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U OF M / Economics / ECON 1101 / What is incentives?

What is incentives?

What is incentives?


School: University of Minnesota
Department: Economics
Course: Principles of Microeconomics
Professor: Thomas holmes
Term: Fall 2015
Cost: 50
Name: Exam 1 Notes
Description: Notes from all relevant chapters organized by week. Includes some notes from lectures at the end. Good Luck!
Uploaded: 10/09/2015
13 Pages 9 Views 14 Unlocks

Carter Bjorklund (Rating: )

Faiza Hassan (Rating: )

very detailed notes

Pichen Liu (Rating: )

Greta (Rating: )

Abby (Rating: )

Nick Andersen (Rating: )

Decker Grass (Rating: )

notes are good, if she had maybe had some examples of charts or some of the math portions it would have been awesome

Charlie Parker (Rating: )

Notes were average at best - did not go into depth enough on several key topics for the midterm.

Week 1

What is incentives?

Chapter 1: Ten Principles of Economics 


-The study of how society manages its resources

-Economists study how people make decisions  

-How people interact with each other (i.e. how equilibrium in auction is reached) -Patterns and forces that may affect economy (i.e. rate that prices increase)

Ten Principles of Economics:

1. People face trade-offs

-Everything comes with a price; in order to get something, you have to give something  (ex. if you choose to go to bed to rest before an exam, you’re giving up time that you  could spend studying for it and vice versa)

-Trade-offs between efficiency (society gets maximum benefits from resources) and  equality (benefits are distributed evenly among members of society

2. The Cost of Something is What You Give Up to Get It

-Every decision you make has benefits and downsides

What are the two different roles in economics?

If you want to learn more check out what is The Great Schism?

-Opportunity cost: what you give up in order to acquire certain item

3. Rational People Think at the Margin

-Assumed that people are rational and therefore make rational choices

-Marginal Change: slight adjustment to a plan or course of action

-Rational people weigh marginal benefits and costs when making a decision (ex. not  should I eat ice cream or not, but should I have an extra spoonful?)

-Rational people only take an action if the marginal benefit outweighs the cost

4. People Respond to Incentives

Incentive: Something that induces someone to take act (punishment or reward) Rational people respond to incentives (ex. higher tax on gasoline may result in people  driving less)

5. Trade Can Make Everyone Better Off

-Competition between countries in making goods may seem bad however, it also allows  countries to specialize in what they do best, giving everyone access to variety of goods  and services for lower cost

What is market?

We also discuss several other topics like Who is BILL GATES?

6. Markets are Usually a Good Way to Organize Economic Activity -Instead of central planning where the government oversees market actions, market  economy is better

Market economy: the millions and millions of people make the decisions (prices adjust  accordingly to buyers’ and consumers’ actions: invisible hand)

7. Governments can Sometimes Improve Market Outcomes

-Government is needed to set policies so people can own and control resources -Also needed to promote efficiency (size of economic pie or equality (how pie is divided) -Market failure: market fails to produce efficient allocation of good

-One cause is an externaility: One person’s actions affect well-being of a bystander -Market power: One person or firm can control prices of good

8. A Country’s Standard of Living Depends on Its Ability to Produce Goods and  Services

-Almost all disparities in living standards can be described by a country’s productivity (how  much is produces for each person producing it)

-With higher productivity comes higher standard of living  

9. Prices Rise when the Government Prints Too Much Money

-Inflation: increase in prices overall

-Often caused by growth in quantity of money; value of money falls when there is more of it

10. Society Faces a Short-Run Trade-Off between Inflation and Unemployment -In the long-term, increase in money rises prices

-In the short-term, increase of money can increase spending thus creating greater demand for  goods and a need to hire more workers in order to produce more

-policymakers can exploit this short term trade-off by changing government spending, taxes,  and amount of money printed If you want to learn more check out What is Space?

