REVIEW CHAPTER 1 TEN PRINCIPLES OF ECONOMICS 1. Scarcity - Scarcity means that society has limited resources and therefore cannot produce all the goods and services people wish to have. - Economics is the study of how society manages its scarce resources EXAMPLE 1. When a society cannot produce all the goods and services people wish to have, it is said that the economy is experiencing Ⓐ scarcity Ⓑ surpluses Ⓒ inefficiencies Ⓓ inequalities 2. The overriding reason as to why households and societies face many decisions is that Ⓐ resources are scarce Ⓑ goods and services are not scarce Ⓒ incomes fluctuate with business Ⓓ people, by nature, tend to cycles disagree 2. Trade – off To get something that we like, we usually have to give up something else that we also like. Making decisions requires trading off one goal against another. + trade-off is between “guns and butter: The more a society spends on national defense (guns) to protect itself from foreign aggressors, the less it can spend on consumer goods (butter) to raise its standard of living + trade-off between a clean environment and a high level of income: Laws that require firms to reduce pollution raise the cost of producing goods and services. Because of these higher costs, the firms end up earning smaller profits, paying lower wages, charging higher prices, or doing some combination of these three + Another trade-off society faces is between efficiency and equality Efficiency means that society is getting the maximum benefits from its scarce resources. Equality means that those benefits are distributed uniformly among society’s members. In other words, efficiency refers to the size of the economic pie, and equality refers to how the pie is divided into individual slices EXAMPLE 1. A tradeoff exists between a clean environment and a higher level of income in that Ⓐ studies show that individuals Ⓑ efforts to reduce pollution with higher levels of income typically are not completely pollute less than low-income successful individuals Ⓒ laws that reduce pollution raise Ⓓ employing individuals to clean costs of production and reduce up pollution causes increases in incomes employment and income 3. Opportunity cost The opportunity cost of an item is what you give up to get that item EXAMPLE 1. Mary decides to spend three hours working overtime rather than watching a video with her friends. She earns $8 an hour. Her opportunity cost of working is Ⓐ the $24 she earns working Ⓑ the $24 minus the enjoyment she would have received from watching the video Ⓒ the enjoyment she would have Ⓓ nothing, since she would have received had she watched the received less than $24 of video enjoyment from the video 2. May decides to spend two hours taking a nap rather than attending her classes. Her opportunity cost of napping is Ⓐ the value of the knowledge she Ⓑ the $30 she could have earned if would have received had she she had worked at her job for attended class those two hours Ⓒ the value of her nap less the Ⓓ nothing, since she would valued value of attending class sleep more than attendance at class 4. Rational People think at the Margin - Marginal change is a small incremental adjustment to a plan of action (Explain) - Rational people make decisions by comparing marginal benefits and marginal costs (Expain) - A rational decision maker takes an action if and only if the action’s marginal benefit exceeds its marginal cost (Explain) This principle explains why people use their movie streaming services as much as they do, why airlines are willing to sell tickets below average cost, and why people pay more for diamonds than for water. It can take some time to get used to the logic of marginal thinking, but the study of economics will give you ample opportunity to practice EXAMPLE 1. A rational decisionmaker Ⓐ ignores marginal changes and focuses instead on “the big picture.” Ⓒ takes an action only if the marginal benefit of that action exceeds the marginal cost of that action Ⓑ ignores the likely effects of government policies when he or she makes choices Ⓓ takes an action only if the combined benefits of that action and previous actions exceed the combined costs of that action and previous actions 2. People are willing to pay more for a diamond than for a bottle of water because Ⓐ the marginal cost of producing Ⓑ the marginal benefit of an extra an extra diamond far exceeds the diamond far exceeds the marginal cost of producing an marginal benefit of an extra extra bottle of water bottle of water Ⓒ producers of diamonds have a Ⓓ water prices are held artificially much greater ability to low by