Economics Exam 1 Comprehensive Review Notes

Exam Review Disclaimer and Study Strategy

• Review Purpose: The provided review is intended solely as a tool for additional practice. It is explicitly noted that working through this review in isolation is not a sufficient study strategy for the examination.

• Recommended Study Steps:     - Read or re-read Chapters 1 through 3 of the textbook.     - Watch all instructional videos posted under the Modules section in Webcourses.     - Review all previously distributed chapter worksheets.     - Review past quizzes and assignments completed on the Connect platform.     - Contact the professor or Teaching Assistants (TAs) for clarification on difficult concepts.     - Avoid waiting until the last minute to begin preparations.     - Focus on learning definitions and engage in repetitive practice, as repetition is key to mastery.

Fundamental Economic Principles

• Decision Making and Exchange: It is incorrect to state that all economic decisions involve the exchange of money. However, all economic decisions involve trade-offs.

• Opportunity Cost Components: Opportunity cost is the sum of both explicit and implicit costs.     - Explicit Costs: Out-of-pocket expenses involving an actual exchange of money (e.g., spending $500$ on a road trip).     - Implicit Costs: The value of benefits forgone without a direct monetary exchange, such as time or lost wages (e.g., forgoing $1,000$ in weekly earnings to take a vacation).

• The Value of Time: Time spent on an activity (e.g., $6$ hours researching a car purchase) constitutes an implicit cost and is therefore part of the total opportunity cost.

• Marginal Analysis: When making decisions, rational people compare marginal benefit ($MB$) to marginal cost ($MC$). Decisions should be pursued as long as $MB \ge MC$.

• Economic Statements:     - Positive Statements: These are objective and descriptive. They state what is. Example: "When the price of gas rises, people purchase a smaller quantity of gas."     - Normative Statements: These are subjective and prescriptive. They involve an opinion or what "ought to be."

• Factors of Production: These are the resources used to produce goods and services. Examples include Land, Labor, Capital, and Entrepreneurship.

• Categories of Income: Income is derived from factors of production. Examples include Wages (for Labor), Rent (for Land), Interest (for Capital), and Profit (for Entrepreneurship).

Production Possibilities Frontier (PPF)

• Definition: The PPF identifies different combinations of goods that can be produced given a fixed set of resources and technology.

• Feasibility and Efficiency:     - On the Line: Points on the PPF curve are both feasible (possible to produce) and efficient (resources are fully utilized).     - Inside the Line: Points inside the PPF are feasible but inefficient (resources are underutilized or misallocated).     - Outside the Line: Points outside the PPF are not feasible with current resources and technology.

• PPF Slope: The slope of the PPF measures the opportunity cost of producing one good in terms of the other.

• PPF Shape:     - Straight Line: Indicates constant opportunity costs.     - Bowed-Out (Concave): Indicates increasing opportunity costs due to the specialization of resources. Resources are not equally suited to producing all goods.

• Calculating Opportunity Cost from a Table:     - Opportunity Cost of $1$ more unit is calculated as: $\frac{\text{Amount of Good Given Up}}{\text{Amount of Good Gained}}$.     - Example Data (Potatoes vs. Fish):         - Point B to C: Give up $200$ potatoes to gain $200$ fish. Opportunity cost = $\frac{200}{200} = 1$ potato per fish.         - Point D to E: Give up $200$ potatoes to gain $50$ fish. Opportunity cost = $\frac{200}{50} = 4$ potatoes per fish.         - If the cost per fish increases as more fish are produced (e.g., from $1$ to $4$), the PPF exhibit increasing opportunity costs.

• Feasibility Problem: If points $A(100 \text{ cars}, 60 \text{ computers})$ and $B(150 \text{ cars}, 30 \text{ computers})$ are on a linear PPF, a point like $(125 \text{ cars}, 48 \text{ computers})$ is not feasible because the linear midpoint would be $(125 \text{ cars}, 45 \text{ computers})$; thus, $48$ computers is beyond the production capacity.

Comparative and Absolute Advantage

• Absolute Advantage: The ability to produce more of a good than another producer using the same amount of resources (or time).

• Comparative Advantage: The ability to produce a good at a lower opportunity cost than another producer.

• Trade Principles:     - Trade is determined by comparative advantage, not absolute advantage.     - Even if one party has an absolute advantage in all goods, mutual gains from trade are possible if they specialize according to comparative advantage.

• Comparative Advantage Calculation Example (Tivoli vs. Frivoli):     - Tivoli: $20$ spaghetti or $60$ meatballs. Opportunity cost of $1$ meatball = $\frac{20}{60} = 1/3$ spaghetti dinner.     - Frivoli: $60$ spaghetti or $120$ meatballs. Opportunity cost of $1$ meatball = $\frac{60}{120} = 1/2$ spaghetti dinner.     - Conclusion: Tivoli should produce meatballs because $1/3 < 1/2$.

