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Synthesis Econ 109 Fall 2002 Looking Back 1 Synthesis Econ 109 Fall 2002 Looking Back 1

Outline • Themes: The Big Issues • Economic Concepts • Perspectives By Course Section Outline • Themes: The Big Issues • Economic Concepts • Perspectives By Course Section – What We Learned – Why We Learned It – How We Can Use It 2

The Big Issues • Looking Out for # 1 – answer: save and invest The Big Issues • Looking Out for # 1 – answer: save and invest (Course: Part I) • Can a country (or civilization) generate a surplus to finance military power and/or the arts and sciences? – Answer: Malthus- landowners squeeze the peasants – Answer: Marx- capitalists squeeze the workers, (Course: Part III) – Answer: Adam Smith- markets lead to efficiency and general welfare 3

The Big Issues (cont. ) – Answer: Modern economists- population growth increases the labor The Big Issues (cont. ) – Answer: Modern economists- population growth increases the labor force; saving and investing increases capital; capital deepening increases worker productivity; research and development promotes technologival change (Course: Parts II and III) – Answer: Monopoly power squeezes consumers (Course: Part III) 4

Is Globalization & Trade Good or Bad? • Good • trade permits decoupling of Is Globalization & Trade Good or Bad? • Good • trade permits decoupling of production and consumption, i. e. promotes specialization • growth in GDP per capita leads to more equity • trade promotes competition and curbs monopoly power • Bad • growth uses up world resources • global warming • loss of forests • loss of clean oceans and rivers (Course: Part IV) 5

Is Capitalism a Good Economic System or Not? (Course: Parts II, IV) • Good Is Capitalism a Good Economic System or Not? (Course: Parts II, IV) • Good • if markets are competitive, then economy is efficient • Bad • instability, subject to fear, decreases in consumption and investment, capital flight • monopoly power exploits consumers, wastes resources, and corrupts democracy 6

Economic Concepts • Economic Paradigm: A Way of Thinking – #1 set out your Economic Concepts • Economic Paradigm: A Way of Thinking – #1 set out your options for choice – #2 value these options ( using market prices or personal values or social values) – #3 optimize, i. e. pick the best choice • Marginal Principle – set marginal benefit(revenue) equal to marginal cost (if marginal revenue is constant then marginal revenue=average revenue=price) • Reality Principle • Scarcity and Opportunity Cost • Diminishing Returns 7

Concept Applications • Economic Paradigm – buying a car; Lecture 2 – supplying your Concept Applications • Economic Paradigm – buying a car; Lecture 2 – supplying your time to the labor market: L. 4 – choosing the investments with the average rate of return-risk tradeoff that is best for you: L 5 – crime (pollution)-consumption possibility frontier, community choice of optimal crim (pollution) levels L. 17 8

Tools Applications • Keynesian Cross: L. 6, L. 7 & L. 10 • Production Tools Applications • Keynesian Cross: L. 6, L. 7 & L. 10 • Production Possibility Frontier – Guns or Butter L. 8, L. 10 – Agricultural goods or manufacturing goods L. 12 – Ag. Or mfg. Goods: a closed economy vs. trade andan open economy • Demand Supply – demand for mortgage credit: L. 3 – demand & supply of funds in the bond market: L. 4 – demand & supply of banking reserves: L. 9 & L. 10 9

Tools Applications • Demand Supply – demand supply of world copper L. 14 – Tools Applications • Demand Supply – demand supply of world copper L. 14 – demand supply of pesos: capital flight from peso L. 15 – demand & supply of $, capital flight from the baht L. 16 – demand supply of bahts, capital flight from the baht L. 16 – demand & supply of low-skilled labor contrasted to demand & supply of high-skilled labor, the wage differential for skill L 16 10

