Macroeconomics
THE ULTIMATE CREDIT-BY-EXAM STUDY GUIDE FOR: Macroeconomics 1 st Edition
2/01/2024
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Contents Chapter 1: Basic Economic Concepts
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A. Basic Defnitions of Economic Principles
1 4 5 8 9
B. The Economy
C. Factors of Production
D. Scarcity, Choice, and Opportunity Costs E. Production Possibilities Curve (PPC)
F. Comparative Advantage, Specialization, and Exchange
18 23 25 42
G. Gains from Trade
H. Demand, Supply, and Market Equilibrium
Chapter 1: Review Questions
Chapter 2: Measurement of Economic Performance
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A. Introduction to Economic Performance
45 46 57 70 74 78 82 83 89 96 77
B. National Income Accounts
C. Inflation Measurement and Adjustment
D. Unemployment
Chapter 2: Review Questions
Chapter 3: National Income and Price Determination
A. Aggregate Demand (AD)
B. Business Cycles and Economic Fluctuations
C. Multiplier and Crowding-Out Effects
D. Aggregate Supply (AS)
E. Macroeconomic Equilibrium F. Self-Correction of Output Gaps
102 104 108
G. Long-Run Self-Adjustments in the AD-AS Model
Chapter 3: Review Questions
Chapter 4: Financial Sector
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A. Defnition of Financial Assets: Money, Stocks, and Bonds B. Time Value of Money (Present and Future Value)
111 116 117 119 122 125 128 131 133
C. Measures of Money Supply
D. Financial Institutions
E. Banks and Creation of Money
F. Money Demand G. Money Market
H. Real vs. Nominal Interest Rates
I. Loanable Funds Market
J. Central Bank and Control of the Money Supply
139 140 146 146 148 151 152 155 156 157 158 161 166 169 170 175 179 180 183 186 189 190 192 195 197 200 201 202 204 206 208 214 216 218 151 186 206
K. Tools of Central Bank Policy L. Limitations of Monetary Policy M. Quantity Theory of Money Chapter 4: Review Questions
Chapter 5: Inflation, Unemployment, and StabilizationPolicies
A. Fiscal Policy
B. Demand-Side Effects of Fiscal Policy C. Government Defcits and Debt
D. Crowding out
E. Automatic Stabilizers
F. The Reserve Market Model
G. Monetary Policy
H. Supply-Side Effects and Policies
I. Policy Mix
J. Inflation and Unemployment
K. Changes in the AD-AS and Phillips Curve Models
L. Role of Expectations M. Economic Philosophies Chapter 5: Review Questions
Chapter 6: Economic Growth and Productivity
A. Economic Growth and Real GDP per Capita B. Economic Growth vs. Economic Expansion
C. Sources of Economic Growth
D. Labor Productivity
E. Research and Development and Technological Progress
F. The Aggregate Production Function
G. Benefts and Drawbacks of Economic Growth
H. Growth Policy
I. Additional Reading: The Trajectory of Productivity Since the 1950s
Chapter 6: Review Questions
Chapter 7: Open Economy: International Trade and Finance
A. Closed Economy vs. Open Economy B. Balance of Payments Accounts C. How and Why the BOP is Balanced
D. Exchange Rates
E. Demand for Foreign Exchange
F. Supply of Foreign Exchange G. Exchange Rate Determination
221 223 225 225 228
H. Exchange Rate Effects on the Economy
I. Exchange Rate Policies Chapter 7: Review Questions
Glossary
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Chapter 1: Basic Economic Concepts Overview
This chapter introduces core macroeconomics concepts, laying the groundwork for understanding complexnationaleconomies.Fundamentalprincipleslikescarcityandopportunitycostguideindividual and national resource allocation decisions. Chapter 1 discusses thefactorsofproduction(land,labor, capital, entrepreneurship) that drive economic activity and explore the Production Possibilities Curve (PPC) as a tool for understanding trade-offs and growth. Furthermore, this chapter will examine comparative advantage andspecialization,revealingthebasisformutuallybenefcialtrade.Lastly,this chapter analyzes demand and supply, the invisible forces shaping market prices and resource allocation. Learning Objectives ● Defne key economic principles such as scarcity, opportunity cost, and different economic systems. ● Distinguish macroeconomics from microeconomics. ● Recognize factors of production and defne land, labor, capital, and entrepreneurship, and how they combine for production. ● Navigate scarcity and choices by understanding how to apply opportunity cost calculations to understand trade-offs in economic decisions. ● Master market dynamics through the comprehension of demand, supply, and macroeconomic equilibrium to analyze market responses. A. Basic Definitions of Economic Principles Economics isasocialsciencethatstudieshowindividuals,frms,societies,andnationsmake choices to use scarceresources .Itexaminestheallocationofresources,thebehaviorofmarkets,andtheimpact of various factors on economic outcomes. The fundamentaleconomicproblem arisesbecause resources ,whicharethe“inputs”usedtoproduce goods and services, are scarce (meaning they are limited) and may not be enough to fulfll people’s basic needs as well as society’s essentially unlimitedwants . Study Tip In economics, needs are limited and representanythingthatisnecessaryforsurvivalsuchasfood, water, shelter, and clothing. Wants , on the otherhand,arenotessentialforlivingbutareunlimited desires that make lifemoreenjoyableandcomfortable.Forexample,ahumanbeing needs waterto drink, but may want juice or soda. By the end of this chapter, you should be able to:
