AP Economics Comprehensive Review Basic Economic Concepts

Basic Economic Concepts

A. Scarcity, choice and opportunity costs

Economics is the social science concerned with the efficient use of limited or scarce resources to achieve maximum satisfaction of human economic wants. Economics is the study of scarcity and choice. Every economic issue involves, at its most basic level, individual choice—decisions by individuals about what to do and what not to do.

Resources are scarce. Resources: labor, land (or natural resources), capital, and entrepreneurial ability (also described as human capital). These resources are also called factors of production. • labor (the effort of workers), • land (natural resources), • capital (machinery, buildings, tools, and all other manufactured goods used to make other goods and services); these are examples of physical capital • entrepreneurship (risk taking, innovation, and the organization of resources for production); these are examples of human capital

Wants and Needs. Scarcity is a problem where we have limited amount of resources to meet an unlimited amount of needs and wants. • Wants: desires (examples: iPods, iPads, iMacs, etc.) • Needs: required for survival (examples: clean air, clean water, food, clothing, and shelter)

Economic resources are limited/scarce which implies that the goods/services they produce must also be limited. Scarcity requires that choices be made. Choices imply that things are given up. These choices, sacrifices are called opportunity costs. To get more of one thing, you forgo the opportunity of getting something else.

Opportunity cost. The real cost of something is what you must give up to get it.

Example. You purchase a digital camera that costs $100, and decided not to buy a pair of running shoes that also cost $100. The opportunity cost of buying the camera is $100, plus the forgone enjoyment of the running shoes.

Macroeconomics. The branch of economics that studies the overall ups and downs of the economy. Macro focuses on economic aggregates—economic measures such as unemployment rate, the inflation rate, and GDP—that summarize data across many different markets. Microeconomics. The branch of economics concerned with how individuals make decisions and how these decisions interact. Microeconomics focuses on choices made by individuals, households, or firms—the smaller parts that make up the economy as a whole.

Positive economics. Economic analysis used to answer questions about the way the world works. Statements of “what is” or “what will be.” No value judgments are applied.

Normative economics. Economic analysis that involves saying how the world should work. Statements of “what should be.” Involves value judgments of what is “right,” “wrong,” or “best.”

AP Economics Comprehensive Review Basic Economic Concepts

B. Production Possibilities Curve

A production possibilities curve is a graphical representation of different production choices that use all of the available resources. It identifies the various possible combinations of the two types of goods that can be produced when all available resources are employed fully and efficiently.

Simplifying assumptions: • Available supply of resources is fixed in quantity and quality at this point in time. Technology is constant during analysis. • Economy produces only two types of products. • Production occurs during a given time period—usually one year. • Technology does not change.

Efficiency. The red curve is the production possibilities curve. All points along the PPC are efficient in production. One good can not be increased without a corresponding decrease in another good.

Points inside the PPC represent underutilization of resources. At point I, only 20 million of each type of good is made, from a possible 50 million if production was maximized for one good. As such, point I is inefficient.

Points outside the PPC are unattainable. There are not enough resources or technology to produce at point U.

Opportunity costs are represented within the PPC. Assume capital goods are represented by cars and the consumer goods are represented by potatoes.

At point D, the economy can make 30 million cars and 34 million potatoes. Assume that the economy decides to make 40 million cars, which lowers potato production to 20 million. In order to make 40 million cars, the economy must give up 14 million potatoes. That 14 million potatoes is the opportunity cost of making 10 million more cars.

At point D, the economy can make 30 million cars and 34 million potatoes. Assume that the economy decides to make 43 million potatoes, which lowers car production to 20 million cars. In order to make 43 million potatoes, the economy must give up 10 million cars. That 10 million cars is the opportunity cost of making 13 million more potatoes.

Ultimately, it does not matter the initial point on the PPC. The opportunity cost of one more item is always the same. The slope of the opportunity cost is constant. This reflects that the two items in the PPC are perfect substitutes.

AP Economics Comprehensive Review Basic Economic Concepts

Math of the Opportunity Cost in PPC • The opportunity cost of the good graphed on x-axis is always the slope of the PPC. • The opportunity cost of the good graphed on y-axis is always the inverse of slope of PPC.

