Chapter 1- Microeconomics and Macroeconomics: The Basics:Part 1
In this chapter, we will learn that economics is all about the choices we make. Specifically, people make purposeful choices with scarce resources and interact with other people when they make these choices. More than anything else, economics is the study of how people deal with scarcity. Scarcity is a situation in which individuals, businesses, and governments have unlimited wants but resources are limited. Economic interactionbetween people occurs every time they trade or exchange goods with each other.
Economic interactions can occur either within an organization or a group, such as a family, or in a market. A market is simply an arrangement by which buyers and sellers can interact and exchange goods and services with each other.
Consider Stacy, who is going for a hike in the park on a sunny day. Stacy would love to wear a hat and sunglasses on the hike, but she has brought neither with her. But Stacy has brought $20 with her, and there is a store in the park that is having a two-for-one sale. She can buy two hats for $20 or two pairs of sunglasses for $20. She can't buy both for $20. Her scarcity of funds causes her to make a choice. The opportunity cost of a choice is the value or cost of a positive alternative that was not chosen. If Stacy chooses to buy sunglasses instead of the hat, then the opportunity cost is the loss from not being able to buy the hat. In teenager terminology, the opportunity cost is the girl or boy you decided not to go out with and instead chose someone else.
Now suppose that Adam and Stacy meet each other in the park (don't get any ideas; they are only friends). Let's consider the possibility of economic interaction between them. Stacy bought two pairs of sunglasses and Adam bought two hats, so Stacy and Adam can trade with each other. Gains from tradereallocates (exchanges) goods between the two individuals in a way that benefits both of them.
Economic interaction allows for specialization: people concentrating on what they are good at. Mr. Scale's specializes in AP US History and Mr. Sadow specializes in AP Microeconomics and Macroeconomics. This specialization creates a division of labor. A division of labor occurs when some workers specialize in one task while others specialize in another task. They divide the overall production into parts.
Let us suppose that production in the economy can be divided into two broad categories. Suppose the economy can produce either computers or movies. With a scarcity of resources such as labor (workers) and capital (money for business), there is a choice between producing some goods, such as computers, versus other goods, such as movies. The table below gives an example of the alternative choices, or the production possibilities, for computers and movies. Each choice, A-F, leads to different production numbers.
The opportunity cost of producing more movies is the value of the computers not produced, and vice versa. The opportunity cost, in terms of computers, of producing more movies increases as we require a loss of more and more computers. What we've just described is called increasing opportunity costs. Moving from production possibility A to B requires an opportunity cost of 1,000 computers (25,000 to 24,000), but moving from production possibility A to C increases the opportunity cost to 3,000 computers (25,000 to 22,000).
The figure on the right is a graphical representation of the production possibilities table on the left. We put movies on the horizontal axis and computers on the vertical axis on the graph.
A production possibilities curve/frontier (PPC/PPF) graphs both short-run (SR) and long-run (LR) tradeoffs, communicates choices, scarcity, and opportunity costs. A production possibilities curve/frontier with a curve indicates increasing/not proportional opportunity costs anywhere on the line for both items. When moving from point A to B, to make two computers (0 to 2) requires an opportunity cost of two bikes (14 to 12). Moving from B to C increases the number of computers by two (2 to 4) but the opportunity cost is now about 3 bikes (12 to 9). Notice that the changes aren't constant/proportional. The resources being used are not easily adaptable between both products.
A production possibilities curve/frontier with a straight line indicates constant/proportional opportunity costs anywhere on the line. The resources are easily adaptable between both products. If the PPC/PPF is a straight line, the amount of Y you have to give up to make one more X is the same everywhere, and the amount of X you have to give up to make one more Y is the same everywhere as well.
This means that the production of goods X and Y uses resources that are perfect substitutes for each other. Below, for every increase of 30 of good B, there is a decrease of good A by 60. For every increase of good A by 60, there is a decrease of good B by 30. Both goods have constant opportunity costs.
