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WMU / Economics / ECON 2020 / What is the study of how people make choices under scarcity and the re

What is the study of how people make choices under scarcity and the re

What is the study of how people make choices under scarcity and the re


School: Western Michigan University
Department: Economics
Course: Principles of Macroeconomics
Professor: James hueng
Term: Fall 2018
Tags: Macroeconomics, Economics, supply, and demand
Cost: 50
Name: Macroeconomics Midterm 1 Study Guide
Description: This study guide covers chapters 1, 3, 4, 5, and 6 that will be on our first exam coming up on Thursday.
Uploaded: 10/01/2018
13 Pages 154 Views 4 Unlocks

luke.j.schaffner (Rating: )

Most everything is on it just a little confusing with some formulas

Macroeconomics Midterm 1 Review 

How people make choices under scarcity and the results of these choices for society?

Chapter 1 

 Economics: The study of how people make choices under scarcity and the  results of these choices for society.

 Scarcity Principle: People have unlimited wants and limited resources. Having  more of one good means having less of another.

o Also called “No Free-Lunch Principle”

 Cost Benefit Principle: Take an action if and only if the extra benefits are at  least as great or greater as the extra costs.

o Assume people are rational

 A rational person has well defined goals and tries to fulfill those  goals as best they can. If you want to learn more check out Why do we study human anatomy and physiology?

o Would you walk to town to save $10 on an item?

What causes a shift in the demand curve?

If you want to learn more check out What is an example of a defense of negligence?
We also discuss several other topics like What did the 1907 gentlemen's agreement do?

 Benefits are clear

 Costs are harder to define

o Examples: You clip grocery coupons, but Bill and Melinda Gates do not ∙ To someone as rich as the Gates’ family, the costs to  

gather coupons and use them  

outweigh the benefits from savings  

form the coupons.

 Economic Surplus: Total benefits – total costs

 Opportunity Cost: The value of what must be foregone in order to undertake  an activity.

o Examples:

o Give up an hour of babysitting to go to the movies

o Give up watching TV to walk to town If you want to learn more check out Where does the krebs cycle occur?

o NOT the combined value of all possible activities

How do you calculate gdp using the income approach?

“Three Decision Pitfalls” in economic analysis

 3 general cases of mistakes

o Measuring costs and benefits as proportions instead of absolute  amounts

 Would you walk to town to save $10 on a $25 item? If you want to learn more check out What is a utilitarian appeal?

 Would you walk to town to save $10 on a $2500 item?

o Ignoring implicit costs

 The value of a frequent flyer coupon depends on its next best  use

∙ Expiration date

∙ Do you have time for another trip?

∙ Cost of the next best trip

o Failure to think at the margin

 Sunk costs cannot be recovered

∙ Eating at an all-you-can-eat buffet

∙ Attend a second year of law school

 Normative economic principle: How people should behave

o Gas prices are too high

o Building a space base on the moon will cost too much

 Positive Economics: Predicts how people will behave

o The average price of gasoline in May 2010 was higher than in May  2009

Difference between Macroeconomics and Microeconomics  Microeconomics studies choice and its implications for price and quantity in  individual markets

o Sugar, Carpets, House cleaning services

 Considers topics such as:

o Costs of production If you want to learn more check out How many terms can a governor be reelected?

o Demand for a product

o Exchange rates

 Macroeconomics studies the performance of national economies and the  policies that governments use to try to improve performance.

Chapter 3 

 Demand Curve: a graph showing the total quantity of a good or service that  buyers wish to buy at each price.

o The only thing we allow to change along a given demand curve is the  price of the good itself. If anything else changes, the curve will shift.  Demand curves have a negative slope

o B/c consumers buy less at higher prices and

o Buy more at lower prices.

 A change in quantity demanded is a movement along the demand curve that  occurs in response to a change in price.

 A change in demand is a shift of the entire demand curve

 Reservation Price: The most a buyer is willing to pay and the least a seller is  willing to sell for

 What causes a shift in the demand curve?

o Change in the price of a complement  

o Change in the price of a substitute

o Change in the price of consumer income

o Change in the preferences of consume

 Two goods are complements in consumption if an increase in the price of one  causes a leftward shift in the demand curve for the other.

