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SOS Midterm_1 Review_2.pdf

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Sofy Carayannopoulos

EC120 TEST #1 EXAM-‐AID 7XWRU▯▯-DVRQ▯´--‐'DZJµ▯)ULWWDLRQ Coordinator: Alanna Davoren Some images used from course slides. 1 AGENDA Go through Chapters 1-‐6 ‡ Intro to Economics and Opportunity Cost ‡ PPF, Trade, and Comparative Advantage ‡ Demand, Supply, and Price ‡ Elasticity ‡ Government Policy (Price Floors and Ceilings) 2 Intro to Economics and Opportunity Cost 3 A Few Qualitative Points ‡ Economics is pretty much the study of motives and relationships that cause all the interactions of the market. ‡ The economy is self-‐organizing through these motives (self-‐interest, incentives, etc.). When the economy is self-‐organizing, we consider it to be an open market (constantly striving for efficiency). ‡ Land, labour, and capital are what produce the goods and services we consume (also known as factors of production). ‡ These resources are however limited (scarcity). Therefore we must manage these resources, making decisions among our needs and unlimited wants. ‡ Opportunity cost illustrates this concept of trade-‐off. 4 Opportunity Cost ´7KH▯IRUHJRQH▯EHQHILWV▯RI▯WKH▯QH[W▯EHVW▯ DOWHUQDWLYH▯µ These costs include explicit costs (out of pocket expenses such as paying for a movie ticket) and implicit costs (foregone earnings such as going to the movies versus working that night) They DO NOT include sunk costs (unrecoverable costs). These are basically the costs that must be incurred regardless of which course of action is taken. 5 EXAMPLE # 1 Answer: (b) WHY? If he hires a plumber and chooses to go to work, he will have to pay the plumber $200, which is an out of pocket expense; hence it will be included as an opportunity cost. If he GRHV▯LW▯KLPVHOI▯▯KLV▯IRUHJRQH▯HDUQLQJV▯WKDW▯KH▯FRXOG·YH▯PDGH▯E\▯ working would be his opportunity cost. 6 EXAMPLE # 2 Answer: (b) WHY? Before the fertilizer was discovered, if the farmer had chosen to plant potatoes (5), he would have to give up the benefit of growing 10 corn. In other words, in order to grow 1 potato, he would have to give up 2 corn. Now that a new fertilizer has been discovered which doubles the per acre yield, in order to grow potatoes (10), he would have to give up the benefit of growing 20 corn. In other words, in order to grow 1 potato, you would have to give up 2 corn again. Same rule applies to the option of growing corn instead. 7 PPF, Comparative Advantage, and Trade 8 Production Possibilities Frontier ‡ Shows the combinations of goods that can be produced if all resources are fully employed. ‡ Points inside the PPF are attainable, but you are not fully using your resources. ‡ Points outside are unattainable and can only be attained by new technology or a stronger labour force. ‡ Slope of the PPF indicates opportunity cost of the good on the x-‐axis. ‡ PPF has a concave shape because OC rises as productivity declines in the transfer of resources. ‡ PPF shifts if technology or resources change. ² It can also pivot on one axis if technology or resources only changes for one good. 9 Production Possibility Frontier The  negatively  sloped  boundary  shows  the  combinations  that  are  just   DWWDLQDEOH▯ZKHQ▯DOO▯RI▯VRFLHW\¶V▯UHVRXUFHV▯DUH▯HIILFLHQWO\▯HPSOR\HG▯▯ 10 Trade ‡ Adam Smith proposed trade in terms of absolute cost. ‡ David Ricardo took it a step further saying that trade should be based on a comparative level (comparing opportunity costs to other countries). ‡ By trading, goods can be acquired at lower opportunity costs and specialization can further increase consumption possibilities. ‡ The terms of trade between two countries (what to price the goods at in terms of the other goods, I.e. 1 pencil sharpener = 3 cans of pop) have to be so that each country is never paying more than the opportunity cost of producing the good domestically. 11 Comparative Advantage ´7KH▯VLWXDWLRQ▯WKDW▯H[LVWV▯ZKHQ▯D▯FRXQWU\▯FDQ▯SURGXFH▯D▯ good with less foregone output of other goods than can DQRWKHU▯FRXQWU\▯µ ‡ Comparative advantages reflect opportunity costs that differ between countries. ‡ Even though a country may have an absolute advantage in all goods, it cannot have a comparative advantage in all goods. ‡ The gains from specialization and trade depend on the pattern of comparative, not absolute advantage. ² Absolute advantage refers to when a country can produce more of a good, given the same amount of resources (usually referring to labour). 