I.    Review of the Definitions of Microeconomics and Macroeconomics 

A.   Definition of microeconomics: the study of how households and firms make decisions and how they interact in markets.

 B.   Definition of macroeconomics: the study of economy-wide phenomena including inflation, unemployment, and economic growth.

 II.   The Economy’s Income and Expenditure

     A.   To judge whether or not an economy is doing well, it is useful to look at Gross Domestic Product (GDP).

1.   GDP measures the total income of everyone in the economy. 

2.   GDP measures total expenditure on an economy’s output of goods and services.

 B.   For an economy as a whole, total income must equal total expenditure.

             1.   If someone pays someone else $100 to mow a lawn, the expenditure on the lawn service ($100) is exactly equal to the income earned from the production of the lawn service ($100).
             2.   We can also use the circular-flow diagram from Chapter 2 to show why total income and total expenditure must be equal.

a.   Households buy goods and services from firms; firms use this money to pay for resources purchased from households. 

b.   In the simple economy described by this circular-flow diagram, calculating GDP could be done by adding up the total purchases of households or summing total income earned by households. 

c.    Note that this simple diagram is somewhat unrealistic as it omits saving, taxes, government purchases, and investment purchases by firms. However, because a transaction always has a buyer and a seller, total expenditure in the economy must be equal to total income.

III. The Measurement of Gross Domestic Product

A.   Definition of gross domestic product (GDP): the market value of all final goods and services produced within a country in a given period of time.

      B.   “GDP Is the Market Value . . .”

              1.   To add together different items, market values are used.
              2.   Market values are calculated by using market prices.

       C.   “. . . Of All . . .”

             1.   GDP includes all items produced and sold legally in the economy.
             2.   The value of housing services is somewhat difficult to measure.

                     a.   If housing is rented, the value of the rent is used to measure the value of the housing services.
                     b.   For housing that is owned (or mortgaged), the government estimates the rental value and uses this figure to value the housing services.

             3.   GDP does not include illegal goods or services or items that are not sold in markets.

a.   When you hire someone to mow your lawn, that production is included in GDP.

b.   If you mow your own lawn, that production is not included in GDP.

         D.   “. . . Final . . .”

             1.   Intermediate goods are not included in GDP.
             2.   The value of intermediate goods is already included as part of the value of the final good.
             3.   Goods that are placed into inventory are considered to be “final” and included in GDP as a firm’s inventory investment.

                     a.   Goods that are sold out of inventory are counted as a decrease in inventory investment.
                     b.   The goal is to count the production when the good is finished, which is not necessarily the same time that the product is sold.

E.   “. . . Goods and Services . . .”

             1.   GDP includes both tangible goods and intangible services.

         F.   “. . . Produced . . .”

             1.   Only current production is counted.
             2.   Used goods that are sold do not count as part of GDP.

         G.   “. . . Within a Country . . .”

                     1.   GDP measures the production that takes place within the geographical boundaries of a particular country.
                     2.   If a Canadian citizen works temporarily in the United States, the value of his output is included in GDP for the United States. If an American owns a factory in Haiti, the value of the production of that factory is not included in U.S. GDP.

H.   “. . . in a Given Period of Time.”

             1.   The usual interval of time used to measure GDP is a quarter (three months) or a year.
             2.   When the government reports GDP, the data are generally reported on an annual basis.
             3.   In addition, data are generally adjusted for regular seasonal changes (such as Christmas).

IV.  The Components of GDP

A.   GDP (Y ) can be divided into four components: consumption (C ), investment (I ), government purchases (G ), and net exports (NX ).

B.   Definition of consumption: spending by households on goods and services, with the exception of purchases of new housing.

       C.   Definition of investment: spending on capital equipment, inventories, and structures, including household purchases of new housing.

                 1.   GDP accounting uses the word “investment” differently from how we use the term in everyday conversation.

                 2.   In GDP accounting, investment means purchases of investment goods such as capital equipment, inventories, or structures.

D.   Definition of government purchases: spending on goods and services by local, state, and federal governments.

1.   Salaries of government workers are counted as part of the government purchases component of GDP.

2.   Transfer payments are not included as part of the government purchases component of GDP. 

E.   Definition of net exports: spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports).

V.   Real Versus Nominal GDP

A.   There are two possible reasons for total spending to rise from one year to the next.

1.   The economy may be producing a larger output of goods and services.

             2.   Goods and services could be selling at higher prices.

B.   When studying GDP over time, economists would like to know if output has changed (not prices).

C.   Thus, economists measure real GDP by valuing output using a fixed set of prices.

D.   A Numerical Example

.   Two goods are being produced: hot dogs and hamburgers.

2.   Definition of nominal GDP: the production of goods and services valued at current prices.

Nominal GDP for 2008 = ($1 × 100) + ($2 × 50) = $200.

Nominal GDP for 2009 = ($2 × 150) + ($3 × 100) = $600.

Nominal GDP for 2010 = ($3 × 200) + ($4 × 150) = $1,200.

