
2. Find P from D
the demand MR
curve at this Q.
Q Quantity

Profit-maximizing output
CHAPTER 15 MONOPOLY 11
 The Monopolist’s Profit

Costs and
Revenue MC

As with a P
ATC
competitive firm, ATC
the monopolist’s
profit equals D
(P – ATC) x Q MR

Q Quantity

CHAPTER 15 MONOPOLY 12
 A Monopoly Does Not Have an S Curve
A competitive firm
▪ takes P as given
▪ has a supply curve that shows how its Q depends
on P
A monopoly firm
▪ is a “price-maker,” not a “price-taker”
▪ Q does not depend on P;
rather, Q and P are jointly determined by
MC, MR, and the demand curve.
So there is no supply curve for monopoly.
CHAPTER 15 MONOPOLY 13
 Case Study: Monopoly vs. Generic Drugs

Patents on new drugs The market for

Price a typical drug
give a temporary
monopoly to the seller.
When the PM
patent expires,
the market PC = MC
becomes competitive, D
generics appear.
MR

QM Quantity
QC

CHAPTER 15 MONOPOLY 14
 The Welfare Cost of Monopoly
▪ Recall: In a competitive market equilibrium,
P = MC and total surplus is maximized.
▪ In the monopoly eq’m, P > MR = MC
• The value to buyers of an additional unit (P)
exceeds the cost of the resources needed to
produce that unit (MC).
• The monopoly Q is too low –
could increase total surplus with a larger Q.
• Thus, monopoly results in a deadweight loss.

CHAPTER 15 MONOPOLY 15
 The Welfare Cost of Monopoly
Competitive eq’m:
Price Deadweight
quantity = QE loss MC
P = MC
total surplus is P
P = MC
maximized
MC
Monopoly eq’m:
quantity = QM D
P > MC MR
deadweight loss
QM QE Quantity

CHAPTER 15 MONOPOLY 16
 Public Policy Toward Monopolies
▪ Increasing competition with antitrust laws
• Examples: Sherman Antitrust Act (1890),
Clayton Act (1914)
• Antitrust laws ban certain anticompetitive
practices, allow govt to break up monopolies.
▪ Regulation
• Govt agencies set the monopolist’s price
• For natural monopolies, MC < ATC at all Q,
so marginal cost pricing would result in losses.
• If so, regulators might subsidize the monopolist
or 15
CHAPTER setMONOPOLY
P = ATC for zero economic profit. 17
 Public Policy Toward Monopolies
▪ Public ownership
• Example: U.S. Postal Service
• Problem: Public ownership is usually less
efficient since no profit motive to minimize costs
▪ Doing nothing
• The foregoing policies all have drawbacks,
so the best policy may be no policy.

CHAPTER 15 MONOPOLY 18
 Price Discrimination
▪ Discrimination is the practice of treating people
differently based on some characteristic, such as
race or gender.
▪ Price discrimination is the business practice of
selling the same good at different prices to
different buyers.
▪ The characteristic used in price discrimination
is willingness to pay (WTP):
• A firm can increase profit by charging a higher
price to buyers with higher WTP.
CHAPTER 15 MONOPOLY 19
 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist Consumer
charges the same Price
surplus
price (PM) to all Deadweight
buyers. PM loss
A deadweight loss
results. MC
Monopoly
profit D
MR

QM Quantity

CHAPTER 15 MONOPOLY 20
 Perfect Price Discrimination vs.
Single Price Monopoly
Here, the monopolist
produces the Price
competitive quantity, Monopoly
profit
but charges each
buyer his or her WTP.
This is called perfect
MC
price discrimination.
D
The monopolist
captures all CS MR
as profit.
Quantity
But there’s no DWL. Q
CHAPTER 15 MONOPOLY 21
 Price Discrimination in the Real World
▪ In the real world, perfect price discrimination is
not possible:
• no firm knows every buyer’s WTP
• buyers do not announce it to sellers
▪ So, firms divide customers into groups
based on some observable trait
that is likely related to WTP, such as age.

CHAPTER 15 MONOPOLY 22
 Examples of Price Discrimination
Movie tickets
Discounts for seniors, students, and people
who can attend during weekday afternoons.
They are all more likely to have lower WTP
than people who pay full price on Friday night.
Airline prices
Discounts for Saturday-night stayovers help
distinguish business travelers, who usually have
higher WTP, from more price-sensitive leisure
travelers.

CHAPTER 15 MONOPOLY 23
 Examples of Price Discrimination
Discount coupons
People who have time to clip and organize
coupons are more likely to have lower income
and lower WTP than others.
Need-based financial aid
Low income families have lower WTP for
their children’s college education.
Schools price-discriminate by offering
need-based aid to low income families.

CHAPTER 15 MONOPOLY 24
 Examples of Price Discrimination
Quantity discounts
A buyer’s WTP often declines with additional
units, so firms charge less per unit for large
quantities than small ones.
Example: A movie theater charges $4 for
a small popcorn and $5 for a large one that’s
twice as big.

CHAPTER 15 MONOPOLY 25
16 Oligopoly

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 Introduction:
Between Monopoly and Competition
Two extremes
• Competitive markets: many firms, identical
products
• Monopoly: one firm
In between these extremes
• Oligopoly: only a few sellers offer similar or
identical products.
• Monopolistic competition: many firms sell
similar but not identical products.
CHAPTER 16 OLIGOPOLY 1
 Measuring Market Concentration
▪ Concentration ratio: the percentage of the
market’s total output supplied by its four largest
firms.
▪ The higher the concentration ratio,
the less competition.
▪ This chapter focuses on oligopoly,
a market structure with high concentration ratios.

CHAPTER 16 OLIGOPOLY 2
Concentration Ratios in Selected U.S. Industries
Industry Concentration ratio
Video game consoles 100%
Tennis balls 100%
Credit cards 99%
Batteries 94%
Soft drinks 93%
Web search engines 92%
Breakfast cereal 92%
Cigarettes 89%
Greeting cards 88%
Beer 85%
Cell phone service 82%
Autos 79%
 EXAMPLE: Cell Phone Duopoly in Smalltown

P Q ▪ Smalltown has 140 residents

$0 140
5 130
▪ The “good”:
cell phone service with unlimited
10 120
anytime minutes and free phone
15 110
20 100 ▪ Smalltown’s demand schedule
25 90
▪ Two firms: Cingular, Verizon
30 80
(duopoly: an oligopoly with two firms)
35 70
40 60 ▪ Each firm’s costs: FC = $0, MC = $10
45 50
CHAPTER 16 OLIGOPOLY 4
 EXAMPLE: Cell Phone Duopoly in Smalltown

P Q Revenue Cost Profit Competitive

$0 140 $0 $1,400 –1,400 outcome:
P = MC = $10
5 130 650 1,300 –650
Q = 120
10 120 1,200 1,200 0
Profit = $0
15 110 1,650 1,100 550
20 100 2,000 1,000 1,000
25 90 2,250 900 1,350 Monopoly
30 80 2,400 800 1,600 outcome:
35 70 2,450 700 1,750 P = $40
40 60 2,400 600 1,800 Q = 60
45 50 2,250 500 1,750 Profit = $1,800

CHAPTER 16 OLIGOPOLY 5
 EXAMPLE: Cell Phone Duopoly in Smalltown

▪ One possible duopoly outcome: collusion

▪ Collusion: an agreement among firms in a
market about quantities to produce or prices to
charge
▪ Cingular and Verizon could agree to each produce
half of the monopoly output:
• For each firm: Q = 30, P = $40, profits = $900
▪ Cartel: a group of firms acting in unison,
e.g., Cingular and Verizon in the outcome with
collusion
CHAPTER 16 OLIGOPOLY 6
ACTIVE LEARNING 1:
Collusion vs. self-interest
P Q Duopoly outcome with collusion:
$0 140 Each firm agrees to produce Q = 30,
5 130 earns profit = $900.
10 120 If Cingular reneges on the agreement and
15 110 produces Q = 40, what happens to the
20 100
market price? Cingular’s profits?
25 90 Is it in Cingular’s interest to renege on the
30 80 agreement?
35 70 If both firms renege and produce Q = 40,
40 60 determine each firm’s profits.
45 50 7
ACTIVE LEARNING 1:
Answers
If both firms stick to agreement,
P Q
each firm’s profit = $900
$0 140
If Cingular reneges on agreement and
5 130
produces Q = 40:
10 120
Market quantity = 70, P = $35
15 110
Cingular’s profit = 40 x ($35 – 10) = $1000
20 100
Cingular’s profits are higher if it reneges.
25 90
Verizon will conclude the same, so
30 80
both firms renege, each produces Q = 40:
35 70
Market quantity = 80, P = $30
40 60
Each firm’s profit = 40 x ($30 – 10) = $800
45 50
 Collusion vs. Self-Interest
▪ Both firms would be better off if both stick to the
cartel agreement.
▪ But each firm has incentive to renege on the
agreement.
▪ Lesson:
It is difficult for oligopoly firms to form cartels and
honor their agreements.

CHAPTER 16 OLIGOPOLY 9
ACTIVE LEARNING 2:
The oligopoly equilibrium
P Q If each firm produces Q = 40,
$0 140 market quantity = 80
5 130 P = $30
10 120
each firm’s profit = $800
15 110 Is it in Cingular’s interest to increase its
20 100 output further, to Q = 50?
25 90 Is it in Verizon’s interest to increase its
30 80 output to Q = 50?
35 70
40 60
45 50 10
ACTIVE LEARNING 2:
Answers
P Q If each firm produces Q = 40,
$0 140 then each firm’s profit = $800.
5 130 If Cingular increases output to Q = 50:
10 120 Market quantity = 90, P = $25
15 110 Cingular’s profit = 50 x ($25 – 10) = $750
20 100 Cingular’s profits are higher at Q = 40
25 90 than at Q = 50.
30 80 The same is true for Verizon.
35 70
40 60
45 50 11
 The Equilibrium for an Oligopoly
▪ Nash equilibrium: a situation in which
economic participants interacting with one another
each choose their best strategy given the strategies
that all the others have chosen
▪ Our duopoly example has a Nash equilibrium
in which each firm produces Q = 40.
• Given that Verizon produces Q = 40,
Cingular’s best move is to produce Q = 40.
• Given that Cingular produces Q = 40,
Verizon’s best move is to produce Q = 40.
CHAPTER 16 OLIGOPOLY 12
 A Comparison of Market Outcomes
When firms in an oligopoly individually choose
production to maximize profit,

• Q is greater than monopoly Q

but smaller than competitive market Q

• P is greater than competitive market P

but less than monopoly P

CHAPTER 16 OLIGOPOLY 13
 The Output & Price Effects
▪ Increasing output has two effects on a firm’s profits:
• output effect:
If P > MC, selling more output raises profits.
• price effect:
Raising production increases market quantity,
which reduces market price and reduces profit
on all units sold.
▪ If output effect > price effect,
the firm increases production.
▪ If price effect > output effect,
the firm
CHAPTER reduces
16 OLIGOPOLY production. 14
 The Size of the Oligopoly
▪ As the number of firms in the market increases,
• the price effect becomes smaller
• the oligopoly looks more and more like a
competitive market
• P approaches MC
• the market quantity approaches the socially
efficient quantity
Another benefit of international trade:
Trade increases the number of firms competing,
increases Q, keeps P closer to marginal cost

CHAPTER 16 OLIGOPOLY 15
 Game Theory
▪ Game theory: the study of how people behave
in strategic situations
▪ Dominant strategy: a strategy that is best
for a player in a game regardless of the
strategies chosen by the other players
▪ Prisoners’ dilemma: a “game” between
two captured criminals that illustrates
why cooperation is difficult even when it is
mutually beneficial

CHAPTER 16 OLIGOPOLY 16
 Prisoners’ Dilemma Example
▪ The police have caught Bonnie and Clyde,
two suspected bank robbers, but only have
enough evidence to imprison each for 1 year.
▪ The police question each in separate rooms,
offer each the following deal:
• If you confess and implicate your partner,
you go free.
• If you do not confess but your partner implicates
you, you get 20 years in prison.
• If you both confess, each gets 8 years in prison.
CHAPTER 16 OLIGOPOLY 17
 Prisoners’ Dilemma Example
Confessing is the dominant strategy for both players.
Nash equilibrium:
Bonnie’s decision
both confess
Confess Remain silent
Bonnie gets Bonnie gets
8 years 20 years
Confess
Clyde Clyde
Clyde’s gets 8 years goes free
decision Bonnie goes Bonnie gets
Remain free 1 year
silent Clyde Clyde
gets 20 years gets 1 year

CHAPTER 16 OLIGOPOLY 18
 Prisoners’ Dilemma Example
▪ Outcome: Bonnie and Clyde both confess,
each gets 8 years in prison.
▪ Both would have been better off if both remained
silent.
▪ But even if Bonnie and Clyde had agreed before
being caught to remain silent, the logic of
self-interest takes over and leads them to
confess.

