MicroEconomics Final

Economics

the science of how individuals make choices under scarcity

Scarcity

the concept that there is less of something freely available from nature than people would like

Rationing

allocates scarce goods to those who want them

Capital

human made resources used to produce other goods and services

Trade-offs

made due to resources being scarce

Opportunity Cost

the highest valued alternative that must be sacrificed when choosing an option

Utility

the subjective benefit or satisfaction a person expects from a choice or course of action

Law of Diminishing Marginal Utility

as consumption increases, the marginal utility derived from each additional unit declines

Cost-Benefit Analysis

when making a decision one compares the marginal benefits and the marginal costs

Secondary Effect

the indirect impact of an event or policy that may not be easily and immediately observable

Positive Economics

the scientific study of what is (TESTABLE)

Normative Economics

judgements about what ought to be (NOT TESTABLE)

Ceteris Paribus

all other things held constant

Nirvana Fallacy

The logical error of comparing the actual situation with its idealized counterpart rather than the alternative

Mircroeconomics

focuses on how human behavior affects the conduct of affairs within individually defined units such as households or firms

Macroeconomics

Focuses on how human behavior affects outcomes in highly aggregated markets such as the nations market for labor

Pitfalls to Avoid in Economic Thinking

1. Violation of the ceteris paribus principle

2. the belief that good intentions guarantee desirable outcomes

3. the belief that association is causation

4. fallacy of composition: the fallacious belief that what is true for one is true for all

How trade creates value

• When individuals engage in a voluntary exchange, both parties are made better off.

• By channeling goods and resources to those who value them most, trade creates value and increases the wealth created by a society's scarce resources

Reasons why trade leads to economic progress

• gains from specialization and division of labor

• gains from mass production methods

• gains from innovation

Creation of Wealth

the process by which people become rich in a market economy will make the economic pie bigger

Transaction Costs

the time, effort, and other resources needed to search out and complete an exchange (do not include paid price)

Middleman

a person or business that buys and sells goods and services or arranges trades- reduces transaction costs

Private property rights

• the right to exclusive use of the property

• legal protection against invasion from other individuals

• the right to sell, transfer, exchange, or mortgage the property

Incentives Created by Property Rights

1. to use resources in ways that are considered beneficial to others

2. to care for and manage what they own

3. to conserve for the future

4. to make sure their property does not damage your property

Production Possibilities Curve (PPC)

1. fixed amount of productive resources

2. given amount of technical knowledge

3. full and efficient use of resources

4. conducive institutional environment

Factors that Shift the PPC

1. a change in available resources

2. changes in technology

3. a change in the institutions

4. changes in work habits

Law of Comparative Advantage

The total output of a group of individuals, an entire economy, or a group of nations will be greatest when the output of each good is produced by whoever has the lowest opportunity cost

Three Economic Questions

1. What will be produced?

2. How will it be produced?

3. For whom will it be produced?

Coercion

someone will devote resources to make you worse off if you dont comply

Investment

the purchase, construction, or development of resources

Socialism

A system of economic organization where:

1. ownership and control of the means of production rest with the government

2. resource allocation is determined by centralized planning

Capitalism

A system of economic organization where:

1. productive resources are owned privately

2. goods and resources are allocated through market prices

Collective Decision Making

the method of organization that relies on public sector decision making to resolve basic economic questions

Market Organization

A method of organization in which private parties make their own plans and decisions with the guidance of market prices

Law of Demand

there is an inverse (negative) relationship between the price of a good and the quantity that buyers are willing to purchase
-results in a downward sloping demand curve
-as price increases, quantity demanded decreases

Consumer Surplus

The difference between the maximum amount consumers would be willing to pay and the amount that they pay
-the area below the demand curve but above the price

Change in Quantity Demanded

• a movement along the curve

• caused by a change in price

• increase: movement to the right

• decrease: movement to the left

Change in Demand

• a shift of the curve

• caused by a change in anything that effects the demand other than the price

• increase: curve shifts right

• decrease: curve shifts left

Shifters of Demand

1. Change in consumer income

2. Change in number of consumers

3. Change in the price of a related good

4. Change in expectations

5. Change in consumer tastes and preferences

Law of Supply

There is a direct (positive) relationship between the price of a good or service and the amount that suppliers are willing to provide

Producer Surplus

the difference between the minimum prices that producers are willing to accept for a product and the price they actually receive
- the area above the supply curve but below the price of the good or service

Shifters of the Supply Curve

1. Change in Resource Prices

2. Change in Technology

3. Change in the number of suppliers

4. Change in producer expectations

Market Equilibrium

• A state in which the conflicting forces of supply and demand are in balance

• Occurs where the demand curve intersects the supply curve

Efficient Market Equilibrium

• no excess supply or excess demand

• Excess Supply: QS > QD

• Excess Demand: QD > QS

Invisible Hand Principle

The tendency for people, while pursuing their own self-interests, to promote the economic well-being of society

The Labor Market

• Businesses and entrepreneurs demand resources in order to produce goods and services to sell in the market

• Price for labor is called the wage (W)

• Quantity of labor is called employment (E)