governments, since water manipulate diamond prices than is necessary for life producers of water have to manipulate water prices 5. Three KEY Economic Questions: Because economic resources are limited every society must answer three key economic questions - WHAT goods and services should be produced? - HOW should these goods and services be produced? - WHO consumers or gets these goods and services? EXAMPLE 1. Which of the following is NOT one of the three basic economic questions that each society must answer/ Ⓐ What goods and services are to Ⓑ How are the goods and services be produced? to be produced? Ⓒ Who decides what goods and Ⓓ Who will receive the goods and services are in demand? services? 2. Which of the following is NOT considered a basic economic question? Ⓐ How will the system Ⓑ What goods and services will be accommodate change? produced? Ⓒ Who will receive the goods and Ⓓ How will these goods and services? services be produced? CHAPTER 4 THE MARKET FORCES OF SUPPLY AND DEMAND 1. Demand - Quantity demanded: the amount of a good that buyers are willing and able to purchase - Law of demand the claim that, other things being equal, the quantity demanded of a good falls when the price of the good rises P QD P QD - Demand curve: a graph of the relationship between the price of a good and the quantity demanded - Market Demand versus Individual Demand We sum the individual demand curves horizontally to obtain the market demand curve (Figure 2. page 65 – Mankiw) - Shifts in the Demand Curve Variable Price of the good itself Income Prices of related goods Tastes Expectations Number of buyers A Change in This Variable . . . Represents a movement along the demand curve Shifts the demand curve Normal good I D : the demand curve shifts to the right I D : the demand curve shifts to the left Inferior good I D : the demand curve shifts to the left I D : the demand curve shifts to the right Shifts the demand curve Substitute goods (A,B) PA DB : the demand curve shifts to the right PA DB : the demand curve shifts to the left Complementary goods (A,B) PA DB : the demand curve shifts to the left PA DB : the demand curve shifts to the right Shifts the demand curve Shifts the demand curve Shifts the demand curve EXAMPLE 1. Which of the following changes would not shift the demand curve for a good or service? Ⓐ a change in income Ⓑ a change in the price of the good or service Ⓒ a change in expectations about Ⓓ a change in the price of a related the future price of the good or good or service service 2. Each of the following is a determinant of demand except Ⓐ tastes Ⓑ technology Ⓒ expectations Ⓓ the prices of related goods 3. Currently you purchase 6 packages of hot dogs a month. You will graduate from college in December, and you will start a new job in January. You have no plans to purchase hot dogs in January. For you, hot dogs are Ⓐ a substitute good Ⓑ a normal good Ⓒ an inferior good Ⓓ a complementary good 4. Suppose that a decrease in the price of good X results in fewer units of good Y being sold. This implies that X and Y are Ⓐ complementary goods Ⓑ normal goods Ⓒ inferior goods Ⓓ substitute goods 5. If a study by medical researchers found that brown sugar caused weight loss while white sugar caused weight gain, then we likely would see Ⓐ an increase in demand for brown Ⓑ a decrease in demand for brown sugar and a decrease in demand sugar and an increase in demand for white sugar for white sugar Ⓒ an increase in demand for both Ⓓ no change in demand for either brown sugar and white sugar type of sugar because weight loss is not a determinant of demand 6. What will happen in the rice market now if buyers expect higher rice prices in the near future? Ⓐ The demand for rice will Ⓑ The demand for rice will increase decrease Ⓒ The demand for rice will be Ⓓ The supply of rice will increase unaffected 2. Supply - Quantity supplied: the amount of a good that sellers are willing and able to sell - Law of supply the claim that, other things being equal, the quantity supplied of a good rises when the price of the good risess P QS P QS - Supply curve: a graph of the relationship between the price of a good and the quantity supplied - Market Supply versus Individual Supply we sum the individual supply curves horizontally to obtain the market supply curve (Figure 6. page 71 – Mankiw) - Shifts in the Supply Curve Variable Price of the good itself Input prices Technology Expectations Number of sellers A Change in This Variable . . . Represents a movement along the supply curve Shifts the supply curve Shifts the supply curve Shifts the supply curve Shifts the supply