12 Gains from Trade ‡ Trade allows importing countries to acquire goods at a lower opportunity cost than if they produced the goods themselves. ‡ Whenever opportunity costs differ between countries, it is always possible to increase consumption of goods if countries specialize in producing the product they have a comparative advantage in. ‡ TIP: Whenever calculating OC, put the one you want to find in the bottom (denominator). ² I.e. with guns and pillows. If I want to find the OC of guns in Canada, do: Canadian Pillows Canadian Guns 13 Example! Answer: b) Why? Overall, the Foreign cannot produce more of either good (no absolute DGYDQWDJH▯▯▯EXW▯LW¶V▯RSSRUWXQLW\▯FRVW▯LV▯ORZHU▯ZKHQ▯LW▯FRPHV▯WR▯SLOORZV▯▯ Opportunity Costs Guns Pillows Home 2 pillows 0.5 guns Foreign 2.5 pillows 0.4 guns 14 Example! Opportunity Costs Guns Pillows Home 2 pillows 0.5 guns Foreign 2.5 pillows 0.4 guns Answer: b) Remember, no country would ever want to trade when the relative price of a good LV▯JUHDWHU▯WKDQ▯LW¶V▯RSSRUWXQLW\▯FRVW▯IRU▯WKDW▯JRRG▯▯EHFDXVH▯WKH\▯PD\▯DV▯ZHOO▯PDNH▯ it themselves then). The OC of guns ranges between 2-2.5. Therefore, terms of trade must be within this range. 15 Example! Answer: b) a) Wrong ± why would countries export goods just to import the same two goods back? b) Correct ± the Foreign country has the comparative advantage and should therefore export (as opportunity cost is lower). c) Wrong ± the Home country has a higher (opportunity) cost of making pillows, so they should leave it to the Foreign country. d) Wrong ± the Home country has a comparative advantage in making guns. e) Wrong ± both can gain from trade by specializing in the good whic16they have lower opportunity cost in. Supply and Demand 17 Supply and Demand Quantity  Demanded: total   Price Demand amount  of  any  particular   good  or  service  that   consumers  wish  to  purchase   in  some  time  period  at  a   certain  price.   Pe Quantity  Supplied: total   amount  of  any  particular   good  or  service  that  suppliers   Supply wish  to  supply  in  some  time   period  at  a  certain  price. Qe Quantity 18 Factors of Demand ‡ Change in the price of a substitute good ‡ Direct relationship (I.e. Pepsi prices increases, Coke Demand increases) ‡ Change in the price of a complementary good ‡Inverse relationship (I.e. Pillow prices rise, pillowcase demand falls) ‡ Change in consumer income ‡Direct relationship (I.e. minimum wage increases, demand for beer increases) ‡ Change in population ‡ Direct relationship (every fall, the population of Waterloo increases by about 30,000 students, demand for eating out increases) ‡ Change in tastes and Preferences ‡ Direct Relationship (The people of Waterloo generally become more health conscious, the demand for healthy food increases) ‡ Fu‡ Direct Relationship (Y2K example: the public thinks some crazy stuff is gonna go down, therefore the demand for canned soup sky rockets now ) 19 Factors of Supply ‡ Price of an input ‡ Inverse Relationship: the price of yarn goes up, therefore the supply of J-‐ 'DZJ·V▯KDQG▯NQLWWHG▯PLWWHQV▯JRHV▯GRZQ ‡ Technology ‡ Direct relationship: new technology is discovered in regards to getting the caramel inside of the chocolate, therefore the supply of Caramilk bars goes up ‡ # of Suppliers ‡ Direct relationship: the number of restaurants being built in Waterloo goes up, therefore the supply increases ‡ Expectations ‡ If suppliers expect prices to rise in the future, they may reduce supply in order to sell more later at a higher price ‡ Natural Events ‡ Weather that destroys crops, or a severe tornado that destroys machinery and a factory will decrease the supply of that good. 20 Demand and Supply Key Points TO KEEP IN MIND: ‡ Both quantity demanded and quantity supplied represent flows of those goods over a time period (not a stock of goods). ‡ For the time being, we are assuming markets to be perfectly competitive (many buyers and sellers who have no appreciable influence over prices ² the market determines prices). Therefore, market forces cause price to always move towards EQUILIBRIUM (where Qd = Qs). ‡ $▯FKDQJH▯LQ▯D▯JRRG·V▯SULFH▯▯3▯▯FDXVHV▯D ² Movement along a demand or supply curve and a change in quantity demanded or supplied ‡ A change in any of the factors of demand or supply (Price not being one of them) causes ² Shift of a demand/supply curve 21 Example! Answer: a) a) Correct ± Wages of workers are an input, price of an input going up causes supply to decrease. b) Wrong ± This is a factor of demand. c) Wrong ± An increase in the number of suppliers will increase the supply. d) Wrong ± A decrease in the price causes a decrease in the quantity supplied, not the actual supply. e) Wrong ± Wrong because d) is wrong. 22 Four Laws of Demand and Supply 1. An increase in demand causes an increase in both the equilibrium price and the equilibrium quantity exchanged. 2. A decrease in demand causes a decrease in both the equilibrium price and quantity exchanged. (when demand shifts, P and Q move in the same direction!) 23 Four Laws of Demand and Supply &RQWLQXHG«▯ 3. An increase in supply causes a decrease in the equilibrium price and an increase the equilibrium quantity exchanged. 4. A decrease in supply causes an increase the equilibrium price and a decrease quantity exchanged. (when Supply shifts, P and Q move in opposite directions!) 24 Laws Sum Up ,I« ² D P e Qe ² D P e Qe ² S Pe Q e ² S Pe Q e 25 Are there
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