Exam 1 Flashcards
What is allocation?
What we choose to use resources for
What is scarcity?
When there are more wants than availability
What are resources?
Land, labor, capital, time
What is a model?
A simplified representation of a real situation that is used to better understand real-life situations
What is ceteris paribus?
Holding all other things constant
What are the 5 postulates of human behavior?
- People have preferences
- Preferences can and do differ across individuals
- More is preferred to less
- People are willing to substitute one good for another
- The more we have of a good, the less we value of an additional unit of that good
Explanation of: People have preferences
Given a choice between goods, consumers can make a decision about which is preferred
Explanation of: Preferences can and do differ across individuals
Allows for trades to occur
What is the demand schedule?
Table showing how much of a good or service consumers will want to buy at different prices
What is the demand curve?
A curve which graphically represents the quantity of a particular good a consumer is willing to buy at each price level; graphical representation of the demand schedule
What is the Law of Demand?
The quantity demanded of a good is inversely related to price of that good, holding other factors constant
As price falls, quantity demanded increases
What is value?
The amount of other goods an individual is willing to give up in order to obtain some good
What is Total Value (TV)?
Amount of other goods an individual would be willing to give up in order to consume all units presently consumed instead of none at all
Sum of all marginal values of all units of good consumed
What is Marginal Value (MV)?
Amount of other goods an individual would be willing to give up in order to consume an incremental unit of good
What is the Law of Diminishing Marginal Value?
The Marginal Value of a good decreases as more units are consumed (Reason why individual demand curves are downward sloping)
What is Total Expenditure (TE)?
Total amount actually spent to purchase a given quantity of a good
TE = price x quantity
What is Consumer Surplus (CS)?
Net benefits to the consumer. The difference between what a consumer would be willing to pay for the units purchased (TV) and what the consumer actually pays (TE)
CS = TV - TE
What does how much the individual consumer consumes depend upon?
Price and marginal value
What is price?
How much the consumer must give up for each additional unit consumed
What is marginal value?
How much the consumer is willing to give up for each additional unit consumed
When do consumers stop consuming a good?
When price > marginal value
How is the marginal value represented on the demand curve?
The height of the demand curve at a given quantity
How is total value represented on the demand curve?
It is the area under the demand curve for all consumers in the market?
How is the consumer surplus represented on the demand curve?
Area between the demand curve and price
Quantity Demanded vs Demand?
Quantity Demanded: The actual amount of a good consumers are willing to buy at some specific price
Demand: Shows the amount of a good consumers are willing to buy at every price
How is change in quantity demanded represented graphically?
Movement from one point on a demand curve to another point on a demand curve
How is change in demand represented graphically?
Shift in the entire demand curve
Rightward shift in demand curve?
Increase in demand
Leftward shift in demand curve?
Decrease in demand
What 5 factors cause entire demand curves to shift?
- Change in the price of related goods
- Changes in Income
- Change in the Number of Consumers
4, Change in Information about the Uses of a Good - Change in Expectations about Future Prices
What are complements?
Two good used jointly in consumption
What does the increase in price of a complement lead to?
Leftward shift in demand curve
What does the decrease in price of a complement lead to?
Rightward shift in demand curve
What are substitutes?
Two goods that satisfy similar wants or desires
What does increase in price of a substitute lead to?
Rightward shift in demand curve
What does decrease in price of a substitute lead to?
Leftward shift in demand curve
What are normal goods?
A good which demand increases when income increases
For normal goods, an increase in income leads to
A rightward shift in demand curve
For normal goods, a decrease in income leads to
A leftward shift in demand curve
What are inferior goods?
A good for which demand decreases when income increases
For inferior goods, an increase in income leads to
A leftward shift in demand curve
For inferior goods, a decrease in income leads to
A rightward shift in demand curve
Increase in the number of consumers leads to
A rightward shift in demand curve
Decrease in the number of consumers lead to
A leftward shift in demand curve
If expect future price to be higher
Leads to rightward shift in demand curve today
If expect future price to be lower
Leads to leftward shift in demand curve today
What is the supply schedule?
A table showing how much of a good or service suppliers will want to sell at different prices
What is the supply curve?
A curve which graphically represents the quantity of a particular good a supplier is willing to sell at each price level
Summarizes the relationship between quantity supplied of a good and the price of that good, holding all other factors constant
Graphical representation of the supply schedule
The Law of Supply?
The quantity of a good is typically positively related to the price of that good, holding other factors constant
What is Total Cost (TC)?
Cost of all units of output currently produced
Sum of all marginal costs
What is Marginal Cost (MC)?
Cost of producing an additional unit of output
What is Total Revenue (TR)?
The sum of receipts a firm receives from the sale of output
TR = Price x Quantity Sold
What is producer surplus (PS)?
