HANDOUT # 2

APPLIED ECONOMICS: ECON 716

Professor I.M. Cole

SECTION I:

MICRO-ECONOMIC CONCEPTS AND ISSUES: (You will find much of the material in this section useful for the case study and the other assigned projects. Also, the material for Exam 1 will come from this section).

L E C T U R E O U T L I N E:

AE1: OVERVIEW: HOW ECONOMISTS ANALYZE PROBLEMS: METHODOLOGY (Chapters 1-3 in the text, and material from the lecture).

I .What is the scientific method?

2. What is the role of assumptions in economic analysis?

3. Give examples of models that simplify reality to improve our understanding of the economy: (i) the circular flow model (ii) the production possibilities model.

4. Describe the role of economists as 'scientist' and adviser.

5. What is positive and normative analysis?

6. Why do economists so often appear to disagree?

7. Give examples of issues on which most economists agree.

8. Economics in private vs. public sector decision making ______________________________________________________________________________

AE2: A REVIEW OF THE MARKET FORCES OF DEMAND AND SUPPLY (Chapter 4 and material from the lecture).

1. What is a market, and when is a market perfectly competitive?

2. What are the laws of demand and supply?

3. How would you decide how much of a product to buy per unit of time, and what factors affect your decision?

4. Explain and apply 'shifts in demand.'

5. Assume you are running a small business. What factors will determine the amount you are willing to offer for sale?

6. Explain and apply 'shifts in supply.'

7. What is market equilibrium, and why do the actions of buyers and sellers naturally move markets towards equilibrium?

8. Predict how various events will affect market price and quantity.

9. Explain how prices allocate resources.

10. Skip Section 4.7 on Price Controls: pp. 87-89

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AE3: CONSUMER AND PRODUCER SURPLUS (Chapter 5: Section 5.5; and material from the lecture). These concepts are useful for cost-benefit analysis, among other things.

1. What is consumer surplus?

2. How is consumer surplus measured?

3. How do changes in the price of a product affect consumer surplus?

4. For what purpose is the concept of consumer surplus used?

5. Is consumer surplus a good measure of economic well being of buyers?

6. What is producer surplus?

7. How is producer surplus measured?

8. How do changes in the price of a product affect producer surplus?

9. For what purpose is the concept of producer surplus used?

10. Is producer surplus a good measure of economic well being of sellers?

11. Can consumer surplus and producer surplus be used to evaluate the efficiency of free markets? Explain.

12.The conclusion that markets are efficient is based on several assumptions. Explain.

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AE4: BENEFIT - COST ANALYSIS (CBA) (Lecture material) (Let me know if you need some reading material on CBA).

1. What is the purpose of CBA?

2. What is the simple idea behind CBA?

3. What methods are used to evaluate benefits and costs?

4. What are the strengths and limitations of CBA?

5. You must be able to conduct a CBA if given the appropriate information

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AE5: CONSUMER AND PRODUCER SURPLUS AND GOVERNMENT REGULATION (TAXES) (Chapter 5: section 5.6 and lecture material).

1. Who bears the burden of government regulation?

2. Calculate the burden of such regulation to consumers and producers.

3. How much does the government gain from the regulation in terms of tax revenue?

4. What is the excess burden to society of the government regulation?

5. How is the excess burden (deadweight loss) affected by elasticity?

6. Note: Skip the segment on the welfare effects of price ceilings and floors (pp. 120 - 123).

AE6: PROBLEM: APPLYING CONSUMER SURPLUS TO GOVERNMENT REGULATION

Suppose the government imposes a tax on sales of new cars equal to $1,000 per car, raising the price of cars by the amount of the tax. As a result of the tax the number of new cars sold declines from 5 to 4 million per year. The price of a new car before the tax was $12,000. Focusing on just the demand side of the market, draw and label the graph illustrating the above situation, and then refer to the graph to do the following :

(i) Prior to the price increase consumer surplus was equal to the area _________

(ii)The increase in price due to the tax reduces the consumer surplus to the area ___________

(iii) The loss in consumer surplus is represented by the area ______________

(iv) The area representing the tax revenue taken in by the government is ______________

(v) The tax revenue taken in by the government is $ ______________

(vi) The total loss in consumer surplus due to the tax is $ ______________

(vii) The excess burden (deadweight loss) of the tax amounts to $ ______________

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AE7: APPLYING CONSUMER AND PRODUCER SURPLUS TO INTERNATIONAL

TRADE (chapter 19 : Section 19.3 - 19.4, and lecture material).

1. How does international trade affect economic well being?

2. If a government allows its citizens to import and export steel, what would happen to the price of steel and the quantity of steel sold in the domestic steel market?

