Introduction to Economic Principles

Question 1

What is economics?

Answer 1

The study of how people interact with each other and with the natural environment in producing their livelihoods

Question 2

What is positive economic analysis?

Answer 2

The objective study of the economy - what questions

Question 3

What is normative economic analysis?

Answer 3

The how questions - involving subjective value judgments

Question 4

What restricts the system of the economy?

Answer 4

Availability of resources (physical for production, time) -> trade-offs

Question 5

Rapid economic growth caused these 3

Answer 5

1. Higher living standards
2. Large inequality
3. Natural degradation (pollution, climate change)

Question 6

3 things a capitalist economy needs

Answer 6

1. Private property rights (enforced by the state)
2. Markets (enough freedom to buy and sell what you want)
3. Firms (individuals organizing themselves to produce products and lent money to buy capital goods)

Question 7

A “laissez faire” economy will create

Answer 7

Inequality and natural degradation

Question 8

6 roles for the government in modern society

Answer 8

1. Redistribute income
2. Use expenditures to influence market outcomes directly
3. Use norms to influence market outcomes directly (minimum wage)
4. Regulation to prevent natural degradation
5. Regulation to prevent unhealthy behavior
6. Use information campaigns to prevent individuals from taking decisions they’ll later regret

Question 9

What is opportunity costs?

Answer 9

Choosing something means that you cannot choose something else (=scarcity); the best alternative is called opportunity costs

E.g., if you can either work and earn 50 euros and watch TV at home -> the opportunity cost of watching TV is 50 euros

Question 10

What is the budget-line?

Answer 10

A line that describes all feasible combinations that can be chosen. Economists assume that individuals will desire a decision on the feasible frontier as it maximizes the trade-off involved

E.g., feasible frontier

Question 11

What are indifference curves?

Answer 11

A set of lines that describe the preference of the individual - the highest indifference curve representing the highest level of happiness.

E.g., the utility function

Question 12

What system yields a general efficient allocation of resources?

Answer 12

Competitive markets

Question 13

4 assumptions of a competitive market

Answer 13

1. Property rights are well-defined and secure
2. Consumers and suppliers are price takers (do not have market power, so cannot influence price themselves)
3. Perfect information (price and quality)
4. No entry or exit barriers

Question 14

If the 4 assumptions of competitive markets hold, what happens?

Answer 14

Prices will signal the social marginal production costs of products. The decision of how much of a product to buy aligns with the trade-off faced by society as a whole

Question 15

The demand curve reflects

Answer 15

The willingness to pay for the product by consumers

Question 16

The supply curve reflects

Answer 16

The social marginal production costs of the product

Question 17

What is the equilibrium?

Answer 17

Where the supply curve meets the demand curve. There is no surplus left, meaning that the consumer pays exactly the price they want, and the firm selling the good does not make a profit, but only covers production costs

Question 18

Infra-marginal consumers

Answer 18

Pay a price less than their own valuation -> they get a surplus

Question 19

On a competitive market, producers and consumers cause the surplus to be maximized without…

Answer 19

Government interference

Question 20

The surplus of all the markets in an economy is a proxy for…

Answer 20

Welfare

Question 21

If the surplus is not maximized, it is due to

Answer 21

Market failure(s)

Question 22

What is a common good?

Answer 22

A common good requires collective action, it’s benefits are non-excludable but consumption is somewhat rivalrous (if I get some, you might have a bit less)

Question 23

6 types of common goods?

Answer 23

1. Fair distribution of income
2. Fair distribution of wealth
3. Quality of local environmental and global climate
4. Health and healthy behavior
5. Quality of government
6. Collective action, dislike of cheating

Question 24

What is the size of direct taxes compared to indirect taxes (on consumption)?

Answer 24

They are comparable in size

Question 25

According to the Laffer curve, why does raising the tax not always lead to more tax revenues?

Answer 25

The tax revenue function is an inverted U-shape. If you increase the taxes beyond the middle point of the function, the revenue gains are exactly the same or smaller than a tax before the middle point. Why? The revenues lost due to people not buying a product anymore as it becomes too expensive (and thus government cannot collect taxes on it) is exactly the same or bigger than the increase in tax revenues gained from the increase in tax

Question 26

When does a higher tax rate yield more taxes?

Answer 26

When the tax rate is on the upward sloping part of the Laffer Curve

Question 26

What is the tax base elasticity?

Answer 26

With what percentage does the tax base decline when the tax rate increases with 1%?

Question 26

On the upward sloping part of the Laffer curve, the tax base elasticity…

Answer 26

Is smaller than 1

Question 27

Economic incidence of a tax might differ from

Answer 27

Statutory incidence (who pays the tax legally)

Question 27

What is tax incidence?

Answer 27

Analysis of which actors feel the burden of the tax on their real income

Question 28

Why would suppliers lower their prices if a tax is imposed that is paid by the consumers?

Answer 28

A new tax lowers demand for the product. If suppliers keep charging the original price, they will feel a big drop in demand. Instead, they accept the new reality and lower their price to meet demand -> they start to share in the tax burden

Question 28

What is a budget-neutral reform?

Answer 28

Replacing a tax with another which yields the exact same revenues as before

E.g., replacing the tax on consumers with a tax paid by producers, but which yields exactly the same amount of revenue

Question 29

What happens if a tax is introduced that is payable by consumers?

Answer 29

Demand falls -> demand curve goes down

Price received by suppliers is the new equilibrium

Price paid by consumers is the point above the new equilibrium on the demand curve

Question 30

What happens if a tax is introduced that is payable by the suppliers?

Answer 30

The supply curve shifts up

Price paid by consumers us the new equilibrium

Price received by suppliers is point below new equilibrium on supply curve

Question 31

What determines the tax incidence?

Answer 31

The relative elasticity of demand and supply! The party that is the least elastic (the most steep slope) will pay the highest share of the tax