Furyion21 - Exam notes

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Exam Study Guide: pp 1 - 119

Introductory: the 10 Principles of Economics

  1. People face tradeoffs.
  2. Opportunity Cost: the fact that, to obtain something, one must give up another

thing.

  1. Rational people think at the margin.
  2. People respond to incentives.
  3. Trade can make everyone better off.
  4. Markets are usually an effective way of organizing economic activity.
  5. Governments can sometimes improve market outcomes.
  6. A country’s standard of living depends on its ability to produce goods and

services.

  1. Inflation: prices rise when the government prints too much money.
  2. Society faces a short-run tradeoff between inflation and unemployment.

Chapter 1: What is Economics? (pp 1 – 18)

Key Concepts

  • Economics is also referred to as the science of choice: the science that studies the choices

that people make in the face of scarcity.

  • All economic questions and problems arise from scarcity – the fact that our wants exceed

the resources available.

  • All economic choices can be categorized into five primary questions:
    • What?
    • How?
    • Who?
    • Where?
    • When?
  • The benefit that arises from an increase in an activity is called marginal benefit.
  • The cost of an increase in an activity is called marginal cost.
  • If the marginal benefit exceeds the marginal cost, an increase in the action is rational.
  • If the marginal cost exceeds the marginal benefit, the action should not be taken.
  • The central idea of economics is that, by looking for changes in the marginal cost and

marginal benefit, we can predict the way choices will change in response to changes in incentives.

  • All parties involved benefit from a voluntary exchange.
  • Exchanges take place in markets. They are efficient in the sense that they send

resources to the place where they are valued most.

  • Market failure is a state in which the market does not use resources efficiently.
  • Market failure can be averted by government intervention. Taxes and subsidization are

governmental tools to add incentive, positive or negative, to the consuming of certain products.

  • Expenditure equals income and the value of production.
  • Living standards improve when production per person increases.
  • The value of production can increase for any three reasons:
    • prices rise
    • productivity increases
    • population increases
  • Prices rise in a process called inflation: when the quantity of money increases faster

than production.

  • Unemployment can result from market failure, and is sometimes wasteful. It is ever

present, however. Unemployment fluctuates over the business cycle.

  • Microeconomics is the study of decisions of individual people and businesses, and the

interaction of those decisions in markets.

  • Macroeconomics is the study of national and global economy. Average prices, total

employment, income, and production all fall under this category as well.

  • Positive statements are “what is”.
  • Normative statements are “what ought to be”.
  • The task of economic science is to discover and catalogue positive statements that are

consistent with what we observe in the world. This task is broken down into three steps:

    • Observation and measurement
    • Model building
    • Model testing
  • An economic model is a description of some aspect of the economic world that includes

only those features of the world that are needed for the purpose at hand.

  • An economic theory is a generalization that summarizes what we think we understand

about the economics choices that people make. It is the bridge between an economic model and the real, pragmatic economy.

  • Fallacies, the product of flawed reasoning or logic, come in two forms in the economic

world:

  • The fallacy of composition occurs when one issue is falsely said to be true for the

whole.

  • The post hoc fallacy occurs when a later event is falsely said to have caused an

earlier event.

Vocabulary

Capital goods: human-made, tangible resources used to produce goods more efficiently

Ceteris paribus: “with all other factors or things remaining the same”

Command system: an economy that is planned and controlled by a central administration

Economic model: a description of some aspect of the economic world that includes only

those features of the world that are needed for the purpose at hand

Economic theory: a theory of commercial activities (such as the production and consumption of goods)

Economics: the social science that deals with the production, distribution, and consumption of goods and services and with the theory and management of economies or economic systems; the science of choice; the social science that studies the choices made in the face of scarcity

Efficiency: producing something at the lowest possible opportunity cost

Expenditure: the act of consuming or spending money for goods or services

Goods and services: all things we value and are willing to pay for

Human resources: the quantity and quality of the labour force as a contributor to the production of goods and services

