micro midterm 1

1. All economic analysis is based on a set of basic principles that apply to three levels of economic activity. First, we study how individuals make choices; second, we study how these choices interact; and third, we study how the economy functions overall.

2. Everyone has to make choices about what to do and what not to do. Individual choice is the basis of economics—if it doesn’t involve choice, it isn’t economics.

3. The reason choices must be made is that resources—anything that can be used to produce something else—are scarce. Individuals are limited in their choices by money and time; economies are limited by their supplies of human and natural resources.

4. Because you must choose among limited alternatives, the true cost of anything is what you must give up to get it—all costs are opportunity costs.

5. Many economic decisions involve questions not of “whether” but of “how much”—how much to spend on some good, how much to produce, and so on. Such decisions must be made by performing a trade-off at the margin—by comparing the costs and benefits of doing a bit more

6. r a bit less. Decisions of this type are called marginal decisions, and the study of them, marginal analysis, plays a central role in economics.

7. The study of how people should make decisions is also a good way to understand actual behavior. Individuals usually respond to incentives—exploiting opportunities to make themselves better off.

8. The next level of economic analysis is the study of interaction—how my choices depend

9. n your choices, and vice versa. When individuals interact, the end result may be different from what anyone intends.

10. Individuals interact because there are gains from trade: by engaging in the trade of goods and services with one another, the members of an economy can all be made better off. Specialization—each person specializes in the task he or she is good at—is the source of gains from trade.

11. Because individuals usually respond to incentives, markets normally move toward equilibrium—a situation in which no individual can make himself or herself better off by taking a different action.

12. An economy is efficient if all opportunities to make some people better off without making other people worse off are taken. Resources should be used as efficiently as possible to achieve society’s goals. But efficiency is not the sole way to evaluate an economy: equity, or fairness, is also desirable, and there is often a trade-off between equity and efficiency.

13. Markets usually lead to efficiency, with some well-defined exceptions.

14. When markets fail and do not achieve efficiency, government intervention can improve society’s welfare. Summary of Chapter 2

15. Almost all economics is based on models, “thought experiments” or simplified versions

16. f reality, many of which use mathematical tools such as graphs. An important assumption in economic models is the other things equal assumption, which allows analysis of the effect of a change in one factor by holding all other relevant factors unchanged.

17. One important economic model is the production possibility frontier. It illustrates

18. pportunity cost(showing how much less of one good can be produced if more of the other good is produced); efficiency(an economy is efficient in production if it produces on the production possibility frontier and efficient in allocation if it produces the mix of goods and services that people want to consume); and economic growth (an outward shift of the production possibility frontier). There are two basic sources of growth: an increase in factors of production— resources such as land, labor, capital, and human capital, inputs that are not used up in production—and improved technology.

19. Another important model is comparative advantage, which explains the source of gains from trade between individuals and countries. Everyone has a comparative advantage in something—some good or service in which that person has a lower opportunity cost than everyone else. But it is often confused with absolute advantage, an ability to produce a particular good or service better than anyone else. This confusion leads some to erroneously conclude that there are no gains from trade between people or countries.

20. Economists use economic models for both positive economics, which describes how the economy works, and for normative economics, which prescribes how the economy should work. Positive economics often involves making forecasts. Economists can determine correct answers for positive questions but typically not for normative questions, which involve value judgments. The exceptions are when policies designed to achieve a certain objective can be clearly ranked in terms of efficiency.

21. There are two main reasons economists disagree. One, they may disagree about which simplifications to make in a model. Two, economists may disagree—like everyone else—about values.

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Summary of Chapter 3

1. The supply and demand model illustrates how a competitive market, one with many buyers and sellers, none of whom can influence the market price, works.

2. The demand schedule shows the quantity demanded at each price and is represented graphically by a demand curve. The law of demand says that demand curves slope downward; that is, a higher price for a good or service leads people to demand a smaller quantity, other things equal.

3. A movement along the demand curve occurs when a price change leads to a change in the quantity demanded. When economists talk of increasing or decreasing demand, they mean shifts of the demand curve—a change in the quantity demanded at any given price. An increase in demand causes a rightward shift of the demand curve. A decrease in demand causes a leftward shift.

4. There are five main factors that shift the demand curve:

   • A change in the prices of related goods or services, such as substitutes or complements

   • A change in income: when income rises, the demand for normal goods increases and the demand for inferior goods decreases

   • A change in tastes

   • A change in expectations

   • A change in the number of consumers

5. The market demand curve for a good or service is the horizontal sum of the individual demand curves of all consumers in the market.

6. The supply schedule shows the quantity supplied at each price and is represented graphically by a supply curve. Supply curves usually slope upward.

