AP Macroeconomics

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AP Macroeconomics

• Key Assumptions in Economics, Scarcity,
  Opportunity Cost and the Production
  Possibilities Curve

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Key Assumptions in Economics

• People are rationally self-interested
• They seek to maximize their utility (happy
  points)
• People generally make decisions at the margin
• They weigh the marginal benefit against the
  marginal cost of a decision
• Ceteris Paribus
• Economists hold factors constant, except for
  whats being considered

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Marginal Analysis

• Most decisions are made based upon a change in
  the status quo.
• Example You have one cup of coffee (the status
  quo) and are deciding whether to have another.

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Marginal Analysis

• You have studied five hours for an economics exam
  (the status quo) and need to decide if it is in
  your best interest to study another hour.

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Marginal Analysis

• These decisions are said to be made at the
  margin. The next cup of coffee brings with it
  additional (or marginal) benefits to the
  consumer, but comes at additional (marginal)
  costs.
• The rational consumer weighs the additional
  benefits against the additional costs.

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Marginal Analysis

• Marginal Cost (MC) The additional cost incurred
  from the consumption of the next unit of a good
  or service.
• Marginal Benefit (MB) The additional benefit
  received from the consumption of the next unit of
  a good or service.

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Example
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Marginal Analysis Rules

• Do something if the marginal benefits are greater
  than the marginal costs of doing it.
• Stop doing something when the marginal benefits
  equal marginal costs of doing it
• Never do anything when the marginal benefits are
  less than marginal costs.

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Basic Economic Vocabulary

• Economics
• The study of choices people make to satisfy their
  needs and wants
• Microeconomics
• The study of how individuals and firms deal with
  scarcity
• Macroeconomics
• The study of how society as a whole deals with
  scarcity

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Basic Economic Vocabulary

• Needs
• Necessities for survival
• Wants
• Goods and services consumed beyond what is
  necessary for survival

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Basic Economic Vocabulary

• Goods
• Physical objects that can be purchased
• Services
• Actions or activities performed for a fee
• Consumers
• People who purchase goods and services
• Producers
• People who supply goods and services

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Resources a.k.a. The Factors of Production

• Economists classify resources into 4 categories
• Land
• Natural resources
• The payment for Land is RENT
• Labor
• Human resources
• The payment for Labor is WAGES
• Capital (a product of Investment)
• Tools, machines, factories
• The payment for Capital is INTEREST
• Entrepreneurship
• The special ability of risk-takers to combine
  land,
• labor and capital in new ways in order to
  make profit
• The payment for Entrepreneurship is PROFIT

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The Fundamental Problem of Economics Scarcity

• People have unlimited wants but the resources to
  satisfy those wants are scarce.
• Therefore, we must make choices about how to use
  our scarce resources. We face trade-offs when it
  comes to using available resources.
• Ex. Assume flour is a scarce resource 3 cups of
  flour can be used to make a loaf of bread or a
  cake, but the 3 cups cannot be used to make both.

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The Fundamental Problem of Economics Scarcity
OR
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Trade-offs

• The fact that we are faced with scarce resources
  implies that individuals, firms, and governments
  are constantly faced with trade-offs.

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Trade-Offs

• Individual Rent or buy a home, employment and
  education choices.
• Firms Which goods to produce, restaurant
  staying open late on a Saturday night.

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Opportunity Cost

• The value of what was given up in the following
  examples is called opportunity cost.

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Opportunity Cost

• Once a resource or factor of production has been
  put to productive use an opportunity cost is
  incurred.
• Opportunity cost is the next best alternative use
  for a resource.
• Ex. If the 3 cups of flour are used to bake
  bread, then the opportunity cost is the cake that
  could also have been baked with the 3 cups of
  flour.
• No matter what we do with our time or resources,
  we always incur opportunity cost. TINSTAAFL.

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Opportunity Cost

• Example You have one scarce hour to spend
  between studying for an exam, working at a coffee
  shop for 8 per hour, or mowing your uncles lawn
  for 10 per hour.
• If you choose to study what is the opportunity
  cost?

