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Study Guide for Exam 2

by: Eleni McGee

Study Guide for Exam 2 ECON 1010

Marketplace > Tulane University > Economcs > ECON 1010 > Study Guide for Exam 2
Eleni McGee

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This is a comprehensive and detailed study guide for the second exam of Microeconomics. This study guide is extremely helpful in describing conceptual topics of Chapters 6-9, which will be covered ...
Jonathan Pritchett
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This 7 page Study Guide was uploaded by Eleni McGee on Friday February 26, 2016. The Study Guide belongs to ECON 1010 at Tulane University taught by Jonathan Pritchett in Spring 2016. Since its upload, it has received 110 views. For similar materials see Microeconomics in Economcs at Tulane University.


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Date Created: 02/26/16
Compiled by Eleni McGee ( STUDY GUIDE FOR ECON 1010 EXAM #2 Chapters 6-9 Chapter 6: Price Ceilings and Floors Price ceilings- regulations that prevent the price from rising above a certain price Ex. Rent control or rent ceiling (a price ceiling in housing) - If the rent ceiling is above equilibrium rent, then there is no effect. - If rent ceiling below equilibrium rent, there are effects --> housing shortage (the quantity demanded exceeds the quantity supplied) o When this happens there is inefficiency (marginal social benefit from housing exceeds marginal social cost so there is a deadweight loss) o When this happens, you have to find other ways to buy a house:  Greater search activity (costly)  Black markets (illegal, when arrangements made between renters and landlords that are above the rent ceiling) Price floor- regulations that keep price above a certain specified level. Ex. minimum wage - If minimum wage is below eq. wage rate there is no effect. - If min. wage is above eq. wage rate, there are effects surplus of labor (quantity supplied by workers exceeds quantity demanded by employers) o Because we can’t eliminate surplus from the min. wage, min. wage creates unemployment o This leads to inefficiency and a deadweight loss. o The minimum wage is an efficiency and equity tradeoff. o Unionized labor and minimum wage labor are substitutes. o Min. wage might increase unemployment in low-skilled workers. Chapter 6: Tax Subsidies Taxes- income tax and social security tax is deducted from pay, state sales tax is added to the thing you buy. Tax incidence- how we divide up taxes between the buy and the seller. Tax drives a wedge between what the demander has to pay vs. what the supplier gets to keep. When the price rises, the demander pays tax. If the price stays the same, the supplier pays the tax. The burden of tax is the fraction of the tax that is paid for by different people. Legal incidence- fact that you have to pay the tax, shows who is literally assigned the tax. Economic Incidence- repercussions of tax: who pays for it. (Most tax is actually paid by employee not the employer. The division of tax between buyers and sellers (burden of tax) depends on elasticity of supply and demand. Perfectly inelastic demand: buyers pay entire tax Perfectly elastic demand: sellers pay entire tax. So… the more inelastic the demand, the larger the buyers’ share of the tax. Perfectly inelastic supply: sellers pay entire tax. Perfectly elastic supply: buyers pay entire tax. So… the more elastic the supply, the larger the buyers’ share of the tax. Taxes are usually levied on goods and services with an inelastic demand or inelastic supply. Ex. Alcohol, tobacco, and gas all have inelastic demands so the buyers will pay most of the tax on these. But labor has an inelastic supply so the seller pays most of the tax. Excise taxes- taxes imposed on suppliers. Often the demanders end up paying this tax because it is already embedded in the price. Consumers don’t bear all of the tax burden in this case, but they bear a lot of it. Sales taxes- taxes imposed on demanders. It is added on in the price (ex. Tax on a ballpoint pen). This affects willingness to pay (demand), which is reduced by the amount of the tax. Consumers bear all of the tax burden in this situation. In both cases (excise tax and sales tax) burden of tax is governed by supply and demand, but just because you assign the tax (legal incidence) does not mean that you want to the person who bears the tax to bear it (economic incidence). Taxes create inefficiency and a deadweight loss. (there is a lost gain from trade because tax revenue is less than loss of a producer and consumer surplus) BUT economists propose two principles of fairness of a tax system: 1. Benefits principle a. People should pay taxes equal to the benefits they receive from gov. services. (so those who pay most benefit most) 2. Ability-to-pay principle a. People should pay taxes according to how easily they can bear the burden of the tax. b. So rich people pay more tax. Besides tax, there are other ways that governments can intervene in markets: 1. Production quotas a. Limit on how much you can produce b. Effects: i. Increase price