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ECON200 MIDTERM 1 STUDY GUIDE
CHAPTER 2: SPECIALIZATION AND EXCHANGE
Production Possibilities Frontier (PPF)
∙ Production Possibilities Frontier (PPF) is a line or a curve which shows all the possible combinations of outputs that can be produced with a given amount of resources.
5 Attainable points
Good 1 4
Unattainable with given resources
2 Attainable but
0 1 2 3 4 5 6 7 8 Good 2
∙ If the economy operates on the PPF, it is using its resources efficiently.
∙ Opportunity cost is the amount of a good that must be given up in order to gain an amount on another good. Here, the opportunity cost of 5th unit of good 1 is 2 units of good 2 if we were initially producing 2 units of good 1.
∙ Opportunity cost is represented by the slope of the PPF. Here, the slope is -0.6 which means that we must sacrifice 0.6 units of good 1 to gain 1 unit of good 2. [Opportunity cost/slope calculate between points (2,4) and (5,2)] Don't forget about the age old question of What are the equation laws?
∙ In general, as more and more resources are shifted towards one good, the opportunity cost of producing an additional unit of the good increases. This is because no resource is
equally efficient in producing both the goods. Due to this, the PPF is concave to the origin most of the times.
∙ PPF is concave to the origin.
∙ PPF can shift due to:
o A change in resources – An increase in resources shifts the PPF to the right and a decrease in resources shifts the PPF to the left. We also discuss several other topics like What makes delusions different from hallucinations?
Inc. in resources Dec. in
o A change in technology – An improvement in
technology for a good rotates the PPF of the good outwards and vice-versa.
Improvement in technology for good on x axis
ABSOLUTE AND COMPARATIVE ADVANTAGE
∙ Absolute advantage – The ability to produce more of a good or a service than others with the same amount of resources. ∙ Comparative advantage – The ability to produce a good or service at a lower cost than others. We also discuss several other topics like What are the types of advertising media?
∙ A country can have a comparative advantage without having the absolute advantage.
∙ A country must have comparative advantage at something and no country can have comparative advantage at anything.
∙ Specialization is spending all our time and resources on producing one good or service.
∙ Specialization increases total production even though resources and technology remain constant.
∙ When a country specializes, it only produces one good. In order to obtain the other good, it must trade with another country which specializes in that good.
∙ Gains from trade – Enhancement in output when producers specialize and exchange goods and services. We also discuss several other topics like What is the human leukocyte antigen complex?
∙ If a country specializes and trades with another country, its consumption possibilities increases beyond the PPF even without increase in resources or technology. Therefore, trade is beneficial for all.
∙ PPF however doesn’t tell how much trade should be done. It is based on the consumer preferences and the costs.
CHAPTER 3: MARKETS
∙ Market – It refers to the buyers and sellers who exchange goods and services.
∙ Market economy – An economy in which private individuals make the decisions.
∙ Competitive market – A market in which price-taking buyers and sellers exchange a standardized good or service and everyone has perfect knowledge about the market. ∙ Features of this market:
o Price-taker – A buyer or seller can’t affect the market price because there are lots of buyers and sellers exchanging a standardized good or service.
o Standardized good – A good for which any two goods have the same features and are interchangeable. o The price is constant and there is full information about the price and features of the good which is sold. o There are no transaction costs which means there is no extra cost when buyers and sellers agree to Don't forget about the age old question of What are the three main classes of membrane proteins?
∙ Very few markets in real world are perfectly competitive.
∙ Quantity demanded- The amount of a good that buyers will purchase at a given price during a given period of time. ∙ Law of demand states that all else equal, quantity demand rises as price falls.
∙ Demand schedule – A table showing different quantities of a good that consumers are willing and able to purchase at different prices during a given period of time.
∙ Demand curve – A graphical representation of different quantities of a good that consumers are willing and able to purchase at different prices during a given period of time.
∙ Non-price determinants of Demand
o Price of related goods- Related goods are of two types:
Substitute goods – Goods which can be used in place of another to satisfy a particular want. If
price of a substitute good increases, demand for the good we are looking at increases and vice
Complementary goods – Goods which are used together to satisfy a particular want. If price of a complementary good rises, demand for the good falls and vice-versa. We also discuss several other topics like What does satellite altimetry use radars?
o Income of consumers- If a good is a normal good, then its demand increases as income increases and vice-versa. If it is an inferior good, then its demand decreases as income increases and vice-versa.
o Consumer preferences- Consumers have likes and dislikes which influence their purchases. For goods towards which they develop a liking, they will demand more of it and vice-versa.
o Expectations of future prices- If consumers expect the price of a good to fall in the future, they will
demand less of it now in the hope of buying it in the future for a lower price. If they expect the price to rise in the future, they will buy more of it now.
o Number of buyers- More number of buyers in the market mean more demand for a good.
∙ When the price of the good changes, there is a movement along the same demand curve.
