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Economics
The study of how people, firms, and societies use their scarce productive resources to best satisfy their unlimited material wants.
Resources
Factors of production, 4 categories: labor, physical capital, land/natural resources, and entrepreneurial ability
Scarcity
The imbalance between limited productive resources and unlimited human wants
Opportunity Cost
The most desirable alternative given up as the result of a decision
Marginal Benefit (MB)
The additional benefit received from the consumption of the next unit of a good or service
Marginal Cost (MC)
The additional cost incurred from the consumption of the next unit of a good or a service
Marginal Analysis
The rational decision maker chooses an action if MB ≥ MC
Law of Increasing Costs
The more of a good that is produced, the greater the opportunity cost of producing the next unit of that good
Absolute Advantage
Exists if a producer can produce more of a good than all other producers
Comparative Advantage
Exists if a producer can produce a good at lower opportunity cost than all other producers
Specialization
When firms focus their resources on production of goods for which they have comparative advantage
Productive Efficiency
Production of maximum output for a given level of technology and resources. All points on the PPF are productively efficient
Allocative Efficiency
Production of the combination of goods and services that provides the most net benefit to society. The optimal quantity of a good is achieved when the MB = MC of the next unit and only occurs at one point on the PPF
Economic Growth
Occurs when an economy's production possibilities increase. This can be a result of more resources, better resources, or improvements in technology.
Market Economy (Capitalism)
An economic system based upon the fundamentals of private property, freedom, self-interest, and prices
Law of Demand
Holding all else equal, when the price of a good rises, consumers decrease their quantity demanded for that good
Absolute prices
The price of a good measured in units of currency
Relative Prices
The number of units of any other good Y that must be sacrificed to acquire good X. Only relative prices matter
Substitution Effect
The change in quantity demanded resulting from a change in the price of one good relative to other goods
Income Effect
The change in quantity demanded that results from a change in the consumer's purchasing power (or real income)
Determinants of Demand
Consumer income, prices of substitute and complementary goods, consumer tastes and preferences, consumer speculation, and number of buyers in the market all influence demand
Normal Goods
A good for which higher income increases demand
Inferior Goods
A good for which higher income decreases demand
Substitute Goods
Two goods are consumer substitutes if they provide essentially the same utility to consumers
Complementary Goods
Two goods are consumer complements if they provide more utility when consumed together than when consumed separately
Law of Supply
Holding all else equal, when the price of a good rises, suppliers increase their quantity supplied for that good
Determinants of Supply
Costs of inputs, technology and productivity, taxes/subsidies, producer speculation, price of other goods that could be produced, and number of sellers all influence supply
Market Equilibrium
Exists at the point where the quantity supplied equals the quantity demanded
Shortage
Excess demand; a shortage exists at a market price when the quantity demanded exceeds the quantity supplied
Surplus
Excess supply; exists at a market price when the quantity supplied exceeds the quantity demanded.
Total Welfare
The sum of consumer surplus and producer surplus
Consumer surplus
The difference between your willingness to pay and the price you actually pay. It is the area below the demand curve and above the price
Producer surplus
The difference between the price received and the marginal cost of producing the good. It is the area above the supply curve and under the price
Price elasticity
Ed = (%dQd)/(%dP). Ignore negative sign
Price elastic demand
Ed > 1, meaning consumers are price sensitive
Price inelastic demand
Ed < 1
Unit elastic demand
Ed = 1
Perfectly inelastic
Ed = 0, no response to price change
Perfectly elastic
Ed = ∞, infinite change in demand to price change
Determinants of elasticity
Substitutes, cost as percentage of income, and time to adjust to price changes all influence price elasticity
Total Revenue
TR = P * Qd
Total Revenue Test
Total revenue rises with a price increase if demand is price inelastic and falls with a price increase if demand is price elastic
Income Elasticity
Ei = (%dQd good X)/(%d Income)
Luxury
Ei > 1
Necessity
0 < Ei < 1
Cross-Price Elasticity of Demand
Ex,y = (%dQd good X) / (%d Price Y). If Ex,y > 0, goods X and Y are substitutes. If Ex,y < 0, goods X and Y are complementary
Price Elasticity of Supply
Es = (%dQs) / (%dPrice)
Excise Tax
A per unit tax on production results in a vertical shift in the supply curve by the amount of the tax
Incidence of Tax
The proportion of the tax paid by the consumers in the form of a higher price for the taxed good is greater if demand for the good is inelastic and supply is elastic
Dead Weight Loss
The lost net benefit to society caused by a movement away from the competitive market equilibrium
Subsidy
Has opposite effect of an excise tax, as it lowers the marginal cost of production, forcing the supply curve down
Price floor
A legal minimum price below which the product cannot be sold. If a floor is installed at some level above the equilibrium price, it creates a permanent surplus
Price Ceiling
A legal maximum price above which the product cannot be sold. If a floor is installed at some level above the equilibrium price, it creates a permanent shortage
Law of Diminishing Marginal Utility
The marginal utility from consumption of more and more of that item falls over time
Constrained Utility Maximization
For one good, constrained by prices and income, a consumer stops consuming a good when the price paid for the next unit is equal to the marginal benefit received
Utility Maximizing Rule
MUx / Px = MUy/Py or MUx/MUy = Px/Py
Accounting Profit
The difference between total revenue and total explicit costs
Economic Profit
The difference between total revenue and total explicit and implicit costs
Explicit costs
Direct, purchased, out-of-pocket costs paid to resource suppliers provided by the entrepreneur
Implicit costs
Indirect, non-purchased, or opportunity costs of resources provided by the entrepreneur
Short run
A period of time too short to change the size of the plant, but many other, more variable resources can be changed to meet demand
Long Run
A period of time long enough to alter the plant size. New firms can enter the industry and existing firms can liquidate and exit
Production function
The mechanism for combining production resources, with existing technology, into finished goods and services
Fixed inputs
Production inputs that cannot be changed in the short run. Usually this is the plant size or capital
Variable inputs
Production inputs that the firm can adjust in the short run to meet changes in demand for their output. Often this is labor and/or raw materials
Total Product of Labor (TPL)
The total quantity, or total output of a good produced at each quantity of labor employed
Marginal Product of Labor (MPL)
The change in total product resulting from a change in the labor input. MPL = dTPL/dL, or the slope of total product
Average Product of Labor (APL)
Total product divided by labor employed. APL = TPL/L
Total Fixed Costs (TFC)
Costs that do not vary with changes in short-run output. They must be paid even when output is zero.
