ECC1000 EXAM

Microeconomics

The study of how individuals and firms make decisions, and how those decisions interact with each other.

Macroeconomics

Aggregates markets into whole industries, whole economies and whole countries (rather than individuals, households and firms up to a single market).

International economics

The study of interactions between countries.

Positive question

A "what is / what happens" question. It has a factual answer and is testable. Economics focuses on these.

Normative question

A "what should we do" question. It involves value judgments, so it is left to philosophy/political science. Economic findings can inform normative debates, but the analysis itself stays positive.

Principle 1: Scarcity necessitates choice

Resources (time, money, food, fuel etc.) are limited, so we must choose how to allocate them. The goal is to allocate scarce resources to get as much of what we want as possible.

Principle 2: Opportunity cost

The true cost of something is its opportunity cost, not just the money paid.

Opportunity cost (definition)

The value of your next best alternative that you give up.

Opportunity cost formula

Opportunity cost = explicit (direct) cost + implicit cost (foregone benefit, e.g. foregone wages). Costs you pay regardless of which option you choose are NOT part of the opportunity cost.

Principle 3: Decisions are made at the margin

"How much" decisions (continuous) are broken into a series of "one more unit?" decisions. This is different from "whether" decisions (discrete, yes/no).

Marginal thinking decision rule

Keep doing an activity as long as marginal gain > opportunity cost. Stop once marginal gain falls below opportunity cost.

Principle 4: People respond to incentives

People respond to rewards and punishments, but not always as expected. Badly designed incentives can backfire and cause unintended (perverse) outcomes.

Principle 5: Gains from trade

When individuals (or countries) specialise in tasks they are relatively good at and then trade, everyone can get more than if they were self-sufficient.

Principle 6: Markets move toward equilibrium

Equilibrium is a situation where no individual can make themselves better off by changing their behaviour, given what everyone else is doing. Markets move toward it because people exploit profitable opportunities until none are left.

Economic model

A simplified representation of reality (like a roadmap) that includes only the most relevant details. Models leave out nuance to stay useful and clear, so they are imperfect but still informative.

Production Possibilities Frontier (PPF)

A curve showing all combinations of two goods that can be produced when all resources are fully used.

How to draw a PPF

(1) Find the maximum of good A if ALL resources go to A and plot it on its axis. (2) Find the maximum of good B if ALL resources go to B and plot it on its axis. (3) Connect the intercepts (a straight line if productivity per worker is constant).

How to find a PPF intercept

Max output of a good = number of workers x output per worker, assuming all workers produce that one good.

Points ON the PPF

Feasible and efficient: all resources are used, and you cannot increase one good without decreasing the other.

Points INSIDE the PPF

Feasible but inefficient: not all resources are used, so more of at least one good could be produced without giving up anything.

Points OUTSIDE the PPF

Infeasible: they require more resources than are available.

How to test if a bundle is feasible

Calculate the workers needed = (quantity of good A / output per worker of A) + (quantity of good B / output per worker of B). If this is more than the available workers, the bundle is infeasible. If equal, it is on the PPF. If less, it is inside the PPF.

What shifts the PPF outward?

Economic growth: (1) an increase in factors of production (e.g. population grows), which shifts the whole PPF outward in parallel; (2) technological improvement.

Technology improvement affecting only one good

The PPF pivots: only the intercept for the improved good moves outward, and the other intercept stays the same (not a parallel shift).

Opportunity cost on a straight-line PPF

Constant everywhere because the slope is constant.

Opportunity cost formula on a PPF

Opportunity cost of good A = (amount of good B given up) / (amount of good A gained).

Bowed-out (curved) PPF

Shows increasing opportunity cost: the more of a good you produce, the more of the other good you give up for each additional unit.

Why does opportunity cost increase along a bowed-out PPF?

Resources are better suited to producing one good than another. As you shift more resources to a good, you must reallocate increasingly unsuitable resources, so you give up more and more of the other good per extra unit. Bowed-out PPFs are more realistic than straight-line PPFs.

Absolute advantage

Being able to produce more of a good than another producer with the same resources (i.e. a higher maximum output). Compare the maximum output of each producer.

Comparative advantage

Having a LOWER opportunity cost of producing a good than another producer.

How to find comparative advantage

(1) Calculate each producer's opportunity cost of good A = max of B / max of A. (2) Calculate each producer's opportunity cost of good B = max of A / max of B. (3) The producer with the lower opportunity cost of a good has the comparative advantage in it.

Opportunity cost reciprocal rule

In a two-good economy, the opportunity cost of good A is the reciprocal (flipped fraction) of the opportunity cost of good B. E.g. if 1 wine costs 2 food, then 1 food costs 1/2 = 0.5 wine.

Can one producer have comparative advantage in both goods?

No. If two producers have different opportunity costs, one cannot have the comparative advantage in both goods. Gains from trade only disappear if both have identical opportunity costs.

Is absolute advantage relevant to specialisation?

No. Only comparative advantage (relative opportunity cost) determines who should specialise in what and whether trade is beneficial. A producer with an absolute advantage in everything still gains from trade.

