AP Economic

Unit 1: Basic Economic Concepts

1.1 Scarcity, Choice, and Opportunity Cost

This is the bedrock of economics. The fundamental problem is that scarcity exists because human wants for goods, services, and resources exceed what is available.

Resources are factors of production: land, labor, capital, and entrepreneurship.

Because of scarcity, choice is necessary.

Every choice involves a trade-off, meaning you give up one thing to get another.

• Opportunity Cost: The value of the next best alternative that was not chosen. It's what you forgo when you make a choice. It applies to individuals, firms, and governments.

1.2 Production Possibilities Curve (PPC)

A Production Possibilities Curve (PPC), also known as a Production Possibilities Frontier

(PPF), is a model that illustrates scarcity, trade-offs, opportunity cost, and efficiency. It shows the maximum combinations of two goods that can be produced with a given set of resources and technology.

• Graphing: Typically, two goods are on the X and Y axes. The curve bow-outward (concave to the origin) due to increasing opportunity cost.

• Points on the PPC: Efficient and attainable.

• Points inside the PPC: Inefficient (resources are unemployed or underutilized) but attainable.

• Points outside the PPC: Unattainable with current resources and technology.

• Increasing Opportunity Cost: Reflects that as more of one good is produced, increasingly more of the other good must be sacrificed. This is why the PPC is typically bowed out.

• Shifts in the PPC: Represents economic growth or contraction.

• Outward Shift (Growth): Caused by an increase in resource quantity/quality or technological advancements.

• Inward Shift (Contraction): Caused by a decrease in resource quantity/quality (e.g.,
  natural disaster).

1.3 Comparative Advantage and

Gains from Trade

This concept explains why specialization and trade can benefit everyone involved.

• Absolute Advantage: An individual, firm, or country has an absolute advantage if it can produce_more_ of a good or service using the same amount of resources (or the same amount of a good using fewer resources).

• Comparative Advantage: An individual, firm, or country has a comparative advantage if it can produce a good or service at a lower opportunity costthan another.

• Principle: Everyone is better off when each individual/country specializes in producing the good for which they have a comparative advantage and then trades.

• Calculating Opportunity Cost for Trade:
  To determine comparative advantage, calculate the opportunity cost for each producer for each good. The producer with the lower opportunity cost for a good has the comparative advantage in that good.

• "Output" method (per unit): Opportunity
  cost = (Other good / Good being
  produced).

"Input" method (time/resources per unit): Opportunity cost = (Other input /

Input being produced).

Unit 2: Supply and Demand

2.1 Demand

Demand refers to the desire, willingness, and ability to buy a good or service at various prices over a period of time.

• Law of Demand: As the price of a good increases, the quantity demanded decreases, ceteris paribus (all else being equal). This implies an inverse relationship.

• Demand Curve: A downward-sloping line on a graph, illustrating the inverse relationship between price (Y-axis) and quantity demanded (X-axis).

• Quantity Demanded vs. Demand: A change in price causes a movement along the demand curve (change in quantity demanded). A change in a _determinant of demand_ causes the entire demand curve to shift (change in demand).

  • Determinants (Shifters) of Demand (TRIPE):

  • Tastes and preferences

  • Related goods' prices (substitutes increase demand, complements decrease demand)

  • Income (normal goods increase demand, inferior goods decrease demand)

  • Population (number of buyers)

  • Expectations (future prices, income)

2.2 Supply

Supply refers to the desire, willingness, and ability of producers to offer a good or service for sale at various prices over a period of time.

• Law of Supply: As the price of a good increases, the quantity supplied increases, ceteris paribus. This implies a directrelationship.

• Supply Curve: An upward-sloping line on a graph, illustrating the direct relationship between price (Y-axis) and quantity supplied (X-axis).

• Quantity Supplied vs. Supply: A change in price causes a movement along the supply curve (change in quantity supplied).
  A change in a determinant of supply causes the entire supply curve to shift (change in supply).

• Determinants (Shifters) of Supply (STONER):

• Subsidy (decreases cost, increases supply), Taxes (increases cost, decreases supply)

• Technology (improves efficiency, increases supply)

• Other goods' prices (producers might shift to more profitable goods)

• Number of sellers (more sellers, more supply)

• Expectations (future prices)

• Resource costs/input prices (increases cost, decreases supply)

2.3 Price Elasticity of Demand

Price Elasticity of Demand (PED) measures the responsiveness of quantity demanded to a change in price. It indicates how sensitive buyers are to price changes.