-How these strategies are used is up for debate

Chapter 2: Thinking Like an Economist 

-Theory and observation are used in economics

-Experiments are usually inappropriate (cannot influence market economy); study natural  trends and economic events in history

-Use different assumptions when studying short and long-term effects of a change in quantity  of money

Circular-Flow Diagram: Shows how pieces of economy fit together and interact (page 23) The Production Possibilities Frontier: Various combinations of goods that economy can  produce given available factors of production and technology  

Ex. If you have enough resources to make 200 cars and 400 computers, you could also  produce 0 cars and 800 computers or 100 cars and 600 computer, etc. This is also an  example of trade-off (i.e. if you make more of one, you have to make less of another)  (page 24)

∙ Because resources are scarce some outcomes will be better than others ∙ An outcome is considered efficient if economy maximizes all it can get from available  resources

Microeconomics: Study of how households and firms interact and make decisions in market Macroeconomics: Study of economy-wide phenomena

∙ Two different roles in economics: Scientist and policy adviser Don't forget about the age old question of what is Oddvertising?

Positive statement: states how the world is

Negative statement: states how world should be

∙ Positive and negative statements are intertwined

-Majority of economics revolves around positive statements; economists figure out how  economy works (scientist)

-This can effect what normative policies are desired (policy adviser)

Week 2

Chapter 4: The Market Forces of Supply and Demand 

-Supply and demand are the forces that determine the quantity of good produced and price it is  sold

Market: group of buyers and sellers who determine the demand of a good and supply of good Competitive market: instance where there are so many buyers and sellers that each has little  impact on market price

Perfectly competitive: 1. Goods for sale are all the same 2. Large number of buyers and sellers  so no single person has great influence on price

-In this situation, buyers and sellers are price takers because they must accept market price Monopoly: One seller sets the price

∙ There are different variations of markets that fall between the two extremes


Quantity demanded: amount of good consumers are willing and able to buy Law of Demand: Assuming all other factors that influence demand are held constant, when  price of good rises, demand falls and when price of good decreases, demand increases Demand schedule: table that shows relationships between price of good and quantity demanded Don't forget about the age old question of What are the Examples of bias/prejudice in primary sources?
Don't forget about the age old question of what is virus?

∙ Price is on y axis, quantity is on x axis

-On a graph, demand curve slopes downward: lower the price, the greater the demand -When curve is shifted right, there is an increase in demand

-When there is a decrease in demand, curve is shifted left

Variables that shift demand curve


∙ If demand of good falls when income does, good is called a normal good ∙ If demand for good rises when income falls, it is called an inferior good (ex. Bus rides) Prices of related goods:

∙ Substitutes: When decrease in price of one good causes a decrease in demand for another,  the two goods are called substitutes (i.e. Goods used in place of each other such as  hotdogs and hamburgers)

∙ Complements: When decrease in price of one good causes increases in demand for  another good, the two goods are called complements (i.e. Goods used together such as  cars and gas)


∙ Economists study what happens when tastes change


∙ Expectations about future may affect today’s decisions ex. Expectation of higher income  later on may lead you to save less now

Number of Buyers:

∙ Greater number of buyers means greater demand

(Page 67-72)


Quantity supplied: amount that sellers are willing and able to sell

Law of Supply: when price of good rises, the quantity supplied of that good rises and when  price of good falls, the quantity supplied falls

Supply schedule: table that shows relationship between price of good and quantity supplied

-On a graph, supply curve slopes upward because higher price means more quantity supplied -Supply curve shifts right if there’s an increase in supply

-Supply curve shifts left if there’s a decrease in supply

Variables that shift supply curve

Input Prices:  

∙ When input costs rise (that is anything that goes into production such as labor cost,  machines, ingredients, etc.), less product is sold


∙ Advancement in technology reduces costs and therefore increase supply Expectation:  

∙ If a firm expects the price of a good to rise in the future, they may decide to sell less  today and save more to sell later

Number of sellers:

∙ More sellers, more supply

(Page 73-76)

Equilibrium: where the supply and demand curves intersect

-Quantity of good that buyers are willing and able to buy is exactly equal to the quantity sellers  are willing and able to sell (also called the market-clearing price)

-Equilibrium price is the price for the good at this point, and equilibrium quantity is the quantity  demanded at this point