curve EXAMPLE 1. Wheat is the main input in the production of flour. If the price of wheat decreases, then we would expect the Ⓐ demand for flour to increase Ⓑ demand for flour to decrease Ⓒ supply of flour to increase Ⓓ supply of flour to decrease 2. What will happen in the rice market now if sellers expect higher rice prices in the near future? Ⓐ The supply of rice will increase Ⓑ The supply of rice will decrease Ⓒ The supply of rice will be Ⓓ The demand for rice will unaffected decrease 3. Equilibrium - Equilibrium: a situation in which the market price has reached the level at which quantity supplied equals quantity demanded - Equilibrium price: the price that balances quantity supplied and quantity demanded - Equilibrium quantity: the quantity supplied and the quantity demanded at the equilibrium price surplus a situation in which quantity supplied is greater than quantity demanded shortage a situation in which quantity demanded is greater than quantity supplied EXAMPLE 1. Which of the following events would unambiguously cause a decrease in the equilibrium price of orange juice? Ⓐ a decrease in the price of apple Ⓑ an increase in the price of apple juice and an increase in the price juice and an decrease in the price of orange of orange Ⓒ a increase in the price of apple Ⓓ a decrease in the price of apple juice and an increase in the price juice and a decrease in the price of orange of orange 2. What would happen to the equilibrium price and quantity of flashlight if the price of battery increased? Ⓐ Equilibrium quantity would rise Ⓑ Equilibrium quantity would fall and equilibrium price would and equilibrium price would increase increase Ⓒ Equilibrium quantity would rise Ⓓ Equilibrium quantity would fall and equilibrium price would and equilibrium price would decrease decrease 3. Which of the following events would cause the price of oranges to fall? Ⓐ There is a shortage of oranges Ⓑ An article is published in which it is claimed that tangerines cause a serious disease, and oranges and tangerines are substitutes Ⓒ The price of land throughout Ⓓ All of the above are correct Florida decreases, and Florida produces a significant proportion of the nation’s oranges 4. True or False? Briefly explain a. When a seller expects the price of its product to increase in the future, the seller's supply curve shifts left now. T b. When Mario's income decreases, he buys more pasta. For Mario, pasta is a normal good. F 4. Controls on Prices Price ceiling - Price ceiling: a legal maximum on the price at which a good can be sold - When the government imposes a price ceiling there are two possible outcomes: + The price ceiling is not binding if set above the equilibrium price + The price ceiling is binding if set below the equilibrium price, leading to a shortage Price floor - Price floor: a legal minimum on the price at which a good can be sold - When the government imposes a price floor there are two possible outcomes: + The price floor is not binding if set below the equilibrium price + The price ceiling is binding if set above the equilibrium price, leading to a surplus CHAPTER 5 ELASTICITY 1. The Elasticity of Demand - The price elasticity of demand measures how much the quantity demanded responds to a change in price - Midpoint Method - Elasticity along a Linear Demand Curve + At points with a low price and high quantity, the demand curve is inelastic + At points with a high price and low quantity, the demand curve is elastic - Total Revenue and the Price Elasticity of Demand Luxuries Necessities - Factors Affecting Price Elasticity of Demand + Availability of substitutes + Percentage of consumer’s budget + Time period of adjustment + Necessities versus Luxuries + Definition of the market 2. Income Elasticity of Demand - The income elasticity of demand measures how the quantity demanded changes as consumer income changes - Midpoint Method - Normal Normal goods Inferior goods EDI > 0 EDI < 0 I,Q I,Q I,Q I,Q goods and Inferior goods The concept of income elasticity of demand therefore measures the percentage change in quantity demanded of a given product due to a percentage change in income. The measures of income elasticity of demand may be either positive or negative numbers and these have been used to classify products into "normal" or "inferior goods" or into "necessities" or "luxuries". A normal good has a positive elastic relationship with income and demand. This means that changes in income and demand move in the same direction. Consumers tend to buy products at a higher price or indulge more in eating out and partaking in leisure activities when they earn more because they have a higher budget. Therefore, the demand for normal goods increases when income increases. An inferior good has a negative elastic relationship with income and demand. This means that changes in income and demand move in the opposite direction. When consumers earn less due to economic downfalls, they buy fewer expensive products and use fewer expensive services. In that case, the products and services become inferior goods. 