Economics Power Guide

2012
2013
18
YE
AR
DO
Post-Soviet
Communist
Recovery
OU
RB
EDITION
ECONOMICS
ING
EST
, SO
YO
U
CA
N
ECONOMICS
POWER GUIDE
EDITOR
Christina Minich
the World
Scholars Cup
ALPACA-IN-CHIEF
Daniel Berdichevsky
DO
YO
U
RS
ECONOMICS
POWER GUIDE
AUTHORS WELCOME...................................................................................................................................... 1
CURRICULUM OVERVIEW ............................................................................................................................... 2
FUNDAMENTAL ECONOMIC CONCEPTS......................................................................................................... 3
MICROECONOMICS ........................................................................................................................................ 14
MACROECONOMICS ....................................................................................................................................... 56
COMMUNIST ECONOMIC SYSTEMS .............................................................................................................. 98
REFORM UNDER MIKHAIL GORBACHEV...................................................................................................... 103
REFORM UNDER BORIS YELTSIN.................................................................................................................. 109
VLADIMIR PUTIN & DMITRI MEDVEDEV ..................................................................................................... 115
SECTION I - III SUMMARIES .......................................................................................................................... 119
SECTION IV SUMMARY ................................................................................................................................ 123
PRACTICE TEST ANALYSIS ........................................................................................................................... 150
ABOUT THE AUTHOR ................................................................................................................................... 152
BY
EDITED BY
CATHERINE TRAN
ROBB DOOLING
UNIVERSITY OF TEXAS: AUSTIN

SEVEN LAKES HIGH SCHOOL
ROCHESTER INSTITUTE OF TECHNOLOGY

OMAHA BURKE HIGH SCHOOL
DEDICATED TO MR. IRISH, MR. MARZEN,

AND THE 2011 SEVEN LAKES ACDEC TEAM
2012 DEMIDEC
DemiDec, The World Scholars Cup, Power Guide, and Cram Kit are registered trademarks of the DemiDec Corporation.
Academic Decathlon and USAD are registered trademarks of the United States Academic Decathlon Association.
.
Economics Power Guide | 1
AUTHORS WELCOME
You hold the Economics Power Guide in your hands. This may look like a pile of paper with some
words and numbers on it, but this pile of paper came into your hands through hundreds of
individual decisions. Every step of the way, someone performed a cost-benefit analysis and with
stars in their eyes said this is worth it. And you, my starry-eyed friend, will too. I promise you. So
love it. Cherish it.
My name is Catherine Tran, but you can call me Cat. I joined the Academic Decathlon at Seven
Lakes High School in search of a challenge, and I found a surplus of challenge in the Economics
event.
Mastering Economics requires the ability to harmonize concepts and facts. If you study right,
everything should click together and just make sense. The Power Guide helps you achieve this goal
by organizing all these concepts and facts in a logical way.
Critical words, names, numbers, and other testable terms are bolded throughout the guide. You
can find definitions for these terms in the Power Lists at the end of the guide, broken up into
understandable and manageable sub-lists. In addition, Power Tables synthesize related information
for efficient studying sans 1 page flipping. Here, I will integrate all bolded Russian reforms into a
table and all bolded events and years into a timeline.
See that little number one in the previous paragraph? Prepare to see many more of these floating,
little numbers. This guide includes three kinds of footnotes. First, enrichment footnotes (such as
the first footnote) provide information that will not be tested but help increase your understanding
of the material. Second, Demi footnotes include my signed comments on the material. They serve
as presumed comic relief and desperate pleas for attention 2. You will also see some signed
comments from last years authors and past and present beta testers. Last, I use unsigned
miscellaneous footnotes for instructional comments about the curriculum and guide.
A high score in economics demands commitment. Fortunately, this guide will supply you with a
lot to commit yourself to learning. To minimize the costs and maximize the benefits of your study
time, I suggest you first read through the entire guide once. Then focus on really understanding
the models. Being able to sketch out and manipulate models is the most powerful tool to use on
economics tests. Quizzing yourself on the terms in the Power Lists will also help.
The investment you put into internalizing this guide will bring you great rewards in the future.
You are entering a planned economy in which your target output is a 1000 on economics.
1
2
Sans means without in French

Love me! Cat
CURRICULUM OVERVIEW
Section I: Fundamentals of Economics = 10% (5 questions)
Section I discusses the study of economics as a whole. This section covers basic
assumptions about human behavior. These core ideas form the basis for the study of both
microeconomics and macroeconomics.
Section II: Microeconomics = 40% (20 questions)
Section II narrows in on microeconomics, which focuses on the behavior of individual
markets. This section covers different types of competition, supply and demand, absolute
and comparative advantage, market failure, roles of government, and classification of
goods.
Section III: Macroeconomics = 30% (15 questions)
Section III moves to macroeconomics, which explains how to analyze a national economy.
This section covers measurement of GDP, inflation, unemployment, financial markets,
short-run fluctuations, and government policy.
Section IV: Economics of Communist and Post-Communist Russia = 20% (10 questions)
Section IV focuses on the economics of this years theme, Russia. This section covers the
economics of Russia before and after the fall of the Soviet Union as well as its recent (and
controversial) transition from a planned to market-based economy. It outlines the effects of
its economic reforms under various leaders.
If you have the time, focus on concepts, because these take the longest to learn. Once you
understand what demand really is, its not as hard to grasp what can impact it.
If you run short on time, look for the areas of greatest marginal benefit to you as a Decathlete.
Focus on the Power Lists and Power Tablesor consult the Cram Kit. Read through the section
summaries at the end of this guide and spot-check concepts that give you trouble. Good luck!
Section IV - Russia
20%
Section III Macroeconomics

30%
Section I Fundamentals
10%
Section II Microeconomics
40%
FUNDAMENTAL ECONOMIC CONCEPTS

POWER PREVIEW
This section eases the reader into the field of
economics. It begins with the logic and
common sense of economic analysis, continues
with important definitions, and concludes with
some basic assumptions of economics. Most of
microeconomics and a good portion of
macroeconomics will rely on these concepts.
POWER NOTES
10% of the exam (5 questions) will be from this section, but
the concepts in this section can appear in questions on
other sections.
5 questions from the USAD practice test are on topics from
this section.
This section loosely covers pgs. 5 8 of the USAD
Economics Resource Guide, including the Introduction.
Introduction3
What does economics address?

The field of economics explains how individuals make choices about allocating scarce resources
to satisfy unlimited wants and how these choices interact with each other
Economists study how human societies organize themselves to transform available
resources into what their members wish to consume
The field emerged over 200 years ago
Adam Smith established the field of modern economic analysis with An Inquiry into the
Nature and Causes of the Wealth of Nations (1776)
Even before Smith, Aristotle wrote on topics relevant to economics
Two main approaches
Microeconomics analyzes individual decisions and how those decisions intersect in the market
Macroeconomics considers entire economies and develops models to explain them
The two fields start from different points, but assume the same basic things about human
behavior
Why Economics?
Economics and everyday life

While economics may appear obscure, it concerns three simple ideas
(1) Everyday life
(2) Choices a person makes in his or her daily life
(3) Impact of these choices on the world around us
Examining life through the lens of economics illuminates hidden wonders in the everyday
world around us
The local supermarket
The average supermarket carries nearly 47,000 4 different items
Each item purchased at a grocery store is the result of a long chain of complicated decisions
Nothing ensures any of these products will be at the supermarket
No one commanded anyone to create them
USAD is not supposed to test on anything covered just in the Introduction. This has not stopped them from doing so in the past. I
recommend reading the Intro once or twice, but not to fret about it a great deal.
4
This is just the sort of obscure detail USAD would test on, even though the number is likely outdated by now.
3
Farmer
grew wheat
Milling
company
bought the
wheat and
ground it
into flour
Bakery
bought the
flour to
make a loaf
Loaf
delivered in
a timely
manner to a
store
Someone
bought the
loaf of bread
At each step along the way, each person made decisions for his or her own self interest
This example is only one supermarket out of thousands across the country
Supermarkets are only one of the millions of businesses in our economy
Economics explains why our economy functions and why it does not
Basic Assumptions of Economics
Scarcity and no free lunches!

Humans have unlimited wants
Economists assume people cannot fulfill their desires
Desires are insatiable
When one desire is satisfied, people will think of
something else that they want
If I buy a new laptop, I will want a wireless mouse
5
If I buy a wireless mouse, I will need batteries for it
6
This situation can be framed quantitatively through the concept of utility
Utility is happiness, or how much we benefit from something, made into a number
Economists assume humans prefer higher utility numbers
Consuming goods adds to an individuals utility
Individuals maximize their utility given their preferences
Marginal utility is the utility obtained from getting one more of a good or service
The more goods that are consumed, the smaller the marginal utility
Example: The first slice of pizza tastes very good. The tenthnot so much.
7,8
Marginal anything refers to the effect of getting one more of something
Scarcity is an inescapable fact of our existence
Scarcity is the finite nature of resources to which we have access
We only have a finite amount of time to devote to our activities
Only a finite amount of energy and capital are available for our use
Humans have limited knowledge
Because of these constraints, both individuals and governments must choose where to devote
resources
Trade-offs
Because of scarcity and unlimited wants, people must make trade-offs
And if you give a mouse a cookie- Christina

And who says money cant buy happiness? Tad
7
Marginal costs/benefits/etcetera are covered later in microeconomics.
8
Zurich is really, really, really, really, really expensive. More often than not, I went to McDonalds because it was the only reasonably
priced restaurant. Except last week, when I bought three snack wraps, thinking they cost 1.50 Swiss Francs each and were snacksized. No, I wasnt wearing my contacts and they actually cost 7.50 Swiss Francs each and were meal sized. By the third one, all I
could think was, Negative marginal utility. Negative marginal utility. But I paid almost $10 for this thing! Must eat. Negative
marginal utility. Negative marginal utility. Sophy
6
To get one thing we want, we must give up something else, since we have limited wealth
Individuals maximize utility within their budget constraints
A free lunch would lead to a benefit without a trade-off
This benefit would quickly be used to the point of scarcity
9
There can only be so many free lunches in the world
The ability to identify policies that offer free lunches is a necessity for all economists 10
We all make trade-offs every day, even if we do not realize it
11
Instead of reading this Power Guide, you could be sleeping
If you decide to play video games for an hour, that is one less hour to watch Digimon
If you choose to spend $50 on Portal 2, then you have $50 less to save for college
Opportunity cost
The opportunity cost of something is what you give up to get something else 12
More formally, opportunity cost is the lost benefit of the next best alternative to a choice
The opportunity cost of reading this Power Guide is spending the same amount of time
(and effort) on the next best alternative activity
That other activity may pay you $50, which will enter into the opportunity cost of
reading this Power Guide
Opportunity cost is not just monetary
The other activity may only give you utility, but that benefit enters into opportunity
cost as well
If a friend gives you a ticket to a soccer game, then the ticket is free
The opportunity cost of going to the game is the value of what you would have
been doing during that time had you not gone to the soccer game
Note that the costs of an alternative do not enter opportunity cost, just its benefits
Applying opportunity cost can be tricky
Suppose you go to college
The cost of attending college includes tuition, books, room, and board
This sum excludes the cost of time
By choosing to attend college and study, you give up time spent working
If you did not go to college, however, you still need somewhere to live and things to eat
Room and board therefore are not really part of the cost of college
Factoring them into the monetary cost of college can overstate its true expense
Human rationality
Economists assume human beings maximize their utility given limited resources and options
13,14
In other words, human beings are rational
People compare the benefits of each action with the opportunity costs of the action, and
pick the action with the greatest perceived benefit
Each person derives different amounts of benefit from certain actions
Rationality is facilitated by cost-benefit analysis
Going along with how Zurich is really, really, really, really, really expensive: very morning, I make myself an extra sandwich or two
or three at my hostels free buffet breakfast. See, there really is such thing as a free lunch. Sophy
10
Alternatively: The ability to identify places that offer free lunches is a necessity for all economics degree candidates. Sophy
11
I think Jessica knew Id be beta testing this guide at 3 A.M. Tad
12
There is a very subtle distinction between trade-offs and opportunity cost. Trade-offs are the choices made. Opportunity cost is the
benefit you forgo to do something else.
13
Whether humans are actually rational is a thriving area of economic research.
14
An excellent book to read is The Social Animal by David Brooks. If you still believe humans are rational by the end of that book,
you and I need to have a chat. Sophy
9
This process entails making a list of the pros and cons of a decision and weighing them
Benefits come in the form of utility for consumers or profits for producers
Rational agents have to consider the full economic cost of a decision
Cost-benefit analysis is often intuitive and approximate
Most people are not born with the ability to calculate costs and benefits without fail
By studying economics, we can become better decision makers
Gains from trade
Individuals differ in their interests, abilities, and resources
Therefore, we excel at and get more pleasure from differing activities
By specializing and then trading with someone else, both parties are better off
As long as an exchange is voluntary, everyone involved benefitsotherwise, why make it?
Comparative Advantage and the PPF15
Why do we depend on each other for just about everything?

Almost everything we use is the product of other peoples work
We rely on people whom we do not know to supply goods for our daily lives
Modern society is highly interdependent
People would not engage in interdependent trade if they did not receive benefits from it!
One of economics fundamental insights is that voluntary exchange makes people better off
Simplifying trade Mr. Robinson and Ms. Crusoe 16
Imagine two nearby islands entirely independent of each other
17
Mr. Robinson lives on the first island
Durians abound on this island
Mangosteens, on the other hand, cannot grow in the soil
Ms. Crusoe lives on the second island, marked by a large abundance of mangosteens
People on this island cannot stand the smell of durians and have outlawed them
The soil is ideal for more fragrant mangosteen orchards
Sharks and giant whirlpools infest the waters between them, so nothing can move from
island to island
In this state, Mr. Robinson and Ms. Crusoe will consume only their own products
Robinson will only consume durians, and Crusoe will only consume mangosteens
Say a volcanic eruption occurs, and a land bridge forms between the two islands
Both individuals are tired of eating just their own produce
Trade benefits everyone as they will be able to enjoy both mangosteens and durians
The benefits from trade are obvious in this case, but what if Robinson and Crusoe could
both produce mangosteens and durians?
Introducing Ivan and Olga citizens of Moscalf Archipelago
Like Mr. Robinson and Ms. Crusoe, Ivan and Olga live on different islands and cannot reach
each other
This section was originally named International Trade and buried deep in microeconomics, after the material on taxes. I relocated
it here because the concept of comparative advantage ties in very closely with gains from trade.
16
Our team had a board where we would jot down some notes while studying. When we got to this subject, we drew a visual of
Robinson and Crusoe. It was veryinteresting. Robinson was a scrawny guy, and he was so happy with his fish and coconuts.
Crusoe was an extremely scary, muscular girl with a serious face and a spear. Amanda
17
It makes me feel better to imagine this island on a disk-shaped world, on the back of four elephants, on the back of a turtle flying
through space. I havent been reading the Discworld novels while writing this power guide, not at all
15
However, since the two are extremely gifted and artistic, they can both produce mangosteens
and durians
Will the two benefit from trade?
The Production Possibility Frontier
A production possibilities frontier (PPF) summarizes an economys production options
Because there are a finite number of hours in a day and a finite amount of exertion, Ivan
and Olga must choose between producing mangsoteens and durians
Ivan may make a table of his possible production combinations for a day
Mangosteens Durians
24
21
18
15
12
Plotting these combinations will yield Ivans PPF

Similarly, Olga may construct a table of her production possibilities
Mangosteens Durians
36
32
28
24
12
20
16
16
20
12
24
28
32
36
Olga produces both more mangsoteens and durians than Ivan at any given point
Moving along the PPF curve substitutes production of one good for another
Producing more mangosteens must mean producing fewer durians
Any combination on the curve is completely efficient
Production cannot be expanded at the current ratio of goods
Points inside the curve are inefficient because there is a corresponding point on
the frontier that maintains the same ratio of production
Mangosteens
A
Durians
Points A and B are both possible production points
Both have the same ratio of durians to mangosteens, but B has more output
Any point outside the curve cannot be produced with current resources
The slope of the curve measures the opportunity cost of production
Ivans curve is linear because it is a straight line with a constant slope
In this case, the slope reflects the opportunity cost of mangsoteens in terms of durians
If the slope were, say, -3, Ivan would have to give up three mangosteens to get
one durian
The slope of Olgas curve is -1
She trades one mangosteen for one durian
Their opportunity costs of production are constant since their curves are linear
PPFs are typically linear if the two goods are perfectly interchangeable in
production
Most PPF curves usually bow
out from the origin
A Bowed Out PPF
The curve bows outward

because certain resources are
better-suited for producing
Mangoone good than others
steens
As the economy uses

inappropriate resources to
produce one good, the cost of
producing that good increases
Note that this increased cost

Durians
includes increased
opportunity costs
Resources are typically suited for producing only one type of good
Using the same resources to produce another good will decrease efficiency 18
Ivan can select any point he wishes along the curve
Each point is equally efficient
The point he chooses depends on his relative preferences for durians and
mangosteens
The example my coach always used was guns and butter. Gun factories and butter factories simply are not suited for producing
the other good, and so a higher opportunity cost is paid.
18
Absolute and comparative advantage

A party has an absolute advantage for a good if it produces the good more efficiently
Whoever uses the least amount of inputs for a given amount of production has the
absolute advantage
Given equal inputs, if one traders PPF is higher on a goods axis than the others PPF,
that trader has an absolute advantage for that good
Absolute advantage compares the direct
costs of production for two traders
36
The party with the least direct costs

Olgas PPF
has the advantage
In our example, time and care are the only
Mangoinputs, and the market only has two goods
steens
Therefore, the amount produced within
a fixed time period determines absolute
Durians
advantage
Olga has an absolute advantage in both
36
mangosteen and durian production
Her PPF is above and to the right

of Ivans at every point
How can trading with Ivan benefit her?
Comparative advantages, on the other hand,
Ivans PPF
use opportunity costs instead of direct costs
2
Efficiency is defined in this case to have a
lower opportunity cost
Mango Ivan, for example, gives up three
steens
mangosteens for every durian he
Durians
produces (or, 1/3 of a durian for one
mangosteen)
Olga gives up only one durian for every
8
one mangosteen
Therefore, Ivan is more efficient at
producing mangosteens and has a comparative advantage
Ivan gives up less durians

Likewise, Olga has a comparative advantage in durians
Olga gives up fewer mangosteens for each durian she produces

The two should benefit from trading
Although a party can have an absolute advantage for all goods (like Olga), it is impossible
to have a comparative advantage for everything
The opportunity cost of one good is the inverse of the opportunity cost of the other
Opportunity Cost of
One Durian
One Mangosteen
Ivan
3 mangosteens
1/3 durians
Olga
1 mangosteens
1 durian
If Olgas opportunity cost of mangosteen production is higher than Ivans, Ivans

opportunity cost of durian production must be higher than Olgas
Comparative advantage is about how good someone is at making one good versus another
good
Absolute advantage deals with how a trader produces relative to other traders
A trader could be dead awful at producing everything (implying a universal absolute
disadvantage), but he will still have a comparative advantage in something
As long as two parties have differing comparative advantages, they will benefit from
trading with each other
Returning to Moscalf Archipelago
From the opportunity cost table, Olga has a comparative advantage for durians, and Ivan has a
comparative advantage for mangosteens
Comparative advantages follow efficiency in production
Since Olga does not have to spend as much time to raise durians, her opportunity cost
of durian production is lower than Ivans
A lower opportunity cost leads to a comparative advantage in producing that good
For simplicitys sake, we will assume both Ivan and Olga prefer to have equal amounts of both
mangosteens and durians (perhaps they are good complements)
Ivan will produce six durians and six mangosteens for his own consumption
Olga will farm 18 of each good
Just as with Mr. Robinson and Ms. Crusoe, a bridge appears between the two islands
Ivan approaches Olga and makes a proposition
Ivan
"We can both be better off if we trade."
Olga
"How so? I grow more durians and mangosteens than you do."
Ivan
"Look at these numbers."

"Right now, I am producing and consuming 6 mangosteens and 6 durians while you
have 18 of each."
"Together, we are producing 24 of each."
"If I grew only mangosteens, I could have 24 mangosteens."
"Meanwhile, you could produce 4 mangosteens and 32 durians."
"That's 28 mangosteens and 32 durians together, 4 more mangosteens and 8 more
durians than before!"
"If we split that, then we both get 2 more mangosteens and 4 more durians. So all told, I
could consume 8 mangosteens and 10 durians!"
Olga
"And I could have 20 mangosteens and 22 durians!"
Ivan
"Yep. Since we are better at different things, we could pick another combination of
numbers and still benefit from trading."
Olga
So if we stick to what we're good at doing, more gets done for everyone?"
Ivan
"Yes, ma'am!"
Even though both traders could live by themselves, they have a very tangible benefit
associated with interdependence
We like to be interdependent because there are economic advantages in doing so!
Interdependence facilitates specialization in what we are good at as we can rely on
other people for everything else
Models and Economic Theory
Building models
Economic analysis relies on four things
(1) Careful observation
(2) Description
(3) Measurement of economic theory
(4) Theory
We build theoretical models to capture details of economic interactions while stripping away
unnecessary detail
In doing so, we better understand how observed economic phenomena fit together
Models come in different forms
Simplicity
Models are diagrams or mathematical formulas
These models may appear too simplistic
The simplicity allows us to identify what assumptions and characteristics are important
The true test of a model is how well it captures what we want to understand
Positive and Normative Economics
Positive economics
Positive economics uses economic theory to make provable statements about economic
phenomena
Positive statements present reality with simple models
They also work in the reverse fashion, predicting the result of a potential action
A critic can disprove a positive economic statement
Positive statements do not have to be true, but they must be able to be proven one way or
the other
Example: The sun never sets on the British Empire
This statement can be proven false by finding a counterexample, or a time at which the
British Empire is in the dark
Example: Spending money on technological research will increase the interest rate
Finding a historical counterexample could disprove this statement
An economist could also disprove this statement by applying a theoretical model and
proving a different result
Positive economics does not contain value judgments
The economist just presents the information
He does not express an opinion on the merits of different choices
Normative economics 19
Normative economics fill the gap left by positive economics and introduce opinion
I remember the difference because our coach used to yell Youre positive about your facts at us to help us differentiate. Normative
statements are always opinion based so look for words like should to tell you which one it is. Tad
19
Normative statements combine economic analysis with value judgments

Tools like cost-benefit analysis structure a discussion on what choices to make
Choosing between outcomes usually requires referring to criteria beyond the scope of
economic theory
Some outcomes may hurt some and help others
The minimum wage debate is subject to such criteria and analysis
Pros
Increase income of minimum wage
workers
Better standard of living
Cons
Some minimum wage workers would
lose jobs
Others would be unable to find
employment
Less profits for employers
Costs may be passed on to
consumers
Normative statements describe what should be in a society, not what is
These statements cannot be proved false directly as they are opinionated
Example: Economists should focus on minimizing disparities in wealth as large income

gaps have deleterious social results
Example: The Federal Reserve should aim for consistently low inflation rates
Normative statements often address the desirability of a positive economic statement
Example: Using monetary policy to stabilize the economy will cause long term inflation,
but economists should prioritize short term results
Example: Taxing socially undesirable products produces inefficiency, but the long term
social benefits are worth it
Normative statements can sneak in without explicitly using the word should
Example: GDP is not a good measure of a countrys output because it does not include
necessary components of a society
Example: Keynesian models of the economy lead to undesirable economic policies
Efficiency as a Goal
Pareto efficient
An economic state satisfies Pareto efficiency if no one benefits without hurting someone else
Italian economist Vilfredo Pareto (1848-1923) was the first to make use of this concept
Pareto efficient states do not have to be equal
Example: If one person has everything in a society, the state is Pareto optimal
In order for someone else to benefit, something must be taken away from the person
who has everything
There is a lot of Pareto optimal distributions in an economy
Moving from one state to another requires redistribution
A change in a competitive market can redistribute wealth and move from one Pareto
optimal distribution to another
Pareto efficiency provides no way to judge whether one distribution is superior to another
Value judgements remain a part of normative economics
Economists will often offer their own opinions with positive analysis
Maximizing well-being
Efficiency is an important step in maximizing well-being
When using resources, we should not waste them
Microeconomics and Macroeconomics
Microeconomics
Microeconomics addresses the economy on the individual level and works its way up
Microeconomists make assumptions about individuals and their behavior
These assumptions create models of decision patterns for firms and households
By putting models of firms and households togther, microeconomics can explain the
behavior of markets
Putting models of markets together creates a model for the whole economy
Microeconomics internalize changes on an individual level, such as changes in consumer
preferences
Large scale phenomena, such as the money supply, are more difficult to analyze with a
strictly microeconomic approach
Macroeconomics
Macroeconomics takes a top-down approach
It tries to make sense of economy-wide fluctuations
Macroeconomists make models of broad components of the economy rather than
individual elements
Models typically use aggregated variables, such as the price level
Similarities
Microeconomics and macroeconomics are closely linked
Both share common assumptions about human behavior
Looking at economic activity on different scales means different aspects of human behavior
become important
Microeconomics and macroeconomics differ enough to consider separately
MICROECONOMICS
POWER PREVIEW
POWER NOTES
This section covers basic microeconomics. We will build a

model of competitive markets from assumptions about
consumer and producer behavior and then address weaknesses
in the model. In addition, we will cover concepts like basic
supply and demand and the production possibilities frontier.
40% of the exam (20 questions) will focus

on microeconomics
17 questions from the USAD practice test
are on topics from this section
This section loosely covers pgs. 10 56 of
the USAD Economics Resource Guide
Microeconomic Basics
Overview of microeconomics
Microeconomics centers on supply and demand
In our economy, the interaction between
supply and demand produces a highly
coordinated market
The actions of buyers and sellers dominate the
market
They determine the price and quantity of
each product or service bought or sold
Consumers, or buyers, demand goods and
supply factors of production
Firms, or suppliers supply goods and
demand factors of production
Microeconomics focuses on the economic
decisions of individual agents
Agents are typically individual consumers,
groups of consumers, and producers
Microeconomics explains how these agents
behave and interact
Microeconomics answers the question of how to distribute scarce resources
It involves the determining price through the interacting behavior of economic agents
Consumers distribute resources through utility maximization
Producers distribute resources based on profit maximization
Perfectly Competitive Markets
Markets
A market consists of all of the buyers and sellers of a particular good or service
Some markets are highly organized
In an organized market, buyers and sellers come together at a single location
An auctioneer sets a price at which exchanges take place
Examples include the New York Stock Exchange (NYSE) and the Chicago Mercantile
Exchange (CME)
Usually, markets are less formal than the NYSE and CME
Consider gasoline
Sellers are all of the local gas stations in a town
Buyers are vehicle owners in town and anyone passing through that needs gas
Each seller posts their price
Buyers buy gas, depending on price and convenience

Perfect competition
A market is perfectly competitive when it has four qualities
(1) The good or service is highly standardized or homogenous
(2) The number of buyers and sellers is large
(3) Everyone involved is well informed about the market price
2021
(4) The market has no barriers to entry
Consider the gasoline market again
Even within a small community, there are usually many buyers and sellers
These buyers and sellers exchange a small fraction of the gasoline
No one can influence gasolines price or quantity sold
Gas station owners know other stations sell a similar product
If the owners prices are too high, customers will go elsewhere
If he goes too low, he cuts into his income
In the same way, no one buyer can affect market price and quantity of gasoline
either
The price and quantity sold are determined by the combined actions of all buyers and
sellers
22
Each buyer and seller is a price taker and must accept the price set by the market
Only a few markets conform to the assumptions of perfect competition
However many real world markets are characterized by a high degree of competition so the
perfectively competitive model can be useful
Perfect competition is useful to compare with the outcomes of other types of markets
Demand
Law of demand
The quantity demanded for any good is the amount that buyers (consumers) are willing and
able to purchase
One of the most important factors in deciding quantity demanded is the goods price
If the price is low, then consumers will demand more
If the price is high, then buyers will demand less of the good
The law of demand refers to the negative relationship between a goods price and the
quantity demanded of the good
Alternatively, the two are inversely related
The law of demand results from the cost-benefit analysis that rational decision-makers use
As the price of a good increases, the opportunity cost of consuming that good also
increases
The consumer must cut back on consuming other goods in order to afford the higher price
Therefore, as price increases, they will want less of that good and more of other goods
This is not explicitly stated in the Power Guide, but might as well be: Imperfect competition arises because of barriers to entry in
the market (page 56, right column). Barriers to entry will be discussed later in microeconomics.
21
If no barriers to entry exist, firms can easily enter and leave the market until economic profits fall to zero. In imperfectly
competitive markets, economic profits exist because barriers to entry prevent other firms from entering the market to take them.
22
The term price taker is not in the main text, but it is in the glossary, under the description of a competitive market.
20
Because scarcity limits wealth, consumers must decide how much of each good they want
The consumers preference determines the marginal utility of a good
Marginal utility decreases with each increase in quantity consumed

The ratio of marginal utility to price is like the bang for the buck of a good
Consuming more of a good will decrease this bang for the buck, thanks to
diminishing marginal utility (also called diminishing returns)
The goal of a consumer is to equate all ratios of marginal utility to price
If all bangs for the buck are the same, there is no extra bang for the buck to be
derived from substituting one good for another
If we all got the same benefit from chocolate chip cookies as from spinach, no one
would care which one they ate
More formally, substituting between goods cannot increase the consumers utility
Increasing the price of a good must be accompanied with an increase in the marginal
utility of that good to keep the ratios equal
Marginal utility can be increased by decreasing the amount consumed

Decreasing the price requires a diminished marginal utility, increasing the amount
consumed
Therefore, an increase in the price of a good will lead to a decrease in the amount
of that good wanted
Demand curve
The law of demand relates the price of a good to how much the consumer wants
23
Applied to a range of prices, this relationship leads to a table called a demand schedule
Demand Schedule for Alfreds Alpacas

Price per Alpaca
$5
$10
$15
$20
$25
Quantity Demanded
20
15
10
Plotted on a chart with quantity and price as the axes, the schedule becomes a curve
The Demand Curve
Price
Quantity Demanded
23
The curve slopes downward and to the right

Note that price is on the vertical axis and quantity is on the horizontal axis
This choice is peculiar because independent variables are usually on the horizontal axis
The independent variable is the variable you manipulate
In our case, price is the independent variable

The dependent variable is the variable that responds
Occasionally, the demand function (curve) is referred to as a demand schedule, but USAD uses the different terms.
Quantity is the dependent variable

Quantity demanded is the number demanded by a consumer at any given point
24
Demand is the curve itself
Demand is a relationship between price and quantity demanded
When price changes, move along the curve and change quantity demanded
25
Whenever something shifts the demand curve, move the curve itself
Adding up the demand curves of individuals forms a market demand curve
The market demand curve relates price to quantity for the whole market
This process is a simple summation of all the individual demand curves
Note that this assumes an individuals purchasing patterns do not affect others
To create a market demand curve, add up the quantity that every consumer demands
at each possible price
The result is adding the demand curves horizontally to obtain the market demand
Shifts in the demand curve
The law of demand only accounts for price as a variable that alters quantity demanded
Many other things can influence the quantity demanded
If one of these factors changes, the demand curve shifts
A shift represents a change in the quantity demanded at all prices, or a whole new
demand curve
An inward shift (to the left, or toward the origin) means that the quantity demanded at
all prices has decreased
An outward shift (to the right, or away from the origin) means that the quantity
demanded at all prices has increased
A change in price will lead to movement along the demand curve
Movement along the Demand Curve
Price
Shift in the Demand Curve
Price
Quantity Demanded
Quantity Demanded
Five factors can shift the demand curve 26
24
(1) A change in the income of consumers will cause a shift

The direction of the shift depends on the type of good in question
Most goods fall under two categories: normal goods and inferior goods
Never forget this distinction! Cat

Shifts of the demand curve are covered in the next section. Remember price quantity demanded. Anything else shift the
curve. I dont recall an Economics test that didnt test on the distinction, so be sure to learn it.
26
Six, if you split up prices of related goods into substitutes and complements like my team did, but if USAD asks what are some
of the most important factors affecting the quantity demanded, then the answer is five.
25
As a consumers income increases, he will buy more normal goods and fewer
inferior goods
Consumers prefer to buy normal goods over inferior goods if they have the income
to do so
27
For normal goods, an increase in consumer income will lead to an increase in
demand
Demand is positively related to income
The demand curve will shift to the right

For inferior goods, an increase in income will lead to a decrease in demand
Demand is inversely related to income
The demand curve will shift to the left

28
Example: New cars are normal goods, and used cars are inferior goods
If Car-Crazy Carmen doesnt have much money and decides to buy a car, shell
probably get a used car rather than a new one
If Carmen gets a raise and starts doing better financially, shell be more likely to
buy a new car
(2) The prices of related goods also affect demand for a good
Demand for a good can change due to a change in the price of a substitute good
Substitute goods serve the same purpose another good
Utility functions for substitute goods are the sum of the individual goods
Since the consumer can use both goods equally, the utilities just add up
A consumer can switch from one good to the other without a decrease in utility
Two substitute goods are usually the same quality
Example: Pepsi and Coca-Cola are widely considered substitutes
If the price of Pepsi increases, the quantity demanded of Pepsi will decrease in
accordance with the law of demand
To avoid the higher price of Pepsi, many consumers will switch to Coca-Cola
because Coca-Cola is just as satisfying
As a result, the demand of Coca-Cola increases; its demand curve shifts to
the right
A decrease in the price of Pepsi will result in a decrease in the demand of CocaCola; the demand curve for Coca-Cola shifts to the left
A rise in the price of one good leads to a decrease in demand for its substitute
A fall in the price of a good leads to an increase in demand for its substitute
Demand for a good can change because of a change in the price of a complement
Complementary goods are goods that are required for each others use
Purchasing one requires purchasing the other
Having extra of one good provides no utility
A good example is a mechanical pencil and pencil lead
If the price of mechanical pencils increases, the quantity demanded of

mechanical pencils will decrease
Because people buy mechanical pencils and pencil lead together, fewer people
will buy pencil lead
27
28
Normal goods are sometimes referred to as superior goods. Christopher

A friend on the Pearland team showed me that children are also in fact inferior goods: http://tinyurl.com/3mbozpn
As a result, the demand for pencil lead will decrease, and the demand curve for
pencil lead will shift to the left
On the other hand, a decrease in the price of mechanical pencils will shift the
demand for pencil lead outward
Note that the market for mechanical pencils moves along the same demand curve,
while the market for pencil lead gets a new demand curve through a shift 29
(3) Changes in consumer preferences or tastes can affect demand
Preferences reflect the utility value that consumers assign to goods
A good that is preferred is popular or in style
If the popularity of electric cars increases it will lead to an increase in demand for
electric cars
A shift of preferences away from vinyl records, for example, will lead to a decrease in
demand for vinyl records
(4) Changes in consumer expectations can also affect demand
If consumers expect a newer, better good to emerge in the near future, the demand for
the current good will decrease 30
If consumers expect a decrease in the price of a good in the future, the current demand
for that good will decrease
Consumers wait for the lower price