How to specialise

Each producer puts 100% of resources into the good in which they have the comparative advantage. Total production of both goods is then higher than before specialisation, which is the source of gains from trade.

How to find acceptable trade terms

A producer only trades if the terms are at least as good as their own opportunity cost. The buyer pays AT MOST their own opportunity cost of making the good; the seller accepts AT LEAST their own opportunity cost. The price must lie between the two opportunity costs.

Trade price range

Seller's opportunity cost < price < buyer's opportunity cost. Economics can identify the range, but the exact price depends on bargaining/negotiation.

How to confirm gains from trade

Compare total production of each good before trade (sum of both producers' original output) with total production after specialisation. If both totals are higher, specialisation plus trade has expanded what can be consumed.

Explicit cost

The actual money paid out of pocket to do something.

Implicit cost

The dollar value of the next best alternative you give up (a foregone benefit, e.g. foregone salary, foregone rent or interest).

Opportunity cost = ?

Explicit cost + implicit cost. This is the true full cost of a decision, not just the cash spent.

Accounting profit

Revenue - explicit costs only.

Economic profit

Revenue - explicit costs - implicit costs (= revenue - opportunity cost). Unless stated otherwise, "profit" in economics means economic profit.

Either/or decision rule

Choose the option with positive economic profit. Accounting profit can mislead, so always use economic profit for real decisions.

Two-option shortcut

In a two-option decision, if one option has negative economic profit the other automatically has positive economic profit, so you only need to calculate one.

Capital

The total value of an individual's or firm's assets, both financial (savings, bonds) and physical (real estate, machines, computers).

Do you count the cost of capital you already own?

Yes. Even if you own an asset, you must count its opportunity cost (what you could have earned using or renting it elsewhere). Owning capital just shifts costs from explicit to implicit; it does not lower the true opportunity cost or change the decision.

How to decide between more than two options

(1) Compare the first two options and discard the one with negative economic profit. (2) Compare the winner with the next option and discard the loser. (3) Repeat until every option has been compared.

Marginal cost

The additional cost of producing (or doing) one more unit of a good/service. It is an opportunity cost, so it includes implicit costs, not just explicit money costs.

Increasing marginal cost

Each additional unit costs more than the last (e.g. each extra hour of studying is harder than the previous one).

Constant marginal cost

Each additional unit costs the same.

Decreasing marginal cost

Each additional unit costs less than the last (e.g. you get faster and better with practice).

Marginal benefit

The additional benefit gained from one more unit of a good/service.

Decreasing marginal benefit

Each additional unit gives LESS benefit than the last (the most common assumption in economics, e.g. the 6th glass of water is worth less than the 1st).

Increasing marginal benefit

Each additional unit gives MORE benefit than the last. This is rare (e.g. acquired tastes).

Constant marginal benefit

Each additional unit gives the same benefit.

Optimal quantity (Q*)

The largest quantity where marginal benefit >= marginal cost. Graphically, it is where the MB and MC curves intersect.

How to solve for Q* algebraically

Write MB and MC as equations in terms of quantity, set MB = MC, and solve for the quantity. Beyond that quantity, MC > MB so it is no longer worth doing more.

Sunk cost

A cost that has already been paid and cannot be recovered, whatever you do now. Sunk costs should be completely ignored in all future decisions.

Sunk cost fallacy

Letting an already-spent, unrecoverable cost influence a current decision (e.g. "I'd be wasting what I already paid"). It is wrong because the cost is the same whichever option you choose.

Behavioural economics

The field arguing that people are not fully rational, but their irrationality is predictable and systematic ("predictably irrational").

Systematic deviations from the rational model

(1) Sunk cost fallacy. (2) Fairness concerns: people care how their outcome compares to others'. (3) Overconfidence: overestimating own abilities/outcomes. (4) Bounded rationality: limited time/ability to consider every outcome, so value may be left on the table.

Why keep using economic models if they are imperfect?

Models are simplified and imperfect but still useful and informative, so they should not be discarded just because they are not perfect.

Utility

A measure of the satisfaction a consumer gets from consuming goods/services, measured in made-up units called "utils". Utils have no real-world meaning and are only useful for comparison.

Total utility

The total satisfaction from consumption. It generally increases with more of a good you like, but at a decreasing rate.

Marginal utility (MU)

The change in total utility from consuming one additional unit of a good. Formula: MU = change in total utility / change in quantity. It is typically decreasing (diminishing marginal utility).

Expenditure formula

Expenditure = (price of good 1 x quantity of good 1) + (price of good 2 x quantity of good 2), summed across all goods.

Budget constraint

The set of all consumption bundles where total expenditure<= income.

Budget line

The set of bundles that use up all income, with nothing left over: P1 x Q1 + P2 x Q2 = income (an equation, not an inequality).

How to draw a budget line

(1) Spend all income on good 1: quantity = income / price of good 1. (2) Spend all income on good 2: quantity = income / price of good 2. (3) Plot these as intercepts and join them with a straight line. Everything on or inside the line is affordable; only points on the line use 100% of the budget.

