Exam 2 Flashcards
What is opportunity cost?
What must be given up in order to consume or produce more of a good
What is marginal cost?
The (opportunity) cost of producing an additional (incremental) unit of a good
What is absolute advantage
When one producer can produce more of a good than another producer in a certain period of time
What is comparative advantage?
When one producer can produce a good at a lower opportunity cost than another producer
What is specialization?
Concentrating one’s efforts in a specific activity or field
What is Production Possibility Frontier (PPF)?
Represents the possible combinations of goods that an economy or individual can produce in a certain period of time
How is it possible to combine for more goods than was possible when acting alone?
Specialization and engaging in trade
What is the key to specialization?
Each side producing according to their comparative advantage
What are the 3 Limitations on Specialization?
- Requires sufficient ability to produce enough to meet demand
- Transportation costs must be low enough to make specialization worthwhile
- Specialization limited by extent of the market
Where is specialization the greatest?
Big Cities > Rural Areas
The larger variety of goods and services become available
What does the Production Possibility Frontier represent graphically?
All possible combinations of two goods that can be produced when a given amount of resources and technology
Shows the maximum quantity of one good that can be produced for any given amount of production of the other good
What does movement along the Production Possibility Frontier (PPF)?
It shows the trade-offs that exist in production
Diverting resources from production of one good to another
What are the three key concepts illustrated by PPF?
- Efficiency
- Opportunity Cost
- Economic Growth
What is efficiency in production?
No way to produce more of one good without producing less of another good
What is the efficiency of all points on PPF?
Efficient in production
What is the efficiency of points inside PPF?
Feasible but not efficient
What is the efficiency of points outside PPF?
Not feasible
How is opportunity cost represented graphically?
Slope of the PPF is the opportunity cost of producing the good on the horizontal axis measured in terms of the good on the vertical axis
How is constant opportunity cost represented graphically?
PPF is a straight line
Opportunity cost of production does not change as production increases
How is increasing opportunity cost represented graphically?
PPF bowed outward
Opportunity cost rises as production increases
As more is produced, less suitable resources are being used in production
Resources are not easily transferable between production of goods
What is economic growth?
Growing ability of economy to produce goods and services
How does economic growth affect PPF?
Causes an outward shift in PPF
What causes an outward shift in PPF?
Increases in factors of production
Changes in technology
What are imports?
Goods and services purchased from other countries
What are exports?
Goods and services sold to other countries
When does a country have a comparative advantage over another?
If the opportunity cost of producing the good or service is lower for that country than for other countries
What are 4 main sources of comparative advantage between countries?
- Differences in Climate
- Differences in Factor Endowments
- Differences in education level of workers
- Differences in Technology
What is the Domestic Demand Curve?
Shows the quantity demanded by domestic consumers depends on the price of that good
What is the Domestic Supply Curve?
Shows how the quantity supplied of a good by domestic producers depends on the price of that good
What is world price?
Price at which the good can be bought or sold abroad
What price will market go to when open to trade?
Competition among importers or exporters drives the domestic price to equality with the world price
If world price < domestic price?
Trade leads to imports and a fall in the domestic price towards the world price
What are effects of imports?
Net benefits increase for importing country: There are overall gains from trade because consumer gains exceed the producer losses
Who are the winners of imports?
Price to domestic consumers falls
Who are the losers of imports?
Price received by domestic suppliers falls
Demand for workers in domestic industry drops, reduces wages to domestic workers in those industries
If world price > domestic price?
Trade leads to exports and a rise in the domestic price
What are the effects of exports?
Net benefits increase for exporting country: There are overall gains from trade because producer gains exceed the consumer losses
Who are the winners from export
Price received by domestic suppliers increases
Demand for workers in domestic industry increases, increases wage to domestic workers in those industries
Who are the losers from export
Price paid by domestic consumers increases
What is free trade?
When the government does not attempt either to reduce or to increase the levels of exports and imports that occur naturally as a result of supply and demand
What is a tariff?
A tax levied on imports
How do tariffs affect price?
They raise the domestic price above the world price, leading to a fall in trade and total consumption and a rise in domestic production
Who are the winners from a tariff?
