Economics Midterm Exam Review

Economic

• Economic Perspective - The economic way of thinking 

• Scarcity - Limited supply of resources to make goods/services

• Opportunity Cost - To sacrifice certain products and services when making a decision

• Utility - Pleasure or happiness from consuming goods and services

• Marginal Analysis - compares MB to MC

Microeconomics vs Macroeconomics

• Micro - Decision making by individual households and business firms

• Macro - Examining the performance and behavior of the economy as a whole, including inflation, interest rates, governments

Positive vs Normative Economics

• Within both micro and macroeconomics

• Positive - Facts and cause-and-effect relationships

• Normative - Value judgements and “what ought to be”

Factors of Production

• Land - Includes resources extracted from the ground

• Labor - Workers who produce goods/services

• Capital (capital goods) - Manufactured aids used to produce consumer goods/services

• Entrepreneurial Ability - Involves taking risks and developing ideas

Production Possibilities Model

• Production Possibilities Curve - Displays combination of goods and services that a society can produce to maximize potential (full employment, fixed resources, fixed technology)

• Points on the curve attainable if all resources are used

• Under or beyond curve is unattainable

• Optimal Allocation - Optimal amount that an activity should occur is where MB = MC

• International specialization and trade allow a nation to get more desired goods with less sacrifice of another good

Economic Systems

• An economic system is a set of institutional arrangements to respond to an economic problem (what goods, how are they produced, who are the consumers, etc.)

• Laisse-fair capitalism - minimum government intervention

• Command system - governments have total control, majority fail due to central plans

• Markets systems or mixed economies - varying degrees of govt involvement, heavily relies on private individuals and firms

Freedom of Enterprise & Choice

• Freedom of Enterprise - entrepreneurs and businesses are free to use resources to produce their choice of goods and services + sell in chosen markets

• Freedom of Choice - Enables owners to employ or dispose of their property and money as they see fit

• Self-interest - Motivating force of trying to achieve your own particular goal

Technology and Capital Goods

Advancements in technology and capital goods make production more efficient and not adapting can make it difficult

Demand

• Shows various amounts of a product consumers are willing to purchase at possible prices

• Quantity demanded rises when price falls, quantity demanded falls when price rises (Negative/Inverse relationship)

• Income effect - a lower price enables the buyer to purchase more product, increasing the power of their income

• Substitution effect - a lower price, buyers may want to buy (substitute)  more of the less expensive product than the more expensive one

• Change in quantity demanded is a movement one point to another

• Determinants for change in demand (shift entire demand curve to the right, increase, or to the left, decrease): preference, number of buyers (increase buyers - increases demand), consumers incomes, prices of related goods

Supply

• Shows the various amounts of a product that producers are willing to make available for sale

• Quantity supply rises as prices rises, quantity supply falls as price falls (Positive/Direct relationship)

• Change in quantity supplied is a movement from one point to another on a fixed supply curve

• Non price determinants of change in supply (shift entire demand curve to the right, increase, or to the left, decrease): resource prices, technology, taxes/subsidies, number of sellers in the market

Market Equilibrium

• MC = MB, Equilibrium price is the prices where the intention of buyers and sellers match

• Surplus - excess of supply (drives prices down)

• Shortage - excess of demand (drives prices up)

• Rational function of prices - A price at which the selling and buying decision are consistent

• Production efficiency - produce a good the least costly way

• Allocative efficiency - mix of goods/services most valued by society with minimum-cost production

Equilibrium Continued

• Supply increases or demand decreases, the equilibrium price falls

• Supply decreases or demand increases, the equilibrium price rises

• Price ceiling - sets the maximum legal price a seller can charge for a product/service (rent control)

• Price Floor - minimum price fixed by the govt (minimum wage)

Market Failures

• Impossible for the market to correctly weigh costs and benefits in a situation

• 1. Demand-side failures - demand curves do not reflect consumers’ full willingness to pay for a good/service (it's impossible in certain cases to charge customers for a product)

• 2. Supply-side failures - supply curves do not reflect the full cost of producing a good/service (a firm does not have to pay the full cost of producing its output)

Consumer Surplus

• The benefit surplus received by a consumer or consumers in a market

• Difference between the maximum price a consumer is willing to pay + the price they actually do

Producer Surplus

• Difference between the actual price a producer received and the minimum acceptable price a consumer would have to pay

Private Goods vs Public Goods

• Private goods - offered for sale in stores, shops, the internet, and distinguished by rivalry and excludability  (buying a single backpack, it’s no longer available to purchase), firms “tap market demand” for private goods

• Public goods - opposite characteristics of private goods and distinguished by non-rivalry and non-excludability (street lighting, national defense)

• Quasi-public goods - some public goods that governments provide where exclusion is possible (education, streets, police, libraries)

Free-Riding

• A public good that everyone, including nonpayers, can obtain the benefit from

• Not expressed in the market, more free riding means less demand, and potential demand collapse if all consumers free ride

