ECON exam 1

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The study of how human beings coordinate their wants and desires, given the decision-making mechanisms, social customs, and political realities of the society.

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3 central problems of economics:

  1. What, and how much, to produce.

  2. How to produce it.

  3. For whom to produce it.

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Limiting people’s wants and increasing the amount of work individuals are willing to do to fulfill those wants.

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Opportunity Cost

The benefit that you might have gained from choosing the next-best alternative. (Must give up something else).

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Marginal cost

The additional cost to you over and above the costs you have already incurred.

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Sunk costs

Costs that have already been incurred and cannot be recovered.

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Marginal costs

The additional benefit above what you’ve already derived.

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The economic decision rule:

If the marginal benefits of doing something exceed the marginal costs, do it.

If the marginal costs of doing something exceed the marginal benefits, don’t do it.

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Economic forces

The necessary reactions to scarcity (rationing mechanisms).

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Market force

An economic force that is given relatively free rein by society to work through the market.

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Invisible hand

The price mechanism, the rise and fall of prices that guides our actions in a market

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2 elements of scarcity

  • Our wants

  • Our means of fulfilling those wants

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Economic reality is controlled by 3 forces:

  1. Economic forces (the invisible hand)

  2. Social and cultural forces

  3. Political and legal forces.

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Method of analysis that uses a combination of inductive and deductive methods.

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Economic model

A framework that places the generalized insights of the theory in a more specific contextual setting.

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Economic principle

A commonly held economic insight stated as a law or general assumption.-ex: when you learned to add you didn’t memorize 147+138 (you learned a principle of addition).

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Experimental economics

A branch of economics that studies the economy through controlled laboratory experiments.

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Natural experiments

Naturally occurring events that approximate a controlled experiment where something has changed in one place but has not changed somewhere else.

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Propositions that are logically true based on the assumptions in a model.

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Policy rules that conclude that a particular course of action is preferable.

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The Invisible Hand Theorem

A market economy, through the price mechanism, will tend to allocate resources efficiently.

  • When the quantity supplied is greater than the quantity demanded, price has a tendency to fall.

  • When the quantity demanded is greater than the quantity supplied, price has a tendency to rise.

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Achieving a goal as efficiently as possible.

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The study of individual choice, and how that choice is influenced by economic forces.

  • study things like pricing policies of firms, household decisions on what to buy etc

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The study of the economy as a whole.

  • study inflation, unemployment, business cycles, growth

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Economic policies

Actions taken by government to influence economic actions.

  • to carry out economic policy effectively, one must understand how institutions might change as a result of the economic policy

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Positive economics

The study of what is, and how the economy works.

  • explores the pure theory of economics (lots of assumptions)

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Normative economics

The study of what the goals of the economy should be.

  • What should distribution of income be?

  • What should tax policy be designed to achieve?

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Art of economics (political economy)

The application of knowledge learned in positive economics to the achievement of the goals one has determined in normative economics.

  • To achieve the goals that society wants, how would you go about it, given the way the economy works?

  • art of economics is about policy; designed to arrive at precepts (guides for policy)

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Production possibility table

A table that lists a choice’s opportunity costs by summarizing what alternative outputs you can achieve with your inputs.

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A result of an activity.

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What you put into a production process to achieve an output.

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Production possibility curve (PPC)

A curve measuring the maximum combination of outputs that can be obtained from a given number of inputs.

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What does PPC demonstrate:

  1. There is a limit to what you can achieve, given the existing institutions, resources, and technology.

  2. Every choice you make has an opportunity cost. You can get more of something only by giving up something else.

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Slope of PPC

Production Possibility Curves are downward sloping. Most are outward bowed because of increasing marginal opportunity cost; if opportunity cost doesn’t change, the PPC is a straight line.

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The principle of increasing marginal opportunity cost

In order to get more of something, one must give up ever-increasing quantities of something else.

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Comparative advantage

The ability to be better suited to the production of one good than to the production of another good.

