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Macroeconomics Test Review I:  Understanding Economic Activity   e-mail Walter with suggestion    
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I. Economics Defined chapter 1
   
A. Economics is the social science concerned with the use of scarce resources like land and labor to fulfill unlimited human wants.
   B. Resources are the inputs, want satisfaction is the output
   C. Key Concepts
         1. Scarcity of resources results in the need for choices by participants.
         2  Participants, buyers and sellers, exhibit purposeful behavior to enhance their own rational self interest.
         3. Marginal analysis where the change in benefit received is balanced with the change in cost is a common purposeful behavior.
     D. Economic methodology 
         1. Positive economics 
             a. What something is     b. Objective, can be measured   c. Example: measuring disposable personal income which is an individual's salary after taxes
        2. Normative economics
            a. What something ought to be    
            b. Subjective, difficult to measure     
            c. Requires value judgments by citizens, Political Action Committees (PAC's), politicians, etc
            d. Examples: should the minimum wage be increased, should defense spending increase and social spending be lowered
        3. Descriptive Economics is looking at the real-world to develop Economic Theory
            a. Economic Theory is a generalizations concerning economic behavior based upon real-world observations, empirical by nature
                1. Economic theories are objective "positive economics"   
                2. Assumes behavior is rational and economic (self-serving)     
                3. Example: as the price of a product increases, consumers tend to buy less
           b. Economic Policy is an application of economic theory to solve economic problems  
               1. Economic policies are subjective, "normative economics".
               2. How society makes economic choices such as in the 1980's when
                   a. spending for the elderly (Social Security) increased  
                   b. spending for children (Head Start) decreased 
            c. Economic Model is a simplified representation of real-world economic activity
                1. Requires Ceteris Paribus: Latin for holding other economic variables constant
                2 Models like the Production Possibility Curve explained in the next chapter are a simplified description of how some aspect of an economy works.
     E. Economic goals of the United States
       
 1. Economic growth
         2. Full employment of all economic resources
         3. Price stability (low inflation)
         4. Positive balance of payments (international flow of dollars)
         5. Economic freedom
         6. Equitable distribution of income
         7. Economic security (if you have A through F, you have G)
     F
. The study of economics is divided into two disciplines.

Macroeconomics1is the study of  total economic activity.

Microeconomics2  is the study of  individual segments of the economy.

Macro Activity Complementary Micro Activity
1. Inflation rate 1. A product's price
2. Economic growth 2. Pollution
3. Total employment 3. Poverty
4. The  business cycle 4. A competitive market
1  Wiki explanation is extensive, for now, 
the first few paragraphs are sufficient.

2 Wiki explanation is extensive, for now, the first paragraph is sufficient.

 

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II. Economizing Scarce Resources chapter 2 
   
A. Factors of Production

Factor

Definition

Income

Land

Anything fixed (natural resources)

Rent

Labor

Physical and mental talents

Wages

Capital

Something physical to aid production (factories, computers, an educated/trained labor force)

Interest

Enterprise

Initiative, risk taking, innovation

Profit

    B. The Production Possibility Frontier (Curve) measures how many of two types of goods can be produced.

1. Static Model (time is constant, inputs are fixed)
    a. Consumer goods such as televisions, pizzas, and social security bring current satisfaction. 
     b. Capital goods such as machinery, tractors, and improved technology increase future productive capabilities.
    c. Point F on the production possibility frontier represents full employment of
dll resources (100% efficiency).
    d. Point U represents unemployment of some economic resources.
    e. Having more capital goods requires giving up some consumer goods.
    f. Applies to individuals as you can invest by building a deck or going to school or you can go on an expensive vacation.
    g. How society and individuals answer these economic questions is explored in chapters five and six.
2.
Dynamic Model (time is not constant, inputs like factors and technology are not fixed, growth indicated by, arrows occur
    a. As inputs increase, growth occurs and the curve shifts right.
    b. Point S represents slow growth due to high consumption.
    c. Point R represents rapid growth due to high capital investment.
    d. Economic and political system chosen and run by a society determines the location and movement of these variables

       3.Opportunity costs
         
a. The cost of Item A measured in terms of what must be foregone of Item B.
          b. When considering doing A, we consider the highest valued alternative as limited resources means we can't afford both.
          c. For more information visit
the Production Possibilities Curve from Wikipedia.
        
