ec 5 study guide 1

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Tufts University
Kelly Greenhill

Econ 5 Fall 2013 Economic Foundations and Models Economics- the study of the choices people make to attain their goals, given their scarce resources • Is technically a social science as it considers human behavior- particularly decision-making behavior- in every context (not just the context of business) • The rule that guides decision making never changes, even when circumstances change. Economic model- a simplified version of reality used to analyze real-world economic situations Steps to develop an economic model: 1­ decide on the assumptions to use in developing the model 2­ formulate a testable hypothesis 3­ use economic data to test the hypothesis 4­ revise the model if it fails to explain the economic detail well 5­ retain the revised model to help answer similar economic questions in the future The role of assumptions in economic models: economic models make behavioral assumptions about the motives of consumers and firms. Typically assume that firms aim to maximize profits and consumers aim to maximize utility or well-being. Economic variable- something measurable that can have different values, such as the wages of software programmers or the price of rare earths Hypothesis- a testable statement about how an economic variable may be determined: usually as a result of a casual relationship within the economic model (i.e. What will happen to the price or rare earths if China restricts their exports of rare earths?) Positive analysis- analysis concerned with what is (how the economy behaves) (generally, economics focuses on positive analysis, which measures the costs and benefits of different courses of action) Normative analysis- analysis concerned with what ought to be MarginalAnalysis Marginal analysis- analysis that involves comparing marginal benefits and marginal costs Marginal benefit- for consumers, the additional cost incurred in purchasing one more unit; for producers, the additional cost incurred in producing one more unit Optimal choice- where marginal benefit equals marginal cost Econ 5 Fall 2013 Economic ProblemsAll Societies Must Solve Scarcity- a situation in which unlimited wants exceed the limited resources available to fulfill those wants; a situation in which unlimited wants exceed the limited resources available to fulfill those wants; requires trade-offs: allocating scarce resources to one use means that they are not available for other uses Trade-off- the idea that because of scarcity, producing more of one good or service means producing less of another good or service; with trade-offs, society is forced to make choices to the following three fundamental questions: 1. What goods and services will be produced? 2. How will the goods and services be produced? 3. Who will receive the goods and services produced? Opportunity cost- the highest-valued alternative that must be given up to engage in an activity (cost of production of one product will cost the reduction of the production of another product) (the opportunity cost of the two items compared in a graph will be inversely related) Mixed economy- an economy in which most economic decisions result from the interaction of buyers and sellers in markets but in which the government plays a significant role in the allocation of resources and in determining the “rules” governing the operations of markets Product efficiency- a situation in which a good or service is produced at the lowest possible cost Allocative efficiency- a state of the economy in which production is in accordance with consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to society equal to the marginal cost of producing it Voluntary exchange- a situation that occurs in markets when both the buyer and seller of a product are free to choose whether or not to trade with each other; with a voluntary exchange both buyer and seller are made better off; buyer pays a price that is less than the maximum they are willing to pay while the seller is getting paid more than expected Equity- the fair distribution of economic benefits; an efficient allocation need not be equitable (i.e. you have everything, I have nothing) Micro vs. Macro Microeconomics- the study of how households and firms make choices, how they interact in markets, and how the government attempts to influence their choices Macroeconomics- the study of the economy as a whole, including topics such as inflation, unemployment, and economic growth Econ 5 Fall 2013 Trade-Offs and ComparativeAdvantage New products compete with products from other companies as well as the products within their own company. Must consider who, what, when, where, why, how much… Productive possibilities frontier (PPF)- a curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology; a point above the line is unattainable with the current resources, a point below is inefficient with current resources; whether the line is linear or exponential will be dependent on the type of resources and if they are more suitable for the production of one item versus another Trade- the act of buying and selling Comparative advantage- the drive behind decisions of trading; trade is based off of individuals or countries exploiting their comparative advantages; regardless of situation, a trade can usually be made (through specializing) so both parties are better off; the ability of an individual, firm, or country to produce a good or service at a lower opportunity cost than competitors (find it and exploit it); should always specialize in comparative advantage; can’t (usually) have