Law of increasing opportunity costs. When producers switch from one item of production to another, the more and more it costs to produce that second item. Economic resources are not completely adaptable to alternative uses. 1. The amount of other products that must be foregone to obtain more of any given product is called the opportunity cost. 2. The more of a product produced the greater its opportunity cost (marginal cost). 3. The slope of the PPC becomes steeper (left to right) demonstrating increasing opportunity cost. This makes the curve appear bowed out, concave from the origin. The law of increasing opportunity costs indicates movement along the PPC.

AP Economics Comprehensive Review Basic Economic Concepts

Economic Growth. Economic growth means an expansion of the economy’s production possibilities: the economy can produce more of everything. When talking about the PPC, economic growth refers to shifts of the PPC.

Panel (a). Rightward shifts of the PPC • Increase in size of labor • Increase in skills of labor • Increase in the amount of capital • Parallel shift implies the change that occurred affected production of both goods equally.

Panel (b). Leftward shifts of the PPC • Decrease in size of labor • Decline in skills of labor (efficiency)

AP Economics Comprehensive Review Basic Economic Concepts

• Decrease in the amount of capital • Parallel shift implies the change that occurred affected production of both goods equally.

Panel (c). Increase in resources of technology benefiting consumer goods • When such a change occurs, the PPC expands from A to A’.

Panel (d). Increase in resources of technology that benefits capital goods • When such a change occurs, the PPC expands from F to F’.

Change in Resource Availability Increases in Capital Stock Technological Change (Quantity or Quality) Increase Right Increase Right Employs available resources Decrease Left Decrease Left more efficiently

PPC Summary • Efficiency. PPC represents combinations of output that are possible given the economy’s resources and technology. Movements along PPC. • Scarcity. Given resources and technology, the economy can produce only so much. • Economic Growth. Rightward shifts of the PPC

C. Comparative advantage, absolute advantage, specialization and exchange

Comparative advantage. An individual has a comparative advantage in producing a good or service if the opportunity cost of producing the good or service is lower for that individual than for other people.

The basic principle of comparative advantage rests on differing opportunity costs of producing various goods and services. Trading partners can both benefit if they specialize and trade based upon comparative advantage.

Absolute advantage. An individual as an absolute advantage in producing a good or service if he or she can make more of it with a given amount of time and resources. Having an absolute advantage is NOT the same thing as having a comparative advantage.

Specialization. Each person specializes in the task that he or she is good at performing.

AP Economics Comprehensive Review Basic Economic Concepts

Example 1. Apples vs. Timber in Oregon and Washington

Before trade, both states are self-sufficient in apples and timber, and produce at the following levels:

State Apples Timber Opportunity Opportunity Cost of 1 Timber Cost of 1 Apple Oregon 10 40 0.25 Apple 4 Timber Washington 40 10 4 Apple 0.25 Timber

Oregon has a comparative and absolute advantage in timber and Washington has a comparative and absolute advantage in apples. Note the following PPCs:

Assume both Oregon and Washington are producing and consuming timber and apples at midpoint. Oregon has 20 timber, 5 apples. Washington has 20 apples, 5 timber.

Total timber production: 25 Total apple production: 25

The principle of comparative advantage says that total output will be greatest when each good is produced by the state that has the lower opportunity cost. • Washington has comparative advantage in apple production and should specialize in apples. • Oregon has comparative advantage in timber and should specialize in timber. If Oregon and Washington specialize, they’ll produce (together) more apples and timber than they had individually without specialization.

Total timber production: 40 (all in Oregon) Total apple production: 40 (all in Washington)

Problem. Pretty sure wood is not edible. Also, never seen houses made out of apples, not even on the Smurfs.

AP Economics Comprehensive Review Basic Economic Concepts

Solution: Trade—providing goods and services to others and receive goods and services in return. Oregon will export timber, Washington will export apples.