Incentive: an inducement to take a particular action (positive)

Income: the amount of money or its equivalent received during a period of time in exchange for labour or services, from the sale of goods or property, or as profit from financial investments

Inflation: the rise of prices due to the quantity of money increasing faster than production

Macroeconomics: the study of the national and global economy, seeking to explain average prices and total employment, income, and production

Margin: the minimum return that an enterprise may earn and still pay for itself; the difference between the cost and the selling price of securities or commodities

Marginal benefit: the benefit that arises from the said action

Marginal cost: the cost of the said action

Markets: a system of trade organization in which exchanges take place

Market failure: a state in which the market does not use/allocate resources efficiently

Microeconomics: the study of the decisions of individual people and businesses and the interaction of those decisions in markets

Opportunity cost: the highest valued alternative forgone in the face of scarcity

Productivity: production per person

Resources: factors of production that are used to produce the goods and services that give us utility

Scarcity: limited availability of things that we desire

Tradeoff: giving up something to get something else

Unemployment: the percentage or number of people who are involuntarily unemployed (without a paying job)

Utility: the benefits individuals receive from owning or consuming goods and services

Voluntary exchange: an unforced exchange in which both parties receive benefits

Chapter 2: Making and Using Graphs (pp 19 – 36)

Key Concepts

  • Graphs are used to show relationships among variables in economics models.
  • Time-series graphs show trends, cycles, and other fluctuations in economic data.
  • Scatter diagrams show the relationship between two variables. They show whether two

variables are positively related, negatively related, or unrelated.

  • Cross-section graphs show how variables change across the members of a population.
  • Relationships can be positive, negative, fluctuating, or unrelated.
  • The slope of a line, point, or arc can be calculated by using the following formula: ∆y/


Chapter 3: The Economic Problem (pp 37 – 62)

Key Concepts

  • Resources are:
    • labour
    • land
    • capital, human or otherwise
    • entrepreneurship
  • The production possibility frontier, PPF, is the boundary between production levels that

are attainable and those that are not attainable.

  • Efficiency is attained when production is on the PPF.
  • Inefficiency is attained when production is inside the PPF.
  • It is impossible to attain a point of production outside the PPF.
  • Production efficiency is achieved if we cannot produce more of one good without

producing less of some other good.

  • Resource use is efficient when we produce the goods and services that we value the most

highly.

  • The opportunity cost of all goods increases as the production of the good increases;

thus, movement along the PPF curve comes at an increasing opportunity cost.

  • The marginal cost of a good is the opportunity cost of producing one more unit.
  • The marginal benefit of a good is the benefit that one receives from consuming one

more unit of a good or service.

  • The marginal benefit of a good decreases as the amount of the said good available

increases.

  • Resources are used efficiently when the marginal cost is equal to its marginal benefit.
  • Economic growth is the expansion of the PPF, resulting from capital accumulation or

technological change.

  • To grow economically, one must forgo current consumption in favour of capital.
  • Specialization is the phenomena of the concentration on the production of one or a few

goods.

  • A person has a comparative advantage in producing a good if that person can produce

the good at a lower opportunity cost than everyone else can.

  • A person has an absolute advantage in producing goods if that person can produce

more units of those goods than anyone else.

  • Dynamic comparative advantage, or learning-by-doing, is a comparative advantage

gained as a result of specialization.

  • Trade is organized by using social institutions:
  • Property rights (real, financial, intellectual)
  • Markets: any arrangement that enables buyers and sellers to get information and

to do business with each other. Markets coordinate to individual changes through price adjustments.

Chapter 4: Supply and Demand (pp 63 – 88)

Key Concepts

  • Money price is the price of a good or service in dollars.
  • Relative price is the price of a good or service is the ratio of one price to another,

otherwise known as opportunity cost.

Demand

  • If a consumer demands something, then they a) want it, b) can afford it, and c) have

made a definite plan to purchase it.