Tools Applications • Production Function, wage bill, surplus L. 11 • Marginal product of Tools Applications • Production Function, wage bill, surplus L. 11 • Marginal product of labor (demand), supply of labor, surplus L. 12 – demand & supply of labor: minimum wage L. 12 – demand & supply of labor: capital deepening L. 13 – demand & supply of labor: technological change L. 13 • Consumer Surplus & Competitive Markets L. 13 – consumer surplus, monopoly profit, and dead-weight loss L. 14 11

Tools Applications • Lorenz Curve and Gini Coefficient: L. 16 12 Tools Applications • Lorenz Curve and Gini Coefficient: L. 16 12

Perspective • What we learned • Why we learned it • How we can Perspective • What we learned • Why we learned it • How we can use it 13

Part I: Personal Finance, Economics of Everyday Life 14 Part I: Personal Finance, Economics of Everyday Life 14

Purchasing the Big Ticket Items: Cars and Homes • Why: Need to be well Purchasing the Big Ticket Items: Cars and Homes • Why: Need to be well informed about the important decisions in our lives • What: cars and houses last a while, and a $ this year is equivalent to a $ next year times one plus the interest rate $(t) = $(t+1)(1 + r) • What: cars depreciate physically and most cars depreciate economically • What: houses depreciate physically and will likely appreciate in value in CA 15

Cont. • What: mortgage payments on loans are front loaded with interest, so equity Cont. • What: mortgage payments on loans are front loaded with interest, so equity will build slowly • What: Need to save for the down payments, so we need to budget our expenditures • How to use this info: when the time comes, tools are available for free on the internet or at low cost in common software packages 16

Tool: Income-Expense Statement Savings Equals Income Minus Expenditure 17 Tool: Income-Expense Statement Savings Equals Income Minus Expenditure 17

Economic Principles • A dollar today is not the same as a dollar tomorrow! Economic Principles • A dollar today is not the same as a dollar tomorrow! – $10 today @ 6. 9% = $10 * 1. 069 next year • The “opportunity cost” of spending your money is the foregone interest. • The cost of buying the services of the car, neglecting operating costs: – depreciation: owning a new car – foregone interest 18

Increasing the Length of the Loan Tradeoffs • • monthly payment amount decreases amount Increasing the Length of the Loan Tradeoffs • • monthly payment amount decreases amount of total payments increases amount of total interest payments increases total interest as % of total payments increases 19

Thinking About Problems: The Economic Paradigm • describing the alternatives to choose among • Thinking About Problems: The Economic Paradigm • describing the alternatives to choose among • pricing the alternatives • choosing the best alternative 20

The Economic Paradigm example: buying a car • describing the alternatives to choose among The Economic Paradigm example: buying a car • describing the alternatives to choose among – cash: the opportunity cost of losing interest – lease: depreciation included in payments – loan: sell the car to account for depreciation • pricing the alternatives: valuation – Oscar Wilde- economists know the price of everything and the value of nothing • choosing the best alternative – best: lowest cost – possibly subject to a constraint: having the $ 21

What to Do with Those Savings • Why: investments that earn more will let What to Do with Those Savings • Why: investments that earn more will let you buy your cars and house sooner • What: investments have two attributes, average rate of return(the reward), a good, and variability in the rate of return(the risk), a bad • What: You want the investment with the highest average rate of return for a given level of risk • What: returns are equal to capital gains (losses) plus dividends 22

An Example of Two Alternative Investments 23 An Example of Two Alternative Investments 23

Tool: Efficient Portfolio- Most Return for Given Risk Economic paradigm step 1 24 Tool: Efficient Portfolio- Most Return for Given Risk Economic paradigm step 1 24

Economic Paradigm step 2: Valuation of Mean Return and Risk Assumption: Mean Return is Economic Paradigm step 2: Valuation of Mean Return and Risk Assumption: Mean Return is Good, Risk is Bad: U =U(M, R) better Mean Return, M worse B C A Iso - Preference Curves Prefer B to A; Prefer B to C Risk, R 25