CHAPTER 16 OLIGOPOLY 19
 Oligopolies as a Prisoners’ Dilemma
▪ When oligopolies form a cartel in hopes
of reaching the monopoly outcome,
they become players in a prisoners’ dilemma.
▪ Our earlier example:
• Cingular and Verizon are duopolists in
Smalltown.
• The cartel outcome maximizes profits:
Each firm agrees to serve Q = 30 customers.
▪ Here is the “payoff matrix” for this example…

CHAPTER 16 OLIGOPOLY 20
 Cingular & Verizon in the Prisoners’ Dilemma
Each firm’s dominant strategy: renege on agreement,
produce Q = 40.
Cingular
Q = 30 Q = 40
Cingular’s Cingular’s
profit = $900 profit = $1000
Q = 30
Verizon’s Verizon’s
profit = $900 profit = $750
Verizon
Cingular’s Cingular’s
profit = $750 profit = $800
Q = 40
Verizon’s profit Verizon’s
= $1000 profit = $800

CHAPTER 16 OLIGOPOLY 21
ACTIVE LEARNING 3:
The “fare wars” game
The players: American Airlines and United Airlines
The choice: cut fares by 50% or leave fares alone.
• If both airlines cut fares,
each airline’s profit = $400 million
• If neither airline cuts fares,
each airline’s profit = $600 million
• If only one airline cuts its fares,
its profit = $800 million
the other airline’s profits = $200 million
Draw the payoff matrix, find the Nash equilibrium.
22
ACTIVE LEARNING 3:
Answers
Nash equilibrium:
both firms cut fares American Airlines

Cut fares Don’t cut fares

$400 million $200 million

Cut fares

United $400 million $800 million

Airlines
$800 million $600 million
Don’t cut
fares
$200 million $600 million
23
Other Examples of the Prisoners’ Dilemma
Ad Wars
Two firms spend millions on TV ads to steal
business from each other. Each firm’s ad
cancels out the effects of the other,
and both firms’ profits fall by the cost of the ads.
Organization of Petroleum Exporting Countries
Member countries try to act like a cartel, agree to
limit oil production to boost prices & profits.
But agreements sometimes break down
when individual countries renege.

CHAPTER 16 OLIGOPOLY 24
Other Examples of the Prisoners’ Dilemma
Arms race between military superpowers
Each country would be better off if both disarm,
but each has a dominant strategy of arming.
Common resources
All would be better off if everyone conserved
common resources, but each person’s dominant
strategy is overusing the resources.

CHAPTER 16 OLIGOPOLY 25
 Public Policy Toward Oligopolies
▪ Recall one of the Ten Principles from Chap.1:
Governments can sometimes
improve market outcomes.
▪ In oligopolies, production is too low and prices
are too high, relative to the social optimum.
▪ Role for policymakers:
promote competition, prevent cooperation
to move the oligopoly outcome closer to
the efficient outcome.

CHAPTER 16 OLIGOPOLY 26
 Restraint of Trade and Antitrust Laws
▪ Sherman Antitrust Act (1890):
forbids collusion between competitors
▪ Clayton Antitrust Act (1914):
strengthened rights of individuals damaged by
anticompetitive arrangements between firms

CHAPTER 16 OLIGOPOLY 27
 Controversies Over Antitrust Policy
▪ Most people agree that price-fixing agreements
among competitors should be illegal.
▪ Some economists are concerned that
policymakers go too far when using antitrust
laws to stifle business practices that are not
necessarily harmful, and may have legitimate
objectives.
▪ We consider three such practices…

CHAPTER 16 OLIGOPOLY 28
1. Resale Price Maintenance (“Fair Trade”)
▪ Occurs when a manufacturer imposes lower limits
on the prices retailers can charge.
▪ Is often opposed because it appears to reduce
competition at the retail level.
▪ Yet, any market power the manufacturer has
is at the wholesale level; manufacturers do not
gain from restricting competition at the retail level.
▪ The practice has a legitimate objective:
preventing discount retailers from free-riding
on the services provided by full-service retailers.
CHAPTER 16 OLIGOPOLY 29
 2. Predatory Pricing
▪ Occurs when a firm cuts prices to prevent entry
or drive a competitor out of the market,
so that it can charge monopoly prices later.
▪ Illegal under antitrust laws, but hard for the courts
to determine when a price cut is predatory and
when it is competitive & beneficial to consumers.
▪ Many economists doubt that predatory pricing is a
rational strategy:
• It involves selling at a loss, which is extremely
costly for the firm.
• It can backfire.
CHAPTER 16 OLIGOPOLY 30
 3. Tying
▪ Occurs when a manufacturer bundles two products
together and sells them for one price (e.g., Microsoft
including a browser with its operating system)
▪ Critics argue that tying gives firms more market
power by connecting weak products to strong ones.
▪ Others counter that tying cannot change market
power: Buyers are not willing to pay more for two
goods together than for the goods separately.
▪ Firms may use tying for price discrimination,
which is not illegal, and which sometimes
increases economic efficiency.
CHAPTER 16 OLIGOPOLY 31
17 Monopolistic Competition

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

Introduction to Monopolistic Competition
▪ Monopolistic competition:
a market structure in which many firms sell
products that are similar but not identical.
▪ Examples:
• apartments
• books
• bottled water
• clothing
• fast food
• night
CHAPTER 17 MONOPOLISTIC
clubs COMPETITION 1
 Comparing Perfect & Monop. Competition

perfect monopolistic
competition competition

number of sellers many many

free entry/exit yes yes

long-run econ. profits zero zero

the products firms sell identical differentiated

firm has market power? none, price-taker yes

downward-slopi
D curve facing firm horizontal
ng

CHAPTER 17 MONOPOLISTIC COMPETITION 2

Comparing Monopoly & Monop. Competition
monopolistic
monopoly
competition
number of sellers one many

free entry/exit no yes

long-run econ. profits positive zero

firm has market power? yes yes

downward-slopin
downward-slopi
D curve facing firm g
ng
(market demand)
close substitutes none many
CHAPTER 17 MONOPOLISTIC COMPETITION 3
Comparing Oligopoly & Monop. Competition

monopolistic
oligopoly
competition

number of sellers few many

importance of strategic
high low
interactions between firms
likelihood of fierce
low high
competition

CHAPTER 17 MONOPOLISTIC COMPETITION 4

 A Monopolistically Competitive Firm
Earning Profits in the Short Run
The firm faces a
downward-sloping
D curve. Price
profit MC
At each Q, MR < P. ATC
P
To maximize profit,
firm produces Q ATC
D
where MR = MC.
The firm uses the MR
D curve to set P.
Q Quantity

CHAPTER 17 MONOPOLISTIC COMPETITION 5

 A Monopolistically Competitive Firm
With Losses in the Short Run
For this firm,
P < ATC
Price
at the output where MC
MR = MC.
losses ATC
The best this firm
ATC
can do is to
minimize its losses. P

D
MR
Q Quantity

CHAPTER 17 MONOPOLISTIC COMPETITION 6

A Monopolistic Competitor in the Long Run

Entry and exit

occurs until
P = ATC and Price
profit = zero. MC
Notice that the ATC
firm charges a P = ATC
markup of price
markup
over marginal
cost, and does D
MC MR
not produce at
minimum ATC. Q Quantity

CHAPTER 17 MONOPOLISTIC COMPETITION 7

 Why Monopolistic Competition Is
Less Efficient than Perfect Competition
1. Excess capacity
• The monopolistic competitor operates on the
downward-sloping part of its ATC curve,
produces less than the cost-minimizing output.
• Under perfect competition, firms produce the
quantity that minimizes ATC.
2. Markup over marginal cost
• Under monopolistic competition, P > MC.
• Under perfect competition, P = MC.
CHAPTER 17 MONOPOLISTIC COMPETITION 8
 Advertising
▪ In monopolistically competitive industries,
product differentiation and markup pricing
lead naturally to the use of advertising.
▪ In general, the more differentiated the products,
the more advertising firms buy.
▪ Economists disagree about the social value of
advertising.

CHAPTER 17 MONOPOLISTIC COMPETITION 9

 The Critique of Advertising
▪ Critics of advertising believe:
• Society is wasting the resources it devotes to
advertising.
• Firms advertise to manipulate people’s tastes.
• Advertising impedes competition –
it creates the perception that products are
more differentiated than they really are,
allowing higher markups.

CHAPTER 17 MONOPOLISTIC COMPETITION 10

 The Defense of Advertising
▪ Defenders of advertising believe:
• It provides useful information to buyers.
• Informed buyers can more easily find and
exploit price differences.
• Thus, advertising promotes competition and
reduces market power.

▪ Results of a prominent study:

Eyeglasses were more expensive in states
that prohibited advertising by eyeglass makers
than in states that did not restrict such advertising.
CHAPTER 17 MONOPOLISTIC COMPETITION 11
 Advertising as a Signal of Quality
A firm’s willingness to spend huge amounts
on advertising may signal the quality of its product
to consumers, regardless of the content of ads.
• Ads may convince buyers to try a product once,
but the product must be of high quality for people
to become repeat buyers.
• The most expensive ads are not worthwhile
unless they lead to repeat buyers.
• When consumers see expensive ads,
they think the product must be good if the company
is willing to spend so much on advertising.
CHAPTER 17 MONOPOLISTIC COMPETITION 12
 Brand Names
▪ In many markets, brand name products coexist
with generic ones.
▪ Firms with brand names usually spend more on
advertising, charge higher prices for the products.
▪ As with advertising, there is disagreement about
the economics of brand names…

CHAPTER 17 MONOPOLISTIC COMPETITION 13

 The Critique of Brand Names
▪ Critics of brand names believe:
• Brand names cause consumers to perceive
differences that do not really exist.
• Consumers’ willingness to pay more for brand
names is irrational, fostered by advertising.
• Eliminating govt protection of trademarks
would reduce influence of brand names,
result in lower prices.

CHAPTER 17 MONOPOLISTIC COMPETITION 14

 The Defense of Brand Names
▪ Defenders of brand names believe:
• Brand names provide information about quality
to consumers.
• Companies with brand names have incentive
to maintain quality, to protect the reputation of
their brand names.

CHAPTER 17 MONOPOLISTIC COMPETITION 15

 Aggregate Demand and Aggregate
33 Supply

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 Introduction
▪ Over the long run, real GDP grows about
3% per year on average.

▪ In the short run, GDP fluctuates around its trend.

• recessions: periods of falling real incomes
and rising unemployment
• depressions: severe recessions (very rare)

▪ Short-run economic fluctuations are often called

business cycles.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 1

Three Facts About Economic Fluctuations
FACT 1: Economic fluctuations are
irregular and unpredictable.

FACT 2: Most macroeconomic

quantities fluctuate together.

FACT 3: As output falls,

unemployment rises.
 Introduction, continued
▪ Explaining these fluctuations is difficult, and the
theory of economic fluctuations is controversial.
▪ Most economists use the model of
aggregate demand and aggregate supply
to study fluctuations.
▪ This model differs from the classical economic
theories economists use to explain the long run.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 3

 Classical Economics—A Recap
▪ The previous chapters are based on the ideas of
classical economics, especially:

▪ The Classical Dichotomy, the separation of

variables into two groups:
• real – quantities, relative prices
• nominal – measured in terms of money
▪ The neutrality of money:
Changes in the money supply affect nominal but
not real variables.
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 4
 Classical Economics—A Recap
▪ Most economists believe classical theory
describes the world in the long run,
but not the short run.

▪ In the short run, changes in nominal variables

(like the money supply or P ) can affect
real variables (like Y or the u-rate).

