Economics Exam Notes

Scarcity and Economics

• Scarcity: Human wants exceed available resources.
• Economics: Study of decision-making under scarcity.

Division of Labor and Specialization

• Division of labor: Dividing production into separate tasks to increase efficiency.
• Specialization: Focusing on specific tasks, leading to advantages based on talent and expertise.
• Economies of scale: Cost per unit decreases as production increases (e.g., bulk buying).

Microeconomics vs. Macroeconomics

• Microeconomics: Focuses on individual agents (households, workers, businesses).
• Macroeconomics: Focuses on the economy as a whole (growth, unemployment, inflation).

Economic Policies

• Monetary policy: Managing interest rates and credit availability, determined by the central bank.
• Fiscal policy: Government spending and taxation, determined by the legislative body.

Economic Systems

• Traditional economy: Agricultural-based, follows established customs (Asia, Africa, South America).
  • Family-based production and consumption.
  • Limited economic progress.
• Command economy: Government controls resources and makes economic decisions.
  • Government sets production, prices, and wages.
  • Provides necessities like healthcare and education.
• Market economy: Decentralized decisions, private ownership, supply and demand driven.
  • Market: Interaction between buyers and sellers.
  • Private enterprise: Private individuals/groups own and operate production.

Market Orientation and Globalization

• US: Primarily market-oriented with some government involvement.
• Europe: Market-oriented with greater government involvement.
• China: Moving towards a market economy.
• Globalization: Increased buying and selling across national borders.
• Gross Domestic Product (GDP): Measures total economic production.
• Underground economy: Illegal economic activities.

Budget Constraint and Opportunity Cost

• Budget constraint: Combinations of two items attainable when ALL income is spent.
  • Highlights trade-offs.
  • Opportunity cost: What is given up when choosing something else.
• Opportunity set: Possible consumption combinations given income (not all income needs to be spent).
• Budget Formula: Budget = P1 \times Q1 + P2 \times Q2
  • P1 and P2 are the prices of good 1 and good 2, respectively.
  • Q1 and Q2 are the quantities of good 1 and good 2, respectively.

Marginal Analysis and Diminishing Returns

• Marginal analysis: Evaluating benefits and costs of incremental choices.
• Law of Diminishing Returns: Marginal benefit decreases as more resources are added.
• Diminishing Marginal Utility: Additional utility declines with each additional unit consumed.
• Sunk costs: Unrecoverable costs that should not influence future decisions.

Production Possibilities Frontier (PPF)

• PPF: Shows productively efficient combinations of two products given available resources.
  • Illustrates opportunity cost.
• Law of Increasing Opportunity Cost: Marginal opportunity cost increases as production of a good increases.
• Points inside PPF: Productively inefficient.
• Slope of PPF: Opportunity cost.

Efficiency (Productive and Allocative) and Comparative Advantage

• Productive efficiency: Impossible to produce more of one good without decreasing another.
• Allocative efficiency: Mix of goods represents societal preferences.
• Comparative advantage: Producing a good at a lower opportunity cost than another country.

Economic Perspectives

• Positive statements: Describe the world as it is (factual).
• Normative statements: Describe how the world should be (opinion).

Invisible Hand

• Invisible hand: Self-interested behavior can lead to positive social outcomes.
  • Consumers drive businesses to meet their needs.

Demand and Supply

• Demand: Quantity consumers are willing to purchase at a certain price.
• Law of Demand: Price increases, quantity demanded decreases, and vice versa.
• Demand Schedule: Table of prices and corresponding quantities demanded.
• Supply: Quantity producers are willing to supply at each price.
• Law of Supply: Price increases, quantity supplied increases, and vice versa.
• Supply Schedule: Table of prices and corresponding quantities supplied.

Equilibrium

• Equilibrium: The point where quantity demanded equals quantity supplied.
• Equilibrium Price: The price at the equilibrium point.
• Surplus (Excess Supply): Quantity supplied exceeds quantity demanded.
• Shortage (Excess Demand): Quantity demanded exceeds quantity supplied.

