ECO 2013 / MACRO PROF. H.J.

VAN BOVEN

Chapter 1: Limits, Alternatives, and Choices (11 pages)

I. Economics is a social science

A. Examines how individuals, institutions, and society make optimal (best) choices under conditions
of scarcity.

B. Defined as the efficient use of limited resources to achieve the maximum satisfaction of our wants.

C. Human action is conscious or purposeful behavior meaning that people make decisions facing
constraints with some desired outcome in mind.

↔ Scarcity
II. Economic way of thinking ↔ Purposeful behavior ↔ Efficiency
↔ Benefit – cost analysis

A. Visual representation of scarcity

Unlimited wants > Limited output produced using factors of production

Output is limited because __________________________

Big circle (unlimited wants) > Small circle (output or production)

Efficiency is shown as output or production being maximized

B. Scarcity forces people to make constrained optimization decisions.

1. Can’t have it all. According to Mick Jagger, You can’t always get what you want.

2. There is no such thing as a free lunch

3. All decisions involve tradeoffs: To obtain more of one thing, society or individuals must
forego the opportunity of getting the next best thing

4. Opportunity cost of an activity refers to the value of the forgone benefit of the next best
alternative to the activity chosen
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C. Decision making uses marginal analysis, comparing the marginal benefit to its marginal cost

1. Marginal benefit (MB) refers to the additional benefit of a specific activity.

2. Marginal cost (MC) refers to the additional cost, opportunity cost, of a specific activity.

3. If the MB (activity X) exceeds the MC (activity X), then ______________________

If the MB (activity X) is less than the MC (activity X), then ______________________

If the MB (activity X) equals the MC (activity X), then the optimal has been
achieved (see page 5.F.1)

III. Theories, principles, and models

A. Economics uses the scientific method

1. Discover systematic patterns in reality in order to establish cause-and-effect

relationships, a.k.a. principles, models, or laws

2. Facts (data) Û Hypothesis (to be tested) Û Principle, model, law

3. Decisions and economic policies should be based on economic principles to resolve

specific economic problems.

B. Abstractions ---- principles, models, laws, theories, (maps) ---- are simplifications of reality.

C. Ceteris paribus means variables other than those being considered are assumed to not change.

Purpose of the ceteris paribus assumption is that it allows us to examine a functional

relationship between a dependent variable (effect) and an independent variable (cause)
without the intrusion of other relevant variables.

D. Problems in applying the scientific method in economics

1. Economic conditions and institutions are constantly changing.

2. Controlled laboratory experiments are difficult to do or impossible.

3. Ceteris paribus is only an assumption.

IV. The beach versus the sand, rocks, and shells

A. Macroeconomics examines the performance or behavior of the entire economy or its major
aggregates.

B. Microeconomics examines the behavior of individual buyers, workers, and business firms in
specific product and resource markets.
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C. All fields of study have two categories of statements

1. Positive statements or positive economics

a. Objective . . . . Fact . . . . What is . . . .

b. Functional cause-and-effect relationships.

c. Is not necessarily true, but can be proven to be either true or false.

2. Normative statements or normative economics

a. Subjective . . . . Opinion . . . . What ought to be . . . .

b. Value judgments.

c. Cannot be proven to be true or false by reference to the facts.

V. Society’s economizing problem or problem of scarcity

A. Economic wants exceed the productive capacity of an economy’s limited resources

B. Scarcity is a problem faced by all economic systems (e.g., capitalism, socialism, communism)

C. Scarcity can never be eliminated

D. Four general categories of economic resources, factors of production, or inputs

1. Land (N) refers to “gifts of nature” (natural resources) used in the production
process

2. Capital (K) refers to _____________________________________________________

a. Investment means: the production of more machines, tools, and equipment

b. Financial capital ---- money, stocks, and bonds ---- are not “capital” because
money (or stocks) in of themselves produce nothing

3. Labor (L) refers to the physical actions and mental activities that people
contribute to the production of goods and services.

4. Entrepreneurial ability (E) refers to the entrepreneur or innovator

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VI. The production possibilities model

A. Visual representation of scarcity, different levels of production, opportunity cost, unsatisfied wants

│
│
│ Given existing technology and the
│ current supply of inputs, it is
│ impossible for an economy to produce
│ outside its PPF
│
│ Unattainable today
│
│ Possible to produce a combination
│ of output inside the PPF
│
│ Attainable, but inefficient
│
│
│
│________________________________________________________________________________

The ceteris paribus assumptions for a given PPF:

1. The available supplies and quality of the factors of production are currently fixed.
Land (N), labor (L), capital (K), entrepreneurial ability (E)

2. Technology and thus productivity are currently fixed.

B. Production possibilities frontier shows the __________________ combinations of output that

can be produced when the economy uses its limited resources efficiently.

C. To achieve efficiency or “doing the best with what we have” requires ____________________
of available resources.
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D. Tradeoffs, opportunity costs, no free lunch

A fully employed economy must sacrifice one good to get more of another good

E. The production possibilities curve is bowed out from (concave to) the origin because of the
law of increasing opportunity cost.