Since each state would like some of both goods, they will now have to trade. However, the original cost conditions in each country will limit the terms of trade. • In Washington 1 apple = .25 timber, so Washington must get more than .25 Timber for each 1 unit of apples exported, or they will not benefit from export. • In Oregon 1 apple costs 4 timber, so Oregon will not give up more than 4 timber to get 1 apple. The rate of exchange will be somewhere between .25 and 4 timbers for each apple. If the rate of exchanges falls below or above this range, then the trade will not occur. Same if it was apple for timber.

Suppose Washington and Oregon set up a trade where Washington sends 20 apples to Oregon in exchange for 20 timber.

Consumption after trade: • Oregon: 20 Timber and 20 Apples • Washington: 20 Timber and 20 Apples

Now, plot these points on the appropriate PPCs above. Notice that each state is constrained by the PPC—they can not produce more than what’s available in their individual economies. However, by trading the items they have a comparative advantage in, they are beyond the PPC.

Example 2. Coconuts vs. Fish between Tom and Hank

Before trade, both Tom and Hank are self-sufficient in coconuts and fish, and produce at the following levels:

Castaway Coconuts Fish Opportunity Opportunity Cost of 1 Cost of 1 Fish Coconut Tom 30 40 1 1/3 fish 3/4 coconut Hank 20 10 1/2 fish 2 coconuts

Tom has a comparative advantage in catching fish and Hank has a comparative advantage in gathering coconuts. Remember, comparative advantage is not about numbers, but about opportunity cost. Hank has a comparative advantage over Tom in producing coconuts because his opportunity cost is lower than Tom’s. It costs Hank only half of one fish to produce 1 coconut. For Tom, it costs him 1 1/3 fish to make 1 coconut. The same is true if we look at the economy in terms of fish. It costs Tom only 3/4 of a coconut to make 1 fish. Hank, on the other hand, requires 2 coconuts to make 1 fish. Note the following PPCs:

AP Economics Comprehensive Review Basic Economic Concepts

Assume both Tom and Hank are producing and consuming coconuts and fish near the midpoint. Tom has 30 coconuts and 40 fish. Hank has 20 coconuts and 10 fish.

Total coconut production: 50 Total fish production: 50

The principle of comparative advantage says that total output will be greatest when each good is produced by the state that has the lower opportunity cost. • Tom has comparative advantage in fish and should specialize in fish. • Hank has comparative advantage in coconuts and should specialize in coconuts. If Tom and Hank specialize, they’ll produce (together) more coconuts and fish than they had individually without specialization. Now look at total production after specialization:

Total coconut production: 20 (all by Hank) Total fish production: 40 (all by Tom)

This may seem uneven at first, but there are a couple of things to consider. First in terms of absolute advantage, Tom has the absolute advantage in both coconuts and fish. Tom can produce more output with a given amount of input than Hank. This would seem to indicate that Tom has nothing to gain from trading with Hank, who would seem to be more valuable if Tom just simply cannibalized him. Yum.

Second and however, that’s not the case. The basis for mutual gain is comparative advantage, NOT absolute advantage. As such, it is absolutely irrelevant how much time Hank takes in gathering coconuts to trade for fish. All that matters is that Hank’s opportunity cost of that coconut in terms of fish is lower. So Tom and Hank can trade with each other for mutual. Tom’s benefit is the extra time he could use by catching fish. Or laying on the beach. Or talking to Wilson. Hank, on the other hand, can focus on coconut gathering.

AP Economics Comprehensive Review Basic Economic Concepts

The key here is to specialize in the comparative advantage and trade. By specializing and trading, Tom and Hank can produce and consume more of both goods. Both Tom and Hank can consume more of both goods than either could without trade.

Nevertheless, there is still an exchange problem. Remember, the original cost conditions for Tom and Hank will limit the terms of trade. • For Tom 1 coconut = 1 1/3 fish, so Tom must get less than 1 1/3 fish per coconut, or he will not benefit from trade. • For Hank 1 coconut = 1/2 fish, so Hank must get more than 1/2 fish per coconut, or he will not benefit from trade. The rate of exchange will be somewhere between 1/2 and 1 1/3 fish for each coconut. If the rate of exchange falls below or above this range, then the trade will not occur.

