These notes are designed to give you the skills and confidence you need to succeed in IB Economics. Before we get started, here are a few key points!
Keep in mind that this course is designed to support your face-to-face instruction and is not designed to be a replacement.
That’s it! Let’s get started!
Throughout the entire economics course in the IB, you will need to reference the Key Concepts. The Key Concepts are designed to connect themes throughout the curriculum to the real world broadly. You will use these Key Concepts in numerous ways in the course but, most notably, in each of your internal assessment commentaries, which we’ll get to later.
Definitions to Know
| Term | Definition |
| Economics | Economics is the study of how to make the best possible use of scarce or limited resources to satisfy unlimited human needs and wants. |
| Scarcity | The limited availability of economic resources relative to society’s unlimited needs and wants of goods and services. |
Free goods | Goods such as air or sea water that are not considered scarce and thus do not have an opportunity cost. |
Utility | A measure of the satisfaction derived from consuming a good or service. |
| Choice | A law stating that as the price of a good falls, the quantity demanded will increase over a certain period of time, ceteris paribus. |
| Opportunity Cost | The next best alternative foregone when an economic decision is made. |
Sustainability | Refers to the preserving the environment so that it can continue to satisfy needs and wants into the future. Relates to the concept of “sustainable development”. |
Economic well-being | A multidimensional concept relating to the level of prosperity and quality of living standards in a country. |
Ceteris paribus | A Latin expression meaning “other things being equal”. |
Economics is all around us. It influences our decisions, the prices we pay, the jobs we pursue, and how societies function. At its core, economics studies how individuals, businesses, and governments allocate scarce resources to fulfill their needs and wants.
The most fundamental concept in economics is scarcity. It refers to the limited nature of resources relative to our infinite wants and desires. Because of scarcity, we must choose how to use our resources wisely.
Scarcity reminds us that resources, such as time, money, and materials, are limited compared to individuals’ and societies’ endless wants and needs. Therefore, scarcity compels individuals and societies to make choices. As we navigate a world of limited resources, we face a constant dilemma – making choices. Every decision, from the most trivial to the most significant, involves trade-offs. When we allocate resources to one particular option, we forgo the opportunity for others.
However, not all choices are created equal and in actuality, we frequently narrow down our choices to a few top contenders. In economics, we use the term opportunity cost for the next best alternative given up when making a decision.
Economics In Story
Imagine this scenario: You and your friends are planning to go out for dinner at a popular restaurant known for its diverse and exquisite menu. As you all gather at the restaurant, you are greeted with a plethora of options, each dish prepared with fresh and sustainable ingredients. However, you quickly realize that you are faced with a classic economic challenge – scarcity.
The restaurant, dedicated to offering high-quality dishes, has limited availability of certain seasonal ingredients. Some of your favourite choices from the menu are unavailable tonight due to the scarcity of these specific ingredients.
Now, you find yourself making a choice between two delectable options: a mouthwatering vegetarian lasagna with layers of rich marinara sauce and cheese or a delightful quinoa and avocado salad with a tangy lemon vinaigrette. Both dishes are equally tempting, but you know that choosing one means forgoing the other. Herein lies the concept of opportunity cost.
The opportunity cost, in this case, is the satisfaction and delight you would have experienced from the dish you did not choose. If you opt for the lasagna, the opportunity cost is the joy of savouring the refreshing quinoa and avocado salad. On the other hand, if you choose the salad, the opportunity cost is the enjoyment you would have derived from indulging in the flavorful vegan lasagna.
This dinner scenario beautifully exemplifies the essence of economics in everyday life, even in the realm of dining. Scarcity urges us to make choices, and each choice comes with an opportunity cost. Whether it’s selecting a dinner option, deciding on a career path, or allocating resources in a nation’s economy, understanding these trade-offs is crucial in making informed decisions.
As we progress through this course, we will continue to explore how scarcity, choices, and opportunity cost influence various aspects of economics, applying these principles to dinner choices and broader economic scenarios.
Practice Problem (KEY BELOW)
Read each scenario and answer the accompanying questions.
Question: What resources are scarce in this scenario? What are the opportunity costs associated with the farmers’ decision between growing wheat and corn?
Question: What resources are scarce in this scenario? What are the opportunity costs associated with the student’s decision between studying and participating in the charity event?
Question: What resources are scarce in this scenario? What are the opportunity costs associated with the business owner’s decision between investing in new machinery and employee training?
ANSWER KEY
1.
Answer:
Resources that are scarce: Land (limited farmland).
Opportunity costs:
If the farmers choose to grow wheat, the opportunity cost is the potential crop of corn they could have grown on the same land. If the farmers choose to grow corn, the opportunity cost is the potential crop of wheat they could have grown on the same land.
2.
Answer:
Resources that are scarce: Time (limited hours in the weekend).
Opportunity costs:
If the student chooses to study for the economics exam, the opportunity cost is the time they could have spent supporting the charity event and making a positive impact on the community.
If the student chooses to participate in the charity event, the opportunity cost is the time they could have spent studying and preparing for the upcoming exam.
3.
Answer:
Resources that are scarce: Financial resources (limited funds).
Opportunity costs:
If the business owner chooses to invest in new machinery, the opportunity cost is the potential improvement in employee skills and productivity that could have resulted from employee training.
If the business owner chooses to allocate funds to train employees, the opportunity cost is the potential increase in production efficiency that could have been achieved by investing in new machinery.
Definitions to Know
| Term | Definition |
| Factors of Production | Resources used in the production of goods and services; include land (natural resources), labour, capital and entrepreneurship. |
| Capital | Physical capital refers to means of production that include machines, tools, equipment and factories; the term may also refer to the infrastructure of a country. Human capital refers to the education, training, skills and experience embodied in the labour force of a country. |
| Human capital | The education, training, skills, experience and good health embodied in the labour force of a country. |
| Entrepreneurship | Refers to the ability of certain individuals to organize the other factors of production (land, labour, capital) and their willingness to take risks. |
| Land | One of the four factors of production that refers to the natural resources with which an economy is endowed, also referred to as “gifts of nature”. |
| Labour | One of the four factors of production that refers to the physical and mental contribution of workers to the production process. |
| Resource allocation | Apportioning available resources or factors of production to particular uses for production purposes. |
| Planned Economy | An economy where the means of production (land and capital) are owned by the state. The state determines what/how much to produce, how to produce, and for whom to produce. |
| Free Market Economy | An economy where the means of production are privately owned and where market forces determine the answers to the fundamental questions (what/how much, how and for whom) that all economies face. |
| Mixed Economy | An economy that has elements of a planned economy and elements of a free market economy. In reality, all economies are mixed. What is different is the degree of the mix from country to country. |
By now, you’re delving into the heart of economics, exploring the intricate mechanisms that shape the distribution of resources, wealth, and opportunities in society. Let’s jump right in and continue our journey by exploring different economic systems and how they shape the world around us.
Who Decides Who Gets What?
Imagine society as a vast puzzle, with each piece representing a resource, a good, or a service. But who decides how these pieces are distributed among the people? This pivotal question unravels the fabric of economic systems. The way a society answers this question determines its economic system – the rules, structures, and forces that govern how resources are allocated.
In fact, every society must address three crucial economic questions:
In this module, we will explore the fundamental concepts of equilibrium and disequilibrium in the context of economics. Understanding these concepts is essential for grasping how markets function and the forces that drive them. Let’s begin!
Free Market System: Unleashing Consumer Power Enter the Free Market system, a creation of the visionary economist Adam Smith. In this dynamic system, consumers hold the reins. They own the factors of production and, through the intricate dance of supply and demand, determine what goods and services flourish in the market. This vibrant interplay requires minimal government intervention, fostering competition and innovation.
Picture a marketplace where the best ideas win, where products and services compete to win the hearts and wallets of consumers. This vibrant competition often results in high-quality offerings that meet consumers’ needs and desires. However, this system’s Achilles’ heel lies in its potential to widen inequality gaps, as those with greater resources and advantages tend to thrive. While some countries lean heavily toward a free market model, no nation is entirely devoid of government intervention.Planned Economy: The State Takes the Helm Karl Marx, another prominent economist, gave birth to the Planned Economy. In this system, the government becomes the puppeteer, controlling all factors of production and making decisions on what, how, and for whom to produce. On the surface, this appears to promote equality, as resources are meant to be distributed more equitably.
Yet, this approach comes with challenges. A heavy reliance on central planning can lead to inefficiencies, lack of incentives for innovation, and poor-quality goods due to limited competition. Countries that adopt a Planned economy often grapple with issues like corruption and bureaucracy. Take North Korea as an example of a Planned-focused economy, where the government exercises significant control over its citizens’ economic activities.The Reality Check: Mixed Economies In reality, most countries do not fit perfectly into the Free Market or Planned Economy boxes. Instead, they embrace Mixed Economies that blend elements of both systems. Let’s consider France as an illustration. While they value capitalism and free enterprise, the government still plays a role in certain sectors to ensure public welfare and stability.
Mixed economies aim to harness the strengths of both free market competition and centralized control, striving for a balance that maximizes efficiency, innovation, and social welfare.Wrapping Up Congratulations! You’ve now explored the fascinating world of economic systems. You’ve seen how the decisions about what, how, and for whom to produce shape societies and their outcomes. Remember, economic systems aren’t set in stone – they evolve over time, influenced by culture, technology, and changing global dynamics.
Watch this video to finish learning about economic systems.
Building to a Paper 1: (Answer Key Below)
In 2 paragraphs, compare and contrast the Free Market and Planned Economy economic systems.
Identify their key features, benefits, and drawbacks, and provide an example of a country for each system.
ANSWER KEY
| Free Market Economy Key Features: Consumers own factors of production. Supply and demand determine production and consumption. Minimal government intervention. Benefits: Fosters competition and innovation. High-quality goods and services driven by consumer preferences. Efficient allocation of resources. Drawbacks: Can lead to inequality due to varying access to resources. May not adequately address public goods and services. Example Country: United States | Planned Economy: Key Features: Government owns factors of production. Central planning dictates production and distribution. High degree of government control. Benefits: Aims for more equitable resource distribution. Potential for reduced wealth inequality. Drawbacks: Limited incentives for innovation and competition. Bureaucracy, inefficiency, and lack of consumer choice. Example Country: North Korea |
Comparison
Similarities:
Definitions to Know
Actual growth | A measure of the responsiveness of an economic variable (such as the quantity demanded of a product) to a change in another economic variable (such as its price or income). |
| Potential output | A curve showing the relationship between consumers’ income and quantity demanded of a good. It indicates whether a good is normal or inferior. |
Efficiency | In general, involves making the best use of scarce resources. May refer to producing at the lowest possible cost or to allocative efficiency where marginal social costs are equal to marginal social benefits or where social surplus is maximum. |
Growth in production possibilities | A measure of the responsiveness of the quantity demanded of a good or service to a change in its price. |
Production possibilities curve (PPC) | The responsiveness of demand for a good or service to a change in income. |
Productive capacity | Where a change in the price of a good or service leads to a proportionately larger change in the quantity demanded of the good or service in the opposite direction. (PED is greater than one.) |
We’re about to explore a crucial tool in understanding resource allocation, trade-offs, and efficiency in an economy – the Production Possibilities Curve (PPC). This visual model is the first you will learn in the course and will help you grasp the dynamics of scarcity, choice, opportunity cost, and growth in a captivating way. So, let’s dive in!
Understanding the Production Possibilities Curve
The PPC is like a compass that guides an economy’s journey through resource allocation and output possibilities. Before we delve into its features, let’s lay down the four key assumptions that underpin this concept:
Opportunity Costs and Increasing vs. Constant Opportunity Costs
The concept of opportunity cost is at the core of the PPC. Opportunity cost refers to the value of the next best alternative given up when a choice is made. In the PPC context, it’s about the trade-off between producing one good over another.
There are two scenarios in terms of opportunity costs: increasing and constant. In increasing opportunity cost, as you produce more of one good, you need to sacrifice increasing amounts of the other. This often happens due to the specialization of resources. Consider a country producing both guns and butter. As more resources are devoted to guns, the butter production sacrifices proportionally more.
In contrast, constant opportunity cost occurs when resources are easily adaptable between producing the two goods. Imagine an economy that can easily shift its resources between producing cars and computers.
Increasing Opportunity Costs | Constant Opportunity Costs |
 |  |
Features of the Model
The PPC encapsulates a multitude of economic principles. Here are some of its defining features:
Interpreting the Diagram
To create a PPC diagram, follow these steps:
1. Draw a horizontal axis for one good and a vertical axis for the other good.
2. Identify the maximum quantities of each good that can be produced with available resources. This forms the endpoints of the curve.
3. Plot points on the curve to represent different production combinations.
4. For increasing opportunity cost, the curve will be bowed outward. For constant opportunity cost, it will be a straight-line curve.
5. Label your axes and curve accordingly.
6. Use arrows to illustrate shifts outward for growth scenarios.
Remember, the PPC is a tool that vividly captures the essence of an economy’s resource allocation, choice, and opportunity cost. It’s your window into understanding how an economy navigates the seas of scarcity and growth.
Shifters of the PPC Curve
While the core assumptions we discussed earlier provide a solid foundation for the PPC, shifts in the curve occur due to external changes. Two primary shifters are responsible for altering the curve:
Technological Advancements: Technological progress can significantly impact an economy’s production capabilities. Improvements in technology often allow an economy to produce more output with the same amount of resources, leading to an outward shift of the PPC. Think about how innovations like automation, artificial intelligence, and improved manufacturing processes can revolutionize production possibilities.
Quantity/Quality of Factors of Production: Changes in the availability, quantity, and quality of resources also drive shifts in the curve. For instance, if a country discovers new oil reserves or experiences a sudden influx of skilled labor, its production potential can expand, resulting in an outward shift.Watch this video to finish learning about equilibrium and disequilibrium.
Shifts vs. Movements Along the Curve
It’s crucial to differentiate between shifts in the PPC curve and movements along the curve:
Shifts: A shift occurs when there is a change in one of the curve’s underlying factors – technology or the quantity/quality of factors of production. A shift implies that an economy’s potential to produce has changed, either positively (outward shift) or negatively (inward shift). For instance, a nation investing in education to improve its workforce’s skills can lead to an outward shift of the PPC curve.
Movements Along the Curve: A movement along the curve, on the other hand, doesn’t involve a change in the curve’s underlying factors. Instead, it reflects a change in resource allocation. If an economy produces more of one good at the expense of the other, it leads to a movement along the curve. For instance, if a country shifts resources from food production to technology manufacturing, it moves along the PPC curve.
Putting It All Together: Understanding Shifts and Movements
Imagine a country that invests heavily in renewable energy technology. This investment improves production efficiency and increases the nation’s capacity to produce both goods. As a result, the PPC curve shifts outward, indicating the economy’s expanded possibilities.
Conversely, consider a scenario where an adverse climate event disrupts agricultural production. This setback reduces the nation’s capacity to produce both goods, leading to an inward shift of the PPC curve.
In contrast, if the country shifts resources from manufacturing to agriculture due to a change in consumer preferences, it results in a movement along the curve. The economy’s potential production capabilities remain the same, but the distribution of resources has changed.
Understanding the dynamics of shifts and movements along the Production Possibilities Curve is akin to deciphering economic puzzles. These concepts empower economists and policymakers to predict and respond to changes in an economy, shaping resource allocation and growth strategies.
Watch this video to finish learning about the PPC Curve!
Practice Problem Set (KEY BELOW)
Read each scenario below and determine whether the Production Possibilities Curve (PPC) shifts or if there is a movement along the curve. Draw your own PPC diagram for each scenario, indicating the shift or movement and its direction.