 Inferior good: a good whose demand curve shifts leftward when the incomes'  of buyers increase

 Supply Curve: a graph (or schedule) showing total quantity of a good that  sellers wish to sell at each price

o Has a positive slope b/c:

 Producers want to supply more at higher prices

 Producers want to sell less at lower prices

 A change in quantity supplied is a movement along the supply curve that  occurs in response to a change in price

 A change in supply is a shift of the entire supply curve

o Has taken place if, at the same price, a different quantity is supplied. What shifts a supply curve?

 Changes in the costs of materials, labor, or other inputs used in production  Improvement in technology

 Shift in weather

 Change in the number of producers

 An expectation of a future change in prices

o An expectation of higher prices in future shifts supply curve to the right o Expectation of lower future prices shifts supply curve left

 Market Equilibrium- When all buyers and sellers are satisfied with their  respective quantities at the market price

 Excess Supply- Producers supply more than consumers are willing to buy o Qs>Qd

 Excess Demand- Consumers demand more than what producers are willing to supply

o Qd>Qs

Different Shifts

 Demand Increases

o When demand increases, market equilibrium price and quantity  both increase

 Demand decreases

o Demand decreases, market equilibrium price and quantity both  decrease

 Supply Increases

o When supply increases, market equilibrium price decreases and quantity increases

 Supply Decreases

o Supply decreases, market equilibrium price increases and quantity  decreases

 Increases in Demand and Supply (2 cases)

o Small increase in demand and large increase in supply, market  equilibrium price decreases a little and quantity increases a lot o Large increase in demand and small increases in supply, market  equilibrium price increases a lot and quantity increases a little  Decreases in Demand and Supply (2 cases)

o Small decrease in demand and large decrease in supply, market  equilibrium price increases a little and quantity decreases a lot o Large decrease in demand and small decrease in supply, market  equilibrium price decreases a little and quantity decreases a lot   Increase in Demand and Decrease in Supply (2 cases)

o Small increase in demand and large decrease in supply, market  equilibrium price increases a lot and quantity decreases a little o Large increase in demand and small decrease in supply, market  equilibrium price increases a lot and quantity increases a little  Decrease in Demand and Increase in Supply

o Small decrease in demand and large increase in supply, market  equilibrium price decreases a lot and quantity increases a little

o Large decrease in demand and small increase in supply, market  equilibrium price decreases a lot and quantity decreases a little  Price Floor: Specifies a minimum legal price below which goods cannot be  sold

o Example: Minimum wage

 Price Ceiling: Specifies the highest price that firms may leally charge. o Example: Rent Control

 Equilibrium Principle: A market in equilibrium leaves no unexploited  opportunities for individuals

o BUT it may not exploit all gains achievable through collective action o Only when the seller pays the full cost of production and the buyer  captures the full benefit of the good.

Chapter 4 

 GDP(Gross Domestic Product): The market value of all final goods and  services produced in a country during a given period of time.

o GDP in the United States has been steadily increasing for decades  GNP(Gross National Product): The market value of all final goods and services produced by resources supplied by a country during a given period of time,  regardless of where they are located.

o Differences:

 GDP measures the production of resources located in the U.S.,  regardless of who owns them.

 GNP measures the production of resources owned by U.S.  

residents, regardless of where the  

resources are located.

GDP Accounting

o There are three approaches to measure GDP:

 (1)Market Value Approach

 (2)Expenditure Approach

 (3)Income Approach

Market Value Approach to GDP (1)

 GDP(Gross Domestic Product): The market value of all final goods and  services produced in a country during a given period of time.

o This definition has 3 components:

 Market Value (a)

 Final Goods and Services (b)

 Produced within a Nation's Border (c)

 (a)Market Value: This is the selling price of goods and services in the open  market.

o It measures GDP in terms of market value, not in terms of solely  quantity of output.

o Aggregate measure of quantities produced

o More expensive items receive a higher weighting

 Willingness to pay is an indication of benefit received from the  good


o Suppose total production in a country is 4 purses ($20 each), 2 cookies ($1 each), and 1 television ($600)

 GDP= $682 -> ((20x4)+(1x2)+(600x1))

 (b)Final Goods and Services

o GDP includes only final goods and services.

Final Goods: Consumed by the ultimate user

o Example: Bread

Intermediate Goods: Used up in the production of final goods (not counted as  a part of GDP)

o Example: grain, flour

GDP avoids double counting by using the value added approach  The value added by any firm equals the market value of its product or service minus the cost of inputs purchased from other firms

 All output should be included in GDP, but not all output is accounted into GDP.  Some output is not sold through markets and is difficult to value o Examples: Police protection

 Public school education

 Work of a homemaker

 Volunteering

 Change in GDP is based on currently produced goods and services  Transactions in existing assets are not included

 Key: GDP= Gross Domestic Product

 GDP includes any goods produced within the nation's borders regardless of a  company's home country.

o Examples:

o If Toyota makes cars in Oklahoma, is that part of U.S. GDP?  Yes

o If Apple (U.S. based) makes iPhones in Canada, is that part of U.S.  GDP?