▪ To study the short run, we use a new model.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 5

 The Model of Aggregate Demand and
Aggregate Supply
P
The price
level
SRAS

“Short-Run
The model P1 Aggregate
determines the Supply”
eq’m price level “Aggregate
Demand” AD

and the eq’m Y

Y1
level of output
(real GDP). Real GDP, the
quantity of output
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 6
 The Aggregate-Demand (AD ) Curve
P
The AD curve
shows the P2
quantity of
all g&s
demanded
in the economy P1
at any given AD
price level.
Y
Y2 Y1

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 7

 Why the AD Curve Slopes Downward
Y = C + I + G + NX P
C, I, G, NX are
the components P2
of agg. demand.
Assume G fixed
by govt policy.
P1
To understand
the slope of AD, AD
must determine
Y
how a change in P Y2 Y1
affects C, I, and NX.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 8

 The Wealth Effect (P and C )
▪ Suppose P rises.
▪ The dollars people hold buy fewer g&s,
so real wealth is lower.
▪ People feel poorer, so they spend less.
▪ Thus, an increase in P causes a fall in C
…which means a smaller quantity of g&s
demanded.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 9

 The Interest-Rate Effect (P and I )
▪ Suppose P rises.
▪ Buying g&s requires more dollars.
▪ To get these dollars, people sell some of their bonds
or other assets, which drives up interest rates.
…which increases the cost of borrowing to fund
investment projects.
▪ Thus, an increase in P causes a decrease in I
…which means a smaller quantity of g&s demanded.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 10

The Exchange-Rate Effect (P and NX )
▪ Suppose P rises.
▪ Interest rates go up (the interest-rate effect).
▪ U.S. bonds more attractive relative to foreign bonds.
▪ Foreign investors purchase more U.S. bonds,
but first must convert their currency into $
…which appreciates the U.S. exchange rate.
▪ Makes U.S. exports more expensive to people
abroad, imports cheaper to U.S. residents.
▪ Thus, an increase in P causes a decrease in NX
…which means a smaller quantity of g&s
demanded. 11
The Slope of the AD Curve: Summary
An increase in P P
reduces the quantity
of g&s demanded P2
because:
• the wealth effect
(C falls) P1
• the interest-rate AD
effect (I falls)
• the exchange-rate Y
Y2 Y1
effect (NX falls)

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 12

 Why the AD Curve Might Shift
Any event that changes
C, I, G, or NX P
– except a change in P –
will shift the AD curve.
Example:
P1
A stock market boom
makes households feel
wealthier, C rises,
AD2
the AD curve shifts right. AD1
Y
Y1 Y2

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 13

 The Aggregate-Supply (AS ) Curves
The AS curve shows P LRAS
the total quantity of
g&s firms produce SRAS
and sell at any given
price level.
In the short run,
AS is
upward-sloping.
In the long run, Y
AS is vertical.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 14

The Long-Run Aggregate-Supply Curve (LRAS )

The natural rate of P LRAS

output (YN) is the
amount of output
the economy produces
when unemployment
is at its natural rate.
YN is also called
potential output
or
Y
full-employment YN
output.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 15

 Why LRAS Is Vertical
YN depends on the P LRAS
economy’s stocks of
labor, capital, and
natural resources,
and on the level of P2
technology.
P1
An increase in P
does not affect
any of these,
so it does not Y
YN
affect YN.
(Classical dichotomy)
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 16
 Why the LRAS Curve Might Shift
P LRAS1 LRAS2
Any event that
changes any of the
determinants of YN
will shift LRAS.
Example:
Immigration
increases L,
causing YN to rise.
Y
YN Y’
N

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 17

 Using AD & AS to Depict LR Growth and
Inflation
LRAS2000
Over the long run, P LRAS1990
tech. progress shifts LRAS1980
LRAS to the right
and growth in the P2000
money supply shifts
P1990
AD to the right.
AD2000
P1980
Result:
ongoing inflation AD1990
and growth in AD1980
Y
output. Y1980 Y1990 Y2000

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 18

 Short Run Aggregate Supply (SRAS )

The SRAS curve P

is upward sloping:
SRAS
Over the period
of 1-2 years, P2
an increase in P
causes an P1
increase in the
quantity of g & s
supplied. Y
Y1 Y2

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 19

 Why the Slope of SRAS Matters
P LRAS
If AS is vertical,
fluctuations in AD Phi
SRAS
do not cause Phi
fluctuations in output
or employment.
ADhi
If AS slopes up, Plo
then shifts in AD AD1
Plo
do affect output ADlo
Y
and employment. Ylo Y1 Yhi

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 20

 Three Theories of SRAS
In each,
• some type of market imperfection
• result:
Output deviates from its natural rate
when the actual price level deviates
from the price level people expected.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 21

 Three Theories of SRAS
P

SRAS
When P > PE

the expected
PE
price level

When P < PE

Y
YN
Y < YN Y > YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 22

 1. The Sticky-Wage Theory
▪ Imperfection:
Nominal wages are sticky in the short run,
they adjust sluggishly.
• Due to labor contracts, social norms.
▪ Firms and workers set the nominal wage in
advance based on PE, the price level they
expect to prevail.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 23

 1. The Sticky-Wage Theory
▪ If P > PE,
revenue is higher, but labor cost is not.
Production is more profitable,
so firms increase output and employment.
▪ Hence, higher P causes higher Y,
so the SRAS curve slopes upward.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 24

 2. The Sticky-Price Theory
▪ Imperfection:
Many prices are sticky in the short run.
• Due to menu costs, the costs of adjusting
prices.
• Examples: cost of printing new menus,
the time required to change price tags.
▪ Firms set sticky prices in advance based
on PE.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 25

 2. The Sticky-Price Theory
▪ Suppose the Fed increases the money supply
unexpectedly. In the long run, P will rise.
▪ In the short run, firms without menu costs can
raise their prices immediately.
▪ Firms with menu costs wait to raise prices.
Meantime, their prices are relatively low,
which increases demand for their products,
so they increase output and employment.
▪ Hence, higher P is associated with higher Y,
so the SRAS curve slopes upward.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 26

 3. The Misperceptions Theory
▪ Imperfection:
Firms may confuse changes in P with changes
in the relative price of the products they sell.

▪ If P rises above PE, a firm sees its price rise

before realizing all prices are rising.
The firm may believe its relative price is rising,
and may increase output and employment.

▪ So, an increase in P can cause an increase in Y,

making the SRAS curve upward-sloping.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 27

 What the 3 Theories Have in Common:
Each of the 3 theories implies Y deviates from YN
when P deviates from PE.

Y = YN + a (P – PE)
Output Expected
price level
Natural rate
of output a > 0,
measures Actual
(long-run) price level
how much Y
responds to
unexpected
changes in P

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 28

 SRAS and LRAS
▪ The imperfections in these theories are
temporary. Over time,
• sticky wages and prices become flexible
• misperceptions are corrected
▪ In the LR,
• PE = P
• AS curve is vertical

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 29

 SRAS
and LRAS Y = YN + a (P – PE)

P LRAS
In the long run, SRAS
PE = P
and
PE
Y = Y N.

Y
YN
CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 30
 The Long-Run Equilibrium

In the long-run P LRAS

equilibrium,
SRAS
PE = P,
Y = YN ,
PE
and unemployment
is at its natural rate.
AD
Y
YN

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 31

 Economic Fluctuations
▪ Caused by events that shift the AD and/or
AS curves.
▪ Four steps to analyzing economic fluctuations:
1. Determine whether the event shifts AD or AS.
2. Determine whether curve shifts left or right.
3. Use AD-AS diagram to see how the shift
changes Y and P in the short run.
4. Use AD-AS diagram to see how economy
moves from new SR eq’m to new LR eq’m.

CHAPTER 33 AGGREGATE DEMAND AND AGGREGATE SUPPLY 32

 The Influence of Monetary and
34 Fiscal Policy on Aggregate Demand

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 Aggregate Demand
▪ Recall, the AD curve slopes downward for three
reasons:
• the wealth effect the most important
of these effects for
• the interest-rate effect the U.S. economy
• the exchange-rate effect
▪ Next: a supply-demand model that helps explain
the interest-rate effect and how monetary policy
affects aggregate demand.

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 1

 The Theory of Liquidity Preference
▪ A simple theory of the interest rate (denoted r)
▪ r adjusts to balance supply and demand
for money
▪ Money supply: assume fixed by central bank,
does not depend on interest rate

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 2

 The Theory of Liquidity Preference
▪ Money demand reflects how much wealth people
want to hold in liquid form.
▪ For simplicity, suppose household wealth
includes only two assets:
• Money – liquid but pays no interest
• Bonds – pay interest but not as liquid
▪ A household’s “money demand” reflects its
preference for liquidity.
▪ The variables that influence money demand:
Y, r, andTHE
CHAPTER 34 P.INFLUENCE OF MONETARY AND FISCAL POLICY 3
 Money Demand
▪ Suppose real income (Y) rises. Other things
equal, what happens to money demand?
▪ If Y rises:
• Households want to buy more g&s,
so they need more money.
• To get this money, they attempt to sell some of
their bonds.
▪ I.e., an increase in Y causes
an increase in money demand, other things equal.

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 4

 How r Is Determined

Interest MS curve is vertical:

rate MS
Changes in r do not
affect MS, which is
r1 fixed by the Fed.
Eq’m MD curve is
interest downward sloping:
rate MD1 a fall in r increases
money demand.
M
Quantity fixed
by the Fed
CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 5
 How the Interest-Rate Effect Works
A fall in P reduces money demand, which lowers r.
Interest P
rate MS

r1
P1

r2 P2
MD1 AD
MD2
M Y1 Y2 Y

A fall in r increases I and the quantity of g&s demanded.

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 6
Monetary Policy and Aggregate Demand
▪ To achieve macroeconomic goals, the Fed can
use monetary policy to shift the AD curve.
▪ The Fed’s policy instrument is the money supply.
▪ The news often reports that the Fed targets the
interest rate.
• more precisely, the federal funds rate – which
banks charge each other on short-term loans
▪ To change the interest rate and shift the AD curve,
the Fed conducts open market operations
to change the money supply.
CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 7
The Effects of Reducing the Money Supply
The Fed can raise r by reducing the money supply.
Interest P
rate MS2 MS1

r2
P1
r1
AD1
MD AD2
M Y2 Y1 Y

An increase in r reduces the quantity of g&s demanded.

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 8
Fiscal Policy and Aggregate Demand
▪ Fiscal policy: the setting of the level of govt
spending and taxation by govt policymakers
▪ Expansionary fiscal policy
• an increase in G and/or decrease in T
• shifts AD right
▪ Contractionary fiscal policy
• a decrease in G and/or increase in T
• shifts AD left
▪ Fiscal policy has two effects on AD.
CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 9
 The Multiplier Effect
▪ If the govt buys $20b of planes from Boeing,
Boeing’s revenue increases by $20b.
▪ This is distributed to Boeing’s workers (as wages)
and owners (as profits or stock dividends).
▪ These people are also consumers, and will spend
a portion of the extra income.
▪ This extra consumption causes further increases
in aggregate demand.
Multiplier effect: the additional shifts in AD
that result when fiscal policy increases income
and thereby increases consumer spending
CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 10
 The Multiplier Effect

A $20b increase in G P
initially shifts AD
to the right by $20b.
AD2 AD3
The increase in Y AD1
causes C to rise,
P1
which shifts AD
further to the right. $20 billion

Y1 Y2 Y3 Y

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 11

 Marginal Propensity to Consume
▪ How big is the multiplier effect?
It depends on how much consumers respond to
increases in income.
▪ Marginal propensity to consume (MPC):
the fraction of extra income that households
consume rather than save
▪ E.g., if MPC = 0.8 and income rises $100,
C rises $80.

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 12

 The Crowding-Out Effect
▪ Fiscal policy has another effect on AD
that works in the opposite direction.
▪ A fiscal expansion shifts AD to the right,
but also raises r,
which reduces investment and, thus,
reduces the net increase in agg demand.
▪ So, the size of the AD shift may be smaller than
the initial fiscal expansion.
▪ This is called the crowding-out effect.
CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 13
 How the Crowding-Out Effect Works
A $20b increase in G initially shifts AD right by $20b
Interest P
rate MS

AD AD2
r2 AD1 3

P1
r1
MD2 $20 billion

MD1
M Y1 Y3 Y2 Y

But higher Y increases MD and r, which reduces AD.

