E201 Exam 1
Definition of Economics
Economics is the social science that studies the choices that individuals, businesses, governments, and entire societies make as they cope with scarcity and the incentives that influence and reconcile those choices. It is also the study of how society plans to allocate its resources to the production of goods and services in order to satisfy unlimited wants. Economics is a social science that follows a standard scientific method.
Definition of Incentive
An incentive is a reward that encourages an action or a penalty that discourages one. Prices are an example of incentives.
Definition of Scarcity
Scarcity is our inability to get everything we want. It forces us to make choices over the available alternative. The choices we make depend on incentives. Money is scarce, and so is time.
Factors of Production
Land, Labor, Capital, Entrepreneurship
Economically speaking, land is “natural resources.” It encompasses actual land, minerals, oil, gas, coal, water, air, forests, and fish.
Labor is the work time and work effort that people devote to producing goods and services. Labor includes the physical and mental efforts of all people who work on farms, construction sites, factories, shops, and offices.Quality depends on human capital.
Is responsible for the quality of labor; human capital is the knowledge and skill people obtain from education, on-the-job training, and work experience. Human capital expands over time. Today 87% of the American adult population have completed high school and 29% have college degrees.
The tools, instruments, machines, buildings, and other constructions that businesses use to produce goods and services. Capital goods are human-made goods that do not directly satisfy human wants.
The human resource that organizes land, labor, and capital; they come up with new ideas about what and how to produce, make business decisions, and bear the risks that arise from those decisions.
How do the factors of production generate income?
Land earns rent; Labor earns wages; Capital earns interest; and Entrepreneurship earns profit.
What factor of production earns the most income?
Labor: wages and fringe benefits are around 70% of total income.
Financial capital is the money value of paper assets such as stocks, bonds, or deeds to a house. Financial capital is not directly productive but indirectly productive.
Microeconomics is the study of the choices that individuals and businesses make, the way these choices interact in markets, and the influence of governments. Ex. of microeconomic questions: Why are people downloading more movies? How would a tax on e-commerce affect eBay?
Macroeconomics is the study of the performance of the national and global economies. Egs: Why is the U.S. unemployment high? Can the Federal Reserve make our economy expand by cutting interest rates?
How do choices end up determining WHAT, HOW, and FOR WHOM goods and services are produced?
This question generally refers to the “Three Fundamental Economic Questions” that every economist must answer. WHAT = goods and services. HOW = these goods and services are produced using productive resources (factors of production). FOR WHOM = Those who earn incomes and use said incomes to buy things (incomes generating from the factors of production on another card).
Can the pursuit of self-interest promote the social interest?
Four examples: globalization, the information-age economy, climate change, and economic instability. (others include privatization, post 9-11 economy, corporate scandals, HIV/AIDS, disappearing tropical rainforests, water shortages, unemployment, deficits and debts).
Definition of Efficiency
Economists say that efficiency is achieved when the available resources are used to produce goods and services at the lowest possible cost and in the quantities that give the greatest possible value or benefit.
Institutions that are essential to aligning self-interest to economic activity that promotes the social interest.
1.) Property Rights that are enforceable by a system of laws to protect them. 2.) A dependable and non-corrupt Legal System. 3.) A stable political system with non-corrupt government. 4.) Competitive and Open Markets that enable voluntary exchange.
Globalization means the expansion of international trade, borrowing and lending, and investment. It is in the self-interest of those consumers who buy low-cost goods and services produced in other countries as well as in the self-interest of multinational firms that produce in low-cost regions and sell in high-price regions.
The Information-Age Economy
The technological change of the past forty years.
Every self-interested decision that you make involving electricity, gasoline, etc. contributes to carbon emissions and leaves the ‘carbon footprint.’
A tradeoff is an exchange–giving up one thing to get another. The answers to all fundamental questions of economics all involve tradeoffs. Ex: Government redistribution of income plays a role in answering “for whom” goods and services are produced, but redistribution confronts society with the tradeoff between equity and efficiency.
A rational choice is one that compares costs and benefits and achieves the greatest benefit over cost for the person making the choice.
The benefit of something is the gain or pleasure that it brings and is determined by preferences (by what a person likes and dislikes and the intensity of those feelings).
The opportunity cost of something is the highest valued alternative that must be given up to get it. Opportunity cost is not limited to cost but also time. For example if you are in school the opportunity costs could include spending more time with your friends, getting a job (the highest paid job you could have is $25,000/yr etc.) Opportunity cost weighs things out in an all or nothing approach; most situations are not like that, however.
The benefit that arises from an increase in an activity is the marginal benefit. It is an examination of the effects of additions to or subtractions from a current situation. Choosing at the margin or making choices at the margin means looking at the tradeoffs that arise from making small changes in an activity.