 No

Expenditure Approach to GDP (2)

 GDP= consumption

+ investment

+ government purchases

+ net exports

 Consumption: Spending by households on goods and services except the  purchase of homes (purchase of new homes is considered as investment).  Types of Consumption

o Consumer Durables- Long-lived consumer goods

 Eg: cars, furniture

o Consumer Nondurables- Short-lived consumer goods

 Eg: Food, clothing

o Services- Largest component of consumption

 Hair cut, taxi ride, legal service

 U.S. personal consumption has increased since the '60s with dips when  depressions and recessions have occurred.

 Investment: Spending by firms on final goods and services- primarily capital  goods

 A capital good is a long-lived good that is used in the production of other  goods or services.

o (factories, machines, houses, apartment buildings)

 Types of Investment

o Business Fixed Investment- Purchase by firms of new capital goods  such as machinery factories and office buildings.

o Residential Investment- Construction of new homes and apartment  buildings

o Inventory Investment- Addition of unsold goods to company inventories (as if the company bought the goods from itself)

 Government purchases: Government purchases of final goods and services. o Eg: Paying government employees, buying fighter planes, buying  furniture or government offices

 Transfer payments are not part of government spending

 Transfer payments are payments made by the government in return for which no current goods or services are received.

o Examples: Social Security benefits, unemployment benefits, pensions  to government workers, and welfare payments.

 Net Exports = Exports - Imports

 Exports: Domestically produced final goods and services that are sold abroad  Imports: Purchased by domestic buyers of goods and services that were  produced abroad

o Imports are excluded because they are already accounted for in  consumption, investment, and government spending.

 Formal Representation of GDP

o Y = C + I + G + NX


 C is consumption

 I is Investment

 G is Government purchase

 NX is next export (export - import)

Income Approach to GDP (3)

 When a good is sold, its proceeds are distributed to workers or business  owners.

 GDP = labor income + capital income

 Labor income is wages, salaries, benefits, and incomes of the self employed. o It constitutes 2/3 of GDP

 Capital Income is made of payments to owners of:

o Physical capital (such as factories, machines, and office buildings) o Intangibles (such as copyrights and patents)

 Components of capital income:

o Profits for business owners

o Rent for land

o Interest for bond or stock holders

o Royalties for holders of copyrights and patents

 GDP changes over time.

o Prices change

o Quantity of output changes

 Quantity increases (not price) to show GDP (output) growth

 To see how much output has grown, use only the changes in quantities o Hold prices  

 Nominal GDP values output in the current year using prices from the current  year

o Nominal GDP is the current dollar value of production

 Real GDP values output in the current year using the prices from the base  year.

o The base year is a reference year that seldom changes

 Real GDP measures the actual physical volume of production. Chapter 5 

 Price level: The average price of a given class of goofs or services (relative to  the price of the same goods and services in a base year)

 Consumer Price Index (CPI): A measure of the cost of a standard set, or  basket, of goods and services in that period relative to the cost of the same  basket of goods and services in a fixed year, called the based year

o CPI is the basic tool economists use to measure the price level. o A measure of the “cost of living” during a particular period relative to  what it was in the base year.

 CPI = cost of base-year basket of goods and services in current year/cost of  base-year basket of goods and services in base year

 Inflation: a situation in which the prices of most goods and services are rising  over time.

o The inflation rate is the percentage rate per period at which price level  is rising, as measured, for example, by the CPI

 Deflation: A situation in which the prices of most goods and services are  falling over time.

o For deflation, the rate of inflation is negative.

 Hyperinflation: an extremely high rate of inflation

 Adjusting for Inflation: The process of dividing a nominal quantity by the price level to express the quantity in real terms.

 Normal Quantity: A quantity that is measured in terms of current (today’s)  dollars.

 Real Quantity: A quantity that is measured in physical terms (units)  The real wage is the wage paid to the worker measured in terms of  purchasing power.

o Real wage for any given period is calculated by dividing the nominal  wage by the CPI for that period.

