1. © 2009 South-Western, a part of Cengage Learning, all rights reserved C H A P T E R Course Review in Brief M acroeonomics B R I E F P R I N C I P L E S O F 1-15

2. TEN PRINCIPLES OF ECONOMICS 1 What Economics Is All About  Scarcity: the limited nature of society’s resources  Economics: the study of how society manages its scarce resources, e.g.  how people decide what to buy, how much to work, save, and spend  how firms decide how much to produce, how many workers to hire  how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs

3. TEN PRINCIPLES OF ECONOMICS 22 Micro vs. Macro  Microeconomics: The study of how individual households and firms make decisions, interact with one another in markets.  Macroeconomics: The study of the economy as a whole.  We begin our study of macroeconomics with the country’s total income and expenditure.

4. TEN PRINCIPLES OF ECONOMICS 3 HOW PEOPLE MAKE DECISIONS All decisions involve tradeoffs. Examples:  Going to a party the night before your midterm leaves less time for studying.  Having more money to buy stuff requires working longer hours, which leaves less time for leisure.  Protecting the environment requires resources that could otherwise be used to produce consumer goods. Principle #1: People Face Tradeoffs

5. TEN PRINCIPLES OF ECONOMICS 4 HOW PEOPLE MAKE DECISIONS  Society faces an important tradeoff: efficiency vs. equality  Efficiency: when society gets the most from its scarce resources  Equality: when prosperity is distributed uniformly among society’s members  Tradeoff: To achieve greater equality, could redistribute income from wealthy to poor. But this reduces incentive to work and produce, shrinks the size of the economic “pie.” Principle #1: People Face Tradeoffs

6. TEN PRINCIPLES OF ECONOMICS 5 HOW PEOPLE MAKE DECISIONS  Making decisions requires comparing the costs and benefits of alternative choices.  The opportunity cost of any item is whatever must be given up to obtain it.  It is the relevant cost for decision making. Principle #2: The Cost of Something Is What You Give Up to Get It

7. TEN PRINCIPLES OF ECONOMICS 6 HOW PEOPLE MAKE DECISIONS Examples: The opportunity cost of… …going to college for a year is not just the tuition, books, and fees, but also the foregone wages. …seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater. Principle #2: The Cost of Something Is What You Give Up to Get It

8. TEN PRINCIPLES OF ECONOMICS 7 HOW PEOPLE MAKE DECISIONS Rational people  systematically and purposefully do the best they can to achieve their objectives.  make decisions by evaluating costs and benefits of marginal changes – incremental adjustments to an existing plan. Principle #3: Rational People Think at the Margin

9. TEN PRINCIPLES OF ECONOMICS 8 HOW PEOPLE MAKE DECISIONS Examples:  When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education.  When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue. Principle #3: Rational People Think at the Margin

10. TEN PRINCIPLES OF ECONOMICS 9 HOW PEOPLE MAKE DECISIONS  Incentive: something that induces a person to act, i.e. the prospect of a reward or punishment.  Rational people respond to incentives. Examples:  When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs.  When cigarette taxes increase, teen smoking falls. Principle #4: People Respond to Incentives

11. TEN PRINCIPLES OF ECONOMICS 10 Demand  The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.  Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal

12. TEN PRINCIPLES OF ECONOMICS 11 A C T I V E L E A R N I N G 1 Demand Curve A. The price of iPods falls B. The price of music downloads falls C. The price of CDs falls 11 Draw a demand curve for music downloads. What happens to it in each of the following scenarios? Why?

13. TEN PRINCIPLES OF ECONOMICS 12 A C T I V E L E A R N I N G 1 A. Price of iPods falls 12 Q2Q2 Price of music down- loads Quantity of music downloads D1D1 D2D2 P1P1 Q1Q1 Music downloads and iPods are complements. A fall in price of iPods shifts the demand curve for music downloads to the right. Music downloads and iPods are complements. A fall in price of iPods shifts the demand curve for music downloads to the right.

14. TEN PRINCIPLES OF ECONOMICS 13 A C T I V E L E A R N I N G 1 B. Price of music downloads falls 13 The D curve does not shift. Move down along curve to a point with lower P, higher Q. The D curve does not shift. Move down along curve to a point with lower P, higher Q. Price of music down- loads Quantity of music downloads D1D1 P1P1 Q1Q1 Q2Q2 P2P2

15. TEN PRINCIPLES OF ECONOMICS 14 A C T I V E L E A R N I N G 1 C. Price of CDs falls 14 P1P1 Q1Q1 CDs and music downloads are substitutes. A fall in price of CDs shifts demand for music downloads to the left. CDs and music downloads are substitutes. A fall in price of CDs shifts demand for music downloads to the left. Price of music down- loads Quantity of music downloads D1D1 D2D2 Q2Q2

16. TEN PRINCIPLES OF ECONOMICS 15 Supply  The quantity supplied of any good is the amount that sellers are willing and able to sell.  Law of supply: the claim that the quantity supplied of a good rises when the price of the good rises, other things equal

17. TEN PRINCIPLES OF ECONOMICS 16 A C T I V E L E A R N I N G 2 Supply Curve 16 Draw a supply curve for tax return preparation software. What happens to it in each of the following scenarios? A. Retailers cut the price of the software. B. A technological advance allows the software to be produced at lower cost.

