Firms and Households in the Economy

Firms

Firms are the primary producing units in the economy, responsible for creating goods and services.

• Definition: Organizations that use resources to produce output for sale.

• Example: Nike manufactures shoes for consumers.

• Non-example: A household buying shoes is not a firm; it is a consumer.

Households

Households are the consuming units and also supply resources (like labor) to the economy.

• Definition: Individuals or groups that consume goods/services and provide resources to firms.

• Example: A family buys groceries and provides labor to firms.

• Non-example: A business producing groceries is a firm, not a household.

Markets: Output and Input

Output Market

• Firms: Supply goods and services (e.g., a restaurant sells meals).

• Households: Demand goods and services (e.g., a student buys a laptop).

Input Market

• Households: Supply resources such as labor (e.g., a worker supplies labor to a company).

• Firms: Demand resources (e.g., a store hires workers).

Labor Market

• Households: Supply labor.

• Firms/Government: Demand labor.

Basic Economic Principles

Ceteris Paribus

Ceteris paribus means "all other things held constant," allowing economists to isolate the effect of one variable.

• Example: Studying the effect of a price change while keeping income fixed.

Demand and Supply

Law of Demand

• Definition: As price rises, quantity demanded falls, ceteris paribus.

• Relationship: Price and quantity demanded move inversely.

• Formula: (where decreases as increases)

• Example: Movie tickets get cheaper, so more are bought.

Quantity Demanded vs. Demand

• Quantity Demanded: Amount consumers buy at a specific price (a point on the demand curve).

• Change in Quantity Demanded: Movement along the demand curve due to a price change.

• Change in Demand: Shift of the entire demand curve due to non-price factors (e.g., income, tastes).

Shifts in Demand

• Increase in Demand: Demand curve shifts right (e.g., more buyers enter the market).

• Decrease in Demand: Demand curve shifts left (e.g., income falls for a normal good).

Types of Goods

• Normal Good: Demand rises as income rises (e.g., restaurant meals).

• Inferior Good: Demand falls as income rises (e.g., instant noodles).

Related Goods

• Substitutes: Goods used in place of each other (e.g., Pepsi and Coca-Cola).

• Complements: Goods used together (e.g., printers and ink cartridges).

• Effect of Price Changes:

  • Price of a substitute rises → demand for the other rises.

  • Price of a complement rises → demand for the other falls.

Demand Shifters

• Income

• Tastes and preferences

• Prices of related goods

• Expectations

• Number of buyers

Market Demand

• Definition: Sum of individual quantities demanded at each price.

• Example: At $5, Alex wants 2 and Sam wants 3 → market Qd = 5.

Law of Supply

• Definition: As price rises, quantity supplied rises, ceteris paribus.

• Relationship: Price and quantity supplied move directly.

• Formula: (where increases as increases)

Quantity Supplied vs. Supply

• Quantity Supplied: Amount producers offer at a specific price (a point on the supply curve).

• Change in Quantity Supplied: Movement along the supply curve due to a price change.

• Change in Supply: Shift of the entire supply curve due to non-price factors (e.g., input costs, technology).

Shifts in Supply

• Increase in Supply: Supply curve shifts right (e.g., cheaper inputs).

• Decrease in Supply: Supply curve shifts left (e.g., input prices rise).

Supply Shifters

• Input costs

• Technology

• Expectations

• Number of sellers

• Related production

Market Supply

• Definition: Sum of individual quantities supplied at each price.

Market Equilibrium

• Definition: Quantity demanded equals quantity supplied.

• Equation: Set and solve for (price), then (quantity).

• Example:

Disequilibrium: Shortage and Surplus

• Shortage: Price below equilibrium; Qd > Qs.

• Surplus: Price above equilibrium; Qs > Qd.

Effects of Shifts on Equilibrium

• Demand increases (supply unchanged): Price and quantity rise.

• Demand decreases (supply unchanged): Price and quantity fall.

• Supply increases (demand unchanged): Price falls, quantity rises.

• Supply decreases (demand unchanged): Price rises, quantity falls.

Measuring National Output and Income

Gross Domestic Product (GDP)

• Definition: Market value of all final goods and services produced within a country in a given period.

• Example: A new car produced in the U.S. counts in U.S. GDP.