 Real wage = nominal wage/P

o The nominal wage expressed in terms of purchasing power.

o The quantity of goods and services a given nominal wage will  purchase.

 Indexing: The practice of increasing a nominal quantity each period by an  amount equal to the percentage increase in a specified price index (CPI) o Indexing prevents the purchasing power of the nominal quantity from  decreasing over time.

 Nominal Interest Rates: The annual percentage increase in the nominal value  of a financial asset.

 Real Interest Rates: The annual percentage increase in the purchasing power  of a financial asset.

o Real interest rate = nominal interest rate – current inflation rate  Costs of inflation:

o “Noise” in the price system (a)

o Distortions (b)

o Shoe-leather costs (c)

o Unexpected redistribution of wealth (d)

o Interference with long-term planning (e)

Noise in the price system (a)

 When inflation is high, the signals transmitted by the price system become  more difficult to interpret.

 People may be unsure if a price increase is due to inflation or due to supply  and demand shifts

 Because of this, they may make bad choices.

Distortions of the tax system (b)

 U.S. income taxes are indexed.  

o People with higher incomes pay a larger percentage of their incomes in federal income taxes.

o Inflation tends to increase nominal incomes. That is, during inflationary times, people find their nominal incomes rising.

o If tax brackets were not indexed, inflation would cause people to pay  more and more of there incomes in the form of taxes.

Shoe-Leather costs (c)

 Inflation increases the cost of holding currency.

 Because currency is more expensive to hold, people hold less currency and  make more trips to the bank to get currency.

o Hence, the cost of these trips to the bank is known as shoe-leather  costs.

Unequal redistribution of wealth (d)

 Inflation, especially unexpected inflation, redistributes income from  individuals on fixed incomes to individuals on flexible incomes.

o Inflation redistributes income from lenders to borrowers.

Interference with long-term planning

 Inflation makes planning, especially financial planning, more difficult for  households and firms.

o Example: planning for retirement, business strategies

Chapter 6

 Supply and demand analysis can be used to find the price of labor (real  wages) and the quantity (employment)

o Analysis will consider the number of workers employed, not work-hours per year.

 Labor market is an input market

o Firms buy labor to produce goods and services.

 Macroeconomics look at aggregate levels of employment and real wages. o Microeconomics looks at wage determination for a category of workers.  The labor market constitutes

o Labor Supply (the supply of labor)

o Labor Demand (demand for labor)

Individual Labor Supply

 Reservation wage is the lowest wage a worker would accept for a given job. o Opportunity cost of working is your leisure activity.

o Work compensates you for lost leisure

 If working conditions are unpleasant or dangerous, a premium  for that would be included in the wage

o Cost – Benefit Principle at work

Aggregate Labor Supply

 Macroeconomics determinants of labor supply.

o Size of working age population

 Domestic birthrate

 Immigration and emigration

 Ages when people enter and retire from the work force.

o Share of working-age population willing to work

 The labor supply curve slopes up because at a higher real wage, more people are willing to work.

Shifts of Labor Supply

 Shifts in LS are primarily caused by changes in the size of the labor force. o These shifts imply that there is a change in the number of workers  willing to work at each wage.

Shifters of Labor Supply

 Baby Booms

 Higher net immigration

 Increasing age at retirement

 Women’s participation in the labor force has increased in the last 50 years.

Labor Demand

 The demand for labor curve (LD) relates w to the Qd of N firms  LD is downward sloping; the higher w, the lower N

Wages and Demand for Labor

 The demand for labor depends upon:

o The productivity of workers

 Greater productivity increases employment

o The price of the worker’s output

 A higher real price increases employment

 Diminishing returns to labor

o Assume non-labor inputs are held constant

o Adding one worker increases output but by less than the previous  worker added

 Value of Marginal Product (VMP) is extra revenue that an added worker  generates

Demand Curve for Labor

 Hire an extra worker if and only if the VMP exceeds the wage paid  The lower the wage, the more workers employed

Shift of Labor Demand

 Demand shifts when the value of the marginal product of a worker changes  Two factors determine the demand (VMP) for labor

o The price of the company’s output

o The productivity of the workers

Shifters of Labor Demand

 An increase in market demand

 Greater quantity of non-labor inputs

 Organizational change

 Training and education

Explaining the Trends in the U.S. w and N

 We mentioned major trends in wages and employment for the US in the last  century

 Last 100 years- substantial growth in real wage

o Increases demand for labor

o Both real wages and employment increased

 Productivity increases due to:

o Technological progress

o Increases in capital

 Since 1970, the rate of increase in real wage (w) has slowed and N has  increased.