If consumers expect an increase in the price of a good in the future, they will demand
more now in order to take advantage of the price while it lasts
(5) Changes in the number of consumers will also affect demand
If consumer numbers drop, then the demand will decrease
If consumers increases, the demand will increase
When testing curves, remember: everything else besides the factor that shifts remains the same
Normal goods
Income
Inferior goods
Substitutes
Factors that shift

the demand curve
Prices of related
goods
Complements
Consumer tastes
Consumer
expectations
Number of
consumers
Elasticity of demand 31
The shape of the demand curve is related to its elasticity
29
Changes in price are reflected through movement along the demand curve. Changes in income, related goods, expectations, tastes,
and the number of buyers are reflected through movement of the entire curve.
30
For example, knowing the iPhone 5 is coming out next month might decrease your demand for an iPhone 4 this week. Cat
31
I split up the Elasticity section into the elasticity of demand and elasticity of supply.
Elasticity is a measurement of the percent change of one variable in response to a percent

change in another
Qf -Qi
E=
% Quantity
% Pr ice
Qi
Pf - Pi
Pi
In the equation, f stands for final and i stands for initial

Elasticity is one variables sensitivity of to changes in another
Elasticity is inversely related to the slope of a curve
A steep line will have a low elasticity
A shallow line will have a high elasticity
The graph for an inelastic good goes up and down like an inelastic brick wall
The graph for an elastic good, on the other hand, looks like an elastic rubber band
flying sideways through the air
The price elasticity of demand measures how sensitive quantity demanded is to price changes
QD f - QD i
E denand =
% Quantity demanded
% Pr ice
QD i
Pf - Pi
Pi
32
According to the law of demand, quantity demanded is negatively (inversely) related to

price, so this ratio is always negative
Convention says we ignore this sign when considering elasticity of demand
Absolute value signs indicate this convention
Elasticity is useful because it does not rely on units of measurement
For example, the slope of the demand curve for milk will differ depending on whether
its in gallons or liters
However, in both cases, the elasticity of the demand curve will be the same
If demand elasticity is less than one, the good is said to be price-inelastic (or inelastic with
respect to price)
A price-inelastic good is not sensitive to changes in price
32
Goods which are price-inelastic are necessities such as food and clothing
Consumers must consume these goods regardless of income or price
These goods do not have many substitutes
If price increases, consumers keep buyiny anyway
Graphically, the inelastic curve is very steep
If demand elasticity is equal to zero, the good is perfectly price-inelastic
Any change in price will not result in any change in quantity demanded
Graphically, a perfectly inelastic demand curve is vertical
The perfectly price-inelastic is purely theoretical
Even for absolute necessities, price will eventually become prohibitively high
Example: Diabetics need insulin but they will eventually be entirely unable to pay
for it
And hair dye in my case. Cat
If demand elasticity is greater than one, the good is price-elastic (or just elastic)
An elastic good is sensitive to changes in price
Increasing the price of a good will lead to a decrease in total revenue
A price-elastic good is usually a luxury or has readily available substitutes
If its price increases, consumers can stop purchasing the item or switch to a
substitute with a lower price
Example: If the price of Bentleys goes up, consumers can choose to switch to
BMWs or not buy a luxury car at all
Graphically, an elastic demand curve is very flat
If demand elasticity equals infinity, a good is perfectly price-elastic
Any change in price will result in an infinite change in the quantity demanded
33
Consumers will only demand goods at one price
Like perfectly inelastic goods, perfectly elastic goods are purely theoretical
If elasticity is equal to one, a good is said to be unit elastic
Perfectly Elastic
Perfectly Inelastic
Price
Price
Quantity Demanded
Quantity Demanded
Inelastic
Price
Price
Price
Quantity Demanded
Elastic
Unit Elastic
Quantity Demanded
Quantity Demanded
Four factors influence the price elasticity of demand
33
(1) The degree to which a good can be substituted affects elasticity

Goods with substitutes tend to have high elasticities of demand
Consumers can easily switch from one to another
Elasticity of demand for a particular soda (like Sprite or Pepsi) is high
If the price of Sprite rises, consumers can easily switch to another brand
Conversely, when close substitutes do not exist, elasticity of demand tends to be lower
(2) A goods degree of necessity affects its elasticity as well
Necessities tend to have lower price elasticities of demand than luxuries
Since people need the good, they will continue to buy it at any price until they cannot
afford it
Perfectly competitive markets have perfectly elastic demand. Consumers only demand the good at the market price.
(3) The price elasticity of a good is also related to time

In the short run, individuals have less time to look for alternative goods
As a result, goods are generally more inelastic in the short run

In the long run, individuals can find alternatives or change their lifestyles to adjust
Consequently, goods are generally more elastic in the long run

Example: Gas is inelastic in the short run because cars cannot run on any other form of
fuel, and consumers do not have any other form of transportation
Even if the price of gas increases, people have no choice but to fill up
They can drive less and carpool more, but their overall demand for gas does not
change dramatically
In the long run, however, consumers can buy electric cars, relocate closer to their
jobs, take public transportation, and so on
(4) The scope of the demand market affects its elasticity
Scope refers to the size of the market
Example: The market for beverages is bigger in scope than the market for Gatorade
Markets with a larger scope tend to have lower elasticities
In other words, the broader the good category, the more inelastic the good
Since the market is bigger, there are fewer substitutes available
Example: It is easier to find a substitute for Gatorade than for beverages as a whole. 34
Substitutes
Necessity
Factors influencing
demand elasticity
Scope of market
Time horizon
Elasticity falls continuously along the demand curve
34
A linear demand naturally has a constant slope

Let us call this slope e
P
Q
e=
The ratio
The elasticity of demand along a linear demand curve is equal to
P and Q in this case are for a specific point along the demand curve
Moving down the demand curve, P is falling and Q is rising
Therefore,
b=
All considered, the elasticity of demand must be falling
Q 1
= = b is naturally also a constant
P
e
P
must be falling
Q
1
is constant, since the demand curve is linear
e
I cant even imagine what a substitute for beverages would be. Cat
P
b
Q
Price Elasticity of Demand

Number Range
Name
Relation to Total
Revenue (TR)
Graphical
Representation
Other Notes
E=0
Perfectly
inelastic
Increase in price leads

to increase in TR;
decrease in price leads
to decrease in TR
Perfectly vertical
line
Purely theoretical
Inelastic

to increase in TR;
to decrease in TR
Steep line
Applies to goods that

are necessities and
goods that have few
available substitutes;
goods are more
inelastic in the short
run
Unit elastic
Change in price has no

effect on TR
Line with
a slope of -1
Changes in quantity
demanded are
exactly proportional
to changes in price
Relatively flat line
Applies to goods that

are luxuries and
goods that have
many available
substitutes; goods
are more elastic in
the long run
Perfectly
horizontal line
Purely theoretical
E<1
E=1
E>1
Elastic

to decrease in TR;
to increase in TR
E=
Perfectly elastic
Change in price leads

to loss of all TR
Supply
Law of supply
The quantity supplied of any good is the amount sellers are willing and able to produce
The most important factor affecting quantity supplied is the price suppliers receive
The higher the price received, the more suppliers are willing to produce
The law of supply is the positive relationship between price and quantity supplied
The law of supply results from the cost-benefit analysis performed by rational suppliers
Suppliers compare the benefits of the marginal good sold with the opportunity cost of their
time, effort, and expense
As price rises, it is rational to devote more resources to supply that good
As long as price received exceeds opportunity cost, they will be willing to supply
Supply curve
The law of supply relates the price of a good and how many units a profit-maximizing
producer will be willing to supply
Supply is the quantity of a good or service that producers are willing and able to produce
at any given price
The quantity supplied is the amount of a good supplied at a specific price
Price and quantity supplied are directly or positively related
Quantity supplied is a point on the supply curve
Supply refers to the entire supply curve

The law of supply creates a table called a supply schedule
The supply schedule lists the number of goods producers can supply at each price
The prices are unit prices, which represent the price of each good supplied
Supply Schedule for Alejandros Alpacas

Price per Alpaca
$5
$10
$15
$20
$25
Quantity Supplied
10
15
20
A supply schedule plotted on a plane becomes a supply curve
The curve is a continuous relationship because it allows the calculation of quantity

supplied at any price
The Supply Curve
Price
Quantity Supplied
Just as with demand, the vertical axis represents price and the horizontal axis quantity 35
The supply curve slopes upward: the slope of the curve is positive
The supply curve slopes upward because producers are more willing to supply a good at
higher prices
Thus, the quantity supplied increases as price increases
The market supply curve is obtained by adding all the quantities supplied at each price by all
suppliers within that market
Like the market demand curve, this is the same as adding the individual supply curves
horizontally
Shifts in the supply curve
A movement along the supply curve indicates a change in quantity supplied
A movement along the curve is from one point to another on the curve
A shift of the entire supply curve indicates a change in supply
When the supply curve shifts, the quantity supplied of a good at all prices changes
An inward shift (left, or toward the origin) means that the quantity supplied at any given
price decreases
An outward shift (right, or away from the origin) means that the quantity supplied at any
given price increases 36
Four important factors cause shifts in the supply curve
Anyone else think it odd that we say supply and demand but learn about demand first 99% of the time?
Economists often use the terms left and right to describe decreases and increases in supply. Be careful not to use up and
down: a shift upward in the supply curve actually represents a decrease in supply. This gets confusingso stick to left and right.
35
36
(1) If the cost of the factors of production increases or decreases, the supply curve will shift to
the left or right, respectively
Firms cannot produce as much for a given price, so they must supply less quantity
If the price of inputs decreases, firms are willing to produce more goods at existing
prices, pushing the supply curve to the right
(2) If technological progress occurs, the supply curve will shift outward 37
A breakthrough in productive technology will decrease the cost of producing a good,
shifting supply to the right
(3) Expectations of price changes can shift the supply curve
An expected decrease in the price of a good will lead firms to supply more so they can
sell the good at the current higher price
An expected increase in prices will lead firms to decrease supply now so they can wait
for the higher prices
(4) A change in the number of firms supplying a good will shift the markets supply curve
If the number of firms supplying a good increases, the supply curve shifts to the right
If the number of firms supplying a good decreases, the supply curve shifts to the left
Cost of
inputs
Technology
Things that
shift the
supply
curve
Expectation
s
Number of
suppliers
A change in the price of a good only leads to a movement along the supply curve for that
good, not a shift in the curve itself
When solving supply shift problems, remember that all other factors will remain the same
Shift in the Supply Curve
Movement Along the Supply Curve
Price
Price
Quantity Supplied
Quantity Supplied
Elasticity of supply
The price elasticity of supply describes the shape of the supply curve
37
Technological regression would supply to decrease, but, unless all the electricity in the world stops working, it is unlikely.
Supply elasticity measures how sensitive supply is to changes in price

Additionally, it reflects how easily suppliers can alter the quantity of production
Elasticity of supply is defined analogously to elasticity of demand
QS f - QS i
E sup ply =
% Quantity sup plied

% Pr ice
QS i
Pf - Pi
Pi
Three factors affect elasticity of supply
(1) The difficulty of entry and exit into a market relates to elasticity
If few barriers to entry exist, supply tends to be more elastic
(2) Elasticity for supply curves typically has a time factor
In the short run, firms will have already made their production decisions
Firms cannot change the quantity supplied much, if at all, to respond to price changes
Quantity supplied is thus often inelastic (not very responsive) to changes in price
In the long run, firms are able to plan all of their production decisions
Firms will enter or leave the market if the market price is different than the price
that yields normal profit
Quantity supplied is elastic, or very responsive to changes in price

(3) Scarcity of inputs affects supply elasticity
If inputs are scarce, then the supply will be inelastic
Like elasticity of demand, supplys elasticity
has five cases
Factors
affecting
(1) Perfectly inelastic
Scarcity
elasticity of
of inputs
Perfectly inelastic demand curves do
supply
not exist
Only perfectly inelastic supply
Time
curves exist
horizon
These curves are for goods that are
no longer produced or for which
Presence of
barriers to
the inputs no longer exist 38
entry
(2) Inelastic
(3) Unit elastic
(4) Elastic
(5) Perfectly elastic
Perfectly Elastic
Perfectly Inelastic
Price
Price
Quantity Supplied
38
Quantity Supplied
For example, suppliers cannot make any more antique cabinets from the year 1850.
Using elasticity 39
If a good is inelastic, an increase in price will cause a smaller decrease in either quantity
demanded or quantity supplied
The firm can increase the price thereby increasing revenue
Revenue equals price multiplied by quantity
Revenue is graphically depicted as a rectangle
The intersection of supply and demand form one corner of this rectangle
The increased price makes up for the lost quantity
If a good is unit elastic, an increase in price will cause an equivalent decrease in quantity
Inelastic
Price
Price
Price
Quantity Supplied
Elastic
Unit Elastic
Quantity Supplied
Quantity Supplied
A change in price will not affect revenue
If a good is elastic, an increase in price will cause a greater decrease in quantity
The firm will lose revenue if they increase prices

The increase in price does not make up for the decrease in quantity
If the firm decreases their prices, revenue will increase
Price Elasticity of Supply
Number
Range
Name
Relation to Total Revenue (TR)
Representation
E=0
Perfectly
inelastic
Increase in price leads to increase in TR; decrease in

price leads to decrease in TR
Perfectly vertical
line
E<1
Inelastic
Increase in price leads to increase in TR; decrease in

Steep line
E=1
Unit elastic
Change in price has no effect on TR
Line with
a slope of 1
E>1
Elastic
Increase in price leads to decrease in TR; decrease in

price leads to increase in TR
Relatively flat line
E=
Perfectly
elastic
Change in price leads to loss of all TR
Perfectly
horizontal line
Equilibrium
What is equilibrium?
Most people first hear of equilibrium in their science classes
39
This is adapted from the Using Elasticity section, starting on page 28 of the USAD Resource Guide.
Equilibrium is used in both the physical and
social sciences
Equilibrium is the point at which all the
forces in a system are balanced
40
Something at equilibrium is stable
For economics, equilibrium is the point where
no participant in the market has any reason to
change their behavior
The price in a competitive market acts as a
signal between producers and consumers
If the price is right, consumers will
signal this by purchasing the
equilibrium quantity of product
On the other hand, if the price is too high, consumers will refuse to buy the product
Where is equilibrium?
Market equilibrium occurs where the market supply curves and demand curves meet
Market equilibrium is when the price and quantity are at the intersection point
Since the two curves slope in opposite directions, there can only be one point of intersection 41
Characteristics of competitive market equilibrium
Consumers and producers interact in markets
Potential buyers and potential sellers form a market when they come into contact with one
another to exchange goods or services
Perfectly competitive markets rely on the assumptions discussed earlier
These four assumptions hold true for all perfectly competitive markets
(1) The good or service in question is homogenous
(2) The number of buyers and sellers is large
(3) Everyone involved is well informed about the market price
(4) The market has no barriers to entry
Happily, competitive markets tend to gravitate toward the equilibrium quantity and price
This tendency has two desirable effects
(1) Competitive markets effectively allocate resources
The price tells suppliers about the value consumers place on a good
Likewise, prices inform demanders about the opportunity cost of supplying the good
This way, scarce goods and services are produced at the lowest cost and allocated to
those who value them the highest
(2) Competitive equilibrium maximizes benefits for both buyers and sellers
The available supply goes to those who value the good the highest
The ones who supply the good are those who supply it at the lowest cost
Buyers receive a number of benefits from participating in the market
The height of the demand curve at each point reveals the willingness of the marginal
buyer 42 to pay
Suppose four fans of an extremely popular card game want to buy new booster packs
Each fan values the booster pack at different prices
However, something that is in equilibrium is not necessarily static.

Sorry, Yoda.
42
The marginal buyer is the buyer, who at a certain price, is indifferent between buying the good or not buying it.
40
41
Buyer
Willingness to Pay
Yugi
$100
Joey
$80
Tristan
$70
Ta
$50
The actual price of the booster pack is $60
Ta will not buy a pack, since she only values it at $50 43
The other three duelists will buy a pack, but each receives a different benefit from
purchasing the booster pack
The consumer surplus is the surplus benefit received by consumers
Buyer
Benefit from Purchase
Yugi
$40
Joey
$20
Tristan
$10
Added all together, the total consumer surplus is $70

Graphically, a line is drawn horizontally from the market price out to the price axis
The difference between the height of the demand curve and this line is the
consumer surplus
It is triangle shaped
Suppliers benefit from participating in the market
The height of the supply curve at each quantity measures the willingness of the marginal
seller 44to supply
It also measures the opportunity cost to the marginal seller
If the market price exceeds the opportunity cost, the difference is the producer surplus
The total producer surplus is found by adding the surplus of all suppliers in the market
Similar to the consumer surplus, the area above the supply curve and below the market
price graphically illustrates producer surplus
Supply and demand graphs include consumer and producer surplus between the supply and
demand curves
Consumerand
andProducer
ProducerSurpluses
urpluses
Consumer
Price
Supply
A
B
Demand
Quantity
43
44
How thrifty of her! Cat

Analogous to the marginal buyer, the marginal seller is the seller who would leave if the price of the good got any lower.
Triangle A is the consumer surplus 45

The top of the triangle is the section of the demand curve above the market price
This section stands for those who are willing to pay more than the market price
The vertical difference between the demand curve and the market price is in dollars per
good
The horizontal base of the triangle is the quantity sold of the product
46
Therefore, the area of the triangle is in dollars
Triangle B is the producer surplus

The section of the supply curve used is the part below the market price
This section stands for the sellers who would be willing to sell at cheaper prices
than the market price
The base of the triangle is the quantity sold in the market
Just as with consumer surplus, producer surplus is measured in dollars
The sum of triangles A and B is the total market surplus
Total market surplus measures the total benefits that market participants receive
One goal of a benevolent social planner is to maximize total market surplus
In theory, this will produce the greatest good
Maximizing total surplus satisfies Pareto efficiency
When total market surplus is maximized, no way exists to make anyone better off
without reducing making someone else worse off
To achieve efficiency, a market planner needs to know two things
(1) The value that each consumer places on the good
(2) The cost of producing each unit of the good
In addition, the market planner must answer the
three fundamental questions of economics
How
How much should be produced?
much
to
Who should produce the good?
produce?
Who should receive the goods?
Answering these questions and calculating these
values would be difficult
A competitive market answers these questions
The self-interested actions of the markets
participants leads the market to equilibrium
These participants only respond to changes in
the market price
Applications of the Competitive Market Model
Basics of market equilibrium

The demand curve for an individual producer is perfectly elastic
Consumers are price responsive
A seller that increases its prices will lose all of its customers
Since goods exchanged are homogenous, consumers have no preference for one good
over another; they simply buy the cheapest one
45
I remember that consumer surplus is above producer surplus because C comes before P in the alphabet. Cat
We will use dollars, but any currency would work (as long as its used consistently). The assumption is that the United States
Academic Decathlon would most likely use dollars as well.
46
In a perfectly competitive market, firms obey the market price

If the market price is below the equilibrium point, firms will leave the market
Supply decreases and price increases until economic profits are nonnegative
If the market price is above the equilibrium point, economic profits will be made
More firms will enter the market and drive up supply
47
Because demand is perfectly elastic, it is always equal to marginal revenue
Marginal revenue is the additional revenue earned by selling one more of a good
Firms only sell their good at one price, so every unit purchased (regardless of total
quantity) brings the same revenue
Furthermore, both marginal revenue and demand are equal to the price of the good
Perfectly competitive markets include most primary commodity markets
A classic example is the wheat market
All wheat is essentially the same, so all prices for wheat are the same
Perfect Competition (Firm)
Perfect Competition (Market)

Price
Supply
MC
Price
Demand = MR = Price
Demand
Quantity
Quantity
Changes in market equilibrium

Markets are not always static
One or both the supply and demand curves for a particular market can shift due to the factors
discussed earlier
Test questions will usually ask you to identify the curve shift(s) and then deduce how price
and quantity change
If only one curve shifts, the effects on price and quantity are unambiguous
If supply increases, the price will fall but quantity will increase
If supply decreases, the price will increase and quantity will decrease
If demand increases, both the price and quantity will increase
If demand decreases, both price and quantity will decrease

A change in supply directly changes quantity and inversely changes price
A change in demand directly changes both quantity and price
If both curves shift at the same time, either price or quantity (but not both) will be
ambiguous
If supply and demand shift in the same direction, then the change in exchange
price is ambiguous
47
Marginal revenue will be further discussed in the section on the profit motive and the behavior of firms.
If supply and demand both increase, quantity will increase, but the change in
the price is uncertain
If supply and demand both decrease, exchange quantity will decrease, but the
effect on price is uncertain
If supply and demand shift in opposite directions, the change in exchange quantity
will be ambiguous
If supply increases but demand decreases, then price will decrease, but the
change in quantity is uncertain
If supply decreases but demand increases, then the price will increase, but
quantity is uncertain
These shifts are ambiguous because they contain two opposing forces moving in
opposite directions
For example, if both supply and demand shift outward, the increase in demand
tries to raise the price
The increase in supply, however, tries to bring the price down
We do not know which effect will take over unless we have quantitative data
(which USAD will not expect you to crunch)
Both the supply and demand shifts agree to increase quantity
Market Equilibrium
Price
B
2
4
Quantity
In the graph above, line A represents the original demand curve, line C the original
supply curve, and point 1 the original market equilibrium
If demand shifts from A to B and supply (line C) remains the same, then the new
market equilibrium is at point 2
Price and quantity have both increased
If supply shifts from C to D while demand (line A) remains the same, then the new
market equilibrium is point 3
Price has decreased while quantity has increased
If both curves shift (demand from A to B and supply from C to D), then the new
market equilibrium is point 4
Quantity has increased, but price is ambiguous
If you are not convinced that the change in price is ambiguous, try shifting the
curves different amounts
If you shift demand more, the price is higher than the original value
Inversely, if you shift demand less than the graph did, the price is lower
Rather than memorize all the different combinations, break up shifts into their
individual parts
Draw one graph in which you shift only demand and one in which you shift only
supply
Then analyze the effect on quantity and price in each graph
One of the two will change in the same direction in both graphs while the other
will change in the opposite direction
The one which changes in the opposite direction is indeterminate
In addition to price and quantity, surplus changes when curves shift
The effects of curve shifts on surplus are analyzed graphically
To analyze shifts and their effect, remember that surpluses are triangle-shaped
Shift the supply and demand curves as needed
Compare the size of the new triangle-shaped surpluses to the old ones
Remember that quantitative data will clear ambiguities
USAD will not expect you to crunch such data
Shifts of Supply and Demand 48, 49
Shift
Result
Supply
Demand
Producer
surplus
Consumer
surplus
Total
surplus
No shift
ambiguous
No shift
ambiguous
No shift
ambiguous
No shift
ambiguous
ambiguous
ambiguous
ambiguous
ambiguous
ambiguous
ambiguous
ambiguous
ambiguous
ambiguous
ambiguous
The Profit Motive and the Behavior of Firms50
All about firms

Firms are economic actors who are responsible for supplying goods and services
Firms combine many inputs to produce the products consumers want
Labor
Capital equipment
Raw materials
Economic and accounting profits
A firms goal is to maximize profits 51
You know, in case you want to memorize the shifts and their effects anyway
In this chart, an means increase and means decrease. Otherwise, shifting supply upwards means supply is decreasing and
shifting supply downwards means supply is increasing. Jimmy
50
The section Evaluating Government Policy was relocated to after this one.
48
49
Total revenue is the amount the firm receives from selling its goods or services
Mathematically, total revenue is equal to the total quantity of output multiplied by its
price
Total costs are the cost of supplying the good or service
Accounting costs include actual monetary costs
Accounting profit is the monetary profit earned

Economic costs include both monetary and opportunity costs of resources used
Economic profit is monetary profit minus opportunity costs
In the long-run, economic profits are always equal to zero (more in the next
section)
Economic Analysis
Accounting Analysis
Economic profit
Accounting profit
Revenue
Revenue
Implicit costs
Total
opportunity
costs
Explicit costs
Explicit costs
A number of costs are included in economic costs 52
In this graphic, the top, green squircles 53 represent the profits associated with each analysis
The lower, red ones are the costs subtracted to get revenue
Explicit costs are costs with direct monetary value, like wages
Implicit costs are opportunity costs, like what the shop owner could get if he ran a
different business
Firms evaluate their position by examining their marginal costs
Marginal costs have two components
Fixed costs are costs a firm must pay regardless of how many units it produces
The more a firm produces, the lower its average fixed cost for each additional
unit 54
The cost is spread over more units of output
By definition, firms cannot change fixed costs in the short run
This rule excludes non-profit organizations.

USAD will most likely not test on these names, since most are not in the resource guide.
53
Squectangle just doesnt have the same ring to it. Cat
54
Maximizing production to lower fixed costs is also called economies of scale.
51
52
A lease on a factory is a fixed cost; the firm must pay the cost regardless of how
many units or even if no units are produced
In the long run, however, the firm considers all costs (including fixed costs)
Variable costs change with the amount produced
A firm only incurs variable costs when it produces something
Variable costs increase as the firm adds more variable inputs (such as labor) to fixed
inputs (such as capital)
Examples of variable costs include wages (firms can hire and fire workers) and
purchases of raw materials
Producing more units of goods requires more laborers and more raw materials
If no units are produced, then a firm will not incur any variable costs but will
still have fixed costs
By definition, firms can alter variable costs in the short run

The marginal cost is the cost incurred by producing one more unit of output
Marginal costs generally increase as production increases
The producer will produce until marginal revenue is equivalent to marginal cost 55
Marginal revenue is the revenue from producing one additional unit

Average cost is the total production cost of each unit of output
Average cost is the sum of fixed costs and total variable costs divided by the total
number of units produced
Average Total Cost =
Total fixed cos ts + Total var iable cos ts

Total number of units produced
Firms spread fixed costs over multiple units of output
The more a firm produces, the lower the average fixed cost (fixed cost per unit
of output)
Variable costs drag average cost upward after a certain point of production
This upward trend is due to diminishing returns
As more and more variable inputs enter the production process, they become
less productive
Adding more workers in a factory, for example, doesnt help boost production
if there are no machines for them to use
This phenomenon of decreasing then increasing marginal cost is called

diminishing returns to scale
In the long run, all factors are variable, so all costs are variable
A fixed cost in the short run is always a variable cost in the long run
For all short-run decisions, firms face a mix of fixed costs and variable costs
The marginal cost curve is usually U-shaped and resembles a rounded checkmark
If a firm initially produces more of a good, the marginal cost drops because the
fixed costs of production are spread over more units
This effect was not captured in our model of production above but is a closer
approximation of reality
After a certain point, the marginal cost curve climbs upward as variable costs increase
The graph 56 below features all the different types of costs discussed
55
56
This is the Golden Rule of (Micro)Economics.

USAD will not test on the shapes of curves, but visualizing them helps some people.
Cost Curves
Marginal cost
Average
total cost
Price
Average
variable
cost
AFC
Average
fixed cost
Quantity Produced
Note the U shape of the marginal cost (MC) curve
The MC curve decreases, then increases

Notice how the average fixed cost (AFC) curve continues to decline
This reflects the fact that average fixed costs continue to decline as the firm
produces more and more units
Since average total cost (ATC) is equal to average variable cost (AVC) plus average
fixed costs (AFC), the distance between the ATC and AVC curves is the AFC
This distance decreases as the AFC decreases and more units are produced.
It is important to observe that the MC curve intersects the ATC and AVC curves at
the minimum of each
A marginal increase over the average will increase the average
A marginal decrease below the average will decrease the average
Example: Intelligent Izzy diligently studying for his final in AP Economics
He wants to know the grade he needs on the final to get an A in the class
He knows his average in the class is 90%
Through his calculations, he realizes that any score above 90% on the final will
raise his average
Any score below 90% will lower his average
Izzys class grade is the average, and his prospective score on the final is the
marginal increase
On the graph, we can see how minimums and maximums come into play at a firm
Profit Maximization
$
Average
total cost
Marginal
Profit
maximization
Average
variable cost
Average
fixed cost
Quantity
To the left of the intersection of MC and AVC curves, MC is less than AVC at
all points
As a result, AVC decreases until the two intersect
After the two intersect, MC remains above AVC
As a result, AVC continues to rise
The same observations hold true when comparing MC and ATC

This graph also gives us the profit-maximizing level of output (but only for one input,
unlike our previous approach)
Find the intersection of the marginal cost and marginal revenue curves
Marginal revenue in a competitive market is constant and equal to the market

price 57
The line drawn downward is the profit-maximizing quantity

As long as diminishing returns to scale applies, marginal costs rise as output increases
Since opportunity costs are increasing, this firms supply curve will slope upwards
Entry, exit, and the market supply curve
Suppose that Intelligent Izzy is so intelligent that he opened a store that has now expanded
into a multibillion-dollar franchise
58
This franchise sells crests as accessories
At first, as the only seller of crests, Izzy will earn an economic profit
Recall that economic profit is monetary profit earned minus opportunity costs
Naturally, others will begin producing crests when they see that Izzy is making substantial
economic profits
59
Old childhood friends T.K., Yamato, and Sora enter the market for crests as well
More producers means the market supply curve will shift outwards
The equilibrium price then falls
Once economic profits for all producers equal zero, entry by other producers stops
If economic profits ever went below zero, people would begin leaving
This might happen due to a shift in consumer preferences
Maybe their friends Mimi and Daisuke started making much fancier eggs that have
the same function as these crests
Friends Tai, Hikari, and Joe have no reason to enter the market, as economic profits
are zero
Two points are worth bearing in mind
(1) In a competitive market, in the long run, all owners will earn zero economic profits and
be content with it
The owners are earning their opportunity wage
Whatever business they are engaged in remains their best alternative
(2) Prices not only ration scarce goods but allocate productive resources between different
activities
Say prices exceed production costs while Mimi and Daisuke are initially making their
egg accessories
Positive economic profits cause their buddies Yolei and Iori to enter the market
The positive profits means that additional resources should be deployed to fake-egg
production 6061
This is not the case in a market that doesnt follow competitive market principles, but well get to that in another section.
Go with it
59
+10 awesome if you can guess where these and the following names are from.
57
58
Evaluating Government Policy: the Impact of Price Controls and Taxes
Price controls
Economists use surplus to explain the effects of government intervention in the market
The government can implement price controls through price ceilings or price floors
Price ceilings and floors affect the market, are binding, if they are below or above the
market price, respectively 62
Price ceilings set a maximum price on a good
A binding price ceiling will create a shortage as the price will be below the marketclearing price
Quantity demanded will increase because consumers are willing to purchase

more at the lower price
Quantity supplied will decrease because firms are not as willing to supply the
good at the lower price
Consumers who would be willing to buy the good at the current price are unable
to do so because firms will not supply enough
Quantity demanded is greater than quantity supplied

Price Ceiling
Price
Price
Ceiling
Quantity
Trapezoid A is consumer surplus
Note that the original triangle of consumer surplus is choked by the limited
supply
Triangle B is producer surplus
The triangle is heavily contracted due to the decreased price and quantity
Triangle C is the markets deadweight loss
Deadweight loss is the surplus that someone would have received if the market
was in equilibrium
No one gets this surplus
It is lost to inefficiency
Price floors set a minimum price on a good
A binding price floor will create a surplus since the price will be above the market
price
And then Ken enters the market and slaughters them all, until Takeru/T.K. punches some sense into him. Oops, spoilers.
Thank goodness this is after the time of those pesky black gears. Imagine those running rampant in this already fragile theoretical
economy. Those poor DigiDestined. :P Ariel
62
Imagine that you are in a house. Like equilibrium price, you are below the ceiling and above the floor. Cat
60
61
Quantity demanded will decrease because consumers are not willing to

purchase the good at the higher price
Quantity supplied will increase because firms are willing to supply more at the
higher price
Consumers will not buy all of the goods, and the market will not clear
Quantity demanded is less than quantity supplied
Price Floor
A
Price
Floor
Price
B
Quantity
As before, A is consumer surplus
B is producer surplus
C is deadweight loss
Note that any deviation from the competitive market price in a closed economy
leads to a deadweight loss
Therefore, moving toward the market price is a Pareto efficient move
The market recovers deadweight loss without hurting anyone

Some suggest government interventions could set a better price
Usually, such efforts come with significant social cost
Consider placing a price ceiling (below the market price) on apartments in Mumbai
(1) The consumer surplus of some renters increases, while the producer surplus of
landlords decreases
Landlords will supply fewer apartments, so some renters will not be able to find a
place to live
Landlords may stop maintaining their apartments, since they are not worthwhile
investments
(2) Total surplus is reduced, since the price ceiling prevents some mutually beneficial
transactions from taking place
Landlords would like to rent apartments at a high price
Some consumers would be willing to pay a higher price

Additionally, rent controls disrupt how apartments are usually allocated
In the competitive market, apartments are rationed using price
Everyone who wants an apartment at or above the market price can get one
Landlords willing to supply at or below this price can rent them

With rent controls in place, landlords are in a position to select tenants
Potential renters might be required to pay a finders fee
Landlords might rent to their friends
The landlords might discriminate based on characteristics they like or dislike

History points to the negative effects of rent controls
In the short-run the supply and demand for housing in a city is highly inelastic
Rent controls can lower the price of apartments without creating a large excess of
demand
Over time, supply and demand become much more elastic
Landlords will cut back on maintenance costs
Apartments will deteriorate
Eventually, landlords will remove those apartments completely, decreasing

supply
Meanwhile, low prices attract more people to the city 63
Taxes
All levels of government use taxes to raise revenue to pay for public expenditures
An important issue is who should bear the burden of a particular tax
Governments attempt to control the distribution of burdens through legislation, but things
are never that simple
A marginal tax creates a different price for producers than consumers
Example: A $20 tax on a $600 computer would lead to consumers paying $620
and producers only receiving $600
Therefore, consumers only demand as much quantity as they would at $620,

and producers only supply as much quantity as they would at $600
The government wedges 64 itself between consumers and producers by instituting

a tax
The tax sits between the consumer and producer prices
Similarly, tax revenue sits between consumer and producer surplus
Marginal taxation policies have the effect of setting a fixed quantity below market
quantity
Marginal Taxation
Price
Tax
Consumer
price
C
Producer
price
B
Quantity
As before, A and B are the consumer and producer surpluses, respectively
Ironically, increased demand and decreased supply increase the price and has an ambiguous effect on quantity. Even here, the
market tries to get to equilibrium.
64
Im mad craving an orange right now. Sophy
63
C is the deadweight loss associated with the tax
Deadweight loss occurs because both consumers and producers move less
quantity than they would without the tax
Deadweight loss indicates a reduction in social welfare
D is tax revenue
Tax revenue is the tax per unit multiplied by the number of unitsthe area of
box D
Any area measurement on a supply demand graph is in terms of dollars. 65

