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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 5 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? 6 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 7 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 8 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 9 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 10 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. 11 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 12 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) 13 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. 21 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. 22 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. 23 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. 25 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. 26 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. 27 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. 28 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) 30 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 31 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 32 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 crimerate. 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 36 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? 37 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