Factors Shifting Demand Curve

• Ceteris Paribus: "Other things being equal."
• Income: Higher income usually increases demand (shift to the right).
• Tastes/Preferences: Changes in what people want affect demand.
• Population: Changes in population composition affect demand.
• Prices of Substitutes/Complements: Affect demand for related goods.
• Expectations about the future: (e.g., hurricane).

Types of Goods

• Normal Good: Demand increases with income.
• Inferior Good: Demand decreases with income.
• Substitute: Used in place of another good.
• Complement: Used together with another good.

Factors Shifting Supply Curve

• Cost of Production: Higher costs decrease supply (shift to the left).
• Inputs/Factors of Production: Labor, materials, machinery.
• Natural Conditions.
• Input prices.
• Technology.
• Government policies.

Determining Equilibrium Changes

• Step 1: Draw initial supply and demand curves.
• Step 2: Determine if the event affects supply or demand.
• Step 3: Determine the direction of the shift (right or left).
• Step 4: Identify the new equilibrium and compare it to the original.

Price Controls

• Price Ceilings: Maximum legal price.
• Price Floors: Minimum legal price.
• Price ceilings can lead to shortages.
• Price floors can lead to surpluses.

Surplus (Consumer, Producer, Social) and Deadweight Loss

• Consumer Surplus: Willingness to pay minus actual payment.
  • Area above market price and below the demand curve.
• Producer Surplus: Actual price received minus the minimum acceptable price.
  • Area between market price and supply curve.
• Social Surplus: consumer surplus + producer surplus.
• Deadweight Loss: Loss of social surplus due to inefficient quantity produced.

Labor Market

• Labor market: Supply and demand for labor.
• Law of demand in labor markets:
  • Higher wage (price) in the labor market leads to a decrease in the quantity of labor demanded by employers.
  • Lower wage (price) leads to an increase in the quantity of labor demanded by employers.
• Law of supply in labor markets:
  • Higher price for labor = higher quantity of labor supplied
  • Lower price for labor = lower quantity of labor supplied

Factors Shifting Labor Demand

• Demand for output.
• Education and training.
• Technology.
• Number of companies.
• Government regulations.
• Price/availability of other inputs.

Factors Shifting Labor Supply

• Number of workers.
• Required education.
• Government policies.

Financial Capital

• Savings = supply of financial capital
• Borrowing = demand for financial capital
• Financial capital - economic resources measured in terms of money
• Interest Rate: The "price" of borrowing financial capital.
• Usury laws: Laws limiting interest rates.

Intertemporal Decision Making

• Intertemporal decision making - deciding when to consume goods: now or in the future
• In the early 2000s, financial investors from foreign countries were investing several hundred billion dollars per year more in the U.S. economy than U.S. financial investors were investing abroad
• When foreign countries start seeing US debt growing, they stop investing money so the supply decreases, shifting supply to the left. The new equilibrium occurs at a higher interest with a lower quantity of financial investment. This means borrowers will have to pay more interest on borrowing.

Generalized Demand and Supply Models

• Horizontal Axis: Quantity of goods/services, labor, or financial capital.
• Vertical Axis: Price of goods/services, wage, or interest rate.

Elasticity

• Price elasticity - the ration between the percentage change in Qd or Qs and the corresponding percent change in price
• Price Elasticity of Demand: Percentage change in quantity demanded divided by percentage change in price.
• Price Elasticity of Supply: Percentage change in quantity supplied divided by percentage change in price.
• Elastic Demand/Supply: Elasticity > 1 (high responsiveness to price).
• Inelastic Demand/Supply: Elasticity < 1 (low responsiveness to price).
• Unitary Elasticity: Elasticity = 1 (proportional responsiveness).

Zero and Infinite Elasticity

• Infinite elasticity or perfect elasticity - either Qd or Qs changes by an infinite amount in response to any change in price at all
• Qd or Qs is extremely responsive to price changes, moving from 0 to prices close to P to infinite when prices reach P
• Zero elasticity or perfect inelasticity - a percent change, no matter how large, results in zero change in quantity

Unitary Elasticity Curves

• Demand curve with unitary elasticity will be curved
• Price demanded and price are proportional in each step
• Supply curve with unitary elasticity is a straight line that goes thru origin
• Each step the percent increase in quantity and percent increase in price is the same

Inelastic vs Elastic Demand

• In a, demand is inelastic and a big drop in price, very slightly increases demand. However, in b, demand is very elastic so even a slight change in price greatly increases demand.
• Consumers benefit more when demand is inelastic because the price drops more.

