Test 1 Flashcards
Define the features of the Great Depression
- period of severe economic contraction and high unemployment that began in 1929, throughout the 1930s
- started off with the stock market crash of 1929. Over the next 10 years, around 9,000 banks went bust, resulting in huge unemployment levels. Protectionism (the SH tariff act) worsened these conditions.
What was the problem with simple classical models when explaining the Great Depression’s high unemployment?
classical economics couldn’t explain how goods could go unsold and workers could be left unemployed.
In classical economics, the prices and waged would fall until the market cleared, and all goods and labour were sold. Keynes = offered new theory that explained why markets might not clear.
Keynes’ theory was that the classical quantity theory broke down because people and businesses tend to hold on to their cash in difficult economic times.
What did Keynes believe governments could do in response to the Great Depression etc?
intervene in the economy and affect the level of output and unemployment.
During periods of low private demand, the gov can stimulate aggregate demand to lift the economy out recession.
Define the term “Inflation”
The rate of change of the general price level
Define the term “Unemployment”
A measure of the number of people looking for work, but who are without jobs
Define the term “Output”
Real GDP of an economy
Define the term “Economic Growth”
Its shown by increases in real GDP. It’s an indication of the expansion of the economy’s total output
Define the term “Macroeconomic Policy”
A variety of policy measures used by the gov and central bank to affect the overall performance of the economy
Define the term “International Trade”
How does being a part of a global economic system affect nations’ economies?
What are the 2 traits of economic powerhouse economies?
1/ They grow their level of output fast
2/ They manage the problems of unemployment and inflation well by undertaking appropriate macro policies
Why is the PPF negatively sloped and concave?
It’s negatively sloped because of scarcity.
It’s concave because of the inadaptability of resources –as the production of one good rises, the opportunity cost of producing that good also increases. Not all factor inputs are equally suited to producing items
Define the term “Inefficiency”
If more output could be produced from a given quantity of inputs, or the same output from less inputs
Define the term “Allocative Efficiency”
Achieved when production represents consumer preferences i.e. where MR = MC (demand = supply)
Why might the PPF shift outwards?
- Discovery of new resources
- Increase in work force i.e. migration
What might shift the demand curve?
- Price of substitute
- Price of a complement
- Consumer income
What might shift the supply curve rightwards?
- Falling costs
- Technological improvements
Define the term “Consumer Surplus”
Difference between the total amount that consumers are willing to pay and the total amount that they actually pay (i.e. market price)
Define the term “Producer Surplus”
The difference between the amount at which they are willing to supply and the price that they actually receive
What are the 3 reasons why governments exist?
- Establish and maintain property rights = markets rely on property rights to function
- Provide non-market mechanisms for allocating scarce resources = choices made pursuing self-interest may not always be in the social interest and governments may reallocate resources
- Redistribute income and wealth = the market economy delivers a distribution of income and wealth that many people regard as unfair.
What are signs of an appropriate policy intervention?
- Corrects failure
- Raises social value/welfare i.e. controlling/breaking up monopolies
- The benefits gained are higher than the costs of intervention
- Does not cause other failures
- Minimises conflict with other policy aims
What are the reasons for market failure?
- Price and quantity regulations
- Monopoly
- Externalities
- Public goods
- Asymmetric information
What are the features of monopoly power?
- P>MC
- Low production, surplus loss and lower social value
What are potential policy responses to a monopoly?
- Limit pricing
- Break-up monopoly
- Regulate price discrimination
- Control merges
- Limit barriers to entry
- Regulate natural monopoly
Define the term “External Costs”
Costs imposed on 3rd parties not priced in markets i.e. pollution, road congestion, health hazards etc
What are some policy responses to externalities?
- Create a market for externalities i.e. pollution permits
- Tax production of good creating external cost
Define the term “Public choice”
A decision that has consequences for many people, maybe even a society
2 traits of public goods?