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Economicsisdividedintotwomainbranches,macroeconomicsandmicroeconomics,eachwithitsown distinct focus. Macroeconomics vs. Microeconomics Macroeconomics isthebranchofeconomicsthatfocusesonthe overallbehaviorandperformanceof an economy . It examines large-scale economic phenomena such as economic growth, inflation, unemployment, and national income. At its core, macroeconomics aims to establish not justeffcient production and exchange , but also overall economicstability . Microeconomics ,ontheotherhand, analyzesindividualcomponentsoftheeconomy ,likeconsumers, frms, and markets, to understand how they make decisions and interact to determine prices and quantities of goods and services while considering resource constraints. It helps derive useful conclusionsabouthowresourcesareallocatedandhowmarketswork.Inotherwords,microeconomics deals with individual decisions, whereas macroeconomics deals with the sum of theseindividuals.In macroeconomics, sums are referred to as “ aggregate .” Complementary Insights: Recognizing the intricate interplay between microeconomics and macroeconomics is crucial.Bothfeldstogetherformthebedrockofunderstandingeconomics holistically. Microeconomics provides a keen insight into individual behaviors and smaller interactions , which is invaluable forunderstandingthenutsandboltsoftheeconomy.Onthe otherhand, macroeconomicsequipsuswiththetoolsneeded todecipherbroadertrendsand influences that shape the economy's larger tapestry.
Key Macroeconomic Concepts
Key Microeconomic Concepts
Economics indicators: Gross Domestic Product, inflation, unemployment Aggregate demand, aggregate supply, and macroeconomic equilibrium
Elasticity
Marginal analysis
Fiscal and monetary policies
Production theory
Economic growth
Forms of market competition
Balance of payments
Market failure
Checkpoint Quiz 1: Classify each of the following topics under macroeconomics or microeconomics . a. The unemployment rate recorded in an economy in a given time period. b. The price that a single frm should set for its product in order to maximize proft.
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c. A consumer’s decision to substitute a product with a cheaper one.
(Checkpoint answers are located at the end of the chapter under the review question answers.)
Economic Models The fundamental economic problem forcesalleconomiestoanswerthefollowing resourceallocation questions :
1. What to produce? 2. How to produce? 3. For whom to produce?
To deduce how individuals and entities can be incentivized to make choices that lead to the best possible outcomes forsociety,economistsbuildanduseformal models thatsimplifyrealityandmake simplifyingassumptions.Thishelpsthem predictoutcomes bothatindividualandcollectivelevels(i.e., howdifferenteconomicagentsanswerthe3abovequestions)andtherefore recommendpolicies that maximize effciency and utility . The Production Possibilities Curve, that will be explained later in this chapter, is an example of an economic model used by economists to construct generalizations. The Method of Economics: Positive vs. Normative Statements In economics, you will come across two types of economic statements and questions: positive and normative.
Positive statements describe what exists in an economy and how it works withoutmakinganyjudgments .Theyare objective andinvolve factsthatcan be tested . Example: The unemployment rate in 2022 is 2%.
This statement states a fact that can be verifed by looking at the data.
Normative statements , on the other hand, consist of opinions since they analyze economic behaviorand evaluatewhethertheyaregoodorbad .They may also suggest courses of action. Normative statements cannot be tested since they are subjective . Example: The government should cut taxes in half to increase disposable incomes. This statement expresses a value judgment that cannot be proven right or wrong. The key word in this statement is “should.” Whenever a statement in economics has terms such as “should” and “ought”, it can be classifed as normative.
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B. The Economy The economy refers to the system through which goods and services are produced, distributed, exchanged,andconsumedwithinasociety.Itencompassesalleconomicactivitiesandinteractionsthat occur, involving individuals, frms, markets, and governments.
