AP Macro Unit 1 Basic Econ Concepts Notes 5 Key Assumptions

Economics is the science of scarcity and the 1) Society has unlimited wants and limited
study of choices resources (scarcity).
 Limited resources & unlimited human wants 2) Due to scarcity, choices must be made.
 Study of how individuals and societies deal Every choice has a cost (a trade-off).
with Scarcity 3) Everyone’s goal is to make choices that
maximize their satisfaction. Everyone acts
Certeris Paribus – all other things being equal in their own “self-interest.”
4) Everyone makes decisions by comparing
Scarcity- we have unlimited wants but limited the marginal costs and marginal benefits
resources. of every choice.
 Since we are unable to have everything we 5) Real-life situations can be explained and
desire, we must make choices on how we analyzed through simplified models and
will use our scarce resources. graphs.
 In order to be considered scarce, a good or
service must be (1) limited, (2) desirable, (3)
Marginal analysis (aka: “thinking on the
have a cost
 In economics we will study the choices of margin”) making decisions based on increments
individuals, firms, and governments.  In economics the term marginal =
additional (1 more unit)
MICROeconomics - study of small economic  You will continue to do something as long
units such as individuals, firms, and industries as the marginal benefit is greater than the
(ex: supply and demand in specific markets,
marginal cost
production costs, labor markets, etc.)
 MB > MC = good decision
MACROeconomics - study of the large  MC > MB = bad decision/not worth it
economy as a whole or economic aggregates Trade-offs and Opportunity Cost
(ex: economic growth, government spending,
inflation, unemployment, international trade) All decisions involve trade-offs

Positive v. Normative Economics  Trade-offs - ALL the alternatives that we

Positive Statements- Based on facts. Avoids give up when we make a choice
value judgements (what is).  Ex: If you choose to study for an
economics test, then you give up a
Normative Statements- Includes value chance to go to the movies or read a
judgements (what ought to be). book (trade-offs)
 Opportunity cost- most desirable
alternative given up when you make a
choice.
 #1 trade-off you give up

“THERE IS NO SUCH THING AS A FREE

LUNCH!” (TINSTAAFL)
There’s ALWAYS a COST!
Economic Terminology (Must Know!) 3. Capital -
 Physical Capital - Any human-made
 Utility = Satisfaction
resource that is used to create other
 Marginal = Additional
goods and services ( Ex: tools, tractors,
 Allocate = Distribute
machinery, buildings, factories, etc.)
What’s the price? vs. How much does that cost?  Human Capital - Any skills or
 Price = Amount buyer (or consumer) pays knowledge gained by a worker through
 Cost = Amount seller pays to produce a education and experience
good 4. Entrepreneurship - ambitious leaders that
combine the other factors of production to
 Investment = the money spent by create goods and services.
BUSINESSES to improve their production  Ex: Henry Ford, Bill Gates, Inventors,
 Ex: $1 million investment in new Store Owners, etc.
factories or capital equipment  Entrepreneurs take the initiative,
 In economics, Investment ALWAYS innovate, and are “risk-takers” in order
refers to businesses purchasing CAPITL to make a PROFIT
GOODS Profit = Revenue – Costs

