Chapter 1: Managers, Profits, and Markets

1. Ten Principles of Economics

- Resources are scarce
- Scarcity: the limited nature of society’s resources
 Society has limited resources and therefore cannot produce all the goods and services people wish to have
 Economics - The study of how society manages its scarce resources
- Economist’s study:
 How people make decisions
 Work, buy, save, …
 Invest, produce, …
 How people interact with one another
 The forces and trends that affect the economy as a whole
- How people make decisions
Principle 1: People face trade-offs (to attain sth, pple have to give up sth because the resources are limited)
Principle 2: The cost of something is what you give up to get it
Principle 3: Rational people think at the margin (Marginal profit = the profit of one more product is
produced)
Principle 4: People respond to incentives
- How people interact
Principle 5: Trade can make everyone better off
Principle 6: Markets are usually a good way to organize economic activity
Principle 7: Governments can sometimes improve market outcomes
- How the economy as a whole works
Principle 8: A country’s standard of living depends on its ability to produce goods and services
Principle 9: Prices rise when the government prints too much money
Principle 10: Society faces a short-run trade-off between inflation and unemployment

2. Managerial Economics & Theory

- What is the role of managers?
o Know how to use economic analysis to make decisions to achieve firm’s goal of profit maximization
- Managerial economics applies microeconomic theory to business problems
- Draws on two closely related areas of economic theory: microeconomics and industrial organization.
3. Microeconomics
- Study of behavior of individual economic agents: individual consumers, workers, owners of resources,
individual firms, industries, and markets.
- Develops numbers of foundation concepts and optimization techniques that help managers make everyday
business decisions (business practices or tatics) in order to create the greatest possible profit for the specific
business environment faced by the firm.
- Using marginal analysis for optimization problems in business, microeconomics provides the foundation for
understanding everyday business decisions.  Make Decision Ab How To Maximize The Profit
- Industrial organization
o Specialized branch of microeconomics focusing on behavior & structure of firms & industries
o Provides foundation for understanding strategic decisions through application of game theory
 o Strategic decisions are business actions taken to alter market conditions and behavior of rivals in
ways that increase and/or protect the strategic firm’s profit.
o While routine business practices are necessary for the goal of profit-maximization, strategic decisions
are generally optimal actions managers can take as circumstances permit
o
4. Economic Profits
- Economic profits are not accounting profits
- Economic profits are equal to revenues minus economic costs: PROFITS = TR – TC
- All economic costs are measured in terms of opportunity costs - Choices represent foregone opportunities

5. Economic Cost of Resources

- Opportunity cost of using any resource is: What firm owners must give up to use the resource
- Market-supplied resources: Owned by others & hired, rented, or leased
- Owner-supplied resources: Owned & used by the firm
- Total Economic Cost = Sum of opportunity costs of both market-supplied resources & owner-supplied
resources
- Explicit Costs: Monetary payments to owners of market-supplied resources
- Implicit Costs: Nonmonetary opportunity costs of using owner-supplied resources
- Types of Implicit Costs: Opportunity cost of cash provided by owners (Equity capital); Opportunity cost of
using land or capital owned by the firm; Opportunity cost of owner’s time spent managing or working for the
firm
- Economic Cost of Using Resources (Figure 1.2):

* Differences between Economic Profit vs Accounting Profit

Economic profit = Total revenue – Total economic cost
= Total revenue – Explicit costs – Implicit costs
Accounting profit = Total revenue – Explicit costs
 Accounting profit does not subtract implicit costs from total revenue
 Firm owners must cover all costs of all resources used by the firm –
 Objective is to maximize economic profit
6. Maximizing the Value of a Firm
- Value of a firm
o Price for which it can be sold
o Equal to net present value of expected future profit
- Risk premium
 o Accounts for risk of not knowing future profits
o The larger the risk, the higher the risk premium, & the lower the firm’s value
 Maximize firm’s value by maximizing profit in each time period: Cost & revenue conditions must be
independent across time periods
1 2 T T
T
  ...  
Value of a firm =
(1  r ) (1  r )2 (1  r )T t 1 (1  r )t

In the case: Infinite Annuity

- R = constant dollar annual return
- I = risk adjusted expected rate of return
- V = present value of future returns
=> Present value is negatively ralated to
discount rate

7. Some Common Mistakes Managers Make

- Never increase output simply to reduce average costs
- Pursuit of market share usually reduces profit
- Focusing on profit margin won’t maximize total profit
- Maximizing total revenue reduces profit
- Cost-plus pricing formulas don’t produce profit-maximizing prices
8. Separation of Ownership & Control
- Principal-agent problem: Conflict that arises when goals of management (agent) do not match goals of
owner (principal)
Ex. Mortgage brokers
- Moral Hazard: When either party to an agreement has incentive not to abide by all its provisions & one
party cannot cost effectively monitor the agreement
Ex. Preexisting conditions
9. Corporate Control Mechanisms
- Require managers to hold stipulated amount of firm’s equity
- Directors not serving on the firms’ management team
- Finance corporate investments with debt instead of equity
10. Price-Takers vs. Price-Setters
- Price-taking firm
o Cannot set price of its product
o Price is determined strictly by market forces of demand & supply
- Price-setting firm
o Can set price of its product
o Has a degree of market power, which is ability to raise price without losing all sales
 11. What is a Market?
- A market is any arrangement through which buyers & sellers exchange goods & services
- Markets reduce transaction costs - Costs of making a transaction other than the price of the good or
service
Because:
Buyers wishing to purchase something must spend valuable time and other resources finding sellers,
gathering information about prices and qualities, and ultimately making the purchase itself.
Sellers wishing to sell something must spend valuable resources locating buyers (or pay a fee to sales
agents to do so), gathering information about potential buyers (e.g., verifying creditworthiness or legal
entitlement to buy), and finally closing the deal.
These costs of making a transaction happen, which are additional costs of doing business over and above
the price paid, are known as transaction cost.
12. Market Structures
Market characteristics that determine the economic environment in which a firm operates
o Number & size of firms in market
o Degree of product differentiation
o Likelihood of new firms entering market
a. Perfect Competition
- Large number of relatively small firms
- Undifferentiated product
- No barriers to entry
b. Monopoly
- Single firm
- Produces product with no close substitutes
- Protected by a barrier to entry
c. Monopolistic Competition
- Large number of relatively small firms
- Differentiated products
- No barriers to entry
d. Oligopoly
- Few firms produce all or most of market output
- Profits are interdependent
- Actions by any one firm will affect sales & profits of the other firms
13. Globalization of Markets
- Economic integration of markets located in nations around the world
o Provides opportunity to sell more goods & services to foreign buyers
o Presents threat of increased competition from foreign producers

Chapter 2: Demand, Supply, and Market Equilibrium

a. Demand:
- Quantity demanded (Qd): Amount of a good or service consumers are willing & able to purchase during a
given period of time.
Definitions
- Demand function: Quantity demand as a function of the independent variables that influence the quantity
demanded
- Direct demand: The direct relationship between the quantity demanded and price (other independent
variables held constant)
- Inverse demand: The direct relationship between price and quantity demanded
- Demand curve: A graphical presentation of inverse demand
General Demand Function

- b, c, d, e, f, & g are slope parameters

• Measure effect on Qd of changing one of the variables while holding the others constant
- Sign of parameter shows how variable is related to Qd

• Positive sign indicates direct relationship

• Negative sign indicates inverse relationship
Six variables that influence Qd
- Price of good or service (P)
- Incomes of consumers (M)
- Prices of related goods & services (PR)
- Taste patterns of consumers (T)
- Expected future price of product (Pe)
- Number of consumers in market (N)
a. General demand function

- Inferior good: higher income, lower demand  instant noodles

- Normal good: higher income, higher demand  clothing, household appliances
- Substitute good: Pepsi and Cocacola. Higher pepsi price -> higher demand for Cocacola
- Complement good: higher price of 1 good  lower demand for the both 2 goods . example: cereal and milk,
coffee and condensed milk.
b. Direct Demand Function: The direct demand function, or simply demand, shows how quantity demanded,
Qd, is related to product price, P, when all other variables are held constant: Qd = f(P)
Law of Demand
- Qd increases when P falls, all else constant
- Qd decreases when P rises, all else constant
- ∆Qd/∆P must be negative

Direct Demand Function: Qd = f(P):

Inverse Demand Function: P = f(Qd)
 a. Inverse Demand Function
The price (P) is plotted on the vertical axis & quantity demanded (Qd) is plotted on the
horizontal axis
The equation plotted is the inverse demand function, P = f(Qd)
How much consumers are willing to pay as a function of quantity

b. Graphing Demand Curves

- A point on a direct demand curve shows either:
o Maximum amount of a good that will be purchased for a given price
o Maximum price consumers will pay for a specific amount of the good
- Change in quantity demanded
o Occurs when only price changes
o Movement along demand curve
- Change in demand
o Occurs when one of the other variables, or determinants of demand, changes
o Demand curve shifts rightward or leftward
c. Supply:
- Quantity supplied (Qs): Amount of a good or service offered for sale during a given period of time supply
- Six variables that influence Qs
o Price of good or service (P)
o Input prices (PI )
o Prices of goods related in production (Pr)
o Technological advances (T)
o Expected future price of product (Pe)
o Number of firms producing product (F)
a. General supply function: Qs = f(P, PI, Pr, T, Pe, F)

- k, l, m, n, r, & s are slope parameters

o Measure effect on Qs of changing one of the variables while holding the others constant
- Sign of parameter shows how variable is related to Qs
o Positive sign indicates direct relationship
o Negative sign indicates inverse relationship
- Direct for complements (Pr): Sugar and Candy
b. Direct Supply Function
- The direct supply function, or simply supply, shows how quantity supplied, Qs, is related to product price, P,
when all other variables are held constant: Qs = f(P)

c. Inverse Supply Function

- Price (P) is plotted on the vertical axis & quantity supplied (Qs) is plotted on the horizontal axis
- The equation plotted is the inverse supply function, P = f(Qs)
d. Graphing Supply Curves
- A point on a direct supply curve shows either:
o Maximum amount of a good that will be offered for sale at a given price
o Minimum price necessary to induce producers to voluntarily offer a particular quantity for sale

- Change in quantity supplied

o Occurs when price changes
o Movement along supply curve
- Change in supply
o Occurs when one of the other variables, or determinants of supply, changes
o Supply curve shifts rightward or leftward
d. Market Equilibrium
- Equilibrium price & quantity are determined by the intersection of demand & supply curves
- At the point of intersection, Qd = Qs
 Consumers can purchase all they want & producers can sell all they want at the “market-clearing” or
“equilibrium” price
- Excess demand (shortage): Exists when quantity demanded exceeds quantity supplied Qd > Qs
- Excess supply (surplus): Exists when quantity supplied exceeds quantity demanded Qd < Qs
e. Ceiling & Floor Prices
- Ceiling price:
o Maximum price government permits sellers to charge for a good
o When ceiling price is below equilibrium, a shortage occurs
- Floor price
o Minimum price government permits sellers to charge for a good
 o When floor price is above equilibrium, a surplus occurs

Find Market Equilibrium point:

Qd  1,400  10 P
Qs  400  20 P
Qd  Qs
1,400  10 P  400  20 P
Pe  $60
Qe  800

$50 Price Ceiling: A price ceiling is only effective when it is set below the equilibrium price

Qd  1,400  10 P
Qd  1,400  10(50)
Qd  900
Qs  400  20 P
Qs  400  20(50)
Qs  600
Excess demand  Qd  Qs  300

Marginal Valuation:

Qd  1,400  10 P
Qs  600

600  1,400  10 P

P  80
Highest black market price

$80 Price Floor:

 Qd  1,400  10 P
Qd  1,400  10(80)
Qd  600
Qs  400  20 P
Qs  400  20(80)
Qs  1,200
Excess supply  Qs  Qd  600

500 Unit Quota

f. Measuring the Value of Market Exchange

o Consumer surplus
Difference between the economic value of a good (its demand price) & the market price the consumer must pay
Total consumer surplus for 400 units is measured by the area bounded by the trapezoid uvsr
Total consumer surplus for 800 units (E point) is measured by the area bounded by the trapezoid uvA
o Producer surplus
For each unit supplied, difference between market price & the minimum price producers would accept to supply
the unit (its supply price)
Total producer surplus for 400 units is measured by the area of the trapezoid vwts.
o Social surplus = Sum of consumer & producer surplus = Area below demand & above supply over the
relevant range of output

g. Changes in Market Equilibrium

- Qualitative forecast
 o Predicts only the direction in which an economic variable will move
- Quantitative forecast
o Predicts both the direction and the magnitude of the change in an economic variable
- Simultaneous Shifts
o When demand & supply shift simultaneously
 Can predict either the direction in which price changes or the direction in which quantity changes, but not
both
 The change in equilibrium price or quantity is said to be indeterminate when the direction of change
depends on the relative magnitudes by which demand & supply shift

Simultaneous Shifts: (D, S) Simultaneous Shifts: (D, S)

Simultaneous Shifts: (D, S) Simultaneous Shifts: (D, S)

Chapter 3: Marginal Analysis for Optimal Decision

1. Optimization
- An optimization problem involves the specification of three things:
o Objective function to be maximized or minimized
o Activities or choice variables that determine the value of the objective function
o Any constraints that may restrict the values of the choice variables
- Maximization problem: An optimization problem that involves maximizing the objective function
- Minimization problem: An optimization problem that involves minimizing the objective function

- Unconstrained optimization: An optimization problem in which the decision maker can choose the
level of activity from an unrestricted set of values
Ex: profit maximization in the long-run
- Constrained optimization: An optimization problem in which the decision maker chooses values for
the choice variables from a restricted set of values
Ex: optimal combination of capital and labor given a cost constraint
 Choice Variables: Choice variables determine the value of the objective function
o Continuous variables: Can choose from uninterrupted span of variables.
Ex: 1,2,3,4
o Discrete variables: Must choose from a span of variables that is interrupted by gaps
2. Net Benefit (NB)
- Difference between total benefit (TB) and total cost (TC) for the activity: NB = TB – TC
 Optimal level of the activity (A*) is the level that maximizes net benefit
3. Marginal Benefit & Marginal Cost
- Marginal benefit (MB): Change in total benefit (TB) caused
by an incremental change in the level of the activity
- Marginal cost (MC): Change in total cost (TC) caused by an
incremental change in the level of the activity
To maximize profit: MB = MC
4. Optimal Level of Activity

5. Relating Marginals to Totals

Marginal variables measure rates of change in corresponding total variables
 Marginal benefit & marginal cost are also slopes of total benefit & total cost curves, respectively
Relating Marginals to Totals (Figure 3.2)
6. Using Marginal Analysis to Find Optimal Activity Levels – Conclusion of Unconstrained
Maximization with Discrete Choice Variables
- If marginal benefit > marginal cost
 Activity should be increased to reach highest net benefit
- If marginal cost > marginal benefit
 Activity should be decreased to reach highest net benefit
- Optimal level of activity
 When no further increases in net benefit are possible
 Occurs when MB = MC
Using Marginal Analysis to Find A*

7. Irrelevance of Sunk, Fixed, and Average Costs

- Sunk costs: Previously paid & cannot be recovered
- Fixed costs: Constant & must be paid no matter the level of activity
 - Average (or unit) costs: Computed by dividing total cost by the number of units of the activity
 These costs do not affect marginal cost & are irrelevant for optimal decisions
8. Constrained Optimization
- Typical constrained maximization problem
o Multiple beneficial activities
o Constraint on the total resources available. The resources must be allocated efficiently among
the activities.
o Scarce resources must be allocated among various activities so as to maximize total benefit
- The ratio MB/P represents the additional benefit per additional dollar spent on the activity
 Ratios of marginal benefits to prices of various activities are used to allocate a fixed number of
dollars among activities
- Expenditure on resources is optimally allocated when the last dollar spend on each activity provides
identical marginal benefits
Maximize Sales – example:

Steps in Decision Process

o Calculate marginal benefit of additional resources for all activities.
o Calculate marginal benefit from last dollar spent on resources devoted to each activity.
o Allocate each additional dollar of the resource to the activity that provides the greatest additional
benefit
Chapter 5: Theory of Consumer Behavior
- The Consumer’s Optimization Problem:
- Individual consumption decisions are made with the goal of maximizing total satisfaction from
consuming various goods and services
o Subject to the constraint that spending on goods exactly equals the individual’s money income
- Consumer Theory
- Assumes buyers are completely informed about:
o Range of products available
o Prices of all products
o Capacity of products to satisfy
o Their income
- Requires that consumers can rank all consumption bundles based on the level of satisfaction they would
receive from consuming the various bundles
- Typical Consumption Bundles for Two Goods, X & Y