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 14
 Automatic Stabilizers
▪ Automatic stabilizers:
changes in fiscal policy that stimulate
agg demand when economy goes into recession,
without policymakers having to take any
deliberate action

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 15

 Automatic Stabilizers: Examples
▪ The tax system
• Taxes are tied to economic activity.
When economy goes into recession,
taxes fall automatically.
• This stimulates agg demand and reduces the
magnitude of fluctuations.

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 16

 Automatic Stabilizers: Examples
▪ Govt spending
• In a recession, incomes fall and
unemployment rises.
• More people apply for public assistance
(e.g., unemployment insurance, welfare).
• Govt outlays on these programs automatically
increase, which stimulates agg demand and
reduces the magnitude of fluctuations.

CHAPTER 34 THE INFLUENCE OF MONETARY AND FISCAL POLICY 17

 The Short-Run Trade-off Between
35 Inflation and Unemployment

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 Introduction
▪ In the long run, inflation & unemployment are
unrelated:
• The inflation rate depends mainly on growth in
the money supply.
• Unemployment (the “natural rate”) depends on
the minimum wage, the market power of unions,
efficiency wages, and the process of job search.
▪ In the short run,
society faces a trade-off between
inflation and unemployment.
CHAPTER 35 THE SHORT-RUN TRADE-OFF 1
 The Phillips Curve
▪ Phillips curve: shows the short-run trade-off
between inflation and unemployment

CHAPTER 35 THE SHORT-RUN TRADE-OFF 2

 Deriving the Phillips Curve
▪ Suppose P = 100 this year.
▪ The following graphs show two possible
outcomes for next year:
A. Agg demand low,
small increase in P (i.e., low inflation),
low output, high unemployment.
B. Agg demand high,
big increase in P (i.e., high inflation),
high output, low unemployment.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 3

 Deriving the Phillips Curve
A. Low agg demand, low inflation, high u-rate
P inflation

SRAS
B B
5%
105
A
103 3% A
AD2
PC
AD1

Y1 Y2 Y 4% 6% u-rate

B. High agg demand, high inflation, low u-rate

CHAPTER 35 THE SHORT-RUN TRADE-OFF 4
 The Phillips Curve: A Policy Menu?
▪ Since fiscal and mon policy affect agg demand,
the PC appeared to offer policymakers a menu
of choices:
• low unemployment with high inflation
• low inflation with high unemployment
• anything in between
▪ 1960s: U.S. data supported the Phillips curve.
Many believed the PC was stable and reliable.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 5

 The Vertical Long-Run Phillips Curve

▪ 1968: Milton Friedman and Edmund Phelps

argued that the tradeoff was temporary.
▪ Natural-rate hypothesis: the claim that
unemployment eventually returns to its normal or
“natural” rate, regardless of the inflation rate
▪ Based on the classical dichotomy and the
vertical LRAS curve.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 6

 The Vertical Long-Run Phillips Curve
In the long run, faster money growth only causes
faster inflation.
P inflation
LRAS LRPC

high
P2 infla-t
ion
P1 AD2 low
infla-t
AD1 ion
Y u-rate
natural rate natural rate of
of output unemployment
CHAPTER 35 THE SHORT-RUN TRADE-OFF 7
 The Phillips Curve Equation
Natural
Unemp. Actual Expected
= rate of – a –
rate inflation inflation
unemp.

Short run
Fed can reduce u-rate below the natural u-rate
by making inflation greater than expected.
Long run
Expectations catch up to reality,
u-rate goes back to natural u-rate whether inflation is
high or low.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 8

 How Expected Inflation Shifts the PC
Initially, expected &
actual inflation = 3%,
inflation
unemployment = LRPC
natural rate (6%).
Fed makes inflation
2% higher than expected, B C
5%
u-rate falls to 4%.
In the long run, 3% A
expected inflation PC2
increases to 5%, PC1
PC shifts upward,
unemployment returns to 4% 6% u-rate
its natural rate.
CHAPTER 35 THE SHORT-RUN TRADE-OFF 9
 Another PC Shifter: Supply Shocks
▪ Supply shock:
an event that directly alters firms’ costs and
prices, shifting the AS and PC curves
▪ Example: large increase in oil prices

CHAPTER 35 THE SHORT-RUN TRADE-OFF 10

 The Cost of Reducing Inflation
▪ Disinflation: a reduction in the inflation rate
▪ To reduce inflation,
Fed must slow the rate of money growth,
which reduces agg demand.
▪ Short run: output falls and unemployment rises.
▪ Long run: output & unemployment return to
their natural rates.

CHAPTER 35 THE SHORT-RUN TRADE-OFF 11

 The Cost of Reducing Inflation
▪ Disinflation requires enduring a period of
high unemployment and low output.
▪ Sacrifice ratio: the number of percentage points
of annual output lost in the process of reducing
inflation by 1 percentage point
▪ Typical estimate of the sacrifice ratio: 5
• Reducing inflation rate 1% requires a sacrifice
of 5% of a year’s output.
▪ This cost can be spread over time. Example:
To reduce inflation by 6%, can either
• sacrifice 30% of GDP for one year
CHAPTER 35 THE SHORT-RUN TRADE-OFF 12
Rational Expectations, Costless Disinflation?
▪ Rational expectations: a theory according to
which people optimally use all the information
they have, including info about govt policies,
when forecasting the future
▪ Early proponents:
Robert Lucas, Thomas Sargent, Robert Barro
▪ Implied that disinflation could be much less
costly…

CHAPTER 35 THE SHORT-RUN TRADE-OFF 13

 The Volcker Disinflation
Fed Chairman Paul Volcker
• appointed in late 1979 under high inflation &
unemployment
• changed Fed policy to disinflation
1981-1984:
• Fiscal policy was expansionary,
so Fed policy needed to be very contractionary
to reduce inflation.
• Success: Inflation fell from 10% to 4%,
but at the cost of high unemployment…
CHAPTER 35 THE SHORT-RUN TRADE-OFF 14
24 Measuring the Cost of Living

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 How the CPI Is Calculated
1. Fix the “basket.”
The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical
consumer’s “shopping basket.”
2. Find the prices.
The BLS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the
basket.
CHAPTER 24 MEASURING THE COST OF LIVING 1
 How the CPI Is Calculated
4. Choose a base year and compute the index.
The CPI in any year equals
cost of basket in current year
100 x
cost of basket in base year

5. Compute the inflation rate.

The percentage change in the CPI from the
preceding period.
inflation CPI this year – CPI last year
= x 100%
rate CPI last year
CHAPTER 24 MEASURING THE COST OF LIVING 2
EXAMPLE basket: {4 pizzas, 10 lattes}

price of price of
year cost of basket
pizza latte
2003 $10 $2.00 $10 x 4 + $2 x 10 = $60
2004 $11 $2.50 $11 x 4 + $2.5 x 10 = $69
2005 $12 $3.00 $12 x 4 + $3 x 10 = $78

Compute CPI in each year:

Inflation rate:
2003: 100 x ($60/$60) = 100
15%
2004: 100 x ($69/$60) = 115
2005: 100 x ($78/$60) = 130 13%

CHAPTER 24 MEASURING THE COST OF LIVING 3

ACTIVE LEARNING 1:
Calculate the CPI
movie text-bo
The basket contains tickets oks
20 movie tickets
and 10 textbooks. 2004 $10 $50

The table shows their 2005 $10 $60

prices for 2004-2006. 2006 $12 $60
The base year is 2004.

A. How much did the basket cost in 2004?

B. What is the CPI in 2005?
C. What is the inflation rate from 2005-2006?
4
ACTIVE LEARNING 1:
Answers
movie text-bo
The basket contains tickets oks
20 movie tickets
and 10 textbooks. 2004 $10 $50
2005 $10 $60
A. How much did 2006 $12 $60
the basket cost
in 2004?
($10 x 20) + ($50 x 10) = $700

5
ACTIVE LEARNING 1:
Answers
movie text-bo
The basket contains tickets oks
20 movie tickets
and 10 textbooks. 2004 $10 $50
2005 $10 $60

B. What is the CPI 2006 $12 $60

in 2005?
cost of basket in 2005
= ($10 x 20) + ($60 x 10) = $800
CPI in 2005 = 100 x ($800/$700) = 114.3

6
ACTIVE LEARNING 1:
Answers
movie text-bo
The basket contains tickets oks
20 movie tickets
and 10 textbooks. 2004 $10 $50
2005 $10 $60
C. What is the
inflation rate 2006 $12 $60
from 2005-2006?
cost of basket in 2006
= ($12 x 20) + ($60 x 10) = $840
CPI in 2006 = 100 x ($840/$700) = 120
Inflation rate = (120 – 114.3)/114.3 = 5%
7
 What’s in the CPI’s Basket?

CHAPTER 24 MEASURING THE COST OF LIVING 8

 Problems With the CPI:
Substitution Bias
▪ Over time, some prices rise faster than others.
▪ Consumers substitute toward goods that
become relatively cheaper.
▪ The CPI misses this substitution because it uses
a fixed basket of goods.
▪ Thus, the CPI overstates increases in the cost of
living.

CHAPTER 24 MEASURING THE COST OF LIVING 9

 Problems With the CPI:
Introduction of New Goods
▪ When new goods become available,
variety increases,
allowing consumers to find products
that more closely meet their needs.
▪ This has the effect of making each dollar more
valuable.
▪ The CPI misses this effect because it uses a
fixed basket of goods.
▪ Thus, the CPI overstates increases in the cost
of living. 10
CHAPTER 24 MEASURING THE COST OF LIVING
 Problems With the CPI:
Unmeasured Quality Change
▪ Improvements in the quality of goods in the
basket increase the value of each dollar.
▪ The BLS tries to account for quality changes,
but probably misses some quality improvements,
as quality is hard to measure.
▪ Thus, the CPI overstates increases in the cost of
living.

CHAPTER 24 MEASURING THE COST OF LIVING 11

 Contrasting the CPI and GDP Deflator
Imported consumer goods:
▪ included in CPI
▪ excluded from GDP deflator
Capital goods:
▪ excluded from CPI
▪ included in GDP deflator
The basket: (if produced domestically)
▪ CPI uses fixed basket
▪ GDP deflator uses basket of
currently produced goods & services
This matters if different prices are
changing
CHAPTER 24by differentTHE
MEASURING amounts.
COST OF LIVING 12
ACTIVE LEARNING 2:
CPI vs. GDP deflator
In each scenario, determine the effects on the
CPI and the GDP deflator.
A. Starbucks raises the price of Frappuccinos.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
C. Armani raises the price of the Italian jeans it
sells in the U.S.

13
ACTIVE LEARNING 2:
Answers
A. Starbucks raises the price of Frappuccinos.
The CPI and GDP deflator both rise.
B. Caterpillar raises the price of the industrial
tractors it manufactures at its Illinois factory.
The GDP deflator rises, the CPI does not.
C. Armani raises the price of the Italian jeans it
sells in the U.S.
The CPI rises, the GDP deflator does not.

14
 Correcting Variables for Inflation:
Comparing Dollar Figures from Different Times

▪ Inflation makes it harder to compare dollar

amounts from different times.
▪ We can use the CPI to adjust figures so that they
can be compared.

CHAPTER 24 MEASURING THE COST OF LIVING 15

 EXAMPLE: The High Price of Gasoline

▪ Price of a gallon of regular unleaded gas:

$1.42 in March 1981
$2.50 in August 2005

▪ To compare these figures, we will use the CPI to

express the 1981 gas price in “2005 dollars,”
what gas in 1981 would have cost if the
cost of living were the same then as in 2005.

▪ Multiply the 1981 gas price by

the ratio of the CPI in 2005 to the CPI in 1981.

CHAPTER 24 MEASURING THE COST OF LIVING 16

 EXAMPLE: The High Price of Gasoline
Gas price in
date Price of gas CPI
2005 dollars
3/1981 $1.42/gallon 88.5 $3.15/gallon
8/2005 $2.50/gallon 196.4 $2.50/gallon

▪ 1981 gas price in 2005 dollars

= $1.42 x 196.4/88.5
= $3.15
▪ After correcting for inflation, gas was more
expensive in 1981.
CHAPTER 24 MEASURING THE COST OF LIVING 17
ACTIVE LEARNING 3:
Exercise
1980: CPI = 90,
avg starting salary for econ majors = $24,000
Today: CPI = 180,
avg starting salary for econ majors = $50,000
Are econ majors better off today or in 1980?