7. A movement along the supply curve occurs when a price change leads to a change in the quantity supplied. When economists talk of increasing or decreasing supply, they mean shifts

8. f the supply curve—a change in the quantity supplied at any given price. An increase in supply causes a rightward shift of the supply curve. A decrease in supply causes a leftward shift.

9. There are five main factors that shift the supply curve:

   • A change in input prices

   • A change in the prices of related goods and services

   • A change in technology

   • A change in expectations

   • A change in the number of producers

10. The market supply curve for a good or service is the horizontal sum of the individual supply curves of all producers in the market.

11. The supply and demand model is based on the principle that the price in a market moves to its equilibrium price, or market-clearing price, the price at which the quantity demanded is equal to the quantity supplied. This quantity is the equilibrium quantity. When the price is above its market-clearing level, there is a surplus that pushes the price down. When the price is below its market-clearing level, there is a shortage that pushes the price up.

12. An increase in demand increases both the equilibrium price and the equilibrium quantity; a decrease in demand has the opposite effect. An increase in supply reduces the equilibrium price and increases the equilibrium quantity; a decrease in supply has the opposite effect.

13. Shifts of the demand curve and the supply curve can happen simultaneously. When they shift in opposite directions, the change in equilibrium price is predictable but the change in equilibrium quantity is not. When they shift in the same direction, the change in equilibrium quantity is predictable but the change in equilibrium price is not. In general, the curve that shifts the greater distance has a greater effect on the changes in equilibrium price and quantity. Summary of Chapter 4

14. The willingness to pay of each individual consumer determines the demand curve. When price is less than or equal to the willingness to pay, the potential consumer purchases the good. The difference between willingness to pay and price is the net gain to the consumer, the individual consumer surplus.

15. Total consumer surplus in a market, the sum of all individual consumer surpluses in a market, is equal to the area below the market demand curve but above the price. A rise in the price of a good reduces consumer surplus, a fall in the price increases consumer surplus. The term consumer surplus is often used to refer to both individual and total consumer surplus.

16. The cost of each potential producer, the lowest price at which he or she is willing to supply a unit of a particular good, determines the supply curve. If the price of a good is above a producer’s cost, a sale generates a net gain to the producer, known as the individual producer surplus.

17. Total producer surplus in a market, the sum of the individual producer surpluses in a market, is equal to the area above the market supply curve but below the price. A rise in the price

18. f a good increases producer surplus; a fall in the price reduces producer surplus. The term producer surplus is often used to refer to both individual and total producer surplus.

19. Total surplus, the total gain to society from the production and consumption of a good, is the sum of consumer and producer surplus.

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20. Usually, markets are efficient and achieve the maximum total surplus. Any possible reallocation of consumption or sales, or a change in the quantity bought and sold, reduces total surplus. However, society also cares about equity. So government intervention in a market that reduces efficiency but increases equity can be a valid choice by society.

21. An economy composed of efficient markets is also efficient, although this is virtually impossible to achieve in reality. The keys to the efficiency of a market economy are property rights and the operation of prices as economic signals. Under certain conditions, market failure

22. ccurs, making a market inefficient. The three principal causes of market failure are market power, externalities, and a good which, by its nature, makes it unsuitable for a market to allocate efficiently. Summary of Chapter 5

23. Even when a market is efficient, governments often intervene to pursue greater fairness or to please a powerful interest group. Interventions can take the form of price controls or quantity controls, both of which generate predictable and undesirable side effects consisting of various forms of inefficiency and illegal activity.

24. A price ceiling, a maximum market price below the equilibrium price, benefits successful buyers but creates persistent shortages. Because the price is maintained below the equilibrium price, the quantity demanded is increased and the quantity supplied is decreased compared to the equilibrium quantity. This leads to predictable problems: inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation to consumers, wasted resources, and inefficiently low quality. It also encourages illegal activity as people turn to black markets to get the good. Because of these problems, price ceilings have generally lost favor as an economic policy tool. But some governments continue to impose them either because they don’t understand the effects or because the price ceilings benefit some influential group.

25. A price floor, a minimum market price above the equilibrium price, benefits successful sellers but creates persistent surplus. Because the price is maintained above the equilibrium price, the quantity demanded is decreased and the quantity supplied is increased compared to the equilibrium quantity. This leads to predictable problems: inefficiencies in the form of deadweight loss from inefficiently low quantity, inefficient allocation of sales among sellers, wasted resources, and inefficiently high quality. It also encourages illegal activity and black markets. The most well-known kind of price floor is the minimum wage, but price floors are also commonly applied to agricultural products.