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UCSB / econe / eco 107 / What is the cost of next best alternative forgone?

What is the cost of next best alternative forgone?

What is the cost of next best alternative forgone?


School: University of California Santa Barbara
Department: econe
Course: Econe
Professor: Econe
Term: Winter 2016
Tags: Econ Test Prep notes
Cost: 75
Name: Econ Test Prep notes
Description: Econ Test Prep notes
Uploaded: 01/20/2016
10 Pages 131 Views 2 Unlocks

Important Terms & Definitions | H2 Economics  

What is the cost of next best alternative forgone?



1. Introduction to Economics  


Situation where limited resources available unable to satisfy unlimited  human wants

Opportunity Cost (OC)

Cost of any activity measured in terms of next best alternative forgone

Production Possibility Curve  (PPC)

Shows all different maximum attainable combinations of goods &  services produced when all available resources are used efficiently at  given state of technology

Law of Increasing Opportunity  Cost

As more of a good is produced, more of another good has to be  sacrificed in production

Comparative Advantage

When one can perform an activity at a lower opportunity cost than  anyone else

Law of Comparative Advantage

Trade can benefit countries if they specialize in goods in which they  have a comparative advantage

What is the problem of unlimited needs and wants with limited resources?

2. Demand & Supply  

Law of Demand

Inverse relationship exists between price of good and quantity  demanded of good, ceteris paribus

Law of Supply

Direct relationship exists between price of good and quantity supplied  of good, ceteris paribus

Price Elasticity of Demand (PED)

Degree of responsiveness of quantity demanded of good to a change in  its own price, ceteris paribus

Income Elasticity of Demand  (YED)

Degree of responsiveness of demand to a change in income of  consumers, ceteris paribus

Cross Elasticity of Demand (XED)

Degree of responsiveness of demand for one product to a change in  price of another, ceteris paribus

Price Elasticity of Supply (PES)

Degree of responsiveness of quantity supplied of good to a change in its  own price, ceteris paribus

Consumer Surplus (CS)

Excess of price buyers willing and able to pay for good over actual price  paid

Producer Surplus (PS)

Excess of what producer willing and able to put up for sale for a good  over actual price paid

Deadweight Loss

Loss in welfare not gained by anyone in society

Tax Incidence

Division of tax between consumers & producers


Fixed amount of money given to producers for each unit sold that  lowers cost of good

Price Floor (minimum price)

Legally established minimum price above market equilibrium price

Price Ceiling (maximum price)

Legally established maximum price below market equilibrium price

Black Market

Market where sellers ignore government’s price restrictions & sell  illegally at whatever price equates illegal demand & supply

Will a nation tend to export or import goods for which it has a comparative advantage?

Don't forget about the age old question of What is the most popular philosophy?

3. Cost Theory & Size of Firms

Fixed Factor

Factor of production whose quantity cannot be changed in short run to  change output

Variable Factor

Factor of production whose quantity can be changed within time period to  change output

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Important Terms & Definitions | H2 Economics  

Short Run

Production period in which there is / are fixed factor(s)

Long Run

Production period in which there are no fixed factors

Law of Diminishing Marginal  Returns (LDMR)

As more units of a variable factor are added to an unchanging fixed factor,  the marginal product generated by adding the variable factor will  eventually decrease

Marginal Cost

Additional cost from additional output

Economies of Scale

Unit costs decrease as scale of production increases

Diseconomies of Scale

Unit costs increase as scale of production increases

Minimum Efficient Scale  


Occurs at where LRAC curve stops falling / lowest point of LRAC curve

Internal Expansion

Expanding productive capacity to enjoy internal EOS

Horizontal Integration

Merger of two firms at same stage of production

Vertical Integration

Merger of two firms at different stages of production

Conglomerate Integration

Combination of two firms of different industries with nothing in common

Don't forget about the age old question of What are some events that can trigger anger in us?
Don't forget about the age old question of Define elasticity.