To draw taxes and determine their effect, one can do three things, depending on who
the tax is applied to
(1) Shift the market demand curve down by the amount of the tax
(2) Shift the market supply curve up by the amount of the tax
(3) Find the point where the distance between the curves is equal to the amount of
the tax
Therefore, taxes have two main effects
(1) Taxes reduce social welfare
(2) The government collects revenue
The government usually does not, however, collect as much revenue as expected
By introducing a tax, price naturally increases and people will demand less
If either the supply or demand curves flatten out, or become more elastic, tax revenue
decreases
The right hand side of the tax revenue box gets pushed to the left, decreasing the area
The deadweight loss triangle increases in area as it becomes longer
Therefore, goods with elastic demands and/or supplies are not very effective to tax
66
On the other hand, the government can tax inelastic goods effectively
Notice that even though the government levied the tax on consumers (only their price
went up), both consumers and producers paid for the tax in lost surplus
In a competitive market, a marginal tax cannot target only consumers or producers
The elasticities of supply and demand distribute the burden of taxation between producers and
consumers
The more inelastic party will bear more of the tax
If the elasticities are the same, the tax splits equally between consumers and producers
Note that market elasticities are typically outside of the direct influence of government
The political economy of trade 67
We can extend the perfectly competitive market model to situations with international trade
We will assume the domestic economy is small and does not greatly influence the world
economy
The domestic economy acts as a price taker
The world price for a good is taken as a given
The domestic economy cannot affect the world price of the good
Therefore, international trade is equivalent to the price controls discussed before
The difference is that the international market buys up the surplus or provides goods
for the shortage
If the world price is higher than the domestic equilibrium price, the economy exports
Or yen, or euros, or pounds, or rupees

Taxes on cigarettes are a good example.
67
This section and the Comparative Advantage section in Section I are united in the resource guide under International Trade
65
66
Exporting Economy
A
C
Price
World
Price
B
D
Quantity
Triangle A is consumer surplus, as usual
Note that consumers generally lose surplus when an economy opens up to

trade and exports
Consumers have to compete with other consumers in the world
The big triangle B is producer surplus
Producer surplus includes domestic surplus plus the gains from international trade
Triangle C represents the gains from trade
Producers receive all of this surplus
Total social welfare increases
Rectangle D is the value of the goods exported (quantity times price)
This situation is analogous to a price floor, which would usually leave a surplus of
goods
The surplus is sold to the world market
Note that there is no deadweight loss

If the world price is lower than domestic equilibrium price, the economy imports
Importing Economy
Price
A
C
B
World
Price
Quantity
The big triangle A is consumer surplus
Consumers gain surplus because they have access to the lower world price
Triangle B is producer surplus
Producers lose customers to imports and have to produce at the lower world
price
Triangle C represents the gains from trade, which all go to the consumer, who gets
to enjoy lower prices
Total social welfare increases

Triangle D is the value of the goods imported
Failures of the Perfectly Competitive Model
Market failures
A market failure is when competitive markets fail to produce socially desirable outcomes
Two types of market failures exist
(1) Externalities
(2) Public goods
Addressing these market failures is one of the most prominent roles of government in our
economy
No externalities
Externalities are costs or benefits that affect a third party uninvolved in the activity or
transaction in question
Individuals usually do not factor externalities into their decision-making because they do
not pay the costs or receive the benefits
Externalities take two forms
Negative externalities occur when an individuals (or firms) decision imposes some harm
on others
The individual does not have to pay for this harm and, consequently, does not factor it
into his or her decision
Negative externalities thus lead to situations that are not socially optimal
Example: Jons Wall of Sound may produce noise pollution (a negative externality) as a
byproduct of its being loud
When Lame Lucius walks by, he incurs a cost in the form of hearing damage
Ideally, Jon would factor the social cost of noise pollution into his decision-making
and turn his volume down
Since Jon does not factor in this cost, however, Jon is louder than is optimal for
society
Positive externalities result when an individuals (or firms) decision results in positive
effects for society or other individuals
Since the individual does not benefit from these effects,
he does not factor them into his decision
Positive externalities also lead to suboptimal situations
They do not provide enough of an incentive to

encourage decision-makers to repeat their behavior
resulting in the positive externality
Example: Gardener Gary might plant a large patch of
fresh roses on his front lawn
Though Gary was the only person involved in

planting them, neighbors and passers-by enjoy the
roses sweet fragrance
The strangers olfactory pleasure is a positive externality 68
68
Assuming the strangers dont have allergies to roses or overzealous shnen stereotypes.
Garys neighbors, Ash and Misty, of course, want him to plant more roses so they
can enjoy even more of the scent
The positive externality (their happiness) does not, however, encourage Gary to
plant more roses
Consequently, Gary plants fewer roses in his lawn than is socially optimal
Externalities enter the competitive market model when agents internalize costs or benefits
An individual internalizes a cost when he pays it directly (building it into the market)
An individual internalizes a benefit when he enjoys it
An individual takes costs or benefits into account only when he internalizes it

Taxes, fines, and regulations can internalize the costs of negative externalities
These measures discourage an activity by increasing its cost
In our example, a loudness tax may encourage Jon to turn down his Wall of Sound
Subsidies, tax incentives, and other inducements can internalize some of the benefits
from positive externalities
These measures encourage an activity by increasing its benefit
Gardener Gary would be more likely to plant more roses in his garden if Ash and
Misty chipped in to help cover the cost of the flowers
Internalizing externalities help move the individual (or firm) toward the socially
optimal level of activity
Even for a negative externality, the optimal level is not zero
The activity that generates the externality still has a positive value
The cost of reducing this activity too much outweighs the additional benefits of reducing
the externality
We can depict the true social cost of production by shifting the supply curve left (for
negative externalities) or right (for positive) by the cost of the externality
Market participants have incentives to attempt solving problems that externalities create
Often, the two parties pay off one another to prevent or encourage the externality
Another approach is to internalize the externality
According to the Coase Theorem developed by Ronald Coase, private parties should be
able to resolve inefficiencies created by externalities
But the parties need to be able to negotiate with each other
And property rights need to be clearly defined
Despite these simple conditions, externalities are a major problem
In many cases, property rights are poorly defined
The costs of negotiation may be too high

Pollution is a good example
Many people suffer mininal harm from pollution, so the total effect is large
But because the individual effects are small no one has any incentive to negotiate,
and a lawsuit would be long and drawn out
Where private negotiations fail, governments step in
Some use taxes or subsidies to correct externalities
Using taxes is most effective when the externalitys value is easily estimated
Otherwise, using a quota works as well
A quota is a numerical limit on how much of something is allowed
One problem with using a quota is that the people who value the good or service
the most may not get it
This can be resolved by creating a market where people buy and sell the permit for
that good or service
Property rights and public goods
One of the most prominent institutions is property
69
Even though property is a very familiar concept, it is incredibly nuanced
For most of us reading this, the property rights seem natural
Property rights are not natural, however, but are a social innovation
Goods in general fall under one of four categories
Four Types of Goods
Rival
Non-Rival
69
70
Excludable
Non-excludable
Private Goods
Common Resources
(food, clothes, cars)
(crowded free roads, fishing ponds)
Collective Goods
Public Goods
(uncrowded toll roads, electricity)
(national defense, air)
Each category is characterized by rivalry and excludability

One persons consumption of a rival good prevents others from using that same good
Example: If Colin is using the floor microwave to heat up his lunch, his suitemate
Creevey cannot use the microwave
The microwave is a rival good

If a good is non-rival, one persons consumption of the good does not limit other
individuals use of the good
National defense is a common example of a non-rival good
Everyone in the United States enjoys the protection of the government
No ones enjoyment of this protection inhibits anyone elses safety 70

Access to an excludable good can be limited
Example: Suppose Rincewind loves orange juicehe buys five gallons of it per week
Rincewind can prevent Twoflower, who also loves orange juice, from buying his OJ
Rincewinds orange juice is an excludable good

No one can prevent other individuals from consuming non-excludable goods
A common example is air

Property rights ensure the security of private goods
Owners of private goods can exclude other persons from using their goods
Owners of private goods have the right to dispense, rent out, or lease their own
private property to others
Slices of pizza, computers, and toy alpacas are private goods

Common goods or resources are rival and non-excludable
The tragedy of the commons plagues these types of goods
Individual users may exploit or overuse a common resource, thus degrading (or
even destroying) that resource
Environmental situations like excessive fishing and overgrazing of communal

farmland, are examples of the tragedy of the commons
Property law is unfathomable. Sujay

In theory; Anyone in this case, only refers to Americans.
People do better when they decide collectively what to do with these goods, since
externalities are internalized
Usually, these goods are the sources of externalities

Society at large holds public goods
These goods are non-rival and non-excludable
Since public goods are non-rival, the marginal cost of providing them is near zero
Public goods include publicly funded transportation systems (like highways), public
education, public parks, clean water, and the global environment
When public goods are provided, the quantity supplied will be too low
Since public goods are available to consumers at no marginal cost, there is a rational
incentive to overuse or abuse them 71
Collective goods are non-rival but highly excludable
72
Collective goods are easily privatized and tend to be natural monopolies
Since these goods are non-rival in consumption, the marginal cost of producing them
is nearly zero
Monopolies can profitably supply these goods, but have the tendency to set prices
too high and supply too little
For this reason, governments like to regulate or directly provide collective goods
Good examples are satellite radio and pay-per-view television
As mentioned before, public goods are a major source of externalities 73
Government intervention usually helps negate the effects of the externalities
Imperfect Competition
Market power
Perfect competition is an approximation for the economy

At the same time, the markets for some very important products are dominated by a few very
large firms
Computer operating systems
Commercial airplanes
Automobiles
Air travel
Mobile phones
Other times, only one supplier of a good exists
Electricity
Water
Cable television
Markets with only one or a few suppliers are imperfectly competitive
Just like firms in perfectively competitive markets, firms in imperfectly competitive
markets want to maximize profits
Unlike perfectly competitive firms, however, these other firms face a downward sloping
demand curve
Their decisions about how much to supply affect the price they get
Firms with a downward sloping demand curve possess market power
71
Because clean air is totally overrated. I was never a huge fan of breathing anyway. Christina
These are discussed in the next section on imperfect competition.
73
Public goods cause the free-rider problem. Consider roads, which are neither rival nor excludable. Who would pay for the
construction and maintenance of roads? The answer is no one. Everyone would just wait for someone else to pay for it and then use it
for free. Government solves this by forcing everyone to pay taxes to fund the roads.
72
Instead of taking prices as given, they choose their price

The price and quantity available for firms to choose from are determined by the
market demand
Monopoly
If the number of firms decrease to one, we are left with a monopoly
Monopolies can purposefully create scarcity, called contrived scarcity
Under contrived scarcity, the monopolist produces less than what consumers demand
at the given market price
Contrived scarcity drives up profits while simultaneously leaving some consumer
demand unmet (thus decreasing the general welfare)
In other words, monopolies produce less and charge more than is socially optimal
Monopolies impose a welfare loss on society primarily through contrived scarcity
By producing less and charging more, monopolies are able to capture some of the
consumer surplus as producer surplus
Even more of the consumer surplus disappears and no one benefits
This lost surplus is called a deadweight loss
It is surplus lost by consumers but not regained by producers

Monopolies can be inefficient due to lack of competition
While monopolies are profit-maximizers, they can produce inefficiently due to laziness,
incompetence, or lack of having competitors around to keep them on their toes
In competitive markets, efficient firms run inefficient firms out of business
Monopolies can remain inefficient, which results in wasted resources, higher

production costs, and higher prices for consumers
One can distinguish between monopolies that have earned their position and those
which have not
Microsoft is a monopoly that has arguably earned its position in the market for PC
operating systems
It provides products that consumers demand and maintains a level of innovation

Economic profits can reward such successes
Long-term monopoly can give a firm a stable position that facilitates innovation to
maintain economic profits
Monopolies arise from barriers that prevent competitors from entering the market
(1) Ownership of a key resource
Most residential electricity is a monopoly since one company owns the retail electricity
distribution system
The diamond industry also tends towards monopolies
Until early this millennium, the DeBeers company owned 80% of the worlds
diamond mines
(2) Government-created
These barriers to entry include patents, copyrights, and other property protections
If the government gives someone a patent, the inventor gets the exclusive right to
use the technology for 20 years in exchange for revealing the details
An author is a monopolist over their book under copyright laws

These barriers allow a firm to operate exclusively in a given market for a period of time
Government licensing or similar regulations can create artificial monopolies if the
government authorizes only one firm to provide a good in a given region
(3) Natural monopolies
Natural monopolies emerge when economic conditions make it practical for one seller
to operate in a given market
Natural monopolies emerge through economies of scale
If a natural monopoly exists, it is economically preferable for only one firm to

operate
Usually, there are large fixed costs that cause the firms average costs to fall as
more goods are produced
In this case, the government usually works to regulate the natural monopolist to
ensure public welfare
Natural monopolies often result from market forces or the nature of producing
certain goods
Example: Train services and utility companies (electricity, gas, water, etc.) are
typically natural monopolies
Three most important

barriers to entry for
monopoly
Ownership of a
key resource
Government
intervention
Natural
monopolies
Monopoly supply is very similar to supply for a perfectly competitive firm
Like a firm in a perfectively competitive market, a monopoly will set their price and
quantity supplied where marginal revenue equals marginal cost
Unlike a perfectively competitive firm, increasing supply until marginal revenue equals
marginal cost increases economic profits
No other firms can enter the market and drive economic profits to zero
The presence of monopolies has two effects
(1) Consumer surplus is transferred to the monopolist
Demanders still buy the good at the monopolys price
These same demanders, however, would have been able to purchase the same product
at a lower price in a perfectly competitive market
(2) Overall social well-being decreases
In a monopoly, supply is restricted to be less than the competitive quantity
The additional quantity would cost less to supply than the amount that consumers
value it
The monopolist will not supply that amount, since doing that would reduce the
revenue it gets from those willing to pay the monopoly price
Governments have devised their own methods for dealing with monopolies
(1) Use of legislation
In 1890, the Sherman Anti-Trust Act was passed in the United States
Large mergers and acquisitions are reviewed to ensure they do not reduce competition
in certain markets
Additionally, large companies can be broken up or other steps taken
In 1984, AT&T was broken up
Recently, Microsoft was required to unbundle Internet Explorer from Windows

(2) Regulation
Many natural monopolies are allowed to exist but are closely regulated
Public utilities are not allowed to set prices independently
Public oversight agencies often approve their rates
(3) Public ownership
Municipal governments often local services
Water
Sewer
Sanitation
Firms separate their customers into different groups
This strategy is called perfect price discrimination
Price discrimination is the act of charging different consumers different prices
Obviously, each consumer values certain goods at different prices
Ideally, a firm could choose to charge different prices to customers based on how much
they valued that good
The firm could avoid negative effects of expanding sales
Normally, to expand sales a firm would have to lower its prices
With price discrimination, a firm will not suffer such effects

Such a firms marginal revenue curve would be identical to the market demand curve
Price discrimination allows monopolies to capture more profits
The monopoly captures more of the benefits produced by each transaction
Complete, perfect price discrimination transfers all consumer surplus to the

producer as profit
Fortunately, price discrimination increases social welfare
The market moves closer to the socially efficient quantity

For price discrimination to be successful, a firm must be able to meet two requirements
(1) It must separate the market into two or more groups based on their demand
elasticity
(2) The firm must prevent the resale of its products
In other words, those who are buying the good for less than others must not be
able to resell the good to those who would otherwise pay more
Example: Assume Farsighted Farah plans to vacation in San Francisco on April 10
She books her flight a month in advance with Generic Airlines and pays $150 for
her round-trip ticket
On April 7, Businessman Brandons boss tells him he needs to go to San Francisco

on April 10 to meet with some clients
Brandon also books his round-trip ticket with Generic Airlines
His round-trip ticket costs $325
This scenario is an example of price discrimination
Brandon and Farah are purchasing the same good, but Brandon is paying more
Brandons demand for the flight is relatively inelastic
He has to go on a specific day, and there are not many days left before the flight by
the time he buys his seat
Farahs demand, on the other hand, is relatively elastic
She has plenty of time to choose the airline she wants
Her schedule is, presumably, somewhat flexible
Because of their differing demand elasticity, Brandon is willing to pay more for
a ticket than Farah is
The airline price discriminates by charging these two customers different amounts
in attempting to capture each consumers surplus
Price discrimination restores some efficiency lost when firms with market power increase
the price above the market price
Price discrimination allows consumers who would not be able to afford the higher
price to purchase the product
It is not as efficient as pricing in a perfectly competitive market
Of course, companies rarely discriminate perfectly between customers

However, they can split consumers into different groups
Cable companies offer differently priced packages of channels
Movie theatres often have discounts for children and for seniors
Airlines discount those willing to stay over a Saturday night
Colleges offer need-based financial aid, effectively reducing tuition for needy
students
Oligopoly
Few industries are truly monopolies
In most cases, a small number of producers supplies most of the market
Tennis balls
Breakfast cereals
Aircraft
Electric light bulbs
Washing machines
Cigarettes
A market with a few interdependent firms is an oligopoly
Firms in an oligopoly feature highly differentiated products or homogenous products
In either case, oligopolistic markets have long periods of price stability
There is almost no price competition, only non-price competition
Oligopolies are common in the real world
The car market is an oligopoly of highly differentiated products
The market for steel is an oligopoly of homogenous products
The most notable oligopoly is OPEC
OPEC (Organization of Petroleum Exporting Countries) is an oil cartel that

manipulates crude oil prices
In 1972, oil was $11 a barrel
OPEC played a major role in raising prices to $35 a barrel in 1981

Collusion is a common characteristic of many oligopolies
Collusion occurs when firms cooperate to artificially raise market prices by restricting
supply
Producers must consider both the downward sloping demand curve in a certain market, as
well as the choices of other producers
A group of firms that colludes to control prices is called a cartel
Cartels are illegal under U.S. anti-trust law 74

A cartel essentially acts as a monopoly because all the firms work together
The main problem with collusion is the high incentive to cheat
Since the market price is artificially high and the quantity supplied is artificially low, a
firm could make a lot of profit by supplying more than the other firms
Doing so, however, would drive up the market supply and, in turn, decrease the
market price
The other firms in the oligopoly would have to follow suit and lower their prices,
resulting in price competition
Thus, the collusive agreement effectively self-destructs
In 1986, oil prices collapsed back to $13 a barrel when the OPEC countries
ceased limiting production
Due to the threats of a price war and the incentive to maintain profits, oligopolies
generally work together (outside the United States)
Firms in an oligopoly benefit from working together, making them interdependent
Each firm relies on other firms to maintain the same prices
But given incentives to cheat, oligopolies become very unstable
Oligopolies become more stable when members have a way to sanction cheaters such as
imposing costs or punishments
Oligopolies, like all other firms, maximize profits by equating marginal revenue and
marginal cost
For an oligopoly, the outcome will be between the extremes of monopoly and perfect
competition
Without numbers or knowing the specifics of each market, we cannot say exactly
where
We can say that an oligopolistic market results in some reduction to social welfare, but
the degree of reduction depends on the market
Monopolistic competition
The most common type of market is the monopolistically competitive model
Book publishing
Restaurants
Clothing
75
Breakfast cereals
Local service industries
Markets with a large number of firms and product differentiation are in monopolistic
competition
Product differentiation is the difference between similar goods in the market
Example: Computers all do the same thing, but consumers differentiate between Apple
computers, HP computers, and so on
Many competing sellers exist in the market, so firms do not have absolute market power
Some barriers to entry exist, giving monopolistic firms some control over price (some
market power)
Firms in a monopolistically competitive market still produce at a point that maximizes profits
In a monopolistically competitive market, a firm can charge a price above the market price
But not any international laws.

My team had an argument about whether cereal belonged to an oligopoly or a monopolistically competitive market, since its listed
under both. Our conclusion was that USAD needed more proofreaders. Seriously, if it does come up, dispute it. - Sophy
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75
Like all other firms, they will produce where marginal revenue equals marginal cost
Since the firms demand curve slopes downward, marginal revenue is less than price
At this point (where marginal revenue equals marginal cost), market price is greater
than marginal cost of production
A firm in a monopolistically competitive market will not earn economic profits
Barriers to entry in a monopolistically competitive market are at most low
Firms can easily enter and start supplying similar goods and services
Existing firms will see their demand curves shift left, and profits fall
Product differentiation causes firms to engage in non-price competition
Advertising, branding, and other activities allow a firm to make its product stand out
from alternatives
Doing so allows a firm to charge consumers a high price for its differentiated product
Monopolistic firms use advertising and marketing to gain market power so they can
imitate monopolist pricing techniques
Advertising does not make sense in a perfectly competitive market because all
goods are the same
Advertising is also not necessary for a monopolist because there are no other sellers
Advertising may play other roles, however, such as boosting demand for the
product among consumers who may not otherwise demand it
Differentiated products present a barrier to entry for new firms because they must be able
to differentiate their product successfully before they can compete
Product differentiation is an extremely expensive advertising process
The fashion industry is a great example of monopolistic competition
Brands spend huge sums on advertising to differentiate their products from the rest
Several points must be noted about monopolistically competitive markets
(1) Since price is greater than marginal cost, some social inefficiencies exist
Some consumers value a product at more than the marginal cost of more production
The failure to take advantage of this is a failure to exploit mutually beneficial exchanges
Monopolistically competitive firms have an incentive to restrain production
(2) Diversification of products in a monopolistically competitive market gives consumers
more choices
Types of Markets
Monopoly
Oligopoly
Less competitive
Less efficient
Monopolistic Competition
Perfect Competition
More competitive
More efficient
Creative Destruction: the Profit Motive and the Sources of Economic Change76
Economic profits
Economic profits, as seen, are a payment above and beyond the opportunity wage
Self-interested economic agents want to identify opportunities to earn economic profits
Economic agents can achieve economic profits by escaping the constraints of competitive
markets
76
Long title, one of the shortest sections in the packet
Producers create barriers to entry that in turn create imperfect competition

Entrepreneurship
To establish market power, firms can innovate
Entrepreneurs are individuals who take on the risk
of creating new products or services, new markets,
or new methods of production
Although risk is high, entrepreneurs can earn
significant economic profits by being the first to
market a new product
For scientific innovations, entrepreneurs can
obtain a legal monopoly through patents
In other cases, market power arises because
entrepreneurs can differentiate their goods from
others in the market
(1) Defining the desirable characteristics of

their product
(2) Possession of trade secrets

While innovation create barriers to entry, it can also
break down existing market imperfections
Profits encourages efforts to invent around existing
barriers to entry
Creative destruction
Economist Joseph Schumpeter described the impact of entrepreneurs as creative destruction
Continuing to develop new and improved products is one of the key sources of long-run
improvements in well-being
The opportunity to earn economic profits is the catalyst of creative destruction
Many economists think the inefficiency of market transition is a small price to pay for innovation
Institutions, Organizations, and Governments
Collective decision-making
Collective decision-making institutions are used to overcome the effects of departures from
perfect competition
Analyzing how collective decision-making processes emerged in modern economies is
extremely complex
But, analyzing them is important
Economists believe that worldwide variations in standards of living and how to deal with
such differences stem from challenges in collective decision-making
Institutions and organizations
So far, we have analyzed human interaction and decision making in a vacuum
We state that markets organize buyers and sellers together
However, we have not really given a good description of how they do so
Markets rely upon institutions to ensure that they function properly
Institutions are formal or informal rules that structure human interaction
Institutions set the rules of the game
They ensure functioning of markets by facilitating exchange
Institutions can include government institutions, private institutions, laws, regulations,
and even general codes of conduct or social norms
Most markets are also institutions

Like institutions, organizations also organize human interactions
Unlike institutions, the rules and structures of organizations are more formal
Examples include commodity and stock exchanges
Corporations and organized religions are organizations as well
Institutions and organizations require voluntary cooperation to be effective
Self-interested individuals only conform to the rules of organizations and institutions as
long as such cooperation makes them better off
As we have seen, there are powerful incentives to cheat on voluntary agreements
Government
Compared to institutions and organizations, governments possess two distinctive powers
(1) Ability to tax its citizens
Businesses only earn revenue through selling products, and only if consumers are
willing to buy
Governments ability to compel payment of tax is not absolute
Citizens are free to move between cities, counties, and states
If they do not like the level of taxation in one area, they can move elsewhere
European Union members are free to move from one country to another
Usually though, international mobility is limited
The United States imposes significant restrictions on legal immigration

(2) Legal monopoly on the legitimate use of force
Government uses force for three purposes
(1) To restrain criminals
(2) To compel military service 77
(3) To protect national security

Clearly, governments ability to use force underlies its ability to collect taxes
In most cases, this ability compels citizens to act in ways that are not in the
individuals immediate self-interest
Things such as taxes are essential to support a system of private property
The whole system of voluntary exchange rests on the assumptions of private

property rights
Government supports a broader range of voluntary cooperation than otherwise possible
Governments enforce contractual obligations
Contracts are agreements entered into voluntarily because both parties anticipate that
they will gain from the agreement
If circumstances change, one party might regret entering into the contract
Without the court system, individuals would be more reluctant to enter into them
Government is not all good deeds 78
Governments can also be a source of inefficiency and corruption
Remember that elected officials and government employees are self-interested individuals
Their interests may diverge from the majority
Economics identifies these conflicting forces more clearly
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Even in the United States, men over 18 register for Selective Service. Its not a draft, but it could become one if needed.
Its our wonderful, condescending economics resource guide. Of course it isnt.
Pork barrel politics

Pork barrel politics refers to the tendency for elected officials to steer money to their
constituents by introducing projects
Naturally, that legislators constituents are happy with the projects
Together, these pet projects increase the cost of government
Suppose a member of the House introduces an amendment to a bill that will bring $10
million in benefits to his districtbuilding a new high-tech highway overpass
The cost of the program to the federal government would be $15 million
To the community in question, however, the cost would be a tiny fraction of that
By supporting a fellow colleagues pet project, the other voting legislators can get votes for
their own pet projects
Vote trading among elected officials is termed logrolling
Such vote trading accounts for some degree of wasteful government spending
In 2010, pork barrel projects consumed 0.45% of the federal budget
Rent seeking
Inefficiencies arise when gains from government programs are concentrated while their costs
are spread widely
Currently, the United States provides price supports for domestic sugar growers
Additionally, the United States restricts importing cheaper sugar
Overall, U.S. sugar prices are almost twice world levels
The cost to U.S. consumers exceeds $1 billion a year
Spread across 300 million people, however, the cost per person is small
Sugar growers can hire lobbyists to influence legislators to continue price supports
Most voters are unaware of these policies
Even if they were, most would find the effort to counter them not worth it
Even projects with more benefit than cost can generate wasteful resource allocation
Lobbyists compete to influence the location of expensive federally supported activities
These lobbyists spend a lot of money
Rent seeking refers to activities that redirect, rather than create, economic benefits
Most lobbying and petitioning of government is rent seeking to a certain degree
The public does not gain from constant lobbying
What is the proper role for government?
Deciding the proper role for government lies in the realm of normative economics
People differ in their opinions on size of government and the extent of its influence
Economics illuminates the issues at hand and frames the choices of citizens more clearly
Government is not essential to a market economy
However, since governments enforce the law, more exchanges occur with than without them
Most of us accept losing some autonomy in exchange for individual and property protection
Unconstrained government can become intrusive and reduce individual freedoms
MACROECONOMICS
POWER PREVIEW
This section covers the basics of
macroeconomics. We will construct two
different models in the process of
understanding the economy better. These
models will then be applied to government
policy and international trade.
POWER NOTES
30% of the exam (15 questions) will focus on
macroeconomics
18 questions from the USAD practice test are on topics
from this section
This section loosely covers pgs. 57-103 of the USAD
Economics Resource Guide
Macroeconomic Basics
Economics on the national level

Different perspectives often exist within the same field
Biologists who study proteins use different approaches than those who study ecosystems
Both sets of biologists, however, rely on the same set of fundamental principles
Economics is much the same way
Macroeconomics is the study of national economies
The models and data that economists use to study entire economies differ from those used
to study markets within these economies (such as in microeconomics)
Long- and short-run issues
Macroeconomics is concerned with two questions
(1) The factors that affect things in the long-run
Size of economies
Standard of living
Two
Price level
questions
(2) The causes and consequences of short-run
fluctuations
Level of economic activity
Unemployment
Long-run
Short-run
Inflation
Additionally, economists have developed aggregate
Level of
economic indicators to describe the performance of
Size of
economic
economies
national economies
activity
Gross Domestic Product (GDP)
Cost of living
Standard of
79
Unemployment
Unemployment rate
living
Macroeconomic Issues
Price level
Inflation
Economic growth and living standards
Real Gross Domestic Product (Real GDP)
measures the total quantity of goods and services
produced in an economy in a given year, adjusted to remove inflation 80
Since 1900, real GDP for the United States has increased by a factor of nearly 32
79
80
Unemployment is a state of being, unemployment rate is a number (glossary). These will be touched on later.
GDP and its variations will be studied more in-depth later.
Naturally, there are some ups and downs

81
The Great Depression , from 1929 to 1933, featured a decline in output
Output expanded from 1941 to 1945, during World War II
Overall, the impact of individual events is dwarfed by expansion of the total economy
At the national level, the amount people consume is limited by the amount produced
Since population has been increasing, it follows that production has risen as well
Output has grown much faster than population since 1900
The United States population has only increased by a factor of four since 1900
This data implies average output per person since 1900 has risen by a factor of eight
Output (or GDP) per person is also termed output per capita
The phrase per capita comes from Latin
Literally, it means per head
Per capita is commonly used to denote averages for entire populations
Average output per capita naturally indicates what the typical person can consume
Average labor productivity is a measure of how much the typical worker can produce
Mathematically, average labor productivity is equivalent to the economys total output
divided by the total number of workers employed 82
Average labor productivity =
Economy' s total output (national GDP )

Total number of wor ker s
Variations in production per person can be very large
In 2008, the average output per person in the United States was $43,000
Chinas population is five times that of the United States
Chinas total output is only a fraction of the United States
Production per person is about one-fifth (20%) of the United States
This is about 5% of the United States output per capita 83

The countries with the lowest level of production per capita are located in Africa
In Ghana, output per person averages $458
This value is just over 1% of output per capita in the United States
This is less than $2 per day

Even the poorest citizens of industrialized nations enjoy many things that the average citizen in
a poorer country cannot
Human happiness depends on more than just material levels of consumption
(1) Living a long and healthy life
(2) Access to education
(3) A clean environment
Still, the material resources that higher levels of production create make these things possible
The business cycle
The economy alternates between periods of growth and decline
81
PSA to all my 2011 Decathletes: Grapes of Wrath. The New Deal. Ella Fitzgerald. Artesian wells. Okay, Im done. Cat
Output per capita would be total output divided by the entire population. After all, not everyone works.
83
On a multiple choice test, I guess itd be smart to rule out any options that dont have a 5 in them.
82
The business cycle represents the cyclical
fluctuations in total output, or real GDP, that

most economies experience
Though the business cycle features periods of
growth and decline, the general trend of the
cycle is upwards
An expansion (or upturn) occurs when the
economy shows an increase in real GDP
Expansion continues until the economy
reaches a peak
By definition, a downturn occurs after a peak
Real GDP begins to decline
A recession occurs when the economy
experiences a persistent downturn
An extremely severe recession is called a
depression
The Great Depression from 1929 to 1933 is the most severe episode of economic decline
observed to date 84
Recessions continue until the economy reaches a trough, after which the economy begins
to expand again
The National Bureau of Economic Research defines a recession as a significant decline in
economic activity spread across the economy, lasting more than a few months, normally visible
in real GDP, real income, employment, industrial production, and wholesale-retail sales
Most governments work to moderate the business cycle through policy
Expansions are dampened to prevent inflation and to ease future downturns
Recessions are dampened to relieve social problems (such as unemployment)
The United States economy has experienced business cycles, just like any other economy
Business cycle fluctuations are one of the fundamental features of the economy that
macroeconomics attempts to explain
One central focus of macroeconomic policy is to reduce the severity and durations of
periods of recession
Unemployment
Apart from output, macroeconomists are concerned with employment, a measurement of what
fraction of the labor force has a job
Unemployment is the state of actively seeking paid work and not finding it
The labor force of a given economy includes all members of the population who are employed
or actively looking for work (unemployed)
In other words, the size of the labor force is equal to the number of people employed plus
the number of people unemployed
Only adults (ages 16 and over) who are not incarcerated (in jail) can count as part of the
labor force
The percent of the eligible population of an economy which is in the labor force is known
as the labor force participation rate
An individual is only counted as participating in the labor force if he is either
employed or actively looking for work
84
As opposed to the Pretty Bad Depression, Mediocre Depression, and That Wasnt Bad At All Depression Cat
Stay-at-home moms and dads, retired persons, children, those serving in the armed
forces, and other individuals not looking for work are not counted as part of the labor
force
A critical factor impacting the participation rate is the number of women in the workforce
The entry of more women into the workforce over the last half-century has significantly
increased the participation rate in the United States
The employment rate is the number of persons employed divided by the number of persons in
the labor force
The unemployment rate is the number of persons unemployed (but still in the labor force)
divided by the number of persons in the labor force, 85 usually expressed as a percentage
The number of unemployed persons in a given economy is equal to the number of people
in the labor force minus the number of people who are employed
Adding the employment rate and the unemployment rate should always yield 100%
(barring statistical discrepancies)
With a high unemployment rate, finding work is difficult
People who do have jobs find it harder to get promoted or to get a pay raise
This phenomenon goes hand-in-hand with the fact that the unemployment rate goes
up during recessions and down during expansions
Keep in mind two important things
(1) Unemployment is never zero
Somewhere out there, someone is looking for a job
New job-seekers are always entering the market 86
Within industries or regions, fortunes are always changing
Even during the Great Depression, some companies were hiring

(2) The American unemployment rate has not increased in the long-run
The Bureau of Labor Statistics (BLS) is responsible for measuring the unemployment rate
each month
The BLS surveys about 60,000 households a month
Everyone in the population aged 16 and over belongs to one of three categories set by the BLS
Employed
An employed person worked for pay (full- or part-time) during the past week
Otherwise, the person is on vacation or sick leave from a job
Unemployed
The person in question did not work during the past week
The person, however, made an effort to find paid work during the past four weeks
Out of the labor force
The person did not work in the past week or try to find work in the past four weeks
The person could also be a member of one of the groups mentioned above
(incarcerated, military, too young, retired, homemaker, etc.)
Each month, the BLS collects data on the U.S. labor force
85
86
The labor force, NOT the total population.

