Principles and Practice of Economics

What is Economics?

Economics is the study of how people choose to use resources. It encompasses both individual (microeconomics) and aggregate (macroeconomics) decision-making, focusing on how choices affect output, jobs, inflation, growth, and trade.

• Resources include time, money, labor, capital, and natural resources.

• Economics is broad, covering choices by individuals, firms, and governments.

Three Core Principles

• Optimization: People and firms try to do the best they can given constraints.

• Equilibrium: Markets tend to move toward a state where no agent has an incentive to change behavior.

• Empiricism: Economists use data to test theories and inform policy.

Economic Science: Using Data and Models

The Scientific Method in Economics

Economists use models—simplified representations of reality—to generate predictions and test them with data.

• Models are not exact but are useful for understanding and predicting economic phenomena.

• Assumptions are necessary to simplify complex realities.

Causation vs. Correlation

• Correlation: Two variables move together but one does not necessarily cause the other.

• Causation: One variable directly affects another.

• Omitted variables and reverse causality can lead to incorrect conclusions.

Optimization: Doing the Best You Can

Optimization in Levels and Differences

• Levels: Choose the option with the highest net benefit (total benefit minus total cost).

• Differences: Consider whether doing a little more yields greater marginal benefit than marginal cost.

Opportunity Cost

• The value of the next best alternative forgone when making a choice.

• Includes not just monetary costs but also time, effort, and foregone opportunities.

Demand, Supply, and Equilibrium

Markets and Market Price

A market is a collection of buyers and sellers for a good or service. The market price is where transactions occur.

Demand

• Quantity Demanded: Amount buyers are willing to purchase at a given price.

• Demand Curve: Plots quantity demanded at different prices, holding other factors constant.

• Shifts in demand occur due to changes in tastes, income, prices of related goods, number of buyers, or expectations.

Supply

• Quantity Supplied: Amount sellers are willing to sell at a given price.

• Supply Curve: Plots quantity supplied at different prices, holding other factors constant.

• Shifts in supply occur due to changes in input prices, technology, number of sellers, or expectations.

Market Equilibrium

• Occurs where quantity supplied equals quantity demanded.

• Competitive equilibrium price and quantity are determined by the intersection of supply and demand curves.

The Wealth of Nations: Measuring Macroeconomic Aggregates

Gross Domestic Product (GDP)

• GDP: The market value of all final goods and services produced within a country in a given period.

• Three approaches:

  • Production: Value of output minus value of intermediate goods.

  • Expenditure: Sum of consumption (C), investment (I), government spending (G), and net exports (X-M).

  • Income: Sum of all incomes earned in production (wages, profits, etc.).

What is Not in GDP?

• Depreciation, home production, underground economy, negative externalities, leisure, and production by nationals abroad (GNP covers this).

Aggregate Incomes

Comparing Incomes Across Countries

• GDP per capita is used to compare living standards.

• Conversion methods:

  • Exchange-rate approach: Converts using current exchange rates (can be misleading due to price differences and fluctuations).

  • Purchasing Power Parity (PPP): Adjusts for differences in price levels using a representative basket of goods.

Productivity and the Aggregate Production Function

• Productivity is output per worker or per hour worked.

• Determinants: Human capital, physical capital, and technology.

Aggregate Production Function

Describes how output (Y) depends on inputs of capital (K), labor (L), and technology (A):

• Diminishing marginal product of capital: Each additional unit of capital increases output by less than the previous unit.

• Better technology shifts the production function upward.

Economic Growth

Types of Growth

• Catch-up growth: Poor countries grow rapidly by adopting existing technologies.

• Sustained growth: Steady, long-term growth in advanced economies.

How Does Growth Happen?

• Growth results from increases in savings (S), investment (I), capital accumulation (K), and technological progress.

Sources of U.S. Economic Growth

• Technology has been the largest contributor to growth, followed by physical and human capital.

Growth, Inequality, and Poverty

• Growth reduces poverty and raises incomes, but may increase inequality.

• GDP per capita is positively correlated with life expectancy, human development, and income of the poorest.

Employment and Unemployment

Defining and Measuring Employment & Unemployment

• Potential workers: All people except children under 16, active military, and institutionalized persons.

• Categories:

  • Employed: Paid job (full or part time).

  • Unemployed: No job, actively searching.

  • Not in labor force: No job, not searching.

Official and Alternative Unemployment Rates

• U-3: Official unemployment rate (actively seeking work).

• U-4: U-3 plus discouraged workers.

• U-5: U-4 plus other marginally attached workers.

• U-6: U-5 plus part-time for economic reasons.

Labor Market Equilibrium

• Equilibrium real wage and quantity of labor are determined by labor demand (firms) and labor supply (workers).

Types of Unemployment

• Frictional: Due to time needed to match workers with jobs.

• Structural: Due to persistent mismatch between skills and jobs, or wage rigidity.

• Wage rigidity: Wages held above equilibrium by minimum wage laws, unions, efficiency wages, or worker aversion to wage cuts.

Measuring GDP and Inflation

National Income Accounts

• GDP can be measured by production, expenditure, or income approaches.

• Expenditure approach:

Nominal vs. Real GDP

• Nominal GDP: Value of production at current prices.

• Real GDP: Value of production at constant base-year prices.

• GDP Deflator:

Inflation Measures

• Consumer Price Index (CPI): Measures prices paid by urban consumers for a fixed basket of goods.

• Personal Consumption Expenditures (PCE) Price Index: Measures prices of goods and services purchased by or for consumers, allows for substitution.

• GDP Deflator: Measures prices of all domestically produced final goods and services.

• Producer Price Index (PPI): Measures prices received by domestic producers.

Inflation Rate Formula

CPI vs. PCE

• CPI uses a fixed basket; PCE allows for consumer substitution, often showing lower inflation.

Appendix: Key Tables

Summary Table: Types of Unemployment

Summary Table: Inflation Measures