Goods v. Services
Economic Systems
Goods - physical objects that satisfy needs and
wants Every society must answer the 3 basic economic
 Consumer Goods - created for direct questions?
consumption and individual’s utility
 Ex: pizza, tennis shoes, car, etc. 1) What goods and services should be
 Capital Goods - created for indirect produced?
consumption (ex: oven, knives, bulldozer) 2) How should these goods and services be
 Goods used to make consumer goods; produced?
without capital goods there will be no 3) Who consumes these goods and services?
consumer goods The way these questions are answered
Services - actions or activities that one person determines the economic system
performs for another (teaching, cleaning, Economic system is the method used by a
cooking) society to produce and distribute/allocate goods
and services.
Factors of Production/Productive Resources
ALL resources can be classified as one of the 1. Centrally Planned (Command) Economy-
following four factors of production: the government (Communism)…
 owns all the resources
1. Land -All natural resources that are used  answers the 3 economic questions
to produce goods and services. (Ex: water,
sun, plants, animals) Ex: Cuba, China, North Korea, former USSR
2. Labor -Any effort a person devotes to a task Why do centrally planned economies face
for which that person is paid; workforce problems of poor-quality goods, shortages, and
(Ex: manual laborers, doctors, teachers, unhappy citizens?
waiters, etc.)  Little incentive to work harder and
central planners have a hard time
predicting preferences
Advantages of Communism: individuals seek their own self-interest.
 Low unemployment-everyone has a job Competition and self-interest act as an invisible
 Great Job Security-the government hand that regulates the free market.
doesn’t go out of business
 Equal incomes means no extremely poor 3. Mixed Economies - A system with free
people markets but also some government
 Free Health Care intervention.
 Almost all countries, including the US, have
Disadvantages of Communism: mixed economies
 No incentive to work harder
 No incentive to innovate or come up
with good ideas Productivity creates WEALTH!
Countries with free markets, property rights, and
 No Competition keeps quality of goods
The Rule of Law, have historically seen greater
poor.
economic growth because they are more
 Corrupt leaders productive
 Few individual freedoms
 The End Result: There is a shortage
of goods that consumers want, 7 Economic & Social Goals
produced at the highest prices and the
lowest quality 1. Economic Freedom – freedom to buy or
sell what we want, make choices with little
2. Free Market System (aka: Capitalism) interference by the government
 Little government involvement in the 2. Economic Efficiency/Innovation – making
economy. (Laissez Faire = Let it be) the most of scarce resources, using your
 Individuals OWN resources and answer resources wisely and productively by
improving upon existing technology
the three economic questions.
3. Economic Growth – improving the
 The opportunity to make PROFIT gives
economy from year to year, improving
people INCENTIVE to produce quality people’s standard of living
items efficiently. 4. Full Employment – highest amount of the
 Wide variety of goods available to labor force that could be employed within an
consumers. economy at any given time (95%
 Competition and Self-Interest work employment rate or better)
together to regulate the economy (keep 5. Economic Security – government will
prices down and quality up). provide a safety net in times of economic
downturns
 The End Result: Most efficient 6. Price Stability – knowing that goods &
production of the goods that services will consistently be available at
consumers want, produced at the stable prices (Beware Inflation!!!)
7. Economic Equity – Fair pay for equal
lowest prices and the highest quality.
work; being paid according to your skill
level & not discriminating based on
race/ethnicity, gender, age, religion, etc.

Adam Smith’s Invisible Hand Theory: Production Possibilities Curve (Frontier)

The concept that society’s goals will be met as
A production possibilities curve (PPC) is a another, increasingly more resources are needed
model that shows alternative ways that an to increase the production of the second product,
economy can use its scarce resources which causes opportunity cost to rise
 This model graphically demonstrates  PPC has a concave (bowed-out) curve
scarcity, trade-offs, opportunity costs, and
Basketballs
efficiency 8
4 Assumptions of the PPC 6
1. Only two goods can be produced
2. Full employment of resources 4
3. Fixed Resources (Ceteris Paribus – all other
2
things being equal)
4. Fixed Technology 0
1 2 3 4 5 6
Whoopie Cushions

Constant Opportunity Cost - Resources are

easily adaptable for producing either good.
Result is a straight line PPC (not common)
 PPC has a straight line

Corn
4
3 --
2 -----
PPC shows that nothing is free & everything
has an opportunity cost, if society wants more 1 --------
of one thing it must give up something in return
 Efficiency – condition in which economic 1 2 3 Wheat
resources are being used to produce the
maximum amount of goods & services (on
the curve – Full Employment)
 Underutilization – condition in which
economic resources aren’t being used to
their full potential (inefficient; inside the
curve - Recession)
 Unattainable – production cannot be
attainable for an extended period of time
with current resources and technology
(outside the curve/frontier)

 Points A, B, C are all efficient, operating at

Full Employment (on the curve)
 Point D is inefficient, showing the economy
is in a Recession (inside line)
 Point E is unattainable for long periods of
time (outside the line) and represents an
economy experiencing an Inflationary Gap
2 Types of Efficiency
Law of increasing opportunity costs states that Productive Efficiency - products are being
as production switches from one product to produced in the least costly way.
  Any point ON the Production A
Possibilities Curve
Allocative Efficiency - products being produced
B
are the ones most desired by society.
 This optimal point on the PPC
depends on the desires of society.
Pizzas
3 Changes can Cause the PPC to Shift Right
PPC can shift outward to the right showing Point A would be more beneficial for this
long term economic growth: society to experience economic growth in the
1. Increase productive resources (quantity or long-run and extend the PPC to Point X because
quality) its producing more machines (capital goods) and
 F.O.P: land, labor, capital (physical & less pizzas (consumer goods).
human capital), entrepreneurship
2. New technology = efficiency & productivity Because each nation has certain productive
3. International Trade* (based on resources & cannot produce everything it wants,
Comparative Advantage) individuals, businesses, & nations must decide
what goods & services to focus on
Guns  Specialization – a situation that occurs
when individuals or businesses produce a
narrow range of products to maximize
resources, increase productivity, & make a
profit
A B Economic Growth  Economic interdependence – a situation in
which producers in one nation depend on
others to provide goods & services they
don’t produce (opposite of isolationism)

Butter Absolute v. Comparative Advantage

Countries that produce more capital goods Absolute Advantage - the producer that can
will have more growth in the future because produce the most output OR requires the
capital goods produce other goods while least amount of inputs (resources)
consumer goods are made to increase  Ex: Papa John has an absolute advantage in
individual’s utility (satisfaction) pizzas because he can produce 100 and
Ronald can only make 20.

