Microeconomics

From Wikipedia, the free encyclopedia

The supply and demand model describes how prices vary as a result of a balance between product availability at each price (supply) and the desires of those with purchasing power at each price (demand). The graph depicts a right-shift in demand from D1 to D2along with the consequent increase in price and quantity required to reach a new market-clearing equilibrium point on the supply curve (S).

Economics

Economies by region

General categories
Microeconomics Macroeconomics History of economic thought Methodology Mainstream & heterodox

Mathematical & statistical methods

Fields and subfields

Behavioral Cultural Evolutionary Growth Development History International Economic systems Monetary and Financial economics Public and Welfare economics Health Education Welfare Population Labour Managerial Business Information Industrial organization Law Agricultural Natural resource Environmental Ecological Urban Rural Regional Geography

Lists
Journals Publications Categories Topics Economists Economy: concept and history Business and Economics Portal
This box: view talk edit

Microeconomics (from Greek prefix micro- meaning "small" + "economics") is a branch of economics that studies the behavior of how the individual modern household and firms make decisions to allocate limited resources.[1] Typically, it applies to markets where goods or services are being bought and sold. Microeconomics examines how these decisions and behaviours affect the supply and demand for goods and services, which determines prices, and how prices, in turn, determine the quantity supplied and quantity demanded of goods and services.[2][3] This is in contrast to macroeconomics, which involves the "sum total of economic activity, dealing with the issues of growth, inflation, and unemployment."[2] Microeconomics also deals with the effects of national economic policies (such as changing taxation levels) on the aforementioned aspects of the economy.[4] Particularly in the wake of the Lucas critique, much of modern macroeconomic theory has been built upon 'microfoundations' i.e. based upon basic assumptions about micro-level behavior. One of the goals of microeconomics is to analyze market mechanisms that establish relative prices amongst goods and services and allocation of limited resources amongst many alternative uses. Microeconomics analyzes market failure, where markets fail to produce efficient results, and describes the theoretical conditions needed for perfect competition. Significant fields of study in microeconomics include general equilibrium,

markets under asymmetric information, choice under uncertainty and economic applications of game theory. Also considered is the elasticity of products within the market system.
Contents
[hide]

1 Assumptions and definitions 2 Modes of operation 3 Opportunity cost 4 Applied microeconomics 5 References 6 Further reading 7 External links

[edit]Assumptions

and definitions

The theory of supply and demand usually assumes that markets are perfectly competitive. This implies that there are many buyers and sellers in the market and none of them have the capacity to significantly influence prices of goods and services. In many real-life transactions, the assumption fails because some individual buyers or sellers have the ability to influence prices. Quite often, a sophisticated analysis is required to understand the demand-supply equation of a good model. However, the theory works well in situations meeting these assumptions. Mainstream economics does not assume a priori that markets are preferable to other forms of social organization. In fact, much analysis is devoted to cases where so-called market failures lead to resource allocation that is suboptimal by some standard (defense spending is the classic example, profitable to all for use but not directly profitable for anyone to finance). In such cases, economists may attempt to find policies that will avoid waste, either directly by government control, indirectly by regulation that induces market participants to act in a manner consistent with optimal welfare, or by creating "missing markets" to enable efficient trading where none had previously existed. This is studied in the field of collective action and public choice theory. It also must be noted that "optimal welfare" usually takes on a Paretiannorm, which in its mathematical application of KaldorHicks method. This can diverge from the Utilitarian goal of maximising utility because it does not consider the distribution of goods between people. Market failure in positive economics (microeconomics) is limited in implications without mixing the belief of the economist and his or her theory. The demand for various commodities by individuals is generally thought of as the outcome of a utilitymaximizing process, with each individual trying to maximise their own utility. The interpretation of this

relationship between price and quantity demanded of a given good assumes that, given all the other goods and constraints, the set of choices which emerges is that one which makes the consumer happiest.

[edit]Modes

of operation

It is assumed that all firms are following rational decision-making, and will produce at the profit-maximizing output. Given this assumption, there are four categories in which a firm's profit may be considered to be.

A firm is said to be making an economic profit when its average total cost is less than the price of each additional product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.

A firm is said to be making a normal profit when its economic profit equals zero. This occurs where average total cost equals price at the profit-maximizing output.

If the price is between average total cost and average variable cost at the profit-maximizing output, then the firm is said to be in a loss-minimizing condition. The firm should still continue to produce, however, since its loss would be larger if it were to stop producing. By continuing production, the firm can offset its variable cost and at least part of its fixed cost, but by stopping completely it would lose the entirety of its fixed cost.

If the price is below average variable cost at the profit-maximizing output, the firm should go into shutdown. Losses are minimized by not producing at all, since any production would not generate returns significant enough to offset any fixed cost and part of the variable cost. By not producing, the firm loses only its fixed cost. By losing this fixed cost the company faces a challenge. It must either exit the market or remain in the market and risk a complete loss.

[edit]Opportunity

cost

Main article: Opportunity cost Opportunity cost of an activity (or goods) is equal to the best next alternative foregone. Although opportunity cost can be hard to quantify, the effect of opportunity cost is universal and very real on the individual level. In fact, this principle applies to all decisions, not just economic ones. Since the work of the Austrian economist Friedrich von Wieser, opportunity cost has been seen as the foundation of the marginal theory of value[citation needed]. Opportunity cost is one way to measure the cost of something. Rather than merely identifying and adding the costs of a project, one may also identify the next best alternative way to spend the same amount of money. The forgone profit of this next best alternative is the opportunity cost of the original choice. A common example is a farmer that chooses to farm her or his land rather than rent it to neighbors, wherein the opportunity cost is the forgone profit from renting. In this case, the farmer may expect to generate more profit alone. Similarly, the

opportunity cost of attending university is the lost wages a student could have earned in the workforce, rather than the cost of tuition, books, and other requisite items (whose sum makes up the total cost of attendance). The opportunity cost of a vacation in the Bahamas might be the down payment for a house. Note that opportunity cost is not the sum of the available alternatives, but rather the benefit of the single, best alternative. Possible opportunity costs of a city's decision to build a hospital on its vacant land are the loss of the land for a sporting center, or the inability to use the land for a parking lot, or the money that could have been made from selling the land, or the loss of any of the various other possible uses but not all of these in aggregate. The true opportunity cost would be the forgone profit of the most lucrative of those listed. One question that arises here is how to determine a money value for each alternative to facilitate comparison and assess opportunity cost, which may be more or less difficult depending on the things we are trying to compare. For example, many decisions involve environmental impacts whose monetary value is difficult to assess because of scientific uncertainty. Valuing a human life or the economic impact of an Arctic oil spill involves making subjective choices with ethical implications. It is imperative to understand that nothing is free. No matter what one chooses to do, he or she is always giving something up in return. An example of opportunity cost is deciding between going to a concert and doing homework. If one decides to go the concert, then he or she is giving up valuable time to study, but if he or she chooses to do homework then the cost is giving up the concert. Opportunity cost is vital in understanding microeconomics and decisions that are made.

