Macroeconomics Chapter 2
List the three basic economic questions that all societies must answer
(1.) What will be produced? (2.) How will it be produced? (3.) Who will get what is produced?
What is a command economy?
A command economy is one in which a central government either directly, or indirectly, sets output targets, incomes, and prices. It may even involve direct government ownership of the means of production and central planning of the economy.
Explain what a graph is and how it can be used
A graph is a two-dimensional representation of a set of numbers. It can be used to demonstrate the relationship between two or more variables.
What is a laissez-faire economy?
A laissez-faire economy is one in which individuals and firms pursue their own self-interests without any central direction or regulation.
Explain the difference between absolute advantage and comparative advantage
A person has an absolute advantage in the production of a good if he or she is more productive at producing the good. A person has a comparative advantage in the production of a good if he or she can produce it at the lowest opportunity cost.
What does a production possibility frontier represent?
A production possibility frontier is a graph that shows all of the combinations of goods and services that can be produced if all of society's resources are used efficiently.
How does an individual know whether or not an investment in education is worthwhile?
A worthwhile investment is one for which the expected present value of future benefits exceeds the present value of costs.
What are the implications for economic growth for countries specializing in capital goods rather than consumer goods? What is the opportunity cost of this decision?
All else equal, countries that specialize in capital goods will likely grow more than those that specialize in consumer goods, because specializing in capital goods will allow for more goods to be produced in the future. The opportunity cost of this decision is that the economy will experience a lower standard of living in the present than they would otherwise.
What are the implications for economic growth for countries specializing in consumer goods rather than capital goods? Assume the countries consume what they produce.
All else equal, countries that specialize in consumer goods will likely grow less than those that specialize in capital goods, because specializing in capital goods will allow for more goods to be produced in the future.
Comment on the following statement: "I decided to buy a car from a dealer in a town 100 miles away because he was offering a price that was $100 lower than the dealer in my hometown. Therefore, I saved $100."
Assuming that the individual had no other reason to travel the 100 miles, the savings from the purchase of the car is less than $100. Travel costs should be taken into account, including the opportunity cost of time.
What is the difference between capital goods and consumer goods?
Capital goods are goods that will be used to produce other goods in the future. Consumer goods are goods that are used for current consumption.
What is meant by consumer sovereignty?
Consumer sovereignty is the idea that consumers ultimately dictate what will be produced (or not produced) by choosing what to purchase (or not to purchase).
What is meant by the term economic growth?
Economic growth occurs when the total output in an economy increases.
What are some of the problems that exist with a laissez-faire economy?
Free markets may not always produce the goods and services that people want at the lowest cost. They are not always efficient. Also, income may be distributed unequally.
Why do poor countries often have lower rates of economic growth than richer countries?
If a large part of a country's population is poor, it is very difficult to forgo current consumption to invest in research and development of new technologies or new capital equipment. With less investment, the rate of economic growth in the country will be lower.
According to the idea of consumer sovereignty, what will happen in the market for widgets if consumers decide they no longer desire widgets?
If consumers no longer desire widgets, they will send a message to producers by not purchasing widgets. Since firms will be unable to make a profit selling widgets, widget-producing firms will go out of business (or switch to producing something else) and widgets will no longer be produced. Thus, the consumers' preferences dictate what is produced.
What can we say about the employment of resources if the economy is at a point on its production possibility frontier?
If the economy is at a point on its production possibility frontier, this implies that there is full resource employment and productive efficiency.
Suppose that you have saved $100. You can spend it today or you can put it in your savings account for a year and earn 5% interest. What is the opportunity cost of spending the money today?
If you put the money in your savings account, you will have $105 to spend next year on the item (or items) of your choice. Thus, the opportunity cost of spending the money today is the enjoyment you give up by not having the $105 to buy something next year.
Use a graph and comment on the following statement: "If an economy is producing inside its production possibilities frontier, it could possibly produce more of one good without giving up any of the other."
In the graph shown on the next slide, we can see that, at point A, the economy has three options if it begins to produce more efficiently. First, it could continue producing the same level of guns and produce more butter. Second, it could continue producing the same level of butter and produce more guns. Last, the economy could increase production of both guns and butter.
What is the difference between income and wealth?
Income is a flow variable. It is the amount a household earns over a period of time such as a year. Wealth is a stock variable. It is the amount of assets a household has accumulated at a point in time from past income or through saving or inheritance.
In economic terminology, what is the meaning of investment?
Investment is the process of using resources to produce new capital. The new capital produced can be physical (new machinery) or human (education) in nature.
In a laissez-faire economy, what determines the distribution of output?
It is determined by income and wealth. These in part depend on the skills an individual can offer in the labor market.
What are resources? Describe two different types of resources
Resources are anything provided by nature or previous generations that can be used directly, or indirectly, to satisfy human wants. Capital resources include machinery, equipment, and structures used to produce other goods and services. Human resources include labor, skills, and knowledge. Products of nature can also be used as resources.
Critically evaluate the following statement. "Only poor nations face scarcity. Rich nations have everything they need and have therefore conquered scarcity."
Rich nations simply face different choices than do poor nations. The existence of choices naturally presumes that there is scarcity. Since all resources are limited there is only so many goods and services that can be produced by any nation whether it is poor or rich.
Explain Ricardo's theory of comparative advantage.
Specialization and free trade will benefit all trading partners, including those that may be absolutely more efficient producers.