ANSWER KEY
Scenario 1: Technological Advancements
Shift: Outward
Explanation: The introduction of automation technology increases the economy’s capacity to produce more goods with the same resources.
Scenario 2: Natural Resource Depletion
Shift: Inward
Explanation: The depletion of oil reserves reduces the nation’s capacity to produce both goods, leading to an inward shift of the PPC curve.
Scenario 3: Skilled Workforce Expansion
Shift: Outward
Explanation: The increase in skilled labor resources improves the economy’s production capabilities, resulting in an outward shift of the PPC curve.
Scenario 4: Shift in Consumer Preferences
Movement Along the Curve
Explanation: The change in consumer preferences causes a movement along the curve as resources shift from manufacturing to agriculture. The economy’s potential production capabilities remain unchanged.
Definitions to Know
Term | Definition |
Circular Flow of Income | A simplified illustration that shows the flows of income and expenditures in an economy. |
Households | Groups of individuals in the economy who share the same living accommodation, who pool their income and jointly decide the set of goods and services to consume. |
Income | A flow of earnings from using factors of production to produce goods and services. Wages and salaries are the factor reward to labour and interest is the flow of income for the ownership of capital. |
Stakeholder | An individual or group of individuals who have an interest, or stake, in an economic activity or outcome. |
Leakages | Income not spent on domestic goods and services. It includes savings, taxes and import expenditures. |
Injections | Within the circular flow model these refer to spending on domestic output that does not originate from households and thus includes investment spending by firms, government expenditures and exports. |
Foreign sector | In an open economy the term refers to exports and imports. |
Get ready to explore a fundamental model that illustrates the intricate dance of income and expenditure within an economy – the Circular Flow of Income. This model captures the dynamic interdependence between households, firms, the government, the financial sector, and the foreign sector. By the end of this module, you’ll understand how leakages and injections influence this circular flow. Let’s dive in!
The Circular Flow of Income: An Overview
At the heart of any economy lies the circular flow of income – a model that showcases the interconnected relationships between different economic players. Imagine a bustling marketplace where income flows from one entity to another, forming a continuous loop of economic activity.
Interdependence of Economic Stakeholders
In the circular flow, households, firms, the government, the financial sector, and the foreign sector are all interdependent – their actions impact and influence one another. Here’s a glimpse of their roles:
Households: They are the primary consumers and owners of factors of production. Households offer their labor and receive wages, while they also spend on goods and services.
Firms: These are businesses that produce goods and services. They hire labor from households, pay wages, and generate revenue from the sale of goods and services.
Government: The government collects taxes from households and firms, which it uses to provide public goods and services. Government spending injects money into the circular flow.
Financial Sector: This sector includes banks and other financial institutions that facilitate the flow of funds between households and firms. They enable saving and borrowing, which affect the circular flow.
Foreign Sector: International trade and transactions with foreign countries are a part of the circular flow. Exports and imports influence the circular flow of income.
Leakages and Injections: Influencing the Flow
While the circular flow appears seamless, it’s influenced by leakages and injections. Leakages are exits from the circular flow, such as savings, taxes, and imports, which reduce the flow of income within the economy.
Injections, on the other hand, are additions to the circular flow, such as investment, government spending, and exports, which enhance income circulation.
Diagram 1: Circular Flow Model
“File:Five Sector Circular Flow of Income Model.jpg” by Ari89 is marked with CC0 1.0.
INSIDER TIP: While drawing the Circular Flow of Income might not be a common task, explaining the way payments for goods and services move within an economy is crucial. Imagine it as explaining a dynamic dance of financial exchanges, where leakages and injections play a significant role in influencing the economy’s health and vitality. So, focus on mastering the flow and its nuances to tackle questions with confidence!
Watch this video until 4:45 to deepen your understanding of the circular flow model.
Practice Problem Set (KEY BELOW)
Read each scenario below and identify whether it represents a leakage or an injection in the Circular Flow of Income. Indicate your choice and briefly explain your reasoning.
Scenario 1:
The government increases its spending on infrastructure projects, such as building roads and bridges, to stimulate economic growth.
Scenario 2:
Households decide to save a larger portion of their income in banks due to economic uncertainty.
Scenario 3:
A technology firm invests heavily in research and development, leading to innovations that increase productivity across various industries.
Scenario 4:
Imports of consumer electronics increase significantly due to changing consumer preferences, causing money to flow out of the country’s economy.
Scenario 5:
The financial sector offers loans to businesses, enabling them to expand their operations and hire more employees.
Scenario 6:
The government raises taxes on high-income households to fund social welfare programs for low-income citizens.
Scenario 7:
A foreign company purchases a significant quantity of locally-produced goods, contributing to increased revenue for domestic firms.
ANSWER KEY
Scenario 1:
Injection
Explanation: Increased government spending is an injection into the circular flow as it adds funds to the economy.
Scenario 2:
Leakage
Explanation: Increased saving by households represents a leakage as it removes money from the spending flow.
Scenario 3:
Injection
Explanation: Investment by the technology firm leads to innovations and increased productivity, which is an injection into the circular flow.
Scenario 4:
Leakage
Explanation: Increased imports represent a leakage as money flows out of the economy.
Scenario 5:
Injection
Explanation: Loans from the financial sector enable business expansion, representing an injection into the circular flow.
Scenario 6:
Leakage
Explanation: Taxes collected from households represent a leakage as they are taken out of the circular flow.
Scenario 7:
Injection
Explanation: The purchase of domestically produced goods by a foreign company is an injection into the circular flow as it adds revenue.
Unit 1 Definitions
Economic Foundations Terms to Know |
| Actual growth | Occurs when real output (real GDP) increases through time and is a result of greater or better use of existing resources. In the PPC model it can be illustrated by a movement from a point inside a PPC to another point in the northeast direction. | Leakages | Income not spent on domestic goods and services. It includes savings, taxes and import expenditure. |
| Capital | Physical capital refers to means of production that include machines, tools, equipment and factories; the term may also refer to the infrastructure of a country. Human capital refers to the education, training, skills and experience embodied in the labour force of a country. | Mixed economy | An economy that has elements of a planned economy and elements of a free market economy. In reality, all economies are mixed. What is different is the degree of the mix from country to country. |
| Ceteris paribus | A Latin expression meaning “other things being equal”. | Monetarist/new classical counter revolution | An economic school of thought arguing that the price mechanism along with well-functioning competitive markets are sufficient to lead the economy to full employment. In this school of thought, government intervention is not necessary to manage the level of aggregate demand. |
| Economics | Economics is the study of how to make the best possible use of scarce or limited resources to satisfy unlimited human needs and wants. | Normative economics | Deals with areas of the subject that are open to personal opinion and belief, thus not subject to refutation. |
| Economic well-being | A multidimensional concept relating to the level of prosperity and quality of living standards in a country. | Opportunity cost | The next best alternative foregone when an economic decision is made. |
| Entrepreneurship | Refers to the ability of certain individuals to organize the other factors of production (land, labour, capital) and their willingness to take risks. | Planned economy | An economy where the means of production (land and capital) are owned by the state. The state determines what/how much to produce, how to produce, and for whom to produce. |
| Equity | The concept or idea of fairness. | Positive economics | Deals with areas of the subject that are capable of being falsified, or shown to be correct or not. |
| Factors of production | Resources used in the production of goods and services; include land (natural resources), labour, capital and entrepreneurship. | Potential output | Output produced by an economy when it is at full employment equilibrium, or long-run equilibrium according to the monetarist/new classical model. |
| Foreign sector | In an open economy the term refers to exports and imports. | Production possibilities curve (PPC) | A curve showing the maximum combinations of goods or services that can be produced by an economy in a given time period, if all the resources in the economy are being used fully and efficiently and the state of technology is fixed. |
| Free goods | Goods such as air or sea water that are not considered scarce and thus do not have an opportunity cost. | Productive capacity | The greatest capability of an economy to produce, usually measured by maximum possible output of an economy. |
| Free market economy | An economy where the means of production are privately owned and where market forces determine the answers to the fundamental questions (what/how much, how and for whom) that all economies face. | Refutation | A method used in the natural sciences and social sciences where any proposition must be subjected to an empirical test in order to see if it can be disproven or refuted. If it is disproven or refuted, then the proposition must be rejected. |
| Growth in production possibilities | When the production possibilities of a country increase because of more/better resources and/or better technology becoming available; illustrated by a shift outwards of the PPC. | Resource allocation | Apportioning available resources or factors of production to particular uses for production purposes. |
| Households | Groups of individuals in the economy who share the same living accommodation, who pool their income and jointly decide the set of goods and services to consume. | Scarcity | The limited availability of economic resources relative to society’s unlimited needs and wants of goods and services. |
| Human capital | The education, training, skills, experience and good health embodied in the labour force of a country. | Social sciences | Academic studies of human societies and how people in society interact with each other. |
| Income | A flow of earnings from using factors of production to produce goods and services. Wages and salaries are the factor reward to labour and interest is the flow of income for the ownership of capital. | Stakeholder | An individual or group of individuals who have an interest, or stake, in an economic activity or outcome. |
| Injections | Within the circular flow model these refer to spending on domestic output that does not originate from households and thus includes investment spending by firms, government expenditures and exports. | Sustainability | Refers to the preserving the environment so that it can continue to satisfy needs and wants into the future. Relates to the concept of “sustainable development”. |
| Keynesian revolution | An economic school of thought based upon the works of John Maynard Keynes, challenging the classical (laissez faire) viewpoint and advocating an interventionist role for the government in managing the level of aggregate demand and thus of economic activity. | Utility | A measure of the satisfaction derived from consuming a good or service. |
| Labour | One of the four factors of production that refers to the physical and mental contribution of workers to the production process. | Circular flow of income | A simplified illustration that shows the flows of income and expenditures in an economy. |
| Laissez faire | The view that if market forces are left alone unimpeded by government intervention the outcome will be efficient. | Say’s Law | A proposition stating that the supply of goods creates its own demand. |
| Land | One of the four factors of production that refers to the natural resources with which an economy is endowed; also referred to as “gifts of nature”. |
Definitions to Know
| Term | Definition |
Microeconomics | The study of the behaviour of individual consumers, firms, and markets and the determination of market prices and quantities of goods, services, and factors of production. |
| Demand | The relationship between possible prices of a good or service and the quantities that individuals are willing and able to buy over some time period, ceteris paribus. |
| Law of Demand | A law stating that as the price of a good falls, the quantity demanded will increase over a certain period of time, ceteris paribus. |
| Demand Curve | A curve illustrating the relationship between possible prices of a good or service and the quantities that individuals are willing and able to buy over some time period, ceteris paribus. It is normally downward sloping. |
| Income Effect (HL Only) | The income effect states that if the price of a good increases, then the real income of consumers decreases and, typically, they will tend to buy less of the good. |
| Substitution Effect (HL Only) | When the price of a product falls relative to other product prices, consumers purchase more of the product as it is now relatively less expensive. This forms part of an explanation of the law of demand. |
| Diminishing Marginal Utility (HL) | The idea that as an individual consumes additional units of a good, the additional satisfaction enjoyed decreases |
| Non-Price Determinants of Demand | Factors other than the price of a product that influences the quantity demanded by consumers |
| Market Demand | The sum of the individual demand curves for a product of all the consumers in a market. |
Substitutes | Goods that can be used in place of each other, as they satisfy a similar need. |
Complements | Goods that are jointly consumed, for example, coffee and sugar. |
Price expectations | The forecasts or views that consumers or firms hold about future price movements that play a role in determining demand. |
Demand is foundational to the entire field of microeconomics. The law of demand states that as the price of a good increase, the quantity of consumers that demand it decreases. Take yourself, for example. Imagine your school cafeteria has a snack stand where you purchase a snack regularly. Then, you walk in one day, and the prices have increased! Of course, your immediate reaction is to evaluate whether you still want to buy the product; ultimately, some people will not.
Let’s continue looking at the demand curve through the example of this Sushi in Japan. Look at the demand curve below.
Due to the law of demand, a demand curve slows downward, illustrating the inverse relationship between price on the Y-axis and quantity on the X-axis. You can see that as sushi prices decrease, the amount demanded increases steadily.
INSIDER TIP: Any time the price of a good changes, it will result in a movement along the demand curve, causing a change in QUANTITY DEMANDED, but not DEMAND. When we speak of demand changing, it means the entire demand curve moves.
So what happens when something other than price changes that still impact demand? We call these changes “non-price determinants of demand” or “shifters of demand.” There are five shifters of demand, and they are:
A change in any of these shifters listed will result in the entire demand curve shifting to the right or left. Here is an example of decreased computer demand as laptops become more popular and cheaper. Note that the price of this good will remain constant, but fewer consumers will demand the product.
Watch this video to finish learning about our shifters of demand!
Practice Problem Set (KEY BELOW)
Scenario: The T-Shirt Company “CoolThreads”
In each problem, make sure to draw a demand diagram, identify the shift, and explain what happens to demand.
ANSWER KEY
1.
2.
3.
4.
5.
Definitions to Know
| Term | Definition |
| Supply | Quantities of a good that firms are willing and able to supply at different possible prices, over a given time period, ceteris paribus. |
| Law of Supply | A law stating that as the price of good rises, the quantity supplied will rise over a certain period of time, ceteris paribus. |
| Supply Curve | A curve showing the relationship between the price of a good or service and the quantity supplied, ceteris paribus. It is normally upward-sloping. |
| Law of Diminishing Marginal Returns (HL Only) | A short-run law of production stating that as more and more units of the variable factor(usually labour) are added to a fixed factor(usually capital) there is a point beyond which total product continues to rise but at a diminishing rate or, equivalently, marginal product starts to decrease |
| Market Supply | The horizontal sum of the individual supply curves for a product of all the producers in a market. |
| Firm | An entity such as a business that uses factors of production in order to produce and sell goods and services and earn profits. It is an important decision maker in a market economy. |
Competitive supply | When goods that a firm is producing use the same resources in their production process. The goods thus compete with each other for the use of the same resources. |
Joint supply | Goods jointly produced, for example beef and cattle hides; producing one automatically leads to the production of the other. |
Supply refers to the quantity of a good or service that producers are willing and able to offer for sale at different prices in a given market. It represents the relationship between price and quantity supplied. Understanding supply is essential in analyzing market behaviour and making predictions about producer decisions.
The law of supply states that there is a direct or positive relationship between the price of a product and the quantity supplied. As the price of a product increases, producers are typically motivated to supply more of it to the market. Conversely, as the price decreases, the quantity supplied tends to decrease. It’s important to note that the supply curve assumes that other factors influencing supply, such as production costs, technology, and government policies, remain unchanged. Any shifts in these factors will cause the supply curve to shift, indicating a change in the quantity supplied at each price level. While, any change in the price of the product itself will result in a shift along the supply curve.
Let’s continue looking at the supply curve through the example of smartphones. Let’s consider the market for smartphones when the price of smartphones increases, manufacturers and suppliers are incentivized to produce and supply a greater quantity of smartphones. This is because higher prices result in higher profits for each unit sold, providing an opportunity for businesses to capitalize on increased demand. As a result, more resources, such as labour and raw materials, are allocated to smartphone production, leading to a higher quantity supplied in the market.
Diagram 1: Smartphones
INSIDER TIP: Any time the price of a good changes, it will result in a movement along the supply curve, causing a change in QUANTITY SUPPLIED, but not SUPPLY. When we speak of supply changing, it means the entire supply curve moves.
