Economics STATE Practice!
Go for the GOLD!!!
Basic Economic Assumptions
A. Because of Scarcity, People Choose: Economists emphasize that we live in a world of scarcity. By this, they mean that there are never enough productive resources to provide all the goods and services that people want. The result is that people must constantly choose among competing alternatives. (This concept is the basis for the oft-repeated phrase, “There's no such thing as a free lunch!” The idea is that no scarce good or service is ever really free — someone has to give up something to get it.)
B. All Choices Have an Opportunity Cost: Every time an investor, saver, consumer, or producer makes a decision, there is an alternative course of action that could be taken. Economists refer to the best-forgone alternative as the opportunity cost of a decision. It is very important that students recognize the importance of considering the opportunity cost when making a decision.
- People decide whether to spend or save their after-tax income. A person who chooses to save $100 gives up goods and services now as the opportunity cost of the decision to save.
- The opportunity cost of choosing to put money into a bank savings account instead of purchasing a long-term government bond is accepting less interest income.
D. Market Forces and Economic Systems Influence Choices: People make financial decisions in the context of an economic system. The type of economic system (market, command, traditional, or some combination) will have a significant impact on the decisions people make. For example, in a market system, changing prices help guide decisions, such as where people invest their savings or what type of insurance they purchase.
- The different wages and salaries of certain occupations (e.g. doctor, teacher, store clerk), which are influenced to a significant degree by supply and demand in the market for human resources, will have an effect on whether or not a person decides to enter a certain field.
- In a strict command economy, where most property is owned and controlled by the government (e.g. North Korea), most people do not have the choice to invest in a stock market.
- A person’s choice to become a doctor will have intended consequences – many years of advanced school and training, hard work, but probably a higher income.
- A government may try to help consumers by putting a cap on gasoline prices; however, this will probably lead to the unintended consequences of long lines at the pump, black markets, and lots of irritation.
- When a person agrees to work for a company, the company benefits from the work the person provides and the person then benefits from the wage or salary received.
- When a person purchases a shirt, both the shirt producer and the person making the purchase benefit from this exchange.
A. Production Possibilities Curve
The production possibilities curve represents the combinations of maximum output
that can be reached in the economy. It is a frontier because it shows the limit of
output. Anything under the curve is attainable, but involves inefficient use of
resources. Anything outside the curve is unattainable with current resources.
Usually, the curve is some type of consumer goods versus some type of capital goods.
Each point on the curve represents a maximum output of the two goods. Different
points on the curve mean different production combinations of the two goods.
The curve bows outwards because of the Law of Increasing Opportunity Cost, which
states that the amount of a good which has to be sacrificed for each additional unit of
another good is more than was sacrificed for the previous unit. The rationale for this
law is that some economic resources are not completely adaptable to alternative uses,
so the resources will yield less of one product.
Shifts in this curve can be caused by increases in resource supplies or advances in
technology. Also, if an economy favors “future goods” (technology, etc), the curve will
shift faster because of more economic growth.
A. A change in Price is a Change in Quantity and is a movement along the curve
B. Determinants that shift the curve
C - change in consumer population
H - has preferences
e- expectation in future price
A - allowance income
P - price of related goods
G- government regulations
e- expectation of future price
S- change in the number of suppliers
P - Productivity
A - advancement in technology
i - input costs
D - demand for related goods
Elasticity is a measure of a variable's sensitivity to a change in another variable.
In business and economics, elasticity refers the degree to which individuals, consumers or producers change their demand or the amount supplied in response to price or income changes. It is predominantly used to assess the change in consumer demand as a result of a change in a good or service's price.
A. Consumer surplus is an economic measure of consumer benefit, which is calculated by analyzing the difference between what consumers are willing and able to pay for a good or service relative to its market price, or what they actually do spend on the good or service. A consumer surplus occurs when the consumer is willing to pay more for a given product than the current market price.
B. Consumer surplus is measured as the area below the downward-sloping demand curve, or the amount a consumer is willing to spend for given quantities of a good, and above the actual market price of the good, depicted with a horizontal line drawn between the y-axis and demand curve. Consumer surplus can be calculated on either an individual or aggregate basis, depending on if the demand curve is individual or aggregated. Consumer surplus always increases as the price of a good falls and decreases as the price of a good rises.
