Study Guide for Honors Economics Semester Exam, 2015
Chapter 1: What is Economics?
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Difference between a want and a need
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Difference between a good and a service
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Difference between a scarcity (more demand than there is possible supply) and a shortage (g/s
unavailable at current price)
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Factors of production (CELL)
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Capital (any human-made resource that is used to create other g/s)
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Can be human capital (skills, knowledge) or
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Physical capital (tools and buildings)
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Entrepreneurs
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Labor
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Land
Gains in either can improve efficiency.
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Tradeoffs (all the alternatives we give up when we choose something)
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Opportunity cost (the most desirable alternative given up)
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“Thinking at the margins” (making decisions based on small changes in resources). Involves a
cost-benefit analysis. Once opportunity cost outweighs what you gain, the g/s becomes
unfavorable.
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Production possibility curve (or production possibility frontier; same thing).
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The graph showing tradeoffs made assuming maximum production.
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We have this frontier b/c of scarcity of resources.
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Curved b/c it reflects the law of increasing cost.
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As we shift factors of production from making one g/s to making another, the
opportunity cost of making the second item increases.
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FOPs are more efficient for some things than for others. Thus, you can get a lot
of increase in the alternative initially by shifting the FOPs but the gains slow
down the more you shift.
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PPC reflects maximum efficiency; you can’t be outside the curve but you can be inside.
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If there is some change – like better technology, discovery of new resource, more labor,
etc. – then the PPC can shift outward, but you can never be to the right of the curve.
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Shift outward reflects a growing economy; a shift inward reflects a shrinking economy.
Chapter 2: Economic Systems
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Economic system:
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how a society produces and distributes g/s.
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Involves 3 questions:
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What g/s should be produced?
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How the g/s should be produced?
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Who gets to consume the g/s?
The answers will depend on what a society’s goals are.
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Efficiency (maximize use of scarce resources)
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Freedom (buy what we want, within reason)
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Security/predictability (stable prices; well-established rules; safety net for the
needy)
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Equity (determining fair distribution of wealth and taxes)
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Growth/innovation (improve standard of living for all)
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Etc.
Three basic types of economies (most countries are mixed)
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Traditional
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Market
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Command
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What is a market (an arrangement that allows buyers and sellers to exchange g/s; they exist b/c
they allow for specialization and more efficient use of resources)
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5 characteristics of a market economy
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exchanges where things are sold and prices get determined
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consumer controls how much is paid and what gets produced
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private property rights
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competition
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profit motive
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Free markets are theoretically self-regulating – Adam Smith’s invisible hand
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Free markets offer the following advantages:
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Efficiency (responds to wants/needs)
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Freedom (we work where we want, consume what we want, make what we want – all
within reason, of course)
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Growth (encourage innovation, reward risk-taking)
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Limits of the free market (we’re greedy and so some rules are needed to check our baser instincts;
some problems too big for free market; free market produces winners and losers, and society has
to figure out what to do about the losers)
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Centrally Planned Economies:
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Gov’t answers the key questions.
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Gov’t owns the land and capital; gov’t tells workers where to work, what to make, how
much they earn, etc.
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Theoretical advantages (easy way to jump-start an economy; provides job security;
arguably more humane than capitalism)
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Disadvantages (how can gov’t know what people want; no incentive to work hard;
change is hard; individual freedoms sacrificed)
Laissez faire economy
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gov’t should not interfere in private sector
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Limits: some problems too big for private sector; need some rules to prevent cheating or
other unfair competition; some problems result in public benefit so gov’t should provide
and all should pay (e.g., education)
Chapter 3: American Free Enterprise
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Basic principles (7 of them)
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Profit motive – we keep most of what we earn
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Respect for private property
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Competition – let the best g/s win
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Opportunity – all may compete
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Legal equality – all get same legal protections
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Freedom of contract – do b’ness with whomever you want, subject of course to laws
preventing discrimination based on race, sex, etc.
