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University of Calgary
ECON 203
Douglas Mc Clintock

ECON NOTES – MIDTERM 1 CHAPTERS 1­2 (review) Economics = is the study of the way scarce resources are allocated among alternative uses to satisfy human  wants and needs. (In other words, it’s how society manages its scarce resources) An Economy = is a set of interrelated consumption and production activities in order to maintain a standard of  living. Resources – sometimes known as factors of production Land = Natural resources that are used in the production of goods and services. This would include our forests,  oil and gas, minerals, water and of course, the land we farm and build on. Land includes everything that Mother  Nature provides for us. CapitalThese are goods used to make other goods.  Capital includes all the manufactured aids to production  such as tools, machinery, buildings, trucks etc. These are things that humans use to produce other things.  Capital does not include money. Money is referred to as…  Financial Capital. Money does not produce anything (in itself) although we would not have a productive and  modern economy without it. Labor  = Sweat equity and the intelligence that is needed to produce goods and services. The labor that it takes  to teach a class, build a house, make a dress etc. Labor includes all mental and physical human resources,  including intelligence, entrepreneurial capacity and management skills. Goods are tangible items (e.g., cars, shoes, CD’s, TV’s etc.) and services are intangible (e.g., haircuts,  education, house cleaning) In economics, (and life in general), we assume that human wants are unlimited but resources are limited. As a  result, we have scarcity Scarcity means that there are not enough goods and services to meet everyone’s needs and desires. Scarcity  forces us to make choices and when we do, these choices involve costs. The costs are known as opportunity  costs. An opportunity cost is the best­foregone alternative.  In other words, it’s the next best alternative when  you make a choice.  Ten Principles of Economics How People Make Decisions: 1) People face tradeoffs. 2) The cost of something is what you give up to get it. 3) Rational people think at the margin. 4) People respond to incentives. 5) Trade can make everyone better off. How People Interact: 6) Markets are usually a good way to organize economic activity. 7) Governments can sometimes improve market outcomes. How The Economy as a Whole Works 8) A country’s standard of living depends on its ability to produce goods and services (i.e.  productivity). 9) Prices rise when governments print too much money. 10) Society faces a short run tradeoff between inflation and unemployment. 4 Key Economic Problems (Every Society faces these key economic problems) 1)  What is produced and how ? • This refers to what goods should be produced by society and how efficiently can they be  produced. 2)  What is consumed and by whom  ? • Who gets these goods? (Who gets a lot, who gets a little)  This question deals with how society  allocates goods and services throughout its economy. 3)  Why are resources idle?  • In times of recessions, economies have idle resources (unemployment, excess manufacturing  capacity in plants, decreasing aggregate demand). In this case, should governments do  something to correct the situation? 4)  Is production capacity growing  • Is the economy growing? Are jobs being created? Again, should the government intervene to  try to create jobs? ECONOMIC SYSTEMS For society, the solution to the 4 economic problems depends on the type of economic system that society wants  (or gets) Spectrum of Government Control (extremes) Command         Pure Market Economy      (Laissez Faire) COMMAND ECONOMY (Sometimes referred to as Centrally  Planned Economy or Communism)  Karl Marx, Frederick Engels Wrote the Communist Manifesto in 1848 • Felt capitalism exploited labor since labor was the primary cause of production. • Capitalism would cause a “Reserve Army of Unemployed”. • Capitalism would create a huge gap in the distribution of income. (between the Bourgeoisies and the  proletariat) Solution • State should own almost all of the resources • Collective participation of resources would increase the amount of production. • Profits (or surplus) would be reallocated back to workers • Distribution of goods should be centrally planned Pure Market or Laissez Faire Economies (Often referred to as capitalism) First introduced by Adam Smith in his famous book titled “The Nature and Causes of the Wealth of  Nations” (generally known as The Wealth of Nations ­1776) • He felt that governments should have a very minor role in the economy. (The government should  still be responsible for national defense, taxation, courts, police, fire, and basic government  services).  • He thought that the pricing system was the most efficient way of allocating resources. (invisible  hand) • Private property rights determine ownership. • Legal system allows individuals to contact with each other. • Self interest (and not benevolence) is therefore the foundation of “Economic Order” Characteristics of a Market Economy (The characteristics that produce this spontaneous self-organization)  Self-Interests – individuals pursue their own self interests (buying and selling at what seems best for themselves and their families)  Incentives – people respond to incentives (buy more items at low prices. Sell more items at higher prices; go to university to get a degree – make more money, more prestige etc.) - People make decisions are the margin – weighing the marginal benefit and the marginal cost  Market Prices and Quantities - For the most part, goods and services are allocated by the pricing system.  