Purdue | Econ 252 | Dr. Vargas | Exam 1

Economic Agent

Any group or individual that makes choices.

What is Economics the study of?

How agents make choices among scarce resources and how those choices affect society

Scarcity

A situation of having unlimited wants in a world of limited resources

When are resources scarce?

Resources are scarce when the quantity that people want exceeds the quantity that is available

Positive Economics

Describes what people actually do, or makes predictions about the world that can be verified with data. (Example: In July, the unemployment rate in Indiana was 4.6 percent)

Normative Economics

Recommends what an individual or society ought to do. It depends on subjective judgments. (Example: The government should increase the minimum wage to $15 per hour to reduce poverty.)

Microeconomics

The study of individuals, firms, and government

Macroeconomics

The study of the whole economy

Three Principles of Economics:

Optimization, Equilibrium, Empiricism

Optimization

Making the best choice possible with the given information

Equilibrium

When everyone is optimizing, no one would be better off with a different choice

Empiricism

Using data to test theories and determine what is causing things to happen in the world (testing ideas using data)

When do Tradeoffs arise?

When some benefits must be given up in order to gain others

What do economists use to describe tradeoffs?

Budget Constraints (Example: 5 hours of free time = Hours surfing the web + Hours working)

Opportunity Cost

The best alternative use of a resource

The Scientific Method

1. Developing models that explain some part of the world

2. Testing those models using data to see how closely the model matches what we actually observe

What is a Model?

A simplified description of the world, also referred to as a Theory

Two important features of models

1. They are not exact

2. They generate predictions that can be tested with data

Hypothesis

Predictions, typically generated by a model, that can be tested with data

Causation

When one thing directly affects another through a cause and effect relationship

Correlation

When two things are correlated, there is a mutual relationship between them

Positive Correlation

They both change in the same direction

Negative Correlation

They change in opposite directions

Why isn't correlation the same thing as causality?

1. Omitted variables

2. Reverse Causality

Omitted Variables

If we ignore something that contributes to cause and effect, then that something is an omitted variable. A correlation might not make sense until the omitted variable is added

Reverse Causality

When there is cause and effect, but it goes in the opposite direction as what we thought

Optimization in Levels

Look at the net benefit = total benefit - total cost (calculate the total net benefit of different alternatives and then choose the best alternative.)

Optimization in Differences

Look at the change in the net benefit of one option compared to another (calculate the change in net benefits when a person switches from one alternative to another and then use these marginal comparisons to choose the best alternative.)

Comparative Statics

The comparison of economic outcomes, before and after some economic variable is changed

Optimizing in Levels Procedure

1. Express all costs and benefits in the same unit

2. Calculate total net benefit for each option

3. Choose the option with the highest net benefit

Marginal Analysis

The extra cost generated by moving from one feasible alternative to the next feasible alternative

Principle of Optimization at the Margin

If an option is the best choice, you will be made better off as you move toward it, and worse off as you move away from it

Optimizing in Differences Procedure

1. Express all costs and benefits in the same unit

2. Calculate how the costs and benefits change as you move from one option to another

3. Apply the Principle of Optimization at the Margin--Choose the option that makes you better off by moving toward it and worse off by moving away from it

Market

A group of economic agents who are trading a good or service, and the rules and arrangements for trading

Market Price

The price at which buyers and sellers conduct transactions

Perfectly Competitive Market

1. All sellers sell an identical good or service

2. There are numerous buyers and sellers, and no buyer or seller is big enough to influence that market price

3. Every buyer pays and every seller charges the same market price

Price Takers

Take the market price as given

Quantity Demanded

The amount of a good that buyers are willing to purchase at a given price

Demand Schedule

A table that reports the quantity demanded at different prices, holding all else equal

Law of Demand

States that the quantity of a good demanded decreases when the price of this good increases

Willingness to Pay

The maximum price that the buyer is willing to pay for an additional unit of the good

Diminishing Marginal Benefit

As you consume more of a good, your willingness to pay for an additional unit declines

Market Demand Curve

1. The sum of the individual demand curves of all the potential buyers

2. The Market Demand Curve plots the aggregate quantity of a good that consumers are willing to buy at different prices, holding all else equal

Demand Function

Know Demand Function (Q = f(Px,Py,I,H)

If the change increases the willingness of consumers to acquire the good

The demand curve shifts right

If the change decreases the willingness of consumers to acquire the good

The demand curve shifts left

Quantity Supplied

The amount of a good that sellers are willing to sell at a given price

Supply Schedule

A table that reports the quantity supplied at different prices

Supply Curve

Plots the quantity supplied at different prices

Law of Supply

States that the quantity of a good offered increases when the price of this good increases

Willingness to Accept

The lowest price a seller is willing to get paid to sell an extra unit of good.

