Economics Part 1

Factors of production

The resources used to produce goods and services: land, labor, capital, and entrepreneurship.

Land (as a factor of production)

All natural resources used in production, such as soil, water, minerals, oil, forests, and air. Its payment is called rent.

Labor (as a factor of production)

The physical and mental effort people contribute to producing goods and services. Its payment is called wages.

Capital (as a factor of production)

Human-made goods used to produce other goods and services, such as machines, tools, factories, and computers. Its payment is called interest.

Entrepreneurship

The factor of production that organizes the other three, takes risks, and innovates to start businesses. Its payment is called profit.

Capital goods vs. financial capital

Capital goods are physical tools and equipment used in production. Financial capital is money used to buy capital goods; money itself is not a factor of production.

Scarcity

The basic economic problem: unlimited wants but limited resources, so choices must be made.

Opportunity cost

The value of the next best alternative given up when making a choice.

Trade-off

Giving up one thing to get another because resources are limited.

Payment to land

Rent

Payment to labor

Wages (and salaries)

Payment to capital

Interest

Payment to entrepreneurship

Profit

Market structure

The characteristics of a market, including the number of sellers, type of product, ease of entry, and the amount of control firms have over price.

Perfect competition

Many small sellers, identical products, easy entry and exit, and firms are price takers. Example: wheat or corn farming.

Monopolistic competition

Many sellers, differentiated products, easy entry and exit, and some control over price through branding and advertising. Example: restaurants, clothing brands.

Oligopoly

A few large firms dominate the market, there are high barriers to entry, and firms' decisions are interdependent. Examples: airlines, cell phone carriers, automakers.

Monopoly

One seller, no close substitutes, very high barriers to entry, and the firm is a price maker. Example: a local utility company.

Price taker

A firm that has no power to set price and must accept the market price. Characteristic of perfect competition.

Price maker

A firm with market power that can set its own price. Characteristic of monopoly, and to a lesser degree oligopoly and monopolistic competition.

Barriers to entry

Obstacles that make it difficult for new firms to enter a market, such as high startup costs, patents, government licenses, and control of key resources.

Product differentiation

Making a product seem different from competitors' through quality, features, branding, or advertising. Key feature of monopolistic competition.

Natural monopoly

A market where one firm can supply the entire market at a lower cost than multiple firms because of very high fixed costs. Examples: water, electricity, natural gas.

Collusion

When firms in an oligopoly secretly agree to fix prices or limit output. Usually illegal in the U.S.

Cartel

A group of firms or countries that formally agree to control prices or production. Example: OPEC.

Antitrust laws

Laws that promote competition and prevent monopolies and price fixing (for example the Sherman Act).

Market structure with the most competition

Perfect competition

Market structure with the least competition

Monopoly

Economic system

The way a society organizes the production, distribution, and consumption of goods and services.

Three basic economic questions

What to produce? How to produce it? For whom to produce it?

Traditional economy

Economic decisions are based on custom, habit, and history. Roles are passed down through generations. Common in small farming or hunting communities.

Command economy

The government makes the economic decisions and owns most resources. Examples: North Korea, Cuba, the former Soviet Union.

Market economy

Individuals and businesses make economic decisions through voluntary exchange with little government involvement. Driven by supply and demand and self-interest.

Mixed economy

Combines private decision-making with government involvement and regulation. Most modern economies, including the U.S., are mixed.

Capitalism

An economic system with private ownership of resources and businesses, driven by profit and competition.

Socialism

An economic system where the government or community owns major industries and resources to promote equality.

Pros of a market economy

Efficiency, innovation, consumer choice, and economic freedom.

Cons of a market economy

Inequality, possible lack of public goods, and market failures such as pollution.

Pros of a command economy

Can provide basic needs and limit inequality; government can direct resources to national goals.

Cons of a command economy

Lack of incentives, inefficiency, shortages, and limited consumer choice and freedom.

Inflation

A general, sustained increase in the overall price level in an economy over time, which reduces purchasing power.

Deflation

A general, sustained decrease in the overall price level.

Disinflation

A slowdown in the rate of inflation (prices are still rising, but more slowly).

Hyperinflation

Extremely rapid and out-of-control inflation, often over 50% per month.

Stagflation

A combination of high inflation, high unemployment, and slow or negative economic growth.

Consumer Price Index (CPI)

A measure of the average change in prices paid by consumers for a fixed basket of goods and services over time. The most common measure of inflation.

Inflation rate formula

((New CPI - Old CPI) / Old CPI) x 100

Purchasing power

The amount of goods and services that one unit of money can buy. It falls when inflation rises.

Demand-pull inflation

Inflation caused by total demand in the economy exceeding total supply ("too much money chasing too few goods").

Cost-push inflation

Inflation caused by rising production costs (wages, raw materials, energy) that force businesses to raise prices.

Nominal vs. real value

Nominal values are not adjusted for inflation. Real values are adjusted for inflation to show actual purchasing power.

Who is hurt by inflation?