3. Cross – price Elasticity of Demand - The cross-price elasticity of demand measures how the quantity demanded of one good responds to a change in the price of another good - Midpoint Method EXAMPLE 1. When the price of a good is $5, the quantity demanded is 100 units per month; when the price is $7, the quantity demanded is 80 units per month. Using the midpoint method, the price elasticity of demand is about Ⓐ 0.22 Ⓑ 0.67 Ⓒ 1.33 Ⓓ 1.5 2. A person who takes a prescription drug to control high cholesterol most likely has a demand for that drug that is? Ⓐ inelastic Ⓑ unit elastic Ⓒ elastic Ⓓ highly responsive to changes in income 3. An increase in the supply of grain will reduce the total revenue grain producers receive if Ⓐ the supply curve is elastic Ⓑ the supply curve is inelastic Ⓒ the demand curve is inelastic Ⓓ the demand curve is elastic 4. If income decreases, the quantity and price of good X rise. X is Ⓐ an inferior good Ⓑ a normal good Ⓒ a luxury good Ⓓ none of the above is correct 5. A good will have a more inelastic demand, Ⓐ the greater the availability of Ⓑ the broader the definition of the close substitutes market Ⓒ the longer the period of time Ⓓ the more it is regarded as a luxury 6. For Susie, a 7 percent increase in income results in a 12 percent increase in the quantity demanded of pizza. For Susie, the income elasticity of demand for pizza is Ⓐ negative, and pizza is a normal good Ⓒ positive, and pizza is an inferior good Ⓑ negative, and pizza is an inferior good Ⓓ positive, and pizza is a normal good 7. If, for two goods, the cross-price elasticity of demand is 1.25, then Ⓐ the two goods are luxuries Ⓒ one of the goods is normal and the other good is inferior Ⓑ the two goods are substitutes Ⓓ the demand for one of the goods conforms to the law of demand, but the demand for the other good violates the law of demand 8. The case of perfectly elastic demand is illustrated by a demand curve that is Ⓐ vertical Ⓒ downward-sloping but relatively steep Ⓑ horizontal Ⓓ downward-sloping but relatively flat 9. Which of the following is not a determinant of the price elasticity of demand for a good? Ⓐ the time horizon Ⓒ the definition of the market for the good Ⓑ the steepness or flatness of the supply curve for the good Ⓓ the availability of substitutes for the good 10. If the price elasticity of demand for a good is 0.25, then a 20 percent decrease in price results in a Ⓐ 0.0125 percent increase in the quantity demanded Ⓑ 4 percent increase in the quantity demanded Ⓒ 5 percent increase in the quantity Ⓓ 80 percent increase demanded quantity demanded 11. When demand is elastic, an increase in price will cause Ⓐ an increase in total revenue Ⓒ no change in total revenue, but an increase in quantity demanded in the Ⓑ a decrease in total revenue Ⓓ no change in total revenue, but a decrease in quantity demanded 4. The Elasticity of Supply - The price elasticity of supply measures how much the quantity supplied responds to changes in the price - Midpoint Method - How the Price Elasticity of Supply Can Vary The elasticity of supply may be very high at low levels of quantity supplied and very low at high levels of quantity supplied - The Determinants of Supply Elasticity + The more easily sellers can change the quantity they produce, the greater the price elasticity of supply. + For many goods, price elasticity of supply is greater in the long run than in the short run. CHAPTER 13 THE COSTS OF PRODUCTION - Fixed costs (FC) costs that do not vary with the quantity of output produced - Variable costs (VC) costs that vary with the quantity of output produced - Total cost (TC) the market value of the inputs a firm uses in production TC = VC + FC - Average total cost (ATC) total cost divided by the quantity of output ATC = TC/Q - Average fixed cost (AFC) fixed cost divided by the quantity of output AFC = FC/Q - Average variable cost (AVC) variable cost divided by the quantity of output AVC = VC/Q - Marginal cost (MC) the increase in total cost that arises from an extra unit of production MC= ∆TC/∆Q = ∆VC/∆Q - The Relationship between MC, ATC and AVC EXAMPLE 1. A firm is producing 10 units