Macroeconomics Exam Unit 1 Course Study Guide

Macroeconomics Exam: Course Study Guide [ UNIT I ] What is economics? the systematic study of choice textbook definitions – refer to the allocation of scarce resources in order to satisfy societal wants What is the basic problem of economics? scarcity scarcity is the problem in the world that humans invented economics in order to address ▪ scarcity CANNOT be solved, only addressed or accommodated ▪ scarcity is the state of affairs in the world where a finite amount of stuff exists to satisfy a virtually infinite amount of human wants ▪ [scarcity = wants > resources ] ▪ to be scarce, something must be both limited and desirable ▪ scarce ≠ scarcity Sometimes, definitions of economics incorporate the three basic questions of economics: 1. What to make/produce? 2. How to make/produce it? 3. For whom do we make/produce it? As a practical matter, before any of the 3 basic questions can be addressed we must first take stock of what our resources include. In other words, what do we have to make stuff with? The categories (of what we have to make stuff with) are often collectively referred to as our resources, inputs, or factors of production 4 categories exist: 1. Land [natural resources]: stuff that came with the Earth ▪ sometimes called the stuff God made or gifts of nature 2. Labor: physical/mental human effort employed in the production process 3. Capital: stuff we make in order to make stuff a. physical capital: tools, equipment, etc. that we make in order to better make stuff ▪ includes factories, tools, roads, and other things specifically made to assist in production b. human capital: special knowledge, education, training, skills, and attributes utilized in the production process ▪ “traditional buzzwords” for [human capital questions] include education and health 4. Entrepreneurship: combination of the other factors of production in a novel way in search of a profit Societies have organized themselves in three ways to address the three basic economic questions: 1. Tradition: characterized by subsistence agriculture and tribal/village life 2. Command: ranges from Ancient Egypt to Stalin’s USSR ▪ contemporary manifestations often employ central planning as a synonym 3. Market: exists as an ideal in accord with 19th century Laissez Faire ▪ emphasizes the presence of private property rights and the profit incentive 4. Mixed: #1-3 exist as points on a continuum rather than as actual existing forms of life ▪ all societies in existence tend to manifest attributes of #1-3 ▪ the term mixed tends to refer to some combination of command (government regulation, planning, and/or control) and market structures TWO BASIC MODELS of an economy are introduced in UNIT I: Simple Circular-Flow Diagram & Production Possibility Frontier/Curve [PPF/PPC] Simple Circular-Flow Diagram The simple circular-flow illustrates how the basic agents (1producers / 2consumers) in an economy interact with each other through two distinct markets (1input/resource/factor market AND 2output/goods&services/product market). producers – often referred to as businesses/firms ▪ illustrated by a factory-shaped icon consumers – often referred to as households/individuals ▪ illustrated by a house-shaped icon The circular-flow diagram illustrates two distinct flows in the economy: 1the flow of money and 2the flow of stuff Both money and stuff get specialized names contingent on the contextual circumstances. [IMPORTANT] money = stuff | output = input | output = income 1 Input/Resource/Factor Market: Households/individuals/consumers are the owners of the factors of production and exchange them for money. The money households/individuals/consumers receive is collectively called income. From the perspective of the firms/businesses, this money is collectively called factor payments. Each factor of production has a specific name for its payment: payments for… are called… land = rent labor = wages & salaries capital = interest entrepreneurship = profit Output/Goods&Service/Product Market: Households/individuals/consumers take their income earned through their participation in the factor market and exchange it for goods and services in the product market. What they purchase is called goods & services and the money they spend is called household/consumer expenditures. The money from the perspective of firms is called revenue. From the perspective of the firms, the inputs are combined through the production process adding value along the way and converting it into goods & services. [Historical Note] The big-picture idea illustrated through the simple circular-flow is that production exists in order to generate income. The relationship was understood as income exists to generate production in the 19 th century. The difference in perspective represents our cultural belief in consumer sovereignty. The Simple Circular-Flow Diagram: Product, Output, Goods & Service Market $ $ Businesses Firms Producers “I” $ Input, Resource, Factor Market 2 