AP Macroeconomics

History of Economics

Adam Smith (Father of modern of Economics)

• Wrote The Wealth of Nations published in 1776

• Strongly opposed mercantilism

• Moral philosopher—foundation of good society is good morals

• Classical economics

  • “Propensity to truck, barter and exchange one thing for another is common to all men, not found in any other races of animals”

  • "Virtue is more to be feared than vice, because its excesses are not subject to the regulation of conscience”

  • “It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest”

    • Good society results from self-interest not adhering to moral values—in market economy business stimulated by demand no need for government to tell them/control what to do

  • “The real and effectual discipline which is exercised over a workman is that of his customers. It is the fear of losing their employment which restrains his frauds and correct his negligence”

    • No need to be told to act morally; too many civil servants come up with too many unnecessary regulations

  • “No human wisdom or knowledge could ever be sufficient for the duty of superintending the industry of private people”

    • Forces of the market supply and demand should decide prices

• Key Ideas of Classical Economics

  • Invisible Hand of the Market (forces of demand and supply) vs visible hand of the government

  • Division of labor- greater efficiency

  • Free trade/exchange

  • Market/market system (exchange products of their labor with each other)

  • Pursuit of self-interest (not egoism)- no contradiction between self interest and common good vs doing things at the expense of others/society

  • 3 laws of economics: Law of Supply and Demand, Law of Self-Interest, Law of Competition (lack of competition does not incentivize businesses to produce high quality goods/services)

  • Classical economists: Adam Smith, David Ricardo, John Stuart Mill, Jean-Baptiste Say

John Maynard Keynes

• Demand side economics/Keynesian economics government intervention

  • Helped solve great depression—government create public works jobs

• Intellectual, civil servant, director of the Bank of England, Cambridge

• Wrote the General Theory of Employment, Interest and Money which was published in 1936

• Made the transition from statics to dynamics, converted economics into a study of the flow of income; concern with the economic health of the community a measured by the national income and symbolized by state of employment

Milton Friedman (Chicago School of Economics)

• Supply-side economics—monetarism

  • Tax cuts, support companies to create supply

• Wrote Monetary History of the US which was published in 1976

  • Due to US unable to compete with Japanese companies

• Strongly opposed demand side economics

  • “When government in pursuit of good intentions tries to rearrange the economy, legislate morality, or help special interests, the cost come in inefficiency, lack of motivation, and loss of freedom”

Karl Marx

• Founder of scientific socialism/communism/Marxist economics

• Wrote Das Kapital which was published in 1867

• Strongly opposed capitalist system—against private property (means of production—factory, machines, etc.) believed it was the root of evil

• Quote: “like slave labor, like serf labor, hired labor is but a transitory and inferior form, destined to disappear before associated labor plying its toil with a willing hand, a ready mind and a joyous heart”

• Independent scholar, philosopher, economist, free-lance journalist (wrote articles supported by Abraham Lincoln)

Austrian School of Economics

Ludwig von Mises

• Wrote The Theory of Money and Credit 1912

Fredrich von Hayek*

• Wrote The Road to Serfdom 1943

• Ideas adapted to Ronald Reagan—criticized communist/socialist economic policies

Peter Drucker

• Laid foundation of modern business corporation

Joseph Schumpeter

• Theory of innovation (“creative destruction”)

• Whenever new industries created old industries are replaced

Carl Menger

• Marginal theory of value/marginalism—all value is subjective society/government no place to impose objective concepts on society (no intervention in economy)

Eugen von Bohm-Bawerk

• Theory of interest—savings as investments

Level of Government Control

Government Control: Marxism—ownership, wages, level of production, prices

Government Intervention: Keynesian Economics—involvement when economy is failing in times of crisis

Limited Government: Chicago School

Laissez Faire: Austrian School

Level of Government Involvement

• Adam Smith: Border protection, enforce civil law (policing), public works (infrastructure)

• Chicago School: Subsidies and tax cuts (to stimulate business—supply side economics), low interest rate (encourage investments)

• Austrian School: No government intervention—society perspective is wrong as values are subjective

• Keynesian (British): Government spending when economy is not doing well

Laissez Faire

• “Let us make” coined by Finance minister Jean-Batiste Colbert at end of 17th century

• Economics is a dismal (miserable) science - Thomas Caryl because it’s very technical vs. Poetry was considered a “joyful science”

• Thomas Malthus famously predicted that short-term gains in living standards would inevitably be undermined as human population growth outstripped food production thereby driving living standards back toward subsistence causing societal collapse; believed human population increases geometrically while food production only increases arithmetically; however food production and yields also increased exponentially

Unit 1 Basic Economics Concepts

• Economics is the science of scarcity- we have unlimited wants but limited resources and since we have everything we desire, we must make choices on how we will use our resources—study the choices of individuals, firms, and governments

