Kristina Durham

Final Exam Review (Answers) ECO2023

December 7, 2020

Disclaimer: this final review guide does not cover every topic that may be on the exam.

Zoom poll key:

1. C2. D3. A4. B5. False (B)6. D7. A8. D9. C10. True (A)

Module 1: Fundamentals

Microeconomics: The study of the economy at the small-scale level, examining individuals and specific markets.

Macroeconomics: The study of the economy at the large-scale level, examining total output, the price level, and other aggregate measures in the economy.

Resources: land, labor, capital, entrepreneurial ability Opportunity cost: The value of the next-best forgone alternative; the value of the opportunity

that you gave up when you chose one activity, or opportunity, instead of another.o Not a monetary cost/something that you buy

Rational decision making: people make choices in their best interest (self interest), at the margin (evaluate the additional benefit versus additional cost of an action), and optimization (want to maximize the overall benefit of an action subject to its cost, if the MB is greater than or equal to marginal cost)

Marginal benefits and cost:o The amount of gain or cost that comes with producing or consuming one additional unit

of a goodo Optimal output is when marginal benefits equal marginal costo With increased production… marginal benefit tends to fall and marginal cost tends to

rise because of diminishing marginal returns

Production Possibilities Frontier:

Source: Principles of Economics 2e

Absolute advantage: the ability to produce a good using fewer inputs than another producero It is possible for a producer to have the absolute advantage in both goods

Comparative Advantage: The ability to produce a good or service at a lower relative opportunity cost than another producer

o Key word here is “relative.” Comparative advantage differs from absolute advantage because a producer can only have the comparative advantage in one good

Specialization: producing a single good rather than multiple goods o Use specialization to increase total production

Source: Principles of Economics 2e

Terms of trade: price of a good in terms of anothero Must be beneficial for both participants: seller’s opportunity cost < price < buyer’s

opportunity costo The terms of trade must be higher than the seller’s opportunity cost for that good but

lower than the buyer’s opportunity cost Gains from trade: the benefit to a buyer or seller that comes from trading one good for another

(the additional benefit does not have to be monetary)

Circular flow model: a model that describes how goods, services, resources, and money flow back and forth in an economy

Source: Principles of Economics 2e

Module 2: Demand

Law of Demand: A principle in economics which states that as the price of a good, service, or resource rises, the quantity demanded will decrease, and vice versa, all else held constant

o Demand curves are always downward sloping Income effect Diminishing marginal utility Substitution

Change in Quantity Demanded: caused by a change in price, moves ALONG the demand curve, does NOT shift the whole curve

o Increase in quantity demanded: move down & to the right on the curveo Decrease in quantity demanded: move up & to the left on the curve

Change in Demand: caused by a NONPRICE determinant (ex: change in income, taxes, substitute price change, number of buyers, tastes and preferences, expectations) and causes a shift of the whole demand curve

o Increase in demand: shift righto Decrease in demand: shift left

Normal good: as income increases, demand increases (ex nice clothing) Inferior good: as income increases, demand decreases (ex ramen noodles) Substitutes: goods that are viewed as replacements for each other (ex coke & pepsi, butter &

margarine, mittens & gloves, pizza & calzones, coffee & tea, etc) Complements: goods that are used or consumed with each other (ex peanut butter and jelly,

cereal and milk, coffee & pastries, cell phones & cell phone cases, etc)

Module 3: Supply

Law of Supply: A principle in economics that states that as the price of a good, service, or resource rises, the quantity supplied will increase, and vice versa, all else held constant

Change in quantity supplied: shift ALONG the supply curve, caused by a price change o Increase in quantity supplied: shift along the curve to the right/upo Decrease in quantity supplied: shift along the curve to the left/down

Change in supply: shift of the whole curve, caused by nonprice determinants of supplyo Increase in supply: shift of the whole curve to the righto Decrease in supply: shift of the whole curve to the left

Source: Khan Academy

Nonprice determinants of supplyo Subsidies o Taxeso Resourceso Technologyo Price expectationso Number of sellers

Module 4: Market Equilibrium and Policy

Equilibrium price: price at which the quantity supplied of a good equals the quantity demanded o Price where the demand and supply curves intersect

Equilibrium quantity: quantity traded when the quantity supplied of a good equals its quantity demanded

o Quantity where the demand and supply curves intersect Surplus: quantity supplied is greater than the quantity demanded at the current market price

(aka excess supply) Shortage: quantity demanded is greater than the quantity supplied at the current market price

(aka excess demand)

Which of the following statements does not describe equilibrium?

