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.

TEN PRINCIPLES OF ECONOMICS5

HOW PEOPLE MAKE DECISIONS

All decisions involve tradeoffs.

Examples….

Principle #1: People Face Tradeoffs

Principle #2: The Cost of Something is What You Give Up to Get It

Principle #3: Rational People Think at the Margin

Principle #4: People Respond to Incentives

Principle #1: People Face Tradeoffs

Principle #2: The Cost of Something is What You Give Up to Get It

Principle #3: Rational People Think at the Margin

Principle #4: People Respond to Incentives

TEN PRINCIPLES OF ECONOMICS6

HOW PEOPLE MAKE DECISIONS

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?

Principle #1: People Face TradeoffsPrinciple #1: People Face Tradeoffs

TEN PRINCIPLES OF ECONOMICS7

HOW PEOPLE MAKE DECISIONS

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.

Principle #2: The Cost of Something Is

What You Give Up to Get It

Principle #2: The Cost of Something Is

What You Give Up to Get It

Paul Solman: Opportunity Cost

TEN PRINCIPLES OF ECONOMICS8

HOW PEOPLE MAKE DECISIONS

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

Principle #3: Rational People Think at the MarginPrinciple #3: Rational People Think at the Margin

TEN PRINCIPLES OF ECONOMICS9

HOW PEOPLE MAKE DECISIONS

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?

Principle #4: People Respond to IncentivesPrinciple #4: People Respond to Incentives

Freakonomics Reading

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

A C T I V E L E A R N I N G 1

Applying the principles

10

Cost of fixing transmission = $600

A. Blue book value is $6500 if transmission works, $5700 if it doesn’tBenefit 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’tBenefit of fixing the transmission is only $500.Paying $600 to fix transmission is not worthwhile.

A C T I V E L E A R N I N G 1

Answers

11

TEN PRINCIPLES OF ECONOMICS12

HOW PEOPLE INTERACT

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

Principle #5: Trade Can Make Everyone Better Off

Principle #5: Trade Can Make Everyone Better Off

TEN PRINCIPLES OF ECONOMICS13

HOW PEOPLE INTERACT

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)

Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

NPR

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

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

Core Principles of Adam Smith

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

Friedman: Wage and Price Controls

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 distributedFriedman:

Capitalism vs. Socialism

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

Stages of economic development Pre-determined Tribal, Slave-Owning, Feudal, Capitalist, Socialist,

Communist

Thesis Antithesis

Synthesis

Frederick Engels Karl Marx

TEN PRINCIPLES OF ECONOMICS21

HOW PEOPLE INTERACT

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.

Principle #7: Governments Can Sometimes Improve Market OutcomesPrinciple #7: Governments Can Sometimes Improve Market Outcomes

TEN PRINCIPLES OF ECONOMICS22

HOW PEOPLE INTERACT

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.

Principle #7: Governments Can Sometimes Improve Market OutcomesPrinciple #7: Governments Can Sometimes Improve Market Outcomes

TEN PRINCIPLES OF ECONOMICS23

HOW PEOPLE INTERACT

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.

Principle #7: Governments Can Sometimes Improve Market OutcomesPrinciple #7: Governments Can Sometimes Improve Market Outcomes

TEN PRINCIPLES OF ECONOMICS25

HOW THE ECONOMY AS A WHOLE WORKS

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.

Principle #8: A country’s standard of living depends on its ability to produce goods & services.

Principle #8: A country’s standard of living depends on its ability to produce goods & services.

TEN PRINCIPLES OF ECONOMICS26

HOW THE ECONOMY AS A WHOLE WORKS

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.

Principle #8: A country’s standard of living depends on its ability to produce goods & services.

Principle #8: A country’s standard of living depends on its ability to produce goods & services.

TEN PRINCIPLES OF ECONOMICS27

HOW THE ECONOMY AS A WHOLE WORKS

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.

Principle #9: Prices rise when the government prints too much money.Principle #9: Prices rise when the government prints too much money.

TEN PRINCIPLES OF ECONOMICS28

HOW THE ECONOMY AS A WHOLE WORKS

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.

Principle #10: Society faces a short-run tradeoff between inflation and unemployment

Principle #10: Society faces a short-run tradeoff between inflation and unemployment

Chapter 2

Thinking Like an Economist

THINKING LIKE AN ECONOMIST30

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)

THINKING LIKE AN ECONOMIST31

FIGURE 1: The Circular-Flow Diagram

Households: Own the factors of production,

sell/rent them to firms for income

Buy and consume goods & services

Households: Own the factors of production,

sell/rent them to firms for income

Buy and consume goods & services Household

sFirms

Firms: Buy/hire factors of

production, use them to produce goods and services

Sell goods & services

Firms: Buy/hire factors of

production, use them to produce goods and services

Sell goods & services

THINKING LIKE AN ECONOMIST32

FIGURE 1: The Circular-Flow Diagram

Markets for Factors of Production

Households

Firms

IncomeWages, rent, profit

Factors of production

Labor, land,

capital

Spending

G & S bought

G & S sold

RevenueMarkets for

Goods & Services

Production Possibilities CurveUse of the Production Possibilities

CurveCost

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.

EfficiencyMaximum

production or output of goods and

services.Any point on the

PPFUnderutilization

GrowthExpanding the

ability to produce. Shift of the entire

PPF to the rightResources/

Technology

Growth

Underutilization

Efficiency

Production Possibilities

Curve~~~~~~~~~~

A graph that shows alternative

ways to use an economy’s resources.

Economics as a Social Science Economists seek to discover how the economic

world works. In order to best do this they must distinguish between positive and normative statements.

Positive statements A statement about “what is” Can be right or wrong Can be tested against facts

Normative statements A statement about “what ought to be” Depends on values, opinions Cannot be tested

Identify the following statements as positive or normative: 1. The gap between the lower class and upper class has grown

over the past three decades. 2. An increase in the minimum wage will bring more teenage

unemployment. 3. The minimum wage should not be increased. 4. The poor should pay less for housing.5. The number of farms has decreased over the last 50 years. 6. The population in rural areas has remained constant over

the past decade.7. An increase in the tax on cigarettes will decrease teen

smoking.8. An increase in the number of police on the inner-city streets

will reduce the crime rate. 9. The United States should place 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.

5,0000

4,000100

2,500250

1,000400

50,0000

40,00010,000

25,00025,000

10,00040,000

0500050,000

E

D

C

B

A

WheatComputersWheatComputers

ProductionEmployment of

labor hours

THINKING LIKE AN ECONOMIST36

Point on

graph

Production

Com-puters

Wheat

A 500 0

B 400 1,000

C 250 2,500

D 100 4,000

E 0 5,000 0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

A

B

C

D

E

PPF Example

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?

A C T I V E L E A R N I N G 1

Points off the PPF

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A C T I V E L E A R N I N G 1

Answers

38

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.

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons)

F

A C T I V E L E A R N I N G 1

Answers

39

0

1,000

2,000

3,000

4,000

5,000

6,000

0 100 200 300 400 500 600

Computers

Wheat (tons) Point G:

300 computers, 3500 tons wheat Point G requires 65,000 hours of labor. Not possible because economy only has 50,000 hours.

G

THINKING LIKE AN ECONOMIST40

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