Econ Midterm 1

Economics

Economics studies how people make decisions under resource constraint

• how people allocate their limited resources to satisfy nearly unlimited wants

Microeconomics

the study of the individual units that make up the economy like households & businesses

Macroeconomics

the study of the overall aspects and workings of an economy such as inflation, growth, employment, interest rates and the productivity of the economy

5 foundations of economics

1. Incentives

2. Trade-offs

3. Opportunity cost

4. Marginal thinking

5. Trade creates value

Incentives

• The factors that motivate you to act or exert effort

• What pushes people?

• they are used to affect how people respond

Positive Incentive

• encourage action by offering rewards or payments

• Ex: extra credit for participating in class

Negative Incentive

• discourage action by providing undesirable consequence or punishments

  • Ex: going to jail for stealing candy from a store like laws

Direct Incentives

• quid pro quo

• Ex: giving a kid a gift if they get straight A’s

Indirect Incentives

• a secondary change in behavior brought on by the original incentive

• Ex:cheating on a test in order to keep all A’s

Unintended Consequences

an unplanned result (usually negative and unwanted) of an incentive

• policymakers have to figure out how to balance the benefits brought on by policy with potential unintended consequences

Trade-Offs

• b/c of scarce resources, people have to choose some things over others

• doing one thing often means you will not have the time, resources, or energy to do something else

  • every decision incurs a cost

Opportunity Cost

• the highest valued alternative that must be sacrificed to get something else

  • “what or how much is being given up?”

• the best possible decision is the one that minimizes the opportunity cost

Economic Thinking

• a purposeful evaluation of the available opportunities to make the best decision possible

Marginal Thinking

• evaluating whether the benefit of one more unit of something is greater than its cost

Marginal benefit

• additional benefit derived from extra unit

Marginal cost

• additional cost incurred from extra unit

Rational

• decisions are made based on the optimal benefits or utility

What facilitates trade?

Markets buy bringing buyers and sellers together to exchange goods and services

Circular Flow Diagram

shows how goods, services and resources flow through the economy

How does the circular flow diagram works?

• households buy goods and services from firms in product markers (Ex:when you buy groceries)

• households are also sellers by the input they provide or resources that firms use to produce their outputs. This takes place in resource markets (Ex: when you put in time at your job and get a paycheck in return, resource market transaction)

• The circular flow of goods and services appears as the red inner loop

• The circular flow of funds to purchase goods and services appears as the green outer loop

Trade

• the voluntary exchange of goods and services between two or more parties

What are the benefits of trade?

• trade creates value

• trade fosters exchange of goods and promotes specialization

Comparative advantages

• the situation in which an individual, business, or country can produce at a lower opportunity cost than a competitor

• harnesses the power of specialization

Positive Statement

• can be tested and validated

• describes “what is”

  • Ex: income in the U.S. has been increasing

Normative Statement

• an opinion that cannot be tested or validated

• describes “what ought to be”

  • Ex: the U.S. should send foreign aid to other countries

Ceteris Paribus assumption

• allows the economists to study the effect of changing one variable while holding everything else constant

• central assumption in model building

Types of factors

• Endogenous factors: variables that can be controlled for inside a model

• Exogenous factors: variables that cannot be accounted for in a model

What makes a model more realistic?

as more exogenous variables are added into the model(making them endogenous), the more realistic the model becomes

Danger of faulty assumptions

• we do not want to leave any important assumptions out of the model but we also don’t want to include faulty ones

• faulty assumptions could lead to poor economic decisions

Production Possibilities Frontier (PPF)

• model that shows the combinations of outputs a society can produce if all of its resources are being used efficiently (describes producing capabilities)

• Assumptions: (allows us to model trade-offs more clearly)

  • technology is fixed

  • quantity of resources fixed: affects the ability to produce

  • society produces only two goods

Downward sloping of PPF

• must give up one good to increase production of another

• The slope of the PPF will equal to the negative value of the opportunity cost of the producing good Y in terms of good X

When are resources being used in the most efficient way along the PPF?

at any point on the PPF slope

When are resources being used in an inefficient way along the PPF?

any point inside of the PPF slope

When are resources impossible along the PPF?

any point outside the PPF slope

The Law of Increasing Opportunity Cost

• the opportunity cost of producing a good rises as society produces more of it b/c resources are not all the same