[edit]Applied

microeconomics

Applied microeconomics includes a range of specialized areas of study, many of which draw on methods from other fields. Industrial organization examines topics such as the entry and exit of firms, innovation, and the role of trademarks. Labor economics examines wages, employment, and labor market dynamics. Public economics examines the design of government tax and expenditure policies and economic effects of these policies (e.g., social insurance programs). Political economy examines the role of political institutions in determining policy outcomes. Health economics examines the organization of health care systems, including the role of the health care workforce and health insurance programs. Urban economics, which examines the challenges faced by cities, such as sprawl, air and water pollution, traffic congestion, and poverty, draws on the fields of urban geography and sociology. Financial economics examines topics such as the structure of optimal portfolios, the rate of return to capital, econometric analysis of security returns, and corporate financial behavior. Law and economics applies microeconomic principles to the selection and enforcement of competing legal regimes and their relative efficiencies. Economic history examines the evolution of the economy and economic institutions, using methods and techniques from the fields of economics, history, geography, sociology, psychology, and political science.

[edit]References

1.

^ Marchant, Mary A.; Snell, William M.. "Macroeconomic and International Policy Terms". University of Kentucky. Retrieved 2007-05-04.

2. 3.

a b

"Economics Glossary". Monroe County Women's Disability Network. Retrieved 2008-02-22.

^ "Social Studies Standards Glossary". New Mexico Public Education Department. Archived from the original on 2007-08-08. Retrieved 2008-02-22.

4.

^ "Glossary". ECON100. Retrieved 2008-02-22.

Rate of turn overs

[edit]Further

reading

Bade, Robin; Michael Parkin (2001). Foundations of Microeconomics. Addison Wesley Paperback 1st Edition.

Colander, David. Microeconomics. McGraw-Hill Paperback, 7th Edition: 2008. Dunne, Timothy, J. Bradford Jensen, and Mark J. Roberts (2009). Producer Dynamics: New Evidence from Micro Data. University of Chicago Press. ISBN 9780226172569.

Eaton, B. Curtis; Eaton, Diane F.; and Douglas W. Allen. Microeconomics. Prentice Hall, 5th Edition: 2002. Frank, Robert A.; Microeconomics and Behavior. McGraw-Hill/Irwin, 6th Edition: 2006. Friedman, Milton. Price Theory. Aldine Transaction: 1976 Hagendorf, Klaus: Labour Values and the Theory of the Firm. Part I: The Competitive Firm. Paris: EURODOS; 2009.

Harberger, Arnold C., 2008. "Microeconomics," The Concise Encyclopedia of Economics. Hicks, John R. Value and Capital. Clarendon Press. [1939] 1946, 2nd ed. Hirshleifer, Jack., Glazer, Amihai, and Hirshleifer, David, Price theory and applications: Decisions, markets, and information. Cambridge University Press, 7th Edition: 2005.

Jehle, Geoffrey A.; and Philip J. Reny. Advanced Microeconomic Theory. Addison Wesley Paperback, 2nd Edition: 2000.

Katz, Michael L.; and Harvey S. Rosen. Microeconomics. McGraw-Hill/Irwin, 3rd Edition: 1997. Kreps, David M. A Course in Microeconomic Theory. Princeton University Press: 1990 Landsburg, Steven. Price Theory and Applications. South-Western College Pub, 5th Edition: 2001. Mankiw, N. Gregory. Principles of Microeconomics. South-Western Pub, 2nd Edition: 2000. Mas-Colell, Andreu; Whinston, Michael D.; and Jerry R. Green. Microeconomic Theory. Oxford University Press, US: 1995.

McGuigan, James R.; Moyer, R. Charles; and Frederick H. Harris. Managerial Economics: Applications, Strategy and Tactics. South-Western Educational Publishing, 9th Edition: 2001.

Nicholson, Walter. Microeconomic Theory: Basic Principles and Extensions. South-Western College Pub, 8th Edition: 2001.

Perloff, Jeffrey M. Microeconomics. Pearson - Addison Wesley, 4th Edition: 2007. Perloff, Jeffrey M. Microeconomics: Theory and Applications with Calculus . Pearson - Addison Wesley, 1st Edition: 2007

Pindyck, Robert S.; and Daniel L. Rubinfeld. Microeconomics. Prentice Hall, 7th Edition: 2008. Ruffin, Roy J.; and Paul R. Gregory. Principles of Microeconomics. Addison Wesley, 7th Edition: 2000. Varian, Hal R. (1987). "microeconomics," The New Palgrave: A Dictionary of Economics, v. 3, pp. 46163. Varian, Hal R. Intermediate Microeconomics. & Company, 7th Edition. Varian, Hal R. Microeconomic Analysis. W. W. Norton & Company, 3rd Edition.

[edit]External

links

Wikibooks has a book on the topic of Microeconomics

Open Source Introduction to Microeconomics (see wiki article) by R. Preston McAfee - California Institute of Technology

Amosweb.com homepage - online economics dictionary X-Lab: A Collaborative Micro-Economics and Social Sciences Research Laboratory Micro Economics - the role of micro economics in supporting the social fabric of macro economies Simulations in Microeconomics
v d eMicroeconomics Major topics

Aggregation Budget Consumer Convexity and non-convexity Cost Cost-benefit analysis Distribution Deadweight loss Duopo scope Elasticity Exchange Expected utility Externality Firms General equilibria Household Information Indifference curve I structure Monopoly Monopsony Oligopoly Opportunity cost Preferences Prices Production Profit Public goods Returns to sc demand Surplus Uncertainty Utility Welfare

Related

Behavioral Business Computational Decision theory Econometrics Experimental Game theory Industrial organization Mathem Macroeconomics Managerial Operations research Optimization v d eEconomics

Adaptive expectations Aggregate demand Balance of payments Business cycle Capital flight Capacity utilization Central b Macroeconomics

shock DSGE Economic indicator Effective demand General Theory of Keynes Great Depression Growth Hyperinflation

rate Microfoundations Money Monetary policy National accounts NAIRU Profit rate PPP Rational expectations Reces shock Unemployment Macroeconomic publications

