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means “All else equal” and allows us to analyze relationship between two variables while values of other variables aren’t changed.
Economic efficiency refers to allocative efficiency and is all about people getting resources efficiently at the lowest cost.
1. What gets produced?
2. How is it produced?
3. Who gets what is produced?
Opportunity cost is the value of the best alternative that we give up when making a decision. It differs from monetary cost because it refers to all resources including time.
Comparative advantage is when a person/firm has an advantage at being able to produce a good at a lower opportunity cost. Absolute advantage just means they can produce more than the other person using fewer resources (time).
Specialization makes both parties better because it allows both parties to gain goods they wouldn’t get without it. Whoever has the lower opportunity cost of a good produces that good and then people can make what they are best at doing efficiently.
The PPF represents all the combinations of production that can be produced if society uses its resources efficiently.
The decreasing slope shows that with the more you produce of one good, the more you are giving up of another.
What is economic growth and how does it cause shifts of the production possibility frontier? Understand Figure 2.7.
Economic growth is the increase in total output of an economy. Growth occurs when a society or firm acquires new tech making it possible to produce more, curve moves out.
What types of arrangements (economic systems) do societies use to answer the three basic questions?
What are substitutes and complementary goods? What happens to the demand for good X when the price of one of its substitutes rises, ceteris paribus? What happens to the demand for good X when the price of one of its complements rises, ceteris paribus?
Substitutes are goods that can serve as replacements for one another, when the price of one increases, demand for the other increases. Perfect Substitutes are identical. Complements are goods that go together, a decrease in price of one results in an increase in demand for the other.
What are the equilibrium price and quantity? How do you find them on a supply and demand diagram?
· Equilibrium – the condition that exists when thequantity demanded and the quantity supplied are equal. At equilibrium there isno tendency for price to change.
· Found where the supply and demand curve, crosseach other.
Prices change to elimante excess demand/supply because these are inefficient so incentive is there to raise, lower price, or supply.
-increase in income: Demand- normal goods shift right; inferior goods shift left
- increase in price of substitute: Demand- shift right
-increase in price of complement: Demand- shift left
-increase in cost of production: Supply- shift left
-Decrease in cost of production: Supply- shift right
1. What is an elasticity? In what terms does it measure the responsiveness of one variable to another?
Elasticity- a general concept used to quantify the response in one variable when another variable changes
Elasticity of A with respect to B =
% change in A
% change in B
What does a perfectly inelastic demand curve look like? A perfectly elastic one?
Price elasticity of demand us the ratio of the percentage of change in QD to the % Change of price.
%Change in QD/%Change in Price
value halfway between Q1 and Q2 as the base for calculating percentage change in qd, and the value halfway between P1 and P2 for the base in calculating the percentage change in price.
% change in qd = 100 × __Q2 – Q1
(Q1 + Q2) / 2
% change in p = 100 × __P2 – P1
(P1 + P2) / 2
Price increase for inelastic = Increase P, Decrease QD = Inrease in TR
Price increase for Elastic = increase P, Decrease QD = Decrease in TR
Price Cut on Elastic = Decrease Price, Increase QD = Increase TR
Price Cut on Inelastic= Decrease Price, Increase QD = Decrease TR
%Change in Qd/ % Change in Income.
Many firms, each being small relative to industry and producing virtually identical producs, no firm is large enough to have control over prices. Profit opportunities eliminated quickly because people take advantage quickly.
- Budget constraint: the limits imposed on household choices by income, wealth, and product prices
-shows all possible consumption options within a budget
- choice set or opportunity set: a set of options that is defined and limited by a budget constraint.
Utility is the satisfaction a product yields. MU is the additional satisfaction gained by the consumption or use of one more unit of a good.
How does a rational person allocate theirspending so as to maximize their utility? What is the utility maximizing rule?Be able to explain the logic behind this rule.
What are the income and substitution effects of a price change? Understand Figure 6.5.
Income Effect= Price falls more income to spend. Also, Price rises, less income to spend.
Substitution Effect: Price Falls so opportunity cost falls, household buys more. Also, price rises and oppo cost rises, household buys less.
10. How can the choice between consuming goods today and consuming goods tomorrow be used to explain an individual’s saving? How do the income and substitution effects of a change in the interest rate alter saving?
1) use present income to finance future spending (saving)
2) use future income to finance present spending (borrow)
An organization that comes into being when a person or a group of people decides to produce a good or service.
What three decisions must all competitive firms make? What do economists assume to be the firm’s objective when they make those decisions?
1. How much output to supply? (quantity of product)
2. How to produce that output (which production technique/technology to use)
3. How much of each input to demand
important to note: firms do NOT make decision of price
Economists assume the firm’s objective when they make these decisions is to maximize profits.
3. What is the economic definition of profit? How does it differ from the accounting definition of profit?
Economic profit is the difference between total revenue and total cost
Profit = TR – TC
Accounting profits only include the explicit costs of doing business, such as depreciation, interest and taxes, and tend to be higher than economic profits as they omit certain implicit costs, such as opportunity costs.