The economic rationale for the law of increasing cost is economic resources are not
completely adaptable to
alternative uses

F. Using marginal analysis to achieve the optimal (best) level of output or the best point on the PPF.

1. Resources are allocated efficiently or allocative efficiency is achieved when:

a. (using an equation) MR = MC

b. (verbally) that combination of goods and services that society values

most highly are produced (not too little nor not too much)

2. Visual representation allocative efficiency ☺

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VII. The production possibilities model as it relates to some key macroeconomic issues

A. Unemployment

1. If the economy’s level of output is on the PPF, then resources are fully employed

2. If the economy’s level of output is inside the PPF, then resources are unemployed
or underutilized

B. Economic growth

1. Refers to the ability of an economy to “bake a larger economic pie” or produce a

larger potential output

2. Illustrated by the economy’s PPF shifting outward.

3. Sources of economic growth

a. Increase in the quantity and quality of inputs (N, L, K, E)

b. Advances in technology and thus increases in labor productivity

C. Economic decline

D. Present choices and future possibilities

1. What is the benefit of shifting resources from the production of consumer goods to
the production of capital goods?

2. What is the opportunity cost of shifting resources from the production of consumer
goods to the production of capital goods?

3. Visual representation ☺
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VIII. Critical thinking applied learning exercises

A. Given the change in economic circumstance, ceteris paribus, indicate whether the production
possibilities curve or frontier shifts outward, shifts inward, or does not shift.
Be able to explain why.

1. __________ Advances in computer technology increase labor productivity

2. __________ Increase in the number of women in the labor force

3. __________ Elimination of discrimination

4. __________ Emigration of workers from a nation

5. __________ Utilizing previously unemployed labor resources (VIII.B.2 is similar)

6. __________ Government establishes and enforces well-defined property rights

7. __________ Government tax incentives encourage firms to increase investment

8. __________ Government policies encourage entrepreneurial efforts

9. __________ Increase in international specialization and trade

10. __________ Increase in stock market prices

11. __________ Federal Reserve increases the money supply

12. __________ Prices of consumer goods and services increase substantially

13. __________ Substantial increase in consumer wants

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IX. Critical thinking applied learning exercises

Draw a production possibilities graph to indicate how each of the following changes in economic
circumstance will affect a nation. Label the axes. Explain your answer.

1. The federal government decides to allocate more resources to national defense.

This example illustrates tradeoffs and opportunity cost.

2. The unemployment rate declines from 10% to 5%.

Labor force (L) = Unemployed + Employed (chapter 9)

This example illustrates the business cycle (chapter 9)

3. Technological advance in the production of books, but not in the production of beer.

This example illustrates that technological advance leading to economic growth

does not necessarily mean proportionate increases in a nation’s capacity to produce
all its products.

4. “Grade inflation” promotes mediocracy

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X. Pitfalls to objective economic reasoning (Last Word section)

A. Biases, preconceptions, or prejudices.

B. Loaded terminology frequently used by the news media

C. Errors in reasoning or logic

1. Fallacy of composition

a. Assumes what is true for the individual must necessarily be true for the group.

b. Examples:

2. False-cause fallacy (post hoc, ergo propter hoc fallacy)

a. Assumes that because one event (B) follows another (A) it must be the result of the
first (A). Do not confuse correlation with causation.

b. Examples:

XI. Chapter 1 Appendix: Graphs and their meaning

A. Three types of relationships between two variables

1. Direct (positive) relationship occurs when the two variables move in the same direction

Visual representation ☺

2. Inverse (negative) relationship occurs when the two variable move in the opposite
direction

Visual representation ☺

3. No relationship, variables are unrelated or independent of one another.

B. If a variable that was assumed constant (ceteris paribus) changes, then the curve shifts
or changes location.

C. Slope of a line measures the amount by which one variable changes as the other changes.
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XII. Self-Assessment Diagnostic (chapter 1)

1. T F Economics is primarily concerned with determining the most equitable distribution of

society’s income.

2. T F Scarcity arises when people find themselves living in poverty.

3. T F Scarcity arises when there is never enough of anything.

4. T F “No free lunch” means that we must pay money for everything we get.

5. T F Costs exist because resources are limited and have alternative uses.

6. When the government chooses to build more roads these resources are no longer available
for public education. This dilemma illustrates the concept of __________.

7. Professor Van Bo is thinking about attending Dr. Wolfgang von Graph’s seminar on Remaking the
Configurations of Scarcity. A ticket costs $50. He will have to cancel his economics classes that
day and lose $500 in pay. The cost of attending the seminar is __________.
a. $ 50 c. $550
b. $500 d. $550 minus the benefit of attending the seminar.

8. Professor Van Bo makes $500 a day as an economics professor. After equilibrating the benefits and
costs at the margin he decides to take two days off work without pay to fly to another city to attend
a concert of his favorite band, Dѐ Mand and the Shifters. The cost of transportation and lodging for
the trip is $2,000. The cost of the concert ticket is $200. The opportunity cost of Professor VB’s
decision to attend the concert is:
a. $2,200 c. $2,700
b. $3,200 d. $1,700

9. T F One economic explanation why most college-aged movies stars do not attend college is
that the MB (college) < MC (college) or the opportunity cost is too high.

10. T F When a student decides to attend another year of college the student has concluded that the
marginal benefit of attending college has increased that year.

11. T F According to marginal analysis a decision maker takes an action if the marginal benefit of
the action is positive.

12. T F A household’s savings account at a commercial bank is considered a capital resource.

13. T F A factory used by an automobile manufacturer is considered a capital resource.

14. T F The process of accumulating common stocks and bonds is known as investment.

15. T F Building a new factory is classified as investment.

16. T F The production possibilities frontier (PPF) is downward sloping because of scarcity.
S.A.D (chapter 1) 11

17. T F Economic efficiency means that an economy is producing the maximum output, i.e., its
potential output, from its available resources.

18. T F If an economy is operating efficiently, it is not possible to increase production of any good.

19. T F To realize an efficient allocation of resources an economy must achieve an equitable

distribution of income.

