ECON 001 REVIEW

MIDTERM 1
1. Opportunity Cost = value of the best foregone alternative to any decision
a. All actions imply an opportunity cost
b. Opportunity costs = true economic costs
i. Time is the most important component of the true cost
2. Scarcity and Choice: The Economic Problem
a. Economics : The study of the allocation of scarce resources to
satisfy unlimited wants.
i. The need to satisfy these unlimited wants has caused the
development of market and trade
b. Production Possibilities Frontier
i. PPF = a graph showing the maximal different combinations
of output for a given amount of inputs
1. More of one good less of another
2. Illustrates opportunity costs in production (the slope_
ii. The PPF determines opportunity cost.
1. The marginal cost of a good or service is the
opportunity cost of producing one more unit of it.
2. The marginal benefit is the amount that a person is
willing to pay for an additional unit of a good or
service.
a. Benefit a person receives from consuming one
more unity of a good or service.
b. Measure the marginal benefit: by the dollar
value of other goods and services that a
person is willing to give up to get one more unit
of it.
c. Efficiency = no waste
i. Production efficiency : all available resources are utilized.
ii. Cannot produce more of one good without decreasing
production of the other good.
d. Economic growth = increase in production of goods and services
i. Shift of the PPF out
ii. Due to technological improvement or investment in capital
goods.
e. Allocative Efficiency
i. When we cannot produce more of any one good without
giving up some other good that we value more highly.
ii. Producing at the point on the PPF that we prefer above all
other points.
3. Comparative Advantage: The Basis for Exchange

a. A person has an Absolute Advantage if they can produce more

per unit of input (e.g. time).
b. Relatively more efficient lower opportunity cost for good
c. A person has a Comparative Advantage in an activity if he/she
can perform an activity at a lower opportunity cost than others.
i. Principles of comparative advantage:
1. Specialize good with the lowest opportunity cost of
production
2. Comparative advantage specialization
d. Trade:
i. Trading ratio will be set between the parties Opportunity
Costs.
ii. Allows the Consumption Possibilities Frontier (CPF) or
Trade Line to be different from the PPF.
iii. Specialization and trade according to comparative
advantage increases consumption.
1. Specialization requires exchange
2. Trading leads to increased production because it
permits specialization.
4. Supply and Demand
a. Demand Curve = a schedule or graph showing the quantity of a
good that buyers wish to buy at each price.
i. (All other influences on consumers purchases remain the
same)
ii. Negative slope: lower prices increase quantity demanded.
b. Supply Curve = a curve or schedule showing the quantity of a
good that sellers wish to sell at each price.
i. (All other influences on sellers remain constant)
ii. Positive slope: at higher prices sellers are willing to sell more
units
c. There is normally one price where quantity of supply = quantity of
demand
i. Equilibrium Price & Quantity: The price and quantity for
which quantity demanded = quantity
ii. Market Equilibrium: Occurs in a market when all buyers
and sellers are satisfied with their respective quantities at the
market price.
d. Surplus and Shortage
i. Market surplus/Excess supply: a situation in which the
quantity supplied is greater than the quantity demanded.
ii. Market shortage/Excess demand: a situation in which
quantity demanded is created in the quantity supplied.
5. Elasticity: The Responsiveness of Demand and Supply
a. Price elasticity of demand: the responsiveness of the quantity
demanded to a change in price, measured by dividing the