Price Floor

• above the equilibrium creates a surplus

• below equilibrium does nothing

Price Ceiling

• below the equilibrium creates a shortage

• above equilibrium does nothing

Average Tax Rate

tax liability / taxable income

Marginal Tax Rate

change in tax liability / change in taxable income

The Laffer Curve

a curve illustrating the relationship between tax rate and tax revenue

Subsidy

a payment the government makes to either the buyer or seller when a good or service is purchased or sold - are costly

Economic Efficiency

1. all actions generating more benefits than costs should be undertaken

2. no actions generating more costs than benefits should be undertaken

Lack of Competition

With no competition, a firm can provide lower quantities and raise prices
Firms make larger profits while customers pay higher prices for fewer goods

Negative Externality

harmful side effect that affects an uninvolved third party
ex.- loud music in apartment building

Positive Externality

beneficial side effect that affects an uninvolved third party
ex.- immunizations

Free-Rider

A person who receives the benefit of a good without paying for it
This will cause the good to become under- supplied

4 types of market failure

1. lack of competition

2. externalities

3. public goods

4. lack of information

Law of Marginal Utility

As the consumption of a product increases, the marginal utility derived from additional consumption will eventually decline

Price elasticity of demand

%∆QD / %∆P

Inelastic

• describes demand that is not very sensitive to price changes

• The price effect dominates - Increasing price increases total revenue

Elastic

• describes demand that is very sensitive to a change in price

• The quantity effect dominates - Increasing price decreases total revenue

• more substitutes available

Normal Good

positive income elasticity

Necessity Good

income elasticity between 0 and 1

Luxury Good

income elasticity is greater than 1

Inferior Good

negative income elasticity

Residual Claimants

Individuals who personally receive the excess of revenues over costs
They have the incentive to increase revenues or reduce costs

Principle-Agent Problem

The incentive problem that occurs when the purchaser of services lacks full information about the circumstances faced by the seller, and therefore, cannot knowhow well the seller performs the service

Explicit Costs

the payments a firm makes to purchase the goods and services of productive resources

Implicit Costs

The opportunity costs associated with the firm's use of resources that it owns

Economic Profit

The difference between the firm's total revenue and its total costs (including both explicit and implicit costs)

Accounting Profit

The sales revenue minus the expenses of the firm (does not usually include implicit costs)

Normal Profit Rate

Zero economic profit, the competitive rate of return on the capital and labor of the owners

Short Run

A period so short that a firm is unable to vary some of its factors of production.

Long Run

period long enough to allow the firm to vary all its factors of production

Law of Dimininishing Returns

As more and more units of a variable resource are applied to a fixed number of other resources; output will eventually increase by smaller and smaller amounts

Average Total Cost

u-shaped graph

Average Fixed Cost

falls with output

he Long Run Average Total Cost Curve (LRATC)

Shows the minimum average cost ofproducing each output level when the firm is free to choose among all possible plant sizes

Economies of Scale

Occurs when the firm's per-unit costs decrease as output increases (the left of the LRATC)

Diseconomies of Scale

Occurs when the firm's per-unit costs increase as output increases (the right of the LRATC)

Sunk Costs

costs that have already been incurred as a result of a past decision- should be ignored

Price Takers

The sellers who must take the market price in order to sell their product

Price Searchers

Firms that choose the price they charge for their product, but the quantity they are able to sell is inversely related to price

Characteristics of Price Taker Markets

1. there are many firms in the market

2. Each firm produces identical products

3. Their output is small relative to the total market

4. They can sell all of their output at the market price

5. There are no barriers to entry or exit of firms in the market

Barriers to Entry

Obstacles that limit the freedom of potential rivals to enter and compete in an industry or market

Profit Maximizing Rule

MR=MC

• a firm should produce when MR > MC

• a firm should never produce when MC > MR

Economic Profit

If MR \= MC occurs above the ATC curve

Economic Loss

If MR \= MC below the ATC curve

Entry and Exit in the Long Run

1. If firms are making an economic profit: new firms will enter and drive price down

2. If firms are making an economic loss: firms will leave the market and drive price up

Competitive Price Searcher

1. Has low barriers to entry

2. Faces a downward sloping demand curve (because they produce differentiated products)

Long Run Equilibrium

When firms in a price searcher market make an economic profit (loss), new firms will enter(exit) and drive price down (up) by shifting demand.
In the Long-run, firms will make zero economic profit.

Contestable Market

1. Prices above the level necessary to achieve zero economic profits will not be maintained

2. The costs of production will be kept to a minimum

Price Discrimination

1. Identify and separate at least two groups with different elasticities of demand

2. Prevent those who buy at the low price from reselling to those who buy at the high price

Bundling

The sale of two or more goods and services together

Tying

The act of making the purchase of one good conditional on the purchase of a second good

What causes high barriers to entry?

1. Economies of scale

2. Government licensing and other legal barriers to entry

3. Patents

4. Control over an essential resource

Monopoly

• High barriers to entry

• A single seller of a well-defined product that has no good substitutes

Oligopoly

market that consists of a small number of sellers

1. A small number of rival firms

2. Interdependence among the sellers

3. High barriers to entry in the market

Game Theory

The analysis of strategic choices made by competitors in a conflict situation