The opportunity cost of an increase in activity is called marginal cost. Ex: For you, the marginal cost of studying one more night is the cost of not spending that night with your friends. To make decisions, you compare the marginal benefit and marginal cost. If the marginal benefit from an extra night of study exceeds its marginal costs, you would study and extra night. If the marginal costs exceeds the benefit, you do not.
Choices to Respond to Incentives
Changes in marginal benefits and marginal costs alter the incentives that we face when making choices. When incentives change, people’s decisions change.
A positive statement is about what IS. It says what is currently believed to be about how the world operates; this statement could be right or wrong and can be checked with facts.
A normative statement concerns how things OUGHT to be. It depends on values and cannot be tested. Ex: policy goals are normative.
An economic model describes some aspect of the economic world that includes only those features needed for the purpose at hand. Ex: An economic model of a cell-phone network might include features as the prices of calls, the number of cell phone users, volume of calls, etc. But the model would ignore cell phone colors and ringtones.
An economic theory is a generalization that summarizes what we think we understand about the economic choices that people make and the performance of industries and entire economics. It is the bridge between the economic model and the real economy.
Ceteris Paribus Assumption
Cet Par: means “if all other relevant things remain the same.” To isolate the relationship of interest in a laboratory experiment, a scientist holds everything constant except for the variable whose effect is being studied; same thing for economists when there is more than two variables.
The Production Possibilities Frontier (PPF)
The PPF is the boundary between those combinations of goods and services that an economy can produce and those that it cannot in a given period of time with is available resources and technology. When looking at PPF in action, usually all other variables are held constant. Graph indicates scarcity since we cannot attain the points outside of the frontier (similar to a less than or equal to curve). Points within the frontier, while possible, are inefficient because resources are unused (idle, but could be working) or misallocated. Perfect example of tradeoff.
We achieve production efficiency if we produce goods and services at the lowest possible cost. This occurs at all points on the PPF. We gain one thing at the (opportunity) cost of losing something else.
PPF and Opportunity Cost
The PPF makes the idea of opportunity precise and enables us to calculate it. Along the PPF, there are only two goods so only one option is forgone. The opportunity cost of one good is the good that we must reduce or stop production for.
Opportunity Cost as a Ratio
Opportunity cost is a ratio; it is the decrease in the quantity produced of one good divided by the increase in the quantity produced of another good as we move along the possibilities frontier. Being a ratio, the opportunity cost of producing one more cola (for example) is the inverse of producing one more pizza.
Increasing Opportunity Cost
Steep bows in the frontier indicate rising opportunity costs. The opportunity cost of pizza increases as the quantity of pizza produced increases. When we produce a large quantity of pizza and a small quantity of cola, the frontier gets steeper. The PPF is bowed outward because resources are not all equally productive in all activities. For example, those who can make pizza may not know much about making cola.
Using Resources Efficiently
We achieve productive efficiency at every point along the frontier. However, the point along the curve which is best is that which goods and services are produced at the lowest possible cost and in the quantities that provide the greatest possible benefit.
The PPF and Marginal Cost
The marginal cost of a good is the opportunity cost of producing one more unit of it; this can be calculated from the slope of the PPF. This can be used to price goods and services in terms of the opportunity costs of others.
Preferences and Marginal Benefit
Marginal benefit from a good or service is the benefit received from consuming one more unit of it. This benefit is subjective as it is based on people’s preferences. Marginal benefit and preferences stand in sharp contrast to marginal cost and production possibilities; preferences are what people want, possibilities are the limits and constraints on what is feasible.
Marginal Benefit Curve
This is a curve that shows the relationship between the marginal benefit from a good and quantity consumed of that good. The marginal benefit curve is wholly unrelated to the PPF and cannot be derived from it. We measure the MBC of a good or service by calculating the most that people are willing to pay for an additional unit of it i.e. the most you are willing to pay for something is the marginal benefit.
The Principle of Decreasing Marginal Benefit
It is a general principle that the more we have of any good or service, the smaller its marginal benefit and the less we are willing to pay for an additional unit of it. This principle implies that a marginal benefit curve slopes downward.
We are producing at the point of allocative efficiency–the point on the PPF that we prefer to all other points; the BEST point where we cannot produce more of one good without giving up some other good that provides greater benefit. The marginal cost and marginal benefit of producing a certain good or service are equal at this point.
Definition of Economic Growth
The expansion of production possibilities; it raises the standard of living but does not overcome scarcity or opportunity cost.
Sources of Economic Growth
Sources of economic growth include changes in technology (where there are newer and better ways of producing goods and services) and capital accumulation (growth of capital resources, including human capital). Pizza and Pizza Oven Example: if we devote more resources to making ovens, the greater the expansion of future pizza production. The opportunity cost of more pizzas in the future is less pizzas today.