percentage change in the quantity demanded of a product by the

percentage change in the products price.
i. Calculating Elasticity:
1. % change in Qdemanded / % change in Price
ii. Price Elasticity can range from zero to infinity
1. Elastic demand = price elasticity of demand > 1
2. Inelastic demand = price elasticity of demand < 1
3. Unit Elastic demand = price elasticity of demand = 1
4. Price elasticity = Q/Q / P/P
iii. Total Revenue and Elasticity
1. The total revenue = the total amount of funds
received by a seller of a good or service, calculated
by multiplying price per unit by the number of units
sold.
a. TR = P * Q
b. When the price changes, total revenue also
changes.
2. The change in total revenue due to a decrease in
price:
a. If demand is elastic TR increases
b. If demand is inelastic TR decreases
c. If demand is unitary elastic TR remains
unchanged.
iv. The elasticity of demand for a good depends on:
1. The availability of close substitutes
2. The time elapsed since a price change
3. Luxuries vs. necessities
4. Definition of the market
v. Cross-price Elasticity of Demand
1. The percentage change in quantity demanded of one
good divided by the percentage change in the price of
another good.
2. % in Qdemanded / % in Psubstitute or
complement
3. Cross-price elasticity > 0 substitutes
4. Cross-price elasticity < 0 complements
vi. Income Elasticity of Demand
1. A measure of the responsiveness of quantity
demanded to changes in income, measured by the
percentage change in quantity demanded, divided by
the percentage change in income.
2. % in Qdemanded / % in income
3. Income elasticity > 0 normal good
4. Income elasticity < 0 inferior good
b. Elasticity of Supply

i. Price elasticity of supply: the responsiveness of the

quantity supplied to a change in price, measured by dividing
the percentage change in the quantity supplied of a product
by the percentage change in the products price.
ii. Price elasticity of supply = Q/Q / P/P
iii. Elasticity of supply depends on:
1. Input substitution
2. The time frame for supply decisions
6. Efficiency and Equity
a. Efficiency in Production
i. Produce without wasting resources: on the PPF
b. Efficient allocation of resources:
i. Produce the goods and services that people value most
highly: the right point on the PPF.
ii. Pareto Efficiency
1. It is not possible to make one party better off without
making another worse off
c. Consumer surplus:
i. The value of a good (marginal benefit) minus the price paid,
summed over the quantity bought.
ii. Measure by the area under the demand curve and above the
price, up to the quantity bought.
d. Producer surplus:
i. The price of a good minus the marginal cost of producing it,
summed over the quantity sold.
ii. Measured by the area below the price and above the supply
curve, up to the quantity sold.
e. Is the Competitive Market Efficient?
i. Adam Smiths invisible hand in the Wealth of Nations
competitive markets send resources to their highest valued
use in society.
ii. Consumers and producers pursue their own self-interest and
interact in markets market transactions generate an
efficient use of resources
f. Is the Competitive Market Fair?
i. The big tradeoff: efficiency vs. fairness.
7. Taxes and Government Intervention
a. Taxes
i. Tax incidence: the division of the burden of a tax between
the buyer and the seller
1. Tax Division and Elasticity of Demand
a. Perfectly inelastic demand: the buyer pays the
entire tax.
b. Perfectly elastic demand: the seller pays the
entire tax.

c. The more inelastic the demand, the larger is

the buyers share of the tax.
2. Tax Division and Elasticity of Supply
a. Perfectly inelastic supply: the seller pays the
entire tax.
b. Perfectly elastic supply: the buyer pays the
entire tax.
c. The more elastic the supply, the larger is the
buyers share of the tax.
ii. Dead Weight Loss: a measure of inefficiency. Equals the
decrease in the sum of consumer surplus and producer
surplus that results from an inefficient level of production.
iii. Efficiency and Elasticity of Demand & Supply
1. The greater the elasticity of demand and supply, the
greater the DWL
2. Perfectly inelastic supply or perfectly inelastic
demand: no DWL
b. Subsidies
i. A negative tax
ii. Pd + s = Ps
iii. Causes overproduction and DWL
8. Consumer Theory
a. Consumption Possibilities
i. The budget line describes the limits to the households
consumption choices.
ii. The Budget Equation:
1. PaQa + PbQb = Y
2. Qa = Y/Pa (Pb/Pa)Qb
a. The term Y/Pa is real income in terms of good
a.
b. The term Pb/Pa is the relative price of good b
in terms of good a.
b. Preferences and Indifference Curves
i. An indifference curve is a line that shows combinations of
goods among which a consumer is indifferent.
ii. The marginal rate of substitution, (MRS) measures the
rate at which a person is willing to give up one good (good y)
to get an additional unit of another good (x) and at the same
time remain indifferent.
iii. A diminishing marginal rate of substitution: a tendency
for a person to be willing to give up less of one good to get
one more unit of another good and at the same time remain
indifferent, as the quantity of a good increases.
iv. Degree of Substitutability