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Voluntary exchange – buy what you want at whatever price you can agree on
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Free enterprise supported through property rights (like patents and trademarks) and contract rights
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Role of gov’t in supporting free enterprise (facilitate flow of info; protect public health/safety;
provide research grants, land grants for colleges)
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Measurements of growth/stability
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gross domestic product (total value of all final g/s produced in an economy)
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unemployment (but who is being counted? Bureau of Labor Statistics has several
measures (e.g., the U-3, U-6, etc.); most frequently reported one does not count people
who’ve quit looking for work; also know the Labor Force Participation Rate)
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inflation rate (measured by comparing price of same basket of goods each month)
Providing public goods:
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A public good is one that would be inefficient or impractical for the private sector to
produce.
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This makes sense when the benefit to each person is less than the cost that to that person
if he had to pay for it privately and the total benefits to society are greater than the cost.
Ex: roads, dams, parks.
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Free rider problem: someone enjoying the public good without paying. Ex: fire
protection. Neighbors will put out a fire in your house in order to keep it from spreading
to theirs, even if you didn’t pay for the fire protection. Solution: tax all for the service.
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Free riders one example of a “market failure” – i.e., an inefficient distribution of
resources.
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Externalities another market failure: it’s when an economic side effect of a g/s results in
a cost or benefit to someone other than the person who is deciding how much to produce
or consume. Can be positive or negative. Ex of neg: pollution. Factory pollutes and
society pays. Another ex: cigarettes.
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Safety net:
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Be familiar with the different programs our country offers (e.g., TANF, AFDC,
Social Security, unemployment insurance, workers’ compensation, in-kind
benefits, Medicare, Medicaid, CHIP, SNAP, public schools, faith-based
initiatives, etc.).
Chapter 4: Demand
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2 parts of demand: desire to own and ability to pay for it.
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Law of demand: price goes up? Demand goes down. Price goes down? Demand goes up.
Inverse relationship between price and demand.
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This law works in part b/c of two things:
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Substitution effect: when P goes up, consumers substitute a cheaper alternative.
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Income effect: as income goes up, you buy more things.
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Demand schedule: how many widgets one person will buy at any given price.
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Market demand schedule: how many widgets everyone will buy at any given price.
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Demand curve:
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shows relationship of quantity demanded (Qd) to price (P).
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P is on vertical axis, Qd on horizontal.
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Curve is downward sloping, given the inverse relationship between P and Qd.
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Note that this shows what happens if the only thing that changes is P (or, in econ-speak,
ceteris paribus).
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Change in price will result in change in Qd, which is shown by movement along the D
curve.
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But note difference between change in Qd and change in D: change in Qd results in
movement along the D curve, while a change in D results in a movement of the D curve.
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Change in Qd results when P changes; change in D results when anything other than P
changes (like change in income, change in consumer expectations, change in size of
population, change in consumer taste, etc.).
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Normal goods (we’d buy more of them if we have more $) v. inferior goods (we’d buy
less of them if we have more $).
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Change in D for one good may be affected by changes in demand for another.
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Complementary goods: D for skis up? D for ski boots up, too.
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Substitute goods: P of skis up? D for snowboards may go up if they are now
relatively cheaper than skis.
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Complementary v substitute goods.
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Elasticity of D. A measure of how sensitive D is to changes in price.
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Inelastic? Big change in price will not change D much.
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Elastic? Even a small change in price will result in big change in D.
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Formula for E: E = % change in Qd
% change in P
You compute % change as follows:
(old # - new #)
_________________
x 100%
old #
Remember to ignore negative numbers.
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D is considered elastic when E > 1. It’s inelastic when E < 1. It’s unitary elastic when E
= 1.
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Factors affecting E:
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Relative importance. If you spend a lot on a good already, then even a small
change in price will result in a big hit to your budget and so you might cut back.
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Is the item a want or a need?
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Can market meet a rapidly changing D? If not, D likelier to be inelastic until
substitute is available.
E will influence how a firm sets its prices. Inelastic D? Price can be raised a lot. Elastic
D? Better keep prices low.
Chapter 5: Supply
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The Law of Supply: As P goes up, quantity supplied (Qs) goes up as well. P and Qs are directly
related.
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Quantity supplied: How much of a good is offered at a specific price.
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Supply is the amount of goods available.
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Supply schedule: How much of a good a supplier will offer at different prices.
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The supply curve:
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P on vertical axis, Qs on the horizontal.
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Is upward sloping (b/c of direct relationship between P and Qs)
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Does not change if the only thing that’s changing is P.
