Economics for managers

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 Microeconomics is the study of how households and firms
make decisions and how these decision makers interact in the
marketplace. In microeconomics, a person chooses to
maximize his or her utility subject to his or her budget constraint.

Macroeconomic events arise from the interaction of many

people trying to maximize their own welfare. Therefore, when
we study macroeconomics, we must consider its
microeconomic foundations.
 Markets and Prices
–A market is any arrangement that enables buyers and
sellers to get information and do business with each
other.
–A competitive market is a market that has many buyers
and many sellers so no single buyer or seller can
influence the price.
–The money price of a good is the amount of money
needed to buy it.
–The relative price of a good—the ratio of its money
price to the money price of the next best alternative
good—is its opportunity cost.
 Demand
–If you demand something, then you
–1. Want it,
–2. Can afford it, and
–3. Have made a definite plan to buy it.
–Wants are the unlimited desires or wishes
people have for goods and services. Demand
reflects a decision about which wants to satisfy.
–The quantity demanded of a good or service is
the amount that consumers plan to buy during a
particular time period, and at a particular price.
 Demand
•The Law of Demand
–The law of demand states:
–Other things remaining the same, the higher the price
of a good, the smaller is the quantity demanded; and …
–the lower the price of a good, the larger is the quantity
demanded.
–Why does a change in the price change the quantity
demanded? Two reasons:
 Substitution effect
 Income effect
 Demand
–Substitution Effect
–When the relative price (opportunity cost) of a good or
service rises, people seek substitutes for it, so the quantity
demanded of the good or service decreases.

–Income Effect
–When the price of a good or service rises relative to
income, people cannot afford all the things they previously
bought, so the quantity demanded of the good or service
decreases.
 Demand
–Figure 3.1 shows a demand curve for energy bars.
 Demand
A rise in the price, other things remaining
the same, brings a decrease in the quantity
demanded and a movement up along the
demand curve.

A fall in the price, other things remaining

the same, brings an increase in the quantity
demanded and a movement down along
the demand curve.
 Demand
•A Change in Demand
–When some influence on buying plans other than the
price of the good changes, there is a change in demand for
that good.
–The quantity of the good that people plan to buy changes
at each and every price, so there is a new demand curve.
–When demand increases, the demand curve shifts
rightward.
–When demand decreases, the demand curve shifts
leftward.
 Demand
–Six main factors that change demand are
 The prices of related goods
 Expected future prices
 Income
 Expected future income and credit
 Population
 Preferences
 Demand
–Prices of Related Goods
–A substitute is a good that can be used in place
of another good.
–A complement is a good that is used in
conjunction with another good.
–When the price of a substitute for an energy bar
rises or when the price of a complement of an
energy bar falls, the demand for energy bars
increases.
 Demand
–Expected Future Prices
–If the price of a good is expected to rise in the
future, current demand for the good increases and
the demand curve shifts rightward.
–Income
–When income increases, consumers buy more of
most goods and the demand curve shifts rightward.
–A normal good is one for which demand increases
as income increases.
–An inferior good is a good for which demand
decreases as income increases.
 Demand
–Expected Future Income and Credit
–When income is expected to increase in the
future or when credit is easy to obtain, the
demand might increase now.
–Population
–The larger the population, the greater is the
demand for all goods.
–Preferences
–People with the same income have different
demands if they have different preferences.
 Demand
–Figure 3.2 shows an increase in demand.
–Because an energy bar is a normal good, an increase
in income increases the demand for energy bars.
 Demand
–A Movement along
the Demand Curve
–When the price of
the good changes
and other things
remain the same, the
quantity demanded
changes and there is
a movement along
the demand curve.
 Demand