18
ACTIVE LEARNING 3:
Answers
1980: CPI = 90,
avg starting salary for econ majors = $24,000
Today: CPI = 180,
avg starting salary for econ majors = $50,000

Solution
Convert 1980 salary into “today’s dollars”
$24,000 x (180/90) = $48,000.
After adjusting for inflation, salary is higher today
than in 1980.
19
 Correcting Variables for Inflation:
Indexation

A dollar amount is indexed for inflation

if it is automatically corrected for inflation
by law or in a contract.

For example, the increase in the CPI automatically

determines
• the COLA in many multi-year labor contracts
• the adjustments in Social Security payments
and federal income tax brackets

CHAPTER 24 MEASURING THE COST OF LIVING 20

 Correcting Variables for Inflation:
Real vs. Nominal Interest Rates
The nominal interest rate:
• the interest rate not corrected for inflation
• the rate of growth in the dollar value of a
deposit or debt
The real interest rate:
• corrected for inflation
• the rate of growth in the purchasing power of a
deposit or debt
Real interest rate
= (nominal interest rate) – (inflation rate)
CHAPTER 24 MEASURING THE COST OF LIVING 21
 Real and Nominal Interest Rates:
EXAMPLE
▪ Deposit $1,000 for one year.
▪ Nominal interest rate is 9%.
▪ During that year, inflation is 3.5%.
▪ Real interest rate
= Nominal interest rate – Inflation
= 9.0% – 3.5% = 5.5%
▪ The purchasing power of the $1000 deposit
has grown 5.5%.
CHAPTER 24 MEASURING THE COST OF LIVING 22
29 The Monetary System

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 What Money Is, and Why It’s Important
▪ Without money, trade would require barter,
the exchange of one good or service for another.
▪ Every transaction would require a double
coincidence of wants – the unlikely occurrence
that two people each have a good the other wants.
▪ Most people would have to spend time searching for
others to trade with – a huge waste of resources.
▪ This searching is unnecessary with money,
the set of assets that people regularly use to buy
g&s from other people.
CHAPTER 29 THE MONETARY SYSTEM 1
 The 3 Functions of Money
▪ Medium of exchange: an item buyers give to
sellers when they want to purchase g&s

▪ Unit of account: the yardstick people use to

post prices and record debts

▪ Store of value: an item people can use to

transfer purchasing power from the present to
the future

CHAPTER 29 THE MONETARY SYSTEM 2

 The 2 Kinds of Money
Commodity money:
takes the form of a commodity
with intrinsic value
Examples: gold coins,
cigarettes in POW camps

Fiat money:
money without intrinsic value,
used as money because of
govt decree
Example: the U.S. dollar

CHAPTER 29 THE MONETARY SYSTEM 3

 The Money Supply
▪ The money supply (or money stock):
the quantity of money available in the economy
▪ What assets should be considered part of the
money supply? Here are two candidates:
• Currency: the paper bills and coins in the
hands of the (non-bank) public
• Demand deposits: balances in bank accounts
that depositors can access on demand by
writing a check

CHAPTER 29 THE MONETARY SYSTEM 4

 Measures of the Money Supply
▪ M1: currency, demand deposits,
traveler’s checks, and other checkable deposits.
M1 = $1.4 trillion (October 2005)

▪ M2: everything in M1 plus savings deposits,

small time deposits, money market mutual funds,
and a few minor categories.
M2 = $6.6 trillion (October 2005)
The distinction between M1 and M2
will usually not matter when we talk about
“the money supply” in this course.

CHAPTER 29 THE MONETARY SYSTEM 5

 Bank Reserves
▪ In a fractional reserve banking system,
banks keep a fraction of deposits as reserves,
and use the rest to make loans.
▪ The Fed establishes reserve requirements,
regulations on the minimum amount of reserves
that banks must hold against deposits.
▪ Banks may hold more than this minimum amount
if they choose.
▪ The reserve ratio, R
= fraction of deposits that banks hold as reserves
= total reserves as a percentage of total deposits
CHAPTER 29 THE MONETARY SYSTEM 6
 Bank T-account
▪ T-account: a simplified accounting statement
that shows a bank’s assets & liabilities.
▪ Example: FIRST NATIONAL BANK
Assets Liabilities
Reserves $ 10 Deposits$100
Loans $ 90

▪ Banks’ liabilities include deposits,

assets include loans & reserves.
▪ In this example, notice that R = $10/$100 = 10%.
CHAPTER 29 THE MONETARY SYSTEM 7
Banks and the Money Supply: An Example
Suppose $100 of currency is in circulation.
To determine banks’ impact on money supply,
we calculate the money supply in 3 different cases:
1. No banking system
2. 100% reserve banking system:
banks hold 100% of deposits as reserves,
make no loans
3. Fractional reserve banking system

CHAPTER 29 THE MONETARY SYSTEM 8

Banks and the Money Supply: An Example
CASE 1: no banking system
Public holds the $100 as currency.
Money supply = $100.

CHAPTER 29 THE MONETARY SYSTEM 9

Banks and the Money Supply: An Example
CASE 2: 100% reserve banking system
Public deposits the $100 at First National Bank (FNB).
FNB holds
100% of FIRST NATIONAL BANK
deposit Assets Liabilities
as reserves:
Reserves $100 Deposits$100
Loans $ 0
Money supply
= currency + deposits = $0 + $100 = $100
In a 100% reserve banking system,
banks do not affect size of money supply.
CHAPTER 29 THE MONETARY SYSTEM 10
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
Suppose R = 10%. FNB loans all but 10%
of the deposit:
FIRST NATIONAL BANK
Assets Liabilities
Reserves $100
10 Deposits$100
Loans $ 0 90

Money supply = $190 (!!!)

depositors have $100 in deposits,
borrowers have $90 in currency.
CHAPTER 29 THE MONETARY SYSTEM 11
Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
How did the money supply suddenly grow?
When banks make loans, they create money.
The borrower gets
• $90 in currency (an asset counted in the
money supply)
• $90 in new debt (a liability)
A fractional reserve banking system
creates money, but not wealth.

CHAPTER 29 THE MONETARY SYSTEM 12

Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
Suppose borrower deposits the $90 at Second
National Bank (SNB).

Initially, SNB’s SECOND NATIONAL BANK

T-account Assets Liabilities
looks like this: Reserves $ 909 Deposits$ 90
Loans $ 0 81

If R = 10% for SNB, it will loan all but 10% of the

deposit.

CHAPTER 29 THE MONETARY SYSTEM 13

Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
The borrower deposits the $81 at Third National
Bank (TNB).

Initially, TNB’s THIRD NATIONAL BANK

T-account Assets Liabilities
looks like this: Reserves $$8.10
81 Deposits$ 81
Loans $ $72.90
0

If R = 10% for TNB, it will loan all but 10% of the

deposit.

CHAPTER 29 THE MONETARY SYSTEM 14

Banks and the Money Supply: An Example
CASE 3: fractional reserve banking system
The process continues, and money is created with
each new loan.
$ In this
100.00 example,
Original deposit = $ $100 of
FNB lending = 90.00 reserves
SNB lending = $ generate
TNB lending = 81.00 $1000 of
.. money.
. $
72.90
..
CHAPTER 29 THE MONETARY SYSTEM . 15
 The Money Multiplier
▪ Money multiplier: the amount of money the
banking system generates with each dollar of
reserves
▪ The money multiplier equals 1/R.
▪ In our example,
R = 10%
money multiplier = 1/R = 10
$100 of reserves creates $1000 of money

CHAPTER 29 THE MONETARY SYSTEM 16

ACTIVE LEARNING 1:
Exercise
While cleaning your apartment, you look under the
sofa cushion find a $50 bill (and a half-eaten taco).
You deposit the bill in your checking account.
The Fed’s reserve requirement is 20% of deposits.
A. What is the maximum amount that the
money supply could increase?
B. What is the minimum amount that the
money supply could increase?

17
ACTIVE LEARNING 1:
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
The maximum possible increase in deposits is
5 x $50 = $250
But money supply also includes currency,
which falls by $50.
Hence, max increase in money supply = $200.
18
ACTIVE LEARNING 1:
Answers
You deposit $50 in your checking account.
A. What is the maximum amount that the
money supply could increase?
Answer: $200
B. What is the minimum amount that the
money supply could increase?
Answer: $0
If your bank makes no loans from your deposit,
currency falls by $50, deposits increase by $50,
money supply remains unchanged.
19
 The Fed’s 3 Tools of Monetary Control
1. Open-Market Operations (OMOs): the purchase
and sale of U.S. government bonds by the Fed.
▪ To increase money supply, Fed buys govt bonds,
paying with new dollars.
…which are deposited in banks, increasing reserves
…which banks use to make loans, causing the
money supply to expand.
▪ To reduce money supply, Fed sells govt bonds,
taking dollars out of circulation, and the process
works in reverse.

CHAPTER 29 THE MONETARY SYSTEM 20

 The Fed’s 3 Tools of Monetary Control
2. Reserve Requirements (RR).
Affect how much money banks can create by
making loans.
▪ To increase money supply, Fed reduces RR.
Banks make more loans from each dollar of reserves,
which increases money multiplier and money supply.
▪ To reduce money supply, Fed raises RR,
and the process works in reverse.
▪ Fed rarely uses reserve requirements to control
money supply: Frequent changes would disrupt
banking.
CHAPTER 29 THE MONETARY SYSTEM 21
 The Fed’s 3 Tools of Monetary Control
3. The Bank Rate:
the interest rate on loans the Fed makes to banks
▪ When banks are running low on reserves,
they may borrow reserves from the Fed.
▪ To increase money supply,
Fed can lower discount rate, which encourages
banks to borrow more reserves from Fed.
▪ Banks can then make more loans, which increases
the money supply.
▪ To reduce money supply, Fed can raise discount rate.
CHAPTER 29 THE MONETARY SYSTEM 22
 The Federal Funds Rate
▪ On any given day, banks with insufficient reserves
can borrow from banks with excess reserves.
▪ The interest rate on these loans is the federal
funds rate.

CHAPTER 29 THE MONETARY SYSTEM 23

Problems Controlling the Money Supply
▪ If households hold more of their money as
currency, banks have fewer reserves,
make fewer loans, & money supply falls.
▪ If banks hold more reserves than required,
they make fewer loans, & money supply falls.
▪ Yet, Fed can compensate for household
& bank behavior to retain fairly precise control
over the money supply.

CHAPTER 29 THE MONETARY SYSTEM 24

 Introduction
▪ This chapter introduces the quantity theory of
money to explain one of the Ten Principles of
Economics from Chapter 1:
Prices rise when the govt prints
too much money.
▪ Most economists believe the quantity theory
is a good explanation of the long run behavior
of inflation.

CHAPTER 30 MONEY GROWTH AND INFLATION 0

 The Value of Money
▪ P = the price level
(e.g., the CPI or GDP deflator)
P is the price of a basket of goods, measured in
money.
▪ 1/P is the value of $1, measured in goods.
▪ Example: basket contains one candy bar.
• If P = $2, value of $1 is 1/2 candy bar
• If P = $3, value of $1 is 1/3 candy bar
▪ Inflation drives up prices, and drives down the
value of MONEY
CHAPTER 30
money.GROWTH AND INFLATION 1
 The Quantity Theory of Money
▪ Developed by 18th century philosopher
David Hume, and the classical economists.
▪ Asserts that the quantity of money determines the
value of money.
▪ We study this theory using two approaches:
1. a supply-demand diagram
2. an equation

CHAPTER 30 MONEY GROWTH AND INFLATION 2

 Money Supply (MS)
▪ In real world, determined by Federal Reserve,
the banking system, consumers.
▪ In this model, we assume the Fed precisely
controls MS and sets it at some fixed amount.

