Econ 221 Midterm Study Guide
Econ 221 Midterm Study Guide ECON 221 001
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This 15 page Study Guide was uploaded by Megan Wenzel on Sunday January 31, 2016. The Study Guide belongs to ECON 221 001 at California Polytechnic State University San Luis Obispo taught by Solina Lindahl in Winter 2016. Since its upload, it has received 106 views. For similar materials see Principles of Microeconomics in Economcs at California Polytechnic State University San Luis Obispo.
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Economics 221 (Principles of Microeconomics) Midterm Study Guide Econ 221 History General Notes ● How it used to be: subsistence (choice was easy; ie. food or die) ○ The Heart of Economics is in choice ○ Economics : how people interact with the material world ○ Agriculture: nomads planted and towns growing; society starting to change ○ Authority: choice is harder; made decisions to uphold safety and stability ○ Reformation: declining power of catholic church as decide; anything prior to industrial revolution (greed is bad) ○ Innovation as the enemy: outside the box was seen with revulsions throughout much of our history because it could “disrupt society” ○ Renaissance: humanity is reborn ● Invention begins and Machines are the game changers ○ This prompts society’s relationships to change because production is changing ● Factories Karl Marx believes “labor as a commodity” ● Adam Smith order in the chaos; greed may be good ○ Wealth of Nations: self interest can be good because self interest may serve others ● Laissez faire: “let it be” meaning markets don’t need a babysitter Individual Choice: The principles A. The choices are necessary because resources are scarce ie. money a. Resource: anything that can be used to make something ie. land, labor, capital, entrepreneurship B. The true cost of something is its opportunity cost ie. what you give up in order to get something C. “How much” is a decision at the margin a. trade off: comparison of the costs and benefits of doing something i. marginal decision : decision made at margin about whether to do more or do less of that activity ii. marginal analysis: study of marginal decisions iii. incentive: anything that offers reward D. People respond to incentives, exploiting opportunities to make themselves better off E. There are gains from trade because trade allows us to consume more than otherwise Chapter 2: Economic Models: Trade offs and Trade A. To calculate opportunity cost (see def. above) you look at X production and how increases in X alters Y production and vice versa. a. Other things equal assumption: all relevant factors remain unchanged when look at a model (representation of a real situation to gain understanding) B. The production possibility frontier a. Shows trade offs facing an economy that produces two goods i. Illustrates “efficiency” (aka no missed opportunities) in production and allocation b. Economic growth: growing ability of economy to produce goods and services i. factors of production (resources) increase ii. technology progress C. Gains from trade c. Mutual gains individuals achieve by specializing in different things and trading i. Basis for mutual gain > comparative advantage: (applies to firms and people) a country has it if it’s opportunity cost of that production of an item is lower for that country than for other countries 1. In simpler terms: whichever country has a lower opportunity cost, that country has the comparative advantage. Aka who is giving up less?) ii. Absolute Advantage: If one country produces more output per worker than the other country, they have the absolute advantage D. Positive Economics: branch of economic analysis that describe way economy actually works ~definite right and wrong “description” E. Normative Economics: saying how economy should work “prescription” Ch. 3 Supply and Demand A. Competitive Market is a market in which there are many buyers and sellers of the same good or service. None can influence the price at which the good or service is sold (*Note: no individua ’s action can have an effect on price) a. Supply and Demand Model: 5 key elements i. demand curve ii. supply curve iii. factors causing demand curve and supply curve to shift iv. Market equilibrium = equilibrium price and equilibrium quantity v. The way market equilibrium changes when supply or demand curve shifts B. The Demand Curve a. The demand schedule shows the quantity demanded at each price and is represented graphically by a demand curve. i. The law of demand says that demand curves slope downward; meaning that an increasing price will lead people to demand a smaller quantity of that good or service. b. Movement ALONG the Demand Curve i. A movement along the demand curve occurs when a price changes leads to a change in the quantity demanded (not demand, quantity demanded) ii. A shift of the demand curve is what economists usually refer to when they talk about increasing or decreasing demand. This is a change in the quantity demanded at any given price. 