Tax Incidence

• Tax Incidence: Division of the tax burden between consumers and producers.
• The division of the tax burden between consumers and producers.
• Shows who actually pays the tax in terms of higher prices or lower revenues.
• Shows who actually pays the tax in terms of higher prices or lower revenues.
• Who bears the tax burden depends on relative elasticity of the supply and demand curves:
  • If demand is more inelastic than supply, consumers bear most of the tax burden, and if supply is more inelastic than demand, sellers bear most of the tax burden.

Elasticity and Time

• Elasticities are lower in the short run than in the long run because people need time to adjust their behavior.
• Short-run demand is more inelastic (ex: energy use) since immediate changes are hard to make.
• Long-run demand becomes more elastic as consumers can make bigger lifestyle or purchasing changes (like buying fuel-efficient cars).

Income Elasticity of Demand

• For most products, most of time, the income elasticity of demand is positive
• That is, a rise in income will cause an increase in the quantity demanded

Cross-Price Elasticity and Wage Elasticity

• Cross-price elasticity of demand - the percentage in change in quantity of good A that is demanded as result in percentage change price good B
• Wage elasticity of labor supply - the percentage change in labor supplied divided by percent change in wages
• Wage elasticity in labor demand - the percent change in labor demanded by percent change in wages

Goals, Framework, and Policy Tools for Macroeconomy

• Goals - a consensus of what are the most important goals for macroeconomy
• Framework- what economists use to analyze macroeconomic changes (ex: inflation or recession)
• Policy tools - the tools the federal govt uses to influence the macroeconomy
• GDP - the value of the output of all final goods and services produced within a country in a given year
  • Demand for production can be divided into four parts:
    • Consumer spending (consumption)
    • Business spending (investment)
    • Govt spending on goods and services
    • Spending on net exports

Exports vs Imports & Trade Balance

• If imports exceed exports, we have a trade deficit
• If exports exceed imports, we have a trade surplus
• GDP net export component (trade balance) is equal to dollar value of exports (X) minus dollar value of imports (M)
• Trade balance - the gap between exports and imports (X-M)
• Trade surplus - when country’s exports are larger than its imports (X-M)
• Trade deficit - when imports are larger than exports (M-X)
• GDP = consumption + investment + govt spending + trade balance = C + I + G + (X-M)

Production Components of GDP

• Production can be divided into 5 parts:
  • Durable goods: long-lasting (car)
  • Nondurable goods: short-lived (food)
  • Services: intangible (entertainment)
  • Structures: buildings used as factory, office, retail, etc
  • Change in inventories - good that has been produced but not yet sold
• Every market transaction must have a buyer and seller so GDP must be the same whether measured by what is demanded or produced
• Services make up over 60% of production side of GDP
• Durable and nondurable goods constitute the manufacturing sector and ave declined from 45% to 30% of GDP
  Final vs. Intermediate Goods
• Final goods and services - output used directly for consumption, investment, government, and trade purposes
  • Goods at furthest stage of production at the end of a year
• Intermediate goods - output provided to other business at an intermediate stage of production, not for final users
  • Excluded from GDP calculation
  • Double counting - output that is counted more than once as it travels thru stages of production
  • Double counting - output that is counted more than once as it travels thru stages of production

Measuring the Economy with National Products

• Gross National Product (GNP): includes what is produced domestically and what is produced by domestic labor and business abroad in a year
  • GNP is based more on what a country's citizens and firms produce, wherever they are located, and GDP is based on what happens within a certain country's geographic boundaries
  • Net National Product (NNP) - GNP minus value of depreciation (certain things that lose value over time)
    • Depreciation - the process by which capital ages and loses value
    • NNP can be further subdivided into national income -- includes all incomes earned: wages, profits, rent, profit income