Economic Paradigm step 3: Choosing the Best Investment for You Optimum for B Investor Economic Paradigm step 3: Choosing the Best Investment for You Optimum for B Investor B: not very risk averse 26

Personal Earnings and Human Capital • Why: Your major source of $ is likely Personal Earnings and Human Capital • Why: Your major source of $ is likely to be income • What: Your Earnings will depend upon – your ability – your knowledge – your work experience • How: Hang in until you get your college degree 27

Families: Average Income and Average Net Worth, 1995 Even with wealth of $100, 000, Families: Average Income and Average Net Worth, 1995 Even with wealth of $100, 000, at 5%, you earn only $ 5, 000 of income so you will need to work Source: Consumer Federation of America 28

Tool: Earnings Opportunities: Trading Time for Money Earnings $480 Opportunities for trading leisure for Tool: Earnings Opportunities: Trading Time for Money Earnings $480 Opportunities for trading leisure for earnings (income) at a rate, $20 per hour, the market wage, determined by your stock of human capital(step one of the paradigm: describing the alternatives for choice) Economic Paradigm step 1 $0 0 hours 24 hours Leisure (learning) 29

Tool: Your preferences (tastes) for 2 goods, income & leisure Earnings $480 Depicting your Tool: Your preferences (tastes) for 2 goods, income & leisure Earnings $480 Depicting your tastes graphically low value high Iso-Preference Curves: You value all points on a curve equally Economic paradigm step 2 high value $0 0 hours Leisure 24 hours (learning) 30

Putting the 2 tools together: explaining your supply of labor Earnings $480 low value Putting the 2 tools together: explaining your supply of labor Earnings $480 low value high Individual’s Supply of Labor Economic paradigm step 3 $180 for 9 hrs of work $0 0 hours Optimum high value 15 hours of leisure Leisure (learning) 24 hours 31

Part Five: Economic Welfare and Public Policy • Why: we need to consider the Part Five: Economic Welfare and Public Policy • Why: we need to consider the welfare of fellow citizens, not just me-me-me • What: most folks that are poor because they do not work • What: most folks that do not work have a low level of human capital, i. e. the labor market places a low value on their time • What: persistent pockets of poverty among female heads of households and their kids 32

Cont. • In the US, the rich are getting richer and the poor are Cont. • In the US, the rich are getting richer and the poor are getting poorer • In the US economy, there is a growing earnings premium on ability, on education, and on experience, i. e. on human capital • In the US, we can’t seem to get the poverty rate below 10% • How to use this info: on public policy issues when you vote 33

Life does not offer very good options for the uneducated Earnings $480 low value Life does not offer very good options for the uneducated Earnings $480 low value slope of the iso-preference curve through the 24 hour high endowment is the lowest wage at which you are willing to work $96 $0 0 hours 24 hours Leisure (learning) dropout is unwilling to work for $4/hr 34

Poverty and Female Heads of Households Lab 10: Children, Poverty, and Politics: US Census Poverty and Female Heads of Households Lab 10: Children, Poverty, and Politics: US Census Bureau: Poverty in the United States: 2000 35

One Difficulty in Reducing Poverty: Adverse Social Trends 36 One Difficulty in Reducing Poverty: Adverse Social Trends 36

Poverty and Youth Lab 10: Children, Poverty, and Politics 37 Poverty and Youth Lab 10: Children, Poverty, and Politics 37

In the US, the Rich Get Richer and the Poor get Poorer 38 In the US, the Rich Get Richer and the Poor get Poorer 38

Ratio of Median Earnings, Males: College Grad to High School Grad Source: Economic Report Ratio of Median Earnings, Males: College Grad to High School Grad Source: Economic Report of the President, 1997 39

Growing Wage Differentials Between the Less Skilled and More Skilled: Less Demand for Less Growing Wage Differentials Between the Less Skilled and More Skilled: Less Demand for Less Skilled and More Demand for the More Skilled Source: Economic Report of the President, 1997 40