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Any change other than a change in P will cause the S curve to shift, left or right
depending on the change.
Elasticity of supply:
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E = %ΔQs
%ΔP
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Use the same formula for computing %Δ, which is
(old # - new #)
____________
x 100%
old #
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Time affects E of supply. Can be hard to increase supply of a good quickly (think what it took for
firms to make a competitor to the iPad). But if you’re talking about a service (like practicing law),
you can immediately start working more hours if the P of legal services increases.
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Costs of Production:
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Marginal costs: the cost of producing one more unit. Includes costs of inputs like labor,
raw materials, electricity, etc.
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Marginal product of labor: how much more can one more worker make. Usually another
worker means you can make more widgets, but it’s possible that more workers could
decrease output. In econ-speak you can go from
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Increasing marginal return to
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Decreasing marginal return to
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Diminishing marginal return.
Production costs:
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Fixed costs—costs that don’t change no matter how much is produced. Ex:
rent.
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Variable costs—costs that rise or fall depending on how much is produced. Ex:
raw materials.
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Total cost: fixed + variable cost.
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Marginal cost (MC): The additional cost of producing one more widget.
Revenue:
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Marginal revenue (MR): the additional income from selling one more widget.
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Total revenue (# of widgets sold x MR)
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Optimal output: where MC = MR.
Changes in Supply: Things other than a change in P will shift the supply curve. Like what?
Changes in technology, new taxes, gov’t subsidies, change in regulation, future expectations.
Chapter 6: Prices
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Combining Supply & Demand
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This happens at equilibrium (E), namely where S and D intersect.
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Disequilibrium happens when you have excess D or excess S.
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P too low? You’ll have excess D. Suppliers will raise prices.
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P too high? You’ll have excess S. Suppliers have to lower P to attract more
buyers.
The markets tend toward E unless the gov’t intervenes, perhaps through price ceilings (like rent
controls) or price floors (like minimum wage laws).
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Price ceilings increase Qd of whatever is being sold but decrease Qs of that good or
service.
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Price floors increase Qs of labor but decrease Qs of labor.
Changes in E: Excess D will cause firms to raise P; excess S will cause firms to cut prices. But
there are factors other than P can affect S and D (like advances in technology, taxes, more people,
etc. – all those things we identified in the previous chapter).
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Ex: better technology makes it cheaper to make the good; that should translate into
higher profits, which will incent the supplier to make more. Thus, the S curve will shift
to the right, meaning the supplier will supply more at every price.
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But note that a shift to the right will lead to an excess of S unless the supplier lowers P.
As P goes down, Qd goes up, and the supplier sells more.
The role of prices in helping achieve E.
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Price allows markets to function efficiently. Sends signals to buyers and sellers; provides
incentives to act (either buy more/less or sell more/less).
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Pros and cons of bartering, rationing.
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Advantages of price (flexible, free)
Barriers to efficient allocation of goods:
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Imperfect competition: monopolies and oligopolies.
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Imperfect knowledge
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Spillover costs (a/k/a externalities)
Chapter 7: Market Structures
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4 things needed for perfect competition
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Many buyers and sellers; no one powerful enough to control the market.
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Sellers offering identical products – called “commodities”
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Buyers and sellers well-informed about the products; they know enough to know what is
a good deal/fair price
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Sellers able to enter and exit the market easily; makes it easy for new competition to
come in if pricing or supply gets out of whack.
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Barriers to entry – anything that makes it hard/expensive for a new firm to enter a market.
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Start-up costs – what it costs a firm to start making something.
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Monopolies: markets dominated by a single seller.
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Caused by barriers to entry (maybe economies of scale, technology, natural monopoly)
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Economies of scale: high start-up costs that get averaged out over lots of sales. Think
the dam example.
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Might have a monopoly b/c of a patent (i.e., the gov’t giving you the exclusive right to
sell your invention for a certain number of years).
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Problems with monopolies:
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They lead to higher prices and
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lower demand (assuming elastic demand).
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For monopolists, marginal revenue (MR) decreases when it lowers price to increase
sales (b/c it has to lower the price on all goods sold). Thus, there is no incentive for the
monopolist to try to increase sales by lowering P.
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Monopolists are price makers (i.e., they set the price), so they don’t have to worry about
keeping their prices the same as the competition.
