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AP Macroeconomics Unit 1 I. Basic Economic Concepts Scarcity: wants > resources Economics – study of how people satisfy wants with scarce resources Economics is the study of choices. Microeconomics deals with specific economic units such as individuals, households, & businesses. Macroeconomics: Deals either with the economy as a whole or basic subdivisions such as government, households, or business sectors. I. Basic Economic Concepts relation v. causation: Just because something happens when something else happens does not mean one caused the other. It may just be that they are correlated. positive statement-the way things are normative statement-the way things ought to be CETERIS PARIBUS: If all other things stay the same. The economy resembles a complex machine or a living organism. To better determine how it works (or what’s wrong with it), simple models are used that assume ceteris paribus. In this way, we seek to determine how one part of the machine affects another. I. Basic Economic Concepts Utility=satisfaction Marginal utility is the satisfaction of getting one more. The law of diminishing marginal utility: utility declines with each additional unit. By dividing MU by P, one can see how much bang they’re getting for their buck. By comparing MU/P for a variety of goods, one makes rational purchasing decisions. I. Basic Economic Concepts The Factors of Production Categories of resources needed to produce goods/services They are: Land – all natural resources (landforms, oil, animal life, minerals, climate, etc.) Capital – stuff we make to make other stuff (tools, machinery, human capital, etc.) Labor – workers applying efforts, abilities, & skills Entrepreneurship – when risk-takers combine the FOP into new products II. Opportunity Cost The O.C. of an item is what you give up to get that item. The O.C. of an item is the best alternative foregone. Consumer Goods vs. Capital Goods Consumer Goods vs. Military Spending “There is no such thing as a free lunch.” II. Opportunity Cost The Production Possibilities Curve is a chart that illustrates the limits of what can be produced by an economy. Assumes: Fixed resources & technology 2 products Efficiency and/or Full Employment II. Opportunity Cost 2 types of efficiency: productive-full use of all resources allocative-who gets what The PPC represents productive efficiency. Allocative efficiency depends on what you consider to be “fair”. II. Opportunity Cost Operating inside the PPC is inefficient. Operating outside the PPC for a long period of time is impossible. II. Opportunity Cost Why is the PPC curved/concave? The Law of Increasing Opportunity Costs: Not all resources are easily converted to producing the other good/ service. II. Opportunity Cost What happens if: -additional resources become available? -technological advances increase productivity of labor and/or capital? Which is better, A or B? How can we reach D? XI. Economic Systems Traditional: 3 Qs answered by custom. Resources allocated by inheritance. Subsistence farmers, cattle herders, hunter/gathers, etc. African Mbuti, Aborigines, Inuits. XI. Economic Systems Disadvantages: New ideas discouraged. Low standard of living. Persecution/land encroachment. XI. Economic Systems Command: Central authority answers 3 Qs. There are no “pure” command economies. North Korea, Cuba, & Vietnam are usually considered command economies. XI. Economic Systems Market: Producers & consumers answer 3 Qs. Producers provide the goods/services consumers want to buy. U.S., Canada, Japan, South Korea - are close XI. Economic Systems Freedom Command Market Security Equity Growth Efficiency Price Stability Employment*** N Y ? N N Y Y Y N ? Y Y N N ***Employment is sometimes included under the goal of Security XII. Competition & Free Enterprise Capitalism: citizens own FOP Free enterprise: limited gov’t interference; competition encouraged Voluntary exchange: buyers & sellers benefit (GDP) XII. Competition & Free Enterprise Private property rights motivate people to work, save & invest Profit motive encourages entrepreneurship & drives growth Competition helps lower prices II. Opportunity Cost What is Crusoe’s O.C. of four fish? What is Crusoe’s O.C. of each fish? What is Crusoe’s O.C. of eight coconuts? What is Crusoe’s O.C. of one coconut? Per-unit opportunity cost can be determined by making the ends of the PPC into a ratio & setting 1 side equal to one. II. Opportunity Cost What is the opportunity cost of 90 guns? What is the opportunity cost of 50 butter? XI. Economic Systems Traditional: 3 Qs answered by custom, ritual, and habit. Resources allocated by inheritance. Subsistence farmers, cattle