Total variable costs (TVC)
Costs that change with the level of output. If output is zero, so are TVCs.
Average Fixed Cost (AFC)
AFC = TFC/Q
Average Variable Cost (AVC)
AVC = TVC/Q
Average Total Cost (ATC)
ATC = TC/Q = AFC + AVC
Economies of Scale
The downward part of the LRAC curve where LRAC falls as plan size increases. This is the result of specialization, lower cost of inputs, or other efficiencies of larger scale.
Constant Returns to Scale
Occurs when LRAC is constant over a variety of plant sizes
Diseconomies of Scale
The upward part of the LRAC curve where LRAC rises as plant size increases. This is usually the result of the increased difficulty of managing larger firms, which results in lost efficiency and rising per unit costs.
Perfect competition
Characterized by many small price-taking firms producing a standardized product in an industry in which there are no barriers to entry or exit
Profit Maximizing Rule
All firms maximize profit by producing where MR = MC
Break-even Point
The output where ATC is minimized and economic profit is zero
Shutdown Point
The output where AVC is minimized. If the price falls below this point, the firm chooses to shut down or produce zero units in the short run
Perfectly competitive long-run equilibrium
Occurs when there is no more incentive for firms to enter or exit. P=MR=MC=ATC and profit = 0
Normal Profit
Another way of saying that firms are earning zero economic profits or a fair rate of return on invested resources
Constant cost industry
Entry (or exit) of firms does not shift the cost curves of firms in the industry
Increasing Cost Industry
Entry of new firms shifts the cost curves for all firms upward
Decreasing Cost industry
Entry of new firms shifts the cost curves for all firms downward
Monopoly
The least competitive market structure, characterized by a single producer, with no close substitutes, barriers to entry, and price making power
Market power
The ability to set the price above the perfectly competitive level
Natural Monopoly
The case where economies of scale are so extensive that it is less costly for one firm to supply the entire range of demand
Monopoly long-run equilibrium
Pm > MR = MC, which is not allocatively efficient and dead weight loss exists. Pm > ATC, which is not productively efficient. Profit > 0 so consumer surplus is transferred to the monopolist as profit
Price discrimination
The practice of selling essentially the same good to different groups of consumers at different prices
Monopolistic competition
A market structure characterized by a few small firms producing a differentiated product with easy entry into the market
Monopolistic competition long-run equilibrium
Pmc < MR = MC and Pmc > minimum ATC so outcome is not efficient, but profit = 0.
Excess Capacity
The difference between the monopolistic competition output Qmc and the output at minimum ATC. Excess capacity is underused plant and equipment
Oligopoly
A very diverse market structure characterized by a small number of interdependent large firms, producing a standardized or differentiated product in a market with a barrier to entry
Four-firm concentration ratio
A measure of industry market power. Sum the market share of the four largest firms and a ratio above 40% is a good indicator of oligopoly
Non-collusive oligopoly
Models where firms are competitive rivals seeking to gain at the expense of their rivals
Collusive oligopoly
Models where firms agree to mutually improve their situation
Cartel
A group of firms that agree not to compete with each other on the basis of price, production, or other competitive dimensions. Cartel members operate as a monopolist to maximize their joint profits
Marginal Revenue Product (MRP)
Measures the value of what the next unit of a resource (e.g., labor) brings to the firm. MRPL = MR x MPL. In a perfectly competitive product market, MRPL = P x MPL. In a monopoly product market, MR < P so MRPm < MRPc.
Marginal Resource Cost (MRC)
Measures the cost the firm incurs from using an additional unit of input. In a perfectly competitive labor market, MRC = Wage. In a monopsony labor market, the MRC > Wage
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