• changes in relative cost mean that a society faces a significant trade-off if it tries to produce an extremely large amount of a single good

• effect on PPF:

  • the slope will get steeper as we move left to right

Economic Growth

• the process that enables a society to produce more output in the future

• shown by an outward shift

• Factors:

  • new resources

  • technology

Movement along the PPF curve

• the slope will get steeper as we move left to right

• as we move from left to right on PPF slope, the gain in producing good X becomes smaller while the gain in producing good Y increases

Movement of the PPF curve

• upward shift of PPF indicates economic growth of good X or good Y

• outward and upward shift of PPF indicates economic growth for good X and Y

Specialization

• the limiting of one’s work to a particular are

• Assumptions:

  • tech is fixed

  • quantity of resources fixed

  • society produces only two goods

  • two people have different abilities in the production of two goods

Absolute Advantage

• one producer’s ability to make more than another producer with the same quantity of resources

Comparative Advantage

• the ability to make a good at a lower opportunity cost than another producer

What does the difference in producers’ ability to produce goods allow?

it allows them to specialize in what they have a comparative advantage in and trade for other goods that they want

What is the effect of specialization and trade?

It causes each person to consume more than they otherwise could have

Trade off in the short run

• the period in which we make decisions that reflect our immediate or short-term wants, needs or limitations

• consumers can only partially adjust behavior

Trade off in the long run

• the period in which we make decisions that reflect our needs, wants, and limitations over a long-term horizon

• consumers have time to fully adjust to market conditions

Consumer goods

• good produced for current consumption

• Ex: food

Capital goods

• goods that help produce other valuable goods

• Ex: factories

Investments

• using resources to create or buy new capital

What is the benefit of investing in capital goods instead of producing consumer goods?

• it allows an economy to expand its PPF in the future

• the more capital goods are produced, the more the ppf will expand in the long run

Human Capital

• Ex: going to college, acquiring new skills

Market

• the place where trade happens

• where buyers and sellers meet (doesn’t have to be a physical place)

• the buyer creates the demand for produce while the sellers produce the supply

Firms

• supply goods or services

Consumers

• purchases goods supplied by firms

How does exchange happen?

• it happens through prices established in markets

• supply or demand factors can change the market price

What are the fundamentals of market?

• market economy:

  • resources are allocated among households and firms with little or no government interference

  • producers and economy are motivated by self-interest

  • the invisible hand of the market guides resources to their hight-valued use

    • although no party has no intention to promote market efficiency, self-interest will eventually push the market to reach the nest outcome

Characteristics of a competitive market

• many buyers and sellers

• the goods sold by each vendors are similar

• no one individual has any influence over the price

  • b/c there are many buyers and sellers they each have only a small impact on the market price and output

  • the price and quantity sold of a good are determined by the market rather than by any one person or business

Imperfect markets

• markets in which the buyer or sellers has an influence on the price

Market power

• a firm’s ability to influence the price of goods or service

  • how?

    • by exercising control over its demand, supply or both

Monoply

• a single company that supplies the entire market for a good or service

Quantity demanded

• the amount of a good buyers are willing and able to produce at the current price

The law of demand

• all else equal, there is an inverse relationship between price and quantity demanded

  • increase in price, decrease in quantity demanded

  • decrease in price, increase in quantity demanded

demand schedule

• table showing the relationship b/w price and quantity demanded

demand curve

• graph of the relationship between price and quantity demanded

market demand

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

Calculating market demand

sum of quantity demanded from both factors

Change in quantity demand

• movement along a demand curve

• caused by a change in the price of the good

• different point on the same demand curve

Movement along the curve

• change in quantity demand

• higher point to lower point = decrease in price

• lower point to higher point = increase in price

Change in demand

• shift of the demand curve.

