Basic economic concepts · AP Macro

Chapter 1 · Basic economic concepts

scarcity, choice, trade and markets

There is never enough of everything. Economics is the study of how people choose what to do with what they have.

The figure shows a hypothetical island that can catch fish or build boats with the same workers, land and tools. The curve is every best combination it can make. Walk along it from A to F: each extra thousand tonnes of fish costs boats, and each costs more boats than the last. The red bars on the right are those costs, 1, 2, 3, 4, 5: they rise.

That one picture holds the chapter. Resources are scarce, so choosing one thing means giving up another: its opportunity cost. Different people and countries have different opportunity costs, so they gain by specializing and trading. And in a market, the choices of buyers and sellers meet as demand and supply, and settle on a price.

This is Unit 1 of AP Macroeconomics, 5–10% of the multiple-choice section. It is short, but every later unit leans on it: aggregate demand and supply (Unit 3), the money market (Unit 4) and the foreign exchange market (Unit 6) are all drawn and shifted the way this chapter draws and shifts a market.

1.1 · Scarcity

limited resources, unlimited wants

Scarcity means that wants are unlimited but the resources to satisfy them are limited. It is why every choice has a cost.

Economists sort resources into four factors of production, each with its own payment:

Land: natural resources, from fields to fish stocks and oil. Paid rent.
Labor: human effort, physical and mental. Paid wages. Skills and education are human capital.
Capital: things made to make other things: tools, machines, buildings. Paid interest. Money is not capital in this sense; it buys capital.
Entrepreneurship: organizing the other three and taking the risk of a new business. Paid profit.

The figure gives the island 24 units of resources. Each works at fishing or at boatbuilding, not both. Moving one unit to fishing (red) makes more fish and fewer boats. Whatever the split, the outputs never reach what the islanders want (gray): 8 thousand tonnes of fish and 20 boats. That gap never closes. It is scarcity.

Scarcity is not poverty: a rich country faces it too, because its wants grow with its means. And it is not a shortage, which is a market’s temporary gap at one price (1.6).

1.1 · Who decides

economic systems, and how economists argue

Because resources are scarce, every society answers three questions: what to produce, how to produce it, and for whom.

In a market economy individuals and firms answer them, through prices, with private property and voluntary exchange. Adam Smith’s Wealth of Nations (1776) argued that people pursuing their own interest in markets are led, as if by an invisible hand, to serve others.
In a command economy the government decides: it owns the resources and plans the output.
Every real economy is a mixed economy: mostly markets, with government providing some goods, setting rules and redistributing income. Economies differ in the mix.

Microeconomics studies the choices of single households, firms and markets; macroeconomics, this course, studies the economy as a whole: total output, unemployment, inflation, growth.

A positive statement says what is, and can be tested: ‘a higher minimum wage reduces teenage employment.’ A normative statement says what ought to be: ‘the minimum wage should be raised.’ Words like should, fair or too much mark a normative one.

Economic models also hold everything else constant, ceteris paribus, to see one cause at a time. Every curve in this chapter is drawn that way.

1.2 · Opportunity cost

the production possibilities curve

The opportunity cost of a choice is the value of the next best alternative given up.

A production possibilities curve (PPC) shows the most an economy can make of two goods, with its resources and technology fixed and fully used. The island’s:

point	A	B	C	D	E	F
fish (thousand t)	0	1	2	3	4	5
boats	15	14	12	9	5	0
boats given up	–	1	2	3	4	5

Moving from C to D gains 1 thousand tonnes of fish and costs 12 − 9 = 3 boats. The opportunity cost of that fish is 3 boats. Going back, from D to C, the opportunity cost of each of those 3 boats is 1/3 thousand tonnes of fish: one is the reciprocal of the other.

The figure draws each step: blue, one more unit of fish; red, the boats given up. Between two points, opportunity cost is the slope of the curve (ignoring its sign): what falls on the vertical axis per unit gained on the horizontal.

The red steps grow, 1, 2, 3, 4, 5: increasing opportunity cost. The first resources moved to fishing are the ones best at it and worst at boatbuilding; the last are skilled shipwrights, who catch few fish and leave many boats unbuilt. Because resources are not equally suited to both goods, the PPC is bowed out (concave to the origin).

1.2 · On, inside and outside the curve

efficiency, and constant cost

Where a point lies against the PPC says how well the economy uses its resources.

On the curve: productively efficient. Making more of one good means making less of the other.
Inside it: inefficient, or resources unemployed. At (2, 6) the island could make 6 more boats at no cost in fish. A recession puts an economy here; it does not shift the curve.
Outside it: unattainable with today’s resources and technology, such as (4, 10). Growth or trade (1.3) can reach it.

Every point on the curve is productively efficient, but they are not equally good. The one point that makes the mix society values most is allocatively efficient.