What is meant by the normal rate of profit or normal rate of return? How does it relate to the opportunity cost of capital?
When someone decides to start a firm, that person must invest resources, or capital. Whenever resources are used to invest in a business, there is an opportunity cost. Instead of opening a store, I could put my funds into an alternative use such as a certificate of deposit or a government bond and gain interest.
5. What distinguishes the short run from the long run? What two things can firms do in the long run that they can’t do in the short run?
The optimal method of production minimizes cost
What is the production technology? Know the difference between labor intensive and capital intensive
Production technology is the relationship between inputs and outputs. Labor intensive relies heavily on human labor while capital relies heavily on capital like a dumptruck or a crane.
Law of diminishing returns states that when additional units of a variable input are added to fixed inputs, after a certain point, the marginal product of the variable input declines. Short Run
What are fixed costs? What is average fixed cost? How do they vary in response to changes in the level of output? Understand Figure 8.2
Fixed costs are any costs that do not depend on firms level of output. AFC is total fixed cost divided by number of units of input. More you produce the costs spread out and get smaller on average.
Variable costs refer to costs that depend on level of production. AVC is TVC/Output. The more you produce the higher the VC and the lower the AVC.
In the short run, every firm is constrained by some fixed input that leads to diminishing returns and limits capacity to produce. AS firm approaches that capacity, it becomes increasingly costly to produce more.
If revenues exceed variable costs, operating profit is positive and can be used to offset fixed costs and reduce losses, and it will pay the firm to keep operating
If revenues are smaller than variable costs, the firm suffers operating losses that push total losses above fixed costs. In this case, the firm can minimize its losses by shutting down.
The scale of operation
To enter/exit the market
Size of the company – discounts for bulk
When size of a firm increases too much – problems organizing labor and more difficult to manage operations
Increasing returns to (economies of) scale – An increase in a firms scale of production leads to lower cost per unit produced
Constant Returns to Scale – A increase in a firms scale of production has no effect on cost per unit produced
Decreasing returns to (economies of) scale – An increase in affirms scale of production leads to larger cost per unit produced.
What happens to the scale of firms in the long run? What motivates firms to choose the scale of operation that they do?
In the long run, firms can choose any scale of production that they want because there are not fixed factors of production.
Competition drives firms to adopt the most efficient scale of operation in the long run
Firms will expand as long as they are earning profits and economies of scale exist
The short-run supply curve will shift right and push prices down
Firms have an incentive to exit the industry, which will reduce supply
The short-run supply curve will shift left and prices will rise
P = SRMC = SRAC = LRAC
If prices are below P, that means firms are suffering losses and they will exit the industry
LRIS: traces out price and total output over time as an industry expands
An event that changes the equilibrium in one market might change the equilibrium in many other markets.
Ex: a change in the price of one factor will probably change the prices of other factors.
Ex: buying ore capital changes the marginal revenue product of labor and shifts the labor demand curve
Ex: a change in the price of a single good or service usually affects household demand for other goods and services
Efficient change: when everyone is either better off or indifferent
Potentially Efficient change: if the winners win more than the losers lose, then the losers can be compensated
No one is worse off, and some are better off, so as a whole, people are “better off” – depends on own standards
Goods should be produced using the lowest-cost technology – most efficient – if more output could be produced with the same input, it would be possible to make some people better off without making others worse off
Inputs must be allocated across firms in the best possible way – the free market takes care of this because firms want to make the most profit, so they do what is best for themselves
Everything that is distributed must make people better off and no one worse off
The free market takes care of this because people won’t voluntarily choose to purchase something that makes them worse off
Market Failure: occurs when resources are misallocated, or allocated inefficiently. The result is waste or lost value.
Imperfect Competition (monopoly)
Public Goods (national security)
Externalities (outside forces)
Imperfect Information (absence of full knowledge about products)
What is consumer surplus? How can you measure the consumer surplus that consumers receive from purchasing a given quantity of a good from the demand curve for that good? Understand Figure 4.6.
Consumer surplus is the difference between the maximum amount a person is willing to pay for a good and its current market price. The total value of consumer surplus is roughly equal to the area of the shaded triangle in Figure 4.6(b)
What is producer surplus? How can you measure the producer surplus that producers receive from selling a given quantity of a good from the supply curve for that good? Understand Figure 4.7.
