Exam 1 Study Guide
Key Terms & Definitions
Economics: The study of how people, both individually and collectively, manage resources.
Tangible Resources are resources that can be quantifiably observed or measured, such as cash, property, employees, and capital.
Intangible Resources can’t be observed or measured. They include things like experience, education, time, and relationships.
Microeconomics: The study of how the economy works on a small scale, such as within families and small businesses.
Macroeconomics: The study of the economy on a much larger scale, ranging from cities, to regions, and countries.
Scarcity: The condition of wanting or needing more than what your limited resources can get you. Scarcity is a universal principle it applies to everyone.
Opportunity Cost: The value of what you give up in order to get/do something else. The [value of] the next best alternative.
Marginal Decision Making: Comparing additional benefits against additional costs, without thinking about the related benefits/costs of past choices.
Sunk Costs: Costs that have already been incurred (charged) and can’t be refunded or re collected. [Sidenote: Marginal costs will NEVER include sunk costs.]
Efficiency: The use of resources in the most productive way possible to produce the goods and services that have the greatest total economic value on society.
Correlation: A consistently observed relationship between two events or variables. Causation: A relationship between two events in which one brings about the other. [Correlation doesn’t always mean causation!]
Positive Statement: Factual claim about how the world actually works. These statements are always true, or are at least presented to be true.
Normative Statement: A claim about how the world should/could be. If you want to learn more check out lacey durrance clemson
The Invisible Hand: A term used by Adam Smith to describe his belief that individuals seeking their economic selfinterest actually benefit society more than they would if they tried to benefit society directly.
Production Possibility: Any combination of goods that a group of workers can produce in a given period of time.
Production Possibilities Frontier (PPF): A graph that shows all possible variations of production of a producer based on the available resources.
Absolute Advantage: The business scenario in which one producer can make more of a product than every other producer in the market.
Comparative Advantage: The business scenario in which one producer can make a good at a lower opportunity cost than all other producers in the market. We also discuss several other topics like georgia tech physics
Specialization: The practice of spending all of your resources producing a particular good. If you want to learn more check out organic chemistry 2 study guide
Gains from Trade: The practice of trading your excess goods that you produced with another producer for some other good that they specialize in.
Markets: The buyers and sellers who trade particular goods or services. Not necessarily physical locations.
Competitive Markets: Markets that include fullyinformed, pricetaking buyers and sellers who can easily and freely trade a good or service.
[Components of Competitive Markets] If you want to learn more check out arh 205 class notes
Standardized Goods: Goods for which any two units have the same features and are interchangeable (e.g. gas, staple foods, water).
Full Information: Market participant knows everything about the price and features of the product.
Transaction Costs: The costs incurred by buyer and seller in agreeing to and executing a sale of goods or services. >>> Transaction costs are NOT included in a competitive market. <<< Price Takers: Buyers/sellers who cannot affect the market price. Don't forget about the age old question of what is the point when resources reach full capacity and cannot handle any additional demands?
Don't forget about the age old question of once in the bloodstream, carbohydrates travel to the liver through the
Demand describes how much of something people are willing and able to buy under certain circumstances.
Quantity Demanded: The amount of a particular product that buyers in a market will buy at a given price.
Demand Schedule: A table that shows the different quantities demanded at different market prices.
Demand Curve: The same data from a demand schedule, just shown on a graph. The demand curve is a graphical representation of quantities demanded at different prices.
Substitutes are goods that serve a similar enough purpose that a consumer might purchase one in the place of the other.
Complements are goods that are consumed together, so purchasing one will make consumers more likely to purchase the other. [Example: Peanut Butter and Jelly]
Normal Goods: Goods that are bought more frequently following an increase in income. Inferior Goods lose demand following an increase in income. [Example: Ramen Noodles]
Supply describes how much of a good or service producers will offer under given circumstances.
Quantity Supplied is the amount of a particular good or service that producers will offer at a given price.
Equilibrium Price: The point at which quantity supplied equals quantity demanded. Surplus (Excess Supply): When quantity supplied exceeds quantity demanded. Shortage (Excess Demand): When quantity demanded exceeds quantity supplied.
Elasticity: A measure of how much consumers and producers will react to changes in the market, or how sensitive they are to market changes.
Price Elasticity of Demand: A measurement of how much quantity demanded will change in response to a change in price of a product.
Elastic: When demand has an absolute value of elasticity greater than 1.
Inelastic: When the absolute value of price elasticity of demand is less than 1. UnitElastic: When the absolute value of elasticity is equal to 1 exactly.
Total Revenue: The amount that a firm receives from the sale of goods and services.
Price Elasticity of Supply: The size of the change in the quantity supplied of a product when its price changes. It measures producers’ responses to a change in price.
Crossprice Elasticity of Demand: A measure of how the quantity demanded of a good changes when the price of a different good changes. [Example: Changes in price of Apple phones could impact sales of Samsung phones.]
Income Elasticity of Demand: Describes how much the quantity demanded of a good changes in response to change in consumer income.
Willingness to Pay: The value (price) that a consumer places on a good. The amount that a consumer would be willing to pay for a good or service.