20. T F Allocative efficiency is achieved when to goods most highly valued by society are
produced and in the right amount.

21. On a production possibilities curve, the single or best combination of output for an economy:
a. is a point near the top of the curve.
b. is a point at the precise midpoint of the curve.
c. is at a point near the bottom of the curve.
d. depends on the preferences of the people in that economy.

22. T F Resources are being efficiently allocated to a product when the marginal benefit
(MB) of the product equals its marginal cost (MC).

23. T F If the marginal benefit (MB) of an activity exceeds its marginal cost (MC),
then society is under-allocating resources to this activity or producing too little.

24. When the marginal cost (MC) of an activity exceeds its marginal benefit (MB), then society is
__________ resources to this activity or producing too much, “there is too much of a good thing.”

25. T F If an economy is experiencing high unemployment its level of output is inside its
production possibilities curve.

26. T F The effect of reducing high unemployment will be to shift the economy’s production
possibilities curve outward.

27. T F Economic growth is represented by a movement from a point inside the production
possibilities curve to a point on the curve.

28. T F Economic growth is represented by an outward shift of the production possibilities

curve.

29. The opportunity cost of economic growth is the current _________ that must be forgone.

30. T Macroeconomics rocks!

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ECO.2013 / MACRO PROF. H.J. VAN BOVEN

Chapter 2: The Market System and the Circular Flow (6 pages)

I. Economic system

A. A set of institutional arrangements and a coordinating mechanism used to respond to

the condition of scarcity or the economizing problem

B. Examples of an economic system include capitalism, socialism, and communism

C. Economic System (“ism”)

↕ ↕

Rules of the Game Fundamental Questions

Why do rules (laws) exist? Scarcity forces people to

answer these questions in order
to survive
1. Institutional arrangements

1. Output question
a. Ownership of resources
2. Input question

b. Legal structure 3. Distribution question

4. Change question
2. Methods for coordinating economic activity
5. Progress question

a. Social process (don’t rock the boat)

All economic systems face
scarcity and must address these
b. Political process (force) five questions

i. Collective-voting method

ii. Command method

c. Market process (voluntary)

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II. Capitalism or the market system

A. An economic system that gives private individuals and institutions the right to own the
resources (land, labor, capital, E) used in production.

B. Decision-making process used to respond to the Fundamental Questions is primarily the

market process.

III. Characteristics of capitalism

A. _________________________

B. Economic freedom; a few legal limitations to economic freedom may exist

1. Freedom of enterprise

2. Freedom of choice

C. Self-interest is the motivating force

1. Self-love (Adam Smith)

Concerned with status which involves vanity, veneration, and virtue

2. Gives direction, order, and consistency to what might otherwise be chaos

D. Competition or competitive markets (not monopolistic markets)

1. Basic regulatory or controlling mechanism of capitalism

2. Independently acting economic agents pursuing their self-interest

3. Freedom of buyers and sellers to enter or leave a market

4. Diffusion of economic power; no economic unit has any market power

E. Markets and prices

1. The organizing or coordinating mechanism

2. Market price is “discovered” through the voluntary interaction of buyers and sellers
in the product and resource markets.

3. Market system is a gigantic communications system where price is a signal that

serves as the coordinating or rationing mechanism
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F. Limited government

1. Providing the legal structure

Establish and enforce the legal “rules of the game” to protect private property
rights and provide the services needed for a market economy to operate effectively.

2. Maintain competition

Restrict anticompetitive market activity because competition promotes efficiency

3. Reallocate resources

Correct market failures (chapter 4)

a. Public goods

b. Externalities

4. Government failure (chapter 5)

IV. Some characteristics common to all economic systems

A. Use of technology and capital goods

B. Specialization

1. Self-sufficiency breeds inefficiency

2. Human specialization or division of labor

3. Geographic specialization

4. The economic benefit of specialization

a. Promotes the efficient use of society’s or the world’s limited resources

b. Increases regional or world total output

C. M-o-n-e-y
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V. The market system or capitalism answering the Fundamental Questions

A. Output question. What goods and services will be produced?

1. Guiding function of prices and profits

From society’s point of view, the function of economic profits and losses
is to signal that resources should be reallocated from less desired uses to
more desired uses.

2. Consumer sovereignty

3. Market system promotes allocative efficiency (chapter 1)

B. Input question. How will the goods and services be produced?

1. Profit maximization implies cost minimization

2. Productive efficiency occurs when firms use the best technology and right mix of
productive resources to achieve minimum production costs (least-costly method).

3. Market system promotes productive efficiency

C. Distribution question. Who will get the goods and services?

1. Depends on one’s income.

2. Money income depends on:

a. The quantities of human and property resources supplied

b. The prices of those resources in the resource market

3. Market justice: To each according to what he/she creates.

4. Is the market system efficient? Yes, objective Is the market system fair? No, opinion

D. Change Question. How will the system accommodate change?

1. Consumer preferences, technology, supplies of resources change over time; prices and
profits are signals that convey this information. Guiding function of prices and profits

2. Market system is a highly effective communications system

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E. Progress question. How will the system promote progress?

1. Higher standard of living as measured by increasing income (output) per person

2. Technological advance promotes capital accumulation, economics growth, and

creative destruction

VI. Competition and the Invisible Hand

A. Adam Smith, The Wealth of Nations, 1776

B. Invisible hand metaphor: Resource suppliers and firms, seeking to further their own
self-interest within a competitive market system, will
automatically promote the public interest (as if guided by an
invisible hand)

Self-interest or private interest means maximizing utility, income, and profits.

