Comparative Advantage and Demand

• The document is a review sheet for an Economics exam and covers ten principles of economics, thinking like an economist, interdependence and gains from trade, market forces of supply and demand, and elasticity.

Ten Principles of Economics

• People face trade-offs.
• The cost of something is what you give up to get it.
• Rational people think at the margin.
• People respond to incentives.
• Trade can make everyone better off.
• Markets are usually a good way to organize economic activity.
• Governments can sometimes improve market outcomes.
• A country's standard of living depends on its ability to produce goods and services.
• Prices rise when the government prints too much money.
• Society faces a short-run trade-off between inflation and unemployment.

Thinking Like an Economist

• Circular Flow Diagram illustrates how money moves through an economy.
• Production Possibilities Frontier (PPF) shows the maximum possible output combinations of two goods or services an economy can achieve when all resources are fully and efficiently employed.
• Points on the PPF are possible and efficient, meaning all resources are fully utilized.
• Points under the PPF are possible but inefficient, implying some resources are underutilized.
• Points above the PPF are not feasible with the current level of resources and technology.
• Moving along a PPF involves shifting resources from the production of one good to another.
• Society faces a tradeoff when moving along the PPF, as getting more of one good requires sacrificing some of the other.
• The slope of the PPF shows the opportunity cost of one good as measured in terms of the other good.
• A straight-line PPF indicates a constant opportunity cost.
• A bowed-outward PPF indicates increasing opportunity cost.
• As more units of a good are produced, increasing amounts of the other good must be given up.
• Economists believe the PPF often has a bowed shape, meaning the opportunity cost of a good is not constant.
• Differentiating between positive (descriptive) and normative (prescriptive) statements is important in economic analysis.

Interdependence and the Gains from Trades

• Absolute advantage refers to the ability to produce a good using fewer inputs than another producer.
• Comparative advantage refers to the ability to produce a good at a lower opportunity cost than another producer.
• It is possible to have an absolute advantage in both goods.
• It is impossible to have a comparative advantage in both goods.
• The opportunity cost of one good is the inverse of the opportunity cost of the other.
• Gains from specialization and trade are based on comparative advantage.
• Trade can benefit everyone in society because it allows people to specialize in activities who have comparative advantage.
• The price at which trade occurs must lie between the two opportunity costs for both parties to gain from trade.

The Market Forces of Supply and Demand

• Changes in quantity demanded are movements along the demand curve caused by a change in the good's price.
• Changes in demand are shifts of the entire demand curve caused by changes in non-price determinants such as:
  • Income (differentiating between normal and inferior goods)
  • Prices of related goods (substitutes vs. complements)
  • Tastes
  • Expectations
  • Number of buyers
• Changes in quantity supplied are movements along the supply curve caused by a change in the good's price.
• Changes in supply are shifts of the entire supply curve caused by changes in non-price determinants such as:
  • Input prices
  • Technology
  • Expectations
  • Number of sellers
• Equilibrium (E) is the point where supply equals demand.
• Equilibrium price (PE) is the price at equilibrium.
• Equilibrium quantity (QE) is the quantity at equilibrium.
• A surplus occurs when quantity supplied exceeds quantity demanded.
• A shortage occurs when quantity demanded exceeds quantity supplied.
• It's important to analyze how events affect equilibrium price and quantity.
• An increase in demand causes an increase in both price and quantity.
• A decrease in demand causes a decrease in both price and quantity.
• An increase in supply causes a decrease in price and an increase in quantity.
• A decrease in supply causes an increase in price and a decrease in quantity.

Elasticity

• Price elasticity of demand measures how much the quantity demanded of a good responds to a change in the price of that good.
• Price elasticity of demand = Percentage change in quantity demanded / Percentage change in price.
• Determinants of price elasticity of demand include:
  • Availability of close substitutes: Goods with close substitutes tend to have more elastic demand.
  • Necessities versus luxuries: Necessities tend to have inelastic demand, while luxuries have elastic demand.
  • Definition of the market: Narrowly defined markets tend to have more elastic demand than broadly defined ones.
  • Time horizon: Demand tends to be more elastic over longer periods of time.
• Income elasticity of demand measures how much the quantity demanded of a good responds to a change in consumers' income.
• Income elasticity of demand = Percentage change in quantity demanded / Percentage change in income.
• Normal goods have positive income elasticity.
• Inferior goods have negative income elasticity.
• Cross-price elasticity of demand measures how much the quantity demanded of one good responds to a change in the price of another good.
• Cross-price elasticity of demand = Percentage change in quantity demanded of good 1 / Percentage change in the price of good 2.
• It is positive if the two goods are substitutes.
• It is negative if the two goods are complements.
• Midpoint Method for Price elasticity of demand = [Q2-Q1 / (Q1+Q2)/2] / [P2-P1 / (P1+P2)/2].

Explore scenarios demonstrating comparative advantage and the dynamics of supply and demand. Understand how consumer income, prices of related goods, and tastes impact market demand. Learn about shifts in demand versus changes in quantity demanded.