–A Shift of the Demand

Curve
–If the price remains the
same but one of the
other influences on
buyers’ plans changes,
demand changes and the
demand curve shifts.
 Supply
–If a firm supplies a good or service, then the firm
–1. Has the resources and the technology to produce it,
–2. Can profit from producing it, and
–3. Has made a definite plan to produce and sell it.
–Resources and technology determine what it is
possible to produce. Supply reflects a decision about
which technologically feasible items to produce.
–The quantity supplied of a good or service is the
amount that producers plan to sell during a given time
period at a particular price.
 Supply
•The Law of Supply
–The law of supply states:
–Other things remaining the same, the higher the
price of a good, the greater is the quantity supplied;
and
–the lower the price of a good, the smaller is the
quantity supplied.
–The law of supply results from the general
tendency for the marginal cost of producing a good
or service to increase as the quantity produced
increases
 Supply
•Supply Curve and Supply Schedule
–The term supply refers to the entire relationship
between the quantity supplied and the price of a
good.
–The supply curve shows the relationship
between the quantity supplied of a good and its
price when all other influences on producers’
planned sales remain the same.
 Supply
–Figure 3.4 shows a supply curve of energy bars.

A rise in the price, other

things remaining the same,
brings an increase in the
quantity supplied.
 Supply
•A Change in Supply
–When some influence on selling plans other than
the price of the good changes, there is a change in
supply of that good.
–The quantity of the good that producers plan to sell
changes at each and every price, so there is a new
supply curve.
–When supply increases, the supply curve shifts
rightward.
–When supply decreases, the supply curve shifts
leftward.
 Supply
•The six main factors that change supply of a
good are:
 The prices of factors of production
 The prices of related goods produced
 Expected future prices
 The number of suppliers
 Technology
 State of nature
 Supply
–Prices of Factors of Production
–If the price of a factor of production used to
produce a good rises, the minimum price that a
supplier is willing to accept for producing each
quantity of that good rises.
–So a rise in the price of a factor of production
decreases supply and shifts the supply curve
leftward.
 Supply
–Prices of Related Goods Produced
–A substitute in production for a good is another
good that can be produced using the same
resources.
–The supply of a good increases if the price of a
substitute in production falls.
–Goods are complements in production if they must
be produced together.
–The supply of a good increases if the price of a
complement in production rises.
 Supply
–Expected Future Prices
–If the price of a good is expected to rise in the
future, supply of the good today decreases and
the supply curve shifts leftward.
–The Number of Suppliers
–The larger the number of suppliers of a good, the
greater is the supply of the good. An increase in
the number of suppliers shifts the supply curve
rightward.
 Supply
–Technology
–Advances in technology create new products and
lower the cost of producing existing products.
–So advances in technology increase supply and
shift the supply curve rightward.
–The State of Nature
–The state of nature includes all the natural forces
that influence production—for example, the
weather.
–A natural disaster decreases supply and shifts the
supply curve leftward.
 Supply
–Figure 3.5 shows an increase in supply.
–An advance in the technology increases the supply
of energy bars and shifts the supply curve rightward.
 Supply
•A Change in the Quantity Supplied Versus a
Change in Supply
• Figure 3.6 illustrates the distinction between a
change in supply and a change in the quantity
supplied.
 Supply
–A Movement Along the
Supply Curve
–When the price of the
good changes and other
influences on sellers’ plans
remain the same, the
quantity supplied changes
and there is a movement
along the supply curve.
 Supply

–A Shift of the
Supply Curve
–If the price remains
the same but some
other influence on
sellers’ plans
changes, supply
changes and the
supply curve shifts.
 Market Equilibrium
–Equilibrium is a situation in which opposing forces
balance each other. Equilibrium in a market occurs
when the price balances the plans of buyers and
sellers.
–The equilibrium price is the price at which the
quantity demanded equals the quantity supplied.
–The equilibrium quantity is the quantity bought
and sold at the equilibrium price.
 Price regulates buying and selling plans.
 Price adjusts when plans don’t match.
 Market Equilibrium
–Figure 3.7 illustrates the market equilibrium—the price at
which quantity demanded equals quantity supplied.

13
15
 Market Equilibrium
•Price as a Regulator

–There is a surplus of 6 million energy bars.

13
15

If the price is $2.00 a bar, the

quantity supplied exceeds the
quantity demanded.
A surplus of 6 million bars.
 Market Equilibrium
–There is a surplus of 6 million energy bars.