Similar to demand, there are certain determinants of supply that can change and move the entire supply curve. There are six shifters of supply, and they are:
A change in any of these shifters listed will result in the supply curve shifting to the right or left. Here is an example of decreased electric vehicle supply as chip shortages around the world increase production costs. Note that the price of this good will remain constant, but fewer suppliers will produce the product.
Diagram 2: Electric Vehicles
Watch this video to finish learning about our shifters of supply!
Practice Problem Set (KEY BELOW)
Scenario: A coffee company”BrewBuddies”
In each problem, make sure to draw a supply diagram, identify the shift, and explain what happens to the supply.
ANSWER KEY
Scenario: BrewBuddies
1.
2.
3.
4.
5.
Definitions to Know
| Term | Definition |
| Equilibrium | A state of balance that is self-perpetuating in the absence of any outside disturbance. |
Market | Any arrangement where buyers and sellers interact to carry out an economic transaction. |
Competitive market | A market with many firms acting independently where no firm has the ability to control the price. |
| Market equilibrium | In a market, this occurs at the price where the quantity of a product demanded is equal to the quantity supplied. This is the market clearing price since there is no excess demand or excess supply. |
Quantity demanded | The quantity of a good or service demanded at a particular price over a given time period, ceteris paribus. |
Quantity supplied | The quantity of a good or service supplied at a particular price over a given time period, ceteris paribus. |
| Excess Supply (Surplus) | Occurs when quantity supplied at some price is greater than quantity demanded. |
| Excess Demand (Shortage) | Occurs when quantity demanded at some price is greater than quantity supplied. |
| Market Mechanism | The system in which the forces of demand and supply determine the prices of products. Also known as the price mechanism. |
Price mechanism | The system where the forces of demand and supply determine the prices of products. Also known as the market mechanism. |
Incentive role of prices | Prices provide producers and consumers the incentive to respond to price changes. Given a price change, producers have the incentive to change the quantity supplied in accordance with the law of supply, while consumers have the incentive to change the quantity demanded based on the law of demand. |
| Rationing System | A method used to divide or apportion goods and services or resources among the various interested parties. |
Consumer surplus | The difference between how much a consumer is at most willing to pay for a good and how much they actually pay. |
Producer surplus | The benefit enjoyed by producers by receiving a price that is higher than the price they were willing to receive. |
Social/community surplus | The sum combination of consumer surplus and producer surplus. |
Welfare loss | A loss of a part of social surplus (consumer plus producer surplus) that occurs when there is market failure so that marginal social benefits are not equal to marginal private benefits. |
In this module, we will explore the fundamental concepts of equilibrium and disequilibrium in the context of economics. Understanding these concepts is essential for grasping how markets function and the forces that drive them. Let’s begin!
Equilibrium is the state in which the quantity demanded for a good or service is equal to the quantity supplied, resulting in a balanced market. For example, consider the market for apples. If the quantity of apples demanded by consumers matches the quantity supplied by producers at a certain price, we have equilibrium. However, disequilibrium occurs when the quantity demanded and the quantity supplied are not in balance. This leads to imbalances in the market and requires adjustments.
Excess supply occurs when the quantity of a good or service supplied exceeds the quantity demanded at the prevailing price. An example of excess supply is the housing market during a recession. When there is a surplus of houses available for sale, sellers may struggle to find buyers, leading to lower prices and a buildup of unsold houses. On the other hand, excess demand arises when the quantity demanded exceeds the quantity supplied at the prevailing price. A classic example of excess demand is the frenzy surrounding the release of a new video game console. Limited supply coupled with high demand often results in scarcity, leading to higher prices and long waiting lists.
Diagram 1: Video Games (Excess Demand)
Diagram 2: Corn (Excess Supply)
INSIDER TIP: Martini Glass Trick. Once you draw the equilibrium and current price on your diagram, connect the dots. Think of that triangle as a martini glass. An upside-down martini glass means that you have a shortage (excess demand) of liquid because it has all been poured out. Alternatively, a right-side-up martini glass will result in a full martini glass, meaning you have a surplus (excess supply) of martini.
In the free market system, prices will adjust back to equilibrium through the price mechanism process through the use of signalling and incentives.
In the case of excess supply, prices tend to decrease as sellers compete to attract buyers and reduce their inventories. This price adjustment serves as a signal to both buyers and sellers. Buyers are signalled that the good or service is available at a lower price, incentivizing them to purchase more. At the same time, sellers receive a signal that their current production level is higher than what the market demands, motivating them to adjust their production levels downward.
On the other hand, in the case of excess demand, prices tend to increase due to competition among buyers striving to secure limited supply. The higher prices act as a signal to both consumers and producers. Consumers are signalled that the good or service is scarce and in high demand, which may incentivize them to reduce their consumption or search for substitutes. Producers, on the other hand, receive a signal that there is an opportunity to increase their production and capture the excess demand by expanding their operations or introducing new products.
Understanding the concepts of equilibrium and disequilibrium, as well as the role of the price mechanism, provides valuable insights into how markets operate in the real world. By examining scenarios of excess supply and excess demand, we can gain a deeper understanding of market dynamics and the forces that drive prices. In the next module, we will delve further into real-world examples and case studies to solidify our understanding of these concepts.
Watch this video to finish learning about equilibrium and disequilibrium.
Practice Problem Set (KEY BELOW)
In each problem, make sure to draw a supply and demand diagram on the same diagram, identify the shift, and explain what happened in the diagram.
ANSWER KEY
1.
2.
3.
4.
Definitions to Know
| Term | Definition |
Anchoring | Refers to situations when people rely on a piece of information that is not necessarily relevant as a reference point when making a decision. |
Behavioural economics |
A subdiscipline of economics that relies on elements of cognitive psychology to better understand decision-making by economic agents. It challenges the assumption that economic agents (consumers or firms) will always make rational choices with the aim of maximizing with respect to some objective. |
Biases | Systematic deviations from rational choice decision-making. |
Bounded rationality |
A term introduced by Herbert Simon that suggests consumers and businesses have neither the necessary information nor the cognitive abilities required to maximize with respect to some objectives (such as utility), and thus choose to satisfice. They therefore are rational only within limits. |
Bounded self-control |
The idea that individuals, even when they know what they want, may not be able to act in their interests. Findings of bounded self-control include evidence of procrastination (for example, among students, professionals and others) that may result in self-harm, and submitting to temptation (for example, dieters). |
Bounded selfishness | The idea that people do not always maximize self-interest but also have concern for the well-being of others as shown by volunteer work and charity contributions. |
Business confidence | A measure of the degree of optimism that businesses have about the economic future. |
Choice architecture | The design of environments based on the idea that the layout, sequencing, and range of choices available affect the decisions made by consumers. |
Default choice |
When a choice is made by default, meaning that when given a choice it is the option that is selected when one does not do anything. |
Framing | In behavioural economics, the term refers to the way choices are presented as a simple change of the “frame”, that may affect the choice made. For example, highlighting the positive or the negative aspects of the same choice may lead to different decisions. |
Imperfect information | When the information about a market or a transaction is incomplete. |
| Nudge theory | Nudges (prompts, hints) are used to influence the choices made by consumers in order to improve the well-being of people and society. |
Perfect information | Where all stakeholders in an economic transaction have access to the same information. |
Rational consumer choice | Occurs when consumers make choices based on the following assumptions: they have consistent tastes and preferences, they have perfect information and they arrange their purchases so as to make their utility as great as possible (maximize it). It is assumed in standard microeconomic theory. |
Rational producer behaviour | Occurs when firms try to maximize profit. This is an assumption in standard microeconomic theory. |
Restricted choices | This is when the choice of a consumer is restricted by the government or other authority. |
Rules of thumb | Rules of thumb are mental shortcuts (heuristics) for decision-making to help people make a quick, satisfactory, but often not perfect, decision to a complex choice. |
Satisficing | A business or firm objective to achieve a satisfactory outcome with respect to one or several objectives, rather than to pursue any one objective at the possible expense of others by optimizing (maximizing), for example, profit, revenue or growth. It is essentially a mix of the words “satisfy” and “suffice”. |
In this module, we’ll dive into the captivating realm of behavioural economics and explore how human behaviour and choices often deviate from traditional economic assumptions. We’ll also delve into the world of business objectives, where profit maximization is not the only goal. Let’s get started!
Rational Consumer Choice
Traditionally, economics assumes that consumers are perfectly rational decision-makers who seek to maximize their utility, possess perfect information, and make choices based on clear cost-benefit analyses. However, behavioural economics challenges these assumptions and sheds light on the limitations of rational consumer choice.
Key Concepts and Limitations
Biases: Humans often rely on cognitive shortcuts or biases, such as rule of thumb, anchoring and framing, and the availability heuristic, when making decisions. These biases can lead to suboptimal choices.
Examples:
Bounded Rationality: In reality, consumers have limited cognitive resources and time to make decisions. Bounded rationality recognizes that individuals may not always make fully rational choices due to these limitations.
Examples:
Bounded Self-Control: People sometimes struggle with self-control, making choices that may not align with their long-term preferences due to impulsivity or lack of willpower.
Examples:
Bounded Selfishness: Traditional economics often assumes that individuals act solely in their self-interest. In reality, people may exhibit altruistic behaviour and consider the welfare of others.
Examples:
Imperfect Information: Consumers often face incomplete or imperfect information, making it challenging to make fully rational choices.
Examples:
Behavioral Economics in Action
Choice Architecture: This concept recognizes that how choices are presented can significantly influence decision-making. Different choice architectures, including default options, restricted choices, and mandated choices, can steer individuals toward specific decisions.
Real World Examples:
Nudge Theory: Nudge theory involves using subtle interventions to guide people’s choices without restricting their freedom. For example, altering the default option for retirement savings from opt-in to opt-out can significantly impact participation rates.
Real World Examples:
Business Objectives
Traditional economic theory suggests that businesses exist solely to maximize profit. However, in the real world, firms pursue a variety of objectives beyond profit maximization.
Profit Maximization: Maximizing profit remains a fundamental business objective. Firms aim to earn revenue exceeding their costs to achieve this goal.
Alternative Business Objectives
Corporate Social Responsibility (CSR): Many firms adopt CSR initiatives to address social and environmental concerns, even if these actions may reduce short-term profits.
Market Share: Some businesses prioritize gaining a larger market share over immediate profit maximization, believing that market dominance will lead to greater long-term profitability.
Satisficing: Firms may seek to achieve satisfactory, rather than maximal, outcomes. They aim to meet basic objectives without striving for maximum profit.
Growth: Expansion and growth are critical objectives for many firms, as they seek to increase their reach, influence, and market presence.
Additional Real-World Examples to Deepen Understanding
Behavioural Economics: The anchoring bias is evident when consumers make decisions based on the initial piece of information they receive. For instance, a product originally priced at $1,000 but discounted to $800 may appear more attractive than a similar product initially priced at $600.
Choice Architecture: Employers can influence employees’ retirement savings by changing the default enrollment option from opt-in to opt-out. This small alteration can significantly boost participation rates in retirement plans.
Corporate Social Responsibility: Many tech companies invest in renewable energy and environmental sustainability initiatives, even if it requires substantial resources and reduces short-term profits.
Market Share: Fast-food chains often engage in price wars to gain a larger share of the fast-food market, even if it means temporarily lowering prices and sacrificing immediate profits.
Satisficing: Some small businesses may prioritize maintaining a steady, sufficient income rather than aggressively pursuing higher profits.
Growth: Companies like Amazon have focused on aggressive expansion and diversification into various industries, even if it means operating at slim profit margins for extended periods.
This module highlights the importance of recognizing that traditional economic assumptions, such as perfect rationality and profit maximization, do not always align with real-world behavior and business objectives. Behavioral economics provides valuable insights into how individuals make choices, while businesses pursue diverse goals beyond profit alone. Understanding these complexities is essential for a more comprehensive grasp of economics in practice.
Watch this video to finish learning about behavioural economics.
Review Activity: Discovering Behavioral Economics in Everyday Life (KEY BELOW)
Instructions: Your task is to identify real-world examples of behavioral economics in action from your everyday experiences. For each example, briefly describe the situation and explain how behavioral economics concepts or biases are at play.
1. During a sale at a clothing store, you notice a pair of shoes originally priced at $150, but they are now on sale for $99. The store advertises it as a great deal.
2. You recently started a new job, and as part of your benefits package, you’re automatically enrolled in the company’s retirement savings plan with a 3% contribution rate unless you choose to opt-out.
3. While grocery shopping, you notice a display of chocolate bars strategically placed near the checkout counter. Despite your intention to stick to a healthy diet, you impulsively add a chocolate bar to your cart.
4. You’re aware of a major tech company that invests in renewable energy projects and regularly donates to environmental causes, even though these actions may reduce its short-term profits.