An economy can be a representation of various scopes, ranging from a nation or region to a singular industry or even a household unit.
An economic system or structure refers to the way in which production is organized andchoicesare made in an economy. It identifes the means by which households, frms, and governments make decisionsrelatingtothethreeresourceallocationquestionsofwhattoproduce,howtoproduce,andfor whom to produce.
There are 3 main economic systems:
● Market Economy (also known as Laissez-Faire orFreeMarketEconomyandCapitalism): In thiseconomicsystem,resourcesareallocatedthroughthe pricemechanism whichisbasedon the forcesofdemandandsupply .Thismeansthathouseholdsandfrmsinteractasbuyersand sellers and make decisionsonhowtoallocateresourcestosatisfytheirwantsandneeds.The government has little to no control over the process of resource allocation. In addition, productive resources and assets are owned by individualsand private frms . For example, when excess supply exists because too much is being produced compared to demand,goodsstockpileinshopsandwarehouses.Inanattempttoencouragepeopletobuyand clearthestock,frmsreduceprices.Thismaycleartheexcesssupply;however,somefrmsmight choose to stop producing at lower prices. With less suppliers in the market, the price rises. Assumingnochangeindemandoccurs,frmsmaydecidetore-enterthemarketleadingtoafall in price and the whole process will continue. This shows that prices and the self-interest of individuals and frmsguidethedecisionsinamarketeconomywithouttheneedforgovernment intervention.
The United States is one of the closest examples of a market economy globally.
● CommandEconomy(alsoknownasaPlannedorCentrallyPlannedeconomy): Contrarytoa market economy, in a planned economy the government has a signifcant role in making decisions related to resource allocation. In principle, all choices made in terms of what to
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produce,howtoproduce,andforwhomtoproducearecontrolledbythestate.Inaddition,the statehasownershipofproductiveresourcesandproperty,meaningthatthemarkethasnoreal role in the allocation of resources.
North Korea and Cuba are as close to planned economies as the theory suggests.
Itisimportanttoavoidthecommonmisconceptionthattheclassifcationofeconomiesisexactbecause bothmarketandplannedeconomiesintheirtrueformsonlyexistintheory.Instead,amixedeconomyis the typical economic system. ● Mixed Economy: In a mixed economic system, both the private sector (individuals and private frms) and the public sector (the government) have a role in allocating resources. Decisionsconsistofaninteractionbetweenindividuals,private frms,labor,andthegovernment.Thereisprivateownershipof assets as well as some public ownership. C. Factors of Production When defning economics, there is always a mention of the allocation of scarce resources to satisfy needs and unlimited wants; but what are these resources? Theresourcesavailableinaneconomyarereferredtoasthe factorsofproduction .Theyarethemeans by which an economy produces goods and services.
There are 4 main types of factors of production:
Land: Thisreferstoall naturalresources usedinproduction,suchasminerals, forests, water bodies,andagriculturalland,aswellasotherresourceslikeoil andnaturalgas.Land,asafactorofproduction,playsavitalroleinthecreation ofgoodsandservices.Itprovidesthe rawmaterials necessaryforproduction, serving as the foundation upon which economic activities are built. Natural resources derived from land are transformed into intermediate or fnished goods through various production processes.
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From an economic viewpoint, "land" takes on a specialized defnition beyond its literal meaning. In economics, "land" is not limited to physical terrain but encompasses all natural resources used in production . For example, water used in corn farms to grow crops is an example ofland,whereasan offce building is not. Land rewards its owner with rent , which is thepaymentmadefortheuseoflandanditsassociated natural resources.
Labor: Labor represents the human effort and work that goesinto production.Itincludesboth physicalandmentalcontributions from workers.Laborencompassesnotonlythequantityofworkersbutalso their skills, education, intellectual contributions, and expertise.
Thecompensationindividualsreceivefortheirlaborisareflectionof thevaluetheycontributetotheproductionofgoodsandservices.The reward for labor is the wage or earnings paid for their services. Theeffciencyandproductivityoflabor arecriticalconsiderationsin economics.Howeffcientlylaborisutilizedimpactstheoveralloutput and economic growth. Factors such as education, training, and technologicaladvancements caninfluencetheproductivityandqualityoflabor,enablingindividualsto produce more output with the same amount of effort. Labor also plays a role in determining wages and income distribution within an economy. The demand for different types of labor, influenced by factors like skill level and demand for specifc jobs, affects wage levels. The supply of labor, influenced by factors such as population and participation rates, also contributes to wage dynamics. Capital: Capital refers to any physicalproductmadebyhumans tohelpwiththeproductionofother goodsandservicessuchasthetools,equipment,machinery,informationtechnology,andinfrastructure used in the production process. It helps generate income, increase the value of a business, and/or increase the effciency and output of labor.