- Properties of Consumer Preferences

- Completeness
For every pair of consumption bundles, A and B, the consumer can say one of the following:
A is preferred to B
B is preferred to A
The consumer is indifferent between A and B
- Transitivity
If A is preferred to B, and B is preferred to C, then A must be preferred to C
- Nonsatiation
More of a good is always preferred to less
 - Utility
- Benefits consumers obtain from goods & services they consume is utility
- A utility function shows an individual’s perception of the utility level attained from consuming each
conceivable bundle of goods
U = U(x,y)
- Indifference Curves
1. Locus of points representing different bundles of goods, each of which yields the same level of total
utility
2. Negatively sloped & convex
o Indifference curves are downward sloping. Because the consumer obtains utility from both goods, when
more X is added, some Y must be taken away in order to maintain the same level of utility. Consequently,
indifference curves must be downward sloping.
o Indifference curves are convex. A convex shape means that as consumption of X is increased relative to
consumption of Y, the consumer is willing to accept a smaller reduction in Y for an equal increase in X in
order to stay at the same level of utility.
 Show a combination off 2 goods that give consumer equal satisfaction and utility.
- Marginal Rate of Substitution
3. MRS shows the rate at which one good can be substituted for another while keeping utility constant
o Negative of the slope of the indifference curve
o Diminishes along the indifference curve as X increases & Y decreases
o Ratio of the marginal utilities of the goods
4. The marginal rate of substitution is 2, meaning that the consumer is willing to give up two units of Y for
each unit of X added.
5. Slope of an Indifference Curve & the MRS

6. Indifference Map
 The higher indifferent curve  higher level of satisfaction
Ex: Any consumption bundles on II is preferred than consumption bundles on I.
- Marginal Utility
- Addition to total utility attributable to the addition of one unit of a good to the current rate of consumption,
holding constant the amounts of all other goods consumed
- Consumer’s Budget Line
- Shows all possible commodity bundles that can be purchased at given prices with a fixed money income

M  PX X  PY Y
or
M: income
Px/Py = Slope = Relative price

Consumer’s Budget Constraint; Px =$1, Py = $2; I = $200

Typical Budget Line:

- Shifting Budget Lines

When the income changes  become higher  the budget constraint will
shift to the right (The consumer intend to buy more to maximize their
satisfactions)
 When the price of X changes, the budget line will rotate outside (changes in
X price just only affect quantity of X)

- Utility Maximization
- Utility maximization subject to a limited money income occurs at the combination of goods for which the
indifference curve is just tangent to the budget line
Y MU X PX
MRS    
X MUY PY
- Consumer allocates income so that the marginal utility per dollar spent on each good is the same for all
MU X MUY

commodities purchased PX PY

The absolute value of the slope of the budget line is

the price of burgers divided by the price of pizzas, or
PB/PP = $4/$8 = 1/2

- This indicates that to consume one additional $4 burger, Johnson must give up half of an $8 pizza.
Alternatively, 1 more pizza can be bought at a cost of 2 burgers.
- The highest possible level of utility is reached when Johnson purchases 30 pizzas and 40 burgers a month,
represented by point E, at which the budget line is tangent to indifference curve III.

- Johnson can purchase many combinations along her budget line (such as point A,B,C) other than the one at
point E. These other combinations all lie on lower indifference curves, therefore less preferred
- Suppose the MRS at combination C is 1/10 (the absolute value of the slope of tangent T equals 1y10),
meaning that Johnson is just willing to give up 10 burgers in order to obtain an additional pizza. Because the
absolute value of the slope of the budget line is 1/2, she can obtain the additional pizza by giving
up only 2 burgers. She clearly becomes better off by sacrificing the 2 burgers for the additional pizza.

- The marginal rate of substitution is the rate at which the consumer is willing to substitute one good for
another.
- The price ratio is the rate at which the consumer is able to substitute one good for another in the market.
- Demand
a. Individual Consumer Demand
- An individual’s demand curve for a specific commodity relates utility-maximizing quantities purchased
to market prices
o Money income & prices held constant
o Slope of demand curve illustrates law of demand—quantity demanded varies inversely with price
Deriving a Demand Curve
When the price is decreasing from 8 to 5$  the
demand for X as well as consumption of quantity of X
both increased.

b. Market Demand & Marginal Benefit

- List of prices & quantities consumers are willing & able to purchase at each price, all else constant
- Derived by horizontally summing demand curves for all individuals in market
- Because prices along market demand measure the economic value of each unit of the good, it can be
interpreted as the marginal benefit curve for a good

- Substitution & Income Effects

- When price changes, total change in quantity demanded is composed of two parts
o Substitution effect: S: Change in consumption of a good after a change in its price, when the consumer
is forced by a change in money income to consume at some point on the original indifference curve
 o Income effect: I: Change in consumption of a good resulting strictly from a change in purchasing power
Income & Substitution Effects: A Decrease in Px (Figure 5.12)

Consider the substitution effect alone:

- Amount of good consumed must vary inversely with price
- Income effect reinforces the substitution effect for a normal good & offsets it for an inferior good

Summary of Substitution & Income Effects (Table 5.2)

Inferior good: hàng hóa có cầu giảm khi thu nhập thực tế của người tiêu dùng tăng

 Application 1: Giffen Goods

Suppose the goods are potatoes and meat, and potatoes are an inferior good.
If price of potatoes rises,
o substitution effect: buy less potatoes
o income effect: buy more potatoes
If income effect > substitution effect, then potatoes are a Giffen good, a good for which an increase in price
raises the quantity demanded.
- Giffen good whose demand curve slopes upward because the (negative) income effect is larger than the
substitution effect.
  Application 2: Wages and Labor Supply
Budget constraint
o Shows a person’s tradeoff between consumption and leisure(thời gian rảnh rỗi).
o Depends on how much time she has to divide between leisure and working.
o The relative price of an hour of leisure is the amount of consumption she could buy with an hour’s
wages.
Indifference curve
Shows “bundles” of consumption and leisure that give her the same level of satisfaction.
- At the optimum, the MRS between leisure and consumption equals the wage.
 An increase in the wage has two effects on the optimal quantity of labor supplied.
- Substitution effect (SE): A higher wage makes leisure more expensive relative to consumption.

The person chooses less leisure, i.e., increases quantity of labor supplied.
- Income effect (IE): With a higher wage, she can afford more of both “goods.”

She chooses more leisure, i.e., reduces quantity of labor supplied.

 Cases where the income effect on labor supply is very strong:
- Over last 100 years, technological progress has increased labor demand and real wages.
The average workweek fell from 6 to 5 days.
- When a person wins the lottery or receives an inheritance, his wage is unchanged—hence no substitution
effect.

But such persons are more likely to work fewer hours, indicating a strong income effect.
 Application 3: Interest Rates and Saving
A person lives for two periods.
Period 1: young, works, earns $100,000
consumption = $100,000 minus amount saved
Period 2: old, retired
consumption = saving from Period 1 plus interest earned on saving
- The interest rate determines the relative price of consumption when young in terms of consumption when old.

A change in the interest rate

- Suppose the interest rate rises.
Substitution effect
Current consumption becomes more expensive relative to future consumption.
Current consumption falls, saving rises, future consumption rises.
Income effect
Can afford more consumption in both the present and the future. Saving falls.
Chapter 6: Elasticity and Demand
1. Elasticity
Price Elasticity of Demand (E): Measures responsiveness or sensitivity of consumers to changes in the price of
 Q
E
a good  P
o P & Q are inversely related by the law of demand so E is always negative
o The larger the absolute value of E, the more sensitive buyers are to a change in price
2. Sign of Price Elasticity of Demand
- The coefficient of the price elasticity of demand is always negative
- It is intuitively more appealing to talk about price elasticity in terms of its absolute value.
Price Elasticity of Demand (E)

Inelastic => Hàng thiết yếu

o Elastic Demand  Lower the price then TR will increase
o Inelastic Demand  increase the price then TR will increase (Parking fee on special occasion is higher
but ppl still pay for it)

3. Price Elasticity of Demand (E)

- Percentage change in quantity demanded can be predicted for a given percentage change in price as:
%Qd = %P x E
- Percentage change in price required for a given change in quantity demanded can be predicted as:
%P = %Qd ÷ E

Price Elasticity & Total Revenue

 4. Factors Affecting Price Elasticity of Demand
- Availability of substitutes
The better & more numerous the substitutes for a good, the more elastic is demand
- Percentage of consumer’s budget
The greater the percentage of the consumer’s budget spent on the good, the more elastic is demand
- Time period of adjustment
The longer the time period consumers have to adjust to price changes, the more elastic is demand
- Necessities versus Luxuries
Luxuries have a more elastic demand
- Definition of the market
The more finely defined the market the more elastic the demand. (Thị trường càng được xác định rõ ràng
thì cầu càng co giãn.)
The more aggregate the definition of the market the more inelastic the demand
Ex: hamburger < beef <all meat products
5. Calculating Price Elasticity of Demand
- Price elasticity can be calculated by multiplying the slope of demand ( Q/P) times the ratio of price to
quantity (P/Q)

-
Price elasticity can be measured at an interval (or arc) along demand, or at a specific point on the demand
curve
o If the price change is relatively small, a point calculation is suitable
o If the price change spans a sizable arc along the demand curve, the interval calculation
provides a better measure
Note:
o Regression analysis provides a point estimate
o Arc elasticity is typically only used for teaching purposes

a. Computation of Elasticity Over an Interval

- When calculating price elasticity of demand over an interval of demand, use the interval or arc elasticity
formula

Q Average P
E 
P Average Q
 b. Computation of Elasticity at a Point
- When calculating price elasticity at a point on demand, multiply the slope of demand (Q/P),
computed at the point of measure, times the ratio P/Q, using the values of P and Q at the point of measure

Slope of demand = (Q/P) = -100 = (800 – 600) / (16 – 18)

Ratio P/Q at point a = 18/600

Method of measuring point elasticity depends on whether demand is linear or curvilinear

EXPLAINATION:
- Consider a general linear demand function of three variables—price (P), income (M), and the price of a
related good (PR): Q = a + bP + cM + dPR
- When values of the demand determinants (M and PR in this case) are held constant, they become part of the
constant term in the direct demand function:
Q = a′ + bP where a′ = a + cM + dPR and the slope parameter is b = ∆Q ∕ ∆P
- Point elasticity when demand is linear:
P P
Eb or E 
Q PA
Where P and Q are values of price and quantity demanded at the point of measure along demand, and (A= –a′ ∕
b) is the price-intercept of demand

Ex: Direct demand function is Q = 2,400 - 100P, so b= -100 and

Ex: point c: A = -a/b. In Figure 6.1, let us apply this alternative formula to calculate again the elasticity at point
c (P =9) => the price-intercept A is $24 = -2,400/-100, so the elasticity is

Q P P
E  
- Point elasticity when demand is curvilinear P Q P  A
 Where ∆Q ∕ ∆P is the slope of the curved demand at the
point of measure, P and Q are values of price and quantity
demanded at the point of measure, and A is the price-
intercept of the tangent line extended to cross the price axis

Elasticity (Generally) Varies Along a Demand Curve

Different intervals or points along the same demand curve have differing elasticities of demand, even when the
demand curve is linear
- For linear demand, price and Evary directly
o The higher the price, the more elastic is demand
o The lower the price, the less elastic is demand
- For curvilinear demand, no general rule about the relation between price and quantity
 Special case of Q = aPb which has a constant price
elasticity (equal to b) for all prices
1. Q  P 
log Q  log   log P
2. Q / P   (  ) P  1

3.   ( Q / P )( P / Q )   (  ) P  1 
P
P 
 

6. Marginal Revenue, Demand, And Price Elasticity

- Marginal revenue (MR) is the change in total revenue per unit change in output
- Since MR measures the rate of change in total revenue as quantity changes, MR is the slope of the total
revenue (TR) curve
- Demand & Marginal Revenue
o When inverse demand is linear,
P = A + BQ (A > 0, B < 0)
Marginal revenue is also linear, intersects the vertical (price)
axis at the same point as demand, & is twice as steep as demand
MR = A + 2BQ
Total Revenue

All demand & marginal revenue curves, the relation between marginal revenue, price, & elasticity can be
 1
MR  P  1  
expressed as:  E
Note that as E  -∞ that MR  P
7. Income Elasticity
- Income elasticity (EM) measures the responsiveness of quantity demanded to changes in income,
 Qd Qd M
EM   
holding the price of the good & all other demand determinants constant
 M M Qd
o Positive for a normal good
o Negative for an inferior good

8. Cross-Price Elasticity
Cross-price elasticity (EXR) measures the responsiveness of quantity demanded of good X to changes in the
price of related good R, holding the price of good X & all other demand determinants for good X constant
o Positive when the two goods are substitutes
o Negative when the two goods are complements
  Q X Q X PR
E XR   
 PR PR QX
Example: Q = 49,800 - 750P + 0.85M + 400P L - 625PP
The general manager decides to calculate the cross-price elasticities for hockey tickets and parking fees, EXL
and EXP, respectively, at the point on demand corresponding to the current values of the demand variables: P =
$75, M = $50,000, PL = $45, and PP = $15
o The cross-price elasticity of Buccaneer ticket demand with respect to Lightning ticket prices (EXL)

- The cross-price elasticity between Buccaneer and Lightning tickets is positive (for substitutes) but
rather small, indicating football and hockey are rather weak substitutes in Tampa

o The cross-price elasticity of Buccaneer ticket demand with respect to parking fees (EXP)

- The cross-price elasticity between football and parking is negative (as expected for complements) but
small, indicating that Buccaneer fans are not particularly responsive to changes in the price of parking

Interval Elasticity Measures

o To calculate interval measures of income & cross-price elasticities, the following formulas can be

employed
Point Elasticity Measures
o For the linear demand function Q = a + bP + cM + dP R, point measures of income & cross-price

elasticities can be calculated as

APPLICATION: Does Drug Interdiction Increase or Decrease Drug-Related Crime?

