Economics Chapter: Incentives and Trade-Offs

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Questions and Answers

What effect does an increase in consumer income have on normal goods?

Supply of normal goods decreases.

Demand for normal goods increases. (correct)

Demand for normal goods does not change.

Demand for normal goods decreases.

Which factor shifts the demand curve to the left?

A decrease in the price of complements.

An increase in population.

A decrease in demand. (correct)

An increase in income.

What happens to the demand for a good if the price of its substitute decreases?

Demand for the good increases.

Demand for the good remains the same.

Demand for the good decreases. (correct)

Supply of the good increases.

What is the effect of an increase in supply on the supply curve?

Shifts the supply curve to the right. Signup and view all the answers

Which of the following best describes an inferior good?

Demand decreases as consumer income increases. Signup and view all the answers

What typically occurs due to the expectation of a reduction in future supply?

Supply increases today. Signup and view all the answers

How does a technological innovation typically affect supply?

Decreases production costs, thereby increasing supply. Signup and view all the answers

What is indicated by the law of supply?

As price rises, quantity supplied increases. Signup and view all the answers

What happens to current supply when suppliers expect prices to increase in the future?

Current supply decreases. Signup and view all the answers

How does a tax on output affect production costs?

It increases the costs of production. Signup and view all the answers

Which scenario would lead to a rightward shift of the supply curve?

Entry of new producers in the market. Signup and view all the answers

What is the effect of an increase in opportunity costs on the supply curve?

The supply curve shifts up and to the left. Signup and view all the answers

What defines a good as having greater elasticity?

A larger share of the budget is devoted to it. Signup and view all the answers

When demand is inelastic, what happens to revenue when the price increases?

Revenue increases. Signup and view all the answers

Which characteristic is associated with elastic demand?

Availability of substitutes. Signup and view all the answers

What happens to the elasticity of supply when a supply curve is flatter?

It indicates the supply is more responsive to price changes. Signup and view all the answers

What is the primary function of incentives in economic behavior?

To motivate individuals to achieve their goals Signup and view all the answers

What happens when markets do not operate efficiently according to Adam Smith's principles?

Government can intervene using incentives like taxes Signup and view all the answers

Which of the following illustrates a trade-off in drug approval processes?

Delaying approval of safe drugs to ensure thorough testing Signup and view all the answers

When considering marginal changes, which aspect is typically evaluated?

The cost of a single additional unit Signup and view all the answers

What is the theory of comparative advantage focused on?

Trading goods in which one has a low opportunity cost Signup and view all the answers

How do strong institutions contribute to economic growth?

By providing incentives for saving and investing Signup and view all the answers

What is a consequence of scarcity in economic terms?

Decisions must be made on resource allocation Signup and view all the answers

What effect does specialization due to trade typically have?

Increased productivity and efficiency Signup and view all the answers

What is the primary purpose of futures contracts in financial markets?

To allow speculation without taking possession of physical goods Signup and view all the answers

What determines who ultimately pays a tax imposed on a good?

The relative elasticities of supply and demand Signup and view all the answers

When demand is more elastic than supply, who bears most of the cost of the tax?

Sellers bear most of the cost Signup and view all the answers

What can firms do to escape the burden of a tax more effectively than workers?

They can substitute capital for labor Signup and view all the answers

What is a subsidy in economic terms?

Financial support provided to producers or consumers by the government Signup and view all the answers

What effect does a subsidy generally have on trade and market efficiency?

It creates deadweight loss due to non-beneficial trade Signup and view all the answers

In the context of cotton subsidies in California, which statement is correct?

Farmers receive the majority of the subsidy benefits due to inelastic supply Signup and view all the answers

What does it mean when a market has a more elastic supply than demand?

Most of the tax burden falls on buyers Signup and view all the answers

What characterizes perfectly inelastic supply?

A perfectly steep slope on the graph Signup and view all the answers

Which statement about equilibrium is correct?

