Study Guide for Exam 1
Study Guide for Exam 1 ECON 1010
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This 10 page Study Guide was uploaded by Eleni McGee on Saturday January 30, 2016. The Study Guide belongs to ECON 1010 at Tulane University taught by Jonathan Pritchett in Spring 2016. Since its upload, it has received 188 views. For similar materials see Microeconomics in Economcs at Tulane University.
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Date Created: 01/30/16
Compiled by: Eleni McGee (email@example.com) STUDY GUIDE FOR ECON 1010 EXAM #1 Chapter 1: Intro to Economics Economics- the study of choice, how people allocate scarce resources to satisfy their desires. Scarcity- when we want more of something that is freely available. Almost everything is scarce. Economics=social science that relies on observation, has theories that have models abstracted from reality Microeconomics vs. Macroeconomics- MICRO: study of individual markets and players, and influence of government on these choices MACRO: study of economy as a whole (national and global) and the choices that individuals, businesses and governments make. Goods and services- the objects that people value and produce to satisfy wants. America is much more service oriented right now. Factors of production- used to make goods and services. Four categories: 1. Land a. “gifts of nature” b. earns RENT 2. Labor a. Work time and effort b. Earns WAGES 3. Capital a. Human capital i. Knowledge and skills people obtain from education, on the job training and work experience. ii. It has grown very much over the years (more people going to school) iii. Earns INTEREST b. Capital i. Tools, instruments, machines, buildings used to produce goods and services. ii. Earns INTEREST 4. Entrepreneurship a. Human resource that organizes land, labor and capital. b. Earns PROFIT Factors of production- resources that businesses use to produce goods and services. Income varies depending on who owns these factors of production. Incentives- choices you make that are best for you= SELF interest. Choices that are best for society= SOCIAL interest. There is conflict between self and social interest. Tradeoffs- an exchange, giving up one thing to get another. “Guns vs. butter” Opportunity cost- You give up one opportunity to get the highest valued alternative. Choice implies opportunity cost. Choosing at the margin- people make choices to make incremental changes in the use of their resources. Marginal benefit- benefit from pursuing an incremental increase in activity. The opportunity cost of marginal benefit is marginal cost. Getting back to incentives… o If marginal benefit exceeds marginal cost, people have incentive to do more of that activity and vice versa. Positive vs. Normative statements- POSITIVE o What is, can be proven right/wrong and tested by facts o *does NOT necessarily have to be true NORMATIVE o What ought to be, depends on personal values, cant be tested Ceteris Paribus- assuming all other factors to be equal Fallacy of composition- statement that what is true of the parts is true of whole and vice versa. (what is true for individual is not true for the group.) Post Hoc Fallacy- error of reasoning that a first event causes a second event just because the first event happened before the second. Chapter 2: Production and Exchange Scarcity- there are insufficient resources to satisfy humans’ wants because humans’ wants are insatiable. Absolute price vs. relative price- Absolute price o The number of dollars that must be given up in exchange for an item Relative price o Ratio of one price to another. o AKA Opportunity costs! o “price falling” means the price falls relative to the average price of other goods and services Production possibilities frontier (PPF)- illustrates max # of 2 goods that can be produced. We assume ceteris paribus. Ex. Guns and butter points outside the PPF are unattainable, points inside are attainable production efficiency occurs when we can not produce more of one good without producing less of the other good. These points are ON the PPF. Every choice along the PPF involves a tradeoff: give up some guns to get more butter or give up some butter to get more guns. Opportunity cost of the guns is the inverse of the opportunity cost of butter PPF is bowed outward because as quantity of each good increases so does its opportunity cost. NOTE: see the graphs on slides to get a better grasp on this. Marginal cost- the opportunity cost of producing one more unit of a good. As you move along the PPF slope (with butter on x axis and guns on y axis) the marginal cost of butter increases. Preferences- person’s likes and dislikes, they determine where you end up on the PPF. Marginal benefit- used to describe preferences. It is the benefit of a good/service received by consuming one more unit of it. Measured by the amount that a person is willing to pay for an additional unit of this good/service. General rule: the more we have of any good/service, the more our marginal benefit (willingness to pay) decreases. (known as principle of decreasing marginal benefit) * Note that when marginal benefit > marginal cost and you buy more, marginal benefit goes down and marginal cost goes up. You should keep buying until marginal cost=marginal benefit to maximize net benefit. Economic growth- the expansion of production possibilities and an increase in the standard of living. Cost: using research and development to promote new capital, so we must decrease our production of consumption of goods and services (tradeoff) o Ex. When you increase your number of butter making machines, the PPF will shift outward in the future, but the more butter making machines you make the less butter. o Hong Kong vs. USA example Hong Kong’s PPF grew faster than the US’s because it devoted more of its resources to capital accumulation. (but Hong Kong still has lower production possibilities. 