I double entered the job market this June. Doing DemiDec and working a retail job is beyond exhausting. Cat
Group
Number of people (in 1000s 87, 88)
Adult, non-incarcerated population
236,086
154,577
Labor force
Employed
139,649
Not in labor force
Unemployed
14,928
81,509
In 2009, the labor force participation rate was about 66%

Overall unemployment was 9.7%
Among sub-groups, this statistic differed
Group
Unemployment
All workers
9.7%
Teenagers
25.5%
Black / African American
15.1%
Hispanic or Latino
13%
Adult men
10.1%
White
8.9%
Adult women
7.6%
Unemployment is generally categorized in three ways
87
88
Structural unemployment is unemployment which results from changes in the goods that
consumers demand or changes in technology
For workers experiencing structural unemployment, the rest of the economy may be in
perfect health while they are out of work
Not enough jobs exist in a specific market for the number of workers who want jobs
Structural unemployment ultimately results from a mismatch between the skills a
worker possesses and the skills demanded by the market
In the 1980s, the U.S. steel industry contracted while the computer industry expanded
Unfortunately, laid-off steel workers were mostly located in the industrial northeast
Most of the newly expanding industries were located in the Sunbelt
Many of these workers lacked the skills to pursue jobs in the new industries
Structural unemployment can only be reduced by retraining workers for new jobs
Structural unemployment is persistent unless the labor force catches up with demand
Cyclical unemployment is unemployment which results from changes in the business cycle
If the economy is in recession, unemployment will be above normal
If the economy is growing, then unemployment should be lower than normal
Example: Unlucky Ulysses works at United Steel
Faced with a severe recession, United Steels sales fall drastically, and fires hundreds
of workers, including Unlucky Ulysses
Unlucky Ulysses is cyclically unemployed
So just stick three zeros onto the end of each number and youre good.
This data is from August 2009.
Frictional unemployment is unemployment which results from looking for work

Frictional unemployment results from the time-lag between when a worker is fired or
quits his or her job and when he finds a new job
Relocation, as well as searching, applying, and interviewing for jobs, contribute to
frictional unemployment
Frictional unemployment can never be eliminated because some time lag will always
exist between leaving one job and finding another
Time lags can be reduced, though, by ensuring that a dynamic and flexible labor
market exists so that new jobs are readily available 89
All economies have a natural rate of unemployment
The natural rate of unemployment is the unemployment rate which exists in an economy
at full employment
Full employment is NOT 100% of all adult people have paid jobs
Unemployment can never drop below its natural rate (at least, not for long)
When unemployment drops below its natural rate, firms compete fiercely for workers
To attract new workers, firms have to increase wages (or other benefits), which
increases labor costs
As labor costs increase, the price of goods will also increase, increasing inflation
The natural rate of unemployment can thus be described as the level of

unemployment that corresponds to no inflation
Even when the economy is at full employment, some types of unemployment are
inevitable
Frictional unemployment will always exist to some degree as workers switch jobs
Frictional unemployment is a majority of natural unemployment
Structural unemployment is also a part of natural unemployment
Cyclical unemployment should be negligible in a healthy economy

The natural rate of unemployment for any economy is the overall unemployment rate
minus cyclical unemployment
An economy at full employment has only natural unemployment
The natural rate of unemployment itself can fluctuate due to changes in the market
During the 1970s and 1980s, women entered the labor force and subsequently
raised the natural rate of unemployment
More recently, the natural rate of unemployment has fallen

Inflation in brief 90
Inflation occurs when all prices rise together
It means that the goods people consume are becoming more expensive
Inflation reduces purchasing power, the number of goods and services that a person can
purchase with one unit of currency
The rate of inflation in the United States has varied considerably over time
Prior to 1940, prices actually decreased during certain periods
During the World Wars and the 1970s, inflation was quite high
Since World War II, prices have risen consistently
Since the early 1980s, inflation has been low
Seasonal unemployment is not covered in the USAD resource guidebut it is relatively intuitive. The job market for men who
look like Santa Claus dies in January and revives in November; some jobs only exist, in other words, seasonally. People who rely on
these jobs are seasonally unemployed when their job is out of season.
90
We will return to inflation when discussing CPI/GDP Deflator and money.
89
Macroeconomic MeasurementGDP
Aggregation
Aggregation is the process of combining different things into one variable
Well-constructed aggregates allow us to see the big picture
Aggregation often obscures other important details
Developing economic aggregates is an important branch of macroeconomics
To understand these aggregates and what they tell us, we need to take them apart
Measuring total output: GDP
Economists developed Gross Domestic
Product (GDP) as a way to measure the
The market value of all final goods and
services
produced within a country during a
total output in an economy
specified period of time
While this seems simple, there are several
The formal definition of GDP
important points to note
Market value
In the United States, most goods and services are priced in dollars
It follows that to combine all the different types of things the U.S. produces, we just add up
their dollar values
We have to multiply by the quantity of each good before adding them all up
Since we use market prices, more expensive goods contribute more to GDP
91
Market prices reflect the value the marginal consumer places on that good or service
Goods that have a higher value to consumers have higher prices
These goods contribute more to total output
Final goods and services
Everything we consume results from a complex chain of production activities
Only end products count toward GDP
Intermediate goods are those goods used up in the production of a final good
Intermediate goods are not counted
Excluding intermediate goods ensures GDP is not affected by vertical integration
Vertical integration occurs when industries that manufacture different aspects or parts of a
product are combined
For example, Toyota may own both car assembly factories and steel refineries
The steel is used to make cars
The value of the steel is included in the final price of the cars
Even if another company sold steel to Toyota, the value of the steel would still be
counted in the cars value
By excluding whatever transactions surround intermediate goods, we get the same

contribution to GDP, regardless of industry ownership
Some goods can be either final goods or intermediate goods
Only the portion of production that is sold to final users counts toward GDP directly
The portion that serves as an intermediate good is reflected in the cost of the final products
that it is used for
Capital goods are goods that are produced so they can produce other goods and services
Capital goods are not used up in production
Examples include machinery or factory buildings
Capital goods are counted once in the year they were produced
91
Marginal consumers value a certain good or service the least and will leave the market if the price rises by any amount.
Building capital goods invests in the future

If capital goods were not counted, a country that produced more capital goods would
appear to have a lower GDP than one that made all consumer goods
Within a country
GDP is Gross Domestic Product
Domestic means only goods produced within the borders of the relevant country are counted
Toyota and Honda are Japanese car makers, but cars they produce within the U.S. country
count toward the United States GDP
A McDonalds restaurant in South Korea contributes to South Korean GDP, not U.S. GDP
During a specified period of time
GDP includes items produced within a specific period of time
Usually, economists consider annual or quarterly (three-month) periods
Goods produced in earlier periods are not included
Suppose Intelligent Izzy buys up his fellow crest-makers companies
He then sells one crest-making factory to young upstarts Henry and Takato
The cost of the transaction does not count toward GDP, since the cost of the factory was
counted when it was produced
The 6% commission of real estate agent Ruki does count toward GDP, since her services
were provided in the current year
What GDP measures
Interest in measuring economic output stems back to the mid-17th century
th
In the mid-17 century, Sir William Petty was assigned by the British government to
assess the ability of the Irish to pay taxes to the crown 92
The basis for measuring GDP was developed in the 1930s
To fight the Great Depression the government needed information on economic activity
In 1932, the U.S. Department of Commerce commissioned Simon Kuznets to
develop a system to measure national output
Kuznets presented his findings to the U.S. Senate in 1934

The U.S. perfected techniques for measuring output and collecting data in World War II
In 1971, Kuznets received the Nobel Prize in Economic Science
Despite their usefulness, Kuznets concepts have a number of limitations
(1) It is not always easy to determine what good or service is final
Conventionally, spending on national defense (the military) falls within GDP
Kuznets noted that military spending could be viewed as an intermediate good, since it
enables a countrys citizens to enjoy final goods and services
(2) GDP excludes goods that are not bought and sold in markets
Housekeeping and childcare performed by those in a family do not count toward GDP
But these same services are included when purchased through a market
Over the past 60 years, women have increasingly entered the paid labor force
Some purchased commercially provided childcare and housecleaning
GDP has risen twofold as a result, but the childcare would have taken place anyway
Anything sold on the black market will not be counted in GDP
(3) Measuring GDP ignores activities that deplete natural resources or pollute
Measuring the value of natural resources and the environment is difficult
Only normative economics provides a way to judge what goes into GDP
92
He did a petty good job. Amanda
Ways to Measure GDP
Expenditures equal production

GDP is supposed to measure the quantity of goods and services produced
93
However, goods that are produced are also purchased
Therefore, we can think of GDP as a measure of the total expenditures within a country
There are four categories of purchasers
(1) Households
(2) Firms
(3) Government
(4) Foreign sectorforeign purchasers of domestic goods
For each of these categories, there is a separate category of spending
(1) Consumption expenditures
(2) Investment spending
(3) Government purchases
(4) Net exports
Household purchases are called consumption expenditures or consumption
Consumption is subdivided into multiple areas
Consumer durables are long-lived consumer goods
Automobiles
Washing machines
Furniture
Consumer nondurables are used more quickly
Food
Clothing
Services are intangible
Education
Legal services
Purchase of houses falls under investment, not consumption
Spending by firms on final goods and household purchase of houses are termed investment
Investment is also subdivided
Business fixed investment includes the purchase of capital equipment by firms
Factories
Offices
Machinery
Residential fixed investment is the purchase of new homes and apartment buildings
Inventories are the addition of unsold goods to company inventories
94
Investment does not include purely financial assets (stocks, bonds)
Purchase of these transfers ownership, but does not create new assets
Purchases by federal, state, or local governments are government purchases
These include wages and expenditures on goods
Military spending falls under government purchases
Transfer payments do not fall under government purchases
Transfer payments are the transfer of money from one party to another
Nothing is created during the transfer
93
94
eventually. :P Sophy
This can be confusing, because in common conversation/understanding, we refer to stocks and bonds as investments.
Social security benefits are transfer payments

The interest paid on government debt does not factor into government purchases either
The purchases conducted in the foreign sector are net exports
Mathematically, net exports is the difference between the value of locally produced goods
sold to foreigners and the value of foreign-produced goods bought by domestic buyers
More simply, net exports are exports minus imports
NX = exports imports
When exports exceed imports, the nation is running a trade surplus and GDP increases
When imports exceed exports, the nation is running a trade deficit and GDP decreases
95
The United States is slightly less dependent on trade than other countries due to its size
But trade has been increasing in recent years
96
In the long run, the levels of imports and exports move in similar ways
There have been shifts in levels of imports and exports relative to each other
Up until the late 1950s, the U.S. exported more than it imported
Since the 1970s, imports have exceeded exports

The expenditures method of calculating GDP can be summarized by one equation
GDP = expenditures = C + I + G + NX
Services
C is consumption
I is investment
G is government purchases
NX is net exports 97,98
Consumer
nondurables
Consumer
durables
Household
consumption
Net exports
Government
purchases
Firm
investment
Inventories
Residential
fixed
investment
Business
fixed
investment
This is from the extremely brief section on page 62.

Meaning that imports and exports will either both increase or both decrease in the long run.
97
One of our varsities thought that cigarettes would be a good mnemonic for this (stands for CIGX). Since he was a varsity, we
visibly shunned the idea on principle, but its good for those just starting out.
98
So I had this great idea to use CIG-er-X (Or cigarettes) to remember CIGNX, but the honors on our team shunned it based
on principle. Oh Tad
95
96
Income equals production (which equals expenditures)

We have seen that GDP can be measured with production (output) or spending (expenditures)
GDP can also be thought of as income
When a good is sold, the revenue received is split between workers and owners of the
capital used to produce the good
When technical adjustments are made, the combined income of labor and capital equals
expenditures
Expenditures in turn equal production
GDP = production = expenditures = income
These terms are used interchangeably by economists when discussing the concept of GDP
Real GDP
The problems with GDP and price

The size of GDP depends on the quantity and price of goods produced
Economists need a way to separate the effects of changes in price from changes in quantity
produced
One of the purposes of GDP is to track changes in economic activity over time
In most cases, the quantities of some goods are increasing, while others are decreasing
Prices do not change consistently
Economists construct real GDP by using prices from a single year and converting the current
prices (and consumption) to that year
Real and nominal
Nominal GDP is GDP in prices from the current year
Normally, nominal anything means that it is measured with regard to the current year
Anything measured in real terms is measured with regard to a base year
Measuring Inflation
The CPI
The Consumer Price Index (CPI) is the method governments use to measure inflation
In the U.S., it is calculated each month by the Bureau of Labor Statistics
The CPI compares the prices of a basket of goods between the current year and a base year
The CPI basket includes the goods which an average household would buy on a
regular basis
The main component is housing
For the CPI to work, the variety and quantity of individual items in the basket must be
the same
Changing the make-up of the basket of goods from year to year would make
comparing prices impossible because the comparisons would be between different
goods 99
The baskets vary by income and geographic region, to show differences in
consumption patterns
Every month, the BLS employees visit stores and websites for the items in each basket
The Consumer Expenditure Survey dictates what will be in each basket
The CPI in the base year is always 100
99
Like comparing apples and oranges. Or Star Wars and Star Trek. -Christina
The number represents a percentage

A CPI of 150 would mean that prices are 50% higher than in the base year
A CPI of 90 would mean that prices are 90% of what they were in the base year
In other words, prices have gone down by 10%

To calculate the CPI in a given year (here, t), use the following formula
CPI year =
cos t of bundle year t

cos t of bundle base year
100
The CPI holds practical importance

Social Security benefits are adjusted to reflect changes in the cost of living, which are
determined by changes in the CPI
Many union employment contracts tie wage increases to the CPI
Informally, employers and employees consider CPI changes when thinking about wage
rate adjustments
The CPI has advantages
It captures changes in price for basic consumer goods, which form one of the largest
(and most important) parts of aggregate demand
With CPIs, the inflation rate is easy to calculate
The goal of the CPI is to measure how changes in price affect the ability to maintain the
same level of well-being as in the base year
In actuality, the CPI measures how changes in price affect the cost of a fixed bundle
The CPI tends to overstate the true increase in cost of living
The CPI has shortcomings
New goods and services are introduced all of the time
Over time, changing consumer demands, technology, or other factors may render
the fixed CPI basket inaccurate or irrelevant
For example, VCRs were a significant consumer good ten years ago but are not
important today due to the emergence of DVD players
Goods are not added to the CPI until they gain wide market penetration
The CPI does not account for substitution biases
If one good in the basket becomes too expensive, consumers may switch to a
substitute good
The fixed nature of the CPI does not account for this
The CPI does not account for changes in quality
While the price of cars is certainly more today than it was 15 years ago, part of this
increase is due to the use of more expensive (improved) technology
In 1996, economist Michael Boskin headed the Boskin Commission
This commission reviewed the methods used to calculate CPI
They found that the CPI overstated the rate of price inflation by 1.3% a year
The GDP deflator
An alternative to the CPI is the GDP deflator
The GDP deflator is a broad price index used to correct for price increases in nominal
GDP
The GDP deflator allows us to convert nominal GDP to real GDP
No min al GDP =
GDP deflator
100
Re al GDP
Alternatively,
GDP deflator =
No min al GDP
Re al GDP
100
A GDP deflator of 100 indicates that there is no inflation

A GDP deflator less than 100 tells us the economy is experiencing deflation
A GDP deflator greater than 100 tells us that there is currently inflation
Compared to the CPI, the GDP deflator is less volatile
The GDP deflator rises less at peaks and decelerates less at troughs
Over its entire course, the GDP deflator has risen less than the CPI
The GDP deflator has two main differences compared to the CPI
(1) The GDP deflator only reflects prices of domestically produced goods
The CPI market basket can include imports

In the beginning and end of the 1970s, the CPI rose much faster than the deflator
Rising oil prices pushed the CPI upward
Since oil was mainly produced overseas, the GDP deflator was not affected
(2) The GDP deflator and CPI weight goods and services differently
The CPI uses a fixed basket of goods, while the GDP deflator weights prices by
production level
Therefore, the GDP deflator adjusts to changing consumption patterns over time
The GDP deflator has some shortcomings
This value is difficult to accurately calculate
As a result, it is only published once each year
Consequently, it cant track inflation very quickly
Like CPI, the GDP deflator fails to account for changes in quality
Though the GDP deflator presents a more accurate picture of inflation across the economy, it
is not suitable for guiding government policyit takes too long and is too difficult to calculate
Money100
What is money?
Money is anything with the following three functions
(1) A medium of exchange used by buyers to purchase goods and services
Sellers need to be confident they can use the money they earn selling things to buy things
Therefore, people are willing to hold onto money even if it accrues no interest, because
they gain the ability to complete transactions quickly
(2) A unit of account is a yardstick to establish the values of goods
Unit of account allows us to make comparisons.
Money as a medium of exchange is closely linked to money as a unit of account
Money is used to buy things
Prices are expressed in money terms

Suppose a Pokball is worth 37 vintage records and a Digivice is worth 12 of
Intelligent Izzys crests
If we had a common unit of account, the prices of the Pokball and the Digivice
would be easier to express and compare
100
This section was moved from after financial markets.
(3) A store of value is just what it sounds like, something that keeps its purchasing power
into the future
Sellers can hold onto money for weeks, months, or years before becoming a buyer
Money pays no interest
Wealth is all the value in an economy
To distinguish what makes wealth, economists use liquidity
Liquidity measures how an asset can be converted into that economys particular medium
of exchange
Currency is the most liquid asset
Checking accounts, most stocks and bonds, and shares of mutual funds are highly
liquid
Real estate and antiques are more difficult to sell and therefore less liquid
Commodity and fiat money
Commodity money is money with intrinsic value
The moneys component material has worth
Money made of gold or silver is considered commodity money
During World War II, prisoners of war used cigarettes as money
Fiat money is money with no inherent worth
A fiat is an order or decree
Likewise, fiat money is money by government decree
Most money in the world today is fiat money 101
Medium
of
exchange
Unit of
account
Store of
value
Commodity
money
Money
Fiat money
Measuring money
To analyze the effects of money on the economy, we must know how much there is
In the United States, the stock of money is made up of several things
The money supply is the stock of liquid assets in an economy that can be exchanged for goods
Currency is money in the form of paper or coins and is used in everyday transactions
We are most familiar with currency
Currency can be made of something valuable (a commodity), backed by a commodity,
or based purely on fiat (or faith)
In early America, the government exchanged currency for silver
In other words, American currency was backed by the commodity of silver

Currency is the most liquid form of money
Demand deposits consist of money stored in accounts at banks
101
Fiat money. Dolla dolla bills yall.
Demand deposits can be withdrawn at any time without prior notice

Typically, demand deposits are checking accounts
Demand deposits are more commonly known as savings deposits
Time deposits also consist of money stored in accounts, typically at banks
Time deposits differ from demand deposits in that time deposits cannot be withdrawn
at any time
Time deposits cannot be withdrawn for a predetermined period of time
Examples of time deposits are certain savings accounts and certificates of deposit (CDs)
Money market accounts are another form of deposits that have a variety of restrictions
Money market accounts require a larger initial deposit in exchange for higher returns
on that deposit
Money market accounts limit the number of transactions their owners can make in a
given time period (usually a month)
Money markets also require owners to keep larger balances to maintain higher interest
payments on deposits
Other forms of money include travelers checks, types of liabilities, and Eurodollars
Eurodollars include dollar accounts held outside of the United States
These accounts can be located anywhere
Credit cards and similar devices are NOT considered money
Think of credit cards as a convenient form of an I.O.U., to be paid back later
Credit cards reduce the economys need for money
Credit cards are convenient

There are several different definitions of the money supply 102
Definitions of money supply usually differ from one another based on liquidity
The monetary base, or M0, is the narrowest possible definition of the money supply,
including only coins and paper currency
These are the most liquid forms of money
It includes all currency in bank vaults and held by the general (non-bank) public
M1 is restricted to very liquid forms of money; it is more inclusive than the monetary base
It includes currency in the hands of the public, travelers checks, demand deposits, and
other deposits against which checks can be written
This definition of the money supply emphasizes transactions
M2 is a broader definition of the money supply and includes less liquid forms of money
M2 includes everything in M1 plus savings accounts, time deposits of under $100,000,
and balances in money market funds/retail money funds
Time deposits under $100,000 are considered small
M2 is less liquid than M1 but includes forms of money which are still useful for
everyday transactions
Many economists consider M2 the best definition of the money supply
When trying to memorize things like what is in M1 and M2(explained on the next page), a really good trick is thinking of a scene,
or a story, that involves elements from whatever youre memorizing. Like for M1, I think about a traveler at a bank, who is currently
demanding that he check his deposits. Tad
102
Example Money Supply in a

Recent Year
M1
M2
Dollar amount
(in billions)
Currency
758.7
Nonbank travelers
checks
6.3
Demand/checking
deposits
294.8
Other checkable deposits
306.8
M1
1366.6
Savings deposits
3033.7
Small denomination time

deposits
1218.9
Retail money funds
959.9
Total
6579.1
The Financial System 103
Saving and investment

To an economist, saving happens when someone has more income than he wants to spend
Investment describes the purchase of new capital equipment
Financial institutions coordinate the saving and investment decisions within the economy
Financial markets
Financial markets are institutions where people who wish to save can supply their funds to
those who wish to borrow for investment
A bond is a certificate of indebtedness that specifies the obligations of the borrowers to the
bond holder
104
The sale of bonds is called debt finance
A bond details the date of maturity and the interest rate to be paid until the loan is repaid
The date of maturity is the date when the loan will be repaid
The original amount of the bond is called the principal
The bond purchaser will receive both the principal and periodic interest payments
Usually, large corporations sell bonds to the public to finance their investments
The purchaser of the bond can hold the bond until maturity or sell the bond to
someone else
Market interest rates fluctuate with the fortunes of the marketplace
Subsequently, the price at which a bond can be sold will change to equate the
promised bond payments with the new interest rate
The bond purchaser assumes the risk of this price fluctuation
The longer the maturity of the bond, the greater the risk of changes in price
Borrowers must pay more to the buyers of the bond

The bond purchaser risks that the borrower may default on their obligation by
declaring bankruptcy
103
104
This section was before the money stuff in the resource guide.
Both bond and debt have the letter b in them!
To compensate for this, a borrower must offer high enough rates of interest to their
bond buyers
The United States government is a safe credit risk 105, so it can borrow at lower rates
than private companies
Financially insecure companies must pay high interest rates to attract bond
purchasers
A stock represents a share in ownership for a firm
The sale of stock shares is termed equity finance
A company will sell stocks to make money
Shareholders enjoy benefits if the company succeeds through the payment of dividends
or an increase in the value of their shares
The company will only make money on the initial sell of the stock, not any subsequent
resellings
These new transactions do not contribute to the nations investment
Stocks can be sold on an organized stock exchange, such as NASDAQ (National
Association of Securities Dealers Automated Quotation System) or New York Stock
Exchange (NYSE)
The prices of these shares depend on the supply and demand for shares in the company
The supply and demand for shares of stock respond to the current profits and future
prospects of the company
The ease with which shareholders can buy and sell stock on organized exchanges
contribute to the shareholders willingness to hold assets
Most companies use equity and debt finance
Shareholders receive dividends or more valuable shares if a company does well
The bondholders only get interest payments
If the company runs into trouble, bondholders are paid before shareholders
Financial intermediaries
An intermediary is a third party, acting as a link between two others
Two important intermediaries are banks and mutual funds
Small businesses are likely to turn to banks in order to get the funds they need
Banks get their funds from people who wish to save their money in deposits
Banks give their depositors interest and charge borrowers more than they pay to depositors
Deposits have little risk, since most banks deposits are fully insured and can fund can be
withdrawn whenever the account holder wishes
Banks facilitate purchases of goods and services with checking accounts
Mutual funds allow savers with little money to purchase stocks and bonds
Mutual funds purchase portfolios of stocks and bonds, and then sell the shares to savers
The shareholders of mutual funds assume the risks of decline in the value of the stocks and
bonds in the portfolio
Savers like mutual funds for two reasons
(1) Mutual funds make a high degree of diversification possible
When someone holds the stock or bonds of just one company, that person takes on
a high degree of risk 106
Diversification reduces potential ups and downs
105
Even with all the current concern about the national debt, it remains just about the worlds safest currency for investors. That may
change someday, of course.
106
Putting all of your eggs in one basket.
(2) Mutual funds provide their savers access to the knowledge and insight of
professional money managers
Individuals do not have to closely follow developments in the market
The Federal Reserve System and Financial Markets107
The Federal Reserve

The amount of money in the economy of the United States is determined by the interaction
between three groups
(1) The public
(2) The commercial bank system
(3) The Federal Reserve system
The Federal Reserve System is often called the Fed and serves as the central bank of the
United States
A central bank is created to oversee the banking system of a country and regulate the
money supply
The Federal Reserve was created in 1913
It features 12 regional banks owned by the commercial banks in their respective regions
The Federal Reserve is run by a seven member board of governors
The members of the board are appointed by the President and confirmed by the Senate
The term of each governor lasts for 14 years, to ensure the actions of the Fed are
immune to political pressure
The 12 regional banks oversee commercial banks in their regions and facilitate transactions
by clearing checks
These regional banks act as a bankers bank, allowing them to borrow funds
Whenever a member bank is unable to get funds from other sources, the Fed banks
maintain the stability as a lender of last resort
The task of controlling the money supply belongs to the Federal Open Market Committee
(FOMC)
The FOMC is seven Fed governors and five regional bank presidents
The president of the New York Federal Reserve bank is always a member, but the other
four places on the FOMC rotate
The FOMC meets every six weeks in Washington, D.C.
They assesses the state of the economy and determine if changes in monetary policy are
necessary
Monetary policy are policies instituted by the Fed affecting the money supply, which
influences aggregate demand 108
Changing the money supply
The FOMC can alter money supply with three activities
(1) Open-market operations are the usual means through which the Federal Reserve,
through the FOMC, conducts monetary policy
Open-market operations are the buying and selling of government securities (treasury
bonds)
To increase the money supply, the FOMC buys bonds from bondholders
Buying bonds takes securities out of the economy and injects money into it
107
108
This stuff was located after the money.

This will be discussed later.
To reduce the money supply, the FOMC sells bonds
Selling bonds takes money out of the economy and replaces it with securities 109
(2) Adjustments to the discount rate and the federal funds rate by the Board of Governors
are the next most-utilized ways of conducting monetary policy
The discount rate is the rate of interest which the Federal Reserve charges commercial
banks for loans
Commercial banks will seek loans to meet cash shortfalls or to maintain reserve
requirements
As the lender of last resort, the Federal Reserve acts as the bank for commercial
banks
Commercial banks use the Federal Reserve as a last-resort source of short-term

credit
Lowering the discount rate encourages commercial banks to make loans because
borrowing from the Federal Reserve in case of a shortfall will be less costly
Increasing the discount rate increases the cost of borrowing from the Fed, which
will discourage commercial banks from making loans
The more banks loan, the more money is injected into the economy
Raising the discount rate decreases the money supply
Lowering the discount rate increases the money supply
The Federal Reserve exercises direct control over the discount rate and can set the
rate as it wishes
Commercial banks, can, however, seek other sources of credit
If a bank is forced to borrow from the Federal Reserve, others will think that
bank is experiencing financial difficulty
The federal funds rate is the overnight rate of interest charged on loans between banks
As with the discount rate, banks will loan more at a lower rate, less at a higher rate
More loans means more money in the economy
The Federal Reserve does not set the federal funds rate directly
It can only influence it through market operations
Buying and selling government securities impacts the interest rate as well as directly
influencing how much money is in the economy
(3) The final way the Federal Reserve can conduct monetary policy is by changing the
reserve requirement
The reserve requirement (also known as the reserve-deposit ratio) is the percentage of
deposits which a bank must have on hand at any given time
When banks loan money, the money is taken from deposits given to them by
customers
If all deposits are loaned out, depositors will be unable to withdraw their money
when they want to do so
Reserves are the extra money that banks keep on hand to be able to pay
depositors
If banks run out of deposits, they can collapse and savers may lose their money
This situation happened to many savers during the Great Depression
Ensuring that banks always have a certain amount of money on hand means that
depositors will always be able to withdraw their deposits
109
A nice mnemonic for you: Buy Bonds = Bigger Bucks, and Sell Bonds = Smaller Bucks Lawrence
Making reserve requirements legally binding means that banks will always have to
meet these requirements
If reserves dip below the required amount, banks have to borrow money from
other banks or Federal Reserve to restore required levels
This is one way changes in discount and federal funds rates affect money supply
The impact of changes in the reserve ratio on the money supply can be measured
through the money multiplier (MM)
The money multiplier is the inverse of the reserve requirement (RR)
MM =
For example, if the reserve requirement is 20% of total deposits, then the money
multiplier will be 5: 1 .2 = 5
To calculate the impact of a new deposit in a bank on the money supply, multiply
the amount of the deposit by the money multiplier
If the reserve ratio is 20% and someone deposits $1 million in a bank, the net
result will be a $5 million increase in the money supply:
$1 million x 5 = $5 million
Theoretically, the bank will loan out $800,000 (80%) of the initial $1 million deposit
Eventually, this $800,000 will all be re-deposited, either by the borrower or by

others (such as firms that receive the money as payment for goods)
Of this $800,000 that is re-deposited, 80% ($640,000) will be loaned out again
The cycle continues
Eventually, the impact on the money supply will be an increase of $5 million

If the reserve ratio is decreased, banks have to keep less money on hand
Consequently, they can loan out more funds, increasing the money supply
If the reserve ratio is increased, banks have to keep more money on hand
They cant loan out as much money, and the money supply decreases
Unlike open-market operations and changes in interest rates, changes in the reserve
requirement are initiated by the Federal Reserves Board of Governors, not the FOMC
The reserve requirement is not usually utilized as a policy tool because it alters the
banking system, which creates difficulties for banks
Banks can hold reserves beyond what is required, so as to more easily pay depositors
The reserve requirement is enabled by fractional reserve banking
In a system of fractional reserve banking, banks keep a fraction of their deposits
Depositors still own the money they have deposited in the bank, but banks can
loan this money to borrowers
These loans create additional money, increasing the money supply
Changes in the reserve requirement accelerate or hinder this activity
A banks reserves and the loans it makes are called assets
Likewise, the deposits in the bank are called liabilities

Economists have an equation that shows the effects of changing reserve requirements
on the money supply
The Fed provides M dollars of currency
The public holds C dollars of currency
Therefore, the banking sector holds M C in reserves
The monetary base (M) is the total of currency and reserves
1
RR
R is the fraction of each dollar that banks hold in reserve
Money supply = deposits + C =
M-C
R
+C=
R C+M-C
R
M + (R - 1) C
R
The smaller C or R are, the larger the money supply

Tools Of Monetary Policy
Policy Tool
Who
Acts?
What Happens?
Expansionary/
Contractionary
How Does It Work?
Used How
Often?
Open-Market
Operations
FOMC
The Federal Reserve

buys and sells
American securities
E: Buy securities
C: Sell securities
Injects or removes money

from the economy
Daily
Discount Rate
(DR)
Board of
Governors
The Federal Reserve

changes the interest
rate for loans from
the Federal Reserve
to member banks
E: DR
C: DR
Changes the cost of

borrowing from the Fed
Rarely
Federal Funds
Rate (FFR)
Board of
Governors
The Federal Reserve

changes bank-tobank lending rates
E: FFR
C: FFR
Changes the cost of

loans between all banks
About once
per quarter
Reserve
Requirements
(RR)
Board of
Governors
The Federal Reserve

changes the reserve
requirements for
banks
E: RR
C: RR
Changes the amount of

reserves banks must
maintain
Very rarely
Note that the Federal Reserve does NOT change the money supply by actually creating new
currency (printing new bills and minting new coins)

The printing of new currency requires special Congressional legislation
Instead, the Federal Reserve changes the effective supply of money
This is the M in the above equation
The graphs below illustrate how monetary policy functions
Monetary Policy
Real
Interest
Rate
Investment Rates
Interest
Rate
Money
Supply
Money
Demand
Quantity of Money
Investment
Demand
Quantity of Investment
All of the monetary policy tools serve to increase or decrease the effective money supply
The money supply curve shifts to the left or right if the policy tool is contractionary or
expansionary, respectively
Contractionary monetary policy decreases the money supply
Expansionary monetary policy increases the money supply
A change in the interest rate through monetary policy influences the amount of investment
in an economy
Expansionary monetary policy leads to lower interest rates, which encourages investment
Remember that investment is a component of GDP
Expansionary monetary policy, therefore, increases GDP through increases in investment
Contractionary monetary policy decreases GDP through decreases in investment
Think of the curves as the market for money and the market for investment, respectively
Do not forget that monetary policy refers to changes in the money supply which can only be
done by the Federal Reserve
Bank runs
Fractional reserves are problematic when the public decides it wants to hold more currency
A bank run is a rush of depositors to a bank in order to withdraw their deposits prior to other
depositors
Banks only hold reserves equal to a fraction of their liabilities
Even the solvent banks will be unable to pay all of their depositors
A solvent banks assets exceed its liabilities
Banks will be forced to shut their doors until loans are repaid or borrow more funds
At points like this, the Fed must act as a lender of last resort to prevent disruptions
In the past, bank runs were a frequent source of financial disruption
Saving and investment in aggregate 110
Remember that GDP equals production, income, and expenditures
This equality is an identity
By virtue of being an identity, it is always true
Let us assume that the economy in question is closed to trade
Therefore, GDP = Y = C + I + G
Naturally, I = Y C G
The right side (Y C G) is national savings
This implies another identity, that savings equals investment (S = I)
We can subtract net taxes (T) from each side
S = (Y C T) + (T G) = I
This means that savings is equal to the sum of private savings and government saving
Private savings is the amount of money that households have left over after taxes and
consumption spending
For households, taxes are an expense, but they are income for the government
If government savings (T G) is positive, the government is running a budget surplus
Otherwise, the government is running a budget deficit
Note that whenever the government runs a deficit, it reduces investment, which in turn
reduces the growth of living standards
International capital flows in an open economy
In an open economy, domestic savings no longer have to equal domestic investment
There are two types of international capital flows
(1) Foreign direct investment describes when a company or individual acquires assets in a
foreign country that they will actively manage
Mitsubishi bought Rockefeller Center in 1989
110
The next few sections are actually from after everything on the Fed.
(2) Portfolio investment occurs when an individual or company purchases stocks or bonds
issued by a foreign corporation
Similar to net exports, we now must consider net capital outflow
Net capital outflow (NCO) equals the purchase of foreign capital or financial assets by
domestic residents minus foreign purchase of domestic assets
In an open economy, NCO always equals NX
This holds true because it is an identity
Recall that Y = C + I + G + NX
Rearrange so that Y C G = S = I + NX
Since NCO and NX are the same, S = I + NCO
This means that in an open economy, savings can differ from investment only to the extent
by which the difference is offset by net capital outflow
How financial markets coordinate saving and investment
We will consider a closed economy, the situation will be quite similar
Even though there is a large number of financial markets, they are all closely linked
111
Individuals with excess savings
can easily move their funds between markets to get
the most return
Borrowers have many different markets to choose from
Therefore, we can merge these markets into a single financial market when analyzing them
The financial market features the supply of savings and the demand for savings
The demand for savings is equivalent to investment
The supply and demand for savings are equalized through adjustments of the interest rate
We graph quantity on the horizontal axis and the real interest rate on the vertical axis
In the financial market, the real interest rate acts as the price of a loan
The real interest rate is how much borrowers pay for the loan and how much savers
receive for making the loan
For a lender (saver), saving is a decision to postpone consumption until the future
Lenders do this because they know that by receiving interest, they can consume
more in the future
We graph the real interest rate because that is
Financial Market
what lenders and borrowers consider
Real
Supply of
The real interest rate is the nominal
Interest
Savings
Rate
interest rate minus the rate of inflation
The higher the real interest, the greater
the amount that people will save
This is why the supply of savings is
upward sloping
Savings
The lower the real interest, the more
Demand
investment projects businesses will pursue
Businesses only borrow and invest if
Quantity of Money
they believe the new revenues they can
earn will exceed the cost of borrowing
This is why the demand for savings is downward sloping
Consider three possible changes 112 in market equilibrium
111
112
I dont think I would ever have excess savings, but this is probably a personal failing on my part. Jessica
There are more, but these are the only three USAD mentions.
(1) New, more productive technology shifts the money demand curve out
Interest rates rise and more people save and invest
(2) The government increases its deficit and causes the supply of savings to shift left
Interest rates are higher, but the total amount of saving and investment decreases
(3) The government gives a tax credit that ends up encouraging savings
Interest rates fall, while saving and investment increase
Money and Inflation in the Long Run
Price level and inflation