Willingness to Sell: The minimum price that producers are willing to sell their good or service for.
Consumer Surplus: When a consumer buys a good below his willingness to pay. Producer Surplus: When a producer sells a good above his willingness to sell.
Total Surplus: The value of the existence of the market. It is the combined benefits of all market participants.
Market Equilibrium: The price that maximizes total possible surplus of all buyers and sellers in the market.
Deadweight Loss: The buyers/sellers that are lost when prices deviate from market equilibrium.
Market Failure: The result of an interfering body with the market.
Price Controls: Regulations that set maximum/minimum prices for particular goods. Price Ceilings: Maximum legal prices at which goods can be sold.
Price Floors: Minimum legal prices at which goods can be sold.
Tax Wedge: Difference between amount paid by consumers and amount received by producers due to some level of tax.
Tax Incidence: The tax burden taken by buyers and sellers. Tax incidence refers to who actually does pay the tax.
Statutory Incidence: The person/corporation who is legally bound to the tax. Statutory incidence refers to who’s supposed to pay the tax.
Subsidies are the reverse of taxes. They are requirements for the government to pay an extra amount to producers (or consumers) of a good.
Important Equations to Memorize
Opportunity Cost =Giveup
Price elasticity of Demand ( ) ε = change∈Quantity demanded change∈price
% change in quantity = [(Q 2−Q1)
Q1] ×100 *[Q1= Quantity 1, Q2 = Quantity
% change in price = [ (P2−P1)
P1] ×100 *[P1 = Price 1, P2 = Price 2]
Midpoint Method to determining price elasticity of demand:
ε = (Q 2−Q1)/[(Q 1+Q 2)/2]
Price Elasticity of Supply = change∈Quantity supplied change∈price
Midpoint method to determining price elasticity of supply:
Price Elasticity of Supply = (Q 2−Q1)/[(Q 1+Q 2)/2] (P2−P1)/[(P1+P2)/2]
CrossPrice Elasticity of Demand b/t product A & product B:
change∈quantity of Ademanded
change∈price of B
Income Elasticity of Demand = change∈quantity demanded change∈income
Tax Wedge = (price paid by buyers) (price received by sellers) = Tax
Economics is dependent on the principle of Rational Behavior, the assumption that people behave in order to achieve a goal. There are four questions of rational behavior: 1. What are the wants and constraints (limitations) of the people involved? 2. What are the tradeoffs? (Cost/benefit analysis)
3. How will others respond?
4. Why isn’t everyone already doing it?
Four factors of business:
2. Market Failure
4. Goals other than profit
The Production Possibilities Frontier (PPF)
Production by a producer will always lie either on or in the production curve of the PPF. Points on the curve are called efficient points. Points within the curve are called inefficient points.
Nonprice determinants of demand:
a. Some cell phones are better than others! Some
people are more inclined to pick certain brands over others *cough* apple *cough*
2. Prices of related goods
a. Substitutes are goods that serve a similar enough
purpose that a consumer might purchase one in the place of the other.
b. Complements are goods that are consumed
together, so that purchasing one will make consumers more likely to
purchase the other
c. A decrease in the price of cell phones will probably
cause in increase in demand for cell phone cases, a complementary good. 3. Incomes
a. If a consumer experiences a rise or fall in his
income, it will affect his spending choices accordingly.
b. Most goods are normal goods, meaning that an
increase in income causes an increase in demand. A cell phone is a normal good.
c. Some goods get the opposite. These goods, called
inferior goods, lose demand as a consumer’s income increases. Example: ramen noodles.
4. Expectations of future prices
a. If the iPhone is currently $400, and it’s expected to
drop to $200 by December, then most savvy buyers will hold off until then to buy the product. Therefore, current demand decreases.
5. The number of buyers in the market
a. As more and more private entities (corporations,
government agencies, etc.) started to buy cell phones for its employees,
this changed the landscape of the cell phone market. In general, an
increase in the number of potential buyers in a market will increase
demand. Inversely, a decline in consumer population will decrease
Shifts in the demand curve are caused by changes in the nonprice determinants of demand. These shifts are also called increases/decreases in demand. Movements in the demand curve are caused by changes in price. These movements are called increases/decreases in quantity demanded.
Nonprice determinants of supply are divided into 5 categories:
1. Prices of related goods
a. If you can manufacture and sell a different yet related good for a
greater profit, then you will.
a. If you can produce more efficiently using fewer resources, you
3. Prices of inputs
a. If prices of materials or resources that go into your product
increase, then the price of your product will increase too.
a. If you expect the prices of a product to go up in the near future,
then you will decrease production until then. Likewise, if you expect prices to fall, then you will rush to sell product before then.
5. The number of sellers
These factors determine opportunity cost of production and therefore the tradeoffs that producers are faced with.
Following a change in a nonprice determinant, there are three questions that should be asked:
1. Does demand increase/decrease? If so, how?
2. Does supply increase/decrease? If so, how?
3. How does the combination of changes in supply and demand affect equilibrium price and quantity?
Price elasticity of demand will always be a negative number. This is because out of percentage change in quantity and percentage change in price, one of the two must be negative, because one of the two is decreasing. Think about it, they both go in opposite directions.