Cont. • What: In the world, developed countries have a more equitable distribution of Cont. • What: In the world, developed countries have a more equitable distribution of income than undeveloped countries, one of the positive consequences of growth • What: In the world, political systems and history also count. Socialist countries and countries with mixed economies tend to be more equitable. However, their tax burden is also greater 41

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Tool: Lorenz Curves for Hungary and Brazil 43 Tool: Lorenz Curves for Hungary and Brazil 43

Income Inequality Across the World Lab 7, Ch. 23, Internet Exercises, World Bank Links Income Inequality Across the World Lab 7, Ch. 23, Internet Exercises, World Bank Links http: //www. worldbank. org/depweb/ 44

Higher Tax Burden in France than in the US Lab 7, Ch. 23, Internet Higher Tax Burden in France than in the US Lab 7, Ch. 23, Internet Exercises, “Taking a Look at the Level of Economic Development and Well-Being in Countries Around the World” Link to Handbook of International Economic Statistics 45

Part Two: Macroeconomics and the US Economy • Why: because the economy affects your Part Two: Macroeconomics and the US Economy • Why: because the economy affects your prospects for finding and keeping a job, the interest rate you pay on loans, and the return you get on your investments • What: There are two ways to measure the size of an economy, National Income and National Expenditure or GDP (circular flow). They have to be the same, i. e. in equilibrium 46

Cont. • What: GDP is equal to consumption by consumers plus investment by firms, Cont. • What: GDP is equal to consumption by consumers plus investment by firms, plus spending by government plus net exports ( exports minus imports) • GDP = C + I + G + X - M 47

: Chapter Twenty • Conceptual Framework: Circular Flow Firms Income Firms Labor Supply Goods : Chapter Twenty • Conceptual Framework: Circular Flow Firms Income Firms Labor Supply Goods Demand Goods Households Income Perspective Expenditure Perspective Y = GDP 48

Expenditure Perspective: Open Firms Exports (Sales) Supply Goods Demand Goods Imports (puchases) Households Government Expenditure Perspective: Open Firms Exports (Sales) Supply Goods Demand Goods Imports (puchases) Households Government Households: Consumption of Goods and Services Firms: Investment in Plant and Equipment Government: Purchase of Goods and Services All Three: Exports - Imports = Net Exports 49

Bust Consumption, C Investment, I GDP Aggregate Expenditure 450 Income = expenditure I. e. Bust Consumption, C Investment, I GDP Aggregate Expenditure 450 Income = expenditure I. e. Y = GDP = C + I +G Total Expenditure GDP Line Unemployment Rate Oct. 2000 = 3. 9% GDP = Y National Unemployment Rate Income, Y Sept 2001 = 4. 9 % Graphical Tool: The Keynesian Cross 50

US Postwar Expansions 51 US Postwar Expansions 51

Cont. • What: In addition to fiscal policy, I. e taxation policy and government Cont. • What: In addition to fiscal policy, I. e taxation policy and government spending, the US central bank, the Federal Reserve, engages in monetary policy • What: the Fed can buy government securities on the secondary bond market (open market operations) and if it buys from a private bank, for example, credits this bank with reserves. This private bank can use any excess reserves over those required by the Fed to make loans to consumers and businesses. In turn these groups can spend. 52

Cont. • What: the federal funds rate is the rate of interest banks pay Cont. • What: the federal funds rate is the rate of interest banks pay to borrow from one another. If the Fed increases the supply of reserves through open market operations, this results in a decrease in the federal funds rate. • What: The central bank acts as a bank of last resort, lending money to private banks at the discount window, charging them interest at the discount rate. 53

Impact of the Supply of Reserves on the Federal Funds Rate FFR, price of Impact of the Supply of Reserves on the Federal Funds Rate FFR, price of reserves Demand for Reserves by Banks Supply of Reserves: Fed quantity of reserves 54

