Econ 102 Midterm 2

What does economics study?

Production and trade — a social order, a coordinated system.

What is a “society,” in the economics sense?

A group of people who have moral, political, or economic relationships with each other.

What is a “social system”?

A set of rules that determine the role of physical force in human relationships.

What is spontaneous order?

Order that's a product of human action, not human design — no one is in charge of the entire process.

What does the pencil example (“I, Pencil”) illustrate?

No one person can make a pencil entirely from scratch — its materials come from many uncoordinated people, showing spontaneous order.

How does microeconomics relate to macroeconomics?

Microeconomics IS economics — the core framework. Macro is a subfield focused on money, banking, and economic growth.

What is positive analysis?

Analysis that attempts to describe the way things are in reality.

What is normative analysis?

Analysis that describes a value judgment.

Is economics a positive or normative science?

Positive — though that doesn't mean economists don't care about normative issues, or that economics can't inform normative beliefs.

What is an economic theory?

An abstract explanation of some phenomenon.

What defines a market economy?

A social system in which resources are privately owned and controlled.

What is a property right?

A moral and legal right to control a resource and exclude others from using it, based on consent.

What are the implications of a market economy?

The initiation of force is prohibited, and social interaction is based on consent.

What are some alternate names for a market economy?

Free market system, free enterprise system, laissez-faire capitalism.

What defines a command economy?

A social system in which resources are collectively owned or controlled, typically through government.

What are the implications of a command economy?

Resource allocation is managed by a planning agency, and social interaction isn't voluntary — there's an explicit or implicit threat of force to compel compliance.

What is socialism?

Collective ownership/control of the means of production — includes communism, democratic socialism, fascism/national socialism, and syndicalism.

What is a mixed economy?

A social system where some resources are privately owned/controlled and some are owned/controlled by government.

What is scarcity (exact definition)?

The amount of goods available is not sufficient to satisfy all human desires.

What is the “unlimited desires” starting point?

No matter one's current circumstances, it's always possible to imagine and achieve a more desirable state of affairs.

Do “need” and “want” differ in kind?

No — only in degree. A need is just a very high-priority want.

What is methodological individualism?

The principle that the individual human being is the basic unit of research in the social sciences.

What is “rational choice,” as a starting point of economics?

People pursue their values — they're goal-directed, self-interested, and respond to incentives.

Does “rational choice” mean people only care about themselves?

No — there's a difference between rational and moral; economics just takes people's values as given. Rational people can still make mistakes.

What is the price system?

A network of interrelated prices of goods and services.

What was the Exchange of Equivalents Theory (4th c. BC), and why was it wrong?

The theory that people trade one good for another when both value the goods equally. Wrong — each side must value what they're getting more than what they give up; value is subjective.

What was the Just Price Theory (8th c. AD)?

The theory that there's a single “just” price at which each good should be sold — wrong, because value is subjective.

What did mercantilists (17th c. AD) believe?

That social order requires government planning, that money itself constitutes a nation's real wealth, that exchange is a zero-sum game, and that there's a “public interest” separate from actual individuals' interests.

What's the difference between nominal and real value?

Nominal value is the face value of money. Real value is the goods/services that money can actually purchase.

What is a zero-sum game, and why is it a flawed view of exchange?

A situation where for one party to gain, another must lose. Refuted by mutually beneficial exchange — a trade that benefits both parties.

Who is credited with founding economic science, and when?

Adam Smith (1723–1790), with The Wealth of Nations in 1776.

What is the “invisible hand”?

Adam Smith's metaphor for the power of individual self-interest to create spontaneous order.

What is the subjective theory of price?

The theory that a good's price is determined by its utility.

Did the classical economists accept the subjective theory of price?

No — they rejected it, largely because of the Water-Diamonds Paradox.

What is the Water-Diamonds Paradox?

Water is very useful but has a low price, while diamonds aren't very useful but have a high price — a problem for any theory that says utility alone sets price.

What did the classical economists propose instead of the subjective theory of price?

