Review for the Midterm Exam.

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1 Review for the Midterm Exam. 1. Chapter 1 The principles of decision making are: o People face tradeoffs. o The cost of any action is measured in terms of foregone opportunities. o Rational people make decisions by comparing marginal costs and marginal benefits. o People respond to incentives. The principles of interactions among people are: o Trade can be mutually beneficial. o Markets are usually a good way of coordinating trade. o Govt can potentially improve market outcomes if there is a market failure or if the market outcome is inequitable. The principles of the economy as a whole are: o Productivity is the ultimate source of living standards. o Money growth is the ultimate source of inflation. o Society faces a short-run tradeoff between inflation and unemployment. 2. Chapter 2 Economists play two roles: scientists and policy advisors. As scientists, economists make positive statements, which attempt to describe the world as it is. As policy advisors, economists make normative statements, which attempt to prescribe how the world should be. You should know how to conduct two simple models, the Circular-Flow Diagram and the Production Possibilities Frontier. The Circular-Flow Diagram: A visual model of the economy that shows how dollars flow through markets among households and firms. The Production Possibilities Frontier (PPF): A graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology. The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth. A bow-shaped PPF illustrates the concept of increasing opportunity cost. Microeconomics studies the behavior of consumers and firms, and their interactions in markets. Macroeconomics studies the economy as a whole. 3. Chapter 4 A competitive market has many buyers and sellers, each of whom has little or no influence on the market price. Economists use the supply and demand model to analyze competitive markets. 1

2 The downward-sloping demand curve reflects the Law of Demand, which states that the quantity buyers demand of a good depends negatively on the good s price. Besides price, demand depends on buyers incomes, tastes, expectations, the prices of substitutes and complements, and # of buyers. If one of these factors changes, the D curve shifts. The upward-sloping supply curve reflects the Law of Supply, which states that the quantity sellers supply depends positively on the good s price. Other determinants of supply include input prices, technology, expectations, and the # of sellers. Changes in these factors shift the S curve. The intersection of S and D curves determine the market equilibrium. At the equilibrium price, quantity supplied equals quantity demanded. If the market price is above equilibrium, a surplus results, which causes the price to fall. If the market price is below equilibrium, a shortage results, causing the price to rise. We can use the supply-demand diagram to analyze the effects of any event on a market: o First, determine whether the event shifts one or both curves. o Second, determine the direction of the shifts. o Third, compare the new equilibrium to the initial one. In market economies, prices are the signals that guide economic decisions and allocate scarce resources. 4. Chapter 5 Elasticity measures the responsiveness of Q d or Q s to one of its determinants. We use midpoint method to calculate percentage change in elasticity. Price elasticity of demand equals percentage change Q d in divided by percentage change in P. When it s less than one, demand is inelastic. When greater than one, demand is elastic. When demand is inelastic, total revenue rises when price rises. When demand is elastic, total revenue falls when price rises. Demand is less elastic in the short run, for necessities, for broadly defined goods, or for goods with few close substitutes. Price elasticity of supply equals percentage change in Q s divided by percentage change in P. When it s less than one, supply is inelastic. When greater than one, supply is elastic. Price elasticity of supply is greater in the long run than in the short run. The income elasticity of demand measures how much quantity demanded responds to changes in buyers incomes. The cross-price elasticity of demand measures how much demand for one good responds to changes in the price of another good. 2

3 5. Chapter 6 A price ceiling is a legal maximum on the price of a good. An example is rent control. If the price ceiling is below the eq m price, it is binding and causes a shortage. A price floor is a legal minimum on the price of a good. An example is the minimum wage. If the price floor is above the eq m price, it is binding and causes a surplus. The labor surplus caused by the minimum wage is unemployment. A tax on a good places a wedge between the price buyers pay and the price sellers receive, and causes the eq m quantity to fall, whether the tax is imposed on buyers or sellers. The incidence of a tax is the division of the burden of the tax between buyers and sellers, and does not depend on whether the tax is imposed on buyers or sellers. The incidence of the tax depends on the price elasticities of supply and demand. 6. Chapter 7 The height of the D curve reflects the value of the good to buyers their willingness to pay for it. Consumer surplus is the difference between what buyers are willing to pay for a good and what they actually pay. On the graph, consumer surplus is the area between P and the D curve. The height of the S curve is sellers cost of producing the good. Sellers are willing to sell if the price they get is at least as high as their cost. Producer surplus is the difference between what sellers receive for a good and their cost of producing it. On the graph, producer surplus is the area between P and the S curve. To measure of society s well-being, we use total surplus, the sum of consumer and producer surplus. Efficiency means that total surplus is maximized, that the goods are produced by sellers with lowest cost, and that they are consumed by buyers who most value them. Under perfect competition, the market outcome is efficient. Altering it would reduce total surplus. 7. Chapter 8 A tax on a good reduces the welfare of buyers and sellers. This welfare loss usually exceeds the revenue the tax raises for the govt. The fall in total surplus (consumer surplus, producer surplus, and tax revenue) is called the deadweight loss (DWL) of the tax. A tax has a DWL because it causes consumers to buy less and producers to sell less, thus shrinking the market below the level that maximizes total surplus 3

4 The price elasticities of demand and supply measure how much buyers and sellers respond to price changes. Therefore, higher elasticities imply higher DWLs. An increase in the size of a tax causes the DWL to rise even more. An increase in the size of a tax causes revenue to rise at first, but eventually revenue falls because the tax reduces the size of the market. 8. Chapter 10 Gross Domestic Product (GDP) measures a country s total income and expenditure. The four spending components of GDP include: Consumption, Investment, Government Purchases, and Net Exports. Nominal GDP is measured using current prices. Real GDP is measured using the prices of a constant base year, and is corrected for inflation. GDP is the main indicator of a country s economic well-being, even though it is not perfect. The GDP deflator is a measure of the overall level of prices. o GDP deflator = 100(nominal GDP/ real GDP) 9. Chapter 11 The Consumer Price Index is a measure of the cost of living. The CPI tracks the cost of the typical consumer s basket of goods & services. o CPI = 100(cost of basket in current year/ cost of basket in base year) The CPI is used to make Cost of Living Adjustments, and to correct economic variables for the effects of inflation. o Inflation =100 [(CPI this year CPI last year)/ CPI last year] The real interest rate is corrected for inflation, and is computed by subtracting the inflation rate from the nominal interest rate. You should know what problems with CPI are. o Substitution bias. o Introduction of new goods. o Unmeasured quality change. Why CPI and GDP deflator are different? o CPI includes imported consumer goods, GDP deflator does not. o GDP deflator includes capital goods, CPI does not. o CPI uses fixed basket while GDP deflator uses basket of currently produced goods & services. 10. Chapter 12 There are great differences across countries in living standards and growth rates. Productivity (output per unit of labor) is the main determinant of living standards in the long run. 4

5 Productivity depends on physical and human capital per worker, natural resources per worker, and technological knowledge. Growth in these factors especially technological progress causes growth in living standards over the long run. Policies can affect the following, each of which has important effects on growth: o saving and investment o international trade o education, health & nutrition o property rights and political stability o research and development o population growth Because of diminishing returns to capital, growth from investment eventually slows down, and poor countries may catch up to rich ones. 5

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