There are 2 different types of capital:
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Table 1: The Difference Between Physical and Human Capital
Physical Capital Physical capital encompasses all human-made resources strategically employed to produce various goods and services. This category includes various tools, tractors, machinery, buildings, factories, and more. These tangible assets play a pivotal role in enhancing theeffciencyandscopeofproductionprocesses, thereby contributing to economic growth.
Human Capital Humancapital,ontheotherhand,delvesintothe intangible yet immensely valuable sphere of skills and knowledge that workers accumulate over time through education and hands-on experience. This accumulation of expertise includes educational achievements like college degrees and vocational training, etc . Human capital signifcantly elevates workforce productivity, innovation, and adaptability, making it a driving force behind economic advancement.
In essence, while physical capital comprises the concreteresourcesinstrumentalingeneratinggoods and services, human capital representstheintellectualprowessthatelevatesindividualandcollective productivity, ultimately bolstering economic development.
The reward for capital is interest ,or the fnancial return from using or renting it. Entrepreneurship: Entrepreneurshipinvolvesthe innovation,risk-taking,and decision-makingskills ofindividualswho organize,manage,andimplement the other factors of production . Entrepreneurs identify opportunities, mobilizeresources,andtakecalculatedriskstobringproductsandservicesto market. Entrepreneurship is a catalystforeconomicgrowthbymergingthefactorsof production to create goods and services. Entrepreneurs drive innovation, generateemploymentopportunities,andcontributetoexpandingmarkets,all of which foster economic advancement.
Enterprisingleaders,suchasLornaRutto,SatoshiNakamoto,BillGates,SteveJobs,JackMaandothers, aswellasinventorsandstoreowners,harnessthisfactortointegratetheotherelementsintoacohesive whole. In exchange for taking the risk of starting a new enterprise, entrepreneurship is rewarded with proft .
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What is the broader impact of entrepreneurship beyond individual ventures? Entrepreneurship's influence extends to both macro and micro levels of the economy. It fuels the growthofmassiveglobalcorporationswhilenurturingthedevelopmentofsmallbusinesseswithinlocal communities.
The 4 factors of production work in conjunction to create goods and services. Land provides the raw materials, labor contributes the human effort, capital enhances productivity, and entrepreneurship drives the entire process by combining and organizing these resources effectively. Each factor is crucial in its own right, and their interaction determines an economy's ability to generate wealth and economic growth. D. Scarcity, Choice, and Opportunity Costs
As a student, time is a valuable commodity. Exams loom next week, but the allure of the cinema beckons. Choosing between studying and seeking entertainment requires careful consideration. One must weigh theimmediatepleasureofgoingtothemoviesagainstthepotentialbeneftsofothertime and money investments. This same process is applied in economics when making choices and decisions. Scarcity, choice, and opportunity costs arefundamentalconceptsineconomicsthattogetherhighlight therealityoflimitedresourcesandthedecision-makingprocessesindividuals,businesses,andsocieties undertake: 1. Scarcity: Refers to the basic fact that resources are fnite while human wants are virtually limitless.Thisimbalancecreatesasituationwherepeoplehavetochoosehowtoallocatetheir resources effectively among competing alternatives. Scarcity is the foundation of economic study, driving the need for thoughtful decision-making. 2. Choice: Due to scarcity,individualsandsocietiesmustmakechoices.Choicesinvolvedeciding betweendifferentalternatives,whetherit'saboutspendingtime,money,oreffort.Everychoice involves considering trade-offs—what is gained and lost by selecting one option over another. 3. OpportunityCosts: Opportunitycostisthevalueofwhatisgivenupwhenoneoptionischosen overanother.It'sthenextbestalternativeforegoneasaresultofone’sdecision.Makingachoice means acceptingoneoutcomeandrejectinganother.Thisprocess,knownasopportunitycost, considers the value of what is foregone in favor of what is gained. Opportunity cost helps quantifythecostofdecisionsintermsofwhatcouldhavebeengainedfromthealternativethat was dropped. Example: Suppose individual Ahas$20tospend.IndividualAcaneitherbuyashirtthatcosts $20ortwoscarvesfor$10each.IndividualAcannotbuyboththeshirtandthescarves.Achoice has to be made. Individual A decides to buy the shirt. The nextbestalternativeisthescarves. Therefore, the opportunity cost of the shirt is the two scarves.
