Econ Final Exam Review

Law of diminishing marginal returns

• reflects people’s preferences

• each additional unit provides less marginal utility than the previous one

Demand

the relationship between the price of a good and the amount the buyer is willing to purchase

The Law of Demand

• holding all else equal, the quantity demanded for a good falls as the price rises and vice versa

Ceteris Peribus

(all else equal)

The Law of Supply

Holding all else equal, the quantity of a good supplied rises if the price rises and vice versa

The decision to sell something is based on what

• the marginal principle

• cost-benefit principle

• only sell if marginal benefit > marginal cost

Assumptions about firms

• Only objective is to maximize profit

• Firms operate in a competitive marketplace

• Buyers and sellers are price takers —→ cannot influence price they sell at, they just choose how much to sell

The rational rule for sellers

continue making product until marginal cost = price

Why don’t firms sell infinite things?

• diminishing marginal returns —→ the cost to produce more rises and it is not worth it to produce one extra thing

Demand Schedule

Supply Schedule

What is Quantity demanded if the demand/supply function gives you a negative answer?

0

Market Demand

sum of all individual quantities demanded by each buyer in the market

1. find each person’s individual quantity demanded at each price

2. at each price, add up the quantity demanded by everyone

3. Plot total quantity demanded at each price for market demand curve

Demand vs Quantity demanded

• Demand: relationship between price and quantity

• Quantity demanded: the exact amount people will buy at a SPECIFIC price

Supply vs Quantity supplied

• Supply: relationship between price and quantity supplied

• Quantity supplied: the exact amount that firms would sell at a SPECIFIC

6 Factors that shift demand

• The number of buyers

  • more buyers = more demand

• The price of other things

  • higher price of complements —→ lower demand

  • higher price of substitutes —→ higher demand

• Income

  • normals good: higher income —→ higher demand

  • inferior good: higher income —→ lower demand

• Preferences

• Expectations

  • Expect prices to go up —→ higher demand today

  • expect lower prices —→ lower demand today

• Network effects and congestions

  • Network (insta/snap): more people = more demand

  • Congestion (beaches/restaurants): more people = less demand

5 Shifters of Supply

• Number of sellers

  • more sellers = higher demand

• The price of other things

  • Complements: higher price —→ decrease supply

  • Substitutes: higher price —→ higher supply

• Price of inputs

  • higher input price —→ decreased supply

• Productivity & Technology

  • Higher productivity/technology —→ higher supply

• Expectations

  • higher price in the future —→ lower supply now

    • ONLY IF GOOD IS STORABLE

if price increases by $2 then plug in P-2 in Qs equation

Is voluntary trade common?

Yes

Production Possibilities Frontier (PPF)

• shows what combination of things a person/business/nation can produce

• Below the frontier —→ inefficient use of resources

• Outside the frontier —→ unattainable productivity

• PPF always slopes down

What is opportunity Cost

• what you give up/what you get

Why is PPF bulging outwards instead of linear?

• law of diminishing marginal returns

For people to engage in trade both need to benefit

Absolute advantage

• ability to do a task using fewer resources

• tells us who can produce more using the same inputs

Will someone always have a comparative advantage?

• yes, as long as opportunity costs are different

What is the price of trade?

• Between the opportunity cost of that thing

• If you are trying to find the terms of trade for 1 collected data set it is in-between the opportunity cost for the collected data set of each person

What is economics?

• study of people “in the business of ordinary life”

• study of decision making under scarcity

• how people use resources and respond to incentives

• social science that studies the production, consumption, and distribution of goods

Scarcity

• condition where demand for something exceeds the supply

Economic Surplus

Total benefit - total cost

Does every market have a price for transactions?

yes

Why is price an incentive?

• sellers produce more

• buyers consume less

Equilibrium

• no tendency for change

• Qs = Qd

• occurs when buyers and sellers are in agreement

What happens if buyers and sellers disagree?

• shortage Qd > Qs

• surplus Qs > Qd

What happens if a market is out of equilibrium

• prices and economic fundamentals push it back to equilibrium

How do businesses maximize profit

• marginal principle —→ keep inching up the price to see until when buyers will buy

What happens at equilibrium?

Everyone who wants to buy at the equilibrium price gets to buy as much as they want

Symptoms of market at disequilibrium

• Queuing (lines for things)

• Secondary markets (unofficial channels to buy something at higher prices)

Positive analysis

• objective statements

• true/false

Normative analysis

• prescribing what should happen

• involves a value judgement

• who is going to bear the consequences or reap the benefits

Economic Efficiency

• more economic surplus = more economic efficiency

• surplus is size of economic pie while efficiency is how to make the pie bigger

efficiency does not mean more equity

• even if a policy hurts some people it might still be worth it

• all policy has winners and losers

Consumer surplus = MB - P

Producer Surplus = P - MC

Market

• brings together buyers and sellers or trading partners

Price

• communicates value, scarcity, and cost

• incentive for buyers and sellers

Equilibrium

• point at which there is no tendency for change in a market

• Quantity supplied = quantity demanded

• buyers n sellers are in equilibrium

what happens when market goes out of equilibrium?