2 key factors influence economic growth o Technological change: development of new goods and better ways of producing goods/services. o Capital accumulation: growth of capital resources (buildings, tools, etc.) and/or human capital. Comparative vs. absolute advantage- comparing opportunity cost vs. comparing productivity. Comparative o Person has comparative advantage in activity if that person can perform the activity at a lower opportunity cost than anyone else (sacrifice less than anyone else) Absolute o Person has absolute advantage if that person is more productive than other. Gains from trade- when 2 parties get together and each do the thing that they are better at (have a comparative advantage in). ex. Liz and Joe’s smoothie/salad bar (see slides). Both of them specialize so it allows both individuals to get more in total. Barter exchange- trading one commodity for another. Requires a double coincidence of wants, which means that both parties have to want what the other has. Double coincidence of wants is hard to achieve in a real economy. So… we use money as a medium of exchange! Money allows for multilateral trade! Trade is voluntary: both buyer and seller benefit, can harm some people, but there is a net benefit. Dynamic comparative advantage- when a person/nation gains a comparative advantage by: learning by doing then specializing by repeatedly producing a particular good or service to become more productive in that activity. Lowers opportunity cost of producing that good over time. To gain from trade, the choices of these social institutions must be coordinated: 1. Firms a. Hires factors of production and organizes those factors to sell goods/services. b. Note that households are demanders of products and firms are suppliers of products. 2. Markets a. Where exchanges work, requires any buyer/seller to get good info and do business. 3. Property Rights a. The social arrangements that govern ownership, use and disposal of resources, goods and services. 4. Money- a. Any commodity/token that is acceptable as means of payment. There is economic coordination: so factors of production/goods/services flow in one direction and money flows in the other (between households, firms, goods markets and factor markets) Markets coordinate individual decisions through price adjustments. Chapter 3: Supply and Demand Rationing- because there is scarcity, we ration. Types of rationing: 1. Time (or queuing) a. People who wait get goods b. Queuing is when people send other people to wait in line for them. It is wasteful because the buy loses the opportunity cost of her time seller gets nothing. 2. Price a. Useful way of rationing, reflects willingness to pay b. People who bid most for goods get them c. The price system is efficient but allocations through the price system may be inequitable (unfair)… So something that is efficient is NOT ALWAYS good. 3. Collective decisions a. 35% of national income is taken by government, government may be inefficient, resources may not go to the people who value them the most. 4. Personal characteristics a. Racist landlord might not rent to blacks, sexist employer might refuse to hire women. 5. Coercion a. The bully gets what he/she wants Demand- when a person wants something that they can afford. Quantity demanded of a good is the amount that consumers plan to buy during a time period at a given price. Law of demand- the higher the price of a good, the smaller the quantity demanded. The law of demand works because: 1. Substitution effect: substituting in things for the more expensive goods. 2. Income effect: you are better off because of lower prices and worse off because of high prices. Demand curves show relationship between quantity demanded of a good and its price (assume ceteris paribus). It is also a willingness and ability to pay curve. The smaller the quantity available, the higher the price that someone is willing to pay for another unit. (Marginal benefit) When demand INCREASES the demand curve shifts TO THE RIGHT or OUTWARD When demand DECREASES the demand curve shifts TO THE LEFT or INWARD Demand schedules are a list of quantities demanded and their prices. Demand changes because of: o Price of related goods Substitute- a good that can be used in place of another good, ex. Coke and Pepsi Complement- a good that can be used in conjunction with another good, ex. Burger and fries Increase in price substitute= increase in demand of product Decrease in price complement= increase in demand of product Increase in price complement= decrease in demand of product o Income When income increases, consumers buy more of most goods and demand curve shifts rightward. Normal good- a good that’s demand increases when income increases. Ex. Cool cars Inferior good- a good that’s demand decreases when income increases. Ex. Spam, fast food o Population The larger the population, the greater the demand for all goods o Preferences People with the same income have different demands if they have different preferences. o Expected future prices If a price of good is expected to rise, current demand for the good goes up and curve shifts rightward. IMPORTANT: change in quantity demanded vs. change in demand Change in quantity demanded: movement along the curve. Changes in price affect this. Change in demand: entire shift of the curve. Supply- if a firm has a good or service, the firm: Has resources and tech to make it Can profit Has plan to make and sell it Quantity supplied- the amount that producers plan to sell during a time period at a particular price Law of supply- when prices go up, firm wants to make more of it, when prices go down, firm wants to make less of it because… firm wants PROFIT. A supply curve shows relationship between quantity supplied of a good and its price. (ceteris paribus) An INCREASE in supply causes graph to shift TO THE RIGHT or OUTWARD. A DECREASE in supply causes graph to shift TO THE LEFT or INWARD. IMPORTANT: Change in quantity supplied vs. change in supply Change in quantity supplied- movement alont the graph Change in supply- entire shirt of curve. Changes in supply occur because of: Price of factors of production o If the thing used to make the good’s price rises, then profits go down and supplier less willing to make the good. Prices of related goods produced o Substitute in production- when a good can be produced in place of the other using the same resources. o Complement in production- when two goods must be produced together Expected future prices o If price expected to