ANSWER KEY
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Unit 2 Definitions
Microeconomics Terms to Know |
| Abnormal profit | This arises when average revenue is greater than average cost (greater than the minimum return required by a firm to remain in a line of business). |
| Abuse of market power | When a firm acts with the intention to eliminate competitors or to prevent entry of new firms in a market. |
| Adverse selection | A type of market failure involving asymmetric information, where the party with the incomplete information is induced to withdraw from the market. The buyer, for example, of a used car, may hesitate to buy without knowing about the quality of the vehicle. The seller, for example of health insurance, may hesitate to sell a policy without knowing the health of the buyer. |
| Allocative efficiency | Achieved when just the right amount of goods and services are produced from society’s point of view so that scarce resources are allocated in the best possible way. It is achieved when, for the last unit produced, price (P) is equal to marginal cost (MC), or more generally, if marginal social benefit (MSB) is equal to marginal social cost (MSC). |
| Allocative inefficiency | When either more or less than the socially optimal amount is produced and consumed so that misallocation of resources results. MSB ≠ MSC. |
| Anchoring | Refers to situations when people rely on a piece of information that is not necessarily relevant as a reference point when making a decision. |
| Anti-monopoly regulation | Laws and regulations that are intended to restrict anti-competitive behaviour of firms that are abusing their market power. |
| Asymmetric information | A type of market failure where one party in an economic transaction has access to more or better information than the other party. |
| Average costs | Total costs per unit of output produced. |
| Average revenue | Revenue earned per unit sold; average revenue is thus equal to the price of the good. |
| Barriers to entry | Anything that deters entry of new firms into a market, for example, licenses or patents. |
| Behavioural economics | A subdiscipline of economics that relies on elements of cognitive psychology to better understand decision-making by economic agents. It challenges the assumption that economic agents (consumers or firms) will always make rational choices with the aim of maximizing with respect to some objective. |
| Biases | Systematic deviations from rational choice decision-making. |
| Bounded rationality | A term introduced by Herbert Simon that suggests consumers and businesses have neither the necessary information nor the cognitive abilities required to maximize with respect to some objectives (such as utility), and thus choose to satisfice. They therefore are rational only within limits. |
| Bounded self-control | The idea that individuals, even when they know what they want, may not be able to act in their interests. Findings of bounded self-control include evidence of procrastination (for example, among students, professionals and others) that may result in self-harm, and submitting to temptation (for example, dieters). |
| Bounded selfishness | The idea that people do not always maximize self-interest but also have concern for the well-being of others as shown by volunteer work and charity contributions. |
| Business confidence | A measure of the degree of optimism that businesses have about the economic future. |
| Choice architecture | The design of environments based on the idea that the layout, sequencing, and range of choices available affect the decisions made by consumers. |
| Circular economy | An economic system that looks beyond the linear take-make-dispose model and aims to redefine growth, focusing on society-wide benefits. It is based on three principles: design out waste, keep products and materials in use, and regenerate natural systems. |
| Collusive oligopoly | A market where firms agree to fix price and/or to engage in other anticompetitive behaviour. |
| Common pool resources | A diverse group of natural resources that are non-excludable, but their use is rivalrous, for example, fisheries. |
| Competitive market | A market with many firms acting independently where no firm has the ability to control the price. |
| Competitive market equilibrium | Occurs if in a free competitive market, quantity demanded is equal to quantity supplied. |
| Competitive supply | When goods that a firm is producing use the same resources in their production process. The goods thus compete with each other for the use of the same resources. |
| Complements | Goods that are jointly consumed, for example, coffee and sugar. |
| Concentration ratios | The proportion of industry sales accounted for by the largest firms; the greater this proportion, the greater the degree of market power of the firms in the industry. |
| Consumer nudges | Small design changes that include positive reinforcement and indirect suggestions that can influence the behaviour of consumers. |
| Consumer surplus | The difference between how much a consumer is at most willing to pay for a good and how much they actually pay. |
| Corporate social responsibility | A corporate goal adopted by many firms that aims to create and maintain an ethical and environmentally responsible image. |
| Default choice | When a choice is made by default, meaning that when given a choice it is the option that is selected when one does not do anything. |
| Demand | The relationship between possible prices of a good or service and the quantities that individuals are willing and able to buy over some time period, ceteris paribus. |
| Demand curve | A curve illustrating the relationship between possible prices of a good or service and the quantities that individuals are willing and able to buy over some time period, ceteris paribus. It is normally downward sloping. |
| Demerit goods | Goods or services that not only harm the individuals who consume these but also society at large, and that tend to be overconsumed. Usually they are due to negative consumption externalities. |
| Economies of scale | Falling average costs that a firm experiences when it increases its scale of operations. |
| Efficiency | In general, involves making the best use of scarce resources. May refer to producing at the lowest possible cost or to allocative efficiency where marginal social costs are equal to marginal social benefits or where social surplus is maximum. |
| Elasticity | A measure of the responsiveness of an economic variable (such as the quantity demanded of a product) to a change in another economic variable (such as its price or income). |
| Engel curve | A curve showing the relationship between consumers’ income and quantity demanded of a good. It indicates whether a good is normal or inferior. |
| Equilibrium | A state of balance that is self-perpetuating in the absence of any outside disturbance. |
| Excess demand | Occurs when quantity demanded at some price is greater than quantity supplied. |
| Excess supply | Occurs when quantity supplied at some price is greater than quantity demanded. |
| Excludable | A characteristic that most goods have that refers to the ability of producers to charge a price and thus exclude whoever is not willing or able to pay for it from enjoying it. |
| Externalities | External costs or benefits to third parties when a good or service is produced or consumed. An externality arises when an economic activity imposes costs or creates benefits on third parties for which they are not compensated or do not pay for respectively. |
| Firm | An entity such as a business that uses factors of production in order to produce and sell goods and services and earn profits. It is an important decision maker in a market economy. |
| Firms | Productive units that transform inputs (factors of production) into output (goods and services), usually aiming at earning profits. |
| Framing | In behavioural economics, the term refers to the way choices are presented as a simple change of the “frame”, that may affect the choice made. For example, highlighting the positive or the negative aspects of the same choice may lead to different decisions. |
| Free rider problem | Arises when individuals consume a good or service without paying for it because they cannot be excluded from enjoying it. |
| Game theory | A branch of mathematics that studies the strategic interaction of decision-makers that may be individuals, firms, countries, and so on. |
| Homogeneous product | Goods that are considered identical across firms in the eyes of consumers; examples include mostly primary sector goods like corn, wheat or copper. |
| Imperfect competition | A market structure where firms have a degree of market power as they face a negatively sloped demand curve and can thus set price. |
| Imperfect information | When the information about a market or a transaction is incomplete. |
| Incentive role of prices | Prices provide producers and consumers the incentive to respond to price changes. Given a price change, producers have the incentive to change the quantity supplied in accordance with the law of supply, while consumers have the incentive to change the quantity demanded based on the law of demand. |
| Income effect | The law of demand is explained by the substitution and the income effect. The income effect states that if the price of a good increases then the real income of consumers decreases and, typically, they will tend to buy less of the good—thus working in the same direction as the substitution effect. |
| Income elasticity of demand (YED) | The responsiveness of demand for a good or service to a change in income. |
| Indirect taxes | Taxes on expenditure to buy goods and services. |
| Inferior goods | Lower quality goods for which higher quality substitutes exist; if incomes rise, demand for the lower quality goods decreases. |
| Joint supply | Goods jointly produced, for example beef and cattle hides; producing one automatically leads to the production of the other. |
| Law of demand | A law stating that as the price of a good falls, the quantity demanded will increase over a certain period of time, ceteris paribus. |
| Law of diminishing marginal returns | A short-run law of production stating that as more and more units of the variable factor (usually labour) are added to a fixed factor (usually capital) there is a point beyond which total product continues to rise but at a diminishing rate or, equivalently, marginal product starts to decrease. |
| Law of diminishing marginal utility | The idea that as an individual consumes additional units of a good, the additional satisfaction enjoyed decreases. |
| Law of supply | A law stating that as the price of a good rises, the quantity supplied will rise over a certain period of time, ceteris paribus. |
| Long run in microeconomics | The period of time when all factors of production are variable. |
| Loss (economic) | Occurs when total costs of a firm are greater than total revenues. It is equal to total cost minus total revenue. |
| Luxury goods | Goods that are not considered essential by consumers therefore they have a price elastic demand (PED > 1), or income elastic demand (YED > 1). |
| Mandated choices | Choices made by consumers who are required to state whether or not they wish to take part in an action. |
| Manufactured products | Products or goods that have been produced by workers often working with capital goods. |
| Marginal benefit | The extra or additional benefit enjoyed by consumers that arises from consuming one more unit of output. |
| Marginal costs | The extra or additional costs of producing one more unit of output. |
| Marginal revenue | The extra or additional revenue that arises for a firm when it sells one more unit of output. |
| Marginal social benefit (MSB) | The extra or additional benefit/utility to society of consuming an additional unit of output, including both the private benefit and the external benefit. |
| Marginal social cost (MSC) | The extra or additional cost to society of producing an additional unit of output, including both the private cost and the external costs. |
| Marginal utility | The extra or additional utility derived from consuming one more unit of a good or service. |
| Market | Any arrangement where buyers and sellers interact to carry out an economic transaction. |
| Market concentration | The extent to which the total sales in a market are accounted for by the largest firms, providing an indication of the degree of market power in the industry. It is measured by the concentration ratio. |
| Market demand | The sum of the individual demand curves for a product of all the consumers in a market. |
| Market equilibrium | In a market this occurs at the price where the quantity of a product demanded is equal to the quantity supplied. This is the market clearing price since there is no excess demand or excess supply. |
| Market failure | The failure of markets to achieve allocative efficiency. Markets fail to produce the output at which marginal social benefits are equal to marginal social costs; social or community surplus (consumer surplus + producer surplus) is not maximized. |
| Market mechanism | The system in which the forces of demand and supply determine the prices of products. Also known as the price mechanism. |
| Market power | The ability of a firm (or group of firms) to raise and maintain price above the level that would prevail under perfect competition (or P > MC). |
| Market share | The percentage of total sales in a market accounted for by one firm. |
| Maximum price | A price set by a government or other authority that is below the market equilibrium price of a good or service, also known as a price ceiling. |
| Merit goods | Goods or services considered to be beneficial for people that are under-provided by the market and so under-consumed, mainly due to positive consumption externalities. |
| Microeconomics | The study of the behaviour of individual consumers, firms, and markets and the determination of market prices and quantities of goods, services, and factors of production. |
| Minimum price | A price set by a government or other authority above the market equilibrium price of a good or service, also known as a price floor. |
| Monopolistic competition | A market structure where there are many sellers, producing differentiated products, with no barriers to entry. |
| Monopoly | A market structure where there is only one firm in the industry, so the firm is the industry. There are high barriers to entry. |
| Moral hazard | A type of market failure involving asymmetric information where a party takes risks but does not face their full costs by changing behaviour after a transaction has taken place. It is very common in insurance markets. |
| Natural monopoly | A monopoly that can produce enough output to cover the entire needs of a market while still experiencing economies of scale. Its average costs will therefore be lower than those of two or more firms in the market. |
| Necessity | The degree to which a good is necessary or essential. If the increase in demand for a necessity good is less than proportional to the rise in income; then the necessity good is income elastic. If the change in quantity demanded for a necessity good is less than proportional to a change in price; then the necessity good is price inelastic. |
| Negative externalities of consumption | Negative effects suffered by a third party whose interests are not considered when a good or service is consumed, so the third party are therefore not compensated. |
| Negative externalities of production | Negative effects suffered by a third party whose interests are not considered when a good or service is produced, so the third party are therefore not compensated. |
| Non-collusive oligopoly | Firms in an oligopoly do not resort to agreements to fix prices or output. Competition tends to be non-price. Prices tend to be stable. |
| Non-excludable | A characteristic of a good, service or resource where it is impossible to prevent a person, or persons, from using it. |
| Non-price competition | Competition between firms that is based on factors other than price, usually taking the form of product differentiation. |
| Non-rivalrous | A characteristic of some goods such that their consumption by one individual does not reduce the ability of others to consume them. It is a characteristic of public goods. |
| Normal goods | A good where the demand for it increases as income increases. |
| Normal profit | The minimum return that must be received by a firm in order to stay in business. A firm earns normal profit when total revenue is equal to total cost, or when average revenue or price is equal to average cost. |
| Nudge theory | Nudges (prompts, hints) are used to influence the choices made by consumers in order to improve the well-being of people and society. |
| Oligopoly | A market structure where there are a few large firms that dominate the market, with high barriers to entry. |
| Payoff matrix | A table showing all possible outcomes of decisions taken by decision-makers in game theory. |
| Perfect competition | A market structure where there is a very large number of small firms, producing identical products, with no barriers to entry or exit, and perfect information. All the firms are thus price takers. |
| Perfect information | Where all stakeholders in an economic transaction have access to the same information. |
| Perfectly elastic demand | Occurs with a horizontal demand curve signifying that any amount can be bought at a particular price. (PED is infinite.) |
| Perfectly elastic supply | Occurs with a horizontal supply curve signifying that any amount can be offered at a particular price. (PES is infinite.) |
| Perfectly inelastic demand | Where a change in the price of a good or service leads to no change in the quantity demanded of the good or service. (PED is equal to zero.) |
| Perfectly inelastic supply | Where a change in the price of a good or service leads to no change in the quantity supplied of the good or service. (PES is equal to zero.) |
| Pigouvian taxes | An indirect tax that is imposed to eliminate the external costs of production or consumption. |
| Positive externalities of consumption | The beneficial effects that are enjoyed by third parties whose interests are not accounted for when a good or service is consumed, therefore they do not pay for the benefits they receive. |
| Positive externalities of production | The beneficial effects that are enjoyed by third parties whose interests are not accounted for when a good or service is produced, therefore they do not pay for the benefits they receive. |
| Price ceiling (maximum price) | A price imposed by an authority and set below the equilibrium price. Prices cannot rise above this price. |
| Price competition | Competition between firms that is based on price, for example, a firm that wants to increase its sales at the expense of other firms will lower its price. |
| Price controls | Prices imposed by an authority, set above or below the equilibrium market price. |
| (Price) elastic demand | Where a change in the price of a good or service leads to a proportionately larger change in the quantity demanded of the good or service in the opposite direction. (PED is greater than one.) |
| Price elasticity of demand (PED) | A measure of the responsiveness of the quantity demanded of a good or service to a change in its price. |
| Price elasticity of supply (PES) | A measure of the responsiveness of the quantity supplied of a good or service to a change in its price. |
| (Price) elastic supply | Where a change in the price of a good or service leads to a proportionately larger change in the quantity supplied of the good or service in the same direction. (PES is greater than one.) |
| Price expectations | The forecasts or views that consumers or firms hold about future price movements that play a role in determining demand. |
| Price floor (minimum price) | A price imposed by an authority and set above the market price. Prices cannot fall below this price. |
| (Price) inelastic demand | Where a change in the price of a good or service leads to a proportionately smaller change in the quantity demanded of the good or service in the opposite direction. (PED is less than one.) |
| (Price) inelastic supply | Where a change in the price of a good or service leads to a proportionately smaller change in the quantity supplied of the good or service in the same direction. (PES is less than one.) |
| Price maker | A firm that is able to influence the price at which it sells its product. Includes firms in all market structures except perfect competition. |
| Price mechanism | The system where the forces of demand and supply determine the prices of products. Also known as the market mechanism. |
| Price taker | A firm that is unable to influence the price at which it sells its product, being forced to accept the price determined in the market. It includes firm in perfect competition. |
| Price war | Occurs when firms successively cut their prices in an effort to match the price cuts of other firms, resulting in lower profits, possibly losses. |
| Primary commodities | Raw materials that are produced in the primary sector. Examples include agricultural products, metals and minerals. |
| Producer surplus | The benefit enjoyed by producers by receiving a price that is higher than the price they were willing to receive. |
| Product differentiation | The process by which firms try to make their products different from the products of other firms in an effort to increase their sales. Differences involve product quality, appearance, services offered and many others. |
| Profit maximization | A possible objective of firms that involves producing the level of output where profits are greatest: where total revenue minus total cost is greatest or where marginal revenue equals marginal cost. |
| Public goods | Goods or services that have the characteristics of non-rivalry and non-excludability, for example, flood barriers. |
| Quantity demanded | The quantity of a good or service demanded at a particular price over a given time period, ceteris paribus. |
| Quantity supplied | The quantity of a good or service supplied at a particular price over a given time period, ceteris paribus. |
| Rational consumer choice | Occurs when consumers make choices based on the following assumptions: they have consistent tastes and preferences, they have perfect information and they arrange their purchases so as to make their utility as great as possible (maximize it). It is assumed in standard microeconomic theory. |
| Rational producer behaviour | Occurs when firms try to maximize profit. This is an assumption in standard microeconomic theory. |
| Rationing | A method used to divide or apportion goods and services or resources among the various interested parties. |
| Restricted choices | This is when the choice of a consumer is restricted by the government or other authority. |
| Revenues | Payments received by firms when they sell their output. |
| Rivalrous | Goods and services are considered to be rivalrous when the consumption by one person, or group of people, reduces the amount available for others. |
| Rules of thumb | Rules of thumb are mental shortcuts (heuristics) for decision-making to help people make a quick, satisfactory, but often not perfect, decision to a complex choice. |
| Satisficing | A business or firm objective to achieve a satisfactory outcome with respect to one or several objectives, rather than to pursue any one objective at the possible expense of others by optimizing (maximizing), for example, profit, revenue or growth. It is essentially a mix of the words “satisfy” and “suffice”. |
| Screening | In asymmetric information, the use of a screening process by the participant with less information to gain more information regarding a transaction, and so reduce adverse selection. |
| Shortage | Arises when the quantity demanded of a good or services is more than the quantity supplied at some particular price. |
| Short run in microeconomics | The period of time when at least one factor of production is fixed. |
| Signalling | In asymmetric information, the participant with more information sending a signal revealing relevant information about a transaction to the participant with less information, to reduce adverse selection. |
| Social/community surplus | The sum combination of consumer surplus and producer surplus. |
| Socially optimum output | This occurs where there is allocative efficiency, or where the marginal social cost of producing a good is equal to the marginal social benefit of the good to society. Alternatively, it occurs where the marginal cost of producing a good (including any external costs) is equal to the price that is charged to consumers (P = MC for the last unit produced). |
| Subsidies | An amount of money paid by the government to a firm, per unit of output, to encourage production and lower the price to consumers. |
| Substitutes | Goods that can be used in place of each other, as they satisfy a similar need. |
| Substitution effect | When the price of a product falls relative to other product prices, consumers purchase more of the product as it is now relatively less expensive. This forms part of an explanation of the law of demand. |
| Supply | Quantities of a good that firms are willing and able to supply at different possible prices, over a given time period, ceteris paribus. |
| Supply curve | A curve showing the relationship between the price of a good or service and the quantity supplied, ceteris paribus. It is normally upward sloping. |
| Surplus | An excess of something over something else. It occurs: when quantity supplied is greater than quantity demanded at a particular price
when tax revenues are greater than government spending (budget surplus)
on an account when credits are greater than debits in the balance of payments.