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Productive efficiency

Achieving as much output as possible from a given amount of inputs or resources.

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Getting less output from inputs that, if devoted to some other activity, would produce more output. (Inside the PPC so this is bad)

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Achieving a goal using as few inputs as possible. (On the PPC)

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Outside PPC…

Unattainable, given our resources and technology.

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Trade and Comparative Advantage (Adam Smith)

Adam Smith argued that it is humankind’s proclivity to trade that leads to individuals using their comparative advantage.

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Benefits of trade

Both parties benefit from a trade, otherwise why would they be doing it?

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An economic policy of leaving coordination of individuals’ actions to the market.

  • Laissez-faire is not a theorem; it is a precept

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The relocation of production once done in the U.S. to foreign countries.

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The relocation of production done abroad to the U.S.

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Comparative advantage (countries)

If one country has a comparative advantage in producing one set of goods, the other country has to have a comparative advantage in the other set of goods.

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The increasing integration of economies, cultures, and institutions across the world.

  • In a globalized world economies of the world are highly integrated.

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Affects of globalization on firms:

Positive: because the world economy is so much larger than the domestic economy, the rewards for winning globally are much larger than domestically.

Negative: it is much harder to win, or stay in business competing in a global market.

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Exchange rate

The value of a currency relative to the value of foreign currencies.

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The Law of One Price

The wages of workers in one country will not differ significantly from the wages of (equal) workers in another institutionally similar country.

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Law of demand

Quantity demanded rises as price falls, other things constant

  • or Quantity demanded falls as price rises, other things constant

  • ex of “other things constant” = income, taste

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Demand curve

The graphic representation of the relationship between price and quantity demanded.

  • Slopes downward

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A schedule of quantities of a good that will be bought per unit of time at various prices, other things constant.

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Quantity demanded

A specific amount that will be demanded per unit of time at a specific price, other things constant.

  • demand refers to entire demand curve

  • quantity demanded refers to a point on a demand curve

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Movement along a demand curve

The graphical representation of the effect of a change in price on the quantity demanded.

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Shift in demand

The graphical representation of the effect of anything other than price on demand.

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Shift factors of demand

  1. Society’s income

  2. The price of other goods

  3. Tastes

  4. Expectations

  5. Taxes and subsidies to consumers

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Types of goods

  • Normal goods – rise in income = rise in demand (steak)

  • Inferior goods – rise in income = decrease in demand (spam)

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Substitutes vs Complements

  • Substitutes – when price of substitute rises, demand for original good rises (ex. Jeans and khakis, when price of jeans rises and price of khakis stays the same, demand for khakis rises)

  • Complements – when price of good goes down, the demand for the good’s complement goes up (ex. Movie tickets and popcorn)

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Market demand curve

The horizontal sum of all individual demand curves.

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Law of supply

Quantity supplied rises as price rises, other things constant

  • or Quantity supplied falls as price falls, other things constant

  • law of supply is based on substitution and the expectation of profit

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Supply curve

The graphical representation of the relationship between price and quantity supplied.

  • Slopes upward (quantity supplied varies directly with the price)

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A schedule of quantities a seller is willing to sell per unit of time at various prices, other things constant. (refers to whole supply curve)

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Quantity supplied

A specific amount that will be supplied at a specific price. (refers to point on supply curve)

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Movement along a supply curve

The graphical representation of the effect of a change in price on the quantity supplied.

  • ex. change in quantity supplied that occurs because of a higher price

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Shift in supply

The graphical representation of the effect of a change in a factor other than price on supply.

  • ex. change in supply that occurs because of one of the shift factors

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Shift factors of supply

  1. Price of inputs

  2. Technology

  3. Expectations

  4. Taxes & Subsidies

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Supply shift - Price of inputs

If costs rise, profits decline and supply falls.

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Supply shift - Technology

Reduction in cost of production increases profits, leading to increase in supply.