• Beneficial Rate of Exchange:     - A beneficial exchange rate must fall between the opportunity costs of the two parties.     - Example: Country A's cost for $1$ pie is $2$ cakes. Country B's cost for $1$ pie is $3$ cakes. A trade of $2$ pies for $5$ cakes (which is $1 \text{ pie} = 2.5 \text{ cakes}$) is beneficial because $2 < 2.5 < 3$.

• Trade Range (T-shirts and Pencils):     - Country A: $20 \text{ T-shirts}$ or $40 \text{ Pencils}$ ($1 \text{ T-shirt} = 2 \text{ Pencils}$).     - Country B: $25 \text{ T-shirts}$ or $75 \text{ Pencils}$ ($1 \text{ T-shirt} = 3 \text{ Pencils}$).     - For $5 \text{ T-shirts}$, Country A (seller) wants at least $10 \text{ pencils}$. Country B (buyer) will pay no more than $15 \text{ pencils}$.

Market Dynamics: Demand and Supply

• Competitive Market Characteristics: Defined by many buyers and many sellers, such that no single participant can influence the market price.

• Law of Demand: As the price of a good rises, the quantity demanded decreases, ceteris paribus (all else held constant).     - Movement vs. Shift:         - A change in the price of the good itself causes a movement along the demand curve ($P \uparrow, Q_D \downarrow$).         - A change in an external variable causes a shift of the demand curve.     - Demand Shifters:         - Income: For normal goods, income increases demand ($D \uparrow$); for inferior goods, income decreases demand ($D \downarrow$).         - Preferences/Tastes: Increased preference shifts demand right.         - Price of Related Goods:             - Substitutes: If $P_{\text{Waffles}} \uparrow$, then $D_{\text{Pancakes}} \uparrow$.             - Complements: If $P_{\text{Jelly}} \uparrow$, then $D_{\text{Peanut Butter}} \downarrow$.         - Number of Buyers.         - Expectations.

• Law of Supply: As the price of a good rises, the quantity supplied increases, ceteris paribus.     - Movement vs. Shift:         - A change in the price of the good itself causes a movement along the supply curve ($P \uparrow, Q_S \uparrow$).         - A change in external factors causes a shift of the supply curve.     - Supply Shifters:         - Input Prices: An increase in the price of inputs (e.g., wages or raw materials like cheese) decreases supply ($S \downarrow$).         - Technology: Improvements (e.g., faster pizza ovens) increase supply ($S \uparrow$).         - Number of Sellers: An increase in the number of shops (e.g., frozen yogurt shops tripling) increases supply ($S \uparrow$).         - Expectations.

Market Equilibrium and Simultaneous Changes

• Equilibrium: The point where quantity demanded equals quantity supplied ($Q_D = Q_S$).

• Single Shift Scenarios:     - Increase in Demand: Price increases ($P \uparrow$), Quantity increases ($Q \uparrow$).     - Increase in Supply: Price decreases ($P \downarrow$), Quantity increases ($Q \uparrow$).     - Decrease in Supply (e.g., higher input costs): Price increases ($P \uparrow$), Quantity decreases ($Q \downarrow$).

• Simultaneous Shift Scenarios (The Market for Pizza):     - Scenario: Demand increases (preference up) AND supply decreases (cheese price up).     - Effect on Price: Both shifts put upward pressure on price. Therefore, Price definitely increases ($P \uparrow$).     - Effect on Quantity: Increased demand increases quantity, but decreased supply decreases quantity. The net effect is uncertain/ambiguous without knowing the magnitudes of the shifts.

Marginal Analysis Case Study: Advertising

• Scenario:     - Cost of advertising = $100/\text{hr}$.     - Customer spend = $10/\text{customer}$.     - Data Table:         - $0 \text{ hours} = 40 \text{ customers}$         - $1 \text{ hour} = 60 \text{ customers}$         - $2 \text{ hours} = 75 \text{ customers}$         - $3 \text{ hours} = 88 \text{ customers}$         - $4 \text{ hours} = 98 \text{ customers}$         - $5 \text{ hours} = 105 \text{ customers}$

• Marginal Benefit ($MB$) Calculation (for the 1st hour):     - Gain in customers = $60 - 40 = 20 \text{ customers}$.     - $MB = 20 \text{ customers} \times 10/\text{customer} = 200$.

• Marginal Cost ($MC$) Calculation (for the 1st hour):     - $MC = 100$ (constant hourly rate).

• Profit Maximization:     - Optimization occurs at the point where $MB = MC$.     - For the 4th hour: $98 - 88 = 10 \text{ customers} \times 10 = 100$. Since $MB (100) = MC (100)$, $4$ hours is the optimal duration.     - For the 5th hour: $105 - 98 = 7 \text{ customers} \times 10 = 70$. Since $MB (70) < MC (100)$, the 5th hour should not be purchased.