AP ECONOMICS UNIT ONE

CHAPTER ONE
Key Terms

Opportunity cost

Abstraction Theory Correlated Economic model

The opportunity cost of some decision is the value of the next best alternative that must be given up because of that decision (for example, working instead of going to school). Abstraction means ignoring many details so as to focus on the most important elements of a problem. A theory is a deliberate simplification of relationships used to explain how those relationships work. Two variables are said to be correlated if they tend to go up or down together. Correlation need not imply causation. An economic model is a simplified, small-scale version of some aspect of the economy. Economic models are often expressed in equations, by graphs, or in words.

Summary 1. Ten Important Ideas: a. Opportunity cost is the correct measure of cost. b. Attempts to fight market forces often backfire. c. Nations can gain from trade by exploiting their comparative advantages. d. Both parties gain in a voluntary exchange. e. Good decisions typically require marginal analysis that weighs incremental costs against incremental benefits. f. Externalities may cause the market mechanism to malfunction, but this defect can be repaired by market methods. g. Governments have tools that can mitigate cycles of boom and bust, but these tools are imperfect. h. There is a trade-off between efficiency and equality. Many policies that promote one damage the other. i. In the short run, policy makers face a trade-off between inflation and unemployment. Policies that reduce one normally increase the other. j. In the long run, productivity is almost the only thing that matters for a societys well-being. Common sense is not always a reliable guide in explaining economic issues or to making economic decisions. Because of the great complexity of human behavior, economists are forced to abstract from many details, to make generalizations that they know are not quite true, and to organize what knowledge they have in terms of some theoretical structure called a model. Correlation need not imply causation. Economists use simplified models to understand the real world and predict its behavior, much as a child uses a model railroad to lean how trains work.

2. 3.

4. 5.

6.

Although these models, if skillfully constructed, can illuminate important economic problems, they rarely can answer the questions that confront policy makers. Value judgments are needed for this purpose, and the economist is no better equipped than anyone else to make them.

CHAPTER TWO
Key Terms

Factors of Production, or Inputs Outputs Gross domestic product (GDP) Open economy Closed economy Recession Transfer payments Progressive tax Mixed economy
Summary 1.

Inputs or factors of production are the labor, machinery, buildings, and natural resources used to make outputs. The outputs of a firm or an economy are the goods and services it produces. Gross domestic product (GDP) is the sum of the money values of all final goods and services produced in the domestic economy and sold on organized markets during a specified period of time, usually a year. An open economy is one that trades with other nations in goods and services, and perhaps also trades in financial assets. A closed economy is one that does not trade with other nations in either goods or assets. A recession is period of time during which the total output of the economy declines. Transfer payments are sums of money that the government gives certain individuals as outright grants rather than as payments for services rendered to employers. Some common examples are Social Security and unemployment benefits. A progressive tax is one in which the average tax rate paid by an individual rises as income rises. A mixed economy is one with some public influence over the workings of free markets. There may also be some public ownership mixed in with private property.

2. 3.

4. 5.

6.

The U.S. economy is the biggest national economy on earth, both because Americans are rich by world standards and because we are a populous nation. Relative to most other advanced countries, our economy is also exceptionally privatized and closed. The U.S. economy has grown dramatically over the years. But this growth has been interrupted by periodic recessions, during which unemployment rises. The United States has a big, diverse workforce whose composition by age and sex has been changing substantially. Relatively few workers these days work in factories or on farms; most work in service industries. Employees take home most of the nations income. Most of the rest goes, in the forms of interest and profits, to those who provide the capital. Governments at the federal, state and local levels employ one-sixth of the American workforce (including the armed forces). These governments finance their expenditures by taxes, which account for about 28 percent of the GDP. This percentage is one of the lowest in the industrialized world. In addition to raising taxes and making expenditures, the government in a market economy serves as referee and enforcer of the rules, regulates business in a variety of ways, and redistributes income through taxes and transfer payments. For all of these reasons, we say that we have a mixed economy, which blends private and public elements.