When it comes to price elasticity of demand, there are 5 factors that determine how great the change in elasticity will be.
1. Availability of Substitutes ~ If a product with close substitutes experiences an increase in price, then buyers will just purchase the substitute instead. Substitutes cause greater elasticity.
2. Degree of Necessity ~ These are goods that people need, and will therefore pay for whatever the market price is. Examples include airconditioning, cars, or jackets. People need these products, so an increase in prices won’t really change the elasticity. Vice versa, if the prices drop people won’t rush to buy any more of what they already have, therefore not really changing the elasticity there either.
3. Cost Relative to Income ~ This one is exactly what it sounds like. The book uses a good example. If consumers spend a very small share of their income on a good, their demand for the good will be less elastic than otherwise. For example, most people can buy a year’s supply of salt for about $5. If the price doubled to $10, most people wouldn’t care that much. Now imagine that a 3week beach vacation could be had for only $2,500. If the cost were suddenly doubled to $5,000 a lot less people would go on beach vacations. Basically, if the cost of a good takes up a large portion of a person’s income, it will be more elastic.
4. Adjustment time ~ This factor says that the effects of elasticity usually have more consequences over the long term than the short term.
5. Scope of the Market ~ This factor has to do with categories of goods. A banana might have high price elasticity of demand, while the category of fruit overall can have low elasticity of demand.
When demand is perfectly elastic, the demand curve is horizontal, or flat going left to right. When demand is perfectly elastic, that means that demand is extremely sensitive to price. Sometimes, demand is perfectly inelastic, and has a vertical demand curve, this means it is a straight line, going up and down. In this case, quantity demanded doesn’t change no matter the price.
Three factors affect a supplier’s ability to change the quantity produced in response to price changes. They are:
1. Availability of Inputs
a. If chocolate suddenly became expensive, chocolate chip cookies
would rise in price.
2. Flexibility of the Production Process
a. Whether or not a producer can efficiently transition from making
one product to a different one. Example: farming.
3. Adjustment Time
a. Gives producers time to produce alternative products.
For substituted goods, crossprice elasticity of demand is positive.
For complementary goods, crossprice elasticity of demand is negative.
Consumers often have their own value that they will pay for a good. This number is called their willingness to pay. In the same way, producers have a price that they will not go below when selling a product. This number is their willingness to sell. When you find the sweet spot that fits between both the consumer’s willingness to pay and producer’s willingness to sell, then everyone involved is better off. This is what makes markets work.
Willingness to pay, when graphed (on a large scale), comes out to form a demand curve. Likewise, when various values of willingness to sell are graphed, it makes out a supply curve.
Every single government in the world intervenes in markets in some way. There are typically three reasons for this:
1. Correction of market failure Markets don’t always work efficiently in the real world. When the assumption of an efficient competitive market fails to hold, a market failure is said to have occurred. Examples include a monopolized product with an inefficiently high price, or imposing prices on others from pollution caused by burning gasoline from your car.
2. Changing the distribution of surplus Efficiency can still be unfair. When a market situation is efficient but blatantly unfair, the government may intervene. The point here is to evenly distribute the surplus, or profit. Example A regulated minimum wage.
3. Encouraging/discouraging consumption of certain goods Governments can pose taxes on products that have negative effects. Examples include cigarettes, alcohol, and tobacco. Conversely, governments can subsidize (financially support) producers of positive things, such as farmers, educators, and doctors.
Taxes have two primary effects. First, they discourage consumption and production of the taxed good. Second, they raise gov’t revenue. Taxes have many effects on sellers. First, they decrease the supply that sellers produce. This makes sense. If production of a good costs extra due to taxes, the amount that producers can make with the same amount of money will go down. When a good is taxed, demand does stay the same. This is because taxes don’t change the nonprice determinants of demand. Lastly, taxes on sellers cause equilibrium price to rise and quantity demanded to fall. Essentially, taxes cause the market to shrink.
Taxes cause deadweight loss and redistribute surplus. This deadweight loss is equal to the lost buyers and sellers who would have traded at the pretax price. Under a tax, both consumers and producers lose surplus.
What happens when buyers are taxed? The outcome is the same. None of the nonprice determinants of supply are affected. Supply stays the same, demand decreases, and equilibrium price/quantity both fall. A tax on buyers creates a tax wedge just like a tax on sellers.
When the gov’t gives subsidies to sellers, supply increases. This is obvious. Demand/the demand curve stays the same, because buyers aren’t really affected. The equilibrium price decreases, while the equilibrium quantity increases. A subsidy benefits both buyers and sellers, therefore increasing total surplus in the market. What they make up for to buyers/sellers, they take away from the government and taxpayer dollars.
To sum things up, subsidies have the following effects on buyers/sellers:
1. Equilibrium quantity increases, which encourages production and consumption of the good.
2. Buyers pay less and sellers receive more of the good.
3. The gov’t has to pay for the subsidy. This cost is equal to the amount of the subsidy multiplied by the new equilibrium quantity.