3 - Who would gain from free trade in steel, and who would lose, and would the gains exceed the losses? 4. What would be the welfare effects of a tariff (a tax on steel imports)?

AE8: ECONOMIC THEORY OF CHOICE: CHOICE AND UTILITY (Chapter 5: Section 5.4; and material from the lecture)

1. Choices are limited by time, income and other factors.

2. What is total utility? What is marginal utility?

3. What is the law of diminishing marginal utility?

4. How does this law explain the law of demand?

5. What are the basic properties of a well-defined preference?

6. What is an indifference curve / indifference map?

7. What is the marginal rate of substitution?

8. What is the budget constraint?

9. What are the main conditions for utility maximization?

10. What is attribute analysis?

11. Explain brand switching using attribute analysis.

12. Some applications.

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AE9: THE CONCEPT OF ELASTICITY (Chapter 5: Sections 5.1 - 5.3 and lecture material).

1. What is elasticity?

2. How is it measured?

3. What factors determine elasticity?

4. What are the different types of elasticity?

5. How does elasticity affect total revenue / sales?

6. Of what practical value is elasticity?

7. Apply the concept of elasticity to various issues.

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AE10: EXTERNALITIES (Chapter 6, and lecture material)

1. What is an externality? Give some examples.

2. What are the different types of externalities?

3. Using demand and supply analysis describe how externalities affect economic well-being.

4. Explain why market outcomes are inefficient in the presence of externalities.

5. Describe the various ways in which private actors and public policy makers can solve the

problem of externalities.

6. What are public goods? What is the free-rider problem?

7. What is public choice theory?

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AE11: THE COSTS OF PRODUCTION (Chapter 7, and lecture material).

1. What items are included in the firm's costs of production?

2. Distinguish between economic profit and accounting profit

3. What are the various measures of cost?

4. Briefly describe how costs behave in the short run as opposed to the long run.

5. What is a production function?

6. How are the costs of production related to the production function?

7. Define economies of scale and diseconomies of scale, and explain why they might arise.

8. Apply the concept of economies of scale to an important issue, for example, the issue of whether a company should export its product or license production to a foreign company.

9. What is strategic cost analysis?

10. What are learning and experience curves?

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SECTION II

MACRO-ECONOMIC CONCEPTS AND ISSUES (The material for Exam 2 will come from this section).

L E C T U R E O U T L I N E:

AE12: AN OVERVIEW OF THE MACRO-ECONOMY (Chapter 11, and lecture material)

1. What is macroeconomics all about?

2. What are the major macroeconomic issues?

3. What are the major macro-economic goals?

4. What gave the government the right to pursue these goals?

5. What are the key provisions of the Employment Act of 1946?

6. Two major issues: unemployment and inflation:

i. define the unemployment rate, and the natural unemployment rate

ii. what causes unemployment?

iii. what are the sources or reasons for unemployment?

iv. what are the consequences of unemployment?

v. what is Okun’s law?

vi. what are the different types of unemployment?

vii. does new technology lead to greater unemployment?

viii. define inflation; vi. what are the different types of inflation? (p. 332)

ix. who loses with inflation? how does anticipated inflation affect the nominal interest rate?

7. What are business cycles?

8. Briefly describe the different phases of the business cycle.

9. Explain why and how each of the Leading Economic Indicators (LEI) is used as part of the LEI index to predict where the economy may be headed (p.268).

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AE13: MEASURING AND PREDICTING ECONOMIC PERFORMANCE (GROWTH) (chapters 12, 13, and lecture material):

1 Explain how the economy's total final output is measured.

2. what are some of the deficiencies of such measurement? (p. 287).

3. Explain how economic performance (growth) is measured.

4. Describe the main factors that are frequently identified as the major sources of economic growth.

5. Describe a simple model (the production function) which is often used to identify some of the sources of economic growth.

6. What can the government do to increase the level of economic growth?

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AE14: UNDERSTANDING AGGREGATE DEMAND: A FOCUS ON CONSUMER SPENDING AND SAVING (chapter 14, lecture material and handout):

1 Justify the need for studying consumer spending and saving.

2. What is the simple Keynesian consumption function, and why has it often been inadequate when it comes to forecasting consumer spending (p. 208).

3. Compare and contrast the Life-cycle (LCT) and Permanent-income (PIT) theories of consumption. How do these theories improve on the simple keynesian theory of consumption?.

4. Describe the role of wealth in both the LCT and PIT theories of consumption.

5. The LCT demonstrates the Wealth Effect on consumer spending. Apply this concept in explaining how consumer spending will respond to stock market activities (e.g. a stock market crash), and how this, in turn, will affect the performance of the economy.