Domestic producers and the government gain, but consumer losses more than offset this gain, leading to deadweight loss
What is a firm?
An entity that converts inputs into outputs
What are inputs?
Land, labor, capital
What is capital?
Durable goods used in production of other goods
What are outputs?
Goods or services sold to consumers
What is the profit maximization assumption
Firms attempt to maximize profits
What is profit?
Profit = Total Revenue (TR) - Total Cost (TC)
What is total revenue?
Price x Quantity
How does total cost depend on quantity?
Total cost is a function of quantity
How must a firm maximize profits?
Produce a given quantity as efficiently as possible
What is the production function?
Describes the relationship between the quantities of inputs used and the maximum quantity of output that can be produced with those inputs
What are examples of factors of production?
Labor and capital are inputs into production
What is Total Product (TP)?
Total amount of product that factors of production create
What is the relationship between total product and amount of factors used?
Total product increases with increases in amount of factors used
What is Average Product (AP)?
Ratio of total output to number inputs used to produce that output
What is AP(Labor)?
Quantity/Units of Labor
Q/L
What is AP(Capital)?
Quantity/Units of Capital
Q/K
What is Marginal Product (MP)?
The change in output that occurs when an incremental unit of an input is added
What is Marginal Product of Labor?
Change in quantity of output / Change in quantity of labor
∆Q/∆L
What is Marginal Product of Capital?
Change in quantity of output / Change in quantity of capital
∆Q/∆K
What are Short-Run Time Horizons?
Periods of time short enough such that at least one factor of production is fixed (cannot be changed)
Whether capital or labor is fixed in the short-run depends on the industry
What are Long-Run Time Horizons
Periods of time long enough that all factors of production can be varied
What is the Law of Diminishing Marginal Product?
As additional units of the variable input are added to fixed inputs, eventually the marginal product of the variable input will decline
Holds only if other factors are held fixed
What is the Total Product Curve?
A graphical representation of how the quantity of output depends on the quantity of the variable input, for a given quantity of the fixed input (holding quantity of the fixed input constant)
What is an explicit cost?
A cost that involves actually laying out money
Direct, out-of-pocket payments for inputs into the production process
Accounting costs
What is an implicit cost?
A cost that does not require an outlay of money; it is measured by the value, in dollar terms, of the benefits that are forgone
What is sunk cost?
Costs incurred in the past that cannot be recovered regardless of current decision making
Sunk costs should be ignored when making decisions about future actions
How do sunk costs relate to future actions?
Sunk costs should be ignored when making decisions about future actions
No matter what choice is made today, sunk costs are lost either way
What does a firm’s cost structure depend on?
- Technology available
2. Prices paid for factors of production
What is Fixed Cost (FC)?
Cost that does not depend on the quantity of output produced
Does not change with output
Expenditures on factors that are fixed in the short-run
What is Variable Cost (VC)?
Cost that does depend on the quantity of output produced
Increases with increased output
Expenditures on factors that are variable in the short-run
What is Total Cost (TC)?
The total cost of producing a given quantity
Total Cost (TC) = Fixed Cost (FC) + Variable Cost (VC)
What is Marginal Factor Cost (MFC)?
The additional cost to a firm from hiring one more unit of a factor
Labor = Wage Capital = Rental rate of capital
What is the equation for Marginal Cost (MC)?
Change in total cost / Change in quantity of output
∆TC/∆Q
What is Average Fixed Cost (AFC)?
Fixed costs per unit of output
Falls as output rises because fixed cost is spread over more units (spreading effect)
AFC = FC/Q
Why does Average Fixed Cost (AFC) decrease as more units are produced?
Because fixed cost is spread over more units
What is Average Variable Cost (AVC)?
Variable cost per unit of output
Shape determined by Marginal Cost
AVC = VC/Q
What is the equation for Average Fixed Cost (AFC)?
Fixed Cost / Quantity of Output
FC/Q
What is the equation for Average Variable Cost (AVC)?
Variable Cost / Quantity of Output
VC/Q
What is Average Total Cost (ATC)?
Average Cost
Total cost per unit of output
ATC = TC/Q = AFC + AVC
What is the equation for Average Total Cost (ATC)?