herders, hunter/gathers, etc. African Mbuti, Aborigines, Inuits. XI. Economic Systems Advantages: Life is stable, predictable, and continuous. Low income inequality. Disadvantages: New ideas discouraged. Low standard of living. Persecution/land encroachment. XI. Economic Systems Command: Central authority answers 3 Qs. There are no “pure” command economies. North Korea, Cuba, & Vietnam are usually considered command economies. Command Advantages: If circumstances require a quick change in resource allocation it can meet this need rapidly. Disadvantages: Little incentive to work hard. Large bureaucracies slow day 2 day decisions high cost XI. Economic Systems Market: Producers & consumers answer 3 Qs. Producers provide the goods/services consumers want to buy. U.S., Canada, Japan, South Korea - are close Market Advantages: markets can adjust over time when producers answer 3 q’s, it is more efficient individual decisions direct the use of scarce resources larger variety of goods Market Disadvantages: the way FOR WHOM is answered without government regulations, without enforced rules of the game, adequate competition may not occur or may fade away only rewards production, so those who don’t produce suffer (young, old, sick) XI. Economic Systems Freedom Command Market Security Equity Growth Efficiency Price Stability Employment*** N Y ? N N Y Y Y N ? Y Y N N ***Employment is sometimes included under the goal of Security I. Capitalism FOP privately owned individuals must have control of property (Corp. clip) intellectual, artistic, etc. property ownership. Freedom of enterprise and choice owners must be able to use property any way they see fit workers must have access to any occupation they see fit consumers must have access to all goods and services I. Capitalism Prices set by market (goes hand-in-hand with market system) market: mechanism or arrangement bringing buyers and sellers together through price, the market decides what is to be produced, for whom, and how. Role of self-interest: all parties must be free to try to get the most out of the system. Buyer tries to get a low P. seller tries to get a high P I. Capitalism Competition: Large # buyers/sellers, each free to enter/exit the market Large # of buyers/sellers ensures that no individual buyer or seller can influence the price. Under such competition, what would happen if one seller decided to increase the price of their goods? Limited government interaction. The market must be self-regulating. I. Capitalism Advantages: efficiency, freedom, individual satisfaction consumer sovereignty: to make profits, producers must make things consumers will buy, so the consumer indirectly answers the WHAT question Disadvantages: underproduction of public goods, only produces for those with $$, unstable II. Socialism Gov’t owns/runs some basic resources, distributes some output for social goals Elected officials make many economic decisions. Pros: everyone gets certain benefits Cons: lower efficiency, higher taxes, special interests get “entrenched” Sweden, Norway, Venezuela, China III. Communism Needs of individual less important than needs of society. Gov’t owns FOP Gov’t officials answer 3 Q’s No prices Pros: stability, spirit of sharing, no unemployment Cons: low freedom, low incentive to work hard, lack flexibility for day2day changes, inefficiency of centralized planning Vietnam, Cuba, North Korea III. Absolute Advantage When 1 person/ business/country, etc. can produce a good or service more efficiently than another person/business/country, etc. Young guy has absolute advantage in coconuts & fish. Max they can produce of each Coconuts Young Guy 10 10 Old Guy 4 8 Fish III. Absolute Advantage Max they can produce of each good Young Guy (A) Old Guy (B) Coconuts Fish 10 10 4 8 III. Absolute Advantage Some problems ask you to consider inputs rather than outputs to determine O.C. and/or absolute advantage. Output problems state that you get a certain amount of product out of a given input. Input problems state that it takes a certain amount of input to get a given product. III. Absolute Advantage Input = Hours to build 1: Company X: Company Z: Car 2 3 Tank 2 1 Who has the absolute advantage in Cars? Tanks? IV. Comparative Advantage Specialization: doing one thing. Benefits of? Costs of? IV. Comparative Advantage Lower opportunity cost = comparative advantage. To get B’s O.C. Coconuts: 4C 8F 4 4 B’s O.C. Coconuts = 2 Fish IV. Comparative Advantage B’s O.C. Fish: 4C 8F 8 8 B’s O.C. Fish = 4/8 or 1/2 Coconuts A’s O.C. Fish = 1 Coconut Who has lower O.C. of Fish? IV. Comparative Advantage EVEN IF a country has an absolute advantage in all goods, trade can still be beneficial. All countries benefit