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Inthisexample,IndividualA wants twothingsbuthasa limited amountofmoneytobuythem. Therefore, Individual A needs to make a choice . Choosingone of the things costs the other. In essence, these concepts are interconnected: scarcity necessitates choices, andchoicescomewith opportunitycosts.Aspeoplemakedecisionsintheirpersonallivesorasbusinessesandsocietiesmake decisions on a larger scale, understanding these principles help them make more informed and thoughtful choices that align with their goals and resources.
E. Production Possibilities Curve (PPC) Trade-Of and Opportunity Cost
Everydecision,whetherinreallifeorineconomictheory,involvesatrade-offandanopportunitycost.A trade-off istheprocessofchoosingbetweentwoormorealternatives.Eachtrade-offisassociatedwith anopportunitycostwhichrepresentsthevaluethatcouldhavebeengainedfromtheoptionthatwasnot chosen. For example, there is a trade-off between working more hours and spending more time on leisure. Ifonedecidestospendmoretimeonleisure,theincomelostduetoworkinglesshoursisthe opportunity cost. Inessence,atrade-offinvolvesweighingdifferentoptionsagainsteachother,whereasopportunitycost captures what might have been gained from the dropped alternative. In economics, opportunity cost serves as a fundamental principle for decision-making . It helps individuals,businesses,andgovernmentsevaluatetheirchoicesbycomparingwhattheygainwithwhat theysacrifce,leadingtomoreinformedandeffectiveeconomicactions.Theconceptofopportunitycost can apply in all economic contexts including investment choices, resource allocation, education and work choices, and trade-offs in production.
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Definition and Key Assumptions The ProductionPossibilitiesCurve(PPC) ,alsoknownastheProductionPossibilitiesFrontier(PPF),isan economic model that shows all the possible combinations of two goods or services that can be produced if all of an economy’s resources are used effciently.Inotherwords,itisasimplegraphical representation of the maximum level of output or production that an economy can achieve given its current resources and technological level. Imagine an economy that haslimitedresourcesandtechnologytomakethings.ThePPChelpsussee the different combinations of goods it can produce. It's similar to planning how to spend time and money – choices have to be made, and the PPC helps visualize those choices.
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ThisPPCshownaboverepresentstheproductionchoicesofaneconomythatonlyproducestwogoods: carsonthex-axis(horizontallineatthebottom)andlaptopsonthey-axis(verticallineontheleftside). Assumingthatallavailableresourcesareusedeffciently,thiseconomycanproduce anycombination of laptopsandcars onthePPCcurve suchaspointA(200laptopsand50cars),pointB(180laptopsand 150 cars), and so on. Thecurveitselfshowcasesthevariouschoicesaneconomycanmakewhenallocatingitsresourcesand applying technology to produce these two products. The curve's shape and position reveal how effciently resources are utilized (to be discussed soon).
Study Tip AtypicalPPCusuallyfeaturesconsumergoodsandcapitalgoodsonitsaxes.A consumergood isone produced for immediate consumption and the satisfaction of wants (e.g., toys, books), whereas a capitalgood isonethatcontributestotheproductionofothergoodsorservices(e.g.,equipmentused infactories,coffeemachinesinshops,trains).Ineconomics,thecreationofcapital(i.e.,thepurchase or putting in place of equipment, buildings, roads, etc.), is referred to as investment .
Checkpoint Quiz 2:
Based on the previous PPC, which combination of goods does this economy produce at point C?
(Checkpoint answers are located at the end of the chapter under the review question answers.)
When constructing or analyzing a PPC, always remember the following key assumptions: ➔ Focus on Two Goods: The PPC examines the production possibilities of an economy by considering only two goods at a time.
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➔ FullResourceEmployment: Itassumesthatallavailableresourceswithintheeconomyarefully employed in the production process.
➔ Fixed Technology: The PPC operates under the assumption that the level of technology used for production remains constant. ➔ Fixed Resources: It further assumes thatthequantity and quality of resources, such as labor, capital, and natural resources, do not change.