For example, Hank will not accept any deal where he must give up more than 2 coconuts per fish. 1/2 = 1 coconut, 1 fish = 2 coconuts. If the deal requires Hank to give more than 2 coconuts per 1 fish, he won’t make the deal. There is no advantage for him. Hank will accept 1 coconut for 1 fish, however. The advantage for Hank is that he would be getting two for the price of one.

Tom, by the way, would accept the 1 coconut for 1 fish exchange. His comparative advantage is in fish. So long as he does not have to give up more than 1 1/3 fish per coconut, then the deal is advantageous, and he will make the trade.

People will be willing to engage in trade only if the price of the good each person is obtaining from the trade is less than his own opportunity cost of producing the good himself.

As long as there are different opportunity costs, everyone has a comparative advantage in something, and everyone has a comparative disadvantage in something.

AP Economics Comprehensive Review Basic Economic Concepts

Example 3. Aircraft vs. Pork in Canada and the United States

The same principles with comparative advantage also apply to international trade. In this example, the U.S. has a comparative advantage in pork and Canada has a comparative advantage in aircraft. The U.S. and Canada can achieve mutual gains from trade. If the U.S. focuses production on pork production and ships some of the pork to Canada, while Canada concentrates on aircraft and ships some of its output to the United States, both countries can consume more than if they were self- sufficient.

The mutual gains don’t depend on each country’s being better at producing one kind of good. Even if one country has a higher output per person-hour in both industries—absolute advantage—there are still mutual gains from trade so long as each country has a comparative advantage in a good.

D. Macroeconomic issues: business cycle, unemployment inflation, growth

Business cycle is the alternation between economic downturns and upturns in the macroeconomy.

Phases of the business cycle over a several-year period 1. A peak is when business activity reaches a temporary maximum with full employment and near capacity output. The unemployment rate is at its lowest level.

AP Economics Comprehensive Review Basic Economic Concepts

2. A recession is a decline in total output, income, employment, and trade lasting six months or more. The unemployment rate is beginning to rise. 3. The trough is the bottom of the recession period. The unemployment rate is at its highest level. 4. Recovery is when output and employment are expanding toward full-employment level. The unemployment rate is beginning to fall. 5. The entire business cycle is measured by the elapsed time between peaks in the cycle.

Employment, Unemployment, and the Business Cycle (See Section II, below)

Aggregate Output and the Business Cycle (See Section III, below)

Aggregate output is the economy’s total production of goods and services for a given time period, usually a year. Aggregate output is closely related to employment. When the economy is strong, near the peak of the business cycle, many goods and services are being produced, firms need to hire workers, employment is high, and the unemployment rate is low. When the economy is weak, during a recession of the business cycle, fewer goods and services are being produced, firms need to lay off workers, employment is low, and the unemployment rate is high.

Inflation, Deflation, and Price Stability (See Section V, below)

Inflation is a rise in the overall price level. Inflation is bad because it reduces our ability to purchase goods and services. A dollar of hard-earned income doesn’t go as far if the prices of most goods and services are rising. If inflation is rapid, wages could become useless for consumption.

Deflation is a fall in the overall price level. Deflation is bad too. When overall prices are falling, consumers will hold onto their dollars and continue to wait for lower and lower prices. This waiting creates a problem as producers find they can’t sell goods and services. Producers respond by lower prices and consumers respond by waiting even longer to make a purchase.

Economic Growth (See Section VI, below). Economic growth is an increase in the maximum amount of goods and services an economy can produce.

Ceteris Paribus—Other things equal assumption. Ceteris paribus means that all other relevant factors remain unchanged.

E. Demand, supply and market equilibrium

A market is an institution or mechanism that brings together buyers (demanders) and sellers (suppliers) of particular goods and services. A market may be local, national, or international in scope. For macroeconomics, we’re concerned with competitive markets with a large number of independent buyers and sellers. Individually, each of these buyers and sellers are so small that they cannot affect the price of the product. Together, they can destroy it.

Demand. The law of demand states, all other things equal, that for all goods and services, when the price increases, quantity demanded will decrease. When the price decreases, quantity demanded

AP Economics Comprehensive Review Basic Economic Concepts will increase. Mathematically, this is represented by an inverse relationship in a demand curve or demand schedule.