• Formula:

PED =

%Change in Quantity Demanded

%Change in Price

(often using the midpoint formula for accuracy)

• Interpretation of Coefficient: (Always use the absolute value for PED)

• PED > 1
  : Elastic (Quantity demanded changes proportionally more than price. Buyers are verv responsive.)

• PED < 1: Inelastic (Quantity demanded changes proportionally less than price.
  Buyers are not very responsive.)

• PED = 1: Unit Elastic (Quantity demanded changes proportionally the same as price.)

• PED = o: Perfectly Elastic (Horizontal demand curve; consumers will buy an infinite amount at one price, but nothing if price rises even slightly.)

• PED = 0: Perfectly Inelastic (Vertical demand curve; consumers buy the same amount regardless of price.)

• Total Revenue Test: Relates PED to changes in Total Revenue (Price * Quantity).

• If demand is elastic: Price increase $ implies$ Total Revenue decrease; Price decrease $ implies$ Total Revenue increase.

• If demand is inelastic: Price increase $ \implies$ Total Revenue increase; Price decrease $\implies$ Total Revenue decrease.

• If demand is unit elastic: Price changes $ limplies$ Total Revenue unchanged.

• Determinants (Factors) of PED (SPLIT):

• Substitutes (more substitutes, more elastic)

• Proportion of income (larger proportion, more elastic)

• Luxuries vs. Necessities (luxuries more elastic)

• Interestingness/time (longer time period, more elastic)

• Tariff/market definition (narrower market, more elastic)

2.4 Price Elasticity of Supply

Price Elasticity of Supply (PES) measures the responsiveness of quantity supplied to a change in price. It indicates how sensitive producers are to price changes.

Formulas

PES = %Change in Quantity Supplied

%Change in Price

• Interpretation of Coefficient: (Always positive)

• PES > 1
  : Elastic (Producers are very responsive to price changes.)

• PES < 1: Inelastic (Producers are not very responsive to price changes.)

• PES = 1: Unit Elastic

• PES = ∞0: Perfectly Elastic (Horizontal supply curve.)

• PES = 0: Perfectly Inelastic (Vertical supply curve.)

• Determinants of PES:

• Resource mobility: How easily resources can be shifted to produce more of a good (more mobility, more elastic).

• Storage capacity: Ability to store goods (more capacity, more elastic).

• Time horizon: Longer time period allows producers to adjust more, making supply more elastic (momentary, short-run, long-run.

  • Production capacity: How close firms are to full capacity.

  2.5 Other Elasticities

  Beyond price elasticity, other elasticities help understand market relationships.

  • Income Elasticity of Demand (YED):

  Measures the responsiveness of quantity demanded to a change in consumer income.

  • Formula:

  YED = %Change in Quantity Demanded

  %Change in Income

  • Interpretation (sign matters!):

  • YED > 0
    (Positive): Normal good (demand increases with income).

  • O<YED<1
    : Income inelastic normal good (necessity).

• YED > 1: Income elastic normal good (luxury).

• YED < 0 (Negative): Inferior good (demand decreases with income).

• Cross-Price Elasticity of Demand (XED):
  Measures the responsiveness of quantity demanded for good X to a change in the price of good Y.

• Formula:
  XED = %Change in Quantity Demanded of Good X
  %Change in Price of Good Y

• Interpretation (sign matters!):

• XED > 0
  (Positive): Goods are substitutes (e.g., price of Coke rises, demand for Pepsi rises).

• XED < 0 (Negative): Goods are complements (e.g., price of hot dogs rises, demand for hot dog buns falls).

• XED = 0: Goods are unrelated.

2.6 Market Equilibrium and Consumer and Producer Surplus

• Market Equilibrium: Occurs at the price and quantity where quantity demanded
  equals quantity supplied (QD = Qs) and
  the demand and supply curves intersect.
  This is the equilibrium price (PE) _ and equilibrium quantity (QE). At equilibrium, there is no tendency for the price or quantity to change, creating an efficient outcome.