13
15

If the price is $1.00 a bar, the

quantity demanded exceeds the
quantity supplied.
A shortage of 9 million bars.
 Market Equilibrium
–There is a surplus of 6 million energy bars.

13
15

If the price is $1.50 a bar, the

quantity supplied equals the
quantity demanded.
No shortage or surplus of bars.
 Market Equilibrium
•Price Adjustments
–At prices above the
equilibrium price, a surplus
forces the price down.
–At prices below the
equilibrium price, a
shortage forces the price
up.
–At the equilibrium price,
buyers’ plans and sellers’
plans agree and the price
doesn’t change until some
event changes either
demand or supply.
 Predicting Changes in Price and
Quantity
•An Increase in Demand
–Figure 3.8 shows that
when demand increases
the demand curve shifts
rightward.
–At the original price,
there is now a shortage.
The price rises, and the
quantity supplied increases
along the supply curve.
 Predicting Changes in Price and
Quantity
•An Increase in Supply
–Figure 3.9 shows that
when supply increases
the supply curve shifts
rightward.
–At the original price,
there is now a surplus.
The price falls, and the
quantity demanded increases
along the demand curve.
 Predicting Changes in Price and
Quantity
•All Possible Changes
in Demand and Supply
–A change in
demand or supply or
both demand and
supply changes the
equilibrium price and
the equilibrium
quantity.
 Predicting Changes in Price and
Quantity
When demand decreases,
the equilibrium price falls
and the equilibrium quantity
decreases.
 Predicting Changes in Price and
Quantity
When supply decreases, the
equilibrium price rises and
the equilibrium quantity
decreases.
 Predicting Changes in Price and
Quantity
Increase in Both Demand and
Supply

An increase in demand and an

increase in supply increase the
equilibrium quantity.

The change in equilibrium price

is uncertain because the
increase in demand raises the
equilibrium price and the
increase in supply lowers it.
 Predicting Changes in Price and
Quantity
Decrease in Both Demand and
Supply

A decrease in both demand and

supply decreases the
equilibrium quantity.

The change in equilibrium price

is uncertain because the
decrease in demand lowers the
equilibrium price and the
decrease in supply raises it.
 Predicting Changes in Price and
Quantity
Decrease in Demand and
Increase in Supply

A decrease in demand and an

increase in supply lowers the
equilibrium price.

The change in equilibrium

quantity is uncertain because
the decrease in demand
decreases the equilibrium
quantity and the increase in
supply increases it.
 Predicting Changes in Price and
Quantity
Increase in Demand and
Decrease in Supply

An increase in demand and a

decrease in supply raises the
equilibrium price.

The change in equilibrium

quantity is uncertain because the
increase in demand increases the
equilibrium quantity and the
decrease in supply decreases it.
ELASTICITY
In December 2011, taxi fares in Singapore rose by 20
percent and customer numbers fell by 30 percent.

But by April 2012, customers returned and cabbies’

earnings were up.

To answer these and similar questions, we use the neat

tool that you study in this chapter:

