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Midterm

MIDTERM REVIEW
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Department
Economics
Course
ECN 104
Professor
Tsogbadral Galaabaatar
Semester
Fall

Description
Midterm Review (Chapter 1 –9) Chapter 1: What Economics Is All About  Scarcity: the limited nature of society’s resources  Economics: the study of how society manages its scarce resources, e.g.  how people decide what to buy, how much to work, save, and spend  how firms decide how much to produce, how many workers to hire  how society decides how to divide its resources between national defence, consumer goods, protecting the environment, and other needs HOW PEOPLE MAKE DECISIONS  Society faces an important tradeoff: efficiency vs. equality  Efficiency: when society gets the most from its scarce resources  Equity: when prosperity is distributed uniformly among society’s members  Tradeoff: To achieve greater equality, could redistribute income from wealthy to poor. But this reduces incentive to work and produce, shrinks the size of the economic “pie.”  Making decisions requires comparing the costs and benefits of alternative choices.  The opportunity cost of any item is whatever must be given up to obtain it.  It is the relevant cost for decision making  Examples: The opportunity cost of…  …going to college for a year is not just the tuition, books, and fees, but also the foregone wages.  …seeing a movie is not just the price of the ticket, but the value of the time you spend in the cinema HOW PEOPLE INTERACT  Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods.  Countries also benefit from trade & specialization:  Get a better price abroad for goods they produce  Buy other goods more cheaply from abroad than could be produced at home  The invisible hand works through the price system:  The interaction of buyers and sellers determines prices.  Each price reflects the good’s value to buyers and the cost of producing the good.  Prices guide self-interested households and firms to make decisions that, in many cases, maximize society’s economic well-being. HOW THE ECONOMY AS A WHOLE WORKS  Huge variation in living standards across countries and over time:  Average income in rich countries is more than ten times average income in poor countries.  The Canadian standard of living today is about eight times larger than 100 years ago.  The most important determinant of living standards: productivity, the amount of goods and services produced from each hour of a worker’s time.  Productivity depends on the equipment, skills, and technology available to workers.  Other factors (e.g., labour unions, competition from abroad) have far less impact on living standards.  In the short-run (1 – 2 years), many economic policies push inflation and unemployment in opposite directions.  Other factors can make this tradeoff more or less favourable, but the tradeoff is always present. Chapter 2: The Economist as Scientist  Economists play two roles: 1. Scientists: try to explain the world 2. Policy advisors: try to improve it  In the first, economists employ the scientific method, the dispassionate development and testing of theories about how the world works. Assumptions & Models  Assumptions simplify the complex world, make it easier to understand.  Example: To study international trade, assume two countries and two goods. Unrealistic, but simple to learn and gives useful insights about the real world.  Model: a highly simplified representation of a more complicated reality. Economists use models to study economic issues. Our First Model: The Circular-Flow Diagram  The Circular-Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households and firms  Two types of “actors”:  households  firms  Two markets:  the market for goods and services  the market for “factors of production” Our Second Model: The Production Possibilities Frontier  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  Example:  Two goods: computers and wheat  One resource: labour (measured in hours)  Economy has 50,000 labour hours per month available for production. Microeconomics and Macroeconomics  Microeconomics is the study of how households and firms make decisions and how they interact in markets.  Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment, and economic growth.  These two branches of economics are closely intertwined, yet distinct – they address different questions. The Economist as Policy Advisor  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.  Positive statements can be confirmed or refuted, normative statements cannot.  The Govt of Canada, like other governments, relies on the advice of economists. Many government agencies and departments, including the Bank of Canada employ economists. The Economist as Policy Advisor  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.  Positive statements can be confirmed or refuted, normative statements cannot.  The Govt of Canada, like other governments, relies on the advice of economists. Many government agencies and departments, including the Bank of Canada employ economists. Chapter 3: Interdependence -Every day you rely on many people from around the world, most of whom you’ve never met, to provide you with the goods and services you enjoy.  One of the Ten Principles from Chapter 1: Trade can make everyone better off.  We now learn why people – and nations – choose to be interdependent, and how they can gain from trade. Our Example  Two countries: Canada and Japan  Two goods: computers and wheat  One resource: labour, measured in hours  We will look at how much of both goods each country produces and consumes  if the country chooses to be self-sufficient  if it trades with the other country Consumption With and Without Trade  Without trade,  Canadian consumers get 250 computers and 2500 tons wheat.  Japanese consumers get 120 computers and 600 tons wheat.  We will compare consumption without trade to consumption with trade.  