- One side effect of illegal drug use is crime: Users often turn to crime to finance their habit.
- We examine two policies designed to reduce illegal drug use and see what effects they have on drug-
related crime.
- For simplicity, we assume the total dollar value of drug-related crime equals total expenditure
on drugs.
- Demand for illegal drugs is inelastic, due to addiction issues.
Policy 1: Interdiction
Policy 2: Education

2. An Increase in Supply in the Market for Wheat

Compute the Price Elasticity of Demand When There Is a Change in Supply
=> Inelastic demand
100  110
(100  110) / 2
ED 
3.00  2.00
(3.00  2.00) / 2

0.095
  0.24
0.4

Chapter 8: Production and Cost in the Short Run

1. Basic Concepts of Production Theory

- Production function: Maximum amount of output that can be produced from any specified set of inputs,
given existing technology
- Technical efficiency: Achieved when maximum amount of output is produced with a given combination of
inputs
- Economic efficiency: Achieved when firm is producing a given output at the lowest possible total cost
- Inputs are considered variable or fixed depending on how readily their usage can be changed
o Variable input: An input for which the level of usage may be changed quite readily
 o Fixed input: An input for which the level of usage cannot readily be changed and which must be
paid even if no output is produced (fixed cost that you have to paid even you don’t produce such as
rent fee)
o Quasi-fixed input: A “lumpy” or indivisible input for which a fixed amount must be used for any
positive level of output; None is purchased when output is zero (Fixed cost but paid only when you
produced such as electricity Office cost)
- Short run
o At least one input is fixed
o All changes in output achieved by changing usage of variable inputs
- Long run
o All inputs are variable
o Output changed by varying usage of all inputs
2. Sunk Costs
- Payment for an input that, once made, cannot be recovered should the firm no longer wish to employ that
input
- Not part of the economic cost of production
- Should be ignored for decision making purposes
3. Avoidable Costs
- Input costs the firm can recover or avoid paying should it no longer wish to employ that input
- Matter in decision making and should not be ignored
- Reflect the opportunity costs of resource use
4. Short Run Production
- In the short run, capital is fixed.
- Only changes in the variable labor input can change the level of output
Short run production function
5. Average & Marginal Products
- Average product of labor: AP = Q/L
- Marginal product of labor: MP = Q/L
o When AP is rising, MP is greater than AP
o When AP is falling, MP is less than AP
o When AP reaches it maximum, AP = MP
Law of diminishing marginal product
- As usage of a variable input increases, a point is reached beyond which its marginal product decreases

Total, Average, & Marginal Product Curves

 6. Law of Diminishing Marginal Product (Returns)
- Only holds in the short-run (capital)
- As the quantity of the variable input (labor) increases, the capital to labor ratio declines
- Eventually an incremental increase in the variable input adds less to output than the previous incremental
increase in the variable input

7. Short Run Production Costs

- Total variable cost (TVC)
o Total amount paid for variable inputs
o Increases as output increases
- Total fixed cost (TFC)
o Total amount paid for fixed inputs
o Does not vary with output
- Total cost (TC)
TC = TVC + TFC
Total Cost Curves

8. Average Costs
 Short Run Marginal Cost
Short run marginal cost (SMC) measures rate of change in total cost (TC) as output varies
TC TVC
SMC  
Q Q
Short Run Average & Marginal Cost Curves

ATC

o Short Run Cost Curve Relations

o AFC decreases continuously as output increases  Equal to vertical distance between ATC & AVC
o AVC is U-shaped
o Equals SMC at AVC’s minimum
o ATC is U-shaped
o Equals SMC at ATC’s minimum
o SMC is U-shaped
o Intersects AVC & ATC at their minimum points
o Lies below AVC & ATC when AVC & ATC are falling
o Lies above AVC & ATC when AVC & ATC are rising

Chapter 9: Production and Cost in the Long Run

1. Production Isoquants
- In the long run, all inputs are variable & isoquants are used to study production decisions
 o An isoquant is a curve showing all possible input
combinations capable of producing a given level of output
o Isoquants are downward sloping; if greater amounts of labor
are used, less capital is required to produce a given output
A Typical Isoquant Map

2. Marginal Rate of Technical Substitution

The MRTS is the slope of an isoquant & measures rate at which the two inputs can be substituted for the one
another while maintaining a constant level of output
K
MRTS  
L
The minus sign is added to make MRTS a positive number since ∆K / ∆L, the slope of the isoquant, is negative
MPL
MRTS 
The MRTS can also be expressed as the ratio of two marginal products:
MPK
As labor is substituted for capital, MPL declines & MPK rises causing MRTS to diminish
K MPL
MRTS   
CONCLUSION:
L MPK
Proofing:
K
MRTS  
L
Y  ( MPL  L )  ( MPK  K )
0  ( MPL  L )  ( MPK  K )
MPL K
  MRTS
MPk L

3. Isocost Curves
- Show various combinations of inputs that may be purchased for given level of expenditure (C) at given

C w r  $ 10
K  L w  $5
input prices (w, r) r r C  $ 100
- Slope of an isocost curve is the negative of the input price ratio (-w/r) C  wL  rK
- K-intercept is C/r
C  5L  10 K
o Represents amount of capital that may be purchased if zero labor is purchased
Isocost Curves (Figures 9.2 & 9.3) C w
K   L
r r
100 5
K   L
10 10
 4. Optimal Combination of Inputs
- Minimize total cost of producing Q by choosing the input combination on the isoquant for which Q is just
tangent to an isocost curve
o Two slopes are equal in equilibrium
o Implies marginal product per dollar spent on last unit of each input is the same
MPL w MPL MPK
 or 
MPK r w r
5. Optimal Input Combination to Minimize Cost for Given Output
a. The principle of minimizing the total cost of producing a given level of output
Suppose
𝑀𝑃 = 2, 𝑤 = $1
𝑀𝑃 = 3, 𝑟 = $2

? Is the firm using the right combination of inputs?

? If not, how should the firm reallocate its expenditure?
? Use the last dollar rule
MPL 2
 2
w $1
MPK 3
  1.5
r $2
Last dollar spent on labor increases output by more
than the last dollar spent on capital
Increase use of labor relative to capital
Decrease use of capital relative to labor
- Produce 10,000 units of output at the lowest possible cost.
- The price of labor (w) is $40 per unit, and the price of capital (r) is $60 per unit.
at point A where K =100 and L = 60

Solution
Manager uses information about marginal products and input prices to find the least-cost input combination, we
return to point A in Figure 9.4, where MRTS is greater than w/r.
o Assume that at point A, MPL = 160 and MPK = 80; thus MRTS = 2 (= MPL /MPK = 160/80).
o Because the slope of the isocost curve is 2/3 (= w/r = 40/60)

1. MRTS is greater than w/r, as

2. The firm should substitute labor, which has the higher marginal product per dollar, for capital, which has
the lower marginal product per dollar
 b. Production of Maximum Output with a Given Level of Cost
When managers can spend only a fixed
amount on production and wish to attain the highest
level of production consistent

At point E, the highest attainable isoquant, isoquant Q3 ,

is just tangent to the given isocost, and MRTS = w/r or
MPL /w=5 MPK/r

6. Optimization & Cost

Expansion path gives the efficient (least-cost) input combinations for every level of output
o Derived for a specific set of input prices
o Along expansion path, input-price ratio is constant & equal to the marginal rate of technical
substitution
Isoquants Q1, Q2, and Q3 show, respectively,
the input combinations of labor and capital
that are capable of producing 500, 700, and
900 units of
output. The price of capital (r) is $20 and the
price of labor (w) is $10. Thus, any isocost
curve would have a slope of 10/20 = ½
At optimal input combinations A, B, and C,
MRTS = w/r = 1/2. In the figure, the
expansion path connects these optimal points
and all other points so generated.

7. Long-Run Costs
Long-run total cost (LTC) for a given level of output is given by: LTC = wL* + rK*
o Where w & r are prices of labor & capital, respectively, & (L*, K*) is the input combination on the
expansion path that minimizes the total cost of producing that output
Long-run average cost (LAC) measures the cost per unit of output when production can be adjusted so that the
optimal amount of each input is employed: LTC
LAC 
o LAC is U-shaped Q
o Falling LAC indicates economies of scale
o Rising LAC indicates diseconomies of scale

Long-run marginal cost (LMC) measures the rate of change in long-run total cost as output changes along
expansion path LTC
o LMC is U-shaped LMC 
Q
o LMC lies below LAC when LAC is falling
o LMC lies above LAC when LAC is rising
o LMC = LAC at the minimum value of LAC

Derivation of a Long-Run Cost Schedule (Table 9.1)

Long-Run Total, Average, & Marginal Cost (Figure 9.8)
Long-Run Average & Marginal Cost Curves (Figure 9.9)

8. FORCES AFFECTING LONG-RUN COSTS

a. Economies of Scale
- Larger-scale firms are able to take greater advantage of opportunities for specialization & division of labor
o Specialization and division of labor: Dividing production into separate tasks allows workers to
specialize and become more productive, which lowers unit costs.
- Scale economies also arise when quasi-fixed costs are spread over more units of output causing LAC to fall
- Variety of technological factors can also contribute to falling LAC [P355 – CHAP 9 BOOK A]
Returns to Scale: f (cL, cK) = zQ
If all inputs are increased by a factor of c & output goes up by a factor of z then, in general, a producer
experience:
Increasing returns to scale if z > c; output goes up proportionately more than the increase in input usage
Decreasing returns to scale if z < c; output goes up proportionately less than the increase in input usage
Constant returns to scale if z = c; output goes up by the same proportion as the increase in input usage
Returns to Scale
Economies & Diseconomies of Scale (Figure 9.10)
b. Constant Long-Run Costs
Absence of economies and diseconomies of scale
o Firm experiences constant costs in the long run
o LAC curve is flat & equal to LMC at all output levels
Constant Long-Run Costs (Figure 9.11)

c. Minimum Efficient Scale (MES)

- The minimum efficient scale of operation (MES) is the lowest level of output needed to reach the minimum
value of long-run average cost
Minimum Efficient Scale (MES) (Figure 9.12)

MES (minimum efficient scales) with Various Shapes of LAC (Figure 9.13)
 9. Economies of Scope
- Exist for a multi-product firm when the joint cost of producing two or more goods is less than the sum of
the separate costs for specialized, single-product firms to produce the two goods:
LTC (X, Y) < LTC(X,0) + LTC (0, Y)
- Firms already producing good X can add production of good Y at a lower cost than a single-product firm
can produce Y:
LTC (X, Y) – LTC(X,0) < LTC (0, Y)
- Arise when firms produce joint products or employ common inputs in production
 Purchasing Economies of Scale
- Purchasing economies of scale arise when large-scale purchasing of raw materials enables large buyers to
obtain lower input prices through quantity discounts

Purchasing Economies of Scale (Figure 9.14)

10. Learning or Experience Economies

“Learning by doing” or “Learning through experience”:
o When cumulative output increases, causing workers to become more productive as they learn
by doing and LAC shifts downward as a result
- As total cumulative output increases, learning or experience economies cause long-run average
cost to fall at every output level
Learning or Experience Economies (Figure 9.15)
 11. Relations Between Short-Run & Long-Run Costs
- LMC intersects LAC when the latter is at its minimum point
- At each output where a particular ATC is tangent to LAC, the relevant SMC = LMC
- For all ATC curves, point of tangency with LAC is at an output less (greater) than the output of minimum
ATC if the tangency is at an output less (greater) than that associated with minimum LAC
Long-Run Average Cost as the Planning Horizon (Figure 9.16)

Figure 9.16 shows the three short-run average total cost (ATC) curves for the three plant sizes that make up the
planning horizon in this example: ATCK=10, ATCK=30, and ATCK=60.
o Output from 0 to 4,000 units, manager will choose the small plant size with the cost structure given
by ATCK=10 because the average cost, and hence the total cost, of producing each output over this range
is lower in a plant with 10 units of capital than in a plant with either 30 units or 60 units of capital
o When the firm wishes to produce output levels between 4,000 and 7,500 units, the manager would
choose the medium plant size (30 units of capital) because ATC K=30 lies below both of the other two
ATC curves for all outputs over this range.
o The set of all tangency points, such as r, m, and e in Figure 9.16, form a lower envelope of average
costs. For this reason, long-run average cost is called an “envelope” curve
12. Restructuring Short-Run Costs
- Because managers have greatest flexibility to choose inputs in the long run, costs are lower in the long
run than in the short run for all output levels except that for which the fixed input is at its optimal level
o Short-run costs can be reduced by adjusting fixed inputs to their optimal long-run levels when
the opportunity arises

Restructuring Short-Run Costs (Figure 9.14)

- The long-run and short-run costs are identical when the firm produces the output in the short run for
which the fixed plant size (capital input) is optimal.
- if demand or cost conditions change and the manager decides to increase or decrease output in the short
run, then the current plant size is no longer optimal. Now the manager will wish to restructure its short-run
costs by adjusting plant size to the level that is optimal for the new output level, as soon as the next
opportunity for a long-run adjustment arises
- The cost structure corresponds to the firm’s short-run expansion path in Figure 9.17, which is a horizontal
line at 60 units of capital passing through point E on the long-run expansion path. As long as the firm
produces 10,000 units in the short run, all of the firm’s inputs are optimally adjusted and its long- and short-
run costs are identical: Total cost is $7,200 (= $40 x 90 + $60 x 60) and average cost is $0.72 (=
$7,200/10,000).
- When the firm is producing the output level in the short run using the long-run optimal plant size, ATC and
LAC are tangent at that output level.
- If the manager decides to increase or decrease output in the short run, shortrun production costs will then
exceed long-run production costs because input levels will not be at the optimal levels given by the long-run
expansion path.
* For example, if the manager increases output to 12,000 units in the short run, the manager must employ
the input combination at point S on the short-run expansion path in Figure 9.17.
- The short-run total cost of producing 12,000 units is $9,600 (= $40 x 150 + $60 x 60) and average total cost
is $0.80 (= $9,600/12,000) at point s in Figure 9.17.
*The manager realizes that point F is a less costly input combination for producing 12,000 units,
because input combination F lies on a lower isocost line than S.
- Increasing capital to 70 units causes the short-run expansion path to shift upward as shown by the broken
horizontal line in Figure 9.17.
- By restructuring short-run production, the manager reduces the short-run total costs of producing 12,000
units by $600 (= $9,600 - $9,000)
Chapter 11: Managerial Decisions in Competitive Markets
1) Characteristic of Perfect Competition
- There are many buyers and sellers in the market
o Each produces only a very small portion of total market or industry output
- All firms produce a homogeneous product
 Firms are price-takers
- Entry into & exit from the market is unrestricted

2) Demand for a Competitive Price-Taker

- Demand curve is horizontal at price determined by intersection of market demand & supply (figure 11.2)
o Perfectly elastic
- Marginal revenue equals price (MR=P)
o Demand curve is also marginal revenue curve (D = MR)
- Can sell all they want at the market price
o Each additional unit of sales adds to total revenue an amount equal to price (D = MR = P)
 Demand for a Competitive Price-Taking Firm (Figure 11.2)

3) Profit-Maximization in the Short Run

- In the short run, managers must make two decisions:
o Produce or shut down?
 If shut down, produce no output and hires no variable inputs
 If shut down, firm loses amount equal to TFC
o If produce, what is the optimal output level?
 If firm does produce, then how much?
 Produce amount that maximizes economic profit
- In the short run, the firm incurs costs that are:
o Unavoidable and must be paid even if output is zero
o Variable costs that are avoidable if the firm chooses to shut down
- In making the decision to produce or shut down, the firm considers only the (avoidable) variable costs
& ignores fixed costs
1. The Output Decision: Earning Positive Economic Profit
- Profit Margin (or Average Profit)
o Level of output that maximizes total profit occurs at a higher level than the output that
maximizes profit margin (& average profit)
- Managers should ignore profit margin (average profit) when making optimal decisions
o Managers cannot maximize both profit and profit margin at the same level of output. For this reason,
profit margin—or, equivalently, average profit—should be ignored when making profit-
maximizing decisions. When a firm can make positive profit in the short run, profit is maximized at
the output level

Short-Run Output Decision

o The firm will shut down if:
 Total revenue cannot cover total avoidable cost (TR < TVC) or, equivalently, P  AVC
 Produce zero output
 Lose only total fixed costs
 Shutdown price is minimum AVC

o Firm will produce output where P = SMC

  Total revenue ≥ total avoidable cost or total variable cost (TR  TVC)
 Equivalently, the firm should produce if P  AVC
 If MR > MC: increase production
 If MR < MC: decrease production
 Maximize profit where MR = MC
2. Fixed, Sunk & Average Costs
- Fixed, sunk, & average costs are irrelevant in the production decision
o Fixed costs have no effect on marginal cost or minimum average variable cost—thus optimal
level of output is unaffected
o Sunk costs are forever unrecoverable and cannot affect current or future decisions
o Only marginal costs, not average costs, matter for the optimal level of output
Profit Maximization: P = $36 (Figure 11.3)

The points U and V in Figure 11.4 (100 units and 950 units) are sometimes called break-even points
because total revenue equals total cost and the firm earns zero profit. (TR = TC)
Short-Run Loss Minimization: P = $10.50 (Figure 11.5)
 Total Revenue = 300 x 10.5 = 3,150
TC = 300 X 17 = 5,100

Loss of profit = 3150 – 5100 = - 1,950 if the firm

produce at Q = 300

TFC = TC – TVC = 5,100 – 9x300 = 2,400

If the firm stop produce, it must pay -2,400 for fix cost

 To minimize the cost, the firm decide to continue

produce to reduce cost from 2,400 to 1,950.

Summary of Short-Run Output Decision

 AVC tells whether to produce
o Shut down if price falls below minimum AVC (P < AVC => SHUT DOWN)
 SMC tells how much to produce
o If P  minimum AVC, produce output at which P = SMC
 ATC tells how much profit/loss if produce
o π = (P – ATC)*Q

 Figure 2

Marginal Cost as the Competitive Firm’s Supply Curve

 An increase in the price from P1 to P2 leads to an increase in the firm’s profit-maximizing quantity from
Q1 to Q2. Because the marginal-cost curve shows the quantity supplied by the firm at any given price, it
is the firm’s supply curve.