Aggregation Budget Consumer Convexity Cost Cost-benefit analysis Distribution Deadweight loss Duopoly Equilibri Microeconomics

scope Elasticity Exchange Expected utility Externality Firms General equilibria Household Information Indifference cu

structure Monopoly Monopsony Non-convexity Oligopoly Opportunity cost Preferences Prices Production Profit Pub choice Sunk costs Supply & demand Surplus Uncertainty Utility theory Welfare Microeconomic publications

Sub-disciplines

International Development Labor Environmental Institutional Behavioural Experimental Normative Positive Financial finance Psychology Sociology Geography Law and economics Political economy

Methodology

Mathematical economics Econometrics Economic data Experimental economics Computational economics Heterodox econo

History of economic thought

Ancient economic thought Classical economics Marxian economics Neo-classical economics Institutional economics Keyne economics

Famous economists

Adam Smith Vilfredo Pareto Francis Ysidro Edgeworth John Maynard Keynes Joseph Schumpeter Jacob Marschak Harol Frisch Tjalling Koopmans Paul Samuelson Kenneth Arrow Herbert A. Simon more Business and economics portal Category Outline Lists Publications

Macroeconomics
From Wikipedia, the free encyclopedia

Circulation in macroeconomics

Macroeconomics (from Greek prefix "macr(o)-" meaning "large" + "economics") is a branch of economics dealing with the performance, structure, behavior, and decision-making of the entire economy. This includes a national, regional, or global economy.[1][2] Withmicroeconomics, macroeconomics is one of the two most general fields in economics. Macroeconomists study aggregated indicators such as GDP, unemployment rates, and price indices to understand how the whole economy functions. Macroeconomists develop models that explain the relationship between such factors as national income, output, consumption,unemployment, inflation, savings, investment, international trade and international finance. In contrast, microeconomics is primarily focused on the actions of individual agents, such as firms and consumers, and how their behavior determines prices and quantities in specific markets. While macroeconomics is a broad field of study, there are two areas of research that are emblematic of the discipline: the attempt to understand the causes and consequences of short-run fluctuations in national income (the business cycle), and the attempt to understand the determinants of long-run economic growth (increases in national income). Macroeconomic models and their forecasts are used by both governments and large corporations to assist in the development and evaluation of economic policy and business strategy.
Contents
[hide]

1 Basic macroeconomic concepts

o o o

1.1 Output and income 1.2 Unemployment 1.3 Inflation and deflation

2 Macroeconomic policies 3 Development of macroeconomic theory

o o o o o o

3.1 Origins 3.2 Keynes and the his followers 3.3 Monetarism 3.4 New classicals 3.5 New Keynesian response 3.6 Austrian School

4 See also 5 Notes 6 References

[edit]Basic

macroeconomic concepts

Macroeconomics encompasses a variety of concepts and variables, but three are central topics for macroeconomic research.[3] Macroeconomic theories usually relate the phenomena of output, unemployment, and inflation. Outside of macroeconomic theory, these topics are also extremely important to all economic agents including workers, consumers, and producers.

[edit]Output

and income

National output is the total value of everything a country produces in a given time period. Since everything that is produced and sold produces income, output and income are usually considered to be equivalent and the two terms are often used interchangeably. Output can be measured as total income, or, it can be viewed from the production side and measured as the total value of final goods and services or the sum of all value added in the economy.[4] Macroeconomic output is usually measured by Gross Domestic Product (GDP) or one of the other national accounts. Economists interested in long-run increases in output study economic growth. Advances in technology, increases in machinery and other capital, and better education and human capital all lead to increased economic output overtime. However, output does not always increase consistently. Business cycles can cause short-term drops in output called recessions. Economists look for macroeconomic policies that prevent economies from slipping into recessions and that lead to faster long-term growth.

[edit]Unemployment
The amount of unemployment in an economy is measured by the unemployment rate, the percentage of workers without jobs in the labor force. The labor force only includes worker's actively looking for jobs. People who are retired, persuing education, or discouraged from seeking work by a lack of job prospects are excluded from the labor force. Unemployment can be generally broken down into several types based related to different causes. Classical unemployment occurs when wages are too high for employers to be willing to hire more workers. Wages may be too high because of minimum wage laws or union activity. Consistent with classical unemployment, frictional unemployment occurs when appropriate job vacancies exist for a worker, but the length of time needed to search for and find the job leads to a period of unemployment.[5] Structural unemployment covers a variety of possible causes of unemployment including a mismatch between workers' skills and the skills required for open jobs.[6] Large amounts of structural unemployment can occur when an economy is transitioning industries and workers find their previous set of skills are no longer in demand. Structural unemployment is similar to frictional unemployment since both reflect the problem of matching workers with job vacancies, but structural unemployment covers the time needed to acquire new skills not just the short term search process. [7] While some types of unemployment may occur regardless of the condition of the economy, cyclical unemployment occurs when growth stagnates. Okun's law represents the empirical relationship between unemployment and

economic growth.[8] The original version of Okun's law states that a 3% increase in output would lead to a 1% decrease in unemployment.[9]

[edit]Inflation

and deflation

A general price increase across the entire economy is called inflation. When prices decrease, there is deflation. Economists measure these changes in prices with price indexes. Inflation can occur when an economy becomes overheated and grows too quickly. Similarly, a declining economy can lead to deflation. Central bankers, who control a country's money supply, try to avoid changes in price level by using monetary policy. Raising interest rates or reducing the supply of money in an economy will reduce inflation. Inflation can lead to increased uncertainty and other negatives consequences. Deflation can lower economic output. Central bankers try to stabilize prices to protect economies from the negative consequences of price changes.

[edit]Macroeconomic

policies

To try to avoid major economic shocks, such as The Great Depression, governments make adjustments through policy changes they hope will stabilize the economy. Governments believe the success of these adjustments is necessary to maintain stability and continue growth. This economic management is achieved through two types of governmental strategies:

Fiscal policy Monetary policy

[edit]Development

of macroeconomic theory

Main article: History of macroeconomic thought

Economics

Economies by region [show]

General categories
Microeconomics Macroeconomics History of economic thought Methodology Mainstream & heterodox

Mathematical & statistical methods

Mathematical economics Game theory Optimization Computational Econometrics Experimental National accounting

Fields and subfields

Behavioral Cultural Evolutionary Growth Development History International Economic systems Monetary and Financial economics Public and Welfare economics Health Education Welfare Population Labour Managerial Business Information Industrial organization Law Agricultural Natural resource Environmental Ecological Urban Rural Regional Geography

Lists

Journals Publications Categories Topics Economists Economy: concept and history Business and Economics Portal
This box: view talk edit

[edit]Origins
Macroeconomics descended from the once divided fields of business cycle theory and monetary theory.[10] The quantity theory of money was particularly influential prior to World War II. It took many forms including the version based on the work of Irving Fisher:

In the typical view of the quantity theory, money velocity (V) and the quantity of goods produced (Q) would be constant, so any increase in money supply (M) would lead to a direct increase in price level (P). The quantity theory of money was a central part of the classical theory of the economy that prevailed in the early twentieth century.