1. The shape of the indifference curves reveals the

degree of substitutability between two goods.
c. Predicting Consumer Behavior
i. The consumers best affordable point is:
1. On the budget line
2. On the highest attainable indifference curve
3. This implies that:
a. At optimal point: the marginal rate of
substitution between the two goods equals the
relative price of the two goods
d. Substitution Effect and Income Effect
i. The substitution effect is the effect of a change in price on
the quantity bought when the consumer remains indifferent
between the original situation and the new situation.
ii. The income effect is the effect of a change in income on the
quantity bought when the price ratio is held constant.
e. Work-Leisure Choices
i. Labor Supply
1. Indifference curves can be used to study the
allocation of time between work and leisure.
2. The two goods are leisure and income, which
represents all other goods.
9. Cost Curves
a. The Goal: Maximum Profit!
i. The firms objective: profit maximization.
ii. Profits = Revenue Cost = P * Q(P) TC(Q(p))
b. Decision Time Frames
i. Short run: the quantity of one or more resources used is
fixed.
1. Short-Run Technology Constraint
a. Total product: total output produced in a given
period.
b. Marginal product (of labor): the change in
total product that results from a one-unit
increase in the quantity of labor employed, with
all other inputs remaining the same.
c. Average product: total product divided by the
quantity of labor.
d. Law of Diminishing Returns: as a firm uses
more of a variable input, with a given quantity
of fixed inputs, the marginal product of the
variable input eventually diminishes.
2. Short-Run Cost
a. Total Cost

i. A firms total cost (TC): the cost of all

resources used.
ii. Total fixed cost (TFC): the cost of the
firms fixed inputs
iii. Total variable cost (TVC): the cost of
the firms variable inputs
iv. TC(Q) = TFC + TVC(Q)
b. Marginal Cost
i. Marginal cost (MC): the increase in
total cost that results from a one-unit
increase in total product.
ii. Average fixed cost (AFC): total fixed
cost per unit of output
iii. Average variable cost (AVC): total
variable cost per unit of output
iv. Average total cost (ATC): total cost per
unit of output
v. ATC(Q) = AFC(Q) + AVC(Q)
c. Shifts in Cost Curves
i. The firms cost curves depend on:
1. Technology
2. Input prices
ii. Long run: the quantity of all resources can be varied.
10. Perfect Competition
a. Perfectly competitive market no individual supplier has
significant influence on the price of the product firms are price
takers
i. Standardized Product
ii. Many buyers & sellers
iii. No barriers to new firms entering the market
iv. Full information
b. Profit Maximization in Perfect Competition
i. Two methods to find the optimal output:
1. Calculate Profit at every possible point
2. Set MC = MR = P Find q*
a. Where MR (marginal revenue) is the change
in total revenue from selling one more unit of
the a product.
ii. Note: Maximum profit does not equal positive economic
profit
c. Supply in Perfect Competition
i. The supply curve of the perfectly competitive firm is the MC
curve.
1. In the short run: the MC curve above min AVC
2. In the long run: the MC curve above min ATC