Elasticity
 Price Elasticity of Demand
•You know that when supply decreases, the equilibrium
price rises and the equilibrium quantity decreases.
•But does the price rise by a large amount and the
quantity decrease by a little?
•Or does the price barely rise and the quantity
decrease by a large amount?
•The answer depends on the responsiveness of the
quantity demanded of a good to a change in its price.
 Price Elasticity of Demand
–The price elasticity of demand is a units-free
measure of the responsiveness of the quantity
demanded of a good to a change in its price when
all other influences on buying plans remain the
same.
–Calculating Price Elasticity of Demand
–The price elasticity of demand is calculated by
  using the formula:
 Price Elasticity of Demand
–To calculate the price elasticity of demand:
–We express the change in price as a percentage
of the average price—the average of the initial
and new price, …
–and we express the change in the quantity
demanded as a percentage of the average
quantity demanded—the average of the initial and
new quantity.
 Price Elasticity of Demand
–A Units-Free Measure
–Elasticity is a ratio of percentages, so a change in
the units of measurement of price or quantity
leaves the elasticity value the same.
–Minus Sign and Elasticity
–The formula yields a negative value, because
price and quantity move in opposite directions.
–But it is the magnitude, or absolute value, that
reveals how responsive the quantity change has
been to a price change.
 Price Elasticity of Demand
•Inelastic and Elastic Demand
–Demand can be inelastic, unit elastic, or elastic,
and can range from zero to infinity.
–If the quantity demanded doesn’t change when
the price changes, the price elasticity of demand is
zero and the good has a perfectly inelastic
demand.
 Price Elasticity of Demand
–If the percentage change in the quantity
demanded is smaller than the percentage change
in price,
 the price elasticity of demand is less than 1 and
the good has inelastic demand.
–If the percentage change in the quantity
demanded is greater than the percentage change
in price,
 the price elasticity of demand is greater than 1 and
the good has elastic demand.
 Price Elasticity of Demand
•The Factors That Influence the Elasticity of
Demand
– The elasticity of demand for a good depends on:
 The closeness of substitutes
 The proportion of income spent on the good
 The time elapsed since a price change
 Price Elasticity of Demand
–Closeness of Substitutes
–The closer the substitutes for a good or service,
the more elastic is the demand for the good or
service.
–Necessities, such as food or housing, generally
have inelastic demand.
–Luxuries, such as exotic vacations, generally have
elastic demand.
 Price Elasticity of Demand
–Proportion of Income Spent on the Good
–The greater the proportion of income consumers
spend on a good, the larger is the elasticity of
demand for that good.
–Time Elapsed Since Price Change
–The more time consumers have to adjust to a
price change, or the longer that a good can be
stored without losing its value, the more elastic is
the demand for that good.
 Price Elasticity of Demand
•Total Revenue and Elasticity
–The total revenue from the sale of a good or
service equals the price of the good multiplied by
the quantity sold.
–When the price changes, total revenue also
changes.
–But a rise in price doesn’t always increase total
revenue.
 Price Elasticity of Demand
–The change in total revenue due to a change in
price depends on the elasticity of demand:
 If demand is elastic, a 1 percent price cut increases
the quantity sold by more than 1 percent, and
total revenue increases.
 If demand is inelastic, a 1 percent price cut
increases the quantity sold by less than 1
percent, and total revenues decreases.
 If demand is unit elastic, a 1 percent price cut
increases the quantity sold by 1 percent, and total
revenue remains unchanged.
 Price Elasticity of Demand
–The total revenue test is a method of estimating the
price elasticity of demand by observing the change in
total revenue that results from a price change (when all
other influences on the quantity sold remain the same).
 If a price cut increases total revenue, demand is
elastic.
 If a price cut decreases total revenue, demand is
inelastic.
 If a price cut leaves total revenue unchanged,
demand is unit elastic.
 Elasticity of Supply
•You know that when the demand for a good increases, its
equilibrium price rises and the equilibrium quantity of the
good increases.
•But does the price rise by a large amount and the quantity
increase by a little?
•Or does the price barely rise and the quantity increase by
a large amount?
•The answer depends on the responsiveness of the
quantity supplied of a good to a change in its price.
•The answer depends on the elasticity of supply of the
good.
 Elasticity of Supply
–The elasticity of supply measures the
responsiveness of the quantity supplied to a
change in the price of a good, when all other
influences on selling plans remain the same.
–Calculating the Elasticity of Supply
–The elasticity of supply is calculated by using the
formula:
 