When resources are equally good at both goods, the opportunity cost is the same at every step and the PPC is a straight line: constant opportunity cost. On the small graph, each unit of fish always costs 2 boats, the slope of the line. AP questions use straight-line PPCs for comparative advantage (1.3); curved ones for increasing cost.

1.2 · Shifting the curve

economic growth

Economic growth is an outward shift of the PPC: the economy can make more of both goods.

The PPC is drawn for given resources and technology, so only a change in them shifts it:

Out: more resources (a larger labor force, more capital, new natural resources), more human capital, or better technology.
Pivot: better technology for one good only. Better nets move the fish end out; the boat end stays where it was, since all-boats output has not changed. Even so the island can now have more boats too: making its fish takes fewer resources, leaving more for boats.
In: resources destroyed or lost, by a war, a natural disaster or emigration.

Not shifters: unemployment and recessions (a point inside the curve), and changes in what people want (a move along it).

Today’s choice moves tomorrow’s curve. Boats are capital goods; fish are consumer goods. An island that builds more boats now eats less now, but with more boats its PPC shifts out further later. An economy that chooses more capital goods grows faster.

1.3 · Comparative advantage

who should make what

A producer has a comparative advantage in a good when it can make it at a lower opportunity cost than another producer. Trade follows comparative advantage, not absolute advantage.

Two hypothetical countries, each using all its resources (an output table):

	wheat	cloth
Country A	60	30
Country B	24	24

Country A has an absolute advantage in both goods: with its resources it makes more of each. That does not settle who should make what. Opportunity costs do. A gives up 30 cloth for 60 wheat, so 1 wheat costs it 30/60 = 0.5 cloth. With output figures, divide the other good by the good you are costing (‘other over’).

opportunity cost	of 1 wheat	of 1 cloth
Country A	0.5 cloth	2 wheat
Country B	1 cloth	1 wheat

A makes wheat more cheaply (0.5 against 1 cloth): A has the comparative advantage in wheat. B makes cloth more cheaply (1 against 2 wheat): B has it in cloth. Opportunity costs are reciprocals, so each country always has a comparative advantage in one good (unless their costs are equal).

The same facts as an input table, the hours each needs for one unit (given 120 hours of work):

hours for one unit	wheat	cloth
Country A	2	4
Country B	5	5

Fewer hours is the absolute advantage. Now divide the good’s own hours by the other’s (‘input: own over’): 1 wheat costs A 2/4 = 0.5 cloth. The same answers.

David Ricardo made the case in 1817 with the same twist: Portugal needed fewer men than England for both wine and cloth, yet both gained when Portugal made wine and England cloth.

1.3 · Gains from trade

specialize, trade, and consume beyond the curve

When each country specializes in the good of its comparative advantage and they trade, both can consume a combination outside their own PPC.

Without trade each country consumes what it makes, a point on its own PPC: A at (40, 10), B at (12, 12), wheat first. Together: 52 wheat and 22 cloth.

Now A makes only wheat (60) and B only cloth (24). Together: 60 wheat and 24 cloth, more of both. A sends B 16 wheat for 12 cloth: 0.75 cloth per wheat.

	without trade	with trade	gain
Country A	40 wheat, 10 cloth	44 wheat, 12 cloth	+4 wheat, +2 cloth
Country B	12 wheat, 12 cloth	16 wheat, 12 cloth	+4 wheat, +0 cloth

Each red point leaves its country’s PPC. A could make only 36 wheat with 12 cloth on its own; B only 12.

The terms of trade, the price of one good in the other, must lie between the two opportunity costs, here between 0.5 and 1 cloth per wheat. At 0.75, A gets more cloth for its wheat than the 0.5 it would give up making cloth itself, and B pays less than the 1 cloth that wheat would cost it at home. Outside that range one country would rather make the good itself.

1.4 · Demand

the law of demand

Demand is how much buyers are willing and able to buy at each price, other things equal. The law of demand: as price rises, quantity demanded falls.

A hypothetical market for coffee, quantity in thousands of cups a day:

price ($ a cup)	1.50	2.00	2.50	3.00	3.50	4.00	4.50
quantity demanded	70	60	50	40	30	20	10
quantity supplied	10	20	30	40	50	60	70

The demand curve slopes down for three reasons:

Substitution effect: a higher price makes other goods relatively cheaper, so buyers switch to them.
Income effect: a higher price makes the same income buy less.
Diminishing marginal utility: each extra cup adds less satisfaction than the last, so buyers pay less for more.

In the figure the price first moves, from $2.00 to $4.00: the point slides along the curve. That is a change in quantity demanded, from 60 to 20. A change in the good’s own price never shifts its demand curve.

1.4 · Shifting demand

a change in demand

A change in demand shifts the whole curve: at every price, buyers want more (right) or less (left). Only a change in something other than the good’s own price does that.