People on fixed incomes, savers (whose money loses value), and lenders when inflation is higher than expected.

Who benefits from inflation?

Borrowers (they repay with money worth less) and people whose incomes rise faster than prices.

Business cycle

The recurring pattern of expansion and contraction in economic activity (real GDP) over time.

Four phases of the business cycle

Expansion, peak, contraction (recession), trough.

Expansion

A phase of the business cycle where real GDP rises, unemployment falls, and consumer spending and business investment increase.

Peak

The highest point of economic activity in a cycle, right before a downturn begins.

Contraction (recession)

A phase where real GDP falls, unemployment rises, and spending and production decline.

Trough

The lowest point of economic activity in a cycle, right before recovery begins.

Recession

A significant decline in economic activity lasting more than a few months. A common rule of thumb is two consecutive quarters of falling real GDP.

Depression

A very severe and prolonged recession with extremely high unemployment. Example: the Great Depression of the 1930s.

Recovery

The period after the trough when the economy starts growing again.

Gross Domestic Product (GDP)

The total market value of all final goods and services produced within a country in a given period.

Economic indicators of a recession

Falling GDP, rising unemployment, falling consumer spending, and falling business investment.

Law of demand

As the price of a good rises, the quantity demanded falls, and vice versa (inverse relationship), all else equal.

Law of supply

As the price of a good rises, the quantity supplied rises, and vice versa (direct relationship), all else equal.

Change in quantity demanded vs. change in demand

A price change causes movement ALONG the demand curve (quantity demanded). A non-price factor causes the whole curve to SHIFT (change in demand).

Shifters of demand (TRIBE)

Tastes and preferences, Related goods (substitutes and complements), Income, Buyers (number of consumers), Expectations.

Shifters of supply (ROTTEN)

Resource (input) costs, Other goods' prices, Technology, Taxes and subsidies, Expectations, Number of sellers.

Substitute goods

Goods used in place of each other. If the price of one rises, demand for the other increases (for example Coke and Pepsi).

Complementary goods

Goods used together. If the price of one rises, demand for the other falls (for example cars and gasoline).

Normal good

A good for which demand increases when income increases.

Inferior good

A good for which demand decreases when income increases (for example instant noodles, generic brands).

Increase in demand

The demand curve shifts right. Results in a higher equilibrium price and higher equilibrium quantity.

Decrease in demand

The demand curve shifts left. Results in a lower equilibrium price and lower equilibrium quantity.

Increase in supply

The supply curve shifts right. Results in a lower equilibrium price and higher equilibrium quantity.

Decrease in supply

The supply curve shifts left. Results in a higher equilibrium price and lower equilibrium quantity.

Equilibrium

The point where quantity demanded equals quantity supplied. The market clears at the equilibrium price and quantity.

Surplus

When quantity supplied is greater than quantity demanded because the price is ABOVE equilibrium. Prices tend to fall.

Shortage

When quantity demanded is greater than quantity supplied because the price is BELOW equilibrium. Prices tend to rise.

Price ceiling

A legal maximum price. If set below equilibrium, it causes a shortage. Example: rent control.

Price floor

A legal minimum price. If set above equilibrium, it causes a surplus. Example: minimum wage.

Subsidy

A government payment to producers that lowers production costs and shifts supply right.

Fiscal policy

The government's use of spending and taxation to influence the economy. Controlled by Congress and the President.

Expansionary fiscal policy

Increasing government spending and/or cutting taxes to boost demand and fight a recession.

Contractionary fiscal policy

Decreasing government spending and/or raising taxes to slow demand and fight inflation.

Budget deficit

When government spending is greater than tax revenue in a year.

Budget surplus

When government tax revenue is greater than spending in a year.

National debt

The total amount of money the government owes, built up from accumulated deficits over time.

Automatic stabilizers

Government programs that automatically adjust with the business cycle without new legislation, such as unemployment insurance and progressive income taxes.

Multiplier effect

The idea that an initial change in spending leads to a larger change in total GDP because spending becomes someone else's income.

Crowding out

When government borrowing raises interest rates and reduces private investment.

Drawbacks of fiscal policy

Time lags (recognition, legislative, impact), political disagreement, increased debt, and crowding out.

Monetary policy

Actions by a central bank to control the money supply and interest rates to influence the economy. In the U.S., it is controlled by the Federal Reserve (the Fed).

Federal Reserve (the Fed)

The central bank of the United States. Its dual mandate is maximum employment and stable prices (about 2% inflation).

Federal Open Market Committee (FOMC)

The Fed committee that meets regularly to set the target for the federal funds rate and guide monetary policy.

Federal funds rate

The interest rate banks charge each other for overnight loans of reserves. The Fed's main policy target.

Open market operations

The Fed buying or selling government securities to change the money supply. The most commonly used monetary tool.

Discount rate

The interest rate the Fed charges commercial banks for short-term loans.

Reserve requirement

The percentage of deposits that banks must hold in reserve and not lend out.