ATC = Total Cost / Quantity of Output ATC = TC / Q = (FC + VC) / Q = AFC + AVC
What are the four cost curves?
- Marginal cost
- Average Variable Cost
- Average Fixed Cost
- Average Total Cost
Describe the slope of the marginal cost curve
Eventually upward sloping due to diminishing returns
Increasing specialization leads to lower marginal cost, but diminishing returns set in once benefits from specialization are exhausted and marginal cost rises
Describe the slope of the average variable cost curve
Shape determined by marginal cost
Flatter than marginal cost curve
Describe the slope of the average fixed cost curve
Always downward sloping due to spreading effect
Describe the slope of the average total cost curve
Tends to be U-shaped (AFC + AVC)
How does the spreading effect change the average fixed cost curve
Fixed costs are spread over more units, and AFC drops
How does the diminishing returns effect change the marginal cost and average variable cost curves
As output increases, eventually diminishing marginal product sets in
As marginal product falls, marginal cost rises, pulling up AVC
How does the average fixed cost (AFC) curve behave at low outputs?
AFC is dropping rapidly
How does the average variable cost (AVC) curve behave at low outputs?
AVC may also be dropping
May fall initially if production function has increasing marginal product initially
How does the average total cost (ATC) curve behave at low outputs?
ATC dropping
How does the average fixed cost (AFC) curve behave at high outputs?
AFC still falling, but having smaller impact on ATC (flatter)
How does the average variable cost (AVC) curve behave at high outputs?
AVC rising due to diminishing marginal product
How does the average total cost (ATC) curve behave at high outputs?
ATC rising
Can fixed input be changed in short run?
No
Can fixed input be changed in long run?
Yes, no factors are fixed in the long run
What are Constant Returns to Scale?
Proportional increase in all input levels leads to output growth of the same proportion
Ex: Doubling all inputs results to doubling the output
What are Increasing Returns to Scale?
Proportional increase in all input levels leads to greater than proportional output growth
Ex: Doubling all inputs results in more than doubling the output
What are reasons for Increasing Returns to Scale?
Greater specialization
Learning by doing
What are reasons for Decreasing Returns to Scale?
Organizational Difficulties
What are Decreasing Returns to Scale?
Proportional increase in all inputs leads to less than proportional increase in outputs
How does average cost of production change for increasing returns to scale
average cost of production falls
Total costs are increasing, but output is increasing at a faster rate
How does average cost of production change for constant returns to scale
Average cost of production stays constant
Flat AC curve
How does average cost of production change for decreasing returns to scale
Average cost of production increases
Total costs are increasing and output is increasing at a slower rate
Known as diseconomies of scale
What are the effects of a tariff?
Domestic Price Increases
Domestic Production Increases
Trade Decreases
Total Consumption Decreases
Winners: domestic producers, government
Losers: consumers
Are markets better or worse off with trade?
Both domestic and international markets are better off with trade
According to the theory of diminishing marginal product, as additional units of the variable input are added to fixed inputs, what will happen to marginal product?
Marginal product of the variable input will decline (adding so much it causes organizational difficulties)
What is diseconomies of scale?
Rising average total cost (of production) when quantity increases
What is economies of scale?
Falling average total cost (of production) when quantity increases
What is the equation for accounting profit?
Total Revenue minus Explicit Cost
TR - EC
What is equation for economic profit?
Total Revenue minus Explicit Cost minus Implicit Cost
TR - (EC + IC)
What do imports do to domestic price?
Decrease in price
What do imports do to domestic production/employment?
Decrease in domestic production/employment
What do tariffs do to domestic producers?
Benefits them (more production due to tariff)
Do tariffs benefit domestic society?
Overall, they do not
What effects to tariffs have on producer surplus?
Increase in producer surplus
Slope of the X-Y graph of two goods is the marginal cost of which good?
The one on the X-axis (MCx = #Y’s)
How does exporting goods affect the domestic producer surplus?
It would increase
How do tariffs affect domestic consumer surplus?
Reduction in DCS
Simple look at supply and demand for importing
Producing Less (others from other countries are making more)
Demanding more (lower prices)
Simple look at supply and demand for exporting
Producing more (making some overseas now)
Demanding less (higher prices)