Land Labor Capital Entrepreneurship Households Individuals Consumers “C” Rent Wages & Salaries Interest Profit Production Possibilities Frontier/Curve Production possibilities curves illustrate the limits of what is possible to produce for an economy if all resources are fully employed. A PPC illustrates the possible combinations of output available to an economy and addresses the basic economic question of what to make. Five types of PPC curves could be drawn, illustrating the trade-offs and types of opportunity costs involved in production. Important vocabulary that fits here: opportunity cost & trade-off These are related, but NOT synonymous words. Trade-offs are analogous to the possibilities represented to the curve before a decision is made and the opportunity cost can be measured after the decision has been made. This PPC illustrates no relationship between Good A and Good B This PPC also illustrates no relationship between Good A and Good B but merely shifts the axes. We define opportunity cost as “the next best thing”, but text definitions tend to involve what was forgone or alternative use of the common inputs. THREE TYPES OF PPC CURVES could be drawn: Increasing Opportunity Cost Curve bowed-out or concave to the origin Constant Cost Curve looks like: a right triangle Most PPC curves will be of this type. As more of one good is made, it entails an increasing cost in terms of the other good forgone. This is a less common but possible variety of PPC. The ratio of exchange between good A and good B is a constant. 3 Decreasing Opportunity Cost Curve looks like: a ski-jump These are NOT possible!!! NEVER pick this as an example… even Harry Potter could not make this happen. Production Possibilities Curves (cont.): We distinguish THREE TYPES OF POINTS on a PPC: A. Any point just inside the PPC is understood to be characteristic of an economy “not fully employing all factors of production at the highest level of technology.” More simply put, the economy is not using everything it has as best it can – it is inefficient. B. Any point on the PPC curve is understood to be characteristic of an economy “fully employing all factors of production at the highest level of technology.” – using everything it has as best it can, or efficiently. Economists cannot distinguish any point on the curve as preferable to another without more contextual information often in the form of normative preferences. Positive economic analysis requires economists to consider all points on the curve as equal in so far as they are all efficient. C. Any point outside of the curve is considered desirable (because more is better), but not possible, given current levels of factors of production and technology, alone. The “comma alone” is an important device to remind students that through the specialization of production based on lowest opportunity cost (comparative advantage) and exchange with another economy (trade), a consumption possibility can be achieved beyond what is possible alone (autarky). K. This point represents a level of extreme inefficiency characteristic of a severe recession, depression, and/or market failure. We use “K” to indicate that this is a setting when Keynesian economics is most likely to be appropriate. Increases are graphically expressed as a shift to the right such as, PPC1 to PPC2. + factors of production - costs of production + technology Decreases are graphically expressed as a shift to the left, such as PPC1 to PPC2. - factors of production + costs of production - technology 4 Basic SUPPLY and DEMAND GRAPHS are a vital component of UNIT I: DEMAND Increase Demand (Shift D Right) Decrease Demand (Shift D Left) D P (P1-P2) Q (Q1-Q2) 1. 2. 3. 4. 5. 6. D P (P1-P2) Q (Q1-Q2) Increase in the # of consumers Increase in income Increase in expectations of future price Increase in taste (advertising) Increase in the price of a substitute good Decrease in the price of a complementary good 1. 2. 3. 4. 5. 6. Decrease in the # of consumers Decrease in income Decrease in expectations of future price Decrease in taste (advertising) Decrease in the price of a substitute good Increase in the price of a complementary good SUPPLY Increase Supply (Shift S Right) Decrease Supply (Shift S Left) S P (P1-P2) Q (Q1-Q2) S P (P1-P2) Q (Q1-Q2) 1. 2. 3. 4. Increase in the # of producers Increase in the # of inputs Increase in technology Decrease in the cost of production (Increase in quality of inputs) 5. Decrease in government regulation and/or taxes 6. Positive exogenous supply shock (acts of God/OPEC) 1. 2. 3. 4. Decrease in the # of producers Decrease in the # of inputs Decrease in technology Increase in the cost of production (Decrease in quality of inputs) 5. Increase in government regulation and/or taxes 6. Negative exogenous supply shock (acts of God/OPEC) * Supply is really only effected by change in # of inputs, cost of inputs, and technology. * Change in price results in a change in quantity demanded or quantity supplied. Don’t fall for it. 5