Public interest or social interest means promoting the efficient allocation of resources.

C. Virtues of the market system

1. ________________________________________________________

Getting the maximum output from society’s limited resources

2. Incentive structure (self-interest) promotes skill acquisition, hard work, investment,

risk taking, and innovation

3. Emphasizes and promotes economic freedom

VII. The demise of the command systems (Soviet Union, China)

A. The coordination problem of central planning

B. The incentive problem of central planning

VIII. The circular-flow model

A. Visual representation of the flows (real flow and money flow) between the sectors

B. Households and businesses (sole proprietorships, partnerships, corporations)

C. Resource market and product market

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IX. Think about it

The basic economic problems of life are what to produce, how to produce it, and how the fruits of
production are distributed among the members of society. The survival of all life forms depends on the
ability, as member of a collective (ants, fish, elephants, humans, etc.), to solve these problems or answer
these Fundamental Questions. Except for some advanced human societies, no other life forms interact via
contracts, money, and markets, to solve the basic economic problems of survival.

Only in relatively recent times (the 18th and 19th centuries) and only in some highly developed economic
systems have humans created and utilized the market system as the primary tool for organizing production
and exchange transactions. The standard of living of humans that have not developed market institutions
are, like lower life forms, closely tied to their natural environment by Malthusian principles. When
Nature is bountiful and generous, they thrive. When the conditions of supply provided by Mother Nature
turns frugal and the environment turns bleak, they die. This is not necessarily true for humans living in an
entrepreneurial market system. The residents of market economies gained the means to thrive with ever-
rising standards of living even during periods of harsh natural supply conditions.

Two cheers for the market system, but not three. Why not three cheers?

X. Self-Assessment Diagnostic (chapter 2)

1. T F A characteristic of capitalism is central planning.

2. T F A characteristic of capitalism is the private ownership of the means of production.

3. T F Consumers express self-interest when they seek the lowest price for a product.

4. T F Workers express their self-interest by seeking jobs with the best combination of wages and
benefits.

5. T F Producers are “kings” in a market economy because they determine what is produced.

6. T F The maximization of profit or the minimization of losses is the primary factor affecting the
economic decisions of entrepreneurs.

7. T F The invisible hand refers to the unseen exploitation of consumers and workers by
powerful multinational corporations.

8. T F The invisible hand refers to the federal government taxing the rich and making transfer
payments to the poor to ensure a more equitable distribution of income.

9. T F A virtue of the market system is that it results in an equal distribution of income.

10. T F A virtue of the market system is that it eliminates environmental pollution.

To find the answers navigate to the course’s homepage page on Canvas

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ECO 2013 / MACRO PROF. H.J. VAN BOVEN

Chapter 3: Demand, Supply, and Market Equilibrium (10 pages)

I. Alfred Marshall in his Principles of Economics (1890) was the first economist to bring the two opposing
forces of supply (sellers) and demand (buyers) together into a formal model.

A. Market:

institution or that brings buyers and sellers together to establish the

mechanism equilibrium price
and quantity

B. Demand: Supply:

Relationship between product price and Relationship between product price and
the quantity buyers are ______________ the quantity sellers are willing and able
to buy at each price which might exist to sell at each price which might exist
during a given time period. during a given period of time.

C. Law of demand: Law of supply:

Price and the _____________________ Price and the quantity supplied

are inversely (or negatively) related, are directly (or positively) related,
assuming all other influences on buyers’ ceteris paribus.
planned purchases remain the same.

D. Interpreting the demand curve Interpreting the supply curve

For a given quantity, the demand curve For a given quantity, the supply curve
shows the maximum price buyers are shows the minimum price that sellers are
willing and able to pay for that quantity. willing to accept for that quantity.

For a given price, the demand curve For a given price, the supply curve
shows the quantity buyers are willing shows the quantity sellers are willing
and able to buy at that price. and able to sell at that price.

E. Why is the demand curve downward Why is the supply curve upward sloping?
sloping?

skip for ECO 2013 skip for ECO 2013

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II. Factors that affect supply and demand [Mechanics of the supply and demand model ☺]

A. Determinants of demand Determinants of supply

Factors that change demand; Factors that change supply;

demand shifters supply shifters

1. Income of buyers 1. Costs of production

a. Normal good: a. Prices of the factors of production

Income and demand are b. Business taxes (statutory incidence
directly related, ceteris paribus. falls on the seller)
c. Business subsidies received
b. Inferior good:
Income and demand are
inversely related, ceteris paribus.

2. Prices of other goods purchased 2. Prices of other goods produced

by the buyer by the seller (skip for ECO 2013)

a. Substitute goods: a. Substitutes in production (skip):

Goods used in place of each other. Goods produced in place of each other

The price of good W and the demand The price of good R and the supply
for good X are directly related, of good S are inversely related,
ceteris paribus. ceteris paribus.

b. Complementary goods: b. Complements in production (skip):

Goods used together. Goods produced together.

The price of good Y and the demand The price of good T and the supply
for good Z are inversely related, of good U are directly related,
ceteris paribus. ceteris paribus.

c. Independent goods:
Goods that are not related

3. Preferences of buyers 3. New technologies and productivity

4. Expectations of buyers 4. Expectations of sellers

5. Number of buyers 5. Number of sellers

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III. Markets and prices are the organizing mechanism that coordinates the decisions of buyers and sellers.

