Midterm 1 Flashcards
Economist as a scientist
Approach like scientists - theories, collect and analyze data to refute theories
—scientific method: the dispassionate development and testing of theories about how the world works (nation’s economy) - can’t manipulate data (inflation), so study natural experiment’s through history
Role of assumptions
Simplify the complex world and make it easier to understand - then apply to the complex world(more focused and direct)
–assume away many details of economy that are irrelevant to the current question at hand
Circular flow diagram
explains in general terms how economy is organized and how participants interact with each other - shows how dollars flow through markets among households and firms
FIRMS - Produce goods and services using inputs (labor, land and capital) - inputs are called FACTORS OF PRODUCTION
—households own the factors of production and consume all the goods
HOUSEHOLDS are buyers and FIRMS are sellers
TWO MARKETS - in circular flow diagram
- Markets for Goods and services - households BUY (goods and services) and firm SELL (goods they produce)
- Markets for factor of production - households SELL (inputs - land, labor, capital) and firms USE the those inputs to produce
Flow of money - households buy goods from firms - use revenue to pay for FOP (L,L,C) - wages to hire employees - make profit and income to firm owner’s, who are member’s of households
Production Possibilities Frontier
Graph that shows the combinations of output that the economy can possibly produce - with available FOP and Technology
SLOPE - Measures OPP. Cost (loss of potential gain from other alternatives when one is chosen) of a car (x) in terms of computers (y)
Beyond curve is INFEASIBLE POINT - Cn’t produce bc limited resources/ FOP
outcomes are efficient if on the curve and inefficient if inside it
OPP. Cost of a car is the slope of the frontier (rise/run)
–flat = low slope and low opp. cost - steep = high slope and high pop. cost
ADV. IN tech. of computer (y) - Cars stays same place and same steep but # comp. produced increases and bulges upward to be more steep
Microeconomics
Study of how HOUSEHOLDS and FIRMS make decisions and interact in the economy (Small - microscope)
EX. Effects of rent control in NYC, Impact of foreign comp. on auto industry, effects of school attendance on workers’ earnings
study of businesses and individuals
Macroeconomics
study of economy wide phenomena - inflation, unemployment, and economic growth (big picture) - looks at changes in totals
Ex. study effects of borrowing by deferral gov. changes overtime in rate of unemployment, or alternative policies to improve living conditions
study the forces and trends that affect the economy as a whole
-study of gov. and large societies
Economist as a policy adviser
when they are trying to explain the world they are scientists, when trying to improve it they are policy advisers - explain economic events and recommend policies to improve
Scientists (make claims how the world works)
policy advisers (claim how they would like to change
Positive statements
descriptive - claim to explain how the world is - scientists
-measurable, quantifiable, verifiable
normative statements
Prescriptive - claim how the world ought to be - policy advisers
judge 2 stmts differently - can confirm or refute positive stmts by examining evidence - use ethics, religion and political philosophy to decide good or bad policy (normative)
3 parts of gov. that regularly rely on economists
President, Congress and Federal Reserve
Economists disagree for 3 reasons (give conflicting advice)
- disagree about the validity of alternative positive theories of how world works
- have different values - diff. normative views about what gov. policy should aim to accomplish
- Perception vs. reality - broken window fallacy
Differences in scientific judgement vs. diff. in values
disagree about whether gov. should tax household income of consumption (spending) ◦ —Consumption tax would encourage those to save bc income isn’t taxed - spend less would free resources for accumulation and make for rapid productivity - other side believes they wouldn’t respond differently to changes
—-diff. normative views bc have different positive views about saving’s responses
values - disagree with who should be taxed more - higher income = higher taxes? moral fair?
