Economics Basics

Economics and the choices we make in regards to money. These are my notes from books I have read on the subject.

Economics books on Amazon

Thinking About Money

One of the first things to think about in Economics is scarcity. Scarcity is when human wants are greater than the available supply of time, goods, and resources. The problems of scarcity and choice are basic economic problems faced by every society. Resources are the basic categories of inputs used to produce goods and services. Land is any natural resource provided by nature that is used to produce a good or service. Labor is the mental and physical capacity of workers to produce goods and services. Entrepreneurship is the creative ability of individuals to seek profits by taking risks and combining resources to produce innovative products.

Capital is a human-made good used to produce other goods and services. Money by itself does not produce goods and services. It is only a means to facilitate the purchase and sale of resources and consumer goods. Economics is therefore the study of how society chooses to allocate its scarce resources to the production of goods and services to satisfy unlimited wants. Macroeconomics is the branch of economics that studies decision making for the economy as a whole. Microeconomics is the branch that studies decision making by a single individual, household, firm, industry, or level of government. 

A model is a simplified description of reality used to understand and predict the relationship between variables. Ceteris paribus is a Latin phrase that means while certain things change, all other things remain unchanged. A theory cannot be tested legitimately unless its ceteris paribus assumption is satisfied. The fact that one event follows another does not necessarily mean that the first event caused the second event. 

Positive economics is an analysis limited to statements that are verifiable. Economists’ forecasts can differ because using the same methodology, economists can agree that event X causes event Y, but disagree over the assumption that event X will occur. Normative economics is an analysis based on subjective value judgements. When opinions or points of view are not based on facts, they are scientifically untestable. 

A direct relationship is a positive association between two variables. When one variable increases, the other variable increases. Also, when one variable decreases, the other variable decreases. An inverse relationship is a negative association between two variables. When one variable decreases, the other also decreases. The slope of a graph is the ratio of the change in the variable on the vertical axis to the change in the variable on the horizontal axis. An independent relationship means a zero association between two variables. When one variable changes, the other variable remains unchanged.

A shift in a curve occurs only when the ceteris paribus assumption is relaxed and a third variable not shown on either axis of the graph is allowed to change. 

Production Possibilities

The opportunity cost is the best alternative sacrificed for a chosen alternative. Marginal analysis is an examination of the effects of additions or subtractions from a current situation. The production possibilities curve shows the maximum combinations of two outputs an economy can produce in a given period of time with its available resources and technology. 

Technology is the body of knowledge applied to how goods are produced. Scarcity limits an economy to points on or below its production possibilities curve. The production possibilities curve consists of all efficient output combinations at which an economy can produce more of one good only by producing less of the other good. 

The law of increasing opportunity costs is the principle that the opportunity cost increases as production of one output expands. Because resources are not equally well -suited to producing all products, it is common to experience increasing opportunity costs and a bowed-out production possibilities curve. Economic growth is the ability of an economy to produce greater levels of output, represented by an outward shift of its production possibilities curve. 

An investment is the accumulation of capital, such as factories, machines, and inventories, used to produce goods and services. A nation can accelerate economic growth by increasing its production of capital goods in excess of the capital being worn out in the production process. 

Demand and Supply

The law of demand is the principle that there is an inverse relationship between the price of a good and the quantity buyers are willing to purchase in a defined time period. A demand curve shows the various quantities of product consumers are willing to purchase at possible prices during a specified period of time. 

A change in quantity demanded is a movement between points along a stationary demand curve. The change in demand is an increase or decrease in the quantity demanded at each possible price. An increase in demand is a rightward shift in the entire demand curve. A decrease in demand is a leftward shift in the entire demand curve. Under the law of demand, any decrease in price along the vertical axis will cause an increase in quantity demanded, measured along the horizontal axis, and appears as a movement along the demand curve. Changes in non-price determinants can produce only a shift in the demand curve and not a movement along the demand curve.

A normal good is any good for which there is a direct relationship between changes in income and its demand curve. An inferior good is any good for which there is an inverse relationship between changes in income and its demand curve. A substitute good is one that competes with another good for consumer purchases. As a result, there is a direct relationship between a price change for one good and the demand for its competitor good. The complementary good is a good that is jointly consumed with another good. As a result, there is an inverse relationship between a price change for one good and the demand for its “go together” good. 

The law of supply is the principle that there is a direct relationship between the price of a good and the quantity sellers are willing to offer for sale in a defined time period. The supply curve shows the various quantities of a product sellers are willing to produce and offer for sale at possible prices during a specified time period.  Only at a higher price will it be profitable for sellers to incur the higher opportunity cost associated with producing and supplying a larger quantity. 