Externalities

• Occurs when some of the costs and benefits of a good/service are passed onto or “spill over to” someone other than the immediate buyer or seller

• Negative Externality (caused by supply-side market failures) happens when producers don't consider the costs that they impose others

• Cause firms’ supply curves to shift to the right (or below) where firms would be if they accounted for all costs

• Reduce negative externalities by passing legislation to limit the activity

• Positive Externality happens when market demand curves fail to include willingness to pay of the third parties who receive external benefits 

• Shifts market demand curves to left of (or below) where they would be if they included all benefits and willingness to pay of the third parties and primary beneficiaries

• Markets fail to produce all units for which benefits exceed costs, underproduction

Government’s Economic Role

• Government economic functions include setting laws to make private coercion illegal, outlawing forms of theft, provide goods/services that would be unproduced by private firms, and modifying distribution of income 

• Possess the legal right to force people to do things, encouraging involuntary transactions (punishment for not paying taxes or fines for violating pollution laws)

• Government failures - economically inefficient outcomes caused by shortcoming in the public sector, can be caused by voting problems

Correcting Market Failures

• Govts can improve economic efficiency by using involuntary collected tax money to subsidize production when positive externalities occur

• Reduce overproduction and improve economic efficiency by using involuntary policies (direct control, pollution taxes) to force producers to bear higher costs when negative externalities occur

• Challenges that govts have in delivering economically optimal outcomes include massive size/scope, difficult communication between lower levels and higher levels, lack of accountability

Government Failure

Causes of failures in representative democracies:

• principle-agent problems - tasks delegated by one group (Principles) to another (agents)

• special-interest effect - a small group obtain a govt policy that gives them large gains at the expense of a larger group who suffers small losses

• rent seeking - any payment in excess of the minimum amount needed to keep a resource employed (obtain extra profit like tariffs)

Deficits

• An annual budget deficit is when the govt’s tax revenues are less than its spending, causing them to borrow money (issuing bonds) that is added to the overall pile of debt

• Chronic deficits cause: economic inefficiency - allow the govt to control and direct an inefficiently large fraction of the economy’s resources OR debts crises - accumulated debt level may rise so high that investors lose faith in the govt’s ability to pay it

Stabilization Policy

• Fiscal policy - Attempts to use changes in tax rates and spending levels to offset the business cycle

• Monetary policy - Attempts to use changes in interest rates to regulate the economy

Price Elasticity of Demand

• Percentage change in quantity demanded/Percentage change in price (Values must me in decimal form), measure of responsiveness of buyers to change in price of a product/resource

• Midpoint formula - Method for calculating price elasticity of demand or supply ((change in quantity/ sum of quantities/2)/ change in price/ sum of prices/2))

• Elastic demand - Price of elasticity is > 1, significant change in price leads to significant change in quantity demanded

• Inelastic demand - Price of elasticity is < 1, lower change in price leads to less change in quantity demanded

• Unit elasticity - Price of elasticity is = 1, equal change in quantity and price

• Perfectly inelastic demand - price can be of any amount at a particle quantity demanded

• Perfectly elastic demand - quantity demanded can be of any amount at a particle price

Determinants of Price of Elasticity of Demand

• Substitutability - the more substitutes available, the greater the price elasticity of demand

• Proportions of income - the higher price of a good relative to consumers’ incomes, the greater the price of elasticity demand

• Luxuries versus necessities - price elasticity of demand is higher for luxury goods than necessities

• Time - product demand is more elastic over longer time periods (consumers need time to find alternatives)

Utility Maximization

• Diminish marginal utility - Satisfaction declines as a consumer acquires additional units of a given product

• Three characteristics of utility: utility and usefulness are not the same, utility is subjective, utility is difficult to quantify

• Total utility- total amount of satisfaction a person gets from consuming a specific quantity

• Marginal utility - the extra satisfaction from an additional unit of that product

Consumer Behavior

Consumer choice and budget constraint:

• rational behavior - consumer tries to use their money income to get maximum satisfaction

• preferences - each consumer has a preference for certain goods/services

• budget constraint - the consumer has a fixed, limited amount of money income

• prices - every good carries a price tag

Behavior vs Neoclassical Economics

• Behavior economists reflects that people are not perfectly rational, which can help understand the mental processes to make better decisions 

• They believe that improvement in utility must be made by making better selection from the set of options already available to them

• Neoclassical economics focuses on production, assuming that people are rational and can separate what people do and how they do it

• Posses unrealistic assumptions: stable preferences, people are eager/accurate calculating machines, good planners with willpower, and almost entirely selfish

• They want to provide people with more options, believing that a fully rational person can be trusted to make a choice that will make him best off

Cognitive Biases

Misperception of misunderstanding that causes systemic errors:

• Self-serving biases (take credit for success, blame others for wrongdoings)

• Hindsight bias (Believed to predict past events)

• Availability heuristic (Base estimates on whether not similar events come to mind)

• Planning fallacy (underestimate the time needed to complete a task)