Formulas

• GDP = 400 + 60 + 120 + (100 - 120) = 580 - 20 = 560
• Net exports = 100 - 120 = -20
• NNP = GDP + income receipts from rest of world - income payments to rest of world - depreciation = 560 + 10 - 8 - 40 = 522

Nominal vs. Real Value

• Nominal value - economic statistic actually announced at that time, not adjusted for inflation
  • Real value - an economic statistic after it has been adjusted for inflation
    • Generally, real value is more important
    • The GDP deflator is a price index measuring the average prices of all final goods and services included in the economy. (GDP deflator is also called price index)

Recession and Depression

• Recession - a significant decline in national output/ GDP
• Depression - an especially lengthy and deep recession
• Peak - during the business cycle the highest point of output before recession begins
• Trough - during the business cycle, the lowest point of output in recession before recovery begins
  • Recession lasts from peak to through

GPD PER capita

• To compare GDP of different countries with different currencies, it is necessary to have a “common denominator” using exchange rates
  • Exchange rate: the value or price of one currency in terms of another currency
  • US has largest GDP in the world
• GDP per capita - the GDP divided by population GDP per capita = GDP/population
• Standard of living - all elements that affect people’s happiness and well-being, whether they are bought and sold in market or not

What GDP Does Not Include

• GDP does not include:
  • Leisure time
  • Actual levels of environmental cleanliness, health, and learning
  • Production that is not exchanged in market
  • Level of inequality in society
  • What tech and products are available

Modern Economic Growth

• Modern economic growth - period of rapid economic growth from 1870 onward
  • Rapid and sustained economic growth is relatively recent experience for human race
  • Industrial revolution - the widespread use of power driven machinery and the economic and social changes that resulted in first half of 1800s
    • Led to increasing inequality among nations
    • 1870: GDP of top economies in the world was 2.4 times GDP per capita of world’s poorest economies
    • 1960: top economies had 4.2 times GDP per capita of world’s poorest economies
      Influence and Sustained Long Term Economic Growth
• Adherence to rule of law:
  • Princess of enacting laws that protect individual and entity rights to use their property as they see fit
  • Laws must be clear, public, fair, and enforced and applicable to all members of society
    • Protection of contractual rights:
    • Rights of individuals to enter into agreements with others regarding the use of their property
    • Providing recourse thru the legal system in event on noncompliance
    • Sustained long term economic growth come from increases in worker productivity
    • Labor productivity - value of what is produced per worker, per hour worked (sometimes called worker productivity)

Determinants of Worker Productivity

• Human capital: accumulated knowledge (from edu and experience), skills, and expertise that the average worker in an economy possesses
  • Technological change: a combination of invention and innovation that
    • Invention: advances in knowledge
    • Innovation: putting advances in knowledge to use in new product or service
    • Economies of scale - cost advantages that industries obtain due to size
      Production function - process whereby firm turns economic inputs like labor, machinery, and raw materials into outputs like goods/services that consumers use
• A microeconomic production function describes a firm’s or an industry’s inputs and outputs
• In macroeconomics, we call the connection from inputs to outputs for the entire economy an aggregate production function aggregate production function
  • Aggregate production function - the process where economy as a whole turns economic inputs such as human capital, physical capital, and technology into output measured as GDP per capita
• An economy’s rate of productivity growth is closely linked to growth rate of its GDP per capita

Productivity and Wages

• A common measure of US productivity per worker is the dollar value (output) per hour that the worker contributes to the employer’s output.
  • Productivity growth is also closely linked to the average level of wages. Over time, the amount that firms are willing to pay workers will depend on the value of the output those workers produce.

Compound Growth

• Even small changes in rate of growth when sustained and compounded over long period of time, make a great difference in standard of living
• To calculate what GDP will be at the given growth rate in the future:
• GDP{future} = GDP{present} * (1 + growth \ rate)^{years} Also written:
• Example: an economy that starts with a GDP of 100 and grows at 3% per year will reach a GDP of 209 after 25 years; that is, 100 (1.03)^{25}= 209
  • Compound growth rate (compound rates of economic growth) - means that we multiply the rate of growth by a base that includes past GDP growth, with dramatic effects over time.