The change in quantity supplied is a movement between points along a stationary supply curve. Under the law of supply, any increase in price along the vertical axis will cause an increase in the quantity supplied, measured along the horizontal axis, and appears as a movement along the supply curve. A change in supply is an increase or decrease in the quantity supplied at each possible price. An increase in supply is a rightward shift in the entire supply curve. A decrease in supply is a leftward shift in the entire supply curve. Changes in non-price determinants can produce only a shift in the supply curve and not a movement along the supply curve. 

A market is any arrangement in which buyers and sellers interact to determine the price and quantity of goods and services exchanged. A surplus is a market condition existing at any price where the quantity supplied is greater than the quantity demanded. A shortage is a market condition existing at any price where the quantity supplied is less than the quantity demanded. 

The equilibrium is a market condition that occurs at any price and quantity at which the quantity demanded and the quantity supplied are equal. Graphically, the intersection of the supply curve and the demand curve is the market equilibrium price-quantity point. When all other non-price factors are held constant, this is the only stable coordinate on the graph. A price system is a mechanism that uses the forces of supply and demand to create an equilibrium through rising and falling prices. 

The Markets

The price ceiling in a market is a legally established maximum price a seller can charge. Conversely, a price floor is a legally established minimum price a seller can be paid. A price ceiling or price floor prevents market adjustment in which competition among buyers and sellers bids the price upward or downward to the equilibrium price. A market failure in which market equilibrium results in too few or too many resources being used in the production of a good or service. This inefficiency may justify government intervention. 

An externality is a cost or benefit imposed on people other than the consumers and producers of a good or service. When the supply curve fails to include external costs, the equilibrium price is artificially low, and the equilibrium quantity is artificially high. External costs cause the market to overallocate resources. Then, when the demand curve fails to include external benefits the equilibrium price is artificially low, and the equilibrium quantity is artificially low. External benefits cause the market to underallocate resources. A public good has two properties. Users collectively consume benefits and there is no way to bar people who do not pay from consuming the good or service. 

If public goods are available only in the marketplace, people wait for someone else to pay, and the result is an underproduction or zero production of public goods.

Price Elasticity of Demand

Price elasticity of demand is the ratio of the percentage change in the quantity demanded of a product to a percentage change in its price. Elastic demand is a condition in which the percentage change in quantity demanded is greater than the percentage change in price. 

The total revenue is the number of dollars a firm earns from the sale of a good or service, which is equal to its price multiplied by the quantity demanded.

Inelastic demand is a condition in which the percentage change in quantity demanded is less than the percentage change in price. Unitary elastic demand is a condition in which the percentage change in quantity demanded is equal to the percentage change in price. Perfectly elastic demand is a condition in which a small percentage change in price brings about an infinite percentage change in quantity demanded. 

Perfectly inelastic demand is a condition in which the quantity demanded does not change as the price changes.  The price elasticity coefficient of demand applies only to a specific range of prices. 

The price elasticity coefficient of demand is directly related to the availability of suitable substitutes for a product. The price elasticity coefficient of demand is directly related to the percentage of one’s budget spent for a good or service. In general, the price elasticity coefficient of demand is higher the longer a price change persists. 

If the demand curve slopes downward and the supply curve slopes upward, sellers cannot raise the price by the full amount of the tax. In the case where demand is perfectly inelastic, sellers can raise the price by the full amount of a tax.  

Production Costs

Explicit costs are payments to nonowners of a firm for their resources. Implicit costs are the opportunity costs of using resources owned by a firm. Economic profit is total revenue minus explicit and implicit costs. 

Normal profit is the minimum profit necessary to keep a firm in operation. A firm that earns normal profits earns total revenue equal to its total opportunity cost. Since business decision making is based on economic profit, rather than accounting profit, the word profit always means economic profit. 

Fixed input is any resource for which the quantity cannot change during the period of time under consideration. A variable input is any resource for which the quantity can change during the time under consideration.  A short run is a period of time so short that there is at least one fixed input. A long run is a period of time so long that all inputs are variable. The production function is the relationship between the maximum amounts of output a firm can produce and various quantities of inputs. A marginal product is the change in total output produced by adding one unit of a variable input, with all other inputs used being held constant. 

The  law of diminishing returns is the principle that beyond some point the marginal product decreases as additional units of a variable factor are added to a fixed factor. The total fixed cost is a cost that does not vary as output varies and that must be paid even if output is zero. These are payments that the firm must make in the short run, regardless of the level of output. The total variable cost is the cost that is zero when output is zero and varies as output varies. The total cost is the sum of total fixed cost and total variable cost at each level of output. 