CHAPTER 30 MONEY GROWTH AND INFLATION 3

 Money Demand (MD)
▪ Refers to how much wealth people want to hold
in liquid form.
▪ Depends on P:
An increase in P reduces the value of money,
so more money is required to buy g&s.
▪ Thus, quantity of money demanded
is negatively related to the value of money
and positively related to P, other things equal.
(These “other things” include real income,
interest rates, availability of ATMs.)
CHAPTER 30 MONEY GROWTH AND INFLATION 4
The Money Supply-Money Demand Diagram

Value of Price
Money, 1/P Level, P
As the value of
money rises, the
1 1
price level falls.
¾ 1.33

½ 2

¼ 4

Quantity of
Money
CHAPTER 30 MONEY GROWTH AND INFLATION 5
 The Money Supply-Demand Diagram

Value of Price
Money, 1/P MS1 Level, P

1 1

¾ 1.33

The Fed sets MS

½ 2
at some fixed value,
regardless of P.
¼ 4

$1000 Quantity of
Money
CHAPTER 30 MONEY GROWTH AND INFLATION 6
 The Money Supply-Demand Diagram

Value of A fall in value of money Price

Money, 1/P (or increase in P) Level, P
increases the quantity
1 of money demanded: 1

¾ 1.33

½ 2

¼ 4
MD1

Quantity of
Money
CHAPTER 30 MONEY GROWTH AND INFLATION 7
 The Money Supply-Demand Diagram

Value of P adjusts to equate Price

Money, 1/P MS1 quantity of money Level, P
demanded with
1 money supply. 1

¾ 1.33
eq’m eq’m
value A
½ 2 price
of
level
money
¼ 4
MD1

$1000 Quantity of
Money
CHAPTER 30 MONEY GROWTH AND INFLATION 8
 The Effects of a Monetary Injection

Value of Price
Money, 1/P MS1 MS2 Level, P

Suppose the
1 Fed 1
Then the value
increases the of money falls,
money supply.
¾ and P rises.
1.33
A
½ 2
eq’m eq’m
value B
¼ 4 price
of MD1 level
money
$1000 $2000 Quantity of
Money
CHAPTER 30 MONEY GROWTH AND INFLATION 9
 Real vs. Nominal Variables
▪ Nominal variables are measured in monetary
units.
examples: nominal GDP,
nominal interest rate (rate of return measured in $)
nominal wage ($ per hour worked)

▪ Real variables are measured in physical units.

examples: real GDP,
real interest rate (measured in output)
real wage (measured in output)

CHAPTER 30 MONEY GROWTH AND INFLATION 10

 Real vs. Nominal Variables
Prices are normally measured in terms of money.
• Price of a compact disc: $15/cd
• Price of a pepperoni pizza: $10/pizza
A relative price is the price of one good relative to
(divided by) another:
• Relative price of CDs in terms of pizza:
price of cd $15/cd
= = 1.5 pizzas per cd
price of pizza $10/pizza
Relative prices are measured in physical units,
so they are real variables.
CHAPTER 30 MONEY GROWTH AND INFLATION 11
 Real vs. Nominal Wage
An important relative price is the real wage:
W = nominal wage = price of labor, e.g., $15/hour
P = price level = price of g&s, e.g., $5/unit of output
Real wage is the price of labor relative to the price
of output:
W $15/hour
= = 3 units output per hour
P $5/unit of output

CHAPTER 30 MONEY GROWTH AND INFLATION 12

 The Classical Dichotomy
▪ Classical dichotomy: the theoretical separation
of nominal and real variables
• all nominal variables – including prices –
will double.
• all real variables – including relative prices –
will remain unchanged.

CHAPTER 30 MONEY GROWTH AND INFLATION 13

 The Neutrality of Money
▪ Monetary neutrality: the proposition that changes
in the money supply do not affect real variables
▪ Doubling money supply causes all nominal prices
to double; what happens to relative prices?
▪ Initially, relative price of cd in terms of pizza is
price of cd $15/cd
= = 1.5 pizzas per cd
price of pizza $10/pizza
The relative price
▪ After nominal prices double, is unchanged.
price of cd $30/cd
= = 1.5 pizzas per cd
price of pizza $20/pizza
CHAPTER 30 MONEY GROWTH AND INFLATION 14
 The Neutrality of Money
▪ Monetary neutrality: the proposition that changes
in the money supply do not affect real variables
▪ Similarly, the real wage W/P remains unchanged, so
• quantity of labor supplied does not change
• quantity of labor demanded does not change
• total employment of labor does not change
▪ The same applies to employment of capital and
other resources.
▪ Since employment of all resources is unchanged,
total output is also unchanged by the money supply.
CHAPTER 30 MONEY GROWTH AND INFLATION 15
 The Neutrality of Money
▪ Most economists believe the classical dichotomy
and neutrality of money describe the economy in
the long run.
▪ In later chapters, we will see that monetary
changes can have important short-run effects
on real variables.

CHAPTER 30 MONEY GROWTH AND INFLATION 16

 The Velocity of Money
▪ Velocity of money: the rate at which money
changes hands
▪ Notation:
P x Y = nominal GDP
= (price level) x (real GDP)
M = money supply
V = velocity
PxY
▪ Velocity formula: V =
M

CHAPTER 30 MONEY GROWTH AND INFLATION 17

 The Velocity of Money
PxY
Velocity formula: V =
M
Example with one good: pizza.
In 2006,
Y = real GDP = 3000 pizzas
P = price level = price of pizza = $10
PxY = nominal GDP = value of pizzas =
$30,000
M = money supply = $10,000
V = velocity = $30,000/$10,000 = 3
The average dollar was used in 3 transactions.
CHAPTER 30 MONEY GROWTH AND INFLATION 18
 The Quantity Equation
PxY
Velocity formula: V =
M
▪ Multiply both sides of formula by M:
MxV = PxY
▪ Called the quantity equation

CHAPTER 30 MONEY GROWTH AND INFLATION 19

ACTIVE LEARNING 1:
Exercise
One good: corn. The economy has enough labor,
capital, and land to produce Y = 800 bushels of corn.
V is constant. In 2005, MS = $2000, P = $5/bushel.

a. Compute nominal GDP and velocity in 2005.

For 2006, the Fed increases MS by 5%, to $2100.
b. Compute the 2006 values of nominal GDP and P.
Compute the inflation rate for 2005-2006.
c. Suppose tech. progress causes Y to increase to
824 in 2006. Compute 2005-2006 inflation rate.

20
ACTIVE LEARNING 1:
Answers
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2005.
a. Compute nominal GDP and velocity in 2005.

Nominal GDP = P x Y = $5 x 800 = $4000

PxY $4000
V = = = 2
M $2000

21
ACTIVE LEARNING 1:
Answers
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2005.
For 2006, the Fed increases MS by 5%, to $2100.
b. Compute the 2006 values of nominal GDP and P.
Compute the inflation rate for 2005-2006.
Nominal GDP = P x Y = M x V (Quantity Eq’n)
= $2100 x 2 = $4200
PxY $4200
P = = = $5.25
Y 800
$5.25 – 5.00
Inflation rate = = 5% (same as MS!)
5.00 22
ACTIVE LEARNING 1:
Answers
Given: Y = 800, V is constant,
MS = $2000 and P = $5 in 2005.
For 2006, the Fed increases MS by 5%, to $2100.
c. Suppose tech. progress causes Y to increase 3%
in 2006, to 824. Compute 2005-2006 inflation rate.
First, use Quantity Eq’n to compute P:
MxV $4200
P = = = $5.10
Y 824
$5.10 – 5.00
Inflation rate = = 2%
5.00
23
 Hyperinflation
▪ Hyperinflation is generally defined as inflation
exceeding 50% per month.

▪ Recall one of the Ten Principles from Chapter 1:

Prices rise when the government
prints too much money.

▪ Excessive growth in the money supply always

causes hyperinflation.

CHAPTER 30 MONEY GROWTH AND INFLATION 24

 The Inflation Tax
▪ When tax revenue is inadequate and ability to
borrow is limited, govt may print money to pay
for its spending.
▪ Almost all hyperinflations start this way.
▪ The revenue from printing money is the
inflation tax: printing money causes inflation,
which is like a tax on everyone who holds
money.
▪ In the U.S., the inflation tax today accounts for
less than 3% of total revenue.
CHAPTER 30 MONEY GROWTH AND INFLATION 25
 The Fisher Effect
▪ Rearrange the definition of the real interest rate:
nominal inflation real interest
= +
interest rate rate rate

▪ The real interest rate is determined by saving &

investment in the loanable funds market.
▪ Money supply growth determines inflation rate.
▪ So, this equation shows how the nominal interest
rate is determined.

CHAPTER 30 MONEY GROWTH AND INFLATION 26

 The Fisher Effect
nominal inflation real interest
= +
interest rate rate rate

▪ In the long run, money is neutral,

so a change in the money growth rate affects
the inflation rate but not the real interest rate.
▪ So, the nominal interest rate adjusts one-for-one
with changes in the inflation rate.
▪ This relationship is called the Fisher effect
after Irving Fisher, who studied it.

CHAPTER 30 MONEY GROWTH AND INFLATION 27

The Fisher Effect & the Inflation Tax
nominal inflation real interest
= +
interest rate rate rate

▪ The inflation tax applies to people’s holdings of

money, not their holdings of wealth.
▪ The Fisher effect: an increase in inflation causes
an equal increase in the nominal interest rate, so
the real interest rate (on wealth) is unchanged.

CHAPTER 30 MONEY GROWTH AND INFLATION 28

 The Costs of Inflation
▪ The inflation fallacy: most people think inflation
erodes real incomes.
▪ But inflation is a general increase in prices,
of the things people buy and the things they sell
(e.g., their labor).
▪ In the long run, real incomes are determined by
real variables, not the inflation rate.

CHAPTER 30 MONEY GROWTH AND INFLATION 29

 The Costs of Inflation
▪ Shoeleather costs: the resources wasted when
inflation encourages people to reduce their
money holdings
• includes the time and transactions costs of
more frequent bank withdrawals
▪ Menu costs: the costs of changing prices
• printing new menus, mailing new catalogs, etc.

CHAPTER 30 MONEY GROWTH AND INFLATION 30

 The Costs of Inflation
▪ Misallocation of resources from relative-price
variability: Firms don’t all raise prices at the
same time, so relative prices can vary…
which distorts the allocation of resources.
▪ Confusion & inconvenience: Inflation changes
the yardstick we use to measure transactions.
Complicates long-range planning and the
comparison of dollar amounts over time.

CHAPTER 30 MONEY GROWTH AND INFLATION 31

 The Costs of Inflation
▪ Tax distortions:
Inflation makes nominal income grow faster than
real income.
Taxes are based on nominal income,
and some are not adjusted for inflation.
So, inflation causes people to pay more taxes
even when their real incomes don’t increase.

CHAPTER 30 MONEY GROWTH AND INFLATION 32

A Special Cost of Unexpected Inflation
▪ Arbitrary redistributions of wealth
Higher-than-expected inflation transfers
purchasing power from creditors to debtors:
Debtors get to repay their debt with dollars that
aren’t worth as much.
Lower-than-expected inflation transfers purchasing
power from debtors to creditors.
High inflation is more variable and less predictable
than low inflation.
So, these arbitrary redistributions are frequent
when inflation is high.
CHAPTER 30 MONEY GROWTH AND INFLATION 33
23 Measuring a Nation’s Income

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

 Micro vs. Macro
▪ Microeconomics:
The study of how individual households and
firms make decisions, interact with one another
in markets.

▪ Macroeconomics:
The study of the economy as a whole.

▪ We begin our study of macroeconomics with the

country’s total income and expenditure.

CHAPTER 23 MEASURING A NATION’S INCOME 1

 Income and Expenditure
▪ Gross Domestic Product (GDP) measures
total income of everyone in the economy.
▪ GDP also measures total expenditure on the
economy’s output of g&s.

For the economy as a whole,

income equals expenditure, because
every dollar of expenditure by a buyer
is a dollar of income for the seller.