with an average total cost of $15 and a marginal cost of $20. If it were to increase production to 11 units, which of the following must occurs? Ⓐ marginal cost would decrease Ⓑ marginal cost would increase Ⓒ average total cost would Ⓓ average total cost would increase decrease 2. Quick Quiz (4-263) CHAPTER 14 FIRMS IN COMPETITIVE MARKETS - A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker - Market equilibrium & Firm’s demand curve - For competitive firms + Average revenue = P + Marginal revenue = P - The Competitive Firm’s Supply Curve: - The Firm’s Short-Run Decision + Profit Maximization P = MC + Break even P = ATCmin + Economic loss (AVC<P<ATC) + Shut down P < AVCmin CHAPTER 15 MONOPOLY 1. Characteristics of Monopoly - Single seller – one firm industry; firm and industry are synonymous - Unique products – there are no close substitutes - Price maker – the monopolist is a price maker; discriminating monopolists charge different prices to different classes of consumers - Barriers to Entry – barriers to entry prevent other firms from entering an industry in which a monopolist may be earning profit + Government franchises + Patents and copyrights + Economies of scale + Ownership of a scale input 2. Demand for Monopolies - The monopolist faces a downward sloping demand curve - MR is less than price for every level of output except the first (because the monopolist must lower the price in order to sell more units - The AR is the same as price (AR = P) => AR = P > MR - The monopolist always sets price in the elastic region of the D curve. 3. Profit Maximization - The profit-maximizing condition of a monopolist firm is: MR = MC - How a Profit-Maximizing Monopoly Decides Price In Step 1, the profit-maximizing Q is where MR=MC In Step 2, find P from the demand curve at this Q In Step 3, as with a competitive firm, the monopolist’s profit equals (P-ATC)xQ 4. No supply curve for the monopoly - As a price maker, it sets price when it decides how much to produce. There’s no single, unique P associated with each level of Q 5. The Welfare Cost of Monopoly - Competitive equilibrium quantity - Qc P = MC total surplus is maximized - Monopoly equilibrium quantity – QM PM > MC QM < Qc and PM > PC With monopoly, there is deadweight loss Market failure due to market power 6. Perfect Price Discrimination - Perfect price dicrimination, occurs when a firm charges a different price for every unit consumed - All consumer surplus is eliminates - Output is increased (equal to that as under perfect competition) - Deadweight loss is eliminated 7. A summary comparison – Competition vs. Monopoly EXAMPLE Barbara is a producer in a monopoly industry. Her demand curve, total revenue curve, marginal revenue curve and total cost curve are given as follows: P = 160 – 4Q MR = 40 - 2Q MC = 10 + Q TC = 0.5Q2 + 10Q + 50 a. How much output will Barbara produce? b. The price of her product will be ________? c. How much profit will she make? ---0o0--Barbara maximizes her profit when the marginal revenue is equal to her marginal cost: MR = MC 40 – 2Q = 10 + Q Q = 10 P = 120 Thus, the profit maximizing price is 120 the profit maximizing quantity is 10 Her profit = TR – TC we have TR = 40Q – Q2 TC = 0.5Q2 + 10Q + 50 Her profit = [40*10 – 102] – [0.5*102 + 10*10 + 50] Her profit = 100 MC 160 120 D 10 MR 10 CHAPTER 23 MEASURING A NATION’S INCOME 1. Gross Domestic Product (GDP) is... ...the market value of all final goods and services produced within a country in a given period of time. - market value: Goods are valued at their market prices, so: All goods measured in the same units (e.g. dollars, pounds). But: Things that don’t have a market value are excluded, e.g., housework you do for yourself. - final goods: GDP records only the value of final goods, not intermediate goods (the value is counted only once). - goods and services; GDP includes tangible goods (like DVDs, muontain bikes, beer) and intangible services (drying cleaning, concerts, cell phone service). - produced: GDP includes currently produced goods, not goods produced in the past - within a country: GDP measures the value of production that occurs within a country’s borders, whether done by its own citizens or by foreigners located there. - given period of time: usually a year or a quarter (3 months) 2. The Components of GDP - GDP (denoted Y) Consumption (C) Investment (I) Government Purchases (G) Net Exports (NX) These components add up to GDP: Y = C + I + G + NX 3. Real versus Norminal GDP We have two versions of GDP - Norminal GDP: values output using current prices (current price x quantity) - Real GDP: values