ii. Shutdown point: the minimum point on the firms average

variable cost curve; if the price falls below this point, the firm
shuts down production in the short run.
iii. What shift Supply?
1. Technology
2. Input prices
3. Number of suppliers
4. (changes in prices of other products)
d. Entry and Exit
i. New firms enter an industry in which existing firms earn an
economic profit.
ii. Firms exit an industry in which they incur an economic loss
iii. Long run profits = zero
e. Perfect competition and efficiency
i. The forces of competition will drive the market to be:
1. Productively efficient
2. Allocatively efficient
11. Monopoly
a. Monopoly product is differentiated and there are barriers to
entry
i. Firms are price setters
ii. The monopoly faces:
1. The same types of technology constraints as the
competitive firm.
2. A different market constraint
iii. Price setting MR < P
1. Sets Q such that MC = MR < P
a. P is determined by the demand curve
iv. Monopoly produces less than a firm in perfect competition
v. Monopoly charges more
vi. Consumer surplus (monopoly) < Consumer surplus (p.c.)
vii. Producer Surplus (monopoly) > Producer surplus (p.c.)
viii. Total surplus (monopoly) < Total surplus (p.c.) DWL
b. Are monopolies ever good?
i. Product innovation
ii. Economics of scale and scope
12. Price Discrimination
a. Price discrimination: selling different units of a good or service for
different prices.
b. To be able to price discriminate, a monopoly must:
i. Identify and separate different buyer types
ii. Sell a product that cannot be resold
c. Efficiency and Rent Seeking with Price Discrimination

i. The more perfectly a monopoly can price discriminate the

more efficient is the outcome.
ii. But: The monopoly captures the entire consumer surplus!
13. Monopoly and Oligopoly Regulation
a. Government intervenes in monopoly and oligopoly markets in two
main ways:
i. Regulation: Marginal and Average Cost Pricing
ii. Antitrust Laws
b. Regulation of Natural Monopoly
i. A natural monopolys ATC curve falls throughout the relevant
rage of production so that the firms MC curve is below its
ATC curve when the MC curve crosses the demand curve.
14. Monopolistic Competition
a. Monopolistic competition is a market with the following
characteristics:
i. A large number of firms
ii. Each firm produces a differentiated product
iii. Firms compete on product quality, price, and marketing
iv. Firms are free to enter and exit the industry.
b. Output and Price
i. The firms short-run output and price decision
1. Profit maximization quantity at which MR = MC
2. Price is determined from the demand curve
ii. Long Run: Zero Economic Profit
1. In the long run, economic profit induces entry.
2. Entry continues as long as firms in the industry earn
an economic profitas long as (P > ATC)
3. Demand falls with firm entry until P = ATC and firms
earn zero economic profit
c. Monopolistic Competition vs. Perfect Competition
i. Excess capacity
ii. Markup
iii. Bottom line: people value variety but variety is costly.
d. Price Discrimination
i. Efficiency and Rent Seeking with Price Discrimination
1. The more perfectly a monopoly can price discriminate
the more efficient is the outcome
2. But: The monopoly captures the entire consumer
surplus.
15. Labor Markets
a. Demand for Labor

i. Derived demand: demand for a factor of production is

derived from the demand for the goods or services produced
by the factor
ii. Marginal revenue product of labor (MRP): the change in
total revenue that results from employing one more unit of
labor.
iii. MRP = MP x MR
iv. The marginal revenue product curve for labor is the demand
curve for labor
b. Equivalence of Two Condition for Profit Maximization
i. The firm has two equivalent conditions for maximizing profit
1. Hire the quantity of labor at which the MRP equals the
wage rate (W)
2. Produce the quantity of output at which marginal
revenue (MR) equals marginal cost (MC)
c. Changes in the Demand for Labor
i. The demand for labor changes and the demand for labor
curve shifts if:
1. The price of the firms output changes
2. The prices of other factors of production change
3. Technology changes
ii. Complementary inputs: when an increase in one input
increased the MPP of the other input
iii. Substitutes: when an increase in one input decreases the
MPP of the other input.
d. Supply of Labor
i. People allocate their time between leisure and labor
1. This choice depends on the wage rate
ii. Substitution effect
1. The opportunity cost of leisure increases with the
wage.
2. Higher wages more labor
iii. Income effect
1. An increase in income enables the consumer to buy
more of all goods.
a. Leisure is a normal good: higher wages
more leisure less labor
iv. Backward-bending supply of labor curve
1. At low wage rates: substitution effect > income effect
2. At high wage rates: income effect (may) > substitution
effect
3. The labor supply curve may bend backward at high
wage rates
v. What will change the supply of labor?
1. The adult population changes
2. Technology and capital in the home change