CHAPTER 23 MEASURING A NATION’S INCOME 2

 The Circular-Flow Diagram
▪ Illustrates GDP as spending, revenue,
factor payments, and income.
▪ First, some preliminaries:
• Factors of production are inputs like labor,
land, capital, and natural resources.
• Factor payments are payments to the factors
of production. (e.g., wages, rent)

CHAPTER 23 MEASURING A NATION’S INCOME 3

FIGURE 1: The Circular-Flow Diagram

Households:
▪ own the factors of production,
sell/rent them to firms for income
▪ buy and consume g&s

Firms Households

CHAPTER 23 MEASURING A NATION’S INCOME 4

FIGURE 1: The Circular-Flow Diagram

Firms Households

Firms:
▪ buy/hire factors of production,
use them to produce g&s
▪ sell g&s

CHAPTER 23 MEASURING A NATION’S INCOME 5

FIGURE 1: The Circular-Flow Diagram

Revenue (=GDP) Spending (=GDP)

Markets for
G&S Goods &
G&S
sold Services bought

Firms Households

Factors of Labor, land,

production Markets for capital
Factors of
Wages, rent, Production Income (=GDP)
profit (=GDP)
CHAPTER 23 MEASURING A NATION’S INCOME 6
 What This Diagram Omits
▪ The government
• collects taxes
• purchases g&s
▪ The financial system
• matches savers’ supply of funds with
borrowers’ demand for loans

▪ The foreign sector

• trades g&s, financial assets, and currencies
with the country’s residents
CHAPTER 23 MEASURING A NATION’S INCOME 7
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

Goods are valued at their market prices, so:

• GDP measures all goods using the same units
(e.g., dollars in the U.S.), rather than “adding
apples to oranges.”
• Things that don’t have a market value are
excluded, e.g., housework you do for yourself.
CHAPTER 23 MEASURING A NATION’S INCOME 8
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

Final goods are intended for the end user.

Intermediate goods are used as components
or ingredients in the production of other goods.
GDP only includes final goods, as they already
embody the value of the intermediate goods
used in their production.
CHAPTER 23 MEASURING A NATION’S INCOME 9
Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP includes tangible goods

(like DVDs, mountain bikes, beer)
and intangible services
(dry cleaning, concerts, cell phone service).

CHAPTER 23 MEASURING A NATION’S INCOME 10

Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP includes currently produced goods,

not goods produced in the past.

CHAPTER 23 MEASURING A NATION’S INCOME 11

Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

GDP measures the value of production that occurs

within a country’s borders, whether done by its own
citizens or by foreigners located there.

CHAPTER 23 MEASURING A NATION’S INCOME 12

Gross Domestic Product (GDP) Is…
…the market value of all final goods &
services produced within a country
in a given period of time.

usually a year or a quarter (3 months).

CHAPTER 23 MEASURING A NATION’S INCOME 13

 The Components of GDP
▪ Recall: GDP is total spending.
▪ Four components:
• Consumption (C)
• Investment (I)
• Government Purchases (G)
• Net Exports (NX)
▪ These components add up to GDP (denoted Y):
Y = C + I + G + NX

CHAPTER 23 MEASURING A NATION’S INCOME 14

 Consumption (C)
▪ is total spending by households on g&s.
▪ Note on housing costs:
• For renters, consumption includes rent
payments.
• For homeowners, consumption includes
the imputed rental value of the house,
but not the purchase price or mortgage
payments.

CHAPTER 23 MEASURING A NATION’S INCOME 15

 Investment (I)
▪ is total spending on goods that will be used in
the future to produce more goods.

▪ includes spending on
• capital equipment (e.g., machines, tools)
• structures (factories, office buildings, houses)
• inventories (goods produced but not yet sold)
Note: “Investment” does not
mean the purchase of financial
assets like stocks and bonds.

CHAPTER 23 MEASURING A NATION’S INCOME 16

 Government Purchases (G)
▪ is all spending on the g&s purchased by govt
at the federal, state, and local levels.

▪ G excludes transfer payments, such as

Social Security or unemployment insurance
benefits.
These payments represent transfers of income,
not purchases of g&s.

CHAPTER 23 MEASURING A NATION’S INCOME 17

 Net Exports (NX)
▪ NX = exports – imports
▪ Exports represent foreign spending on the
economy’s g&s.
▪ Imports are the portions of C, I, and G
that are spent on g&s produced abroad.
▪ Adding up all the components of GDP gives:
Y = C + I + G + NX

CHAPTER 23 MEASURING A NATION’S INCOME 18

ACTIVE LEARNING 1:
GDP and its components
In each of the following cases, determine how much
GDP and each of its components is affected (if at all).
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
B. Sarah spends $1800 on a new laptop to use in her
publishing business. The laptop was built in China.
C. Jane spends $1200 on a computer to use in her
editing business. She got last year’s model on sale
for a great price from a local manufacturer.
D. General Motors builds $500 million worth of cars,
but consumers only buy $470 million worth of them.
19
ACTIVE LEARNING 1:
Answers
A. Debbie spends $200 to buy her husband dinner
at the finest restaurant in Boston.
Consumption and GDP rise by $200.

B. Sarah spends $1800 on a new laptop to use in

her publishing business. The laptop was built in
China.
Investment rises by $1800, net exports fall
by $1800, GDP is unchanged.

20
ACTIVE LEARNING 1:
Answers
C. Jane spends $1200 on a computer to use in her
editing business. She got last year’s model on
sale for a great price from a local manufacturer.
Current GDP and investment do not change,
because the computer was built last year.

D. General Motors builds $500 million worth of cars,

but consumers only buy $470 million of them.
Consumption rises by $470 million,
inventory investment rises by $30 million,
and GDP rises by $500 million.
21
 Real versus Nominal GDP
▪ Inflation can distort economic variables like GDP,
so we have two versions of GDP:
One is corrected for inflation, the other is not.
▪ Nominal GDP values output using current prices.
It is not corrected for inflation.
▪ Real GDP values output using the prices of
a base year. Real GDP is corrected for inflation.

CHAPTER 23 MEASURING A NATION’S INCOME 22

EXAMPLE:
Pizza Latte
year P Q P Q
2002 $10 400 $2.00 1000
2003 $11 500 $2.50 1100
2004 $12 600 $3.00 1200

Compute nominal GDP in each year:

Increase:
2002: $10 x 400 + $2 x 1000 = $6,000
37.5%
2003: $11 x 500 + $2.50 x 1100 = $8,250
30.9%
2004: $12 x 600 + $3 x 1200 = $10,800

CHAPTER 23 MEASURING A NATION’S INCOME 23

EXAMPLE:
Pizza Latte
year P Q P Q
2002 $10 400 $2.00 1000
2003 $11 500 $2.50 1100
2004 $12 600 $3.00 1200
Compute real GDP in each year,
using 2002 as the base year: Increase:
2002: $10 x 400 + $2 x 1000 = $6,000
20.0%
2003: $10 x 500 + $2 x 1100 = $7,200
16.7%
2004: $10 x 600 + $2 x 1200 = $8,400
CHAPTER 23 MEASURING A NATION’S INCOME 24
 The GDP Deflator
▪ The GDP deflator is a measure of the overall
level of prices.
▪ Definition:
nominal GDP
GDP deflator = 100 x
real GDP

▪ One way to measure the economy’s inflation

rate is to compute the percentage increase in
the GDP deflator from one year to the next.

CHAPTER 23 MEASURING A NATION’S INCOME 25

EXAMPLE:
Nominal Real GDP
year GDP GDP Deflator
2002 $6000 $6000 100.0
14.6%
2003 $8250 $7200 114.6
2004 $10,800 $8400 12.2%
128.6

Compute the GDP deflator in each year:

2002: 100 x (6000/6000) = 100.0

2003: 100 x (8250/7200) = 114.6

2004: 100 x (10,800/8400) = 128.6

CHAPTER 23 MEASURING A NATION’S INCOME 26

ACTIVE LEARNING 2:
Computing GDP
2004 (base yr) 2005 2006
P Q P Q P Q
good A $30 900 $31 1,000 $36 1050
good B $100 192 $102 200 $100 205

Use the above data to solve these problems:

A. Compute nominal GDP in 2004.
B. Compute real GDP in 2005.
C. Compute the GDP deflator in 2006.

27
ACTIVE LEARNING 2:
Answers
2004 (base yr) 2005 2006
P Q P Q P Q
good A $30 900 $31 1,000 $36 1050
good B $100 192 $102 200 $100 205
A. Compute nominal GDP in 2004.
$30 x 900 + $100 x 192 = $46,200

B. Compute real GDP in 2005.

$30 x 1000 + $100 x 200 = $50,000

28
ACTIVE LEARNING 2:
Answers
2004 (base yr) 2005 2006
P Q P Q P Q
good A $30 900 $31 1,000 $36 1050
good B $100 192 $102 200 $100 205
C. Compute the GDP deflator in 2006.
Nom GDP = $36 x 1050 + $100 x 205 = $58,300
Real GDP = $30 x 1050 + $100 x 205 = $52,000
GDP deflator = 100 x (Nom GDP)/(Real GDP)
= 100 x ($58,300)/($52,000) = 112.1
29
 GDP and Economic Well-Being
▪ Real GDP per capita is the main indicator of
the average person’s standard of living.
▪ But GDP is not a perfect measure of
well-being.
▪ Robert Kennedy issued a very eloquent
yet harsh criticism of GDP:

CHAPTER 23 MEASURING A NATION’S INCOME 30

 GDP Does Not Value:
▪ the quality of the environment
▪ leisure time
▪ non-market activity, such as the child care
a parent provides his or her child at home
▪ an equitable distribution of income

CHAPTER 23 MEASURING A NATION’S INCOME 31

 Open-Economy Macroeconomics:
31 Basic Concepts

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2006 Thomson South-Western, all rights reserved

 Introduction
▪ One of the Ten Principles of Economics
from Chapter 1:
Trade can make everyone better off.
▪ This chapter introduces basic concepts of
international macroeconomics:
• the trade balance (trade deficits, surpluses)
• international flows of assets
• exchange rates

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 1

 Closed vs. Open Economies
▪ A closed economy does not interact with other
economies in the world.
▪ An open economy interacts freely with other
economies around the world.

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 2

 The Flow of Goods & Services
▪ Exports:
domestically-produced g&s sold abroad
▪ Imports:
foreign-produced g&s sold domestically
▪ Net exports (NX)
= value of exports – value of imports

▪ Another name for NX: the trade balance.

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 3

Variables that Influence Net Exports
▪ consumers’ preferences for foreign and domestic
goods
▪ prices of goods at home and abroad
▪ incomes of consumers at home and abroad
▪ the exchange rates at which foreign currency
trades for domestic currency
▪ transportation costs
▪ govt policies
CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 4
 Trade Surpluses & Deficits
NX measures the imbalance in a country’s trade in
goods and services.
• Trade deficit:
an excess of imports over exports
• Trade surplus:
an excess of exports over imports
• Balanced trade:
when exports = imports

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 5

 The Flow of Capital
▪ Net capital outflow (NCO):
domestic residents’ purchases of foreign assets
minus
foreigners’ purchases of domestic assets
▪ NCO is also called net foreign investment.

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 6

 The Flow of Capital
The flow of capital abroad takes two forms:
▪ Foreign direct investment:
Domestic residents actively manage the foreign
investment, e.g., McDonalds opens a fast-food
outlet in Moscow.
▪ Foreign portfolio investment:
Domestic residents purchase foreign stocks or
bonds, supplying “loanable funds” to a foreign
firm.

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 7

 The Flow of Capital
NCO measures the imbalance in a country’s trade
in assets:
• When NCO > 0, “capital outflow”
Domestic purchases of foreign assets exceed
foreign purchases of domestic assets.
• When NCO < 0, “capital inflow”
Foreign purchases of domestic assets exceed
domestic purchases of foreign assets.

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 8

 Variables that Influence NCO
▪ real interest rates paid on foreign assets
▪ real interest rates paid on domestic assets
▪ perceived risks of holding foreign assets
▪ govt policies affecting foreign ownership of
domestic assets

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 9

 The Equality of NX and NCO
▪ An accounting identity: NCO = NX
• arises because every transaction that affects
NX also affects NCO by the same amount
(and vice versa)
▪ When a foreigner purchases a good
from the U.S.,
• U.S. exports and NX increase
• the foreigner pays with currency or assets,
so the U.S. acquires some foreign assets,
causing NCO to rise.
CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 10
 The Equality of NX and NCO
▪ An accounting identity: NCO = NX
• arises because every transaction that affects
NX also affects NCO by the same amount
(and vice versa)
▪ When a U.S. citizen buys foreign goods,
• U.S. imports rise, NX falls
• the U.S. buyer pays with U.S. dollars or
assets, so the other country acquires
U.S. assets, causing U.S. NCO to fall.