Over the last 50 years, the CPI has increased more than seven times
In 1960, the CPI was 29.6
In 2008, this number rose to 215.3
Prices have risen since 1960
In the long-term, prices have actually fallen during some years
Between 1929 and 1933, the aggregate price level fell almost 25%
Between 1920 and 1922, the aggregate price level dropped a little over 16%
The price level measures prices relative to a base
The aggregate price level is the level that prices are at for the entire economy
The price level, as demonstrated by the numbers above, rises and falls over time
For example, the price of many goods has risen over time
This does not mean that people enjoy these goods more
More likely, the money they used to purchase these goods has lost value
Inflation focuses on the changes in the value of money, rather than the value of goods
When an economys price level rises, it takes more money to buy a fixed basket of goods
Alternatively, the value of money relative to goods has gone down
Suppose P is the price level as measured by the CPI and GDP deflator
Therefore, P also measures the cost of a basket of goods
The amount of goods and services that can be bought with $1 is 1/P
This means that 1/P is also the value of money, measured in goods and services
The money market in the long run
In the long run, the value of money is determined by the interaction of supply and demand
The supply of money depends on the decisions of the Fed and the banking system
The demand for money depends on how much people want to hold their money rather
than have it in other forms
People mainly hold money because it is useful as a medium of exchange
An increased number of ATMs or credit cards will reduce the demand for money
The two most important determinants of how much money people demand are associated
with the transactions that take place
(1) Volume of transactions
(2) Prices at which the transactions take place
Assuming the real level of activity in the economy remains the same, doubling prices
should double the demand for money
The long run is the time period for the price level to adjust and equate the demand for money
with the money supply
At this point, the value of money (1/P) and the quantity of money in the market will settle
where the money supply and money demand intersect
1/P (the value of money) belongs on the vertical axis
Quantity, as always, goes on the horizontal axis

Money demand slopes downward to reflect the that people need less money to purchase
goods as the value of money rises (the price level falls)
The money supply is inelastic, as it is set by the Fed
Money Market
Value of
money
(1/P)
Money
Supply
Money
Demand
Quantity of Money
Suppose the Fed decides to double the money supply
People will find they have more money than they want 113
114
Many people will put their extra money into a bank, increasing the supply of savings
Increasing the supply of savings will cause interest rates to fall
In turn, businesses and consumers will increase spending
Therefore, demand for goods and services in the economy will increase
Since the supply of goods and services remains unchanged, higher demand will cause the
price level to increase
Prices will continue rising until they have risen enough for money demand to equal money
supply
At this new point, the value of money has fallen by half (the price level doubled)
In short, the change in the money supply initiated by the Fed, in the long run, is equal to
the increase in the price level
The long-run neutrality of money means that changes in the quantity of money have no effect
on real quantities in the nations economy
Monetary changes will only affect real quantities
Real quantities, measured in physical units, will not be affected by monetary changes
The money supply multiplied by the number of times money is used should be equal to the
output in the economy at current prices
115
The quantity theory of money states that M x V = P x Y
This equation is also known as the equation of exchange
M is the stock of money or money supply (how much money exists)
M is determined independently of the other variables
In other words, it is an independent variable in the equation

V is the velocity of money, or how often money circulates through the economy
Velocity is how often a dollar bill is spent or changes hands in a given period
V is considered to have a constant equilibrium value
113
Yea, right. Cat

This is a different graph, discussed just one section earlier.
115
Also, Q can be replaced with Y (meaning real GDP) to make VM = PY. I always remembered it as vampy. Cat
114
It varies over time but will always average out to its equilibrium value
Y (or T or Q) is the output of goods and services
Y is said to be given: real output at a given point in time is fixed
Note that P Y = nominal GDP = M V

P is the average current price level
P is the dependent variable in the equation
It is influenced by the other three
Since V and Y are typically assumed to be fixed, changes in P are directly

dependent upon changes in M
The equation states that the amount of money spent equals the amount of money used
Increasing the money supply will have one of three effects
(1) Velocity of money will fall
(2) Real GDP will increase
(3) Price level will increase
This equation shows that, given V and Y as constants, increases in M (the money supply)
will result in increases in P (inflation)
A key foundation of macroeconomics is the long term neutrality of money
As we saw, changing monetary variables can only change the price level, not real variables
Example: Increasing the money supply cannot increase long run real output
Increasing long run real output would require increasing labor productivity, capital
investment, and so on
Inflation
Inflation is a sustained rise in the general price level
The rate of inflation is the rise in the price level per unit of time
In the United States, most official measurements of inflation are by quarter
A quarter is equal to three months (a quarter of a year)
Inflation decreases the value (purchasing power) of money
Inflation weakens moneys ability to serve as a store of value because it erodes moneys
value over time
As inflation continues, more and more money is needed to buy the same goods
Inflation is unpopular
Inflation rates reached the double digits in the 1970s
During this time, many consumers saw inflation as the countrys number one problem
Even though money is neutral in the long run, inflation can have powerful short-term effects
(1) Inflation reduces the value of money
Inflation acts as a tax on those that choose to hold money
People will have to go to the bank or ATM more often
Firms will have to adjust the prices of their products more frequently
(2) Inflation distorts prices
Not all firms adjust prices at the same time
Relative prices will not always accurately reflect the costs of production
The information conveyed to consumers by market prices becomes less valuable

(3) Inflation introduces confusion about the value of goods in the future
When someone lends their savings, they are postponing consumption
If that person cannot predict the rate of inflation, they will not be able to calculate
future purchasing power
This increases the risks that borrowers and lenders face
Subsequently, the supply of savings and demand for investment decrease

Investment is crucial to economic growth, so inflation serves to reduce economic
growth
Economic Growth, Productivity, and Living Standards
Economic growth
Sustained economic growth began over 200 years ago in the United States and Western
Europe
During the 19th and 20th centuries, economic growth spread to Japan and portions of Latin
America
The 1950s brought economic growth to many more countries around the world
The circular flow model
The circular flow model shows the relationship between different sectors of the economy
(1) Households
(2) Firms
116
(3) Government
The circular flow model goes two ways, and we will separate the different flows for simplicity
Goods and services move clockwise, while money moves counter-clockwise
Factor
Markets
Land, capital
labor
Households
Factors of
production
Transfer
payments
Government
Firms
Goods and
services
Goods and
services
116
The foreign sector is not included.
Goods and
Services
Markets
Goods and
services
Income (GDP)
Households
Factor
Markets
Wages and
rent
Government
Firms
Taxes
Government
purchases
Consumption
Goods and
Services
Markets
Revenue
The model has three main components
(1) Households provide resources, such as labor

These resources are used to make goods and purchase goods in the market
117
The goods that households produce are factors of production,
such as labor,
land, and capital
Households use the income they receive to buy goods and services, pay taxes, and save
in financial markets
Both households and firms borrow from financial markets, to pay for consumer
durables and capital equipment
(2) Firms (also referred to as the business sector) consume resources to produce goods to sell to
households in the market
Firms use income to pay for the factors of production they purchase from households
(3) The government sits between consumers and the goods market
The government taxes households, earning income
The government borrows from financial markets
It uses both of these sources of income to purchase goods and services
The circular flow model has two basic markets, both of which are governed by the forces of
supply and demand
The market in which firms buy factors of production from households is the factor market
The market in which households buy final goods and services from firms is the market for
goods and services
The only places at which new wealth enters the cycle are households
Households provide human labor that can be used to work
This model assigns ownership of inputs such as land to individuals in households, who
rent it out to businesses
I remember using the mnemonic CELL to remember the factors of production: capital, entrepreneurship, land, and labor.
USAD does not emphasize this as much as in previous years, but I do recall seeing a couple of questions on which one was NOT a
factor of production (money would be the answer).
117
In general, all factors of production are originally owned by households

Differences in GDP per capita
Closely examining the circular flow model, we see that the economys output depends on the
total quantity of goods and services that firms can produce
This in turn depends on the quantity of factor inputs that households can supply to the
firms and the ability of the firms to turn the inputs into outputs that others will buy
Everything else being equal, larger economies should produce more than smaller economies
None of this explains differences in GDP per capita
Real GDP per capita is equal to real GDP per worker multiplied by the fraction of the
population employed
Real GDP per capita = real GDP per worker x fraction of population employed
GDP GDP
N
=
POP
POP
N
POP is the countrys total population

N is the labor force
real GDP
POP
is real GDP per capita or the amount of goods and services available to be
consumed by each person

When you cancel out N in the two fractions on the right, the right side equals the left, so
this equation is always true
The quantity of goods and services that can be consumed by each person depends on
average labor productivity and the part of the populace engaged in production
Average labor productivity is the average amount each worker can produce
Most differences in GDP per capita are explained by differences in average labor productivity
The proportion of the population engaged in production has been remarkably consistent
In the United States, labor force participation increased as women entered the market
and had less children (increasing the relative size of the working-class)
Earlier retirement and longer education have served to negate this steady increase
In other countries, this trend holds as well
Average labor productivity and standard of living
Five factors affect average labor productivity
(1) Physical capital
Workers with better tools, machinery, and up-to-date factories will be more productive
than those without them (or less of them)
Capital equipment is produced
Increasing future capital stock means giving up consumption in the present

(2) Human capital
Human capital refers to the skills and experience acquired through education, training,
and on-the-job experience
Human capital, unlike physical capital, is not tangible
Like physical capital, creating human capital usually requires sacrificing current
consumption
The time spent learning and training could be used in productive activities
(3) Natural resources
The wealth of many countries depends on their vast natural resources
Saudi Arabia and Kuwait gain much wealth from their oil fields
Other natural resources like iron ore and petroleum contribute to a countrys wealth
In a global world, domestic natural resources are not essential to a high standard of
living or maintaining a high average labor productivity
For example, Japan imports raw materials produced elsewhere

(4) Technological knowledge
Technological knowledge is the knowledge about techniques that transform inputs
into the goods and services households desire
Historically, advances in technological knowledge are the single most important factor in
raising average labor productivity
Progress in technological knowledge comes in two main categories
(1) Inventing new products
Semiconductors
Integrated circuits
Lasers
Genetic engineering
(2) Developing better methods of organization
Example: the moving assembly line by Henry Ford

(5) Political and legal environment
Some technological knowledge is kept as trade secrets or is patented
Most technological knowledge is available to be learned and copied
The growth of living standards in countries like Japan, South Korea, and China
illustrates that countries can advance rapidly if they borrow and adapt
The fact that some countries are persistently poor indicates that significant barriers
to successfully borrowing and creating new ideas still exist
Dysfunctional political and legal systems prevent many countries from exploiting the
potential of modern manufacturing techniques
After World War II, North and South Korea had similar resources, populations,
and standards of living
Today, South Korea enjoys a standard of living like that in other developed nations
Poverty and starvation are widespread in communist North Korea 118
Creating appropriate incentives is essential to achieving a high standard of living
118
Governments should encourage investment in physical and human capital
I recommend a documentary called Inside North Korea if you want an inside look at how the North Korean government operates.
Its moving and disturbing. National Geographic has it on their YouTube channel: http://tinyurl.com/37atf8q Cat
Beyond a certain point, however, declining return would kick in

If all current output were directed toward investing, we would have no goods and
services to consume (the Soviet Union came close to this in their early Five Year Plans)
New technological knowledge should also be encouraged through research and
development (R&D)
New knowledge is a public good
Private incentive to create new knowledge can lead to underinvestment
Government can encourage R&D in various ways
Tax credits
Subsidies
Direct expenditures (paying for research directly)
Legal protections, such as patents
Short-Run Economic Fluctuations
Economic fluctuations
Business cycles and their accompanying fluctuations have been a characteristic of industrial
societies since at least the late 18th century
Recessions occur when real GDP declines for two consecutive quarters (six months)
The National Bureau of Economic Research (NBER) is responsible for researching these
short-run fluctuations
The Great Depression lasted for 43 months, starting in August 1929
The nations real GDP fell by more than 25%
Since World War II, recessions have generally been short
Only three have lasted longer than twelve months
119
Recessions since World War II have been mild in terms of drop in real GDP
Expansions lasted longer than most recessions
Most lasted more than two years
Real GDP has trended upward
Characteristics of short-run fluctuations
The two most important correlates of fluctuations in the economys aggregate growth are
unemployment and inflation
Recessions are characterized by increased unemployment
Businesses are slow to increase hiring in the early phases of an expansion
Increased employment tends to lag behind the next stage of economic growth
Periods of expansion feature accelerating inflation
Between 1960 and 1979, the rate of inflation trended upward with the business cycle
Periods of recession are linked to slowing inflation 120
Potential Output, the Output Gap, and the Natural Rate of Unemployment
Output gap
Think of the actual level of GDP as having two parts
(1) The potential output of the economy
119
The USAD guide (except the Russia portion) predates the recent Great Recession.
If inflation occurs during a recession, an economy is experiencing stagflationhigh inflation and unemployment. A stagflation
crisis plagued the United States in the late 1970s, when the rising price of oil knocked the economy off-kilter.
120
Potential output is the quantity of goods and services that the economy could produce
when using all its resources at normal rates
The level of potential output can increase over time as technology improves and the
country obtains more resources
The variable Y* will be used to denote potential output
Actual output will be symbolized with Y

(2) The output gap
The output gap is the difference between actual output and potential output
In equation form, output gap = Y Y*
When an output gap exists, the economys resources are not being fully utilized
Unemployment rises when the economy is below its potential output, or in recession
More specifically, the cyclical component of unemployment rises when the economy is
in recession
If this cyclical component were zero, only the natural rate of unemployment would
prevail, 121 composed of only frictional and structural unemployment
In the 1960s, Arthur Okun noted that there was a relationship between the output gap
and the level of cyclical unemployment
Okun was one of President Kennedys chief economic advisors
Okuns Law states that for every 1% the unemployment rate differs from the natural
rate of unemployment, the output gap deviates by 2%
If cyclical unemployment increases from 1% to 2%, the output gap would increase
from 2% to 4%
Explaining short-run fluctuations
Variations in the growth of output over time can be caused by two things
(1) Changes in the growth rate of potential output
(2) Actual output falling above or below potential output
Changes in the growth rate of potential output depend on three factors
(1) Growth rate of the population
(2) Rate at which the capital stock increases
(3) Changes in the pace of technological advances
In the long run, changes in the growth rate of potential output can affect economic growth
In the short-run, variation is mostly due to divergence between actual and potential output
In a magical world where prices adjust immediately to balance supply and demand, the
economys actual output wouldnt deviate from potential output
Firms do not constantly adjust their prices to respond to changes in market demand
Instead, most firms set their prices and sell what is demanded
Only after a sustained period of imbalance between demand and desired supply do firms
change their prices
Since firms respond to variations in demand by changing production rather than prices in the
short-run, output in the economy in the short-run is determined by the level of aggregate
demand
Aggregate demand is the total desired spending on final goods and services by all of the
people in the economy
Mathematically, like GDP, aggregate demand equals the sum of consumption, investment,
government purchases, and net exports
121
This was discussed in the earlier section on unemployment, toward the beginning of macro.
Over the long run, firms will adjust prices to move back to the normal level of production
These price changes eliminate the gap between actual and potential output
Since adjustments take time, government policies can eliminate output gaps more quickly
Variations in rate of growth of output
LONG RUN
Changes in growth rate of potential output
Growth rate
of population
Rate of
increase of
capital stock
Changes in
pace of
technological
advances
SHORT RUN
Actual output
relative to
potential
output
British economist John Maynard Keynes (1883-1946) developed a model to explain short-run
economic fluctuations
He first established his theory in his 1936 book, The General Theory of Employment,
Interest, and Money
Keynes believed current microeconomic models were inadequate to account for the events
of the Great Depression
This is called the Keynesian model
The Keynesian Model
Similarities to microeconomics
The intersection of supply and demand in microeconomics gave us an equilibrium price and
quantity
The intersection of aggregate supply and aggregate demand in the macroeconomic AD/AS
model yields an equilibrium price level and level of real output (GDP)
Curves and axes
According to Keynes, short-run fluctuations in the level of activity in an economy can be
summarized with the interaction of two curves
Aggregate demand (AD) curve
SR
Short-run aggregate supply (SRAS or AS )
Additionally, there is a long-run aggregate supply (LRAS) curve that is perfectly inelastic,
drawn at the point where Y = Y* (where output equals potential output)
The horizontal axis measures real GDP
The vertical axis measures the aggregate price level
While the Keynesian model looks very similar to the supply and demand diagrams that analyze
individual markets, the reasons for the shapes of the curves are different
An Economy in Long-Run Equilibrium

LRAS
Price Level
SRAS
AD
Full Employment
Output
Aggregate Demand
Real Level of
Output
The aggregate demand curve

Adding these four components yields aggregate demand
Consumer spending on goods
Investment spending (usually by firms) on capital equipment and inventories
Government spending on goods for the state or public welfare
Net exports, or total value of goods exported minus total value of goods imported
Summing these four components recalls the expenditure approach for calculating GDP
Unlike microeconomics, aggregate demand maps the price level, not price, to real output
We built the microeconomic demand curve from substitution and income effects
These effects do not directly apply on the economys level
At the level of the economy, a decline in the aggregate price level means the prices of
all goods decreased
The substitution and income effects will not apply
To derive the demand curve, we must rely on three different effects
(1) The first is the wealth effect, analogous to the income effect
As the price level decreases, incomes increase, allowing consumers to buy more goods
Remember that real incomes are adjusted for the price level
If the price level goes down but nominal wages stay constant, the real value of the
nominal wages increase
This increase in purchasing power leads consumers to an increase in the level of

output demanded
This follows from the quantity equations, M x V = P x Y 122
If V and M remain the same, a lower P will leader to a higher Y

(2) The second is the interest effect
As the price level increases, more money is needed for transactions
As a result, more people try to borrow money
This competition is essentially an increase in the demand for money, so real

interest rates (the price of money) increase
122
Oh theres the vampy equation! Cat
This increase makes borrowing more expensive, discouraging consumption and

(primarily) investment
Aggregate demand decreases as price level increases
When people have more money than they want, they will save in financial markets
Increased savings cause interest rates to fall and encourages households and
firms to borrow more
(3) The third is the foreign exchange effect, analogous to the substitution effect
When domestically-produced goods grow cheaper at home, they are also cheaper abroad
The result is more consumption and exports, increasing the level of output demanded
The end result is a downward sloping curve that relates real output to price level
The Aggregate Demand Curve

Price
Level
Real Level of Output
Shifts of the aggregate demand curve

The aggregate demand curve can shift due to certain changes in the economy 123
(1) Changing consumption decisions can shift the AD curve
This can alter the values for consumption and net exports, respectively
(2) Firms altering investment levels shift the AD curve
To increase investment spending, a firm spends more on capital goods, which will shift
aggregate demand to the right
In this situation, investment (one of the components of aggregate demand) rises
Firms increase planned investment spending because they expect to do well in the
future or see future opportunities for which to prepare
If firms expect rough times ahead, they will decrease planned investment, which shifts
aggregate demand to the left
During the dot.com boom of the 1990s, many of the companies made substantial
investments, which shifted the AD curve right temporarily
(3) Consumer sentiment can change
Consumer sentiment affects consumption spending and shifts the AD curve left or right
In the wake of the 9/11 attacks, consumer confidence and stock prices dropped
Wealth was reduced and consumers reduced their spending at each price level
(4) Governments can spend directly or impose taxes
By increasing or decreasing spending, the government directly changes one of the
elements of aggregate demand, shifting the curve itself
Many state governments cut spending during the 2008-2009 recession, which shifted
the AD curve left
123
USAD only lists some of these changes, so dont worry about learning everything you would in AP Macro.
When the government cuts taxes, consumers have more income to spend, which shifts
the AD curve right
Remember that a shift in the aggregate demand curve represents a change in the level of
output demanded at all price levels
A change in the price level itself only causes a movement along the aggregate demand curve
Aggregate Supply
The aggregate supply curves

Economists use different supply curves for different time frames
Short-run aggregate supply (SRAS) is the potential supply of all goods in the short-run 124
The short run aggregate supply curve slopes upwards, like the microeconomic supply curve
There is a connections between level of output and price level
As price levels increase, suppliers across the economy increase production
In the microeconomic model, the supply curve sloped upward because higher prices
attracted firms producing other products
As the price of Dukes Dice increases, people who were producing Setos Playing Cards
will switch to the Dice
At the aggregate level, resources cannot be shifted from other activities
The aggregate supply curve slopes upward to reflect the relationship between price
adjustments and anticipated sales
Firms fix prices and sell as much as consumers demand
Only over time do firms adjust prices
The position of the aggregate supply curve depends on the economys long-run potential
output and expectations for the price level
When an output gap does not exist, the SRAS will pass through the LRAS at a price level
equal to the expectation about aggregate prices at Y*
Shift in the aggregate supply curves
Shifts in the short-run aggregate supply curve occur for two reasons
(1) Changes in the aggregate price level are the most common cause of shifts in the
position of SRAS
At the expected aggregate price level, SRAS is equal to Y*
An increase in the expected price level will cause SRAS to shift upward
A decrease in the expected price level will cause SRAS to shift down
125
(2) Aggregate supply shocks also shift the aggregate supply curve
Positive weather and climate conditions affect agricultural production
A good harvest means that more agricultural commodities are available at each
price, which shifts SRAS rightward 126
In 1973, OPEC initiated an oil embargo
The shortage of imported oil caused a reduction in quantities produced in the

United States at every price
SRAS subsequently shifted leftward
When economists (or USAD, for that matter) say aggregate supply, they are generally referring to short-run aggregate supply.
The resource guide apparently decided to combine a bunch of shifts under this generic cause.
126
If the climate and weather are permanently beneficial to agricultural production, then LRAS would eventually shift right.
124
125
Short-Run Aggregate Supply

Price Level
Level of Output
Over time, technological progress can cause the LRAS to shift rightward
This increase in potential output accounts for the long-run growth of real GDP
Remember that changes in the price level cause a movement along the aggregate supply curve
Only the factors listed above cause the curve itself to shift
The Keynesian Model and Short-Run Fluctuations
Intersection point
The LRAS is drawn where Y = Y*
The long-run aggregate supply curve is determined by the availability and productivity of
the factors of production
Supply is independent of the price level and fixed at the full employment level of output
The long-run aggregate supply curve as a whole is perfectly inelastic, or vertical
Changes in the aggregate supply curve can only come from real changes in the productivity
of an economy
The perfect inelasticity of the long run aggregate supply curve is really a statement
about monetary neutrality
An Economy in Long-Run Equilibrium
LRAS
Price Level
SRAS
AD
Full Employment
Output
Real Level of
Output
The output level of the long-run aggregate supply curve is at the point of full employment
If the LRAS curve passes through the intersection of the SRAS curve and the aggregate
demand curve, the economy is in long-run equilibrium (see graph above)
If the LRAS curve does not pass through this point, the economy is either experiencing
inflation or recession
A recession occurs when the production level of long-run aggregate supply is greater
than the current level of production
The economys production potential is not being realized
According to classical economic theory, prices will fall, consumption and production
will increase, and the economy will move back toward long-run equilibrium
In March 2001, the United States economy went into a recession
Firms, pessimistic about future sales, decreased investment spending
Interest rates were also rising
Declining investment, along with the events of 9/11, decreased aggregate demand
Some businesses will lower prices, causing the aggregate price level to decrease
Falling prices shift SRAS downward

An Economy in Recession
Price Level
SRAS
LRAS
SRAS
New equilibrium
AD2
AD1
Real Level of
Output
Eventually, the economy returns to equilibrium at a lower price level (but the
same potential output)
Recessions can also occur when SRAS decreases
In 1973, OPEC significantly reduced the supply of oil to the United States
SRAS decreased
Price Level
LRAS
SRAS1
SRAS2
AD
Real Level of
Output
Firms found that actual sales were not meeting expectations

Eventually, firms cut prices, causing SRAS to shift down
Price Level
LRAS
SRAS1 / SRAS3
SRAS2
New equilibrium
(that happens to be
the same as the old)
AD
Real Level of
Output
An economy returns to equilibrium at the same price level and potential output 127
Inflation occurs when the production level of long-run aggregate supply is less than the
current level of production
Factors are being over-utilized and the economy is overheated
According to classical economic theory, prices will rise, consumption and production
will drop, and the economy will move back toward long-run equilibrium
Suppose excessive government spending (in an attempt to mitigate a recession)

causes the aggregate demand curve to shift too far right
The new equilibrium is now right of potential output
This is because all the SRAS is doing is shifting. Note the direction of the arrows. Graphically, shifting left is the same as shifting
down, and shifting right is the same as shifting up.
127
An Overheated Economy
SRAS
Price Level
AD2
LRAS
AD1
Real Level of
Output
The economy cannot stay in such a state for long

Firms will cut back on production once they see the higher aggregate price level
At a higher price level, sales will not meet the expectations of firms
The economy will return to equilibrium at a higher aggregate price level and
the same potential output 128
An Overheated Economy
SRAS2
Price Level
SRAS1
New
equilibrium
AD2
LRAS
AD1
Real Level of
Output
Recessions and expansions

Recessions and expansions occur because of unpredictable shocks to the economy
These shocks become recessions or expansions due to short-run inflexibility of prices
If prices everywhere adjusted instantly, then output would never differ from potential
The short run itself is the period in which the performance of the economy deviates from the
long-run predictions
129
Recessions and expansions are short run phenomena, lasting from one to three years
I wont treat how economies overheat and return with regard to shifts of SRAS since its a good exercise and just like for a
recession, but backwards. Not that I cant come up with a scenario or anything
129
How long is the short run? Economists disagree, but, for our purposes, USAD writes, You will notice that up until now, we have
been somewhat vague about the period of time that is represented by the short run. That is because the definition of the short run is
128
Inflation in the Keynesian model

So far, we have assumed the level of inflation is zero
In the long run, the aggregate price level will rise only if the money supply grows faster than
the economys potential output
This conclusion directly follows from the quantity equation, MV = PY
In the Keynesian model, increasing the money supply shifts the AD curve right
If people are accustomed to the price rise, the SRAS will shift upward
The AD and SRAS curves will intersect at the economys potential output
Full employment equilibrium can exist with any level of inflation
Unexpected shocks that are not anticipated are the only thing that can cause employment
not to follow equilibrium levels
In the 1960s, President Johnson financed a military build-up through borrowing
His actions were unexpected, so inflation increased
In the long run, no policy will maintain output at a level different from potential output
Influencing the EconomyThe Effect of Government
Fiscal policy
Fiscal policy allows the government to impact overall economic activity
Fiscal policy is government spending and taxation used to influence the economy
Increased government spending results in increased aggregate demand and, thus, higher GDP
Remember: C + I + G + NX = production = GDP = AD
C = consumption spending
I = investment spending
G = government spending
NX = net exports = Exports Imports = X M
Expansionary fiscal policy (increased government spending and/or lowered taxes) offsets
recessions and restores full employment
Contractionary fiscal policy (decreased government spending and/or increased taxes) cools
down expansions and brings employment back down to the natural rate
The two types of fiscal policy are direct or indirect spending through taxes
Cutting taxes increases income, which increases spending
Increased spending, in turn, shifts AD to the right
Arguments 130 for and against government intervention
Supporters of intervention argue that deviations of actual output from potential output are costly
When resources are not fully employed, the economy loses what could have been produced
Unemployment causes significant hardships
Whenever resources are overemployed, inflation results
Detractors have two arguments against government intervention
(1) It is difficult to identify what the potential output is and what interventions are needed
It takes time to collect information about the aggregate economy
The first estimates of GDP for a given year take three months to calculate
These estimates are subject to revision
effectively the period of time in which the performance of the economy deviates from the predictions of the long-run model. Judging
from the length of typical economic cycles, this is usually from one to three years.
130
Normative economic statements ahead! Cat
Most information about the economy lags,

so policymakers must act on incomplete data
Pros
(2) It may not be practical to carry out fiscal and
monetary policy
Once policies are enacted, the effects of
actions take time
Deviations
Businesses will not invest right away, as
from longrun
investments must be planned and funded
equilibrium
When Congress approves a spending bill, it
are costly
can take six months or a year to implement
Some fiscal policy may not take effect

until the economy is already recovering
As a result, the economy may overshoot

full employmentresulting in inflation
Activist policies might turn out to be counterproductive
Cons
May not be
practical to
carry out
economic
policy
Hard to
identify when
and what
interventions
are needed
COMMUNIST ECONOMIC SYSTEMS

POWER PREVIEW
After the Russian Civil War, the path of Russias economy
changed drastically to embody the Marxist-Leninist ideology
of its new leaders. As the Russian Empire became the Soviet
Union, the nation experienced rapid collectivization and
industrialization under the leadership of Joseph Stalin. This
section will focus on the principles and mechanics behind the
socialist system in the context of Russias transition into a
new economic system.
POWER NOTES
According to the USAD outline, 10
questions should come from Section IV.
10 questions (20%) come from Section IV
on the USAD Economics Practice Test
This subsection covers pgs. 104-107 of the
USAD Economics Resource Guide
Planned Economy
Russias transition to planned economics

In a planned economy, the state regulates or plans production and price
Planned economies are also called command economies
From the late 1920s to 1991, the Soviet Union operated under a planned economy
The ideology of Marxism-Leninism inspired the use of this system
Marxism-Leninism encourages public ownership of means of production
Conversion to a planned economy began after the end of the Russian Civil War in 1920
The Bolsheviks seized control of Russia after this war
Vladimir Lenin (1870-1924) led the Bolsheviks during the war
The Soviet government collectivized agriculture in the late 1920s and 1930s
Collectivization formed communities in which property is shared
Property was owned by the community, not individuals

Joseph Stalin (1878-1953) spearheaded collectivization
Stalin succeeded Lenin as leader of the Bolshevik Party
The Bolshevik Party became the Communist Party of
the Soviet Union
Stalin aimed to transform Russia into a socialist economy 131
In this economy, property and society belonged collectively
to all workers
Stalin eliminated the class of people who owned
property without contributing labor
This class is referred to as the capitalists

To achieve this goal, the government attempted to
nationalize all private property
This included all factories and equipment, which were known as capital
Russias transition to market-based economics
Russia now operates under a market-based economy
Transitioning from a planned to market-based economy took 20 years (1991-2011)
Most of the transformation occurred in the 1990s
131
According to Marxist theory, socialism is a state that exists between the overthrow of capitalism and establishment of communism.
Both socialism and communism emphasize public ownership of property and means of production. The Soviet Union could be
described as both socialist and communist. http://tinyurl.com/7oj9xgm
Russia no longer operates under communism

Russia experienced rapid growth from 1999 to 2008
Growth ended abruptly with the global economic crisis in 2008
Russia faces significant challenges
Several problems stall Russias development in the global economy
Forms of Property
The classical socialist system

Three forms of property comprise the classical socialist system
132
These forms are state-owned firms , budgetary institutions, and cooperatives
State-owned firms
There were both national firms and regional firms
National firms fell under the jurisdiction of national-level ministries
Regional firms fell under the jurisdiction of provincial and local governments
Subnational governments were controlled by the national government
Economist Janos Kornai stated that categorizing firms as state-owned was meaningless
All income from production contributed to state coffers
Firms could not be bought or sold
These firms provided employment and housing on a massive scale
State-owned firms encompassed most heavy industry
Heavy industry includes auto plants and defense factories
The Soviet model emphasized economies of scale in every industry
133
Economies of scale describes the gains a firm achieves from expanding production
Individual plants commonly employed over 100,000 workers
The place of employment included all essential social services
Workers had access to apartments, daycare, schools, and other social services
This system gave rise to the communist cradle to grave system of social services
Due to this living and working situation, laborers lacked mobility
In order to move, workers had to acquire a new job, residence, and housing permit
A housing permit was called a propiska
The process of moving took years
Low worker mobility simplified the process of devising production plans
Government planners needed to keep track of labor at every individual firm
Privatization of state-owned firms started in 1992
Budgetary institutions
Budgetary institutions included universities, research and educational institutions, training
centers, trade schools, hospitals, and museums
National or regional government budgets funded budgetary institutions
Budgetary institutions had no obligation to make income cover expenditures
Cooperatives
Cooperatives operate similarly to state-owned firms but were mostly located in agriculture
The cooperative, or collective farm, was called a kolkhoz
Like state-owned firms, cooperative farms operated on a massive scale
Farms included social services such as housing
132
133
For simplicitys sake, all enterprises, companies, corporations, and businesses will be referred to as firms in this guide.
For example, economies of scale can be achieved by increasing production to take the most advantage of fixed overhead costs.
In the 1930s, Stalin collectivized agriculture by stripping all citizens of property
The state assumed ownership of all output

The government had several motives for collectivizing agriculture
First, collective farms intended to provide a steady supply of grain for cities
134
The state believed larger farms would produce more efficiently than smaller farms
Politically, bureaucratic control of farmers prevented them from fighting back
Farmers could not become a social, political, or economic force
They fit seamlessly into the body of the Soviet system
They could not leave the farm or outsource labor
Essentially, farmers always remained members of the collective
Summary of socialism
Socialism replaces private ownership with public ownership
The state owns all property
Capitalists could no longer exploit workers
All members of society collectively worked and owned property

Public ownership of production transferred the responsibility of allocating resources from
market mechanisms to bureaucratic economic planning
State
Committee/Ministry
of Planning (Gosplan)
writes plans
Central Committee of
the Communist Party
approves plans
Council of Ministers
and its respective
ministries execute
plans
The Planning System
The role of bureaucracy

The bureaucracy planned all economic activity in a top-down fashion
Plans originated in the bureaucracy and traveled down through all levels of the economy
Fulfilling plans was compulsory for all members of the economy
The planned economy sought to eliminate the anarchy of the market
The state would organize the economy on a national scale
135
The bureaucracy, not the market forces , controlled the vitality of a firm
Bureaucratic planning sought to distribute goods more equitably
This goal followed the ideals of Marxism
Five-year plans dictated the Soviet economy
Each five year plan was split into annual plans
Five-year plans functioned as statements of policy intent rather than specific plans
The first plan began in 1928
The last plan deteriorated in the late 1980s
Planning involved determining inputs and estimating outputs for each individual factory
136
This task was enormous, especially since the Soviet Union spanned 13
time zones
134
Everythings bigger in Soviet Russia! Cat

In a market economy, firms succeed or fail depending on their ability to remain profitable. In a planned economy, firms are only
expected to follow a specific plan. The government decides if or when to terminate each firm.
136
Unlucky number for an unlucky state. Cat
135
Number of cars to
produce
Steel required for

cars
Iron required for

steel
Machines
required to mine
iron ore
Labor required to
work machines
Flawed estimations often resulted in shortages

A lack of inputs caused a lack of outputs
Plans determined each firms level of technical development, capital investment, and trade
A system of bureaucracy-controlled price lists designated prices of all goods
Gosplan manually calculated every aspect of the entire Soviet economy
For most of this period, planners lacked access to computers
The role of managers 137 and labor
Plans required coordination of the Communist Party, state
Gosplan
ministries, and individual firms
Gosplan used the following strategies to break these
Individual ministries
systems down into manageable parts
138
Planners disaggregated
the plan in a downward
Directorates/sectors
flow of information
Higher levels sent directions to lower levels
State plans did not recommend or suggest actions
Individual firms
The term command economy derives from this
process
Planners received an upward flow of information
While drafting a plan, planners received information from lower levels
Lower levels contributed nonbinding recommendations about target output levels

The bureaucracy chose managers at every level of the economy
Each manager held a specific and mandatory role in each plan
Plans specified the amount of labor allocated to each sector and factory
Incentives and attitudes
Plans required firms to produce exactly the amount stated in the plan
As a result, managers lacked motivation to innovate
Managers were not rewarded for producing a surplus
But the state punished managers for failing to meet plan targets
Managers could be removed from office, sent to a labor camp, or accused of sabotage
An accusation of sabotage could lead to a death sentence

The Soviet economy operated under central planning and central management
Managers found motivation in an ideological sense of duty to the Communist Party
Managers received bonuses for good work
Bonuses included awards and privileges
But the penalties of taking risks outweighed the potential rewards
Without ownership, managers lacked incentive to exceed the bare minimum
Kornai states that, among managers, servility and a heads down mentality prevailed
Political and moral convictions toward socialism motivated the bureaucracy
In addition, political power and prestige provided sources of motivation
For some, material benefit and fear were motivators
137
138
For simplicitys sake, directors will be referred to as managers in this guide.

