Economics Exam Notes
Introduction to Economics
Macroeconomics vs. Microeconomics
Macroeconomics: Studies the economy as a whole, focusing on broad issues such as inflation, unemployment, and economic growth.
Microeconomics: Studies the behavior of individuals, households, and firms in making decisions regarding the allocation of scarce resources.
Positive vs. Normative Questions
Positive Questions: Are objective and fact-based; they describe "what is" and can be tested. E.g., "What is the effect of a minimum wage on unemployment?"
Normative Questions: Are subjective and value-based; they describe "what ought to be" and involve opinions. E.g., "Should the minimum wage be increased?"
Trade-offs: The act of giving up one benefit in order to gain another. Scarcity necessitates choices, and choices involve trade-offs.
Opportunity Cost: The value of the next best alternative that must be forgone when making a choice. It represents what is given up.
Production Possibilities Frontiers (PPFs)
A Production Possibilities Frontier (PPF) is a curve illustrating the varying amounts of two products that can be produced if all resources are used efficiently. It graphically represents all possible combinations of two goods or services that an economy can produce efficiently given its resources and technology.
Efficiency: Points on the PPF represent efficient production, meaning all available resources are fully employed and utilized to their maximum potential. Points inside the PPF indicate inefficient production, where resources are either unemployed or underutilized. Points outside the PPF are unattainable given the current resources and technology.
Opportunity Cost on the Slope: The absolute value of the slope of the PPF at any given point represents the opportunity cost of producing one additional unit of the good on the horizontal axis, measured in terms of the units of the good on the vertical axis that must be foregone.
Linear PPF: Occurs if there is a constant trade-off between the production of two goods, implying that resources are perfectly interchangeable between the production of both goods. The opportunity cost remains constant.
Bowed-Out PPF: Occurs if the Law of Increasing Opportunity Cost holds. This law states that as production of one good increases, the opportunity cost of producing an additional unit of that good increases. This is typical because resources are specialized and not equally productive in all uses.
Shifts in the PPF
Increases in Resources: An increase in the total quantity of available resources (e.g., labor, capital, natural resources) will shift the entire PPF outward, indicating that the economy can produce more of both goods.
Improvements in Technology: Technological advancements will shift out the PPF. If technology improves for the production of one good, the PPF will shift outward predominantly along the axis corresponding to that particular good. If technology improves for both goods, the entire PPF shifts outward.
Gross Domestic Product (GDP)
Purpose: GDP is the primary measure used to gauge the size and health of an economy.
Definition: The market value of all final goods and services produced domestically in a given year.
Market Value: Calculated by multiplying the price (P) of goods and services by their quantity (Q). Only goods and services exchanged in markets are counted, hence non-market activities are excluded.
Final Goods and Services: Only goods and services sold to the final user are counted to prevent double-counting intermediate goods (e.g., the flour used to make bread is not counted, but the final bread product is).
Domestic Production: Only production that takes place within the geographical borders of a country, regardless of the nationality of the producing entity.
Given Year: Only goods and services produced within a specific calendar year are counted. Sales of used goods or financial assets, which represent transfers of existing assets, are excluded.
Measurement Approaches: GDP can theoretically be measured using three main approaches:
Production Approach: Summing the market values of all final goods and services produced.
Income Approach: Summing all income earned by factors of production (wages, rent, interest, profit).
Expenditures Approach: Summing total spending on final goods and services by all sectors of the economy.
Focus on Expenditures Approach: This is commonly expressed as: GDP = C + I + G + NX
C (Consumption): Spending by households on goods and services (e.g., durable goods, non-durable goods, services), excluding new housing.
I (Investment): Spending by firms on capital goods (e.g., machinery, factories), new residential construction (new housing), and changes in business inventories.
G (Government Purchases): Spending by local, state, and federal governments on goods and services (e.g., infrastructure, defense, public education) and salaries for government employees. It specifically excludes transfer payments (e.g., Social Security, unemployment benefits).
NX (Net Exports): The difference between a country's exports and imports. NX = Exports - Imports
Exports: Goods and services produced domestically and sold to residents of other countries.
Imports: Goods and services produced in other countries and purchased by domestic residents.
Real GDP vs. Nominal GDP:
Nominal GDP: Measures the value of goods and services at current prices in the year they are produced. Its increase can reflect either increased output or increased price levels.
Real GDP: Measures the value of goods and services using constant prices from a designated base year. This adjustment removes the effect of price changes, providing a more accurate measure of actual changes in the quantity of output.
Calculation of Real GDP:
Real hinspace GDPt = rac{Nominal hinspace GDPt}{Price hinspace Levelt} imes Price hinspace Level{Base hinspace Year}
Growth Rates: Used to calculate the percentage change in GDP over time.
GDP hinspace Growth hinspace Rate = rac{GDPt - GDP{t-1}}{GDP_{t-1}} imes 100Shortcomings of GDP as a Measure of Well-being:
Excludes Non-Market Production: Activities such as household production (e.g., cooking, cleaning, childcare within the home) or volunteer work are not captured because they do not involve market transactions.
Excludes Underground Economy: Illegal activities, undeclared income from legitimate work, and untaxed transactions are not included in official GDP figures.
Does Not Account for Environment: Fails to measure the negative environmental externalities of production (e.g., pollution, resource depletion).