by making what they have a comparative advantage in, & trading. IV. Comparative Advantage Amounts they consume before trade TOTALS Coconuts Fish Young Guy 6 4 Old Guy 2 4 IV. Comparative Advantage Amounts they produce with trade Young Guy (A) Old Guy (B) Coconuts Fish 10 0 0 8 IV. Comparative Advantage Amounts they consume before trade Young Guy Coconuts 6 Fish Amounts they produce with trade Coconuts Fish 4 Young Guy 10 0 Old Guy 0 8 10 8 Old Guy 2 4 Totals: 8 8 IV. Comparative Advantage Amounts they consume before trade Young Guy (A) Old Guy (B) Totals: Coconuts Fish 6 4 2 4 8 8 Amounts they consume after trade Young Guy (A) Old Guy (B) Coconuts Fish 7 4 3 4 10 8 IV. Comparative Advantage Amounts they consume after trade Young Guy (A) Old Guy (B) Coconuts Fish 7 4 3 4 IV. Comparative Advantage Product per hour Corn Wheat Mike 8 6 John 2 4 Corn Mike’s O.C.: 6/8 8/6 John’s O.C.: 4/2 2/4 Who should make Wheat IV. Comparative Advantage Input Method Apples needed to make one: Pie Juice Jeff 5 3 Judy 6 3 Convert to outputs Units per apple: Pie Juice Jeff 1/5 1/3 Judy 1/6 1/3 Jeff’s OC 5/3 Judy’s OC 6/3 Who should make what? 3/5 3/6 IV. Comparative Advantage Absolute/Comparative Advantage; Input/Output Worksheet IV. Comparative Advantage Terms of Trade: the rate by which one unit of one good will be traded for another good. Determine each country’s O.C. of each good. Nebraska IV. Comparative Advantage Nebraska-Wheat; Florida-Pears Now, Nebraska is willing to give up up to 4 wheat per pear, & Florida wants at least 3 wheat per pear. Terms of Trade: 1 Pear will be traded for between 3 & 4 Wheat Nebraska IV. Comparative Advantage Other benefits of specialization: More efficient use of resources. Increased production without increase in resources. Effects of specialization on PPC? Practice Time (Problems in Class Notes) I. Basic Economic Concepts 3 Basic Questions: What should we produce? How should we produce it? For whom should we produce? The “Spruce Goose”-Largest airplane ever built. -319 ft wingspan -Could carry 750 soldiers or one Sherman Tank -Made of wood VI. Productivity The amount of goods/services produces by each unit of labor input. Drives economic growth. Affected by interdependence. Increase Productivity: Specialization- doing what you have an advantage in Division of labor- splitting big jobs up Investing in human capital. More education = more income. VII. Demand A market is an arrangement that allows buyers and sellers to exchange things. Demand is the desire, ability, & willingness to buy a product at a range of prices. Quantity demanded is the amount that would be purchased at a certain price. VII. Demand Joe Schmoe’s demand schedule for hamburgers per week: Price Quantity Demanded $5 1 $3 4 $1 8 VII. Demand The demand curve shows how quantity (Q) demanded varies depending on price (P) of good/service; it is just a visual representation of the demand schedule. P is on vertical axis, Q is on horizontal Demand curve slopes down. VII. Demand Price VII. Demand Price Quantity VII. Demand Price $5 $4 $3 $2 $1 Quantity VII. Demand Price $5 $4 $3 $2 $1 Quantity 1 2 3 4 5 6 7 8 9 10 VII. Demand Price . $5 $4 . $3 $2 . $1 Quantity 1 2 3 4 5 6 7 8 9 10 VII. Demand Price . 5 4 . 3 2 . 1 D Quantity 1 2 3 4 5 6 7 8 9 10 VII. Demand Price Changes in QUANTITY DEMANDED . 5 4 . 3 2 . 1 D Quantity 1 2 3 4 5 6 7 8 9 10 VII. Demand Price P’ An increase in price causes a decrease in quantity demanded. . 5 4 P . 3 2 . 1 D Quantity 1 Q’ 2 3 4 Q 5 6 7 8 9 10 VII. Demand Price A decrease in price causes an increase in quantity demanded. . 5 4 P . 3 2 P’ . 1 D Quantity 1 2 3 4 Q 5 6 7 8 Q’ 9 10 Mr. Cook’s Demand For Video Price Quantity Games 90 80 70 60 Price $80 $55 $35 $20 $18 $15 $12 $11 $9 Demanded 1 2 3 4 5 6 7 8 9 50 40 Line 1 30 20 10 0 1 2 3 4 5 6 7 8 9 Quantity VII. Demand The Law of Demand: As P goes up, Q demanded falls, & vice versa. The demand curve slopes downward because of the: income effect substitution effect VII. Demand A change in demand is caused by a change in: Income (normal/inferior goods) Consumer Tastes Price change in substitute/complement Consumer expectations about prices & income # of buyers Complementary Goods Potato Market What effect does a fall in the price of potatoes have on the market for sour cream? Complementary Goods Potato Market Sour Cream Market A decrease in the price of potatoes causes… an increase in the demand for sour cream. Substitute Goods Margarine What effect does an increase in the price of margarine have on the market for butter? Substitute Goods Margarine Market Butter Market An increase in the price of margarine causes an increase in the demand for butter. VII. Demand Elasticity measures sensitivity to price changes. Elasticity coefficient = Q/[(Q2+Q1)/2] . P/[(P2+P1)/2] Demand is: Elastic if small P causes big Q. [more sensitive] Elasticity coef.