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For suppliers in a perfectly competitive market, the D curve is horizontal; any change in
price leads to one of 2 outcomes:
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Higher price? Supplier goes out of business b/c buyers just go elsewhere.
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Lower price? Supplier goes out of business b/c supplier is not recovering costs.
Monopolistic competition and oligopolies
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Lots of firms competing to sell similar goods, with each having a monopoly over its
brand. Think blue jeans.
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Need a lot of firms
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Low barriers to entry
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Differentiated products
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Slight control over prices
Oligopoly: a small number of firms dominates a market.
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Rule of thumb: if 4 largest firms control 70%-80% of the market, it’s an
oligopoly.
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Problem with oligopolies is that they can collude on P or S.
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They form when there are high barriers to entry.
Regulation and deregulation
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Some firms will engage in predatory pricing – i.e., charging an artificially low price to
drive competition out of b’ness.
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Antitrust laws have made collusion and price-fixing illegal. See the Sherman Antitrust
Act.
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Deregulation: eliminating rules that restrict actions or prices. Can be good or bad. You
have to ask what the appropriate role for the gov’t is. Sometimes you’ll need the gov’t
to step in to correct or prevent private sector conduct that is unfair.
Chapter 8: Business Organizations
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3 basic options:
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Sole proprietorships
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Owned and managed by a single individual
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The greatest % of businesses but the smallest % of sales
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Pros: easy to establish, not a lot of regulations, all profit goes to the individual
(i.e., no double taxation), full control over the b’ness, easy to shut down.
[Don’t forget the Ch. 8 worksheet that we filled in during class of all the pros/
cons of the various corporate structures.]
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Cons: unlimited personal liability; hard to attract good workers and money to
expand; complete responsibility for b’ness; b’ness might fold when sole
proprietor dies/retires.
Partnerships
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An agreement between 2 or more people regarding division of responsibilities
and profits.
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Small percentage of total b’nesses (7%), sales (5%).
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3 basic types
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General. Unlimited personal liability.
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Limited. One General Partner (GP) and as many ltd partners as you
want.
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Limited liability. Like a general p’ship but liability for each partner is
limited.
Corporations
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About 20% of b’nesses but 90% of sales.
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Raise money for their b’nesses by selling shares of stock. Stockholders own a
piece of the b’ness. Can make $$ two ways:
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Dividends
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Stock price goes up (called “appreciation”)
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Types of corporations
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Closely held—owned by a few people, often from same family.
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Publicly held—owned by lots of people. Active market for the buying
and selling of the company’s stock.
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All corporations are controlled by a board of directors, who oversee the job that
management and labor do.
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Advantages of a corporation: limited liability; easy to raise money; easier to
attract talented employees; permanent.
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Disadvantages: double taxation (company’s profits are taxed, then the
dividends paid to shareholders is taxed as income to the shareholders); harder
to set up; possible loss of control of the company you created; lots more
regulatory burden.
Chapter 9: Labor
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Definition of “employed” (nonmilitary people who worked at least 1 hour for pay or 15 hours for
no pay in a family b’ness during preceding week; + those who had a job but didn’t work due to
illness, vacation, labor strike, bad weather).
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“Unemployed” measurements often do not count people who have given up looking for work.
The BLS “U6” is more accurate, counting all “unemployed” + people who want to work and have
looked for work in past 12 months. The U6 is around 14% now, while the “official”
unemployment rate is around 7.7%.
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“Learning effect” v “screening effect”
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Trends:
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more women working outside the home (although % seems to have leveled off).
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More temporary and part-time workers now. Cheaper for b’nesses, b/c they don’t have
to pay benefits, easier to shrink size if b’ness declines.
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Union membership is declining (1983: 20.1% of all workers; 2012: 11.3%)
Right-to-work states (can’t be forced to join a union).
Chapter 10: Money and Banking and Chapter 16: The Federal Reserve and Monetary Policy
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What is money? Anything that can be used as
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Medium of exchange—things used to determine value.
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Unit of account—way of keeping score (think wages).
