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Micro Economics Mid Term Test #1 Review.docx

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Hannah Holmes

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Economics Mid Term Review Economics is the study of how society allocates scarce resources to satisfy people unlimited wants (Ex: how do we decide who get to use each room at each time) Scarcity - Society has limited resources and therefore we cant produce everything that people want (Ex: there is only a limited amounts of rooms for each lecture) Market Economy - Everybody is free to decide what to do themselves, everything is free will - Def. Allocates resources through the decentralized decisions of firms and households Command Economy - All production and distributed decisions are made by a central authority - Ex: Soviet Union dictated how each business, or individual produced or received - Canada is considered a mixed economy, because we have some market economy, but also some government businesses Economic Rationality: Involves making decisions that maximize the benefits and decision maker receives from their decision Perfect Information: - You know everything you need to make the best decision - No risk or uncertainty - The more information you have, the better informed your decision will be Asymmetrical Information -Someone knows more about something than someone else - Ex: eBay, the seller knows all the detailed information about the good being sold, however the buyer only knows what the seller has said or what the buyer cans see from a picture Resources are Scarce - Resource: anything used to make something else - We also call resources factors of production - The big 3 resources are Land, Labor and Capital - To get one thing we usually have to give up something else (Food vs Clothing, Lesiure vs Work) Opportunity Cost - Opportunity cost of something is everything you have to give up to get that something - It’s the best foregone alternative - Ex: coming to school- Can have a job, cant hang out with friends - EXAMPLE •You decide to attend Mac. Your tuition costs $8000, books cost $1000 and your apartment costs $6000. Your total explicit costs are $15000. •You could have spent that money on something else – say, a car. hat car is a foregone alternative – it is an implicit cost of coming to Mac Marginal Changes - Small, incremental adjustment to existing plan of action - The “invisible hand” - Concept by Adam Smith, saying there is an invisible hand that the market will settle on a price and quantity traded (bought and sold) that benefits everyone Efficiency -When resources are used to their best ability to meet societies goals Society’s welfare is maximized Markets that are left to operate freely usually lead to efficiency Equity: The fair distribution of resources ( Ex: government legislating a price of a good) Positive vs Normative Statements - Positive Statements: are about how the world actually is, descriptive analysis - Normative Statements: Are about how the world should be (Ex: Raise minimum wage so poor people will be better off) Economic Models - Economists use models for many reasons, - We try to model human behavior so we can make accurate predictions about potential economic outcomes - This involves making assumptions based on theory Circular Flow Diagram Firms • Produce and sell goods and services • Hire and use factors of production Households • Buy and consume goods and services • Own and sell factors of production Markets for Goods and Services -Firms sell -Households buy Markets for Factors of Production -Households Sell --Firms Buy Factors of Production - Land, Labor, Capital Refer to PowerPoint Production Possibilities Frontier Production possibilities frontier, PPF: • Is a graph that shows the combinations of output that an economy can possibly produce given its resources and the available technology - It shows the best an economy can do if it uses all its resources efficiently, given the current technology. Example: MacLand •Consider the economy of Macland. It produces only 2 goods: computers and cars. •Macland’s technology is given (it is what it is). •Its resources are fixed. •The following table shows combinations of computers and cars Macland can produce if it uses all its resources, given the current technology: COMPUTERS and CARS – Refer to PowerPoint A 3000 0 B 2200 600 C 2000 700 D 0 1000 Note that this is only a partial table. Let’s graph these combinations: - We have to assume resources are “Perfectly Mobile”(resources are interchangeable between making cars or computers) •However, you could be on the PPF but you could be producing a combo of goods that society doesn’t want= wrong combo (of cars and computers) •This is then referred to as producing at a point that is socially inefficient •Efficiency, then includes productive efficiency (on the PPF) and social efficiency (producing the combo of goods that society wants) Going From A to B •To move from 0 cars to 600 cars: To get 600 cars, give up 800 computers To get 1 car, give up 800/600 = 1.33 computers The opportunity cost of a car going from A to B= 1.33 computers. Going From B to C •To move from 600 cars to 700 cars: To get 100 cars, give up 200 computers To get 1 car, give up 200/100 = 2 computers The opportunity cost of a car going from B to C = 2 computers •We can easily calculate the opportunity cost