output using the prices of base year (price in the base year x quantity) - Real GDP shows how the economy’s overall production of goods and services changes over time Real GDP uses constant base-year prices to value the economy’s production of goods and services. Because price changes do not affect real GDP, changes in real GDP reflect only changes in the quantities produced. Thus, real GDP measures the economy’s production of goods and services. EXAMPLE TRUE/FALSE 1. An increase in nominal U.S. GDP necessarily implies that the United States is producing a larger output of goods and services F 2. Real GDP evaluates current production using prices that are fixed at past levels and therefore shows how the economy’s overall production of goods and services changes over time T 4. The GDP Deflator - The GDP delator is a measure of the overall level of prices. - Definition: - The GDP delator tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities produced. - One way to measure the economy’s inflation rate is to compute the percentage increase in the GDP deflator from one year to the next year - Inflation rate using GDP deflator: 5. Gross National Product (GNP) - Gross National Product (GNP): Total income earned by the nation’s factors of production, regardless of where located - GNP = GDP + (Factor payments from abroad) – (Factor payments to abroad) 5. GDP & Economic well-being - GDP is a good measure of the economic well-being of a society - GDP per person tells us the income and expenditure of the average person in the economy. - Higher GDP per person indicates a higher standard of living - GDP is not a perfect measure of the happiness or quality of life. - Some things that contribute to well-being are not included in GDP + The value of leisure (WHY) + The value of a clean environment + Non-market activity, such as the child care a parent provides his or her child at home + An equitable distribution of income EXAMPLE 1. Greg, a U.S. citizen, works only in Canada. The value of the output he produces is Ⓐ included in both U.S. GDP and U.S. GNP Ⓒ included in U.S. GNP, but it is not included in U.S. GDP Ⓑ included in U.S. GDP, but it is not included in U.S. GNP Ⓓ included in neither U.S. GDP nor U.S. GNP 2. An American company operates a fast food restaurant in Romania. The value of the output produced by this fast food restaurant is included in Ⓐ U.S. GDP and Romaria GDP Ⓒ U.S. GDP and Romania GNP Ⓑ U.S. GNP and Romania GNP Ⓓ U.S. GNP and Romania GDP 3. Which of the following would affect the value of U.S. GDP? a. goods and services produced by foreign citizens working in the U.S b. the difference in the price of the sale of an existing home and its original purchase price c. known illegal activities d. final goods and services that are purchased by the U.S. federal government e. intermediate goods that are produced in the U.S. but that are unsold at the end of the GDP accounting period f. the estimated value of production accomplished at home, such as backyard production of fruits and vegetables g. the value of illegally-produced goods and services h. the value of cars and trucks produced in foreign countries and sold in the U.S i. unpaid cleaning and maintenance of houses j. the value of unpaid housework k. the value of vegetables and other foods that people grow in their gardens l. services such as those provided by lawyers and hair stylists m. carrots grown in your garden and eaten by your family n. carrots purchased at a farmer’s market and eaten by your family o. carrots purchased at a grocery store and eaten by your family p. the estimated rental value of owner-occupied housing 4. What components of GDP (if any) would each of the following transactions affect? Explain a. You buy a burger and fries at your favorite fast food restaurant Consumption rises GDP rises b. the estimated rental value of owner-occupied housing Consumption rises GDP rises c. Mary purchases of newly-constructed homes Investment rises GDP rises d. A company purchases new computers Investment rises GDP rises e. Hai Ha company imports a machinery from Japan Investment rises Net export falls GDP unchanges f. Goverment pays for a construction of a brige Government purchases rise GDP rises g. A household buys refrigerator from inventory Consumption rises Investment falls GDP unchanges h. You buy an used car from your uncle It does not effect GDP 5. GDP is not a perfect measure of well – being; for example, GDP does not reflect the value of leisure GDP does not reflect the value of goods and services produced at home GDP does not reflect the quality of the environment