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ECN203 Review Exam 1 (1).doc

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Syracuse University
ECN 203

Economics 203 Exam 1 Review I. Introduction A. Define economics, microeconomics, macroeconomics. What if the fundamental concept of Economics? i. Economics – the study of how individuals, businesses, and societies manage scarce resources…compares our choices to find the best one. ii. Microeconomics – the study of decision making at the individual level. 1. Ex. Personal, household, business, market  Business  what to produce, quality and quantity, how to produce (minimizing costs)  Market  ex. Sneaker market iii. Macroeconomics – the study of the overall performance of the economy in a given region. 1. Ex. National production, unemployment, inflation  Production  GDP (measures how the economy is doing) iv. the fundamental concept is that we all face scarcity and thus we must make choices B. Define opportunity cost. i. Opportunity cost is the cost pursuing a given choice; your next best alternative. Whenever we make a decision, there is always a cost. C. What role do assumptions play in economic models? What is ceteris paribus? i. Models are based on assumptions; omit irrelevant details. They are also simplified representations of reality. (ex. A road map that only has major highways) ii. Ceteris paribus – a commonly used assumption in economics that holds all else constant. D. Other terms • Scarcity – resources are finite or scare relative to our wants and needs • Optimal allocation – the best use of our scare resources • Circular flow model – a simplified representation of how the economy works. Assumes the main sectors in the economy are households and business firms. • Economy – the system of producing and distributing goods and services in a region/nation…Free Markey vs. Command II. Individual choice (How do individuals make decisions according to our model?) A. With just one option and assuming no scarcity (Jack and his pizza slices example) 1. Continue on until reach bliss/ satiation point . This is where MU = 0 2. Know how to calculate marginal utility and total utility 1. Marginal Utility – a change in TU resulting from a change in the quantity (Q)…Formula: MU = Change in TU/ Change in Q 2. Total Utility – an individual’s total satisfaction and happiness  Utils – measure of utility B. With several options and no scarcity (if consuming goods, money replaces time) -- Reach bliss/ satiation point where: MU = MU = ………….=MU = 0. Can drop unit of resource. 1 2 n With several options and scarcity (must find Optimal allocation - allocation of scarce resources that maximizes one’s total utility) • Take the total utility of both parts of both tables (add up the TUs of each table for each pair chosen to find max total utility) • Equal margins principle – the best allocation is always found where the marginal utilities are equal across options. -- Cannot reach bliss/satiation point. Do each until utilities are equal across all options MU =1MU = 2……….=MU = X (where n>0) implies scarcity and can X and unit of resource. C. With several options for using productive resources (such as labor) and face scarcity - Value of the Marginal Products are equal across all options 1. Marginal product – a change in output (Q) due to each additional unit of resource (assume it diminishes) (ex. How much you can produce in each hour) 2. Value of marginal product (V) – utility derived from each additional unit of a productive resource. (combines MP and MU) (ex. The pleasure he gets after consuming each fish) - (V =1V =2……=V = X (wnere X>0) If constraints change, a new allocation must be found. - ASK ABOUT EXAMPLE # 4 D. How do future consequences and risks affect our decisions? -- Define present value, discount rate, risk and uncertainty. • Our most important decisions are usually intertemporal – have consequences across time, such as going to college. • Present value – value of future utility choices put into today’s value and allows comparisons across time • Discount rate – a measure of one’s willingness to wait for utility o Low discount rate – more willing to wait o High discount rate – less willing to wait o A discount rate can change overtime • Risks – events that may affect one’s decision with some perceived probability • Uncertainty – events that may affect one’s decision, but with no perceived probability. Risks enter our decision process, uncertainty does not. III. Markets for Goods A. Why do markets form? 1. Define Absolute Advantage & Comparative Advantage 1. Market – a means of exchanging goods and services 2. Specialization – each worker focuses on the production of a single good  Creates surpluses to be traded  As a result, markets must form 3. Gains from trade – the increased utility made possible by specialization and trade 4. Absolute advantage – the ability to produce more of a good than others using the same amount of resources. 5. Comparative advantage – the ability to produce more of a good at a lower opportunity cost than the other.  