A. Producer surplus is an economic measure of the difference between the amount a producer of a good receives and the minimum amount the producer is willing to accept for the good. The difference, or surplus amount, is the benefit the producer receives for selling the good in the market. Producer surplus is generated by market prices in excess of the lowest price producers would otherwise be willing to accept for their goods.
B. Producer surplus is shown graphically below as the area above the producer's supply curve that it receives at the price point (P(i)), forming a triangular area on the graph. The size of the producer surplus and its triangular depiction on the graph increases as the market price for the good increases, and decreases as the market price for the good decreases.
Producer surplus combined with consumer surplus equals overall economic surplus or the benefit provided by producers and consumers interacting in a free market as opposed to one with price controls or quotas. If a producer had the ability to price discriminate perfectly, or rather charge every consumer the maximum price the consumer is willing to pay, then the producer could capture the entire economic surplus. In other words, producer surplus would equal overall economic surplus.
Taxes and Dead weight Loss
A. The deadweight loss of taxation refers to the harm caused to economic efficiency and production by a tax. In other words, the deadweight loss of taxation is a measurement of how far taxes reduce the standard of living among the taxed population.B. The deadweight loss of taxation is normally represented graphically. After a tax is imposed, it forces the supply curve of some good or service (or in aggregate cases consumer spending) left along the demand curve. The vertical change between the two levels of output, measuring additional net receipts to the government, is smaller than the loss in productive output except in cases where the supply curve is perfectly vertical. The difference between the new taxes and the total reduction in output is the deadweight loss.
Imagine the U.S. federal government imposes a 40% income tax on all citizens. Through this exercise, the government collects an additional $1.2 trillion in taxes. However, those funds are no longer available to be spent in private markets. Suppose consumer spending and investments decline at least $1.2 trillion, and total output declines $2 trillion. In this case, the deadweight loss is $800 billion.
Ceiling and Floors
Specialization is when a nation or individual concentrates its productive efforts on producing a limited variety of goods. It oftentimes has to forgo producing other goods and relies on obtaining those other goods through trade
David Ricardo addresses specialization on a global, macroeconomics level to explain why countries specialize and enter into trade. Ricardo's justification is based on the concept of opportunity cost. Opportunity cost is the cost of the next best alternative, or what you are giving up to do what you are currently doing. Ricardo explains why opportunity cost is an incentive for rational people and nations to specialize and enter into trade. This concept can be illustrated with a simple example.
Consider the situation where you and I are stranded in the wilderness. I can either pick 100 berries or catch 5 fish. You can either pick 50 berries or catch 10 fish. For me to catch 5 fish, it will cost me 100 berries. Therefore, the opportunity cost of each fish is 20 berries. For me to pick 100 berries, I have to forgo 5 fish. The opportunity cost of each berry is 1/20 fish.
Following the same logic, your opportunity cost of each fish is 5 berries and of each berry is 1/5 fish. I have a lower opportunity cost for berries, 1/20 fish compared to your 1/5 fish, therefore I have a comparative advantage in picking berries.
Someone is said to have a comparative advantage in producing a good when he or she has the lowest opportunity cost to produce that good. You have a comparative advantage in catching fish. This is not to be confused with absolute advantage. Absolute advantage means you can produce a good with fewer resources than another person or nation. When you specialize in what you have a comparative advantage in producing, you will be maximizing net benefits by minimizing opportunity cost.
Pork Barrel Politics
Pork-barrel politics describes a process that legislators use to obtain funding from a central government to finance projects benefiting the legislators' local constituents. The benefits of such projects typically do not extend beyond a legislator's constituency, despite the fact that funding was obtained through taxation of the larger geographic region. This form of political patronage helps attract campaign contributions and the support of local voters.
