Exam Review 2009
Lecure 1- Introduction toEconomics
Chapters 1, 2 Basic Principles of Microeconomics
Economics- the study of how society allocates its scare resources to satisfy peoples unlimited wants.
Microeconomics- focuses on the individual parts of the economy
Macroeconomics- focuses on the economy as a whole
Market Economy- decentralized allocations of resources by firms and households
Command/ Centrally Planned – planned by a centralauthority
Mixed - Canada has mixed economy
Resource – anything that can be used to produce something else ( labour , land)
Opportunity Cost – what you have to give up to get it
Marginal Changes – small incremental adjustments to an exsistant plan , usually by 1
Adam Smith – the wealth of nations , invisiblehand
Equilibrium- no incentive to change
Efficiently - when resources are best used
Equity - fair use of resources
Market Failure - when the market fails to properly distribute resources
Market Power – the ability of a single entity to unduly influence the market
Externality- additional factors not compensated for intraditional models.
Positive Statements - world as is
Normative Statements - world as it should be Lecure 2- Production Possibility Frontier
PPF - a graph that shows the possible combinations of output that the economy can possibly produce
given all the available factors
The ppf is always possible , but only certain combinations of product are socially desirable. It also very
neatly demonstrates opportunity costs.
For example: to get 600 cars, you give up 800 computers
So to get 1 car you give up 800/600 = 1.33 computers
From 700 to 1000 , you give up 2000 computers
So 300 cars for 2000 computers
The slope of ppf x , is the opportunity cost of x.
Change in production choices are demonstrated by a slide along the production possibilities frontier.
However changes in production capabilities are demonstrated with a changing of the line. In this
example a rubber shortage willmean that fewer tires and car parts will be available, however the
production of computers is not affected so the change looks like this: Lecure 3- Comparative advantage and Gains from Trade
In this chapter we explore how the advantages of trade can allow individuals to produce beyond their
individual production possibility frontiers. In this hypothetical situation we are introduced to Peyton
and Brett , two farmers on an isolated island.
Oppertunity Cost Potato Oppertunity Cost Meat
Peyton ¼ Meat 4 Potatoes
Brett ½ Meat 2 Potatoes
-We say that Peyton has a comparative advantage in potatoes: he has a lower opportunity cost.
-We say that Brett has comparative advantage in meat because he has a lower opportunity cost.
Therefore each individual shouldecialize in the production of the product that they have a
comparative advantage in , and then should trade with eachother to consumer more goods.
Name Produce Without Trade With Trade Gains
Peyton Potatoes 16 17 +1
Meat 4 5 +1
Brett Potatoes 24 27 +3
Meat 12 13 +1 The producer that requires a smaller quantity of inputs to produce a good, the more productive one, is
said to have anabsolute advantage in producing that good.
Productivity = Quantity Produced
Number of Inputs Used
Lecure 4- Market Forces of Supply & Demand
Market – group of buyers and sellers of a particular good or service
Supply and Demand – refer to the behaviour of people as they interact with oneanother in markets
Buyers determine Demand
Sellers determine Supply
Market Demand and Market Supply refers to the sum of all individual demands and supplies in a
Quantity Demanded, Qd the amount of a good that consumers will pay at a given price.
Quantity Supplied,Qs the amount of a good that producers will produce at a given price.
Law of Demand - other things being equal when the price of a good rises the quantity demanded of
that good falls.
Income - Increases in income will cause you to buy more normal goods and less inferior goods,
decreases in income will cause you to buy more inferior goods and less normal goods.
Substitutes - Pepsi and Coke, if one rose their prices people would substitute the other drink for that
Complement- TV and DVD players. Ifpeople buy less tv players , they will buy less DVD players since
they complement each other.
Tastes - can be modified by advertising and government policy Expectations- what you pay in the future may affect your demand for a good today, example gas prices
Population - as the number of consumers increases the demand will increase
Demand Schedules – table that show the relationship between price and quantity for a good
Demand Curves - a graphical representation of demand schedules
All of the above factors would cause a change in the placement of the demand curve, however a change
in price doesn’t affect the population demand , it justchanges the number of people who are willing to
pay a certain price. An increase in demand pushes the curve to the right , and a decrease pushes the
curve to the left. Factors of Supply
Law of Supply- all things being equal , ( ceteris paribus) the quantity supplied of a good rises when the
price of the good rises.
Input Price- the costs of factors of production. If these become less expensive then suppliers will
produce more of a good for a lower price, if it becomes more expensive, sellers will produce less at a
Technology – technologicalimprovements can improve the producing process, decreasing costs
Number of Firms- more firms in the market means more supply
Expectations - what firms think the market will be like in the future will dictate their actions.
Supply schedule - the table that shows the relationship between price and quantity supplied
Supply Curve - is a graphof the supply schedule
Equilibrium - refers to a situation in which the price has reached the level where quantity supply and
quantity demand are equal
When Qd = Qs = we are equilibrium price, equilibrium quantity and quantity traded Shortage and Surplus = when Qd does not Equal Qs , we will either not have enough shortage , or have
too much surplus of quantity. We have a surplus is price is above equilibrium price, and a shortage if
price is below equilibrium price.