Disaggregating a plan involves breaking it into smaller parts.
Economic distortions
A chronic shortage economy emerged in almost every sector
The planning system misestimated the supply and demand for goods
In a free market economy, changes in price eliminate excess demand and supply
This shortage condition affected consumer goods
Managers had built-in incentives to underreport production
This ensured that plan targets for the next year would not exceed the firms capabilities
A firm that could produce 150% of the target plan might produce only 101%
This signaled improvement but not enough to cause expectations of it to increase
Managers hid extra output and sold it on the black market
Outputs differed in proportion to inputs
Target plans only specified that firms meet a goal, not fully utilize the allocated inputs
As a result, excess inputs existed in some sectors while shortage existed in others
This caused poor allocation of resources and waste
Socialism overemphasized rapid growth
Quantity of production took precedence over quality
Inferior quality of goods still impedes Russias ability to compete in world markets
The state prioritized industrial production over consumer production
A black market emerged in response to the chronic shortage state
A black market is called a shadow economy
It consists of economic activity that lacks official state approval
In the socialist system, private property and private means of production do not exist
Black market participants circumvented price lists and other restrictions of the system
Some analysts believed the black market kept the system alive
The black market remedied some of the failures of the planning system
It also fueled corruption at every level of the economy
Russia still feels the effects of the black market today
REFORM UNDER MIKHAIL GORBACHEV

POWER PREVIEW
Mikhail Gorbachev rose to power in 1985 as the General
Secretary of the Communist Party of the Soviet Union. This
section will cover Gorbachevs successes and failures in
reform. In many ways, he provided an impetus for change by
encouraging open communication and re-introducing private
property rights. However, his inability to improve the Soviet
Unions troubled economy ultimately resulted in the systems
collapse in 1991.
POWER NOTES
Mikhail Gorbachevs Rise To Power
Mikhail Gorbachev
Mikhail Gorbachev (b. 1931) became the General
Secretary of the Communist Party in March 1985
139
A coup was attempted against him coup in 1991
The Soviet Union collapsed later that year
Problems facing Gorbachev upon entering office
Soviet Russias stagnating economy was the greatest
challenge
Its planning system lacked flexibility
The complexity of calculating economic needs
exceeded the capabilities of state planners
Tim Colton believed planners could not
anticipate the need for computerization
As the economys size and complexity increased, so did planning failures
Values and motivation suffered under the overbearing state
Reform and reconstruction
Gorbachev immediately recognized a need for an overhaul of the economy
This goal was referred to as perestroika, literally translating to reconstruction
He did not intend to establish a market-based liberal system
He sought to reform the existing communist system
Criticism
Many critics argued that Gorbachev ignored the Soviet economy
They compared his actions to Chinese leader Deng Xiaopings actions in the 1980s
They accused him of sequencing reform
This practice involves favoring easier political reforms
In contrast, Gorbachev began his reforms with the economic challenge
Gorbachevs economic policies between 1985 and 1991 followed four phases 140
139
In August 1991, parts of the Soviet government and military trapped Mikhail Gorbachev in his house and demanded he resign.
Boris Yeltsin and thousands of Russians demanded he be restored to office. The coup failed. Gorbachev returned, but the coup
damaged his reputation and his authority over the Soviet Union soon dissolved. He resigned in December 1991.
140
Gorbachev doesnt actually execute policies in all of the phases, but it may be helpful to learn his term in four parts.
Phase 1: 1985-86: Recovering Worker Productivity and Infrastructure
Anti-alcohol campaign
First, Gorbachev tackled worker absenteeism and low labor productivity
He initiated an anti-alcohol campaign to reduce chronic alcoholism among workers
The campaign closed down some alcohol factories
Some Russians resorted to producing bootleg liquor
This created the unintended sugar shortage
The consumption of bootleg liquor also meant that productivity remained low
Uskorenie
Gorbachev attempted to invest in old infrastructure
He launched a project called uskorenie, literally meaning acceleration
Uskorenie referred to the acceleration of investment in old plants and factories
The Soviet Union lagged behind the Wests technological progress
Poor infrastructure impeded labor productivity
Failure of both reforms
Both initiatives failed socially and economically
The anti-alcohol campaign worked against the investment project
Closed alcohol factories reduced state revenue
Decreased revenue hindered increases in investment
Neither initiative improved worker discipline, economic productivity, or infrastructure
Workers still consumed bootleg liquor
The budget deficit increased 141
Phase II: 1987-88: Glasnost and Demokratizatsiia
Glasnost
Glasnost142 refers to a policy that allowed greater public discussion
Gorbachev initiated it at the Central Committee of the Communist Party plenum in
1987
A plenum is a planning meeting
Glasnost allowed citizens to openly discuss the merits of the communist and market systems
The Soviet Union had never allowed this level of free speech
Glasnost enabled the Soviet media and politicians to discuss issues freely
143
Politicians of this time comprised a new super parliament
in 1989
More importantly, glasnost jumpstarted discussion on private property
The subject had always remained taboo
Demokratizatsiia
Demokratizatsiia introduced limited accountability into Soviet politics
The term demokratizatsiia translates to democratization
It enabled greater participation of interest groups in the political process
Introduction of private property rights
Cooperative enterprises represented the introduction of quasi-property rights
These firms operated in the commercial and service sectors
141
Mikhail Gorbachev gets a gold star for trying. And by gold star I mean an attempted coup by his own Politburo. Cat
I remember glasnost because it kind of has glass in it, which is transparent like discussion was intended to be. Also, you make
windows out of glass, and you can open windows. Whatever works! Cat
143
Mikhail Gorbachevs democratization reforms allowed non-Communist candidates to compete against Communist Party
candidates in the March 1989 election for positions in the new Parliament Congress of Peoples Deputies.
142
Cooperative enterprises lacked clear governance or ownership structure

They offered business initiative among a small group of entrepreneurs
Gorbachev granted managers more autonomy on what to produce
Managers still had limited opportunities to explore new markets
Gorbachev maintained the collective farming system
He refused to reinstate private farming
Intermittent food shortages persisted
Miscommunications caused by privatization
Loosening the planning system caused errors 144 in information between planners and managers
Sometimes, managers privatized their firms while planners remained unaware
Some exploited loose oversight by hording inputs and excess outputs
Managers then sold them on the black market
These managers acquired the means required to participate in privatization later on
Laws failed to define cooperatives as private or public
The relationship of cooperatives to the overall economy was also unclear
These partial reforms worsened the overall economic situation
No sweeping economic reform
Gorbachev tended to compromise with conservative members of his Politburo
The Politburo consisted of a cabinet of elite communist party officials
Compromising stalled implementing far-reaching economic reforms
He missed the chance to initiate reforms before the onset of stagflation
Stagflation describes inflation with zero or negative economic growth
This presents the worst possible situation for an economy
Normally high growth accompanies inflation
This concern still plagues Chinas economy

Gorbachev may have lacked the means to initiate widespread economic reform
He may have lacked enough control within the Communist Party
He also may have lacked desire for change
He believed in the communist system, not liberal capitalism
Phase III: 1989: Stagflation and the Fall of Communism in Eastern Europe
Collapse of communism in Eastern Europe
Gorbachevs reforms met a receptive audience in Eastern Europe
The Berlin Wall 145 fell in November 1989
Several satellite communist governments 146 in Eastern Europe followed suit
The collapse destroyed guaranteed markets for inferior Soviet goods
This loss further damaged the Soviet economy
Gorbachevs indecision
Gorbachev attempted to please both radical reformers and conservatives
As a result, his inconsistent policies deepened the economic crisis
Reform efforts created larger budget deficits
Sustained subsidies to industry drained the states funds
Inflation plagued the economy even as growth declined
144
Because the system of imperfect information wasnt bad enough already! Marin Young
The Soviet Union built the Berlin Wall in 1961 to separate Soviet-controlled East Berlin from democratic West Berlin.
146
Satellite states refer to countries heavily influenced by another country. Soviet Russias satellite states included Poland, Bulgaria,
Czechoslovakia, Romania, Hungary, and East Germany. Discuss: what are American satellite states?
145
The economy experienced stagflation

Too much currency was circulating
High wages also caused inflation
The state lacked a mechanism to collect taxes
Restrictions on the development of cooperative movements prevailed
The practice of barter grew
Barter involves trade without currency
Agriculture experienced limited reform
The Soviet Union faced widespread food shortages
This problem had not plagued Russia since World War II
The economy experienced negative growth rates
Production fell by about 10% per year until 1991
The Soviet Union collapsed in 1991
Phase IV: 1990-91: Boris Yeltsin and Reform Alternatives
The Five Hundred Day Plan

In the summer of 1990 147, a group of young Russian economists devised a plan
They dubbed it the Five Hundred Day Plan
Gorbachev adviser and economist Stanislav Shatalin led the project
Economist Grigori Yavlinsky also helped produce the plan
They sought to imitate a recently successful example of economic shock therapy
They borrowed this idea from Poland
The plan sought to transform the Soviet Union into a market system
The Five Hundred Day Plan entailed several immediate reforms
Elimination of price controls
148
Establishment of the convertibility
of the ruble 149
Privatization of property
Stabilization of the economy
Liberalization of trade
The group of economists presented the Five Hundred Day Plan to Mikhail Gorbachev
Gorbachev considered the plan
He rejected the proposal by the fall of 1990
He favored a slower and more conservative approach to change
He wanted to retain price controls for another two to three years

Gorbachev appointed a likeminded conservative prime minister
Elections across the Soviet Union
The Soviet Union began to lose legitimacy as an economic and political union
Its 15 constituent republics, including Russia, started electing new leaders
Gorbachev authorized these elections
Boris Yeltsin
Boris N. Yeltsin (1931-2007) became Russias first popularly elected president in June 1991
This fact gave him greater political legitimacy than Mikhail Gorbachev
Gorbachev remained the unelected President of the Soviet Union
147
The Five Hundred Days Plan reminds me of 500 Days of Summer. It was written in the summer of 1990 too! Cat
Convertibility describes the ability of a currency to be exchanged for another currency (or gold).
149
The ruble is the currency used in Russia. Several other countries in Eastern Europe influenced by the Soviet Union also used
currencies called the ruble, though they were all different. http://tinyurl.com/8hkvs7q
148
He also remained the unelected General Secretary of the Communist Party

Yeltsin held various positions before becoming president
Member of the Politburo
Provincial Communist Party boss
Elected speaker of a new Russian parliament in 1990
Yeltsin disagreed with Gorbachevs lagging rate of reform
He initiated much more rapid reform, leaving
Gorbachev behind
Gorbachevs last days
Boris Yeltsin gained popularity and power to rival
Gorbachevs position
This challenge pressured Gorbachev to pursue radical
market solutionsbut it was too late
Gorbachevs Politburo attempted a coup in August 1991
This betrayal effectively removed Gorbachev from office
By December 1991, the Soviet Union completely collapsed
The union dissolved into 15 new and separate countries
Russia was the largest of these new countries
It adopted the title of the Russian Federation
Boris Yeltsin remained president
Gorbachevs legacy
Gorbachevs half-measures and indecisive reforms deepened the Soviet Unions economic crisis
By the end of 1990, political motives diverted reform efforts from economic needs
By the end of 1991, shortage and inflation persisted
The inflation rate loomed at over 100%
The Economy Before the Collapse
Pre-existing problems
Although Gorbachev may have fallen short, the Soviet Unions system deteriorated on its own
Production levels declined throughout the late 1970s
They hit a free fall in the late 1980s under Gorbachev
The growing state sector presented problems for future policymakers
The state controlled almost every economic activity
By 1991, most people were on the state payroll
Although the economy appeared fully employed, many people did nothing
We pretend to work and you pretend to pay us became a popular saying 150
Post-Soviet policymakers feared increasing unemployment
Minimal pensions and wages necessitated that people work after retirement
Chronic shortages caused by sub-optimal planning was an enduring problem
Industrial production far outstripped consumer production
This imbalance contributed to the low standard of living
Economic growth under the planning system carried high costs
The system created inefficiency
Because of the systems emphasis on economies of scale, monopolies dominated the economy
Massive firms operated efficiently as monopolies
150
Im hungry was another popular saying. - Cat
The Soviet economic system discouraged technological innovation
Meanwhile, the West developed computer hardware and telecommunications

Even with a strong post-secondary education system, Soviet Russia fell far behind
The lack of incentive to improve production yielded poor-quality goods
Soviet Russias manufacturing sector could not compete globally
Instead, the Soviet economy relied on natural resource exports, especially oil and gas
But global oil and gas prices were falling
The Soviet economy could no longer protect itself from world competition
Before 1989 151, the Soviet Union rarely traded with non-communist countries
152
These conditions exposed the Soviet Union to the resource curse
Flaws of the Soviet system
Money had no real value since prices did not reflect supply and demand
Price lists determined prices for everything sold in the Soviet Union
Additionally, the ruble could not be converted in international markets
About 3,000 different exchange rates existed for almost every item in foreign trade
The state controlled conversion rates
Two types of rubles with different values existed in the economy
Enterprise accounts used one type
Consumers used the other
The Soviet economy lacked important financial institutions and markets
These missing essentials included a private banking system, a real estate market, a stock
market, and private companies
Negative growth rates
Exacerbated by Gorbachevs reforms, these conditions 153 stunted growth
By the collapse of the Soviet Union on December 25, 1991 154, growth rates hit -17%
Growth rates had declined from +3% in 1989
Legacy of the Communist System
Successes of the Communist system

The system industrialized a predominantly agricultural economy in 70 years
This process took Western European countries centuries
The system produced a population with a 99% literacy rate 155
The Soviet Union became a superpower that rivaled America in land, air, sea, and space
Failures of the Communist system
Millions of people died in the industrialization and collectivization process
The peoples demands outpaced the systems capabilities
Lack of incentives to innovate caused the economy to fall behind global economic progress
151
Remember, this is when the Berlin Wall and the communist governments of Eastern Europe fell. The Soviet Union pretty much
lost all its guaranteed markets that year. They lost their training wheels but didnt know how to ride the bike! Cat
152
The resource curse doesnt become a huge problem for Russia until the early 2000s. Ill elaborate more then.
153
A beta tester would also like to add that the dismal state of the economy of the USSR wasnt solely due to their policies; they were
also busy building weapons, lending aid to other possible Communist countries, and researching science that could be used in
warfare, during this period, known as the Cold War. http://tinyurl.com/8uzg3
154
Merry Christmas, Russia! Jared
155
Now if only we could manage that in our Decathlon team. Jared
REFORM UNDER BORIS YELTSIN

POWER PREVIEW
The fifteen newly independent states of the former Soviet
Union diverged in their methods of economic reform. This
section will focus on Russias reform process as implemented
by president Boris Yeltsin. Between the fall of the Soviet
Union in 1991 and the end of Yeltsins presidency in 2000,
Russia made great strides in breaking down the planning
system and opening the door to privatization.
POWER NOTES
Shock Therapy in Theory
The return of shock therapy

In the fall of 1991, Boris Yeltsin surveyed reform options proposed by groups of economists
He settled on the plan put forth by a group of young economists led by Yegor Gaidar
Yeltsin appointed Gaidar prime minister
Gaidar advocated rapid transition to a market economy through shock therapy
The approach demanded three immediate and simultaneous reforms 156
Stabilization
End of subsidies to
unprofitable industries
Control of budget
deficit
Liberalization
Exposure of domestic markets to
competition (both foreign and
domestic)
Establishment of convertibility of
the ruble
Privatization
Separation of ownership and
management
Introduction of new profitmotivated practices
These three key policies 157158 inflicted a short-term shock on the population
Prices increased suddenly

Inflation quickly reached high levels
Unemployment rose as the state allowed unprofitable industries to fail
Market mechanisms would eventually kick in
Gaidar expected the economy to grow within three years
The economy would stabilize well before Yeltsin was up for re-election
Shock Therapy in Practice

Shock therapy began with the sudden freeing of prices on January 2, 1992
Average prices increased by 245% overnight
Production dropped as expected
With relaxed import controls, foreign goods filled the market
156
The main tenets closely match the Five Hundred Day Plan, but there are extra details to remember.
Stabilization. Liberalization. Privatization. Slap? Single Ladies Party? Find a way to remember this! Cat
158
How about SLIP (Stabilization LIberalization Privatization)? Adeolu
157
Larger cities imported the most foreign goods

Freed price controls and relaxed import controls solved the chronic shortage state
But prices mostly surpassed the average Russians budget
Gaidar assured Yeltsin that market mechanisms would push prices down
He believed Russian manufacturers would try to match the quality of foreign goods
He also believed they would offer lower prices to Russian consumers

Backlash
By April 1992, industrial enterprise managers opposed shock therapy
They were referred to as red managers
They opposed the end of subsidies to their firms
Some refused to restructure to accommodate market mechanisms
Others lacked the means to restructure even if they wanted to
Debt accumulated as managers traded for industrial inputs without money
In the early 1990s, barter economies existed in both agriculture and industry
The end of shock therapy
To assuage opposition, the state issued Central Bank credits to firms in the spring of 1992
They also increased printing of the ruble
This compromise caused spikes in the budget deficit and inflation
These effects especially hurt consumers
This violation of fiscal austerity and deficit control signaled the end of shock therapy 159
All other areas of the reform plan receded as well
Russia opted for more gradual reforms after 1992
This path necessitated abandoning several aspects of liberal market reform
Privatization in Theory
Main goals of privatization

The Russian government pursued three 160 main goals in privatization
First, creation of socioeconomic stratification, particularly a middle class
Private property rights and ownership would allow classes to form
Economically, middle classes provide a reliable source of taxation
161
Politically, they represent varied interests that support political pluralism
Political pluralism contributes to the creation of a democracy

Second, creation of a market economy
Yeltsins main political legacy is destroying the communist economic system
The introduction of private property prevented an easy return to the old system
Economist Anders Aslund believes two thirds of an efficient market economy must be
private
No more than one third of national employment can exist in the public sector
Third, separation of ownership from management
In the planned economy, managers did not legally own their firms
They only controlled them because of their access to information about the firm
This system of ministerial control declined under Gorbachev in the late 1980s
159
In essence, firms could not survive the initial shock. The lack of anticipation for this problem spelled the end of shock therapy.
Gaidar was a little too ambitious and optimistic, in my opinion, but it was a start. Cat
160
USAD doesnt list a fourth goal.
161
Political pluralism is the view that power should be spread among a variety of groups representing different interests as opposed to
concentrating power among one group of elites.
Newly empowered managers lacked oversight from a board of directors
They pocketed extra money from selling excess products on the black market
Yeltsin hoped to introduce managerial accountability to a board of directors
This principle was referred to as corporatization
He intended to incentivize managers with the principles of supply and demand
Directors would assess managers on profit and loss, instead of political criteria
Competitive managers would replace poor-quality, command-era managers
Privatization in Practice
Classification of privatization
Gaidar and Yeltsin passed the privatization legislation in June 1992
They initiated the program a month later, in July 1992
The program attempted to satisfy conflicting ownership claims between managers, local
governments, and workers
It created the State Committee on Property to oversee the process
162
This committee was also called the Goskomimushchestvo
They classified firms eligible for privatization as small, medium, or large
Small firms employed less than 200 employees
Medium firms employed 200-1,000 employees
Large firms employed over 1,000 employees

The committee divided firms into federal, provincial, and municipal property
They forced specific firms to privatize
Wholesale trade
Retail trade
Food services
Construction
Consumer services
Privatization options
Firms could choose between three different paths of privatization
These options differed in the percentage of shares owned by insiders
Insiders include managers and workers of the firm
The firm auctioned off their remaining shares or traded them for vouchers
All three options granted insiders favored access to shares
They allowed for over 25% insider ownership
Gaidar made this sacrifice to incentivize managers to participate in privatization
This decision was political, not economic

Critics called this a giveaway
They believed this concession prevented separation of ownership and management

First stage of privatization: voucher program
As previously stated, firms had the option of auctioning off shares
Share auctions began in December 1992
Thousands of auctions occurred every month between December 1993 and June 1994
Firms traded shares for vouchers through the voucher program
The voucher program began in August 1992
This phase of privatization was brief
162
In other words, the really long one. Cat
Vouchers had to be claimed by the end of January 1993 and invested by July 1, 1994
The state distributed privatization vouchers to every man, woman, and child 163
The effort hoped to involve public sector workers in the process of privatization
Doctors and teachers did not privatize their firms but could still participate
Citizens could trade their vouchers for shares of privatizing firms
This feature aimed to create a vibrant stock market
Initially, each voucher held a value of 10,000 rubles in shares
When the first privatization legislation passed in June 1992, vouchers were worth $84
Russians received an average of $50 a month in wage
Vouchers held considerable value

Russians could use their vouchers in various ways
Buy shares of the firm they worked for (as long as it underwent privatization)
Buy shares of other privatizing firms
Buy shares through mutual funds
This diversified their portfolio and spread risk across different firms
Buy shares in a voucher fund
Sell them
164
Give them away
Firms resisted the voucher program because they did not receive money from it
In May 1993, Yeltsin stated that firms must sell 29% of all shares for vouchers
This proved moderately successful as the average came closer to 20%
Citizens invested most vouchers by 1994
The first stage of privatization finished that year
Second stage of privatization: auctions of state holdings
In July 1994, Yeltsin initiated the second stage of privatization
This stage involved auctioning off remaining state holdings for cash
Firms received part of the proceeds as capital for restructuring
The government received the rest of the proceeds
The government aimed to finance its budget deficit without increasing inflation
They anticipated billions of dollars of revenues
The government also intended to create larger blocks of shares for foreign investors
Foreign investors could then increase their role in corporate governance
During the second stage of privatization, the benefits to insiders decreased
The second stage of privatization failed in many ways
165
Vladimir Polevanov, the more conservative Minister of Privatization, froze privatization
Nationalists and communists in parliament influenced this decision
Polevanov advocated the re-nationalization of many firms
This prospect scared off foreign investors
Loans for shares scheme 166
The failure of the second stage of privatization made the government desperate for revenue
In 1995, the Russian government settled on the loans for shares scheme
167
They auctioned off 12 blue-chip
companies to a group of commercial banks
163
No matter what I tell him, little Boris only seems to want to invest in candy! Cat
This is an example of leakage, the failure to make a rational decision. Marin
165
Makes you wonder why he chose to be the Minister of Privatization - Cat
166
This can be thought of as the third stage of privatization, though USAD doesnt explicitly say so. Cat
167
A blue-chip company refers is a nationally known, well-established company with reliable earnings and dividends.
164
All interested bidders, foreign and domestic, could participate

The bank offering the largest loan to the government won a block of shares
Banks could not sell the shares until September 1, 1996
They could only keep a third of the capital gains after they sold the shares
The government made 1 billion dollars
Corruption in the loans for shares scheme
On the surface, bidders appeared to support the
government
However, banks mainly wanted to control Russias
largest companies
Ultimately, the Russian government could not repay the
loans
The banks assumed ownership of the companies
The loans for shares scheme spawned a backlash
Few banks had the strength to participate
Participating banks organized auctions themselves
This system presented a conflict of interest
between auction participants
By the end of the process, banks openly quarreled
The process tainted the reputation of privatization
It transferred a large portion of the economy to a
small group of wealthy business people
168
This group became known as the oligarchs
Other corruption
Organized crime groups often purchased shares from failing firms at little cost
This practice stripped the firm of value
Purchasing shares this way did nothing for capital stock or the economy in general
The effects of the privatization program
By 1996, 75% of large and mid-sized firms successfully underwent privatization
Almost 90% of industrial output also privatized
Conservatives called privatization a crime against the nation
Privatization succeeded in redistributing assets
They did not reach the middle class as originally intended
The efforts did not provoke major social revolt
However, many people took issue with the speed of its implementation
Privatization also occurred at the same time as other pervasive negative changes 169
As a result, the public linked privatization and negative changes
Causes of the 1998 Economic Crisis
Non-inflationary measures
By 1996, inflation and the ruble exchange rate stabilized
The years 1996 and 1997 were characterized by stabilization and low inflation
The ruble reached a semi-convertible state
Russia achieved stabilization by stopping the Central Bank from printing money
168
169
The powerful few Marin

The resource doesnt specify the negative changes, but I believe it is alluding to rising prices and unemployment. Cat
Reducing the money supply decreased inflation

The government borrowed money to handle the growing deficit
They issued short-term treasury bills and some longer-term treasury bills
170
They received loans from the International Monetary Fund
Federal revenues decreased and the state reduced spending
Federal and regional governments failed to collect taxes
This setback benefited large oil and electrical firms
They provided energy to firms who could not afford it
In return, the state allowed them to export without paying taxes and tariffs
Over time, these firms accrued tax debts to the government

The state also withheld wages from state-sector employees
In 1996 and 1997, the state fell behind on payment of wages and pensions
Russians worked for no pay
Growing debt
By late spring and summer of 1998, the state started borrowing foreign currency
These loans financed their troubling domestic short-term debt
In the first eight months of 1998, Russias foreign debt increased by 18.5 million dollars
This reduced the foreign currency reserves required to support the ruble
On July 20, 1998, the International Monetary Fund offered Russia aid
The package they offered aimed to finance wages and domestic short-term debt
Instead, Russia used the package to attempt to save the ruble and failed
Effects of the 1998 Financial Crisis
Effects
The financial crisis occurred on August 17, 1998
On this day, Russia devalued the ruble
It defaulted on its domestic and international debts
The crisis eliminated all savings in Russia
Devaluation of the ruble made imported goods too expensive
Russians returned to purchasing domestic products
171
This increase in consumption boosted the recovery of domestic industry
By 1999, Russias economy started to grow for the first time since the collapse of the Soviet
Union
The recovery of domestic manufacturing played a part
Increases in prices for raw material exports also contributed greatly
Growth continued until the global financial crisis in 2008
170
171
The International Monetary Fund is an organization of 188 countries that encourages cooperation, stability, and trade.
Every cloud has a silver lining. Think about Russias domestic industry next time youre having a bad day. - Cat
VLADIMIR PUTIN & DMITRI MEDVEDEV

POWER PREVIEW POWER NOTES
During Vladimir Putins presidency from 2000 to 2008,
Russias economy experienced extraordinary growth with the
rise of global commodity prices. However, the effects of the
resource curse spelled the doom of Russias economy in
2008. This section will cover the conditions leading to the
2008 financial crisis and Dmitri Medvedevs efforts to
improve Russias struggling economy.

Economic Growth from 2000 to 2008
President Vladimir Putin

Vladimir Putin assumed the presidency in 2000
In his first term (2000-2004), he enacted a series of reforms drafted by Yeltsin
Flat income tax of 13%
New legal code
Systems to prevent money laundering
172
Regime for liberalizing currency
Reduction of taxes on profits from 35% to 24%
New land code allowing Russians to own commercial and residential land
GDP reached an all-time high of 8.5% in 2000 and sustained high levels growth
Year
# Growth GDP
Year
# Growth GDP
2000
8.5%
2004
7%
2001
6%
2005
7%
2002
6%
2006
7%
2003
7%
2007
9%
Economic growth
Between 1999 and the summer of 2008, Russias economy grew rapidly
The result: budget surpluses, no foreign debt, and sizeable hard-currency reserves
Inflation remained modest
GDP growth reached an all-time high in 2000
Rising oil prices
Russias growth coincided with a rise in prices for Urals crude oil
This crude oil blend was Russias chief export
The value of a barrel increased from $12 USD in 1998 to $70 in 2007
This rise in prices increased government and personal income
Higher incomes increased demand for manufactured goods and commercial services
Professor Philip Hanson states that, It is by their indirect effects that oil and gas
price rises fuelled Russian growth.
172
This involved removing requirements for special bank accounts and making the ruble fully convertible to other currencies.
Resource Curse
Russia and the resource curse

The resource curse describes negative effects associated with abundant natural resources
Some economies experience increasing debt, nationalization of resources, government
corruption, and negative growth
Russia experienced many negative consequences due to its supply of natural gas and oil
Dutch disease
Russias heavy volume of mineral exports invoked a sharp inflow of foreign currency
This influx created a high exchange rate
As a result, domestic manufactured goods became too expensive
Russians purchased imported goods instead
173
This phenomenon is called Dutch disease
Discover natural
resources
Export natural
resources
Increase
quantity of
foreign currency
Increase value
of domestic
currency
Domestic goods
become too
expensive
Consumers
demand fewer
domestic goods
Imported goods
replace
domestic goods
Domestic
manufacturing
worsens
Decay of other industries

Russia was excessively dependent on oil exports
While Russia grew with the record growth of oil prices, Putin loosened fiscal policy
He began permitting oil companies to take on debt
Imports increased with the onset of Dutch disease
In 2003, the state established a Stabilization Fund to store resource extraction tax revenues
This store of money was intended to serve as an emergency fund if oil prices fell
The state could use the money to fight inflation or defend the ruble
In 2008, the government divided the Stabilization Fund into two separate parts
The new parts consisted of the Reserve Fund and the National Prosperity Fund
The government did not use the money to improve the poor manufacturing sector
Russias manufacturing received little attention even after the collapse
The economy lacked alternative industries when oil prices plummeted in 2008
The state did not invest in improving oil extraction technology and infrastructure
This problem greatly hindered Russias ability to recover from the 2008 financial crisis
When oil prices crashed in 2008, so did the Russian economy
Russias economy mirrored the conditions of the period following the 1998 crisis
Analyst Evgeny Gontmakher believes that this is all a result of incorrect economic policy, oil
dependence, and rampant corruption. Until the system changes, these problems will persist.
Increased government ownership
Government ownership of the economy increased between 2003 and 2007
173
The term Dutch disease was first used to describe how the discovery of natural gas fields in the Netherlands seemed to cause the
decline of its manufacturing sector.
The state pressured firms to invest instead of allowing market forces to provide incentives
State ownership of oil expanded considerably
174
The state-controlled natural gas
company Gazprom 175 purchased Sibneft 176
The government also took over gas company Yukos and oil company Rosneft
Government control of oil rose from 19% in 2004 to over 50% by 2008
The Russian gas industry has not undergone privatization yet
The growth rate of oil production fell between 2004 and 2007
Exports fell proportionally
Year
% Rise in Oil
Production
2004
+ 10%
2005
+ 5%
2006
+ 3%
2007
+ 2%
The 2008 Global Financial Crisis
Calm before the storm

Dmitri Medvedev ascended to the presidency in the spring of 2008
When he took office, Russia was in an unprecedented period of prosperity
The stock market thrived
Foreign direct investment grew rapidly
But investment remained low compared to other emerging markets
Real disposable income increased by over 10% a year
Consumer spending increased remarkably
Unemployment fell from 12% in 1999 to 6% in 2008
Poverty fell from 41% at subsistence minimum to 12%
Russia became a part of four notable emerging markets, collectively known as BRIC
BRIC consisted of Brazil, Russia, India, and China
Global financial crisis
The global financial crisis began in September 2008
Between June 2008 and January 2009, Russias stock market lost 70% of its value
The ruble lost 1/3 of its value against the dollar
The Central Bank increased spending to to save the ruble but failed
Russias foreign reserves fell from rising corporate debt, bank trouble, and credit issues
Inflation hit a fourteen-month high of 13.9 by February 2009
According to Bank of America Securities-Merrill Lynch, industrial output fell by 16% between
October 2008 and February 2009
Government revenue fell by 28% in the first quarter of 2009
A decrease in commodity prices, including Urals crude oil, caused this reduction
Urals crude oil was Russias primary mineral export
174
Though both are fossil fuels, oil is liquid from petroleum and natural gas consists (mostly) of gaseous methane.
In 1989, the Soviet Unions Ministry of Gas Industry transformed into a corporation named Gazprom. Gazprom is Russias largest
industry and the worlds largest natural gas extractor. The state still owns most of Gazprom.
176
Sibneft, Russias fifth largest oil producing and refining company, was created in 2005. Gazprom bought 80% of Sibnefts shares
in 2005; Sibneft is now called Gazpromneft.
175
GDP growth declined to -0.2% in 2009
Russia experienced budget deficits for the first time since the 1998 economic crisis
Stunted recovery
By the first quarter of 2009, Russia exhibited
the same ailments as it did in the 1990s
Negative growth
High unemployment
High inflation
Low oil export prices
Weak manufacturing
Prudent fiscal policy 177 and rising oil prices
aided Russias transition out of the 1998 crisis
Boris Yeltsins administration established
these policies before Putin entered office
Putin introduced a more authoritarian
developmental model
He implemented more autocratic and stateled economic policies
Russias growth did not result from these policies
In fact, Putins approach stunted Russias ability to transition out of the 2008 crisis
Recovery depended on several factors that would prove difficult to achieve
Domestic consumer demand would have to increase
High unemployment and inflation strongly worked against this goal
World oil prices would have to rise
The global recession suppressed demand for oil
The state would have to implement prudent fiscal policy
Russia Today
Enduring problems
Russias manufacturing sector fails to compete in the
global marketplace
Russia can only compete in raw materials exports
Russias GDP over-relies on oil and gas
The economy is at the mercy of world markets
Modernization
Dmitri Medvedev initiated a new modernization
The effects of the global economic crisis
necessitated that Russia diversify its economy
Dependence on oil exports made Russias economy fragile
Medvedev launched the construction of a Russian Silicon Valley called Skolkovo
This project intended to use Russias educated labor force to innovate new products
Medvedev located the site in a new economic zone outside Moscow
Skolkovo will probably not contribute significantly to GDP for years or decades
Medvedev promised to stabilize Russias legal regime and approach to property
This change would encourage and protect foreign investors
177
Prudent fiscal policy prioritizes balancing the state budget.
SECTION I - III SUMMARIES