3. Short-Run Supply for the Firm and Industry

- For an individual price-taking firm
o Portion of firm’s marginal cost curve above minimum AVC
o For prices below minimum AVC, quantity supplied is zero
- For a competitive industry
o Horizontal sum of supply curves of all individual firms; always upward sloping
o Supply prices give marginal costs of production for every firm
 Short-Run Producer Surplus
- Short-run producer surplus is the amount by which TR exceeds TVC (=TR - TVC)
- The area above the short-run supply curve that is below market price over the range of output
supplied
- Exceeds economic profit by the amount of TFC
Computing Short-Run Producer Surplus (Figure 11.6)

4. Long-Run Competitive Equilibrium

- All firms are in profit-maximizing equilibrium (P = LMC)
- Occurs because of entry/exit of firms in/out of industry
o Market adjusts so P = LMC = LAC
Long-Run Cost – Illustrate economics and diseconomics of scale.

Long-Run Profit-Maximizing Equilibrium (Figure 11.7) – at S where P = LMC

At M, marginal revenue exceeds marginal cost, so the firm can gain by producing more output.
Long-Run Competitive Equilibrium (Figure 11.8) =>
Condition in which all firms are producing
where P = LMC and economic profits are zero (P = LAC)

The LR Market Supply Curve

5. SR & LR Effects of an Increase in Demand

 Long-Run Industry Supply

o Long-run industry supply curve can be flat (perfectly elastic) or upward sloping
o Depends on whether constant cost industry or increasing cost industry
o Economic profit is zero for all points on the long-run industry supply curve for both types of industries
 Constant cost industry
- As industry output expands, input prices remain constant, & minimum LAC is unchanged
- P = minimum LAC, so curve is horizontal (perfectly elastic)
 Increasing cost industry
- As industry output expands, input prices rise, & minimum LAC rises
- Long-run supply price rises & curve is upward sloping
Long-Run Industry Supply for a Constant Cost Industry (Figure 11.9)
 Long-Run Industry Supply for an Increasing Cost Industry (Figure 11.10)

6. Economic Rent – apply only when the Long-run industry supply curve is up-ward.
- Payment to the owner of a scarce, superior resource in excess of the resource’s opportunity cost
- In long-run competitive equilibrium firms that employ such resources earn zero economic profit
- Potential economic profit is paid to the resource as economic rent
- In increasing cost industries, all long-run producer surplus is paid to resource suppliers as economic
rent
For example:
- A firm A hired a experienced and talented employee who can help the firm to build a house with less
$75,000 cost than other. That firm will gain a competitive advantage towards the other firm in the
market.
- But this employee required for a rising salary by $75,000 from 100,000 to 175,000 for his effeciency, if
not, he will leave to another company.
- In this case, the economic profit of the firm is zero in both case that the firm’s competitive advantage will
transfer to this employee’s salary or the firm will lose its competitive advantage.

Economic Rent in Long-Run Competitive Equilibrium (Figure 11.11)

- The
supply curve is now the industry’s long-run supply curve, SLR.
- At
every point along SLR, the firms in the industry are earning zero
economic profit
o All
producer surplus in the long-run ends up in the pockets of the resource
suppliers, and no producer surplus goes to the firms supplying the output in
this market.

Summary
7. Implementing the Profit-Maximizing Output Decision
- Step 1: Forecast product price
Use statistical techniques from Chapter 7
 -Step 2: Estimate AVC & SMC
AVC = a + bQ + cQ2
TVC = Q(a + bQ + cQ2)
SMC = a + 2bQ + 3cQ2
- Step 3: Check shutdown rule
o If P  AVCmin then produce
o If P < AVCmin then shut down
 To find AVCmin substitute Qmin into AVC equation

- Step 4: If P  AVCmin, find output where P = SMC

o Set forecasted price equal to estimated marginal cost & solve for Q*
P = MR = SMC
P = a + 2bQ* + 3cQ*2

- Step 5: Compute profit or loss

Profit = TR – TC
= P x Q* - AVC x Q* - TFC
= (P – AVC)Q* - TFC
Example
- Forecast market price
o High: $20
o Medium: $15
o Low: $10
- Estimate AVC
AVC = 20 - 0.003Q + 0.00000025Q2
TVC = Q(20 - 0.003Q + 0.00000025Q2)
= 20Q - 0.003Q2 + 0.00000025Q3

SMC = 20 - 2(0.003)Q + 3(0.00000025)Q2

= 20 - 0.006Q + 0.00000075Q2
- Check the shutdown decision
AVC = 20 - 0.003Q + 0.00000025Q2
 What Q  AVCmin?
Qmin = -b/2c = -0.003/(2*0.00000025)= 6,000
AVCmin = 20 - 0.003*6000 + 0.00000025*60002 = 11
o Shut down if P < $11

- The output decision when P = $15  not shutdown  find the output of Q
P = MR = SMC = 20 - 0.006Q + 0.00000075Q2
15 = 20 - 0.006Q + 0.00000075Q2
0 = 5 - 0.006Q + 0.00000075Q2
 o Q1* = 945; Q2* = 7055
o AVCQ=945 = 20 - 0.003(945) + 0.00000025(945)2= $17.39
o AVCQ=7,055 = 20 - 0.003(7,055) + 0.00000025(7,055)2= $11.28
- The total profit when P = $15; Q2* = 7055
Profit = TR – TC = (P*Q) - [(AVC *Q) + TFC]
= ($15* 7,055) - [($11.28*7,055) + $30,000]
= -$3,755

Chapter 12: Managerial Decisions for Firms with Market Power

1. Market Power
- Ability of a firm to raise price without losing all its sales  Firm can set the price
- Any firm that faces downward sloping demand has market power
- Gives firm ability to raise price above average cost & earn economic profit (if demand & cost
conditions permit)
 Monopoly – Characteristic:
o Single firm
o Produces & sells a good or service for which there are no good substitutes
o New firms are prevented from entering market because of a barrier to entry
2. Measurement of Market Power
- Degree of market power inversely related to price elasticity of demand
o The less elastic the firm’s demand, the greater its degree of market power
o The fewer close substitutes for a firm’s product, the smaller the elasticity of demand (in absolute
value) & the greater the firm’s market power
o When demand is perfectly elastic (demand is horizontal), the firm has no market power

- Lerner index measures proportionate amount by which price exceeds marginal cost:
P  MC
Lerner index 
P
o Equals zero under perfect competition
o Increases as market power increases
o Also equals –1/E, which shows that the index (& market power), vary inversely with elasticity
o The lower the elasticity of demand (absolute value), the greater the index & the degree of market
power
- If consumers view two goods as substitutes, cross-price elasticity of demand (EXY) is positive
o The higher the positive cross-price elasticity, the greater the substitutability between two goods, &
the smaller the degree of market power for the two firms
3. Barriers to Entry
- Entry of new firms into a market erodes market power of existing firms by increasing the number of
substitutes
- A firm can possess a high degree of market power only when strong barriers to entry exist
o Conditions that make it difficult for new firms to enter a market in which economic profits are
being earned
- Common Entry Barriers
Economies of scale  cost advantage
When long-run average cost declines over a wide range of output relative to demand for the product,
there may not be room for another large producer to enter market
Barriers created by government
Licenses, exclusive franchises
Essential input barriers
 One firm controls a crucial input in the production process
Brand loyalties
Strong customer allegiance to existing firms may keep new firms from finding enough buyers to make
entry worthwhile
Consumer lock-in
Potential entrants can be deterred if they believe high switching costs will keep them from inducing
many consumers to change brands
Network externalities
Occur when benefit or utility of a product increases as more consumers buy & use it
Make it difficult for new firms to enter markets where firms have established a large base or network of
buyers
4. Demand & Marginal Revenue for a Monopolist
- Market demand curve is the firm’s demand curve
- Monopolist must lower price to sell additional units of output
o Marginal revenue is less than price for all but the first unit sold
- When MR is positive (negative), demand is elastic (inelastic)
- For linear demand, MR is also linear, has the same vertical intercept as demand, & is twice as steep
Example:
- Common Grounds is the only seller of cappuccinos in town. The table shows the market demand for
cappuccinos.
- What is the relation between P and AR? Between P and MR?
Here, P = AR, same as for a competitive firm.
Here, MR < P, whereas MR = P for a competitive firm.

If MR>MC  Increase output

If MR<MC  does not produce additional units

Common Grounds’ D and MR Curves Demand & Marginal Revenue for a Monopolist
=> Demand curve is above MR

5. Short-Run equilibrium for Monopoly

- Monopolist will produce where MR = SMC as long as TR at least covers the firm’s total avoidable cost
(TR ≥ TVC)
o Price for this output is given by the demand curve
 If TR < TVC (or, equivalently, P < AVC) the firm shuts down & loses only fixed costs
 If P > ATC, firm makes economic profit
 If ATC > P > AVC, firm incurs a loss, but continues to produce in short run
i) Short-Run Profit Maximization for Monopoly (Figure 12.3)

It shows a situation in which P > ATC, and thus the monopolist earns an
economic profit

The monopolist maximizes profit by producing 200 units of output where MR =

SMC.

ii) Short-Run Loss Minimization for Monopoly (Figure 12.4)

It illustrates a monopolist that makes losses in the short run.

The monopolist would produce rather than shut down

in the short run.
TR - area 0DCE =70x50) > TVC of $3,250 (= $65 × 50 – 0GFE)
After all variable costs have been covered, there is still some revenue, $500 (area
GDCF), left over to apply to fixed cost. Since total fixed cost in this example is
$750 (= $15 × 50), or area ABFG
 firm loses less by producing 50 units than by shutting down
 If the monopolist shuts down, it would, of course, lose its entire fixed cost
of $750

6. Long-Run Profit maximization for Monopoly

- Monopolist maximizes profit by choosing to produce output where MR = LMC, as long as P  LAC
- Will exit industry if P < LAC
- Monopolist will adjust plant size to the optimal level
o Optimal plant is where the short-run average cost curve is tangent to the long-run average cost at
the profit-maximizing output level
 Long-Run Profit Maximization for Monopoly (Figure 12.5)
 Price = 55 > LAC

7. Profit-Maximizing Input Usage

(a) Price Discrimination
Discrimination: treating people differently based on some characteristic, e.g. race or gender.
o Price discrimination: selling the same good at different prices to different buyers.
 The characteristic used in price discrimination is willingness to pay (WTP):
o A firm can increase profit by charging a higher price to buyers with higher WTP.

 Perfect Price Discrimination vs. Single Price Monopoly

Here, the monopolist charges the same price (PM) to all buyers =>
A deadweight loss results – The consumer leave the market
because they cannot pay the price.

Here, the monopolist produces the competitive quantity, but

charges each buyer his or her WTP.

o This is called perfect price discrimination.

The monopolist captures all Consumer surplus as profit.
But there’s no DWL.
Price Discrimination in the Real World
In the real world, perfect price discrimination is not possible:
- No firm knows every buyer’s WTP
- Buyers do not reveal it to sellers
o Firms divide customers into groups based on some observable trait that is likely related to WTP, such as
age.
Examples:
o Movie tickets
Discounts for seniors, students, and people who can attend during weekday afternoons.
They are all more likely to have lower WTP than people who pay full price on Friday night.
o Airline prices
Discounts for Saturday-night stayovers help distinguish business travelers, who usually have higher
WTP, from more price-sensitive leisure travelers.
o Discount coupons
People who have time to clip and organize coupons are more likely to have lower income and lower
WTP than others.
o Need-based financial aid
Low income families have lower WTP for their children’s college education. Schools price-discriminate
by offering need-based aid to low income families.
o Quantity discounts
A buyer’s WTP often declines with additional units, so firms charge less per unit for large quantities
than small ones.
Example: A movie theater charges $4 for a small popcorn and $5 for a large one that’s twice as big.
8. Monopolistic Competition
 Characteristics:
- Large number of firms sell a differentiated product
o Products are close (not perfect) substitutes
- Market is monopolistic
o Product differentiation creates a degree of market power
- Market is competitive
o Large number of firms, easy entry
- Short-run equilibrium is identical to monopoly
- Unrestricted entry/exit leads to long-run equilibrium
o Attained when demand curve for each producer is tangent to LAC
o At equilibrium output, P = LAC and MR = LMC

Short-Run Profit Maximization for Monopolistic Competition (Figure 12.7)

Like Monololy market => Demand curve above MR curve
Long-Run Profit Maximization for Monopolistic Competition (Figure 12.8)

o Attained when demand curve for each producer is tangent to LAC

o At equilibrium output, P = LAC and MR = LMC

9. Implementing the Profit-Maximizing Output & Pricing Decision

Step 1: Estimate demand equation
Use statistical techniques from Chapter 7
Substitute forecasts of demand-shifting variables into estimated demand equation to get

Step 2: Find inverse demand equation

Solve for P
Step 3: Solve for marginal revenue
When demand is expressed as P = A + BQ, marginal revenue is
 a' 2
MR  A  2 BQ   Q
b b
Step 4: Estimate AVC & SMC

Step 5: Find output where MR = SMC

Set equations equal & solve for Q*
The larger of the two solutions is the profit-maximizing output level

Step 6: Find profit-maximizing price

Substitute Q* into inverse demand
P* = A + BQ*
Q & P are only optimal if P  AVC
* *

Step 7: Check shutdown rule

Substitute Q* into estimated AVC function
Step 8: Compute profit or loss
Profit = TR – TC
= P x Q* - AVC x Q* - TFC
= (P – AVC)Q* - TFC
If P < AVC, firm shuts down & profit is -TFC
10. Maximizing Profit at Aztec Electronics: An Example
- Aztec possesses market power via patents. Sells advanced wireless stereo headphones
(1) Estimation of demand & marginal revenue

(2) Solve for inverse demand (Chuyển từ Q function sang P)

(3) Determine marginal revenue function

P
= 100 – 0.002Q
MR
= 100 – 0.004Q (lấy đạo hàm)

(4) Estimation of average variable cost and marginal cost

Given the estimated AVC equation:
AVC = 28 – 0.005Q + 0.000001Q2
Then,
SMC = 28 – (2 x 0.005) Q + (3 x 0.000001) Q2
 = 28 – 0.01Q + 0.000003Q2
(5) Output decision
-
Set MR = MC and solve for Q*

100 – 0.004Q = 28 – 0.01Q + 0.000003Q2

0 = (28 – 100) + (-0.01 + 0.004)xQ + 0.000003Q2
0 = -72 – 0.006Q + 0.000003Q2
- Solve for Q* using the quadratic formula

(6) Substitute Q* into inverse demand

P* = 100 – 0.002(6,000)
= $88
(7) Shutdown decision

Compute AVC at 6,000 units:

AVC* = 28 - 0.005(6,000) + 0.000001(6,000)2
= $34
Because P = $88 > $34 = ATC, Aztec should produce rather than shut down
(8) Computation of total profit
π = TR – TVC – TFC
= (P* x Q*) – (AVC* x Q*) – TFC
= ($88 x 6,000) – ($34 x 6,000) - $270,000
= $528,000 - $204,000 - $270,000
= $54,000

9. Multiple Plants
- If a firm produces in 2 plants, A & B
o Allocate production so MCA = MCB
o Optimal total output is that for which MR = MCT
- For profit-maximization, allocate total output so that
MR = MCT = MCA = MCB
 MCA = 28 + 0.04QA
MCB = 16 + 0.02QB
QA = 25MCA – 700
QB = 50MCB − 800
Therefore, QT (= QA + QB)
QT = 75MCT − 1,500

 MCT = 20 + 0.0133QT
Noting that when MC = $40, QA = 300 units (point A), QB = 1,200 units (point B), and QT = QA + QB =
1,500 units (point C).
- Suppose that the estimated demand curve for Mercantile’s output is Q T = 5,000 − 100P
The inverse demand function is P = 50 − 0.01QT
and marginal revenue is MR = 50 − 0.02QT
 50 − 0.02QT = 20 + 0.0133QT

Chapter 13: Strategic Decision Making in Oligopoly Markets

1. Oligopoly Markets
- Interdependence of firms’ profits
o Distinguishing feature of oligopoly
o Arises when number of firms in market is small enough that every firms’ price & output
decisions affect demand & marginal revenue conditions of every other firm in market
 Strategic Decisions
- Strategic behavior
o Actions taken by firms to plan for & react to competition from rival firms
- Game theory
o Useful guidelines on behavior for strategic situations involving interdependence
- Simultaneous Decisions
o Occur when managers must make individual decisions without knowing their rivals’
decisions
EXAMPLE: Cell Phone Duopoly in Smalltown
- One possible duopoly outcome: collusion
- Collusion: an agreement among firms in a market about quantities to produce or prices to charge
- T-Mobile and Verizon could agree to each produce half of the monopoly output:
For each firm: Q = 30, P = $40, profits = $900
- Cartel: a group of firms acting in unison,
e.g., T-Mobile and Verizon in the outcome with collusion
2. Dominant Strategies
- Always provide best outcome no matter what decisions rivals make
- When one exists, the rational decision maker always follows its dominant strategy
- Predict rivals will follow their dominant strategies, if they exist
- Dominant strategy equilibrium
o Exists when all decision makers have dominant strategies
Example: Prisoners’ Dilemma
- All rivals have dominant strategies
- In dominant strategy equilibrium, all are worse off than if they had cooperated in making their
decisions
- It shows the four possibilities in a table called a payoff table.

