Download Unit 1: Introduction to economics

UNIT 1: INTRODUCTION TO
ECONOMICS
AP Macroeconomics
Chapter 1:
The Ten Principles of Economics
How People Make Decisions (1-4)
How People Interact (5-7)
How the Economy as a Whole Works (8-10)
The Mankiw Rap
What is Economics?

The social science that studies the choices that
individuals, businesses, and governments make
as they cope with scarcity and the incentives that
influence and reconcile those choices.
The Micro and Macro Views of the World


Microeconomics~ The study of the choices that
individuals and businesses make and the way these
choices interact and are influenced by governments.
Macroeconomics~ The study of the aggregate
effects on the national economy and global
economy of the choices that individuals, businesses
and government make.
HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
All decisions involve tradeoffs.
Principle #2: The Cost of Something is What You
Give Up to Get It
Examples….
Principle #3: Rational People Think at the Margin
Principle #4: People Respond to Incentives
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TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs





Types of trade-offs
Society faces an important tradeoff:
efficiency (self interest) vs. equality (social interest)
Efficiency: when society gets the most from its scarce
resources
Equality: when prosperity is distributed uniformly among
society’s members
Impact of redistribution?
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TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It



Making decisions requires comparing the costs and
benefits of alternative choices.
The opportunity cost of any item is whatever must
be given up to obtain it.
It is the ONLY relevant cost for decision making.
Paul Solman: Opportunity Cost
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TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the Margin
Rational people

systematically and purposefully do the best they can to
achieve their objectives.

make decisions by evaluating costs and benefits of
marginal changes – incremental adjustments to an
existing plan.

MB >MC

Examples
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TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE MAKE DECISIONS
Principle #4: People Respond to Incentives




Incentive: something that induces a person to act,
i.e. the prospect of a reward or punishment.
Rational people respond to incentives.
Impact on policy makers?
Do people always respond to incentives?
Freakonomics Reading
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TEN PRINCIPLES OF ECONOMICS
ACTIVE LEARNING 1
Applying the principles
You are selling your 1996 Mustang. You have already
spent $1000 on repairs.
At the last minute, the transmission dies. You can pay
$600 to have it repaired, or sell the car “as is.”
In each of the following scenarios, should you have the
transmission repaired? Explain.
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
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ACTIVE LEARNING 1
Answers
Cost of fixing transmission = $600
A. Blue book value is $6500 if transmission works,
$5700 if it doesn’t
Benefit of fixing the transmission = $800
($6500 – 5700).
It’s worthwhile to have the transmission fixed.
B. Blue book value is $6000 if transmission works,
$5500 if it doesn’t
Benefit of fixing the transmission is only $500.
Paying $600 to fix transmission is not worthwhile.
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HOW PEOPLE INTERACT
Principle #5: Trade Can Make Everyone
Better Off


Rather than being self-sufficient, people can
specialize in producing one good or service and
exchange it for other goods.
Countries also benefit from trade & specialization:
 Get
a better price abroad for goods they produce
 Buy
other goods more cheaply from abroad than could
be produced at home
 Comparative
Advantage vs. Absolute Advantage
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TEN PRINCIPLES OF ECONOMICS
NPR
HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way to
Organize Economic Activity



Market: a group of buyers and sellers (need not be in a single location)
“Organize economic activity” means determining of the core economic
questions based on economic goals/values.
 What goods and services should be produced? (Consumption Goods
and Services, Capital Goods, Government Goods and Services, Export
Goods and Services)
 How should these goods and services be produced? (Combination of
FOP)
 Who consumes these goods and services? (Public vs. private ownership)
A market economy allocates resources through the decentralized decisions
of many households and firms as they interact in markets.
 Other types of economic systems (centrally planned, traditional, mixed)
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TEN PRINCIPLES OF ECONOMICS
Adam Smith (1723-90)

Father of modern economic theory

Scottish social philosopher/professor
“An Inquiry into the Nature and Causes
of the Wealth of Nations” (1776)
Laissez Faire principle
10 years to write / 5 volumes
Established Economics as its own
discipline




Core Principles of Adam Smith
On the Division of Labor
Increase in quantity of work
1. Dexterity of workers
2. Saves time: no switch from one activity to the next
3. Machines replace manual labor
Division of physical and mental labor: professional specialization;
expertise
Increased productivity = increased wealth for everyone
Motivation for labor
Disposition to barter
Invisible Hand of the Marketplace: highest quality and quantity
of goods produced
Adam Smith and the Invisible Hand