1. An increase in demand shifts the curve right and a decrease in demand shifts the curve left. c. SHIFTS of the Demand Curve i. Five main factors that SHIFT the demand curve: 1. A change in the prices of related goods or services ie. substitutes (Coke and Pepsi) or complements (PB and Jelly) 2. A change in income. When income rises, the demand for normal goods (Target) increases and the demand for inferior goods (Walmart) decreases. 3. A change in tastes 4. A change in expectations 5. A change in the number of consumers C. The Supply Curve a. The supply schedule shows the quantity supplied at each price. This is represented graphically by a supply curve. i. The law of supply states that as price increases, there is also an increase in quantity supplied, so the supply curve slopes upward. b. Movement ALONG the supply curve i. A movement along the supply curve occurs when a price change leads to a change in the quantity supplied. ii. Talk of increasing or decreasing supply usually imply shifts of the supply curve. This is when a change in the quantity supplied occurs at any given price. 1. An increase in supply causes a shift right and a decrease in supply causes a shift leftward of the supply curve. c. SHIFTS of the Supply Curve i. A change in input prices (the price of materials that go into production) ii. A change in the prices of related goods and services iii. A change in technology iv. A change in expectations v. A change in the number of producers D. Supply and Demand Model a. Based on principle that the price in a market moves to its equilibrium price (aka marketclearing price). This is the price where quantity demanded and quantity supplied are equal. The quantity is the equilibrium quantity i. When the price is above its marketclearing level a surplus occurs that will push the price down. ii. When the price is below its marketclearing level, there is a shortage that pushes the price back up. b. Increase in demand will increase both equilibrium price and equilibrium quantity ( a decrease in demand will create the opposite effect) c. Increase in supply reduces the equilibrium prices and increase the equilibrium quantity (a decrease in supply has the opposite effect) E. Shifts of the demand and supply curve can happen at the same time. a. If they shift in opposite directions, the change in equilibrium price is predictable but the change in equilibrium quantity is not. b. If they shift in the same direction, the change in equilibrium quantity is predictable but the change in equilibrium price is not. Notes: a) Price falls, quantity falls; small increase in supply and large decrease in demand. b) Price falls, quantity rises; large increase in supply and small decrease in demand Chapter 4: Consumer and Producer Surplus A. The willingness to pay of each individual consumer determines the demand curve. a. When price is less than or equal to the willingness to pay, the potential consumer purchases the good. The difference between willingness to pay and price is the net gain to the consumer, the individual consumer surplus. B. Total consumer surplus in a market, the sum of all individual consumer surpluses in a market, is equal to the area below the market demand curve but above the price. a. A rise in the price of a good reduces consumer surplus; a fall in the price increases consumer surplus. b. The term consumer surplus is often used to refer to both individual and total consumer surplus. C. The cost of each potential producer, the lowest price at which he or she is willing to supply a unit of a particular good, determines the supply curve. a. If the price of a good is above a producer’s cost, a sale generates a net gain to the producer, known as the individual producer surplus. D. Total producer surplus in a market, the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price. a. A rise in the price of a good increases producer surplus; a fall in the price reduces producer surplus. b. The term producer surplus is often used to refer to both individual and total producer surplus. E. Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus. a. Usually markets are efficient and achieve the maximum total surplus. Any possible reallocation of consumption or sales, or a change in the quantity bought and sold, reduces total surplus. However, society also cares about equity. So government intervention in a market that reduces efficiency but increases equity can be a valid choice by society. F. An economy composed of efficient markets is also efficient, although this is virtually impossible to achieve in reality. a. The keys to the efficiency of a market economy are property rights and the operation of prices as economic signals. b. Under certain conditions, market failure occurs, making a market inefficient. i. Three principal sources of market failure are attempts to capture more surplus that create inefficiencies, side effects of some transactions, and problems in the nature of the good. Chapter 5: Prices Controls and Quotas: Meddling with Markets Markets move to equilibrium (QS=QD) but this does not always please buyers and sellers because buyers want to pay less and sellers want to make more. This creates a strong political demand for governments to intervene in markets A. Price Controls a. Legal restrictions on how high or low a market price may go i. Price ceiling: max price sellers are allowed to charge for a good or service ii. Price floor: minimum price buyers are required to pay for a good or service B. Price Ceilings a. Typically imposed during a crisis ie. Wars, harvest failures, natural disasters because it leads to a price increases (hurts many, gains for few) 1. Example: WWII there was an increased demand for raw materials ie. aluminium and steel. 