First, we need to see how much of each good is produced and traded by the two countries. Two Measures of the Cost of a Good  Two countries can gain from trade when each specializes in the good it produces at lowest cost.  Absolute advantage measures the cost of a good in terms of the inputs required to produce it.  Recall: Another measure of cost is opportunity cost.  In our example, the opportunity cost of a computer is the amount of wheat that could be produced using the labour needed to produce one computer. Opportunity Cost and Comparative Advantage  Comparative advantage: the ability to produce a good at a lower opportunity cost than another producer  Which country has the comparative advantage in computers?  To answer this, must determine the opp. cost of a computer in each country. Comparative Advantage and Trade  Gains from trade arise from comparative advantage (differences in opportunity costs).  When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the world’s “economic pie” is bigger, and all countries can gain from trade.  The same applies to individual producers (like the farmer and the rancher) specializing in different goods and trading with each other. Chapter 4: Comparative Advantage and Trade  Gains from trade arise from comparative advantage (differences in opportunity costs).  When each country specializes in the good(s) in which it has a comparative advantage, total production in all countries is higher, the world’s “economic pie” is bigger, and all countries can gain from trade.  The same applies to individual producers (like the farmer and the rancher) specializing in different goods and trading with each other. Demand  The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase.  Law of demand: the claim that the quantity demanded of a good falls when the price of the good rises, other things equal Market Demand versus Individual Demand  The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price.  Supdose Helen and Ken are the only two buyers in the Latte market. (Q = quantity demanded) Demand Curve Shifters  The demand curve shows how price affects quantity demanded, other things being equal.  These “other things” are non-price determinants of demand (i.e., things that determine buyers’ demand for a good, other than the good’s price).  Changes in them shift the D curve… Market Supply versus Individual Supply  The quantity supplied in the market is the sum of the quantities supplied by all sellers at each price.  Suppose Starbucks and Jitters are the only two sellers in this market. (Q = quantity supplied) Supply Curve Shifters  The supply curve shows how price affects quantity supplied, other things being equal.  These “other things” are non-price determinants of supply.  Changes in them shift the S curve… Supply Curve Shifters: Input Prices  Examples of input prices: wages, prices of raw materials.  A fall in input prices makes production more profitable at each output price, so firms supply a larger quantity at each price, and the S curve shifts to the right. Supply Curve Shifters: Technology  Technology determines how much inputs are required to produce a unit of output.  A cost-saving technological improvement has the same effect as a fall in input prices, shifts S curve to the right. Supply Curve Shifters: # of Sellers  An increase in the number of sellers increases the quantity supplied at each price, shifts S curve to the right. Terms for Shift vs. Movement Along Curve  Change in supply: a shift in the S curve occurs when a non-price determinant of supply changes (like technology or costs)  Change in the quantity supplied: a movement along a fixed S curve occurs when P changes  Change in demand: a shift in the D curve occurs when a non-price determinant of demand changes (like income or # of buyers)  Change in the quantity demanded: a movement along a fixed D curve occurs when P changes SUMMARY:  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.  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 number 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.  Besides price, demand depends on buyers’ incomes, tastes, expectations, the prices of substitutes and complements, and number 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 determines 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: First, determine whether the event shifts one or both curves. Second, determine the direction of the shifts. Third, compare the new equilibrium to the initial one.  In market economies, prices are the signals that guide economic decisions and allocate scarce resources. Chapter 5: Elasticity  Basic idea: Elasticity measures how much one variable responds to changes in another variable. • One type of elasticity measures how much demand for your websites will fall if you raise your price.  Definition: Elasticity is a numerical measure of the responsiveness of Q or Q to s one of its determinants. Price Elasticity of Demand d  Price elasticity of demand measures how much Q responds to a change in P.  Price elasticity of demand equals  Along a D curve, P and Q move in opposite directions, which would make price elasticity negative. We will drop the minus sign and report all price elasticities as positive numbers. What determines price elasticity? To learn the determinants of price elasticity, we look at a series of examples. Each compares two common goods. In each example:  Suppose the prices of both goods rise by 20%. d  The good for which Q falls the most (in percent) has the highest price elasticity of demand. Which good is it? Why?  What lesson does the example teach us about the determinants of the price elasticity of demand? Example 1: Breakfast cereal vs. Sunscreen  The prices of both of these goods rise by 20%. For which good does Q drop the most? Why?  Breakfast cereal has close substitutes (e.g., pancakes, Eggo waffles, leftover pizza), so buyers can easily switch if the price rises.  Sunscreen has no close substitutes, so consumers would probably not buy much less if its price rises.  