In every transaction, the buyer and seller
consider only their self-interest, or their own
personal gain. Self-interest is the motivating
force in the free market.
Producers in a free market struggle for the
dollars of consumers. This is known as
competition, and is the regulating force of the
free market.
The interaction of buyers and sellers, motivated
by self-interest and regulated by competition, all
happens without a central plan. This
phenomenon is called “the invisible hand of the
marketplace.”
The Role of Prices in the Marketplace
Prices are the instrument of the invisible hand in
the marketplace
Natural rates of wages, profits and commodities:
supply = demand
Prices always move toward natural price and
will efficiently allocate resources
When the government intervenes in the
marketplace, prices are distorted and
resources are not effectively distributed
Friedman:
Capitalism vs. Socialism
Friedman:
Wage and
Price Controls
Karl Marx (1818-1883)




German philosopher, political economist and historian
Developed radical approach to understanding and coping with the
problems that occurred in free market systems, namely the
Industrial Revolution
Published the Communist Manifesto in 1848 with close friend
Frederick Engels
Marxism is rooted in an analysis of modern, Western thought.
 18th century Enlightenment
 Classical Economics
 Utopian Socialism
Marxism in Theory

Dialectical materialism
 Materialism
 Philosophical doctrine that matter is the only reality and everything in the
world (thought, will, and feeling) can be explained only in terms of matter.
 Opposite of idealism
 Dialectical
 The theoretical process in the social sciences in which change occurs based on
contradictory, interacting forces
 The forces are based on existing class struggles
Thesis

Antithesis
Stages of economic development
 Pre-determined
 Tribal, Slave-Owning, Feudal, Capitalist, Socialist, Communist
Synthesis
Frederick Engels
Karl Marx
HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes Improve
Market Outcomes
Important role for government: enforce property rights
(with police, courts)
 People are less inclined to work, produce, invest, or
purchase if large risk of their property being stolen.

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TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes Improve
Market Outcomes


Market failure: when the market fails to allocate
society’s resources efficiently
Causes:
 Externalities,
when the production or consumption
of a good affects bystanders (ex. pollution)
 Market power, a single buyer or seller has substantial
influence on market price (ex. monopoly)

In such cases, public policy may promote efficiency.
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TEN PRINCIPLES OF ECONOMICS
HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes Improve
Market Outcomes


Government may alter market outcome to promote
equity
If the market’s distribution of economic well-being
is not desirable, tax or welfare policies can change
how the economic “pie” is divided.
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TEN PRINCIPLES OF ECONOMICS
HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living depends
on its ability to produce goods & services.

Huge variation in living standards across countries
and over time:

Average income in rich countries is more than ten times
average income in poor countries.

The U.S. standard of living today is about eight times
larger than 100 years ago.
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TEN PRINCIPLES OF ECONOMICS
HOW THE ECONOMY AS A WHOLE WORKS
Principle #8: A country’s standard of living depends
on its ability to produce goods & services.



The most important determinant of living standards:
productivity, the amount of goods and services
produced per unit of labor.
Productivity depends on the equipment, skills, and
technology available to workers.
Other factors (labor unions, competition from abroad)
have far less impact on living standards.
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TEN PRINCIPLES OF ECONOMICS
HOW THE ECONOMY AS A WHOLE WORKS
Principle #9: Prices rise when the government prints
too much money.



Inflation: increases in the general level of prices.
In the long run, inflation is almost always caused by
excessive growth in the quantity of money, which causes
the value of money to fall.
The faster the government creates money, the greater
the inflation rate.
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TEN PRINCIPLES OF ECONOMICS
HOW THE ECONOMY AS A WHOLE WORKS
Principle #10: Society faces a short-run tradeoff
between inflation and unemployment


In the short-run (1 – 2 years), many economic policies
push inflation and unemployment in opposite
directions.
Other factors can make this tradeoff more or less
favorable, but the tradeoff is always present.
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TEN PRINCIPLES OF ECONOMICS
Chapter 2
Thinking Like an Economist
Our First Model:


The Circular-Flow Diagram
The Circular-Flow Diagram: a visual model of the
economy, shows how dollars flow through markets
among households and firms
Two types of “actors”:
 households
 firms