>1 Inelastic if big P causes small Q. [less sensitive] Elasticity coef.<1 Unit or unitary Elastic if % P = % Q; E=1 VII. Demand Note: Elasticity does not necessarily equal the slope of the demand curve. VII. Demand Determinants of Demand Elasticity Can purchase be delayed? Are substitutes available? Does purchase use large portion of income? If “yes’s” outnumber “no’s” then demand is elastic. The Total Expenditures Test Price times quantity demanded equals expenditures (P * Q = Ex). Demand curve is: -Elastic if P and Ex move in opposite directions. -Inelastic if P & Ex move in the same direction. -Unit elastic if there is no change in Ex. Understanding the relationship b/w elasticity & profits can help producers effectively price their products. VIII. Supply Supply = Q seller(s) are willing & able to sell at various prices. The Law of Supply = Suppliers will offer more at higher P & less at lower P. Supply curve is always upward sloping. VIII. Supply VIII. Supply VIII. Supply A decrease in price leads to a decrease in Quantity Supplied. A increase in price leads to a increase in Quantity Supplied. VIII. Supply A change in supply occurs when suppliers offer different Q for sale at all prices. Can cause a change in supply: Input costs Productivity Technology Taxes/Subsidies Seller Expectations Regulations # Sellers VIII. Supply Supply is: elastic when a small P change causes a big change in Q supplied. inelastic when P changes have little effect on Q. Remember: Flatter is Elastic! VIII. Supply Determinants of supply elasticity: If adjustments to production can be made quickly, supply is elastic. If not, supply is inelastic. Elastic Supply Inelastic Supply IX. Equilibrium Price and Quantity Together, demand & supply make a complete picture of the market. Price changes allow supply & demand to be = Surpluses: when supply > demand Shortages: when demand > supply Equilibrium price where supply meets demand IX. Equilibrium Price and Quantity IX. Equilibrium Price and Quantity How do prices adjust to equilibrium? Explaining & Predicting Prices If Supply increases, P __ & Q __ If Supply decreases, P __ & Q __ If Demand increases, P __ & Q __ If Demand decreases, P __ & Q __ If Supply & Demand increase, P __ & Q __ If Supply & Demand decrease, P __ & Q __ Supply incrse/Demand decrse, P __ & Q __ Supply decrse/Demand incrse, P __ & Q __ The more elastic a curve is, the less P will change if that curve shifts. The Lemonade Market The Oil Market X. Distorting Market Outcomes Can occur when pursuing equity & security. Example: setting a “socially desirable” P X. Distorting Market Outcomes Price Ceilings create shortages (rent control in Manhattan) X. Distorting Market Outcomes Price Floors create surpluses (minimum wage) XI. Economic Systems Traditional: 3 Qs answered by custom. Resources allocated by inheritance. Subsistence farmers, cattle herders, hunter/gathers, etc. African Mbuti, Aborigines, Inuits. XI. Economic Systems Disadvantages: New ideas discouraged. Low standard of living. Persecution/land encroachment. XI. Economic Systems Command: Central authority answers 3 Qs. There are no “pure” command economies. North Korea, Cuba, & Vietnam are usually considered command economies. XI. Economic Systems Market: Producers & consumers answer 3 Qs. Producers provide the goods/services consumers want to buy. U.S., Canada, Japan, South Korea - are close XI. Economic Systems Freedom Command Market Security Equity Growth Efficiency Price Stability Employment*** N Y ? N N Y Y Y N ? Y Y N N ***Employment is sometimes included under the goal of Security XII. Competition & Free Enterprise Capitalism: citizens own FOP Free enterprise: limited gov’t interference; competition encouraged Voluntary exchange: buyers & sellers benefit (GDP) XII. Competition & Free Enterprise Private property rights motivate people to work, save & invest Profit motive encourages entrepreneurship & drives growth Competition helps lower prices XIII. Role of Government Protector: pass/enforce laws to protect consumers/workers Both a provider & a consumer A regulator by working to preserve competition (anti-trust, property rights) Promote national goals Gov’t intervention makes the U.S. a *mixed economy* or *modified free enterprise economy*. XIV. Business & Market Structures Corporation-limited liability, double taxation Sole P. & Partnerships-unlimited liability Monopoly-1 seller Oligopoly-Few sellers, price leadership, interdependence Perfect-Many, Identical, Independent, No barriers Monopolistic-Like perfect but not identical