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CHAPTER
1-15
Course Review in Brief
Macroeonomics
BRIEF PRINCIPLES OF
© 2009 South-Western, a part of Cengage Learning, all rights reserved
What Economics Is All About
 Scarcity: the limited nature of society’s
resources
 Economics: the study of how society manages
its scarce resources, e.g.
 how people decide what to buy,
how much to work, save, and spend
 how firms decide how much to produce,
how many workers to hire
 how society decides how to divide its resources
between national defense, consumer goods,
protecting the environment, and other needs
TEN PRINCIPLES OF ECONOMICS
1
Micro vs. Macro
 Microeconomics:
The study of how individual households and
firms make decisions, interact with one another
in markets.
 Macroeconomics:
The study of the economy as a whole.
 We begin our study of macroeconomics with the
country’s total income and expenditure.
TEN PRINCIPLES OF ECONOMICS
2
2
HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
All decisions involve tradeoffs. Examples:
 Going to a party the night before your midterm
leaves less time for studying.
 Having more money to buy stuff requires working
longer hours, which leaves less time for leisure.
 Protecting the environment requires resources
that could otherwise be used to produce
consumer goods.
TEN PRINCIPLES OF ECONOMICS
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HOW PEOPLE MAKE DECISIONS
Principle #1: People Face Tradeoffs
 Society faces an important tradeoff:
efficiency vs. equality
 Efficiency: when society gets the most from its
scarce resources
 Equality: when prosperity is distributed uniformly
among society’s members
 Tradeoff: To achieve greater equality,
could redistribute income from wealthy to poor.
But this reduces incentive to work and produce,
shrinks the size of the economic “pie.”
TEN PRINCIPLES OF ECONOMICS
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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 relevant cost for decision making.
TEN PRINCIPLES OF ECONOMICS
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HOW PEOPLE MAKE DECISIONS
Principle #2: The Cost of Something Is
What You Give Up to Get It
Examples:
The opportunity cost of…
…going to college for a year is not just the tuition,
books, and fees, but also the foregone wages.
…seeing a movie is not just the price of the ticket,
but the value of the time you spend in the theater.
TEN PRINCIPLES OF ECONOMICS
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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.
TEN PRINCIPLES OF ECONOMICS
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HOW PEOPLE MAKE DECISIONS
Principle #3: Rational People Think at the
Margin
Examples:
 When a student considers whether to go to
college for an additional year, he compares the
fees & foregone wages to the extra income
he could earn with the extra year of education.
 When a manager considers whether to increase
output, she compares the cost of the needed
labor and materials to the extra revenue.
TEN PRINCIPLES OF ECONOMICS
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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.
Examples:
 When gas prices rise, consumers buy more
hybrid cars and fewer gas guzzling SUVs.
 When cigarette taxes increase,
teen smoking falls.
TEN PRINCIPLES OF ECONOMICS
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Demand
 The quantity demanded of any good is the
amount of the good that buyers are willing and
able to purchase.
 Law of demand: the claim that the quantity
demanded of a good falls when the price of the
good rises, other things equal
TEN PRINCIPLES OF ECONOMICS
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ACTIVE LEARNING
1
Demand Curve
Draw a demand curve for music downloads.
What happens to it in each of
the following scenarios? Why?
A. The price of iPods falls
B. The price of music
downloads falls
C. The price of CDs falls
TEN PRINCIPLES OF ECONOMICS
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ACTIVE LEARNING
1
A. Price of iPods falls
Music downloads
and iPods are
complements.
Price of
music
downloads
A fall in price of
iPods shifts the
demand curve for
music downloads
to the right.
P1
D1
Q1
Q2
TEN PRINCIPLES OF ECONOMICS
D2
Quantity of
music downloads
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ACTIVE LEARNING
1
B. Price of music downloads falls
Price of
music
downloads
The D curve
does not shift.
Move down along
curve to a point with
lower P, higher Q.
P1
P2
D1
Q1
Q2
TEN PRINCIPLES OF ECONOMICS
Quantity of
music downloads
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ACTIVE LEARNING
1
C. Price of CDs falls
CDs and
music downloads
are substitutes.
