roger.jpgUnit I. Basic Economic Concepts

A. Scarcity, choice and opportunity costs

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Scarcity is the fundamental economic problem of having seemingly unlimited human needs and wants, in a world of limited resources. It states that society has insufficient productive resources to fulfill all human wants and needs. Alternatively, scarcity implies that not all of society's goals can be pursued at the same time; trade-offs are made of one good against others.

Opportunity cost is the cost of any activity measured in terms of the best alternative forgone. It is the sacrifice related to the second best choice available to someone who has picked among several mutually exclusive choices

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Rational choice theory, also known as choice theory or rational action theory, is a framework for understanding and often formally modeling social and economic behavior. It is the main theoretical paradigm in the currently-dominant school of microeconomics. Rationality (here equated with "wanting more rather than less of a good") is widely used as an assumption of the behavior of individuals in microeconomic models and analysis and appears in almost all economics textbook treatments of human decision-making. It is also central to some of modern political science and is used by some scholars in other disciplines such as philosophy. It is the same as instrumental rationality, which involves seeking the most cost-effective means to achieve a specific goal without reflecting on the worthiness of that goal. Gary Becker was an early proponent of applying rational actor models more widely. He won the 1992 Nobel Memorial Prize for Economic Sciences for his studies of discrimination, crime, and human capital.

B. Production possibilities curve

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The Production Possibilities Curve, pictured above, represents the point at which an economy is most efficiently producing its goods and services and, therefore, allocating its resources in the best way possible. If the economy is not producing the quantities indicated by the PPF, resources are being managed inefficiently and the production of society will dwindle. The production possibility frontier shows there are limits to production, so an economy, to achieve efficiency, must decide what combination of goods and services can be produced.

Let’s take a look at what each of these points specified mean:

  • Point A- Producing at point A would be an efficient point for a country, since it is located on the PPC. It shows, however, that the country is efficiently producing more units of wine than cotton.

  • Point B- This is also a point at which all resources are being allocated efficiently, since it is another point located on the curve. However, at this point, the country is not focusing on the production of a good, wine or cotton, over the other.

  • Point C- Again, this is another point of efficiency due to this point being located on the curve. However, producing at this point shows that the country focuses more of its resources on the production of wine rather than the production of cotton.

  • Point X- This is the first point examined at which a country would NOT be efficient with allocating its resources. Any point that lies underneath the PPC is underutilization of resources, meaning the country is not producing at its full potential.

  • Point Y- On the first graph pictured, point Y represents a point of output level that cannot be reached with the amount of resources currently available in the country. However, in the second graph, we see the curve itself shift to a new curve, including point Y. This is called growth, and can be caused by a change in technology. (For example, more advanced machinery which increased the amount produced in the same amount of time.)

C. Comparative advantage, absolute advantage, specialization and exchange

We’ll start with some basic definitions:
  • Comparative Advantage- a country has a comparative advantage in the production of a good when they can produce that good with a lower opportunity cost than another country.
  • Absolute Advantage- a country has an absolute advantage simply when they can produce more of a specific good
  • Specialization- this is when a country focuses on the production of specific goods (usually those native to their location). It is also the basis of global trade.

AP_Microeconomics Practice Exam 2
AP_Microeconomics Practice Exam 2

Nation A
Nation B
Opportunity cost of producing one crab = 1/3 of a cake
Opportunity cost of producing one crab = 1 cake
Opportunity cost of producing one cake = 3 crabs
Opportunity cost of producing one cake = 1 crab

Based on the table of opportunity costs and graph above, we can determine which countries have the comparative and absolute advantages in producing crabs and cakes, therefore, which country should specialize in what good.
Nation A has the comparative AND advantage in producing crabs, and Nation B also has both the comparative and absolute advantage in producing cakes. Therefore, Nation A should specialize in producing crabs, and Nation B should specialize in producing cakes.

D. Demand, supply and market equilibrium

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Supply and demand have similar behavior when it comes to micro and macro. However, there are still differences. Let’s compare the above graphs: the one of the left being a micro supply and demand curve, and the one on the right being an aggregate supply and demand schedule.
When converting from Micro to Macro…
  • Price turns into price level.
  • Quantity turns into output, or real GDP
  • Long –run aggregate supply, or full-employment, must be added.
  • The equilibrium still occurs at the point where the demand and supply intersect.