Law of Supply and Demand : left freely, the price of any good adjusts to bring the quantity supplied and
the quantity demanded for that good into balance.
Lecure 5-Elasticity Chapters 5
Price Elasticity of Demand is the measure of how much the Qd responds to a change in the price of that
Price Elasticity = Percentage Change in Qd/ Percentage change inP
This equation is calculating a coefficient of elasticity , we can determine the responsiveness of Q based
on the change in price.
Another formula we used was the midpoint formula . This formula is preferable because it gives us the
same answer regardless of the direction of the change. We use it when we are given two prices and
their corresponding Qd values.
EP = [ ( Q2-Q1)/ Average Q] / [ (P2-P1)/ Average P ]
When we calculate price elasticity we drop the negative signs
Inelastic Demand -> Quantity demanded does not respond strongly to price changes, Ep < 1 , the
demand curve would be fairly steep
Elastic Demand -> Quantity demanded responds strongly to changes in price , Ep>1 , the demand curve
will be fairly flat.
Perfectly Inelastic Demand -> Quantity does not respond to price changes , Ep = 0 the demand curve is
Perfectly Elastic Demand -> quantity demanded changes infinitely with any change in price, Ep= infinity
, the demand curve is horizontal.
Unit elastic -> quantity changes by the same percentage as teh price , Ep= 1 , demand curve is non
Elasticity of Supply = Apply the above principales, with the word and concept supply
Factors that influence elasticity of a good
1. Goods that are necessities tend to have inelastic demands
2. Goods that are luxuries tend to have elastic demands
3. Goods with close substitutes tend to have elastic demands
4. Goods tend to havemore elastic demand over longer time horizons
5. How you define a market example Ep food < Ep Vegetables < Ep broccoli
Elasticity is not the same as slope , nor is a consistant along a linear curve. Elasticity and Revenue
Total Revenue = Price * Quantity Traded
With an inelastic demand curve an increase in price lead sto a decrease in quantity that is proportionally
smaller, so the gain to TR from the P increase will outweigh the loss to TR from a decrease in Q.
TR will increase when P increases in demand is inelastic.
With an elastic demand curve an increase in the price leads to a decrease in quantity demandedthat is
proportionally larger. The gain from TR from the P increase will be outweighed by the loss in TR from
lost Q traded.
TR will decrease if P increases if demand is elastic.
TR will always be maximized at the point on the line where Ep = 1 . ( because you will keep increasing
price until the point where the graph become elastic , this combines the above graph with the
knowledge we just told you.
Income Elasticity of Demand measures how much the Qd of a good responds to a change in income.
Calculated the same fashion as price elasticity, but in this case we keep the plus or minus sign .
If Ei is between 1 and -1 then the good is income inelastic
If the Ei is greater then 1 or less then -1 then the good is income elastic
Cross- Price Elasticity of Demand Denoted as Eab , cross price elasticitymeasures teh response of Qd of Good A to a change in price of
Eab = % in Qd of Good A / % in P of good B
Here the plus or minus sign matters!
If elasticity >0 an increase in the P b will lead to increase in Qd of A , therefore these items are
If elasticity is <0 an increase in P of B will lead to a decrease in Qd of A, therefore these items are
Lecure 6- Consumers, Producers and the efficiencies of Markets and E xternalities
In this chapter we measure the benefit for both buyers and sellers.
Welfare Economics - the study of how the allocation of resources affects economic well-being
Willingness-to-Pay - the max amount a customer is willing to pay for a product, the value they place on
it. Anything they pay less then that is theirConsumer Surplus.,
Producer Surplus - the amount a sellerpaid to produce a good compared to the amount the seller sold
if for ( equilibrium price)
Total Surplus = Consumer Surplus + Producers Surplus = Value to buyers – cost to sellers
If an allocation of resources maximizeas total surplus we sat that allocation is efficient , if an allocation
of resources leads to well-being that’s fairly distributed among society’s members that’sequity.
Surplus is always maximized at equilibrium, at any other price surplus is less.
Because the economy will find its own equilibrium if left alone, and equilibrium maximizes total surplus
than some countries have developed a laisser faire approach to regulating the economy.
Sometimes there arebenefits and costs that are uncompensated.
Positive Exeternality- is a benefit that is enjoyed by society but society doesn’t pay to receive it. Negative Externality - is a cost suffered by society that isn’t paid by the instigator.
Steel factories emit vast amounts of pollution , this is cost to society of steel is greater then the
cost to the company ,who doesn’t worry about the pollution . The social costs include the private cost of
the producers and the cost to the public affected by the pollution. The government can internalize this
externality by taxing the polluters, promoting them to either produce less, or canuse the the revenue
from taxes to pay the social cost. This is known as a Pigovian Tax
The discovery of penicillin as a treatment for STD’s. Not only does this benefit those who have
the disease, it also benefits those who could be exposed to the disease later on. So the value to society
means it is worth a greater price than individual demand. Therefore the government can subsidize the
product to make it cheaper and more affordable for the population with thethought that the money
they are subsidizing it with would have been used on hospital costs ect.