 Elasticity of Supply
–Figure 4.6 on the next slide shows three cases of
the elasticity of supply.
–Supply is perfectly inelastic if the supply curve is
vertical and the elasticity of supply is 0.
–Supply is unit elastic if the supply curve is linear
and passes through the origin. (Note that slope is
irrelevant.)
–Supply is perfectly elastic if the supply curve is
horizontal and the elasticity of supply is infinite.
 Elasticity of Supply
•The Factors That Influence the Elasticity of
Supply
–The elasticity of supply depends on
 Resource substitution possibilities
 Time frame for supply decision
–Resource Substitution Possibilities
–The easier it is to substitute among the resources
used to produce a good or service, the greater is
its elasticity of supply.
 Elasticity of Supply
–Time Frame for Supply Decision
–The more time that passes after a price change,
the greater is the elasticity of supply.
–Momentary supply is perfectly inelastic. The
quantity supplied immediately following a price
change is constant.
–Short-run supply is somewhat elastic.
–Long-run supply is the most elastic.
–Table 4.1 provides a glossary of all the elasticity
measures.
OUTPUT AND COSTS
Decision Time Frames

The firm makes many decisions to achieve its main

objective: profit maximization.
Some decisions are critical to the survival of the firm
Some decisions are irreversible (or very costly to reverse)
Other decisions are easily reversed and are less critical to
the survival of the firm, but still influence profit
All decisions can be placed in two time frames:
 The short run
 The long run
Decision Time Frames

The Short Run

The short run is a time frame in which the quantity of one
or more resources used in production is fixed.
For most firms, the capital, called the firm’s plant, is fixed
in the short run.
Other resources used by the firm (such as labor, raw
materials, and energy) can be changed in the short run.
Short-run decisions are easily reversed.
Decision Time Frames

The Long Run

The long run is a time frame in which the quantities of all
resources—including the plant size—can be varied.
Long-run decisions are not easily reversed.
A sunk cost is a cost incurred by the firm and cannot be
changed.
If a firm’s plant has no resale value, the amount paid for
it
is a sunk cost.
Short-Run Technology Constraint

To increase output in the short run, a firm must increase

the amount of labor employed.
Three concepts describe the relationship between output
and the quantity of labor employed:
 Total product
 Marginal product
 Average product
Short-Run Technology Constraint

Product Schedules
Total product is the total output produced in a given
period.
The marginal product of labor is the change in total
product that results from a one-unit increase in the
quantity of labor employed, with all other inputs remaining
the same.
The average product of labor is equal to total product
divided by the quantity of labor employed.
Short-Run Technology Constraint

Product Curves
Product curves are graphs of the three product concepts
that show how total product, marginal product, and
average product change as the quantity of labor employed
changes.
Short-Run Technology Constraint

The Total Product Curve

Figure shows a total
product curve.
The total product curve
shows how total product
changes with the quantity
of labor employed.
Short-Run Technology Constraint

The total product curve is

similar to the PPF.
It separates attainable
output levels from
unattainable output levels
in the short run.
Short-Run Technology Constraint

The Marginal Product

Curve
Figure shows the marginal
product of labor curve
and how the marginal
product curve relates to
the total product curve.
The first worker hired
produces 4 units of
output.
Short-Run Technology Constraint

The second worker hired

produces 6 units of output
and total product becomes
10 units.
The third worker hired
produces 3 units of output
and total product becomes
13 units.
And so on.
Short-Run Technology Constraint

The height of each bar

measures the
marginal product of
labor.
For example, when labor
increases from 2 to 3,
total product increases
from 10 to 13, so the
marginal product of the
third worker is 3 units of
output.
Short-Run Technology Constraint

To make a graph of the

marginal product of labor,
we can stack the bars in
the previous graph side by
side.

The marginal product of

labor curve passes
through the mid-points of
these bars.
Short-Run Technology Constraint

Almost all production

processes are like the
one shown here and
have:
 Initially increasing
marginal returns
 Eventually
diminishing
marginal returns
Short-Run Technology Constraint

Initially increasing
marginal returns
When the marginal product
of a worker exceeds the
marginal product of the
previous worker, the
marginal product of labor
increases and the firm
experiences increasing
marginal returns.
Short-Run Technology Constraint

Eventually diminishing
marginal returns
When the marginal product
of a worker is less than
the marginal product of
the previous worker, the
marginal product of labor
decreases and the firm
experiences diminishing
marginal returns.
Short-Run Technology Constraint