CHAPTER THREE
Key Terms

Resources

Opportunity cost Optimal decision

Outputs Inputs Production possibilities frontier Principle of increasing costs Efficiency

Resources are the instruments provided by nature or by people that are used to create goods and services. Natural resources include minerals, soil, water, and air. Labor is a scarce resource, partly because of time limitations (the day only has 24 hours) and partly because the number of skilled workers is limited. Factories and machines are resources made by people. These three types of resources are often referred to as land, labor, and capital. They are also called inputs or factors of production. The opportunity cost of some decision is the value of the next best alternative that must be given up because of that decision (for example, working instead of going to school). An optimal decision is one that best serves the objectives of the decision maker, whatever those objectives may be. It is selected by explicit or implicit comparison with the possible alternative choices. The term optimal connotes neither approval nor disapproval of the objective itself. The outputs of a firm or an economy are the goods and services it produces. Inputs or factors of production are the labor, machinery, buildings, and natural resources used to make outputs. The production possibilities frontier is a curve that shows the maximum quantities of outputs it is possible to produce with the available resource quantities and the current state of technological knowledge. The principle of increasing costs states that as the production of a good expands, the opportunity cost of producing another unit generally increases. A set of outputs is said to be produced efficiently if, given current technological knowledge, there is no way one can produce larger amounts of any output without using larger input amounts or giving up some quantity of another ouput. Allocation of resources refers to the societys decisions on how to divide up its scarce input resources among the different outputs produced in the economy and among the different firms or other organizations that produce those outputs. Division of labor means breaking up a task into a number of smaller, more specialized tasks so that each worker can become more adept at a particular job. One country is said to have a comparative advantage over another in the production of a particular good relative to other goods if it produces that good less inefficiently as compared with the other country. A market system is a form of economic organization in which resource allocation decisions are left to individual producers and consumers acting in their own best interests without central direction.

Allocation of resources Division of labor Comparativ e advantage Market system

Summary 1. 2.

3.

Supplies of all resources are limited. Because resources are scarce, an optimal decision is one that chooses the best alternative among the options that are possible with the available resources. With limited resources, a decision to obtain more of one item is also a decision to give up some of another. What we give up is called the opportunity cost of what we get. The opportunity cost is the true cost of any decision. When markets function effectively, firms are led to use resources efficiently and to produce the things that consumers most want. In such cases, opportunity costs and money costs (prices) correspond closely.

When the market performs poorly, or when important, socially costly items are provided without charging and appropriate price, or are given away free, opportunity costs and money costs can diverge. 4. A firms production possibilities frontier shows the combinations of goods it can produce, given the current technology and the resources at its disposal. The frontier is usually bowed outward because resources tend to be specialized. 5. The principle of increasing costs states that as the production of one good expands, the opportunity cost of producing another unit of that good generally increases. 6. Like a firm, the economy as a whole has a production possibilities frontier whose position is determined by its technology and by the available resources of land, labor, capital, and raw materials. 7. A firm or an economy that ends up at a point below its production possibilities frontier is using its resources inefficiently or wastefully. This is what happens, for example, when there is unemployment. 8. Economists define efficiency as the absence of waste. It is achieved primarily by the gains in productivity brought about through specialization that exploits division of labor and comparative advantage and by a system of exchange. 9. Two countries (or two people) can gain by specializing in the activity in which each has a comparative advantage and then trading with another. These gains from trade remain available even if one country is inferior at producing everything. 10. If an exchange is voluntary, both parties must benefit, even if no additional goods are produced. 11. Every economic system must find a way to answer three basic questions: How can goods be produced most efficiently? How much of each good should be produced? How should goods be distributed among users? 12. The market system works very well in solving some of societys basic problems, but it fails to remedy others and may, indeed, create some of its own.