ii. Lower cost of production iii. Consumer surplus decreases iv. Creates deadweight loss (net loss to society) c. Why is it helpful? It increases the price 2. Subsidies a. Payment made by government to a producer b. Effects i. Shift down of supply curve ii. Willingness to supply increases iii. Price lowers, quantity increases iv. Consumer surplus increases v. Creates deadweight loss (net loss to society) c. Why is it helpful? Increases supply (quantity) The Market for Illegal Goods: - Penalty on seller o Increase supply curve as a result of the cost of jail o Price of drugs goes up, less are consumed - Penalty on buyer o Lowers demand by imposing cost on consumers o Lowers the price of drugs, less are consumed - Penalty on both buyer and seller o Reduces amount of drugs being sold (demand and supply both go down) Legalizing and taxing drugs: a high enough tax rate would decrease consumption to the level that occurs when trade is illegal. Chapter 7: International Trade Imports- goods and services that we buy from other countries Exports- goods and services that we sell to other countries There is a general trend that we are becoming more dependent on other countries in terms of what we buy. Balance of trade- the value of exports minus the value of imports. - In the US we buy more than we sell deficit - Borrowing money to do this we have debt - Deficits are a bad thing generally BUT they shows that foreigners want to come in and invest In the US so it shows that we have a good economy. (In other words, there is a surplus in terms of people investing in the US but a deficit in the number of goods we sell) Comparative advantage drives international trade. - When you have a comparative advantage you have a lower opportunity cost - Make the things you are relatively good at and buy the things you are relatively bad at making. This leads to Gains from Trade - National comparative advantage Autarky- trade within; domestic production and domestic consumption For international trade with a comparative DISADVANTAGE: the sum of producer and consumer surplus increases, but consumer surplus has increased because price has decreased. (DISADVANTAGE is when world price is below the domestic eq. price in US) For international trade with comparative ADVANTAGE: consumer surplus decreased because the price has increased. (ADVANTAGE is when world price is above domestic eq. price in US) Tariffs- an additional tax on a good that is imported from another country. This is a restriction on trade, so it creates deadweight loss and inefficiency. Nontariff barriers- actions besides tariffs that restrict trade. (ex. Quantity restrictions, licensing requirements) NAFTA and European Union have their own agreements to have NO tariffs. * Make sure to be able to label a graph of import tariffs and identify the effects of import tariffs which are:  Quantity demanded goes down  Quantity supplied goes up, so imports go down  Deadweight loss that represents the forgone trade  Consumer surplus decreases and producer surplus increases Import quotas- nontariff barriers, the max # of goods that can be imported. Ex. US has import quotas on sugar and textiles *Make sure to be able to label a graph of Import quotas and identify its effects which are:  Supply curve shifts to the right by the amount of the quota as long as the US price is above the world price  Imports decrease  US consumers lose because the price goes up  US producers gain  Importers (people with the right to bring in the goods) gain  There is a deadweight loss The Case Against International Trade: 1. The National Security Argument- in order to protect our country we should promote vital industries (oil, gas etc.) in the US in case we have to go to war or face a disaster 2. Infant Industry Argument- when industries first start out they aren’t as competitive. As industries progress they will get better at their work. We should allow industries to grow until they are mature enough to compete with the other industries. 3. Dumping- idea that foreigners are selling products at lower prices than it actually costs to make them. 4. Penalize Lax Environmental Standards- in other countries people don’t have to worry about environmental production costs. We do in the US 5. Tariff Revenue- this one is no longer a big deal, but it used to be. 6. Rent Seeking- some people benefit, some people are hurt. If we restrict trade some parties are better off. Chapter 8: Utility Utility- a way of measuring people’s preferences/ how much pleasure people get from certain things. There are 2 determining concepts for consumption choice: 1. Budget constraints (how much can I buy) a. Depends on income and prices b. Limits are described by the budget line c. You have different consumption possibilities depending on your budget (ex. You can either get 1 movie and 8 sodas or 5 movies and 0 sodas, etc.) 2. Preferences (how much I want to buy) Marginal utility- is the change in total utility that results from a one-unit increase in the quantity of a good consumed. Total utility- total satisfaction that you get from consuming a good. We measure utility in “utils” for this lesson, but we can’t really measure utility in reality. Diminishing marginal utility-As the quantity consumed of a good increases, the marginal utility from consuming it decreases. The key assumption is that the household chooses the consumption possibility that maximizes total utility. Consumer equilibrium- the utility-maximizing combination. This is how people can do the best they can given their constraints. A consumer’s total utility is maximized by the following rule: Spend all available income and equalize the marginal utility per dollar of all goods (marginal utility of a good divided by its price) So you must allocate income so that you get “the most bang for your buck” or the most total utility Chapter 9: Consumer Choice: Indifference Curves and Budget Lines Budget lines- represent constraints (can afford anything inside the budget line or on the budget line) Indifference curves- represent preferences Consumption possibilities: Divisible goods can bought in any quantity along the budget line while indivisible goods must be bought in whole units at points marked (ex. Movies) Budget Equation: Expenditure=Income PsQ sP Qm= m (where P =sprice of soda, Q = qsantity of soda, etc.) To find the real income and relative price, divide both sides of the equation by P s Then subtract (P /m )QsfrMm both sides to get: Q sY/P –sP /M )S M Real income: Y/P s Relative price: (P MP S Change in Prices: When the price changes on the consumption possibilities graph, the y axis stays the same and the slope steepens with an increase of price and becomes flatter with a decrease in price. Change in Income: With a change in income, the slope DOES NOT change but it shifts to the left with a decrease and to the right with an increase. Indifference Curve- a line that shows combinations of goods among with a customer is indifferent. There are three possible combinations of goods: preferred, not preferred, and just as good as X. An indifference curve joins all the points that are “just as good as X” All the points outside the indifference curve are preferred to all the points inside the indifference curve. Preference map- series of indifference curves. Indifference curves that are farther out (to the right) are preferred to indifference curves that are farther in (to the left) Marginal rate of substitution- measures rate at which a person is willing to give up a good to good an additional unit of that good while remaining on the same indifference curve. This is measured by the SLOPE of the indifference curve. When slope is relatively STEEP, marginal rate of substitution is HIGH. (person willing to give up a large quantity of y in order to get a bit more x) When slope is relatively FLAT, marginal rate of substitution is LOW. (person willing to give up a small quantity of y to get more x) Diminishing rate of substitution- general tendency for a person to be willing to give up less of good y in order to get one more unit of x while remaining indifferent as the quantity of good x increases. (**SEE graphs on PowerPoint) Degree of substitutability- this is determine by the shape of the indifference curve. If it is: 1. curved: ordinary goods 2. 2 straight diagonals- perfect substitutes 3. 2 right angles- perfect complements The consumers best affordable choice is: 1. on the budget line 2. on the highest attainable indifference curve 3. has a marginal rate of substitution between the two goods equal to the relative price of the two goods. **See graphs on PowerPoint to further explain The effect of a change in price of a good on the quantity of the good consumed is called the price effect. See graphs on PowerPoint for predicting price effect. The effect of a change in income on the quantity of a good consumed is called the income effect. See graphs on PowerPoint for predicting price effect. For a normal good, a fall in price ALWAYS increases the quantity consumed. We can prove this by dividing the price effect into 2 parts: substitution effect and income effect. For an inferior good, when income increases, the quantity bought decreases. This effect is negative and works against the substitution effect. So long as the substitution effect dominates, the demand curve still slopes downward. BUT if negative income effect is stronger than the substitution effect, a lower price for inferior goods brings a decrease in quantity demanded- the demand curve slopes upward. (This doesn’t appear to happen in the real world) Work leisure choices: When you forgo income, you have more leisure. So the “price” of leisure is the wage rate forgone. By changing the wage rate, we can find a person’s labor supply curve. An INCREASE in wage rate makes a person’s leisure relatively MORE expensive (substitution effect towards more work) If income effect is weaker than substitution effect, the quantity of work hours increases as the wage rate rises. If income effect is stronger than the substitution effect, the quantity of work hours decreases as the rate rises. NOTE: Look at the graphs on the power points to fully understand these concepts!!


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