Price of
music
downloads
A fall in price of CDs
shifts demand for
music downloads
to the left.
P1
D2
Q2
Q1
TEN PRINCIPLES OF ECONOMICS
D1
Quantity of
music downloads
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Supply
 The quantity supplied of any good is the
amount that sellers are willing and able to sell.
 Law of supply: the claim that the quantity
supplied of a good rises when the price of the
good rises, other things equal
TEN PRINCIPLES OF ECONOMICS
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ACTIVE LEARNING
2
Supply Curve
Draw a supply curve for tax
return preparation software.
What happens to it in each
of the following scenarios?
A. Retailers cut the price of
the software.
B. A technological advance
allows the software to be
produced at lower cost.
TEN PRINCIPLES OF ECONOMICS
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ACTIVE LEARNING
2
A. Fall in price of tax return software
Price of
tax return
software
S1
S curve does
not shift.
Move down
along the curve
to a lower P
and lower Q.
P1
P2
Q2 Q1
TEN PRINCIPLES OF ECONOMICS
Quantity of tax
return software
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ACTIVE LEARNING
2
B. Fall in cost of producing the software
Price of
tax return
software
S1
S2
S curve shifts
to the right:
at each price,
Q increases.
P1
Q1
Q2 Quantity of tax
return software
TEN PRINCIPLES OF ECONOMICS
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Supply and Demand Together
P
$6.00
S
D
$5.00
$4.00
$3.00
Equilibrium:
P has reached
the level where
quantity supplied
equals
quantity demanded
$2.00
$1.00
$0.00
Q
0
5
10 15 20 25 30 35
TEN PRINCIPLES OF ECONOMICS
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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
TEN PRINCIPLES OF ECONOMICS
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Interdependence
Every day
hair gel from
you rely on
Cleveland, OH
many people
cell phone
from around
from Taiwan
the world,
most of whom
dress shirt
you’ve never met,
from China
to provide you
with the goods
coffee from
and services
Kenya
you enjoy.
TEN PRINCIPLES OF ECONOMICS
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Basic international trade terms
 Exports:
goods produced domestically and sold abroad
To export means to sell domestically produced
goods abroad.
 Imports:
goods produced abroad and sold domestically
To import means to purchase goods produced in
other countries.
TEN PRINCIPLES OF ECONOMICS
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Where Do These Gains Come From?
 Absolute advantage: the ability to produce a
good using fewer inputs than another producer
 The U.S. has an absolute advantage in wheat:
producing a ton of wheat uses 10 labor hours
in the U.S. vs. 25 in Japan.
 If each country has an absolute advantage
in one good and specializes in that good,
then both countries can gain from trade.
TEN PRINCIPLES OF ECONOMICS
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Opportunity Cost and
Comparative Advantage
 Comparative advantage: the ability to produce
a good at a lower opportunity cost than another
producer
 Which country has the comparative advantage in
computers?
 To answer this, must determine the opp. cost of
a computer in each country.
TEN PRINCIPLES OF ECONOMICS
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Comparative Advantage and Trade
 Gains from trade arise from comparative
advantage (differences in opportunity costs).
 When each country specializes in the good(s)
in which it has a comparative advantage,
total production in all countries is higher,
the world’s “economic pie” is bigger,
and all countries can gain from trade.
 The same applies to individual producers
(like the farmer and the rancher) specializing
in different goods and trading with each other.
TEN PRINCIPLES OF ECONOMICS
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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
 what goods to produce
 how to produce them
 how much of each to produce
 who gets them
TEN PRINCIPLES OF ECONOMICS
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FIGURE 1: The Circular-Flow Diagram
Revenue
G&S
sold
Markets for
Goods &
Services
Firms
Factors of
production
Wages, rent,
profit
Spending
G&S
bought
Households
Markets for
Factors of
Production
TEN PRINCIPLES OF ECONOMICS
Labor, land,
capital
Income
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Markets and Competition
 A market is a group of buyers and sellers of a
particular product.
