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)
- 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)
- Everybody is free to decide what to do themselves, everything is free will
- Def. Allocates resources through the decentralized decisions of firms and
- All production and distributed decisions are made by a central authority
- Ex: Soviet Union dictated how each business, or individual produced or
- 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
- 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
-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 of something is everything you have to give up to get that
- 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
- 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
-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)
- 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
• Produce and sell goods and services
• Hire and use factors of production
• Buy and consume goods and services
• Own and sell factors of production
Markets for Goods and Services
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
•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
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
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 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
•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).
•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
•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
•Aaron should specialize in producing meat and trade meat for potatoes.
•When they trade with each other, they can consume more of both goods!
-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
•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
-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
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
•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
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
-Coke and Pepsi (Price of pepsi goes up, the demand for coke is higher, b.c it is
-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
-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
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
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
A decrease in demand: Shifts demand curve to the left (demand decreases at every
Shift Factors for Demand
•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
•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
•- in the market this happens, when the price is such that quantity demand=