POWER PREVIEW
This section covers the summaries at the end of each
of the first three sections, which encompass the
theoretical portion of the economics resource. This
section organizes the main topics of economics
fundamentals, microeconomics, and macroeconomics
into broad subtopics. These subtopics focus on
important testable definitions, lists, and concepts.
POWER NOTES
According to the USAD outline, 40 questions
should come from Sections I III.
40 questions (80%) come from Sections I III on
the USAD Economics Practice Test
Section I-III Summaries cover pgs. 8, 55 56, and
102-103 of the USAD Economics Resource Guide
Section I: Fundamentals
Definitions
Economics studies how individuals make choices and how these choices interact
These choices revolve around how to allocate scarce resources
Scarcity describes the inescapable limited nature of resources
Humans desire unlimited goods and services
Every choice requires a trade-off
An individual must give something up, his opportunity cost, to get something else
Rationality states that people use cost-benefit analysis to choose the most beneficial actions
All voluntary trade benefits everyone involved
These benefits are called gains from trade
Economic models illustrate economic phenomena by depicting only essential details
Positive economics analyzes economic phenomena objectively
It predicts future outcomes based on certain circumstances
Normative economics analyzes economic phenomena subjectively
It compares the costs and benefits of different outcomes
Pareto efficiency describes a situation in which resources are fully used
No person can be made better off without making others worse off
Section II: Microeconomics
Supply and demand

Microeconomics focuses on how supply and demand interact
Firms supply goods and services by combining inputs such as raw materials and capital
Firms aim to maximize economic profit
Consumers purchase goods and services from firms and other suppliers
The demand curve illustrates how much a buyer is willing and able to pay at each price
The law of demand states that quantity demanded decreases as price increases
The position of the demand curve depends on several factors
Prices of complements
Prices of substitutes
Tastes
Expectations
Number of buyers
The supply curve illustrates how much a seller is willing and able to sell at each price
The law of supply states that quantity supplied increases as price increases
The position of the supply curve depends on several factors
Price of inputs
Technology
Expectations
Number of sellers
Elasticity
Elasticity measures how responsive supply and demand are to changes in price
This measure ignores units when calculating price and quantity
Perfect competition
A perfectly competitive market meets three important criteria
Large number of buyers and sellers
Homogenous goods or services
Market participants are informed of the market price
A competitive market reaches equilibrium when market participants have no reason to change
their behavior
Equilibrium maximizes total surplus
This point occurs where the supply and demand curves intersect
The competitive market model illustrates equilibrium price and quantity
The model can determine how economic conditions affect equilibrium
It can also measure changes in consumer and producer surplus
Firms enter and exit competitive markets until all firms make zero economic profits
Imperfect competition
Barriers to entry cause the creation of imperfect competition
Three main types of imperfectly competitive markets exist
Monopolies have one producer
Oligopolies have few producers
Monopolistic competition has many producers of similar but differentiated products
The outcome of imperfect competition differs from perfect competition in a few main ways
Lower equilibrium quantity
Higher equilibrium price
Lower total surplus
Trade
Trade makes all participants better off
International trade increases total surplus
However, free trade hurts some members of the economy
Free trade often faces opposition
Market failure
Market failure is the inability of a market to reach a socially efficient outcome
This happens when externalities occur or private property breaks down
Externalities describe economic interactions that occur outside of markets
Creating a market for externalities can solve this problem
Government regulation can also resolve externalities
Categorization of goods
All goods and services are classified by their rivalry and excludability
They are categorized as private, common, collective, or public
Government
Institutions, organizations, and governments organize human interaction through rules
Governments are unique in that they can tax citizens and use force
Governments increase well-being by protecting private property and market transactions
They impose price ceilings and floors, taxes, and subsidies
Revenues from taxes pay for important services
They also increase inefficiencies through pork barrel politics and rent-seeking
Section III: Macroeconomics
Main topics
The study of macroeconomics seeks to answer two questions
What causes the long-run growth and size of an economy?
What causes and results from short-run changes in economy activity, employment, and
inflation?
Gross Domestic Product (GDP)
GDP measures the total output or production of an economy
This includes the market value of all final goods produced domestically within a specific
period of time
Production equals expenditures equals income
Expenditures fall into four categories
Consumption
Investment
Government
purchases
Net exports
Since 1900, GDP of the U.S. has increased by a factor of about 32
U.S. population has increased by a factor of 4
GDP per capita measures the quantity of output per person
This measure depends on average labor productivity

Labor productivity depends on four factors
Quantity of physical and human capital
Natural resources
Technological knowledge
Political and legal climate

Business cycle
The business cycle describes fluctuation between expansions and recessions
Expansions occur when the economy experiences rapid growth
Recessions occur when the economy experiences slower or negative growth
Financial markets
Savings denotes income not spent on consumption within a certain period
Investment describes the purchase of capital
Financial markets coordinate the supply and demand for savings
Individuals and firms borrow other individuals savings to invest
Interest rates adjust to balance the supply and demand for savings
Savings equal investment in a closed economy
Savings equal investment plus net capital outflows in an open economy
GDP
Money supply
Money is a medium of exchange, unit of account, and store of value
Economists categorize money as M1 and/or M2
The Federal Reserve System serves as the central bank of the United States
The Fed was established in 1913
12 district banks and a Federal Reserve Board comprise the Fed
The district banks are located in major cities across the nation
The Federal Reserve Board is located in Washington, D.C.
The Fed manipulates the economys money supply
It lends money to banks as a last resort
In the long run, changes in money supply do not affect real quantities
They only affect prices
In the short run, changes in money supply affect saving and borrowing
They also affect economic activity
Unemployment
The unemployment rate measures the percentage of the labor force who would like to work
but cannot find jobs
Economists divide unemployment into frictional, structural, and cyclical unemployment
Inflation
Inflation describes an increase in all prices in an economy
The Consumer Price Index and Gross Domestic Product Deflator measure inflation
Short-run fluctuations
Economists distinguish between potential output and actual output
Potential output is the quantity produced with all resources fully employed
The difference between potential and actual output is the output gap
In the long run, an economy produces at potential output
In the short run, firms set prices and sell based on demand
An economys level of output depends on its aggregate demand
Aggregate demand may or may not equal potential output
Differences between actual and potential output cause aggregate price level to change
Changes in aggregate price level return the economy to potential output
The government can use monetary and fiscal policy to help close the output gap faster
But the effects of government policy often occur too late
This setback often worsens the economic situation
SECTION IV SUMMARY
POWER PREVIEW
This section covers the summary of Section IV, which
encompasses the portion of the curriculum pertaining to the
economies of the Soviet Union and Russia. This section
divides Russias history based on its leadership and succinctly
examines the mechanics and effects of various economic
reforms.
POWER NOTES
Section IV Summary covers pgs. 121-123 of
the USAD Economics Resource Guide
Communist Economic Systems
Planned economy
Marxism-Leninism provided the ideological backbone of the Soviet economy
This ideology emphasized public ownership of all means of production
Stalin collectivized farms in the 1930s
The state took every Russian farmers private property
Nationalizing property gave the bureaucracy immense economic control through planning
Shifting to a planned economy had three main aims
Remove the anarchy of the market
Organize the economy on a national scale
Distribute goods equitably
From 1928 until the late 1980s, the Soviet economy operated on five-year plans
Each plan coordinated bureaucratic commands among several agencies
Firms made exactly the amount stated in individual target plans
Managers lacked incentives to innovate
The bureaucracy controlled prices through price lists for every product sold
Planning caused dire economic distortions
Every sector experienced chronic shortage
Consumer goods particularly suffered from shortage
Shortage and scarcity necessitated the creation of a black market (shadow economy)
Rampant illicit activity fueled economic corruption
Mikhail Gorbachev
Perestroika
Mikhail Gorbachev came to power in March 1985
Gorbachev aimed to reform and reconstruct the communist system
This policy was called perestroika
He did not intend to transition to a market-based liberal system
Gorbachevs first reforms consisted of an anti-alcohol campaign and uskorenie
These reforms targeted economic productivity
Uskorenie, meaning acceleration, involved increasing investment in old infrastructure
The anti-alcohol campaign worked against investment efforts
Both policies failed to increase economic productivity
Gorbachev then launched a policy for social openness called glasnost
This effort included a policy called demokratizatsiia
Demokratizatsiia, or democratization, allowed some accountability in politics

These reforms granted managers more say in their production
They also introduced quasi-private property rights
Gorbachevs incomplete reforms worsened the economy
End of communism
The fall of communism in Eastern Europe terminated markets for poorly made Soviet goods
Production fell by roughly 10% every year by 1991
The Soviet Unions 15 constituent republics questioned the viability of staying united
In August 1991, Gorbachevs politburo forced his resignation with a failed coup
In December 1991, the Soviet Union collapsed
Communist Legacy
Successes of the planned economy

Soviet leaders industrialized the primarily agricultural economy in 70 years
The population achieved a 99% literacy rate
Costs of the planned economy
The economy experienced chronic shortage
Industrial production far outstripped consumer production
Technological innovation was nonexistant
Monopolies controlled much of the economy
The deteriorating manufacturing sector failed to compete globally
Poor manufacturing caused Russia to become dependent on natural resource exports
Boris Yeltsin
Shock therapy
In 1992, Boris Yeltsin, Russias new president, adopted a policy called shock therapy
This reform package was brought forth by a group of economists led by Yegor Gaidar
Shock therapy involved three major changes
Stabilization of the macro-economy
Liberalization of trade
Privatization of property
The implementation of these changes would cause short-term negative changes (shock)
But the economy would eventually latch on to market mechanisms and grow
The shock therapy policies had significant backlash
Industrial managers, who no longer received subsidies, demanded credits
Yeltsins compliance to this request ended shock therapy
Issuing credits violated the initial goal of fiscal austerity and minimizing deficit spending
Voucher system
In August 1992, the Russian state distributed privatization vouchers to every Russian citizen
Russians could use these vouchers in a variety of ways
Buy shares of privatizing firms directly
Buy shares of privatizing firms through mutual funds
Buy shares in a voucher fund
Sell them
Give them away
State auctions
In July 1994, Yeltsin initiated the second stage of privatization
The second stage involved selling remaining state holdings for cash at auctions
The firms received some of the proceeds as capital for restructuring

The government received the rest of the proceeds
The state hoped this process would alleviate the budget deficit without increasing inflation
Government leaders hoped the auctions would raise billions of dollars
The second stage of privatization failed in many ways
Loans for shares
In 1995, the government developed a new idea to earn much-needed revenues
The loans for shares scheme involved auctioning off 12 reputable companies
The state auctioned off each company separately to a group of commercial banks
A small group of wealthy business people gained a huge portion of the Russian economy
This group of elites became known as the oligarchs
The process was unpleasant and riddled with corruption
The loans for shares scheme delegitimized privatization in the publics minds
1998 economic crisis
By 1996, over 75% of large and mid-sized firms had been privatized
90% of industrial output had been privatized
The state failed to collect taxes
This failure benefited large oil and electrical firms
These firms could export without paying taxes or tariffs
In exchange, they provided energy to firms who could not afford it

The state stopped paying government employees in an effort to decrease inflation
In the first eight months of 1998, Russias foreign debt increased by $18.5 million
Reduction in foreign currency reserves hurt the states efforts to protect the rubles value
The International Monetary Fund gave Russia a package to pay off wages and debt
Instead, Russia used an IMF package to support the ruble, and failed
On August 17, 1998, Russia defaulted on its debt and devalued the ruble
As a result, domestic industry improved because goods became too expensive to import
Vladimir Putin
Economic growth
Vladimir Putin replaced Boris Yeltsin as president of Russia in 2000
Between 1999 and the summer of 2008, Russias economy improved in many ways
Increasing budget surpluses
Elimination of foreign debt
Increasing hard-currency reserves
Low inflation
Resource curse
Increasing oil and gas prices commanded Russias growth
Russia experienced many symptoms of the resource curse
The economy depended heavily on revenues generated from exporting oil
Russia suffered from Dutch disease
Dutch disease involves a high exchange rate caused by large inflows of foreign currency
used to purchase natural resources
This phenomenon causes domestic manufacturing to become expensive
Consumers import goods instead of purchasing domestic goods
The result: more and more reliance on natural resources
Putins government ignored the ailing manufacturing sector while oil prices rose
In 2008, extractive commodity prices fell
Russia had little else to sustain its economy

Putins legacy
Between 2003 and 2007, the government gained much control over the economy
Russian firms often chose to invest only after being politically pressured
Dmitri Medvedev
2008 global financial crisis

Dmitri Medvedev entered office months before the global financial crisis in September 2008
Russia experienced many problems it experienced during the 1990s
Negative growth
High unemployment
High inflation
Low oil export prices
President Medvedev recognized the need to stabilize and diversify Russias economy
He spearheaded the policy of modernization
He promised to stabilize the legal environment to protect foreign investors
POWER TABLES
Factors Of Production
Factor
What Is It?
What Is Its Reward?
Examples
Land
Natural resources
Rent
Farmland; oil; water
Labor
Human resources
Wages
Physical or mental activity
Capital
Goods used to produced other

goods
Interest
Computers; factory machinery
Entrepreneurship
New or improved ways to

produce goods and services
Profits
An intelligent businessman
invents a new, more efficient
production process for
microchips
Factors That Shift Supply

Factor
Relationship to Supply
Cost of Inputs
Negative/Inverse:
Increase in costs leads to decrease in supply
Technological Progress
Positive/Direct:
Increase in technology (technological development) leads to more supply
Number of Suppliers
Positive/Direct:
Increase in number of suppliers leads to increase in supply
Expectations of Changes in Price
Negative/Inverse: Expectations of lower prices in the future leads to increase in

supply now
Factors That Shift Demand

Factor
Relationship to Demand
Other Notes
Number of Demanders
Positive/Direct: Increase in number of demanders leads to

increase in demand
N/A
Price of Complementary Good
Negative/Inverse: Increase in price of complementary

good leads to decrease in demand
Use cross-price elasticity formula to

determine if two goods are
complements
Price of Substitute Good
Positive/Direct: Increase in price of substitute goods

leads to increase in demand
Use cross-price elasticity formula to

determine if two goods are
complements
Consumer Income
Normal goodsPositive/Direct: Increase in consumer

income leads to increase in demand
Inferior goodsNegative/Inverse: Increase in consumer
income leads to decrease in demand
Use income elasticity formula to

determine if a good is normal or inferior
Tastes or Preferences
Positive/Direct: Increase in popularity leads to increase in

demand
N/A
Factors That Shift Demand

Factor
Relationship to Demand
Other Notes
Expectations
Depends on which factor the expectation is related to

Example: Expectations of higher price in the future lead to
increase in demand
N/A
Shifts In Supply And Demand

Demand Shifts
Supply Shifts
Effect on Price
Effect on Quantity
To the right
No shift
Increase
Increase
To the left
No shift
Decrease
Decrease
No shift
To the right
Decrease
Increase
No shift
To the left
Increase
Decrease
To the right
To the right
? Ambiguous
Increase
To the right
To the left
Increase
? Ambiguous
To the left
To the left
? Ambiguous
Decrease
To the left
To the right
Decrease
? Ambiguous
Elasticity
Name
Relation to Total Revenue

(TR)
Graphical
Representation
Other Notes
Perfectly inelastic
Increase in price leads to

increase in TR; decrease in
Perfectly vertical
line
Purely theoretical for demand

Occasionally exists for supply of
goods that can no longer be
produced
E<1
Inelastic

increase in TR; decrease in
Steep line
Applies to goods that are

necessities and goods that have few
available substitutes; goods are
more inelastic in the short run
E=1
Unit elastic
Change in price has no effect

on TR
Line with a slope

of 1 or -1
None
E>1
Elastic

decrease in TR; decrease in
price leads to increase in TR
Flat line
Applies to goods that are luxuries

and goods that have many available
substitutes; goods are more elastic
in the long run
E=
Perfectly elastic
Change in price leads to loss of

all TR
Perfectly
horizontal line
Purely theoretical
Number Range
E=0
Comparing Market Types

Type of Market
Number of
Producers
Kind of
Competition
Barriers to Entry
Another Name for

Firms
Special
Traits
Monopoly
One
None
No entry possible
Price-setter
Only one firm
Oligopoly
A few
Primarily non-price
competition
Medium barriers
(difficult entry)
N/A
Firms can collude

and behave as a
monopolist
Monopolistic
Competition
Many
Non-price
competition; price
competition
Low barriers
(easy entry)
Price-maker
Product
differentiation and
branding
Perfect
Competition
A great many
Price competition
No barriers
(free entry)
Price-taker
Perfectly elastic
demand
Calculating GDP
Method
Process
Expenditures Approach
Add up the value of all finals goods and services in an economy;

C + I + G + NX = GDP = Y = income = expenditures
Income Approach
Remember that income equals production equals expenditures

Add all of the income of the workers and employers together
Types of Unemployment
Type of Unemployment
Definition
When It Occurs
Frictional
Unemployment resulting from the time lag

between when workers leave jobs and
when they find new jobs
Always present in the economy
Structural
Unemployment resulting from structural

changes in the economy; results from a
mismatch of skills demanded and skills
supplied
Always present in the economy, but can be

reduced by retraining unemployed workers
Cyclical
Unemployment resulting from changes in

the business cycle
Only occurs with a downturn in the

business cycle
Tools of Monetary Policy

Who Acts?
What Happens?
Expansionary/
Contractionary
How Does It
Work?
Utilized When?
Open-Market
Operations
FOMC
The Federal Reserve buys and sells

American securities
E: Buy
securities
C: Sell
securities
Injects or removes
money from the
economy
Daily
Discount Rate
(DR)
Board of
Governors
The Federal Reserve changes the

interest rate for loans from the
Federal Reserve to member banks
E: DR
C: DR
Changes the cost

of borrowing from
the Fed
Rarely
Policy Tool
Federal Funds
Rate (FFR)
Board of
Governors
The Federal Reserve changes bankto-bank lending rates
E: FFR
C: FFR
Changes the cost

of loans between
all banks
About once per

quarter
Reserve
Requirements
(RR)
Board of
Governors
The Federal Reserve changes the

reserve requirements for banks
E: RR
C: RR
Changes the
amount of
reserves banks
must maintain
Very rarely
Russian Reforms
Policy
Enactor
Year(s)
Goal(s)
Details
Result
Perestroika
Mikhail
Gorbachev
1985-1991
Restructure the
communist system
Encompassed the antialcohol campaign,

uskorenie, glasnost, and
demokratizatsiia
Indecisiveness and halfmeasures damaged the

economy
Anti-alcohol
campaign
Mikhail
Gorbachev
1985-1986
Eliminate chronic
alcoholism
Decrease worker
absenteeism
Increase worker
productivity
Closed down some alcohol

factories
Failed to reduce
alcoholism or improve
worker productivity
Russians produced
liquor illegally
Caused sugar shortages
Uskorenie
Mikhail
Gorbachev
1985-1986
Increase investment in
decaying infrastructure
Implemented at the same

time as the anti-alcohol
campaign
Failed because the antialcohol campaign

lowered state revenues
Glasnost
Mikhail
Gorbachev
1987-1988
Allow public discussion

on the merits of
communism and
capitalism
Included demokratizatsiia
Spurred introduction of
private property
Allowed politicians and
media to discuss
important issues
pertaining to the
election of the 1989
super parliament
Demokratizatsiia
Mikhail
Gorbachev
1987-1988
Introduce some
accountability and
democratic aspects to
the political process
Allowed interest groups to

participate in the political
process
Contributed to the fall

of communism in
Eastern Europe
Shock therapy
Boris
Yeltsin
January 1992
Transition Russia to a
liberal market-based
economy
Rapidly stabilize the
economy, liberalize
trade, and privatize
property
Eliminated price lists

Increased prices by 245%
overnight
Increased inflation
Increased unemployment as
unprofitable firms failed
Strong backlash from

red managers after
termination of subsidies
Ended with the issuance
of Central Bank credits
Failed by spring 1992
Corporatization
Boris
Yeltsin
July 1992
Separate ownership from

management
Held managers accountable

to a board of directors
Introduced incentives
guided by the principles of
profit and loss
N/A
Voucher
program
Boris
Yeltsin
August 1992
Transfer ownership of
firms from public to
private hands
Involved all Russian citizens

in the process of
privatization
Succeeded in part
Opposed by many firms
because they did not
receive money
Sold 20% of all shares
for vouchers
State auctions
Boris
Yeltsin
July 1994
Finance the budget

deficit without increasing
inflation
Increase foreign
investment
Auctioned off state

holdings for money
Used part of the proceeds
to restructure firms
Failed when Vladimir

Polevanov, Minister of
Privatization, halted
privatization
Discouraged foreign
investment
Modernization
Dmitri
Medvedev
2008
Diversify Russias
economy
Use educated labor to
innovate new
technologies
Constructed a Russian
equivalent of the Silicon
Valley called Skolkovo
N/A
Economics Timeline
1920
The Russian Civil War ends
1920s
Joseph Stalin and the Soviet government collectivize agriculture
late 1970s
The Soviet Unions production levels fall
late 1980s
The Soviet Unions production levels reach a free fall

The system of ministerial control declines
March 1985
Mikhail Gorbachev becomes the General Secretary of the Communist Party of the Soviet Union
1987
Mikhail Gorbachev initiates glasnost
November 1989
The Berlin Wall falls
1990
Boris Yeltsin is elected speaker of the new Russian parliament
summer of 1990
A group of economists presents the Five Hundred Day Plan to Mikhail Gorbachev
fall of 1990
Mikhail Gorbachev rejects the Five Hundred Days Plan
early 1990s
Barter economies present in both agriculture and industry
1990s
Most of Russias transformation to a market system takes place
1991
Shortage and inflation persist

Most Russians are on the state payroll
June 1991
Boris Yetsin is elected president of Russia
August 1991
The Soviet Politburo oust Mikhail Gorbachev from office through an attempted coup
fall of 1991
Boris Yeltsin surveys reform options proposed by groups of economists
December 25, 1991
The Soviet Union collapses
January 2, 1992
Boris Yeltsin frees prices
April 1992
Industrial managers most oppose shock therapy
spring of 1992
The Russian Central Bank responds to opposition by issuing credits to firms, ending shock therapy
Economics Timeline
June 1992
Yegor Gaidar and Boris Yeltsin pass legislation initiating the process of privatization
July 1992
Boris Yeltsin initiates the privatization program

Yeltsin creates the State Committee on Property
August 1992
The voucher program begins
December 1992
Share auctions begin
January 1993
Latest date to claim vouchers
May 1993
Boris Yeltsin issues a decree stating that firms must trade 29% of all shares for vouchers
July 1994
Boris Yeltsin initiates the second stage of privatization
July 1, 1994
Latest date to invest vouchers
1995
Boris Yeltsin initiates the loans for shares scheme
1996
75% of all mid to large-sized firms are privatized

90% of all industrial output is privatized
September 1, 1996
Earliest date banks could sell the shares they received from the loans for shares scheme
1996-1997
Inflation and the ruble exchange rate stabilize

The state falls behind on paying wages and pensions
late spring, summer 1998 Russia starts borrowing foreign currency to finance domestic debt
July 20, 1998
The International Monetary Fund offers Russia a package to pay wages and short-term debt
The state uses it to defend the rubles value and fails
August 17, 1998
The 1998 financial crisis occurs

Russia devalues the ruble and defaults on its domestic and international debts
1999
The Russian economy starts growing for the first time since the Soviet Unions collapse
Unemployment is at 12%
2000
Vladimir Putin assumes the presidency

GDP growth reaches an all-time high of 8.5%
2004
Vladimir Putins first term ends
2008
Unemployment is at 6%
Oil prices fall
Russian government divides the Stabilization Fund into the National Prosperity Fund and the Reserve Fund
spring of 2008
Dmitri Medvedev assumes the presidency
June 2008
Russias stock market begins to lose value
September 2008
The global financial crisis begins
October 2008
Industrial output starts falling
First quarter of 2009
Government revenue falls by 28%
January 2009
Russias stock market loses 70% of its value since June 2008
February 2009
Inflation hits a 14-month high of 13.9

Industrial output has fallen 16% since October 2008
2011
Russia transitions to a market-based economy
POWER LISTS
PERCENTAGES
-0.2% (119)
Percent growth of Russias GDP in 2009
2% (118)
Percent growth of Russias oil production in 2007
3% (111, 118)
Percent growth of Russias GDP in 1989

Percent growth of Russias oil production in 2006
5% (118)
Percent growth in Russias oil production in 2005
6% (119)
Russias unemployment rate in 2008
9.7% (72)
The United States unemployment rate in August 2009
10% (110, 118,

119)
Yearly percent decline in Russias production between 1989 and 1991

Percent growth in Russias oil production in 2004
Increase in Russias real disposable income between 1999 and 2008
12% (#)
Russias unemployment rate in 1999

Percent of Russians living on subsistence minimum in 2008
13%
Flat income tax rate imposed by Vladimir Putin during his first term (2000-2004)
16% (86, 119)
Decline in the United States CPI from 1920 to 1922

Percent decline in Russias industrial output between October 2008 and February
2009, according to Bank of America Securities-Merrill Lynch
-17% (111)
Percent growth of the Soviet Unions GDP by the time of its collapse in 1991
19% (118)
Percent of Russias oil coming from state-owned firms in 2004
20% (114)
Average percent of shares sold by each firm during Boris Yeltsins voucher program
24% (117)
Russias tax rate on profits after Vladimir Putins tax cuts
25% (86, 114)
Decline in the CPI from 1929 to 1933

Percent of insider ownership allowed under Boris Yeltsins voucher program
28% (119)
Decline in Russian government revenue by the first quarter of 2009
29% (114)
Percent of shares that had to be sold during the voucher program under Boris
Yeltsins decree
35% (117)
Russias tax rate on profits before Vladimir Putins tax cuts
41% (119)
Percent of Russians living at subsistence minimum in 1999
50% (118)
Percent of Russias oil coming from state-owned firms in 2008
66% (72)
The United States current labor force participation rate
70% (119)
Percent decline in the value of Russias stock market between June 2008 and
January 209
75% (115)
Percent of Russias large and mid-sized firms privatized by 1996
90% (115)
Percent of Russias industrial output privatized by 1996
99% (107)
The Soviet Unions literacy rate at the time of its collapse
100% (111)
The Soviet Unions inflation rate at the end of 1991
245% (112)
Average percent increase in prices the day after Boris Yeltsin freed prices on January
2, 1992
NUMBERS
2 (59)
Amount (in U.S. dollars) that the average inhabitant of Ghana earns per day
12 (114, 117)
Number of blue-chip companies auctioned off in the loans for shares scheme
Price of a barrel (in US dollars) of Urals crude oil blend in 1998
13 (105)
Number of time zones covered by the Soviet Union
13.9 (119)
Russias inflation rate in February 2009, a 14-month high
15 (110)
Number of countries created from the dissolution of the Soviet Union in 1991
20 (104)
Number of years it took Russia to transition from a command to market-based

economy
29.6 (86)
The CPI of the United States in 1960
43 (92)
Length of decline (in months) of the Great Depression, starting August 1929
50 (114)
Average monthly wage (in US dollars) during Boris Yeltsins voucher program
70 (107, 117)
Number of years it took the Soviet Union to industrialize

Price of a barrel (in US dollars) of Urals crude oil blend in 2007
84 (114)
Value of a voucher (in US dollars) during Boris Yeltsins voucher program
200 (113)
Maximum number of employees to be classified a small firm

Minimum number of employees to be classified a medium firm
215.3 (86)
The CPI of the United States in 2008
458 (59)
Average output per person in Ghana
1,000 (113)
Minimum number of employees to be classified a large firm Maximum number of

employees to be classified a medium firm
3,000 (111)
The number of exchange rates for every item in the Soviet Union
10,000 (114)
Value of a voucher (in rubles) during Boris Yeltsins voucher program
43,000 (58)
Average output per person in the United States in 2008
47,000 (6)
Number of items in the average American supermarket
100,000 (104)
Number of workers employed at many Soviet firms
15 million (72)
Number of unemployed in the United States in August 2009
18.5 million (116)
Increase of Russias foreign debt (in US dollars) over the first 8 months of 1998
140 million (72)
Number of employed in the United States in August 2009
154.6 million (72)
Number of people in the United States labor force in August 2009
236 million (72)
Number of working-age people in the United States in August 2009
1 billion (55, 115)
Cost of United States sugar price supports to American consumers a year

Russias government revenues (in US dollars) earned from loans for shares scheme
TERMS FUNDAMENTALS OF ECONOMICS
Absolute advantage (36)
When one party can produce more of a good than another
Comparative advantage (39)
When one party can produce a good at a lower opportunity cost than
another
Cost-benefit analysis (12, 15)
How rational decision-makers decide on one choice or course of action

as opposed to another, by weighing the pros and cons of a decision in an
attempt to maximize utility
Economics (6)
The study of how individuals make choices regarding allocating scarce

resources to satisfy unlimited wants
Marginal
To have one more of something
Marginal utility
The amount of satisfaction one derives from consuming one more of a

good or service
Normative economics (7)
Economic analysis that focuses on what should be, rather than what
actually is or can be; involves opinion
Opportunity cost (7)
The cost of what is given up when you make a decision; the cost
(monetary or otherwise) of the next best alternative
Pareto efficient (8)
A state where it is impossible to improve one persons well-being

without reducing someone elses well-being
Positive economics (7)
Economic analysis that seeks to describe and explain economic

phenomena
Production Possibilities
Frontier (PPF) (36)
A graphical representation of the different combinations of output that

can be produced
Rational (7)
The state of mind of people that effectively engage in cost-benefit

analysis, only making decisions that benefit them
Scarcity (6)
The fact that all resources are finite
Trade-offs (7)
The idea that in order to get something, we must give up something else
Unlimited wants (6)
The assumption that all people have unbounded desires that can never
be fully fulfilled
Utility (76)
The amount of satisfaction one derives from something; usually

expressed as a number
TERMS MICROECONOMICS
Accounting costs (40)
Part of total costs; includes only actual monetary expenditures
Accounting profit (40)
Profit that does not include opportunity costs
Average cost (44)
Total production costs divided by quantity produced; total production cost

of one input
Barriers to entry (43)
Prevent competitors from entering a market
Binding (34)
Describes a price floor above the equilibrium price, or a price ceiling below
the equilibrium price
Cartel (45)
What results when firms in an oligopoly agree to behave as a monopolist
Coase Theorem (50)
The private market should be able to resolve externalities as long as the

involved parties can negotiate and property rights are clearly defined
Collusion (45)
A situation in which firms in an oligopoly make decisions as one
Complement (15)
Two goods for which a rise in the price of one leads to decline in demand
for another
Consumer surplus (19)
The surplus that consumers receive when buying something at a lower

value than they would be willing to pay
Contracts (54)
Agreements entered into voluntarily
Contrived scarcity
When a monopolist purposely undersupplies the market, increasing prices

above what would otherwise be the market price
Creative destruction (46)
When old practices or goods disappear in favor of newer, more efficient,

better goods that increase social welfare
Deadweight loss (34)
Reduction in social welfare that results from a distortion of the market,

such as government intervention
Demand curve (13)
Depicts the relationship between quantity demanded and the goods price
Demand schedule (13)
A table, depicting the quantity demanded of a good at certain prices
Economic costs (39)
The total cost of producing a good, including opportunity cost
Economic profit (40)
Difference between the revenue a producer receives and the opportunity

cost of producing the good
Elasticity (25)
Percent change in quantity due to a percent change in price
Entrepreneurs (46)
Individuals who take on risk when creating new goods and services, and are
rewarded with economic profits
Equilibrium (17)
In economics, the single combination of price and quantity where a market

settles
Excludability (53)
Describes the ability to control whoever consumes the good in question
Externalities (48)
When the actions of one person affects anothers well-being, but neither
party pays or is paid for these effects
Firms (39)
The economic actors who supply goods and services for an economy
Fixed costs (40)
Costs that cannot be changed in the short run
Homogenous
When goods are exactly the same as each other
Imperfectly competitive (43) Markets with only one or a few suppliers
Inferior goods (15)
Goods for which quantity demanded falls as income of the buyers rises
Innovate (46)
What entrepreneurs do in an attempt to establish market power
Institutions (54)
Formal (and informal rules) that govern human interactions
Internalize (50)
When firms solve externalities by combining the activities that produced

the externalities
Law of demand (12)
The negative relationship between a goods price and quantity demanded
Law of supply (15)
The positive relationship between a goods price and quantity supplied
Logrolling (55)
Vote trading by legislators in an attempt to gain support for pet projects
Marginal cost (41)
The additional cost of producing one more of a good
Marginal revenue (41)
The additional revenue of selling one more of a good
Marginal tax
A tax that creates a price wedge between consumers and producers
Market (10)
Composed of all of the buyers and sellers of a good
Market demand curve (13)
Shows relationship between quantity demanded of a good and its price;

obtained by adding the quantities demanded by all buyers in the market
Market failure (46, 48)
When competitive markets fail to produce socially desirable outcomes
Market power (43)
Firms can choose from combinations of price and quantity determined by

market demand; firms with this face a downward sloping demand curve
Market supply curve (15)
Shows relationship between quantity supplied of a good and its price;

obtained by adding the quantities supplied by all buyers in the market
Microeconomics (10)
Concerns itself with the interaction of supply and demand within markets
Monopolistic competition
(45)
Combines parts of the monopoly and perfectly competitive models; firms

sell similar, but differentiated, products
Monopoly (43)
A market with only one supplier
Negative externalities (48)
Externalities that harm third parities
Normal goods (15)
Goods whose quantity demanded rises as income rises, and quantity

demanded falls as income falls
Oligopoly (45)
A market with a small number of sellers; often characterized by collusion
Organizations (54)
Organize human interaction through formal rules and structures; much

more formal than institutions
Perfect price discrimination

(45)
When firms can sell their product to each customer at the exact value the
customer placed on the product
Perfectly competitive market Market characterized by price taking behavior, lack of market power,
(10)
homogenous goods, no barriers to entry, no transaction costs, perfect
information, and rational behavior
Perfectly price-elastic (28)
A characteristic in which increasing prices above equilibrium results in

nothing supplied or demanded, and decreasing prices results in an infinite
amount being supplied or demanded; purely theoretical
Perfectly price-inelastic (28)
A characteristic in which prices can be raised or lowered without changing

the quantity demanded or supplied; on the demand side, purely theoretical
Pork barrel politics (54)
The tendency for elected officials to steer money to their constituents via
pet projects
Positive externalities (48)
Externalities that benefit third parties
Price ceilings (31)
A maximum price on a good
Price controls (30)
Limits on the prices of a good
Price elasticity of demand