Confessing is the best action Jane can take, no

matter what action she predicts Bill will take.
So both Bill and Jane will probably confess and
end up with sentences of 6 years each

3. Dominated Strategies
- Never the best strategy, so never would be chosen & should be eliminated
- Successive elimination of dominated strategies should continue until none remain
- Search for dominant strategies first, then dominated strategies
- When neither form of strategic dominance exists, employ a different concept for making
simultaneous decisions
Successive Elimination of Dominated Strategies
1st step is search for dominant strategies  no dominant strategies.
2nd step is eliminating the dominated strategies

3rd step: come up with this table, then choose the dominant strategies among the 4 possibilities.
  Making Mutually Best Decisions
- For all firms in an oligopoly to be predicting correctly each other’s decisions:
o All firms must be choosing individually best actions given the predicted actions of their
rivals, which they can then believe are correctly predicted
o Strategically astute managers look for mutually best decisions (win – win case, choose the
best one for yourself)
4. Nash Equilibrium

The Equilibrium for an Oligopoly

ACTIVE LEARNING 3

Super Bowl Advertising: A Unique Nash Equilibrium (Table 13.4)

The best choice for both is HIGH.

- No dominant strategies and dominated strategies to eliminate.
 The Nash equilibrium is the strategies for both firm is the best.
 I is the best because if Coke choose A(60,45), Pepsi will choose Medium – P(57.5,50) to gain
higher price but Coke’s price will reduce.

 When a unique Nash equilibrium set of decisions exists

- Rivals can be expected to make the decisions leading to the Nash equilibrium
 - With multiple Nash equilibria, no way to predict the likely outcome
- All dominant strategy equilibria are also Nash equilibria
- Nash equilibria can occur without dominant or dominated strategies
5. Best-Response Curves
- Analyze & explain simultaneous decisions when choices are continuous (not discrete)
- Indicate the best decision based on the decision the firm expects its rival will make
o Usually the profit-maximizing decision
- Nash equilibrium occurs where firms’ best-response curves intersect
Deriving Best-Response Curve for Arrow Airlines (Figure 13.1)

Best-Response Curves &

Nash Equilibrium (Figure 13.2)
Where BRA intersect with BRB at point N
is defined as nash equilibrium

6. Sequential Decisions
- One firm makes its decision first, then a rival firm, knowing the action of the first firm, makes its
decision
- The best decision a manager makes today depends on how rivals respond tomorrow
Game Tree
- Shows firms decisions as nodes with branches extending from the nodes
o One branch for each action that can be taken at the node
o Sequence of decisions proceeds from left to right until final payoffs are reached
- Roll-back method (or backward induction)
o Method of finding Nash solution by looking ahead to future decisions to reason back to the
current best decision
 Sequential Pizza Pricing (Figure 13.3)
From the game tree chart, Palace
will always choose Low whether Castle’s
decision making.
=> Castle should choose High
because, when Palace choose low, high for
Castle is better than low.

 First-Mover & Second-Mover Advantages

- First-mover advantage: If letting rivals know what you are doing by going first in a sequential decision
increases your payoff
- Second-mover advantage: If reacting to a decision already made by a rival increases your payoff
- Determine whether the order of decision making can be conferring an advantage (mang lại lợi thế)
 Apply roll-back method to game trees for each possible sequence of decisions
 First-Mover Advantage in Technology Choice (Figure 13.4)
Motorola and Sony both make greater profit if
they choose the same technologies than if they
choose opposite technologies: Cells A and D
are both better than either cell C or B. If the
technology decision is made simultaneously,
both cells A and D are Nash equilibrium
cells, and game theory provides no clear way
to predict the outcome
 If Motorola chooses its (analog) technology
first, It will gain a higher profit in case Sony
follow, cell A is the predicted outcome.
Motorola knows that if it chooses Digital, then
it will end up with $11.25 million when Sony
makes its best decision, which is to go Digital. If
Motorola chooses Analog, then it will end up
with $13.75 million when Sony makes its best
decision, which is to go Analog.

 Strategic Moves & Commitments

 Actions used to put rivals at a disadvantage
- Three types
o Commitments
 o Threats
o Promises
- Only credible strategic moves matter (Credible: A strategic move that will be carried out because it is in
the best interest of the firm making the move to carry it out.)
- Managers announce or demonstrate to rivals that they will bind themselves to take a particular action or
make a specific decision
o No matter what action is taken by rivals
a. Commitment: irreversible : ko thể thay đổi

b. Threats & Promises

- Manager make conditional statements
- Threats
o Explicit or tacit
o “If you take action A, I will take action B, which is undesirable or costly to you.”
- Promises
o “If you take action A, I will take action B, which is desirable or rewarding to you.”

7. Cooperation in Repeated Strategic Decisions

- Cooperation occurs when oligopoly firms make individual decisions that make every firm better off
than they would be in a (noncooperative) Nash equilibrium
 Cheating
- Making noncooperative decisions
o Does not imply that firms have made any agreement to cooperate
- One-time prisoners’ dilemmas
o Cooperation is not strategically stable
o No future consequences from cheating, so both firms expect the other to cheat
o Cheating is best response for each
Pricing Dilemma for AMD & Intel (Table 13.5)
 Both firms can do better by cooperating rather than by choosing their dominant strategy–Nash
equilibrium actions.
 Intel and AMD both can choose high prices for their chips and both can then earn greater profits
in cell A than in the noncooperative cell D
 But cell A strategy is not stable, one of two can cheat by set low price while the other set high
price.

Punishment for Cheating: making a retaliatory decision that forces rivals to return to a noncooperative
Nash outcome.
- With repeated decisions, cheaters can be punished
- When credible threats of punishment in later rounds of decision making exist
- Strategically astute managers can sometimes achieve cooperation in prisoners’ dilemmas
Deciding to Cooperate
- Cooperate
o When present value of costs of cheating exceeds present value of benefits of cheating
o Achieved in an oligopoly market when all firms decide not to cheat
- Cheat
o When present value of benefits of cheating exceeds present value of costs of cheating

8. Trigger Strategies
- A rival’s cheating “triggers” punishment phase
- Tit-for-tat strategy
o Punishes after an episode of cheating & returns to cooperation if cheating ends
- Grim strategy
o Punishment continues forever, even if cheaters return to cooperation
 Facilitating Practices
- Legal tactics designed to make cooperation more likely
- Four tactics
o Price matching
o Sale-price guarantees
o Public pricing
o Price leadership
Price Matching
- Firm publicly announces that it will match any lower prices by rivals
o Usually in advertisements
- Discourages noncooperative price-cutting
o Eliminates benefit to other firms from cutting prices
Sale-Price Guarantees
- Firm promises customers who buy an item today that they are entitled to receive any sale
price the firm might offer in some stipulated future period
- Primary purpose is to make it costly for firms to cut prices
Public Pricing
- Public prices facilitate quick detection of noncooperative price cuts
o Timely & authentic
- Early detection
o Reduces PV of benefits of cheating
o Increases PV of costs of cheating
o Reduces likelihood of noncooperative price cuts
Price Leadership
- Price leader sets its price at a level it believes will maximize total industry profit
o Rest of firms cooperate by setting same price
- Does not require explicit agreement
o Generally lawful means of facilitating cooperative pricing
Cartels
- Most extreme form of cooperative oligopoly
- Explicit collusive agreement to drive up prices by restricting total market output
- Illegal in U.S., Canada, Mexico, Germany, & European Union
- Pricing schemes usually strategically unstable & difficult to maintain
o Strong incentive to cheat by lowering price
- When undetected, price cuts occur along very elastic single-firm demand curve
o Lure of much greater revenues for any one firm that cuts price
o Cartel members secretly cut prices causing price to fall sharply along a much steeper
demand curve
Intel’s Incentive to Cheat (Figure 13.6)
 Tacit Collusion
- Far less extreme form of cooperation among oligopoly firms
- Cooperation occurs without any explicit agreement or any other facilitating practices
9. Strategic Entry Deterrence
- Established firm(s) makes strategic moves designed to discourage or prevent entry of new
firm(s) into a market
Two types of strategic moves
- Limit pricing
- Capacity expansion
a) Limit Pricing
- Established firm(s) commits to setting price below profit-maximizing level to prevent entry
- Under certain circumstances, an oligopolist (or monopolist), may make a credible
commitment to charge a lower price forever
Limit Pricing: Entry Deterred (Figure 13.7)

Limit Pricing: Entry Occurs (Figure 13.8)

 b) Capacity Expansion
- Established firm(s) can make the threat of a price cut credible by irreversibly increasing plant
capacity
- When increasing capacity results in lower marginal costs of production, the established
firm’s best response to entry of a new firm may be to increase its own level of production
- Requires established firm to cut its price to sell extra output
Excess Capacity Barrier to Entry (Figure 13.9)

Excess Capacity Barrier to Entry (Figure 13.9)

Chapter 15: Decisions Under Risk and Uncertainty

1. Risk vs. Uncertainty
a) Risk
- Must make a decision for which the outcome is not known with certainty
- Can list all possible outcomes & assign probabilities to the outcomes
b) Uncertainty
- Cannot list all possible outcomes
- Cannot assign probabilities to the outcomes
Measuring Risk with Probability Distributions
- Table or graph showing all possible outcomes/payoffs for a decision & the probability each
outcome will occur
- To measure risk associated with a decision
o Examine statistical characteristics of the probability distribution of outcomes for the
decision
Probability Distribution for Sales (Figure 15.1)
2. Expected Value
- Expected value (or mean) of a probability distribution is:

- Does not give actual value of the random outcome

- Indicates “average” value of the outcomes if the risky decision were to be repeated a large
number of times
3. Variance
- Variance is a measure of absolute risk
- Measures dispersion of the outcomes about the mean or expected outcome

- Identical Means but Different Variances (Figure 15.2)

 - A has smaller range  lower variance  lower risk that you can control
- B has a biiger range  higher vảiance  higher risk
 The higher the variance, the greater the risk associated with a probability distribution

4. Standard Deviation
- Standard deviation is the square root of the variance

-
  Variance( X )
X
 The higher the standard deviation, the greater the risk
5. Coefficient of Variation
- When expected values of outcomes differ substantially, managers should measure riskiness
of a decision relative to its expected value using the coefficient of variation
- A measure of relative risk
Standard deviation 
 
Expected value E( X )
The smaller coefficient of variation, the lower risk.
A = 9/50 = 0.18 / 1
Meaning that for 1 dollar of expected value, you face 0.18 of risk.
6.
Decisions Under Risk
- No single decision rule guarantees profits will actually be maximized
- Decision rules do not eliminate risk
o Provide a method to systematically include risk in the decision-making process
Summary of Decision Rules Under Conditions of Risk

Which Rule is Best?

- For a repeated decision, with identical probabilities each time
o Expected value rule is most reliable to maximizing (expected) profit
o Average return of a given risky course of action repeated many times approaches the
expected value of that action
 - For a one-time decision under risk
o No repetitions to “average out” a bad outcome
o No best rule to follow
- Rules should be used to help analyze & guide decision making process
o As much art as science
7. Expected Utility Theory: A THEORY OF DECISION MAKING UNDER RISK
- Actual decisions made depend on the willingness to accept risk
- Expected utility theory allows for different attitudes toward risk-taking in decision making
o Managers are assumed to derive utility from earning profits
- Managers make risky decisions in a way that maximizes expected utility of the profit outcomes
E U (  )  p1U( 1 )  p2U( 2 )  ...  pnU( n )
- Utility function measures utility associated with a particular level of profit
o Index to measure level of utility received for a given amount of earned profit
a) Manager’s Attitude Toward Risk
MU  U (  ) 
profit
- Determined by the manager’s marginal utility of profit:
- Marginal utility (slope of utility curve) determines attitude toward risk
There are 3 types of Manager’s Attitude Toward Risk
Risk averse
If faced with two risky decisions with equal expected profits, the less risky decision is chosen
Risk loving
Expected profits are equal & the more risky decision is chosen
Risk neutral
Indifferent between risky decisions that have equal expected profit
 Can relate to marginal utility of profit
- Diminishing MUprofit => Risk averse
- Increasing MUprofit - Risk loving
- Constant MUprofit - Risk neutral
 8. Finding a Certainty Equivalent for a Risky Decision (Figure 15.6)

- If the expected utilities of decisions A and B are equal, E(UA) = E(UB)

1 x U($5,000) = 0.95 x U($6,000) + 0.05 x U($1,000)
 U($5,000) = (0.95 x 1) + (0.05 x 0) = 0.95
 The utility index value of 0.95 is an indirect measure of the utility of $5,000 of profit.
So that, the manager is indifferent between having a profit of $5,000 for sure or making a risky decision
having a 95 percent chance of earning $6,000 and a 5 percent chance of earning $1,000

 Certainty equivalent: The dollar amount that a manager would be just willing to trade for
the opportunity to engage in a risky decision.

Maximization of Expected Utility:

i) Case of Risk neutral manager:
 Open its new restaurant in Atlant
 Boston has the highest expected profit [E(p) = $3,750], Boston also has the highest level of risk
(=1,545), and the risk-averse manager at CRC prefers to avoid the relatively high risk of locating the
new restaurant in Boston.
 In this case of a risk-averse decision maker, the manager chooses the less risky
 Atlanta location over the more risky Cleveland location even though both locations have identical
expected profit levels.
ii) Case of Risk-loving manager:
 Conclusion: Expected Utility of Profits
- According to expected utility theory, decisions are made to maximize the manager’s expected
utility of profits
- Such decisions reflect risk-taking attitude
o Generally differ from those reached by decision rules that do not consider risk
o For a risk-neutral manager, decisions are identical under maximization of expected utility or
maximization of expected profit
9. Decisions Under Uncertainty
- With uncertainty, decision science provides little guidance
 Four basic decision rules are provided to aid managers in analysis of uncertain situations
Summary of Decision Rules Under Conditions of Uncertainty

 Maximax rule (Expand 20%)

Trong số các cái max, chọn cái max
=> Recovery is the best outcome for each possible
decision.
=> chọn Expand plant max nhứt trong các cái max
 Maximin rule (Reduce by 20%)
Trong số các cái Min(theo chiều ngang), chọn cái max.
 -$3 million for expanding plant size by 20 percent.
 $0.5 million for maintaining plant size.
 $0.75 million for reducing plant size by 20 percent => choose
 Minimax regret rule (Maintain) -> minimize regret
Trong số các cái max ngang -> chọn cái min
o $3.75 million for expanding plant size by 20 percent.
o $2 million for maintaining plant size.
o $3 million for reducing plant size by 20 percent
 Equal probability rule (Maintain)
Chapter 17: Markets with Asymmetric Information
1. Quality uncertainty and the Market for lemons
- Asymmetric information: situation in which a buyer and a seller possess different information
about a transaction.
- When sellers of products have better information about product quality than buyers, a “lemons
problem” may arise in which low-quality goods drive out high quality goods.
- In (a) the demand curve for high-quality cars is DH. However, as buyers lower their expectations
about the average quality of cars on the market, their perceived demand shifts to DM.

- Likewise, in (b) the perceived demand curve for low-quality cars shifts from DL to DM. As a
result, the quantity of high-quality cars sold falls from 50,000 to 25,000, and the quantity of low-
quality cars sold increases from 50,000 to 75,000.
- Eventually, only low-quality cars are sold.