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Opportunity Cost

• A common mistake is to add up the value of all
  your other options.
• By choosing to study, you really only give up one
  activity, not both.

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Opportunity Cost

• The opportunity cost of using your resource to do
  activity X is the value the resource would have
  in its next best alternative use.
• Therefore, the opportunity cost of studying is
  10, the better of your two alternatives.

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Opportunity Cost

• Do not think just in terms of money.
• Example Community College to Four Year
  University.

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TINSTAAFL
There is no such thing as a free lunch.
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TINSTAAFL
Everything has a cost.
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PPC

• Production Possibilities table lists the
  different combinations of pastries and crusts
  that can be produced with a fixed quantity of
  scarce resources.

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Example

• Pastries Pizza Crust
• 0 10
• 1 8
• 2 6
• 3 4
• 4 2
• 5 0

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Example

• In other words
• The opportunity cost of a pastry is two crusts
• The opportunity cost of a pizza crust is one-half
  of a pastry.

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PPC

• We can graph the example in a production
  possibility curve.
• Each point on the curve represents some maximum
  output combination of the two products.

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PPC

• Some refer to this curve as a production
  possibility frontier because it reflects the
  outer limit of production.
• Any point outside the frontier (e.g. 4,8) is
  currently unattainable, and any point inside the
  frontier (e.g. 1,2) fails to use all the bakerys
  available resources in an efficient way.

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PCC

• The resources used to produce these goods are
  scarce, and thus the production frontier is going
  to act as a binding constraint.

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PCC Example 5.2
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TINSTAAFL Illustrated The PPC

• The PPC The Production Possibilities Curve
• The PPC a graph showing all of the possible
  combinations of output for an economy fully
  employing all of its resources in producing 2
  goods.

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TINSTAAFL Illustrated The PPC
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Law of Increasing Costs

• Tells us the more of a good that is produced, the
  greater its opportunity cost.
• This reality gives us a production possibility
  curve that is concave to the origin, or bowed
  outward.

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Law of Increasing Costs

• Example
• Resources must be reallocated from pizza crust
  production to pastry production.
• Labor, capital, and natural resources must be
  moved from crust production to pastry production.

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Law of Increasing Costs

• Perhaps some of the capital (i.e. pans) are
  better suited to pizza crust than pastry
  production?
• The fact these resources are better suited to the
  production of one good, and less easily adaptable
  to the other good gives us the concept of law of
  increasing costs.

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Law of Increasing Costs

• Example 5.3

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Law of Increasing Costs

• Now as the bakery produces more pastries, the
  opportunity cost (slope) begins to rise.
• Because resources are not perfectly adaptable to
  alternative uses, our production possibility
  curve is unlikely to be linear.

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Comparative Advantage

• Dentist Example

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Comparative Advantage

• The law of increasing costs tells us that it
  becomes more costly to produce goods as you
  produce more of it.
• This reality prompts us to find other, less
  expensive ways to get our hands of additional
  units.

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Comparative Advantage

• The concepts of specialization and comparative
  advantage describe the way individuals, nations,
  and societies can acquire more goods at lower
  costs.

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Table 5.2
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Table 5.2

• Because the bakery can produce more pastries than
  the pizza parlor, the bakery has absolute
  advantage in pastry production.
• Simply being able to produce more of a good does
  not mean the firm produces that good at a lower
  opportunity cost.

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Table 5.2

• Both producers could produce pastries, but the
  bakery can produce pastries at lower opportunity
  cost (0.5 crusts versus 2 crusts)
• The bakery is said to have comparative advantage
  in the production of pastries.

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Table 5.2

• These producers should, and can specialize by
  producing only pastries at the bakery and pizza
  crust at pizza place.
• Because these firms are specializing and
  producing at a lower cost, not only do they
  benefit by earning more profit, but consumers
  around town benefit from lower prices.

