Econ 2005, Final Exam Review

Economics

The Study of choices agents make

Microeconomics

Looks at the actual act of making a decision

Positive Economic statement

a. Assertion about economic reality that can be supported or rejected by evidence

b. Can be true or false - attempts to understand the world around us.

Normative Statement

Statement is an opinion. The words, "should" or "aught to" are contained in the statement.

Resources

Used to create goods and services

The fallacy that association is causation

A common error made in thinking about causation: If event A happens before event B it is not necessarily true that A caused B

The Fallacy of composition

The erroneous belief that what is true for a part is necessarily true for the whole.

Ignoring Secondary effects

Not anticipating unintended consequences or your decision or action

Absolute advantage

A producer has this advantage over another in the production of a good or service if it can produce that product using fewer resources

Comparative advantage

A producer has this advantage over another in the production of a good or service if it can produce that product at a lower opportunity cost

Law of Specialization

each firm should do what they have a comparative advantage in

Production Possibility Frontier (PPF)

A graph that shows all the combinations of goods and services that can be produced if all of society's resources are used efficiently.

Marginal Rate of transformation

The slope of the PPF

The law of increasing opportunity cost

As society makes more of one output good, it needs to give up more and more of the other output good

Economic Growth

an increase in the total output of an economy

Shifts in the PPF associated with economic growth/decline

i. Changes in resource availability - all inputs

ii. increases in capital stock - higher output

iii. Technological change - usually higher efficiency

iv. Improvements in the rule of the game - formal laws or business practices.

Traditional economy

an economy in which tradition alone determines activity

Command economy

a central government either directly or indirectly sets output targets, incomes and prices.

Market economy

Pure capitalism - individual people and firms pursue their own self-interests without any central direction or regulation

Consumer Soverignty

The idea that consumers ultimately dictate what will be produced or not by choosing what to purchase and what not too

Free enterprise

The freedom of individuals to start and operate private business in search of profits

Demand

quantity consumers will buy at a given price of a good

Law of demand

Prices go up means demand goes down. Opposite is true as well

Substitution Effect

As the prices of a good increases you'll buy an inferior good like Ramen or cheap beer.

Income effect

As the prices of everything goes up you'll buy less

Demand Curve

graph illustrating how much of a given product a household would be willing to buy at a different prices

Market Demand

The sum of all quantities of a good or services demanded per period

Shifting Demand

i. Income and Wealth

ii. Prices of other goods and services

iii. expectations

iv. tastes preferences

v. changes in the number of composition or consumer

Wealth

Total value of what a household owns minus what it owes.

Ex. Stock measure

Normal goods

good for which demand goes up when income is higher and for which demand goes down when income is lower

Inferior goods

Goods for which demand tends to fall when income rises

Substitutes

Goods that can serve as a replacement for one another. When the price of one increases demand for the other goes up

Perfect Substitutes

identical or interchangeable products

complements

Goods that go together, a decrease in the price of one results in an increase in demand for the other and vice versa

Expectations

peoples ideas about what will happen in the future influence their current consumption decisions

Tastes preferences

Can change over time

Quantity supplied

the amount of a particular product that a firm would be willing and able to offer for a sale at a particular price during a given time period

Market supply

sum of all that is supplied each period by all produces of a single product

Law of Supply

The positive relationship between price and quantity of a good supplied. An increase in market price will lead to an increase in quantity supplied and a decrease in market price will lead to a decrease in quantity supplied

Shifts of a supply curve

i. change in technology

ii. change in the price of outputs

iii. change in the price of other goods

iv. change in producer expectations

v. change in the number of producers

Change in technology

a breakthrough would cause the supply curve to shift right

Change in the price of outputs

and increase in the price of cheese would cause the supply curve of pizzas to shift to the left

Change in producer expectations

If they think that their product will suddenly become very popular they will increase supply and vice versa

Equilibrium

when quantity demanded and supplied are equal

Price rationing

The process by which the market system allocates goods and services to consumers when quantity demanded exceeds quantity supplied

Price ceiling

A maximum price that sellers may charge for a good, usually set by government

i. leads to shortages

Shortages Can lead to:

a.Waiting in lines

b. black market

c. add-ons and trade

d. favored customers

Price floors

a minimum price below which exchange is now permitted

i. leads to surplus when above the

equilibrim

Elasticity

used to determine the change in demand based on changes in price

Price elasticity of demand

%change in demand over %change in price

Midpoint formula

a precise calculation of elasticity

[(Q2-Q1)/(Q2+Q1)]/[(P2-P1)/(P2+P1)]

Perfectly elastic

any increase in price drops quantity to zero

Elastic demand

ED is between negative infinity and -1

Unitary elastic

ED is -1

Inelastic

not much change in demand, ED between -1 and 0

Perfectly inelastic

ED is 0, no change in demand at all

Total revenue and elasticity

a. if price increases on a product with inelastic demand TR increases

b. prices increases on a product with elastic demand. TR decreases

Elasticity of supply

a measure of the response of quantity of a good supplied to a change in price of that good-positive number

Income elasticity of demand

measures the responsiveness of demand to change in income

Cross Price elasticity

Change in quantity of X demanded / change in price of Y demanded

i. if cross price elasticity is positive then

the goods are substitutes

ii. if cross price elasticity is negative then

the goods are compliments

Utility

the level of satisfaction the consumer derives from consumption of a good or service

MU=(Change in Total Utility)/(Change in

quantity)

Law of diminishing marginal utility

the more you consume, the less utility you get

The utility maximizing rule

(MUx)/Px=(MUy)/Py

All income must be spent

Normal profit(zero profit)

the accounting profit earned when all resources earn their opportunity cost

Implicit Costs

factors in opportunity costs, economic profit

Explicit costs

normal costs, no opportunity costs, accounting profit.

