ECON102 Study Guide

Unit 1: What is Macroeconomics?

1a. Define economics and explain its importance

  • What are economics and scarcity?
  • Why does scarcity drive society's need to acknowledge, track, and allocate limited resources?
  • What is the relationship between production and division of labor?

"Economics is the study of how humans make decisions in the face of scarcity." Human wants for goods, services, and resources exceed the resources available. The limited resources needed to produce and acquire these desired goods and services include labor, tools, land, raw materials, and time.

Government agencies often publish economic and social data to measure and track economic issues and problems. The categories include:

  • Money, banking, finance
  • Population, employment, labor markets (including income distribution)
  • National accounts (gross domestic product and its components), the flow of funds, and international accounts
  • Production and business activity (including business cycles)
  • Prices and inflation (the consumer price index, the producer price index, and the employment cost index)
  • International data from other nations
  • U.S. regional data
  • Academic data (including Penn World Tables and NBER Macrohistory database)

We must often make economic decisions that require choosing between two paths. Perhaps you had to decide whether to enroll in college without the full required tuition and costs in hand. You may have decided to take one or two courses while working part-time. Or you may have decided to take out student loans to study full-time so you could begin your career sooner and hopefully earn a higher salary. Unfortunately, this option requires you to pay off a significant debt after graduation.

What questions help you decide? What do you give up when you choose one path? What do you gain? Given your resource constraints, you should consider the cost of your next best alternative to optimize the return on your time and money. This is an opportunity cost. 

Adam Smith (1723–1790) introduced the concept of the division of labor to meet the challenge of scarcity in The Wealth of Nations (1776). He gave three reasons why workers specialize in certain tasks.

  1. Specialization allows workers to focus on the parts of the production process where they have an advantage.
  2. Workers who specialize can produce more quickly with higher quality.
  3. Economies of scale mean the average cost to produce each unit declines as the production level increases.

The workers can produce much more by specializing than when each worker tries to produce the entire good or service by themselves. These two aspects of efficiency, division of labor and specialization, allow workers to use limited resources most effectively.

To review, see [1.1 What Is Economics, and Why Is It Important?] and [2.1 How Individuals Make Choices Based on Their Budget Constraint].

1b. Compare microeconomics and macroeconomics

  • What is the difference between microeconomics and macroeconomics?
  • What are the major economic aggregates that macroeconomics analyzes?
  • What are the values for these variables in the United States?
  • What are the main goals of U.S. economic institutions (including government) with regard to the macroeconomy?

Microeconomics focuses on individuals, businesses, and their decisions in the marketplace. Microeconomics examines theories of consumer and business behavior, how markets for labor and other resources work, and how markets sometimes fail to work properly.

Conversely, macroeconomics studies the entire aggregate economy in a given country. It uses statistics to compare similar economic trends in other countries. 

Macroeconomics focuses on broad economic issues, such as production, unemployment, inflation, government deficits, and levels of exports and imports. It calculates the level of economic activity in a society – how many goods and services are in demand, the number of jobs available, the standard of living, what causes the economy to speed up or slow down, what causes an increase or decrease in the number of workers, and what causes economic growth. It examines the goals of growth in the standard of living, low unemployment, and low inflation. Governments use monetary and fiscal policy to pursue these goals.

To review, see [1.1 Microeconomics and Macroeconomics].

1c. Describe how theories, models, and tools are used to perform economic analysis

  • What are the differences between theories and models in economics?
  • How do economists use theories to perform economic analysis?
  • How would you compare and contrast traditional, command, and market economies?
  • What is gross domestic product (GDP)?

A theory is a simplified representation of how two or more variables interact. A model is an applied or empirical representation of a theory. Note that many use these terms interchangeably despite these nuanced differences.

Economists use theories and models to analyze issues and problems based on assumptions about human behavior. For example, we discuss the circular flow model in Unit 1.

Economists have created three categories to describe how societies organize themselves in the complex modern economy (production of goods and services, buying and selling, and employment).

  1. Traditional economies are the oldest economic systems. Individuals consume what they produce, and occupations stay in the family. There is little room for economic progress or development.

  2. Command economies have a centralized economic decision-making structure. Economic effort is devoted to the goals a ruler or ruling class dictates. The government dictates what goods and services will be produced, what prices will be charged, the methods of production, and wages for workers. An example is communism.