Physical Capital & Human Capital & Technology

1. Physical Capital
   • Includes machinery, equipment, and infrastructure (like roads).
     • Increases output by:
       • Quantity: More of the same equipment (e.g., more computers).
       • Quality: Better equipment (e.g., faster computers).
2. Human Capital
   • Skills, knowledge, and education that make workers more productive.
     • Grows through education and training.
     • Like physical capital, investing in it now increases future productivity.
3. Technology
   • Broadly includes:
     • Inventions and innovations (smartphones, laser, etc.).
     • Better processes (e.g., assembly lines, quality control).
     • New institutions that improve how inputs become outputs.
     • Increases efficiency, quality, and can lead to completely new products.

GDP per Capita & Capital Deepening

• Capital Deepening:
  • Increasing capital per person (both human and physical).

Special Economic Zone and Convergence

• Special Economic Zone (SEZ) - area of a country, usually w/ access to a port where, among other benefits, the govt does not tax trade
• Convergence - pattern in which economies with low per capita incomes grow faster than economies with high per capita incomes

Arguments Favoring Convergence (Theory)

• Low- income countries might have an advantage in achieving greater worker productivity and economic growth in the future.
• Diminishing marginal returns: low-income economies could converge to the levels that the high-income countries achieve.
• Law-income countries may find it easier to improve their technologies, than high income countries, by applying technology that has already been invented.
• Economist Alexander Gerschenkron names this “the advantages of backwardness”
• Low-income countries have observed the experience of those that have grown more quickly and have learned from it.

Arguments That Convergence Is Neither Inevitable nor Likely

• Developing new technology can provide a way for an economy to sidestep the diminishing marginal returns of capital deepening
• Will technological improvements run into diminishing returns over time?
  • Does not seem so because we can apply widely the ideas of new technology at a marginal cost that is very low or even zero.
  • When it comes to adapting and using new technology, a society's performance is not necessarily guaranteed.

The Slowness of Convergence

• Economic convergence between high-income countries and the rest of the world seems possible, but it will proceed slowly
• High income countries have been building up their advantage in standard of living over decades or even centuries.

Adult Population Categories

• Adult population consists of:
  • Employed: currently working for pay
  • Unemployed: out of work and looking for job
  • Out of labor force: not working or looking
    • Not in labor force

Formulas

• Labor force - the number of employed people plus unemployed people
• Unemployment rate - percentage of adults who are in labor force thus seeking jobs but don't have one
• Hidden unemployment - people who are mislabeled in categorization of employed, unemployed, or out of labor force

US Unemployment

• US unemployment rate movies up and down as economy movies in and out of recessions
• However, over time, unemployment rate seems to return to a range of 4% to 6%
• Unemployment for men used to be lower than for women, now they are fairly equal
• Unemployment rates are highest for young (teens)
• Although unemployment for all groups tend to rise and fall together, black and hispanic is always higher

Comparing Cross-Country Unemployment

• Caution when comparing cross-country unemployment rates due to:
  • Different definitions of unemployment
  • Survey tools for measuring unemployment
  • Poorer countries lack resources and technical capabilities in their statistical agencies

Cyclical Unemployment

• Cyclical unemployment - unemployment closely tied to the business cycle, like higher unemployment during a recession
• In a labor market with flexible wages, the equilibrium will occur at wage W, and quantity Qe
  • Here the number of people who want jobs (shown by S) equals the number of jobs available (shown by D).
    Why Wages Might Be Sticky Downward
• Implicit contract: unwritten agreement in labor market that employer will try to keep wages from falling when economy is weak or business is struggling, and employee won't expect to have huge salary increases when economy/business is strong

Economist Considerations of Economy and Rate of Productivity

• Economist consider economy to be at full employment when actual unemployment rate is equal to natural unemployment rate
  Productivity is rising, increasing the demand for labor. Employers and workers become used to the pattern of wage increases. Then productivity suddenly stops increasing. The expectations of employers and workers for wage increases do not shift immediately, so wages keep rising as before. However, the demand for labor has not increased, so at wage W4, unemployment exists where the quantity supplied of labor exceeds the quanity demanded.