4. Perfect Competition & Monopoly  

Perfect Competition

Market of many buyers and sellers of a homogeneous good


Market of only one seller of a product without substitutes (absence of  competition)

Price Taker

A firm that takes the price from the market as given, without ability to  influence the price

Price Setter

A firm that has the ability to influence the market price

Productive Efficiency

Occurs when firm is able to produce an output at any point along LRAC curve  in long run or least cost at any given period

Allocative Efficiency

Occurs at where output level when price of good equals marginal cost of  producing it

Natural Monopoly

When it is cost efficient to have a single firm in the industry such that it has  lower AC (substantial EOS) over range of market demand

Predatory Pricing

Selling below cost price to drive out competitors


Agreement among existing suppliers to keep out competitors


Occurs when a firm becomes complacent and suffers from inefficiency due to  lack of competition

Price Discrimination

Charging different prices for the same product or for different units of it  when such price differences is not because of cost differences

1st Degree Price  


Monopolist sells each unit to consumers at maximum price they are willing to  pay

2nd Degree Price  


Monopolist sets uniform price per unit for specific quantity of good and  lower price per unit for subsequent units

3rd Degree Price  


Monopolist charges different prices for the same commodity in different  markets

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5. Oligopoly & Monopolistic Competition


Market where few large firms have large market share

Monopolistic Competition

Market where many small firms exist, each providing different products or  services

Price Rigidity

Tendency for prevailing market prices to remain stable over a long time

Mutual Interdependence

Each firm affects rival firms’ decisions and are also affected by rival firms’  decisions

Don't forget about the age old question of Do saturated fats have more hydrogen than unsaturated fats?

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Important Terms & Definitions | H2 Economics  

Product Innovation

Differentiation of product in consumer’s viewpoint through improvements to  product

Process Innovation

Reducing AC without sacrificing profits through streamlining processes

Brand Proliferation

Firms produce many brands to saturate market, leaving no gaps for rivals

Market Segmentation

Segmenting market into sub-markets / market niches with different needs  catered through product innovation

Kinked Demand Curve Theory

Explains price rigidity; TR falls when prices rise / fall as rivals will match price  decreases but not price increases

Price Wars

Used to eliminate new competitors, when a firm lowers its price, other firms  start lowering prices and keep undercutting competitors price

Collusive Oligopoly

When there are tacit / explicit agreements among firms on operations

Cartel Theory

Formal arrangement by sellers to fix prices through manipulating supply to  the market

Price Leadership Theory

Oligopolists agree to set same price as price leader in industry, allowing price  adjustments without price wars

Dominant Firm Price  


Others in industry follow largest producer in industry in price changes

Barometric Firm Price  


Others in industry follow price changes of producer most sensitive to market  conditions

Contestable Market Theory

In a market of free entry & exit, number of firms in industry unimportant  since firms always behave as if competition is very strong (no matter number  of firms)

Differentiated Product

Product that is slightly different from and yet close substitute to product of  other firms in industry

Product Development

Production of good with potentially high demand and different from  products of rival firms or provision / improvement of service to better / differ  from rivals

Excess Capacity Theorem

Firms inefficient in using society’s & own resources, thus not producing at  socially ideal output

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6. Alternative Theories of the Firm  

Profit Satisficing

Where managers of firm make enough profit to satisfy shareholder demands  instead of profit maximizing

Managerial Theories

Managers, with discretionary power and freedom to run the firm, maximize  their own utility instead of profit

Revenue Maximization

Firms aim to maximize sales revenue instead of profits

Growth Maximization

Firms aim to maximize growth instead of profits

Organizational Slack

Tendency of firms in non-competitive markets to produce at higher than AC  (X-Inefficiency)


Industry put under ownership and control of the state


Returning state-owned corporations to private sectors, involving transfer of  assets from public to private sector

7. Market Failure & Government Intervention

Social Efficiency / Pareto  Optimality

Achieved when no one can be made better off without someone being made  worse off

External Benefits

Benefits from production / consumption experienced by people other than  the producer / consumer (third parties)

External Costs

Costs from production / consumption experienced by people other than the  producer / consumer (third parties)