A. The most important variable that influences a buyer’s decision to buy is ______________.

B. The most important variable that influences a seller’s decision to sell is _______________.

C. In a competitive market the rationing mechanism that brings the opposing forces of
supply and demand into balance is ____________________.

D. The market for a product is in equilibrium when there is no tendency for _____________
to change.

E. In a system of impersonal commercial interaction price serves as a signal in a market economy to

coordinate the diverse wants and abilities of the economy’s participants. Coordinating and
guiding functions (chapter 2) and rationing functions of price (chapter 3)

IV. Market equilibrium [Mechanics of the supply and demand model ☺]

A. Situation in which the opposing forces of supply and demand balance each other

B. Equilibrium

1. ___________________________________

2. ___________________________________

3. The market clears. This means that there is no surplus and no shortage.

4. At the equilibrium price the amount that buyers want to buy equals
the amount that sellers want to sell.

Visual representation of equilibrium

5. T F A market is in equilibrium when a fair price is established and the quantity

exchanged is equitable.

C. Number B.5 is false because B.1 – 4 are positive or objective statements while

B.5 is a normative statement or matter of opinion

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V. Disequilibrium [Mechanics of the supply and demand model ☺]

A. When a market is not in equilibrium it is always possible to identify mutually beneficial

trades between buyers and sellers.

B. Shortage or excess demand occurs Surplus or excess supply occurs

when the QD > QS when the QS > QD

C. Visual representation of a shortage Visual representation of a surplus

D. What causes a shortage? What causes a surplus?

_______________________________ The actual market price

is above the equilibrium price

E. How does the market automatically How does the market automatically
eliminate a shortage? eliminate a surplus?

_______________________________ The actual market price

falls towards the equilibrium price

VI. Efficiency

A. The rationing function of price refers to the ability of the competitive forces of supply
and demand to establish a price at which selling and buying decisions are consistent.,
i.e., where QD = QS.

B. Given certain conditions, the market system promotes an efficient allocation of resources.

1. Productive efficiency means producing goods using the latest technology and the least-
costly production methods.

2. Allocative efficiency means producing the particular mix of goods most highly valued by
society.

C. Visual representation of efficiency using demand (MB) and supply (MC) See p.5.F in the
chapter 1 outline
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VII. Changes in supply, demand, and equilibrium [Mechanics of the model ☺]

A. When demand or supply changes follow the three-step process to predict what happens to
equilibrium P and Q

Step 1: Draw the original market and label the price axis (P), the quantity axis (Q),
the supply curve (S), and the demand curve (D).

Step 2: Based on the definitions and concepts on page 2 determine which curve
shifts. Draw the new demand or supply curve.

Step 3: Draw the dashed reference lines then read the graph to “see” what happens to
equilibrium P and Q

B. Change in demand, holding supply constant

For the graphs, see Figure 3.7 (a) and (b) [textbook, p.66]

Increase in demand (shift right) Decrease in demand (shift left)

C. Change in supply, holding demand constant

For the graphs, see Figure 3.7 (c) and (d) [textbook, p.66]

Increase in supply (shift right) Decrease in supply (shift left)

D. Complex cases: Change in demand and a change in supply See Table 3.3 [textbook, p.67]
Skip for ECO 2013

Change in supply Change in demand Effect on price Effect on quantity

Increase Decrease Decrease Indeterminate
Decrease Increase Increase Indeterminate
Increase Increase Indeterminate Increase
Decrease Decrease Indeterminate Decrease

When only one curve shifts both the new equilibrium P and Q will be predictable.

When both curves shift simultaneously either the new equilibrium P or new equilibrium Q will
be indeterminate. This indeterminateness disappears if one knows the relative size of the changes
in supply and demand
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VIII. Critical thinking and scientific reasoning applied learning exercises

A. In a competitive market, the forces of supply and demand (rationing function of price)
automatically move the market towards equilibrium price and quantity as if guided by an
invisible hand [Adam Smith, 1776, in chapter 2]

For the following exercises draw a visual representation of the supply and demand model to predict how a
change in economic circumstance, ceteris paribus, affects equilibrium P and Q. Follow the three-step
process!!!

B. Event: An increase in the cost of building materials.

Predict what happens in the market for new homes.

Market for new homes

P: _______________

Q: _______________

C. Event: The price of new homes in Southwest Florida increase.

New homes and used (existing) homes are substitute goods.

Predict what happens in the used home market.

Market for used homes

P: _______________

Q: _______________

D. Event: A decrease in mortgage rates increase the demand for new homes and favorable
weather conditions increase the supply of new homes.

If both changes in economic circumstance occur simultaneously and independently, predict

how competitive market forces will affect the equilibrium price and quantity of new
homes.

P: indeterminate

Q: _______________
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IX. Government-set prices or price controls [Mechanics of the model ☺]

A. Price controls (non-market clearing prices):

1. Interfere with the rationing function of competitive prices L

2. Are an obstacle to achieving an efficient allocation of resources L

3. Cause undesirable side effects L

B. Price floor

1. The minimum legal price a seller may charge for a good

2. Must be set above the equilibrium price to be an effective price floor

3. Creates a permanent surplus L

4. Visual representation of government imposed price floor

C. Price ceiling

1. The maximum legal price a seller may charge for a good

2. Must be set below the equilibrium price to be an effective price ceiling

3. Creates a permanent shortage L

4. Visual representation of government imposed price ceiling

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X. Does a human kidney have value?

A The National Organ Transplantation Act (1984) is example of the undesirable side effects
or inefficiencies that arise in a government price-controlled market.