Increasing marginal returns arise from increased

specialization and division of labor.
Diminishing marginal returns arises from the fact that
employing additional units of labor means each worker has
less access to capital and less space in which to work.
Diminishing marginal returns are so pervasive that they are
elevated to the status of a “law.”
The law of diminishing returns states that as a firm uses
more of a variable input with a given quantity of fixed
inputs, the marginal product of the variable input eventually
diminishes.
Short-Run Cost

To produce more output in the short run, the firm must

employ more labor, which means that it must increase its
costs.
We describe the way a firm’s costs change as total
product changes by using three cost concepts and three
types of cost curve:
 Total cost
 Marginal cost
 Average cost
Short-Run Cost

Total Cost
A firm’s total cost (TC) is the cost of all resources used.
Total fixed cost (TFC) is the cost of the firm’s fixed
inputs. Fixed costs do not change with output.
Total variable cost (TVC) is the cost of the firm’s variable
inputs. Variable costs do change with output.
Total cost equals total fixed cost plus total variable cost.
That is:

TC = TFC + TVC
Short-Run Cost

Figure shows a firms total

cost curves.
Total fixed cost is the same
at each output level.
Total variable cost
increases as output
increases.
Total cost, which is the sum
of TFC and TVC also
increases as output
increases.
Short-Run Cost

The total variable cost

curve gets its shape from
the total product curve.
Notice that the TP curve
becomes steeper at low
output levels and then less
steep at high output
levels.
In contrast, the TVC curve
becomes less steep at
low output levels and
steeper at high output
levels.
Short-Run Cost

To see the relationship

between the TVC curve
and the TP curve, lets look
again at the TP curve.
But let us add a second x-
axis to measure total
variable cost.

1 worker costs $25; 2

workers cost $50: and so
on, so the two x-axes
line up.
Short-Run Cost

We can replace the

quantity of labor on the x-
axis with total variable
cost.
When we do that, we
must change the name of
the curve. It is now the
TVC curve.
But it is graphed with cost
on the x-axis and output
on the y-axis.
Short-Run Cost

Redraw the graph with

cost on the y-axis and
output on the x-axis, and
you’ve got the TVC curve
drawn the usual way.
Put the TFC curve back
in
the figure,
and add TFC to TVC, and
you’ve got the TC curve.
Short-Run Cost

Marginal Cost
Marginal cost (MC) is the increase in total cost that
results from a one-unit increase in total product.
Over the output range with increasing marginal
returns,
marginal cost falls as output increases.
Over the output range with diminishing marginal
returns,
marginal cost rises as output increases.
Short-Run Cost

Average Cost
Average cost measures can be derived from each of the
total cost measures:
Average fixed cost (AFC) is total fixed cost per unit of
output.
Average variable cost (AVC) is total variable cost per
unit
of output.
Average total cost (ATC) is total cost per unit of output.

ATC = AFC + AVC.

 The Firm
Firm is an organization that controls the
transformation of inputs (resources it owns or
purchases) into outputs (valued products that it sells)
and earns the difference between what it receives in
revenue, and what it spends on inputs.

We typically assume that a firm exists in order to make

money
A firm that wants to make money is called a
for-profit firm, or a profit maximizing firm
 The Firm
• To analyze decision making at the firm, let’s start
with a very basic question
– What is the firm trying to maximize?

• A firm’s owners will usually want the firm to earn as

much profit as possible
• We will view the firm as a single economic decision
maker whose goal is to maximize its owners’ profit
 Total Revenue &Total Cost
• The total inflow of receipts from selling a
given amount of output
• Each time the firm chooses a level of output, it
also determines its total revenue
– Why?
• Because once we know the level of output, we also
know the highest price the firm can charge
• Total revenue—which is the number of units
of output times the price per unit—follows
automatically
 Total Revenue &Total Cost
• Every firm struggles to reduce costs, but there is a
limit to how low costs can go
– These limits impose a constraint on the firm
• The firm uses its production function, and the prices
it must pay for its inputs, to determine the least cost
method of producing any given output level
• For any level of output the firm might want to
produce
– It must pay the cost of the “least cost method” of
production
Total revenue and cost approach
 Total Revenue and Cost graph
Dollars
$3,500
TC
3,000 Profit at 7
Units
2,500 Profit at 5
Units
2,000 Profit at 3 TR
1,500 Units