Sometimes private companies can solve externalities on their own, through moral codes and charities
ect. Some believe that if the could allocate benefitswithout costs they can solve their own externalities,
however high transaction costs can make private agreements impossible.
Lecure 7-Supply Demand and Goverment Policies
Price Controls- enacted when policymakers believe that the market price isunfair to buyers or sellers
Price Ceilling - a legal maximum on the price a good can be sold , this is not binding it the price is above
equilibrium. The price is binding if blow equilibrium price, where it will lead to a shortage*.
In this situtuation sellers can resort to non-price ways of rationaning of housing ( example of rent
Long waiting lists
*The shortage can be calculated by finding the difference between the equations of supply and demand
at a given price Consequences of Shortages
Inefficient allocation to consumers* debatable
Inefficiently low quality ( why make them better if everyone pays the same)
Price Floor – a legal minimum on the price at which a good can be sold , it is not binding if set below the
equilibrium price., is binding if set above equilibrium price causing asurplus of goods.
Downside of Price Floor
o Producers will want to supply more at the higher price
o Surpluses may be stored , destroyed, exported , given away
o Can’t sell surpluses on the domestic level, or seliing price will fall below floor level
Innffeicient allocation of sales
Ineffieciently high quality
Quota – a limit on the quantity of a good that can be sold. Not effective is set above equilirbirum
quantity, only if below. In this case the price will be much higher then the equilibrium price, or the price
that the producer would have beenwilling to sell for at that quantity. The dfference between the price
paid of the demand, and the cost of the sellers is called theta Rent or the Quota Value.
Taxes - a fee governments charge to raise their revenue for public projects
Tax incidence – the distribution of a tax burden
The side of the equilibrium which is more sloped ( more inelastic) willhave a harder time compensating
for the change in price and bear the majority of the tax burden. Since the tax increases the price, it will also reduce the total amount of a good traded, thereby reducing
total surplus. This lose in surplus is known as Deadweight Loss due to Taxation, DWL . The greater the
elasticities of the product the greater the DWL ( because there is a stronger response to the increase in
price) . With every increase in taxation the deadweight of the tax rises even morequickly then the tax
revenue. Lecure 7-Supply Demand and Goverment Policies
Total Revenue, TR - The amount a firm receives for the sale of its output
Total Cost, TC - the market value of the inputs a firm uses in production
Profit ,π = TR- TC
Cost of production includes all the opportunity costs of making its output of goods and services.
Explicit Costs- are input costs that require a directe outlay of money by the firm
Implicit Costs - indirect costs, the money you could have earned if you have invested that money
Economic Profit - includes both implicit and explicit costs
Accounting Profit - only includes explicit costs
Economic profits are always smaller. You can have zero economic profit and have a very positive
Production Function – the relationship between quantity of inputs used and the quantity of outputs
Marginal Product – increase in the output that arises from an additional unit of that input
Diminishing Marginal Product - marginal product of an input declines as the quantity of the input
increases – diminishing returns
Total Product is Maximized when MP = 0
Average Product = is the number of concept the quantity divided by the number of inputs at any given
point. Note the relationship between AP and MP Costs
Fxed Costs - do not vary with the quantity of output produced
Variable Costs – are those costs that do vary with the quantity of output produced
TC = TFC = TVC
Short , SR - the period in which at least one input into production is fixed.
Long Run, LR - the period of time in which all inputs into production can vary
In the short run...
Average total cost = TC/ Q
Average Fixed Costs = TFC/ Q
Average Variable Costs = TVC/Q
ATC = AFC + AVC
Marginal Costs, MC - the increase in total cost that arises from an extra unit of production, rises while
marginal product falls .
Marginal Costs Intersects ATC at the minimum ATC
Where MC < ATC , ATCmust be falling, ect. this logically makes sense
Efficient Scale - where min ATC is
Atc is U shaped because at very low levels of output ATC is high because of the fixed costs, and high
later on because of increasingly high variable costs
Lr- no fixed costs, instead we just have average costs
Minimum efficient scale can be larger then just onepoint when we consider an infinite possibilities..
Economies of Scale - long run average cost falls as quantity increases, also known as increasing returns
to scale, or scale economies
Diseconomies of Scale , long run average total cost rises as quantity increases , also known as
decreasing returns to scale
Constant Returns to Scale , long run average total cost stays the same as quantity increases. Lecure 9- Firms in Competitive Markes
A perfectly competitive market can be defined by the following characteristics :
Many buyers and sellers
Goods are homogeneous (identical)
Firms can freely enter or exit
No barriers , such as patents and exclusive rights , to key inputs
Because there are many firms in the market, each firm is essentially irrelevant therefore Market
demand and supply determine price and every firm are price takers.
Avergae Revenue, AR,