Definition of Investment
Investment means that an economy is producing and accumulating capital. Countries that devote a large fraction of its resources to accumulating capital will greatly and quickly expand its production possibilities and future consumption increases. (See Asian markets: if this is maintained, these markets can close the gap between themselves and the U.S.).
A person has comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else.
A person who is more productive than others in an activity (sometimes many or all activities) has an absolute advantage. Absolute advantage involves comparing productivity–production per hour–whereas comparative is measured in comparing opportunity costs. One who has an absolute advantage does not necessarily have a comparative advantage in all activities.
When one produces only one or only a few goods. Specialization allows countries to produce those goods that they have a comparative advantage in and trade some of these goods for those goods it does not have a comparative advantage in.
Definition of Firm
A firm is an economic unit that hires factors of production and organizes those factors to produce and sell goods and services. Examples of firms: local gas stations, Wal-Mart, GM. Firms coordinate a huge amount of economic activity.
Definition of Market
A market is any arrangement that enables buyers and sellers to get information and to do business with each other. Ex: the world oil market. They have evolved because they facilitate trade; without markets, we would miss out on a lot of benefits from trade.
The social arrangements that govern the ownership, use, and disposal of resources, goods, and services.
Circular Flows through Markets
Households specialize and choose the quantities of labor, land, capital, and entrepreneurial services to sell or rent to firms. Firms then choose the quantities of factors of production to hire; these go through factor markets. Households choose which goods to by and firms choose how much to supply (goods markets); households receive incomes and make expenditures on goods and services to do this.
Price adjustments within markets coordinate firms’ and households’ decisions.
A market that has many buyers and many sellers; this way, no buyer or seller can influence the price
The relative price is an opportunity cost. The theory of supply and demand determines relative prices. When we predict that the price will fall, we do not mean that its money price will fall (although it could); what is meant is that its relative price (relative to the average price of other goods and services) will fall.
The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price; this does not necessarily match up with how much of this good or service is actually bought.
The Law of Demand
Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded; and the lower the price of a good, the greater is the quantity demanded.
Definition of Demand
Demand is a curve or schedule showing various quantities of a product consumers are willing to purchase at possible prices during a specified period of time, ceteris paribus. Note that this curve is a willingness-to-pay curve–for each quantity, the price along the demand curve is the highest price a consumer is willing to pay for that unit of output (a measurement of marginal benefit).
When the price of a good rises, other things remaining the same, its relative price–its opportunity cost–rises. Although each good is unique, it has substitutes–other goods that can be used in its place. As the opportunity cost of a good rises, the incentive to economize on its use and switch to a substitute becomes stronger.
When a price rises, other things remaining the same, the price rises relative to income. Faced with higher price and an unchanged income, people cannot afford to buy all the things they previously bought. They must decrease the quantities demanded of at least some goods and services. Normally, the good whose price has increased will be one of the goods that people buy less of.
Change in Demand
When any factor besides the price of the good changes, there is a change in demand. When demand increases, the demand curve shifts rightward and the quantity demanded at each price is greater.
Six Main Factors that Bring Changes in Demand
1.) Prices of related goods. 2.) Expected future prices. 3.) Income. 4.) Expected future income and credit. 5.) Population. 6.) Preferences
A complement is a related good that is used in conjunction with another good. Hamburgers and friers; energy bars and gym memberships. A price change or demand change could affect the demand.
Income and Change in Demand
Can be seen in the changes of normal goods and inferior goods. Normal goods are any good which there is a direct relationship between changes in income and its demand curve. Inferior goods are any good for which there is an inverse relationship between changes in income and its demand curve.
Law of Supply
Other things remaining the same, the higher the price of a good, the greater is the quantity supplied; and the lower the price of a good, the smaller is the quantity supplied. Higher prices increase the quantity supplied because the marginal costs increase.
A curve or schedule showing the various quantities of a product sellers are willing to produce and offer for ale at possible prices during a specified period of time, ceteris paribus. A supply curve is a minimum supply-price curve–for each quantity, the price along the supply curve is the lowest price a producer must receive in order to produce that unit of input.
Six Factors that Can Cause a Change in Supply
1.) Prices of factors of production. 2.) The prices of related goods produced. 3.) Expected future prices. 4.) The number of suppliers. 5.) Technology. 6.) The state of nature.
Change in only Price and Supply
When only the price changes, there is a change in the quantity demanded.
Change in Quantity Supplied
This creates a shift in the supply curve to indicate a change in supply.
The equilibrium price is the price at which the quantity demanded equals the quantity supplied.