3.   Definition of real GDP: the production of goods and services valued at constant prices.

Let’s assume that the base year is 2008.

Real GDP for 2008 = ($1 × 100) + ($2 × 50) = $200.

Real GDP for 2009 = ($1 × 150) + ($2 × 100) = $350.

Real GDP for 2010 = ($1 × 200) + ($2 × 150) = $500. 

E.   Because real GDP is unaffected by changes in prices over time, changes in real GDP reflect changes in the amount of goods and services produced.

      VI.  Is GDP a Good Measure of Economic Well-Being?

A.   GDP measures both an economy’s total income and its total expenditure on goods and services.

         B.   GDP per person tells us the income and expenditure level of the average person in the economy which should be a good measure of well-being.

C.   GDP, however, may not be always a  good measure of the economic well-being of an individual.

 1.   GDP omits important factors in the quality of life including leisure, the quality of the environment, and the value of goods produced but not sold in formal markets.

 2.   GDP also says nothing about the distribution of income.

 3.   However, a higher GDP does help us achieve a good life. Nations with larger GDP generally have better education and better health care.

I    would you rather have 55K today or 55K in 1900 and all 1900 techno

This is why we like growth

Current size of econ(1+growth rate)^time = future

Assume econ starts at 100

II.         Productivity: Its Role and Determinants

 A.   Why Productivity Is So Important

   Definition of productivity: the amount of goods and services a worker produces in each hour of work.

 B.   How Productivity Is Determined

C.   FYI: The Production Function

1.   A production function describes the relationship between the quantity of inputs used in production and the quantity of output from production.

 III. Economic Growth and Public Policy

A.   Saving and Investment

         1.   Because capital is a produced factor of production, a society can change the amount of capital that it has.

         2.   However, there is an opportunity cost of doing so; if resources are used to produce capital goods, fewer goods and services are produced for current consumption.

B.   Diminishing Returns and the Catch-Up Effect

1.   Definition of diminishing returns: the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases.

2.   An important implication of diminishing returns is the catch-up effect.

a.   Definition of catch-up effect: the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich.

Horse race story

Globalization does not cause poverty

b.   When workers have very little capital to begin with, an additional unit of capital will increase their productivity by a great deal.

C.   Investment from Abroad

             1.   Saving by domestic residents is not the only way for a country to invest in new capital.

             2.   Investment in the country by foreigners can also occur.

D.   Education

1.   Investment in human capital also has an opportunity cost.

                     a.   When students are in class, they cannot be producing goods and services for consumption.

                     b.   In less-developed countries, this opportunity cost is considered to be high; as a result, children often drop out of school at a young age.

2.   Because there are positive externalities in education, the effect of lower education on the economic growth rate of a country can be large.

 3.   Many poor countries also face a “brain drain”—the best educated often leave to go to other countries where they can enjoy a higher standard of living.

E.   Health and Nutrition

1.   Human capital can also be used to describe another type of investment in people: expenditures that lead to a healthier population.

             2.   Other things being equal, healthier workers are more productive.

             3.   Making the right investments in the health of the population is one way for a nation to increase productivity.

F.   Property Rights and Political Stability

1.   Protection of property rights and promotion of political stability are two other important ways that policymakers can improve economic growth.

             2.   There is little incentive to produce products if there is no guarantee that they cannot be taken. Contracts must also be enforced.

             3.   Countries with questionable enforcement of property rights or an unstable political climate will also have difficulty in attracting foreign (or even domestic) investment.

G.   Free Trade

1.   Some countries have tried to achieve faster economic growth by avoiding transacting with the rest of the world.

             2.   However, trade allows a country to specialize in what it does best and thus consume beyond its production possibilities.

             3.   When a country trades wheat for steel, it is as well off as it would be if it had developed a new technology for turning wheat into steel.

             4.   The amount a nation trades is determined not only by government policy but also by geography.

                     a.   Countries with good, natural seaports find trade easier than countries without this resource.

                     b.   Countries with more than 80 percent of their population living within 100 kilometers of a coast have an average GDP per person that is four times as large as countries with 20 percent of their population living near a coast.

H.   Research and Development

1.   The primary reason why living standards have improved over time has been due to large increases in technological knowledge.

             2.   Knowledge can be considered a public good.

             3.   The U.S. government promotes the creation of new technological information by providing research grants and providing tax incentives for firms engaged in research.

4.   The patent system also encourages research by granting an inventor the exclusive right to produce the product for a specified number of years.

I.    Population Growth

Unemployment

The unemployment rate is the percentage of those who would like to work but do not have jobs. The Bureau of Labor Statistics calculates this statistic monthly based on a survey of thousands of households.

One reason for unemployment is the time it takes for workers to search for jobs that best suit their tastes and skills. Unemployment insurance is a government policy that, while protecting workers’ incomes, increases the amount of frictional unemployment.

A third reason for unemployment is the market power of unions. When unions push the wages in unionized industries above the equilibrium level, they create a surplus of labor.

a.   Definition of frictional unemployment: unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills.

b.   Definition of structural unemployment: unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one.