• Economics- Social science concerned with the efficient use of scarce resources to achieve maximum satisfaction of economic wants—how individuals/societies deal with scarcity

• *Shortage- Artificially created (often caused by inefficient management) occurs when producers will not or cannot offer goods/services at current prices; temporary

• Scarcity (natural limitations) occurs at all times for all resources

  Types of Scarcity

  • Absolute (time—24 hours in a day)

  • Relative (water scarcity in certain regions)

  • Supply-induced- insufficient supplies/resources to make products (i.e. supply chains broke)

  • Demand-induced- too high demand

  • Structural- different social groups have different access to resources like housing

  • Created scarcity (panics)

  • Needs and wants

  • Mentality of scarcity

• Utility → satisfaction (satisfaction increases or drops)

• Marginal → additional

• Allocate → distribute

Price, cost, investment

• Price = amount the BUYER pays

• Cost = amount SELLER pays for production of a good

• Investment = money spent by BUSINESSES to improve their production

Goods vs Services

• Goods- physical objects satisfying needs/wants

  • Consumer goods- created for direct consumption

  • Capital goods- indirect consumption help make consumer goods (knives, ovens, blenders)

• Services- actions or activities one person performs for another

Accountants vs Economists

• Accountants look only at EXPLICIT costs (out-of-pocket costs)

• Economists look at EXPLICIT and IMPLICIT costs (opportunity costs like forgone time and income)

Classical vs Behavioral Economics

• Classical economics- assumes people are completely rational—most efficient and optimal way

• Behavior economics- combines elements of economics and psychology to understand how and why people behave the way they do in the real world (i.e. if you prefer to A to B and B to C you must also prefer A to C but that is not always the case)

  • Biases, risk aversion, sensitivity to fairness-

    • Psychological concept of loss aversion: Losses loom larger than gains—people experience/react to losses on average 2-2.5x more strongly than gains

      • Consider famous Samuelson bet where people are offered 50% chance of winning $200 or losing $100 most people decline the bet because they experience losses stronger even though statistically it is worth it—from an economists POV it can be vie

Microeconomics vs Macroeconomics

• Microeconomics studies SMALL economic units such as individuals, firms, and industries (ex. supply, and demand in specific markets, production costs, labor markets, etc.)

• Macroeconomics studies the large economy as a whole or economic aggregates (all together) (ex. economic growth, government spending, inflation, unemployment, GDP, international trade)

How is economics used:

• Economists use the scientific method to make generalizations and abstractions to develop theories—theoretical economics

• Theories applied to fix problems or meet economic goals—policy economics

Positive vs Normative Economics/Statements

• Positive statements- based on facts avoid value judgements (“what is”)—can be tested and validated; Scientific economics

• Normative statements- includes value judgements (“what ought to be”)—often used by policy-makers, voters, philosophers

  • i.e. it is “too” hot, you “should” turn in your assignments on time—assumes a normative value

5 Key Economic Assumptions

1. Scarcity: society’s wants are unlimited ALL resources are limited

2. Trade-offs: due to scarcity choices must be made and each choice has a cost

3. Self-interests: Everyone’s goal is to make choices that maximize their satisfaction—everyone acts in their self-interests

4. Marginal costs/benefits: Everyone makes decisions by comparing the marginal costs and marginal benefits of every choice (cost/benefit from making one additional item)

5. Modeling: Real-life situations can be explained and analyzed through simplified models and graphs

5 Foundations of Economics

1. Incentives- incentives to work, produce; ex. patents and copyright

   • Positive incentives- encourage people to make choices (i.e. bonuses, increased wages, sales)

   • Negative incentives- discourage people to make choices (i.e. fines, punishments)

2. Trade-offs- the principle that each opportunity means the loss of other things/opportunities

   • Qualitative—ALL the alternatives we give up whenever we choose one course of action over others

3. Opportunity Cost- highest value/most desirable alternative (second best option)

   • Quantitative-Calculate best opportunity that you give up whenever making a choice

     • Ex. Going to college 4 years tuition -$108k + implicit cost of money that could have been earned working -$110k = $228k

     • Ex. Working $35 dollars/hour; cutting grass yourself (2 hours) vs paying someone ($45) = $70 - $45 = $25

4. Marginal Thinking

5. Principle that trade creates value

Key terms

• Ceteris paribus- holding everything else constant

• Endogenous (factors that we know about and can control)

• Exogenous (factors beyond our control)

Marginal Analysis

Makes sense to only watch it 2 times because by the 3rd time the cost outweighs the benefit

• Marginal analysis- involves making decisions based on the additional benefit vs additional cost (*Marginal = additional)

• Decision-making process often is not an all or nothing question (should I or should I not do this)—marginal analysis is used more commonly than the all or nothing approach

• Will continue to do so until marginal cost outweighs marginal benefit

4 Factors of Production

• Land- All natural resources (i.e. water, sun, trees, stone, animals, oil)

• Labor- Any effort a person devotes to a task for which the person is paid (manual labor, lawyers, doctors etc.)