[edit]Keynes

and the his followers

Macroeconomics, at least in its modern form,[11] began with the publication of John Maynard Keynes's General Theory of Employment, Interest and Money.[12] When the Great Depression struck, classical economists had difficulty explaining how goods could go unsold and workers could be left unemployed. In classical theory, prices and wages would drop until the market cleared, and all goods and labor were sold. Keynes offered a new theory of economists that explained why markets might not clear. Keynes presented a new theory of how the economy worked. In Keynes's theory, the quantity theory broke down because people and businesses tend to hold on to their cash in tough economic times, a phenomena he described in terms of liquidity preferences. Keynes explained how the multiplier effect would magnify a small decrease in consumption or investment and cause negative declines throughout the economy. Keynes also noted the role uncertainty and animal spirits can play in the economy.[13] The generation following Keynes combined the macroeconomics of the General Theory with neoclassical microeconomics to create the neoclassical synthesis. By the 1950s, most economists had accepted the synthesis view of the macroeconomy.[14] Economists like Paul Samuelson, Franco Modigliani, James Tobin, and Robert Solow developed formal Keynesian theories and developed theories of consumption, investment, and money demand that fleshed out the Keynesian framework.[15]

[edit]Monetarism
Milton Friedman updated the quantity theory of money to include a role for money demand. He argued that the role of money in the economy was sufficient to explain the Great Depression, and aggregate demand oriented explanations were not necessary. Friedman argued that monetary policy was more effective than fiscal policy; however, Friedman doubted the government has ability to "fine-tune" the economy with monetary policy. He generally favored a policy of steady growth in money supply instead of frequent intervention.[16] Friedman also challenged the Phillips Curverelationship between inflation and unemployment. Friedman and Edmund Phelps (who was not a monetarist) proposed an "augmented" version of the the Phillips Curve that excluded the possibility of a stable, long-run trade off between inflation and unemployment. When the oil shocks of the 1970s created a high unemployment and high inflation, Friedman and Phelps were vindicated. Monetarism was particularly influential in the early 1980s. Monetarism fell out of favor when central banks found it difficult to target money supply instead of interest rates as monetarists recommended. Monetarism also became politically unpopular when the central banks created recessions in order to slow inflation.

[edit]New

classicals

Another challenge to Keynesianism came from new classical macroeconomics. A central development in new classical thought came when Robert Lucas introduced rational expectations to macroeconomics. Prior

to Lucas, economists had generally used adaptive expectations where agents were assumed to look at the recent past to make expectations about the future. Under rational expectations, agents are assumed to be more sophisticated. A consumer will not simply assume a 2% inflation rate because that has been the average the past few years; he will look at current monetary policy and economic conditions to make an informed forecast. When new classical economists introduced rational expectations into their models, they showed that monetary policy could only have a limited impact. Lucas also made an influential critique of Keynesian empirical models. He argued that forecasting models based on empirical relationships would be unstable. He advocated models based on fundamental economic theory that would, in principle, be more stable as economies changed. Following Lucas's critique, new classical economists, led by Edward C. Prescottand Finn E. Kydland created real business cycle (RBC) models of the macroeconomy. These models were based on combining fundamental equations in neo-classical microeconomics. They produced models that explained recessions and unemployment with changes in technology. The RBC models did not include a role for money to play in the economy. Critics of RBC models argue that money clearly plays an important role in the economy, and the idea that technological regress can explain recent recessions is also implausible. [17] Despite questions about the theory behind RBC models, they have clearly been influential in economic methodology.

[edit]New

Keynesian response

New Keynesian economists responded to the new classical school by adopting rational expectations and focusing on developing micro-founded models that are immune to the Lucas critique. Stanley Fischer and John B. Taylor produced early work in this area by showing that monetary policy could be effective even in models with rational expectations when contracts locked-in wages for workers. Other new Keynesian economists expanded on this work and demonstrated other cases where inflexible prices and wages led to monetary and fiscal policy having real effects. Like classical models, new classical models had assumed that prices would be able to adjust perfectly and monetary policy would only lead to price changes. New Keynesian models investigated sources of sticky prices and wages, which would not adjust thereby leading monetary policy impact quantities instead of prices. By the late 1990s, economists had reached a rough consensus. The rigidities of new Keynesian theory were combined with rational expectations and the RBC methodology to producedynamic stochastic general equilibrium (DSGE) models. The fusion of elements from different schools of thought has been dubbed the new neoclassical synthesis. These models are now used by many central banks and are a core part of contemporary macroeconomics.[18]

[edit]Austrian

School

Austrian economists generally oppose state intervention in otherwise free markets. Austrian economists view fiscal and monetary policy as primary causes of the "boom-bust" business cycle rather than the cure.

[edit]See

also

AP Macroeconomics Dynamic stochastic general equilibrium Economic development

[edit]Notes

1.

^ Blaug, Mark (1985), Economic theory in retrospect, Cambridge, UK: Cambridge University Press, ISBN 0-521-31644-8

2.

^ Sullivan, Arthur; Steven M. Sheffrin (2003), Economics: Principles in action, Upper Saddle River, New Jersey 07458: Pearson Prentice Hall, pp. 57, ISBN 0-13-063085-3

3. 4. 5. 6. 7. 8. 9.

^ Blanchard (2011), 32. ^ Blanchard (2011), 22. ^ Dwivedi, 443. ^ Freeman (2008). http://www.dictionaryofeconomics.com/article?id=pde2008_S000311. ^ Dwivedi, 444-445. ^ Dwivedi, 445-446. ^ Neely, Christopher J. "Okun's Law: Output and Unemployment. Economic Synopses. Number 4. 2010. http://research.stlouisfed.org/publications/es/10/ES1004.pdf.

10. ^ Dimand (2008). 11. ^ Blanchard (2011), 580. 12. ^ Dimand (2008). 13. ^ Blanchard (2011), 580. 14. ^ Blanchard (2011), 580. 15. ^ Blanchard (2011), 581. 16. ^ Blanchard (2011), 582-583. 17. ^ Blanchard (2011), 587. 18. ^ Blanchard (2011), 590.