See also “consumer surplus” and “producer surplus”. |
| Total costs | All the costs of a firm incurred for the use of resources to produce something. |
| Total revenue | The amount of revenue received by a firm from the sale of a particular quantity of output (equal to price times quantity sold). |
| Tradable permits | Permits to pollute, issued by a governing body, that sets a maximum amount of pollution allowable. These permits may be traded (bought or sold) in a market for such permits. |
| Tragedy of commons | A situation with common pool resources, where individual users acting independently, according to their own self-interest, go against the common good of all users by depleting or spoiling that resource through their collective action. |
| Unitary elastic demand | Occurs when a change in the price of a good or service leads to an equal and opposite proportional change in the quantity demanded of the good or service (PED = 1). |
| Unitary elastic supply | Occurs when a change in the price of a good or service leads to an equal proportional change in the quantity supplied of the good or service (PES = 1). |
| Welfare loss | A loss of a part of social surplus (consumer plus producer surplus) that occurs when there is market failure so that marginal social benefits are not equal to marginal private benefits. |
Definitions to Know
| Term | Definition |
Macroeconomics | The study of aggregate economic activity. It investigates how the economy as a whole works. |
| Business cycle | The short-term fluctuations of real GDP around its long-term trend (or potential output). |
Short-term fluctuations of economic activity | Periods of growth of real GDP followed by periods of contraction, which are part of the business cycle. |
Long-term growth trend | Refers to average growth over long periods of time shown in the business cycle diagram as the line that runs through short-term fluctuations, indicating changes in potential output |
Income approach | One of the three equivalent ways that GDP can be measured, by adding all the incomes generated in the production process (wages, profits, interest and rent) for a given time period. |
Gross national income (GNI) | The income earned by all national factors of production independently of where they are located over a period of time; it is equal to GDP plus factor income earned abroad minus factor income paid abroad. |
National income | The income earned by the factors of production of an economy, equal to wages plus interest, plus rents, plus profits. |
National income accounting | The services provided by a statistical entity in every country that measure the economy’s national income and output as well as other economic activity. |
National income statistics | The statistical data used to measure a nation’s income and output, and perform national income accounting. |
Output approach | One of the three equivalent ways that GDP can be measured, it adds up the value of final goods and services produced in a given time period. |
Expenditure approach | One of three analytically equivalent approaches of measuring GDP that adds all the expenditures made on final domestic goods and services over a period of time by households, firms, the government and foreigners. |
Gross domestic product (GDP) | The value of all final goods and services produced within an economy over a period of time, usually a year or a quarter. |
Consumption (C) | Spending by households on durable and non-durable goods and on services over a period of time. |
Investment (I) | Spending by firms on capital goods such as machines, tools, equipment and factories. |
Government spending (G) | Refers to all spending by the government that is distinguished into current expenditures, capital expenditures and transfer payments. |
Net exports (X – M) | Export revenues minus import expenditure. |
Exports | Goods and services produced in one country and purchased by consumers in another country. |
Imports | The value of goods and services purchased domestically that are produced abroad. |
Nominal gross domestic product | The total money value of all final goods and services produced in an economy in a given time period, usually one year, at current values (not adjusted for inflation). |
Nominal gross national income | The total income earned by all the residents of a country (regardless of where their factors of production are located) in a given time period, usually a year, at current prices (not adjusted for inflation). |
Per capita | Per person. Per capita values are found by dividing the variable by the size of the population. |
Real GDP | The total value of all final goods and services produced in an economy in a given time period, usually one year, adjusted for inflation. |
Real GDP per person (per capita) | Real GDP divided by the population of the country. |
Real GNI per person (per capita) | Real GNI divided by the population of the country. |
Purchasing power parity (PPP) | A method used to make the buying power of different currencies equal to the buying power of US$1. PPP exchange rates are used to make comparisons of income or output variables across countries while eliminating the influence of price level differences. |
Happy Planet Index | An index that combines four elements to show how efficiently residents of different countries are using environmental resources to lead long, happy lives. The elements are well-being, life expectancy, inequality of outcomes and ecological footprint. |
Happiness Index | An index that is used to measure economic well-being of a population using several quality of life dimensions. |
OECD Better Life Index | A tool of monetary policy involving the buying or selling of (short-term) government bonds by the central bank in order to increase or decrease the money supply, thus influencing the rate of interest. |
Welcome to the world of macroeconomics! In this unit, we’ll explore the essential concepts and measures used to understand the overall economic performance of a nation. Let’s dive in!
Measuring Economic Activity: Income, Output, and Expenditure
Economics aims to measure the economic activity of a country, and there are three main equivalent methods for doing so: income method, output method, and expenditure method. These methods provide different perspectives on the same economic reality.
Nominal Gross Domestic Product (GDP)
GDP is a fundamental measure of economic activity. It represents the total monetary value of all final goods and services produced within a country’s borders in a specific time period. GDP has four main components:
Consumption (C): Spending by households on goods and services.
Investment (I): Spending by businesses on capital goods, such as machinery and factories.
Government Spending (G): Expenditure by the government on public goods and services.
Net Exports (XN): The difference between a country’s exports (sales to other countries) and imports (purchases from other countries).
Mathematically, GDP can be represented as:
Nominal vs. Real GDP
Nominal GDP is calculated using current market prices, while real GDP adjusts for inflation or deflation, providing a more accurate measure of a nation’s economic growth over time. In order to find the real GDP, you will need to deflate the nominal GDP using the price deflator.
Multinational Corporations and Gross National Income (GNI)
GDP can sometimes present an inaccurate picture of a country’s economic status, especially when multinational corporations are involved. Gross National Income (GNI) considers the cash inflow and outflow from abroad, making it a more comprehensive measure. The formula for GNI is:
GDP/GNI Per Capita
GDP/GNI per capita divides the total GDP or GNI by a country’s population. It’s a crucial measure to assess the standard of living and well-being of a nation’s citizens.
The Business Cycle
The business cycle is a visual representation of real GDP over time, illustrating the fluctuations in economic activity. It consists of four phases:
Expansion: A period of rising real GDP, increasing employment, and economic growth.
Peak: The highest point in the cycle, marking the end of the expansion phase.
Contraction: A period of declining real GDP, often leading to a recession.
Trough: The lowest point in the cycle, signaling the end of the contraction phase.
Pros and Cons of GDP
Pros:
Comparative Analysis: GDP allows easy comparisons of economic growth over different time periods and between countries.
Indicator of Economic Health: It provides insight into a country’s economic health and overall performance.
Cons:
Neglects Well-being: GDP doesn’t consider factors like standard of living, happiness, or quality of life.
Sustainability: It fails to account for the long-term sustainability of economic growth.
Income Distribution: GDP doesn’t reflect income distribution and may not represent the well-being of all citizens.
To address these limitations, alternative measures like the Happy Planet Index, Happiness Index, and OECD Better Life Index have been developed to provide a more holistic view of societal well-being.
This module sets the stage for our exploration of macroeconomics, where we’ll delve deeper into the complexities of measuring and understanding a nation’s economic activity and well-being.
Watch this video to finish learning about economic measurements and illustrations.
Practice Problem Set (KEY BELOW)
Practice Problem Set: GDP and GNI Calculation ( KEY BELOW)
Problem 1: Calculating GDP Components
Suppose you have the following data for a hypothetical country in a given year:
Calculate the nominal GDP for this country.
Problem 2: Nominal vs. Real GDP
In a particular year, a country’s nominal GDP is $12,000, and the GDP deflator is 120. Calculate the real GDP for this year.
Problem 3: Gross National Income (GNI) Calculation
Consider a country where the GDP is $10,000, and net income earned from abroad is $800. Calculate the Gross National Income (GNI) for this country.
Problem 4: GDP/GNI Per Capita
In a country with a population of 5 million, the GDP is $20 billion. Calculate the GDP per capita for this nation.
Problem 5: Business Cycle Identification
Review the following economic data over a period of five years for a country:
Year 1: Real GDP growth of 4%
Year 2: Real GDP growth of -2%
Year 3: Real GDP growth of 6%
Year 4: Real GDP growth of -1%
Year 5: Real GDP growth of 3%
Identify the phases of the business cycle (Expansion, Peak, Contraction, Trough) for each year.
Problem 6: GDP Limitations and Considerations
Explain in a few sentences how GDP might not accurately reflect the well-being of a nation’s citizens. Provide at least two limitations of GDP.
Problem 7: Alternative Measures
Briefly describe one alternative measure to GDP, such as the Happiness Index or the OECD Better Life Index, and explain what aspects of well-being it considers that GDP does not.
ANSWER KEY
Problem 1: Nominal GDP = C + I + G + (X – M) = $5,000 + $2,000 + $3,500 + ($1,200 – $900) = $10,800.
Problem 2: Real GDP = (Nominal GDP / GDP Deflator) = ($12,000 / 120) = $100.
Problem 3: GNI = GDP + Net Income Earned from Abroad = $10,000 + $800 = $10,800.
Problem 4: GDP Per Capita = GDP / Population = $20 billion / 5 million = $4,000 per capita.
Problem 5:
Year 1: Expansion
Year 2: Contraction
Year 3: Expansion
Year 4: Contraction
Year 5: Expansion
Problem 6: GDP might not accurately reflect well-being because it does not consider factors like income distribution, quality of life, happiness, or environmental sustainability. Additionally, it can neglect the well-being of certain segments of the population.
Problem 7: The Happiness Index measures the well-being of a nation’s citizens by considering factors such as life satisfaction, mental health, and social support, which GDP does not account for.
Definitions to Know
| Term | Definition |
Aggregate demand (AD) | Planned spending on domestic goods and services at different average price levels, per period of time. Consists of consumption, investment and government expenditures plus net exports. |
Aggregate supply (AS) | The planned level of output domestic firms are willing and able to offer at different average price levels. |
Short-run aggregate supply (SRAS) | The total quantity of real output (real GDP) offered at different possible price levels in the short run (when wages and other resource prices are constant). |
Long-run aggregate supply (LRAS) | Aggregate supply that is dependent upon the resources and technology in the economy, thus being independent of the price level. It is vertical at the level of potential output. It can only be increased by improvements in the quantity and/or quality of factors of production as well as improved technology. |
Aggregate demand curve | A curve showing the planned level of spending on domestic output at different average price levels. |
Aggregate supply curve | A curve showing the planned level of output that domestic firms are willing and able to offer at different average price levels. |
Keynesian aggregate supply curve | An aggregate supply curve that shows the level of real output produced in an economy in relation to the price level. It consists of three sections: a horizontal section, an upward-sloping section and a vertical section. Changes in real GDP or the price level depend on aggregate demand and how close to capacity the economy is operating. |
Natural rate of unemployment | The rate of unemployment that occurs when the economy is producing at its potential output or full employment level of output. It is equal to the sum of structural, frictional and seasonal unemployment. |
Short run in macroeconomics | The period of time when the prices of factors of production, especially wages, are considered fixed. |
Long run in macroeconomics | The period of time when the prices of all factors of production, especially wages, change to match changes in the price level. |
In this module, we’ll delve into the key concepts of Aggregate Demand (AD) and Aggregate Supply (AS) in macroeconomics. These concepts are essential for understanding how the overall economy functions and responds to various influences.
Aggregate Demand (AD)
Aggregate Demand represents the total quantity of goods and services demanded in an economy at a given price level and in a given period. The AD formula is:
C (Consumption): Spending by households on goods and services.
I (Investment): Spending by businesses on capital goods and investments.
G (Government Spending): Government expenditure on public goods and services.
X (Exports): Value of goods and services sold to other countries.
M (Imports): Value of goods and services purchased from other countries.
Changes in any of these components will result in a change in AD. Here are the shifters for each component:
Aggregate Supply (AS)
Aggregate Supply represents the total quantity of goods and services that producers in an economy are willing and able to supply at different price levels. There are two different views of AS:
1. Monetarist/New-Classical View:
2. Keynesian View:
In the Keynesian view, the perfectly vertical portion represents the long run, and it indicates a point where the economy cannot increase real GDP further without causing inflation due to sticky wages and prices.
Shifters of LRAS (Applicable to Both Views):
Macroeconomic Equilibrium:
The New Classical model emphasizes the free market’s ability to self-correct, believing that flexible wages and prices will lead the economy to equilibrium along the LRAS line. In contrast, the Keynesian view argues that sticky wages and prices require intervention for the economy to reach equilibrium. Any economy not producing at an equilibrium point on the LRAS portion is in the short run.
Inflationary Gaps and Deflationary Gaps
In the context of AD and AS, we often encounter two significant economic phenomena: inflationary gaps and deflationary gaps.
Inflationary Gap: An inflationary gap occurs when the equilibrium level of real GDP (the point where AD intersects the short-run AS curve) exceeds the full-employment level of real GDP (the LRAS). In other words, the economy is producing beyond its long-term capacity. This situation can lead to upward pressure on prices, resulting in inflation.
Deflationary Gap: A deflationary gap occurs when the equilibrium level of real GDP falls below the full-employment level of real GDP. Here, the economy is underperforming, and unemployment may rise. This situation can lead to deflationary pressures, where prices fall.
SRAS Shifts – Stagflation: A Worst-Case Scenario and Growth: A Best-Case Scenario
Stagflation is a rare and challenging economic situation characterized by stagnant economic growth, high unemployment, and rising prices (inflation) occurring simultaneously. G
Understanding these concepts is essential for analyzing how economies respond to changes in factors like government policies, consumer behaviour, and business investments. In the following modules, we’ll explore these dynamics in more detail.
Watch this video to finish learning about aggregate supply and aggregate demand.
Practice Problem Set (KEY BELOW)
Review Questions on AD/AS Diagrams
Question 1: Draw an AD/AS diagram that represents an economy in long-run equilibrium. Label the LRAS, SRAS, and AD curves. Explain the concept of long-run equilibrium in this context.
Question 2: Illustrate an inflationary gap on an AD/AS diagram. Label the LRAS, SRAS, and AD curves, and show the point of equilibrium. Explain why an inflationary gap is a concern and discuss potential policy measures to address it.
Question 3: Create an AD/AS diagram that depicts a deflationary gap. Label the LRAS, SRAS, and AD curves, and indicate the point of equilibrium. Describe the implications of a deflationary gap for an economy and propose policy actions to close it.
Question 4: Draw an AD/AS diagram representing stagflation. Label the LRAS, SRAS, and AD curves, and explain why stagflation is a challenging economic scenario. Discuss potential strategies that policymakers can consider in response to stagflation.
Question 5: Use an AD/AS diagram to show how an increase in consumer confidence might impact an economy. Label the curves and explain the shifts and changes in equilibrium that occur due to this increase in confidence.
Question 6: Illustrate the effects of a technological advancement on an AD/AS diagram. Label the LRAS, SRAS, and AD curves, and discuss how such advancements can influence an economy’s productive capacity.
Question 7: Create an AD/AS diagram that represents an economy in which the government increases its spending. Label the LRAS, SRAS, and AD curves, and explain how this fiscal policy action affects the economy’s equilibrium and key economic indicators.
