Basic ConceptsPart 1
Economics
Study of scarcity and choice. People, firms, and governments make
choices because of scarcity.
Micro v Macro
Microeconomics Macroeconomics
•Focuses on the choices of individuals, households, and firms•“Bottom-up”
•Questions like:• Should a
business hire another worker
• Should I got to college or get a job?
VIDEO CLIP!
•Focuses on the economy as a whole and aggregate data (GDP, Unemployment, Inflation) and how it can be manipulated•“Top-down”
•Questions like:• How many
people are employed in the US Right now?
• What policies could the government adopt to increase economic growth?
Positive v Normative
Positive Normative
Focuses on concepts that have definitive answers.
Right answer everyone can agree on
Focuses on how the world should work.
“What if” questions or questions where there can be disagreement over the final outcome.
Scarcity: The Fundamental Problem
Rule one of Economics: Resources are scarce Resource = anything used to produce
something else
Productive Resources
A.K.A. Factors of Production Can be divided into four areas
LAND▪ Water, minerals, oil, and other natural resources
LABOR▪ The effort of workers
CAPITOL▪ Machinery, buildings, and tools used in production
of goods and services ENTREPRENUERSHIP
▪ Risk taking, innovation, and orginizational skills
Opportunity Cost
The economic “cost” of the decision is the benefit or alternative you give up to do something.
Example:
Production Possibilities Curves
Before we begin…
Just about every graph we do in this class is in Quadrant I of a x y plane X = Horizontal Y = Vertical O = origin (0,0)
Now that we have reviewed basic math…
I
Production Possibilities Curves
Graphical representation of the trade-off an economy must face when allocating resources between two goods
The frontier of the curve shows the maximum quantity of one good that can be produced for each quantity of the other
Production Possibilities Curve
0 10 20 30 40 50 600
10
20
30
40
50
60
Production Possibilities
Planes
Cars
Cars Planes
50 0
40 10
30 20
20 30
10 40
0 50
Frontier
PPCs and Efficiency
Points that are on the curve (or frontier) itself represent the use of all resources for production Maximum utilization of resources = efficiency
Points falling under the curve are feasible, but not efficient. This is called underutilization. An economy
producing below what it is capable is not efficient.▪ This can be caused by inefficiencies such as high
unemployment,
PPCs and Efficiency
In this graph: Points “H” and “D” (and
all other points on the curve itself) represent efficiency. ▪ more output can be
achieved from the given inputs
Point “B” represents underutilization. ▪ Producing this combination
of goods would be inefficient.
What can we determine about point “A”?
Points outside the PPC Frontier
Points beyond the PPC Frontier are considered to be unattainable due to scarcity of resources.
PPCs and Growth
A change in the amount of resources will change the frontier.
The curve will shift right when: More productive
resources become available
Better technology allows you to use your resources more efficiently.
PPCs and Opportunity Cost
Since resources are scarce, increasing production of a first good entails decreasing production of a second Scarce resources must be transferred to
the first and away from the second. The loss of production of one good to
increase production of the other is the opportunity cost.
Constant Opportunity Cost PPCs If the opportunity cost
to change production remains the same at all production points, the PPC will be straight.
The more similar the resources needed to produce each good, the straighter the PPC will be.
Constant Opportunity Cost PPCs
The slope of a straight line PPC = Opportunity Cost
Slope for a straight line PPC should always be negative
Increasing Opportunity Cost PPCs
The PPC is "bowed outward" (concave) from the origin. This represents INCREASING OPPORTUNITY COST. As more scarce resources are
used to increase production of one good or service, production of another good or service falls by larger and larger amounts.
The less similar the resources needed to produce each good, the further the PPC will be bowed out from the origin.
Economic Systems
System that coordinates production and distribution of goods and services.
Must answer the THREE BASIC questions of: What to produce? How to produce it? Who will consume it?
3 Basic types
Traditional Market Command
3 questions are answered by tradition and custom
3 questions are answered by individuals
3 questions are answered by the government.
• The way these questions are answered (and by whom) determines what type of economy
Centrally Planned Economies
The government…1.owns all the resources. 2.decides what to produce, how
much to produce, and who will receive it.
Examples:Cuba, North Korea, former Soviet
Union, and China
Two Types
COMMUNISM
Communism is a political system characterized by a centrally planned economy with all economic and political power resting in the hands of the government. Communist governments are authoritarian in nature.
SOCIALISM
Socialism is a social and political philosophy based on the belief that democratic means should be used to distribute wealth evenly throughout a society.