B. Visual representation of a government price ceiling in the market for human kidneys

C. As a result of this government policy a(n) shortage of kidneys will arise causing
a(n) increase in the number of people that will die.

D. The market forces of supply and demand are so powerful in promoting an efficient
allocation of resources that black markets will naturally appear, thereby causing an increase in
criminal activity, if the government imposes an effective price ceiling.

E. Is a black market an illegal market?

Is a black market an unethical market?

XI. Non-price rationing mechanisms that arise to circumvent the imbalance in a market
due to the shortage created by a government-imposed price ceiling.

A. Waiting in line, first-come-first-served

B. Favoritism

C. Steal it or an increase in criminal behavior

XII. Additional examples of government price controls

A. Rent controls (an example of a price ceiling)

B. Price ceiling on gasoline

C. Price supports on agricultural products (an example of a price floor)

D. Minimum wage (an example of a wage floor

 9

XIII. Self-Assessment Diagnostic (chapter 3)

1. T F A market refers to a group of buyers who are willing and able to purchase a good.

2. T F Demand refers to the desires of individuals.

3. T F For demand to exist there must be a supply of the product.

4. T F A decrease in the price of Oreo cookies will increase the demand for Oreo cookies.

5. T F A normal good is a good for which demand increases when price decreases.

6. T F An inferior good is a good made with substandard materials.

7. T F The supply curve shows that the larger the quantity suppliers have to sell, the
lower the price they will have to charge in order to sell it.

8. A market is in equilibrium when the __________ equals the quantity supplied

9. T F A market is in equilibrium when the number of buyers equals the number of sellers.

10. T F At the equilibrium price all buyers who want the product will get it.

11. If the quantity of homes supplied in a community is greater than the quantity of homes demanded,
then a __________ of homes will arise and we would anticipate that in a competitive market for
homes the __________ price will __________.

12. T F Allocative efficiency is defined as suppliers of a good using the best technology
and right mix of productive resources to achieve minimum production costs.

Questions #13 through #16 examine the mistakes in an actual newspaper report.
In Cuba at “official” prices there is a constant shortage of consumer goods. People explain that in
Cuba scarcity is caused by low prices. Cuban citizens say that the condition of scarcity will be
eliminated if the government will allow markets to respond to the forces of supply and demand.

13. T F Scarcity is caused by low prices. [From chapter 1, what causes scarcity?]

14. T F Scarcity creates shortages of goods. [From chapter 3, what causes a shortage?]

15. T F The market system automatically eliminates scarcity. [Scarcity can never be eliminated.]

16. The market system automatically eliminates __________.

To find the answers navigate to the course’s homepage page on Canvas

Click Files
Click the link for SAD Question Answers ECO 2013
S.A.D. (chapter 3) 10

For questions #17 through #20 draw a visual representation of the market. Use my three-step process!

17. Assume intercity bus tickets are an inferior good

Event: Income increases over time

Market for intercity bus tickets

P: _______________

Q: _______________

[See Figure 3.7(b), p.59]

18. Choose two goods that are complements. Good X: __________ Good Y: __________
Event: Higher production costs
increase the price of good X

Market for Y

P: _______________

Q: _______________

[See Figure 3.7(a), p.59]

19. Event: Technological advance increases the productivity of construction workers

Market for new homes

P: _______________

Q: _______________

[See Figure 3.7(c), p.59]

20. Event: Government increases the impact fee (excise tax) on new construction.
Market for new homes

P: _______________

Q: _______________

[See Figure 3.7(d), p.59]

ECO 2013 / MACRO PROF. H.J. VAN BOVEN

Chapter 7: Measuring Domestic Output and National Income (10 pages)

I. National income accounting

A. National Income and Product Accounts (NIPA) compiled by the Bureau of Economic
Analysis (BEA), U.S. Department of Commerce

B. Developed in the late-1930s and early-1940s.

C. Set of rules and definitions for measuring actual aggregate economic activity.

D. Measures the flow of money and physical products and resources in the circular flow.

E. Measures the economy’s overall performance over time.

F. Used to formulate policies that will improve the economy’s health over time.

II. Circular flow model of the economy when viewed as a double-entry bookkeeping system shows that there
are two equivalent ways to measure an economy’s output of goods and services in a given year.

Expenditures Method Income Method

Total spending = Total output = Total income

C + I + XN + G = GDP = wages + rent + interest + proprietor’s

income + corporate profits ( + indirect
business taxes + depreciation + net
foreign factor income)

GDP is the market value of all GDP is the income earned producing
final goods and services produced final goods and services
within a nation in a given year within a nation in a given year
 2

III. Gross domestic product (GDP) using the expenditures method

GDP is the market value of all final goods and services produced within a nation in a given year.

A. Market transaction or market value

1. Market value (P ´ Q) solves the aggregation problem involving heterogeneous goods

2. But market value (P ´ Q) creates a measurement problem if the price level changes
over time.

Must differentiate between nominal GDP (market value) and real GDP

3. A few non-market transactions are included in GDP as imputed (estimated) values.

a. Imputed rent for owner-occupied homes

b. Imputed value of food produced and consumed on a farm

B. Only final goods and services included in GDP

1. A final good or service is purchased by the ultimate or final user and is not resold

2. Focus is on final goods because they are the ultimate ingredients for human satisfaction

C. Production by American-owned and foreign-owned resources within the U.S.

D. Current production of sold and unsold goods (or inventories).

E. Compare GDP to GNP.

U.S. gross domestic product consists of the total market value of all final goods and services
produced by American-owned and foreign-owned resources within the borders of the U.S.