Depending on where an economy is during its economic fluctuations/business cycle, this determines the location of the dot. On either line, curved or straight, indicates efficient or production efficient (the maximum amount that can be produced with the available resources at that time). On either line also indicates full use of resources, full employment in an economy, peak efficiency, real GDP (Y) equaling potential (what an economy does produce vs. its potential), and usually but not always socially optimal or allocative efficient (when the resources in a society are being optimally distributed, taking into account all costs and benefits).
To the left of the line indicates unemployment, contraction of the economy, under production, possible labor force reduction and recession, and inefficiency because the economy can produce a larger number. Points inside the production possibilities curve/frontier, like H and B, are possible, but they are inefficient.
Anything to the right of the line indicates long-run (LR) aggregate supply (AS) expansion, over production, and an impossibility because the economy does not have the resources at that time to produce those quantities. Based on a comparison of points A-E, the increasing opportunity cost of making more computers is highest at E since it is the largest amount of computers made with the largest amount of bikes lost.
The production possibilities curve/frontier (PPC/PPF) represents a tradeoff and decisions to be made concerning scarce resources. Do I buy the 90 inch flatscreen LED TV from Best Buy or spend more money on my fiancé's engagement ring? (tough call!) The production possibilities curve is not immovable; it can shift out or in. More workers, technological innovations, more studios, etc.; all could shift the curve out. When the production possibilities curve/frontier shifts out, the economy grows because more goods and services are being produced. As the production possibilities curve/frontier shifts out, impossibilities are converted into possibilities. But, the production possibilities curve/frontier can also shift in, usually during natural disasters like a hurricane or tornado. The PPC/PPF can also shift in or out for only one of the variables while the other variable remains the same.
A country's aggregate supply (AS) (its total supply of goods and services) is impacted by the abilities of those who make the goods, the producers/suppliers. Absolute advantage is a situation in which a person or group, like a country, can produce more of a good than another can. The country can simply make more of a product than another country can. During the 1910s and 1920s, no company came close to producing the number of cars that Henry Ford did. Comparative advantage is a situation in which a person or group, like a country, can produce a good with less opportunity cost than another can. McDonalds can certainly produce more hamburgers more efficiently compared to Best Buy. In other words, production capability (absolute advantage) vs. opportunity cost (comparative advantage). But in comparative advantage, both countries benefit from trade and specialization of a product.
Below, the USA has an absolute advantage in producing both food and clothing; they made more of both than Japan. But, comparative advantage matters more than absolute; comparative advantage determines who will produce what. To calculate opportunity costs= what we give up / what we get or what we now produce less of / what we now produce more of. USA has a comparative advantage in food: 3/6 = .5 vs. Japan 2/1= 2. .5 is less than 2. In clothing, Japan wins: 1/2 = .5 vs. 6/3= 2. The lowest opportunity cost is the winner.
In the graph below, called a production possibilities curve or frontier, India has the absolute advantage in nuts and China in grapes. In grapes, China has the comparative advantage (what we give up / what we get), 10/10 (China) vs. 12/8 (India). In nuts, India has the comparative advantage, 8/12 (India) to 10/10 (China). China will grow grapes and India will grow nuts; both will benefit.
In the production possibility curve/frontier below, India has the absolute advantage in nuts and grapes. In grapes, China has the comparative advantage, 4/6 vs. 18/9. In nuts, India has the comparative advantage, 9/18 vs. 6/4. China will grow grapes and India will grow nuts.
There are three essential questions or problems that every economy must find a way to solve, whether it is a small island economy or a large economy like the U.S.: 1) what is to be produced, 2) how are those goods to be produced, and 3) for whom are the goods to be produced? A free market economy and a command/centrally planned economy offer two alternative approaches to these questions. In a free market economy, democracies base their economies on capitalism; most decisions about what, how, and for whom to produce are made by individual consumers (those who buy), firms (companies), governments, and other organizations interacting in the markets. In a command, or centrally planned economy, such as in a communist or socialist country, decisions about what, how, and for whom to produce are made by those in control of the government. Many economies are mixed economies,or a mixture of both.