1,000
DTR from producing 2nd unit
500
DTR from producing 1st unit
Total Fixed
Cost 0 1 2 3 4 5 6 7 8 9 10
Output
116
 Marginal Revenue
• Marginal revenue
– Change in total revenue from
producing one more unit of output
• MR = ΔTR / ΔQ
• Tells us how much revenue rises per
unit increase in output
 Using MR and MC to Maximize Profits
• Marginal revenue and marginal cost can be used to
find the profit-maximizing output level
– Logic behind MC and MR approach
• An increase in output will always raise profit as long as marginal
revenue is greater than marginal cost (MR > MC)
– Converse of this statement is also true
• An increase in output will lower profit whenever marginal revenue
is less than marginal cost (MR < MC)
– Guideline firm should use to find its profit-maximizing level
of output
• Firm should increase output whenever MR > MC, and decrease
output when MR < MC

Lieberman & Hall; Introduction

118
to Economics, 2005
 MR = MC
• If MR = MC, however, the firm has no
incentive to produce either more or less
output.
• The firm's profits are maximized at the level of
output at which MR = MC.
Marginal Revenue and cost Graph
Dollars

600
MC
500
400
300
200
100
0
1 2 3 4 5 6 7 8 Output
–100
–200 profit rises profit falls
MR
120
 Microeconomics is the study of how households and firms
make decisions and how these decision makers interact in the
marketplace. In microeconomics, a person chooses to
maximize his or her utility subject to his or her budget constraint.

Macroeconomic events arise from the interaction of many

people trying to maximize their own welfare. Therefore, when
we study macroeconomics, we must consider its
microeconomic foundations.
The macro economy includes all buying and
selling, all production and consumption;
everything that goes on in every market in
the economy.

Macroeconomics involves adding up the

economic activity of all households and all
businesses in all markets, together overall
demand and supply in the economy.
What is Government?
• The entity that has a monopoly over
the legitimate use of force to modify
the actions of adults.

An institutional process through which
individuals collectively make choices
and carry out activities.
 Protective Function of Government:

The most fundamental function of

government is the protection of
individuals and their property against
acts of aggression.

Involves the provision of a limited

set of goods that are difficult to supply
through the market.
 Why the Invisible Hand May Fail:
(3) Public Goods
Goods that are :
 jointly consumed
Individuals can simultaneously enjoy
consumption of same product or service
 non-excludable
Consumption of the good cannot be restricted
to the customers who pay for it
Characteristics of a Public Good:

If a public good is made available to one
person, it is simultaneously made available to
others.
 Because those who do not pay cannot be
excluded, no one has much incentive to help
pay for such goods. Each has an incentive to
become a free rider
 a person who receives the benefits of the good
without helping to pay for its cost.
 But, when a lot of people become free riders,
too little is produced.
Characteristics of a Public Good:

It is the characteristics of the good, not the
sector in which it is produced, that distinguishes
a public good.

