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Economics Mid-Term #1.pdf

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Hannah Holmes

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Economics  1B03  Mid-Term  Review Chapter 1  There are never enough resources to satisfy all the wants and needs of a society – management  of  society’s  resources  are  scarce  Economics – study of how society allocates the scarce resources to satisfy  people’s  unlimited  wants    Basic principles: households and economies face many decisions (who will work, what goods to produce, what price to sell goods at); every economic issue involves individual choice  Scarcity – limited resources; can not produce all the goods and products people wish to have  Resources – often allocated not by a single central planner but through combined actions of millions of households and firms  Microeconomics – study of the decisions made by households and firms and how they interact in markets (make decisions) ; focus on individual parts; specificity  Macroeconomics – things that effect economies as a whole and larger scale; economic growth at a national level; ie. inflation, unemployment  Market economy – allocates resources through the decentralized decisions of firms and households (individuals) (each making own individual decisions with no central consensus) ie. firms decide who to hire, what to buy  Command/Centrally planned economy – all production and distribution decisions are made by a central authority, like a government; ie. former USSR – being told who provides, produces and buys what  Traditional economy – refers to underdeveloped economies that rely heavily on agriculture for domestic consumption (subsistence economy); economic decisions based on customs, beliefs, religion, habits  Mixed economies – most economies; combination of market and command economies; mostly free market ex. Canada  We assume that when people are making decisions they are acting rationally:  Economic rationality – making the best decisions that maximize the benefits received from the decision  Perfect information – We assume people have this when making a decision. Everyone knows everything about everything; not settling for anything less b/c they know what is best. Ex. Firms know all prices  Asymmetrical information – Hard to have perfect information, some have more info than others; harder to make the best decision. Ex. Sellers have more info than buyers, Lack of perfect info makes it harder to make the best decisions.  Resource (factors of production) – anything that can be used in production (inputs of production) ; three factors, recently we have been including entrepreneurship as a resource 1. Land (space) 2. Labour (people to create, assemble, produce) 3. Capital (what is needed by the laborers in the space- buildings, physical etc.)  Equilibrium – when no individual would be better off doing something different; markets usually reach equilibrium through price changes; economy’s  situation  is  in  equilibrium  when  there  is  NO  incentive  for   economic actors to change their behavior  Economist’s  Role – when economists are trying to explain the world, they are scientists; when they are trying to change the world, they are policy advisors  Positive statement – describes the world as it IS (descriptive analysis)  Normative statements – describes the world as it SHOULD BE (prescriptive analysis)  Economists disagree – about the validity of alternative positive theories about how the world works; different values therefore different normative views about what policy should try to accomplish  Economic models – economists try to model human behavior so we can make accurate predictions about potential economic outcomes; involves making assumptions based on theory; to help us explain how the economy works  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, labour, capital (+entrepreneurs) How People Make Decisions - Gains from trades, we specialize in goods we produce efficiently and trade them for goods other nations produce efficiently that we need. - Between efficiency and equity - Efficiency – resources are used as best as possible to meet society’s   goals. Welfare of society will be maximized. Markets left to operate freely lead to efficiency. Economics* - Equity – Fairness. The fair distribution of resources. Political* - Higher equity = lower future efficiency Government redistributes income from rich to the poor, reduces the reward for working hard, people work less and produce fewer goods (increase equity, lowers efficiency) - *Acknowledging tradeoffs with respect to equity and efficiency = good future decisions in society Cost of Something Is What You Give Up to Get It - Facing tradeoffs, thus decisions require comparing the costs and benefits of alternative courses of action - Opportunity cost – whatever must be given up to obtain some item; decision makers should be aware of the opportunity costs that accompany each possible action; cost of the BEST forgone alternative - Forgone alternative – what you lose in the process of achieving one goal Rational People Think at the Margin - Rational people – systematically and purposefully do the best they can to achieve their objectives; rationalize to obtain greatest benefit; know that decisions involve shades of gray; consider marginal changes in their decisions - Marginal changes – small incremental adjustments to a plan of action; small changes around the edges (firm producing one more good...) - Marginal benefit – depends on how many units a person already has (diamonds have high marginal benefit; water has low) - *Decision based on marginal benefit > marginal cost = rational decision - Marginal changes in costs or benefits motivate people to respond. If adding one more good adds more revenue than cost it should be produced- being rational. People Respond to Incentives - Incentive – prospective punishment or reward; play a central role in the study of economics; crucial to analyzing how markets work - Example of policy failing to consider the effects of incentive: seat belt initiative intended to increase safety – people then drive faster; therefore, more accidents occur - Must consider not only the direct effects but also the indirect effects of incentives How People Interact Trade Can Make Everyone Better Off - Competition in economy is good: trade amongst countries allows for a greater variety of services - Trade allows countries to specialize in what they do best and enjoy a greater variety of goods and services Markets are Usually a Good Way to Organize Economic Activity - In a market economy – no one is looking out for the economic well-being of society as a whole; yet have proven successful in organizing economic activity in a way that promotes overall economic well-being - Market prices – to society, reflects both the value of a good and the cost of making it; prices guide buyers and sellers to maximize welfare of whole society - Important corollary to the skill of the invisible hand in guiding economic activity: government prevents prices from adjusting naturally to supply and demand  which  impedes  the  invisible  hand’s  ability  to  coordinate  the households and firms that make up the economy (ie. why taxes adversely affect the allocation of resources; taxes distort prices and thus the decisions of households and firms - Invisible hand – free market economy based on consumer and best interest; Adam Smith. Participants in the economy are motivated by self- interest  and  that  the  “invisible  hand”  of  the  marketplace  guides  this  