(25)
Measures how much the quantity demanded of a good responds to changes

in price
Price elasticity of supply

(28)
Measures how much the quantity supplied of a good responds to changes

in price
Price floors (34)
A minimum price on a good
Price taker
For a perfectly competitive market; when buyers and sellers must accept the
market price
Price-elastic (25, 28)
When a 1% change in price results in a greater than 1% change in quantity
Price-inelastic (25, 28)
When a 1% change in price results in a less than 1% change in quantity
Producer surplus (21)
The surplus that producers receive when selling something for more than
they would be willing to
Product differentiation (45)
Distinguishing between different goods that serve the same purpose in the
same market
Property
Social institution that allows an individual exclusive use of a good
Quantity demanded (11)
The amount of a good that consumers are willing and able to buy
Quantity supplied (15)
The amount of a good that sellers are willing and able to produce
Quota (51)
A numerical limit on how much of something is allowed
Rent seeking (55)
Socially unproductive activities that direct, rather than create, economic

benefits
Revenue
What firms receive from selling goods
Rivalry (53)
If one person consumes a good, then that reduces the amount available for
everyone else
Shortage
When quantity demanded exceeds quantity supplied; often happens with

an effective price ceiling
Specialization (36)
When individuals and countries focus on producing what they produce

best (for the lowest opportunity cost relative to others)
Substitute (15)
Goods for which an increase in the price of one increases the demand of
the other
Supply curve (15)
Depicts the relationship between quantity supplied of a good and that

goods price
Supply schedule (15)
A table, depicting the quantity supplied of a good at certain prices
Surplus
When quantity supplied exceed quantity demanded; often happens with an

effective price floor
Tax revenue
The tax per unit times the quantity of units; sits as a rectangle between
producer and consumer surplus
Total costs (39)
The comprehensive cost of supplying a good or service
Total market surplus (21)
The sum of producer and consumer surplus; the total benefit market
participants receive from buying and selling
Total revenue (28)
Equal to equilibrium price times equilibrium quantity; shown graphically

as a rectangle
Tragedy of the commons

(52)
When a resource that is owned jointly is overused because no one accounts

for negative externalities caused by overuse
Unit elastic (25, 28)
When a 1% change in price results in a 1% change in quantity
Variable costs (40)
Costs that can be altered in the short run
TERMS MACROECONOMICS
Aggregate demand (95)
Total demand in the economy at all price levels; reflects the total
expenditures in the economy
Aggregate supply (97)
Total supply in the economy at all price levels; maps price levels to the
real output supplied by firms
Aggregation (63)
Combining many different things into a single variable
Assets
Things owned by an individual or entity
Average labor productivity (58)
The total output of the economy divided by the number of workers

employed
Bank run (86)
When depositors rush to withdraw their deposits from a financial

institution
Banks (77)
A type of financial intermediary; these loan to small businesses and

accept deposits from people who want to save
Bond (77)
A certificate of indebtedness; a form of an IOU; the borrower must pay

the holder of this back, along with interest
Budget deficit (78)
What occurs when taxes minus government spending is negative
Budget surplus (78)
What occurs when taxes minus government spending is positive
Bureau of Labor Statistics

(BLS) (69)
Agency that calculates the Consumer Price Index (CPI) every month
Business cycle (91)
Alternation of expansions and recessions in an economy
Business fixed investment (67)
When firms buy factories, offices, machinery, and other capital goods
Business sector
The part of the circular flow model occupied by firms
Capital goods (65)
Goods that are long-lived and produced to make other goods
Central bank (83)
Institution that regulate the supply of money and oversees a countrys

banking system
Circular flow model (73, 74)
A model that traces the path of money, goods, and services through an
economy
Commodity money (83)
Money with intrinsic value
Consumer durables (67)
Long-lived consumer goods
Consumer nondurables (67)
Short-lived consumer goods
Consumer Price Index (CPI)

(69)
Measures the cost of purchasing a basket of goods and services at market

price that is intended to represent the consumption of an average
consumer; used to measure inflation
Consumption (95)
Spending by households; see consumption expenditures
Consumption expenditures
(95)
Spending by households; see consumption
Contractionary fiscal policy
Spending by legislatures or the government to slow an expansion
Currency (83)
Bills and coins owned by the public; the most liquid asset
Cyclical unemployment (73)
Unemployment caused by the ups and downs of the business cycle
Date of maturity (77)
Specifies the date a loan will be repaid
Debt finance (77)
The sale of bonds
Default (77)
When the borrower of a bond fails to pay some or all of the principal or
interest
Demand deposits (82, 83)
Another name for checking accounts
Depression
An extremely severe recession
Diminishing returns to scale

(41)
An increase in inputs results in a smaller increase in the quantity

produced each time
Discount rate (86)
The interest rate that the Federal Reserve charges on loans to banks
Dividends (77)
The profits enjoyed by shareholders whenever stocks are sold
Downturn
A period in which the economy begins to decline
Employment
The state of either working for pay or being on leave from a regular job
Employment rate
The percentage of the labor force that has a job or is on leave from a
regular job
Equation of exchange
MV = PY; see quantity theory of money
Equity finance (77)
Sale of shares of stock
Eurodollars
All dollar accounts held outside of the United States
Expansion (91)
Periods when the economy grows faster than its long-run trend
Expansionary fiscal policy
Spending by legislatures or the government to mitigate a recession
Exports
Goods that a country sells to foreigners
Factor market (74)
The market where labor, land, and capital are bought and sold
Factors of production (74)
The name for land, labor, capital, and entrepreneurship
Fed
Another name for the Federal Reserve system
Federal funds rate (86)
The interest rate that banks charge when loaning to other banks
Federal Open Market

Committee (FOMC) (84)
Organization that meets every six weeks in Washington, D.C. to

determine if any changes in monetary policy are necessary; composed of
the seven Fed governors and five regional bank presidents
Federal Reserve System (83)
Serves as the central bank of the United States; created in 1913 and
consists of 12 regional banks
Fiat money (83)
Money with no intrinsic value
Final good (65)
What results from a long, complex chain of production activities
Financial institutions
Coordinate the saving and investment decisions in an economy
Financial markets (76)
Institutions where savers can supply their savings to those who wish to
borrow the money for investment
Fiscal policy (101)
Government spending
Foreign direct investment (79)
When a company or individual acquires assets in another country that

they will actively manage
Foreign exchange effect (97)
At a lower domestic price level, domestic consumers will buy fewer

imports, causing net exports to increase and GDP to increase; one of the
reasons aggregate demand slopes downward
Fractional reserve banking
A type of banking where the bank will loan out some of the deposits,
keeping only some in reserve
Frictional unemployment (72)
Unemployment due to the process of matching employees and

employers; this type of unemployment is always present
GDP deflator (71)
A measurement of the relationship between real and nominal GDP that

tells about the degree of inflation
Government purchases (67)
The goods and services purchased by federal, state, and local

governments
Government saving (78)
Equal to taxes minus government purchases
Gross Domestic Product

(GDP) (65)
The market value of all final goods produced within a country during a
certain period of time
High-powered money (85)
Another name for the monetary base; currency plus reserves
Human capital (75)
Skills and experience acquired by humans through training, education,

and on-the-job experience
Identity (78)
An equality that is always true
Imports
Goods that a nation brings in from other countries
Inflation (61)
When all prices rise together
Interest effect
At a low price level, people will have more money than they want and
will try to acquire less liquid assets, increasing the supply of savings; this
decreases interest rates and causes people to borrow more; one of the
reasons aggregate demand slopes downward
Intermediary (77)
A third party that links two others
Intermediate goods (65)
Goods used up while producing another, final good
Inventories (67)
Additions of unsold goods to company inventories
Investment (76)
Spending by firms on final goods; purchases of houses by households
Keynesian model (97)
Model using aggregate curves to explain the economys short-run

fluctuations
Labor force (60)
All people that are either employed or unemployed
Lender of last resort (86)
The Feds responsibility, if a bank looks like it is about to fail
Liabilities
To a bank, the deposits of depositors
Liquidity (83)
How easily something can be converted into money
Long run
The time period in which an economy moves back to equilibrium
Long run aggregate supply

(LRAS) (97)
Drawn as a vertical line where output equals potential output
M0
All of the currency and coins in an economy
M1 (83)
A component of the money stock; includes currency, demand deposits,

nonbank travelers checks, and other checkable deposits
M2 (83)
The best definition of the money supply; includes M1, savings deposits,
small time deposits, and retail money funds
Macroeconomics (57)
The branch of economics concerned with the performance of national

economies
Market for goods and services

(74)
The market where firms sell and households buy final goods
Medium of exchange (82)
An item that can be used to buy goods
Monetary base (85)
See high-powered money; the amount of currency plus reserves
Monetary policy (101)
Instrument used by the Federal Reserve to alter the money supply and
offset short-run economic fluctuations
Money (82)
Anything that is a medium of exchange, unit of account, and store of

value
Money market accounts
A form of deposit similar to retail money funds
Money multiplier (85)
The reciprocal of the reserve ratio; determines the effect of altering the
reserve ratio on the stock of money in the economy
Money supply (84)
The amount of money in the economy, controlled by the Fed
Mutual funds (78)
A portfolio of stocks that inexperienced savers can purchase, allowing to

diversify their holdings
National savings (78)
Equal to national income minus consumption minus government

purchases
Natural rate of unemployment

(95)
Level of unemployment present when actual output is equal to potential

output; includes only frictional and structural unemployment
Net capital outflow (78)
The purchase of foreign assets by domestic residents minus the foreign

purchase of domestic assets
Net exports (67, 68)
Value of domestically made goods sold to foreigners minus value of

foreign-made goods bought by domestic buyers
Neutrality of money (90)
In the long run, changes in the quantity of money have no effect on real
quantities in the economy
Nominal
The cost of anything, without adjusting for inflation
Nominal GDP (69)
GDP calculated with current year prices
Okuns Law (95)
Every 1% that the unemployment rate is off from the natural rate of
unemployment, the output gap deviated by 2%
Open-market operations (84)
The buying and selling of bonds by the Federal Reserve to change the
money supply
Output gap (94)
Difference between actual output and potential output
Peak
The high point of a business cycle
Per capita (57)
Latin phrase; literally means per head (per person)
Portfolio investment (79)
When an individual or firm buys shares of stocks or bonds issued by a

foreign company
Potential output (94)
The quantity of goods that can be produced when the economy is using
all of its resources at normal rates; not fixed over time
Price level
The sum of all prices in the economy
Principal (77)
The original amount loaned out
Private savings (78)
National output minus consumption minus government spending
Quantity theory of money (91)
See exchange equation; also called quantity equation; MV = PY; velocity

of money times the quantity of money equals nominal GDP
Real
Anything expressed with corrections for the effects of inflation
Real Gross Domestic Product

(Real GDP) (68)
GDP adjusted for inflation
Real interest rate (80)
The nominal interest rate minus the rate of inflation
Recession (60)
Periods of slow growth (or even decline) in output/GDP
Reserve requirement (85)
The amount of money banks are required to have in their vaults to pay
back depositors
Reserve-deposit ratio (85)
Also called the reserve ratio; the percentage of deposits banks are
required to keep as reserves
Reserves
The portion of deposits that banks must hold to ensure depositors can
withdraw from their accounts
Residential fixed investment

(67)
When households purchase new homes and apartment buildings
Saving (76)
The difference between what a person earns and what that person
spends
Savings deposits
Another name for a savings account
Services (67)
Intangible goods, such as education, insurance, and financial services
Short run (101)
The period of time the economy deviates from long-run predictions;

usually one to three years
Short-run aggregate supply

(SRAS) (97)
The potential supply of all goods at all price levels; upward-sloping
Solvent (86)
When a banks assets exceed its liabilities
Stock (77)
Represents ownership of a portion of a company
Store of value (83)
An item that people can use to transfer purchasing power from the
present into the future
Structural unemployment (72)
Unemployment due to mismatches between job openings and job seekers
Technological knowledge (76)
Knowledge about the techniques that transform inputs into goods and
services to be purchased by households
Time deposits
A deposit that cannot be withdrawn for a length of time, but accrues

significant interest in the meanwhile
Trade deficit (62)
When imports exceed exports
Trade surplus (62)
When exports exceed imports
Transfer payments (67)
Redistributes money but does not create anything; does not count
toward government purchases and GDP
Travelers checks
A preprinted check
Trough
The lowest point on the business cycle; signals the start of an expansion
Unemployment (57)
State of actively seeking paid work, but unable to find it
Unemployment rate (57, 60)
Percentage of people who would like to work but cannot find jobs
Unit of account (83)
A yardstick that established the value of different goods
Upturn
Another word for expansion
Velocity of money (91)
The number of times the average dollar bill is used in a year
Vertical integration (65)
When industries at different stages of production of a good are

combined
Wealth (76)
The total value of assets, as a store of value
Wealth effect (97)
A phenomenon in which money becomes more valuable and people buy

more goods and services when the aggregate price level declines
TERMS ECONOMY OF COMMUNIST AND POST-COMMUNIST RUSSIA
Barter (112)
Transactions of goods and services without the use of money
Black market (107)
Illegal trade of goods and services
Budgetary institutions (104)
One form of property under the Soviet system, includes universities,

educational and research institutions, training centers and trade schools,
hospitals, and museums
Bureaucracy (105)
A group of un-elected state officials, responsible for planning the Soviet

economy
Capitalists (104)
A class of individuals who owned property (or capital) without

contributing labor
Central management (106)
Organizational structure in which most of a firms decision-makers are

located at one place
Classical socialist system (104)
Consists of three types of property: the state-owned firm, budgetary

institution, and cooperative
Collectivization (104)
Transferring ownership of property from individuals to communities
Command economy (104)
See planned economy
Communism (104)
A theory advocating a fully developed version of socialism in which all

means of production are owned by the state
Convertibility (110)
The ability to exchange one currency for another
Cooperative enterprises (108)
Small businesses created by Mikhail Gorbachev that introduced quasiproperty rights and competitive practice but lacked clear ownership
Cooperatives (105)
One form of property under the Soviet system, huge mostly agricultural
firms, includes social services
Corporate governance (114)
The direction and administration of a firm
Cradle-to-grave (104)
Services that last a persons entire lifetime, important in communism
Downward flow of
information (106)
Process of plans traveling from the Soviet bureaucracy to ministries,

directorates/sectors, and individual firms
Disaggregation of plans (106)
Practice of separating a bureaucratic plan into more manageable parts
Dutch disease (117)
Negative effects caused by a large inflow of foreign currency, associated

with the discovery of natural resources and subsequent decline of the
manufacturing sector
Economies of scale (104)
The advantages of expanding a firms scale of production
Exchange rate (111, 117)
Price of one currency in terms of another, used for conversion purposes
Five-year plans (105)
Bureaucratically crafted statements of intent that dictated the Soviet

economy from 1928 until the late 1980s
Kolkhoz (105)
Collective farm
Large firms (113)
Category established by the State Committee on Property under Boris

Yeltsin, consists of over 1000 employees
Liberalization (110)
Removal of restrictions
Managers (106)
Individual in charge of all or part of a firm
Market-based economy (104)
An economy that emphasizes private property ownership and the

reliance on market forces to allocate resources
Market system (110)
See market-based economy
Marxism (105)
Karl Marxs highly diverse theories on society and politics, used by his
followers to develop the practice of communism
Marxism-Leninism (104)
Ideology created by Vladimir Lenin from Karl Marxs writings on

communism, emphasized government ownership of all means of
production
Medium firms (113)

Yeltsin, consists of 200-1000 employees
Ministerial control (110)
Government control
Mobility (104)
Ability to change ones residence
National firms (104)
State-owned firm controlled by the Soviet national government
Nationalization
Transfer of property from individual to government ownership
Oligarchs (115)
Small group of wealthy business people who inherited a large portion of

the Russian economy as a result of the loans for shares scheme
Planned economy (104)
An economy in which output and price is regulated by the government

instead of by the market
Plan targets (106)
Plan specifying an exact level of output that an individual firm is

responsible for producing, written by bureaucratic planners
Plenum (108)
A planning meeting
Price lists (106)
Lists designating prices for every item sold in an economy, written by

bureaucratic planners
Privatization (109, 110, 112)
Transferring property ownership from the state to individuals
Production plans (104)
See plan targets
Propiska (104)
A housing permit that allows laborers to move to different cities
Quasi-property rights (108)
Partial property rights introduced by Mikhail Gorbachev
Red managers (112)
Industrial managers who opposed Boris Yeltsins shock therapy policies
Regional firms (104)
State-owned firm controlled by Soviet subnational governments
Resource curse (117)
Negative effects associated with discovering natural resources
Sabotage (106)
Intentionally causing damage for personal gain, Soviet managers accused

of this could be sentenced to death
Sequencing reform (108)
Choosing easier political reforms
Shadow economy (107)
See black market
Shortage economy (107)
A state of persistent high scarcity of goods and services
Small firms (113)

Yeltsin, consists of under 200 employees
Socialism (104)
A theory that supports public ownership of an economys means of

production
Socioeconomic stratification
(112)
Hierarchy of classes based on social and economic status
Stagflation (110)
High unemployment and inflation
State coffers (104)
State treasuries holding government revenues
State-owned firms (104)
One form of property under the Soviet system, huge mostly heavy
industrial firms, includes social services, consists of national and regional

firms
Upward flow of information

(106)
The process of lower levels of the Soviet economy sending

recommendations on target output to higher levels during the plan
drafting process
EVENTS
Great Depression (57, 91)
Lasted from August 1929 to 1933 (43 months); most severe episode of
economic decline observed to date; during this time, real GDP declined
by nearly 25%
World War II (60)
Lasted from 1941 to 1945; featured high inflation; provided an impetus

for the U.S. to perfect methods of measuring national output
Russian Civil War (104)
Civil war fought in Russia between the Bolsheviks and anti-Bolsheviks
PEOPLE
Aslund, Anders (113)
Stated that in an efficient market economy, no less than 2/3 of national

employment must exist in the private sector
Boskin, Michael (71)
In 1996, he was assigned to head a committee to review the methods

used to calculated the CPI
Coase, Ronald (50)
Reached the insight that the private market ought to be able to resolve
externalities, as long as the parties involved can negotiate and property
rights are clearly defined
Colton, Timothy (107)
Stated that the Soviet Unions bureaucratic planners needed to

computerize and robotize their jobs but had trouble anticipating the
need for it
Hanson, Philip (117)
Stated that, It is by their indirect effects, that oil and gas price rises
fuelled Russian growth.
Ford, Henry (76)
Introduced the assembly line
Gaidar, Yegor (111)
Primary author of the shock therapy reform enacted by Boris Yeltsin,

acting prime minister of Russia under Yeltsin
Gontmakher, Evgeny (117)
Analyst; commented on Russias experience with the resource curse. He

stated, This is all a result of incorrect economic policy, oil dependence,
and rampant corruption, Until the system changes, these problems will
persist.
Gorbachev, Mikhail (107)
General Secretary of the Community Party of the Soviet Union from

1985 to 1991
Keynes, John Maynard (95)
British economist; lived from 1883 to 1946; wrote the 1936 book The
General Theory of Employment, Interest, and Money
Kornai, Janos (104)
Economist; stated that the distinction between Soviet national and

regional firms was meaningless because national governments strictly
controlled regional governments
Kuznets, Simon (67)
Economist; commissioned by the U.S. Department of Commerce in

1932 to develop a system to measure national output; received the
Nobel Prize in Economic Science for 1971
Lenin, Vladimir (104)
Head of the Bolshevik Party before Joseph Stalin
Medvedev, Dmitri (119)
Russias president from 2008 to 2012
Okun, Arthur (95)
One of President Kennedys chief economic advisors in the early 1960s
Pareto, Vilfredo (8)
Italian economist (1848-1923); first came up with the concept that an

outcome was efficient only if there was no way to improve someones
well-being without reducing someone elses well-being
Petty, Sir William (67)
In the mid-17th century, attempted to measure British national output

to assess the ability of the Irish to pay taxes
Polevanov, Vladimir (114)
Russias Minister of Privatization during Boris Yeltsins presidency,

halted Yeltsins second stage of privatization, advocated renationalization of some firms
Putin, Vladimir (117)
Russias president from 2000 to 2008
Schumpeter, Joseph (46)
Economist; described impact of entrepreneurs as creative destruction
Shatalin, Stanislav (110)
Economist and Gorbachev advisor; helped produce the 500 Day Plan
Smith, Adam (6)
Economist and author of the 1776 An Inquiry into the Nature and
Causes of the Wealth of Nations
Stalin, Joseph (104)
Vladimir Lenins successor as head of the Bolshevik Party, collectivized

agriculture in the Soviet Union in the late 1920s and 1930s
Xiaoping, Deng (108)
Leader of China in the early 1980s, often compared to Gorbachev
Yavlinsky, Grigori (110)
Economist; helped produce the Five Hundred Day Plan
Yeltsin, Boris (110)
President of Russia 1991-2000, Russias first popularly elected president
ORGANIZATIONS
Bolshevik Party (104)
Faction that came to power after the Russian Civil War, eventually
became the Communist Party of the Soviet Union
Central Committee of the

Communist Party (105)
Approved plans
Communist Party of the Soviet

Union (104)
Presided over the Soviet Union, formerly the Bolshevik Party
Council of Ministers (105)
Enacted plans
Gazprom (118)
Russias largest company, largest natural gas extractor in the world, also
controls companies many other sectors such as media and finance
Goskomimushchestvo (113)
See State Committee on Property
Gosplan (105)
See State Committee of Planning
International Monetary Fund
Known as IMF; transnational organization that offered Russia loans
Politburo (109)
Executive committee of elite communist party officials
Rosneft (118)
Russias largest oil company, mostly state-owned
Sibneft (118)
The oil branch of Gazprom, fifth largest oil company in Russia, now
called Gazpromneft
State Committee of Planning
Devised plans to manage the Soviet economy
State Committee on Property
Classified and oversaw firms eligible for privatization under Boris Yeltsin
Yukos (118)
Russian petroleum company that failed to merge with Sibneft and

declared bankruptcy in 2006
TEXTS
The General Theory of

Employment, Interest, and
Money (95)
Work published by John Maynard Keynes in 1936; developed an

explanation for short-run economic fluctuations to respond to the
inadequacy of the microeconomic model
MISCELLANEOUS
Boskin Commission (71)
Acted in 1996; group headed by economist Michael Boskin to review

the CPI and determine how much CPI overstated price inflation (1.3%)
BRIC (119)
Abbreviation for rapidly rising markets of Brazil, Russia, India, and China
Chicago Mercantile Exchange
An example of a highly organized market
DeBeers company (43)
Company that until recently owned 80% of diamond mines
Five Hundred Day Plan (110)
Reform plan by a group of economists who sought to emulate Polands

successful economic shock therapy, rejected by Mikhail Gorbachev
NASDAQ (77)
An example of an organized stock exchange
National Prosperity Fund (118) One of the two parts the Stabilization Fund was divided into in 2008
New York Stock Exchange

(NYSE) (10, 77)
An example of an organized stock exchange
Nobel Prize in Economic

Science (67)
Simon Kuznets received this award in 1971 for his contributions to the
measurement of national production
Organization of Petroleum
Exporting Countries (OPEC)
A cartel formed between oil-producing nations (most in the Middle

East) to influence the price of oil worldwide
Reserve Fund (118)
One of the two parts the Stabilization Fund was divided into in 2008
Russian Federation (110)
Title adopted by Russia after the fall of the Soviet Union
Sherman Anti-Trust Act (44)
Passed in 1890 to increase market competition
Skolkovo (120)
Name of Russian Silicon Valley constructed under Dmitri Medvedev
Stabilization Fund (118)
A fund established in 2003 to store extractive resource tax revenues to

handle future inflation or support the rubles value, broken into the
Reserve Fund and National Prosperity Fund in 2008
U.S. Department of Commerce In 1932, commissioned Simon Kuznets to develop a system to measure
(67)
national output
POWER EQUATIONS
MICROECONOMICS
% change in QD
Price elasticity of demand
E=
Price elasticity of supply
E=
General equation
E=
General maximization
condition
Marginal revenue = marginal cost
Profit maximization for firms
Price = marginal cost
Average total cost
Average Total Cost =
% change in P
(QD1 - QD 0 ) QD 0 )
(P1 - P0 ) P0
% change in QS (QS1 - QS 0 ) QS 0 )
=
% change in P
(P1 - P0 ) P0
% change in dependent var iable
% change in independent var iable
MR = MC
Total Fixed Costs + Total Variable Costs

Total Number of Units Pr oduced
MACROECONOMICS
Gross domestic product
Y = C + I + G + NX
CPI (to find inflation)
CPI =
GDP Deflator (relation to

nominal and real GDP)
Re al GDP =
GDP Deflator
GDP deflator =
Money supply
Money multiplier
Equation of exchange
(quantity theory of money)
Basket price in year t

Basket price in base year
100
No min al GDP
so GDP Deflator =
GDP Deflator
No min al GDP
Re al GDP
100
Money supply
= deposits + C
=
M-C
R
MM =
+C=
1
RR
MV = PQ
R C+M-C
R
M + (R - 1) C
R
No min al GDP
Re al GDP
PRACTICE TEST ANALYSIS

Of the first 40 questions (Sections I-III), 15 (37.5%) are vocabulary questions, 10 (25%) test facts and
concepts verbatim, 5 (12.5%) require matching a term to an example, 5 (12.5%) test applying concepts to
models, 4 (10%) are math problems, and 1 (2.5%) asks a specific question about the U.S. economy. With
this in mind, I recommend you spend most of your time solidifying your ability to define and understand
terms. Then, expand your knowledge of each term by applying the concepts and models to which they
relate. I will provide more detailed explanations of the 25% of this portion which consists of application,
math-based, and oddball questions followed by a brief breakdown of the last 10 questions (Section IV).
Before we go through the sections, I have a few broad tips. Use questions with two-part answers (which
most professional test-writers avoid for this exact reason!) to your advantage. Eliminate the answer choices
that dont fit in the first blank. Then do the same for the second (and third, etc.). Draw out models
whenever you can to help you visualize concepts. Lastly, read the answer choices before you work out a
time-consuming problem; there might be an easier way.
The first 5 questions (1-5) cover Section I: Fundamental Economic Concepts. These questions test your
understanding of vocabulary in a straightforward way. Prepare for these questions by memorizing the
definitions of all the assumptions.
The next 20 questions (6-25) are the largest chunk of the test and cover Section II: Microeconomics. This
section contains a mix of all the types of questions above. It also contains all of the math problems for the
entire test. These require two mental steps: identifying the equation in question and solving it. The first
step often poses a larger problem than the second. On a timed test, skip these questions and come back if
you have trouble figuring out how to solve them. I will run through how to solve a couple particularly
math-based questions and one application question.
Question 11 looks tricky on the surface, but once you figure out what the question is actually asking, the
answer is obvious. The first step to answering this question is knowing to set Q(S) equal to Q(D). The
second is solving the equation. Some quick test takers might also notice that using process of elimination
can easily crack this question. Since Q(S) is a vertical line at 6, Q(D) has to intersect Q(S) at Q = 6. The
only answer choice containing Q = 6 is the correct answer, A. Question 13 repeats the same concept but
re-arranges the equation. Plugging in the P value of 30 shows you that Q(S) = 60. Since we are setting
Q(S) equal to Q(D), Q(D) must also equal 60. Plugging 30 into all of the answer choices until one choice
equals 60 shows that E is the correct answer.
Question 15 requires you to apply elasticity to a model. Prepare for questions like these by understanding
how every concept fits on a model. Memorize what each axis represents and draw them out on your tests.
This is the easiest and most effective way to answer application problems. For this question, memorize the
different levels of elasticity and how they fit into the models on Figures 13 and 14 on page 27.
The next 15 questions (26-40) cover Section III: Macroeconomics. This section is broad but more
straightforward than microeconomics. Most questions test vocabulary and very few require application.
Question 26 is a curveball. Im not sure if USAD meant to test the text, which gives the average output in
2008 (the question asks about 2007) or Figure 31, which shows a line graph of output per capita from
1900 until 2008. Either way, $45,000 comes closest to the correct answer. Dont spend too much time
memorizing these minor facts since this kind of question only appeared once in the entire test.
Question 36 requires understanding the difference between aggregate demand and quantity demanded.
Remember that changes in the price of the goods in one market affect quantity demanded or quantity
supplied, not aggregate demand or aggregate supply. This type of distractor will probably show up at least
once on each test later on, so know the difference!
Question 40 requires the application of concepts to a model. You should be able to eliminate B and E
right off the bat because nothing (at least in the resource) causes the supply curve to rotate. For future
reference, nothing will cause the supply curve to do anything (like steepen, flatten, etc.) but shift, so you
can eliminate those choices as distractors. Remember that increases in supply (such as a positive supply
shock) shift the curve right and vice versa.
The last 10 questions (41-50) cover the Russian economy. All of these questions test fill-in-the-blank
factual information verbatim from the resource. Only one of the 10 questions tests information from after
the fall of the Soviet Union. Even though Section IV covers pages 104-121, half the questions come from
pages 104-107, about the mechanics of the Soviet system. Spend most of your time studying the details of
this portion of the guide. But also have a firm grasp on each Russian leaders reforms and the effects of
these reforms. There may not be as many questions on post-Soviet Russia, but the questions are specific.
Q#
Topic
USAD PG.
Q#
Topic
USAD PG.
Scarcity I
26
U.S. economy III
58, 59
Opportunity cost I
27
Business cycle III
60
Pareto efficiency I
28
Trade surplus and deficit III
62
Positive economics I
29
Capital goods vs. intermediate goods III
65
Microeconomics and Macroeconomics I
30
Real GDP vs. nominal GDP III
68
Markets II
10
31
Abbreviations CPI and BLS III
69
Income and shifts in the demand curve II
15
32
Types of expenditures included in GDP III
67
Substitutes and shifts in the demand curve II
15
33
Labor force III
71
Market supply curve II
15
34
Types of unemployment III
72
10
Shifts in the supply curve II
17
35
Equity finance vs. debt finance III
77
11
Calculating equilibrium II
19
36
Aggregate demand vs. quantity demanded III
97
12
Law of demand II
12
37
Contractionary vs. expansionary policy

Fiscal vs. monetary policy III
101
13
Calculating equilibrium II
19
38
Aggregate supply curve III
99
14
Calculating demand elasticity II
25
39
Quantity equation III
101
15
Graphing elasticity II
27
40
Shifts in the aggregate supply curve III
99
16
Price floors II
34
41
Introduction IV
104
17
Deadweight loss II
34
42
Soviet industry size IV
104
18
Comparative advantage II
39
43
Soviet manager incentives IV
106
19
Comparative advantage II
39
44
Black market IV
107
20
Oligopolies II
45
45
Soviet manager incentives IV
107
21
Diminishing returns II
41
46
Anti-alcohol campaign IV
108
22
Marginal cost II
41
47
Boris Yeltsin IV
110
23
Four types of goods II
53
48
Soviet system IV
111
24
Positive externalities II
48
49
Resource curse IV
117
25
Government corruption II
55
50
Shock therapy IV
111
ABOUT THE AUTHOR

In her lifetime, Catherine Tran has donned black, brown,
blonde, red, and pink hair. This picture shows the result of
what might have been her most impulsive decision ever, next to
joining Academic Decathlon.
Cat competed as an Honor on the 2011 Seven Lakes High
School Academic Decathlon team. She joined the team to feed
her deranged love for studying and test-taking (and to get a
hockey jersey with her name on it). She credits AcDec 178 for her
ability to make it through her first year of college without
falling into a pit of confusion, tears, and stress eating. She
credits Tiesto for her ability to make it through AcDec.
You can normally find Cat in the library simultaneously studying and boogying to dance music through
her headphones. Cat will enter her sophomore year at the University of Texas at Austin this fall. She
studies philosophy and religious studies with aspirations for law school. During her first year of college,
she tutored underprivileged children for a non-profit organization called Learn to Be. She also directed the
Disarmament and International Security Committee at the Central Texas Model United Nations
Conference and will moderate Human Rights Council in October.
Her hobbies include writing about social and political issues, baking, shopping, going to concerts, playing
violin, dancing, making music mash-ups, befriending minor celebrities, dying her hair, and accidentally
leaving her former AcDec coach two-minute voicemails of her rapping to Nicki Minaj. She highly
recommends reading Bossypants by Tina Fey, The Unlikely Disciple by Kevin Roose, and The Grapes of
Wrath by John Steinbeck 179.
If you want to hear her mash-ups, talk about Breaking Bad or Game of Thrones, or ask a difficult moral
question, shoot her an E-mail at catherinetran@utexas.edu. She would love to hear from you!
Vital Stats
178
179
Competed with Seven Lakes High School at the Texas State competition in 2011
Team placed 2nd at State with a score of 48,862
Achieved an 8,382 individual score at State
Decathlon philosophy in a phrase: Its like mental weight-lifting.
Joined DemiDec in June 2012
Yes, I do omit the second a. Sorry, Im not sorry.

I got to read this three times when I was a decathlete, yippee!

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2012

UNIVERSITY OF TEXAS: AUSTIN

ROCHESTER INSTITUTE OF TECHNOLOGY

DEDICATED TO MR. IRISH, MR. MARZEN,

Economics Power Guide | 1

Sans means without in French

Economics Power Guide | 2

Section III Macroeconomics

Economics Power Guide | 3

FUNDAMENTAL ECONOMIC CONCEPTS

What does economics address?

Economics and everyday life

Economics Power Guide | 4

Basic Assumptions of Economics

Scarcity and no free lunches!

And if you give a mouse a cookie- Christina

Economics Power Guide | 5

Economics Power Guide | 6

Comparative Advantage and the PPF15

Why do we depend on each other for just about everything?

Economics Power Guide | 7

Plotting these combinations will yield Ivans PPF

Producing more mangosteens must mean producing fewer durians

Any combination on the curve is completely efficient

Production cannot be expanded at the current ratio of goods

Economics Power Guide | 8

Points A and B are both possible production points

Ivans curve is linear because it is a straight line with a constant slope

The slope of Olgas curve is -1

She trades one mangosteen for one durian

The curve bows outward

As the economy uses

Note that this increased cost

Each point is equally efficient

Economics Power Guide | 9

Absolute and comparative advantage

The party with the least direct costs

Her PPF is above and to the right

Ivan gives up less durians

Olga gives up fewer mangosteens for each durian she produces

Economics Power Guide | 10

If Olgas opportunity cost of mangosteen production is higher than Ivans, Ivans

"We can both be better off if we trade."

"Look at these numbers."

"And I could have 20 mangosteens and 22 durians!"

Economics Power Guide | 11

Models and Economic Theory

Positive and Normative Economics

Economics Power Guide | 12

Normative statements combine economic analysis with value judgments

Normative statements describe what should be in a society, not what is

These statements cannot be proved false directly as they are opinionated

Example: Economists should focus on minimizing disparities in wealth as large income

Economics Power Guide | 13

Microeconomics and Macroeconomics

Economics Power Guide | 14

This section covers basic microeconomics. We will build a

40% of the exam (20 questions) will focus

Perfectly Competitive Markets

Economics Power Guide | 15

Sellers are all of the local gas stations in a town

Each seller posts their price

Buyers buy gas, depending on price and convenience

Gas station owners know other stations sell a similar product