SECTION 1 Review

Module 1

1. Everyone has to make choices about what to do and what not to do. Individual choice is the basis of economics—if it doesn’t involve choice, it isn’t economics. The economy is a system that coordinates choices about production and consumption. In a market economy, these choices are made by many firms and individuals. In a command economy, these choices are made by a central authority. Incentives are rewards or punishments that motivate particular choices, and can be lacking in a command economy where producers cannot set their own prices or keep their own profits. Property rights create incentives in market economies by establishing ownership and granting individuals the right to trade goods and services for mutual gain. In any economy, decisions are informed by marginal analysis—the study of the costs and benefits of doing something a little bit more or a little bit less.

2. The reason choices must be made is that resources—anything that can be used to produce something else—are scarce. The four categories of resources are land, labor, capital, and entrepreneurship. Individuals are limited in their choices by money and time; economies are limited by their supplies of resources.

3. Because you must choose among limited alternatives, the true cost of anything is what you must give up to get it—all costs are opportunity costs.

4. Economists use economic models for both positive economics, which describes how the economy works, and for normative economics, which prescribes how the economy should work. Positive economics often involves making forecasts. Economics can determine correct answers for positive questions, but typically not for normative questions, which involve value judgments. Exceptions occur when policies designed to achieve a certain prescription can be clearly ranked in terms of preference.

5. There are two main reasons economists disagree. One, they may disagree about which simplifications to make in a model. Two, economists may disagree—like everyone else—about values.

6. Microeconomics is the branch of economics that studies how people make decisions and how those decisions interact. Macroeconomics is concerned with the overall ups and downs of the economy, and focuses on economic aggregates such as the unemployment rate and gross domestic product, that summarize data across many different markets.

Module 2

7. Economies experience ups and downs in economic activity. This pattern is called the business cycle. The downturns are known as recessions; the upturns are known as expansions. A depression is a long, deep downturn.

8. Workers are counted in unemployment figures only if they are actively seeking work but aren’t currently employed. The sum of employment and unemployment is the labor force. The unemployment rate is the percentage of the labor force that is unemployed.

9. As the unemployment rate rises, the output for the economy as a whole—the aggregate output—generally falls.

10. A short-term increase in aggregate output made possible by a decrease in unemployment does not constitute economic growth, which is an increase in the maximum amount of output an economy can produce.

11. Rises and falls in the overall price level constitute inflation and deflation. Economists prefer that prices change only slowly if at all, because such price stability helps keep the economy stable.

12. Almost all economics is based on models, “thought experiments” or simplified versions of reality, many of which use analytical tools such as mathematics and graphs. An important assumption in economic models is the other things equal (ceteris paribus) assumption, which allows analysis of the effect of change in one factor by holding all other relevant factors unchanged.

Module 3

13. One important economic model is the production possibilities curve, which illustrates the trade-offs facing an economy that produces only two goods. The production possibilities curve illustrates three elements: opportunity cost (showing how much less of one good must be produced if more of the other good is produced), efficiency (an economy achieves productive efficiency if it produces on the production possibilities curve and allocative efficiency if it produces the mix of goods and services that people want to consume), and economic growth (an outward shift of the production possibilities curve).

14. There are two basic sources of growth in the production possibilities curve model: an increase in resources and improved technology.

Module 4

15. There are gains from trade: by engaging in the trade of goods and services with one another, the members of an economy can all be made better off. Underlying gains from trade are the advantages of specialization, of having individuals specialize in the tasks they are comparatively good at.

16. Comparative advantage explains the source of gains from trade between individuals and countries. Everyone has a comparative advantage in something—some good or service in which that person has a lower opportunity cost than everyone else. But it is often confused with absolute advantage, an ability to produce more of a particular good or service than anyone else. This confusion leads some to erroneously conclude that there are no gains from trade between people or countries.

17. As long as a comparative advantage exists between two parties, there are opportunities for mutually beneficial trade. The terms of trade indicate the rate at which one good can be exchanged for another. The range of mutually beneficial terms of trade for a good are found between the seller’s opportunity cost of making the good and the buyer’s opportunity cost of making the same good.