perception vs. reality
–Broken window fallacy - Sometimes people see that broken window leads to hiring employer, spending and economic activity - but economists see both sides - the money used for broken window could have been spent elsewhere (new suit)
economists often conflict. bc scientific judgments or diff. in values - but at times when agree, policymakers ignore advice bc of many forces and constraints imposed in the political process
Economics
the study of how gov., companies and individuals make choices about how they use scarce resources in the economy
–simple - economics is the study of choice - what motivates gov., companies, and industries to make the choices they make
Independence and gain from trade
trade can make everyone better off
–benefit bc of specialization - easier and then trade for what is more difficult
Production possibilities frontier with trade
Graph always shows the principle of TRADEOFFS - If both parties are self sufficient and do not trade - the PPF is also the consumption possibilities frontier - eat their own produced goods
-but if specialize it improves the possible consumption amount on both sides
Absolute advantage
driving force of specialization
–more efficient than the other person - ability to produce a good using fewer inputs than another producer - requires the smaller quantity of inputs to produce a good
Comparative advantage
ability to produce a good at a lower opp. cost than another producer - if a producer has a lower opp. cost (gives up less to produce than the other) they have comp. advantage
–each is the inverse of the other opp. cost
EX. Frank = meat (4 oz. potatoes) and potatoes (1/4 oz. meat) - comp. adv. in potatoes
Ruby - meat (2 oz. potatoes) and potatoes (1/2 oz. meat) - comp. adv. in meat
specialization
specialize where your comp. advantage is the largest - or where opp. cost is the least - then buy the reast
possible to have abs. adv. in both goods but NEVER possible to ave comp. adv. in both
gains from specialization and trade are based on comparative adv. not absolute
Trade can benefit everyone in society bc…
it allows people to SPECIALIZE in activities in which they have a comparative advantage
- -for both parties to gain from trade, the price at which they trade must lie btw the two opportunity costs
- -used to advocate free trade among countries
however trade sometimes makes individuals worse off even though it improves the country (farmer vs. autoworker)
Marginal cost
maybe one employee is best at everything - but have to give bad employees - good employee gets burnt out after 17 hours and is less efficient than bad employee who is rested - doesn’t matter if you have absolute adv. a everything
forces that drive the market
supply and demand - determine prices and quantity produced of each product
Market/ Competitive market
group of buyers and sellers of a good or service
competitive market - market in which there are many buyers and many sellers so that each has no effect on market price
–each seller has limited control of price bc other sellers are offering similar products (wheat market)
–each buyer has small influence bc each buyer purchases such a small act.
CALLED PRICE TAKERS
in highest form of competition, market has 2 characteristics
- ) the goods offered for sale are all exactly the same
- ) the buyers and sellers are so numerous that no single buyer or seller has any influence over market price
monopoly
markets only have one seller - this seller sets the price
law of demand
other things equal, the quantity demanded of a good falls when the price of the good rises
–QD: amt. of good buyers are willing and able to purchase
market demand - sum of all individual demands of a specific good
demand schedule
table shows the relationship btw price of good and QD
-Price on Y and demand on x axis - line is demand curve
Determinants that shift the DEMAND curve
- NUMBER OF BUYERS IN MARKET
- –inc. # = inc. QD at each price - shifts RIGHT - INCOME
- -Normal good: good for which an increase in income leads to an inc. in demand (Steak, vacations, cruises)
- -inferior good - income rises and demand decreases (Raman noodles) - PRICE OF RELATED GOODS
- –Substitutes: can replace - an inc. in price leads to inc. in demand for other good (coke and Pepsi, laptop and tablets)
- –complements: pairs - if one price rises other demand decreases (hotdogs and buns) (textbooks and tuition) - TASTES
- -switch tastes toward good - inc. in demand - BUYER’S EXPECTATIONS ABOUT FUTURE
- –Expect an inc. in income = inc. in current demand
- -expect higher prices, inc. in current demand
Law of supply
claim that QS of good rises when price of good rises
–as price rises, supply more and more of a good - if price is low, consider closing and not selling
market supply - sum of the quantities of all sellers at each price
–shift right if inc. QS and left if decreases