Public and Labor Market Policies

• On supply side of labor market, public policies to assist unemployed can affect how eager people are to find work.
• What seems to matter most is how long the assistance lasts
• Short term benefits (weeks/months) vs long term benefits (years)
• Govt assistance for job search or retraining can sometimes encourage people to work sooner
• On demand side of labor market some public policies can affect the willingness of firms to hire:
  • Govt rules
  • Social institution
  • Presence of unions

Estimates by Economists of Natural Unemployment Rate

• Reasons for this lower rate:
  • Interest as a job seeking tool
  • Growth of temporary worker industry
  • Aging of the “baby boom generation”
  • Demand employer’s demand for workers
  • Supply amount of workers willing/able to work at that wage

Inflation

• Inflation - a general and ongoing rise in the level of prices in an entire economy
  what about basket of goods and services? computed using weighted average
  what about index number, base year?

Calculating Inflation

• Inflation calculation: [(level in new year - level in prior year)/level in prior year] x 100 = % change

Measures of Inflation

• Consumer price index (CPI) - measure of inflation that US govt statisticians calculate based on price level from fixed basket of goods and services that represent average consumer’s purchases

Problems with CPI

• Substitution bias - inflation rate calculated using a fixed basket of goods over time tends to overstate true rise in cost of living bc it does not take into account that the person can substitute away from goods whos prices rise considerably
  • Quality/new goods bias: inflation calculated using fixed basket of goods over time tends to overstate true rise in COL, bc it doesn’t account for improvements in the quality of existing goods or invention of new goods

Core Inflaction Index

• Core inflation index - takes the CPI and excludes volatile economic variables, like energy and food prices
  • Economists can have better sense of underlying trends in prices that affect cost of living
  • A preferred gauge from which to make important govt policy changes
  • To allow for some substitution between goods, the Bureau of labor statistics uses alternative mathematical methods for calculating the CPI
  • Updates the basket of goods behind the CPI more frequently so that it can include new and improved goods more rapidly
  • The substitution bias and quality/new goods bias has been somewhat reduced
  • The rise in CPI most likely overstates true rise in inflation by only about 0.5% per year

Producer, Employment, and International Price Index

• Producer price index - a measure of Inflation based on prices paid for supplies and inputs by producers of goods and services
  International Price Index (PPI) - a measure of inflation based on the prices of merchandise that are exported or imported
• Employment Cost Index - a measure of inflation based on wages pald in the labor market
  GDP deflator - a measure of inflation based on the prices of all the GDP components (consumption, investment, govemment, exports minus imports).

Deflation and Hyperinflation

• Since inflation is a time when the buying power of money in terms of goods and services is reduced, deflation will be a time when the buying power of money in terms of goods and services increases.
• Deflation has occurred in the early decades of the twentieth century: one following the deep 1920-21 recession and the other during the Great Depression of the 1930s.
  Hyperinflation - outburst of high inflation that often occurs when economists shift from controlled economy to market-oriented economy

Problems Caused by Inflation

• If other economic variables (prices, wages, and interest rates) do not move in sync with inflation, or if they adjust for inflation only after a time lag, then inflation can cause 3 types of problems
  1. Unintended redistributions of purchasing power
  2. Blurred price signals
  3. Difficulties in long term planning

Prices and Inflation Impacts

• Prices are the messengers in a market economy, conveying information about conditions of demand and supply.
• Inflation blurs those price messages.
• Inflation means that we perceive price signals more vaguely, like static on the radio.
  When the levels and changes of prices become uncertain, businesses and individuals find it harder to react to economic signals.
• Inflation can make long-term planning difficult.

The Effects of Cost-of-living adjustments

• More time spent by businesses finding ways of profiting from inflation vs. less time spent on productivity, innovation, or quality of service.
• Over the last several decades in the United States, there have been times when rising inflation rates have been closely followed by lower productivity rates and lower inflation rates have corresponded to increasing productivity rates.
  Indexed - a price, wage, or interest rate is adjusted automatically for inflation.

Examples of Indexing

Examples of indexing arrangements in private markets:

• Cost-of-living adjustments (COLAs) - a contractual provision that wage increases will keep up with inflation.
• Adjustable rate mortgage (ARM) - a type of loan a borrower uses to purchase a home in which the interest rate varies with market interest rates.