Lesson: Price elasticity is higher when close substitutes are available. The Determinants of Price Elasticity: A Summary The price elasticity of demand depends on:  the extent to which close substitutes are available  whether the good is a necessity or a luxury  how broadly or narrowly the good is defined  the time horizon – elasticity is higher in the long run than the short run The Variety of Demand Curves  The price elasticity of demand is closely related to the slope of the demand curve.  Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity.  Five different classifications of D curves.… The Determinants of Supply Elasticity  The more easily sellers can change the quantity they produce, the greater the price elasticity of supply.  Example: Supply of beachfront property is harder to vary and thus less elastic than supply of new cars.  For many goods, price elasticity of supply is greater in the long run than in the short run, because firms can build new factories, or new firms may be able to enter the market. SUMMARY:  Eldsticisy measures the responsiveness of Q or Q to one of its determinants.  Price elasticity of demand equals percentage change in Q 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.  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. Chapter 6: Government Policies That Alter the Private Market Outcome  Price controls • Price ceiling: a legal maximum on the price of a good or service Example: rent control • Price floor: a legal minimum on the price of a good or service Example: minimum wage  Taxes • The govt can make buyers or sellers pay a specific amount on each unit bought/sold. How Price Ceilings Affect Market Outcomes In the long run, supply and demand is more price-elastic. So, the shortage is larger. Shortages and Rationing  With a shortage, sellers must ration the goods among buyers.  Some rationing mechanisms: (1) Long lines (2) Discrimination according to sellers’ biases  These mechanisms are often unfair, and inefficient: the goods do not necessarily go to the buyers who value them most highly.  In contrast, when prices are not controlled, the rationing mechanism is efficient (the goods go to the buyers that value them most highly) and impersonal (and thus fair). Evaluating Price Controls  Recall one of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. Taxes  The govt levies taxes on many goods & services to raise revenue to pay for national defense, public schools, etc.  The govt can make buyers or sellers pay the tax.  The tax can be a % of the good’s price, or a specific amount for each unit sold. • For simplicity, we analyze per-unit taxes only. CONCLUSION: Government Policies and the Allocation of Resources  Each of the policies in this chapter affects the allocation of society’s resources. • Example 1: A tax on pizza reduces eq’m Q. • With less production of pizza, resources (workers, ovens, cheese) will become available to other industries. • Example 2: A binding minimum wage causes a surplus of workers, a waste of resources.  So, it’s important for policymakers to apply such policies very carefully. SUMMARY:  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 labour 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. Chapter 7: Welfare Economics  Recall, the allocation of resources refers to: • how much of each good is produced • which producers produce it • which consumers consume it  Welfare economics studies how the allocation of resources affects economic well-being.  First, we look at the well-being of consumers. Willingness to Pay (WTP) A buyer’s willingness to pay for a good is the maximum amount the buyer will pay for that good. WTP measures how much the buyer values the good. Consumer Surplus (CS) Consumer surplus is the amount a buyer is willing to pay minus the amount the buyer actually pays: CS = WTP – P About the Staircase Shape… This D curve looks like a staircase with 4 steps – one per buyer. CS with Lots of Buyers & a Smooth D Curve At Q = 5(thousand), the marginal buyer is willing to pay $50 for pair of shoes. Suppose P = $30. Then his consumer surplus = $20. CS with Lots of Buyers & a Smooth D Curve CS is the area b/w P and the D curve, from 0 to Q. Recall: area of a triangle equals ½ x base x height Height = $60 – 30 = $30. So, CS = ½ x 15 x $30 = $225. How a Higher Price Reduces CS If P rises to $40, CS = ½ x 10 x $20 = $100. Two reasons for the fall in CS. Cost and the Supply Curve  Cost is the value of everything a seller must give up to produce a good (i.e., opportunity cost).  Includes cost of all resources used to produce good, including value of the seller’s time.  Example: Costs of 3 sellers in the lawn-cutting business. CS, PS, and Total Surplus CS = (value to buyers) – (amount paid by buyers) = buyers’ gains from participating in the market PS = (amount received by sellers) – (cost to sellers) = sellers’ gains from participating in the market Total surplus = CS + PS = total gains from trade in a market = (value to buyers) – (cost to sellers) The Market’s Allocation of Resources  In a market economy, the allocation of resources is decentralized, determined by the interactions of many self-interested buyers and sellers.  Is the market’s allocation of resources desirable? Or would a different allocation of resources make society better off?  To answer this, we use total surplus as a measure of society’s well- being, and we consider whether the market’s allocation is efficient. (Policymakers also care about equality, though are focus here is on efficiency.) Efficiency An allocation of resources is efficient if it maximizes total surplus. Efficiency means:  The goods are consumed by the buyers who value them most highly.  The goods are produced by the producers with the lowest costs.  Raising or lowering the quantity of a good would not increase total surplus. SUMARY:  This chapter used welfare economics to demonstrate one of the Ten Principles:
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