6. Explain how permanent as opposed to temporary tax changes affect saving and consumption behavior.

7. Identify and describe two major policy implications of the LCT and PIT theories.

8. Compare and contrast the traditional and the Barro-Ricadian views on how a debt-financed tax cut affects the performance of the economy.

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AE15: UNDERSTANDING AGGREGATE DEMAND: A FOCUS ON INVESTMENT SPENDING (Chapter 14, lecture material and handout):

1 Justify the need to study business investment behavior

2. What are the three categories of investment (business fixed, residential, and inventory investment), and how is each affected by changing economic conditions.

3.What is the desired capital stock? How does it depend on interest, the rate of depreciation, and taxes?

4. Describe the neoclassical model of business fixed investment. Apply this model to explain the impact of monetary and fiscal policy on investment spending and, hence economic growth.

5. What is the accelerator model of investment? Criticize it.

6. What is Tobin's q, and what does it have to do with investment?

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AE16: UNDERSTANDING AGGREGATE SUPPLY (AS) (Chapter 15, and lecture material).

1. What do the short-run and long-run AS curves represent?

2. What factors shift these curves?

3. What is macro-economic equilibrium, and how is it determined?

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AE17: THE INFLUENCE OF MONETARY AND FISCAL POLICY ON THE ECONOMY (chapters 16, 18, and lecture material).

1. What is monetary policy? What is fiscal policy? (pp. 414 - 420)

2. Explain how the interest rate is determined)? (pp.407-411)

3. Apply the theory of liquidity preference to explain how monetary policy influences aggregate demand and, hence, economic growth (pp. 407-411).

4. Analyze how fiscal policy affects interest rates, aggregate demand and, hence, economic growth.

5. Define the multiplier and the crowding-out effects (pp. 347; 356-357).

6. What are automatic stabilizers? Give an example of a government policy that acts as an automatic stabilizer. Explain why this policy has this effect (p. 355).

7. What is supply-side economics? (pp.360-363)

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AE18: PROBLEMS ON MONETARY AND FISCAL POLICY:

1. Assume Congress reduces spending on national defense by $20 billion. Which way does the aggregate demand curve shift? Explain why the shift might be larger than $20 billion. Explain why the shift might be smaller than $20 billion.

2. Suppose a wave of negative "animal spirits" overruns the economy, and consumer confidence decreases. What happens to aggregate demand? If the Fed wants to stabilize aggregate demand, how should it change the money supply? If it does this, what happens to the interest rate? Why might the Fed choose not to respond in this way?

3. Consider two fiscal policies: a tax cut that will last for only a year, and a tax cut that is expected to be permanent. Which policy will stimulate greater spending by consumers, and why? Which policy will have the greater impact on aggregate demand? Explain.

4. For various reasons, fiscal policy changes automatically when output and employment fluctuate. (a) Explain why tax revenue changes when the economy goes into a recession. (b) Explain why government spending changes when the economy goes into a recession. (c) If the government were to operate under a strict balanced-budget rule, what would it have to do in a recession? Would that make the recession more or less severe?

5. Discuss the debate over whether policy makers should use monetary and fiscal policy to control aggregate demand and stabilize the economy.

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AE19: INTERNATIONAL TRADE (Chapter 19, and lecture material)):

1. What has happened to the volume of trade overtime and what factors are responsible?

2. How do you measure the degree to which international trade is important to a domestic economy?

3.Briefly explain the principles of comparative advantage.

4. Distinguish between the capital account and the current account of the U.S. balance of payments.

5. Distinguish between fixed, freely floating, and managed floating exchange rate systems.

6. Distinguish between currency appreciation (depreciation) and a currency revaluation (devaluation).

7.How are exchange rates determined?

8. List and explain some of the main determinants of the demand and supply of foreign exchange.

9. Explain how a change in foreign income affects domestic output, interest rates, and the level of employment.

10. Explain the link between the currency exchange rate and the level of economic activity.

11.What are the repercussion effects of international trade?

12. NOTE: We covered pp. 435 - 444 in the section : AE7 of this handout. Thus the material from these pages will not be part of the exam for this section.