Movement along the demand curve. All other things equal, a change in price will cause a corresponding change in quantity demanded.

Shifts of the demand curve. Certain events can cause a shift of the entire demand curve. • If demand increases, the demand curve shifts to the right. At any price, consumers wish to buy more. • If demand decreases, the demand curve shifts to the left. At any price, consumers wish to buy less.

AP Economics Comprehensive Review Basic Economic Concepts

Causes of shifts of the demand curve

1. Prices of related goods • Substitute goods—a rise in the price of one good leads to an increase in demand for other good: If the price of Nike rises, demand for New Balance shifts to the right. • Complementary goods—a rise in the price of one good leads to a decrease in the demand for other good: If the price of shoes rises, demand for socks will shift to left. 2. Income • Normal goods—a rise in income increases demand for a good: steak, iPods • Inferior goods—a rise in income decreases demand for a good: second-hand goods, generics 3. Consumer Tastes. Favorable change in tastes leads to an increase in demand; unfavorable change to a decrease.

4. Consumer Expectations. Consumers have expectations about future prices, product availability, and income, and these expectations can shift demand. • If I expect the price of gas to decrease next week, my demand for gas will decrease this week. I will wait for the price to fall. • If I take a new job and expect my salary to rise next month, I may increase my demand for a new suit today.

AP Economics Comprehensive Review Basic Economic Concepts

5. Population. More buyers lead to an increase in demand; fewer buyers lead to decrease. • Demand for prescription drugs has increased, as the population has grown older. • Demand for infant formula would decrease if families had fewer babies.

Supply. The law of supply says that, other things being equal, when the price increases, the quantity supplied will increase. When the price decreases, quantity supplied will decrease. Mathematically, this is represented by a direct relationship in the supply curve or supply schedule.

AP Economics Comprehensive Review Basic Economic Concepts

Movement along the supply curve. All other things equal, a change in price will cause a corresponding change in quantity supplied.

Shifts of the Supply Curve. Certain events can cause a shift of the entire supply curve. • If supply has increased, it has shifted right. At any price, firms want to produce more. • If supply has decreased, it has shifted left. At any price, firms want to produce less.

AP Economics Comprehensive Review Basic Economic Concepts

Causes of shifts of the supply curve

1. Input (Resource) prices. A rise in an input price will cause a decrease in supply or leftward shift in supply curve; a decrease in an input price will cause an increase in supply or rightward shift in the supply curve. a. An increase in the price of fertilizer would cause a decrease in supply of corn. 2. Prices of related goods or services. If the price of a substitute production good rises, producers might shift production toward the higher priced good causing a decrease in supply of the original good. a. An increase in the price of soybeans may cause a farmer to decrease the supply of corn. 3. Technology. A technological improvement means more efficient production and lower costs, so an increase in supply or rightward shift in the curve results. a. Genetically improved seeds will increase supply of corn. 4. Producers’ Expectations. Expectations about the future price of a product can cause producers to increase or decrease current supply. a. Expectations of higher corn prices (next month) may cause farmers to decrease supply to the market today. 5. Population. Generally, the larger the number of sellers the greater the supply.

AP Economics Comprehensive Review Basic Economic Concepts

Equilibrium. An economy is in equilibrium when both demand and supply are met. An individual, either consumer or producer, would be no better off buying or producing at a different price. Equilibrium price occurs at the intersection of price and quantity demanded and supplied. Equilibrium quantity is the quantity of good bought and sold at a equilibrium price.

Surplus exists when the quantity supplied exceeds quantity demanded. Surpluses occur when the price is above its equilibrium level.

At current price, there are no consumers who want to purchase. The surplus creates an incentive for sellers to lower price in order to attract business from other producers and get more consumers to buy.

The result will be to push the price down until it reaches equilibrium.

The price of a good will fall whenever there is a surplus—market price is above equilibrium.

Surplus = QS - QD Shortage exists when quantity demanded exceeds quantity supplied. Shortages occur when price is below equilibrium level.

At current price, there are no producers who want to produce. The shortage creates an incentive for consumers to offer more for the product, or sellers will increase their price.