[edit]References

Blanchard, Olivier (2000), Macroeconomics, Prentice Hall, ISBN 013013306X. Blanchard, Olivier (2011). Macroeconomics Updated (5th ed.). Englewood Cliffs: Prentice Hall. ISBN 9780132159869.

Blaug, Mark (1986), Great Economists before Keynes, Brighton: Wheatsheaf.

Bouman, John: Principles of Macroeconomics - free fully comprehensive Principles of Microeconomics and Macroeconomics texts. Columbia, Maryland, 2011

Dwivedi, D.N. (2001). Macroeconomics : theory and policy. New Delhi: Tata McGrawHill. ISBN 9780070588417.

Friedman, Milton (1953), Essays in Positive Economics, London: University of Chicago Press, ISBN 0226-26403-3.

Heijdra, B. J.; Ploeg, F. van der (2002), Foundations of Modern Macroeconomics, Oxford University Press, ISBN 0-19-877617-9.

Mishkin, Frederic S. (2004), The Economics of Money, Banking, and Financial Markets, Boston: Addison-Wesley, p. 517

Snowdon, Brian, and Howard R. Vane, ed. (2002). An Encyclopedia of Macroeconomics, Description & scroll to Contents-preview links.

Snowdon, Brian; , Howard R. Vane (2005), Modern Macroeconomics: Its Origins, Development And Current State, Edward Elgar Publishing, ISBN 1-84376-394-X.

Grtner, Manfred (2006), Macroeconomics, Pearson Education Limited, ISBN 978-0-273-70460-7. Warsh, David (2006), Knowledge and the Wealth of Nations, Norton, ISBN 978-0393059960.
[hide]v d eMacroeconomics

Schools

History of macroeconomics Keynesian New Classical Macroeconomics New Keynesian Monetarism Stockholm school Supply Theory

Related fields and sub-fields

Development economics Growth economics Monetary economics Political economy

Basic concepts

Inflation Measures of national income and output National Income and Product Accounts Recession Unemployment

Policies

Fiscal policy Monetary policy Central bank Reaganomics

Growth economics

Solow-Swan model Ramsey growth model HarrodDomar model Endogenous growth theory

Open economy

MundellFleming model

Price Theory Lecture 1: Basic Notions and Concepts I. What Is Economics? Economics: the study of choice under conditions of scarcity. This definition requires some unpacking, to be more precise about the notions of choice and scarcity. Microeconomics: the branch of economics that deals with the choices of individuals and firms, and how those choices interact to produce social outcomes. II. Scarcity Scarcity: a situation in which the amount of something available is insufficient to satisfy everyones desire for it. Applies most obviously to resources of a material variety (timber, ore, grain, etc.), but also applies to: Time (only so much time for sleeping and studying) Labor services (only so many workers with so many hours to spend) Energy (in the broadest sense you only have so much energy to expend) Space In short, scarcity is a ubiquitous phenomenon. Scarcity implies the need to make trade-offs: giving up one thing in order to get another. Personal trade-offs (you give up apartment space in return for more spending money) Interpersonal trade-offs (resources spent on one persons project are unavailable for others projects) A market economy typically uses prices to signal scarcity. A more scarce resource will tend to have its price bid up by people competing to use it. III. Opportunity Cost

The notion of choice involves both selecting and setting aside. The term cost is used casually in a variety of ways, but economists attach a special meaning to it; generally, they mean opportunity cost, which refers to that which is set aside in the act of choice. Opportunity cost: the opportunity cost of any choice is [the value of] what we give up when we make that choice. More specifically, it is what you could have gotten with the scarce resources used or otherwise given up for ones choices. Alternative definition: the value of the next best alternative sacrificed when taking an action. Example: Going to a movie. Is the cost just the $9.00 to get in? No its also the cost of getting there (taxicab, your own cars gas) and the time taken. To find the true cost, wed have to consider what could have been done with both the money and the time say, buying a CD and studying some more. Example: Running a sandwich shop. Suppose you run this shop and make total weekly revenues of $2000, with weekly labor, food, and rent totaling $1500. Are you making a profit? What if, instead of running the shop, you could have worked for someone else and gotten paid $800? This forgone payment is part of the opportunity cost of running the shop, and it should be added to the $1500 to get a total cost of $2300. Since this is greater than your $2000 in revenue, you are making an economic loss, not an economic profit. Example: During the Superbowl, the network airing the game shows lots of advertisements for its own television shows. Is the network that airs the game lucky because it gets free air time that other advertisers have to pay $1 million a minute for? No, because the network sacrifices revenues whenever it uses air time for its own advertising instead of paid advertising. The opportunity cost is whatever they could have gotten paid. Of course, it's probably worth it; obviously the network thinks so.

Note: If you have more than two other options available to you, the opportunity cost of your choice is equal to the value of the better forgone option. Example: Two companies, Guinness and Sam Adams, wish to buy advertisement time during the Superbowl. The network uses the time to advertise its primetime line-up instead. Guinness would have paid as much as $800,000, and Coors would have paid up to $700,000. The opportunity cost is $800,000. In all the examples thus far, the alternative activity involved only benefits that would be forgone. But often the alternative activity involves costs that would be forgone as well. (Note that Im using cost here in the traditional sense, not in the economic sense of opportunity cost.) The value of the alternative activity, then, is the net of its benefits and costs. Example: Suppose you have a free ticket to see Eric Clapton (which you cannot resell). Going to the concert would be worth $30 to you. But on the same night, Bob Dylan will be performing. Going to see Bob Dylan would be worth $50 to you, but youd have to pay $40 for the ticket. What is the opportunity cost, and which show should you see? Answer: By choosing to see Clapton, you forgo a benefit of $50 but also a cost of $40, for a net forgone value of $10. So $10 is the opportunity cost. Since seeing Clapton is worth $30, which is greater than $10, you should see Clapton. But there is often more than one way to calculate opportunity cost. This is because the benefit of one activity is the cost (forgone benefit) of another activity, and the cost of one activity is the benefit (forgone cost) of another activity. Example: Same as above. But notice that the $40 cost of buying a Dylan ticket is a benefit of seeing Clapton instead. So an alternative way to solve the problem is to add that $40 to the $30 benefit of seeing Clapton, for a total benefit of $70. The opportunity cost is $50, the value of seeing Dylan. Since $70 is greater than

$50, you should see Clapton. Notice that the answer to the important question which concert to see is the same regardless. The question of whether the opportunity cost is $10 or $50 is semantic; it depends on whether you define it as the gross value of the next best alternative or the net value of the next best alternative. There is some debate among economists on this point, but all good economists will get the right answer to the question of which concert to attend! In this class, we will define opportunity cost as the net value of the next best alternative. The main lesson of opportunity cost is that the cost of doing something is not only the money that must be spent, but also what you could have done instead. In the Clapton/Dylan example, the explicit payment to see Clapton is $0, but that doesnt mean theres no cost to seeing Clapton! The cost is not seeing Dylan. For the remainder of this course, whenever we use the term cost, you should remember that were talking about opportunity cost. Opportunity cost can be divided into two parts, implicit and explicit costs. Explicit cost: costs that require a monetary payment. Implicit cost: costs that do not require a monetary payment. Implicit costs often (but not always) involve forgone payments -- that is, payments you could have receive if you had made a different choice. IV. Production Possibilities On a social or aggregate level, scarcity of resources implies the existence of trade-offs between different uses of those resources. We can summarize these trade-offs with a diagram of the Production Possibilities Frontier. This is a curve representing all combinations of two goods that can be produced with given resources and technology.