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Important Terms & Definitions | H2 Economics  

Private Marginal Benefit  (PMB) of good

Value the consumer places on last unit of good produced, equal to price and  thus represented by demand

Private Marginal Cost (PMC)  of good

OC of resources used up in making additional unit of good, represented by  supply

Social Marginal Benefit  


Sum of PMB and External Benefit to represent marginal benefit on society

Social Marginal Cost (SMC)

Sum of SMC and External Cost to represent marginal cost on society


When in the production of the good, SMB > SMC (production can be  increased to socially optimum output)


When in the production of the good, SMC > SMB (production can be  decreased to socially optimum output)

Market Failure

Free markets, operating without government intervention, fail to deliver  socially efficient allocation of resources to produce good & services

Public Good

Good / service with characteristic of non-excludability and non-rivalry

Positive Externalities

Benefits from production or consumption experienced by society but not by  producers or consumers themselves

Negative Externalities

Costs from production or consumption experienced by society but not by  producers or consumers themselves

Merit Goods

Goods or services deemed socially desirable by government and seen as  underproduced and thus underconsumed

Demerit Goods

Goods or services deemed socially undesirable by government and seen as  overproduced and overconsumed

Geographical Immobility

Where barriers to people moving from one region to another thus  disallowing resources to respond to incentives to produce more goods &  services demanded

Occupational Immobility

Mismatch of skills as labour is not transferable across industries as  demanded, leading to waste of resources

Government Failure

Allocative efficiency is reduced following government intervention aimed to  correct market failure

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1. National Income Accounting  

Important Terms & Definitions | H2 Economics  

National income

Total value of an economy’s final output of goods & services in a year  (NNP at Factor cost)


Basic consumers of finished products & owners of factors of production


Basic producers of finished products & buyers of factor services

Gross Domestic Product (GDP)

Total market value of all final goods & services newly produced within  country

Gross National Product (GNP)

Total market value of all final goods & services newly produced by  productive factors of country’s citizens (GDP + NPIA)

GDP/GNP per capita

GDP / GNP divided by population

Net Property Income from  

Abroad (NPIA)

Difference between property income from abroad & factor income paid  abroad

Market price

Value of output at shop level / price purchasers pay for goods & services  sold

Factor cost

What factors of production received for goods & services produced

GDP at Factor cost

(GDP at market price – Indirect tax + Subsidies)

Capital depreciation

Loss in value of physical assets due to wear & tear

Net National Product (NNP)

(GNP – Depreciation)

Real GNP

Level of output in terms of physical quantities without price changes  (Nominal GNP⁄GNP deflator)

Nominal GNP

Value of output measured at current prices

Purchasing Power Parity (PPP)

How much goods & services can be bought by a unit of currency at  home compared with purchasing power of other countries’ currency

2. National Income Determination

Keynesian Theory

Fundamental problem causing depression is insufficient demand for  goods & services, so fiscal policy can revive the economy

Desired Aggregate Expenditure  (AE)

Total planned expenditure on goods & services in an economy (C + I + G  + X – M for 4-sector economy)

Equilibrium NI

Level of NI once reached will be maintained unless the economy is  disturbed

Leakage / withdrawal

Siphoning off of expenditure from income flow between firms &  households


Additional expenditure into domestic income flow

Autonomous consumption

Minimal consumption households will still spend when income is zero

Induced consumption

Amount of consumption changing when income changes

Average Propensity to Consume  (APC)

Proportion of total income consumed (C⁄Y)

Average Propensity to Save  (APS)

Proportion of total income saved (S⁄Y)

Marginal Propensity to  

Consume (MPC)

Change in consumption as income changes (∆C⁄∆Y or 1 – MPS or 1 -  MPW)

Marginal Propensity to Save  (MPS)

Change in saving as income changes (∆S⁄∆Y)

Marginal Propensity to  

Withdrawal (MPW)

Change in withdrawals as income changes (MPS + MPM + MPT)