of a computer along the PPF. •It is the inverse of the opportunity cost of a car moving between the same points on the PPF. •The opportunity cost of a computer = 1/(opportunity cost of a car). Why do opportunity costs increase as we produce more of a good? -We’re moving resources from the computer sector which were really good at making computers to the car sector where they are not as good •It is also possible that opportunity costs are constant. •- this means an economy always gives up the same amount of one good for more of another at the same rate •Eg: you always give up 50 bushes of wheat to produce 10 tonnes of carrots •If opportunity costs are constant, slope of the PPf will be constant (linear) Shifts to PPF •Any changes to the amount of available resources, their productivity or changes to the available technology will shift the PPF. •Whenever we have economic growth, the PPF shifts to the right Example: Training courses have made workers in the computer sector more productive; PPF rotates up the computer axis. Comparative Advantage- Gains from Trade •Suppose there are 2 people trapped on an island: Robert the potato farmer and Aaron the beef rancher. •Only two goods are produced: potatoes and meat, and each person can produce both goods. •The following table gives information on how much they can produce of each good: MEAT or POTATOES Robert 8 oz 32 oz Aaron 24 oz 48 oz Suppose Robert and Aaron fend for themselves: •Each consumes what they each produce. •So, the production possibilities frontier is also a consumption possibilities frontier. •Let’s compute the opportunity costs of producing each good for each person: (let’s ignore the units of measurement for now). For Robert: •To get 32 potatoes, give up 8 meat To get 1 potato, give up ¼ meat The opp.cost of a potato = ¼ meat The opp.cost of a meat = 4 potatoes For Aaron: •To get 48 potatoes, give up 24 meat To get 1 potato, give up ½ meat The opp.cost of a potato = ½ meat The opp.cost of a meat = 2 potatoes. •Let’s compare their opportunity costs: Opp.Cost of Opp.Cost of a Potato a Meat Robert ¼ meat 4 potatoes Aaron ½ meat 2 potatoes Comparative Advantage •Robert has a lower opportunity cost of producing potatoes (1/4 meat compared to 1/2 meat for Aaron). •We say Robert has a comparative advantage in potatoes: he can produce them at a lower opportunity cost than someone else. •Aaron has a lower opportunity cost of producing meat (2 potatoes compared to 4 potatoes: Aaron has a comparative advantage in meat. •Robert should specialize in the production of potatoes and trade potatoes for meat. •Aaron should specialize in producing meat and trade meat for potatoes. •When they trade with each other, they can consume more of both goods! In summary, -When there exists comparative advantage, each individual should specialize in the production of the good in which they have a comparative advantage -They should trade with each other -Then there will be gains from trade for both •Note that if no economy has a comparative advantage (that is, they have the same opportunity costs), there won’t be any trade. •That’s because there would be nothing to gain from trade. Absolute Advantage •Describes the productivity of one person, firm, or nation compared to that of another. •Who is more productive than someone else •Absolute advantage: The producer who requires a smaller quantity of inputs (fewer resources) to produce a good (i.e: is more productive has an absolute advantage in producing that good) Productivity can be calculated as Productivity = quantity produced number of inputs used Aaron has absolute advantage in meat and also in potatoes. (he's more productive) Why: -Aaron only needs 10 min to produce a potato and 20 for a meat, compare to Robert who needs 15 min for a potato and 60 min for a meat - Aaron is more productive •Aaron uses fewer inputs – in this case, labour time – to produce the same amount of both goods than Robert the farmer. •Aaron the rancher is more productive than Robert the farmer in the production of both meat and potatoes. •NOTE: Even though Aaron has an absolute advantage in both goods, because there exists comparative advantage, there are still gains to be made from trade, as we have seen. Market: A group of buyers and sellers of a particular service Market Demand refers to the sum of all individual demands for a particular good Market Supply: refers to the sum of all individual supplies of a particular good or service Types of Market Structures •A perfectly competitive market: •- So many buyers + sellers, that no one alone can affect the market price •- Usually small firms •- All goods are homogenous (identical) •Basically if one firm sells out, you can just go across the street and buy the exact same product for the exact same price •Firms and Sellers are price takers Demand •Quantity demanded, Qd: the ammount of a good or service, that consumers are willing and able to buy at a given price, P When the price of a good increases, you buy less of that good. • We say price and Qd are negatively related. • As P h , Qd i The Law of Demand Other things being equal (ceteris paribus), : when the price of a good rises, the quantity demanded of that good falls. Other Determinants of Demand Income 1.Normal good: When income increase and you buy more of a good, this good is a normal good (or if income decreases, and you buy less of a good) 2. Inferior