  • Quantity demanded: the amount that consumers plan to buy during a given time period

at a specific price.

  • A change in the price of the good in question affects quantity demand, resulting in a

movement along the demand curve. Thus, the good’s price is the only determining factor in a movement along the curve.

  • Changes in the prices of related goods, expected future prices, real income, population

size, and preferences all affect direct demand, resulting in a shift of the demand curve.

  • An increase in quantity demand results in a rightward movement along the demand

curve.

  • A decrease in quantity demand results in a leftward movement along the demand curve.
  • An increase in direct demand results in a rightward shift of the demand curve.
  • A decrease in direct demand results in a leftward shift of the demand curve.
  • The Law Of Demand states that, ceteris paribus, the higher the price of a good, the

smaller the quantity demanded, for two reasons:

  • Substitution Effect: as the opportunity cost of a good rises, people buy less of

that good and more of its substitutes.

  • Income Effect: when a price changes, ceteris paribus, the price changes relative

to people’s incomes. Faced with a higher price and an unchanged real income, the opportunity cost of purchasing the good rises.

  • A substitute is a good that can be used in the stead of another good.
  • A complement is a good that is used in conjunction with another good.
  • A normal good is a good for which demand increases as real income increases.
  • An inferior good is a good for which demand decreases as real income increases,

resulting from the switch from a lower-quality good to a higher-quality one, namely from an inferior to a normal good.

  • When direct demand increases, both the price and quantity demanded increase.

Supply

  • If a firm supplies a good or service, the firm a) has the resources and technology to

produce it, b) can profit from producing it, and c) has made a definite plan to produce and sell it.

  • Quantity supplied: the amount that producers plan to sell during a given time period at

a specific price.

  • A change in the price of the good in question affects quantity supplied, resulting in a

movement along the supply curve. Thus, the good’s price is the only determining factor in a movement along the curve.

  • Changes in the prices of productive resources, prices of related goods, expected future

prices, the number of suppliers, and technology all affect direct supply, resulting in a shift of the supply curve.

  • An increase in quantity supply results in a rightward movement along the supply

curve.

  • A decrease in quantity supply results in a leftward movement along the supply curve.
  • An increase in direct supply results in a rightward shift of the supply curve.
  • A decrease in direct supply results in a leftward shift of the supply curve.
  • The Law Of Supply states that, ceteris paribus, the higher the price of a good, the

greater the quantity supplied.

  • When direct supply increases, the price falls while quantity supplied increases.

Market Equilibrium

  • Equilibrium is a situation in which opposing forces balance each other.
  • The equilibrium price is the price at which the quantity demanded equals the quantity

supplied.

  • The equilibrium quantity is the quantity bought and sold at the equilibrium price.
  • A market moves towards its equilibrium because:
    • price regulates buying and selling plans
    • price adjusts when plans don’t match to compensate
  • A shortage occurs when the quantity demanded is greater than the quantity supplied.

Often, shortages force prices upwards (compensating by lowering quantity demand).

  • A surplus occurs when the quantity supplied is greater than the quantity demanded.

Often, surpluses force prices downwards (compensating by raising quantity demand).

  • When both demand and supply increase, the equilibrium quantity increases, and the

equilibrium price might increase, decrease, or remain the same, depending on the degree of change of the demand and supply curves.

  • When one curve increases and the other decreases, the equilibrium quantity and the

equilibrium price might increase, decrease, or remain the same, depending on the degree of change of the demand and supply curves.

Chapter 5: Elasticity (pp 89 – 108)

Key Concepts (see p. 103 for a detailed glossary)

Demand Elasticity

  • The price elasticity of demand is a units-free measure of the responsiveness of the

quantity demanded of a good to a change in its price, ceteris paribus.