supply curve - sloped upwards bc higher price means a greater QS
Determinants that shift SUPPLY curve
- INPUT PRICES
- –supply is negatively related to prices of inputs
- -ing. and things used to produce - price inc. then supply decreases - TECHNOLOGY
- -New machine to reduce cost and resources - R shift - EXPECTATIONS
- -if expect price of ice cream to rise in future, will put away ice cream now and save to supply more in future - shift left - NUMBER OF SELLERS
- -Inc. number of sellers and QS increases
equilibrium
market price has reached level where quantity supplied = QD
–equilibrium price and equilibrium quantity
surplus and shortage
surplus - QS is greater than WD - EXCESS SUPPLY
- –respond by CUTTING price = inc. demand and decrease supply
- -price change so MOVES along demand curve but not shift
shortage - not enough supplied to meet QD - EXCESS DEMAND
–respond by RAISING price - QD decrease and supply rise
3 steps to analyze changes in equilibrium
- Decide whether event shifts the supply or demand curve (or both)
- Decide which direction curve shifts
- Use supply and demand diagram to see how shift changes equilibrium price and quantity
law of supply and demand
claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for that good into balance
Fixed curves
Fixed SUPPLY curve
-a change in the quantity supplied - moves along the supply curve but doesn’t shift
fixed DEMAND curve
-moves along demand curve and changes QD but not shift
T/F When both the demand and supply curves shift, the curve that shifts by the smaller magnitude determines the undetermined equilibrium object
FALSE
invisible hand
guides market economies - price guide economic decisions and allocate scarce resources
–price ensures that S and D are in balance`
capitalism and gospel
represents many fundamental parts of the gospel (learn econ for wealth and prosperity, but must be taught within the context of the true and fundamental principles of the gospel - keeps us humble and focused on what really matters in life)
elasticity
responsiveness - measures responsiveness of QD and QS when we change one of its determinants
use midpoint method - # halfway btw start and end values (the average)
if elasticity is 1.8 then for every 1% inc. in price, WD decreases by 1.8% (almost double) 0r vise versa
price elasticity of demand
IF demand elasticity is <1 = inelastic - RAISE PRICES TO RAISE REVENUE
IF elasticity is >1 = elastic - LOWER PRICES to RAISE REVENUE
demand is elastic, price dec. makes revenue inc.
inelastic, price inc. makes revenue inc.
Determinants of price elasticity of demand
- SUBSTITUTES
- –if has close substitutes = more elastic (cereal vs. sunscreen) - necessities are low - NARROWLY DEFINED
- -HIGHER for narrowly defined gods (blue jeans - narrow and many substitutes) clothing is broad and can’t replace - LUXURIES
- -HIGHER for luxury than necessities - LONG RUN
- -HIGHER in long run
supply elasticity
(Q2 - Q1) / (Q2 + Q1)/2
/
(P2 - P1) / (P2 + P1)/2
Determinants of supply elasticty
- LONG RUN
- –More elastic in long run - Beachfront property vs. cars
- –beach is less elastic
WHEN SUPPLY IS INELASTIC - INC. D as greater impact on price than quantity
–when supply is elastic - inc. Das greater imp. on quantity than price
supply tends to be less elastic as Q increases (capacity limits)
price elasticity of DEMAND curves
flatter curve = greater elasticity
–steep curves - smaller price elasticity of demand
perfectly inelastic - straight vertical (regardless of any price, QD stays the same)
perfectly elastic - direct horizontal - small changes in price have large impacts in QD
Total revenue
amount paid by buyers and received by sellers of a good, computes as the price of good times Quantity sold
- -if demand is inelastic - inc. in price causes an inc. in total revenue
- -demand is elastic - change in price causes a DECREASE in total revenue
unit and linear
unit elastic - total revenue remains constant when price changes
over linear demand curve
- -straight line has constant
- -even though SLOPE IS CONSTANT, ELASTICITY IS NOT
- –CLOSER TO Y - HIGH price and LOW QD - More elastic
- -closer to X = HIGH QD and low Price, inelastic
income elasticity of demand
measures how QD changes as consumer income changes
–normal goods - high income raises QD - positive income elasticities bc more in same direction
inferior goods - high income lowers QD - opposite direction so negative elasticity
Cross-price elasticity of demand
measures how much QD of one good respond to change in price of a DIFFERENT good
=% change in QD of GOOD 1 / % change in Price of good 2
whether elasticity is positive or negative depends on whether substitutes or complements
–hot dogs vs. hamburgers - price and QD move in same direction - both inc. so positive (SUBSTITUTES ARE POSITIVE)
Complements - price inc. but QD decreases - negative cross- price elasticity