The lemons problem: With asymmetric information, low-quality goods can drive high-quality
goods out of the market.
  Implications of Asymmetric Information
- Adverse selection: Form of market failure resulting when products of different qualities are sold at a single
price because of asymmetric information, so that too much of the low-quality product and too little of the high-
quality product are sold.
- The market for Insurance: People who buy insurance know much more about their general health than
any insurance company can hope to know, even if it insists on a medical examination. As a result, adverse
selection arises, much as it does in the market for used cars.
- Market of credit: Credit card companies and banks can, to some extent, use computerized credit histories, which
they often share with one another, to distinguish low-quality from high-quality borrowers. Many people,
however, think that computerized credit histories invade their privacy.

-
2. Market signaling
- Market signal: Process by which sellers send signals to buyers conveying information about
product quality.
- To be strong, a signal must be easier for high-productivity people to give than for low-productivity
people to give, so that high-productivity people are more likely to give it.
- Model of Job market signaling to reduce AI:
- Education can be a useful signal of the high productivity of a group of workers if education is
easier to obtain for this group than for a low- productivity group. However, in (b), the high-
productivity group will choose an education level of y* = 4 because the gain in earnings is greater
than the cost.
 Cost–Benefit Comparison
o In deciding how much education to obtain, people compare the benefit of education with the
cost.
o People in each group make the following cost-benefit calculation: Obtain the education level y*
if the benefit (i.e., the increase in earnings) is at least as large as the cost of this education.
3. Moral Hazard (Rủi ro đạo đức)
- Moral hazard: When a party whose actions are unobserved can affect the probability or
magnitude of a payment associated with an event.
- Moral hazard alters the ability of markets to allocate resources efficiently. D gives the demand for
automobile driving.
- With no moral hazard, the marginal cost of transportation MC is $1.50 per mile; the driver drives
100 miles, which is the efficient amount.
- With moral hazard, the driver perceives the cost per mile to be MC = $1.00 and drives 140 miles.

-
4. The principal –Agent Problem
- Principal–agent problem: Problem arising when agents (e.g., a firm’s managers) pursue their own
goals rather than the goals of principals (e.g., the firm’s owners).
o Agent: Individual employed by a principal to achieve the principal’s objective.
o Principal: Individual who employs one or more agents to achieve an objective.
- The principal–Agent Problem in Private Enterprises
o Most large firms are controlled by management.
o Managers of private enterprises can thus pursue their own objectives.
o However, there are limitations to managers’ ability to deviate ( đi chệch hướng) from the
objectives of owners.
o First, stockholders can complain loudly when they feel that managers are behaving
improperly.
o Second, a vigorous market for corporate control can develop.
o Third, there can be a highly developed market for managers.
- Example:
o CEO compensation has increased sharply over time.
o For years, many economists believed that executive compensation reflected an appropriate
reward for talent.
o Recent evidence, however, suggests that managers have been able to increase their power
over boards of directors and have used that power to extract compensation packages that are
out of line with their economic contributions.
o First, most boards of directors do not have the necessary information or independence to
negotiate effectively with managers.
o Second, managers have introduced forms of compensation that camouflage the extraction of
rents from shareholders.
- Incentives in the Principal–Agent Framework

-
- Suppose, for example, that the owners offer the repairperson the following payment scheme
(given costs of putting low and high efforts are $0 and $10,000, respectively):

 Under this system, the repairperson will choose to make a high level of effort.

- This is not the only payment scheme that will work for the owners, however.
- Suppose they contract to have the worker participate in the following revenue-sharing arrangement.
When revenues are greater than $18,000, given costs of putting low and high efforts are $0 and
$10,000, respectively :
W = R - $18,000
(Otherwise, the wage is zero.)
- In this case, if the repairperson makes a low effort, he receives an expected payment of $1000. But
if he makes a high level of effort, his expected payment is $ 2,000.
- Under this bonus arrangement, a low effort generates no payment. A high effort, however, generates
an expected payment of $12,000, and an expected payment less the cost of effort of $12,000 -
$10,000 = $2000. Under this system, the repairperson will choose to make a high level of effort.
5. Managerial incentives in an integrated firm:
- Horizontal integration: Organizational form in which several plants produce the same or related
products for a firm.
- Vertical integration: Organizational form in which a firm contains several divisions, with some
producing parts and components that others use to produce finished products.
- Asymmetric Information and Incentive Design in the Integrated Firm
o In an integrated firm, division managers are likely to have better information about their
different operating costs and production potential than central management has. This
asymmetric information causes two problems.
1. How can central management elicit accurate information about divisional operating costs and
production potential from divisional managers?
2. What reward or incentive structure should central management use to encourage divisional
managers to produce as efficiently as possible?
- For example, if the manager’s estimate of the feasible production level is Qf, the annual bonus in
dollars, B, might be: (17.3)

where Q is the plant’s actual output, 10,000 is the bonus when output is at capacity, and 0.5 is a
factor chosen to reduce the bonus if Q is below Qf.
(Dễ manipulate, division manager can state a lower Qf than available capacity to receive higher
bonus)
- We will use a slightly more complicated formula than the one in (17.3) to calculate the bonus:

(17.4)

The parameters (.3, .2, and .5) have been chosen so that each manager has the incentive to reveal the
true feasible production level and to make Q, the actual output of the plant, as large as possible.
Conclusion:
 A bonus scheme can be designed that gives a manager the incentive to estimate accurately the size of
the plant.
 If the manager reports a feasible capacity of 20,000 units per year, equal to the actual capacity, then
the bonus will be maximized (at $6000).

 Application:
o Companies are learning that bonus schemes provide better results.
o The salesperson can be given an array of numbers showing the bonus as a function of both the sales
target chosen by the salesperson and the actual level of sales.
o Salespeople will quickly figure out that they do best by reporting feasible sales targets and then
working as hard as possible to meet them.
6. Asymmetric information in labor market: efficiency wage theory:
- Efficiency wage theory: Explanation for the presence of unemployment and wage discrimination
which recognizes that labor productivity may be affected by the wage rate.
- 4 reasons why firms might pay efficient wages:
1) Worker health
o In less developed countries, poor nutrition is a common problem.
o Paying higher wages allows workers to eat better, makes them healthier, more productive.
2) Worker turnover
o Hiring & training new workers is costly.
o Paying high wages gives workers more incentive to stay, reduces turnover.
3) Worker quality
o Offering higher wages attracts better job applicants, increases quality of the firm’s workforce.
4) Worker effort
o Workers can work hard or shirk. Shirkers are fired if caught. Is being fired a good deterrent?
o Depends on how hard it is to find another job. If market wage is above eq’m wage, there aren’t
enough jobs to go around, so workers have more incentive to work not shirk.
 Unemployment in a Shirking Model
- Unemployment can arise in otherwise competitive labor markets when employers cannot accurately
monitor workers.
- Here, the “no shirking constraint” (NSC) gives the wage necessary to keep workers from shirking.
 - The firm hires Le workers (at a higher than competitive efficiency wage w e), creating L* − Le of
unemployment.

Macroeconomic: The Data of macroeconomic

Objective: To improve standards of living, the economists will use some index:
Economic growth
Costs of living (inflation)
Unemployment
Budget and public debts
Interest rates and exchange rates
Consumption and savings
Government policies (monetary and fiscal)
1. Economic growth
- Measuring value of economic activity
- Gross Domestic Product (GDP)
o Measures the total income of everyone in the economy
o Measures the total expenditure on the economy’s output of goods and services
- For an economy as a whole
o Income must equal expenditure
- Circular-flow diagram – assumptions:
o Markets
 Goods and services
 Factors of production
o Households
 Spend all of their income
 Buy all goods and services
o Firms
 Pay wages, rent, profit to resource owners
Figure 1: The Circular-Flow Diagram

 The Measurement of GDP

 Gross domestic product (GDP): Market value of all final goods and services produced within a
country in a given period of time
“GDP is the market value…”
Market prices – reflect the value of the goods
“… of all…”
All items produced in the economy
And sold legally in markets
Excludes most items
Produced and sold illicitly
 Produced and consumed at home
“… final…”
Value of intermediate goods is already included in the prices of the final goods
“… goods and services…”
Tangible goods & intangible services
“… produced…”
Goods and services currently produced
The Measurement of GDP, Part 4
“… within a country…”
Goods and services produced domestically
Regardless of the nationality of the producer
“… in a given period of time”
A year or a quarter

The Components of GDP, Part 1

Identity: Y = C + I + G + NX
o Y = GDP
o C = consumption
o I = investment
o G = government purchases
o NX = net exports
Consumption, C
o Spending by households on goods and services
Goods: durable goods, nondurable goods
Services: intangibles, spending on education
o Exception: purchases of new housing
Investment, I
o Purchase of (capital) goods that will be used to produce other goods and services in the future
 Business capital: business structures, equipment, and intellectual property products
 Residential capital: landlord’s apartment building; a homeowner’s personal residence
 Inventory accumulation
Government purchases, G
o Government consumption expenditure and gross investment
o Spending on goods and services
o By local, state, and federal governments
o Does not include transfer payments
Net exports, NX = Exports - Imports
o Exports: Spending on domestically produced goods by foreigners
o Imports: Spending on foreign goods by domestic residents
 In case, increasing export will increase GDP, but it does not reflect the real GDP.
 GNI ( The left income for domestic country) = GDP + Net Factor Income Abroad (*)
 (*) (+) income from bussiness in foreign countries
(-) money invest to business in foreign countries ( outflow)
2. Real versus Nominal GDP:
If total spending rises from one year to the next, at least one of the things must be true:
Economy — producing a larger output of goods and services
And/or goods and services are being sold at higher prices
 Nominal GDP
o Production of goods and services
o Valued at current prices
  Real GDP
o Production of goods and services
o Valued at constant prices
o Designate one year as base year
o Not affected by changes in prices
Noted 1: For the base year: Nominal GDP = Real GDP
Noted 2: use Real GDP to see whether next year produce more with the same price, present the changes in
quantity of production.

This table shows how to calculate real GDP, nominal GDP, and the GDP deflator for a hypothetical
economy that produces only hot dogs and hamburgers.

 Norminal GDP = Price (Current price) x Quantity

 Real GDP = PxQ (P: base year chosen by government)
 Deflator GDP = (Nominal / Real)x100
The GDP deflator
Ratio of nominal GDP to real GDP times 100
Is 100 for the base year
Measures the current level of prices relative to the level of prices in the base year
Can be used to take inflation out of nominal GDP (“deflate” nominal GDP)
 GDP deflator > 100 => Inflation (more Money to buy the same quantity) => increase price level
 GDP deflator < 100 => Deflation
 Inflation:Economy’s overall price level is rising
 Inflation rate: Percentage change in some measure of the
price level from one period to the next
 3. Measuring costs of living
Consumer price index (CPI)
o Measure of the overall level of prices
o Measure of the overall cost of goods and services
 Bought by a typical consumer
o Computed and reported every month by the Bureau of Labor Statistics/GSO in VN
Calculating CPI:
1) Fix the basket
- Which prices are most important to the typical consumer
- Different weight
2) Find the prices
- At each point in time
3) Compute the basket’s cost
Same basket of goods
Isolate the effects of price changes
Cost of basket = P1xQ1 + P2xQ2
4) Chose a base year and compute the CPI
Base year = benchmark
Price of basket of goods and services in current year
Divided by price of basket in base year
Times 100
5) Compute the inflation rate

Example:
 4. The Consumer Price Index
 Inflation rate:
Percentage change in the price index
From the preceding period
 Core CPI
Measure of the overall cost of consumer goods and services excluding food and energy
Because food and energy price show substantial short-run volatility, the core CPI better reflects on
going ìnlation trends.

 Producer price index, PPI

 Measure of the cost of a basket of goods and services bought by firms
 Changes in PPI are often thought to be useful in predicting changes in CPI
Figure 1: The Typical Basket of Goods and Services

 This figure shows how the typical consumer divides spending among various categories of goods and
services. The Bureau of Labor Statistics calls each percentage the “relative importance” of the category.
5. GDP deflator versus CPI:
1st differences
 GDP deflator
o Ratio of nominal GDP to real GDP
o Reflects prices of all goods & services produced domestically
 CPI
o Reflects prices of goods & services bought by consumers

2nd differences
 GDP deflator
o Compares the price of currently produced goods and services
 To the price of the same goods and services in the base year
 CPI
o Compares price of a fixed basket of goods and services
 To the price of the basket in the base year
6. Real and Nominal Interest Rates
Nominal interest rate
Interest rate as usually reported
Without a correction for the effects of inflation
 Real interest rate (r)
Interest rate corrected for the effects of inflation
= Nominal interest rate (i) – Inflation rate (𝜋)
i = r + 𝜋  nominal = real + inflation
5%. 2% 3%
 Real interest rate is used to make decision
 If r>0 => gain more in the future, less saving
 If r<0 => save more, consume less
How is real interest rate determined?
Gross domestic product (GDP, Y): Total income = Total expenditure
Y = C + I + G + NX
Y = gross domestic product, GDP
C = consumption
I = investment
G = government purchases
NX = net exports
7. Accounting Identities
- Closed economy
Doesn’t interact with other economies
NX = 0
- Open economy
Interacts with other economies
NX ≠ 0
 Assume closed economy: NX = 0
 Y=C+I+G
National saving (saving), S: Total income in the economy that remains after paying for consumption and
government purchases
Y–C–G=I
S=Y–C–G
 S=I
T = taxes minus transfer payments
We have: S = Y – C – G
 S = (Y – T – C) + (T – G)
 Private saving, (Y – T – C)
Income that households have left after paying for taxes and consumption
 Public saving, T – G
Tax revenue that the government has left after paying for its spending

Accounting Identities, Part 5

Budget surplus: T – G > 0
Excess of tax revenue over government spending
Budget deficit: T – G < 0
Shortfall of tax revenue from government spending
 Saving and Investing
- Accounting identity: S = I
- Saving = Investment
o For the economy as a whole
o One person’s savings can finance another person’s investment
 8. The Market for Loanable Funds, Part 1
- Market
Those who want to save supply funds
Those who want to borrow to invest demand funds
- One interest rate
Return to saving
Cost of borrowing
- Assumption: single financial market
- Supply and demand of loanable funds
o Source of the supply of loanable funds
 Saving
o Source of the demand for loanable funds
 Investment
o Price of a loan = real interest rate
 Borrowers pay for a loan
 Lenders receive on their saving
 2 Kinds of Supply: Private saving + Public saving = National Saving (S N)
The Market for Loanable Funds, Part 3
- Supply and demand of loanable funds
o As interest rate rises
 Quantity demanded declines
 Quantity supplied increases
o Demand curve: Slopes downward
o Supply curve: Slopes upward
Figure 1
The interest rate in the economy adjusts to balance the supply and
demand for loanable funds. The supply of loanable funds comes
from national saving, including both private saving and public
saving. The demand for loanable funds comes from firms and
households that want to borrow for purposes of investment. Here
the equilibrium interest rate is 5 percent, and $1,200 billion of
loanable funds are supplied and demanded.

