Economics Exam 1 Study Notes

• Study notes for Economics Exam 1.

Ten Principles of Economics:

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

Thinking Like an Economist:

• The circular flow diagram illustrates how money moves through an economy.
• The Production Possibilities Frontier (PPF) shows the maximum possible production combinations.
• Points on the PPF are possible and efficient, using all resources fully.
• Points under the PPF are possible but inefficient, with some resources underutilized.
• Points above the PPF are not feasible with the current resources.
• Moving along a PPF involves shifting resources from producing one good to another.
• Society has to make a tradeoff, producing more of one good requires sacrificing some of the other.
• The slope of the PPF shows the opportunity cost of one good in terms of another.
• A straight-line PPF indicates constant opportunity cost.
• A bowed outward PPF indicates increasing opportunity cost as more units of a good are produced.
• Economists believe PPFs are often bowed because the opportunity cost of a good is not constant.
• Positive statements are descriptive, while normative statements are prescriptive.

Interdependence and the Gains from Trade:

• Absolute advantage relates to the cost of inputs, producing a good using fewer inputs.
• Comparative advantage relates to opportunity cost, producing a good at a lower opportunity cost.
• 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.
• Specialization and gains from trade are based on comparative advantage.
• Trade can benefit everyone by allowing specialization in activities with a comparative advantage.
• For both parties to gain from trade, the trade price must lie between the two opportunity costs.

The Market Forces of Supply and Demand:

• A change in the good's price represents a movement along the demand curve (change in quantity demanded).
• Factors like income, prices of related goods, tastes, expectations, and number of buyers shift the demand curve (change in demand).
• A change in the good's price represents a movement along the supply curve (change in quantity supplied).
• Input prices, technology, expectations, and number of sellers shift the supply curve (change in supply).
• Equilibrium is where supply and demand intersect.
• Equilibrium price is the market price.
• Equilibrium quantity is the market quantity.
• Surplus is an excess of supply.
• Shortage is an excess of demand.
• Increase in demand causes an increase in both price and quantity.
• 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 quantity demanded responds to a change in price.
• Price elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in price.
• Goods with close substitutes tend to have more elastic demand.
• Necessities tend to have inelastic demand, whereas luxuries have elastic demand.
• Narrowly defined markets tend to have more elastic demand than broadly defined ones.
• Demand tends to be more elastic over longer periods of time.
• Income elasticity of demand measures how much quantity demanded responds to a change in consumers' income.
• Income elasticity of demand is calculated as the percentage change in quantity demanded divided by the percentage change in income.
• Normal goods have positive income elasticity.
• Inferior goods have negative income elasticity.
• Cross-price elasticity of demand measures how much quantity demanded of one good responds to a change in the price of another good.
• Cross-price elasticity of demand is calculated as the percentage change in quantity demanded of good 1 divided by the percentage change in the price of good 2.
• It is positive if the two goods are substitutes and negative if they are complements.
• Midpoint Method to work out price elasticity: (Q2-Q1) / [(Q1+Q2)/2] / (P2-P1) / [(P1+P2)/2]