Two markets:
 the
market for goods and services (product market)
 the market for “factors of production” (factor market)
 Land,
Labor, Capital (human and physical)
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THINKING LIKE AN ECONOMIST
FIGURE 1: The Circular-Flow Diagram
Households:
 Own the factors of production,
sell/rent them to firms for income
 Buy and consume goods & services
Firms
Households
Firms:
 Buy/hire factors of production,
use them to produce goods and
services
 Sell goods & services
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THINKING LIKE AN ECONOMIST
FIGURE 1: The Circular-Flow Diagram
Revenue
G&S
sold
Spending
Markets for
Goods &
Services
G&S
bought
Firms
Factors of
production
Wages, rent,
profit
Households
Labor, land,
capital
Markets for
Factors of
Production
Income
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THINKING LIKE AN ECONOMIST
Use of the Production Possibilities Curve
Production Possibilities Curve
Cost
Alternative good or
service given up as a
result of a decision.
Every point on the PPF
indicates a cost in on
item or another.
Efficiency
Maximum production or
output of goods and
services.
Any point on the PPF
Underutilization
Growth
Efficiency
Underutilization
Growth
Expanding the ability to
produce.
Shift of the entire PPF to
the right
Resources/Technology
Production
Possibilities Curve
~~~~~~~~~~
A graph that shows
alternative ways to use
an economy’s
resources.
Economics as a Social Science
Identify
the followingseek
statements
as positive
or the
normative:
 Economists
to discover
how
economic world
1. The works.
gap between
the lower
class do
andthis
upper
classmust
has grown
over the past
In order
to best
they
distinguish
threebetween
decades. positive and normative statements.
2. An
the minimum wage will bring more teenage unemployment.
 increase
Positiveinstatements
3. The minimum
wage should not be increased.
 A statement about “what is”
4. The poor should pay less for housing.
 Can be right or wrong
5. The number of farms has decreased over the last 50 years.
 Can be tested against facts
6. The population in rural areas has remained constant over the past decade.
 increase
Normative
7. An
in thestatements
tax on cigarettes will decrease teen smoking.
 A statement
aboutof“what
be”
8. An increase
in the number
policeought
on thetoinner-city
streets will reduce the
crimerate.
Depends on values, opinions
9. The United
States
 Cannot
beshould
testedplace more emphasis on reducing carbon
emissions.
10.Healthcare should be provided to every American.
PPF Example


Producing one computer requires 100 hours labor.
Producing one ton of wheat requires 10 hours labor.
Employment of
labor hours
Production
Computers
Wheat
Computers
Wheat
A
50,000
0
500
0
B
40,000
10,000
400
1,000
C
25,000
25,000
250
2,500
D
10,000
40,000
100
4,000
E
0
50,000
0
5,000
PPF Example
Production
Point
on
Comgraph puters Wheat
A
500
0
B
400
1,000
C
250
2,500
D
100
4,000
E
0
5,000
Wheat
(tons)
6,000
E
5,000
D
4,000
3,000
C
2,000
B
1,000
A
0
0
100 200 300 400 500 600
Computers
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THINKING LIKE AN ECONOMIST
ACTIVE LEARNING 1
Points off the PPF
A. On the graph, find the point that represents
(100 computers, 3000 tons of wheat), label it F.
Would it be possible for the economy to produce this
combination of the two goods?
Why or why not?
B. Next, find the point that represents
(300 computers, 3500 tons of wheat), label it G.
Would it be possible for the economy to produce this
combination of the two goods?
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ACTIVE LEARNING 1
Answers
 Point F:
100 computers,
3000 tons wheat
 Point F requires
40,000 hours
of labor.
Possible but
not efficient: could
get more
of either good
w/o sacrificing any
of the other.
Wheat
(tons)
6,000
5,000
4,000
3,000
F
2,000
1,000
0
0
100 200 300 400 500 600
Computers
38
ACTIVE LEARNING 1
Answers
 Point G:
300 computers,
3500 tons wheat
 Point G requires
65,000 hours
of labor.
Not possible
because
economy
only has
50,000 hours.
Wheat
(tons)
6,000
5,000
4,000
G
3,000
2,000
1,000
0
0
100 200 300 400 500 600
Computers
39
The PPF: What We Know So Far
Points on the PPF (like A – E)
possible
 efficient: all resources are fully utilized

Points under the PPF (like F)
possible
 not efficient: some resources underutilized
(e.g., workers unemployed, factories idle)

Points above the PPF (like G)

not possible
40
THINKING LIKE AN ECONOMIST