The Market for Loanable Funds, Part 4

Government policies  Can affect the economy’s saving and investment
- Saving incentives
- Investment incentives
- Government budget deficits and surpluses
Policy 1: Saving Incentives
- Shelter some saving from taxation  Affect supply of loanable funds  Increase in supply  Supply
curve shifts right
- New equilibrium:
Lower interest rate
Higher quantity of loanable funds
Greater investment
Figure 2: Saving Incentives Increase the Supply of

 A change in the tax laws to encourage Americans to save more would shift the supply of loanable funds
to the right from S1 to S2. As a result, the equilibrium interest rate would fall, and the lower interest rate
would stimulate investment. Here the equilibrium interest rate falls from 5 percent to 4 percent, and the
equilibrium quantity of loanable funds saved and invested rises from $1,200 billion to $1,600 billion.
Policy 2: Investment Incentives
- Investment tax credit: giving tax advantage to the firm building the new factories or buying new
equipments.  investment becomes attractive
Affect demand for loanable funds
Increase in demand
Demand curve shifts right
New equilibrium
Higher interest rate
Higher quantity of loanable funds
Greater saving
Figure 3: Investment Incentives Increase the Demand for Loanable Funds

 If the passage of an investment tax credit encouraged firms to invest more, the demand for loanable
funds would increase. As a result, the equilibrium interest rate would rise, and the higher interest rate
would stimulate saving. Here, when the demand curve shifts from D 1 to D2, the equilibrium interest rate
rises from 5 percent to 6 percent, and the equilibrium quantity of loanable funds saved and invested rises
from $1,200 billion to $1,400 billion.
Policy 3: Budget Deficit/Surplus
- Government – starts with balanced budget
- Then starts running a budget deficit
Change in supply of loanable funds
Decrease in supply
=>Supply curve shifts left
New equilibrium
Higher interest rate
Smaller quantity of loanable funds
Figure 4: The Effect of a Government Budget Deficit

When the government spends more than it receives in tax revenue, the resulting budget deficit lowers national
saving. The supply of loanable funds decreases, and the equilibrium interest rate rises. Thus, when the
government borrows to finance its budget deficit, it crowds out households and firms that otherwise would
borrow to finance investment. Here, when the supply shifts from S 1 to S2, the equilibrium interest rate rises
from 5 to 6 percent, and the equilibrium quantity of loanable funds saved and invested falls from $1,200 billion
to $800 billion.
9. Identifying Unemployment, Part 1
- Employed
- Those who worked
Paid employees
In their own business
Unpaid workers in a family member’s business
- Full-time and part-time workers
- Temporarily absent
Vacation, illness, bad weather
- Unemployed
- Those who were not employed
Available for work
Tried to find employment during the previous four weeks
- Those waiting to be recalled to a job : Laid off
- Not in the labor force
- Not employed and not unemployed
- Full-time students
- Homemakers
- Retirees
Identifying Unemployment, Part 4
- Labor force: Total number of workers, employed and unemployed
= Number of employed + Number of unemployed
- Unemployment rate: Percentage of labor force that is unemployed
Unemployment rate = (Number of unemployed/Labor force)×100
- Labor-force participation rate:
o Percentage of the total adult population that is in the labor force
o Fraction of the population that has chosen to participate in the labor market
Labor−force participation rate = (Labor force/Adult population)×100
Identifying Unemployment, Part 8
 Natural rate of unemployment
- Normal rate of unemployment around which the unemployment rate fluctuates
- 4.9% in 2015 (close to the actual unemployment rate of 5.3%)
 Cyclical unemployment (vongf xoay unemployment lúc tăng lúc giảm)
- Deviation of unemployment from its natural rate
 Unemployment rate: = UN = UF + US
- Never falls to zero
- Fluctuates around the natural rate of unemployment
 Frictional unemployment
- It takes time for workers to search for the jobs that best suit their tastes and skills
- Explain relatively short spells of unemployment
 Structural unemployment
- Results because the number of jobs available in some labor markets
Is insufficient to provide a job for everyone who wants one
- Results when wages are set above the equilibrium
Minimum-wage laws, unions, and efficiency wages

 Job search
- Process by which workers find appropriate jobs given their tastes and skills
Workers differ in their tastes and skills
Jobs differ in their attributes
Information about job candidates and job vacancies is disseminated slowly
- Some frictional unemployment is inevitable (K thể tránh khỏi)
o Changes in demand for labor among different firms
o Changes in composition of demand among industries or regions (sectoral shifts)
o Changing patterns of international trade
 Workers need to move among industries

Public Policy and Job Search, Part 1

- Government agency: reduce time for unemployed to find jobs
o Reduce natural rate of unemployment
- Government programs – to facilitate job search
o Government-run employment agencies
o Public training programs
 Unemployment insurance
- Government program
- Partially protects workers’ incomes
When they become unemployed
- Increases frictional unemployment
Without intending to do so
 - Qualify – only the unemployed who were laid off because their previous employers no longer needed
their skills
- Unemployment insurance
o 50% of former wages for 26 weeks
o Reduces the hardship of unemployment
o Increases the amount of unemployment
 Unemployment benefits stop when a worker takes a new job
 Unemployed
 Devote less effort to job search
 More likely to turn down unattractive job offers
 Less likely to seek guarantees of job security
 Minimum-Wage Laws, Part 1
- Structural unemployment: Number of jobs – insufficient
- Minimum-wage laws
o Can cause unemployment
o Forces the wage to remain above the equilibrium level
 Higher quantity of labor supplied
 Smaller quantity of labor demanded
 Surplus of labor = unemployment
Figure 4: Unemployment from a Wage above the

 In this labor market, supply and demand are balanced at the wage WE. At this equilibrium wage, the
quantity of labor supplied and the quantity of labor demanded both equal LE.
 By contrast, if the wage is forced to remain above the equilibrium level, perhaps because of a minimum-
wage law, the quantity of labor supplied rises to LS and the quantity of labor demanded falls to LD.
 The resulting surplus of labor, LS – LD, represents unemployment.

 Wages may be kept above equilibrium level

- Minimum-wage laws
- Unions
- Efficiency wages
 If the wage is kept above the equilibrium level
 Result: unemployment
 7. Unions & Collective Bargaining, Part 1
 Union
- Worker association
- Bargains with employers over
o Wages, benefits, and working conditions
- Only 11% of U.S. workers today
o About 33% in the 1940s and 1950s
- Type of cartel (thỏa thuận cạnh tranh)
 Collective bargaining: Process by which unions and firms agree on the terms of employment
 Strike
- Organized withdrawal of labor from a firm by a union
- Reduces production, sales, and profit
 Union workers
- Earn 10-20% more than similar workers who do not belong to unions
Unions & Collective Bargaining, Part 3
 Union – raises the wage above the equilibrium level
- Higher quantity of labor supplied
- Smaller quantity of labor demanded
- Unemployment
- Better off: employed workers (insiders)
- Worse off: unemployed (outsiders)
May stay unemployed
Take jobs in firms that are not unionized
8. Theory of Efficiency Wages, Part 1
 Efficiency wages
- Above-equilibrium wages paid by firms to increase worker productivity
Worker health; Worker turnover
Worker quality; Worker effort
 Worker health
Better paid workers
Eat a more nutritious diet
Healthier and more productive
 Worker turnover
Firm – can reduce turnover among its workers
By paying them a high wage
 Worker quality
Firm – pays a high wage
Attracts a better pool of workers
Increases the quality of its workforce
 Worker effort
High wages – make workers more eager to keep their jobs
Give workers an incentive to put forward their best effort
Macro2: The classical theory: The economy in the long run

The Monetary system

1. The Meaning of Money, Part 2
 Money
Set of assets in an economy
That people regularly use
To buy goods and services from other people
  Liquidity
Ease with which an asset can be converted into the economy’s medium of exchange
2. The Functions of Money
i) Medium of exchange
Item that buyers give to sellers when they want to purchase goods and services
ii) Unit of account
Yardstick people use to post prices and record debts
iii) Store of value
Item that people can use to transfer purchasing power from the present to the future
3. Money in the economy, Part 1
Money stock
Quantity of money circulating in the economy
Currency
Paper bills and coins in the hands of the public
Demand deposits
Balances in bank accounts; depositors can access on demand by writing a check

Money in the economy, Part 2

 Measures of money stock
M1: high liquidity
Demand deposits, Traveler’s checks
Other checkable deposits, Currency
M2: = M1 + Savings : Less liquidity
Everything in M1
Savings deposits, Small time deposits
Money market mutual funds
A few minor categories
Figure 1: Two Measures of the Money Stock in VN
The two most widely followed measures of the money stock are M1 and M2. This figure shows the size of
each measure in January 2016.
  Banks and the Money Supply, Part 1
Money Supply = Currency + Demand deposits
o Currency: bills in your wallet, coins in your pocket
o Demand deposits: balance in checking account
Behavior of banks
 Can influence the quantity of demand deposits in the economy (and the money supply)
 Banks and the Money Supply, Part 2
Reserves: Deposits that banks have received but have not loaned out
 For paying back to the ones wants to withdraw money at any time.
The simple case of 100% reserve banking
- All deposits are held as reserves
- Banks do not influence the supply of money

Fractional-reserve banking
Banks hold only a fraction of deposits as reserves
Reserve ratio
Fraction of deposits that banks hold as reserves
Reserve requirement
Minimum amount of reserves that banks must hold; set by the CB
Fractional-Reserve Banking, Part 2
Excess reserve
Banks may hold reserves above the legal minimum
Example: First National Bank
Reserve ratio 10%

Fractional-Reserve Banking, Part 3

Banks hold only a fraction (nhỏ) of deposits in reserve
Banks create money
- Assets
- Liabilities
Increase in money supply
Does not create wealth
The Money Multiplier, Part 1
The money multiplier
Original deposit = $100.00
First National lending = $ 90.00 [= .9 × $100.00]
Second National lending=$ 81.00 [= .9 × $90.00]
Third National lending = $ 72.90 [= .9 × $81.00]
…
Total money supply = $1,000.00
The Money Multiplier, Part 3
 The money multiplier
Amount of money the banking system generates with each dollar of reserves
Reciprocal of the reserve ratio = 1/R
 The higher the reserve ratio
The smaller the money multiplier
Change in Ms = 1/R * change in D (R= 0.1)
= 1/.1 * $100 = $1000

Financial Crisis of 2008–2009, Part 1

Bank capital
- Resources a bank’s owners have put into the institution
- Used to generate profit

 Assets: usage of fund

 Liabilities + OE : Source of fund
Financial Crisis of 2008–2009, Part 2
Leverage
Use of borrowed money to supplement existing funds for purposes of investment
Leverage ratio
Ratio of assets to bank capital = TA/TE
Ex: TA/TE = 1000/50 = 20/1
For $20 use in business, there is $1 from the owner contribution, $19 is financed by liabilities
 The higher leverage, higher risk.
Capital requirement: Government regulation specifying a minimum amount of bank capital

Financial Crisis of 2008–2009, Part 3

If bank’s assets rise in value by 5%
Because some of the securities the bank was holding rose in price
$1,000 of assets would now be worth $1,050
Bank capital rises from $50 to $100
So, for a leverage rate of 20
A 5% increase in the value of assets
Increases the owners’ equity by 100%
Financial Crisis of 2008–2009, Part 4
If bank’s assets are reduced in value by 5%
Because some people who borrowed from the bank default on their loans
 $1,000 of assets would be worth $950
Value of the owners’ equity falls to zero
So, for a leverage ratio of 20
 A 5% fall in the value of the bank assets
 Leads to a 100% fall in bank capital
Financial Crisis of 2008–2009, Part 5
If bank’s assets are reduced in value by more than 5%
Because some people who borrowed from the bank default on their loans
For a leverage ratio of 20
The bank’s assets would fall below its liabilities
The bank would be insolvent: unable to pay off its debt holders and depositors in full

4. Resolving NPLs: Without using real resources

(*)

Noted: (*) Sell NPLs to VAMC – VAMC just hold the bad debt to help the bank lower NPLs amount.
Then, when the bank is recovered, the VAMC will give NPLs back to the commercial bank.

Tools of Monetary Control, Part 1

i) Influences the quantity of reserves
Open-market operations
CB lending to banks
ii) Influences the reserve ratio
Reserve requirements
Paying interest on reserves
Tools of Monetary Control, Part 2
i) Influences the quantity of reserves
 Open-market operations
o Purchase and sale of government bonds by the CB
o To increase the money supply
 The CB buys government bonds
o To reduce the money supply
 The CB sells government bonds
o Easy to conduct
 o Used more often
Tools of Monetary Control, Part 3
o CB lending to banks
o To increase the money supply
o Discount window
 At the discount rate
o Term Auction Facility
 To the highest bidder
 The discount rate
o Interest rate on the loans that the CB makes to banks
o Higher discount rate
 Reduce the money supply (discoverage the bank borrow money from CB)
o Smaller discount rate
 Increase the money supply
Tools of Monetary Control, Part 6
ii) Influences the reserve ratio
o Reserve requirements
Minimum amount of reserves that banks must hold against deposits
An increase in reserve requirement: decrease the money supply
A decrease in reserve requirement: increase the money supply
Used rarely – disrupt business of banking
Less effective in recent years
Many banks hold excess reserves
 Problems
The CB’s control of the money supply
Not precise
The CB does not control:
The amount of money that households choose to hold as deposits in banks
The amount that bankers choose to lend
5. The Interbank Offered Rate
The interbank offered rate
o Interest rate at which banks make overnight loans to one another
o Lender – has excess reserves
o Borrower – needs reserves
o A change in interbank offered rate
o Changes other interest rates
o Differs from the discount rate
o Affects other interest rates as well
o Is determined by supply and demand in the market for loans among banks
o Targeted by the CB
 Change the interbank offered rate
 Change the money supply
o The CB targets the interbank offered rate through open-market operations
The CB buys bonds
Decrease in the interbank offered rate
Increase in money supply
The CB sells bonds
Increase in the interbank offered rate
Decrease in money supply
Chapter 30: Monetary Growth and Inflation – Book D
1. Inflation, Part 1
Inflation: Increase in the overall level of prices
Deflation: Decrease in the overall level of prices
Hyperinflation: Extraordinarily high rate of inflation
 Overall level of price is such as GDP, CPI, …

2. The Classical Theory of Inflation, Part 1

Classical theory of money
Quantity theory of money
Explain the long-run determinants of the price level
Explain the inflation rate

 Level of Prices; Value of Money

Inflation
Economy-wide phenomenon
Concerns the value of economy’s medium of exchange
Inflation: rise in the price level
Lower value of money
Each dollar buys a smaller quantity of goods and services

The Classical Theory of Inflation, Part 2

Money demand
Reflects how much wealth people want to hold in liquid form
Depends on
Credit cards
Availability of ATM machines
Interest rate
Average level of prices in economy
Demand curve – downward sloping
Money supply
Determined by the Fed and the banking system
Supply curve is vertical
In the long run, Money supply and money demand are brought into equilibrium by the overall level of
prices
Figure 1: How the Supply and Demand for Money: Determine the Equilibrium Price Level
 The horizontal axis shows the quantity of money. The left vertical axis shows the value of money, and the
right vertical axis shows the price level. The supply curve for money is vertical because the quantity of money
supplied is fixed by the Fed. The demand curve for money is downward sloping because people want to hold
a larger quantity of money when each dollar buys less. At the equilibrium, point A, the value of money (on
the left axis) and the price level (on the right axis) have adjusted to bring the quantity of money supplied and
the quantity of money demanded into balance.
 Effects of a Monetary Injection (bơm vào), Part 1
- Economy is in equilibrium
If the Fed doubles the supply of money
Prints bills
Drops them on market
Or the Fed: open-market purchase
New equilibrium
Supply curve shifts right
Value of money decreases
Price level increases
Figure 2: An Increase in the Money Supply

When the Fed increases the supply of money, the money supply curve shifts from MS 1 to MS2. The value of
money (on the left axis) and the price level (on the right axis) adjust to bring supply and demand back into
balance. The equilibrium moves from point A to point B. Thus, when an increase in the money supply makes
dollars more plentiful, the price level increases, making each dollar less valuable.
 Effects of a Monetary Injection, Part 2
Quantity theory of money
- The quantity of money available in the economy determines (the value of money) the price level
- Growth rate in quantity of money available determines the inflation rate
 Effects of a Monetary Injection, Part 3
Adjustment process
Excess supply of money
Increase in demand of goods and services
Price of goods and services increases
Increase in price level
Increase in quantity of money demanded
New equilibrium
3. Classical Dichotomy, Part 1
Nominal variables (GDP, Interest rate): Variables measured in monetary units - Dollar prices
Real variables: Variables measured in physical units – Ex: Relative prices, real wages, real interest rate
Classical dichotomy: Theoretical separation of nominal and real variables
 Classical Dichotomy, Part 2
Developments in the monetary system
Influence nominal variables
Irrelevant for explaining real variables
Monetary neutrality
Changes in money supply don’t affect real variables
Not completely realistic in short-run
Correct in the long run
4. Velocity and the Quantity Equation, Part 1
Velocity of money (V): Rate at which money changes hands
V = (P × Y) / M
P = price level (GDP deflator)
Y = real GDP
M = quantity of money
Velocity and the Quantity Equation, Part 2
Quantity equation: M × V = P × Y
ΔM + Δ V = Δ P + ΔY
5% 0% 5% 0% (ΔK, ΔH, ΔT = 0)
ΔK (Phýical capital: machine, tool) , ΔH (Human: know, ΔT
The quantity equation shows: an increase in quantity of money in an economy
Must be reflected in one of 3 variables:
 Price level must rise
 Quantity of output must rise
 Velocity of money must fall
Figure 3: Nominal GDP, the Quantity of Money, and the Velocity of Money