multiple comparative advantages Absolute advantage- the ability of an individual, firm, or country to produce more of a good or service than competitors, using the same amount of resources The basis for trade is comparative advantage, NOT absolute advantage. Individuals, firms, and countries are better off if they specialize in their comparative advantage to obtain other goods and services they need by trading. The Market System Market- a group of buyers and sellers of a good or service and the institution or arrangement by which they come together to trade Three considerations to how people react in the market 1­ people are rational 2­ people respond to economic incentives 3­ optimal decisions are made at the margin Product markets- markets for goods and services (i.e. food, medical treatment) Factor markets- markets for the factors of production, such as labor, capital, natural resources, and entrepreneurial ability Factors of production- the inputs used to make goods and services; divided into four broad categories: 1- labor includes all types of work 2- capital Econ 5 Fall 2013 refers to physical capital that is used to produce other goods 3- natural resources include land, water, oil, iron ore, and other raw materials that are used in producing goods 4-an entrepreneur is someone who operates a business; entrepreneurial ability is the ability to bring together the other factors of production to successfully produce and sell goods and services Two key groups participate in markets to create a circular floe of income: 1­ households consists of all the individuals in a home 2­ firms are suppliers of goods and services Circular-flow diagram: a model that illustrates how participants in markets are linked Free market- a market with few government restrictions on how a good or service can be produced or sold or on how a factor of production can be employed; no Econ 5 Fall 2013 country operates with totally free markets— firms have constraints on how they can treat labor, consumers have restrictions on the things that they can buy, there are laws protecting intellectual property—but some countries operate with fewer restrictions than others Market Mechanism- • Individuals act in a rational, self-interested way • Adam Smith said firms would be led by the “invisible hand” of the market to provide consumers with whatever they wanted • Firms respond individually to changes in relative prices by making decisions that collectively end up satisfying the wants of consumers Entrepreneur- someone who operates a business, bringing together the factors of production—labor capital, and natural resources—to produce goods and services Property rights- the rights individuals or firms have to the exclusive use of their property, including the right to buy or sell • If property rights are not well enforced, fewer goods and services will be produced. This reduces economic efficiency, leaving the economy inside its production possibilities frontier. • Controlling unauthorized copying is difficult (internet/ cyberspace) Perfectly competitive market- a market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market Demand Demand schedule- a table showing the relationship between the price of a product and the quantity of the product demanded Quantity demanded- the amount of a good or service that a consumer is willing and able to purchase at a given price Demand curve- a curve that shows the relationship between the price of a product and the quantity of the product demanded (y-axis: price per unit, x-axis: quantity) • Q=A-BP • P=a-bQ o Q=quantity o P=prince o a= choke price (the price above which demand falls to zero) o B,b=slope (impact of quantity demanded on price) Market demand- the demand by all the consumers of a given good or service Law of Demand: (assuming that everything else is held constant) • when the price of a product falls, the quantity demanded will increase o price --, demand + • when the price of a product rises, the quantity demanded will decrease Econ 5 Fall 2013 o price +, demand -- Substitution effect- the change in the quantity demanded of a good that results from a change in price, making the good more or less expensive relative to other goods that are substitutes; when the demand of other competing products causes a price change Income effect- the change in the quantity demanded of a good that results from the effect of a change in the good’s price on consumers’purchasing power; price change based on consumers’economic situations (their income) Ceteris paribus (“all else equal”) condition- the requirement that when analyzing the relationship between two variables—such as price and quantity demanded—other variables must be held constant • a shift of a demand curve is caused by a change in demand, due to a change in factors other than price o increase in demand=shift to right o decrease in demand=shift to left o normal goods and inferior good shift differently  normal- a good whose demand increases with income  inferior- a good whose demand increases with the decrease in income (goods of less quality) o substitute goods vs. complementary goods  substitute- goods that could be used for the same thing (Coke and Pepsi)  complementary- goods used together (car and gas) o expected price fall or rise in future also determines demand shift • movement along a demand curve is an increase or a decrease in the quantity demanded, caused by a change in price o curve does not change, just move along it Econ 5 Fall 2013 Econ 5 Fall 2013 Supply Quantity supplied- the amount of a good or servi
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