Because of the quantity and quality of its resources, the U.S. has an absolute advantage in the production of many goods and services. Does this imply that the U.S. cannot benefit from trading with a developing country that has less productive ability? Why or why not?
The U.S. can benefit from trading with less productive countries as long as it produces the goods for which it has a comparative advantage and trades to receive the goods for which it does not.
Is the United States a command economy, a laissez-faire economy, or neither? Explain.
The United States is neither a command economy nor a laissez-faire economy. It is more accurate to describe it as a mixed economy. The U.S. basically has a free market economy, but the government is a large purchaser of goods and services and also produces some goods and services as well. In addition, the U.S. economy has significant amounts of government regulation of business.
What problems does a command economy face when it tries to determine what to produce for the economy?
The biggest difficulty that a command economy faces in determining which goods to produce is the fact that there are no prices in the economy which signal which goods and services are more highly valued than others. As a consequence since the decision to produce is often centralized either too little of some products are produced or too much is produced.
What is the economic problem?
The economic problem is finding a way for a society to answer the three basic economic questions (what will be produced?, how will it be produced?, and who will get what is produced?) given that resources are scarce.
What is the economic problem? How does a command economy solve the economic problem?
The economic problem is that given scarce resources, how exactly do large, complex societies go about answering the basic economic questions? A command economy answers the questions through some centralized authority making decisions about what to produce, how to produce it, and how to distribute it.
Evaluate the following two statements: "He is income rich but he is not very wealthy" "He is income poor but he is wealthy"?
The first person might be making a lot of income but hasn't acquired much wealth in the form of savings account balances or real estate. The second person might not have an income or have a really low income but accumulated a lot of wealth from the past.
What is the difference between a command economy and a laissez-faire economy?
The major difference lies in how the two types of economies answer the three basic questions. In a command economy, a central government either directly or indirectly sets output targets, incomes, and prices. In a laissez-faire economy, individual people and firms pursue their own self-interests without any central direction or regulation.
The following table shows output per hour for Martha and Stewart who make gift baskets and potholders: Output per hour Martha Stewart Giftbaskets 10 8 Potholders 20 12 What is the opportunity cost of a gift basket for Martha? What is the opportunity cost of a gift basket for Stewart? Who has a comparative advantage in producing gift baskets? How can you tell?
The opportunity cost of a gift basket for Martha is 2 potholders. The opportunity cost of a gift basket for Stewart is 1.5 potholders. Stewart has a comparative advantage in the production of gift baskets. His opportunity cost of producing a gift basket is lower.
What is the opportunity cost of attending class today?
The opportunity cost of attending class today is the next best alternative for your time including sleeping, studying for another class, or earning income at a job. But it can't be all of these things since you can only do one of these things at a time.
Explain the economic concept of opportunity cost
The opportunity cost of something is the best alternative that we give up when we make a choice or a decision
Suppose you have saved $300. You can spend it on a new stereo or on a weekend skiing trip. What is the opportunity cost of going on the skiing trip?
The opportunity cost of the skiing trip is the value of the next best alternative for using the $300 you have saved. If the next best alternative is purchasing the stereo, then the opportunity cost of going skiing is the enjoyment foregone by not purchasing the stereo.
Suppose a country produces two goods: corn and cars. New technology is developed that increases the amount of corn that can be produced. Use a graph to show the effect of this graph on the country's production possibility frontier. Explain what occurs in the graph.
The production possibility frontier shifts outward. The y-intercept is unaffected, however. At the y-intercept, the country would be producing all cars and no corn and the new technology would have no effect.
Why is microeconomic theory often referred to as price theory?
The reason is that much of microeconomic theory focuses on the factors which influence and determine prices.
Explain three of the shortcomings of the free-enterprise system.
The shortcomings of the free-enterprise system are: products may not always be produced at lowest cost, income may be unevenly distributed, and periods of inflation and unemployment may recur.
Critically evaluate the following statement. "If a country has an absolute advantage in the production of everything it necessarily follows that it will have a comparative advantage in the production of everything."
This is patently false. Absolute advantage only implies that a good can be produced with fewer inputs versus a rival. Comparative advantage means that a good can be produced at lower opportunity cost than a rival. That means that a rival could have an absolute disadvantage in the production of a good or a service and still have a comparative advantage because of its lower opportunity costs.
Evaluate the following statement. "The nation of Berundi has an absolute disadvantage in the production of everything compared to the United States. Therefore, the United States will have no reason to trade with Berundi".
This statement is false. The reason is that nations don't trade according to their absolute advantage but rather their comparative advantage. Even though the nation of Berdundi has an absolute disadvantage in the production of everything it is very unlikely that it won't have a comparative advantage in the production of at least one good or service vis-à-vis the United States.
Mexico has lower wages than the United States. Does this necessarily mean that it will have a comparative advantage in the production of everything compared to the United States?
Wages are only one factor in the input mix. What matters is the overall opportunity cost of production. If wages are 1/5 the in Mexico compared to what they are in the United States and workers in Mexico are 1/5 as productive as American workers this doesn't translate necessarily into a comparative advantage for Mexico. Also, goods that are produced with a lot of capital which turns out to be more expensive in Mexico and less expensive in the U.S. will tip the comparative advantage to the United States.
Suppose that a local government decides to provide more funds to the local police department in order for the department to hire additional police officers. Is there an opportunity cost of this action? If so, how would you measure it?
Yes, there is an opportunity cost. The opportunity cost should be measured by the next best alternative use of the funds provided to the police department.