18. TEN PRINCIPLES OF ECONOMICS 17 A C T I V E L E A R N I N G 2 A. Fall in price of tax return software 17 S curve does not shift. Move down along the curve to a lower P and lower Q. S curve does not shift. Move down along the curve to a lower P and lower Q. Price of tax return software Quantity of tax return software S1S1 P1P1 Q1Q1 Q2Q2 P2P2

19. TEN PRINCIPLES OF ECONOMICS 18 A C T I V E L E A R N I N G 2 B. Fall in cost of producing the software 18 S curve shifts to the right: at each price, Q increases. S curve shifts to the right: at each price, Q increases. Price of tax return software Quantity of tax return software S1S1 P1P1 Q1Q1 S2S2 Q2Q2

20. TEN PRINCIPLES OF ECONOMICS 19 P Q Supply and Demand Together D S Equilibrium: P has reached the level where quantity supplied equals quantity demanded

21. TEN PRINCIPLES OF ECONOMICS 20 HOW PEOPLE INTERACT  Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods.  Countries also benefit from trade & specialization:  Get a better price abroad for goods they produce  Buy other goods more cheaply from abroad than could be produced at home Principle #5: Trade Can Make Everyone Better Off

22. TEN PRINCIPLES OF ECONOMICS 21 Interdependence Every day you rely on many people from around the world, most of whom you’ve never met, to provide you with the goods and services you enjoy. coffee from Kenya dress shirt from China cell phone from Taiwan hair gel from Cleveland, OH

23. TEN PRINCIPLES OF ECONOMICS 22 Basic international trade terms  Exports: goods produced domestically and sold abroad To export means to sell domestically produced goods abroad.  Imports: goods produced abroad and sold domestically To import means to purchase goods produced in other countries.

24. TEN PRINCIPLES OF ECONOMICS 23 Where Do These Gains Come From?  Absolute advantage: the ability to produce a good using fewer inputs than another producer  The U.S. has an absolute advantage in wheat: producing a ton of wheat uses 10 labor hours in the U.S. vs. 25 in Japan.  If each country has an absolute advantage in one good and specializes in that good, then both countries can gain from trade.

25. TEN PRINCIPLES OF ECONOMICS 24 Opportunity Cost and Comparative Advantage  Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer  Which country has the comparative advantage in computers?  To answer this, must determine the opp. cost of a computer in each country.

26. TEN PRINCIPLES OF ECONOMICS 25 Comparative Advantage and Trade  Gains from trade arise from comparative advantage (differences in opportunity costs).  When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the world’s “economic pie” is bigger, and all countries can gain from trade.  The same applies to individual producers (like the farmer and the rancher) specializing in different goods and trading with each other.

27. TEN PRINCIPLES OF ECONOMICS 26 HOW PEOPLE INTERACT  Market: a group of buyers and sellers (need not be in a single location)  “Organize economic activity” means determining  what goods to produce  how to produce them  how much of each to produce  who gets them Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

28. TEN PRINCIPLES OF ECONOMICS 27 FIGURE 1: The Circular-Flow Diagram Markets for Factors of Production Households Firms Income Wages, rent, profit Factors of production Labor, land, capital Spending G & S bought G & S sold Revenue Markets for Goods & Services

29. TEN PRINCIPLES OF ECONOMICS 28 Markets and Competition  A market is a group of buyers and sellers of a particular product.  A competitive market is one with many buyers and sellers, each has a negligible effect on price.  In a perfectly competitive market:  All goods exactly the same  Buyers & sellers so numerous that no one can affect market price – each is a “price taker”  In this chapter, we assume markets are perfectly competitive.