➔ Ceteris Paribus : The PPC analysis relies on the principle of ceteris paribus , meaning that all other factors influencing production and resource allocation remain constant during the analysis.Forexample,ifwewanttoanalyzetheeffectofanincreaseinthecostofthefactorsof productionusedinmanufacturinglaptopsonthePPCofthepreviouslydescribedeconomy,we assume that all other variables or factors affecting production, such as technology improvements or labor productivity, remain unchanged. Theseassumptionshelpsimplifythemodelandisolatetherelationshipbetweentheproductionoftwo goods, making it easier to understand and analyze an economy's production capabilities. Study Tip A ProductionPossibilitiesTable(PPT) isatablethatlistsvariousproductionpossibilities,indicating howmuchofeachgoodcanbeproducedusingavailableresources.Eachrowinthetablerepresentsa differentallocationofresourcestoproducethetwogoods.ItcanbeusedtoconstructaPPCorreflect one inawaythatmakesiteasiertoshowthetrade-offsandopportunitycostsassociatedwitheach choice. The PPT of the economy producing only laptops and cars would like this:
Laptops
200
180
100
Cars
50
150
305
Opportunity Costs on the Production Possibilities Curve ThenegativeslopeofthePPC,reflectedbythedownward-slopingcurve,isjustifedbytheexistenceof scarcity. Because of limited resources, more ofthegoodonthey-axis(e.g.,laptops)canbeproduced only with less production of the good on the x-axis (e.g., cars). AnimportantconceptillustratedbythePPCisopportunitycost.Ifaneconomydecidestoincreasethe productionofoneproduct,itmustdivertresourcesawayfromtheproductionoftheotherproduct.This trade-offisvisuallyrepresentedonthecurve.Whenaneconomymovesalongthecurvetoproducemore ofonegood,itinevitablyproduceslessoftheother.Thisvisualrepresentationhelpsusunderstandthe choices and sacrifcesaneconomymakeswhendecidinghowtoallocateitsresourcesandtechnology for production.
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Let’s calculate opportunity cost using the following PPC:
● MovementfromPointAtoB :Thismovementrepresentsanincreaseintheproductionofcars. However, this comes at a cost. Fewer laptops will be produced as more resources are now allocated to the production of cars. At point A, 200 laptops and 50 cars are produced. At point B, 180 laptops and 150 carsare produced. Thismeansthatfortheproductionofcarstoincreaseby100units(150minus50), 20 units of laptops were sacrifced (200 minus 180). ● Movement from Point C to A: Now let’s consider another scenario where the production of laptops increases instead (yes, movements on a PPC can be back and forth!) MovingfrompointCtoAindicatesthattheeconomyisnowallocatingitsresourcestoproduce more laptops, which requires a decrease in the production of cars. At point C, 305 cars and 100 laptops are produced. At point A, 50 cars and 200 laptopsare produced.Thismeansthattoachieveanincreaseintheproductionoflaptopsby100units,255 cars were sacrifced. Therefore, the opportunity cost of moving from point A to B is 20 laptops.
Therefore, the opportunity cost of moving from point C to A is 255 cars.
Checkpoint Quiz 3:
Suppose that the economy moves from point B to C on the same PPC. What is the opportunity cost?
(Checkpoint answers are located at the end of the chapter under the review question answers.)
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The“perunitopportunitycost”isausefulformulathathelpsunderstandhowmuchisgivenupofone thingtogetalittlemoreofsomethingelse.It'slikemeasuringthepricepaidintermsof one itemtogain a bit more of another item. Per unit opportunity cost = ℎ ℎ Let’s go back tothemovementfrompointCtoAonthepreviousPPC:255carswere lost to gain 100 additional laptops ⇒ The per unit opportunitycostofmovingfromCtoA=255/100=2.55cars.This means that for every additional laptop produced, 2.55 cars are foregone. Shapes of the PPC The shape of the PPC is signifcant as it reflects the typeofopportunitycostincurredwhenchanging production possibilities. Opportunity cost can be constant, increasing, or decreasing.
1. ConstantOpportunityCost: Thisscenariohighlightsthatthe opportunitycostdoesnotchange asyoumovealongthePPC.Thismeansthatresourcesareeasilyadaptablebetweenproducing thetwogoods.Becauseofthisconstanttrade-off,thegraphforms astraightlinePPC ,whichis uncommon in real-world situations as this requires both goods to use the same factors of production (e.g., where two similar cars are being produced). Example: The following PPC represents an economy that produces airplanes and yachts. By calculatingtheperunitopportunitycostofmovingfromonepointtoanother,wecandeducethat theopportunitycostremainsconstant.Forexample,amovementfrompointCtoDoramovement from point D to E requires the sacrifce of 1 airplane to produce 1 additional yacht.
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2. Increasingopportunitycost: WhenthePPCis curvedoutwards(bowedout) ,theopportunity costchangesastheeconomymovesfromonepointtoanother.Foreachadditionalunitofone goodproduced, theopportunitycostofproducingitgetslarger andlargerastheproductionof the second good decreases. This is known as the law of increasing opportunity cost that mostly applies when two products require different factors of production. Example: In the following PPC, we can calculate thefollowing per unit opportunity costs: ● Movement from C to D: 1 airplane per yacht ● Movement from D to E: 2 airplanes per yacht Notice how the opportunity cost, or the quantity of airplanes foregone toproducemoreyachts, increased from one point to another.