The determinants of demand:

Tastes and preferences: a report that coffee is healthy shifts demand right.
Income: for a normal good, more income raises demand; for an inferior good (bus rides, store brands), more income lowers it.
Prices of related goods: a rise in the price of a substitute (tea) raises demand for coffee; a rise in the price of a complement (pastries, coffee makers) lowers it.
Expectations: buyers who expect prices or their incomes to rise buy more now.
Number of buyers: more people in the market, more demand.

In the figure the price stays at $3.00 and the curve itself moves, 25 thousand cups right, then left: the quantity at $3.00 goes from 40 to 65, then to 15.

Keep the words apart. ‘Demand’ is the whole curve; ‘quantity demanded’ is one point on it. A price change causes a change in quantity demanded; a determinant causes a change in demand.

1.5 · Supply

the law of supply, and what shifts it

Supply is how much sellers are willing and able to sell at each price, other things equal. The law of supply: as price rises, quantity supplied rises.

A higher price makes each cup more profitable, and covers the higher cost of making more: producing extra output usually costs more per unit (increasing marginal cost), as the bowed-out PPC showed. So the supply curve slopes up. In the figure, a price rise from $2.00 to $4.00 raises quantity supplied from 20 to 60: a movement along the curve.

The determinants of supply shift the whole curve:

Input prices: dearer coffee beans or higher wages shift supply left.
Technology and productivity: a faster machine shifts it right.
Number of sellers: more cafés, more supply.
Taxes and subsidies: a tax on each unit shifts supply left; a subsidy right. So does regulation, which raises costs.
Expectations of sellers: if they expect a higher price later, they may hold back supply now.
Prices of other goods the seller could make: if tea pays better, a café supplies less coffee.

A rightward shift is an increase in supply: more is offered at every price. On the graph that is also down: each quantity is now offered at a lower price. Say ‘right’ and ‘left’, never ‘up’, to avoid confusion.

1.6 · Market equilibrium

shortage, surplus, and the price that clears

A market is in equilibrium at the price where quantity demanded equals quantity supplied. There, the market clears.

In the coffee market that is P* = $3.00 and Q* = 40 thousand cups: in the table at $3.00, both are 40.

Hold the price anywhere else and the market is in disequilibrium:

Above equilibrium, at $4.00: sellers offer 60 but buyers take 20. A surplus of 40: unsold coffee. Sellers cut the price.
Below it, at $2.00: buyers want 60 but sellers offer 20. A shortage of 40: queues and empty shelves. Buyers bid the price up.

The red bar is the gap, measured across, in quantity; the arrow is the pressure on price. Either way the price is pushed toward $3.00, and the gap closes. A legal maximum price set below equilibrium (a price ceiling) keeps a shortage; a legal minimum above it (a price floor) keeps a surplus.

Quantity actually sold is the smaller of the two: at $4.00 only 20 are bought, at $2.00 only 20 are sold.

1.6 · Changes in equilibrium

one curve shifts

When demand or supply shifts, the equilibrium moves along the other curve to a new price and quantity.

Work it in three steps, and draw it: (1) which curve shifts, and why; (2) which way; (3) read the new intersection against the old. Label the axes P and Q, the curves D and S, the old equilibrium P₁, Q₁ and the new P₂, Q₂, with an arrow for the shift.

Demand increases (right): P ↑, Q ↑. Here 30 thousand cups: $3.00 → $3.75, 40 → 55.
Demand decreases (left): P ↓, Q ↓: $2.25, 25.
Supply increases (right): P ↓, Q ↑: $2.25, 55.
Supply decreases (left): P ↑, Q ↓: $3.75, 25.

Demand shifts move price and quantity the same way; supply shifts move them opposite ways.

Mind the trap: when demand rises, the price rises, and sellers supply more. That is a movement along the supply curve, an increase in quantity supplied, not an increase in supply. The supply curve has not moved.

1.6 · When both curves shift

one change is certain, the other indeterminate

When demand and supply shift together, one of price and quantity has a certain direction; the other depends on which shift is larger, and is indeterminate without the sizes.

both shift	P	Q
demand ↑, supply ↑	?	↑
demand ↓, supply ↓	?	↓
demand ↑, supply ↓	↑	?
demand ↓, supply ↑	↓	?

Take each shift on its own. Demand up raises P and Q; supply up lowers P and raises Q. Both push Q up, so Q rises for sure. They pull P opposite ways, so P could go either way.

The figure runs each case twice. With demand shifting 30 and supply 10, then the other way round. In the first case, Q rises to 60 both times, but P goes to $3.50 then $2.50: up, then down.

On an exam, an answer that states a definite change in the indeterminate variable is wrong. If the question gives no sizes, the right answer says it is ‘indeterminate’ or ‘cannot be determined’.