• Consumer Surplus (CS): The benefit consumers receive from buying a good or service, measured as the difference between the maximum price consumers are willing to pay for a good and the actual price they pay. Graphically, it's the area below the demand curve and above the equilibrium price.

• Formula: Area of a triangle =
  0.5 × base X height

• Producer Surplus (PS): The benefit producers receive from selling a good or service. measured as the difference between the actual price producers receive for a good and the minimum price they are willing to accept. Graphically, it's the area above the supply curve and below the equilibrium price.

  • Total Surplus (TS): The sum of consumer surplus and producer surplus

  (TS = C'S + PS). At equilibrium, total

  surplus is maximized, indicating allocative efficiency.

  2.7 Market Disequilibrium and Changes in Equilibrium

  • Disequilibrium: Occurs when the market price is not at equilibrium. This leads to either a shortage or a surplus.

  • Shortage (Excess Demand): When the market price is below the equilibrium price (P < PE), quantity demanded exceeds quantity supplied (QD > Qs).
    This creates upward pressure on prices.

  Surplus (Excess Supply): When the market price is abovethe equilibrium price (P > PE), quantity supplied exceeds quantity demanded (Qs > QD).
  This creates downward pressure on prices.

• Changes in Equilibrium: Shifts in either the demand curve or the supply curve (due to changes in their respective determinants) will change the equilibrium price and quantity.

• Increase in Demand: Price $|uparrow$,
  Quantity $\uparrow$

• Decrease in Demand: Price $ (downarrow$, Quantity $|downarrow$

• Increase in Supply: Price $|downarrow$,
  Quantity $|uparrow$

• Decrease in Supply: Price $|uparrow$,
  Quantity $|downarrow$

• Simultaneous Shifts: When both demand and supply shift, either the equilibrium price or quantity will be indeterminate (unknown without knowing relative magnitudes of shifts).

  2.8 Government Intervention in

  Markets

  Governments sometimes intervene in markets to achieve certain social or economic goals, but these interventions often come with unintended consequences, including

  inefficiencies.

  • Price Ceilings: A legal maximum price that can be charged for a good or service. To be effective, a price ceiling must be set below the equilibrium price.

  • Effects: Creates shortages, black markets, reduced quality, and deadweight loss (a loss of total surplus/efficiency).

  • Example: Rent control.

  • Price Floors: A legal minimum price that can be charged for a good or service. To be effective, a price floor must be set above the equilibrium price.

    • Effects: Creates surpluses, reduces quantity demanded, and deadweight loss.

    • Example: Minimum wage, agricultural price supports.

    • Excise Taxes: A per-unit tax on the production or sale of a good. Taxes create a wedge between the price consumers pay and the price producers receive.

    • Effects: Increases consumer price, decreases producer price, reduces quantity traded, generates tax revenue for the government, and creates deadweight loss.

    • Tax Incidence: Who bears the burden of the tax (consumers or producers) depends on the relative elasticities of demand and supply. The more inelastic side of the market bears a greater share of the tax burden.

      2.9 International Trade and Public Policy

      This section extends supply and demand to an international context.

      • Arguments for Trade: Specialization and comparative advantage lead to greater overall production and consumption for all trading partners.

      • Imports and Exports: When a country opens to trade:

      • If the world price is below the domestic equilibrium price, the country will import the good. Domestic consumers gain, domestic producers lose.

      • If the world price is above the domestic equilibrium price, the country will export the good. Domestic producers gain, domestic consumers lose.

        • In both cases, total surplus (national welfare) increases, though there are distributional effects.

        • Trade Barriers: Governments often impose restrictions on international trade.

        • Tariff: A tax on imported goods.

        • Effects: Increases domestic price of imports, reduces quantity imported, increases domestic production, generates government revenue, and creates deadweight loss.

        • Quota: A legal limit on the quantity of a good that can be imported.

        • Effects: Similar to tariffs_without_ government revenue (revenue goes to license holders), increases domestic price, reduces quantity imported, increases domestic production, and creates deadweight loss.

        • Arguments for Protectionism (Tariffs/ Quotas): National security, infant industry, anti-dumping, saving domestic jobs, environmental/labor standards.
          Economists generally view these arguments skeptically due to the costs to consumers and overall efficiency.