AP Macroeconomics Textbook Notes

What is Economics?

• Economics studies how decisions are made and what to buy within the limits of the income they possess/what society produces from a limited set of resources—how people allocate limited resources to satisfy nearly unlimited wants

• Scarcity- limited nature of society’s resources

• Macroeconomics- study of the overall aspects and workings of an economy (i.e. inflation, growth, employment, interest rates, productivity)

  • Microeconomics- study of individual units making up the economy (i.e. one worker is laid-off)

Five Foundations of Economics

1. Incentives- factors that motivate people to act/exert effort (i.e. choosing to study for an exam)

   • Positive/Negative incentives

     • Positive- encourage action (i.e. bonuses, higher prices for suppliers, tax rebates)

     • Negative- encourage action due to fear of negative outcome/punishment (i.e. speeding ticket)

   • Direct/indirect incentives

     • Direct- Usually intended simple results (ex. lower gas prices leading to more business, paying someone for their work)

     • Indirect- Usually unintended larger societal consequences of actions (ex. welfare programs might indirectly take away incentive to work/find jobs)

   • How incentives create unintended consequences

     • Ex) Australia’s baby bonus enacted from July 1 to provide direct incentive for couples to have children caused indirect incentive for couples to delay birth of children till after July 1 possibly harming the health of mothers and infants

   • Incentives and innovations

     • Patent/copyright encourages innovation with financial reward for creativity and hard work—illegal downloads reduce incentives for new content

2. Trade-offs

   • In a world of scarcity every decision incurs a cost, time/resources spent towards one thing means less for another

   • Important in policy decisions i.e. environment vs. higher income

   • Opportunity cost- highest-valued alternative that must be sacrificed/lost to attain something else—assess whether the alternatives are better than the current investments

3. Marginal thinking

   • Economic thinking- process of systemically evaluating a course of action/available opportunities to make the best possible decision

     • Marginal analysis is used to break down decisions into smaller parts (doing more or less of something, how many hours to put towards each thing

   • Marginal thinking- evaluate whether the extra benefit of one more unit of something is greater than the extra cost

     • Marginal benefit- added value of making the additional effort

     • i.e. cleaning dust under the refrigerator—effort of moving the fridge is too great when guests don’t look under the fridge → marginal benefit too low to justify the action

4. Trade

   • The voluntary exchange of goods/services between two or more parties

   • Markets bring buyers/sellers to exchange goods and services

   • Comparative advantage- where one can produce at a lower opportunity cost than a competitor can

     • Harnesses power of specialization—specialize in a certain job/field; companies specialize in certain products/services; countries with skilled labor vs unskilled workers

     • Economic beneficial specialization involves each worker doing what has the lowest opportunity cost + what they are best at compared with other tasks NOT necessarily what they’re best at compared to other workers (absolute advantage)

Chapter 2: Model building and gains from trade

• The scientific method in economics

  • Economists observe a phenomenon that interests them → develop hypothesis → construct a model to test → design experiments to test how well the model works → revise the hypothesis

• Positive and Normative analysis

  • Positive statement- statement that can be tested and validated—objective “what is” (i.e. unemployment rate is 7%)

    • Economists more concerned with positive analysis

  • Normative statement- cannot be tested/validated—subjective/up for debate “what ought to be” (i.e. unemployed worker should receive financial assistance)

    • Normative statements more concerned with by policymakers, voters, philosophers

Economic Models

• Used to analyze component parts of the economy used to predict effect that changes in prices, production, and policies have on behavior—should be simple to understand, flexible in design, able to make famous predictions

• Ceteris Paribus “other things be equal”- Using a controlled setting where only a SINGLE variable is altered while other variables are constant

  • Ex. When making decisions regarding flight tickets only consider costs not personal preference, schedule, etc.

• Endogenous factors- factors we know about and can control

• Exogenous factors- factors outside the model/beyond control

• Danger of Faulty Assumptions

  • All models include faulty assumptions that can lead to policy failures

Production Possibilities Frontier

• A model that illustrates the combinations of outputs a society can produce if all resources are being used efficiently; used to illustrate trade-offs and opportunity costs as well as the role of additional resources/technology in creating economic growth

• Preserve ceteris paribus—assume the technology available for production and quantity of resources remain constant

• Models the trade-offs society makes in the PRODUCTION process

• Models two products (a two-product society) with a certain number of people and resources

• Points

  • A- Using all of its resources to produce product Y

  • B- Using all of its resources to produce product X

  • C & D- mix of the two products (efficient use of resources)

  • E- theoretical point outside the production possibilities frontier that cannot be reached with current resources

  • F- inefficient use of resources (within shaded region)

    

• An economy operating along the frontier will be (productively) efficient at any point but many only be allocatively efficient at some points

Production Possibilities Frontier & Opportunity Cost

• Trade-offs occurring production possibilities frontier represent opportunity cost of producing one good over another

  • Ex. Moving from point C → D gives up 20 pizzas as opportunity cost; D → C 60 wings as opportunity cost

• In reality trade-offs between products is NOT constant all throughout → model is often a curve instead of just a trade-off

• Law of Increasing Relative Cost- Opportunity cost of producing a good increases as MORE of that good is produced—resources not equally efficient at producing all goods

  • Ex. producing more pizzas means using more workers less skilled at making pizzas—pizza production no longer expands at a constant rate

    • Point D → C (Producing 20 extra pizzas give up 30 wings) Point C → B (Producing 20 extra pizzas give up 50 wings) etc.