 d. Politicians seldom talk of the opportunity cost of what they plan to do.
           e. Examples
               1. The opportunity cost of good grades is the value which could have been received by  spending time with family and friends.
               2. The opportunity costs of more capital goods is the value which could have been received from having more consumer goods.
       4. Law of increasing opportunity costs
           a. Opportunity costs usually increase.
               1. To have one unit of Item A you must give up amount X of Item B. To have a second unit of Item A you must give up more than amount X of Item B.
               2. Primary reason for increasing costs is resources are not perfect substitutes.
               3. Examples

                   a) Training more people in math and science would increase productivity for a while but eventually people would be trained to be 
                       engineers who would be  more productive as
managers, teachers, or entertainers etc.
                   b) The gain from replacing people with machines may be large in the beginning but  eventually machines would be used to do what people can do more efficiently.
                   c. When opportunity costs are not increasing, the production possibility curve is a straight line. 
                       High tech investment  may even bend the curve the other way and have decreasing cost, but not forever!
           b. Below is an example of the trade-off between investing people in high tech industries versus 
entertainment industries. 
               Alternative Production Possibilities for
10 entertainers and no technicians'.
                                                                                                    Units of Production

                     High tech                                                                        0     1     2      3     4
                     Entertainment                                                               10    9     7      4     0
             Cost of an additional unit of high tech production                          1     2      3     4
             measured in terms of entertainment given up
Adam Sandler, a great entertainer,  probably would not of been a great computer programmer, though his dad Stan, was an electrical engineer, his sister Elizabeth is a dentist,  and his brother Scott is a lawyer Adam might be the first resource to move.

  
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III. Characteristics of Market System Capitalism chapter 3
     A. Economic systems determine what to produce, how to produce, and who will receive production. 
     B. An economic system must also have the ability to adapt to changing economic environments. For example, America must adapt to changes to September 11?
 
     C.
Adam Smith described the beginning of capitalism. 
         1. His book, The Wealth of Nations, was the first description of capitalism. 
         2. Published in 1776, it described capitalism as it was practiced in 18th century England.
    D. Basic characteristics described by Adam Smith
        1. Private property-the right to own resources and bequeath property
        2. Freedom of enterprise-own a business
        3. Freedom of economic choice-work/not work, spend/not spend
        4. Role of self-interest
            a. People are by nature economic creatures
            b. Self-interest is a fundamental characteristic of people
       5. Competitive market system
           a. Many buyers and sellers
           b. Market participants, buyers and sellers, have little control over price
           c. Competition performs the organizing and controlling functions for a market economy
       6. Limited government
("Laissez-faire ")
            a. Government should let markets be with a hands-off philosophy)
            b. Acceptable government involvement has become an important political question in the United States during the last few decades.
    E. Modern Capitalism has additional features
        1. Complex Market System Setting Prices
        2. Importance of Capital Goods and Technology
        3. Specialized
            a. Complexity requires company produce limit their product lines
    
       b. Division of Labor allows specialization by ability ad training.
 
   F. Creative Destruction described by 20th century sociologist/economist Joseph Schumpeter was an important addition to the idea of capitalism. 
        1. Change involves the creation of improved economic structures based on technology and the destruction of inefficient  economic structures.

        2. Capitalism allows this destruction to take place.

G. Economic Systems
      A. Pure capitalism as described by Adam Smith never existed.
      B. Recent economic systems have are Mixed Economies  (a mixture of Capitalism  and Socialism)
          1. Socialism  emphasizes collective ownership and management of economic resources that are equally distributed.
          2. Democratic Socialism, as practiced in Western Europe, has public ownership of key industries such as transportation and communication 
              a. The economic systems of Europe began moving away from socialism toward capitalism in the late 1970's
              b. Margaret Thatcher, former prime minister of England, started this trend.
              c. Ronald_Reagan agreed and stressed the market system during his presidency (1981-89).
          3. Communism  is the ideal of those practicing a "Marxian system." 
              a. Named after 19th century philosopher Karl Marx
              b. The public owns almost all wealth which is centrally managed, i.e., a planned economy

             
c. Presidential Courage explores how Ronald Reagan deplored Communism.
      C. Traditional economy, where customs determines the economy activity, is practiced by many developing countries.