GDP Expenditure Formula

• Formula:

• Components:

  • Consumption (C): Household spending on final goods/services.

  • Investment (I): Business capital, residential construction, inventory investment.

  • Government Purchases (G): Government spending on goods/services (not transfers).

  • Net Exports (NX): Exports minus imports.

Final vs. Intermediate Goods

• Final Goods: Purchased for final use (e.g., a new laptop for a student).

• Intermediate Goods: Used to produce final goods (e.g., flour for a bakery).

• Used Goods: Excluded from current GDP.

• Stocks and Bonds: Trades of existing financial assets are not counted in GDP.

GDP vs. GNP

• GDP: Based on production location.

• GNP: Based on ownership by a nation's residents.

Nominal vs. Real GDP

• Nominal GDP: Values output using current prices.

• Real GDP: Values output using base-year prices to remove effects of inflation.

• Why use real GDP? To compare output across years without price-level distortion.

GDP Deflator

• Definition: Price index for domestically produced final output.

• Formula:

• Interpretation: A deflator of 125 means the price level is 25% above the base year.

Inflation and Growth Rates

• Inflation: Sustained rise in the overall price level.

• Inflation Rate Formula:

• Real GDP Growth Formula:

• Nominal GDP Growth Formula:

Investment: Planned vs. Actual

• Planned Investment: Investment firms intend to make.

• Actual Investment: Planned investment plus unplanned inventory changes.

• Unplanned Inventory Investment: Unexpected changes in inventory (e.g., unsold products).

• Actual > Planned: Unexpected inventory accumulation.

• Actual < Planned: Inventories fell unexpectedly.

Labor Market and Unemployment

Labor Force Concepts

• Labor Force: Employed plus unemployed individuals.

• Employed: People with jobs.

• Unemployed: No job, available, and actively seeking work (U-3 definition).

• Not in Labor Force: Neither employed nor actively seeking work.

Unemployment Measures

• U-3: Official unemployment rate.

• U-5: Includes U-3 plus marginally attached workers.

• U-6: Includes U-5 plus part-time-for-economic-reasons workers.

• Order: U-3 < U-5 < U-6 (U-6 is broadest).

• U-3 Formula:

Labor Market Trends

• Cyclical Trend: Short-run changes tied to the business cycle (e.g., recession layoffs).

• Secular Trend: Long-run underlying changes (e.g., demographic shifts).

Growth: Linear vs. Exponential

• Linear Growth: Same absolute amount added each period.

• Linear Growth Formula:

• Exponential Growth: Same percentage increase each period.

• Exponential Growth Formula:

Movements vs. Shifts

• Demand: Own price change → movement along curve; non-price factor → shift.

• Supply: Own price change → movement along curve; non-price factor → shift.

Classical Economic Thought

Adam Smith's Invisible Hand

• Definition: Self-interest and price signals coordinate decentralized markets.

• Role of Competition: Channels self-interest through prices and incentives.

Circular Flow Model

• Definition: Illustrates flows of resources, output, income, and spending among sectors.

• Households to Firms: Supply factors and spend income on output.

• Firms to Households: Provide output and pay factor income.

• Key Identity: Total production = total income = total expenditure.

Leakages and Injections

• Leakages: Saving, taxes, imports (withdraw spending).

• Injections: Investment, government spending, exports (add spending).

• Equilibrium Condition:

• Injections > Leakages: Aggregate output tends to expand.

• Leakages > Injections: Aggregate output tends to contract.

Bloom's Taxonomy in Economics

• Remember: Recall facts, definitions, formulas.

• Understand: Explain concepts in your own words.

• Apply: Use concepts/formulas in new situations.

• Analyze: Identify causes, relationships, and effects.

• Evaluate: Defend conclusions using reasoning/evidence.

• Create: Build examples or explanations combining concepts.

Key Narratives and Adjustments

• Nominal vs. Real GDP: Nominal uses current prices; real uses base-year prices to isolate output changes.

• Shortage Adjustment: Low price creates excess demand and upward price pressure.

• Surplus Adjustment: High price creates excess supply and downward price pressure.

• Input Cost Increase: Supply shifts left, raising equilibrium price and lowering quantity.

• Substitute Price Increase: Demand for the other substitute shifts right.

• Planned vs. Actual Investment: Unexpected inventory changes create the difference between planned and actual investment.