• Capital

  • Physical capital- any human-made resource used to create other goods/services (tools, machinery, buildings, factories)

  • Human capital- skills/knowledge gained by a worker through education and experience (college degree, vocational training, etc.)

• Entrepreneurship- ambitious leaders that combine other factors of production to create goods and services to obtain profit (Inventors, store owners, etc.)

  • Entrepreneurs- 1. Take the initiative 2. Innovate 3. Act as risk bearers to obtain profit

  • Most important components are manegeral skills and creativity (ex. Architects run their own business is still an entrepreneur)

4 Factor Payments

• Land- rent

• Labor- wage

• Capital- Interest

• Entrepreneurship- profit (people take risks to receive profit)

Production Possibility Curve (PPC)

• Trade-offs between possible production levels of TWO goods

PER unit Opportunity Cost

• How much each marginal unit costs = Opportunity cost/units gained

• Ex. Moving from A to B is loss of 2 bikes

• Moving from C to D gain +2 computers lose from 9 → 5 bikes costs 4 bikes total; PER UNIT cost is 2 bikes (per computer)

• Moving from D to E gain 2 computers lose 5 → 0 bikes 5 bikes total; PER unit cost is 5/2 bikes

• Above line is unattainable

• Distance between two points is the trade offs

• Each point on PPC curve is productively efficient—maximizing use of resources

Two Types of Efficiency

Productive Efficiency- Products produced in the least costly way/maximizing use of resources

• EVERY point along the curve is productively efficient

Allocative efficiency- Products produced are most DESIRED by society

• FEW points are allocatively efficient

• Ex. Producing primarily size 20 shoes vs size 10 shoes—allocatively inefficient for allocating resources to size 20 shoes that less people wear → better to allocate to making size 10 shoes that have higher demand

4 Key assumptions of the PPC (not based in real-life)

1. Only two goods can be produced

2. Full employment of resources

3. Fixed resources

4. Fixed technology/advancement

   Bonus: (Demand does NOT affect production)

3 Shifters of the PPC (dynamic)

1. Change in resource quantity or quality

   • Increase resources/labor quality—curve shifts to the right; decrease resources/labor quality—curve shifts to left)

   • Ex. Increase in population = increase in labor → shifts to right

2. Change in technology (may increase production)

   • Ex. technology improvement in pizza ovens—increases pizza production but max amount of robots produced is the same but at every single point amount of robots produced increases because less resources needed to produce pizza even when no improvements are made in robot production

3. Change in trade

   • Restricted trade (tariffs, quotas)—shift to left; free trade—shift to right)

Capital Goods and Future Growth- countries producing more capital goods (technology, transportation, etc.) will have more future growth than producing consumer goods

Practice Questions

• New robot making technology

  • Increase max for robot making technology—max number of pizzas stays the same but number of pizzas increases at every single point

• Decrease in demand for pizza

  • Change in demand does NOT affect production

• Mad Cow disease kills 85% of cows

  • Decrease in pizza production

Consumer and Capital goods PPC practice

• Destruction of power plants leads to severe electricity shortage- decrease capital and consumer goods

• Faster computer hardware- increase in capital and consumer goods

• *Many workers unemployed- DOES NOT affect production

  • PPC curve represents the max POTENTIAL production not existing; unemployment would be an underutilization of potential resources but does not change the POTENTIAL production

• Significant increases in education- increase in capital and consumer goods

Comparative Advantage

• Calculating which producer has LOWER opportunity cost

• Ex. Country A- 800 corn max 400 computers max (2:1); Country B- 200 corn max 600 computers max (1:3)

  • Country A- 1 corn costs ½ computer (400/800); 1 computer costs 2 corn (800/400)—comparative advantage in corn production

  • Country B- 1 corn costs 3 computers (600/200); 1 computer costs 1/3 corn (200/600)—comparative advantage in computer production

  • *To calculate opportunity cost of item x → divide item y by item x

  • Beneficial trade any number between ½ and 3 for computers beneficial; any number between 1/3 and 2 for corn is beneficial

Practice Problems

• US 20 planes or 2 cruise ships; France 12 planes or 2 cruise ships

  • Plane - US 1/10 ship and France plane 1/6 ship; Ship- US 10 planes and France 6 planes

  • Comparative Advantage: Plane—US; Ship—France

  • Terms of Trade- 1 Plane for between 1/10-1/6 ships; 1 ship for between 10-6 planes