Why only look at bundles on the budget line when maximising utility?

Any bundle not on the line leaves money unspent that could buy more utility.

Consumer's optimal choice (Method 1: total utility)

List every affordable bundle on the budget line, calculate total utility for each, and choose the bundle with the highest total utility.

Marginal utility per dollar

MU per dollar = marginal utility of one more unit of good X / price of good X.

Consumer's optimal choice (Method 2: MU per dollar)

(1) Calculate MU per dollar for each unit of each good. (2) Buy units in order from the highest MU per dollar to the lowest. (3) After each purchase, subtract its price from the remaining budget. (4) Stop when the budget is exhausted. The result is the utility-maximising bundle, with MU/P roughly equal across goods.

Optimal consumption rule (MU per dollar)

Keep consuming until marginal utility per dollar is equal (or as close as possible) across all goods: MUx/Px = MUy/Py.

How do marginal utility analysis and demand curves connect?

Repeating the MU-per-dollar analysis at different prices of a good shows how the optimal quantity changes as price changes. This builds the individual demand curve, and individual demand curves summed across consumers give the market demand curve.

Marginal Rate of Transformation (MRT)

The rate at which the market lets you trade one good for another: the slope of the budget line. Formula: MRT = price of the x-axis good / price of the y-axis good. It tells you how many units of the y-axis good you give up to get 1 more unit of the x-axis good.

Kinked budget constraint

A budget line that is linear on either side of a kink. It occurs when part of income is restricted to certain goods (an in-kind transfer): spending on the restricted good up to the restricted amount costs nothing in terms of other goods (flat segment), then a normal trade-off resumes. The kink is exactly where the restricted money runs out.

In-kind transfer

A payment that can only be spent on approved goods (e.g. a restricted account usable only for food) rather than as unrestricted cash.

Indifference curve (IC)

A curve showing all bundles of goods that give the same total utility, so the consumer is indifferent between them.

Advantage of indifference curves over the MU-per-dollar method

You don't need to recalculate marginal utility per dollar each time prices change. You just find where the new budget line touches the unchanged indifference curve map.

Marginal Rate of Substitution (MRS)

The amount of the y-axis good you are willing to give up to get 1 more unit of the x-axis good while keeping utility constant. It is the slope of the indifference curve. Formula: MRS = MUx / MUy.

How to calculate MRS between two points on an IC

MRS = (amount of y-axis good given up) / (amount of x-axis good gained) when moving between the two points.

MRS pattern along an indifference curve

MRS decreases as you move right (more of the x good). Each extra unit of x matters less, and the y good becomes relatively more precious, so you are less willing to give it up.

Reading an indifference curve map

Bundles on the same curve give equal utility. Curves further from the origin give higher utility (because more is better).

Five properties of consumer preferences

(1) Complete, (2) Transitive, (3) Continuous, (4) Monotonic, (5) Convex.

Complete preferences

You can always rank any two bundles: prefer A, prefer B, or be indifferent.

Transitive preferences

If you prefer X to Y and Y to Z, then you must prefer X to Z. Preferences must be logically consistent, with no loops or contradictions.

Continuous preferences

Small changes in a bundle lead to only small changes in utility (no sudden extreme jumps).

Monotonic preferences

"More is better": you always prefer more of a good to less. Normal indifference curves therefore slope downward. An upward-sloping IC violates monotonicity.

Convex preferences

Diminishing MRS: indifference curves bow inward toward the origin. Non-convex curves bow outward, which would mean an increasing MRS (not well-behaved).

Utility-maximising tangency condition

The optimal bundle is where the indifference curve is tangent to the budget line, i.e. MRS = MRT.

What if MRS > MRT?

The consumer is willing to give up more of the y good for the x good than the market requires, so they should buy more of the x good. The bundle is not optimal.

What if MRS < MRT?

The consumer values the x good less than the market price implies, so they should buy less of the x good (and more of the y good). The bundle is not optimal.

Substitution effect (SE)

The change in consumption caused by the change in relative prices alone, holding utility constant (a movement along the ORIGINAL indifference curve).

Income effect (IE)

The change in consumption caused by the change in purchasing power alone (a move to a different indifference curve).

Total effect (TE)

Substitution effect + income effect.

How to decompose a price change using indifference curves

(1) Mark the original optimum on the original budget line and IC. (2) Draw the new budget line (new slope/intercept) and find the new optimum on a new IC. (3) Draw a hypothetical budget line with the NEW slope but tangent to the ORIGINAL IC and mark the tangency point. (4) Original point to hypothetical point = substitution effect. (5) Hypothetical point to new optimum = income effect.

Effects of a price rise on the good that became more expensive

Substitution effect is negative (relatively pricier, so buy less) and income effect is negative (poorer, so buy less). Both agree, so consumption unambiguously falls.

Effects of a price rise on the other (relatively cheaper) good

Substitution effect is positive (relatively better deal) but income effect is negative (poorer overall). The total effect is ambiguous and depends on which effect is larger.