Inputs

Land - all natural resources like rent

Labor - all human inputs that help create the output

Capital - all the physical equipment, goods used to make other goods

Entrepreneurial skill - ability to pull all other inputs together, pay them, and then make some money

Labor-intensive technology

tech that relies heavily on human labor instead of capital

Capital-intensive technology

tech that relies heavily on capital instead of human labor

Marginal Product

additional output that can be produced by adding one more unit of specific input

The law of diminishing return

when additional units of a variable input are added to fixed inputs after a certain point, the marginal product of the variable input declines

1. always applies in the short run

Short Run

period of time which conditions hold: the firm is operating under a fixed scale (fixed factor) of production and firms can neither enter nor exit the industry

Long Run

period of time which there are no fixed factors of production: firms can increase or decrease the scale of operation and new firms can enter and existing firms can exit the industry

Fixed costs

any costs that does not depend on the firms level of output

i. incurred even if the firm is producing

nothing, no FCs in the long run

Variable cost

a cost that depends on the level of production

Short Run versus Long run

short run - the period over which the cost of one or more economics is inputs is fixed

long run - the period over which all costs are variable

Total fixed costs (TFC)

the total of all costs that do not change with output, even if output is zero

i. firms have no control over FC in the short

run so they're called fixed costs

Average fixed costs (AFC)

total fixed costs divided by the number of units of output

Spreading overhead

the process of dividing total fixed costs by more units of output. AFC gets closer and closer to zero as quantity increases

total variable costs (TVC)

the total of all costs that vary with output in the short run

Total variable costs curve

a graph that shows relationship between total variable cost and the level of a firms output

In the Short run

Every firm is constrained by some fixed input that leads to diminishing returns to variable inputs and limits its capacity to produce. MC ultimately increases with output in the SR

MC intersects AVC

at the lowest or minimum point of AVC

i. when the marginal is below avg it pulls

the down and vice vers and when they are

equal the avg doesn't change. same

relationship as MC and VC

Average total Cost

total cost divided by the number of units of output

ATC = AFC+AVC

What the costs tell us

i. AFC; as q increases the FC is spread out the curve approaches the x axis

ii. AVC- gives us the shutdown point, if you can't cover the VC then don't amke anything

iii.ATC- gives us info about the level of profits(or losses) a firm will receive for a given amount of output

1. profits = TR-TC, TC=ATC*Q

2. firms needs profts to be greater than

or equal to zero to stay in business

iv.MC- gives the profit maximizing level of output, firms want to produce where P=MC in order to maximize profit

v.if the marginal benefit > MC more of the good should be produced

vi. if the marginal benefit < MC, fewer of the good should be produced

vii. if marginal benefit = MC, it's the social optimal number

Long run costs

In the Long run costs are variable and firms can change anything it wants

Long run average cost curve

A curve that indicates the lowest AVC of production at each rate of output when the size or "scale" or the firm is zero

Increasing returns to scale, or economies of sclale

an increase in a firm's scale of production leads to lower costs per units produced

Constant returns to scale

an increase in a firms scale of production has no effect on costs per unit produced

Decreasing returns to scale, or dis-economies of scale

an increase in a firm's scale of production leads to higher costs per unit produced

Minimum efficient Scale

the lowest point on the LRAC. (Production at lowest possible costs)

Perfect competition

an industry structure with many fully informed buyers and sellers of standardized product and no obstacles to entry or exit of firms in the long run

Homogeneous products

undifferentiated products; products that are identical to or indistinguishable from one another

Characteristics of Perfect Competition

i. Firms are price takers, where the demand curve is very elastic

ii. homogeneous products, most goods are basically interchangeable

iii. everyone has access to full information

iv. unrestricted entry and exit to the market ( no barriers)

v. prices are not fixed or regulated by the state

Perfect competition output decision

i. As long as MR is greater than MC

ii. Profit maximization, PC firms will product up to the point where the price of its output is just equal to short run AC

iii. In PC, since a firms demand curve is flat, price will always be equal to marginal revenue since selling one more unit will increase revenue by the price of the unit

iv. PC supply curve

1. the quantity will be where P=MC, so if P rises then the firm

will increase quantity to a new point where P=MC

PC in the short RUn

1. earn positive economic profits

2.Earn zero economic profits

3.suffer economic losses but continue to operate to reduce or minimize those losses

4.Shut down and bear losses just equal to fixed costs

PC minimizing losses in short run

1. Operating profit (or loss) or net operating revenue TR-TVC

2. As long as price is sufficient to cover average variable costs, the firm stands to gain by operating instead of shutting down. P>AVC stay in and P

PC shutdown point in the Short Run

The lowest point on the AVC curve. WHen price falls below the minimum point on AVC

PC, in the long run

In the long run all PC firms make zero profits b/c the price will be pushed down to the minimum average cost (MC=AC)

Long run competitive equilibrium

When P=SRMC=SRAC=LRAC and profits are zero