Economics review questions

• Rotunda Principles state that trade creates value and incentives affect behavior.

Trade

• Trade involves the voluntary exchange between two or more parties.
• Trade helps both sides, creates value, a positive-sum game, and encourages diverse interactions.
• Jonathan Sacks stated, "It is through trade that a difference becomes a blessing, not a curse."

Five Foundations of Economics

• Incentives
• Trade-offs
• Opportunity cost
• Marginal thinking
• Trade creates value

Factors in Trade

• Marginal thinking evaluates whether the benefit of one more unit of something is greater than its cost.
• A circular flow diagram shows how goods, services, and resources flow through the economy via commerce between households and firms.
• Endogenous factors are those we can control.
• Exogenous factors are those we cannot control.

Specialization, Statements and Ceteris Paribus

• Specialization limits one's work to a particular area.
• A positive statement describes what is.
• A normative statement describes what ought to be.
• Ceteris paribus refers to changing one variable without shifting any others.

Why Trade is Beneficial

• Comparative advantage: an individual or business produces at a lower opportunity cost than a competitor; it's why trade occurs.
• Absolute advantage: producing more than a competitor with the same quantity of resources.
• Gains from trade occur if each competitor specializes in a specific good, and trade can operate above the PPC curve.

Comparative Advantage Example with Pizza and Wings

• Gwen can produce 1 pizza for 2 wings (.5), while Blake produces 1 pizza for 3 wings (.33).
• Gwen producing pizzas and Blake producing wings is due to comparative advantage.
• It would be advantageous to trade at a ratio like 19 pizzas for 47 wings (.4).
• If the trade ratio doesn't fall between these two ratios, one side would decline.

Differentiating the Market

• Consumer good: any good produced for present consumption (e.g., shirt).
• Capital good: any good that helps in the production of other goods or services in the future (e.g., truck, factories).
• Investment: the process of using resources to create or buy new capital.

How the Market Operates

• Invisible hand: consumers are motivated by self-interest and guided to the goods they need or want most, setting the market in society's best interest (Adam Smith).
• Competitive market: producers and consumers each have a negligible impact on market price and quantity.
• Market power: A firm's ability to influence the price of a good or service by exercising control over demand and supply.
• Monopoly: a single company controls a market.

Supply & Demand

• Price is the only thing that can change quantity demanded.
• Demand schedule: a table showing the relationship between the price of a good and the quantity demanded.
• Market demand: the sum of all individual quantities demanded by each buyer in a market.
• Purchasing power: how much you can afford.
• Normal good: demand increases when income increases; inferior good is opposite.
• Remember shortages and surpluses, complements and substitutes.

Economic Theories

• Unconstrained Vision: We have sufficient resources to satisfy everyone.
• Constrained Vision: We have limited resources with unlimited wants at any point in time.

Measuring a National Economy

• GDP = Output = Income
• GDP: market value of all final goods and services produced within a nation during a specific period.
• When GDP rises, national output and income are higher.
• Real GDP is GDP adjusted for inflation.
• Economic growth: the percentage change in real per capita GDP.
• Recession: short-term economic downturn.
• Business cycle: a short-run fluctuation in economic activity.
• Economic expansion: from the bottom of a trough to its next peak (economic activity is increasing).
• Economic contraction: from top of a peak to its next trough (activity decreases).
• Economic growth is the percent change in real GDP per capita.

Details of GDP

• Intermediate goods: price not counted in GDP; goods that firms repackage/bundle with other goods to sell later.
• Final goods: price counted in GDP; what is actually sold.
• GNP: measure of national input; e.g., Nike shoes in Thailand included in U.S. GNP.
• Resold items, stocks, and bonds do not count toward GDP.
• GDP = C + I + G + NX

The Components of U.S. GDP

• Personal consumption expenditures (C): household expenditures for durable and nondurable consumer goods/services ($13.88 trillion).
• Gross private investment (I): business expenditures for capital goods, household purchases of homes, and inventories ($3.58 trillion).
• Government purchases (G): government expenditures for goods and services that the government consumes in providing public goods and for public capital ($3.50 trillion).
• Exports (X): goods or services produced domestically but sold abroad ($2.57 trillion).
• Imports (M): goods or services produced abroad but sold domestically ($3.12 trillion). NX = Exports - Imports = $-0.55 Trillion

Calculating GDP

• Nominal GDP is GDP calculated from current prices.
• Price level is an index of the average prices of goods and services in an economy.
• GDP Deflator is the price level in GDP data.
• Real GDP = (Nominal GDP / Price level) x 100