In a market economy, most prices (P), such as the price of a computer, are freely determined by individuals and firms interacting in markets. These freely determined prices are an essential characteristic of a market economy. The interaction between the sellers and buyers determines the price. Property rights give individuals the legal authority to keep or sell property, whether land or other resources. Moreover, by giving people the right to the earnings from their work, as well as letting them suffer some of the consequences, or losses from their mistakes, property rights provide incentives. In a market economy, sellers have the right to trade at home or abroad. A market economy also benefits from a marginal analysis in order to see the pros and cons of continuing or changing a course of action in a market; do we start making more of an item or continue to make the same amount; the numbers decide, not dictators.
Just because prices (P) are freely determined and people are free to trade in a market economy does not mean that there is no role for government. In certain circumstances, called market failure, the market economy does not provide good enough answers to the "what, how, and for whom" questions, and the government has a role to play in improving the market. However, the government, even in the case of market failure, may do worse than the market, in which case economists say there is government failure. An example of government failure is the U.S. government's inaction during the first few years of the Great Depression.
Chapter 2- Microeconomics and Macroeconomics: The Basics:Part 2
In this chapter, we will get a broad overview of economics by looking at the kinds of things economists actually do. Economics is a way of thinking. It entails accurately describing economic events, explaining why the events occur, predicting under what circumstances such events might take place in the future, and recommending appropriate courses of action.
The best way to measure the size and health of an economy is to measure its gross domestic product (GDP). GDP is the value of a country's overall output of goods and services during a specific period of time. GDP includes all newly made goods, such as cars, trucks, houses, etc.; it also includes services, such as education, health-care, and government. To measure the total value of all products made in the economy, economists add up the dollars that people spend on the products. In 2013, America's GDP was $15,700 billion (GDP is stated in billions) or $15.7 trillion. In 2014, America's GDP was $17.4 trillion, and America's GDP is expected to top $19,000 billion in 2017.
An economic variable is any economic measure that can vary over a range of values. Two variables are correlated if they tend to move up or down at the same time. There is a positive correlationif the two variables move in the same direction: when one goes up, the other goes up. Healthcare spending as a share of GDP and the relative (compared) price of healthcare were positively correlated from 1990 to 1993. Two variables are negatively correlatedif they tend to move in opposite directions, like from 1995 to 2000.
Correlation means that one event is usually observed to occur along with another. For example, high readings on a thermometer occur when it is hot outside. Causation means that one event brings about another event. But correlation does not imply causation. For example, the high reading on the thermometer does not cause the hot weather, even though the high reading and the hot weather are correlated. Valentine's Day leads to an increase in production of roses, but not the other way around. Correlation and causation are importance factors when setting up economic models.
Prediction is one of the most important uses of models, including economic models. In order to use models for prediction, economists use the assumption ceteris paribus, which means "all other things equal." For example, the prediction that a variable will not change assumes there is nothing that can change it. In teenage terminology, if a guy thinks he can date one or two different girls whenever he wishes, he is believing that there is nothing that can change the outcome (what a sucker!; to be fair, girls are the same way).
There are two main branches of economics: microeconomics and macroeconomics; thus, there are both microeconomic and macroeconomic models. Microeconomicsstudies the behavior of individual firms (companies) and households or specific markets like the healthcare market, the college graduate market, the car market, etc in the short-run (SR) (up to one year out). Macroeconomicsfocuses on the whole economy, the whole national economy or even the whole world economy, not only in the short-run but also the long-run (LR) (4-5 years out).
Ever since the birth of economics as a field around 1776, when Adam Smith (the father of economics) published the book the Wealth of Nations, economists have been concerned about and motivated by a desire to improve the economic policy of governments. In fact, economics was originally called political economy. Much of the Wealth of Nations is about what the government should or should not do to affect the domestic or international economy. Adam Smith argued for a system of laissez faire ("hands off" or little government control) where the role of the government is mainly to promote competition, provide for the national defense, and reduce restrictions on the exchange of goods and services.
In debating the role of government in the economy, economists distinguish between positive and normative economics. Positive economics is about what is, the reality; normative economics is about what should be.