Question 8: Draw an AD/AS diagram illustrating an economy in long-run equilibrium in the Keynesian view. Label the LRAS, SRAS, and AD curves and describe why the Keynesian view includes a single AS curve and sticky wages and prices.
Question 9: Depict an economy facing a negative supply shock on an AD/AS diagram. Label the curves and explain how this shock affects short-run and long-run equilibrium, considering both the Monetarist/New-Classical and Keynesian perspectives.
Question 10: Use an AD/AS diagram to show the impact of a decrease in business taxes on an economy. Label the curves and describe how such a tax reduction can influence economic outcomes.
ANSWER KEY
Question 1:
Question 2:
Question 3:
Question 4:
Question 5:
Question 6:
Question 7:
Question 8:
Question 9:
Question 10:
Definitions to Know
| Term | Definition |
Economic growth | Refers to increases in real GDP over time. |
Long-term growth | Growth over long periods of time. In the PPC model this is shown by outward shifts of the PPC. When shown in the AD–AS model (the AD–AS model considers the AD and AS curves together), it is shown by rightward shifts in the LRAS curve. |
Recession | Occurs when real GDP falls for at least two consecutive quarters. |
In this module, we’ll explore the crucial concept of economic growth and its impact on economies, living standards, the environment, and income distribution.
Short-Term Growth
Short-term economic growth is characterized by actual growth within the Production Possibility Curve (PPC). This growth occurs when Aggregate Demand (AD) increases, leading to higher output levels in the short run.
Figure 1: AD/AS showing Actual Growth (Short-term)
| Figure 2: PPC showing Actual Growth (Short-term)
|
Long-Term Growth
Long-term economic growth, on the other hand, involves shifts in the PPC or the Long-Run Aggregate Supply (LRAS) curve, resulting in an increase in an economy’s potential growth capacity. Long-term growth signifies a sustainable and enduring increase in an economy’s ability to produce goods and services.
Figure 3: AD/AS showing Potential Growth (Long-term)
| Figure 4: PPC showing Potential Growth (Long-term)
|
Insider Tip: The LRAS curve and the PPC curve are essentially the same curve with the same shifters!
Calculating Economic Growth
One way to measure economic growth is by comparing Gross Domestic Product (GDP) over time. You can calculate the economic growth rate using the following formula:
Economic Growth Rate
Where:
GDP_New is the GDP in the more recent period.
GDP_Old is the GDP in the earlier period.\
Now, let’s practice calculating economic growth with a table:
Consequences of Economic Growth
Standard of Living: Economic growth generally leads to an improvement in the standard of living for a country’s residents. Higher incomes, increased access to goods and services, and better infrastructure contribute to an enhanced quality of life.
Environmental Impact: Economic growth often comes at a cost to the environment. Increased production and consumption can lead to greater resource depletion, pollution, and habitat destruction. Sustainable development aims to balance economic growth with environmental conservation.
Income Distribution: Economic growth doesn’t always result in equitable income distribution. In some cases, it can exacerbate income inequality, with the benefits primarily accruing to the wealthy. Policymakers may need to implement measures to ensure a more equitable distribution of wealth and income.
Understanding the dynamics of economic growth and its consequences is crucial for policymakers, economists, and citizens alike. It provides insights into the overall health and sustainability of an economy and informs decisions on policies and strategies for achieving long-term growth while addressing associated challenges.
Watch this video to finish learning about economic growth.
Practice Problem Set (KEY BELOW)
Practice Problem 1:
Consider a hypothetical country’s GDP data for two consecutive years:
Year 1: GDP = $8,000
Year 2: GDP = $8,400
Calculate the economic growth rate between Year 1 and Year 2.
Practice Problem 2:
In a different country, the GDP increased as follows:
Year 1: GDP = $12,000
Year 2: GDP = $13,200
Calculate the economic growth rate for this country between Year 1 and Year 2.
Practice Problem 3:
Identify the type of gap depicted in the diagram above. Explain what type of event would occur that would cause this event to occur in an economy.
Practice Problem 4:
Define the term “long-term economic growth.” Discuss the factors that can contribute to long-term economic growth and draw a Production Possibility Curve (PPC) to illustrate how an economy’s potential growth can increase over time.
Practice Problem 5:
Discuss the consequences of economic growth, focusing on its impact on the standard of living, the environment, and income distribution.
ANSWER KEY
Practice Problem 1:
Practice Problem 2:
Practice Problem 3:
Inflationary Gap: An inflationary gap occurs when Aggregate Demand (AD) exceeds an economy’s potential output, leading to rising prices (inflation).
Example: Increased consumer, business, or government spending can lead to an inflationary gap.
Practice Problem 4:
Practice Problem 5:
Consequences of Economic Growth:
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Unit 3 Definitions
Macroeconomics Terms to Know |
| Absolute poverty | People living below the minimum income necessary to satisfy basic physical needs (food, clothing, and shelter); as of October 2015, the World Bank international poverty line is set at US$1.90 PPP per day. |
| Aggregate demand (AD) | Planned spending on domestic goods and services at different average price levels, per period of time. Consists of consumption, investment and government expenditures plus net exports. |
| Aggregate demand curve | A curve showing the planned level of spending on domestic output at different average price levels. |
| Aggregate supply (AS) | The planned level of output domestic firms are willing and able to offer at different average price levels. |
| Aggregate supply curve | A curve showing the planned level of output that domestic firms are willing and able to offer at different average price levels. |
| Automatic stabilizers | Institutionally built-in features (like unemployment benefits and progressive income taxation) that tend to decrease the short-term fluctuations of the business cycle without the need for governments to intervene. |
| Average tax rate | The ratio of the tax paid by an individual over their income expressed as a percentage. |
| Budget deficit | When government expenditures exceed government (tax) revenues usually over a period of a year. |
| Business cycle | The short-term fluctuations of real GDP around its long-term trend (or potential output). |
| Business tax | Tax levied on the income of a business or corporation. |
| Capital gains tax | A tax on the profits realized from the sale of financial assets such as stocks or bonds. |
| Central bank | An institution charged with conducting monetary and exchange rate policy, regulating behaviour of commercial banks, and providing banking services to the government and commercial banks. |
| Consumer confidence | A measure of the degree of optimism that households have about their income and economic prospects. |
| Consumer price index (CPI) | The average of the prices of the goods and services that the typical consumer buys expressed as an index number. The CPI is used as a measure of the cost of living in a country and to calculate inflation. |
| Consumption (C) | Spending by households on durable and non-durable goods and on services over a period of time. |
| Contractionary fiscal policy | Refers to a decrease in government expenditures and/or an increase in taxes that aim at decreasing aggregate demand and thus reducing inflationary pressures. |
| Contractionary monetary policy | A policy employed by the central bank involving an increase in interest rates and aimed at decreasing aggregate demand and thus inflationary pressures. Referred to also as tight monetary policy. |
| Corporate indebtedness | The sum of what a corporation owes to banks or other holders of its debt. |
| Cost-push inflation | Inflation that is a result of increased production costs (typically because of rising money wages or rising commodity prices) and illustrated by a leftward shift of the SRAS curve. |
| Credit rating | A grade assigned by certain agencies (such as Moody’s or Standard and Poor’s) on the borrowing risks a prospective issuer of debt (for example, of a bond) presents to lenders. |
| Crowding out | The idea that expansionary fiscal policy is not very effective in increasing aggregate demand because the increased borrowing needs of the government to finance the increased expenditures could lead to increased interest rates. Thus, reducing private sector investment, consumer spending, and other components of AD. |
| Cyclical (demand-deficient) unemployment | Unemployment that is a result of a decrease in aggregate demand and thus of economic activity; it occurs in a recession. |
| Deflation | A sustained decrease in the average price level of a country. |
| Deflationary/recessionary gap | Arises when the equilibrium level of real output is less than potential output as a result of a decrease in AD. |
| Demand management | Policies that aim at manipulating aggregate demand through changes in interest rates (monetary policy) or changes in government expenditures and taxation in order to influence growth, employment and inflation. |
| Demand-pull inflation | Inflation that is caused by increases in aggregate demand. |
| Demand side policies | Refers to economic policies that aim at affecting aggregate demand and thus macroeconomic variables such as growth, inflation and employment; demand side policies include fiscal policy and monetary policy. |
| Deregulation | Policies that reduce or eliminate regulations related to the operation of firms so that production costs decrease—resulting in increased competition and higher levels of output. |
| Direct taxes | Taxes on income, profits or wealth paid directly to the government. |
| Discount rate | The interest rate that a central bank charges commercial banks for short-term loans (also referred to as the refinancing rate). |
| Disinflation | When the average price level continues to rise but at a slower rate so that the rate of inflation is positive but lower. |
| Economic growth | Refers to increases in real GDP over time. |
| Expansionary fiscal policy | Refers to an increase in government expenditures and/or a decrease in taxes that aim at increasing aggregate demand and thus real output and employment. |
| Expansionary monetary policy | Monetary policy aiming at increasing aggregate demand through a decrease in interest rates; also referred to as easy monetary policy. |
| Expenditure approach | One of three analytically equivalent approaches of measuring GDP that adds all the expenditures made on final domestic goods and services over a period of time by households, firms, the government and foreigners. |
| Exports | Goods and services produced in one country and purchased by consumers in another country. |
| Fiscal policy | A demand-side policy using changes in government spending and/or direct taxation to influence aggregate demand and thus growth, employment and prices. |
| Frictional unemployment | Unemployment of individuals who are in-between jobs, as people quit to find a better job or to move to a different location. |
| Full employment | A goal of macroeconomic policy that aims at fully utilizing the scarce factor of production labour. Full employment exists when the economy is producing at its potential level of real output and thus there is only natural unemployment (the AD–AS model considers the AD and AS curves together). In the production possibilities curve (PPC model), full employment exists when the economy is producing on the PPC. |
| Full employment level of output | The level of output that is produced by the economy when there is only natural unemployment. |
| Gini coefficient | A measure of the degree of income inequality of a country that ranges from zero (perfect income equality) to one (perfect inequality). Diagrammatically it is the ratio of the area between the Lorenz curve and the diagonal over the area of the half-square. |
| Government (national) debt | The sum of all past budget deficits minus any budget surpluses; the total amount the government owes to domestic and foreign creditors. |
| Government spending (G) | Refers to all spending by the government that is distinguished into current expenditures, capital expenditures and transfer payments. |
| Gross domestic product (GDP) | The value of all final goods and services produced within an economy over a period of time, usually a year or a quarter. |
| Gross national income (GNI) | The income earned by all national factors of production independently of where they are located over a period of time; it is equal to GDP plus factor income earned abroad minus factor income paid abroad. |
| Happiness Index | An index that is used to measure economic well-being of a population using several quality of life dimensions. |
| Happy Planet Index | An index that combines four elements to show how efficiently residents of different countries are using environmental resources to lead long, happy lives. The elements are well-being, life expectancy, inequality of outcomes and ecological footprint. |
| Household indebtedness | The money that households owe. |
| Imports | The value of goods and services purchased domestically that are produced abroad. |
| Incentive-related policies | Policies that aim at improving economic incentives of individuals and firms. |
| Income approach | One of the three equivalent ways that GDP can be measured, by adding all the incomes generated in the production process (wages, profits, interest and rent) for a given time period. |
| Industrial policies | A type of interventionist supply-side policies whereby the government chooses to support specific industries through preferential tax cuts, subsidies, subsidized loans and other means as they are considered pivotal in the growth prospects of the economy. |
| Inflation | A sustained increase in the average level of prices. |
| Inflationary gap | The case where equilibrium real output exceeds potential output as a result of an increase in AD. |
| Inflation rate | The percentage change between two periods of the average price level, usually measured through the CPI. |
| Interest rate | The cost of borrowing money or the reward for saving money over a period of time expressed as a percentage. |
| Interventionist supply side policies | A set of policies that aim to increase an economy’s productive capacity that relies on a greater role for the government; these include expenditures on infrastructure, education, health care, research and development, and all industrial policies. |
| Investment (I) | Spending by firms on capital goods such as machines, tools, equipment and factories. |
| Keynesian aggregate supply curve | An aggregate supply curve that shows the level of real output produced in an economy in relation to the price level. It consists of three sections: a horizontal section, an upward-sloping section and a vertical section. Changes in real GDP or the price level depend on aggregate demand and how close to capacity the economy is operating. |
| Keynesian multiplier | The idea that an increase (or, more generally, a change) in any injection will lead to a greater increase (change) in real GDP or national income because an increase in spending generates additional income that leads to further spending, and thus more income. Its size depends on the size of the withdrawals from the circular flow, as these reflect income not spent on domestic output. |
| Labour market flexibility | The labour market is considered flexible if it can adjust fast and fully to changes in labour demand and labour supply conditions. |
| Labour union | An organization of workers whose goals include improving working conditions and achieving higher compensation for members. Unions permit workers to negotiate more effectively with employers. |
| Long-run aggregate supply (LRAS) | Aggregate supply that is dependent upon the resources and technology in the economy, thus being independent of the price level. It is vertical at the level of potential output. It can only be increased by improvements in the quantity and/or quality of factors of production as well as improved technology. |
| Long-run Phillips curve | A curve showing the monetarist view that there is no trade-off between inflation and unemployment in the long run and that there exists a natural rate of unemployment at the level of potential output. |
| Long run in macroeconomics | The period of time when the prices of all factors of production, especially wages, change to match changes in the price level. |
| Long-term growth | Growth over long periods of time. In the PPC model this is shown by outward shifts of the PPC. When shown in the AD–AS model (the AD–AS model considers the AD and AS curves together), it is shown by rightward shifts in the LRAS curve. |
| Long-term growth trend | Refers to average growth over long periods of time shown in the business cycle diagram as the line that runs through short-term fluctuations, indicating changes in potential output |
| Lorenz curve | A curve showing what percentage of the population owns what percentage of the total income or wealth in the economy. It is calculated in cumulative terms. The further the curve is from the line of absolute equality (along the diagonal), the more unequal the distribution of income. |
| Macroeconomics | The study of aggregate economic activity. It investigates how the economy as a whole works. |
| Marginal propensity to consume (MPC) | The proportion of extra or additional income that is spent by households on goods and services (consumption). |
| Marginal propensity to import (MPM) | The proportion of extra or additional income that is spent by households on imported goods and services. |
| Marginal propensity to save (MPS) | The proportion of extra or additional income that is saved by households. |
| Marginal propensity to tax (MPT) | The proportion of extra or additional income that is paid in taxes, also referred to as the marginal tax rate. |
| Marginal tax rate | The proportion of a person’s extra or additional income that is paid in tax, usually expressed as a percentage. |
| Market-based supply side policies | A set of policies based on well-functioning competitive markets in order to promote long-term economic growth, shown by increases in long-run aggregate supply. |
| Market-oriented approaches | Approaches or policies that are based on the actions of private decision-makers operating in markets with a minimum amount of government intervention. |
| Minimum income standards | A measure of poverty that is based on the beliefs of people regarding what is essential in order to achieve a minimum acceptable standard of living. |
| Minimum lending rate | The interest rate that is charged by a central bank when it lends to commercial banks. Also known as discount rate or refinancing rate. |
| Minimum reserve requirements | A requirement by the central bank that sets the minimum amount of reserves that commercial banks must maintain to back their loans. |
| Minimum wage | A type of price floor where the wage rate or the price of labour is set above the market equilibrium wage rate. |
| Monetary policy | A demand-side policy using changes in the money supply or interest rates to achieve economic objectives relating to output, employment and inflation. |
| Money | Anything that is generally accepted as a means of payment for goods and services. It usually consists of currency and checking accounts. |
| Money creation | The process of creating new money by commercial banks, which occurs when they make loans. |
| Money supply | The total amount of money available at a particular time, consisting of currency plus checking accounts. |