T/F The ability of firms to enter and exit a market over time means that in the long run the supply curve is more elastic
TRUE
An increase in supply of a good will DECREASE the total revenue receive if demand curve is
INELASTIC
Tech. advance increases incomes and reduces smart phones price - increase consumers spend on smartphones if income elasticity is greater than ____ and if price elasticity is greater than ___ (zero, one)
(zero, one)
in general in order for price inc. to lead to an inc. in total revenues…
supply and demand must be inelastic
Price ceiling
the legal maximum on the price at which good can be sold (buyers want bc then sellers legally cannot raise prices)
two possible outcomes:
1. NOT BINDING - set as $4 and equilibrium is $3 - below ceiling and has no effect on P or Q
- BINDING CONSTRAINT - set price as $2 - supply and demand tend to move toward EQ. but bc of ceiling, cannot increase - QD exceeds QS and makes SHORTAGE
- –WHEN Gov. imposes binding price ceiling on competitive market, a shortage of the good arises and sellers must ration the scarce goods among a large number of buyers
Ex. of price ceiling
Rent control
- -lower price to help poor to find housing - economists argue it is “the best way to destroy a city, other than bombing” - causes a shortage - bc inelastic in short run, shortage is small - also landlords lose the incentive to take care of apartments (bc usually nicer means higher price) bc people are willing to pay regardless - lower price means lower quality
- –Shortages result in undesirable rationing mechanisms
price floor
legal minimum on price a good can be sold - what sellers want
2 possible outcomes
1. NOT BINDING - ice cream price at $3 and set price at $2 - so equilibrium price is above floor and no effect
- BINDING CONSTRAING - Higher than equilibrium and creates SURPUS
- -RESULT IS UNEMPLOYMENT
- -greatest impact on market for TEENAGE labor (least skilled and least experienced workers - willing to accept lower wage)
earned income tax credit
gov. program that supplements incomes of low wage workers
best option is REST SUBSIDIES (do not reduce QS = no shortage)
Tax incidence
the manner in which the burden of a tax is shared among participants in a market
Taxes on sellers
- Decide whether law affects supply or demand curve
- –Demand curve doesn’t change bc target sellers - makes ice cream business less profitable so shifts supply curve - Decide which way curve shifts
- –Reduces QS at every price (raise cost of producing and selling) shifts to left (by the size of the tax) - Examine how shift affects the equilibrium price and quantity
- –Reduces size of ice-cream market
- -Lowers supply but increases the market price by $.30 - so intended to hit sellers but both buyers and sellers share the burden of the tax
Basic effects
- –Taxes discourage market activity - when good is taxed, the quantity of good sold is smaller in new equilibrium
- –Buyers and sellers share burden of taxes - in new equilibrium, buyers pay more for good and sellers receive less
taxes on buyers
- Impact on demand curve
- Shifts demand curve left - moves market price lower to make up for effect of the tax
- Compare equilibriums - reduces the size of ice-cream market
- –Buyers and sellers share burden - sellers get lower price and buyers pay lower market price but effective price (price including tax) rises
TAXES ON BUYERS AND TAXES ON SELERS ARE EQUIAL - places wedge btw prices but were is the SAME - only diff. is who sends the money to gov.
payroll tax
tax on wages that firms pay their workers (FICA)
elasticity and tax incidence
both share burden but rarely shared equally
- -if tax sellers, supply curve shifts
- -if tax buyers, demand curve shifts
diff. is elasticity of S and D
- –if D is more elastic than supply - sellers share more burden bc price received falls
- –if S is more elastic than D - buyers share burden bc price rises
LEAST ELASTIC CURVE SHARES MAJORITY OF BURDEN
assuming long run demand for oranges is same as short run demand, you would expect…
a binding price ceiling to result in a SHORTAGE that is LARGER in long run than short run
results of rental control laws
- –Nonprice methods of rationing emerge, black markets develop, quality falls, quantity available of rental housing units falls
- —Landlords provide less maintenance and unlikely to upgrade, profitability of owning apt. units decreases so landlords construct fewer units - decreases number available in the future, a shortage results leading to under the table payments to secure an apartment (black market) - alternative methods of rationing increase
when have price control - creates a BLACK MARKET
minimum wage
—Minimum wage - in order for minimum wage to be binding (prevent labor market from reaching equilibrium - must be higher than the equilibrium wage) - equilibrium $10, binding would be more than $10
–Min. wage is ex. of price floor designed to help the supplier
when is market most efficient?