The average fixed cost is the total fixed cost divided by the quantity of output produced. The average variable cost is the total variable cost divided by the quantity of output produced. The average total cost is the total cost divided by the quantity divided by the quantity of output produced. The marginal cost is the change in total cost when one additional unit of output is produced. 

The marginal average rule is the rule that states when marginal cost is below average cost, average cost falls. When marginal cost is above average cost, average cost rises. When marginal cost equals average cost, average cost is at its minimum point. A firm operates in the short run when there is insufficient time to alter some fixed input. The firm plans in the long run when all inputs are variable. 

The long run average cost curve traces the lowest cost per unit at which a firm can produce any level of output when the firm can build any desired plant size. Economies at scale is a situation in which the long run average cost curve declines as the firm increases output. The constant returns to scale is a situation in which the long run average cost curve does not change as the firm increases output. Diseconomies of scale is a situation in which the long run average cost curve rises as the firm increases output. 

Economic profit is equal to total revenue minus both explicit and implicit costs. Explicit costs are payments to nonowners of a firm for their resources. Implicit costs are the opportunity costs of forgone returns to resources owned by a firm. Economic profit is total revenue minus explicit and implicit costs. Economic profit can be positive, zero, or negative. Economic profit is important for decision making purposes because it includes implicit costs and accounting profit does not. Accounting profit equals total revenue minus explicit costs. 

Normal profit is the minimum profit necessary to keep a firm in operation. A normal profit is a zero economic profit, and it signifies there is just enough total revenue to pay the owners for all explicit and implicit costs. 

A fixed input is any resource for which the quantity cannot change during the period of time under consideration. A variable input is any resource for which the quantity can change during the period of time under consideration. 

The short run is a time period during which a firm has at least one fixed input, such as its factory size. The long run for a firm is defined as a period during which all inputs are variable.

A production function is the relationship between output and inputs. Holding all other factors of production constant, the production function shows the total output as the amount of one input, such as labor, varies. 

Marginal product is the change in total output caused by a one unit change in a variable input, such as the number of workers hired. The law of diminishing returns states that after some level of output in the short run, each additional unit of the variable input yields a smaller and smaller marginal product. This range of declining marginal products is the region of diminishing returns.

Total fixed cost consists of costs that do not vary with the level of output, such as rent for office space. Total fixed cost is the cost of inputs that do not change as a firm changes output in the short run. Total variable cost consists of costs that vary with the level of output, such as wages. Total cost is the sum of total fixed cost and total variable cost. 

Marginal cost is the change in total cost associated with one additional unit of output. Average fixed cost is the total fixed cost divided by total output. Average variable cost is the total variable cost divided by total output. Average total cost is the total cost divided by output, or the sum of average fixed cost and average variable cost. 

The marginal-average rule explains the relationship between marginal cost and average cost. When marginal cost is less than average cost, average cost falls. When marginal cost is greater than average cost, average cost rises. Following this rule, the marginal cost curve intersects the average variable cost curve and the average total cost curve at their minimum points. 

The long-run average cost curve is a curve drawn tangent to all possible short run average total cost curves. When it decreases as output increases, a firm experiences economies at scale. If it remains unchanged as output increases, a firm experiences constant returns to scale. If the curve increases as output increases, a firm experiences diseconomies at scale. 

Since business decision making is based on economic profit, rather than accounting profit, the work profit in this text always means economic profit. A firm operates in the short run when there is insufficient time to alter some fixed input. The firm plans in the long run when all inputs are variable. The plant size selected by a firm in the long run depends on the expected level of production.  

Perfect Competition

The market structure is a classification system for the key traits of a market, including the number of firms, the similarity of products they sell, and the ease of entry into and exit from the market. Perfect competition is a market structure characterized by a large number of small firms, a homogeneous product, and very easy entry into or exit from the market. Perfect competition is also called pure competition. The large number of sellers' conditions is met when each firm is so small relative to the total market that no single firm can influence the market price.

A homogeneous product is a good or service that is identical regardless of which firm produces it. If a product is homogeneous, buyers are indifferent as to which seller’s product they buy. A barrier to entry is any obstacle that makes it difficult for a new firm to enter a market. Perfect competition requires that resources be completely mobile to freely enter or exit a market. A price taker is a seller that has no control over the price of the product it sells. 

