EC120 TEST #1 EXAM-‐AID
Coordinator: Alanna Davoren
Some images used from course slides.
Go through Chapters 1-‐6
Intro to Economics and Opportunity Cost
PPF, Trade, and Comparative Advantage
Demand, Supply, and Price
Government Policy (Price Floors and
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
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
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
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
5 EXAMPLE # 1
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
working would be his opportunity cost.
6 EXAMPLE # 2
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
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
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
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
good with less foregone output of other goods than can
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
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
12 Gains from Trade
Trade allows importing countries to acquire goods at
a lower opportunity cost than if they produced the
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
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!
Why? Overall, the Foreign cannot produce more of either good (no absolute
Home 2 pillows 0.5 guns
Foreign 2.5 pillows 0.4 guns 14 Example!
Home 2 pillows 0.5 guns
Foreign 2.5 pillows 0.4 guns
Remember, no country would ever want to trade when the relative price of a good
it themselves then). The OC of guns ranges between 2-2.5. Therefore, terms of
trade must be within this range. 15 Example!
a) Wrong ± why would countries export goods just to import the same two goods
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
Quantity Supplied: total
amount of any particular
good or service that suppliers
Supply wish to supply in some time
period at a certain price.
18 Factors of Demand
Change in the price of a substitute good
Direct relationship (I.e. Pepsi prices increases, Coke Demand
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
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-‐
Direct relationship: new technology is discovered in regards to getting the
caramel inside of the chocolate, therefore the supply of Caramilk bars
# of Suppliers
Direct relationship: the number of restaurants being built in Waterloo goes
up, therefore the supply increases
If suppliers expect prices to rise in the future, they may reduce supply in
order to sell more later at a higher price
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
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).
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!
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
(when demand shifts, P and Q move in the
23 Four Laws of Demand and Supply
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
(when Supply shifts, P and Q move in opposite
24 Laws Sum Up
² D P e Qe
² D P e Qe
² S Pe Q e
² S Pe Q e
25 Are there