GDP incorporates a large number of non-market goods and services that are of little value to society GDP fails to account for the quality of the environment GDP excludes the value of volunteer work GDP does not address the distribution of income GDP does not address environmental quality 6. Quick Quiz CHAPTER 24 MEASURING THE COST OF LIVING I. How the CPI is Calculated 1. Fix the “basket” 2. Find the prices 3. Compute the basket’s cost 4. Choose a base year and compute the index 5. Compute the inflation rate II. Probems with the CPI 1. Substitution Bias - Overtime, some prices rise faster than others - Consumers substitute toward goods that become relatively cheaper, mitigating the effects of price increases. - The CPI misses this substitution because it uses a fixed basket of goods - Thus, the CPI overstates increases in the cost of living 2. Introduction of New Goods - The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs. - In effect, dollars become more valuable - The CPI misses this effect because it uses a fixed basket of goods - Thus, the CPI overstates increases in the cost of living 3. Unmeasured Quality Change - Improvements in the quality of goods in the basket increase the value of each dollar - National statistical services try to account for quality changes but probably misses some, as quality is hard to measure. - Thus, the CPI overstates increases in the cost of living III. GDP deflator vs, CPI Index GDP deflator CPI Index - reflects prices of all goods/services produced domestically (but excludes imports) - reflects prices only a market basket of some goods/services bought by consumers (includes imports) - base – year prices - base-year quantity - quantities variable - Prices variable GDP deflator gives a different rate of inflation than the CPI The GDP deflator uses as a basket all final goods and services produced in the domestic economy, while the CPI basket includes goods and services purchased by typical consumers. + Therefore, changes in the price of imported goods affect the CPI, but not the GDP deflator. Also, changes in the price of domestically produced capital goods affect the GDP deflator, but not the CPI. + Changes in the price of domestically produced consumer goods are likely to affect the CPI more than the GDP deflator because it is likely that those goods make up a larger part of consumer budgets than of GDP EXAMPLE 1. If the CPI was 110 this year and 100 last year, then Ⓐ the cost of the CPI basket of goods and services increased by 110 percent this year Ⓒ the inflation rate for this year was 10 percent higher than the inflation rate for last year Ⓑ the price level increased by 10 percent this year Ⓓ All of the above are correct 2. If the CPI was 125 this year and 120 last year, then Ⓐ the cost of the CPI basket of goods and services increased by 4.2 percent this year Ⓒ the inflation rate for this year was 4.2 percent Ⓑ the price level increased by 4.2 percent this year Ⓓ All of the above are correct 3. If the CPI was 95 in 1955 and is 475 today, then $100 today purchases the same amount of goods and services as Ⓐ $4.75 purchased in 1955 Ⓒ $95.00 purchased in 1955 Ⓑ $20.00 purchased in 1955 Ⓓ $500 purchased in 1955 The formula for turning dollar figures from year T into today’s dollars is the following: 4. If the CPI was 85 in 1975 and is 225 today, then $100 today purchases the same amount of goods and services as Ⓐ $37.78 purchased in 1975 Ⓒ $164.71 purchased in 1975 Ⓑ $40.00 purchased in 1975 Ⓓ $264.71 purchased in 1975 5. Which is likely to have the larger effect on the CPI, a 3 percent increase in gasoline or a 3 percent increase in jewelry. 6. The table below pertains to Pieway, an economy in which the typical consumer’s basket consists of 5 books and 10 calculators. Year Price of a Book Price of a Calculator 2007 $30 $12 2008 $32 $15 a. What are the percentage increases in the price of book and in the price of calculator? b. What is the percentage increase in the CPI? c. Do these price changes affects all consumers to the same extent? Explain. ANS: a. Percentage increase in the price of book is: Percentage increase in the price of calculator is: b. The cost of the market basket in 2007 is: ($30 x 5) + ($12 x 10) = $270 The cost of the market basket in 2008 is: ($32 x 5) + ($15 x 10) = $310 The CPI in 2007 is: The CPI in 2008 is: The percentage increase in the CPI is: c. Because the price of calculation increased relatively more than the price of book, people who purchase a lot of calculation and little book became worse off relative to people who purchase a lot of book and little calculation.