Expenditure on production of capital goods and net additions to goods

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Important Terms & Definitions | H2 Economics  


Marginal Efficiency of  

Investment (MEI)

Negative relationship between interest rates & level of investment

Government expenditure

Current spending & capital spending by the government on provision of  goods & services

Full-employment level of NI

Level where there is no deficiency in demand / full employment of  production factors / production on PPC

Deflationary gap

Shortfall of AE below NI at full-employment level, causing demand deficient unemployment

Inflationary gap

Excess of AE above NI at full-employment level, causing demand-pull  inflation

Multiplier (k)

Number of times income changes as injection changes (∆I⁄∆AE)

Aggregate Demand (AD)

Inverse relationship between price level & real equilibrium output  where planned spending = actual output

Aggregate Supply (AS)

Amount of goods & services all firms in economy willing to supply at  different price levels

3. Unemployment & Inflation


Number of people of working age without work, but willing & able to  take up employment


Economy growing too quickly that high inflation occurs

Labour force

All within working age (15<) who are able & willing to work and are  either employed or seeking employment

Frictional unemployment

Unemployment occurring as workers change jobs / look for jobs after  completing studies

Seasonal unemployment

Unemployment varying with season / weather

Structural unemployment

Unemployment resultant from geographical immobility of labour &  occupational immobility of labour

Geographical immobility of  labour

Labour unwilling to move to another region where prospects are better

Occupational immobility of  labour

Labour that do not have the necessary skills required by the employer

Technological unemployment

Unemployment from labour made redundant as a result of increased  automation

Cyclical / Demand-deficient /  Keynesian unemployment

Unemployment as workers are retrenched in a recession / depression  (as part of the business cycle)

Full employment

Occurs in economy when there is no cyclical unemployment


Sustained increase in general price level of a country, as prices rise and  value of money falls

Consumer Price Index (CPI)

Measures average price level of basket of goods & services consumed by  typical household


Prices rise so fast that money ceases to be a medium of exchange &  normal economic activity breaks down

Demand-pull inflation

Prices rise as supply cannot expand to meet demand

Cost-push inflation

Prices rise as production costs rise

Wage-push inflation

Inflation caused by wages rising faster than productivity gains

Import-price-push inflation

Inflation caused by inflation in other countries where goods are  imported from or when local currency depreciates

Profit-push inflation

Inflation caused by firms use market power to raise prices above what is  required to offset increases in cost of production to increase profits

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Important Terms & Definitions | H2 Economics  

Tax-push inflation

Inflation caused by increases in indirect taxes adding to cost of living

Wage-price spiral

Prices keep rising in vicious cycle as wages rise to offset higher costs of  living & firms increase prices to cover appreciating costs of production

Anticipated inflation

Where rise in general price level is expected

Shoe leather costs

Costs incurred by people & firms trying to minimize holdings of cash

4. Public Finance  

Current / Ordinary expenditure

Expenditure incurred in day-to-day routine work and recurrent year  after year

Development / Capital  


Spending on public investment

Progressive tax

As income increases, proportion of tax on one's income increases

Regressive tax

As income increases, proportion of tax on one's income decreases

Proportional tax

As income increases, proportion of tax on one's income remains the  same

Income tax

Tax on 'earned' & 'unearned' income, taxed progressively

Corporation tax

Tax on firm's profits, usually taxed proportionally

Capital gains tax

Tax on capital gains and capital appreciation of assets (land, shares etc)

Property tax

Tax on annual rental value of land & buildings, usually proportional tax

Stamp duty

Tax on legal & commercial down payments

Ad valorem tax

Tax on fixed proportion of value of good or service (%)

Specific tax

Tax on fixed amount per unit of good or service ($)

Value-added tax (VAT)

Multi-stage tax levied on net value added at each stage of production

Excise duty

Tax on manufacturer of goods so as to curtail domestic consumption

Customs duties / Tariffs

Tax on goods imported from outside the country, to raise revenue or for  protectionist reasons

