AP Macroeconomics

1. AP Macroeconomics Key Assumptions in Economics, Scarcity, Opportunity Cost and the Production Possibilities Curve

2. 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 what’s being considered

3. 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.

4. 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.

5. 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.

6. 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.

7. Example

8. 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.

9. 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

10. Basic Economic Vocabulary • Needs • Necessities for survival • Wants • Goods and services consumed beyond what is necessary for survival

11. 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

12. 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

13. 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.

14. The Fundamental Problem of Economics: Scarcity OR

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

16. 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.

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

18. 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.

19. 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 uncle’s lawn for $10 per hour. • If you choose to study what is the opportunity cost?

20. 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.

21. 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.

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

23. TINSTAAFL There is no such thing as a free lunch.

24. TINSTAAFL Everything has a cost.

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

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

27. 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.

28. 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.

29. 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 bakery’s available resources in an efficient way.

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

31. PCC Example 5.2

32. 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.

33. TINSTAAFL Illustrated: The PPC

34. 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.

35. 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.

36. 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.

37. Law of Increasing Costs • Example 5.3

38. 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.

39. Comparative Advantage • Dentist Example

40. 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.

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

42. Table 5.2

43. 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.

44. 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.

45. 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.

46. Specialization • Before: Each firm devotes half of its resources to pastry production and the other half to crust: • Citywide pastry production= 5+2.5=7.5 • Citywide crust production= 2.5+5=7.5 • After: Each firm specializes in the production of the good for which it has comparative advantage: • Citywide pastry production= 10+0=10 • Citywide crust production= 0+10=10

47. Figure 5.4

48. 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.

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

50. 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.