      

Production Possibilities Frontier & Economic Growth

• Explores what occurs when new technology introduced that increases efficiency or population growth occurs

• New pizza-making technology

  • Ex. New technology enables more pizza to produced with same amount of workers/time → increases the max possible numbers of pizzas produced (does not increase max number of wings produced) + enables more wings to be produced all throughout (allows more workers to make wings)

    

• Population Growth

  • Increases the max possible number of pizzas/wings produced for BOTH and more pizzas/wings to be produced all throughout

    

Benefits of Specialization and Trade

Gains from Trade

• Assuming a two people economy with one person specializing in production of pizzas and the other in wings each will produce what they specialize in then trade to acquire other goods

• Ex. Debra Winger only makes pizzas producing 60 pizzas OR only makes wings to produce 120 wings; Mike Piazza only makes pizzas to produce 24 pizzas OR only makes wings to produce 72 wings

  • Debra’s trade-off between producing pizzas and wings is 1:2 (60 pizzas/120 wings)

  • Mike’s trade-off between producing pizzas and wings is 1:3 (24 pizzas/72 wings)

  • Debra has an absolute advantage in producing pizzas and wings—able to produce more of both with the same quantity of resources overall compared to Mike

  • Assuming both produce equal amounts of pizzas/wings Debra can produce 40 of each while Mike produces 18 of each—WITHOUT TRADING have a combined production of 58 units of pizza + wings

  • Specialization & Trade:

    • Debra specializes in pizza production—60 units of pizza is greater than combined output of 58 pizzas

    • Mike specializes in wings—72 units of wings greater than combined output of 58 wings

    • Specialization results in production of 2 additional pizzas and 14 additional wings—results in greater productivity

    • WITH TRADING if they exchange 19 pizzas for 47 wings each better off by 1 pizza and 7 wings compared to if they didn’t specialize & trade—Debra & Mike’s value gained from trade is 1 pizza and 7 wings

      

Comparative Advantage

• Comparative Advantage- ability to make a good at a LOWER COST than another producer

• Debra has a comparative advantage in producing pizzas → has a lower opportunity cost of producing pizzas than Mike (Gives up 2 wings for each pizza vs. Mike’s 3 wings for each pizza)

• Mike has a comparative advantage in producing wings → has a lower opportunity cost for producing wings than Debra (Gives up 1/3 pizza for each wing vs. Debra gives up ½ pizza for each wing)

  

Finding the right price to facilitate trade

• Trade benefits both sides as long as terms of trade fall between the opportunity costs of trading partners—both benefit from exchanging a good at a price lower than the opportunity cost of producing it

  • Debra’s opportunity cost 1:2 (1 pizza per 2 wings) → any exchange with a value lower than 0.5 is beneficial to her since she ends up with more pizza/wings than she had without trading

  • Mike’s opportunity cost is 1:3 (1 pizza per 3 wings) or 0.33

  • Ratio exchanged must fall BETWEEN Debra’s opportunity cost of 0.5 and Mike’s opportunity cost of 0.33 otherwise both are better off without trading

    • Ex. Trading 19 pizzas for 47 wings 19:47 = 0.4 which falls within the range of both their opportunity costs

    • If Mike insists of trading 1 wing for 1 pizza 1:1 Debra will refuse to trade

    • If Debra insists on trading 1 pizza for 4 wings 1:4 (0.25) Mike will refuse to trade

Trade-offs between having more now vs. having more later

• Many trade-offs in reality deal with long-term decisions (school, job, moving, etc.) such as deciding to save money and give up something you want to buy today or choosing to go to a party tonight instead of staying home to study for exams in the future

Consumer Goods, Capital Goods, and Investment

• Consumer goods- Goods that satisfy our current wants and can be consumed (food, entertainment, clothing)

• Capital goods- assist in production of other goods/services in the future (roads, factories, computers, trucks, etc.)

• Investment- process of using resources to create/buy new capital (i.e. investing in going to college instead of working)

• Societies choose between production of capital vs consumer goods

  • Choosing to produce more consumer goods leads to little growth in the future → production possibilities curve only expands by a little

  • Choosing to produce more capital goods leads to long-term growth with the production possibilities curve expanding outwards much more