Advantages and Disadvantages
ADVANTAGES
1. Low unemployment-everyone has a job
2. Great Job Security-the government doesn’t go out of business
3. Equal incomes means no extremely poor people
DISADVANTAGES
1. No incentive to work harder
2. No incentive to innovate or come up with good ideas
3. No Competition keeps quality of goods poor.
4. Corrupt leaders5. Few individual
freedoms
Free Market System(aka Capitalism)
1. Little government involvement in the economy. (“Laissez Faire” = Let it be)
2. Individuals OWN resources and answer the three economic questions.
3. The opportunity to make PROFIT gives people INCENTIVE to produce quality items efficiently.
4. Wide variety of goods available to consumers.
5. Competition and Self-Interest work together to regulate the economy (keep prices down and quality up).
The “Invisible Hand”
The concept that society’s goals will be met as individuals seek their own self-interest.
Example: Society wants fuel efficient cars…• Profit seeking producers will
make more.• Competition between firms
results in low prices, high quality, and greater efficiency.
• The government doesn’t need to get involved since the needs of society are automatically met.
• Competition and self-interest act as an invisible hand that regulates the free market.
Advantages and Disadvantages
ADVANTAGES
Economic Efficiency As a self-regulating system,
a free market economy is efficient.
Economic Growth Because competition
encourages innovation, free markets encourage growth.
Economic Freedom Free markets offer a wider
variety of goods and services than any other economic system
DISADVANTAGES
Lack of Economic Equity
With freedom comes a degree of instability
The reality
All modern economies are a mix of market and command “Mixed” economies
Continuum of Mixed Economies
Centrally planned Free market
Source: 1999 Index of Economic Freedom, Bryan T. Johnson, Kim R. Holmes, and Melanie Kirkpatrick
Hong KongThe United
States
North Korea
Cuba
China
France
Greece
SingaporeThe United Kingdom
Mixed Economy
Government takes of people’s needs Marketplace takes care of people’s
wants.
Circular Flow model
Simplified view of how money and resources move through an economy.
In the circular flow model, the inter-dependent entities of producer and consumer are referred to as "firms" and "households" respectively and provide each other with factors in order to facilitate the flow of income.
Firms provide consumers with goods and services in exchange for consumer expenditure and "factors of production" from households.
Circular Flow of Economic Activity
Product Market (Goods & Services)
Goods & ServicesGoods & Services
Households/Individuals Businesses/Firms
$$$$$$ $$$$$$$$
Factor/Resource Market
(Factors of Production)
Factors of Production FOP
Circular Flow model
Product Market
Product Market - any setting where goods and services are bought and sold by producers and consumers Kroger, target, Taco Bell, ebay
▪ This type of market is where goods and services are bought by you
▪ Basically any purchase you make is in this market
▪ Bought by Households, sold by firms (businesses)
Factor Market
Factor Market – any setting where land, labor, capital, and entrepreneurship are bought and sold by producers and consumers This market is where Factors of
Production are sold by you (households) and bought by firms (businesses)▪ The best example – wages earned for
your labor▪ This market is where households earn
money to spend in the Product market
http://www.reffonomics.com/TRB/Chapter3/circularflow5.swf
International Trade
The process of buying goods and services from the rest of the world (importing) and that of selling goods and services to the rest of the world (exporting) is referred to as international trade
Why Trade?
Differences in Factor endowments Variety and quality of goods Gains from specialization Political reasons
Absolute Advantage
Adam Smith
1723-1790 “Father of Modern
Economics” Wrote “The Wealth of
Nations” Smith argued that it was
impossible for all nations to become rich simultaneously by followingmercantilismand instead stated that all nations would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage
Absolute Advantage
A country has an absolute advantage in the production of a good when it can produce more of that good than another country with the same resources.
Wine ComputersFrance 70 2
US 50 3
Suppose that by using x units of resources…
The French have an absolute advantage in the production of wine
Another Example
One of your friends, Gina, can print 5 t-shirts or build 3 birdhouses an hour.
Your other friend, Mike, can print 3 t-shirts an hour or build 2 birdhouses an hour.
Because your friend Gina is more productive at printing t-shirts and building birdhouses compared to Mike, she has an absolute advantage in both printing t-shirts and building birdhouses.
Comparative Advantage
David Ricardo
Came up with the law of comparative advantage.
According to this law, specialization and free trade benefits all trading partners. Countries should
specialize in those goods they can produce at the lowest opportunity cost
Comparative Advantage
The ability of a firm or individual to produce goods and/or services at a lower opportunity cost than other firms or individuals. A comparative advantage gives a company the
ability to sell goods and services at a lower price than its competitors and realize stronger sales margins.
This is not the same as being the best at something.
Comparative advantage is the basis for all trade between individuals, regions, and nations.
Production Possibilities without Trade
India can produce 4,000 yards of textile per day or 1 ton of chocolate per day.
Nepal can produce 1,000 yards of textile a day or 4 tons of chocolate per day.
Production Possibilities without Trade
India has a comparative advantage in producing textiles.