The Labor Theory of Value — that a good's price is determined by its cost of production / the labor used to produce it.

What are the four problems with the Labor Theory of Value?

(1) No objective way to measure labor, (2) labor itself already has a price (a wage), (3) it's a theory of intrinsic value, and (4) it ignores the context of the exchange.

What is the Iron Law of Wages?

The theory that the price of labor is set by the cost of human subsistence and reproduction — an attempt to patch problem #2 of the labor theory, but it leads to infinite regress.

What is the Intrinsic Value Theory, and why is it wrong?

The theory that an object's value is inherent in the object itself. Wrong, because value is subjective.

What finally resolves the Water-Diamonds Paradox?

Carl Menger's Marginal Revolution (1870s) — price is set by an object's marginal utility, not its total utility or its labor cost.

Who were the three “marginal revolutionaries,” and where were they from?

Carl Menger (Austria), William Stanley Jevons (England), and Léon Walras (Switzerland) — all around 1871–1874.

What is a “good,” per Carl Menger?

A useful thing that is subject to human control.

What are Menger's four requirements for something to be a good?

(1) A human need must exist, (2) the object has properties that satisfy that need, (3) humans know of this causal connection, and (4) humans have sufficient control over the object to use it.

What is a consumer good (first-order good)?

A good that serves our desires directly.

What is a producer good (higher-order good)?

A good that is used in the production of another good.

What is the “structure of production”?

The set of steps by which producer goods are used to produce a consumer good.

What is the theory of derived demand?

The value of higher-order goods is derived from the value of the corresponding lower-order goods they help produce.

In the wheat example, what are the orders of goods?

Wheat (3rd order) → flour (2nd order) → bread (1st order).

What does “value comes from us” mean, in Menger's framework?

We value the end good (like bread or a car), and that's what makes the raw materials and labor behind it valuable — not the other way around.

What does “marginal” mean?

At the edge.

What is a marginal unit?

The next unit gained or given up.

What is marginal utility?

The additional utility a person gets from having one more unit of a good, or loses from having one less.

What does the Theory of Marginal Utility say determines price?

A good's price is determined by its marginal utility — not its total utility, and not labor.

What is an ordinal ranking?

A list of uses for a good in order of preference.

In the desert/buckets example, what sits “at the margin”?

The line between your satisfied uses (drinking, plants, shower…) and your unsatisfied ones (plant roses, goldfish) — it shifts as you gain or lose buckets.

What is opportunity cost?

The best alternative given up when making a choice.

If you have $1 and buy a Coke, what's your opportunity cost?

The chips you didn't buy.

What is diminishing marginal utility?

As a person acquires more units of a good, the satisfaction from each additional unit is lower than the one before.

What is increasing marginal opportunity cost?

As a person gives up more units of a good, the satisfaction given up with each additional unit is higher than the one before.

What are the four conditions for trade to take place?

(1) The parties have reverse values, (2) both recognize the opportunity for exchange, (3) both have the power to transact, and (4) the benefits outweigh the costs.

Why won't two people trade if they rank the same goods in the same order?

They don't have “reverse values” — there's nothing to gain from swapping if you both prefer the same thing more.

What is the range of indeterminacy?

The range of potential prices for a good, bounded by the highest price a buyer would pay and the lowest price a seller would accept.

What is Menger's definition of the market clearing price?

A price at which anyone who wants to buy or sell can find a willing trade partner.

In the Price Determination Model, who actually sets the price for all traders?

The “marginal” traders — the price is set by the maximum buying price and minimum selling price of the last buyer and seller included in the market.

What happens to the range of indeterminacy as more traders enter a market?

It tends to shrink.

What is quantity demanded?

The amount of a good a person is willing and able to buy at a particular price.

What is the Law of Demand?

Ceteris paribus, there's a negative relationship between a good's price and the quantity demanded.

What does “ceteris paribus” mean?

Holding all other variables constant — “all else equal.”

What is quantity supplied?

The amount of a good a person is willing and able to sell at a particular price.

