First PictureThe Production Possibilities Frontier

Tradeoffs in PicturesQuantity ofComputersProduced

Quantity ofCars Produced

3,000

1,000

2,000

2,200 A

7006003000 1,000

B Feasible but Inefficient

C

D

Infeasible Pts

ProductionPossibilitiesFrontier

EfficientPoints

Supply

Demand

Price of Ice-Cream Cone

Quantity of Ice-Cream Cones

Second PictureSupply and Demand

21 3 4 5 6 7 8 9 10 12110

$3.002.502.00

1.501.00

0.50

Equilibrium

Supplyand

Demandon

Parade

An Increase in Demand

Price ofIce-Cream

Cone

2.00

0 7 Quantity ofIce-Cream Cones

Supply

Initialequilibrium

D1

1. Hot weather increasesthe demand for ice cream...

D2

2. ...resultingin a higherprice...

$2.50

103. ...and a higherquantity sold.

New equilibrium

Harcourt, Inc. items and derived items copyright © 2001 by Harcourt, Inc.

S2

A Decrease in Supply

Price ofIce-Cream

Cone

2.00

0 1 2 3 4 7 8 9 11 12 Quantity ofIce-Cream Cones

13

Demand

Initial equilibrium

S1

10

1. An earthquake reducesthe supply of ice cream...

Newequilibrium

2. ...resultingin a higherprice...

$2.50

3. ...and a lowerquantity sold.

Elastic Demand: Quantity demanded responds dramatically to price

Elasticity is greater than 1

Quantity

Price

4

$51. A 22%increasein price...

Demand

100502. ...leads to a 67% decrease in quantity.

Inelastic Supply: Quantity doesn’t respond much to price

Elasticity is less than 1

Quantity

Price

4

$51. A 22%increasein price...

110100

Supply

2. ...leads to a 10% increase in quantity.

Consumer Surplus and Producer Surplus

Price

Equilibriumprice

0 QuantityEquilibriumquantity

A

Supply

C

B Demand

D

E

Producersurplus

Consumersurplus

Price

0 QuantityEquilibriumquantity

Supply

Demand

Cost to sellers

Value to buyers

Value to

buyers

Cost to

sellers

Value to buyers is greater than cost to sellers.

Value to buyers is less than cost to sellers.

Efficiency of Competitive Market Equilibrium … and the Tax Wedge

Remember

MR = MCand market price is the marginal

revenue of a price-taking competitive firm

MR = P = MC

The Effects of a TariffDeadweight Loss

Priceof Steel

0 Quantityof Steel

Domestic supply

Domestic demand

TariffWorld price

Q1S Q2

S Q2D Q1

D

Price without

tariff

Price with tariff

Imports without tariff

Imports with tariff

A

B

C EG

D F

Deadweight loss

GDP: Real and Nominal• Gross Domestic Product (GDP): Gross Domestic Product (GDP): the market value

of all final goods and services produced within a country during a year.

GDP = C + I + G + Ex – Im GDP = C + I + G + Ex – Im

= C + I + G + NX= C + I + G + NX

• Real GDPReal GDP adjusts for inflation

Nominal GDP = $GDP = P x Q $ GDP = GDP Deflator x Real GDP$ GDP = GDP Deflator x Real GDP

Real GDP = Q = $GDP/P = Nominal GDP divided by

(deflated by) the GDP Price Deflator

Foreign Exchange Rate: Appreciation and Foreign Exchange Rate: Appreciation and DepreciationDepreciation

• A currency A currency appreciatesappreciates when it buys more of a when it buys more of a foreign currency.foreign currency.– AppreciationAppreciation makes foreign goods cheaper. makes foreign goods cheaper.– AppreciationAppreciation Imports Up and Exports Down. Imports Up and Exports Down.

• A currency A currency depreciatesdepreciates when it buys less of a when it buys less of a foreign currency.foreign currency.– DepreciationDepreciation makes foreign goods more expensive. makes foreign goods more expensive.– DepreciationDepreciation Imports Down and Exports Up. Imports Down and Exports Up.

Current Account vs. Financial AccountCurrent Account vs. Financial Account

• The balance of payments must balance

Current Account + Financial Account = 0

– If we buy more goods and services from foreigners than they buy from us, we have to borrow the difference

sell them our IOUs.

Capital inflows help finance domestic investment and the government’s deficit

Interest Rates: Nominal and RealInterest Rates: Nominal and Real

• Nominal Interest Rate (i): the interest rate observed in the market.

• Real Interest Rate (r): the nominal rate adjusted for inflation ().

Real Interest Rate = Nominal Interest Rate

– Inflation Rate

r = i - r = i - • Low real interest rates spur business investment

spending (the II in C + II + G + NX)

Imports and ExportsThe demand for imports depends on current

economic activity, YIM = IMa + mpi Y

“mpi” is the marginal propensity to import Exports are exogenously determined

they depend on conditions in foreign economies, not our economy

Net exports is NX = EX – (IMa + mpi Y) or NX = NXa – mpi Y

Net expects decrease as the economy expands

Demand-Side Equilibrium and the MultiplierAt equilibrium: Y = C + I + G + NX = AE

Increase in Y = Spending Multiplier x {Increase in Autonomous Spending}

Multiplier = 1/(mps + mpi)