∙ When a non-price determinant of demand changes, the whole demand curve shifts to the right when demand increases and to the left when demand falls.
Price Demand rises
∙ Quantity supplied – The quantity of a good or service that producers will offer for sale during a given price during a given period of time.
∙ Law of Supply – It states that all else equal, quantity supplied rises as its price increase and vice-versa.
∙ Supply schedule – A table showing different quantities of a good supplied at different prices during a given period of time.
∙ Supply curve- A graphical representation of different quantities of a good supplied at different prices during a given period of time.
∙ Determinants of Supply:
o Price of related goods – If the price of a related good falls, the producers would like to increase the supply of the given good since there is more opportunity of earning profits from this good than the related good whose price has fallen.
o Price of inputs – If the price of inputs rises, cost of production of the good increases which decreases the profit margin. Hence, supply falls.
o Technology – Improved technology increases the efficiency of a producer by enabling him to produce goods with fewer resources. Hence, it increases supply and vice-versa.
o Expectations – If producers expect the price of a good to increase in the future, they will reduce the supply now and wait.
o Number of sellers – More sellers mean more supply and vice-versa.
∙ When price of a good changes, there is a movement along the same supply curve.
∙ When a non-price determinant of supply changes, the entire supply curve shifts to the right when supply increases and to the left when supply decreases.
Price Supply falls Supply rises
∙ The situation in which quantity supplied equals quantity demanded is called market equilibrium.
∙ Equilibrium price – The price at which quantity supplied equals quantity demanded.
∙ Equilibrium quantity – The quantity that is supplied and demanded at equilibrium price.
∙ When the quantity supplied is greater than quantity demanded, we have a surplus or excess supply. In such a situation, producers want to get rid of their stock so they reduce the prices to attract more customers until it becomes equal to the equilibrium price.
∙ When the quantity demanded is greater than quantity supplied, we have a shortage or excess demand. In such a situation, there are more consumers than the supply of the good so producers increase the price till it reaches equilibrium. At this price, some consumers will go away due to increased price and other consumers who stayed back will get the product.
∙ Market equilibrium changes whenever either supply and/or demand curves shift.
Q inc. P inc.
Q dec. P dec.
Q inc. P dec.
Q dec. P inc.
Q inc. P ???
Q ??? P inc.
Q ??? P dec.
Q dec. P???
CHAPTER 4: ELASTICITY
∙ Law of Demand tells us about the inverse relationship between quantity demanded and price, but it doesn’t tell us by how much quantity demanded changes due to a change in price of the good. This information can be obtained by calculating the elasticity.
∙ Elasticity - measure of how much producers and consumers react to a change in the market conditions. ∙ Types of elasticity:
o Price elasticity of demand: How much quantity demanded changes due to a change in price
o Price elasticity of supply: How much quantity supplied changes due to a change in price
o Cross-price elasticity of demand: How demand changes due to a change in price of related good o Income elasticity of demand: How much demand change due to a change in consumer’s income
∙ Price elasticity of demand = % change in quantity demanded
% change in price
∙ Mid-point formula for calculating elasticity:
(Q2 – Q1)/[( Q2 + Q1 ) /
(P2 – P1)/[( P2 + P1 ) / 2]
∙ Elasticity of demand is always negative due to the inverse relationship between quantity demanded and price. However, the negative sign isn’t written sometimes. ∙ Elasticity of demand is:
o Elastic if > 0
o Inelastic if < 0
o Unitary if = 1
o Perfectly elastic if = infinite
o Perfectly inelastic if = 0
∙ An elastic demand curve is flatter than an inelastic demand curve.
∙ On a demand curve, the elasticity changes at every point. The demand is elastic above a certain point and inelastic below that point. At that point, the demand is unit elastic.
∙ Determinants of price elasticity of demand:
o Availability of substitutes
o Degree of necessity
o Cost relative to income
o Adjustment time
o Scope of the market
∙ Total Revenue – The total amount a firm receives from the sale of a given quantity of goods and services.
Total Revenue = Price per unit x Number of
∙ The type of elasticity of demand for a good effects the total revenue a firm gets when its price changes.
∙ An increase in price effects total revenue in two ways (these effects are opposite when price decreases):
o Price effect – An increase in total revenue due to selling of the product at a higher price.
o Quantity effect – A decrease in total revenue due to selling fewer units of the product.
∙ When price effect is greater than quantity effect, the total revenue increases due to an increase in its price.
∙ When quantity effect is greater than price effect, the total revenue decreases due to an increase in its price.