rise in future, supply of good today decreases and supply curve shits left. Number of suppliers o The larger the number of suppliers, the greater the amount of goods, supply curve shifts right. Technology o Advances in tech create new products that could lower cost of producing existing products, supply curves shift rightward. State of nature o Natural disasters, weather could cause a leftward shift of supply. Market equilibrium- when 2 forces balance each other. Equilibrium occurs when the price balances the plans of buyers and sellers. Equilibrium price- the price at which quantity demanded= quantity supplied. It is the intersection point of the demand curve and the supply curve. Equilibrium quantity- price at which quantity bought and sold at equilibrium price. Note: make sure to look back and review graphs from slides. Chapter 4: Elasticity Elasticity of demand- responsiveness. Responsiveness of quantity dependent on price increase. Total revenue= price x quantity Slope of demand curve depends on units of measurement. Elasticity is independent of the units of measurement. *When the demand curve is relatively flat, a lower price causes an increase in revenue, but when demand curve is relatively steep, the total revenue is decreased. Price elasticity= percent change in quantity demanded/ percent change in price Calculating elasticity: ignore negative sign, use averages. Perfectly inelastic- consumers unresponsive to price change, elasticity= 0. (curve is vertical line) Unit elastic- percentage change in quantity demanded equals percentage change in price. Elasticity=1. On this graph, the top half of the line is generally elastic and the bottom half is generally inelastic. Perfectly elastic- if price changes by any percentage, quantity demanded will fall to zero. Elasticity= infinity. (curve is horizontal line) Inelastic demand- % change quantity is less than % change price. Price elasticity of demand GREATER THAN 0 AND LESS THAN 1. Elastic demand- implies% change in quantity demanded is greater than % change in price. Price elasticity of demand is GREATER THAN 1. Factors that influence elasticity- The closeness of substitutes (closer the substitutes, the more elastic the demand) Proportion of income spent on the good (greater the proportion of income spent on good, the more elastic the demand) Time period of adjustment (the longer the time the more elastic the demand). o Short run demand o Long run demand (as you have more time to respond, you get a bigger response) Total revenue test- price elasticity of demand can be estimated by observing the change in total revenue that results from a price change (ceteris paribus) If price is cut and total revenue increases, demand is elastic If price is cut and total revenue decreases, demand is inelastic If price is cut and total revenue does not change, demand is unit elastic Cross elasticity of demand- measures responsiveness of demand for a good to change in the price of a substitute or complement good. Cross elasticity of demand= % change in quantity demanded/ % change in price of substitute or complement Income elasticity- measures responsiveness of the demand to a change in income. Income elasticity of demand= % change in quantity demanded/ % change in income Can be: 1. Greater than one (normal good, income elastic) 2. Between zero and one (normal good, income inelastic) 3. Less than zero (inferior good) Elasticity of supply- depends on: Resource substitution possibilities (the more unique the resource, the more inelastic the supply) Time frame for the supply decision (the longer producers have to adjust to a price change, the more elastic the supply) o Momentary supply o Long run supply o Short run supply *Make sure to review graphs!! Chapter 5: Efficiency and Equity Efficiency- the resources have been used to produce the goods and services that people value the most. Depends on comparison of marginal cost and marginal benefit. Three possibilities: 1. Marginal benefit exceeds marginal cost 2. Marginal cost exceeds marginal benefit 3. Marginal benefit equals marginal cost Consumer surplus- total value of a good minus the total amount paid for it. If a person buys something for less than they are willing to pay for it, a consumer surplus exists. As you keep buying something, the marginal benefit decreases but as you continue to buy it marginal benefit will eventually equal marginal price. Willingness to pay first few purchases will exceed the price. Diamond Water Paradox: We need water so much but it is so cheap, we don’t need diamonds but they are so expensive. Why? 1. Quantities: we have a lot more water 2. Big demand for water, price represents marginal value which is low because we have a lot of water. Cost- is what the producer gives up Price- is what the producer receives Producer surplus- value of a good minus the opportunity cost of producing it. If a firm sells omething for more than it costs to produce then a producer surplus exists. Recall- supply and demand will force the price toward the equilibrium price At competitive equilibrium, resources are being used efficiently and the sum of consumer surplus and producer surplus is maximized. Sources of Inefficiency: Prices and quantity regulations Taxes and subsidies Monopoly Public goods and common resources External costs and benefits High transactions cost These lead to underproduction or overproduction. Deadweight loss- the decrease in consumer and producer surplus that results from an inefficient allocation of resources. Is the competitive market fair? Utilitarianism- principle that states that we should strive to achieve “the greatest happiness for the greatest number” This ignores the cost of making income transfers. Recognizing these costs leads to the big tradeoff between efficiency and fairness. Symmetry principle- requirement that people in similar situations should be treated similarly. Two rules: state must create and enforce laws that establish and protect private property. Private property may be transferred from one person to another only by voluntary exchange. This means that if resources are allocated efficiently they may also be allocated fairly.
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