CHAPTER FOUR
Key Terms

Invisible hand

Quantity demanded Demand schedule Demand curve

Shift in a demand curve

Quantity supplied Supply schedule

Supply curve

Supply-demand diagram Shortage

Surplus Equilibrium

Law of supply and demand Price ceiling Price floor

The invisible hand is a phrase used by Adam Smith to describe how, by pursuing their own self-interests, people in a market system are led by an invisible hand to promote the well-being of the community. The quantity demanded is the number of units of a good that consumers are willing and can afford to buy over a specified period of time. A demand schedule is a table showing how the quantity demanded of some product during a specified period of time changes as the price of that product changes, holding all other determinants of quantity demanded constant. A demand curve is a graphical depiction of a demand schedule. It shows how the quantity demanded of some product will change as the price of that product changes during a specified period of time, holding all other determinants of quantity demanded constant. A shift in a demand curve occurs when any relevant variable other than price changes. If consumers want to buy more at any and all given prices than they wanted previously, the demand curve shifts to the right (or outward). If they desire less at any given price, the demand curve shifts to the left (or inward). The quantity supplied is the number of units that sellers want to sell over a specified period of time. A supply schedule is a table showing how the quantity supplied of some product changes as the price of that product changes during a specified period of time, holding all other determinants of quantity supplied constant. A supply curve is a graphical depiction of a supply schedule. It shows how the quantity supplied of some product will change as the price of that product changes during a specified period of time, holding all other determinants of quantity supplied constant. A supply-demand diagram graphs the supply and demand curves together. It also determines the equilibrium price and quantity. A shortage is an excess of quantity demanded over quantity supplied. When there is a shortage, buyers cannot purchase the quantities they desire at the current price. A surplus is an excess of quantity supplied over quantity demanded. When there is a surplus, sellers cannot sell the quantities they desire to supply at the current price. An equilibrium is a situation in which there are no inherent forces that produce change. changes away from an equilibrium position will occur only as a result of outside events that disturb the status quo. The law of supply and demand states that in a free market the forces of supply and demand generally push the price toward the level at which quantity supplied and quantity demanded are equal. A price ceiling is a maximum that the price charged for a commodity cannot legally exceed. A price floor is a legal minimum below which the price charged for a commodity is not permitted to fall.

Summary 1. An attempt to use government regulations to force prices above or below their equilibrium levels is likely to lead to shortages or surplusus, to black markets in which goods are sold at illegal prices, and to a variety of other problems. The market always strikes back at attempts to repeal the law of supply and demand. 2. The quantity of a product that is demanded is not a fixed number. Rather, quantity demanded depends on such factors as the price of the product, consumer incomes, and the prices of other products. 3. The relationship between quantity demanded and price, holding all other things constant, can be displayed graphically on a demand curve. 4. For most products, the higher the price, the lower the quantity demanded. As a result, the demand curve usually has a negative slope. 5. The quantity of a product that is supplied depends on its price and many other influences. A supply curve is a graphical representation of the relationship between quantity supplied and price, holding all other influences constant. 6. For most products, supply curves had positive slopes, meaning that higher prices lead to supply of greater quantities. 7. A change in quantity demanded that is caused by a change in the price of a good is represented by a movement along a fixed demand curve. A change in quantity demanded that is caused by a change in any other determinant of quantity demanded is represented by a shift of the demand curve. 8. This same distinction applies to the supply curve: Changes in price lead to movements along a fixed supply curve; changes in other determinants of quantity supplied lead to shifts of the entire supply curve. 9. A market is said to be in equilibrium when quantity supplied is equal to quantity demanded. The equilibrium price and quantity are shown by the point on the supply-demand graph where the supply and demand curves intersect. The law of supply and demand states that price and quantity tend to gravitate to this point in a free market. 10. Changes in consumer incomes, tastes, technology, prices of competing products, and many other influences lead to shifts in either the demand curve or the supply curve and produce changes in price and quantity that can be determined from supply-demand diagrams. 11. A tax on a good generally leads to a rise in the price at which the taxed product is sold. The rise in price is generally less than the tax, so consumers usually pay less than the entire tax. 12. Consumers generally pay only part of a tax because the resulting rise in price leads them to buy less and the cut in the quantity they demand helps to force price down.