Determine the opportunity cost for each  As long as comparative advantage exists for both, trade is beneficial 2. Which above is a necessary condition for trade to be beneficial? 1. Comparative advantage because as long as it exists for both, trade is beneficial. 3. Determine comparative advantage by calculating opportunity cost. 1. (Gilligan and skipper example) B. How are goods exchanged in markets? -- Barter, General Equivalent, 3 roles of Money • Barter – the exchange of goods and services for others of similar value. o Barter system flawed • General equivalent – one commodity that is generally accepted for all other commodities. o Commodity vs. fiat money o Better method of exchange • Three roles of money o Medium of exchange – money facilitates the exchange of goods and services. This is the primary role. o Unit of account – money allows us to measure the value of our holdings o Store of value – money can be spent now or used later C. Demand and Supply Model i. Demand – shows the quantity (Q) of a good buyers are willing and able to buy at various prices ii. Law of demand – Q falls (rises) as P rises (falls) iii. supply – shows the quantity (Q) of a good suppliers are willing and able to produce and sell at various prices. iv. Law of supply – Q rises (falls) when P rises (falls) 1. How does price affect the quantity demanded/ quantity supplied? 1. Changes in price cause movement along the curve  If attitudes of sellers change for reasons other than a change in P (costs of producing), the supply curve shifts. 2. What causes an excess supply or an excess demand to occur? How do markets adjust to eliminate such excesses? 1. Excess supply – quantity supply exceeds quantity demanded at a given price (Q^s > Q^d)  Markets response – price adjust downward until reaches equilibrium 2. Excess demand – quantity demanded exceeds quantity supplied at a given price  Market response – prince adjusts upward until reach equilibrium 3. Equilibrium price and quantity 1. equilibrium price – the price where Q^d and Q^s are equal 2. equilibrium quantity – the quantity where Q^d and Q^s are equal 3. price is the signal, it will adjust until equilibrium is reached 4. Know all variables that shift demand and supply. How do the shifts affect the equilibrium P, Q? 1. Demand shift – quantity demanded changes at all prices  If demand decreases, there will be excess supply. The price will go down until a new equilibrium is reached.  If demand increases, there will be an excess demand. The price will go up until a new equilibrium is reached. 2. Supply shift – quantity supplied changes at all prices  If supply decreases, there is an excess demand. The price will adjust upward until a new equilibrium is reached  If the supply increases, there is excess supply. The price will adjust downward until a new equilibrium is reached. IV. Demand Elasticities A. Price Elasticity of Demand (εP)—responsiveness of Q to P changes i. Price elasticity of demand – measures how quantity demanded (Q^d) of a good responds to a change in its price (P) 1. Depends on:  Necessity vs luxury  Number and quality of substitutes  Market definition  Price change relative to income  Time horizon ii. Perfectly inelastic- extreme case, line is perfectly vertical iii. Perfectly elastic – extreme case, perfectly horizontal iv. Total revenue of a firm – (price of a good) x (quantity sold) 1. Price-elastic (P >1)—flatter demand line – more responsive to changes in price (luxury) 2. Price-inelastic (εP<1)—steeper demand lines – less responsive to changes in price (necessity) 3. Tax on a good— Who bears the burden of the tax? Show graphically tax incidence: after-tax equilibrium, new price buyers pay, new price sellers receive. 1. Excise tax – tax on a specific good 2. Tax incidence – the study of who bears the burden of the tax. The outcome depends on the price elasticity of demand.  Inelastic demand: buyers bear most of the burden i. Space between the first price and the second price  Elastic demand: sellers bear most of the burden i. Space between the first price and the P^s (which is the space furthest down to where the first supply line is located) 3. Shift variables of demand:  Tastes/preferences (T) i. If tastes and preferences for a good rises, demand for a good increases. ii. If tastes and preferences for a good falls, demand for a good falls.  Price of related goods (Pr) i. Change in price in one good can affect demand in another. (hamburgers and French fries example with the pizza substitution)  Income (I) (normal or inferior good)  And the number of buyers B. Cross-price elasticity (ε1x2measures how demand for good 2 responds to change in the price of good 1. 1. Complements: (ε <0)1x2gative signs 2. Substitutes: (ε 1x2 positive signs C. Income elasticity (ε I – measures the effect of an income change on the demand for a good. i. Income elasticity – measures the responsiveness of demand to changes in consumer income (I) 1. Normal Good: (ε>0) If the in
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