1/ Non-rivalrous
2/ Non-excludable
Explain the “Free-rider problem”
- The non-exclusivity of a public good means there is incentive for people to avoid paying for what they consume. Leads the private market to under-produce a public good.
Non-excludable and non-rival + free rider problem => the MC of provision = 0, P = 0, Profit = 0
No private supply = underproduction => MSB > 0, so value is lost. - Policy response:
→ Gov supply at point of demand
→ Total cost financed through tax
Define the term “Moral Hazard”
Incentive one party to an agreement has to act in a manner that brings additional benefits to themselves at the expense of the other party. i.e. insuring and then taking less avoidance care
Define the term “Adverse Selection”
Tendency for people to enter into agreements in which they can use their private information to their own advantage and to the disadvantage of the less informed party. i.e. insurance company and its high-risk clients, or bank and risky borrowers
Explain the “Market for Loans”
- Private info on credit risk:
- Low-risk borrowers likely will repay their loans
- High-risk borrowers likely will default on their loans
- Adverse selection – banks cannot distinguish between 2 classes of borrowers and will treat them the same.
- Banks use proxies to screen borrowers =
- The length of time on the job, marital status, age and other factors correlated with low-risk borrowers to try and determine the risk
- Banks also ration the sizes of the loans they are willing to make
Explain the “Market for Used Cars”
- Used-car seller has private information = cars may be good quality or “lemons”
= adverse selection and moral hazard occur if the seller claims all cars are high quality but in truth only offers “lemons” for sale - consumer unable to distinguish between a “lemon” and a good vehicle, so assumes that all used vehicles for sale are potential “lemons”.
- As a result = used car dealers must price their cars at the highest price that consumers will pay for a “lemon”.
- Private solution = warranties. Used car dealers can offer a warranty on the vehicle = if the dealer gives a warranty on a lemon vehicle, the dealer will face expensive repair costs.
Explain the “Market for Insurance”
- Moral hazard = insured people have less incentive to be careful and avoid risky behaviour
- Adverse selection = mainly high risks want insurance
- Insurance companies need signals to limit the extent of adverse selection problem. i.e. auto insurer looking at an individual’s driving record, or a health insurer looking at an individual’s medical records
Explain the situation of Fire Insurance in New York in 1990s
- Property owners in NY took out full fire insurance:
- Substantial number of fires, especially during economic downturns
- Suspicion of arson in some of the cases
- Insurance companies could not prove that any had been started deliberately
- Paid out according to the clauses of the insurance policy
- Policy response:
- Mandatory/gov insurance
- Legal requirements for info disclosure
- Deductibles (excesses) = the insured person also must pay part of the expense of an incident
Define the term “GDP”
The market value of all final goods and services produced in a country in a given time period.
aka
Its the value of the aggregate production of goods/services in a country during a given time period.
What is meant by the term “Final goods/services”?
For final consumption. Ready and finished product.
The circular flow diagram shows what?
The equality of total income, total expenditure on final goods and the value of production. Shows the transactions among different economic agents (households, firm, governments, and rest of world).
What is factor market income?
i.e. wages to workers, which flows back into the households.
Explain the features of the Factor Market in the circular flow
- Households sell and firms buy of labour services, capital and land
- Firms pay income (flow Y)
- Labour receives wages
- Capital receives interest
- Land receives rent
- Entrepreneurship receives profit
Explain the features of the Goods Markets in the circular flow
- Firms sell and households buy consumer goods and services in the goods market (flow C).
- Firms buy and sell capital equipment in the goods market and put unsold output into inventory (flow I)
Explain the features of the Government in the circular flow
- Government withdraws income from the economy through taxes from households/firms and injects all or some of that income back as government expenditure (G)
- Governments buy goods/services from firms and their expenditure on goods/services = GOVERNMENT EXPENDITURE (red flow G)
Explain the features of the Rest of the world in the circular flow
- Firms in the UK sell goods/services to the rest of the world = EXPORTS, and buy goods/services from the rest of the world = IMPORTS
- The value of exports (X) – value of imports (M) = NET EXPORTS, and is the red flow of diagram X – M.