self- interest into promoting general economic well being Government Can Sometimes Improve Market Outcomes - Markets work only if property rights are enforces; therefore, we all rely on government-provided police service to enforce our rights over the things we produce – the invisible hand counts on our ability to enforce our rights - Governments are important to markets because they enforce property rights and ensure reliable production of goods - Two reasons for a government to intervene in the economy and change the allocation of resources people would choose on their own – promote efficiency and promote equity - Market failure – a market on its own fails to produce an efficient allocation of resources; government intervention needed - Externality – the  impact  of  one  person’s  actions on the well-being of the bystander - Market power – ability of a single person or firm can influence market prices. - Market failure caused by externality and market power  governments can promote efficiency and equity to reduce market failure  governments can  do  what  invisible  hand  can’t   How the Economy Works as a Whole A  Country’s  Standard  of  Living  Depends  on  Its  Ability  to  Produce  Goods  and   Services - Productivity – amount of goods and services produced from each hour of a  worker’s  time - All variation in  living  standards  is  attributable  to  differences  in  countries’   productivity - Greater productivity = greater living standards = better public policy Prices Rise When the Government Prints Too Much Money - Inflation – an increase in the overall level of prices in the economy - Government produces more $  value of $ decreases = inflation Society Faces a Short-Run Tradeoff between Inflation and Unemployment - Short term benefit – stimulates spending and increases demand for goods; therefore more workers are hired and unemployment is temporarily decreased - Higher demand for goods and services may cause firms to raise their prices but not in the short-term - Many economic policies push inflation and unemployment in opposite directions – plays a key role in the business cycle - Business cycle – fluctuations in economic activity such as employment and production Chapter 2 Economist as Scientist - Scientific method – dispassionate development and testing of theories about how the world works - Scientific thinking = theory and observation = making assumptions based on historical episodes - Interplay between theory and observation occurs in the field of economics; but experiments are difficult in economics; therefore, they usually have to make do with whatever data the world happens o give them - Economists make theories based on similar episodes in history since experiments are difficult in economies; use different assumptions to answer different questions (ie. answering questions relating to short term vs. long term calculations – price assumed to be fixed short term and flexible long term) - Assumptions – simplify the complex world and make it easier to understand; allows us to focus our thinking and easily understand more complex situations afterwards - Economists use models to learn about the world, often composed of diagrams and equations; models are built with assumptions - Circular-Flow diagrams – how the economy is organized and how participants in the economy interact; how dollars flow through markets among households and firms; shows economic transactions between buyers and sellers in the economy - Production possibilities frontier – a graph that shows the combinations of output that the economy can possibly produce given the available factors of production and the available production technology; shows which combinations/ amounts of products or services can be carried out with the given resources, the best an economy can do if it uses its resources efficiently given the current technology. - Points outside the frontier are not reachable given  the  economy’s   resources, Points below are inefficient. - Shows the opportunity cost of one good measured in terms of another; PPFs often have a bowed shape - Every point on the PPF is productively efficient; however, you could be on the PPF but producing  a  combination  of  goods  that  society  doesn’t  want   (Ie. The wrong combination) could be resourcefully efficient but not socially efficient; Efficiency, then, includes productive efficiency (on the PPF) AND social efficiency (the right combination of goods) - Efficient – an outcome is said to be efficient if the economy is getting all it can from the scarce resources it has available - Opportunity Cost= give up/get - To find the opportunity cost of the other good, we take the inverse 1/opp. Of the opp. of the good to find opp. of the other good. - As we move down the curve, the opp. Increases this explains why it is rounded out. - If  the  PPF  is  linear,  it’s  the  same  opp.  For  each  good.   - Economic growth shifts the PPF up to the right; inefficient use of resources shifts it in to the left. Chapter 3 Specialization and Trade - Absolute advantage – productivity = quantity produced/ number of inputs used; the comparison among producers of a good according to their productivity; the producer that requires a smaller quantity of inputs (ie. time) to produce a good is said to have an absolute advantage in producing that good; producer who produces more efficiently and quicker and more. - Remember, opportunity cost measures the tradeoff between the two goods that each producer faces - Comparative advantage – the comparison among producers of a good according to how low their opportunity cost is. When comparative advantage exists, each individual or firm should specialize in the good they have the comparative advantage in and trade to the good the other has a comparative advantage in resulting in a gain from trade. - Possible to have an absolute advantage in BOTH goods, but impossible to have a comparative advantage in BOTH goods - When there exists comparative advantage, each individual should specialize in the production of the good in which they have comparative advantage - **On  any  tests  and  the  exam,  we’ll  assume  that  when  a  firm  specializes  in   the production of a good, it produces only that good** - Note that if no economy has a comparative advantage (that is, they have the same opportunity costs), there won’t  be  any  trade - General rule – for both parties to gain from trade, the price at which they trade must lie between the two opportunity costs - The principle of comparative advantage states that each good should be produced by the country that has the smaller opportunity cost of producing that good – trade allows countries to achieve greater prosperity Chapter 4 - Market – group of buyers and sellers of a particular good or service; buyers determine the demand, sellers determine the supply - Supply & demand – refers to the behavior of people as they interact with one another in markets - Price & quantity – are determined by the buyers and sellers as they interact in the marketplace - Competitive market – a market in which there are many buyers and many sellers so that each has a negligible impact on the market price - Market demand – the sum of all individual demands for a particular good or service - Market supply – the sum of all individual supplies of a particular good or service - Perfectly competitive market – all goods are identical (homogenous); since no one can affect market price, everyone who participates in the market is a price taker - Monopoly – one seller who sets the price -
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