-Equilibrium is reached naturally

∙ Ex. If market price is above equilibrium, there is excess supply and sellers cut prices until  market reaches equilibrium (movement along curves)

∙ If market is below equilibrium, there is a shortage of the good and there is excess demand.  Sellers raise prices until equilibrium is reached

Law of Supply and Demand: In free markets, price of good changes so that quantity supplied  and quantity demanded are in equilibrium

(Examples given on page 79-82)

Week 3

Chapter 5: Elasticity and its Application 

Elasticity: How much buyers and sellers respond to changes in market conditions

Price elasticity of demand: measures how much quantity demanded responds to change in price Demand is elastic if quantity demanded responds substantially

Demand is inelastic if quantity demanded changes only slightly

Some variables that influence price elasticity

Availability of close substitutes:  

∙ Goods with close substitutes have great elasticity because consumers can replace that  good with another one (ex. Margarine and butter)

Necessities vs. Luxuries:

∙ Necessities have inelastic demand (ex. If costs of doctor visits rise, people will probably  still go to the doctor)

Definition of the Market:

∙ Narrowly defined markets are more elastic than broadly defined markets because  substitutes are easier to find (ex. Food is a broad category that can’t be replaced and has  an inelastic demand whereas ice cream is more specific and thus can be substituted) Time Horizon:  

∙ Goods have more elastic demand over longer period of time

Price elasticity of demand= %change in Quantity Demanded / %change in price Midpoint Method:

Price elasticity of demand= (Q2-Q1)/[(Q2+Q1)/2]



Elastic demand: elasticity>1 (quantity moves proportionately more than price) Inelastic demand: elasticity<1 (quantity move proportionately less than price) Unit elasticity: elasticity=1 (percentage change in quantity is equal to change in price) Perfectly Inelastic: elasticity=0 (vertical line)

Perfectly elastic: elasticity=0

(Page 93)

Total revenue: amount paid by buyers and received by sellers P*Q (price of good times quantity  sold)

If demand is inelastic, increase in price causes increase in total revenue

If demand is elastic, increase in price causes decrease in total revenue

If demand is unit elastic, total revenue remains constant

∙ Elasticity is the ratio of percentage changes of two variables:

-On a graph, at points on a demand curve where there is low price and high quantity, it is  inelastic. At points where there is high price and low quantity, the demand curve is elastic. (Page 96)

Income elasticity of demand: measures how quantity demanded changes as consumer income  changes

IED= %change in quantity demanded/ %change in income

Normal goods have positive income elasticities

Inferior goods have negative income elasticities

Cross Price Elasticity of Demand: measures how quantity demanded of one good responds to  change in the price of another good

=%change in quantity demanded for good 1/ %change in quantity demanded for good 2 ∙ For substitutes, the cross price elasticity is positive

∙ For complements, the cross price elasticity is negative

Price elasticity of supply: measures how much quantity supplied responds to changes in price Supply is elastic if quantity supplied responds greatly to changes in price Supply is inelastic if quantity supplied responds only slightly to changes in price -Depends on whether or not sellers change the amount of good they produce (ex. Amount of  beachfront land cannot be increased so it’s inelastic; books, cars, etc. are elastic) -Supply is usually more elastic in the long run (allows producers to build new factories, hire  workers, etc.)

Price elasticity of supply= %change in quantity supplied/ %change in in price

Elastic demand: elasticity>1 (quantity moves proportionately more than price) Inelastic demand: elasticity<1 (quantity move proportionately less than price) Unity elasticity: elasticity=1 (percentage change in quantity is equal to change in price) Perfectly Inelastic: elasticity=0 (vertical line)

Perfectly elastic: elasticity=0

(Page 100)

(Examples of demand, supply, and elasticity page 102-107)

Chapter 7: Markets and Welfare 

Welfare economics: study of how allocation of resources affects economic well-being Willingness to pay: maximum amount buyer is willing to pay for a good Consumer surplus: amount buyer is willing to pay minus amount actually pay (Ex. John is  willing to pay 100$ for an item but winds up paying 80$. His consumer surplus is 20$) Marginal buyer: At any quantity, demand curve shows the willingness to pay of the marginal  buyer (the buyer who would leave market if price was any higher)