- If net exports are positive, the net flow of goods/services is from the UK firms to the rest of the world.
- If net exports are negative, the net flow of goods/services is from the rest of the world to UK firms.
What are taxes in the circular flow model?
Leakages from the economy.
How is GDP measured?
2 ways:
1/ Income Approach = sums up the income earned by factors of production
2/ Expenditure Approach = adds together the components of spending
Define the term “Aggregate Expenditure”
Total amount buyers spend on the final goods/services produced. It equals the value of output = GDP.
What does GDP equal?
Output = GDP
What is the formula for GDP via the expenditure approach?
Y = C + I + G + NX
where:
Y = GDP/output
C = Consumption
I = Investment
G = Government expenditure
N = Net exports
X = Aggregate expenditure
- The buyers of aggregate production pay an amount equal to aggregate expenditure, and the sellers of aggregate production pay an amount equal to income.
Define the term “Aggregate income”
Total amount paid for the use of the factors of production i.e. wages, interest, rent and profit
What is the formula for Income?
Wages + interest + rent + profits
Firms pay out all their receipts from the sale of the final goods, so therefore Income = what?
Expenditure
To get from factor cost to market prices, what do you have to do?
Subsidies are added, indirect taxes are subtracted.
What is the gross operating surplus consisting of?
Gross profit income
The Gross Operating Surplus formula is?
Gross output - cost of intermediate goods - compensation of employees
What is mixed income comprised of?
Rental income + imputed rent, income in enterprises where labour and capital contributions can’t be distinguished (i.e. self-employed taxi drivers etc/ sole proprietorship).
Define Nominal GDP
The value of goods/services produced during a given year valued at the prices that prevailed in that same year
Define Real GDP
The value of the final goods/services produced in a given year when valued at the prices of a reference base year.
What is the formula for real GDP?
Nominal GDP/ Price Index * 100
Define the term “Potential GDP”
Value of production when all the economy’s labour, capital, land and entrepreneurial ability are fully employed.
(Aka trend GDP)
Amount of Real GDP produced when the quantity of labour employed is at full-employment levels.
Why does potential GDP grow at a steady pace?
Because of the quantities of the factors of production and their productivity grow at a steady pace.
What does real GDP fluctuate around?
Potential GDP
Define the term “Expansion”
A period during which real GDP increases - from a trough to a peak
Define the term “Recession”
A period during which real GDP decreases - its growth rate is negative for at least 2 successive quarters
What does a shift in PPF show?
An expansion of production capacity
How is economic growth measured?
As rate of increase in real GDP
What is the convergence hypothesis?
in the long run, GDP per capita converges to the same growth path in all countries. This implies that all countries converge to the same level of income per capita (Sorensen et al, 2005).
A model with what 2 components can determine potential GDP?
1/ An aggregate production function
2/ An aggregate labour market
What 2 things make Potential GDP grow?
1/ Growth in supply of labour
2/ Growth in labour productivity
Explain what the growth in supply of labour means for potential GDP growth
- Aggregate hours (total numbers of hours worked by all the people employed) change as a result of changes in:
1. Average hours per worker
2. Employment rate
3. Working-age population
The labour supply curve shifts rightward, and the real wage rate falls, and the aggregate labour hours increase.
The increase in aggregate hours increases potential GDP. Because of diminishing returns, the curve flattens out after a certain point = decreases potential GDP per hour of labour
Explain what is meant by growth in labour productivity in relation to Potential GDP growth
- Labour productivity = real GDP/ aggregate labour hours
- If labour became more productive = firms are willing to pay more for a given number of hours so the demand for labour increases.
Why does labour productivity grow?
- Physical capital growth (K)
- Human capital growth (H)
- Technological advances (A)
Explain physical capital growth (K)
- Results from saving and investment decisions.
