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Concepts for Midterm 1: ECN 2106
Chapter 1
Economics – The study of choices people make to attain their goals, given the
fact that we have scarce resources.
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Scarcity – A situation where we have unlimited wants with limited resources
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Economic Model –simplified versions of reality used to analyze real-world
economic situations
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Assumptions:
o People are rational
 Rational individuals weigh the benefits and costs of each
action, and they choose the action only if the benefits
outweighs the costs.
o People respond to economic incentives
o Optimal decisions are made at the margin
 Economist use the word marginal to mean “extra” or
“additional”
 Economist reason that the optimal decision is to continue any
activity up to the point where the
marginal benefit = marginal cost.
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Correlation is not equal to causation.
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Correlation is when two things “move” together.
o Ex: Temperature and Electricity Demand
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A market is a group of buyers and sellers of a good or service and the
institution or arrangement by which they come together to trade.
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Positive Analysis
o Objective, testable, describes what happens
o Descriptive of what happens and why
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Normative Analysis
o Describes the way things ought to be
o Values, Opinions
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Trade Offs
o Everywhere
o Since there is scarcity, the more you produce of one thing; this means
you have to give up something else.
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The opportunity cost of any activity is the highest-valued alternative that
must be given up to engage in that activity.
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Efficiency
o Productive Efficiency
 Occurs when a good or service is produced at the lowest
possible cost
o Allocative Efficiency
 Occurs when production is in accordance with consumer
preferences
o Equity usually involves a fair distribution of economic benefits.
o There is often a tradeoff between efficiency and equity
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Market Economy
o Goods/services are allocated by consumers and firms
Mixed Economy
o Interaction of buyers and sellers
o Some government interaction
 Ex – United States
Command Economy
o The government determines how goods and services are allocated
o AKA – Central Planning
 Ex – Former USSR
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Chapter 2
Production Possibility Frontier
o A curve showing the maximum attainable combinations of two
products that may be produced with available resources and current
technology.
o All points on the line or inside the PPF are attainable with the
resources available
o Points on the frontier are efficient because all available resources are
being fully utilized and the fewest possible resources are being used
to produce a given amount of output.
o Combinations inside the PPF are inefficient because maximum output
is not being obtained from available resources.
o Points beyond the PPF are unattainable given the firm’s current
resources.
o If a firm is producing efficiently, the only way to produce more of one
good/service is to produce fewer of the other.
o Economic growth means that there will be shifts in the PPF , because
this allows the economy to increase the goods/services produced,
which ultimately raises the standard of living.
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Trade is the act of buying and selling
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Comparative Advantage is the ability of an individual, a firm, or a country to
produce a good/service at a lower opportunity cost than competitors.
o (Specialization)
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Absolute Advantage is the ability of an individual, a firm, or a country to
produce more of a good/service than competitors, using the same amount of
resources
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The basis for trade is comparative advantage, not absolute advantage.
Chapter 3
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Competitive Market
o There are many buyers and sellers that interact in a market place and
have negligible influence on the press.
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Law of Demand
o The inverse relationship between the price of a product and the
quantity of the product demanded.
 Ex - The quantity of goods/services that a buyer is willing and
able to pay for, decreases with the price increase.
Diminishing Marginal Returns
o This is the decrease in the marginal (per-unit) output of a production
process as the amount of a single factor of production is increased,
while the amounts of all other factors of production stay constant.
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Individual vs. Market Demand Curve
o Uses individual demands, summed together to create a market
demand.
o To create a full market demand, you have to sum across divisions in a
market.
o Not all uses of a good or service have the same value to each
individual.
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Quantity Demanded
o The amount of a good or service that a consumer is willing and able to
purchase at a given price.
Market Demand
o The demand by all the consumers of a given good or service
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Movement Along the Demand Curve
o Substitution Effect
 Change in quantity demanded of a good that results from a
change in price, making the good more or less expensive
relative to other goods that are substitutes
o Income Effect
 The change in the quantity demanded of a good the results
from the effect of a change in the good’s price on consumers’
purchasing power.
 Purchasing power is the quantity of goods a consumer can buy
with a fixed amount of income.
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Demand Shifters
o Income
 Normal Good – If income increases, you want more
 Ex – Car, Clothes, Furniture
 Inferior Good- If income increases, your demand decreases
 Ex – Ramen Noodles, Natural Light
o Change in Population
 When a population increases, demand increases
 Ex – Horizontal Summing
o Price of Related Goods
 Complements
 Goods that go together
o Ex – If hot dog price goes up, hot dog bun
demand decreases
 Substitutes
 If price of good A increases, then we will see a shift out
in demand for good B. (increase)
o Ex- The price of pork goes up, so more people
buy chicken instead, so it shifts the demand
curve out for chicken.
o Expectations
 We buy more because we expect the price to increase in the
future
o Tastes & Preferences
 Popularity
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Law of Supply
o When everything else is held constant, increases in the price, cause
increases in the quantity supplied.
Quantity Supplied
o When all else is held equal, this is the quantity of a good that sellers
are willing and able to produce at any price.
Supply Curve
o Corollary of the demand curve
o Traces out quantity supplied at any price
o Shift Out
 At every price, a higher quantity is produced
o Shift In
 At every price, less is produced
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Supply Shifters
o Change in Technology
 Positive
 A firm is able to produce more output, with same
amount of inputs
 Negative
 A firm is able to produce less with the same amount of
inputs
o Changes in Input Prices
 As input prices increase, there is a shift in.