  • Factors that influence the elasticity of demand are:
    • the closeness of substitutes (the degree of possibility of substitution)
    • the proportion of income spent on the good (the greater the %, the more elastic

the demand for the good)

    • the time elapsed since a price change (the more rare a price change, the more

elastic the demand for the good)

  • The formula for calculating the price elasticity of demand is:

PED = Percentage change in quantity demanded 

 Percentage change in price

or 

     %∆Q / %∆P
  • There are many different states of demand elasticity:
    • Let “x” be the elasticity of the said good or service,
    • Perfectly Inelastic: x = 0
    • Inelastic: 0 < x < 1
    • Unit Elastic: x = 1
    • Elastic: 1 < x < ∞
    • Perfectly Elastic: x = ∞
  • Find the elasticity of any point by first multiplying the price at the point by 2, and then

dividing that number by the corresponding quantity.

  • Total revenue from the sale of a good equals the price of the good multiplied by the

quantity sold.

  • If demand is:
    • elastic, a 1% price cut increases the quantity sold by more than 1% and

total revenue increases

    • unit elastic, a 1% price cut increases the quantity sold by 1% and total

revenue does not change.

    • inelastic, a 1% price cut increase the quantity sold by less than 1% and

total revenue decreases (N.B. These principles can be reversibly applied: if a price cut increase total revenue, then demand is elastic... etc.)

  • The formula for calculating the cross elasticity of demand is:

CED = Percentage change in quantity demanded 

 Percentage change in price of a 
     substitute or complement 
The formula for calculating the income elasticity of demand is:

IED = Percentage change in quantity demanded 

          Percentage change in income

Supply Elasticity

  • The elasticity of supply is measures the responsiveness of the quantity supplied to a

change in the price of a good, ceteris paribus.

  • Factors that influence the elasticity of supply are:
    • resource substitution possibilities
    • time frame for supply decisions (momentary, short run, long run)
  • The formula for calculating the elasticity of supply is:

ES = Percentage change in quantity supplied 

         Percentage change in price
  • There are many different states of supply elasticity:
    • Let “x” be the elasticity of the said good or service,
    • Perfectly Inelastic: x = 0
    • Inelastic: 0 < x < 1
    • Unit Elastic: x = 1
    • Elastic: 1 < x < ∞
    • Perfectly Elastic: x = ∞

Chapter 6: Efficiency and Equity (pp 109 – 119)

Key Concepts

  • An efficient allocation of resources occurs when we produce the goods and services

that people value most highly. Thus, resource use is efficient when we cannot produce more of a good or service without giving up some other good or service that we value more highly.

  • Efficiency is based on value, which is based on people’s feelings and sentiments of

particular goods or services.

  • The marginal cost of a good is the opportunity cost of producing one more unit.
  • The marginal benefit of a good is the benefit that one receives from consuming one

more unit of a good or service.

  • To determine the efficient quantity of a good, one must analyze the situation of the

margins. There are three possible cases:

    • marginal benefit > marginal cost, resulting in an increase in production
    • marginal benefit < marginal cost, resulting in a decrease in production
    • marginal benefit = marginal cost, resulting in no chance in production
  • The value of one more unit of a good or service is its marginal benefit.
  • The cost of producing one more unit of a good or service is its marginal cost.
  • A demand curve is a marginal benefit curve.
  • A supply curve is a marginal cost curve.
  • A consumer surplus is the value of the good in question minus the price paid for it.
  • A producer surplus is the price of a good minus the opportunity cost of producing it.
  • There are many obstacles to efficient allocation of resources: 
price ceilings; regulations that make it illegal to charge a price higher than a

specified level.

  • price floors; regulations that make it illegal to pay a lower price than a specified

level.

  • taxes; subsidies, and quotas
  • monopolies; firms that have complete control of a market.
  • public goods; goods or services that are consumed by everyone.
  • external costs and external benefits; externalities borne or accrued to anyone other

than the causer.

  • Deadweight loss is the decrease in consumer surplus and producer surplus that results

from an inefficient level of production, caused by either underproduction or overproduction. This loss is borne by the entire society: it is a social loss due to inefficiency.

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