U.S. gross national product consists of the total market value of all the final goods and services
produced by American-owned resources anywhere in the world.
 3

IV. Not included in GDP

A. Most non-market transactions

Productive use of scarce resources, but difficult to measure since activity does not pass through an
organized market to be recorded

Household production for household consumption

B. Transactions involving intermediate goods and services.

Avoids double counting

An intermediate good or service is purchased for use in producing another good, for further
processing, or for resale; not consumed by the ultimate user.

C. Transactions where nothing was produced

Just a reallocation or transfer of existing funds

1. Public transfer payments, e.g., social security payments, veterans’ benefits,

unemployment benefits, welfare payments.

2. Private transfer payments, e.g., giving a gift of money to someone.

3. Stock and bond market transactions

D. Transactions involving used stuff or secondhand sales.

Nothing was currently produced.

Just a reallocation of existing assets

E. Transactions in the underground economy.

Productive use of scarce resources, but their market value is difficult to measure.

Includes both legal activities done off the books and illegal market transactions not reported.

F. Goods and services produced by American-owned resources (and foreign-owned

resources) outside the United States
 4

V. The four components of GDP using the expenditures method C + IG + XN + G.

A. Personal consumption expenditures (C)

1. Non-durable goods 2. Services (about 60% of C)

3. Durable goods: Products that have expected lives of 3 years or more

B. Gross PRIVATE domestic investment (IG)

1. Nonresidential

Capital goods are vital to a nation’s current and future consumption.

a. Structures
b. Producer’s durable equipment (tools, machinery)
c Intellectual property products
Useful ideas that increase the economy’s ability to produce goods and services
i. Software (excludes software embedded, or bundled, in computers)
ii. Research and development (increases stock of technology and know-how)
iii. Entertainment (music and film), literary, and artistic originals

2. Residential structures (including manufactured homes and improvements)

3. Changes in inventories

Unsold output during the accounting period is added to IG (GDP) because it represents
current production. The firm is the “end user.” When the inventory is sold in the next
accounting period the dollar amount is subtracted from IG (GDP) to avoid counting it twice.

C. Net exports (XN) XN = Exports - Imports

1. Exports include current production of final goods and intermediate goods.

According to national income accounting the “ultimate user” is the foreign nation.

2. Imports are subtracted from exports because imports do not entail production in
the U.S.

D. Government consumption and investment expenditures (G)

1. Includes spending at all levels of government -- federal, state, local. G includes spending
on all public services, e.g., tax collection, public education, military-police-court services,
R & D, new equipment and government structures. The “final user” is society.

Since many government purchases do not pass through an organized market

(e.g., does a market for aircraft carriers exist?), they are valued at the cost of production,
mostly labor costs.

2. Excludes public transfer payments because they do not represent payments for
current production
 5

VI. Value-added method of determining GDP

A. Examine the stages of production to avoid double counting

B. Value added is the market value of a firm’s output minus the market value of inputs
purchased from other firms (at each stage of production

C. Critical thinking applied learning exercise

A consumer pays $6.00 for a gallon of gasoline. The owner of the oil well receives $3.60
per gallon from an oil refiner, the oil refiner receives $5.40 per gallon from a gasoline
wholesaler, the gasoline wholesaler receives $5.60 per gallon from a gas station owner.

1. Value added by the oil well owner $ 3.60 ($3.60 - $0)

2. Value added by the oil refiner $ 1.80 ($5.40 - $3.60)

3. Value added by the gasoline wholesaler $ 0.20 ($5.60 - $5.40)

4. Value added by gas station owner $ 0.40 ($6.00 - $5.60)

5. These market transactions contribute $ 6.00 to GDP

VII. Gross private domestic investment versus net private domestic investment.

A. Two components of gross investment.

1. Net investment (net additions to the economy’s stock of capital).

2. Replacement investment (consumption of fixed capital or depreciation).

3. IG = IN + Depreciation

B. IN (stock) = IG (inflow) - Depreciation (outflow)

1. If IN > 0 then ______________________________________________

2. If IN = 0 then the economy’s ability to produce goods doesn’t change

3. If IN < 0 then the economy’s ability to produce goods decreases

 6

VIII. Measuring GDP using the income approach

A. Compensation of employees: Wages, salaries, and employer paid benefits

B. Rent: Income received by households and businesses that own property resources

C. Interest: Money paid by businesses to the suppliers of financial capital.

D. Proprietors’ income: Net income of sole proprietorships, partnerships, unincorporated firm

E. Corporate profits: Earning of the owners of corporations used for

1. Corporate income taxes
2. Dividends
3. Retained earnings

F. National income (NI) is the income earned by American-owned resources anywhere.

G. To get from NI or GNP (American resources anywhere) to GDP: (skip G)

1. Adjust NI for net foreign factor income

a. If U.S-owned resources earned more overseas than foreign-owned resources

earned in the U.S., then net foreign factor income is positive and GDP > GNP

b. If U.S.-owned resources earned less overseas than foreign-owned resources

earned in the U.S., then net foreign factor income is negative and GDP < GNP

2. Add indirect business taxes (which are included in consumption expenditures)

3. Add consumption of fixed capital (which is not earned by anyone)

IX. Other national accounts

A. National income (NI) is the income earned by American-owned resources anywhere.

B. Personal income (PI) is the income received whether earned or unearned.

C. Disposable income (DI) is income after taxes

 7

X. Nominal GDP and real GDP

A. Nominal GDP year t = Price year t ´ Quantity year t

Nominal means money values or current prices that existed in a particular year

Money or nominal values are the common denominator to sum a heterogeneous output

B. “Ruler” or measurement problem arises when using money values or current prices over
time

1. Inflation: Reduces the real value or purchasing power of a dollar

2. Deflation: Increases the real value or purchasing power of a dollar

3. To make a meaningful comparison between dollar or nominal values from

different years must convert the nominal number to a real number.