Does Not Account for Leisure Time: While increased output might boost GDP, if it comes at the cost of reduced leisure time, it may not necessarily represent an improvement in overall well-being.
Is Not a Perfect Measure of Happiness/Welfare: GDP measures economic activity and output, not overall quality of life, happiness, income distribution, or other non-economic factors that contribute to well-being.
Unemployment
Definition of Unemployed: An individual is considered unemployed if they are actively looking for a job but do not currently have one.
Three Types of Unemployment:
Frictional Unemployment: Temporary unemployment that arises from the normal process of workers changing jobs, entering the labor force, or re-entering the labor force. It is a natural and generally short-term feature of a dynamic labor market as workers search for the best job fit.
Structural Unemployment: Longer-lasting unemployment caused by a fundamental mismatch between the skills workers possess and the skills demanded by employers, or a geographic mismatch between job seekers and available job openings.
Creative Destruction: A process, often associated with structural unemployment, where new industries, technologies, or business models emerge, leading to the obsolescence and decline of existing industries and jobs. This requires workers in declining sectors to acquire new skills or relocate.
Cyclical Unemployment: Unemployment that directly correlates with the business cycle. It increases during economic recessions (when there is a general slowdown in economic activity and aggregate demand) and decreases during economic expansions.
Labor Force: Comprises all individuals who are either employed or unemployed (i.e., actively seeking work). It represents those who want a job, actively seeking or currently holding one.
Formulas:
Labor Force Participation Rate (LFPR): The percentage of the work-eligible population that is in the labor force.
LFPR = rac{Labor hinspace Force}{Work-Eligible hinspace Population} imes 100Unemployment Rate (U): The percentage of the labor force that is unemployed.
U = rac{Unemployed}{Labor hinspace Force} imes 100U-6 Unemployment Rate: A broader measure of labor underutilization than the standard unemployment rate. It includes:
Officially unemployed individuals.
Underemployed workers: Those who desire full-time employment but are working part-time for economic reasons.
Discouraged workers: Individuals who are available for work and have looked for a job in the past year but have given up searching recently because they believe no jobs are available for them.
Marginally attached workers: Individuals who want and are available for work, and who have looked for a job recently (within the last 12 months), but are not currently counted as unemployed because they had not searched for work in the 4 weeks preceding the survey.
Categories for Included and Not Included in Work-Eligible Population and Labor Force:
Work-Eligible Population (or Civilian Non-institutional Population): Typically includes individuals 16 years or older who are not institutionalized (e.g., in prison, mental hospitals) and not in the military. This forms the pool from which the labor force is drawn.
Included in Labor Force: Employed individuals (those working for pay or profit) and Unemployed individuals (those actively seeking work).
Not Included in Labor Force: Retirees, students, homemakers, discouraged workers, institutionalized persons, those under 16, and active military personnel.
Inflation and Price Levels
Inflation: The growth rate of price levels; it is a general and sustained increase in the average price level of goods and services in an economy over a period of time, leading to a fall in the purchasing power of money.
Inflation Rate Formula:
it = rac{Pt - P{t-1}}{P{t-1}} imes 100
Where it is the inflation rate at time t, Pt is the price level at time t, and P_{t-1} is the price level in the previous period (t-1).GDP Deflator: A measure of the price level for all goods and services produced in the economy. It reflects the prices of all domestically produced final goods and services, including consumer goods, investment goods, government purchases, and net exports.
Consumer Price Index (CPI): A measure of the average change over time in the prices paid by urban consumers for a fixed basket of consumer goods and services. It specifically tracks the cost of living for a "typical" consumer, reflecting what they actually purchase.
Calculating Real Values using Price Levels: Price levels can be used to convert a nominal value from one year to its equivalent real value (purchasing power) in another year.
Price{t2} = Price{t1} imes rac{CPI{t2}}{CPI{t1}}
This formula helps adjust a price (or income) from an earlier year (t1) to its equivalent value in a later year (t2) to account for inflation.Costs of Inflation:
Shoe-Leather Costs: The resources wasted when inflation encourages people to reduce their money holdings (e.g., frequent trips to the bank to withdraw smaller amounts, incurring time and transaction costs) because inflation erodes the real value of cash.
Menu Costs: The costs associated with having to physically or digitally change prices (e.g., printing new menus, updating product labels, revising online catalogs).
Wealth Redistribution: Unexpected inflation can arbitrarily redistribute wealth. Borrowers may benefit at the expense of lenders if the actual inflation rate is higher than anticipated, as they repay loans with money that has less real purchasing power. Savers whose returns do not keep pace with inflation also lose.
Money Illusion: Occurs when people mistake changes in nominal prices or wages for changes in real prices or wages, focusing on the numerical value without considering its purchasing power (e.g., feeling richer after a nominal wage increase that is fully offset or exceeded by inflation).
Future Price Level Uncertainty: High and volatile inflation makes it difficult for firms and individuals to plan for the future, hindering long-term investment, contracts, and overall economic stability.
Price Confusion: Inflation makes it harder for consumers and firms to distinguish whether a price change for a specific good reflects genuine changes in its supply and demand or merely a general increase in the price level, leading to misallocation of resources.
Tax Distortions: The tax system is often not fully indexed to inflation. For instance, capital gains taxes may be levied on nominal gains, even if the real value of the asset has not increased, effectively taxing phantom gains, or income tax brackets may not adjust quickly enough, leading to