-On a graph, consumer surplus is shown by the area below the demand curve and above the price - Consumer surplus measures benefit that buyers receive from a good

(Page 138-139)

Cost: Lowest amount that producer is willing to sell his good for

Producer surplus: amount producer is paid minus cost of production (Ex. If someone has a cost  of 500$ but gets paid 600$, producer surplus is 100$)

-On a graph, at any quantity, price given by supply curve shows cost of marginal seller (seller  who would leave market if price was any lower)

-Area below price and above supply curve measures producer surplus

- Producer surplus is the benefit producers receive

(Page 142-143)

Total surplus: sum of producer and consumer surplus

Total surplus=Value to buyers- cost to sellers

∙ Allocation is efficient when allocation of resources maximizes total surplus (if economic  pie is as big as possible)

∙ Equality is when buyers and sellers in the market have similar level of economic well being (how pie is distributed)

-In free markets, supply of goods are allocated to buyers who values them most and demand for  goods are allocated to sellers who can produce them at the lowest cost

-Free markets produce quantity of goods that maximizes total surplus

-In free markets, the equilibrium is an efficient allocation of resources

Week 4

Chapter 6: Supply, Demand, and Government Policies 

-Price controls are often put in place when policymakers find price of good to be unfair to buyers  or sellers

Price ceiling: legal maximum on the price of a good (Ex. If there’s a price ceiling of 3$ on ice  cream, price cannot rise above it)

∙ If price ceiling is above equilibrium of market, it is not binding because economy will  stay at equilibrium.  

∙ If price ceiling is below equilibrium, the ceiling is a binding constraint so new  equilibrium becomes the price ceiling. If there is a binding price ceiling in market, there  is a shortage of goods and sellers must distribute goods among buyers. This usually is  inefficient.  

(Examples given on page 114-115)

Price floor: legal minimum on price (Ex. Price cannot fall below this)

∙ In the case of price floors, if it is below the market equilibrium price, price floor is not  binding.

∙ If price floor is above equilibrium price, it is binding. Market price cannot go below price  floor so the new equilibrium is now the price floor. This causes a surplus of goods. Biases  can affect who is able to sell goods and who isn’t.  

(Example on page 117)

-When policymakers set prices for goods, they are often trying to make things fair, but  sometimes this can have ill effects. (Ex. Low rent is intended to make housing affordable but  may cause landlords to not maintain buildings.)  

-Alternative to controlling prices is through a subsidy which is when government pays a portion  of the cost of a good such as a rent subsidy. These require higher taxes.

Taxes: Used to raise revenue to pay for services

Tax levied on sellers of a good:

∙ Demand curve does not change because consumers are not affected by tax ∙ Tax affects sellers which makes them less profitable therefore supply curve is shifted to  left (quantity of good reduced) Curve is shifted upward the exact amount of the tax.

Tax levied on buyers of a good:

∙ Demand curve shifts to the left because buyers have to pay for cost of ice cream plus tax  to government so demand decreases. Demand curve shifts downward exact amount of tax.

-In both cases, tax puts a wedge between what buyers pay and sellers receive.  -When market reaches its new equilibrium with the tax in place, buyers and sellers share the  burden of tax regardless of who the tax is levied on

-Sellers receive less profit and buyers pay more

How are elasticity and tax related?

-Distribution of tax burden depends on elasticity

Elastic supply and relatively inelastic demand:  

∙ Sellers are responsive to changes in price of good so supply curve is relatively flat  ∙ Buyers are less responsive so demand curve is steep. Most of the tax burden falls on  buyers.

Inelastic supply and elastic demand:  

∙ Sellers are not responsive to changes in market price so supply curve is steeper  ∙ Producers are more responsive so demand curve is flatter. Seller deals with majority of  tax burden.

-The side of the market that is least elastic is the side that takes a greater burden of tax. (Ex.  Small elasticity of demand indicates not very many substitutes for buyers so they are less willing  to leave marketplace.)

Chapter 8: Application: The Costs of Taxation

How does tax affect economic well-being of participants?