5. Fiscal Policy  

Government budget

Estimate of government revenue & expenditure for coming year

Balanced budget

Estimated revenue = Estimated expenditure

Deficit budget

Estimated revenue < Estimated expenditure

Surplus budget

Estimated revenue > Estimated expenditure

Deficit financing

Financing extra spending by government through other methods (e.g.  borrowing)

Fiscal policy

Government policy where government expenditure is increased & taxes  are reduced to stimulate economy

Automatic fiscal stabilizers

Built-in features of economy operating automatically to smooth out  fluctuations in disposable income over business cycles, without  government intervention

Disposable income

Income households have available to spend after paying income taxes &  receiving transfer payments (e.g. unemployment benefits)

Crowding-out effect

Government cuts taxes or expands borrowing to finance increased  expenditure, crowding out private investment due to higher interest  rates

6. Interest Rate Determination & Monetary Policy

Money supply

Quantity / Stock of money held by households & firms in economy

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Important Terms & Definitions | H2 Economics  

Demand deposits

Money deposits in checking accounts (for checks)

Nominal money

Amount of money in dollars & cents

Real money

Amount of goods & services one can purchase with the money

Money substitutes

Items serving as temporary medium of exchange but not stores of value

Fiat money

Notes & coins determined as legal tender but not backed by gold,  circulated by faith alone

Interest rates

(Rate charged) Cost of borrowing & reward for lending

Nominal interest rate

Interest rate charged by lender

Real interest rate

Nominal interest rate minus inflation rate

Demand for money

Desire to hold money rather than spend it or for financial investment

Liquidity preference

Desire to hold non-interest bearing cash balances as part of wealth  portfolio instead of interest-bearing bonds

Transactions motive

Cash balances to meet planned expenses

Precautionary motive

Cash balances to meet unforeseen expenses

Speculative motive / Idle  


Cash balances to purchase assets & bonds to make capital gains

Total demand for money

Active balances (Transactions motive & precautionary motive) + Idle  balances

Loanable funds

Funds available for lending

Central bank

Institution supervising monetary system, implementing monetary policy  & ensuring banks & financial institutions operate efficiently

Monetary policy

Deliberate attempt by Central Bank to regulate money supply or  manipulate interest rates

Irrational exuberance

Consumers continue to spend regardless of high interest rates because  of high consumer confidence

Velocity of money

Rate at which money supply turns over each year

7. Economic Growth  

Economic growth

Annual percentage increase in real value of goods and services  produced by economy

Actual economic growth

Annual percentage increase in national output

Potential economic growth

Speed at which economy could grow / Percentage annual increase in  economy's capacity to produce

Human capital

Accumulated skill & knowledge of workers

8. Supply-side Policy  

Supply-side policy

Focusing on adjusting AS such that the AS curve expands outwards

Prices & income policy

Direct or indirect intervention by government on wage-price setting to  influence inflation rate


Wages + Overtime payments + Bonuses

9. International Trade


Exchange of goods & services between two parties

International trade

Exchange of goods & services across national borders

Factor price equalization

Prices of factor inputs brought closer to each other

Absolute advantage

Where a country can produce more of a good using the same amount of  resources

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Important Terms & Definitions | H2 Economics  

Comparative advantage

Where a country can produce a good at a lower opportunity cost than  another country

Law of comparative advantage

Trade can benefit all countries if they specialize in goods in which they  have a comparative advantage

Terms of trade (TOT)

Rate at which one good can be exchanged for another

Terms of trade index

Comparison of export price index with import price index (Export Price  Index/Import Price Index X 100%)

Balance of trade (BOT)

Difference between value of commodity exports & imports (Export  revenue-Import spending)

Free trade

Exchange of goods & services between countries without any artificial  restrictions


Policy of sheltering domestic industries from foreign competition  through tariff & non-tariff barriers

Infant industry

Industry with potential comparative advantage but too young /  undeveloped to realize potential


Selling of goods in foreign market below cost price / price sold in home  market

Import quota

Legal limit on quantity of imports over given time period


Indirect protection of domestic producers so they become more  competitive against more efficient foreign producers