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Specialization

• Before Each firm devotes half of its resources
  to pastry production and the other half to crust
• Citywide pastry production 52.57.5
• Citywide crust production 2.557.5
• After Each firm specializes in the production
  of the good for which it has comparative
  advantage
• Citywide pastry production 10010
• Citywide crust production 01010

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Figure 5.4
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Comparative Advantage

• Figure 5.4 shows both production possibility
  frontiers, and how a combination of 10 crusts and
  10 pastries (specialization) was previously
  unattainable and is superior to when each firm
  produced at the midpoint (50/50) of their
  individual frontiers.
• If firms and individuals produce goods based upon
  their comparative advantage, society gains more
  production at lower cost.

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Comparative Advantage

• Know the different ways of showing comparative
  advantage.
• Possible free response question

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Efficiency

• If not all available resources are being used to
  their fullest, the economy is operating at some
  point inside the production possibility frontier.
• This is clearly inefficient.

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Efficiency

• But even if the economy is operating at some
  point on the frontier, who is to say that point
  is most desired by the citizens?
• If it does not happen to be the point society
  most wants, we are facing an inefficient
  situation.

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Two Types of Efficiency

• Productive efficiency The economy is producing
  the maximum output for a given level of
  technology and resources.
• All points on the production frontier are
  productively efficient.

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Two Types of Efficiency

• Allocate efficiency The economy is producing
  the optimal mix of goods and services.
• By optimal, we mean that it is the combination of
  goods and services that provides the most net
  benefit to society.

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Efficiency Figure 5.5
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Efficiency Figure 5.5

• The allocatively efficient amount of pizza crust
  is Q, the quantity where the MB of the next crust
  is exactly equal to the MC of producing it.

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Efficiency Figure 5.5

• If we produce anything beyond this point, we have
  created a situation where the MC of producing it
  exceeds our marginal enjoyment of it.
• Clearly we should devote those resources to other
  goods that we desire to a greater degree, and
  that are produced at a lower marginal cost.

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Economic Growth

• At a given point in time, the bakery (or a
  nations economy) cannot operate beyond the
  production frontier.
• Economic growth can push this production frontier
  outward expanding the set of production and
  consumption.

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Economic Growth

• Economic growth the ability to produce a larger
  total output over time, can occur if one or all
  of the following occur

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Economic Growth

• An increase in the quality of resources. Bakery
  acquires another oven.
• An increase in the quality of existing resources.
  The chef acquires the best assistants in the
  city.
• Technological advancements in production.
  Electric vs. hand mixers.

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Figure 5.6
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Figure 5.6

• The frontier has not increased proportionally.
  Max number of crusts has increased 50 percent,
  max number of pastries has increased 100 percent.

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Economic Growth

• Economic growth almost always occurs this way.
• Wireless technology example and cell phones and
  tomatoes example.

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Market Systems

• Keys to Market System are on the following
  slides.
• This will show up on AP exam for sure.

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Keys to Market System

• Private Property Individuals, not government,
  own most economic resources. The private
  ownership encourages innovation, investment,
  growth, and trade.

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Keys to Market System

• Freedom Individuals are free to acquire
  resources to produce goods and services, and free
  to choose which of their resources to sell to
  others so they may buy their own goods and
  services.

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Keys to Market System

• Self-Interest and Incentives Individuals are
  motivated by self interest in their use of
  resources. Entrepreneurs seeks to maximize
  profit, while consumers seek to maximize
  happiness. With these incentives, goods are sold
  and bought.

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Keys to Market System

• Competition Buyers and sellers, acting
  independently, are motivated by self interest,
  freely move in and out of individual markets.
  The issue of incentives is powerful.
• A new firm, eager to compete in a market, only
  enters the market if profits are available.

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Keys to Market System

• Prices Prices send signals to buyers and
  sellers, and resource allocation decisions are
  made based upon this information.
• Prices drive decisions in profit for firms and
  happiness for the consumer.