Trends and Shortcomings in Using GDP

• Nonmarket activities (e.g., work done at home) provide shortcomings in GDP measurement.
• The underground economy (narcotics, gambling) is not accounted for in GDP.
• The underground economy can account for up to 40% of the economy in underdeveloped countries.
• Per capita GDP positively correlates with many human welfare outcomes nearly everyone finds desirable.
• South Korea GDP = 14th in world
• South Korea per capita GDP = $34k
• (Nom GDP / Price level for that year) x 100 = adjusted price

Unemployment

• Unemployment occurs when a worker is searching for a job but is unsuccessful.
• The unemployment rate is the percentage of the labor force that is unemployed.
• Creative destruction is introducing new jobs/products and erasing others.
• Labor force participation rate: (Employed + Unemployed actively seeking) / Relevant population.
• Structural unemployment: jobs become obsolete from creative destruction or changes in the industrial makeup of the economy.
• Frictional unemployment: delays in matching jobs and workers (affected by information availability and government policies).
• Natural unemployment: there's always some; it's only structural and frictional.
• Unemployment insurance guarantees unemployed workers receive a percentage of their former pay while unemployed.
• Cyclical unemployment: caused by economic downturns, generates greatest concern.
• Natural rate of unemployment: the rate of unemployment when the economy normally grows is around 4-5% in the U.S.
• Full employment output (Y*) occurs when the natural rate of unemployment equals the unemployment rate (no cyclical unemployment).
• When the economy is in a recession, unemployment rises above natural unemployment (u > u*).
• Unemployment rate or u = (number unemployed/labor force) x 100
• Marginally attached workers looked for a job in the last twelve months and are willing to work, but haven't sought a job in the last four weeks.
• U-3 Unemployment is unemployed over the labor force.
• U-6 unemployment adds marginally attached individuals plus anyone working part-time who would work full-time if they could.
• RECESSION: u > u* and y < y*

Inflation

• Deflation occurs when prices fall, resulting in negative inflation.

• CPI measures the price level based on the consumption patterns of a typical consumer, measuring inflation. basket price price index = ----------------------------------------- x 100 basket price in base year

• Price index shows growth

                           price level today
  

price in today's dollars = price in earlier time x ------------------------------------ price level in earlier time

• Factors that can affect CPI: substitution, changes in quality, and new goods/services/locations.
• CPI accuracy affects workers or companies negatively.
• Chained CPI reduces the upward bias of CPI by updating monthly.
• Shoe-leather costs are resources wasted when people change behavior to avoid holding onto money.
• Money illusion happens when people interpret changes in wages or prices as real changes.
• Menu costs are the costs of changing prices.
• Capital tax gains are the gains created by selling a product for more than its price.
• Inflation and money supply growth are positively correlated.
• The equation of exchange shows the long-run relationship between price level and quantity of money: (M x V) = (P x Y).
• Price level is the average price of goods/services in an economy at a specific time and a key indicator of inflation, consumer spending power, and the supply-demand chain.
• Velocity of money counts how many times a unit of money exchanges hands over a given year. %ΔΜ + %∆V ≈ %ΔΡ + %ΔΥ

ALL THE FINANCIAL STUFF

• Loanable Funds Market: borrowers and savers supplying funds to borrowers.
• Every dollar borrowed requires a dollar saved.
• Interest rate = opportunity cost of consumption.
• Profit-maximizing firms only borrow money if their expected return is greater than the cost.
• Fisher equation: Real interest rate = Nominal interest rate – Inflation rate or R = r + i

Shifters of Supply in the Loanable Funds Market

• Income and wealth
• Time preferences
• Consumption smoothing

Shifters of Demand in the Loanable Funds Market

• Productivity of capital
• Investor confidence
• Government borrowing
• Equilibrium occurs when savings = investments

SECURITIES AND FINANCIAL MARKETS

• Financial intermediaries: firms that help channel funds from savers to borrowers.
• Banks: private firms that accept deposits and extend firms.
• Indirect finance: savers lend money to financial intermediaries, who then loan the money to borrowers (banks).
• Direct finance: savers lend money directly to borrowers (stocks and bonds).
• Security: a contract that entitles its owner to certain rights (tradeable).
• Bond represents a type of security, representing a debt to be paid.
• Default risk and interest rates are aligned: higher the risk, higher the interest rate.
• All bond grades below BB are denoted “junk bonds.”
• Bond grades of AAA are the best, such as Harvard or Apple.
• Stocks represent ownership shares in a firm.
• Secondary markets are valuable for firms as they lower the cost of borrowing.
• Treasury securities are bonds sold by the national government to pay for the national debt.
• Securitization is creating a new security by combining otherwise separate loan agreements.