Voluntary restraint agreement  (VRA)

Agreement to reduce trade volume in specific good

Exchange control

Government's buying & selling of foreign exchange to regulate imports  & exports to ensure healthy BOP and prevent undue fluctuations in  country's foreign exchange value


Total ban on certain imports

Economic integration

Neighboring countries integrate as an economic unit to take advantage  of extended market & allow better allocation of resources

Free trade area (FTA)

Agreement where member countries agree to remove tariff & non-tariff  barriers among themselves but retain restrictions against non-member  countries

Trade deflection

Imports enter FTA via country with lowest external tariff

Customs union (CU)

Agreement where member countries remove all trade barriers among  themselves & adopt common external tariff for non-member countries

Common market

Member countries operate as a single market, lifting all restrictions on  trade in services, capital & labour movements and adopting laws &  regulations on trade, production & employment

Trade diversion

Trade diverted from more efficient non-member producer to less efficient but tariff-free member nation

Balance of payments (BOP)

Summary statement of money value of economic transactions between  country residents & rest of world

Credit item (+)

International transaction earning foreign currency, providing demand of  domestic currency

Debit item (-)

International transaction requiring foreign currency to make payments,  providing supply of domestic currency

Current account

Flow of goods & services + incomes & net transfer of money flowing into  & out of country

Trade in goods account

Import & export of tangible goods

Trade in services account

Import & export of services (invisibles)

Income flows

Investment income in forms of rent, interest, profits & dividends (net  property income from abroad)

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Important Terms & Definitions | H2 Economics  

Current transfers

Unilateral flows such as government contributions & receipts from  international organizations & remittances

Capital account

Records debt forgiveness, migrant transfers & acquisition & disposal of  non-financial assets such as patents & copyrights

Financial account

Records purchase & sales of assets in terms of direct investment,  portfolio investment & monetary flows

Direct investment

Purchase & sale of real assets (capital goods)

Portfolio investment

Purchase & sale of shares & bonds (long-term investment)

Monetary flows

Bank deposits, loans & debts (short-term investment)

Balancing item

Statistical adjustment to record errors & omissions in calculations

Official Reserves Account (ORA)

Accommodates surpluses or deficits in overall balance

BOP equilibrium

Trade & capital flows into & out of country equal over number of years

BOP disequilibrium

Persistent tendency for outflows to be greater or less than  corresponding inflows

Expenditure-reducing policies

Contractionary demand-side policies to reduce imports and hence AD &  NI of country

Expenditure-switching policies

Policy that raises import prices relative to domestic-produced goods

Marshall-Lerner (ML) condition

Sum of PEDX & PEDM > 1 for devaluation of currency to be successful in  correcting adverse BOP

J-curve effect

Where current account worsens in short-run after currency devaluation  before improving

Foreign exchange (Forex)

Trading of one country's currency for another foreign currency

Exchange rate

Rate at which one currency is exchanged for another

Nominal exchange rate

Exchange rate based on nominal value of currency before adjustment to  price changes

Bilateral exchange rate

Exchange rate between two currencies

Trade-weighted / Effective  exchange rate

Value of currency against basket of other currencies of major trading  partners

Derived demand for currency

Currency demand stems from foreigners' demand for our goods,  services & financial assets


One currency weakens relative to another, when demand for it falls or  supply for it rises


One currency strengthens relative to another, when demand for it rises  or supply for it falls

Purchasing power parity (PPP)  theory

Equilibrium rate of exchange between two currencies determined by  relative domestic purchasing power; exchange rates between two  currencies in equilibrium when equivalent domestic purchasing power

Fixed exchange rate

Government of country fixes & guarantees official price of currency in  terms of other foreign currencies


Government declares lowering of fixed exchange rate


Government declares raising of fixed exchange rate

Freely-floating / Flexible  

exchange rate

Exchange rate determined freely by market forces of demand & supply  in forex market

Managed float exchange rate

Government lets market forces determine exchange rate but will  interfere to change it if beyond certain band

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