The result is to drive up the price until it reaches equilibrium.

The price of a good will rise whenever there is a shortage—market price is below equilibrium.

Shortage = QD - QS

Changes in Equilibrium 17

AP Economics Comprehensive Review Basic Economic Concepts

For the AP Exam, you must be able to do the following: 1. What is causing the shift in the market? 2. What curve is shifting and in what direction? 3. What happens to equilibrium price and quantity?

Shift of the demand curve

Increase in demand. Initially, equilibrium is at the

intersection of D1 and S. When there is an increase in demand, the demand curve will shift to the right from

D1 to D2. After the initial increase, a shortage is created along P1 to D2. Shortage puts pressure on the price to move upward.

As price increases to P2, QD will decrease along the new D2. QS will increase along S until QS and QD are at equilibrium where D2 and S intersect.

P increases, QD decreases.

Decrease in demand. Initially, equilibrium is at the

intersection of D1 and S. When there is a decrease in demand, the demand curve will shift to the left from D1 to D2. After the initial decrease, a surplus is created along P1. Surplus puts pressure on the price to move downward.

As price decreases to P2, QD will decrease along the new D2. QS will decrease along the supply curve until QS and QD reach equilibrium at S and the new D2.

P decreases, QD decreases.

AP Economics Comprehensive Review Basic Economic Concepts

Shift of the Supply Curve

Increase in Supply. Initially, equilibrium is at

intersection of S1 and D. When there is an increase in supply, the supply curve will shift right from S1 to S2. After the initial increase, a surplus is created along P1. Surplus puts pressure on the price to move downward.

As price decreases to P2, QS will decrease along new S2. QD will increase along demand curve until QS and QD reach equilibrium at D and S2.

Price decreases, QS decreases.

Decrease in Supply. Initially, equilibrium is at S1 and D. When there is a decrease in supply, the supply curve

will shift left from S1 to S2. After the initial decrease, a shortage is created along P1. Shortage puts pressure on the price to move upward.

As price increases to P2, QS will increase along new S2. QD will decrease along demand curve until QS and QD reach equilibrium at E2.

Price increases, QS increases.

Note that in each shift, the laws of demand and supply are reflected respectively.

Summary

• Increase in Demand. P increases, QD decreases.

• Decrease in Demand. P decreases, QD decreases.

• Increase in Supply. Price decreases, QS decreases.

• Increase in Supply. Price increases, QS increases.

Simultaneous Shifts of Supply and Demand Curves

When talking about a simultaneous shift and supply, you can’t predict what the ultimate effect will be on the quantity bought and sold without more information. Typically, we can predict one outcome, but not the other, depending on the direction the curves shift.

The example below describes a simultaneous increase of demand and decrease of supply.

AP Economics Comprehensive Review Basic Economic Concepts

The problem comes from not knowing which shift dominated. In panel (a), the increase in demand is dominant, whereas in panel (b), the decrease in supply dominates. As such, we can easily say that there was an increase in price in both cases. However, look at what happens to demand. In panel (a), equilibrium quantity increases. In panel (b) though, equilibrium quantity decreases. However, without knowing which shift had the larger effect, it would be impossible to tell anything about the quantity.

When asked a question on the AP test about simultaneous shifts, you must be able to predict the correct answer, and that includes whether some of the information is indeterminate.

Change in Demand

Demand Increases Demand Decreases

Equilibrium price change Equilibrium price falls. indeterminate. Supply Increases Equilibrium quantity change is Equilibrium quantity increases. indeterminate.

Equilibrium price rises. Equilibrium price change is

Change inChange Supply indeterminate. Supply Decreases

Equilibrium quantity change is Equilibrium quantity decreases. indeterminate.

• Supply and demand curves shift in opposite directions—predict price

o Demand increases and supply decreases: EP increases but change in EQ unknown. o Demand decreases and supply increases: EP falls but change in EQ unknown. • Supply and demand curves shift in same direction—predict quantity

o Demand and supply increase: EQ increases but EP unknown. o Demand and supply decrease: EQ decreases but EP unknown.