Equilibrium price and quantity are stable in a free market Signup and view all the answers

What is the result of a shortage in a market?

Quantity demanded is higher than quantity supplied Signup and view all the answers

How does a change in quantity supplied differ from a change in supply?

Quantity supplied is a movement along a fixed supply curve Signup and view all the answers

What role do prices play in a market?

They integrate markets and motivate entrepreneurs Signup and view all the answers

What typically happens when the supply of a critical resource like oil decreases?

Related product costs, such as candy bars, may increase Signup and view all the answers

Which of the following indicates a movement along a demand curve?

A change in quantity demanded due to a fixed demand curve Signup and view all the answers

Which condition is NOT an implication of the free market maximizing gains from trade?

Every trader must make a profit from each transaction Signup and view all the answers

Study Notes

Incentives Matter

Individuals respond to incentives, which are things that motivate them to try harder and achieve
Incentives can be rewards or penalties that motivate behavior.

When markets work well, individuals pursuing their own self-interest also promote social interest
Adam Smith believed that markets work well to align self-interest with social interest.
When markets don't work well, the government can change incentives through taxes, subsidies, and regulations.

Trade-Offs

Trade-offs involve sacrificing one thing to gain another.
For example, more drug testing means fewer side effects, but it also means more drug lag (harm from delayed approval) and drug loss (safe drugs never developed).
Opportunity cost is the value of the best alternative forgone.

Scarcity

Scarcity means there isn't enough of a resource to satisfy everyone's wants.
The Great Economic Problem is how to arrange scarce resources to satisfy as many wants as possible.

Thinking on the Margin

Marginal means one more or one less.
We make decisions by comparing the benefits and costs of a little more or a little less of something.
Marginal cost, marginal revenue, and marginal tax rates all relate to this concept.

The Power of Trade

Trade benefits go beyond exchange.
Trade increases production through specialization, the focus of labor on specific products.
Trade also allows us to take advantage of economies of scale (lower per-unit costs with increased production).
Comparative advantage explains how people or nations specializing in goods with low opportunity cost can trade to mutual benefit.

The Importance of Wealth and Economic Growth

Economic growth creates wealth, leading to richer and healthier lives.

Institutions Matter

Institutions provide incentives to save and invest in physical capital, human capital, innovation, and efficient organizations.
Institutions that foster growth include property rights protection, political stability, honest government, a dependable legal system, and competitive and open markets.

Demand

Demand is the relationship between price and quantity demanded.
A decrease in demand shifts the demand curve to the left; at each price, people are willing to buy less, and at each quantity, they are willing to pay a lower price.

Factors That Shift Demand

Income:
- Normal goods: demand increases when income increases.
- Inferior goods: demand decreases when income increases.
Population: Changes in population size or composition affect overall demand.
Prices of Substitutes: A decrease in the price of a substitute good decreases demand for the original good.
Prices of Complements: A decrease in the price of a complementary good increases demand for the original good.
Expectations: Expectations about future prices and supply affect current demand.
Tastes: Changes in tastes due to fads, fashions, or advertising can influence demand.

Supply

The supply curve is positively sloped, reflecting the relationship between price and quantity supplied.
Law of Supply: As the price of an item rises, the quantity supplied increases.
Producer surplus is the difference between the market price and the minimum price at which a producer would be willing to sell.
Total producer surplus is the area above the supply curve and below the price.

Shifting the Supply Curve

An increase in supply shifts the supply curve to the right; producers are willing to sell more at each price, and they are willing to accept a lower price at each quantity.
A decrease in supply shifts the supply curve to the left; producers are willing to sell less at each price, and they need a higher price to supply the same quantity.