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Store of value—allows relative value to be consistent over time (assuming no
hyperinflation)
3 kinds of money:
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Commodity money (it has value in itself, like salt)
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Representative money (holder can trade it in for something else, like gold; a dollar used
to represent 1/35 of an ounce of gold; no longer)
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Fiat (has value b/c gov’t says it has value; can’t be traded in for anything)
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Why no gold standard today? B/c gold is a finite resource. An economy needs to be able to have
more or less currency in order to control growth. Unless you find more supplies of gold, an
economy couldn’t grow. You could revalue the worth of a dollar relative to gold, but then you’re
undercutting the reason to have a gold standard.
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The history of American banking: Just know that we’ve gone from times where we had no
central bank to times when we do (and now we have one: it’s called the Federal Reserve Board).
Times when we had no central bank were called the “free banking era” or the “wildcat era.”
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Monetary policy — control over the supply of money. The Federal Reserve Board controls this.
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How money is created
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By banks:
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Bank are required to keep a certain percentage of deposits in reserves. That
requirement is called the “required reserve ratio” (RRR) and it is set by the Fed.
▪
Banks can lend out everything that is not a required reserve.
▪
How much money can be created can be calculated by the “money multiplier” –
(the amount of the original deposit) x 1/RRR.
By the Federal Reserve Board (or “Fed”):
▪
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It uses open-market operations (buying bonds from or selling bonds to a “dealer
bank” to change the amount of $ in the economy).
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If the Fed wants to increase money, it will buy a bond and add the
price of the bond to the dealer bank’s account at the Fed. That bank
now has more $ to lend.
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If the Fed wants to decrease money, it will sell a bond and subtract the
price of the bond from the dealer bank’s account. That bank now has
less $ to lend.
How the Fed works
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Using open market operations (OMO), as discussed above.
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Setting the RRR, as discussed above.
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Setting the discount rate. This is the rate that the Fed charges a bank that needs to
borrow money from the Fed for an overnight loan to meet reserve requirements.
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OMO is by far the most important tool in the Fed’s toolbox.
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Fed funds rate: this is the average rate that banks charge each other for overnight loans needed
by a bank to meet its reserve requirement. Note: The Fed funds rate is so important b/c banks set
other rates based on the Fed funds rate (e.g., Fed funds rate + 2%).
o
The Federal Reserve affects (BUT DOES NOT SET!!!) the Fed funds rate by supplying
more or less money.
o
Remember: money is a commodity. It will be more or less expensive (as reflected in
interest rates you pay to borrow) depending on the demand for money.
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Fed fund rates too high? Not enough money in the economy; people are competing for
it by bidding up the price. So, the Fed will buy bonds and get money into the economy.
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Fed funds rates too low? Too much money in the economy, so the Fed will sell bonds.
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The Fed also could try to influence the Fed funds rate by changing the RRR or the
discount rate, but those are not used nearly as often.
How the Fed controls inflation:
o
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If inflation is too high, the Fed RAISES interest rates. It does so to cool off the
economy and reduce demand for loans. As demand for loans decreases, there is less
money to spend. Prices level off.
How the Fed stimulates the economy:
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Economy in a recession? The Fed will pump money into the economy, by buying bonds.
o
Economy over-heated? The Fed will take money out of the economy by selling bonds.
Stocks
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First, what’s a financial asset? Any contractual right you have to the payment of money. Can be
a stock, a bond, a certificate of deposit, etc.
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Stocks:
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Diversify your stock holdings (called your “portfolio”) if you want to spread risk
around. Can do this through a “mutual fund” (which is a way to pool money with other
people to buy a basket of financial assets).
o
Index funds – a mutual fund that invests in assets in a way that tries to match the
performance of whatever index it’s tracking.
▪
o
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The greater the potential earning (called the return) from a stock, the greater the risk.
Mutual fund
o
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Example: The Dow Jones Industrial Average is the ave. of prices for the 30
largest industrial companies in U.S. An index fund could buy stocks that match
the performance of the Dow.
A collection of a lot of people’s money that is invested in a variety of stocks or other
financial assets
Preferred stock v. common stock
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Preferred: usually nonvoting; holder gets dividends (if any are paid) before common
stockholders; also gets paid before common stockholders if company dissolves.
o
Common: voting stock; last in line to receive dividends or payment if company
dissolves.
PE ratios (price:earnings ratio)
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A measure of how expensive a stock is. This compares the price of a share of stock to
the earnings per share.
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