- The accumulation of new capital, increased capital per worker and increased labour productivity.
Explain human capital growth (H)
- Acquired through education, on-the-job training and learning-by-doing. Is the most fundamental source of economic growth.
- Is the source of increased labour productivity and technological advances.
Explain technological advances (A)
- The discovery and application of new technologies and new goods. Has contributed immensely to increasing labour productivity.
Note: only K is subject to diminishing returns
What are 5 growth policies?
- Improve the quality of education = benefits from education spread beyond the person educated, so there is a tendency to under invest in education
- Encourage international trade = free international trade stimulates growth by extracting all the available gains from specialization and trade. The fastest growing nations are the ones with the fastest growing exports and imports
- Provide international aid to developing countries = if rich countries give financial aid to developing countries, investment and growth will increase. However, data on the effect of aid shows that it has had 0 or -ve effect.
- Stimulate saving = saving finances investment. Higher saving rates might therefore increase physical capital growth. Tax incentives to boost saving.
- Stimulate research and development = benefits not just the innovator. There is also a spill-over effect. Gov subsidies and direct funding to stimulate R&D.
What are the 3 growth theories?
- Classical
- Neo-classical
- New growth theory
Explain the Classical growth theory.
- The view that the growth of real GDP per person is temporary and that when it rises above the subsistence level, a population explosion eventually brings real GDP per person back to the subsistence level.
- Thomas Robert Malthus = “Population, when unchecked, increases in a geometrical ratio. Subsistence increases only in an arithmetical ratio”
Limitation of this model: technology is an outcome not controlled by human actions and operating independently.
Define the term “Subsistence level”
A kind of equilibrium level that real GDP would always revert to in classical theories. Alternatively, if the real GDP fell below this subsistence level, parts of the population would die off and real income would rise back to the subsistence level.
What are the assumptions of the production function?
- Constant returns to scale = if quantities of capital and labour are doubled, then output will also double
- Decreasing returns to capital = refers to the property that increases in capital lead to smaller and smaller increases in output as the level of capital increases
- Decreasing returns to labour = refers to the property that increases in labour, given capital, lead to smaller and smaller increases in output as the level of labour increases.
- Technological change results from chance.
- Diminishing returns to a single factor (capital)
Y = AKαL1-α
Why does real GDP per person grow according to the production function?
- Real GDP per person growths because technological change induces saving and investment and makes capital per worker grow.
- As more capital is accumulated, rates of return fall (due to depreciation)
- Growth ends when technological change stops because of diminishing marginal returns to both labour and capital. Eventually, the pace of capital accumulation slows, only keeping up with population growth.
- Problem: All economies have access to the same technologies. = should lead to “Conditional convergence”
What is the aggregate production function?
Y = f(A, K, L),
where Y = aggregate output
A = technology
K = capital stock
L = labour
- Notice, we have two equations that determine Y. Y = C + I + G + NX (this is the demand side of the economy - what people buy). Also, we have Y = f(A, K, L) (this is the supply side - what firms produce). Note: what is bought - by definition - must equal what is produced
When was the Cobb-Douglas production function developed?
1920s, in order to predict farming production
What is the Cobb-Douglas production function?
Y = AKαL1-α, where alpha is elasticity of production/output
Explain the Cobb-Douglas production function relating to returns to scale
- If α + (1- α) = 1, there are constant returns to scale
- if α + (1- α) > 1, there are increasing returns to scale
- If α + (1- α) < 1, there are decreasing returns to scale
Explain the New Growth Theory
- Real GDP per person grows because of choices that people make in the pursuit of profit.
- Growth can persist indefinitely:
- Discoveries result from choices
- Discoveries bring profit and competition destroys profit (More R&D is undertaken in the hope of creating a new burst of profitable investment and growth).
- Discoveries are a public capital good
- Knowledge is NOT subject to diminishing returns. increasing the stock of knowledge makes capital and labour more productive