good: When income increase, and you buy less of good, this good is an inferior good (or if income goes down and you buy more of a good) •Most goods are normal goods. Examples of inferior goods include Kraft Dinner (as your income increases, you don’t have to eat KD anymore- you can afford steak) and bus rides (as income increases, you can take a cab or buy a car). Price of Related Goods . Substitutes: goods are substitutes, if an increase in the price of one good leads to an increase in the demand for another good Examples: -Coke and Pepsi (Price of pepsi goes up, the demand for coke is higher, b.c it is cheaper) -Satellite and Cable TV Complements: goods are complements, if an increase in the price of one good, leads to a decrease in the demand for another good Examples: -Automobiles and Gasoline (Prices of cars increases, there will be less cars, meaning less demand for gasoline) --Shoes and Shoelaces Tastes: If peoples preferences change toward a good, demand for that good will increase Causes of Change - Things like advertising, government policy, etc. can change preferences Expectations: What you expect in the future, may affect your demand for a good today Ex: Announced increase in gas prices for tmwr, people then think I need to buy gas now, so the demand for gas increases Population: An increase in population (and therefore an increase in the number of consumers) will increase demand. •Demand schedules are tables that show the relationship between price and quantity demanded for a good. -Demand curves are graphs of demand schedules Example- Demand for Ice Cream Cones (with only 2 consumers) Price Kylie’s Qd Jack’s Qd Market D $.00 12 7 19 .50 10 6 16 1.00 8 5 13 1.50 6 4 10 2.00 4 3 7 2.50 2 1 3 To get market demand, we just sum individual Qd at each price. *Refer to PowerPoint •A change in quantity demanded: A movement along the demand due to a change in the price of a good (when we move up and down a curve) The demand curve itself: Does not MOVE Change in Demand •A change in demand: A shift in the demand curve due to a change in any determinant of demand, except price An increase in demand: Shifts demand curve to the right (demand increases at every price) A decrease in demand: Shifts demand curve to the left (demand decreases at every price) Shift Factors for Demand Consumer Income •As income increases, the demand for a normal good will: Demand Increases and demand curve shifts right •As income increases, the demand for an inferior good will: Demand increases, and demand curve shifts left Price of Related Goods •If 2 goods are substitutes: If the price of one good increases, the quantity demand for that good will decrease, but the demand for the substitute good will increase •If 2 goods are compliments: If the price of one good increases, the quantity demand for that good will decrease, and the demand for the complimentary good will decrease Supply •Quantity supplied, Qs: is the amount of a good that firms are willing and able to produce and sell at a given price •When the price of a good increases, ceteris paribus, selling that good becomes more profitable and firms will want to offer more for sale. •Price and Qs are positively related. •As P h, Qs h The Law of Supply Other things being equal (ceteris paribus), the quantity supplied of a good rises when the price of the good rises. Other Determinants of Supply Input Prices: When the price of an input into production (resource), e.g. labor, raw materials, energy, etc.. Increase, the cost of producing any amount of the good increases and producing the good becomes less profitable…firms will offer fewer goods for sale at any price (and vice versa Technology: Advances which reduce production costs will increase supply Expectations: If a firm expects a selling price to increase in the future, it will hold off selling now and current supply will decrease. Ex: SONY may sell less PS3’s to wait for GTA 5 to be released, then they will increase the sales of PS3’s Number of Firms: More firms in the market means more supply The supply schedule is a table that shows the relationship between the price of the good and the quantity supplied. The supply curve is a graph of the supply schedule. Let’s look at the supply schedule for Paul and John, the only 2 firms that sell ice cream cones in our market: Price Paul’s Qs John’s Qs Market S $.00 0 0 0 .50 0 0 0 1.00 1 0 1 1.50 2 2 4 2.00 3 4 7 2.50 4 6 10 3.00 5 8 13 At a price of $0 & $0.50, Paul and John do not want To produce any ice cream, As it is not profitable A Change in Quantity Supply •A change in quantity supplied: A movement along the supply curve due to a change in the price of the good •The supply curve: does not move •A change in supply: Is a shift of the supply curve due to a change in a determinant of supply other than price •An h in supply means a shift to the right. •A i in supply means a shift to the left. •If input prices increase, the supply curve shifts to the left (and vice versa). •Advances in technology and an increase in the number of firms will shift the supply curve to the right. •Expectations will shift supply according to the expectation. Market Equilibrium •Equilibrium: Refers to a situation where there is no incentive for anyone to change their behaviour •- in the market this happens, when the price is such that quantity demand= qu
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