∙ Price elasticity of supply = % change in quantity supplied
% change in price
∙ Price elasticity of supply =
(Q2 – Q1)/[( Q2 + Q1 ) / 2]
(P2 – P1)/[( P2 + P1 ) / 2]
∙ Determinants of price elasticity of supply:
o Availability of inputs
o Flexibility of production process
o Adjustment time
∙ Cross-price elasticity of demand = % change in quantity demanded of good 1
% change in price of good 2
∙ In case of substitute goods, cross-price elasticity is positive. ∙ For complementary goods, cross-price elasticity is negative. ∙ Income elasticity of demand = % change in quantity demanded
% change in income
∙ If a good is a luxury, income elasticity is positive and >1 ∙ If a good is a necessity, income elasticity is positive and <1 ∙ If a good is normal, income elasticity is positive. ∙ If a good is inferior, income elasticity is negative.
CHAPTER 5: EFFICIENCY
∙ Willingness to pay – The maximum price that consumers are willing to pay for a good or service.
∙ Willingness to sell – The minimum price a producer is willing to accept in return for a good or service.
∙ Surplus – A way of measuring who benefits from transactions and by how much. It is the difference between the price at which a buyer/seller is willing to trade and the actual price.
∙ Consumer surplus – It is the benefit a consumer gets from purchasing a good, measured by the difference between the willingness to pay and the actual price.
∙ Producer surplus – It is the benefit a producer gets from selling a good, measured by the difference between the willingness to sell and the actual price.
∙ Total surplus- Combined benefits that everyone receives from participating in an exchange of goods and services. ∙ When there is surplus, both buyers and sellers gain as both gain surplus.
∙ Efficient Market – A situation in which no exchange can make one person better off with someone else becoming worse off. ∙ At equilibrium, the market is efficient.
∙ An intervention, which takes the market away from equilibrium can benefit either producers or consumers, but it decreases total surplus. Hence, the market becomes inefficient.
∙ Deadweight loss – A loss of total surplus when the quantity of a good is exchanged below the equilibrium quantity. ∙ A missing market is the one in which some exchanges don’t happen for any reason. It could be missing because of public policy which bans some goods or due to some tax which makes goods costly to produce.
CHAPTER 6: GOVERNMENT INTERVENTION
∙ Equilibrium in a perfectly competitive market is efficient (total surplus is maximum).
∙ If the government intervenes in a perfectly competitive market, it will become inefficient. ∙ Reasons to intervene:
o Changing the distribution of surplus
o Encouraging or discouraging surplus
o Correcting market failures
∙ Types of intervention:
o Price controls:
o Quantity control
∙ Price ceiling – max legal price at which the good can be sold.
D Qs Q Qd
∙ If there is a price ceiling in the market, the new price falls below the equilibrium market price. At this price, quantity demanded is more than the quantity supplied and hence there is a shortage of the good in the market.
∙ Producer surplus falls as producers are selling fewer goods at a lower price.
∙ The policy of price ceiling helps increase consumer surplus, but decreases producer surplus by a greater number. Hence, total surplus decreases and deadweight loss occurs.
∙ Due to price ceiling, goods must be rationed as there is a shortage.
∙ Rent-seeking behavior is when rationing is done via bribing. ∙ Non-binding price ceiling doesn’t affect the market as the price ceiling is set above the market equilibrium price.
∙ Price floor is a minimum legal price at which a good can be sold.
∙ If there is a price floor in the market, the new price becomes more than the equilibrium price and at that price, quantity demanded is less than quantity supplied. This creates an excess of the good in the market.
∙ Consumer surplus falls as they buy less of the good at a higher price.
∙ The policy of price floor helps increase producer surplus, but decreases consumer surplus by a greater amount, so total surplus falls and deadweight loss occurs.
∙ Due to excess supply, the government can buy the good from producers who couldn’t sell their good to the consumers.
∙ Price floor is said to be non-binding when the price fixed is under the original market equilibrium price. In this case, the market is not affected by the price floor.
TAX AND SUBSIDY
∙ Tax has two effects:
o They discourage production and consumption of a good if it’s taxed.
o They increase government revenue.
∙ When a tax is levied on sellers, decreases the supply but doesn’t affect the demand. Therefore, the equilibrium price increases and quantity falls.
∙ When tax is levied on buyers, it has the same effect. Demand falls while supply is the same. Therefore, equilibrium price and quantity both fall. The tax amount is payed by the buyer to the government.
∙ Tax wedge is the difference in the amount paid by buyers and the amount received by the sellers. It is equal to the tax.
∙ Government tax revenue = Tax * Quantity after tax (source:thismatter.com)
∙ Deadweight loss occurs due to a tax as the number of transactions falls.
∙ The person (consumers or producers) whose curve (demand or supply) is more inelastic bears the burden of the tax. ∙ Statutory incidence of tax – The person who is legally responsible for paying the tax.
∙ Economic incidence – The person who bears the incidence of tax. It doesn’t depend on the statutory incidence. ∙ Subsidy – It’s a requirement that government pay an extra amount to producers or consumers of a good.
∙ A subsidy to sellers increases supply and doesn’t affect the demand. So, equilibrium price falls and quantity increases. ∙ Subsidies also cause Deadweight loss because of overproduction or overconsumption of the good.