Exam 1 Review
A. Define economics, microeconomics, macroeconomics. What if the fundamental concept
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
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
iv. the fundamental concept is that we all face scarcity and thus we must
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
2. Total Utility – an individual’s total satisfaction and
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
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
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
- (V =1V =2……=V = X (wnere X>0) If constraints change, a new allocation must be
- 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
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
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
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
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
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
2. Excess demand – quantity demanded exceeds quantity
supplied at a given price
Market response – prince adjusts upward until reach
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
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
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
If the supply increases, there is excess supply. The
price will adjust downward until a new equilibrium is
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
Price change relative to income
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
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
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:
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
i. Income elasticity – measures the responsiveness of demand to
changes in consumer income (I)
1. Normal Good: (ε>0) If the in