What is the Law of Supply?

Ceteris paribus, there's a positive relationship between a good's price and the quantity supplied.

What is the market clearing price, in supply-and-demand terms (Marshall)?

The price where quantity demanded equals quantity supplied.

What is the market clearing quantity?

The number of exchanges that take place at the market clearing price.

Why do demand curves slope downward?

Diminishing marginal utility — each additional unit is worth less to you, so you'll only buy more if the price drops.

Why do supply curves slope upward?

Increasing marginal opportunity cost — giving up more of a good costs you more at the margin, so you need a higher price to supply more.

What is comparative statics?

Studying how supply and demand curves shift — a before/after comparison.

Which way does a curve shift for an increase vs. a decrease?

Increase = shift right. Decrease = shift left. (Flagged in your notes as quiz material.)

What's the difference between a change in quantity demanded and a change in demand?

A change in the good's own price moves you along the demand curve (change in quantity demanded, read on the x-axis). A change in any other factor shifts the whole curve (change in demand).

What does the demand function say demand depends on?

QD = f(price, consumer tastes, # of buyers, income, prices of related goods). Everything except price is a demand shifter.

Milk is found to cause cancer. What happens to demand, price, and quantity?

Tastes turn against it: demand decreases (shifts left), so equilibrium price and quantity both fall.

Milk is found to cure cancer. What happens?

Demand increases (shifts right), so equilibrium price and quantity both rise.

What happens to demand when the number of buyers rises (e.g., Dr. Seuss books)?

Demand increases — the curve shifts right.

What is elasticity?

A measure of the responsiveness of one variable to changes in another variable.

What is income elasticity of demand?

The effect that a change in a person's income has on their demand for a certain good.

What is a normal good?

A good for which demand increases when income increases (and decreases when income decreases). Example: steak.

What is an inferior good?

A good for which demand decreases when income increases (and increases when income decreases). Example: instant noodles.

Your income rises. What happens to demand for steak vs. instant noodles?

Steak (normal good): demand shifts right. Instant noodles (inferior good): demand shifts left.

What is cross-price elasticity of demand?

The effect that a change in the price of one good has on the demand for another good.

What are substitutes?

Goods that perform a similar function or satisfy a similar human desire.

What are complements?

Goods that are more valuable when consumed together.

The price of good Y rises, and X and Y are substitutes. What happens to demand for X?

It increases — shifts right, as buyers switch toward X. Example: butter gets pricier, margarine demand rises.

The price of good Y rises, and X and Y are complements. What happens to demand for X?

It decreases — shifts left. Example: milk gets pricier, cereal demand falls.

What does the supply function say supply depends on?

QS = f(price, # of sellers, technology, input prices, per-unit taxes or subsidies). Everything except price is a supply shifter.

What happens to supply when the number of sellers rises (e.g., more doctors)?

Supply increases — shifts right; price falls and quantity rises.

What does better technology do to supply (e.g., a car production line)?

Supply increases (shifts right): equilibrium price falls, quantity rises.

What happens to supply when input prices rise (e.g., steel for cars)?

Supply decreases (shifts left): equilibrium price rises, quantity falls.

What happens to supply when input prices fall (e.g., wood for paper and books)?

Supply increases (shifts right): price falls, quantity rises.

What happens to supply when a disaster destroys capacity (e.g., Hurricane Katrina and gasoline)?

Supply decreases (shifts left): equilibrium price rises, quantity falls.

What is a tax, and what does a per-unit tax do to supply?

Tax: when the government takes money from you when you engage in a certain activity. A per-unit tax raises sellers' costs, so supply shifts left.

What is a subsidy, and what does it do to supply?

Subsidy: when the government gives you money when you engage in a certain activity. It shifts supply right (e.g., electric vehicles) — an incentive to produce more.

If input prices affect product prices, isn't that just the labor theory of value?

No. Input prices are one factor affecting product prices, not the sole determinant, and an input's price is itself determined — remember derived demand: higher-order goods get their value from the lower-order goods they help make.