The figure below is a PPF for a society that has only two industries: film and healthcare. The output of these industries is measured in lived saved and films made. Some things to observe about this graph: Downward-sloping curve implies trade-offs. Movements along the curve can be used to show opportunity costs. For example, the choice to move from A to B (producing 100 more feature films) is 50,000 lives not saved. Outward-bowed shape illustrates the law of increasing opportunity cost. The law of increasing opportunity cost says that the more you are doing of an activity, the greater is the added cost of doing yet more. In the diagram above, notice that to get the first 100 films, you only give up 50,000 lives. The next 100 films require 100,000 lives; the next 100 films require 150,000 lives. Why? Because some resources are better suited to one activity than another. So the more of something you do, the more unsuitable resources you have to use. (Imagine drawing brilliant surgeons into the film industry, or training Oliver Stone and Kevin Costner to be surgeons.) Technical inefficiency is illustrated by points inside the PPF, from waste or misused resources. Technical inefficiency is illustrated by points inside the PPF. If youre at any point inside the PPF, you can move upward or rightward to produce more of one good without producing less of the other. This means resources are currently being wasted or misused. Technical efficiency exists when you cannot produce more of one good (or activity) without producing less of another good (or activity), and this is true of any point on the PPF curve. Technical inefficiency exists if you could produce more of one good without producing less of another, and this is true of any point inside the curve. A change in the resources or technology available to society would shift the PPF. An

increase in resources (say, labor) would shift the whole curve out. An improvement in film technology, without an improvement in medical technology, would shift the PPF outward, but the endpoint on the lives saved axis would stay fixed. The new PPF would be flatter than the old one An improvement in medical technology, without an 100 200 300 400 films made 500,000 450,000 350,000 200,000 lives savedimprovement in film technology, would shift the PPF outward, but the endpoint on the films made axis would stay fixed. The new PPF would be steeper than the old one. V. Preferences and Subjectivity Economists work on the assumption that people have preferences that they act to satisfy. They can say, I like this better than that. They can compare situations and alternatives, and say which they consider to be better. Well talk later about the properties we think peoples preferences have. The preferences people have differ across individuals, and we dont have an objective means of saying whose preferences are correct. This is the concept of subjectivity which essentially means personal or individualized. The concept of subjective preferences is important because, in modern economics, we use the subjective theory of value, which says that the value of goods the price they command on the market is determined by consumers' subjective preferences for those goods. Up through the 1870s, just about all economists (including both Adam Smith and Karl Marx) subscribed to the labor theory of value, which says that the value of a good was

equal to the amount of labor that went into producing it. Example: Adam Smiths story of beavers and deer. If it took 2 hours of labor to catch and prepare a beaver, and it took 3 hours of labor to catch and prepare a deer, then 3 beaver should trade for 2 deer. Or, the price of a beaver should be 2/3 that of a deer because it required only 2/3 as much labor. The problem with the labor theory of value is that its manifestly untrue in some cases. People may spend much labor on something that no one wants say, really bad artwork. Also, the labor theory of value cannot explain the market value of labor itself, the wage. The labor theory of value is no longer used by economists. Now we understand that the price a good commands depends crucially on peoples taste for it. Even the price (or wage) of labor depends on how much it contributes to producing things that people want. VI. Rationality Economists typically use a rational choice model of human behavior. Rationality does not mean exactly the same thing in economics as it does in everyday language. In economics, rationality means that people choose means that are appropriate to their ends. They try to do as well as they can, subject to constraints. N.B.: Rationality is not used by economists to judge peoples ends, i.e., their preferences. In short, rationality is not about ends, but about the relationship between means and ends. However, economists sometimes use rationality in a somewhat narrower sense, to describe certain assumptions we make about peoples preferences. Specifically, it refers to peoples preferences being internally consistent (e.g., I dont simultaneously prefer A to B and B to A). But even here, rationality does not involve any kind of value judgment. VII. Costs, Benefits, and Marginal Decision-Making Economists have a very rule principle for how people do, and should, make decisions. It is this: do something if the benefits exceed the costs, and dont do it if the costs exceed

the benefits. Call this the cost-benefit principle. In light of what weve said already, the cost-benefit principle needs to be clarified in a couple of ways. First, when we talk about costs, we mean opportunity costs. Second, both costs and benefits are inherently subjective. Even when a cost or benefit is seemingly objective (as when it takes the form of a dollar payment), the value of those dollars to an individual is subjective, corresponding to what the individual could do with those dollars. To apply the cost-benefit principle correctly, however, it must be applied to a particular choice, and the costs and benefits must be those actually affected by that choice. It turns out that many of the choices we make are at the margin. That means they are not choices about whether to do something at all; they are choices about how much of something to do. The word marginal means next, additional, or incremental. For example, when we talk about the marginal cost of a good, we mean the cost of producing one more unit of the good. The next unit of the good is the marginal unit. It turns out that marginal decisions are extremely important in economics. Why? Because we are rarely in situations where we have to choose between total quantities of things. For example: A firm has to decide whether to increase or decrease production. GM is not usually in the position of choosing between building 10 million cars or none at all; instead, GM decides whether to increase or decrease production from its current level, and how much. You dont generally decide to either study for 10 hours or not study at all. Rather, you decide whether or not to study more than you already have studied or plan to study.