A) Quantity demanded equals quantity supplied at the same price.

B) The market is in balance.

C) There are no shortages or surpluses.

D) Equilibrium is a goal that is seldom achieved in the real world.

(source: Professor Buhagiar’s Module 4 Self Test Questions)

Change in equilibrium: caused by a change in supply or demando Don’t get “shift happy” and shift both curveso For example, show the effect on the market for vitamins after a study comes out saying

that everyone should take vitamins every day. The demand curve for vitamins will shift to the right because a nonprice determinant of demand (preference/taste for vitamins) has increased demand. However, do not shift the supply curve, because the new equilibrium once demand has increased shows the increase in quantity supplied.

Price ceilings: maximum price for a good (imposed by government)o A binding price ceiling must be below equilibrium

Price floors: minimum price for a good (imposed by government)o binding must be above equilibrium

Taxes on suppliers and demanderso Shift supply curve UP (for a tax placed on suppliers)

Tax is not the same as other nonprice determinants of supplyo Shift demand curve DOWN (for a tax placed on demanders)

Tax is not the same as other nonprice determinants of demando Tax revenue: amount of tax multiplied by quantity of good sold

Module 5: Market Efficiency

Consumer surplus: The difference between the maximum price consumers are willing and able to pay for a good or service and the price they actually pay

o Area below demand curve and above price paid by consumers Producer surplus: The difference between the price producers receive for a good or service and

the minimum price they are willing and able to accepto Area above the supply curve and below the price taken by producers

Economic surplus: sum of consumer and producer surplus (total surplus in the market) Deadweight loss: value of economic surplus lost when a market is not allowed to adjust to its

competitive equilibrium

Productive efficiency: producing output at the lowest possible average total cost of production, using the fewest resources possible to produce a good or service

o Most efficient production, demand doesn’t matter Allocative efficiency: producing goods or services that are most wanted by consumers in such a

away that their marginal benefit equals their marginal costo Demand does mattero MB=MC

Price ceilings, price floors, and Taxes: cause disequilibrium in the market

b. Find the new equilibrium price paid by consumers, the price received by suppliers, and the new equilibrium quantity of bottled water traded in the market.

c. Shade the area that represents the tax revenue collected by the government. How much revenue is collected?

d. Shade the area that represents the consumer surplus generated after the imposition of the tax. How much consumer surplus is generated in the market?

e. Shade the area that represents the producer surplus generated after the imposition of the tax. How much producer surplus is generated in the market?

f. Shade the area that represents the deadweight loss generated by the imposition of the tax. How much deadweight loss does the tax generate?

Source: Principles of Economics 2e, page 141-142

Module 6: Elasticity

Elasticity of demand= %change in quantity demanded/% change in priceo %change in quantity demanded= (Q2-Q1)/Q1 x 100o %change in price= (P2-P1)/P1 x 100

Answer: -1.14

Midpoint formula (for both elasticity of supply & demand): o (Q2-Q1)/ [(Q2+Q1)/2] x100o Divided by:o (P2-P1)/ [(P2+ P1)/2] x100o Q2= new quantity demanded o Q1= old quantity demandedo P2= new priceo P1= old price

Elastic demand: price elasticity of demand greater than 1 (absolute value)o If the price changes by 1%, quantity demanded changes by more than 1% as a result

Inelastic demand: price elasticity of demand is less than 1 (absolute value)o If the price changes by 1%, quantity demanded changes by less than 1% as a result

Unit elastic demand: price elasticity of demand equal to 1o If the price changes by 1%, quantity demanded changes by 1%

Total revenue: quantity multiplied by price o If total revenue decreases with a decrease in price, this shows inelastic demand,

because the percentage increase in quantity demanded was smaller than the percentage decrease in price

Determinants of elasticityo Substitutes: many substitutes=elastic demando Income: more expensive goods’ prices are more sensitive to a small change (25% price

raise of a $1 candy bar vs a $25,000 car)o Necessities: less elastico Luxuries: more elastico Time: demand is relatively inelastic in the short run (people don’t have time to search

for substitutes), demand is relatively elastic in the long run (people have time to find a substitute if the price of one good rises)