The difference between the price sellers receive for a good and the marginal cost of producing the good
Net benefits to the supplier
What do supply decisions depend upon?
Price and Marginal Cost
What is Marginal Cost?
The cost of producing an additional unit of a good
When will suppliers stop producing a good?
When Marginal Cost > Price
Quantity Supplied vs Supply?
Quantity Supplied: The actual amount of a good suppliers are willing to sell at some specific prive
Supply: The amount of a good suppliers are willing to sell at every price
How is change in quantity supplied represented graphically?
Movement along the same supply curve in response to change in price
How is change in supply represented graphically?
Change in supply is a shift in entire supply curve
Left shift of the supply curve?
Decrease in supply
Right shift of the supply curve?
Increase in supply
What 4 factors cause the entire supply curve to shift?
- Change in the price of inputs
- Changes in technology
- Change in the number of suppliers
- Change in expectations about future prices
Increase in price of an input results in?
Leftward shift in supply curve
Decrease in price of an input results in?
Rightward shift in supply curve
If technology change reduces the cost of productions?
Rightward shift in supply curve
If technology change increases the cost of productions?
Leftward shift in supply curve
Increase in the number of suppliers leads to
Rightward shift in supply curve
Decrease in the number of suppliers leads to
Leftward shift in supply curve
How does the expectation of future prices to be higher change supply?
Leftward shift in supply curve today
How does the expectation of future prices to be lower change supply?
Rightward shift in supply curve today
What are the benefits of exchange?
Voluntary exchange based on mutual benefits
If agree to trade then both parties must perceive net benefits, or else would not engage in voluntary trade
How long will beneficial trades continue?
Until marginal value equals marginal cost
All gains from trade are exhausted
What is economic efficiency?
When all mutual benefits from trade are exhausted
Net benefits to society are maximized
What is market clearing price?
Price at which the market is in equilibrium
Quantity Demanded = Quantity Supplied
Equilibrium price
What happens when price is higher than market clearing price?
An excess supply (surplus)
In order to rid themselves of these excess, unwanted inventories sellers will being to lower price until market clearing price is reached
What happens when price is lower than market clearing price?
An excess demand (shortage)
Suppliers find that they cannot keep items in stock and can charge a higher price
Some consumers value this good more highly than others, so will offer a higher price for the good
Price of the good gets “bid” up to the market clearing price
How does increase in demand effect equilibrium?
Equilibrium price rises, equilibrium quantity rises
How does decreased in demand effect equilibrium?
Equilibrium price falls, equilibrium quantity falls
How does increase in supply effect equilibrium?
Equilibrium price falls, equilibrium quantity rises
How does decrease in supply effect equilibrium?
Equilibrium price rises, equilibrium quantity falls-
What is elasticity?
Measure of responsiveness of one variable to changes in another variable
What is price elasticity of demand?
Measure of responsiveness of quantity demanded to changes in price
What is income elasticity of demand?
Measure of responsiveness of quantity demanded to changes in income
What is cross price elasticity of demand?
Measure of responsiveness of quantity demanded to changes in the price of related goods
What is price elasticity of supply?
Measure of responsiveness of quantity supplied to change in price
Equation for price elasticity of demand?
% change in quantity demanded / % change in price
Midpoint Method Equation?
(Q2 - Q1) / ((Q1 + Q2)/2)
/
(P2 - P1) / ((P1 + P2)/2)
Why must price elasticity of demand?
Must be negative
Elastic Demand range in values?
- infinity ≤ Ed < -1
Unit Elastic Demand range in values?
Ed = -1
Inelastic Demand range in values?
-1 < Ed ≤ 0
What does an inelastic demand look like graphically?
Relatively “large” price changes associated with “small” quantity changes
Quantity demanded is relatively less responsive to changes in price
What does an elastic demand look like graphically?
Relatively “small” price changes associated with “large” quantity changes
Quantity demanded is relatively more responsiveness to changes in price
What are 3 determinants of price elasticity of demand?
- Availability of substitutes
- Time
- How narrowly defined
How does the availability of substitutes effect the price elasticity of demand?
More substitutes = more opportunity to alter behavior in response to price changes
More substitutes = more elastic
How does time effect the price elasticity of demand?
More time that passes since price change, more opportunity to adjust behavior in response to price changes
How does how narrowly defined effect the price elasticity of demand
More narrowly defined, more substitutes = More elastic
Food (inelastic), Apples (elastic)
What is a price effect?
After a price increase, each unit sold sells at a higher price, which tends to raise revenue?
What is a quantity effect?
After a price increase, fewer units are sold, which tends to lower revenue
Quantity/Price Effect when demand for a good is elastic?
Quantity effect is stronger than price effect
An increase in price reduces total revenue
Quantity/Price Effect when demand for a good is inelastic?
Price effect is stronger than quantity effect
An increase in price increases total revenue
Quantity/Price Effect when demand for a good is unit-elastic?