• Korea 3 cars 9 motorcycles; Germany 4 cars 8 motorcycles

  • Cars- Korea 3 motorcycles Germany 2 motorcycles; Motorcycles Korea 1/3 car Germany ½ car

  • Comparative advantage: Cars—Germany; Motorcycles—Korea

  • Terms of Trade- 1 car for between 2-3 motorcycles; 1 motorcycle for between 1/3-1/2 cat

• Japan 4 laptops 12 phones; Brazil 1 laptop 5 phones

  • Laptops- Japan 3 phones Brazil 5 phones; Phones- Japan 1/3 laptop Brazil 1/5 laptop

  • Comparative Advantage- Laptops—Japan; Phones—Brazil

  • Terms of trade- 1 laptop for between 3-5 phones; 1 phone for between 1/5-1/3 laptop

• Cuba 4 hours TV 12 hours Salsa; Mexico 1 hour TV 5 hours Salsa →

  Cuba ¼ TV per hour 1/12 Salsa per hour; Mexico 1 TV per hour 1/5 salsa per hour

  • TV: Cuba 1/3 Salsa, Mexico 1/5 Salsa; Salsa: Cuba 3 TVs Mexico 5 TVs

  • Comparative Advantage- TV—Mexico; Salsa—Cuba

  • Terms of Trade- 1 TV for between 1/5-1/3 salsa; 1 Salsa for between 3-5 TVs

• Rachel 2 hours bread 1 hour pie; Joey 4 hours bread 4 hours pie

  → Rachel ½ bread per hour 1 pie per hour; Joey ¼ bread and ¼ pie per hour

  • Rachel- 1 Bread-2 pie and 1 Pie- 1/2 bread

  • Joey- 1 Bread 1 pie and 1 Pie- 1 Bread

  • Comparative Advantage: Bread—Joey; Advantage Pie—Rachel

  • Terms of Trade: 1 Bread for between 1-2 pies. 1 Pie for between 1/2-1 bread

• How trade produces more value

  Textbook Method:

  • Ex. Both have 24 hours- Rachel can produce max 24 pies, 12 bread, or split time evenly—12 pies (12 hours) + 6 bread (12 hours)

  • Joey produces either 6 bread, 6 pies, or split time evenly—3 pies (6 hours) + 3 bread (6 hours)

  • Combined total for even production without trade: 12 + 3 = 15 pies and 6 + 3 = 9 bread

  • HOWEVER if Rachel specializes in pie production- 24 pies and Joey specialized in Bread production- 6 bread

  • Combined total gain of 9 pies and loss of 3 bread—net gain of 6 products

  • Trade Joey trades 4 bread for 6 pies (choose 1 bread for 1.5 pies)

  • Joey- 2 bread, 6 pies; Rachel- 4 bread, 18 pies

  • With trade: Rachel gains 6 pies though gives up 2 bread net gain of 4 products; Joey gains 3 pies and gives up 1 bread net gain of 2 products—both receive more products trading than stand-alone

Rossman’s Method:

• Ex. Each person has 12 hours to produce

• Rachel specializes in production of pies makes 12 pies—if making bread max number of breads is 6

  • Exchange trade rate of 0.6 Bread for all her pies → 7.2 > 6 able to reach a point for bread production previously impossible

• Joey specializes in production of bread makes 3 breads max—if making pies 3 pies max

  • Exchange rate of 1.5 for all his bread → 4.5 > 3 pies able to reach a point for pie production previously impossible

• Output vs Input problems

  • Inputs often take into account hours

  • Outputs hh

Demand vs Supply

Demand

• Consumer’s willingness and ABILITY to buy an item at a given price

  • Willingness means buyers want the item

  • Ability means that buyers must have financial resources to afford the item

• Demand refers to BEHAVIOR not a quantity

Law of Demand

• Price of an item determines the quantity demanded

• Lower the price the higher the quantity demanded— cheaper goods buy more

• The higher the price the lower the quantity demanded—expensive goods buy less

• *Therefore price of a good/service is INVERSELY related with quantity demanded

Reasons why the Law of Demand Exists

1. Income effect

   • When thing are expensive—money buys less

   • When things are cheap—money buys more

2. Substitution effect

   • When products are expensive and their substitutions are relatively cheap, buy less of the product and more of the substitute

3. Diminishing Marginal Unity

   • Each additional unit of an item purchased gives less marginal utility (satisfaction) than the previous unit therefore only will buy more if price is lower

Changes in Demand

• Increase in Demand

  • More quantity demanded at all prices

    • Demand curve shifts to the RIGHT

• Decrease in Demand

  • Less quantity demanded at all prices

    • Demand curve shifts to the LEFT

• *Price DOES NOT CHANGE DEMAND it changes the quantity demanded

Changes in Demand