• prices and economic fundamentals push back up to equilibrium

Economic Disequilibrium

• Queuing (people lining up to buy something) —shortage

• Secondary markets (unofficial channels to buy something at higher price) —shortage

What is DWL

• Efficient outcome - Actual economic surplus

Competitive Equilibrium

• maximizes total surplus — ASSUMING perfectly competitive markets

Ways markets fail

1. Market power undermines competition

2. Externalities create side effects

3. Government can impede market forces

4. Information problems undermine trust

5. Irrationality leads to bad decision making

Maximizing efficiency is just one way to conduct normative analysis

Increasing efficiency (economic pie) does not mean:

• increasing equity

The budget problem

• our demand for something is influenced by our budget not just MB

Price Elasticity of demand

Shows how much Qd changes with a 1% change in price

Negative PED

price up, demand down

COMPARING elasticities

• ignore the negative sign; higher number is more elastic

Better way to think about it

• |PED| < 1 = inelastic

• |PED| = 1 = unit elastic

• |PED| > 1 = elastic

• PED = 0 Perfectly inelastic

• PED = infinity Perfectly elastic

Price elasticity of supply

• Es < 1: inelastic

• Es > 1: elastic

Determinants of Price elasticity of Supply

1. More inventory: more elastic

2. More availability of inputs: more elastic

3. Extra capacity: more elastic

4. More barriers to entry/exit: less elastic

5. Time horizon: over time, supply becomes more elastic

Determinants of Price elasticity of Demand

1. More competing products = more elastic

2. Narrow market = more elastic; broad market = less elastic

3. Budget: larger share of budget = more elastic

4. More necessary = less elastic

5. More willing to search = more elastic

6. More time = more elastic

Why do we use the midpoint method

• the direction of price changing doesn’t matter

Cross price elasticity of demand

• how does price change of another good change demand for this good

• + sub

• - comp

Income elasticity of demand

• percent change in Q demanded from a 1% change in income

• + normal goods

• - inferior goods

Price Ceiling

• max price that sellers can legally charge

  • rent control

  • anti- gouging laws

  • laws limiting medical costs

Price Floor

• min price that sellers can legally charge

• minimum wage

Quota

max amount of good that can be bought or sold

Mandate

• minimum amount of good that can be bought/sold

Unexpected consequences of price ceilings

• rent controlled. properties are lower quality

• discrimination

• black markets

• long run, suppliers will pivot into different industries

gov. buys surplus from price floor

What is a businesses ultimate objective?

• to maximize profit

Accounting profit

• total revenue - explicit financial costs

Economic Profit

• Total revenue - explicit costs - implicit costs (opportunity costs)

Production function for individual firms

• land

• labor (workers)

• entrepreneurship (puts all three together)

• capital (machines)

Marginal product

• change in output associated with the next unit of input

Diminishing marginal returns

• if firm increases use of one input the resulting output will become smaller and smaller

Long run

• firms can enter or exit the market

• economic agent has total flexibility to change their decisions

Short Run

• business can only choose weather to operate and how much to make

Story of Firm

1. Increasing marginal returns: business hires more workers and adding new workers increases output at a growing rate

2. Decreasing marginal returns: as the business grows, new workers increases output, but at a decreasing rate

3. Decreasing total returns: adding more people (input) hurts output

Marginal product

• shows how costly increasing production is

Total fixed cost

• cost that firms pay once to begin operations (overhead like rent)

Total Variable Cost

• sum of costs that occur because of a firms output

• variable costs always rise

Average total cost

• total cost/ total output

• always a U shape

Average fixed cost

• fixed cost / quantity

• decreases with more production

Average variable costs

• total variable costs / time

• increases eventually with more production

  • diminishing marginal returns

Average Revenue

• AR = total revenue / total output = price

Profit Margin

• P - ATC

• AR - ATC

Marginal Cost

• change in total cost/ change in total output

• down and then up because of diminishing returns

Marginal costs and avg costs

• when marginal costs are below avg costs, avg costs go down

• when marginal costs are above avg costs, avg costs go up

Marginal Revenue

• tells us what kind of market the firm is operating in

Marginal Revenue

• MR = P for perfectly competitive marketplaces

Firm demand line for perfectly competitive

• Horizontal

Profit maximizing rule

• produce until MR = MC

Perfectly competitive firms

• produce until MR = P

• MRDARP

• profit margin is economic profit margin (P-ATC) x Q

Shutdown point

• AVC = MC

Free Entry

• absence of obstacles that would make it costly to enter or exit an industry

Firm story (low profits)

• negative profits

• firms exit

• supply shifts left

• prices improve

• profit margin tends make to 0

Firm Story (high profits)

• positive profits

• firms enter

• supply shifts right

• prices decrease

• profit margin tends towards 0

Long run:

• P = ATC

• profit margin = 0

• economic profit = 0

• firms could still have positive accounting profit

Free trade is not disagreed upon