 Even when individuals make all-or-nothing decisions, we are often interested in the marginal behavior of a population. For instance, most individuals makes an all-ornothing decision about whether to deal drugs. Either you do or you dont. But if the criminal punishment for selling drugs increases, we can see the marginal effect on the population: some people will continue selling, some will continue not selling, and some will switch from selling to not selling. The people who switch illustrate the marginal response of the population to a change in criminal justice policies. Marginal decision-making is also important because of its relationship to rational choice. If youre trying to get the maximum net benefit from an activity (in terms of your own goals and preferences), you want to find where the difference between total benefits and total costs is greatest. You can do that by increasing the level of an activity whenever the added benefit of doing so exceeds the added cost. That is, do more when MB > MC. Stop when MB < MC. Example: Suppose your only goal is to get the highest grade you can on tomorrows economics exam. There are twelve hours until then, and you can use each hour to study or to sleep. Now, each hour you study will allow you to raise your grade a little bit. But you will learn less each hour, because (a) the things you learn are less likely to be on the exam, and (b) youre getting sleepier, so youre retaining less material. Thus, the marginal benefit (MB) curve slopes downward (see graph). Meanwhile, each hour of study is a lost hour of sleep. Losing sleep causes you to lose points on your exam, because you cant concentrate and arent thinking clearly. And the more sleep you lose, the worse it is. (Having 8 hours of sleep instead of 9 has little effect, but getting 2 hours instead of 3 has a large effect.) Thus, the marginal cost (MC) of studying which is the same as the MB of sleep) is upward sloping (see graph). Suppose youve studied for 2 hours. Should you study for a third? Youll gain 10

points from the studying, but lose 4 from loss of sleep, for a net increase of 6 points so do it. The same goes for hours 4, 5, and 6. But by the time youre thinking of studying a seventh hour, MB < MC. Youll lose more points from lack of sleep than youll gain from studying. So you decide to study for 6 hours and sleep the rest of the night. The rule of MC = MB turns out to be a nearly universal rule for economic decisionmaking. MB MC 6 7 4 10 hours of study --> points 3Marginalism was very important in the historical development of economics. Up through the 1870s, the marginal idea had not been grasped, which led to paradoxes such as the diamond-water paradox. This paradox was resolved by the introduction of marginal thinking. A modern equivalent of the diamond-water paradox: Why do basketball players get paid so much more than teachers, when teachers are so much more important? Because we have plenty of people who are capable of doing what a teacher has to do (at least at the elementary/middle/high school level), whereas we have very few people who can do what a pro basketball player does. Not all decisions are marginal, however. Some decisions really are all-or-nothing: deciding whether to shut down your business or stay open; deciding whether to offer a

new product line; deciding whether to get married; deciding whether to move to New York. For decisions like these, you need to compare the total expected benefit to the total expected cost. VIII. The No Cash on the Table Principle When people observe a chance to have something for free, they will usually take it. Thats assuming it is truly free; that is, there arent hidden costs that make the net benefit zero after all. More broadly, when people see an opportunity to make pure economic profit to claim benefits in excess of costs they take the opportunity. For this reason, economists often say that we dont expect there to be cash on the table. If money is sitting there waiting to be taken, someone will take it. The no cash on the table principle is an important part of the market process. When there are economics profits in a given industry or line of business, those profits will attract more competition (because theres cash on the table). But the entry of more competition will tend to drive down prices, and sometimes to drive up costs. As a result, the economic profits are dissipated. In the long-run, we dont expect true economic profits to persist. There is an important caveat to the no cash on the table principle, however. It must be possible for people to enter a line of business and take the cash. In economics jargon, we say there must not be barriers to entry (or if there are, they must substantial). In the presence of substantial barriers to entry, the no cash on the table principle will cease to operate. When you think you see cash on the table, then, economic theory implies that one of two things is happening. Either (a) there is some barrier to entry that prevents the no cash on the table principle from operating, or (b) youre mistaken, because there are actually hidden costs or other factors that imply the pure economic profit is illusory. Another

possibility is that youre in a temporary state of disequilibrium. Example: Different prices for mens and womens shirt cleaning at a laundry service. IX. Mutually Beneficial Trade Economists used to think people would only trade things of equal value. After all, if A is worth more than B, then why would anyone ever give up A for B? The problem was a lack of subjectivism. If preferences differ across individuals, then there is no difficulty explaining why people trade. They do it because they value things differently, not in spite of it. They make a mutually beneficial trade, which means a transaction that benefits both (or all) parties to the transaction. Example: I trade you an orange for an apple. Clearly, I value the apple more than the orange, and you value the orange more than the apple. It is the fact that we value them differently that makes trade possible. And since both of us benefit from the transaction, there is not a loser here. This is a general feature of almost any voluntary transaction: that each party is necessarily better off, or at least not worse off. Otherwise, why would they agree? They wouldnt, unless they were irrational. When mutually beneficial transactions can be made, but for some reason they are not, economists generally consider this a kind of inefficiency more on that later. X. Specialization & Division of Labor One of the earliest insights of economics, dating back to Adam Smith, is that people can expand their productivity by dividing their labor among different tasks and specializing. Smith observed three main reasons that division of labor increase productivity: Workers get better at a task when they focus exclusively on that one task; they increase their skill at the task. They save time through not having to go from task to task several times a day. They are more likely to discover new techniques and devices for faster or better

completion of their task. To these I would add one more: They can take advantage of innate differences in talents or propensities for different tasks. Example: Suppose in one day Bill and Mary can produce according to the following table: BILL MARY Shoes 4 6 Shirts 6 4 Now suppose each one has one day to work, and they each split their time between shoes and shirts. Then the total production is 2 + 3 = 5 of each good. But if Bill spends all day on shirts, and Mary spends all day on shoes, then the total production is 6 of each good. The opportunity for trade gives Bill and Mary an incentive to take advantage of the division of labor. Neither can live on shirts and shoes alone, but if they can trade with each other, they can get both items in greater quantity. We can use the information in the table above to create a PPF for the society composed of Bill and Mary. First, find the maximum amount of shoes they can produce in a day: 4 + 6 = 10. Mark that point on the shoe axis. Second, find the maximum amount of shirts they can produce in a day: 6 + 4 = 10. Mark that point on the shirt axis. Third, find the point of perfect specialization, which occurs when Bill only makes shirts and Mary only makes shoes. This results in 6 of each; mark this point as well. Then connect the dots using straight lines. The resulting graph looks like so: Note that the PPF is not nicely curved like the earlier PPF, but it is bowed outward. The two straight sections of the PPF correspond to the two different individuals in this society, and their slopes are the two individuals' opportunity costs. If we had a society of