 This figure shows the nominal value of output as measured by nominal GDP, the quantity of money as
measured by M2, and the velocity of money as measured by their ratio. For comparability, all three
series have been scaled to equal 100 in 1960. Notice that nominal GDP and the quantity of money have
grown dramatically over this period, while velocity has been relatively stable.
 Quantity Theory of Money, Part 1
1. Velocity of money: Relatively stable over time
2. Changes in quantity of money, M => Proportionate changes in nominal value of output (P × Y)
 3. Economy’s output of goods & services, Y
o Primarily determined by factor supplies
o And available production technology
o Money does not affect output
4. Change in money supply, M
Induces proportional changes in the nominal value of output (P × Y)
Reflected in changes in the price level (P)
5. When the central bank increases the money supply rapidly
High rate of inflation

Money and prices during four hyperinflations, Part 1

Hyperinflation
Inflation that exceeds 50% per month
The price level increases more than a hundredfold over the course of a year
Data on hyperinflation
Clear link between quantity of money and the price level

6. The Inflation Tax

The inflation tax:
- Revenue the government raises by creating (printing) money.
- Like a tax on everyone who holds money
When the government prints money
The price level rises
And the dollars in your wallet are less valuable
 When the vale of money falls, the ones who are holding money will pay more income tax.
 7. The Fisher Effect, Part 1
- Principle of monetary neutrality
o An increase in the rate of money growth
o Raises the rate of inflation
o But does not affect any real variable
Real interest rate = Nominal interest rate – Inflation rate
 Nominal interest rate = Real interest rate + Inflation rate
8. The Costs of Inflation, Part 1
Inflation fallacy
“Inflation robs people of the purchasing power of his hard-earned dollars”
When prices rise
Buyers pay more
Sellers get more
 Inflation does not in itself reduce people’s real purchasing power
9. The Costs of Inflation, Part 2
 Shoeleather costs: when inflation increase, you intend to keep less money on hand, put money in bank
=> inccur other relevant cost such as time, transportation cost, transaction cost.
Resources wasted when inflation encourages people to reduce their money holdings
Can be substantial
 Menu costs: thay đổi manu thường xuyên do tác động của inflation cost.
Costs of changing prices
Inflation – increases menu costs that firms must bear
 Relative-Price Variability
Market economies
- Relative prices allocate scarce resources
- Consumers compare quality and prices of various goods and services
o Determine allocation of scarce factors of production
- Inflation distorts relative prices
o Consumer decisions are distorted
o Markets are less able to allocate resources to their best use
 Inflation-Induced Tax Distortions, Part 1 – chap 30 p643 -675 ebook
Taxes distort incentives
Many taxes: more problematic in the presence of inflation
Tax treatment of capital gains
Capital gains are profits
Sell an asset for more than its purchase price
Inflation discourages saving
Exaggerates the size of capital gains
Increases the tax burden
Inflation-Induced Tax Distortions, Part 2
Tax treatment of interest income
Nominal interest earned on savings
Treated as income
Even though part of the nominal interest rate compensates for inflation
Higher inflation
Tends to discourage people from saving
Table 1: How Inflation Raises the Tax Burden on Saving

In the presence of zero inflation, a 25 percent tax on interest income reduces the real interest rate from 4
percent to 3 percent. In the presence of 8 percent inflation, the same tax reduces the real interest rate from 4
percent to 1 percent.
 Inflation make the real interest rate after tax is lower under impaction of tax.
 The inflation make higher tax payment because you must pay tax for the inflation too.
 Confusion and Inconvenience => when money value changes so fast, that the owner cannot determine
the value of money they have and whether they’re making profit or not.
Money
Yardstick with which we measure economic transactions
The CB’s job
Ensure the reliability of money
When the CB increases money supply
Creates inflation
Erodes the real value of the unit of account
 Arbitrary Redistributions of Wealth
Unexpected inflation
Redistributes wealth among the population
Not by merit
Not by need
Redistribute wealth among debtors and creditors
Inflation: volatile and uncertain
When the average rate of inflation is high

Macro chapter 31: The Open economy – p653 – D – P685ebook

1. Basic Concepts
 Closed economy
Economy that does not interact with other economies in the world
 Open economy
Economy that interacts freely with other economies around the world
 Open Economy
- Interacts with other economies:
It buys and sells goods and services in world product markets
It buys and sells capital assets such as stocks and bonds in world financial markets
 2. The Flow of Goods, Part 1
- Exports: Goods and services that are produced domestically and sold abroad
- Imports: Goods and services that are produced abroad and sold domestically
- Net exports(Trade balance): Value of a nation’s exports minus the value of its imports
The Flow of Goods, Part 2
 Trade surplus (Positive net exports) – NX > 0
Exports are greater than imports
The country sells more goods and services abroad than it buys from other countries
 Trade deficit (Negative net exports) – NX < 0
Imports are greater than exports
The country sells fewer goods and services abroad than it buys from other countries
 Balanced trade: Exports equal imports – NX = 0 EX = IM
The Flow of Goods, Part 3
 Factors that might influence a country’s exports, imports, and net exports:
- Tastes of consumers for domestic & foreign goods
- Prices of goods at home and abroad
- Exchange rates at which people can use domestic currency to buy foreign currencies
- Incomes of consumers at home and abroad
- Cost of transporting goods from country to country
- Government policies toward international trade: Tarrif + Quota tax
3. The Flow of Financial Resources, Part 1
Net capital outflow (net foreign investment) = Purchase of foreign asset – purchase of domestic asset
o Purchase of foreign assets by domestic residents
 Foreign direct investment
 Foreign portfolio investment
o Minus the purchase of domestic assets by foreigners
 Variables that influence net capital outflow
o Real interest rates paid on foreign assets
o Real interest rates paid on domestic assets
o Perceived economic and political risks of holding assets abroad
o Government policies that affect foreign ownership of domestic assets
 Net Exports=Net Capital Outflow, Part 1
- Net exports (NX): Imbalance between a country’s exports and its imports
- Net capital outflow (NCO): Imbalance between Amount of foreign assets bought by domestic residents
And the amount of domestic assets bought by foreigners
- Identity: NCO = NX (should be)
- When NX > 0 (trade surplus)
Selling more goods and services to foreigners
Than it is buying from them
From net sale of goods and services
Receives foreign currency
Buy foreign assets
Capital is flowing out of the country: NCO > 0
- When NX < 0 (trade deficit)
Buying more goods and services from foreigners
Than it is selling to them
The net purchase of goods and services
Needs financed
Selling assets abroad
Capital is flowing into the country: NCO < 0
 Table 1International Flows of Goods and Capital:
Summary:

This table shows the three possible outcomes for an open economy.
4. Prices for International Transactions, Part 1
- Nominal exchange rate: Rate at which a person can trade currency of one country for currency of another
Ex: Exchange rate = 80 yen per dollar
 Appreciation (strengthen)
- Increase in the value of a currency as measured by the amount of foreign currency it can buy
 Buy more foreign currency
Example: dollar appreciation
Exchange rate (old) = 80 yen per dollar
Exchange rate (new) = 90 yen per dollar
(Yen depreciation)

 Depreciation (weaken)
- Decrease in the value of a currency
- As measured by the amount of foreign currency it can buy
 Buy less foreign currency
Example: dollar depreciation
Exchange rate (old) = 80 yen per dollar
Exchange rate (new) = 70 yen per dollar
(Yen appreciation)
- Real exchange rate
Rate at which a person can trade goods and services of one country
For goods and services of another

Real exchange rate = (e ˣ P) / P*

 e: nominal exchange rate between the U.S. dollar and foreign currencies
 P: price index for U.S. basket
 P*: price index for foreign basket
Example With One Good
A Big Mac costs $2.50 in U.S, 400 yen in Japan
e = 120 yen per $
 e x P = price in yen of a U.S. Big Mac = (120 yen per $) x ($2.50 per Big Mac)
= 300 yen per U.S. Big Mac
Compute the real exchange rate:
 Depreciation (fall) in the U.S. real exchange rate
 U.S. goods: cheaper relative to foreign goods
 Consumers at home and abroad buy more U.S. goods and fewer goods from other countries
Higher exports, Lower imports
Higher net exports
An appreciation (rise) in the U.S. real exchange rate
 U.S. goods - more expensive compared to foreign goods
 Consumers at home and abroad - buy fewer U.S. goods and more goods from other countries
Lower exports, Higher imports
Lower net exports
5. Purchasing-Power Parity, Part 1
Purchasing-power parity, PPP
Theory of exchange rates
A unit of any given currency should be able to buy the same quantity of goods in all countries
Basic logic of purchasing-power parity
Based on the law of one price*
A good must sell for the same price in all locations
 The Law of One Price: the notion that a good should sell for the same price in all markets
- Suppose coffee sells for $4/pound in Seattle and $5/pound in Boston, and can be costlessly transported.
- There is an opportunity for arbitrage, making a quick profit by buying coffee in Seattle and selling it in
Boston.
- Such arbitrage drives up the price in Seattle and drives down the price in Boston, until the two prices are
equal.

Implications of PPP, Part 1

If purchasing power of the dollar is always the same at home and abroad
Then the real exchange rate cannot change
Theory of purchasing-power parity
Nominal exchange rate between the currencies of two countries
Must reflect the price levels in those countries: e = P*/P
Implications:
Nominal exchange rates change when price levels change
When a central bank in any country increases the money supply
And causes the price level to rise
It also causes that country’s currency to depreciate relative to other currencies in the world
6. Exchange risk management:
- The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another
currency on a particular day.
V(value of import of 100 laptops) = $100,000
Pay in 30 days
 US$1 = VND 23,000  V = VND 2,300,000,000
P = VND 27,600,000 (= $1,200)
 TR = 27,600,000 * 100 = VND 2,760,000,000
 Profits= VND 460,000,000
 US$1 = VND 25,000  V = VND 2,500,000,000
 Profits = 2,760,000,000 - 2,500,000,000 = VND 260,000,000
- A forward exchange occurs when two parties agree to exchange currency and execute the deal at some
specific date in the future (30, 60, or 90 days)
 Buy $100,000 after 30 days at a forward exchange of US$1 = VND 24,000
 Profits = VND 360,000,000

7. Model of the Open Economy

Model of the open economy
- To highlight the forces that determine the economy’s trade balance and exchange rate
- Looking simultaneously at the market for loanable funds and the market for foreign-currency exchange
- Examine how various events and policies affect the economy’s trade balance and exchange rate
 Market for Loanable Funds, Part 1
In an open economy, S = I + NCO
Saving = Domestic investment + Net capital outflow
Supply of loanable funds: From national saving (S)
Demand for loanable funds
- From domestic investment (I)
- And net capital outflow (NCO)
Market for Loanable Funds, Part 2
o When NCO > 0, net outflow of capital
Net purchase of capital overseas
Adds to the demand for domestically generated loanable funds
o When NCO < 0, net inflow of capital
Capital resources coming from abroad
Reduce the demand for domestically generated loanable funds
Market for Loanable Funds, Part 3
Loanable funds – interpreted as
Domestically generated flow of resources available for capital accumulation
Purchase of a capital asset
Adds to the demand for loanable funds
Asset located at home: I
Asset located abroad: NCO
Market for Loanable Funds, Part 4
Higher real interest rate
- Encourages people to save: increases quantity of loanable funds supplied
- Discourages investment: decreases quantity of loanable funds demanded
- Discourages Americans from buying foreign assets: reduces U.S. net capital outflow
- Encourages foreigners to buy U.S. assets: reduces U.S. net capital outflow
Market for Loanable Funds, Part 5
o Supply of loanable funds
Slopes upward
o Demand of loanable funds
Slopes downward
o At equilibrium interest rate
Amount that people want to save
Exactly balances the desired quantities of domestic investment and net capital outflow
Figure 1: The Market for Loanable Funds
The interest rate in an open economy, as in a closed economy, is determined by the supply and demand
for loanable funds. National saving is the source of the supply of loanable funds. Domestic investment and
net capital outflow are the sources of the demand for loanable funds. At the equilibrium interest rate, the
amount that people want to save exactly balances the amount that people want to borrow for the purpose of
buying domestic capital and foreign assets.

Figure 3 How Net Capital Outflow Depends on the Interest Rate

Because a higher domestic real interest rate makes domestic assets more attractive, it reduces net
capital outflow. Note the position of zero on the horizontal axis: Net capital outflow can be positive or
negative. A negative value of net capital outflow means that the economy is experiencing a net inflow of
capital.

Figure 2 The Market for Foreign-Currency Exchange

The real exchange rate is determined by the supply and demand for foreign-currency exchange. The
supply of dollars to be exchanged into foreign currency comes from net capital outflow. Because net
capital outflow does not depend on the real exchange rate, the supply curve is vertical. The demand for
dollars comes from net exports. Because a lower real exchange rate stimulates net exports (and thus
increases the quantity of dollars demanded to pay for these net exports), the demand curve slopes
downward. At the equilibrium real exchange rate, the number of dollars people supply to buy foreign
assets exactly balances the number of dollars people demand to buy net exports.
Figure 4 The Real Equilibrium in an Open Economy – combine the 3 above figure:

8. Government Budget Deficits, Part 1

Government budget deficits
When government spending exceeds government revenue
Negative public saving
Reduces national saving
Reduces supply of loanable funds
Increase in interest rate
Reduces net capital outflow
Government Budget Deficits, Part 2
Government budget deficits
Crowd-out domestic investment
Decrease in supply of foreign-currency exchange
Currency appreciates
Net exports fall
Push the trade balance toward deficit
Figure 5 The Effects of a Government Budget Deficit

When the government runs a budget deficit, it reduces the supply of loanable funds from S1 to S2 in panel
(a). The interest rate rises from r1 to r2 to balance the supply and demand for loanable funds. In panel (b),
the higher interest rate reduces net capital outflow. Reduced net capital outflow, in turn, reduces the supply
of dollars in the market for foreign-currency exchange from S1 to S2 in panel (c). This fall in the supply of
dollars causes the real exchange rate to appreciate from E1 to E2. The appreciation of the exchange rate
pushes the trade balance toward deficit.

9. Trade Policy, Part 1

Trade policy
Government policy
Directly influences the quantity of goods and services
That a country imports or exports
Tariff: tax on imports
Import quota: limit on quantity of imports
Voluntary export restrictions
Trade Policy, Part 2
Macroeconomic impact of trade policy (import quota)
Decrease imports
Increase in net exports
Increase in demand for dollars in the market for foreign-currency exchange
Real exchange rate appreciates
Discourage exports
Trade Policy, Part 3
Macroeconomic impact of trade policy (import quota)
No change in real interest rate
 No change in net capital outflow
No change in net exports
Decrease in imports
Decrease in exports
Figure 6 The Effects of an Import Quota

Trade Policy, Part 4

Macroeconomic impact of trade policy
Trade policies do not affect the U.S. trade balance
NX = NCO = S – I
Trade policies affect specific
o Firms
o Industries
o Countries
10. Political Instability and Capital Flight, Part 1

Political instability
Leads to capital flight
Capital flight
Large and sudden reduction in the demand for assets located in a country

Political Instability and Capital Flight, Part 2

Mexico - capital flight affects both markets – context
- 1994, political instability
- Investors – capital flight
Sell Mexican assets, buy U.S. assets, “safe haven”
 - Net-capital-outflow curve – increases
Supply of pesos in the market for foreign-currency exchange – increases
- Demand curve in the market for loanable funds – increases

Political Instability and Capital Flight, Part 3

Mexico - capital flight affects both markets
- Interest rate in Mexico – increases
Reduce domestic investment
Slows capital accumulations
Slows economic growth
- The peso depreciates
Exports – cheaper
Imports – more expensive
Trade balance moves toward surplus

Figure 7 The Effects of Capital Flight

Political Instability and Capital Flight, Part 4

Mexico - capital flight affects both markets
U.S. market
Fall in U.S. net capital outflow
The dollar appreciates in value
U.S. interest rates fall
Relatively small impact on the U.S. economy
Because the economy of the United States is so large compared to that of Mexico
Examples of Capital Flight: Mexico, 1994 (slide)
Examples of Capital Flight: S.E. Asia, 1997
Examples of Capital Flight: Russia, 1998