Fighting Recession, the Fed Cuts the Federal Funds Rate from 6. 5% in Dec. Fighting Recession, the Fed Cuts the Federal Funds Rate from 6. 5% in Dec. 2000 to 2. 5% in Oct 2001 During the Same Period, the Fed Cut the Discount Rate from 6% to 2 % 55

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Part Three: Competition, Monopoly, and Public Policy • Why: Growth in GDP per capita Part Three: Competition, Monopoly, and Public Policy • Why: Growth in GDP per capita increases the standard of living for people and means that we can avoid the Malthusian trap and avoid Marx’s prediction of the increasing immiseration of the working class • What: Growth depends on increasing worker productivity, i. e. output per worker or average product. Output per worker increases as capital per worker rises (capital deepening), including social infrastructure, and as technology improves 57

Cont. • What: Malthus believed that population increases would devour any surplus in output, Cont. • What: Malthus believed that population increases would devour any surplus in output, keeping peasants at a subsistence wage. • What: Marx believed that capitalists would seek more profit by introducing labor saving machines, displacing workers and creating an army of the unemployed. This surplus of workers would keep wages at the subsistence level. Neither Malthus nor Marx foresaw capital accumulation and technological change saving the day. 58

Cont. • What: Because economic growth leads to prosperity, more and more countries are Cont. • What: Because economic growth leads to prosperity, more and more countries are embracing free markets, capitalism, and international trade. • How to use this info: You can stay up at night worrying whether science, engineering and technology will bail us out in the coming century, as it did in the past two, or whether Malthus and Marx will ultimately be right. 59

GNP Per Capita, Growth Rates Around the World 60 GNP Per Capita, Growth Rates Around the World 60

Output per Worker Average, Marginal Product Things Improve with capital deepening: Output per worker Output per Worker Average, Marginal Product Things Improve with capital deepening: Output per worker increase, shifting APL Labor Supply 1874 Labor Supply 1954 Real Wage 1954 MPL 1874 APL Real Wage 1874 MPL 1954 L 1874 L 1954 Input, # of workers 61

Capital Formation National Savings Gross Investment + - Net Investment Capital Stock Depreciation 62 Capital Formation National Savings Gross Investment + - Net Investment Capital Stock Depreciation 62

Table 23. 2 Source of Real GDP Growth, 1929 -1982 (average annual percentage rates) Table 23. 2 Source of Real GDP Growth, 1929 -1982 (average annual percentage rates) Due to capital growth 0. 56 19 % Due to labor growth 1. 34 46 % + technological progress 1. 02 35 % Output growth 2. 92 100 % Source: Edward F. Denison, Trends in Economic Growth 1929 -82 (Washington, DC: The Brookings Institution, 1985). 63

Research and Development as a Percentage of GDP Chapter 23, Figure 23. 5 64 Research and Development as a Percentage of GDP Chapter 23, Figure 23. 5 64

Optimal Size of Plant with Variable Returns to Scale LMC LATC SMCIV D SATCIV Optimal Size of Plant with Variable Returns to Scale LMC LATC SMCIV D SATCIV SMCIII p. M SATCIII Quantity Reference: Lecture 14 S Market (different scale for output) 65

The Social Cost of Monopoly: Example, Constant Returns to Scale Competition Monopoly Market Demand The Social Cost of Monopoly: Example, Constant Returns to Scale Competition Monopoly Market Demand Consumer Surplus Dead Weight Loss PM Profit PM LATC = LMC MR QCOMP QMONOP Under monopoly, some consumer surplus is redistributed to the monopolist as profit, and some is lost to society 66

The Ghost of Malthus 67 The Ghost of Malthus 67

Population Growth Rates Around the World 68 Population Growth Rates Around the World 68

Part Five(again): Economic Welfare and Public Policy • Why: Economic growth and prosperity may Part Five(again): Economic Welfare and Public Policy • Why: Economic growth and prosperity may not be unambiguously good. Growth may bring pollution as a byproduct. Free markets and free societies may have more deviant behavior. • What: Societies must choose through their political system how much GDP to allocate to cleaning up the environment and how much GDP to allocate to fighting crime and keeping citizens and their property safe 69