three individuals, we'd get three sections with three different slopes. If we kept on adding more and more individuals, we'd get closer and closer to a smooth PPF like the one shown earlier. XI. Comparative Advantage This concept is usually introduced in the context of international trade, but it is actually a ubiquitous phenomenon. shirts 10 shoes 10 6 6The basic idea of comparative advantage: that gains from trade resulting from division of labor can be available even if one person (or country) is better at producing both goods. Example: Lawyer Secretary Pages of research 12 2 Pages of typing 64 If both divide their time equally between the two tasks, the total production is 6 + 1 = 7 pages of research and 3 + 2 = 5 pages of typing. If the lawyer specializes in research and the secretary in typing, the total production is 12 research and 4 typing. Now, maybe thats preferable (5 extra pages of research are probably worth more

than one page of typing). But if not, just let the lawyer spend 10 minutes (1/6 hour) on typing to get (1/6)(6) = 1 typed page. That reduces his research by (1/6)(12) = 2 pages, so the totals are now 10 and 5. Thats unambiguously better than 7 and 5. Gains from trade may not always be available, but usually they are. Specifically, gains from trade will exist whenever the traders' opportunity costs differ. Here, the lawyers opportunity cost of a typed page is 2 pages of research. The secretarys opportunity cost of a typed page is 1/2 page of research. Since these are different, there are gains from trade. Here is the PPF for this situation: rsch 10 typing 14 4 12Notice that the point (7, 5), which results from both people splitting their time between the two activities, is inside the PPF. That means its inefficient. N.B.: The principle demonstrated here does not require that each party be better at something. In this example, the lawyer is a better typist and a better researcher, while the secretary is neither. Definition of absolute advantage: You have an absolute advantage over someone else if you can produce more of some good or service in the same amount of time and with the same resources. Definition of comparative advantage: You have a comparative advantage over someone else if you can produce a good or service with a lower opportunity cost. When it comes to explaining why people trade, it turns out that comparative advantage is

much more important than absolute advantage. The importance of comparative advantage is that it means trade can be beneficial to everyone, even when one party is more capable than the other. The intelligent and the stupid, the rich and the poor, the developed and the underdeveloped, etc. XII. Normative versus Positive Economists try to distinguish sharply between two different types of analysis: Positive: how things are or could be or would be under certain circumstances. The analyst does not necessarily like or dislike, approve or disapprove of the result. Normative: how things should be, or whether a situation is good or bad, or better or worse than another situation. In short, it is the distinction between is and ought. A complication: if-then statements. Example: "If you want to decrease unemployment, then you should adopt Policy X." The last half is normative, but it depends for its normative force on accepting the "if" statement. The whole statement is positive, because it does not actually pass judgment about whether you should adopt X or not. XIII. Efficiency There are multiple meanings of this term, but all share the same basic idea: efficiency means doing the best we can with the means we have at our disposal or, in short, not be wasteful. The Pareto Criterion says: Situation A is Pareto superior to situation B if at least one person is better off in A, and no one is worse off in A. Situation A is Pareto inferior to situation B if at least one person is worse off in A, and no one is better off in A. Situations A and B are Pareto incomparable if at least one person is better off in A

and at least one person is better off in B. Example of a Pareto improvement: You offer to trade lunches. I agree, because I like your lunch better. We both trade, and we both get better off. (Alternatively, maybe I agree because Im indifferent.) Pareto Efficiency: Situation A is Pareto efficient if there does not exist another situation that is Pareto superior to A. That is, a situation is efficient if you cant make any Pareto improvements. Advantage: this is a concept of efficiency that requires no IUCs. Disadvantage: leaves a lot of situations being Pareto-incomparable. There are very few policy changes that dont hurt someone. The Kaldor-Hicks Criterion says: Situation A is K-H superior to situation B if those who are better off in A could compensate those worse off in A and still remain better off than in B. (i.e., the gainers gain enough to compensate the losers; the gainers gain more than the losers lose.) Situation A is K-H inferior to situation B if those who are better off in A cannot compensate those worse off in A without making themselves worse off than in B. (i.e., the gainers do not gain enough to compensate the losers; the losers lose more than the gainers gain.) This may seem very intuitive, but heres the hitch: the compensation payments dont actually have to be made. Why not? Because if compensation is actually paid, so that losers dont actually lose, then were back to Pareto. To say anything that the Pareto criterion didnt already say, K-H must make comparisons in cases where compensation is not actually paid. Example of a Kaldor-Hicks improvement: Im a basketball player who gets paid

$1 million per year to play for the Lakers. I bring the owners $1.5 million in added revenue each year, or $500,000 in profit. But they fire me and hire a better player who generates $1.7 million in revenue. They pay him $1.1 million. The new player is better off by $1.1 million (assuming he would have earned nothing otherwise). The owners now earn $600,000 in profit, so they are better off by $100,000. Im worse off by $1 million (assuming I cant get another job), but my loss is less than the total gain shared by the other player and the owners. Note: The Pareto criterion would say the two situations are incomparable, because Im better off in the original situation, but the new player and the owners are better off in the new situation. Kaldor-Hicks Efficiency: Situation A is Kaldor-Hicks efficient if there does not exist another situation that is Kaldor-Hicks superior to A. That is, a situation is efficient if you cant make any Kaldor-Hicks improvements. Advantage of this concept: It overcomes disadvantage number (2) of Pareto efficiency, because it allows more Pareto-incomparable situations to be compared. Disadvantages: (1) Like Pareto, it is consistent with a great deal of unfairness or inequality. (2) It achieves greater comparability than Pareto only by sneaking IUCs in the back door. Essentially, it assumes that the utility value of a dollar is the same to everyone. Lets compare Pareto and Kaldor-Hicks efficiency with an example: Situation ABC Itchy $10 $10 $11 Scratchy $10 $16 $14 According to Pareto efficiency, B is superior to A, C is superior to A, and B and C are incomparable.

According to Kaldor-Hicks, we need only look at the totals in each column. Thus, B is better than C which is better than A ($26 versus $25 versus $20). But what about efficiency? According to Pareto, A is inefficient because B is superior to it (as is C). B and C are both efficient (there is no situation Pareto-superior to B, and there is no situation Pareto-superior to C). According to Kaldor-Hicks, we need only look at the totals: B is efficient, because it generates greater wealth than either alternative. Wealth maximization. Wealth maximization is another kind of efficiency, but its really just a simple extension of Kaldor-Hicks. K-H made us think in terms of money for compensation payments. So why cant we just think in terms of money all the time? Lets say that some policy change will create benefits for some people, and losses for other people. Suppose the dollar value of the benefits is $1 million, while the dollar value of the losses are $500,000. Then obviously, the winners could theoretically pay off the losers. More generally, any time situation A creates greater wealth than situation B when summed across all persons, A is K-H superior to B. Thus, the Kaldor-Hicks Criterion leads easily to wealth maximization as a standard of efficiency. And that is the kind of efficiency that economists usually employ when evaluating policies.