Spring 2025 LE006 Midterm Review

• Course: Econ 1001

Economics

• Definition: Economics is a social science focused on making optimal choices amid scarcity.

• Key Point: Economic wants exceed society's productive capacity.

The Economic Perspective

• Understanding: Individuals and institutions make rational decisions based on self-interest.

• Key Considerations:

  • Scarcity and Choice

  • Opportunity Cost

  • Purposeful Behavior: Aiming to increase utility.

  • Marginal Analysis: Comparing marginal benefits and marginal costs.

The Economizing Problem

• Core Concept: Limited income versus unlimited wants.

• Key Elements:

  • Budget Line: Shows attainable vs unattainable combinations.

  • Trade-offs and Opportunity Costs: Making choices requires sacrifices.

  • Income Changes: Adjustments based on income variations.

Production Possibilities Model: Overview

• Definition: An economic model showing combinations of two goods that an economy can produce.

• Assumptions:

  • Full employment

  • Fixed resources

  • Fixed technology

  • Focus on two goods: Consumer goods and capital goods.

Increasing Opportunity Costs

• Concept: The Law of Increasing Opportunity Costs states that as production of a particular good increases, the marginal opportunity costs also rise.

• Production Possibilities Curve: Describes this relationship, demonstrating a concave shape due to increasing costs.

Economic Systems

• Definition: A set of institutional arrangements that serve as a coordinating mechanism in economies.

• Variations:

  • Degree of decentralized market use.

  • Degree of centralized government control.

The Five Fundamental Questions

• Critical Queries in Economics:

  1. What goods and services will be produced?

  2. How will these goods and services be produced?

  3. Who will receive the goods and services?

  4. How will the system adapt to changes?

  5. How will the system stimulate technological progress?

The Invisible Hand

• Concept: The competition promotes societal interests unintentionally while firms pursue their own.

• Historical Reference: Adam Smith's "Wealth of Nations" (1776).

• Market System Virtues:

  • Efficiency

  • Incentives

  • Freedom

Demand

• Definition: A schedule or curve that indicates consumer willingness and ability to purchase product quantities at various prices.

• Forms:

  • Demand schedule (table)

  • Demand curve (graph)

• Assumptions:

  • Ceteris paribus (all else being equal)

  • Individual and market demand distinctions.

Determinants of Demand

• Factors that can shift the demand curve:

  • Change in Buyers’ Tastes: Example: Fitness trends raise demand for jogging shoes.

  • Change in Number of Buyers: Example: A migration increase raises demand for housing.

  • Change in Income: Increase in income boosts demand for normal goods (e.g., restaurant meals).

  • Change in Prices of Related Goods: Lower airfares decrease demand for train travel (substitutes).

  • Change in Consumer Expectations: Anticipation of higher prices can increase current demand (e.g., toilet paper before a hurricane).

Market Equilibrium

• Definition: Occurs when the demand and supply curves intersect.

• Components:

  • Equilibrium price and quantity

  • Surplus and shortage conditions

  • Rationing function of prices

  • Efficient allocation of resources.

Changes in Demand and Equilibrium

• Graphical representation of demand changes:

  • Increase in Demand: P rises, Q increases.

  • Decrease in Demand: P falls, Q decreases.

Price Ceiling

• Visualization of price ceiling effects:

  • Established below equilibrium price leads to shortages.

Concept of Demand and Supply

• Equilibrium occurs when buyer's maximum willingness to pay (WTP) equals seller's minimum willingness to accept (WTA) or marginal benefit equals marginal cost.

Efficiently Functioning Markets

• Market failures occur when optimal production levels are not met.

• Requirements for efficiency:

  • Demand reflects true willingness to pay.

  • Supply accounts for all production costs.

  • Total Surplus = Consumer Surplus + Producer Surplus.

Consumer Surplus: Example

• Illustration of consumer surplus:

  • Table of individual maximum price willingness compared to actual equilibrium price.

Total Surplus and Efficiency

• Graph representation highlighting consumer and producer surplus.

Efficiency Losses from Underproduction

• Graphical evidence of efficiency loss (deadweight loss) from producing less than optimal amount.

Efficiency Losses from Overproduction

• Graph showing efficiency loss due to excess production leading to market inefficiency.

Externalities

• Definition: Costs or benefits affecting third parties external to the market transaction.

• Types:

  • Negative Externalities: Overproduction issues.

  • Positive Externalities: Underproduction issues.

Correcting for Positive Externalities

• Strategies:

  • Subsidizing consumers or producers to address resource underallocation.

Public vs Private Goods Matrix

• Categorization of goods based on excludability and rivalry:

  • Private Goods: Food, clothes.

  • Common-pool Resources: Fish stocks.

  • Club Goods: Private parks.

  • Public Goods: Clean air, national defense.

Price Elasticity of Demand

• Measure of responsiveness regarding price changes.

• Elastic Demand: Sensitive to price changes, large quantity change.

• Inelastic Demand: Insensitive to prices, small quantity change.

Interpretation of Elasticity of Demand

• Elasticity conditions:

  • Ed > 1: Elastic

  • Ed < 1: Inelastic

  • Ed = 1: Unit elastic

• Extreme cases defined by elasticity thresholds.

Total Revenue Test Overview

• Total Revenue (TR) calculation: TR = Price x Quantity.

• Effects of elasticity on TR:

  • Elastic: Price and TR move in opposite directions.

  • Inelastic: Price and TR move together.

  • Unit elastic: TR remains unchanged with price changes.

Midpoint Formula

• Used for elasticity calculation to ensure consistency:

  • Ed = (Change in quantity / Average quantity) ÷ (Change in price / Average price).

Law of Diminishing Marginal Utility

• Definition: Utility from each additional unit decreases as consumption increases.

• Insight: Explains the downward slope of demand curves.

Utility Maximizing Rule

• Explanation of consumer behavior:

  • Consumers attain equilibrium by equalizing marginal utility per dollar spent across products.

  • Algebraically: MU of product A / Price of A = MU of product B / Price of B.

Indifference Curves

• Definition: Curves representing combinations for a given total utility.

• Characteristics:

  • Downward sloping and convex to the origin, reflecting marginal rates of substitution.

Equilibrium at Tangency

• Condition: Indifference curve is tangent to the budget line, achieving maximum utility.

• Parameters:

  • MRS equals price ratio of two goods.

MRS Example

• Scenario analysis: Determines if a consumer should adjust consumption based on marginal utility per price ratio.