 As input prices decrease, there is a shift out.
o Expectations
 If a firm expects that the price of its product will be higher in
the future than it is today, it has an incentive to decrease
supply now and increase it in the future
o Number of Producers/Sellers
 Horizontal Summation of Supply
 When a new firm enters the market, there is a shift to the right
in the supply curve
 When a firm leaves the market, there is a shift to the left in the
supply curve.
o Changes in Opportunity Costs
 Supply curve shifts back/in when opportunity costs increase
o Price of Substitutes in Production
 What else you could have produced.
Change In Supply vs. Change in Quantity Supplied
o A change in supply refers to a shift of the supply curve
o A change in quantity supplied refers to a movement along the supply
curve as a result of a change in the products price.
Equilibrium
o The system is at rest, stable
Equilibrium Price
o When the quantity that buyers are willing to buy equals exactly the
quantity of gas that sellers are willing and able to supply.
Surplus
o When the quantity supplied is greater than the quantity demanded
o When there is a surplus, firms have unsold goods, which give them an
incentive to increase sales by reducing their prices.
Shortage
o When the quantity demanded is greater than the quantity supplied
o Firms will want to increase price, which will decrease quantity
demanded and eliminate the sortage.
Chapter 6
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Elasticity
o Responsiveness of one economic variable to a change in another
economic variable
o A measure of how responsive the quantity demanded or quantity
supplied is to changes in one of its determinants.
 Price
 Income
 % Change in QD / % Change in Income
 Ei > 1 = Normal Good
 Ei < 1 = Inferior Good
 Cross-Price
 Price of related good
 % Change QD a / % Change Price b
o Elasticity QD(a)Price(b) > 1 = Substitute Good
< 1 = Complimentary
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Quantity will always be in the numerator
Elasticity of Demand
o % Change in QD / % Change in Price
 Ex – 2/1
 For a 1% increase in price, we get a 2% decrease in the
quantity demanded
o If the quantity demanded is very responsive to changes in price, the
percentage change in quantity demanded will be greater thant the
percentage change in price, and the price elasticity of demand will be
greater than 1 in absolute value
 In this case, demand is elastic
o If the quantity demanded is not responsive to changes in price, then
percentage change in quantity demanded will be less than the
percentage change in price, and the price elasticity of demand will be
less than 1 in absolute value.
 In this case, demand is inelastic
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Midpoint Calculation
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Elasticity of Demand > 1 = Elastic Demand
Elasticity of Demand < 1 = Inelastic Demand
Elasticity of Demand = 1 --- Unitary Elastic
If a demand curve is a vertical line, it is perfectly inelastic, which means the
quantity demanded is completely unresponsive to price changes and the
price elasticity of demand equals zero.
If a demand curve is a horizontal line, it is perfectly elastic, which means that
quantity demanded is infinitely responsive to price and the price elasticity of
demand equals infinity.
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Determinants of Demand Elasticity
o Number of Substitutes Available
 Many Substitutes = Elastic
 Few Substitutes = Inelastic
o Passage of Time
 Short Run = inelastic
 Long Run = elastic
o Luxury vs. Necessity
 Luxury is elastic
 Necessity is inelastic
o Definition of the Market
 Narrow Market – Elastic
 Really close substitute
 Wide Market – Inelastic
 Few substitutes
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Elasticity of Demand and Total Revenue
o Total Revenue
 Price x Quantity
o Raising a price when demand is inelastic will increase total revenue.
 The price increase can offset the loss and ultimately gain more
total revenue
o Raising a price when demand is elastic will result in a decrease in total
revenue.
 The price increase cannot offset the amount of loss
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Supply Elasticity
o Measure of responsiveness of the quantity supplied is to a change in
the price.
o % Change in QS / % Change in Price
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Determinants of Supply
o Time
 Short Run – Inelastic
 Long Run - Elastic
o Share of Market for Inputs
 More elastic for smaller markets
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Chapter 4
Welfare Economics
o Techniques for evaluating economic well being
Assumptions
o Many Buyers and Sellers
o Homogeneous Good
o Free Entry and Exit
We get to equilibrium because of competition.
Consumer Surplus
o The economic wellbeing of consumers (demand side)
o The difference between the highest price consumers are willing to pay
and the price that they actually pay.
Producer Surplus
o The difference between the lowest prices a firm would be willing to
accept and the actual price it receives.
Total Surplus
o The sum of producer surplus and consumer surplus
o The wellbeing of producers and consumers
Economic Efficiency
o No waste
o All gains from trade have been made
o The market outcome of where the marginal benefit of consumers for
the last unit equals the marginal cost of the last unit for producers.
o Producers and consumers are maximized at economic efficiency
Dead Weight Loss
o Reduction in total economic surplus from not being at the competitive
equilibrium.
Government Policies
o Price Ceiling
 Maximum price allowed by the law
 Ex – Rent control
 When a price ceiling is below equilibrium price, this creates a
shortage.
o Price Floor
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Intended Consequences
o Things that you intended to happen
 Ex – Lower Rent/ Lower Prices
Unintended Consequences
o Discrimination
o Shortage
o Waiting Lines
o Lower Quality
o Housing Lock-In