Comparative Advantage - The producer with

the lowest opportunity cost
 Ex: Ronald has a comparative advantage in
burgers because he has a lowest PER UNIT
opportunity cost.

Countries should trade if they have a relatively

lower opportunity cost
 They should specialize in the good that is
“cheaper” for them to produce
 Law of comparative advantage – a nation
or person is better off when it produces
Machines goods and services for which it has a
X comparative advantage
Absolute/Comparative Advantage Rules  Company A: 1 PO = 4/3 PB
 Input vs. Output Problems  Company B: 1 PO = 3 PB
 Output problems state that you get a certain
amount of a product out of a given number Company A has lowest Opportunity Cost and
of inputs (resources) should only produce peanut oil with the peanuts
 Ex: miles per gallon of gas, pieces of
gum per dollar
Apples to make one (Input)
Pie Juice
 Input problems state that it takes a certain
amount of inputs (resources) to get a given Glenda 5 3
output (product) David 6 3
 Ex: hours to paint the house, apples to
make a pie Glenda has an AA in Pies, and neither have an
AA in Juice (same # of inputs)

Absolute Advantage Glenda has CA in Pies (5/3 = 1 2/3 is less than

 For Output problems, you look to see who 6/3 = 2), and David has CA in Juice (3/6 = ½ is
(nation, business, individual) can produce less than 3/5)
the most outputs with the same resources
 For Input problems, you look at who uses  Glenda: 1 Pie = 1 2/3 Juice
the least amount of inputs to get the output
 David: 1 Pie = 2 Juice
Comparative Advantage Glenda has the lowest opportunity cost and
 For Output problems, it’s Other Over should only produce Pies with her apples
 Hint: Output = OOO (Triple O’s!)
 For Input problems, it’s Other Under  Glenda: 1 Juice = 3/5 Pie
 You look for the smallest number, which  David: 1 Juice = ½ Pie
signifies the least Opportunity Cost
 There can never be a Comparative David has the lowest opportunity cost and
Advantage in both products should only produce Juice with his apples

Product from 1 ton of peanuts (Output) Both countries can benefit from trade if they
each have relatively lower opportunity costs.
Peanut Butter Peanut Oil Terms of Trade - The agreed upon conditions
that would benefit both countries
Company A 40 30
 Ex: Trade 1 ton of wheat for 1.5 tons of
Company B 60 20 sugar

Company A has the Absolute Advantage (AA)

in producing Peanut Oil, and Company B has
the AA in Peanut Butter
Company B has the Comparative Advantage
(CA) in Peanut Butter (20/60 = 1/3 is less than
30/40 = 3/4) and Company A has the CA in
Peanut Oil (40/30 = 4/3 is less than 60/20 = 3)
 Company A: 1 PB =3/4 PO
 Company B: 1 PB = 1/3 PO
Company B has lowest Opportunity Cost and Circular Flow Model
should only produce peanut butter with the
peanuts Microeconomics can be summarized by the
relationship & interaction between households,
businesses, and government in the
Factor/Resource Market and the Product Market
Product Market - “place” where goods and
services produced by businesses are sold to
households

Resource (Factor) Market - “place” where

resources (land, labor, capital, and Government
entrepreneurship) are sold to businesses by
individuals/households

 Household – Person/group of people living

in a residence (not always a family)
 Consumers use the final goods &
services (outputs) to satisfy wants &
needs (utility)
 Consumers do the demanding in a
market economy
 Firm – business organization that uses
resources to produce goods/services, which
it then sells
Circular Flow Key Vocabulary  Suppliers transform “inputs” (F.O.P.)
into “outputs” (products)
Private Sector- Part of the economy that is run  Producers do the supplying in a
by individuals and businesses market economy
 Factor/Resource Market – markets where
Public Sector- Part of the economy that is resources (F.O.P) are bought & sold
controlled by the government  Households are sellers of inputs
(F.O.P.) & Firms are the buyers
Factor Payments- Payment for the factors of  Labor - Firms hire workers & pay
production, namely rent, wages, interest, and them salaries called wages
profit (how households earn an income)  Land - Earn income from rent
 Capital - Earn interest
Transfer Payments- When the government  Entrepreneurship – earn profits
redistributes income (ex: welfare, social  Product Markets – Households & firms
security) interact; producers sell their goods &
services to consumers
Subsidies- Government payments to businesses  Households are buyers & Firms are
to produce sellers of outputs

Money serves as the MEDIUM of

EXCHANGE in a Market Economy & these
transactions take place between producers and
consumers through non-fraudulent voluntary
exchange to seek mutual benefits.