Cross-price elasticity of demand: %change of quantity demanded in good B/%change in price of good A

o Substitutes: cross price elasticity will be positiveo Complements: cross price elasticity will be negative

Income elasticity of demand: measure of how responsive demand is to a change in consumer income

o %change in quantity demanded/%change in incomeo Normal good: positive income elasticity of demando Inferior good: negative income elasticity of demand

Price elasticity of supply: a measure of how responsive quantity supplied is to a change in priceo %change in quantity supplied/% change in priceo %change in quantity supplied= (Q2-Q1)/Q1 x 100o %change in price= (P2-P1)/P1 x 100

Elastic, inelastic, unit elastic supplyo Same as demand (see above)

Supply in the immediate period, short run, and long runo Immediate: time period in which producers cannot increase their use of economic

resources to increase quantity supplied Supply is perfectly inelastic

o Short run: time period in which at least one input of production is unchanging but other inputs can be changed

Supply is relatively elastico Long run: time period in which all inputs of production can be changed

Supply is most elastic

Module 7: Production

Explicit and Implicit Costso Explicit costs: monetary payments made for the use of land, labor, capital, and

entrepreneurial ability owned by others (aka accounting costs)o Implicit costs: the opportunity costs of using owned resources, costs for which no

monetary payment is explicitly made Economic Costs: sum of explicit and implicit costs Accounting Profit= Total Revenue- Explicit Costs Economic Profit= Total Revenue-Economic Costs Short Run relationships

o Total Product=total outputo Marginal Product= change in TP/change in laboro Average Product= total product/labor

Diminishing marginal returns: marginal product of the next unit of a variable resource utilized is less than that of the previous variable resource

Short run relationshipso Fixed costs: do not change with the amount of output produced

o Variable costs: change with output produced, increase with production and decrease with production

o Total costs: sum of fixed and variable costs Short run relationships

o Average costso Average fixed costs: total fixed cost divided by the amount of output producedo Average variable costs: total VC divided by the amount of outputo Average total costs: TC divided by total output

Short run relationshipso Marginal cost: the additional cost associated with 1 more unit of an activityo Change in total cost/change in quantity

Long run relationshipso Long run average total cost curve: a curve showing the lowest average total cost

possible for any given level of output when all inputs of production are variable Long run relationships

o Economies of scale: long-run average total cost of production decreases as production increases

o Constant returns to scale: long-run ATC of production remains constant as production increases

o Diseconomies of scale: long-run ATC of production increases as production increases

Module 8: Perfect Competition

Characteristics of perfect competition: o large number of sellerso standardized producto price takerso easy entry and exit to market

Price taker: does not influence price, accepts market priceo Price=marginal revenue=average revenue

Operations in the short runo Produce where MR=MCo Anything below this quantity leaves additional production undone where revenue

exceeds cost

Module 9: Pure Monopoly

Pure monopolyo Single sellero No substituteso Price makerso Barriers to entry

Monopoly power: ability of a monopoly to influence prices by controlling the quantities that it produces in the market

Marginal revenue: change in a firm’s total revenue that results from a one-unit change in output produced and sold

o Change in total revenue/change in quantityo Aka (new TR-old TR)/(new Q – old Q)

Pure monopoly pricing Profit maximization

o MR=MCo Economic profit

Economic Efficiencyo Allocative efficiency: for a pure monopoly, look for where the marginal cost curve

crosses the demand curveo Productive efficiency: to find the profit maximizing level of output, see where MR and

MC curves intersect, then project up to the demand curve to find the price Regulation

o Natural monopoly: An industry in which economies of scale are so extensive that the market is better served by a single firm

o Unregulated monopoly price: The profit-maximizing price that will result from an unregulated monopolistic market

o Regulated normal profit price: A regulated price that is equal to the average total cost of production

o Regulated competitive price: A regulated price that is equal to the marginal cost of production

Module 10: Monopolistic Competition and Oligopoly

Monopolistic competitiono Relatively large number of sellerso Differentiated product o Some control over priceo Relatively easy entry and exit

Short run equilibriumo MR=MC

Economic Efficiency: monopolistically competitive markets are not allocatively efficient Oligopolistic competition

o Few large producerso Standardized or differentiated producto Entry barrierso Price makerso Mutually interdependent