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Supply shift - Expectations

ex: if a supplier expects the price of his good to rise in the future, he may store some of today’s output in order to sell it later and make money (decrease supply now & increase it later)

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Supply shift - Taxes & subsides

Taxes increase cost of production, profit declines, suppliers reduce supply

Subsidies to suppliers are payments by the gov to produce goods-

  • they reduce cost of production

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From a supply table to a supply curve

Supply curve represents the set of minimum prices an individual seller will accept for various quantities of a good.

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Individual and market supply curves

Market supply curve is derived from individual supply curves (just like market demand curve).

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Market supply curve

The horizontal sum of all individual supply curves.

  • Slopes upward (rise in price leads to existing suppliers supplying more, and new suppliers entering the market).

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A concept in which opposing dynamic forces cancel each other out.

  • upward pressure on price is exactly offset by downward pressure on price

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Equilibrium quantity

The amount bought and sold at the equilibrium price.

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Equilibrium price

The price toward which the invisible hand drives the market.

  • quantity demanded = quantity supplied

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Excess supply

Surplus, quantity supplied is greater than quantity demanded.

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Excess demand

shortage, quantity demanded is greater than quantity supplied

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Price adjusts

  • Quantity demanded greater than quantity supplied = prices rise

  • Quantity demanded less than quantity supplied = prices fall

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Political and social forces on equilibrium

  • Equilibrium is not good or bad (simply state in which dynamic pressures offset each other)

  • In real world, political and social forces push supply/demand equilibrium away.

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Fallacy of composition

The false assumption that what is true for a part will also be true for the whole.

  • ex. a lone supplier lowers price of his good, so people substitute that good for other goods and quantity demanded increases

  • but what if all suppliers lower prices?

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Demand is elastic if…

Quantity demanded changes significantly as the result of the price change.

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Demand is inelastic if…

Quantity demanded changes a small amount as the result of the price change.

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Determinants of price elasticity of demand

  1. Existence of substitutes

    1. Goods with lots of substitutes vs Goods with no good substitutes

  2. Share of the budget spent on the good

    1. Demand is more elastic for big ticketitems that make up a large portion of income.

  3. Time and adjustment process

    1. Generally, demand for goods tends to become more elastic over time.

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Elasticity - Midpoint Method equation

{(Q2 - Q1) / [ (Q1 + Q2) / 2 ]} / {(P2 - P1) / [ (P1 + P2) / 2 ]}

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Total revenue =

Total revenues = Price x Quantity Purchased

  • Graphically, this is a rectangle connecting the origin and a point on the demand curve.

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E > 1


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E = 1

Unit elastic

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E < 1


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Income elasticity

EI = % change in Quantity demanded / % change in Income

  • Tells us what kind of good (normal, inferior, etc.)

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EI > 0 (positive)

Normal goods are positive, incomes increasing and quantity demanded increasing; incomes decreasing and quantity demanded is decreasing.

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EI < 0 (negative)

Inferior goods are negative, decreasing income and increasing quantity demanded.

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0 < EI < 1

Necessity (normal) good

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EI > 1

Luxury (normal) good

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Cross-Price elasticity

Ec = % change in Quantity demanded (A) / % change in Price (B)

Measures the responsiveness of the quantity demanded of one good to a change in the price of another good.

Substitute vs complement.

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Ec > 0 (positive)


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Ec < 0 (negative)


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Price elasticity of supply

Es = % change in Quantity supplied / % change in Price

  • Price elasticity of supply is positive because of the direct relationship between price and quantity supplied.

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Determinants of price elasticity of supply

  • Flexibility of producers

    • More production flexibility implies more elastic supply.

      • Firms will be very responsive to changes in price.

    • A firm will have more production flexibility if it is able to:

      • Have extra capacity

      • Maintain inventory

      • Relocate easily

  • Time and adjustment process

    • Immediate run

      • Suppliers are stuck with what they have on hand; no adjustment.

    • Short run, long run

      • The more time that passes, the more the firm is able to adjust to market conditions.

      • Supply becomes more elastic over time.

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