Economics: Foundations and Models - Chapters 1-4

• The test is on Thursday, February 27, 2025, at 8 PM in 100 Thomas and covers chapters 1-4 (excluding appendix to Chapter 4 and taxes) + "Thinking Like an Economist"

Chapter 1: Economics: Foundations and Models

• Economics studies how individuals and societies allocate limited resources to satisfy unlimited wants.
• Resources like land, labor, and capital are limited which necessitates choices and trade-offs.
• Opportunity Cost: The value of the next best alternative given up when making a decision.
• Economic models are simplified representations of reality used to analyze complex economic activities.
• Positive analysis is descriptive and fact-based. Example: "Unemployment rate is 5%".
• Normative analysis is opinion-based and prescriptive. Example: "Government should reduce unemployment".
• Microeconomics focuses on individual markets, firms, and consumer behavior.
• Macroeconomics deals with aggregate economic issues like inflation and GDP.
• Ceteris Paribus: Latin for "all else equal," used to isolate the impact of one change in economic analysis.
• Three Fundamental Questions:
  • What to produce?
  • How to produce?
  • For whom to produce?
• Market economy: Individuals and businesses decide what to make, sell, and buy based on supply and demand, with the government having little control
• Command economy: the government makes all economic decisions, like what goods to produce, how much they cost, and who gets them.

Thinking Like an Economist

• Scientific Method: Economists formulate hypotheses, test them with data, and refine theories.
• Economic Assumptions: simplify real-world complexities for better analysis.
• I, Pencil: A lesson on spontaneous order and the invisible hand in markets.
• Circular Flow Diagram: Illustrates the movement of money, goods, and services between households and firms.
• Circular Flow Model:
  • Households spend money in markets for goods and services, which generates revenue for firms.
  • Firms then use this revenue to pay wages, rent, and profits to households in markets for factors of production, which provides income to households.

Chapter 2: Trade-offs, Comparative Advantage, and the Market System

• Four Types of Resources:

  • Land (Natural resources)
  • Labor (Human effort)
  • Capital (Machines, tools, buildings)
  • Entrepreneurship (Risk-taking, innovation)

• PPF (Production Possibilities Frontier):

  • Shows the maximum output combinations of two goods.
  • Points inside the curve = inefficient, on the curve = efficient, outside the curve = unattainable.

• PPF Shifts:

  • Outward shift = economic growth (e.g., better technology).
  • Inward shift = resource depletion (e.g., war, natural disaster).

• Absolute Advantage: Ability to produce more of a good with the same resources.

• Comparative Advantage: Ability to produce a good at a lower opportunity cost, this is the basis for trade.

• Consuming outside of the PPC is achieved through specialization and trade.

Chapter 3: Demand & Supply

• Law of Demand: Price ↑ leads to Quantity Demanded ↓ (Inverse Relationship).
• Law of Supply: Price ↑ leads to Quantity Supplied ↑ (Direct Relationship).
• Equilibrium: Market-clearing price where Qd (quantity demanded) = Qs (quantity supplied).
• Demand curve shifters: Income, tastes, substitutes, complements, expectations, number of buyers.
• Supply curve shifters: Input prices, technology, expectations, number of sellers.
• Simultaneous Shifts: Can make price or quantity changes ambiguous.
• Substitutes: Price of one good ↑, Demand for the other good ↑.
• Complements: Price of one good ↑, Demand for the other good ↓.
• Price ↑ leads to movement along the curve (Change in Quantity Demanded or Supplied).
• A shift to the Right of the curve illustrates an increase in Demand/Supply.
• A shift to the Left of the curve illustrates a decrease in Demand/Supply.

Chapter 4: Efficiency & Price Controls

• Prices allocate resources efficiently in competitive markets.
• Consumer Surplus: Difference between willingness to pay and actual price.
• Producer Surplus: Difference between price received and minimum acceptable price.
• Price Ceilings: Maximum legal price, which causes shortages. (e.g., Rent Control)
• Price Floors: Minimum legal price, which causes surpluses. (e.g., Minimum Wage)
• Consumer surplus is at the top (above equilibrium price)
• Producer surplus is at the bottom (below equilibrium price).
• Deadweight Loss: the loss of total surplus (consumer + producer surplus) that happens when a market is not operating efficiently
• Taxes – A sales tax increases the price for buyers and reduces what sellers receive, leading to fewer transactions.
• Price Ceilings (like rent control) – If rent is set too low, landlords may rent out fewer apartments, creating a shortage.
• Price Floors (like minimum wage) – If wages are set too high, some employers may hire fewer workers, causing unemployment..

Practice Questions & Answers

• A good is scarce if there is not enough of it available to satisfy all human wants at a zero price.
• Opportunity cost is the value of the next best alternative foregone when making a decision.
• Example: If producing 1 unit of coffee means giving up 2 units of nuts, the opportunity cost of 1 coffee = 2 nuts.
• An incentive is something that motivates behavior.
  • Examples: Bonuses for workers, tax breaks for businesses, fines for speeding.
• Demand Increase: Price ↑, Quantity ↑
• Supply Increase: Price ↓, Quantity ↑
• Simultaneous shifts: Depends on magnitude of changes.
• Price ceiling below equilibrium generates a shortage and black markets.
• Price floor above equilibrium generates a surplus and wasted resources.
• Profit = Total Revenue - Total Cost; Firms have costs such as wages, rent, and materials.
• 8 of the 10 key concepts from "Thinking Like an Economist." are:
  • Opportunity Cost
  • Marginal Thinking
  • Incentives
  • Trade
  • Markets
  • Property Rights
  • Rational Behavior
  • Competition