vi. Labor Market Equilibrium

1. Wages and employment are determined by
equilibrium in the labor market.
16. Discounting and Present Value
a. Discounting: converting a future amount of money into a present
value.
i. Future amount = Present Value + (r x Present Value)
ii. Future amount = Present Value x (1+r)
iii. Present Value = Future amount / (1+r)
iv. Amount n years in future = Present Value x (1 + r)^n
v. Present value = Amount n years in future / (1 + r)^n
b. Net Present Value
i. NPV = PV Cost
ii. If NPV > 0 buying the capital is profitable
c. The Demand Curve for Capital
i. As the interest rate rises fewer projects NPV > 0 the
quantity of capital demanded decreases
d. Supply Curve of Capital
i. Higher interest rate (probably) more capital supplied.
17. Income, Economic Rent, and Opportunity Cost
a. The total income = economic rest + opportunity cost
i. The opportunity cost: minimum compensation required to
induce the resource for use.
ii. Economic rent: income over and above the opportunity cost
18. Private Costs and Social Costs
a. The marginal private cost (MC) is the private cost of producing
one more unit of a good or service
b. Marginal external cost is the cost of producing one more unit of a
good or service that falls on people other than the producer
c. Marginal social cost is the marginal cost incurred by the entire
societyby the producer and by everyone else on whom the cost
falls.
i. MSC = MC + Marginal external cost
d. Negative Externalities: the problem
i. In an unregulated market: MB = MC
ii. But MB = MC < MSC market equilibrium is inefficient
iii. The efficient quantity is where MB = MSC
iv. The competitive market overproduces and creates a
deadweight loss.
v. The Coase theorem: if property rights exist, if only a small
number of parties are involved, and if transactions costs are
low, then private transactions are efficient.
e. Negative Externalities: Solutions

i. Three main methods governments use to cope with external

costs:
1. Regulation (e.g. restrictions, permits)
2. Taxes
a. The government can set a tax equal to
marginal external cost
b. The effects of such a tax is to make marginal
private cost plus the tax equal to marginal
social cost,
c. MC + Tax = MSC
3. Marketable permits
f. Game Theory Approach
i. Game theory is a tool for studying strategic behavior, which
is behavior that takes into account the expected behavior of
others and the mutual recognition of interdependence.
19. Public Good Provision: Summary
a. Efficient if MB(q*) > MC(q*)
b. A tax policy must satisfy:
i. Budget constraint t > TC(q*)
ii. Participation constraint for each I beneft(q*) > t i
c. Measuring Economic Inequality
i. The income Lorenz Curve
1. The income Lorenz curve graphs the cumulative
percentage of income earned against the cumulative
percentage of households.
ii. The Gini Ratio
1. To measure inequality as an index number, we use
the Gini ratio, which equals the ratio of round area to
the area of entire triangle.
iii. Poverty: households income too low to buy food, shelter,
and clothing deemed necessary.
iv. Income Redistribution
1. The governments in the United States use three main
ways to redistribute income to alleviate some degree
of economic inequality:
a. Income taxes
i. Progressive income tax: average tax
rate rises with income
ii. Regressive income tax: average tax
rate falls with income
iii. Proportional income tax (also called a
flat-rate income tax): constant average
tax rate.
b. Income maintenance programs
c. Subsidized services
2. The Big Tradeoff

a. Tradeoff between equity and efficiency:

i. Taxes generate a deadweight loss
ii. Subsidized goods generate a
deadweight loss
iii. Services linked with low income:
incentives to work are diminished.

SAs
1. Externalities
a. Vaccines most likely
2. Labor Markets
3. Net Present Value
a. If we invest in the vaccines now?
Labor Markets
MRP = DL = MP X MR