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APPLIED ECONOMICS (H1)

Some key macroeconomic variables:

1. Nominal or real GDP______________ 2. The growth rate of GDP____________

3. Consumer spending ____________ 4. The rate of inflation ____________

5. The rate of unemployment____________ 6. Average hourly earnings ____________

7. Productivity (non-farm business) ___________8. The federal budget deficit/surplus

9. The trade deficit ____________ 10. The money supply (NG or M2) ____________

11. The discount rate___________ 12. The prime rate 13. The federal funds rate ____

THE LEADING ECONOMIC INDICATORS:

1. Average workweek of production workers in manufacturing.

2. Average initial weekly claims for state unemployment insurance.

3. New orders for consumer goods and materials, adjusted for inflation.

4. Vendor performance.

5. Contracts and orders for plant and equipment, adjusted for inflation.

6. New private building permits issued (adjusted for seasonal weather factors)

7. Change in Manufacturers' inventories on hand and on order, adjusted for inflation. 8 Change in sensitive materials prices 9. Index of stock prices

10. Money supply (M2), adjusted for inflation

11. Index of consumer expectations or confidence.

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Measuring Economic Performance (H2)

National Income and Accounting System

Gross Domestic Product (GDP)

Gross National Product (GNP)

GNP = GDP + NFP or

GNP = GDP + FPFF - FPTF

The Expenditure Approach:

i. Consumers (C)

ii. Businesses (I)

iii. Government (G)

iv. Trade sector (X-M)

GDP = C + I + G + (X-M)

GPDI or I = Net I + Dep

if GPDI > Dep, Net I > 0

if GPDI = Dep, Net I = 0

if GPDI < Dep, Net I < 0

Income Approach:

GDP = TW + TR + TI + TP + DEP + IBT + NFF

Other Concepts of Income:

Net domestic product (NDP)

National Income (NI)

Personal Income (PI)

Disposable Income (DI)

Three main measures of inflation:

the consumer price index (CPI)

the producer price index (PPI)

the implicit GDP price deflator

Sources or determinants of Economic growth:

capital accumulation

human capita

small government

property rights

foreign trade

fewer government regulations

technology

consumer spending

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The Life-Cycle Theory (LCT) of Consumption (H3)

Some Key points:

1. The LCT was introduced in 1954 by Brumberg and Modigliani

2- The LCT is an extension of the Keynesian theory of consumption.

3 - The LCT assumes that People base their consumption decisions on expected lifetime income, current income, and wealth.

4. The LCT is based on utility maximization

5 - According to the LCT, tax policies will have an ipact on consumption only if perceived as being Permanent.

6. The age distribution of the population affects consumption and saving ___ younger and older population groups save less, and middle aged population saves more.

7. People consume more than they earn in their early working years, and retirement years.

In between, people consume less than they earn (save more) to pay off debts from borrowing and to save for retirement.

8. Consumption depend, ) wealth, so whatever (including monetary policy) affects wealth is likely to affect consumption. The wealth effect on consumption is small and, thus, the effect of, say, a stock market crash on economic activity will be small.

10. The LCT and the Permanent Income Theory of consumption offer important insights on how federal government debt or deficit affects the economy.

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Determinants of AD: Focus on Investment (H4)

AD = C + I G + (X - M)

Investment, the most volatile component of aggregate spending, adds to the capital stock. The desired capital stock is the level of capital that maximizes expected profits. Firms invest to achieve their desired level of capital stock; when such stock increases, firms invest more.

Categories of Investment:

1. Business fixed investment

2. Residential Investment

3. Changes in business inventories

Theories explaining business fixed investment:

1. The neoclassical theory of investment

2. The accelerator theory of investment

3. Tobin’s q theory of investment

(Details on the theories will be provided in class)

Neoclassical Theory of Investment:

MP = marginal product of capital

MRPk = marginal revenue product of capital

UC = user or rental cost of capital

pk = the price of capital

d = rate of depreciation

r = interest rate

MRPk = PQ x MP

UC = rPk + dPk = (r + d) Pk

UC = 0.08(1000) + 0.10(1000) = $180

Taxes and the investment decision:

(1-t)MRPk = (1- 0.2)300 = $240

(1-t)MRPk = UC

MRPk= UC /(1-t) = (r + d)Pk / (1-t)

K*= f(MRPk, UC) =f(r, d, t, tech, ....)

I = f(r, profit E, tech, business T,

expectations, inventories)

Country:                     Effective tax rate on K

                                            %

Australia                             14.6

Canada                                25.9

France                                 -33.4

Germany                                 4.60

Italy                                     -72.8

U.K.                                     28.0

Sweden                                 1.00

U.S.                                     24.00

The fixed accelerator theory of investment:

a = kt/yt

It = a(yt - yt-1) + depreciation

The flexible accelerator theory of investment:

Kt = Kt + (Kt - Kt-1)

Tobin’s q-ratio investment theory:

q = Mv/Rc

where Mv is the market value of installed capital, and Rc is the replacement cost of installed capital.