1973 there were oil price controls by arab embargo b. If a price ceiling is set above Equilibrium (rather than below), it won’t have any effect. If price ceiling is set below equilibrium there will be a shortage because the quantity supplied is reduced but there is an increase in quantity demanded since prices are cheaper c. How a Price Ceiling causes inefficiency i. inefficiently low quanatity leads to a deadweight loss (the loss in total surplus that occurs whenever an action or a policy reduce the quantity transacted below the efficent market ii. inefficient allocation to consumers : people who want the good badly and are willing to pay a high price may not get it and someone who doesn’t care will get the good iii. wasted resources: people expend money, effort and time to cope with the shortage caused by the price ceiling ie. gasoline price controls iv. inefficiently low quality : sellers offer low quality goods at a low price even though buyers would rather have higher quality and would be qilling to pay a higher price d. Four inefficiencies give incentives for illegal activities ie. Black Markets (goods are bought and sold illegally) e. Why have Price Ceilings? i. 3 Common Results: persistent shortage of the good, deadweight loss, inefficient allocation, wasted resources, low quality, black markets C. Price Floors a. Widely legislated for agricultural products ie. wheat and milk. Example: minimum wage: legal floor on the wage rate b. How price floors cause inefficiency i. inefficiently low quantity because it reduces QD, reduces quantity of a good bought and sold = deadweight loss ii. inefficient allocation of sales among sellers: sellers who are willing to sell at the lowest price are unable to make sales while sales go to sellers who are only willing to sell at a higher price. (price floor = decrease in consumer AND total surplus) iii. wasted resources: ie. government purchases (or elimination of unwanted surplus) iv. inefficiently high quality: sellers offer high quality goods at a high price even though buyers would prefer a lower quality at a lower price c. Illegal Activity: working “off the books” for employers aka black labor d. Why Price Floors? i. Create persistent surplus, the 4 inefficiencies and the temptation to engage in illegal activity D. Controlling Quantities a. Quantity control “Quota”: an upper limit on the 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. i. licenses: gives its owner right to supply a good ii. Demand price: the price (of a given quantity) at which consumers will demand the quantity ie. the medallion taxis, E=10 million rides @ $5 per ride iii. Supply price: price at which producers will supply that quantity demanded iv. wedge: the price paid by buyers ends up being higher than that received by sellers b. Quota rent = (demand pricesupply price (quota limit): the earnings that accrue to the license holder from ownership of the right to sell the good. It is equal to the market price of the license when the licenses are traded c. The Cost of Quantity Controls i. They create deadweight loss, encourage illegal activity and mutual benefits do not occur. *As long as demand price exceeds supply price, deadweight loss occurs* Chapter 6: Elasticity Many economic questions depend on the size of consumer or producer responses to changes in prices or other variables. We use Elasticity as a general measure of responsiveness that can be used to answer these questions. A. Price elasticity of demand: the percent change in the quantity demanded divided by the percent change in price (DROP THE MINUS SIGN) a. It is a measure of the responsiveness of the quantity demanded to changes in the prices. The midpoint method is the best way to calculate because it gives us the percent changes in price and quantity based on the average of starting and final values b. A demand curve is elastic when an increase in price reduces the quantity demanded A LOT ( and vice versa, decrease in price increase QD A LOT) c. A demand curve is inelastic when that same increase in price reduces quantity demanded just A LITTLE i. *Note: The flatter the demand curve, the more elastic it is because that means QD is more responsive to price change B. Elasticity Rule a. Elasticity is not the slope; the flatter the curve = more elastic b. The percent change in QD/ the percent change in price i. We drop the minus sign because price and QD move in opposite directions (for price elasticity of demand only) c. midpoint formula: ((change in X)/(avg. value of X)) x 100 i. the average value of X is the (starting value + final value of X) / 2 ii. You do this for both the QD and the Price d. Number of Substitutes is key for high/low elasticity because lots of substitutes = high elasticity e. Extremely low elasticity of demand = increase in prices leaves QD unchanged C. The responsiveness of the quantity demanded to price can range from perfectly inelastic demand, where the quantity demanded is unaffected by the price, to perfectly elastic demand, where there is a unique price at which consumers will buy as much or as little as they are offered. a. When demand is perfectly inelastic, the demand curve is a vertical line; when it is perfectly elastic, the demand curve is a horizontal line. D. The price elasticity of demand is classified according to whether it is more or less than 1. a. If it is greater than 1, demand is elastic; b. if it is less than 1, demand is inelastic; if it is exactly 1 c. demand is unitelastic. i. This classification determines how total revenue (the total value of sales) changes when the price changes. ii. If demand is elastic, total revenue falls when the price increases and rises when the price decreases. iii. If demand is inelastic, total revenue rises when the price increases and falls when the price decreases. iv. If demand is unitelastic, total revenue is unchanged by a change in price. E. The CrossPrice Elasticity of Demand a. Measures the effect of a change in one good’s price on the QD of another good. If cross price elasticity of demand is positive, the goods are substitutes. If cross price elasticity of demand is negative, the goods are complements. F. The income elasticity of demand is the percent change in the quantity of a good demanded when a consumer’s income changes divided by the percent change in income. a. The income elasticity of demand indicates how intensely the demand for a good responds to changes in income. (% Change in QD) / (% Change in Income) i. It can be negative; in that case the good is an inferior good. ii. Goods with positive income elasticities of demand are normal goods. iii. If the income elasticity is greater than 1, a good is incomeelastic; if it is positive and less than 1, the good is incomeinelastic. G. The price elasticity of supply is the percent change in the quantity of a good supplied divided by the percent change in the price. a. If the quantity supplied does not change at all, we have an instance of perfectly inelastic supply; the supply curve is a vertical line. Price elasticity of supply = 0 because an increase in prices leaves QS unchanged b. If the quantity supplied is zero below some price but infinite above that price, we have an instance of perfectly elastic supply; the supply curve is a horizontal line. Price elasticity of supply = infinite H. What are the determining factors? a. Availability of inputs i. increase production expensive, supply curve inelastic ii. A cheap production increase means an elastic supply curve b. Time i. long run price elasticity of supply is usually higher than short run because people have time to adjust I. Important Notes a. When demand is inelastic the price effect dominates quantity effect; so an increase in price will cause only a slight reduction in the QD. i. In this instance, total revenue will rise when the prices rises (and vice versa) b. Example: Candy bars are elastic because they only cost a small amount of income, and there are lots of substitutes. i. high elasticity demand goes WAY up when lower price and revnue goes up ● The price elasticity of supply depends on the availability of resources to expand production and on time. It is higher when inputs are available at relatively low cost and the longer the time elapsed since the price change. Chapter 9: Decision making by individuals and firms All economic decisions involve the allocation of scarce resources. Some decisions are “either– or” decisions, in which the question is whether or not to do something. Other decisions are “how much” decisions, in which the question is how much of a resource to put into a given activity. A. The cost of using a resource for a particular activity is the opportunity cost of that resource. Some opportunity costs are explicit costs; they involve a direct outlay of money. Other opportunity costs, however, are implicit costs; they involve no outlay of money but are measured by the dollar value of the benefits that are forgone. Both explicit and implicit costs should be taken into account in making decisions. Many decisions involve the use of capital and time, for both individuals and firms. So they should base decisions on economic profit, which takes into account implicit costs such as the opportunity cost of time and the implicit cost of capital. Making decisions based on accounting profit can be misleading. It is often considerably larger than the economic profit because it includes only explicit costs and not implicit costs. B. According to the principle of “either–or” decision making, when faced with an “either–or” choice between two activities, one should choose the activity with the positive economic profit. C. A “how much” decision is made using marginal