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

The Economic Problem Unlimited Wants Scarce Resources – Land, Labour, Capital Resource Use Choices Discussion can take place here about the key elements of the economic problem – the unlimited wants of humans against the scarce resources that exist to meet those wants. The notion of supply and demand can be introduced here and students can be involved by making a list of all the things they would like to buy if they had unlimited amounts of money! If then asked to trim that list down to meet a budget the more outrageous items disappear. This then introduces the notion of having to make choices – this issue can be discussed further using examples drawn from students own experiences about the choices they have had to make – possibly involving the choice of subjects they have had to make at college or school in relation to the time available, etc! How we use our scarce resources can also be linked into this discussion. The wind turbines highlight an issue raised in the In the News section (http://www.bized.ac.uk/cgi- bin/chron/chron.pl?id=1928) about the intention to build wind farms in areas of the UK and the controversies that it creates – useful to link theory and practice at an early stage.

The Economic Problem What goods and services should an economy produce? – should the emphasis be on agriculture, manufacturing or services, should it be on sport and leisure or housing? How should goods and services be produced? – labour intensive, land intensive, capital intensive? Efficiency? Who should get the goods and services produced? – even distribution? more for the rich? for those who work hard? This is the traditional three key questions any economic system has to answer. Many students would have difficulty defining what an ‘economy’ actually is! It is useful at this stage to clear this up – a system for the production and exchange of goods and services to satisfy the wants and needs of the population. This is open ended enough to be able to incorporate all manner of economic systems from a barter system that still exists in remote parts of the world to sophisticated economic systems such as the UK and US! The questions and the examples raised can be used for discussion – get the students to express their views at this stage and be as controversial as possible to stimulate discussion and involvement!

Opportunity Cost Definition – the cost expressed in terms of the next best alternative sacrificed Helps us view the true cost of decision making Implies valuing different choices This is a key concept and one that often causes problems and misunderstanding but is central to students thinking like an economist. The crucial thing to knock out of students is their thinking that everything costs ‘money’. Because we have to make choices there are issues surrounding value judgements about what is important and what is not – it should not be difficult to stimulate discussion about what issues of government spending are important and what are not!

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

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

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

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

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

Production Possibility Frontiers Show the different combinations of goods and services that can be produced with a given amount of resources No ‘ideal’ point on the curve Any point inside the curve – suggests resources are not being utilised efficiently Any point outside the curve – not attainable with the current level of resources Useful to demonstrate economic growth and opportunity cost This slide introduces the key features about PPFs. The activity that accompanies this presentation seeks to apply PPFs in a slightly different way – focussing on using health resources. Going through the theory at this stage and then following it up with the activity will be useful in developing early understanding of the issues.

Production Possibility Frontiers Assume a country can produce two types of goods with its resources – capital goods and consumer goods If it devotes all resources to capital goods it could produce a maximum of Ym. If it devotes all its resources to consumer goods it could produce a maximum of Xm If the country is at point A on the PPF It can produce the combination of Yo capital goods and Xo consumer goods Ym A Yo If it reallocates its resources (moving round the PPF from A to B) it can produce more consumer goods but only at the expense of fewer capital goods. The opportunity cost of producing an extra Xo – X1 consumer goods is Yo – Y1 capital goods. Capital Goods These slides introduce the diagrams and then have animation to show how points on the PPF relate to different resource use and allocation. Moving from point A to point B involves sacrificing some capital goods to gain more consumer goods and thus demonstrates the opportunity cost involved. Students doing history can be reminded about the resource allocation decisions taken by Stalin during the 1930s and the subsequent decisions by successive Soviet premiers since the war about what resources are important for a nation like the USSR! (you might of course have to explain a little bit about what the USSR was!)‏ B Y1 Xo X1 Xm Consumer Goods

Production Possibility Frontiers Production inside the PPF – e.g. point B means the country is not using all its resources C Y1 A .B Yo It can only produce at points outside the PPF if it finds a way of expanding its resources or improves the productivity of those resources it already has. This will push the PPF further outwards. The next slide allows the lecturer to demonstrate what happens when resources are not used efficiently and production takes place within the PPF. It then allows the expansion of the PPF and can be used to illustrate the issue of economic growth and where opportunity cost does not exist if the economy moves from point A to point C (in a simple context of course – there is always some form of sacrifice of using resources!). Capital Goods Xo X1 Consumer Goods

Positive and Normative Economics Health care can be improved with more tax funding Pollution control is effective through a system of fines Society ought to provide homes for all Any strategy aimed at reducing factory closures in deprived areas would be helpful Positive Statements: Capable of being verified or refuted by resorting to fact or further investigation Normative Statements: Contains a value judgement which cannot be verified by resort to investigation or research The final slide introduces positive and normative statements. Definitions are given on the right hand side and then successive statements appear on the left – each of these can be used as a basis of discussion as to whether they are positive or normative statements and why!

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

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

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

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

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

Exercise – Productivity Advantage for Paula and Beth Time to update a web page Time to repair a bi-cycle Paula 20 Minutes 10 Minutes Beth 30 Minutes Total Working hours per day: 6 Draw “Web-Page vs Bike Repair” PPF for Paula and Beth Who is more Productive? What should Paula do as a business? What should Beth do as a business? QUESTIONS

web pages a day Bike repairs a day Paula 60/20 x 6 = 18 60/10 x 6 = 36 Beth 60/30 x 6 = 12

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

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

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

Production Possibility Schedule Paula Beth BR/day WP/Day 36 12 32 2 10.64 1.33 28 4 9.31 2.66 24 6 7.98 3.99 20 8 6.65 5.32 16 10 14 18

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Home Assignment Due on Monday 21 Apr 08 Beer/hr Pizza/hr Harry 1 bottle 0.2 Larry 0.5 bottle 1.5 Now suppose their preferences are as follows: Harry wants 2 beers and as much pizza as he can eat each day; Larry wants 2 pizzas and as much beer as he can consume each day. Question No 3 D. If each man is self reliant, how much pizza and beer will Harry and Larry eat and drink, each day? E. Suppose the two men decide to trade with each other. Draw their joint PPC, and give an example of a trade that will make each of them better off.