 

 

IV. Demand and Supply chapter 4 
     A. A market is defined as an institution or mechanism which promotes trade by bringing together 
          buyers (demanders) and sellers (suppliers).
          1. Replaced barter which is the direct exchange of goods.
          2  Modern market brings money and prices into the circular flow of goods. 
     B. Demand is willingness to buy.
         1. Demand is a schedule of the amounts of goods and services consumers are willing 
             and able to buy at a set of prices.
   
     2. Total demand is the
Horizontal Summation of individual demand.
   
     
  3. Law of demand:: price and quantity are inversely related and as price goes up, 
             quantity demanded goes down and vice versa
  
         4. Why more is bought as price drops.
                  a. Income Effect: as the price of a good drops, consumers feel richer and buy more.
              b. Substitution Effect: as the price of a good drops, it becomes cheaper relative to
                 other goods and consumers buy more

 

 

Price Quantity
1 5
2 4
3 3
4 2
5 1
 
     C. What determines demand   
         
1. Tastes or preferences of consumers
     2. Number of consumers     3. Incomes of consumers
            
 a. normal (superior) goods such as steak and vacations - more is purchased as income increases. 
            
 b inferior goods such as bread and hamburger - less is purchased as income increases.
         
4. Consumer expectations     5. Price of related goods
             
a. Substitutes are goods that compete with each other such as hot dogs and hamburgers. If the price of a good increases, the demand for its substitutes will increase.
          
   b. Complements are goods that are purchased together like hot dogs and rolls.  If the price of a good increases, the demand for its complement will decrease.
    
      5.
''Ceteris Paribus'' is Latin for all other variables remain the same. So we change one variable at a tome.

     D. Changes (shifts) in Demand
     
   1. A decrease in demand shifts the demand curve to the left 
   
     2. An increase in demand shifts the demand curve to the right
     E. Supply is willingness to sell
        
1. Supply is a schedule of the amounts of goods or services producers are willing and 
             able to sell at a set of prices.
         2. Law of supply: price and quantity supplied are directly related because price and 
             expected profit are directly related
             a. As price goes up, quantity supplied goes up
             b. As price goes down, quantity supplied goes down

     D. What determines supply
        
1. Product costs as affected by technology, resource prices, government involvement with taxes
             and subsidies
         2. Price of related goods
             a. If 2 goods are substitutes, price up for one will increase supply of the other (price of gasoline up, 
                supply of alternative fuels increases) as companies see more potential profit
             b. If 2 goods are complements, price down of one will increase supply of other (price of PC's down, 
                 supply of computer software up) as the expected increase in sales of the first item should increase 
                 sales of the complement.
         3. Number of producer and their expectations concerning the above listed variables will affect supply
    E. Changes (shifts) in supply
        1. A decrease in supply shifts the supply curve to the left
        2. An increase in supply shifts the supply curve to the right
     F. Equilibrium is where suppliers and demanders agree on price and quantity as depicted by E. 
         1. If the price is too high, a surplus results and price must be lowered
         2. If the price is too low, a shortage results. This happens with toys every Christmas
              (Cabbage Patch Dolls)
        3. If they can not agree, as happened with Beta videotape machines, then the curves do not intersect
            and the goods are not sold.
         4. Rationing function of price makes for an efficient allocation of resources.
            
When competitive forces of supply and demand result in an equilibrium, a rationing function of
             goods produce to consumers has occurred.
         

 

   G. How changes in supply and demand affect equilibrium price and quantity
         D up and S up equally

         D up causes P up and Q up

         S up causes P down and Q up

        Result is P same and Q up

D up and S down equally

D up causes P up and Q up

S down causes P up and Q down

Result is P up and Q same\

  D down and S up equally

      D down causes P down and Q down

      S up causes P down and Q up

      Result is P down and Q same

D down and S down equally

D down causes P down and Q down

S down causes P up and Q down

Result is P same and Q down

    