There are two methods to convert a nominal value to a real value.

C. Method 1 [use a price index]

1. Price index measures the price level in a given year relative to a base year

GDP Price index year t = Price of market basket year t

Price of market basket base year

2 Steps to follow to calculate real GDP

a. Calculate nominal GDP for each year.

b. Calculate the price index for each year.

c. Calculate real GDP for each year.

Real GDP year t = Nominal GDP year t

Price index year t

D. Method 2 [use constant prices]

1. Steps to follow to calculate real GDP

a. Use constant base-year prices to calculate real GDP for each year.

b. Real GDP year t = Price base year ´ Quantity year t

 8

XI. Critical thinking applied learning exercises

A. Using the price index method to determine real GDP

Between 2009 and 2014 in the nation of Floridastan nominal GDP increased from $360 billion to
$450 billion and the GDP price index increased from 120 to 125 (2008 = 100).

The nation’s nominal GDP ____________________ ($450 - $360)

The nation’s real GDP _______________________ $450 = ? $360 = ?

1.25 1.20

B Using the constant-price method to determine real GDP

The nation of Erewhon produces two goods, hot dogs (HD) and hamburgers (H). The data for the
economy is given below. The base year is 2001. Calculate nominal GDP and use method 2 to
calculate real GDP.

Year Price of HD Quantity of HD Price of H Quantity of H

2001 $1 100 $2 50

2002 $2 150 $3 100

2003 $3 200 $4 150

1. 2001 nominal GDP is $100 + $100 =______

2. 2002 nominal GDP is ____________________
3. 2003 nominal GDP is $600 + $600 = _____

4. 2001 real GDP is $100 + $100 =______

5. 2002 real GDP is ____________________
6. 2003 real GDP is $200 + $300 =______

If you have nominal GDP and real GDP, then you can indirectly calculate the price index without
having to use the more direct “market basket” approach

If Real GDP year t = Nominal GDP year t , then Price index year t = Nominal GDP year t
Price index year t Real GDP year t

7. 2001 GDP price index is ____________

8. 2002 GDP price index is ____________
9. 2003 GDP price index is ____________
 9

XII. Final thoughts about real GDP

A. The relationship between nominal GDP and real GDP

Assuming inflation exists, then after the base year nominal GDP will exceed real GDP

Visual representation ☺

B. The meaning of real GDP

1. Real GDP:

a. is nominal GDP adjusted for changes in the price level. [Method 1]

b. is nominal GDP measured in constant base-year prices. ]Method 2]
c. measures the actual quantity or amount of production. [Verbal]

2. The size of the economy.

a. If real GDP increases, then the size of the “economic pie” increased.

b. If real GDP decreases, then the size of the “economic pie” decreased.

c. If real GDP is larger in year 2 than in year 1, has the nation’s standard of living or
overall measure of welfare increased?

XIII. Shortcomings of GDP in measuring overall welfare or well-being

The purpose of the GDP statistic is to measure the performance of the economy, the size of the economic
pie. Even though there is a high correlation between economic performance and standard of living, the
GDP statistic was never meant to measure overall well-being.

A. Non-market activities not included, e.g., household production for household consumption.
B. Value of leisure time not included, e.g., value of walking in the surf.
C. Improved product quality understated.
D. Underground economy or legal and illegal production not reported.
E. Production of economic “bads” included in GDP, e.g. pollution cleanup, jails.
F. Composition of output, e.g., $200 for an economics textbook vs. $200 for Breyer’s Gelato.
G. Distribution of output, e.g., income skewed towards the rich vs. equally divided.
H. Noneconomic sources of well-being, e.g., aesthetics, beauty, love, and civility.
 10

XIV. Self-Assessment Diagnostic (chapter 7)

1. T F Gross domestic product is the market value of all goods and services produced by
domestic- and foreign-owned resources within a nation in a given year.

2. T F A household purchasing a new home is included in personal consumption expenditures (C)

3. In calculating the net exports (XN) component of GDP, the value of imports is:
a. added to exports because imports reflect spending by Americans.
b. added to exports because imports reflect production by foreigners.
c. subtracted from exports because imports do not entail production in the U.S.
d. subtracted from exports because imports must be bought with foreign currency.

4. T F Public transfer payments are included in GDP because they increase the income and
spending of recipients.

5. T F The total value added to a product and the market value of the final product are equal.

6. T F GDP understates the economic well-being of a nation because it excludes the value of
leisure.

7. The largest expenditures component of U.S. GDP is __________.

8. The largest component of U.S. national income is __________.

9. If the GDP price index is 175 then prices, on average, are __________ higher than in the base
year.

10. T F The GDP price index equals real GDP divided by nominal GDP (multiplied by 100).

11. If nominal GDP increased from $360 billion to $450 billion and the GDP price index increased
from 120 to 125, then real GDP __________ billion.

12. If prices in 2015 are higher on average than in the base year, then 2015 real GDP is __________
2015 nominal GDP

13. T F Real GDP is the market value of all final goods and services produced within a nation.

14. T F Real GDP refers to nominal GDP after adjustments have been made for environmental
pollution.

To find the answers navigate to the course’s homepage page on Canvas

Click Files
Click the link for SAD Question Answers ECO 2013