  • entire demand curve will shift to the left or right

• caused by changes in non price factors

• different demand curves move to the left or right

Increase in demand

shift to the right

decrease in demand

shift to the left

Factors that change demand

1. income change

2. price of related good

3. preference change

4. expected price

5. government interventions

6. increased/decreased buyers

Change in demand: Income change

• increase in income, able to buy more

  • normal good: good we buy more when we get more income

    • when income increases producers will buy more of a normal good

    • ex: meal at a restaurant

  • inferior good: good we buy less of when we get more income

    • when income increases producers will buy less of a inferior good

    • ex: buying filet mignon instead of ramen noodles

Change in demand: price of related goods

• complements: two goods used together

  • when the price of one of the complements rise, the quantity demanded of one of the complements goes down thus the demand for its complement also goes down

• substitutes: goods that can be used in place of each other

  • when the price of the substitute good increases, the quantity demanded declines this the demand of the alternate demand increases

Change in demand: preference change

• a good may become more fashionable or may go out of style

• a good may come into or go out of season

Change in demand: price expectations

• if we expect a price to be higher tomorrow, we are likely to buy more today to beat the price increase = an increase in current demand

• an expectation of a lower price in the future = a decrease in current demand

Change in demand: number of buyers

• b/c market demand curve is the sum of all individual demand curves

• more individual buyers = more market demand

• less individual buyers = less market demand

Change in demand: Taxes and subsidies

• excise taxes: taxes on a single product or service

• sales taxes: general taxes on goods and services

  • higher taxes = lower demand b/c consumers now pay the higher tax in addition to good

  • lower taxes = higher demand

• subsidies(tax break) encourages consumers to purchase more of the subsidized good

When is a shortage and surplus reflected?

• shortage: quantity demanded > quantity supplied

• surplus: quantity demanded < quantity supplied

Factors the shift demand to the left (decrease in demand)

1. income falls (demand for a normal good)

2. income rises (demand for an inferior good)

3. the price of a substitute good falls

4. the price of a complementary good rise

5. the good falls out of style

6. there is a belief that the future price of the good will decline

7. the number of buyers in the market falls

8. taxes increase

9. subsidies to consumers decreases

Factors that shift demand to the right (increase in demand)

1. income rises (demand for a normal good)

2. income falls (demand for an inferior good)

3. the price of a substitute good rises

4. the price of a complementary good falls

5. the goo is currently in style

6. there is a belief that the future price of the good will rise

7. the number of buyers in the market increases

8. taxes decrease

9. subsidies to consumers increase

Quantity Supplied

• the amount of the good or service that producers are willing and able to sell at the current price

Law of supply

• all else equal, there is a direct relationship between price and quantity supplied

  • if price decreases, quantity supplied decreases

  • if prices increases, quantity supplied increases

Supple schedule

• table showing the relationship between price and quantity supplied

Supply curve

• graph of the relationship between price and quantity supplied

Market Supply

• horizontal sum of all individual quantities supplied by each seller in the market at each price

Calculating market supply

sum of all the market supply

Changes in quantity supplied

• movement along a supply curve

• cause by a change in the price of the good

• different point on the same supply curve

Changes in supply

• shift in the supply curve

  • entire supply curve will shift to the left or right

• caused by a change in non price factors

• different supply curves move to the left or right

Factors that change supply

1. cost of resources

2. tech changes

3. taxes and subsidies

4. number of suppliers

5. price expectations

Change in supply: the cost of inputs

• inputs: resources used in the production process

• cost of input decline, profit improves, increase in supply

• cost of input increase, profit decines, decrease in supply

Change in supply: technological changes

• new and improved tech, increase in supply

Change in supply: taxes and subsidies

• taxes:

  • taxes add cost to production = lower profits thus less supply

• subsidies:

  • subsidies reduce cost to production = increase profits thus increase supply

Change in supply: number of firms in the industry

• more individual sellers mean more market supply

• less individual sellers mean less market supply

Change in supply: Price expectations

• the price of the product is anticipated to rise in the future, there is a decrease in supply

• the price of the product is expected to fall in the future, there is an increase in supply

Factors that shift the supply curve to the left (decreases supply)

1. the cost of an input rises

2. business taxes increases

3. subsidies decreases

4. the number of sellers decreases

5. the price of the product is anticipated to rise in the future

6. capital or resource destruction

Factors that shift supply to the right (increase supply)

1. the cost of an input falls

2. business taxes decrease

3. subsidies increase

4. the number of sellers increases

5. the price of the product is expected to fall in the future

6. the business deploys more efficient technology

How is surplus and shortage represented?

• surplus: quantity supplied > quantity demanded

  • price will fall over time toward equilibrium

• shortage: quantity supplied < quantity demanded

  • price will rise over time toward equilibrium

How is the price of a good determined?

• through the market forces of supply and demand

Law of supply and demand

• the market price of any good will adjust to bring the quantity supplied and quantity demanded into balance

The point of equilibrium

• where the demand curve and the supply curve intersect