     H. Government Imposed Price Ceilings and Floors
          1. A price ceiling keeps prices from rising (rent control) helping renters but often resulting in a
              shortage of housing as investors seek higher returns elsewhere.
          2. A price floor keeps prices from falling (farm price supports) helps farmers though a surplus
              often results as more of supported crops are produced.
V. 5 Key Economic Questions Society Must Answer chapter 5
    A. What to produce?
         1. Which goods
              a. Those that can be sold at a profit, consumers vote with dollars
              b. Accounting Profit: The amount by which total revenue exceeds
                  accounting costs (rents, wages, and interest)
              c. Normal Profit
                  1. Amount received for enterprise
                  2. Considered by economists to be a cost
              d. Economic Profit
                  1. The amount by which total revenues exceed all "Factor" costs. 
                  2. Some think of it as a surplus.
                  3. Expanding industries have economic profit. 
                      a) Bill Gates, founder of Microsoft, has earned many
billions of dollars. 
                      b) So has Sam Walton of
Wal-Mart 
         2. How many goods
             a. Level of demand and efficiency of supply determine output.
             b. Society determines total demand (who works, how often and
                 for how many years).
           c.   Success of economic system determines efficiency of supply.
    B. How to produce?
        1. Companies must be competitive
        2. Competition is the "Invisible Hand" assuring
            a. High quality goods are produced.
            b. Efficient production methods are employed.
           
c. Prices and profits are reasonable.
            d. For more read
Adam Smith and the invisible hand by Helen Joyce of
                Plus magazine.
         3. Technology and innovation are instrumental to success.
    C. Who will receive production?
         1. Those willing and able to pay
         2. Function of income, savings, and attitude toward debt financing
    D. How will the economy adapt to changing environments?
        1. Today's economic environment is changing more rapidly because
           of the communication revolution. 
        2. Magnitude of these changes is similar
to that which occurred in the
            last quarter of the 19th century. 
        3. Companies and individuals must "adapt or be gone." 
        4. Capitalism allows creative destruction to work. 
        5. Recently technology has changed rapidly and people are being
           
adversely affected 
            a. Normally, political forces
would attempt to slow creative destruction.
            b. But, the 1990's was the decade of free enterprise so creative 
               destructions moved on.
            c. Perhaps the next recession will slow down the free market 
               revolution.
    E. Market system evaluated
        1. Advantages are resources allocated efficiently, economic freedoms (enterprise,
            choice) 
        2. Disadvantages
            a. Too dependent upon competition eroded by monopoly power  resulting in waste
                 and inefficiency result because of monopoly power exercised by business,
                 unions, governments, and interest groups.
            b. Inequitable distribution of income (economic survival of the fittest)
            c. Market failure occurs 
                1. Not all costs (pollution) and benefits (public health) are properly  accounted for. 
                2. Why? because measuring their cost and benefits in dollars is difficult and
                  subjective.
            d. Political process sometimes interferes with creative destruction.
VI. Government's Economic Functions chapter 6
      A. Provide a proper legal atmosphere (rules) for capitalism
      B. Insure competition
          1. Antitrust laws protect against abuse of monopoly power.
          2. Natural (justifiable) monopolies such as AT&T were allowed because 
              duplicating high-cost fixed investments is illogical.
          3. The emphasis on free markets discussed in chapter 3 has resulted in some natural
              monopolies being broken into smaller companies which had to compete against
              new companies touting  new technologies.
      C. Provide for an equitable distribution of income
           1. Transfer payments where a government moves general revenue to a
               specific group, i.e., Aid to Families with Dependent Children, students...

      
2. Market Intervention (affecting supply and demand)  
              a. Minimum wage decreases supply raising price and lowering quantity.
              b. Excise taxes on alcohol, cigarettes, jewelry, etc., deceases supply.
              c. Farm price supports, aid to small business and education increases supply.
    
  D. Adjust for market failures
           1. Adjust for spillovers (externalities)
               a. Effects of a market system often spillover onto non-participants who are
                   external to the market transaction. 
               b. Both costs and benefits result.
                   1. Pollution hurts (costs) society so government tries to affect the supply of,
                       and demand for, pollution causing products such as automobiles. 
                       For automobiles, they lower supply by requiring catalytic converters and
                       they lower demand with high excise taxes. 
                   2. An educated workforce benefits society so government increases demand
                       (aid to students) and supply (aid to colleges).

 

                   3. Currently, our addiction to gasoline is high, as has global warming hasasasasasas
                       government's attention, but little action.