The equilibrium quantity is the quantity bought and sold at the equilibrium price. A market moves toward its equilibrium because: price regulates buying and selling plans, price adjusts when plans don’t match.
Surplus and Pricing
A surplus is a market condition existing at any price where the quantity supplied is greater than the quantity demanded. This forces the price down.
Shortages and Pricing
A shortage, excess demand, is a market condition existing at any price where the quantity supplied is less than the quantity demanded. This forces the price up.
Elasticity is a unit-less measure of responsiveness to a change in a variable. This is useful when trying to compare the demands of two goods that are measured in unrelated units (such as comparing the demand of pizza with that of soft drinks). This is good for figuring out questions such as: if the supply increases (causing the price to fall and equilibrium quantity to increase) how much does the price fall or quantity increase? (Sometimes, if two terms are related you can measure the slopes of demand).
Price Elasticity of Demand
A units-free measure of the responsiveness of the quantity demanded of a good to change in its price when all other influences on buying plans remain the same. (Price Elasticity of Demand) = (Percentage change in quantity demanded/Percentage change in price). Because it is a ratio of two percentages, the elasticity has no units (the percents cancel out). We take the absolute value of this so it will never be negative. Yay
Occurs when abs(Ed) > 1: A condition in which the percentage change in quantity demanded is greater than the percentage change in price.
Occurs when abs(Ed) < 1: A condition in which the percentage change in quantity demanded is less than the percentage change in price.
Unitary Elastic Demand
Occurs when abs(Ed) = 1: A condition in which the percentage change in quantity demanded is equal to the percentage change in price.
Perfectly Inelastic Demand
Occurs when abs(Ed) = 0: A condition in which the quantity demanded does not change as the price changes. This is a vertical line, slope 0. The book gives ‘insulin’ as an example; diabetics have to have it even if the price changes.
Perfectly Elastic Demand
Occurs when abs(Ed) = infinity. A condition in which a small percentage change in price brings about an infinite percentage change in quantity demanded. Example: two vending machines are side by side offering the same things at the same prices, some by from one and the other; if one of the machines charges more, perfectly elastic demand shows that no one buys from the more expensive one. (This is a horizontal line).
Elasticity Along a Linear Demand Curve
On a linear demand curve, demand is unit elastic at the midpoint (where elasticity = 1), elastic above the midpoint, and inelastic below the midpoint. It changes as you progress along the curve; with the exception of perfectly inelastic and perfectly elastic.
Total Revenue and Elasticity
The total revenue from a sale of a good equals the price of the good multiplied by the quantity sold. If demand is elastic, a 1% price cut increases the quantity sold by more than 1% and total revenue increases. If demand is unit elastic, a 1% price cut increases the quantity sold by 1% and total revenue does not change. If demand is inelastic, a 1% price cut increases the quantity sold by less than 1% and total revenue decreases.
The Total Revenue Test
The total revenue test is a method of estimating the price elasticity of demand by observing the change in total revenue that results from a change in price, when all other influences on the quantity sold remain the same. If 1% price cut/hike increases/decreases revenue, demand is elastic. If nothing changes from a price change, it is unit elastic. If a price cut/hike decreases/increases revenue, demand is inelastic.
Factors that Influence the Elasticity of Demand
1.) Closeness and Availability of Substitutes: the closer the substitutes are to the real ****, the greater the elasticity. (Luxuries usually have lots of substitutes). 2.) Proportion of Income spent on the good: elasticity of demand is direct related to the percentage of one’s budget for a good or service. 3.) Adjustment of a Price Change over Time: the longer since a price change, the more elastic the demand is.
The Cross Elasticity of Demand
The cross elasticity of demand is a measure of the responsiveness of demand for a good to a change in the price of a substitute or a compliment other things remaining the same. (Cross Elasticity of Demand) = (Percentage Change in Quantity Demanded/Percentage Change in Price of a Substitute or Complement).
Income Elasticity of Demand
Income Elasticity of Demand is a measure of the responsiveness of the demand for a good or service to a change in income, other things remain the same. (Income Elasticity of Demand) = (Percentage Change in Quantity Demanded/Percentage Change in Income).
Price Elasticity of Supply
The price elasticity of supply is the ratio of the percentage change in the quantity supplied of a product to the percentage change in its price.
Elasticity of Supply
Elasticity of supply measures the responsiveness of the quantity supplied to a change in the price of a good when all other influences on selling plans remain the same. (Elasticity of Supply) = (Percentage change in quantity supplied/Percentage change in price).
We can think of supply in three general time frames
1.) Momentary Supply: no time to change any inputs or method of production. 2.) Short-run supply: time to change some but not all inputs. 3.) Long-run supply: time to change any input or technology that is changeable.