According to Adam Smith, individuals and businesses can earn income from three sources: profit, wages and rent. Generating profit usually requires risking capital in hopes of a return, while earning wages tends to be labor-intensive and requires hard work. Rent is the easiest and least risky type of income one can earn, as it requires only the ownership of resources and the ability to use those resources to generate income through lending their use to others. Because rent income necessitates less risk or work than other types of income, it follows logically that individuals and companies seek to earn this income whenever possible. Rent-seeking becomes a problem when entities engage in it to increase their share of the economic pie without increasing the size of the pie.
The Coase Theorem
The Coase theorem states that where there is a conflict of property rights, the involved parties can bargain or negotiate terms that are more beneficial to both parties than the outcome of any assigned property rights. The theorem also asserts that in order for this to occur, bargaining must be costless; if there are costs associated with bargaining, such as those relating to meetings or enforcement, it affects the outcome. The Coase theorem shows that where property rights are concerned, involved parties do not necessarily consider how the property rights are granted if they can trade to produce a mutually advantageous outcome.
GDP (Gross Domestic Product): The total dollar (market) value of all final goods and services produced in a given year.
Expenditures approach: GDP = C + Ig + G + Xn
C = personal consumption expenditures (durable consumer goods, nondurable
consumer goods, consumer expenditures for services)
Ig = gross private domestic investment (all final purchases of capital by businesses, all
construction, changes in inventories)
G = government purchases (government spending on products and resources)
Xn = net exports (exports – imports)
Some types of transactions do not involve purchasing of a final good or service, so they
should not be counted in GDP. These include public transfer payments (social
security, welfare, etc), private transfer payments (monetary gifts, etc), security
transactions (stocks and bonds), and secondhand sales (they don’t reflect current production)
What is Counted :
•Goods Produced but not Sold (I)
•Goods produced by a foreign country (Japan) in the U.S. (Honda, Toyota)
•Government spending on the military
•Increase in business inventories
What is not Counted:
•Intermediate Goods (Tires sold by Firestone to Ford)
•Non-Market Activities (Illegal, Underground)
•Transfer Payments (Social Security)
Real and Nominal GDP
•Nominal GDP: GDP measured in terms of current Price Level at the time of measurement. (Unadjusted for inflation)
•Real GDP: GDP adjusted for inflation; GDP in a year divided by a GDP deflator (Price Index) for that year
Real GDP= Nominal GDP adjusted for inflation.
Real GDP = Nominal GDP
Price Index in Hundredths( deflator)
U.S. 2005 Real GDP= $12,4558 (billions)
1.1274 (based on 2000)
Consumer Price Index
Inflation is a rise in the general level of prices
•Reduces the purchasing power of money
•Measured with the Consumer Price Index (CPI)
•Reports the price of a market basket , more than 300 goods that are typically purchased by an urban household
Calculations for CPI and Inflation
This is a measure of inflation. It is calculated by the formula
CPI = price in specific year/price in base year * 100
CPI in Recent Year – CPI in Past Year
Divided by CPI in Past Year
(Number then Multiplied by 100)
Example: 2002 CPI = 179.9
2001 CPI = 177.1
Rate of Inflation: 179.9-177.1 = 1.58%
Types of Inflation
•Demand Pull Inflation: ‘too much money chasing too few goods.”
•AD Curve will shift to the right, resulting in a higher Price Level and greater Output (until reaching Y*
•Cost-Push Inflation: Major cause is a supply shock-OPEC cutting back on oil production
•AS Curve will shift to the left resulting in a higher Price Level and a decrease in Real GDP.
You are considered to be employed if:
•You work for 1 hour as a paid employee (so part-time workers count)
•You are temporarily absent from work (illness, strike, vacation)
•You work 15 hours or more as an unpaid worker (family farms are common)
•Must be looking for work (at least 1 attempt in the past 4 weeks)
•Are reporting to a job within 30 days
•Are temporarily laid off from their job
Not In Labor Force
A person who is not looking for work:
•Stay at home parents
•Discouraged workers: those who have given up hope of finding a job.
Types of Unemployment
•Frictional - temporary and unavoidable
•Structural - results from changes in technology or a business restructure (ex. Merger)
•Seasonal- occurs when industries slow or shut down for a season
•Cyclical - results from a decline in the business cycle.