∙ Taxes on buyers????demand curve shifts downward by tax amount

∙ Taxes on sellers????supply curve shifts upward by that amount

-When there is a tax, price paid by buyers increases and price seller receives decreases. -Tax on an item causes a reduction in how much is sold which leads to deadweight loss (total  surplus that is lost).  

-Tax influences buyers to consume less and producers to produce less so the market falls beneath  its potential equilibrium

Consumer surplus=amount buyers are willing to pay- amount actually paid Producer surplus=amount sellers receive-cost of good

T*Q= total tax revenue (T= size of tax Q=quantity of good sold)

Total surplus= consumer surplus+ producer surplus+ tax revenue

(Page 157-159)

Inelastic supply curve: quantity supplied only changes slightly to change in price (deadweight  loss is small)

Elastic supply curve: quantity supplied responds substantially to change in price (deadweight  loss is larger)

Inelastic demand curve: deadweight loss is small

Elastic demand curve: deadweight loss is larger

-Tax rarely stays the same for longer periods of time. At first, increase in tax causes an increase  in revenue, but as tax continues to increase, revenue starts to fall (this is because with too high a  tax, people would stop buying selling altogether)

(Page 164)

Week 5

Chapter 10: Externalities 

Externality: when a person’s actions affect well-being of bystander but does not pay for or  receive compensation for that impact

-If effect on bystander is good, it is a positive externality

-If it is bad, it is a negative externality

∙ When it comes to externalities in a market, this does not solely include buyers and sellers  but those who are affected indirectly

∙ When there are externalities, the market allocation is not efficient because usually buyers  and sellers do not acknowledge this outside impacts, thus society as a whole is not  benefiting.

(Ex. Aluminum production emits pollution which affects society who breathes in the air.  Due to this externality, the cost to society is larger than the cost to the producers. Social

cost includes cost to producers and cost to society, therefore social cost curve is above  supply curve)

Optimal quantity is where social cost curve intersect demand curve, which is smaller than the  equilibrium quantity

-This is the optimal amount of aluminum from perspective of society

-producers do not make more than this amount because social cost would exceed the value of  aluminum to consumers (page 198)

∙ Market equilibrium (without social cost) is greater than socially optimal quantity ∙ In order to achieve optimal amount of aluminum, a tax could be placed so that  equilibrium would mirror this

Internalizing the externality: when such a tax is placed, it is called internalizing the externality  because it gives buyers and sellers an incentive to take into account outside affects (Page 198-199)

Positive externalities

(Ex. Externalities on education might include less crime, higher productivity, etc.) -Social value curve lies above demand curve because social value is greater than the private  value

Optimal quantity is where social value and supply curve intersect, which is larger than the  equilibrium quantity

(Page 199)

“To move market equilibrium closer to social optimum, a subsidy is put into place Negative externalities lead markets to produce a larger quantity than is socially desirable.  Positive externalities lead markets to produce a smaller quantity than is socially desirable. To  remedy the problem, the government can internalize the externality by taxing goods that have  negative externalities and subsidizing goods that have positive externalities.” (Page 201)

∙ Externalities make allocation of resources inefficient; policies are put into place to move  allocation closer to social optimum

-Governments can respond in two ways

Command and control policies: government regulates people’s behavior directly (prohibit  certain actions, etc.)

Market based policies: align private incentives with social efficiency (taxes or subsidies) Policy 1:

Corrective taxes and subsidies: taxes meant to deal with effects of negative externalities (Also called Pigovian taxes)

-An ideal corrective tax would equal the external cost and an ideal corrective subsidy would  equal external benefit from activity with positive externalities

-When it comes to pollution, corrective tax is better than regulation. If factories are taxed, they  have incentive to use cleaner technology in order to reduce the tax whereas a regulation would  just cap the amount of pollution that can be emitted. (Page 203)

-Usually taxes move allocation of resources away from social optimum, but in the presence of  externalities, they raise revenue of government and enhance economic efficiency, moving it  closer to social optimum.  