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 11

 The Nominal Exchange Rate
▪ Nominal exchange rate: the rate at which
one country’s currency trades for another
▪ We express all exchange rates as foreign
currency per unit of domestic currency.

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 12

 Appreciation and Depreciation
▪ Appreciation (or “strengthening”):
an increase in the value of a currency
as measured by the amount of foreign currency
it can buy
▪ Depreciation (or “weakening”):
a decrease in the value of a currency
as measured by the amount of foreign currency
it can buy

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 13

 The Real Exchange Rate
▪ Real exchange rate: the rate at which the g&s
of one country trade for the g&s of another
exP
▪ Real exchange rate = P*
where
P = domestic price
P* = foreign price (in foreign currency)
e = nominal exchange rate, i.e., foreign
currency per unit of domestic currency

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 14

 The Law of One Price
▪ Law of one price: the notion that a good should
sell for the same price in all markets
• There is an opportunity for arbitrage,
making a quick profit by buying coffee in
Seattle and selling it in Boston.
• Such arbitrage drives up the price in Seattle
and drives down the price in Boston, until the
two prices are equal.

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 15

 Purchasing-Power Parity (PPP)
▪ Purchasing-power parity:
a theory of exchange rates whereby a unit of
any currency should be able to buy the same
quantity of goods in all countries
▪ based on the law of one price
▪ implies that nominal exchange rates adjust
to equalize the price of a basket of goods
across countries

CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 16

 Purchasing-Power Parity (PPP)
▪ Example: The “basket” contains a Big Mac.
P = price of US Big Mac (in dollars)
P* = price of Japanese Big Mac (in yen)
e = exchange rate, yen per dollar
▪ According to PPP, e x P = P*

price of US price of Japanese

Big Mac, in yen Big Mac, in yen

P*
▪ Solve for e: e =
P
CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 17
 PPP and Its Implications
▪ PPP implies that the nominal P*
exchange rate between two countries e =
P
should equal the ratio of price levels.
▪ If the two countries have different inflation rates,
then e will change over time:
• If inflation is higher in Mexico than in the U.S.,
then P* rises faster than P, so e rises –
the dollar appreciates against the peso.
• If inflation is higher in the U.S. than in Japan,
then P rises faster than P*, so e falls –
the dollar depreciates against the yen.
CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 18
 Limitations of PPP Theory
Two reasons why exchange rates do not always
adjust to equalize prices across countries:
▪ Many goods cannot easily be traded
• Examples: haircuts, going to the movies
• Price differences on such goods cannot be
arbitraged away
▪ Foreign, domestic goods not perfect substitutes
• E.g., some U.S. consumers prefer Toyotas over
Chevys, or vice versa
• Price differences reflect taste differences
CHAPTER 31 OPEN ECONOMY MACRO: BASIC CONCEPTS 19
25 Production and Growth

PRINCIPLES OF

FOURTH EDITION

N. G R E G O R Y M A N K I W

PowerPoint® Slides
by Ron Cronovich

© 2007 Thomson South-Western, all rights reserved

A typical family with all their possessions in the
U.K., an advanced economy

Real GDP per capita: $30,800

Life expectancy: 78 years
Adult literacy: 99%
A typical family with all their possessions in
Mexico, a middle income country

Real GDP per capita: $9,800

Life expectancy: 74 years
Adult literacy: 92%
A typical family with all their possessions in
Mali, a poor country

Real GDP per capita: $1,000

Life expectancy: 41 years
Adult literacy: 46%
 Incomes
and Growth
Around the
World

FACT 1:
There are
vast
differences
in living
standards
around the
world.
 Incomes
and Growth
Around the
World

FACT 2:
There is
also great
variation
in growth
rates across
countries.
 Productivity
▪ Recall one of the Ten Principles from
Chapter 1: A country’s standard of living
depends on its ability to produce g & s.
▪ This ability depends on productivity:
the average quantity of g&s produced
per unit of labor input.
▪ Y = real GDP = quantity of output produced
L = quantity of labor
so we can write productivity as
Y/L (output per worker)
CHAPTER 25 PRODUCTION AND GROWTH 6
 Why Productivity Is So Important
▪ When a nation’s workers are very productive,
real GDP is large and incomes are high.
▪ When productivity grows rapidly, so do living
standards.
▪ What, then, determines productivity and its
growth rate?

CHAPTER 25 PRODUCTION AND GROWTH 7

 Physical Capital Per Worker
▪ Recall: The stock of equipment and structures
used to produce g&s is called [physical] capital,
denoted K.
▪ K/L = capital per worker.
▪ Productivity is higher when the average worker
has more capital (machines, equipment, etc.).
▪ i.e.,
an increase in K/L causes an increase in Y/L.

CHAPTER 25 PRODUCTION AND GROWTH 8

 Human Capital Per Worker
▪ Human capital (H):
the knowledge and skills workers acquire
through education, training, and experience
▪ H/L = the average worker’s human capital
▪ Productivity is higher when the average worker
has more human capital (education, skills, etc.).
▪ i.e.,
an increase in H/L causes an increase in Y/L.

CHAPTER 25 PRODUCTION AND GROWTH 9

 Natural Resources Per Worker
▪ Natural resources (N): the inputs into production
that nature provides, e.g., land, mineral deposits
▪ Other things equal,
more N allows a country to produce more Y.
In per-worker terms,
an increase in N/L causes an increase in Y/L.
▪ Some countries are rich because they have
abundant natural resources
(e.g., Saudi Arabia has lots of oil)
▪ But countries need not have much N to be rich
(e.g., Japan imports the N it needs).
CHAPTER 25 PRODUCTION AND GROWTH 10
 Technological Knowledge
▪ Technological knowledge: society’s
understanding of the best ways to produce g&s
▪ Technological progress does not only mean
a faster computer, a higher-definition TV,
or a smaller cell phone.
▪ It means any advance in knowledge that boosts
productivity (allows society to get more output
from its resources).
• e.g., Henry Ford and the assembly line.

CHAPTER 25 PRODUCTION AND GROWTH 11

 The Production Function
▪ The production function is a graph or equation
showing the relation between output and inputs:
Y = A F(L, K, H, N)
F( ) – a function that shows how inputs are
combined to produce output
“A” – the level of technology
▪ “A” multiplies the function F( ),
so improvements in technology (increases in “A”)
allow more output (Y) to be produced from any
given combination of inputs.

CHAPTER 25 PRODUCTION AND GROWTH 12

 The Production Function
Y = A F(L, K, H, N)
▪ The production function has the property
constant returns to scale: Changing all inputs
by the same percentage causes output to change
by that percentage. For example,
▪ Doubling all inputs (multiplying each by 2)
causes output to double:
2Y = A F(2L, 2K, 2H, 2N)
▪ Increasing all inputs 10% (multiplying each by 1.1)
causes output to increase by 10%:
1.1Y = A F(1.1L, 1.1K, 1.1H, 1.1N)
CHAPTER 25 PRODUCTION AND GROWTH 13
 The Production Function
Y = A F(L, K, H, N)
▪ If we multiply each input by 1/L, then
output is multiplied by 1/L:
Y/L = A F(1, K/L, H/L, N/L)
▪ This equation shows that productivity
(output per worker) depends on:
• the level of technology (A)
• physical capital per worker
• human capital per worker
• natural resources per worker
CHAPTER 25 PRODUCTION AND GROWTH 14
ECONOMIC GROWTH AND PUBLIC POLICY

Next, we look at the ways

public policy can affect
long-run growth in productivity
and living standards.

CHAPTER 25 PRODUCTION AND GROWTH 15

 Saving and Investment
▪ We can boost productivity by increasing K,
which requires investment.
▪ Since resources scarce, producing more capital
requires producing fewer consumption goods.
▪ Reducing consumption = increasing saving.
This extra saving funds the production of
investment goods. (More details in the next chapter.)
▪ Hence, a tradeoff between
current and future consumption.

CHAPTER 25 PRODUCTION AND GROWTH 16

Diminishing Returns and the Catch-Up Effect
▪ The govt can implement policies that raise
saving and investment. (Details in next chapter.)
Then K will rise, causing productivity and living
standards to rise.
▪ But this faster growth is temporary,
due to diminishing returns to capital:
As K rises, the extra output from an additional
unit of K falls….

CHAPTER 25 PRODUCTION AND GROWTH 17

The Production Function & Diminishing Returns

Y/L
If workers
Output per
have little K,
worker
giving them more
(productivity)
increases their
productivity a lot.

If workers already
have a lot of K,
giving them more
increases
K/L
productivity
fairly little.
Capital per worker
CHAPTER 25 PRODUCTION AND GROWTH 18
The catch-up
the effect:
property whereby poor countries tend
to grow more rapidly than rich ones
Y/L

Rich country’s
growth

Poor country’s
growth

K/L
Poor country
starts here Rich country starts here
CHAPTER 25 PRODUCTION AND GROWTH 19
 Investment from Abroad
▪ To raise K/L and hence productivity, wages, and
living standards, the govt can also encourage
• Foreign direct investment:
a capital investment (e.g., factory) that is
owned & operated by a foreign entity.
• Foreign portfolio investment:
a capital investment financed with foreign
money but operated by domestic residents.
▪ Some of the returns from these investments
flow back to the foreign countries that supplied
the funds.
CHAPTER 25 PRODUCTION AND GROWTH 20
 Education
▪ Govt can increase productivity by promoting
education–investment in human capital (H).
• public schools, subsidized loans for college
▪ Education has significant effects: In the U.S., each
year of schooling raises a worker’s wage by 10%.
▪ But investing in H also involves a tradeoff
between the present & future:
Spending a year in school requires
sacrificing a year’s wages now
to have higher wages later.
CHAPTER 25 PRODUCTION AND GROWTH 21
 Health and Nutrition
▪ Health care expenditure is a type of investment in
human capital – healthier workers are more
productive.
▪ In countries with significant malnourishment, raising
workers’ caloric intake raises productivity:
• Over 1962-95, caloric consumption rose 44% in
S. Korea, and economic growth was spectacular.
• Nobel winner Robert Fogel:
30% of Great Britain’s growth from 1790-1980
was due to improved nutrition.
CHAPTER 25 PRODUCTION AND GROWTH 22
 Property Rights and Political Stability
▪ Recall: Markets are usually a good
way to organize economic activity.
The price system allocates resources
to their most efficient uses.
▪ This requires respect for property rights,
the ability of people to exercise authority
over the resources they own.

CHAPTER 25 PRODUCTION AND GROWTH 23

 Free Trade
▪ Inward-oriented policies
(e.g., tariffs, limits on investment from abroad)
aim to raise living standards by avoiding
interaction with other countries.
▪ Outward-oriented policies (e.g., the elimination
of restrictions on trade or foreign investment)
promote integration with the world economy.

CHAPTER 25 PRODUCTION AND GROWTH 24

 Research and Development
▪ Technological progress is the main reason why
living standards rise over the long run.
▪ One reason is that knowledge is a public good:
Ideas can be shared freely, increasing the
productivity of many.
▪ Policies to promote tech. progress:
• patent laws
• tax incentives or direct support for
private sector R&D
• grants for basic research at universities
CHAPTER 25 PRODUCTION AND GROWTH 25
 Population Growth
…may affect living standards in 3 different ways:
1. Stretching natural resources
2. Diluting the capital stock
3. Promoting tech. progress

CHAPTER 25 PRODUCTION AND GROWTH 26

 Population Growth
▪ more population = higher L = lower K/L
= lower productivity & living standards.
▪ This applies to H as well as K:
fast pop. growth = more children
= greater strain on educational system.
▪ Countries with fast pop. growth tend to have lower
educational attainment.

CHAPTER 25 PRODUCTION AND GROWTH 27

 Population Growth
2. Diluting the capital stock
To combat this, many developing countries use
policy to control population growth.

• China’s one child per family laws

• contraception education & availability
• promote female literacy to raise opportunity cost
of having babies

CHAPTER 25 PRODUCTION AND GROWTH 28

 Population Growth
3.
▪ More people
= more scientists, inventors, engineers
= more frequent discoveries
= faster tech. progress & economic growth
▪ Evidence from Michael Kremer:
Over the course of human history,
• growth rates increased as the world’s
population increased
• more populated regions grew faster than
less populated ones 29
CHAPTER 25 PRODUCTION AND GROWTH