  3. Market economies have a decentralized decision-making structure based on private enterprise. Businesses supply goods and services based on demand. Income is based on a person's ability to convert resources (such as labor) into something society values. Market forces determine economic decisions, not the government.

Whether a society's economic decision-making is centralized or decentralized, challenges arise due to trends of globalization. Factors such as culture, politics, and economic connections impact the increased buying and selling of goods, services, and assets across national borders. 

One measure of globalization relates to exporting and importing goods and services. Gross domestic product (GDP) measures the size of total production in an economy. The ratio of exports divided by GDP measures the share of a country's total economic production sold in other countries.

To review, see:

1d. Analyze resource allocation based on scarcity, opportunity cost, and making decisions at the margin

  • What are the concepts of scarcity and opportunity cost?
  • How can you analyze resource allocation based on making decisions at the margin?

Humans have unlimited wants. There is no way to satisfy everyone's desires in a world with limited resources. The scarcity of resources necessitates choices about using the amount of resources to satisfy a given amount of wants. Scarcityexists when there is not enough of something (product, service, resource) to satisfy everyone's wants at no cost. Even if the desired item were free, enough would not be available to satisfy its demand.

Opportunity cost is the highest-valued foregone alternative when any choice is made. The cost of one item means the lost opportunity to do something else. It is the value of the next best alternative.

People and societies rarely make all-or-nothing choices. Too much of a good thing is too much! We have discussed the need to consider the opportunity cost of foregone alternatives when making rational decisions. A rational consumer will only purchase additional units of a product if the utility (satisfaction from the product) exceeds the opportunity cost.

When we purchase or consume more units of a product, we derive less satisfaction from each additional unit. This equalizes the choice between the product and the next best-valued alternative.

Marginal analysis examines the cost and benefits of choosing a little more or a little less of a good. Rather than examine the total cost and benefit, we should compare how costs and benefits change from one option to another.

Let's say you are hungry and pay $20 for a big, sloppy pizza. After the fourth slice, you may start thinking about the new book you could have bought with the $20. How about after the sixth slice? You may feel queasy and wish you had bought the book instead. This is the law of diminishing utility! It says the additional (marginal) utility from each additional unit of the good declines as you receive more of a good.

To review, see:

1e. Apply the production possibilities curve to identify production combinations that are efficient, inefficient, and unattainable

  • What is the production possibilities curve?
  • What is the production possibilities frontier (PPF)?
  • What do efficient, inefficient, and unattainable positions on the PPC curve look like?
  • What are some objections to economic models such as the PPF curve?

The production possibilities curve visually displays all potential production combinations of two goods, given that all production factors are utilized completely and efficiently.

The production possibilities frontier highlights various economic principles, including allocative efficiency, economies of scale, opportunity cost, productive efficiency, and resource scarcity.

The graph below shows a PPC for spending on roads and defense. Because there is a limited number of resources (money) to use for these categories, points on the curve (E, B, C) depict points where we can only spend money on roads or defense by taking dollars away from the other category. These points are efficient.

Point A shows where the government can spend on both categories. However, this point is inefficient because dollars are left on the table or wasted (to spend on something else?). Point D is outside the curve. It is unattainable because there are not enough resources (money) available to spend the amount depicted on roads and defense. All points on the curve or inside the curve are attainable; points outside the curve require more resources.

Graph showing spending on roads vs spending on defense. E, B, and C are on the curve, A is inside, D is outside

Note that, as succinct and illustrative economic models, graphs, and theories are, their conclusions are often open to interpretation and opinion. We study two objections to this economic decision-making approach: 1. People, firms, and society do not act like this, and 2. People, firms, and society should not act this way. Human behavior is difficult to predict and not always accurate. However, the economics approach can help analyze and understand the tradeoffs of economic decisions.

To review, see:

1f. Define demand, supply, and market equilibrium

  • What are demand, supply, and market equilibrium?

Markets include buyers and sellers. Demand describes the behavior of buyers in the marketplace.

The Law of Demand – What is the relationship between the quantity demanded and the price of a good? Do we consume more or less of a good when the price increases or decreases? How does the law of demand help us answer these questions?

