AP Macroeconomics Page 1 of 4

Introducing Macroeconomics
Focus Sheets: Unit 1, What is Economics?

Study: Introduction to Economics

Economics is the study of human behavior constrained by scarcity. It is not a field

of business. Economics is used to predict how people—business owners and
consumers—behave when faced with scarcity.

So, what is scarcity? We have scarcity because the world doesn't have enough
resources, or "stuff," to make all the things people want. Scarcity means we have to
make decisions.

There are two broad types of economics: Microeconomics and Macroeconomics.

• Microeconomists look at individual behavior, or the "small picture."

• Macroeconomists look at the economy as a whole, or the "big picture."

Resources are also called factors of production or inputs, because we use

resources to create goods and services. Most economists divide resources into
three categories: land, labor, and capital.

• Land includes all the natural resources that come from the earth.

• Labor includes all human effort, physical and mental.

• Many people think of money when they hear the term capital. But in
economics capital isn't money. It's all the machinery, equipment, buildings,
and human skills used to manage and produce goods and services. Keep in
mind that economists divide capital into two types: physical capital and
human capital.

o Physical capital includes machinery, buildings, and equipment.

o Human capital includes the knowledge and skill used to make goods
and services, but not natural ability. For example, it includes the skills
a ballet dancer developed through lessons, but it doesn't include the
dancer's natural athletic talent.

• Some economists use a fourth category of resources: entrepreneurship.

Entrepreneurs are people who come up with new ways of using the other
resources to produce goods or services. They are the "risk takers."

The United States and many other countries use an economic system called a
market system to distribute goods and services. In a market system, the price of
a good or service depends on its scarcity. Items with high prices are generally more
scarce, and items with low prices are generally less scarce.

The scarcity of a good or service depends on two things: availability and value.
Scarcity can change if the availability of resources changes or if people's wants—
how much they value an item—change. The price of an item doesn't tell us how
much people value an item.

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 AP Macroeconomics Page 2 of 4
Introducing Macroeconomics
Focus Sheets: Unit 1, What is Economics?

Some goods are called "free goods." When the amount of a good available exceeds
the amount that people want, it is a free good. It has a zero price.

The economist's definition of a market is "a place where buyers and sellers
exchange goods or services for a price they agree on." For economists, a market
exists whenever and wherever an exchange takes place.

Markets fall into two large categories: factor markets and product markets.

Resources and semi-finished products are exchanged in the factor market. It's also
called the resource market. Goods and services are exchanged in the product
market.

In the factor market, resource owners receive rent for their land, wages for their
labor, and interest for their capital. These are the prices for each factor. In the
product market, sellers receive the selling price for goods and services.

Generally, sellers (or producers) take these factors of production and make
something (it can be a good or service) then sell it to a buyer (or consumer) in a
product market. Hopefully, the price the buyer pays is more than the cost to the
seller in making the product. The difference between the price a seller receives and
the cost a seller faces is profit. Profit is the total revenue of sales received minus
the total cost of the resources used.

The combined economic activity in factor and product markets is known as the
circular flow of economic activity. Resource owners sell their resources to
business owners in the factor market. In exchange they get rent, wages, or interest.
The business owners then use the resources they bought to make goods or services.
Finally, they sell these goods and services in the product market, to the resource
owners.

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 AP Macroeconomics Page 3 of 4
Introducing Macroeconomics
Focus Sheets: Unit 1, What is Economics?

Study: Economic Systems

No economic system can satisfy all the wants of all its members. Remember the
concept of scarcity? Societies develop economic rules and institutions to choose what
wants get satisfied. Because of their different value systems, different societies
distribute goods and services among people differently.

All economies are designed to answer three fundamental questions:

• What goods and services will be produced?

• How will those goods and services be produced?

• Who will get those goods and services?

In every economic system the answers to these questions determine the production
and allocation of resources, goods, and services.

There are three principal types of economies--market, command, and traditional.

Most modern economic systems are a mixture of all three.

• In a traditional economy, decisions are based on the decisions, customs, or

religious practices of ancestors. Traditional economies were common in the past,
and we can still find them in some parts of the world.

• Command economies are centrally planned. The country's resources and means
of production are publicly owned, and government officials make the economic
decisions.

• In market economies buyers and sellers use prices as a medium to exchange

goods in free markets. In other words, price is used to indicate the value that
buyers and sellers place on goods and services in unregulated markets. In a
pure-market economy, people act in their own best interest, producing whatever
gives them the most profit, buying whatever gives them the most satisfaction.

⇒ In his 1776 book Wealth of Nations, Adam Smith claimed that the market
economy structure was the best market structure. His book still serves as a
"blueprint" for pure market economies. In a pure-market economy,
government stays out of the economy, letting producers and consumers do
what they want. Smith wrote about an "invisible hand," defined as the
forces of a free-market economy. He claimed that when people within a free
market economy act in their own self-interest, the overall effect directs
resources to where they produce the greatest benefit for all. It's just as if an
"invisible hand" guided them.

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 AP Macroeconomics Page 4 of 4
Introducing Macroeconomics
Focus Sheets: Unit 1, What is Economics?

Type of Economy

Economic Question Market Command Traditional

1. What goods and Determined Determined by Determined by

services will be produced? by market. government. society's traditions and
values.

2. How will those goods Determined Determined by Varies.

and services be produced? by producers. government.

3. Who will get those Whoever can Determined by Varies.

goods and services? pay for them. government.

Most economies (including the United States economy) are mixed economies, that
is, they are somewhere in between these three market structures.

• For example, the U.S. economy is based on the idea of a market economy. It
promotes the ideas of capitalism and free markets, and most of the means of
production are privately owned. It also includes aspects of both command and
traditional economies (i.e., the U.S. Postal Service and the custom of tipping).
Government regulation of private businesses is another command element in the
U.S. economy.

Most economic systems try to achieve the same four economic goals.

• People want to use their resources as efficiently as possible. When

people try to satisfy their unlimited wants with scarce resources, they don't
want to waste those resources.

• People want to maintain stable price levels for goods and services. People
want stable prices because it's much easier to make decisions if they have a
good idea of what prices will be in the future. The most common form of price
instability is inflation. Inflation is an increase in prices over time.

• People want to have full employment. Societies want full employment

because when people have jobs they add to the productivity of the economy.
On the other hand, when they don't have jobs they detract from the
economy's productivity.

• People want growth. Economists usually measure economic growth by the

increase in the value of goods and services an economy produces.

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