ECON 2301 Exam 1 Review PDF

Review Sheet for ECON 2301 Exam 1 Chapter 1. Ten Principles of Economics Principle 1: People face trade-offs Principle 2: The cost of something is what you give up to get it Principle 3: Rational people think at the margin Principle 4: People respond to incentive...

Review Sheet for ECON 2301 Exam 1 Chapter 1. Ten Principles of Economics Principle 1: People face trade-offs Principle 2: The cost of something is what you give up to get it Principle 3: Rational people think at the margin Principle 4: People respond to incentives Principle 5: Trade can make everyone better off Principle 6: Markets are usually a good way to organize economic activity Principle 7: Governments can sometimes improve market outcomes Principle 8: A country’s standard of living depends on its ability to produce goods and services Principle 9: Prices rise when the government prints too much money Principle 10: Society faces a short-run trade-off between inflation and unemployment Chapter 2. Thinking Like an Economist The Circular Flow Diagram Production possibilities frontier o Points on the PPF: Possible and efficient: all resources are fully utilized o Points under the PPF: Possible but inefficient: some resources are underutilized (e.g., workers unemployed) o Points above the PPF: Not feasible o Moving along a PPF: Involves shifting resources from the production of one good to the other o Society faces a tradeoff: Getting more of one good requires sacrificing some of the other o The slope of the PPF: Shows the opportunity cost of one good as measured in terms of the other good o Shape of the PPF ▪ Straight line: constant opportunity cost ▪ Bowed outward: increasing opportunity cost ▪ As more units of a good are produced, we need to give up increasing amounts of the other good produced o Economist believe that PPF often have bowed shape: The opportunity cost of a good is not constant Positive Statements vs. Normative Statements Chapter 3. Interdependence and the Gains from Trades Absolute advantage (cost of inputs): o The ability to produce a good using fewer inputs than another producer Comparative Advantages (opportunity cost): o The ability to produce a good at a lower opportunity cost than another producer 1  It is possible for one person to have an absolute advantage in both goods It is impossible for one person to have a comparative advantage in both goods o The opportunity cost of one good is the inverse of the opportunity cost of the other o The gains from specialization and trade are based on comparative advantage o Trade can benefit everyone in society because it allows people to specialize in activities in which they have a comparative advantage. For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs. Chapter 4. The Market Forces of Supply and Demand Demand Change in quantity demanded vs. change in demand A change in the good’s price represents a movement along the demand curve (change in quantity demanded) A change in one of the other variables (non-price determinants) shifts the demand curve (change in demand) o Income (normal good vs. inferior goods) o Prices of related goods (substitute vs. complements) o Tastes o Expectations o Number of buyers Change in quantity supplied v.s. change in supply A change in the good’s price represents a movement along the supply curve (change in quantity supplied) A change in one of the other variables (non-price determinants) shifts the supply curve (change in supply) o Input prices o Technology o Expectations o Number of sellers Equilibrium (E) 𝑃 Equilibrium price (𝑃𝐸 ) Equilibrium quantity (𝑄𝐸 ) Surplus Shortage 𝑃𝐸 𝑄𝐸 𝑄 2  Need to know how to analyze the effects of events on equilibrium price and quantity Demand changes only An increase in demand: causes an increase in both and quantity P D1 A decrease in demand: causes a decrease in both and quantity P D1 Q Supply changes only An increase in supply causes a decrease in price and an increase in quantity P S1 S2 Q 3 A decrease in supply causes an increase in and a decrease in quantity P S1 Q Summary table: demand and supply change together Supply Increase Decrease Demand Increase Quantity increases, effect Price increases, effect on on Price is ambiguous Quantity is ambiguous Decrease Price decreases, effect Quantity decreases, effect on on Quantity is ambiguous Price is ambiguous Chapter 5. Elasticity Price elasticity of demand o A measure of how much the quantity demanded of a good responds to a change in the price of that good. It measures the price-sensitivity of buyers’ demand 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 Price elasticity of demand = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 Determinants of price elasticity of demand o Availability of Close Substitutes ▪ Goods with close substitutes tend to have more elastic demand o Necessities versus luxuries ▪ Necessities tend to have inelastic demand, whereas luxuries have elastic demand o Definition of the market ▪ Narrowly defined markets tend to have more elastic demand than broadly defined ones o Time Horizon 4  ▪ Demand tend to be more elastic over longer periods of time Income elasticity of demand o A measure of how much the quantity demanded of a good responds to a change in consumers’ income 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 o Income elasticity of demand = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑖𝑛𝑐𝑜𝑚𝑒 o Normal goods have positive income elasticity o Inferior goods have negative income elasticity Cross-price elasticity of demand o A measure of how much the quantity demanded of a good responds to a change in the price of another good 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 𝑜𝑓 𝑔𝑜𝑜𝑑 1 o Cross-price elasticity of demand = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑡ℎ𝑒 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑔𝑜𝑜𝑑 2 o It is positive if the two goods are substitute o It is negative if two goods are complements 𝑄 −𝑄 (𝑃 +𝑃 )/2 Midpoint Method: Price elasticity of demand = 𝑃2−𝑃1  (𝑄1 +𝑄2 )/2 2 1 1 2 5