Institutions - set the rules of the game (legislature, courts, government departments) (e.g. provide public goods, grant property rights and enforce contracts, establishing safety and environmental standards (consumer protection), banking and investment laws etc. CHAPTER 5 – National Income Gross Domestic Product (Sometimes referred to as Nominal GDP or GDP) Gross Domestic Product (GDP) is the market value of all final goods and services produced within a country in a given period of time (usually one year)… In other words, GDP measures the market value of all final goods produced domestically within a given period of time. Two approaches to measuring GDP: 1) ExpenditureApproach 2) IncomeApproach As a result, GDP also measures a country’s income during a given period of time. 4 Main Sectors of an Economy Expenditure approach to measuring GDP 1) Consumption (Households) –spending by households on goods and services, includes durable and non- durable goods. • Durable goods – appliances, cars, furniture, TV’s, etc. • Non-durable goods – food, clothing, pencils, toothpaste (consumed or wear out quickly over time) • Services – haircuts, dental work, mechanics, etc. 2) Gross Investment (Businesses or Firms) – called Fixed Gross Capital Formation in the National Accounts – the expenditures for newly purchased capital goods by firms… Includes: • All final purchases or machinery, equipment, and tools • All construction (including residential and non residential) • Changes in inventories (even if the goods are sold in the following year, they are included in the GDP in the year the goods are produced) • NOTE: Net Investment = Gross Investment – Depreciation (Capital ConsumptionAllowance) 3) Government Spending – includes government spending on final goods, invested goods (e.g. buildings), and all direct purchases of resources, including labor. Government Spending includes all sectors of the government: federal, provincial and municipal • NOTE: Does not include transfer payments, such as employment insurance, welfare payments and Canada pension payments. Why?.... These payments were not used for any production or service in the economy so they are not included in GDP. 4) International Sector (Exports – Imports) IncomeApproach to Measuring GDP 1) Wages and Salaries - Includes gross wages, salaries, commissions and bonuses 2) Interest and Miscellaneous Income - Interest earned on bank deposits, interest on loans to firms, other deposits (e.g. Credit Unions), bond interest and misc. investment income (e.g. interest earned on whole life policies) 3) Business Profits (Includes profits from corporations, unincorporated businesses and farms and government business enterprises, such as crown corporations) - These include dividends and retained earnings (savings) of businesses, including profits to corporations, unincorporated businesses (e.g. small businesses), partnerships, farmers and government businesses (e.g. Canada Post, CBC,Alta Treasury Branches, Canada Deposit Insurance Corp. etc.) 4) Indirect Taxes and Less Subsidies - Indludes GST and PST (must add these since we pay them when goods are purchased) NOTE:Asubsidy must be subtracted so that the expenditure side = income side. This relates mostly to agricultural products were a farmer may earn more (due to the subsidy) than the market value of the good). Therefore the subsidy must be subtracted. 5) Depreciation (Capital ConsumptionAllowance) - must be added to the income side since GDP includes Gross Investment from the expenditure side Examples of GDPbreakdown graph from Income and Expenditure side saved on computer (GDP Canada.Table.2005) Other measures of National Income 1) Gross National Product (GNP) The income received (earned) by Canadians regardless of where they were located when the income was produced (e.g. Canadian company operating overseas) GNP = GDP + (investment income received by Canadians from non-residents LESS investment income paid to non-residents) 2) Net National Product (NNP) GNP – Depreciation (D) 3) Net Domestic Product GDP – D 4) Net National Income (NNY or NI) GNP – Depreciation – Indirect taxes (less subsidies) (NI sometimes known as National Income at factor cost) 5) Personal Income (PY) Consumption + Personal Savings + Personal Taxes 6) Personal Disposable Income (PDY) Consumption + Personal Savings 7 Box Diagram showing the breakdown of the measures as well as Income/Expenditure is saved as 7 box diagram Calculating Real GDP and GDP Deflator (GDP deflator is an index of the Price Level of Aggregate Output) This from chart on Blackboard: Index = [Nom GDP / Real GDP] x 100  2006 (base year)  Index 2006 = [$42,000/$42,000] x 100 = 100  2007  Index 2007 = [$49,200/$45,200] x 100 = 109  2008 Index 2008 = [$57,540 / $50,100] x 100 = 114.85  Summary  Year  GDP Deflator Index  2006  100  2007  109  2008  114.85 Definition of Output Gap: Bank of Canada • The output gap is defined as the difference between the actual output of the economy and its  potential output. • Potential output is the maximum level of goods and services an economy can produce on a sustained  basis with existing resources (labour, capital equipment, and technological and entrepreneurial  know­how) without generating inflation pressures.  • Economists also refer to potential output as the production capacity of the economy, trend output, or  full employment output. GDP: Do Omissions Matter? We have seen that many things are not measured by GDP. (Coaching a hockey team, cutting your grass,  economic bads etc.) Given these omissions, should we try to estimate the value of these omissions or should  economists just use the current approach of estimating GDP?  