      E. Affecting total economic activity
          1. This includes a multitude of diverse topics. 
              a. Trying to limit the effects of business cycles by lowering unemployment and
                  inflation 
              b. Assisting companies trying to compete in the new global economy 
              c. Using foreign aid to make sure we have stable oil prices  
                  1. Israel-United States military relations
                  2. US and Foreign Aid Assistance from GlobalIssues.org
          2. Opinions differ substantially as to the responsibilities or lack of responsibilities
              government has in these areas.

 

I. Market System Participant chapter 7
  
A. Households  (families and individuals) receive income in return for their 
    B. Businesses    

C. Federal government 
     1. Government spending has grown because of
         a. Population growth  b. War and defense requirements  c. Urbanization
         d. Environmental concerns  e. Inflation
         f. Transfer payments
            1. Social Security 2. Medicare and Medicaid   3. Terrorism 
            4. Social programs such as Aid to Families with Dependent Children
            5. Mid-1960's were 3% of national output, today they are 12% of output
     2. Government spending and taxing
         a. Federal spending and taxing
            1. Expenditures
               a. Income security   b. Defense (military preparedness)
               c. Interest on public debt  d. Discretionary programs
           2. Receipts
                a. Personal income taxes
                    1. Marginal rate is the rate paid on additional or incremental income. 
                        a) The increase in taxes paid divided by the increase in income. 
                        b) In a progressive tax system, each higher tax bracket (grouping) 
                            has a higher rate on the income in the higher bracket. 
                    2. Average tax rate is the taxes paid divided by total taxable income. 
                b. Payroll Taxes: premiums paid on compulsory insurance plans  
                    1. social security and Medicare (both employer and employee pay)  
                    2. unemployment taxes (just employer pays)
                c. Corporate Income Taxes
                d. Excise Taxes are a sales tax on items such as jewelry, tobacco, and liquor.
                e. Licenses and Fees
D. State and local governments have mandatory balanced budget laws making 
     the accumulation of debt difficult

Legal Form

Definition

Ease of Formation

Length of Life

Raising Capital 

Owner's Liability

Taxes

Sole Proprietorship

One Owner

Easy

Limited

Difficult

Unlimited, personal assets at risk

Once as personal income

Partnership

Two or More Owners

Easy

Shortest

Easier

Unlimited, personal assets at risk

Once as personal  income

 

Corporation

Company is a legal entity

Somewhat Difficult

Unlimited

Easiest

Limited to investment

Twice as income & dividends

 

E. Taxation philosophies 
     1. Ability to pay  taxes those with the ability (income or wealth) more.
         a. Income tax      b. Sales tax    c. Estate taxes
     2. Benefit received (User taxes)
         a. Those who derive a benefit from some government action pay for said activity.
         b. Examples
             1. Gasoline taxes are used to improve roads.
             2. Social security taxes are used to provide retirement and other benefits for
                 participants.
F. Taxation philosophies
     1. Ability to pay
         a. Those with the ability (income or wealth), pay more.
         b. Examples
             1. Income tax   2. Sales tax   3. Estate taxes
     2. Benefit received (User taxes)
         a. Those who derive a benefit from some government action pay for said activity.
         b. Examples
             1. Gasoline taxes are used to improve roads.
             2. Social security taxes are used to provide retirement and other benefits
                  for participants.

G. Types of tax rates
     1. Progressive
         a. Tax rate increases as income increases
         b. Tax rate decreases as income decreases
         c. Those earning higher income pay a higher average tax rate.
         d. Example: Federal Income Tax                
             Note:
Moving into a higher tax bracket does not result in your paying a higher rate on 
             lower bracket earnings.
     2. Proportional
         a. Tax rate as percentage stays the same.
         b. Examples: Social Security taxes are proportional up to the maximum income level of
             about  $76,200 because both employer and employee pay a constant rate of about 8%,
             but then the tax is regressive as the rate drops to zero
     3. Regressive 
         a. Amount paid divided by income drops as income increases.
         b. Happens one of two ways
             1. Rate drops as income increases (FICA after about $76,200 in 2000) 
             2. Amount of tax is constant so at higher incomes, the effective tax rate
                 is lower (excise taxes on cigarettes, liquor, etc.)
H. Shifting the tax incidence
   . 1. Passing the burden of taxes onto others (consumers ultimately pay)
     2. Businesses and professionals try to do this
     3. The consumer bears most of the tax burden in a market economy