locked econ test

Tax on a good effect

A tax raises the price buyers pay, lowers the price sellers receive, and reduces the quantity sold.

Removing a tax on a good

Works like a reduction in production cost: supply increases, quantity rises, and price falls.

What happens in the beer market when there is no tax?

The price buyers pay equals the price sellers receive, and the market produces the equilibrium quantity with no deadweight loss.

What does a $2 tax do in the beer market?

It creates a $2 wedge between the price buyers pay and the price sellers receive, reduces the quantity sold, and transfers part of surplus to the government as tax revenue.

Luxury car $500 tax incidence

Price paid by consumers rises by less than $500 because tax burden is shared between buyers and sellers.

Deadweight loss from a tax

The loss of total surplus (triangle between supply and demand) due to quantity falling below the efficient level.

Tax wedge definition

The difference between the price buyers pay and the price sellers receive, equal to the tax per unit.

Consumer surplus definition

The area below the demand curve and above the price; equals willingness to pay minus price actually paid.

Producer surplus definition

The area above the supply curve and below the price; equals price received minus sellers' costs.

Efficient allocation definition

An allocation that maximizes total surplus (consumer surplus + producer surplus).

Equilibrium and deadweight loss

At competitive equilibrium, total surplus is maximized and there is no deadweight loss.

What happens to consumer surplus when a freeze reduces the lemon supply?

Consumer surplus falls because the price rises and fewer lemons are sold.

How does a rise in lemon prices affect the lemonade market?

Higher input costs reduce lemonade supply, raising price and reducing consumer surplus.

What happens to producer surplus when demand for French bread increases?

Producer surplus rises because the higher price and larger quantity sold increase sellers’ gains.

How does increased French bread production affect flour producers?

Flour demand rises, increasing the price of flour and raising producer surplus for flour sellers.

Positive externality example

Fire extinguishers or restored historic buildings, which benefit others beyond the buyer.

Negative externality example

Pollution, barking dogs, or drunk driving, which impose costs on bystanders.

Coase theorem

If private parties can bargain at low cost, they can solve externality problems without government intervention.

Corrective tax definition

A tax designed to induce private decision makers to take account of the social costs of a negative externality.

Why corrective taxes beat regulation

They give continuous incentives to reduce pollution and allow firms flexibility in how to respond.

Fire extinguishers positive externality

They protect not only the owner's property but also neighbors' property from fire.

Fire extinguisher market vs efficient quantity

Market quantity is below the efficient quantity because social value exceeds private value.

Policy for $10 external benefit per extinguisher

A $10 subsidy per extinguisher shifts demand up to the social‑value curve and yields the efficient quantity.

Excludable good definition

A good where people can be prevented from using it (e.g., pizza, education).

Rival in consumption definition

A good where one person's use diminishes others' ability to use it (e.g., pizza, fish in the ocean).

Public good definition

A good that is non‑excludable and non‑rival (e.g., national defense).

Why private market underprovides public goods

People can free‑ride because they cannot be excluded, so the good is underproduced.

Common resource definition

A good that is rival but not excludable (e.g., fisheries, congested city streets).

Overuse of common resources

People use them too much because they ignore the cost their use imposes on others.

Police protection classification

Often a club good (excludable, not rival) or private good if capacity is limited.

Snow plowing classification

Common resource: once a street is plowed, it's hard to exclude, but plowing one street means not plowing another.

Education classification

Private good (excludable and rival) with positive externalities.

Rural roads classification

Typically public goods: non‑excludable and non‑rival when uncongested.

City streets classification

Common resources when congested; public goods when uncongested.

Why government provides non‑pure public goods

Because of positive externalities (e.g., education) that markets underprovide.

Financial system role

Matches one person's saving with another person's investment.

Bond market definition

Market where large corporations or governments borrow by issuing bonds.

Stock market definition

Market where corporations sell ownership shares (stock).

Financial intermediaries examples

Banks (take deposits, make loans) and mutual funds (sell shares and buy diversified portfolios).

Importance of diversification

Reduces risk by replacing a single risk with many smaller, unrelated risks.

Why diversify holdings

A single asset is riskier than a diversified portfolio; diversification reduces overall risk.

Government budget deficit effect

Reduces national saving, raises interest rates, crowds out private investment, and slows economic growth.

Higher interest rate bond comparison: U.S. vs Eastern Europe

Eastern European government bond pays higher interest due to greater default risk.

Higher interest rate: 2030 vs 2050 bond

The 2050 bond pays a higher rate because of its longer term and greater risk.

Higher interest rate: Coca‑Cola vs garage software company

The garage software company bond pays higher interest due to higher credit risk.

Higher interest rate: federal vs New York State bond

Federal bond pays higher interest because New York State bonds are exempt from federal income tax.

Why firms encourage employees to hold company stock

Aligns employees' incentives with firm profits; they benefit when the firm does well.

Why employees may avoid holding employer stock

It is undiversified risk: if the firm fails, they can lose both their job and their investment.

Interest rate rise effect on Intel borrowing decision

Higher interest rates increase borrowing costs, making the factory less likely to be profitable and less likely to be built.

If Intel isn’t borrowing, why do higher interest rates still matter?

Still matters because of opportunity cost: Intel could instead buy bonds and earn the higher interest rate.

Present value definition

The amount of money today that would be needed, at a given interest rate, to produce a given future amount.

PV of $200 in 10 years at 7%

$200 / (1.07)¹⁰ ≈ $101.67.

PV of $300 in 20 years at 7%

$300 / (1.07)²⁰ ≈ $77.53.

Preferred: $200 in 10 years vs $300 in 20 years at 7%

$200 in 10 years, because its present value is higher.

Diversification benefit: 1→10 vs 100→120 stocks

Greater benefit from going from 1 to 10 stocks than from 100 to 120.

Stocks vs bonds risk and return

Stocks have more risk and therefore pay a higher average return than government bonds.

Why stocks are riskier than bonds

Stock value depends on uncertain future profits; bondholders have prior claim on assets if firms fail.

Risk-return relationship

There is a positive relationship between risk and expected return.

Efficient markets hypothesis (EMH)

Stock prices reflect all available information, so you cannot systematically use current information to predict future price changes.

Evidence for Efficient Mark Hypothesis

Many index funds outperform actively managed mutual funds run by professional managers.

Fundamental analysis definition

The process of studying a company's accounting statements and future prospects to determine its value.

Goal of fundamental analysis

To determine the true value of a company's stock.

Bond price sensitivity to interest rate changes

Bond values fall when interest rates rise, and long‑maturity bonds are more sensitive to interest rate changes.

Rule of 70 for doubling

At 3.5% interest, a value doubles in about 20 years; at 7%, in about 10 years.

Effect of interest rate increase on long vs short bonds

Longer‑maturity bonds experience a larger percentage price drop when interest rates rise.

Risk of stock sensitive to economic conditions

A stock very sensitive to economic conditions has more risk and must pay a higher expected return.

Firm‑specific risk definition

Risk that affects only a particular company (e.g., a competitor entering the market).

Market risk definition

Risk that affects all companies in the market (e.g., a recession).

Higher return demanded due to firm‑specific risk

Shareholders will likely demand a higher return for a stock with greater firm‑specific risk.