Producer surplus is the difference between the current market price and the full cost of production for the firm. The total value of producer surplus is roughly equal to the area of the shaded triangle in Figure 4.7(b)
8. What is deadweight loss? How does overproduction or underproduction (compared to the competitive equilibrium quantity) lead to deadweight loss? How can you measure the deadweight loss from overproduction or underproduction from a supply and demand diagram? Understand Figure 4.9.
deadweight loss: net loss of producer and consumer surplus from underproduction or overproduction
l Consumers are willing to pay more for a product and firms are supplying at a price lower than what people are willing to pay, yet something is stopping production at a fixed point. The result of this is a loss of consumer and producer surplus. (underproduction)
l Consumers are willing to pay less than the cost of production, yet the cost of the resources needed to produce a product above a certain amount exceeds the benefits to consumers, resulting in a net loss of producer and consumer surplus. (overproduction)
Figure 4.9 shows how deadweight loss is measured
*the fewer substitutes the less elastic demand will be for a product*
For a monopolist, an increase in output involves not just producing more and selling it, but also reducing the price of its output to sell it.
Marginal revenue can be derived by looking at the change in total revenue as output changes by one unit and subtracting R1 from R2.
When the demand curve is a straight line, the marginal revenue curve bisects the quantity axis between the origin and the point where the demand curve hits the quantity axis.
1. How do you find the profit-maximizing output level and price for a monopolist? How do you find the profit that they earn? Understand Figure 13.4. How do the monopoly profit-maximizing price and quantity compare to the price and quantity that a perfectly competitive industry would provide? Understand Figure 13.6.
a. Profit maximizing level and price – where MC=MR then where that point = demand
b. Profit = difference between ATC and D
c. Price and quantity are where supply and demand meet for a competitive form and for a monopoly it is where MC=MR then where that Q=D the firm determines the price and there is no supply curve
Why might some of the monopolist’s profits end up as a social loss? What is rent-seeking behavior? Why is it socially wasteful?
a. The monopolist is willing to pay any amount up to the entire rectangle to profit to prevent then entrance of other firms into the market
b. Rent-seeking behavior actions taken by households or firms to preserve positive profits
c. It is wasteful because it consumes resources
Section 1 forbids agreements among firms to fix price including cartels and collusion
Section 2 forbids firms to attempt to monopolize, or combine or conspire with any other persons to monopolize
Rule of Reason: the criterion introduced by the Supreme Court to determine whether a particular action was illegal (unreasonable) or legal (reasonable) within the terms of the Sherman Act
Ex: structure alone does not make a firm guilty – near monopolies are legal as long as they do business in a reasonable fashion
How do firms in a monopolistically competitive industry determine theirprofit maximizing prices and quantities in the short run?
What forces determine equilibrium prices and quantities in a monopolistically
competitive industry in the long run? What is the long-run equilibriumcondition for a monopolistically competitive industry?
What are the consequences of monopolistic competition for economic
efficiency? Are there any advantages to monopolistic competition?
1. How might firms in an oligopoly collude to act like a monopolist in that market? What is a cartel?
a. Firms could get together and price fix and work together like a monpoly
b. A cartel is a group of firms that gets together and makes joint price and output decisions to maximize joint profits
When firms are chargeing the same price without collusion
- Simply just copying other firms prices
1. How does the clear definition of the rights of those involved help the parties to negotiate an efficient result? What difficulties might prevent private bargaining from solving externality problems?
a.All of the parties involved have defined rights and these must be clearly understood by all
b.The conditions might not always be right for bargaining
Not everyone will contribute to the fund
Each contribution is small relative to the whole
All people get to recap the result regardless of whether or not they contributed
1. What are the two defining characteristics of a public good? Why are markets unlikely to be able to supply public goods?
a. Public goods: goods that are non-rival in consumption and their benefits are non-excludable
b. Markets are unlikely to produce them because they are interested in making profits and if payment is not mandatory they will have no incentive to produce it
1. What are the free rider problem and the drop-in-a-bucket problem?
a. Free Rider Problem: a problem intrinsic to public goods because people can enjoy the benefits of public goods whether they pay for them or not they are usually unwilling to pay for them
b. Drop in a bucket problem: a problem intrinsic to public goods the goods or service is usually so costly that its provision generally does not depend on whether
1. How can the economic model of human behavior be applied to people working in government? What does it say about their motives? Is this likely to lead to efficient policies?
a. Government officials are assumed to maximize their own utility not the social good
b. Self-interest could lead to poor decisions and public irresponsibility
c. Efficiency depends on the way incentives facing workers and agency heads are structured
d. Elected officials are difficult to dismiss and their actions and decisions must usually be accepted
-wages/salaries received in exchange for labor
-from property (capital, land, etc)
1. How does the distribution of money income vary across households by race 18.3
a. White households have the most people with higher incomes while few of other races do. The other races are the opposite. The lower 4/5 has most of the income and the top 5th doesn’t have the most
1. What are the main arguments in favor of income redistribution?
That a society’s as wealthy as the US has a moral obligation to provide all its members with the necessities of life
Punish innocent children?
Elderly would have to survive exclusively on savings to survive bad luck not fair?
Utilitarian justice: a dollar in the hand of a rich person is worth less than a dollar in the hand of a poor person
Rawisian Justice: income distribution is necessary to maximize the well-being of the worst off member of society
What is a tariff? quota?
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