at equilibrium - maximize total surplus at equilibrium
welfare economics
study of how the allocation of resources affects economic wellbeing - benefits that buyers and sellers receive from engaging in market transactions and how society can maximize these benefits
In any market - the equilibrium of S and D maximized the total benefits receive by all buyers and sellers combines - markets are the best way to organize economic activity
–naturally moves toward this equilibrium - led by invisible hand
willingness to pay
maximum amt. a buyer will pay for a good - measures how much the buyer values the good (if less, then happy - equal then indifferent, more than = won’t buy it)
consumer surplus
amt. a buyer is willing to pay for a good minus the amt. the buyer actually pays for it
- –Willing to buy for $100 (everyone else dropped out bc too high) and got it for $80 - consumer surplus is $20
- –Consumer surplus measures the benefit buyers receive from participating in a market
- –Total consumer surplus in market = adding up each INDIVIDUAL surplus amt.
- –Related to demand curve - bc on demand schedule - if the range of price is within their willing to pay range…that is the quantity demanded - height of demand curve is represented by person who is willing to pay the most - then staircase
marginal buyer
buyer who would leave market first if price were any higher
—LOWEST on the demand curve
The area below the demand curve and above the price measures the consumer surplus in a market - height of curve measures the value buyers place on the good
consumer surplus 2
helps us make judgements about the desirability of market outcomes - measures the benefit that buyers receive from a good as the buyers themselves perceive it - good measure of economic well-being
Cost
the value of everything a seller must give up to produce a good - includes out of pocket expenses and the value they place on their own time - cost is the lowers price seller would accept for his work (house painter)
- –Measure of willingness to sell his services
- –Willing to sell at a price greater than his cost, refuse to sell at less than
producer surplus
amt. seller is paid for a good minus the seller’s cost of providing it
• Work for $500 and get $600 - surplus is $100
• 2 sellers - one for $500 and one for $600 and both get jobs for $800 - first surplus is $300 and second is $200 - total surplus in the market is $500
marginal seller
the seller who would leave the market first if the price were any lower (highest seller)
The area below the price and above the supply curve measures the producer surplus in a market
-when price RISES QS rises
basic tools economists use to study welfare of buyers and sellers in market
consumer surplus and producer surplus
–want to max. economic well-being of everyone in society
surplus equations
consumer = value to buyers - amt. paid by buyers (buyers benefit for participating in market)
producer = amt. received by sellers - cost)
total surplus = value to buyers - cost to sellers
efficiency
property of resource allocation of maximizing the total surplus received by all members of society (price where more buyers can enter market at lower price and inc. consumer surplus and more sellers can also enter at higher price to inc. producer surplus)
• Whether pie is as big as possible
equality
distributing economic prosperity uniformly among members of society - buyers and sellers have similar economic well-being
• How the pie is sliced and how portions are distributed among members of society
insights from surplus
- Free markets allocate the supply of goods to the buyers who value them most highly - measured by their willingness to pay
- Free markets allocate the demand for goods to the sellers who can produce them at the lowest cost
- Free markets produce the quantity of goods that maximizes the sum of consumer and producer surplus
social planner to MAXIMIZE total surplus
choose quantity where supply and demand intersect
(social planner canNOT raise total well-being by incr. or decreasing the quantity of the good) - also cannot change allocation of consumption among buyers or production among sellers) - best to LEAVE AT EQUILIBRIUM BC EFFICIENT
• Under quantity equilibrium - value of marginal buyer is greater than cost to marginal seller - above equilibrium cost of marginal seller is greater than marginal buyer
invisible hand 2
Even though buyers and sellers in market only care about their own welfare - together they are guided by an invisible hand to equilibrium that maximizes total benefits to buyers and sellers (invisible hand - ADAM SMITH - “economy can work well in free market scenario where everyone will work for his/her own interest”
market power
We assumed perfectly competitive markets - but not always case - a single buyer or seller can control market price and have market power
externalities
market sometimes exhibits side effects that make welfare implications of market activity depend on more than just the value obtained by buyers and cost incurred by sellers
• Ex. Pollution - use of agricultural pesticides affects not only manufactures and buyers but also those who breathe air or drink contaminated water as a result
market failure
inability of unregulated markets to allocate resources efficiently (due to possibly market power and externalities)