Demand Determinants – Many factors affect demand, including income, prices of related goods, population, and preferences. Factors other than price are "shifters" of demand – changes in these variables cause the demand curve to shift up or down.

As you study this material, pay attention to the differences between substitutes and complements and their effect on demand. Make sure you can distinguish between normal and inferior goods and the effects of income on demand for each type of goods. Study the effect of these variables on demand by reviewing the graphical analysis presented in the course materials.

The most important determinants of demand include.

  • Preferences;
  • Prices of related goods and services;
  • Income;
  • Demographic characteristics; and
  • Buyer expectations.

Supply describes the behavior of sellers in the market. The analysis of supply follows a similar path as the analysis of demand in the previous section.

The Law of Supply – What is the relationship between the quantity supplied and the price of a good? Do producers have an incentive to produce and sell more or less of a good when the price increases or decreases? The Law of Supply can help us answer these questions.

Supply Determinants – Many factors affect supply. Factors other than price are "shifters" of supply – changes in these variables cause the supply curve to shift up or down. Study the effect of these variables on supply by reviewing the graphical analysis presented in the course materials.

The most important determinants of supply include. 

  • Prices of factors of production;
  • Returns from alternative activities;
  • Technology;
  • Seller expectations;
  • Natural events; and
  • The number of sellers.

Market equilibrium – The equilibrium is the point where the supply curve and the demand curve intersect. The equilibrium price is the only price where the amount of product consumers want to buy (quantity demanded) equals the amount of product producers want to sell (supply quantity).

For example, at an equilibrium price of $1.40 for 600 million gallons of gasoline, any price above this quantity supplied exceeds the quantity demanded, resulting in excess supply. At a price below market equilibrium, the quantity demanded exceeds the quantity supplied, resulting in excess demand.

Answer this question. What happens to the demand curve when incomes rise or when the price of complementary goods falls? What about when tastes and preferences change to favor a particular good or service or when the number of people or population rises?

  • Increased demand means that at every given price, the quantity demanded is higher. The demand curve shifts to the right.

Hint: Is this all about the quantity or a change in the demand situation?

To review, see:

1g. Explain how changes in demand and supply affect the demand and supply curves and alter the equilibrium prices and quantities

  • What factors can shift the supply curve?
  • What factors can shift the demand curve?

Pay particular attention to the different effects caused by the price of the good and the shifters of demand. A change in the price of a good will not shift the demand curve but will cause a movement along the demand curve.

Many students confuse demand and quantity demanded. Consider that the quantity demanded is illustrated at a specific point on the demand curve. When the price of the good changes, there is a movement along the demand curve, which represents a change in quantity demanded, but demand itself remains in the same position … it does not change. 

Subsequently, if an exam question asks you if demand for a good changes when its price changes, the answer is "no," Demand itself does not shift; only the quantity demanded changes.

It is critical to distinguish between a change in quantity demanded, which is a movement along the demand curve caused by a change in price, and a change in demand, which implies a shift of the demand curve itself.

A change in a demand shifter causes a change in demand. An increase in demand is a shift of the demand curve to the right. A decrease in demand is a shift in the demand curve to the left. The above drawing of a demand curve highlights the difference.

In addition, pay particular attention to the difference in effects caused by the price of the good and the shifters of supply. A change in the price of a good will not shift the supply curve but cause a movement along it. Why is the price of the good not a shifter of supply?

Many students also confuse the supply and quantity supplied. Consider that the quantity supplied is illustrated at a specific point on the supply curve. When the price of the good changes, there is a movement along the supply curve, which represents a change in quantity supplied, but supply itself remains in the same position; it does not change.

Subsequently, if an exam question asks you if the supply of a good changes when its price changes, the answer is "no." The supply itself does not shift; only the quantity supplied changes.

In the graphs below, pay attention to the movement along the supply curve due to changes in the price of the good versus the graph that shows a shift in the supply curve due to the changes in supply.

Remember, factors that can shift the supply curve include: 

Shifts supply curve to the right:

  • Favorable conditions for production
  • A fall in input prices
  • Improved technology
  • Lower product taxes, lower regulations

Shifts supply curve to the left:

  • Poor natural conditions for production
  • A rise in input prices
  • A decline in technology
  • Higher product taxes, more regulations

Graph showing movement along the supply curve: Extension and Contraction

Graph showing changes in supply: decrease and increase

It is important to distinguish between a change in quantity supplied, which is a movement along the supply curve caused by a change in price, and a change in supply, which implies a shift of the supply curve itself. 