Policy 2:

Pollution permits: If two firms have to reduce emission of pollution to 300 tons of glop a year  (regulation policy), pollution permits allow firms to trade (one firm can sell 100 tons of its  allotted glop to the other firm in exchange for $5 million). A market for pollution permits among  firms would be governed by supply and demand with the firms that value permits more highly  getting them

(Page 205)

Types of Private Solution to externalities:

-Moral codes and social sanctions (i.e. it’s the wrong thing to do)


-Self-interest of relevant parties


(Page 208-209)

Coase Theorem: If private parties can bargain over allocation without cost, they can find  solution to externalities on their own. The bargain reached will make everyone better off and be  efficient.

Private solutions don’t always work:

-Transaction costs: Costs that incur during process of bargaining (ex. Lawyers) -Failing to reach an agreement

-There are a large number of parties involved (coordinating with everyone is costly)

Monday 9/28/15 

Market allocation: everything that happens in the economy (i.e. who gets the money, who gets  what widgets, etc.)

General notion of efficiency of the market:  

An allocation is Pareto Efficient if it is feasible. That is, it is efficient.  

-If professor and student have 6 moon pies and each get 3, that’s pareto efficient.  -If professor gets 4 and student gets 2, that is NOT pareto efficient. But if professor gets all 6,  that IS efficient. Unless the professor gives student 1 of his moon pies. Student would be better  off but professor would be worse off.

∙ You cannot make someone better off without someone else being worse of.  ∙ The market economy is like a big pie. If one person gets a bigger slice of the pie,  someone else will have to get a smaller piece. That is not pareto efficient.  

Efficient allocation of Consumption:

In an efficient allocation, consumers with highest reservation price (price willing to pay) will  consume. If this does not work (consumer does not get a widget), consumer can buy from  another consumer with a lower reservation price.

Efficient Allocation of Production:

In any efficient allocation, producers with lowest cost, produce.  

Wednesday 9/30/15 

First Welfare Theorem (Adam Smith Theorem or Invisible Hand Theorem) ∙ Assumptions:  

-Market structure is perfectly competitive  

-No externalities (Realize that your action will either hurt or benefit someone else but this  impact is not taken into account)

-Therefore, unregulated market allocation is Pareto efficient (maximizes size of pie), however  market does not work towards equity, but efficiency.

Taxes: distort decision making in market place

∙ Tax is a wedge between price consumer pays and price producer receive: PD=tax+PS  (top of tax line hits demand curve)

∙ Widget subsidy PS=PD+subsidy (top of subsidy line hits supply curve because  consumers are paying less and sellers are getting more)

∙ Burden of tax depends on elasticity of supply and demand

-If supply is perfectly elastic (horizontal line), consumers pay entire tax -If supply is perfectly inelastic (vertical line), suppliers pay entire tax


Marginal tax rate

∙ Rate paid on last dollar earned

∙ Key rate used in decision making about how much to work

“Name tax” policies give tax breaks at the margin (tax break that allows business to open that  wouldn’t have otherwise)

∙ Tax on earned income has the highest marginal rate

20 (high income capital gains- starts business, owns it, sells business, etc.) 4 (obamacare)

6 (New York tax)


-Spurs job creators, spur investment

∙ Tax is lower on capital gain than earned income

40 federal tax

6 state tax

3 (medicare)

=49 percent

-Tax cuts would require raising taxes elsewhere or cut federal spending

Price Controls:

Price ceiling: no prices can be higher than ceiling (ex. Rent control)

Price floor: no price can be lower than this (minimum wage)


-has a usual fare for an area

-surge pricing

Normal price= 20$

During busy hours, price rises to 40$

∙ If surge price is banned, there is excess demand

∙ Demand curve shifts right, but price stays the same so does not maximize the market  price

∙ Price ceiling: excess demand; not everyone who wants a widget will get one

Perfectly Efficient Rationing: highest paying consumers get widget at price ceiling cost  (consumers are better off) similar to tax but tax revenue goes to consumers who pay Perfectly inefficient rationing: lowest value consumers that want widget get it Uniform rationing: consumers between consumers who are willing to pay the lowest and  highest amount

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