Shifts of the Supply Curve occur when one of the following changes

Input prices, technology or government regulations, number and scale of sellers, producer expectations

Supply Curve Equation

Q = f(Px,W,H)

If the change increases the willingness of producers to offer the good at the same price

the supply curve shifts right

If the change decreases the willingness of producers to offer the good at the same price

the supply curve shifts left

Determinants of Demand

1. Income or Wealth (inferior vs normal good)

2. Prices of Related Goods (subs vs complements)

3. Consumer Preferences (Advertising and Consumer Tastes and Preferences)

4. Number of Buyers

5. Consumer Expectations about the Future

Market Supply Curve

Plots the relationship between the total quantity supplied and the market price, holding all else equal

Shifts of the Supply Curve occurs when one of the following changes

1. Input Prices

2. Technology or Government Regulations

3. Number and scale of sellers

4. Producer expectations

5. Substitutes of Production, Complements of Production.

How does an increase in the price of a good affect the quantity?

An increase in the price of a good results in an increase of the quantity supplied

How does an increase in the price of inputs affect the quantity?

An increase in the price of the inputs results in a shift to the left of the supply curve

How does an increase in the price of a good affect the demand?

An increase in the price of a good results in an decrease in the quantity demanded

How does an increase in the price of a substitute good affect the demand?

An increase in the price of a substitute good results in an increase in demand of the other good

How does an increase in the price of a complement good affect the demand?

An increase in the price of a complement good results in a decrease in demand of the other good.

Competitive Equilibrium

1. It is a price such that, at this price, the quantities demanded and the quantities supplied are the same

2. The point at which the market comes to an agreement about what the price will be and how much will be exchanged at that price

Excess Demand

Occurs when consumers want more than suppliers provide at a given price (results in a shortage)

Excess Supply

Occurs when suppliers provide more than the consumers want at a given price (results in a surplus)

Macroeconomics

Study of economic aggregates and economy-wide phenomena like:

1. Annual growth rate of a country's total economic output

2. Annual percentage increase in the total cost of living

Income per Capita

The average income per person in a country

Recession

Defined as two straight quarters in which aggregate income falls

Unemployment

1. Does not have a job

2. Has actively looked for jobs over the last four weeks

3. Is currently available for work

Unemployment Rate

The fraction of the labor force that is unemployed

National Income Accounts

A measure of the level of aggregate economic activity in a country

National Income and Product Accounts (NIPA)

The system of national income accounts used in the United States

Aggregate Economic Activity in a country can be measured in three ways

1. Production Approach

2. Expenditure Approach

3. Income Approach

Labor Income

Compensation of employees includes the wages, salaries, fringe benefits, social security contributions, and health and pension plans

Capital Income

Rent, Interest, Proprietor's Income, Corporate Profits

Proprietor's Income

Income of incorporated business, sole proprietorships, and partnerships

Corporate Profits

Income of the corporations' stockholders whether paid to stockholders or reinvested

Expenditure Approach

GDP = C+I+G+(X-M)

Production Approach

Calculated by summed the value of sales of goods and adjusting (subtracting) for the purchase of intermediate goods to produce the goods sold (Value added and Final Goods Approach)

Income approach

Calculated by adding up the factor incomes to the factors of production in the society

What fraction of income is paid to labor, and what fraction is paid to capital.

In the United States, labor receives about two-thirds of total income, and capital receives about 1/3 of total income.

Gross Domestic Product (GDP)

The market value of the final goods and services produced within the borders of a country during a particular time period

How is GDP an inaccurate measure of the economy?

1. It omits depreciation of the physical capital stock and resources

2. It excludes home production of cleaning, cooking, and child care done in the household

3. It doesn't capture transactions conducted in the underground economy

4. It doesn't count negative externalities such as pollution, noise, and crime

5. It does not record leisure

Do all these limitations mean that GDP is a poor measure of well-being of an economy?

There is a positive relationship between income per capita and various measures of standards of living.

Does GDP include production by U.S. workers and U.S. capital abroad?

No

Gross National Product (GNP)

Records production of domestically owned labor and capital in the US and abroad. GNP = GDP + Net income inflow from abroad - Net income outflow to foreign countries.

Nominal GDP

The total value of production using current market prices to determine the value of each unit that is produced. Use quantities of that year with prices of that year to calculate nominal GDP.

Real GDP

The total value of production using market prices from a specific base year to determine that value of each unit that is produced. Use quantities of that year with prices of a base year to calculate Real GDP.

Real GDP Growth Rate

is the growth rate of the Real GDP. [((Real GDP Year y)- (Real GDP Year x))/(Real GDP Year x)]x100

GDP Deflator

1. Measure of how prices of new goods and services produced in a country have risen since the base year

2. GDP Deflator = (Nominal GDP)/(Real GDP) x 100

Consumer Price Index (CPI)

1. The price level of a particular basket of consumer goods and services

2. CPI = (cost in current year)/(cost in base year) x 100

Inflation Rate

The percentage change in a price index

Income Per Capita/GDP per capita

GDP/Total Population

Nominal Exchange Rate

The price of one country's currency in units of another country's currency

Purchasing Power Parity (PPP)

Constructs the cost of a representative basket of commodities in each country and uses the relative cost of these baskets for comparing income across countries

GDP per capita

GDP divided by total population

GDP per capita =

GDP per capita in local currency * PPP adjustment

When to use GDP per capita vs GDP per worker

GDP per capita to look at living standards of an economy.

GDP per worker to look at productivity between countries.

Big Mac Index

(GDP in local currency) * (cost of Big Mac in US $)/(cost of Big Mac in local currency)= PPP: this is a simple example of a basket to create a PPP ratio.