Economists have 3 reasons as to why the demand curve slopes downward
  1. The wealth effect: The premise that when the value of stock portfolios rises due to escalating stock prices, investors feel more comfortable and secure about their wealth, causing them to spend more.
  2. The interest-rate effect: the rationale for the down-sloping aggregate demand curve lies in the impact of the changing price level on interest rates and, in turn, on consumption and investment spending. More specifically, as the price level rises so do interest rates; rising interest rates in turn cause reductions in certain kinds of consumption and investment spending.
  3. The foreign purchases effect: if our price level rises relative to foreign countries, Australian buyers will purchase more imports at the expense of Australian goods. Similarly, foreigners will also buy fewer Australian goods, causing our exports to decline. In short, other things being equal, a rise in our domestic price level increases our imports and reduces our exports, thereby reducing the net exports component of aggregate demand in Australia.

As far as shifting the aggregate demand, a change in any of the components of AD (in other words, a change in any of the components of GDP) will shift the demand accordingly. For example, if the government were to increase spending on national security, real GDP, or aggregate demand, would increase. Likewise, government cuts back on their spending, aggregate demand decreases, because government spending is a component of GDP.

E. Macroeconomic issues: business cycle, unemployment, inflation, growth...

Business Cylce

The term business cycle refers to economy-wide fluctuations in production or economic activity over several months or years. These fluctuations occur around a long-term growth trend, and typically involve shifts over time between periods of relatively rapid economic growth (an expansion or boom), and periods of relative stagnation or decline (a contraction or recession).

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Unemployment, as defined by the International Labour Organization, occurs when people are without jobs and they have actively looked for work within the past four weeks. The unemployment rate is a measure of the prevalence of unemployment and it is calculated as a percentage by dividing the number of unemployed individuals by all individuals currently in the labor force.
File:World map of countries by rate of unemployment.svg
File:World map of countries by rate of unemployment.svg

Calculating Unemployment

  • 1
To calculate the unemployment rate for a particular area or region, you will need to know the number of unemployed workers and the total number of people in the labor force in the particular area (such as a state or country). In the United States, this data is available from the Bureau of Labor Statistics. Labor Force refers to the number of people of working age and below retirement age who are actively participating in the work force or are actively seeking employment. Note that the total population of the area or region is irrelevant when calculating the unemployment rate.
  • 2
The formula for calculating the unemployment rate (expressed as a percent) is as follows:Unemployment Rate = (Unemployed Workers / Total Labor Force) * 100
  • 3
For example: A small country has a population of 15,000 people. Of the total population, 12,000 people are in the labor force and 11,500 people are employed. What is the unemployment rate? First, find the number of unemployed by subtracting the number of employed (11,500) from the labor force (12,000). So, 12,000-11,500=500. Therefore, 500 people are unemployed. Now, to find the unemployment rate, plug the numbers into the formula: Unemployment Rate = (500/12,000)*100 = 4.2 percent.


In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a loss of real value in the internal medium of exchange and unit of account in the economy. A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index (normally the Consumer Price Index) over time.

World Rates Of Inflation
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external image inflation_2008.jpg Inflation Calculator Calculating Inflation


Economic growth is the increase of per capita gross domestic product (GDP) or other measures of aggregate income, typically reported as the annual rate of change in real GDP. Economic growth is primarily driven by improvements in productivity, which involves producing more goods and services with the same inputs of labour, capital, energy and materials. Economists draw a distinction between short-term economic stabilization and long-term economic growth. The topic of economic growth is primarily concerned with the long run. The short-run variation of economic growth is termed the business cycle.

The long-run path of economic growth is one of the central questions of economics; despite some problems of measurement, an increase in GDP of a country greater than population growth is generally taken as an increase in the standard of living of its inhabitants. Over long periods of time, even small rates of annual growth can have large effects through compounding. A growth rate of 2.5% per annum will lead to a doubling of GDP within 29 years, whilst a growth rate of 8% per annum will lead to a doubling of GDP within 10 years. This exponential characteristic can exacerbate differences across nations.


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File:Gdp accumulated change.png

©Barb E. Dahl and Chris P. Bacon
AP Economics 2011