30. TEN PRINCIPLES OF ECONOMICS 29 HOW PEOPLE INTERACT  A market economy allocates resources through the decentralized decisions of many households and firms as they interact in markets.  Famous insight by Adam Smith in The Wealth of Nations (1776): Each of these households and firms acts as if “led by an invisible hand” to promote general economic well-being. Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

31. TEN PRINCIPLES OF ECONOMICS 30 HOW PEOPLE INTERACT  The invisible hand works through the price system:  The interaction of buyers and sellers determines prices.  Each price reflects the good’s value to buyers and the cost of producing the good.  Prices guide self-interested households and firms to make decisions that, in many cases, maximize society’s economic well-being. Principle #6: Markets Are Usually A Good Way to Organize Economic Activity

32. TEN PRINCIPLES OF ECONOMICS 31 HOW PEOPLE INTERACT  Important role for govt: enforce property rights (with police, courts)  People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen. Principle #7: Governments Can Sometimes Improve Market Outcomes

33. TEN PRINCIPLES OF ECONOMICS 32 HOW PEOPLE INTERACT  Market failure: when the market fails to allocate society’s resources efficiently  Causes:  Externalities, when the production or consumption of a good affects bystanders (e.g. pollution)  Market power, a single buyer or seller has substantial influence on market price (e.g. monopoly)  In such cases, public policy may promote efficiency. Principle #7: Governments Can Sometimes Improve Market Outcomes

34. TEN PRINCIPLES OF ECONOMICS 33 HOW PEOPLE INTERACT  Govt may alter market outcome to promote equity  If the market’s distribution of economic well-being is not desirable, tax or welfare policies can change how the economic “pie” is divided. Principle #7: Governments Can Sometimes Improve Market Outcomes

35. TEN PRINCIPLES OF ECONOMICS 34 HOW THE ECONOMY AS A WHOLE WORKS  Huge variation in living standards across countries and over time:  Average income in rich countries is more than ten times average income in poor countries.  The U.S. standard of living today is about eight times larger than 100 years ago. Principle #8: A country’s standard of living depends on its ability to produce goods & services.

36. TEN PRINCIPLES OF ECONOMICS 35 HOW THE ECONOMY AS A WHOLE WORKS  The most important determinant of living standards: productivity, the amount of goods and services produced per unit of labor.  Productivity depends on the equipment, skills, and technology available to workers.  Other factors (e.g., labor unions, competition from abroad) have far less impact on living standards. Principle #8: A country’s standard of living depends on its ability to produce goods & services.

37. TEN PRINCIPLES OF ECONOMICS 36 MEASURING A NATION’S INCOME 36 The Components of GDP  Recall: GDP is total spending.  Four components:  Consumption ( C )  Investment ( I )  Government Purchases ( G )  Net Exports ( NX )  These components add up to GDP (denoted Y ): Y = C + I + G + NX

38. TEN PRINCIPLES OF ECONOMICS 37 HOW THE ECONOMY AS A WHOLE WORKS  Inflation: increases in the general level of prices.  In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall.  The faster the govt creates money, the greater the inflation rate. Principle #9: Prices rise when the government prints too much money.

39. TEN PRINCIPLES OF ECONOMICS 38 MEASURING THE COST OF LIVING 38 The Consumer Price Index (CPI)  measures the typical consumer’s cost of living  the basis of cost of living adjustments (COLAs) in many contracts and in Social Security

40. TEN PRINCIPLES OF ECONOMICS 39 MEASURING THE COST OF LIVING 39 How the CPI Is Calculated 1.Fix the “basket.” The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket.” 2.Find the prices. The BLS collects data on the prices of all the goods in the basket. 3.Compute the basket’s cost. Use the prices to compute the total cost of the basket.

41. TEN PRINCIPLES OF ECONOMICS 40 Annual tuition and fees, average of all public four- year colleges & universities in the U.S.  1986-87: $1,414 (1986 CPI = 109.6)  2006-07: $5,834 (2006 CPI = 203.8) After adjusting for inflation, did students pay more for college in 1986 or in 2006? Convert the 1986 figure to 2006 dollars and compare. A C T I V E L E A R N I N G 4 Converting to “today’s dollars” 40

42. TEN PRINCIPLES OF ECONOMICS 41 A C T I V E L E A R N I N G 4 Answers 41 Solution Convert 1986 figure into “today’s dollars” $1,414 x (203.8/109.6) = $2,629 Even after correcting for inflation, tuition and fees were much lower in 1986 than in 2006! Annual tuition and fees, average of all public four- year colleges & universities in the U.S.  1986-87: $1,414 (1986 CPI = 109.6)  2006-07: $5,834 (2006 CPI = 203.8)

43. TEN PRINCIPLES OF ECONOMICS 42 HOW THE ECONOMY AS A WHOLE WORKS  In the short-run (1 – 2 years), many economic policies push inflation and unemployment in opposite directions.  Other factors can make this tradeoff more or less favorable, but the tradeoff is always present. Principle #10: Society faces a short-run tradeoff between inflation and unemployment