analysis, which involves comparing the benefit to the cost of doing an additional unit of an activity. The marginal cost of producing a good or service is the additional cost incurred by producing one more unit of that good or service. The marginal benefit of producing a good or service is the additional benefit earned by producing one more unit. The marginal cost curve is the graphical illustration of marginal cost, and the marginal benefit curve is the graphical illustration of marginal benefit. D. In the case of constant marginal cost, each additional unit costs the same amount to produce as the previous unit. However, marginal cost and marginal benefit typically depend on how much of the activity has already been done. With increasing marginal cost, each unit costs more to produce than the previous unit and is represented by an upwardsloping marginal cost curve. With decreasing marginal cost, each unit costs less to produce than the previous unit, leading to a downwardsloping marginal cost curve. In the case of decreasing marginal benefit, each additional unit produces a smaller benefit than the unit before. E. The optimal quantity is the quantity that generates the highest possible total profit. According to the profitmaximizing principle of marginal analysis, the optimal quantity is the quantity at which marginal benefit is greater than or equal to marginal cost. It is the quantity at which the marginal cost curve and the marginal benefit curve intersect. F. A cost that has already been incurred and that is nonrecoverable is a sunk cost. Sunk costs should be ignored in decisions about future actions because they have no effect on future benefits and costs. G. With rational behavior, individuals will choose the available option that leads to the outcome they most prefer. Bounded rationality occurs because the effort needed to find the best economic payoff is costly. Risk aversion causes individuals to sacrifice some economic payoff in order to avoid a potential loss. People might also prefer outcomes with worse economic payoffs because they are concerned about fairness. H. An irrational choice leaves someone worse off than if they had chosen another available option. It takes the form of misperceptions of opportunity cost; overconfidence; unrealistic expectations about future behavior; mental accounting, in which dollars are valued unequally; loss aversion, an oversensitivity to loss; and status quo bias, avoiding a decision by sticking with the status quo. Chapter 10: The Rational Consumer A. Consumers maximize a measure of satisfaction called utility. a. Each consumer has a utility function that determines the level of total utility generated by his or her consumption bundle (the goods and services that are consumed) i. We measure utility in hypothetical units called utils. B. A good’s or service’s marginal utility is the additional utility generated by consuming one more unit of the good or service. a. We usually assume that the principle of diminishing marginal utility holds: consumption of another unit of a good or service yields less additional utility than the previous unit. b. As a result, the marginal utility curve slopes downward. C. A budget constraint limits a consumer’s spending to no more than his or her income. a. It defines the consumer’s consumption possibilities, the set of all affordable consumption bundles. b. A consumer who spends all of his or her income will choose a consumption bundle on the budget line. c. An individual chooses the consumption bundle that maximizes total utility, the optimal consumption bundle. D. We use marginal analysis to find the optimal consumption bundle by analyzing how to allocate the marginal dollar. a. According to the utilitymaximizing principle of marginal analysis, at the optimal consumption bundle the marginal utility per dollar spent on each good and service—the marginal utility of a good divided by its price—is the same. E. Changes in the price of a good affect the quantity consumed in two possible ways: a. The substitution effect and the income effect. i. Most goods absorb only a small share of a consumer’s spending; for these goods, only the substitution effect—buying less of the good that has become relatively more expensive and more of goods that are now relatively cheaper—is significant. 1. It causes the individual and the market demand curves to slope downward. ii. When a good absorbs a large fraction of spending, the income effect is also significant: 1. an increase in a good’s price makes a consumer poorer, but a decrease in price makes a consumer richer. This change in purchasing power makes consumers demand less or more of a good, depending on whether the good is normal or inferior. b. For normal goods, the substitution and income effects reinforce each other. For inferior goods, however, they work in opposite directions. i. The demand curve of a Giffen good slopes upward because it is an inferior good in which the income effect outweighs the substitution effect. However, data have never confirmed the existence of a Giffen good.
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