 A competitive market is one with many buyers
and sellers, each has a negligible effect on price.
 In a perfectly competitive market:
 All goods exactly the same
 Buyers & sellers so numerous that no one can
affect market price – each is a “price taker”
 In this chapter, we assume markets are perfectly
competitive.
TEN PRINCIPLES OF ECONOMICS
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HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
 A market economy allocates resources through
the decentralized decisions of many households
and firms as they interact in markets.
 Famous insight by Adam Smith in
The Wealth of Nations (1776):
Each of these households and firms
acts as if “led by an invisible hand”
to promote general economic well-being.
TEN PRINCIPLES OF ECONOMICS
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HOW PEOPLE INTERACT
Principle #6: Markets Are Usually A Good Way
to Organize Economic Activity
 The invisible hand works through the price system:
 The interaction of buyers and sellers
determines prices.
 Each price reflects the good’s value to buyers
and the cost of producing the good.
 Prices guide self-interested households and
firms to make decisions that, in many cases,
maximize society’s economic well-being.
TEN PRINCIPLES OF ECONOMICS
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HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
 Important role for govt: enforce property rights
(with police, courts)
 People are less inclined to work, produce, invest,
or purchase if large risk of their property being
stolen.
TEN PRINCIPLES OF ECONOMICS
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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 (e.g. pollution)
 Market power, a single buyer or seller has
substantial influence on market price (e.g. monopoly)
 In such cases, public policy may promote efficiency.
TEN PRINCIPLES OF ECONOMICS
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HOW PEOPLE INTERACT
Principle #7: Governments Can Sometimes
Improve Market Outcomes
 Govt 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.
TEN PRINCIPLES OF ECONOMICS
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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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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 (e.g., labor unions, competition from
abroad) have far less impact on living standards.
TEN PRINCIPLES OF ECONOMICS
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The Components of GDP
 Recall: GDP is total spending.
 Four components:
 Consumption (C)
 Investment (I)
 Government Purchases (G)
 Net Exports (NX)
 These components add up to GDP (denoted Y):
Y = C + I + G + NX
TEN PRINCIPLES
MEASURING
A NATION’S
OF ECONOMICS
INCOME
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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 govt creates money,
the greater the inflation rate.
TEN PRINCIPLES OF ECONOMICS
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The Consumer Price Index (CPI)
 measures the typical consumer’s cost of living
 the basis of cost of living adjustments (COLAs) in
many contracts and in Social Security
TEN PRINCIPLES
MEASURING
THE OF
COST
ECONOMICS
OF LIVING
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How the CPI Is Calculated
1. Fix the “basket.”
The Bureau of Labor Statistics (BLS) surveys
consumers to determine what’s in the typical
consumer’s “shopping basket.”
2. Find the prices.
The BLS collects data on the prices of all the
goods in the basket.
3. Compute the basket’s cost.
Use the prices to compute the total cost of the
basket.
TEN PRINCIPLES
MEASURING
THE OF
COST
ECONOMICS
OF LIVING
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ACTIVE LEARNING
4
Converting to “today’s dollars”
Annual tuition and fees, average of all public fouryear colleges & universities in the U.S.
 1986-87: $1,414 (1986 CPI = 109.6)
 2006-07: $5,834 (2006 CPI = 203.8)
After adjusting for inflation, did students pay more for
college in 1986 or in 2006? Convert the 1986 figure
to 2006 dollars and compare.
TEN PRINCIPLES OF ECONOMICS
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ACTIVE LEARNING
4
Answers
Annual tuition and fees, average of all public fouryear colleges & universities in the U.S.
 1986-87: $1,414 (1986 CPI = 109.6)
 2006-07: $5,834 (2006 CPI = 203.8)
Solution
Convert 1986 figure into “today’s dollars”
$1,414 x (203.8/109.6) = $2,629
Even after correcting for inflation, tuition and fees
were much lower in 1986 than in 2006!
TEN PRINCIPLES OF ECONOMICS
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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.
TEN PRINCIPLES OF ECONOMICS
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