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3. Decreasing opportunity cost: Finally, this is a scenario where the PPC is
curvedinwards(bowedin) toreflecta decrease in opportunity cost as you move alongthecurve.Althoughrarein practice, this happens when the value of the frst good given up to increase the production of the second one decreases as you move along the PPC. Example: NowusethisPPCtocalculate the per unit opportunity costs of the same movements: ● Movement from C to D: 1 airplane per yacht ● Movement from D to E: 0.33 airplanes per yacht Notice how the opportunity cost, or the quantity of airplanes foregone toproducemoreyachts, decreased from one point to another. All of these examples illustrate how the opportunity cost changes as production shifts between airplanesandyachts(oranytwogoodsonthePPC).Eachmovealongthecurveinvolvestradingoffsome airplanesforyachts,andthecalculatedopportunitycosthelpsusunderstandthecostofmakingthese choices and allocating resources. Analyzing Diferent Points on the PPC Diagram NowthatwehaveexplainedthedifferentshapesofthePPC,itistimetoanalyzeitspoints.Isapointon the curve the same as one below it? What does a point beyond the curve mean?
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● Points on the curve (e.g., points AandB):Aspreviouslyexplained,pointsonthePPCindicate that the economy is using all of its existing resources effciently to produce the goods. No resourcesaregoingunused,whichissomethingreferredtoas “fullresourceemployment.” In this case, the economy achieves productive effciency , which is a situation in which a given combinationofoutputisproducedatthe leastcost .However,movingfromonepointtoanother on the PPC still incurs an opportunity cost as discussed in the previous concept. ● Points inside the PPC (e.g, pointC):Theseindicatethe unemploymentorunderutilizationof resources and productiveineffciency .Thisisduetothefactthatsomeresourcesarenotfully employed or are not being used effciently. An economyproducingatpointCisnotproducing airplanes and yachts at their maximum potential given the existing resources. Itcanproduce more of both goods by moving to anypointonthecurve(e.g.,pointsAorB).Suchmovement doesnotincuranopportunitycostbecauseitinvolvesutilizingexistingidleresourcesinsteadof reallocating resources from the production of one good to another. ● Points outside thePPC(e.g.,pointD):Pointslyingoutsidethecurverepresent anunattainable productionorimpossiblecombinationofgoods giventheeconomy’scurrentresourcesand/or technology. Such points represent a position of scarcity sincetheeconomydoesnothavethe resources required to achieve this level of output of airplanes and yachts. Shifts of the PPC Sometimes, certain conditions and changes make points that lie outside the PPClineattainable.This causes the PPC either to pivot from its original position on one of the axes or to shift in its entirety.
A PPC shifts or pivots when:
● More resources become available: This occurs when new resources are discovered, when capital stock increases, or when the quality of the resources used improves. For example, the discoveryofnewfossilfuelreserves or renewable energy sources ortheuse of new machinery allow for an increase in production. Additionally, an increase in labor quality or productivity (the output produced perworker),raisesthe level of production.
● Thereisatechnologicalchangeorimprovement:Positiveandnegativechangesinaneconomy’s technologicallevelaffectthepositionofitsPPC.Technologicalbreakthroughsinproductionfor example allow an economy to produce more of both goods. When one of these factors affects the production of one ofthegoodsonthePPC,thecurvepivotsto show an increase or decrease in the production of that good only.
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In the previous PPC for example, a technological advancement that allowed producers to assemble yachtenginesmorequicklyleadstoanincreaseintheproductionofyachts.Airplaneproductionisnot affected; therefore, the PPC pivots but does not shift entirely. There are situations where the PPC shifts in its entirety, eithertotherightortotheleftofitsoriginal position. This indicates thattheeconomy’s productivecapacityandeconomicgrowth havechanged. Productive capacity refers to the maximum output that can be produced when resources are fully utilized, and economic growth signifes an increase in the total output of an economy.
F. Comparative Advantage, Specialization, and Exchange
In his 1776 book The Wealth of Nations , Adam Smith introduced the concept of specialization that describeshowindividualsspecializeintaskstheymaster. Specializationappliesnotonlytoindividuals,butcanalso be achieved by frmsorbyawholeeconomythattrades and exchanges goods and services withothercountries. Have you ever wondered why your country exports certain goodsandnotothers?Forexample,whyisSpain the top exporter of olive oil while Brazil is the top exporter of coffee beans?Comparativeadvantageisone of the main concepts used to answer these questions.