AP Economics Comprehensive Review Basic Economic Concepts

Marginal Analysis. Many of our decisions are made on an incremental basis. For example, Dagny might consider whether he or she should spend another hour on Facebook. If Dagny believes that the additional benefits received (enjoyable communication with friends) from this activity outweigh the additional costs incurred (like a poor grade on tomorrow’s Microeconomics test), then Dagny will spend another hour on Facebook.

These additional benefits are called marginal benefits. The additional costs are called marginal costs. Economists assume that people will choose actions ONLY IF marginal benefits outweigh marginal costs.

In other words, if MB ≥ MC, do it. If MB < MC, do not.

Price Controls. Legal restriction on how high or low a market price may go.

Price ceiling. Maximum price sellers are allowed to charge for a good. Benefits consumers. If PC is too high, then, price ceiling MUST be set below PE. PC set above PE has no effect.

Effects of Price Ceiling 1. Shortage. PC = QD - QS 2. Inefficient allocation to consumers. People who want the good badly and are willing to pay a high price don’t get it, and those who care relatively little about the good and are only willing to pay a low price do get it. a. Inefficiency. Market or an economy is inefficient if there are missed opportunities--some people could be made better off without making other people worse off. 3. Wasted resources. People spend money and expend effort in order to deal with the shortages caused by the price ceiling. 4. Inefficiently low quality. Sellers offer low-quality goods at Pc, even though buyers would prefer a higher quality at a higher price. 5. Black Markets. Market in which g/s are bought and sold illegally—either because it is illegal to sell them at all or because prices charged are legally prohibited by PC.

Price ceilings are enacted because 1. They benefit consumers. Consumers may have the political clout to persuade government that PE is taking advantage of them. Normative. 2. When they have been in effect for a long time, buyers may not have a realistic idea of what would happen without them. 3. Government officials often do not understand S/D analysis.

Price Floors. Legal minimum price buyers are required to pay for a good. (e.g., minimum wage is a legal floor on the wage rate, market price of labor)

If PE is considered too low, PF is set above PE. PF set below PE has no effect.

AP Economics Comprehensive Review Basic Economic Concepts

Effects of Price Floor 1. Surplus. PC = QS - QD. 2. Inefficiently low quantity. Since PF raises price of a good to consumers, QD falls, so quantity bought and sold falls, creating a loss to society. 3. Inefficient allocation of sales among sellers. Those who would be willing to sell good at lowest price are not always those who actually manage to sell it. 4. Wasted resources. Government PF set above PE cause surpluses which government may be required to buy and destroy. Minimum wages result in fewer jobs available and so would-be workers waste time searching for a job. 5. Goods of inefficiently high quality. Sellers offer high-quality goods at a high price, even though buyers would prefer a lower quality at a lower price. 6. Illegal activity. Bribery of sellers or government officials. (e.g., working for less than minimum wage (off the books) because there is a surplus of labor willing to work).

PF enacted because: 1. They benefit producers. Producers may have the political clout to persuade government that PE is unfairly low. Normative. 2. Price floors create a persistent surplus of the good. 3. Inefficiencies arising from the persistent surplus come in the form of inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, and an inefficiently high level of quality offered by suppliers. 4. Temptation to engage in illegal activity, particularly bribery and corruption of government officials.

Quantity controls/quota. Upper limit on quantity of some good that can be bought or sold. The total amount of the good that can be legally transacted is the quota limit.

A quota is set, a license is given (or auctioned) to producers. A license gives its owner the right to supply the good.

Demand price, PD. Price at which consumers will demand that quantity. Supply price, PS. Price at which producers will supply that quantity.

A quantity control, or quota, drives a wedge between PD and PS of a good.

Quota rent. Difference between PD and PS. Earnings that accrue to license-holder from ownership of right to sell good. It is equal to market price of license when licenses are traded. Quota rent is opportunity cost the holder of the license bears for not renting out license to another producer.

Costs of Quantity Controls 1. Inefficiency. Mutually beneficial transactions that don’t occur. Anytime PD at a given quantity is not equal to PS at that quantity, there will be missed opportunities. 2. Incentives for illegal activities. Suppliers know that additional units could be supplied and buyers could be found. This kind of overproduction would violate the quota.