Nepal has a comparative advantage in chocolate.
Production Possibilities without Trade
1 2 3 4 5
4
3
2
1
5
Chocolate (in tons)
Text
iles
(in
thou
san
ds
of y
ards
)
Nepal
India
McGraw-Hill/Irwin
Production Possibilities without Trade
India has chosen to produce 2,000 yards of textiles and 0.5 tons of chocolate.
Nepal has chosen to produce 500 yards of textile and 2 tons of chocolate.
Production Possibilities without Trade
India’s and Nepal’s Individual Possibilities
Textile per day Chocolate per day
India 2,000 yards 0.5 ton
Nepal 500 yards 2 tons
Total 2,500 yards 2.5 tons
Production Possibilities without Trade
Point A: The combination of textile and chocolate chosen by India.
Point B: The combination of textile and chocolate chosen by Nepal.
Point C: The joint combination without trade.
Production Possibilities without Trade
1 2 3 4 5
4
3
2
1
5
Chocolate (in tons)
Text
iles
(in
thou
san
ds
of y
ards
)
Nepal
India
A
B
C
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Production Possibilities without Trade
The two extreme combinations are: both countries producing only textile
(point D) both producing only chocolate (point E).
The combined production possibilities curve with no trade is drawn by connecting these two points.
Production Possibilities without Trade
1 2 3 4 5
4
3
2
1
5
Chocolate (in tons)
Text
iles
(in
thou
san
ds
of y
ards
)
Nepal
India
A
B
C
D
E
Joint ( trade)
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Production Possibilities with Trade
Point F: This is where each nation is focusing on that activity for which it has a comparative advantage. India produces 4,000 yards of textile. Nepal produces 4 tons of chocolate.
Production Possibilities with Trade
1 2 3 4 5
4
3
2
1
5
Chocolate (in tons)
Text
iles
(in
thou
san
ds
of y
ards
)
Nepal
India
A
B
C
D
E
Joint ( trade)
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
F
Output Questions:
OOO=Output: Other goes Over
58
Input Questions:
IOU= Input: Other goes Under
59
Practice FRQ
A. Which country has an absolute advantage in the production of tractors? Explain how you determined your answer.
B. Which country has an absolute advantage in the production of cars? Explain how you determined your answer.
C. Which country has a comparative advantage in the production of cars? Use the concept of opportunity cost to explain how you determined your answer.
D. For Xanadu, what is the opportunity cost of producing one car?
E. If the two countries specialize and trade with each other, which country will import cars? Explain why?
10 Points Possible (2 Points For EACH: 1 point answer, 1 point
explanation)A. Answer-XanaduExplanation- Because they can produce more total tractors than Atlantis.
B. Answer-AtlantisExplanation- Because they can produce more total cars than Xanadu.
(2 Points For EACH: 1 point answer, 1 point explanation)C. Answer- Atlantis
Explanation- Because the opportunity cost for Atlantis to make one car is 1/3 a tractor which is less than then the opportunity cost for Xanadu (1 car =2 tractors).
D. Answer- Opportunity Costs is 2 Tractors.No explanation required
(2 Points For EACH: 1 point answer, 1 point explanation)E. Answer- Xanadu will import cars
Explanation- Xanadu should not make cars. They should specialize in making tractors and import cars from Atlantis since they have a lower opportunity cost.
Introduction to Macroeconomics
Business Cycle
Simplified view of the upturns and downturns in the macroeconomy
The increases and decreases in output consisting of four phases: Peak: highest point of
output Recession: output declining
for 6 months Trough: lowest point of
output Recovery: output increasing
(trough to peak)
Business Cycle
People generally prefer steady, stable growth to large “ups” and “downs.” Therefore, government policies, both fiscal and monetary (see later sections), are aimed at flattening the business cycle.
The government wants not only to stimulate the economy when it’s slow, but also to slow it down when it’s growing too quickly.
Employment & Unemployment
EMPLOYMENT
Total number of people working for pay
UNEMPLOYMENT
Total number of people looking for work that are not currently employed
LABOR FORCE
• Sum of employment and unemployment.
Unemployment Rate
Percentage of labor force that is unemployed
# UnemployedUnemployment Rate
Labor Force• Increases during
recession• Decreases during a
recovery
Aggregate output
Total production of all goods and services in the economy Measured by real GDP
Decreasing output leads to a recession
Increasing output leads to a recover/expansion
Inflation & Deflation
Inflation Rise in the general level of prices Reduces the purchasing power of money Measured with the Consumer Price Index
(CPI) Increases during periods of expansion
Deflation The opposite of inflation Prices go down Purchasing power of money increases
Activity
1. Draw and label the business cycle2. Explain what happens to output,
unemployment, and inflation in each stage.