A change in supply is caused by a change in a supply shifter. An increase in supply is a shift of the supply curve to the right. A decrease in supply is a shift in the supply curve to the left. The above drawing of a supply curve highlights the difference.

To review, see:

1h. Describe the circular flow model, identifying linkages between the markets for goods and resources and exchanges between businesses and households

  • What are the business sector, household sector, government sector, financial sector, and the global marketplace?
  • What is the flow of payments and resources among these economic entities?

A circular flow diagram is one of the most important economic models because it identifies the economic components and players and their interdependencies.

Spending = Production
↓
Production = Payments to Inputs
↓
Payments to Inputs = Income
↓
Income = Spending


The circular flow of income describes how money flows among different sectors of the economy. 

A circular flow diagram showing the flow between households and firms going around in a circle


The circular flow diagram illustrates the exchange between households and businesses within the goods and services sector and the employment sector. Arrows indicate that households acquire products and services and compensate businesses in the goods and services sector. Conversely, in the employment sector, households supply labor and are compensated by businesses via wages, earnings, and perks.

This representation includes the five main sectors: households, firms, government, the financial sector, and the global marketplace and their contribution to the circular flow of money. For example, note that households contribute through taxes to the government, consumer spending, and private savings. Can you see where other sectors contribute?

A complex circular flow diagram showing households, firms, government, the financial sector, and the global marketplace

To review, see [1.1 What Is Economics, and Why Is It Important?] and [1.6 The Circular Flow of Income and Expenditures].

1i. Analyze price controls and how they create product shortages or market surpluses

  • Compare price controls, price ceilings, and price floors.
  • What happens to the equilibrium point if the government imposes a price control (such as a price ceiling or a price floor)? Note that government intervention means the market is no longer free and unable to respond freely. Remember to distinguish between price controls that are binding or effective and those that are not.

In a free market, capitalist economic system, economists say that buyers and sellers eventually achieve an equilibrium: the point where demand and supply intersect to create an equilibrium price and quantity in the market. Note that a completely free market economy will always reach equilibrium.

Many governments pass laws to regulate prices called price controls to protect certain citizens or businesses from the effects of the market.

For example, many governments impose price ceilings when the market equilibrium price is too high for certain populations to meet certain policy goals. Examples include restrictions against price gouging during a natural disaster – when a retailer could impose a steep price increase to take advantage of high demand for certain goods or services, such as for gas and bottled water during a hurricane when citizens need to get out of harm's way or when clean water is scarce. Rent control policies prevent landlords from increasing the rent for apartments in high-demand areas in response to the lack of affordable housing. These price controls may create long waiting lists because the demand for cheap gas, bottled water, or affordable housing remains high.

A price floor is a government regulation that restricts employers or businesses from selling items too cheaply. For example, minimum wage laws restrict employers from paying employees too little or offering salaries below a certain threshold or living wage. Similarly, the government may impose a price floor to protect valued businesses or industries, such as by imposing a minimum price buyers pay for milk to protect the local dairy industry. A price floor can create market surpluses, such as when dairy farmers raise more cows to sell more milk to take advantage of the above-market price. The government might also support the industry by buying extra milk to give to school children.

Can you think of other examples of price ceilings or price floors? As you review, it may help to draw graphs of supply and demand to review changes in the equilibrium point from shifts in demand or supply.

To review, see:

Unit 1 Vocabulary

  • change in demand
  • change in quantity demanded
  • change in quantity supplied
  • change in supply
  • circular flow diagram
  • command economies
  • demand
  • demand determinants
  • division of labor
  • economies of scale
  • equilibrium price
  • globalization
  • gross domestic product (GDP)
  • law of demand
  • law of diminishing utility
  • law of supply
  • macroeconomics
  • marginal analysis
  • market economies
  • market equilibrium
  • microeconomics
  • model
  • opportunity cost
  • production possibilities curve
  • production possibilities frontier
  • scarcity
  • specialization
  • supply
  • supply determinants
  • supply shifter
  • theory
  • traditional economies
  • utility