| Multidimensional Poverty Index (MPI) | An international measure of poverty covering over 100 of the economically least developed countries. It complements traditional income-based poverty measures by capturing the deprivations that each person faces at the same time with respect to education, health and living standards. |
| National income | The income earned by the factors of production of an economy, equal to wages plus interest, plus rents, plus profits. |
| National income accounting | The services provided by a statistical entity in every country that measure the economy’s national income and output as well as other economic activity. |
| National income statistics | The statistical data used to measure a nation’s income and output, and perform national income accounting. |
| Natural rate of unemployment | The rate of unemployment that occurs when the economy is producing at its potential output or full employment level of output. It is equal to the sum of structural, frictional and seasonal unemployment. |
| Net exports (X – M) | Export revenues minus import expenditure. |
| Nominal gross domestic product | The total money value of all final goods and services produced in an economy in a given time period, usually one year, at current values (not adjusted for inflation). |
| Nominal gross national income | The total income earned by all the residents of a country (regardless of where their factors of production are located) in a given time period, usually a year, at current prices (not adjusted for inflation). |
| Nominal interest rates | Interest rates that have not been adjusted for inflation. |
| OECD Better Life Index | An index to compare well-being across countries, based on several dimensions that the OECD has identified as essential, in the areas of material living conditions and quality of life. |
| Open market operations | A tool of monetary policy involving the buying or selling of (short-term) government bonds by the central bank in order to increase or decrease the money supply, thus influencing the rate of interest. |
| Output approach | One of the three equivalent ways that GDP can be measured, it adds up the value of final goods and services produced in a given time period. |
| Per capita | Per person. Per capita values are found by dividing the variable by the size of the population. |
| Personal income taxes | Taxes paid by individuals or households on their incomes, regardless of the source of the income, such as wages, salaries, interest income or dividends. |
| Phillips curve | A curve showing the relationship between the rate of unemployment and the rate of inflation. |
| Poverty | Arises when the lack of material possessions or money prevent an individual or a family from achieving a minimum satisfactory standard of living. |
| Poverty line | A level of income determined by a government or international body (such as the World Bank) that is just enough to ensure a family can satisfy minimum needs in terms of food, clothing and housing. |
| Price deflator | A price index that removes the impact of changes in the price level when measuring nominal economic variables. |
| Privatization | The sale of public assets to the private sector. May be a type of supply-side policy. |
| Progressive taxation | Taxation where the fraction of tax paid increases as income increases. The average tax rate increases. |
| Proportional tax | A system of taxation where tax is levied at a constant rate as income rises. |
| Purchasing power parity (PPP) | A method used to make the buying power of different currencies equal to the buying power of US$1. PPP exchange rates are used to make comparisons of income or output variables across countries while eliminating the influence of price level differences. |
| Quantitative easing | An expansionary monetary policy where a central bank buys (long term) government bonds or other financial assets, in order to stimulate the economy and increase the money supply. |
| Real GDP | The total value of all final goods and services produced in an economy in a given time period, usually one year, adjusted for inflation. |
| Real GDP per person (per capita) | Real GDP divided by the population of the country. |
| Real GNI per person (per capita) | Real GNI divided by the population of the country. |
| Real interest rates | Interest rates that have been adjusted for inflation. |
| Recession | Occurs when real GDP falls for at least two consecutive quarters. |
| Regressive taxation | Taxation where the fraction of tax paid decreases as income increases. The average tax rate decreases. All indirect taxes are regressive. |
| Relative poverty | A comparative measure of poverty according to which income levels do not allow people to reach a standard of living that is typical of the society in which they live. It is defined as a percentage of society’s median income. |
| Seasonal unemployment | Unemployment that arises when people are out of work because their usual job is out of season, for example, agricultural workers during winter months. |
| Short-run aggregate supply (SRAS) | The total quantity of real output (real GDP) offered at different possible price levels in the short run (when wages and other resource prices are constant). |
| Short run in macroeconomics | The period of time when the prices of factors of production, especially wages, are considered fixed. |
| Short-run Phillips curve | A curve showing the inverse relationship between the rate of unemployment and the rate of inflation, which suggests a trade-off between inflation and unemployment. |
| Short-term fluctuations of economic activity | Periods of growth of real GDP followed by periods of contraction, which are part of the business cycle. |
| Structural unemployment | A kind of long-term unemployment that arises from a number of factors including: technological change; changes in the patterns of demand for different labour skills; changes in the geographical location of industries; labour market rigidities. |
| Supply-side policies | Government policies designed to shift the long-run aggregate supply curve to the right, thus increasing potential output in the economy and achieving economic growth. |
| Sustainable debt | Refers to a level of government debt such that the borrowing government can make its payments of interest and debt repayment while at the same being able to meet the economy’s growth objectives. |
| Transfer payments | Payments made by the government to vulnerable groups in a society, including older people, low income people, unemployed and many more. The objective is to transfer money from taxpayers to those who cannot work, to prevent them from falling into poverty. |
| Unemployment | When a person (who is above a specified age and is available to work) is actively looking for work, but is without a job. |
| Unemployment benefits | Payments, usually made by the government, to people who are unemployed (and actively seeking employment). |
| Unemployment rate | The number of unemployed workers expressed as a percentage of the total workforce. |
| Universal basic income | A regular cash payment given to all persons in an economy that is independent of any other source of income they may have. It is intended to reduce poverty and income inequality. |
| Wage | Payment received by the factor of production labour, which is a certain amount per unit of time. |
| Wealth | The total value of all assets owned by a person, firm, community, or country minus what is owed to banks or other financial institutions. |
| Weighted price index | A measure of average prices over a period of time that gives a weight to each item according to its relative importance in the consumers’ budgets. It is used to measure changes in the price level. |
Definitions to Know
| Term | Definition |
| International trade | Trade that involves the exports and imports of goods or services between countries. |
| Free trade | International trade that is not subject any kind of trade barriers, such as tariffs or quotas. |
| Import expenditure | The value of imports of goods and services. |
| Export revenue | The revenues collected by exporting firms. |
| Absolute advantage (HL Only) | A country has an absolute advantage in the production of a good if it can produce more of it with the same resources or, equivalently, if it can produce the same amount using fewer resources compared to another country. |
| Comparative advantage (HL Only) | When a country can produce a good at a lower opportunity cost compared to another country. |
| Specialization | Refers to when a firm or country focuses on the production of one or a few goods or services. This forms the basis of theory of comparative advantage in international trade. |
| Balance of trade in goods | Part of the balance of payments, it is the value of exports of goods of a country minus the value of imports of goods over a given period of time. |
| Balance of trade in services | Part of the balance of payments, it is the value of exports of services of a country minus the value of imports of services over a given period of time. |
In this module, we will explore the fascinating world of global economics. We’ll start by examining the benefits of international trade and how it impacts economies and markets worldwide. We will also delve into the trade diagram, specifically focusing on the concept of free trade. Let’s embark on this journey to understand the significance of international trade.
Benefits of International Trade
International trade offers a myriad of benefits, shaping economies and markets around the world. These advantages include:
The Free Trade Diagram
Understanding the dynamics of international trade involves the free trade diagram. This diagram is instrumental in visualizing how trade affects domestic markets. In this diagram:
World Price (Wp)
Crucially, the free trade diagram introduces the concept of the world price (Wp). This represents the price at which producers worldwide are willing to offer a particular product. The interplay between the world price and domestic equilibrium price shapes international trade dynamics.
Key Scenarios:
World Price Below Domestic Equilibrium: If the world price is lower than the domestic equilibrium price, efficient domestic suppliers will sell their products until the world price is reached. At this point, consumers opt to import the remaining quantity demanded from international markets.
Diagram 1: Free Trade Diagram illustrating Imports
World Price Above Domestic Equilibrium: When the world price is higher than the domestic equilibrium, domestic suppliers will eagerly sell their goods at the world price, enticed by the prospect of profits. They will sell in domestic and international markets until domestic consumers no longer demand the product. Afterward, any remaining supply is directed toward international markets.
Diagram 2: Free Trade Diagram illustrating Exports
The free trade diagram demonstrates the dynamics of international trade, revealing how domestic producers, consumers, and international markets interact when world prices deviate from domestic equilibrium.
By understanding these principles of international trade and the free trade diagram, we gain insights into the intricate web of global economics and its profound impact on economies worldwide. In subsequent modules, we will delve deeper into the complexities and implications of international trade.
HL Only
In international trade, the concepts of absolute and comparative advantage play a crucial role in determining which goods a country should produce and trade. Understanding these concepts can lead to more efficient resource allocation and gains from trade. This module explores absolute and comparative advantage and their implications for international trade.
Absolute Advantage:
Definition: Absolute advantage refers to a country’s ability to produce a good more efficiently, using fewer resources (e.g., time, labor, or capital), than another country.
Comparative Advantage:
Definition: Comparative advantage arises when a country can produce a good at a lower opportunity cost (the value of the next best alternative foregone) compared to another country.
Gains from Trade: Gains from trade occur when countries specialize in the production of goods in which they have a comparative advantage and then trade these goods with others. By trading, countries can consume more than they could produce in isolation, leading to increased economic welfare for all parties involved.
Sources of Comparative Advantage:
Differences in Resource Endowments: Countries with abundant resources in a particular industry may have a comparative advantage in producing related goods.
Technological Advancements: Superior technology can lead to higher productivity, resulting in a comparative advantage.
Skilled Labor Force: A country with a highly skilled labor force may excel in industries requiring expertise.
Opportunity Costs: Opportunity cost is a critical concept in comparative advantage. When choosing to produce one good over another, the opportunity cost is the value of the next best alternative foregone. Countries should specialize in producing goods with a lower opportunity cost to maximize gains from trade.
Diagram – Linear PPC: This diagram represents a linear Production Possibility Curve (PPC) showing different opportunity costs for two goods. The steeper the slope of the PPC, the higher the opportunity cost. Specialization and trade can lead to shifts in the PPC, allowing both countries to consume more of both goods.
Figure 1: Linear PPC for two Countries
Calculating Absolute and Comparative Advantage
Country A:
Wheat: 20 tons per worker
Computers: 5 units per worker
Country B:
Wheat: 10 tons per worker
Computers: 4 units per worker
Absolute Advantage:
Absolute advantage refers to a country’s ability to produce a good more efficiently than another country. To determine absolute advantage, we compare the productivity of each country in the production of both goods.
In terms of wheat production, Country A produces 20 tons per worker, while Country B produces 10 tons per worker. Therefore, Country A has an absolute advantage in wheat production.
In terms of computer production, Country A produces 5 units per worker, and Country B produces 4 units per worker. Country A also has an absolute advantage in computer production.
Comparative Advantage:
Comparative advantage arises from differences in opportunity costs. To calculate comparative advantage, we compare the opportunity costs of producing each good in the two countries. Opportunity cost is the value of the next best alternative forgone.
In Country A, the opportunity cost of producing 1 ton of wheat is the loss of 5 computer units (20 tons of wheat / 5 computers per worker).
In Country B, the opportunity cost of producing 1 ton of wheat is the loss of 2.5 computer units (10 tons of wheat / 4 computers per worker).
Comparative advantage is determined by comparing opportunity costs. In this case, Country B has a lower opportunity cost of producing wheat (2.5 computers) compared to Country A (5 computers).
Conversely, for computer production:
In Country A, the opportunity cost of producing 1 computer is 4 tons of wheat.
In Country B, the opportunity cost of producing 1 computer is 2.5 tons of wheat.
Again, Country B has a lower opportunity cost for producing computers (2.5 tons of wheat) compared to Country A (4 tons of wheat).
Conclusion:
In this example, Country B has a comparative advantage in producing both wheat and computers because it has lower opportunity costs for both goods. However, both countries still benefit from trade. Country A specializes in computers, and Country B specializes in wheat, maximizing the gains from trade.
Understanding absolute and comparative advantage is essential in international trade. By recognizing where they have a comparative advantage, countries can allocate resources efficiently and achieve gains from trade, ultimately benefiting their economic welfare.
Watch this video to finish learning about free trade and the benefits it creates.
Practice Problem Set (KEY BELOW)
Question 1:
Explain three benefits of international trade. Provide real-world examples to illustrate your points.
Question 2:
In the context of international trade, what is the “world price”? How does it influence a nation’s trade decisions?
Question Set 3:
Analyze the market for corn below and answer the accompanying questions
a. Does this diagram demonstrate that the domestic country will import or export corn?
b. What is the amount of corn that will be purchased domestically?
c. What is the amount of corn that will be imported or exported?
d. What is the overall amount of corn that will be consumed by domestic consumers?
e. What is the overall amount of corn that will be produced by domestic suppliers?
Question Set 4:
Analyze the market for Electric Vehicles (EVs) below and answer the accompanying questions
a. Does this diagram demonstrate that the domestic country will import or export EVs?
b. What is the amount of EVs that will be purchased domestically?
c. What is the amount of EVs that will be imported or exported?
d. What is the overall amount of EVs that will be consumed by domestic consumers?
e. What is the overall amount of EVs that will be produced by domestic suppliers?
HL Only Problems
Practice Problem 1:
Consider two hypothetical countries, Country X and Country Y, engaged in the production of two goods, shoes and smartphones. The table below shows the production figures per worker in each country:
Shoes (pairs per worker) | Smartphones (units per worker) | |
| Country X | 10 | 20 |
| Country Y | 8 | 25 |
Determine which country has an absolute advantage in the production of shoes.
Practice Problem 2:
Now, let’s consider Country A and Country B, which produce cars and bicycles. The table below shows the production figures per worker in each country:
Cars (units per worker) | Bicycles (units per worker) | |
| Country A | 5 | 10 |
| Country B | 6 | 15 |
Determine which country has an absolute advantage in the production of cars.
Remember to compare the production figures and calculate opportunity costs to identify both absolute and comparative advantages for each good in both practice problems.
ANSWER KEY
Question 1:
Three benefits of international trade include:
Increased competition: International trade exposes domestic firms to competition from foreign firms, encouraging efficiency and innovation. For example, the automobile industry experiences competition from global manufacturers, which leads to improved vehicle quality and lower prices.
Lower prices: Imported goods often cost less than domestically produced ones, benefiting consumers. For instance, consumers may buy cheaper clothing imported from low-wage countries.
Greater choice: International trade expands the variety of products available to consumers. For instance, exotic fruits and specialty foods from around the world can be found in local markets.
Question 2:
The “world price” refers to the equilibrium price determined by international supply and demand. It influences a nation’s trade decisions by serving as a benchmark for determining whether to export or import a particular product. If the world price is lower than the domestic equilibrium, the nation will import the product. If the world price is higher, the nation will export it.
Question 3
a) Imports. World Price is below the domestic equilibrium)
b) 13 Million
c) 6 Million Imported
d) 19 Million
e) 13 Million
Question 4
a) Exports. World Price is above the domestic equilibrium)
b) 12 Million
c) 6 Million exported
d) 12 Million
e) 18 Million
HL Only KEY
Practice Problem 1:
Country X has an absolute advantage in the production of shoes because it produces 10 pairs per worker, which is higher than Country Y’s 8 pairs per worker.
Country Y has an absolute advantage in the production of smartphones because it produces 25 units per worker, which is higher than Country X’s 20 units per worker.
Country X has a comparative advantage in the production of shoes because its opportunity cost of producing one more pair of shoes is lower (0.5 smartphone) compared to Country Y (1.25 smartphones).