Tool: Crime (pollution) - Consumption Possibility Frontier Offenses (pollution): bad Minimum possible Opportunity cost Tool: Crime (pollution) - Consumption Possibility Frontier Offenses (pollution): bad Minimum possible Opportunity cost of less crime Consumption: good The first step of the paradigm: the options for choice 70

Community Values Confront Reality: Crime (pollution) - Consumption Possibility Frontier Offenses (pollution): bad optimum Community Values Confront Reality: Crime (pollution) - Consumption Possibility Frontier Offenses (pollution): bad optimum Community preferences Community wish list Consumption: good The second step of the paradigm: pricing the options 71

The Developed Countries Are Increasing the Risk of Global Climate Change 72 The Developed Countries Are Increasing the Risk of Global Climate Change 72

The Developed Countries Are Also the Ones That Can Afford To Clean Up 73 The Developed Countries Are Also the Ones That Can Afford To Clean Up 73

Part Four: Trade, the Balance of Payments and the Global Economy • Why: Globalization Part Four: Trade, the Balance of Payments and the Global Economy • Why: Globalization characterizes our times. World trade is stimulating economic growth, breaking down the barriers that protect inefficient domestic industries. • What: Trade, or voluntary exchange, benefits both parties. Trade allows them to specialize on what they do best, rather than be self-sufficient, and specialization increases productivity. Trade permits the decoupling of production from consumption. 74

Cont. • What: Trade of goods and services may not always be in balance Cont. • What: Trade of goods and services may not always be in balance however. Imports may exceed exports and countries, like people, may borrow to live a little higher on the hog. For people, this is often reflected by credit card debt. In the case of countries, we call them debtor nations. • What: The danger in being a debtor nation is the possibility of capital flight. Foreigners who own a country’s bonds may sell them and then sell this country’s currency to buy their own, i. e. cash out and go home. 75

Cont. • What: If the target country’s central bank does not have sufficient reserves Cont. • What: If the target country’s central bank does not have sufficient reserves of foreign currencies to permit them to buy their own currency, and offset the effect of capital flight on the exchange rate, they will have to devalue their currency. • What: A stable exchange rate means trade and economic activity is less risky. • What: Currently, the only mechanism to offset capital flight and avoid international monetary crises is cooperation among central banks, arranging loans for the target. 76

Growth in World Trade Source: Economic Report of the President, 1997 http: //www. gpo. Growth in World Trade Source: Economic Report of the President, 1997 http: //www. gpo. ucop. edu/catalog/erp 97. html 77

Around the World, Trade is Growing Faster Than GNP 78 Around the World, Trade is Growing Faster Than GNP 78

Trade Allows the West to Decouple Production & Consumption Production Possibility Frontier, PPF Eastern Trade Allows the West to Decouple Production & Consumption Production Possibility Frontier, PPF Eastern Prices: Ag/ Mf = PMf/PAg Agriculture QAg Exports Regional Tastes: B C CAg A Imports QMf CMf Manufactures 79

Capital Flight 1. foreigners sell their Thai investments 2. foreigners exchange their Baht proceeds Capital Flight 1. foreigners sell their Thai investments 2. foreigners exchange their Baht proceeds for say dollars 3. Demand for dollars shifts and price of the dollar in Bahts rises demand for dollars supply of dollars Bahts per US $ quantity of dollars 80

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Course Grading If you complete over 70 % of both the text Problems and Course Grading If you complete over 70 % of both the text Problems and Lab Exercises, then your course grade is increased by 1/3 grade point 86

Thursday, Dec. 12, 4: 00 -7: 00 PM, Final, You will need a scantron Thursday, Dec. 12, 4: 00 -7: 00 PM, Final, You will need a scantron sheet and #2 pencil. • Good Luck 87