Managerial Economics (Macro) Dr. Timothy Simin 2011

Helicopter Tour What Microeconomics? Microeconomics covers: –Price determination via quantities supplied and demanded  Laws of demand –Opportunity costs and sunk costs –Theory of the firm  Monopolies, Oligopolies, and perfect competition  Cost benefit analysis/profit maximization –Theory of the consumer  Utility functions, budget constraints, utility maximization –Specialization, efficiency, comparative advantage –Examples 2

Helicopter Tour What is Macroeconomics? Macroeconomics covers: –Fiscal policy  and –Monetary policy –National Income Accounting  GNP, GDP –Interest rate determination –Exchange rate determination –Business Cycles –Inflation 3

Financial Intermediaries What are they? 4

Financial Markets Some puzzles 1.Why are banks and other financial intermediaries the primary sources of external financing for business, rather than stocks and bonds? 2.Why is the financial system among the most heavily regulated sectors of the economy? 3.Why do only large and well-established firms have access to the securities markets? 4.Why is collateral a prevalent feature of debt contracts? 5

Financial Intermediaries Why do we need them? 1.Information costs –Adverse selection –Moral hazard 2.Transaction costs –Explicit Financial –Implicit 6

Asymmetric Information Adverse selection 1.Asymmetric information problem occurs before the transaction –Securities markets –Banks –Question: Will the asymmetric information problem be more or less of a problem as interest rates rise? 2.Dealing with adverse selection –Private production and sale of information –Government regulation –Intermediation –Collateral 7

Asymmetric Information Moral hazard 1.Asymmetric information problem occurs after the transaction –Debt markets –Equity markets  principle-agent problem 2.Dealing with moral hazard –Intermediation –Debt contracts 8

Trading Costs Another surplus story 1.Start with a perfect financial market –I is the amount of borrowing for investment –S is the amount of savings –r pm and q pm are the perfect market interest rate and level of investment 2.What happens to total surplus? 9

Trading Costs Another surplus story 10 Quantities of Investment and Saving Interest rate S pm I pm r pm q pm Investors Surplus Savers Surplus r s,nb r i,nb Cost of Trading Investors Surplus Savers Surplus Cost of Trading Investors Surplus Savers Surplus r i,b I i,b S i,b qbqb q nb S i,nb I i,nb Dead Weight Loss

Financial Intermediaries What they provide 11 Services Supplied by Financial Intermediaries Reduce information costsReduce transaction costs Reduce search costs Denomination intermediation Credit valuation Maturity intermediation Price discovery Provide payments system Monitoring Diversify risk and Hedge risk

Gross National Product What does it measure? 1.GNP is: –the value of all final goods and services produced and sold –a measure of a country’s output –is the sum of four components  Consumption  Investment  Government expenditures  Current account balance 12

Gross National Product Break down 13

Gross National Product What does it measure? 1.GNP  Y –Individual’s use income to either consume or save while the government taxes and redistributes wealth –GNP measures only the final sale of products  I.E., the price of a computer to the consumer goes into GNP but the price IBM pays for RAM does not. Why? 2.GNP does not account for –Depreciation –Unilateral transfers  Pension payments to retired U.S. citizens abroad  Relief funds –Tax wedge:  Price people pay - Price producers receive 14

Gross National Product What does it mis-measure? 1.Value of leisure 2.Value of government production 3.The illegal economy –Cash transactions –Drugs –Household production 4.Increases in output of goods/services can either be a good or bad thing 15

GNP vs. GDP What’s the difference? 1.GDP = GNP – (income domestic residents earn on wealth held in other countries – payments to foreign owners of domestic wealth) 2.GDP doesn’t correct for domestic output produced by foreign owned capital 3.Are they correlated? 16

Three Price indexes Measuring Inflation GNP deflator –Ratio of nominal GNP in a given year to real GNP –Measure of inflation between the period from which the base prices used in real GNP are taken, to the current period 17

Three Price indexes Measuring Inflation Consumer price index (CPI) –Cost of representative fixed bundle of goods –Prices are of finished or retail goods and services –Problems?  Intertemporal changes in tastes and goods  International differences in tastes and goods  Should we include Food and Energy GNP deflator vs. CPI –Deflator measures wider group of goods than does the CPI –CPI uses fixed basket, deflator uses things produced in a year –The CPI includes imports, deflator only measures U.S. goods – 18

Three Price indexes Measuring Inflation Producer price index (PPI) –Measures the cost of a given basket of raw materials and semi- finished goods –Constructed from prices at the level of the first significant commercial transaction –Often viewed as a predictor of business cycles 19