Examples of public goods:
 national defense
 radio and television broadcast signals
 clean air.
 Markets often develop ways of providing public
goods (e.g. use of advertising to support provision
of radio and television). Nonetheless, public
goods often cause a breakdown in the harmony
between self-interest and the public interest.
•Will the. economy expand more rapidly next year or
will it sink back into another recession?
•To assess the state of the economy and to make big
decisions about business expansion, firms use forecasts
of GDP.
•What exactly is GDP?
•How do we use GDP to tell us how rapidly our economy
is expanding or whether our economy is in a recession?
•How do we take the effects of inflation out of GDP to
reveal the growth rate of our economic well-being?
•And how do we compare economic well-being across
countries?
 Gross Domestic Product
•GDP Defined
–GDP or gross domestic product is the market
value of all final goods and services produced in a
country in a given time period.
–This definition has four parts:
 Market value
 Final goods and services
 Produced within a country
 In a given time period
 Gross Domestic Product
–Market Value
–GDP is a market value—goods and services are
valued at their market prices.
–To add apples and oranges, computers and
popcorn, we add the market values so we have a
total value of output in dollars.
 Gross Domestic Product
–Final Goods and Services
–GDP is the value of the final goods and services
produced.
–A final good (or service) is an item bought by its final
user during a specified time period.
–A final good contrasts with an intermediate good,
which is an item that is produced by one firm, bought
by another firm, and used as a component of a final
good or service.
–Excluding the value of intermediate goods and services
avoids counting the same value more than once.
 Gross Domestic Product
–Produced Within a Country
–GDP measures production within a country—
domestic production.
–In a Given Time Period
–GDP measures production during a specific time
period, normally a year or a quarter of a year.
 Gross Domestic Product
•GDP and the Circular Flow of Expenditure and
Income
–GDP measures the value of production, which also
equals total expenditure on final goods and total
income.
–The equality of income and value of production shows
the link between productivity and living standards.
–The circular flow diagram in Figure 21.1 illustrates the
equality of income and expenditure.
 Gross Domestic Product
–The circular flow diagram shows the transactions among
households, firms, governments, and the rest of the world.
 Gross Domestic Product
–Households and Firms
–Households sell and firms buy the services of labor,
capital, and land in factor markets.
–For these factor services, firms pay income to
households: wages for labor services, interest for the
use of capital, and rent for the use of land. A fourth
factor of production, entrepreneurship, receives
profit.
–In the figure, the blue flow, Y, shows total income
paid by firms to households.
Gross Domestic Product
 Gross Domestic Product
–Firms sell and households buy consumer goods
and services in the goods market.
–Consumption expenditure is the total payment for
consumer goods and services, shown by the red
flow labeled C .
–Firms buy and sell new capital equipment in the
goods market and put unsold output into inventory.
–The purchase of new plant, equipment, and
buildings and the additions to inventories are
investment, shown by the red flow labeled I.
Gross Domestic Product
 Gross Domestic Product
–Governments
–Governments buy goods and services from firms and
their expenditure on goods and services is called
government expenditure.
–Government expenditure is shown as the red flow G.
–Governments finance their expenditure with taxes
and pay financial transfers to households, such as
unemployment benefits, and pay subsidies to firms.
–These financial transfers are not part of the circular
flow of expenditure and income.
Gross Domestic Product
 Gross Domestic Product
–Rest of the World
–Firms in the United States sell goods and services to
the rest of the world—exports—and buy goods and
services from the rest of the world—imports.
–The value of exports (X ) minus the value of imports
(M) is called net exports, the red flow (X – M).
–If net exports are positive, the net flow of goods and
services is from U.S. firms to the rest of the world.
–If net exports are negative, the net flow of goods and
services is from the rest of the world to U.S. firms.
Gross Domestic Product
 Gross Domestic Product
–The blue and red flows are the circular flow of expenditure and
income.
 Gross Domestic Product
–The sum of the red flows equals the blue flow.
 Gross Domestic Product
–That is: Y = C + I + G + X – M
 Gross Domestic Product
–The circular flow shows two ways of measuring GDP.
–GDP Equals Expenditure Equals Income
–Total expenditure on final goods and services equals
GDP.
– GDP = C + I + G + X – M.
–Aggregate income equals the total amount paid for
the use of factors of production: wages, interest, rent,
and profit.
–Firms pay out all their receipts from the sale of final
goods, so income equals expenditure,
– Y = C + I + G + (X – M).
 Measuring U.S. GDP
•The Expenditure Approach
–The expenditure approach measures GDP as the sum
of consumption expenditure, investment, government
expenditure on goods and services, and net exports.
–GDP = C + I + G + (X  M)
–Table 21.1 on the next slide shows the expenditure
approach with data (in billions) for 2012.
– GDP = $11,007 + $2,032 + $3,055  $616
– = $15,478 billion