 Primary causes:

o Smaller increases in productivity – LD shifts outward by smaller  amounts

o Expanding labor force – LS shifts outward by a larger margin.  Since 1970, wage inequality has increased. Wage distribution has been  unequal.

 Primary causes:

o Globalization – expands the market for some goods (software), but  reduces the market for others (textile).

o Technological change – has tended to increase the productivity of  skilled workers. Technology favors skilled workers compared to the  unskilled.

Measuring Unemployment

 In the U.S., measuring unemployment is the responsibility of the Bureau of  Labor Statistics which surveys about 60,000 randomly selected households  each month.

 Each individual over 16 is categorized as:

o Employed

o Unemployed

o Out of the Labor Force

 Employed: if the person worked full-time or part-time during the past week or is on vacation or sick leave from a regular job.

 Unemployed: If the person didn’t work during the preceding week but made  some effort to find work in the past four weeks.

 Out of the Labor Force: If the person didn’t work in the past week and didn’t  look for work in the past four weeks.

Labor Force

 The Labor Force is the total number of employed and unemployed people in  the economy.

o LF = employed + unemployed

 Requirements for inclusion in the labor force:

o A civilian

o Over 16 years of age

o Employed

o Unemployed

Unemployment Rate

 The unemployment rate is the percentage of those in the labor force who are  not employed, but are either looking for employment or have looked in the  last four weeks.

o UR = (unemployed/laborforce) x 100

o UR = (LF – employed/laborforce) x 100

Labor Force Participation Rate

 This is the percentage of the working age population in the labor force.  LF Participation Rate = Labor force x 100%

 Working age population = labor force + out of the laborforce

US Employment Data, August 2014 (in millions)

o Employed: 146.37

o Unemployed: 9.59

o Labor force: 155.96 (146.37 + 9.59)

o Not in the labor force: 92.27

o Working-age population: 248.23

o Unemployment rate = 9.59/155.96 = 6.1%

o Participation rate = 155.9/248.2 = 62.8%


 The length of an unemployment spell is called the duration of  unemployment.

 The unemployment spell begins when the worker becomes  unemployed and ends when the worker becomes employed or leaves  the labor force.

Problems with Measured Unemployment

 1. Involuntary part-time employment

 2. Discouraged workers

 3. Underemployment

 4. False information

1. Involuntary Part-time Employment

 Part time employment – part time workers are counted as being fully  employed. However, many part time workers wish to work full time,  but can’t find suitable full time work or are on short hours for a  temporary period.

 Result: The level of unemployment is overstated and the  unemployment rate is understated.  

2. Discouraged Workers

 Discouraged Workers – Individuals who, after unsuccessfully seeking  employment, become discouraged and drop out of the labor force.  These people would accept employment if it were offered, but have  simply given up looking.

 Result: The level of unemployment and the unemployment rate are  understated.

3. Underemployment

 Underemployment – resources inefficiently used because individuals  are not employed in “optimal’ jobs.

 Result: The level of unemployment and the unemployment rate is  understated.

4. False Information

 2 different cases:

o People claim to be looking for work, but are actually not looking  for any. These people are counted as being employed, even  though they are not actually seeking employment.

 Result: The level of unemployment and the unemployment  rate are overstated.

 Reasons: Unemployment compensation or welfare benefits  may depend on actively seeking unemployment.

o People claim to be unemployed, but are actually working.

 Result: Overstates the level of unemployment and the  

unemployment rate.

 Reasons: underground economy

 Person who is employed, but claims to be  

unemployed to avoid taxes. The job itself is in some  

illegal activity.

 Person who is employed in some illegal profession.

Types of Unemployment

1. Frictional

2. Cyclical

3. Structural

4. Seasonal

Frictional Unemployment

 Frictional Unemployment – The short-term unemployment associated  with the process of matching workers with jobs.

 Frictionally unemployed workers are unemployed in the long term.

Cyclical Unemployment

 Cyclical Unemployment – The extra unemployment that occurs during  the periods of recession.

Structural Unemployment

 Structural unemployment – The long-term and chronic unemployment  that exists even when the economy is producing at a “normal” rate due to many reasons like:

o Lack of skills

o Language barriers

o Discrimination

o Economic change that creates a long-term mismatch between  skills and available jobs.

Seasonal Unemployment

 Seasonal unemployment – some occupations require workers during  only part of the year.

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