Factors That Affect Supply

Technological Innovations: Improvements in technology can reduce production costs and increase supply.
Input Prices: Reductions in input prices (e.g., labor, materials) decrease costs and increase supply.
Taxes and Subsidies: Taxes increase costs and decrease supply; subsidies reduce costs and increase supply.
Expectations: Expectations about future prices influence current supply; suppliers expecting higher prices may store goods, decreasing current supply.
Entry or Exit of Producers: New producers increase supply; exiting producers decrease supply.
Changes in Opportunity Costs: Changes in the price of a good's alternative uses influence supply.

Elasticity of Demand

Measures how responsive quantity demanded is to changes in price.
More responsive = more elastic.
Elasticity rule: A flatter demand curve is more elastic than a steeper one.

Determinants of Elasticity of Demand

Substitutes: Easier to find substitutes = Greater elasticity.
Time: More time to adjust = More substitutes = Greater elasticity.
Definition of the good: Narrow definition (brand) = More substitutes = Greater elasticity.

Necessities vs. Luxuries

Luxuries have higher elasticity; necessities have lower elasticity.
Share of Budget: Goods that make up a larger share of a budget have higher elasticity.

Formula for Elasticity of Demand

Elasticity of Demand = % Change in Quantity Demanded / % Change in Price

Relationship between Elasticity and Revenue

Inelastic Demand: Revenue increases when price increases.
Elastic Demand: Revenue decreases when price increases.

Elasticity of Supply

Measures how responsive quantity supplied is to changes in price.
Elasticity rule: A flatter supply curve is more elastic than a steeper one.
Inelastic Supply: Quantity supplied is less responsive to changes in price.
Elastic Supply: Quantity supplied is more responsive to changes in price.

Calculating the Elasticity of Supply

Elasticity of Supply = % Change in Quantity Supplied / % Change in Price

Applications of Supply and Demand

Policy Making: Governments use supply and demand analysis to assess the impact of regulations and taxes.
Business Strategy: Firms use elasticity concepts to determine pricing strategies to maximize revenue.

Equilibrium

Equilibrium is the price and quantity where quantity demanded equals quantity supplied.
Equilibrium occurs at the intersection of the supply and demand curves.
Equilibrium prices and quantities are stable in a free market.

Surplus and Shortage

Surplus: Quantity supplied is greater than quantity demanded.
Shortage: Quantity demanded is greater than quantity supplied.

Maximizing Gains from Trade

A free market maximizes the gains from trade.
Goods are bought by buyers with the highest willingness to pay.
Goods are sold by sellers with the lowest costs.
There are no exploited gains from trade or wasteful trades.

Demand and Quantity Demanded

Change in Quantity Demanded: Movement along a fixed demand curve.
Change in Demand: Shift of the entire demand curve.

Supply and Quantity Supplied

Change in Supply: Shift of the entire supply curve.
Change in Quantity Supplied: Movement along a fixed supply curve.

Prices

Prices act as signals wrapped in incentives, guiding economic decisions across time, goods, and markets.
Successful firms respond to market signals, while uncompetitive firms fail.
Speculation and futures help smooth price fluctuations and improve predictions of future events.

Commodity Taxes

Taxes on goods like fuel, cigarettes, and liquor.
The effect of a tax is the same regardless of whether it is paid by sellers or buyers.
Who ultimately pays depends on the elasticities of supply and demand.
The more elastic side of the market can escape more of the tax burden.

Tax Question: Who Pays the Tax?

It depends.
If demand is more elastic than supply, producers bear most of the cost.
If supply is more elastic than demand, buyers bear most of the cost.

Subsidies

Government payments to producers or consumers.
Subsidies create deadweight loss because some beneficial trades don't occur.

Cotton Subsidy

Subsidies for water used in cotton agriculture in California.
The high elasticity of demand for cotton (due to substitutes in other states) and the low elasticity of supply (farmers have few alternatives) mean that farmers receive most of the benefit from the subsidy.

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Description

Explore the fundamental concepts of economics focusing on incentives, trade-offs, and the alignment of self-interest with social interest. Delve into how scarcity impacts economic decision-making and the role of institutions in guiding behavior. Test your understanding of these critical economic principles.