Comparative advantage introduces the idea that even if onecountryisbetteratproducingeverything,there'sstill an advantage in specializing inwhatit’srelativelybetter
at. By focusing on strengths andtradingwithotherswhohavedifferentcomparativeadvantages,both parties can beneft from increased effciency and a wider variety of goods and services. In essence, comparative advantage prompts us to consider the opportunity costs involved in differentproduction
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choicesandencouragestradethatallowscountriestoexchangethegoodstheyproducemosteffciently for those they don't produce as effciently. This conceptcontributestothefoundationofinternational trade and cooperation. ● Comparative advantage is a concept that highlights the idea that a country can produce something at an opportunity cost lower than anothercountry.Whenacountryspecializesand exchanges what it has a comparative advantagein,itwillbeneftfromconsumptionatapoint beyond the PPC. For example, suppose that countries A and B can both produce TVs and bikes. Country A foregoes 100 bikes to produce 200 additional TVs, whereas country B foregoes 80 bikes to produce 200 additional TVs. Recall the per unit opportunity cost: For country A, this means that for each additional TV produced, 0.5 bikes are sacrifced (whatislost/whatisgained=100/200),sotheopportunity cost of producing 1 TV = 0.5 bikes. For country B, this means that for each additional TV produced, 0.4 bikes are sacrifced (80/200), so the opportunity cost of producing 1 TV = 0.4 bikes. ⇒ Opportunity cost of producing TVs incountryB(0.4)<opportunitycostofproducingTVsin countryA(0.5);therefore,countryBissaidtohavecomparativeadvantageintheproductionof TVs. It should specialize in producing and exchanging TVs if compared to country A. Furthermore, it would be more effcient and cost-effective for country A to import TVs from country B rather than producing them locally. ● Specialization occurs when individuals, frms, or even countries focusonproducingaspecifc setofgoodsorservicesinwhichtheyhaveacomparativeadvantage.Byconcentratingonwhat they're good at, they can increase their effciency and productivity, ultimatelybeneftingfrom tradeandcooperationwithothers.Inthepreviousexample,countryBspecializesinproducing TVs because it does it more effciently and at a lower opportunity cost than country A. ● Trade or exchange involves the exchange of goods and services between individuals, businesses, or countries. It's driven by the differences in opportunity costs and comparative advantages.
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Comparative Advantage: Solved Example In this example, assumethatJapanandSwedenarecapableofproducingtwodifferentgoods: trucks and helicopters . Let's break down the information and understand the concept of comparative advantage.
Based on the PPCs, Sweden can produce either 30 trucks and 0 helicopters, or10helicoptersand0 trucks,oranycombinationrepresentedbytheblueline.Japan,ontheotherhand,canproduceeither20
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trucksand0helicopters,or40helicoptersand0trucks,oranycombinationrepresentedbytheorange line.
First, calculate the opportunity cost of producing 1 truck in each country: ➔ Sweden: to produce 30 trucks, 10 helicopters are foregone → 10/30 ≈ 0.33 helicopters lost per each truck produced.
➔ Japan: to produce 20 trucks, 40 helicopters are foregone → 40/20 = 2helicopterslostpereachtruck produced. Since it costsSwedenlesstoproducetrucksinterms of the quantity of helicopters sacrifced (0.33 < 2), Sweden has a comparative advantage in truck production and should specialize in that.
Now, calculate the opportunity cost of producing 1 helicopter in each country: ➔ Sweden: to produce 10 helicopters, 30 trucks are foregone → 30/10 = 3truckslostpereach helicopter produced. ➔ Japan: to produce 40 helicopters, 20 trucks are foregone → 20/40 = 0.5truckslostpereach helicopter produced. Since it costs Japan less to produce helicopters in terms of the quantity of trucks sacrifced (0.5 < 3), Japan has a comparative advantage in helicopter production and should specialize in that. After specialization, the total output would become 30 trucks and 40 helicopters. Through trade, Sweden and Japan can exchange their produced goods, leading to mutual beneft and overall effciency in resource utilization. Comparative Advantage Using the Input Approach We have already calculated and identifed comparative advantages based on output or the level of production of economies (i.e., the quantity of products produced). However, in certain cases, we are providedwithinputdatainsteadoftotaloutput.Thisdatacanincludevariablessuchasthenumberof hoursworked,thenumberofworkersemployed,and/ortheamountofcapitalusedtoproduceunitsof output.Insuchcases,theeconomythatusesfewerresourcestoproduceahigheroutputofaproduct has a lower opportunity cost and is therefore said to have a comparative advantage. Example: Assume that China and Singapore both produce chairs and tables. The following table represents the number of hours required to produce one unit in each country.
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