Quantity effect and the price effect exactly offset each other
What is income elasticity of demand?
% change in quantity demanded / % change in income
When income elasticity of demand is positive, then the good is
a normal good
When income elasticity of demand is negative, then the good is
an inferior good
What is cross price elasticity of demand between Goods A and B?
% change in quantity of A demanded / % change in price of B
What type of goods have a positive cross-price elasticity of demand
Substitutes
What type of goods have a negative cross-price elasticity of demand
Complements
What is price elasticity of supply?
% change in quantity supplied / % change in price
What is deadweight loss?
Lost benefits to society that occur whenever output differs from the efficient quantity?
What is price control?
Legal restriction on how high or low a market price may go
Enacted by governments
What is price ceiling?
A maximum price sellers are allowed to charge for a good
Only binding if below market clearing price
What is price floor?
A minimum price buyers are required to pay for a good
Only binding if above market clearing price
What are price ceiling outcomes?
Persistent shortage
Redistribution of economic welfare
• Winners: consumers able to buy the good
• Losers: Suppliers and consumers unable to buy the good
Non-Price rationing to determine who gets the available units
Normally price would rise to ration, but not allowed to do so in this case
What are price floor outcomes?
Persistent surplus
Redistribution of economic welfare
What is tax incidence?
Who pays the tax
What is statutory incidence?
Who is legally responsible for paying the tax to the government
What is economic incidence?
Who actually bears economic burden of the tax
• Consumers: measured by higher price paid for good
• Producers: measured by lower prices received for the good
What effect does a per unit tax have?
Increases the “cost of production” by the amount of the tax
Causes the supply curve to shift up by the amount of the tax
Per unit tax impact on prices?
New price consumers pay (Pc) is higher than the equilibrium price (P*)
New price suppliers receive (Ps) is lower than the equilibrium price (P*)
Ps = Pc - tax Pc = Ps + tax
Per unit tax impact on quantity and economic welfare?
Quantity transacted (Qt) falls below the efficient quantity
CS is reduced
PS is reduced
Deadweight loss now exists
Taxes distort incentives to engage in mutually beneficial transactions
Who pays the tax?
Side of market more able to adjust their behavior will avoid paying more of the tax
If demand is relatively more inelastic: will more of tax
If demand is relatively more elastic: will pay less of the tax
Revenue from an excise tax?
Tax revenue = excise tax rate x quantity transacted
Will an increase in tax rate increase tax revenue?
Amount of revenue depends on tax rate and tax base
Raising tax rate has two effects:
• Increases tax revenue per unit of good taxed
• Reduces tax base by discouraging consumption
If inelastic, more likely will increase revenue (quantity sold will not change much)
What affects deadweight loss?
Elasticity
Elastic demand - larger deadweight loss
Inelastic demand - smaller deadweight loss
How to minimize inefficiency with taxes?
Tax goods that are inelastic?
What is market failure?
The failure of a market to reach an efficient outcome where all goods from trade are exhausted
Occurs when the quantity transacted differs from the effect quantity
Results in deadweight loss
What is externality?
When the activity of one entity (individual or firm) directly impacts the welfare of another in a way that is not reflected in the price
“External” to the market
Unintended impacts not taken into account by the individual decision makers
What is negative externality?
An action that imposes net costs on others without their being compensated
The individual decision maker does not have to pay these costs, so does not take them into account when making decisions
What is private cost?
Cost incurred by the individual decision maker only
What is marginal private cost (MPC)?
Incremental costs to private owner
What is marginal external cost (MEC)?
Uncompensated marginal costs imposed on others as a result of actions taken by individual decision maker
What is social cost?
Total costs incurred by society
What is marginal social cost (MSC)?
Total marginal costs to society
MSC = MPC + MEC
What is positive externality?
An action that provides net benefits to others without their having to pay for it
The individual decision maker does not receive compensation for these benefits, so does not take into account when making decisions
What is private benefit?
Benefits enjoyed by the individual decision maker only
What is marginal private benefit (MPB)?
Incremental benefits to private owner
Individual marginal willingness to pay
What is marginal external benefit (MEB)?
Uncompensated marginal benefits provided to others as a result of actions taken by individual decision maker
What is social benefit?
Total benefits enjoyed by society
What is marginal social benefit (MSB)?
Total marginal benefits to society
MSB = MPB + MEB
Private solution to externality problem?
If property rights are clearly defined and transaction costs are low then can get an efficient outcome through bargaining regardless of who owns the property rights
Will the more elastic or inelastic side end up paying more of a tax?
Inelastic
Inelastic Curve = ___ Curve
Steep
Elastic Curve = ____ Curve
Flat
How is the Diamond-Water Paradox resolved?
Recognizing that the price of a product reflects its marginal value for the last unit consumed, not it’s total value to consumers