Many economists think the current approach is sound because of three reasons: 1) Correcting the major omissions in the measure would be difficult if not impossible to calculate. (E.g. the  value of a drug deal, housework or value of cooking)  2) Even the level of measured GDP in any given year may be inaccurate; the change in GDP from one year to  the next is a good indication of the changes in economic activity (as long as the omissions are themselves  not changing a lot from one year to the next)  3) Policymakers need to measure the amount of market output in the economy in order to design policies  to control inflation and set tax rates. To do this, they would need to know the flow of money payments made to  produce and purchase Canadian output. (Modified measures that include non­market activities (i.e. housework)  distort these figures and likely lead to policy errors GDP as a Measure of Economic Well­Being GDP is a good measure of economic or social welfare (but it’s not perfect) Why? …Countries with higher  incomes have a higher likelihood of providing better education, health care and a higher standard of living.  GDP does not measure:  • The distribution of income.  • The importance of leisure.  • Meaningful friendships.  • Negative externalities. (economic bads)  • The effectiveness of social programs.  • Hidden economy. (approx. 15% in Canada – 60% in Greece)  • Intelligence or wisdom.  GDP does not include: • Used goods  • Intermediate goods (we don’t want to double count)  • Purely financial transactions (e.g. buying a stock – this represents just a transfer of ownership) Productive non­market transactions: • Helping a friend move or paint his/her fence.  • Cutting your grass.  • Cleaning your house or apartment.  • Your labour to renovate your house.  GDP per Capita  A better measure of economic well­being is GDP per capita (per person) but again, it’s not perfect.  (2005 dollars)  Canada: 42,197  USA: 54,800  Norway: 52,746  World Average: 11,414  Haiti, Nigeria and Ethiopia live on per capita incomes of about 1/30th of Canada’s. However, the per capita  numbers are just statistical averages. They do not tell us about the distribution of income in these countries.  CHAPTER 6 – Measuring the Cost of Living Consumer Price Index (CPI) (Annual expenditure of a typical household on a basket of goods) The “CPI” is an index that measures the average price of goods and services that are bought by a typical  Canadian household.  When we construct a price index, the prices are eliminated because the price index shows the price of a  basket of goods at some specific time period relative to the price of the same basket of goods in some base  period. (or other time period)  As a result, the CPI shows the rate of change of this basket relative to some other time period.  Problems with the CPI (overstates inflation) • It assumes that consumers do not change their consumption behavior when prices change (substitute  bias) • The typical basket may not represent many consumers • Many new products (i.e. video games, Blu­ray DVDs, mobile phones etc.) are not included or under­ weighted in the CPI (Since the prices of these products drop significantly over short periods of time, the  exclusion of these products would overstate inflation) • Quality improvements are usually not taken into consideration (Stats Canada does try to adjust for  quality improvements but this is difficult) Core CPI – is the typical basket but excludes taxes, food and energy. [These items are the most volatile and are  usually determined by world supply and demand. Thus a made in Canada policy (i.e. higher interest rates)  usually won’t affect these prices] CPI graph would go: Product Price Quantity Expenditure (total price) Each year has the same products, the same quantity, but changes the price.  ▯To construct a CPI: P of a Market Basket in a Specific Year x 100 P of a Markey Basket in Base Year Now we can use the CPI to calculate Real GDP: Year  CP Index  Nominal GDP Real GDP (Deflator)  ($Billions) (Nom/Index) x 100 2003   100   $1,200  $1,200.00  2004  105.32  $1,250   $1,186.86  2005  113.72  $1,300   $1,143.16  2006  115  $1,500   $1,304.35  ** Since Nominal GDP is deflated by the CPI (sometimes called the deflator), real GDP shows the  actual output in the economy since the price effects are removed. Causes of Inflation Demand Pull  • caused by an increase in aggregate demand for goods and services ­ such as houses, consumer goods, durable  and non­durable goods, government services, infrastructure etc.  Cost Push  • inflation due to rising input prices which are passed on to consumers these include price increases in raw  material such as wood, steel, electronics, intermediate goods used in production, energy prices, interest rates  etc..  Central banks printing too much money  • In the long run, printing too much money causes inflation and in some cases, hyperinflation Inflation   Inflation is the rise in the general price level. It is usually measured by the consumer price index (CPI)  or the GDP deflator.  Problems with Inflation  • diminishes the purchasing power of the dollar  • distribution of income effects  • borrowers gain and lenders lose if inflation is unexpected  • hurts foreign trade  • menu costs to inflation (changing prices)  • bracket creep CHAPTER 7 – Production and Growth Production and Growth Why do some societies have a higher standard of living than others?  1)  Productivity   Productivity is defined as the amount of goods and services produced from each hour of a workers time.  Productivity = Output per worker per hour (sometimes quoted as per day or per year) How is productivity determined? (four important factors of production) a.  Physical Capital : the more capital (buildings, machines, tools) that a worker has available to  him/her, the more productive they will be b.  Human Capital  : the knowledge and skills that workers acquire through education and training  ▯ the know­how through training and education to use physical capital c.  Natural Resources  : Inputs into production that are supplied by nature, such minerals, water,  trees, forests etc.
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