Country Y has a comparative advantage in the production of smartphones because its opportunity cost of producing one more smartphone is lower (0.4 pair of shoes) compared to Country X (0.5 pair of shoes).
Practice Problem 2:
Country B has an absolute advantage in the production of cars because it produces 6 cars per worker, which is higher than Country A’s 5 cars per worker.
Country B has an absolute advantage in the production of bicycles because it produces 15 units per worker, which is higher than Country A’s 10 units per worker.
Country A has a comparative advantage in the production of cars because its opportunity cost of producing one more car is lower (2 bicycles) compared to Country B (2.5 bicycles).
Country B has a comparative advantage in the production of bicycles because its opportunity cost of producing one more bicycle is lower (0.4 car) compared to Country A (0.5 car).
Definitions to Know
| Term | Definition |
| Tariff | A tax that is placed on imports to protect domestic industries from foreign competition and to raise revenue for the government. |
| Quota | An import barrier that set limits on the quantity or value of imports that may be imported into a country. |
| Subsidy (international) | An amount of money paid by the government to a firm, per unit of output, to encourage production and provide the firm an advantage over foreign competition. |
| Export subsidy | Payments made by the government to exporting firms on the basis of the number of units exported. |
| Administrative barriers | Trade barriers in the form of regulations that aim to limit imports into a country. These barriers may take the form of product safety standards, sanitary standards or pollution standards but may also include more stringent than necessary application of customs procedures. |
| Export revenue | The revenues collected by exporting firms. |
| Import expenditure | The value of imports of goods and services. |
| Elasticity of demand for exports | A measure of the responsiveness of the volume of exports to a change in their price. |
| Elasticity of demand for imports | A measure of the responsiveness of the volume of imports to a change in their price. |
Protectionism refers to government policies aimed at shielding domestic industries from foreign competition. Countries enact protectionist measures to safeguard their domestic markets, promote domestic industries, and achieve specific economic and political objectives.
Types of Trade Protection Measures
1. Tariffs
Stakeholders:
Effect on:
2. Quotas
Stakeholders:
Effect on:
3. Subsidies
Stakeholders:
Effect on:
4. Administrative Barriers
Stakeholders:
Effect on:
Conclusion
Trade protectionism can have varied consequences on domestic and international stakeholders. Understanding these policies and their effects is essential for analyzing international trade dynamics and related economic impacts.
Watch this video to finish learning about protectionist policies.
Practice Problem Set (KEY BELOW)
For each diagram, answer the corresponding questions
Question 1
Question 2
ANSWER KEY
Question Set 1
Question Set 2
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Unit 4 Definitions
Global Economy Terms to Know |
| Balance of trade in goods | Part of the balance of payments, it is the value of exports of goods of a country minus the value of imports of goods over a given period of time. |
| Balance of trade in services | Part of the balance of payments, it is the value of exports of services of a country minus the value of imports of services over a given period of time. |
| Absolute advantage | A country has an absolute advantage in the production of a good if it can produce more of it with the same resources or, equivalently, if it can produce the same amount using fewer resources compared to another country. |
| Administrative barriers | Trade barriers in the form of regulations that aim to limit imports into a country. These barriers may take the form of product safety standards, sanitary standards or pollution standards but may also include more stringent than necessary application of customs procedures. |
| Anti-dumping | Typically refers to tariffs that aim at raising the artificially low price of a dumped imported good to the level of the higher domestic price. A dumped good is one that is exported at a price below the cost of producing it. |
| Appreciation | When the price of a currency increases in a floating exchange rate system. |
| Appropriate technology | Technology that relies mostly on the relatively abundant factor an economy is endowed with. |
| Balance of payments | A record of the value of all transactions of a country with the rest of the world over a period of time. |
| Bilateral trade agreement | An agreement between two countries to phase-out or eliminate trade related barriers. |
| Capital account | A subaccount of the balance of payments that includes credit and debit entries for non-produced, non-financial assets as well as capital transfers between residents and non-residents. |
| Capital flight | Occurs when money and other assets flow out of a country to seek a “safe haven” in another country. |
| Capital transfers | Include financial or non-financial assets for items including debt forgiveness, investment, non-life insurance claims. They are part of the capital account of the balance of payments. |
| Carbon (emissions) taxes | Taxes levied on the carbon content of fuel. They are a type of Pigouvian tax. |
| Collective self-governance | In the case of a common pool resource, such as a fishery, users solve the problem of overuse by devising rules concerning the obligations of the users, the monitoring of the use of the resource, penalties of abuse, and conflict resolution. |
| Common market | When a group of countries agree not only to free trade of goods and services but also to free movement of capital and labour. |
| Comparative advantage | When a country can produce a good at a lower opportunity cost compared to another country. |
| Composite indicator | An indicator that is comprised as an average of more than one economic variable, for example, the HDI. |
| Credit items | Refers to transactions within the balance of payments of a country that lead to an inflow of currency (for example, the export of goods); these transactions enter the account with a plus sign. |
| Current account | A subaccount of the balance of payments that records the value of net exports in goods and services, net income and net current transfers of a country over a period of time. |
| Current account deficit | Exists when the sum of net exports of goods and services plus net income plus net current transfers is negative (or simply when debits or outflows are greater than credits or inflows). |
| Current account surplus | Exists when the sum of net exports of goods and services plus net income plus net current transfers is positive (or simply when credits or inflows are greater than debits or inflows). |
| Current transfers | An entry in the current account that records payments between residents and non-residents of a country without something of economic value being received in return and that affect directly the level of disposable income (for example, workers remittances, pensions, aid and grants, and so on). |
| Customs union | An agreement between countries to phase out or eliminate tariffs and other trade barriers and establish a common external barrier toward non-members. |
| Debit items | Refers to transactions within the balance of payments of a country that lead to an outflow of currency (for example, the import of services); these transactions enter the account with a minus sign. |
| Debt relief (cancellation) | A reduction of the debt burden of developing countries organized by the World Bank and the IMF. |
| Debt servicing | Refers to the repayment of principal and interest on the debt of a person, a firm or a country. |
| Depreciation | A decrease in the value of a currency in terms of another currency in a floating or managed exchange rate system. |
| Devaluation | A decrease in the value of a currency in a fixed exchange rate system. |
| Development aid | Aid aimed at assisting developing countries in their development efforts. Includes project aid, program aid and debt relief. It is concessional meaning there are low interest rates and long repayment periods. |
| Dumping | When a firm sells abroad at a price below average cost or below the domestic price. |
| Economically least developed countries (ELDCs) | According to the UN these are low-income countries facing severe structural constraints to sustainable development, with low levels of human assets, highly vulnerable to economic and environmental shocks. |
| Economic development | A multidimensional concept involving a sustained increase in living standards that implies higher levels of income and thus greater access to goods and services, better education and health, a better environment to live in as well as individual empowerment. |
| Economic integration | Economic interdependence between countries usually involving agreements between two or more countries to phase-out or eliminate trade and other barriers between them. |
| Elasticity of demand for exports | A measure of the responsiveness of the volume of exports to a change in their price. |
| Elasticity of demand for imports | A measure of the responsiveness of the volume of imports to a change in their price. |
| Exchange rate | The value of one currency expressed in term of another currency; for example, €1 = US$1.5. |
| Export promotion | Growth policies aiming at expansion of export revenues as the vehicle of economic growth; often contrasted to import substitution. |
| Export revenue | The revenues collected by exporting firms. |
| Export subsidy | Payments made by the government to exporting firms on the basis of the number of units exported. |
| External balance | A situation where the value of a country’s exports is balanced by the value of its imports over a period of time, such that a current account surplus or deficit does not persist over long periods. |
| Financial account | In the balance of payments this records inflows and outflows of portfolio and FDI funds over a period of time, official borrowing and changes in reserve assets. |
| Fixed exchange rate | An exchange rate system where the exchange rate is fixed, or pegged, to the value of another currency (or to the average value of a selection of currencies) and maintained there with appropriate central bank intervention. |
| Floating exchange rate | An exchange rate system where the exchange rate is determined solely by the market demand and market supply of the currency in the foreign exchange market without any central bank intervention. |
| Foreign aid | Refers to flows of grants or loans from developed to developing countries that are non-commercial from the point of view of the donor and for which the terms are concessional (that is, the interest rate is lower than the market rate and the repayment period longer). |
| Foreign direct investment (FDI) | When a firm establishes a productive facility in a foreign country or acquires controlling interest (at least 10% of the ordinary shares) in an existing foreign firm. |
| Free trade | International trade that is not subject any kind of trade barriers, such as tariffs or quotas. |
| Free trade area/agreement | An agreement between two or more countries to phase-out or eliminate trade barriers between them, members of the agreement are free to maintain their own trade policy towards non-members. |
| Gender inequality index (GII) | A composite indicator that measures gender inequalities in three dimensions of human development, namely reproductive health, empowerment and economic status. |
| Human Development Index (HDI) | A composite index of development that reflects the three basic goals of development, which are a long and healthy life, improved education, and a decent standard of living. The variables measured are life expectancy at birth, mean years of schooling and expected years of schooling, and GNI per capita (PPP US$). |
| Humanitarian aid | Aid given to alleviate short-term suffering, consisting of food aid, medical aid, and emergency relief aid usually as a result of a natural catastrophe or war. |
| Import expenditure | The value of imports of goods and services. |
| Import substitution | A growth strategy where domestic production is substituted for imports in an attempt to shift production away from the primary sector and industrialize. This strategy requires that the domestic industry is protected from import competition. |
| Inequality adjusted Human Development Index (IHDI) | A composite indicator consisting of an average of a country’s achievements in health, education and income all adjusted for the degree of inequality characterizing each. |
| Infant industry | Refers to a new industry that should be protected from foreign competition until it is large enough to achieve economies of scale that will allow it to be internationally competitive. It is used as an argument in favour of trade protection in developing countries. |
| Informal economy | Refers to the part of an economy where activity is not officially recorded, regulated or taxed. The activities of the informal economy are not included in a country’s national income figures. |
| Infrastructure | Physical capital typically financed by governments that is essential for economic activity to take place, including roads, power, telecommunications and sanitation, generating significant positive externalities. |
| International Monetary Fund (IMF) | An international financial institution of 189 countries whose objectives include to improve global monetary cooperation and secure financial stability by monitoring the economic and financial policies of its members and providing them with advice and with loans, if they face balance of payments difficulties. |
| International trade | Trade that involves the exports and imports of goods or services between countries. |
| J-curve | Following devaluation or a sharp depreciation, a trade deficit will typically widen before it starts improving thus tracing the letter “J” if plotted against time, because the Marshall-Lerner condition is satisfied only after a period of several months following the decreased value of the currency. |
| Land rights | Property (ownership) legal rights over land holdings that include rights to possess, occupy and use the land. |
| Managed exchange rate | An exchange rate that floats in the foreign exchange markets but is subject to intervention from time to time by domestic monetary authorities, in order to prevent undesirable movements in the exchange rate. |
| Marshall-Lerner condition | A condition stating that a depreciation or devaluation of a currency will lead to an improvement in the current account balance if the sum of the price elasticity of demand for exports plus the price elasticity of demand for imports is greater than one. |
| Microfinance | The provision of small loans to poor entrepreneurs who lack access to traditional banking services. |
| Monetary union | Where two or more countries share the same currency and have a common central bank. |
| Multilateral development assistance | Assistance provided by multilateral organizations such as the World Bank when they lend to developing countries for the purpose of helping them in their development objectives. |
| Multilateral trade agreement | An agreement between many countries to lower tariffs or other protectionist measures, currently carried out within the framework of the WTO. |
| Non-governmental organization (NGO) | Organizations that are not part of the government that promote economic development and/or humanitarian ideals and/or sustainable development. |
| Non-produced, non-financial assets | A measure of the net international sales and purchases of non-produced assets (such as land) and intangible assets (such as patents and copyrights). |
| Official borrowing | International borrowing by a government, often undertaken to help cover a current account deficit. |
| Official Development Assistance (ODA) | Aid that is provided to a country by another government or multilateral agency. It is the most important part of foreign aid. |
| Overvalued currency | A currency whose value or exchange rate is greater than its equilibrium exchange rate, usually achieved through central bank intervention; may occur in a pegged or managed exchange rate system. |
| Portfolio investment | The purchase of financial assets such as shares and bonds in order to gain a financial return in the form of interest or dividends. Appears in the financial account of the balance of payments. |
| Poverty trap/cycle | Any circular chain of events starting and ending in poverty—for example, low income leads to low savings, leads to low investment, leads to low growth, leads to low income. |
| Preferential trade agreement | Where a country agrees to give preferential access (for example, reduced tariffs) for certain products to one or more trading partners. |
| Primary sector | Anything derived from the factor of production land. Includes agricultural products, metals and minerals. |
| Property rights | The exclusive, legal, authority to own property and determine how that property is used, whether it is owned by the government or by private individuals. |
| Quota | An import barrier that set limits on the quantity or value of imports that may be imported into a country. |
| Regional trade agreement | An agreement between a group of countries usually within a geographical region to lower or eliminate trade barriers. |
| Remittances | The transfer of money by foreign workers to individuals, often family members, in their home country. |
| Reserve assets | Foreign currencies and precious metals held by central banks as a result of international trade. Reserves may be used to maintain or influence the exchange rate for the country’s currency. Reserves appear as an item in the financial account of the balance of payments. |
| Revaluation | An increase in the value of a currency in a fixed exchange rate system. |
| Social enterprise | A company whose main objective is to have a social impact rather than to make a profit for their owners or shareholders. It operates by providing goods and services for the market in an entrepreneurial and innovative fashion and uses its profits primarily to achieve social objectives. |
| Specialization | Refers to when a firm or country focuses on the production of one or a few goods or services. This forms the basis of theory of comparative advantage in international trade. |
| Speculation | Refers to a process where something is bought or sold with a view to making a short term profit, for example, currency speculation where currencies are bought or sold so that a profit can be made when the exchange rate changes. |
| Subsidy (international) | An amount of money paid by the government to a firm, per unit of output, to encourage production and provide the firm an advantage over foreign competition. |
| Sustainable development | Refers to the degree to which the current generation is able to meet its needs today but still conserve resources for the sake of future generations. |
| Tariff | A tax that is placed on imports to protect domestic industries from foreign competition and to raise revenue for the government. |
| Trade creation | In international trade it occurs when higher cost imports are replaced by lower cost imports due to the formation of a trading bloc or a trade agreement. |
| Trade diversion | In international trade it occurs when lower cost imports are replaced by higher cost imports due to the formation of a trading bloc or a trade agreement. |
| Trade liberalization | The process of reducing barriers to international trade. |
| Trade protection | Government intervention aiming to limit imports and/or encourage exports by setting up trade barriers that protect from foreign competition. |
| Trading bloc | A group of countries that have agreed to reduce protectionist measures like tariffs and quotas between them. |
| Undervalued currency | A currency whose value or exchange rate is lower than its equilibrium exchange rate, usually achieved through central bank intervention; may occur in a pegged or managed exchange rate system. |
| Unfair competition | In international trade this refers to practices of countries trying to gain an unfair advantage through such methods as undervalued exchange rates. |
| Sustainable development goals (SDGs) | The UN set out 17 global goals including those that aim to end all forms of poverty, fight inequalities and tackle climate change. |
| World Bank | An international organization that provides loans and advice to economically less developed countries for the purpose of promoting economic development and reducing poverty. |
| World Trade Organization (WTO) | An international body that sets the rules for global trading and resolves disputes between its member countries. It also hosts negotiations concerning the reduction of trade barriers between its member nations. |
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