Marginal revenue is the change in total revenue from the sale of one additional unit of output. In perfect competition, the firm’s marginal revenue equals the price, which the firm views as a horizontal demand curve. In perfect competition, the firm maximizes profit or minimizes loss by producing the output where marginal revenue equals marginal cost. The firm will shut down when the price drops below the minimum average variable cost. 

A perfectly competitive firm’s short run supply curve is a firm’s marginal cost curve above the minimum point on its average variable cost curve. The perfectly competitive industry’s short run supply curve is the supply curve derived from horizontal summation of the marginal cost curves of all firms in the industry above the minimum point of each firm’s average variable cost curve. 

A perfectly competitive industry’s long run supply curve is the curve that shows the quantities supplied by the industry at different equilibrium prices after firms complete their entry and exit. A constant cost industry is an industry in which the expansion of industry output by the entry of new firms has no effect on the individual firm’s average total cost curve. The long run supply curve in a perfectly competitive constant cost industry is perfectly elastic and drawn as a horizontal line. 

Market structure consists of three market characteristics; number of sellers, nature of the product, and ease of entry into the market. 

Perfect competition is a market structure in which an individual firm cannot affect the price of the product it produces. Each firm in the industry is very small relative to the market as a whole, all the firms sell a homogenous product, and firms are free to enter and exit the industry. 

A homogenous product is a good or service that is identical regardless of which firm produces it. 

A price taker firm in perfect competition faces a perfectly elastic demand curve. It can sell all it wishes at the market determined price, but it will sell nothing above the given market  price. This is because so many competitive firms are willing to sell the same product at the going market price. 

The total revenue total cost method is one way a firm determines the level of output that maximizes profit. Profit reaches a maximum when the vertical difference between the total revenue and the total cost curve is a maximum. 

The marginal revenue equals marginal cost method is a second approach to finding where a firm maximizes profits. Marginal revenue is the change in total revenue from a one unit change in output. Marginal revenue for a perfectly competitive firm equals the market price. The mr=mc rule states that the firm maximizes profit or minimizes loss by producing the output where marginal revenue equals marginal cost. If the price is below the minimum point on the average variable cost curve, the mr=mc rule does not apply, and the firm shuts down to minimize its losses. 

The perfectly competitive firm’s short-run supply curve is a curve showing the relationship between the price of a product and the quantity supplied in the short run. The individual firm always produces along its marginal cost curve above its intersection with the average variable cost curve. The perfectly competitive industry’s short-run supply curve is the horizontal summation of the short-run supply curves of all the firms in the industry. 

Long run perfectly competitive equilibrium occurs when a firm earns a normal profit by producing where price equals the minimum long-run average cost, the minimum short-run average, and the short-run marginal cost. 

In a constant-cost industry, total output can be expanded without an increase in the individual firm’s average total cost. Because input prices remain constant, the long-run supply curve in a constant-cost industry is perfectly elastic. 

The large number of sellers' conditions is met when each firm is so small relative to the total market that no single firm can influence the market price. If a product is homogenous, buyers are indifferent as to which seller’s product they buy. Perfect competition requires resources to be completely mobile to freely enter or exit a market. In perfect competition, the firms’ marginal revenue equals the prices, which the firm views as a horizontal demand curve.

In perfect competition, the firm maximizes profit or minimizes losses by producing the output where marginal revenue equals marginal cost. The firm will shut down when the price drops below the minimum average variable cost. The long-run supply curve is a perfectly competitive constant-cost industry that is perfectly elastic and drawn as a horizontal line.

Monopoly

A monopoly is a market structure characterized by a single seller, unique product, and impossible entry into the market. A natural monopoly is an industry in which the long run average cost of production declines throughout the entire market. As a result, a single firm can supply the entire market demand at a lower cost than two or more smaller firms. A network good is one that increases in value to each user as the total number of users increases. As a result, a firm can achieve economies of scale. 

Because of economies of scale, a single firm in an industry can produce enough output to satisfy market demand and produce this output at a lower per unit cost than would be possible if the market was served by more than one firm. As the number of people connected to a network goods system increases, the greater the benefits each person receives from being in the network. A price maker is a firm that faces a downward sloping demand curve and therefore it can choose among the price and output combinations along the demand curve.

The demand and marginal revenue curves of the monopolist are downward sloping. In contrast to the horizontal demand and corresponding marginal revenue curves facing the perfectly competitive firm. The marginal revenue curve for a straight line demand curve intersects the quantity axis halfway between the origin and the quantity axis intercept of the demand curve. The monopolist always maximizes profit by producing at a price on the elastic segment of its demand curve. 

If the positions of a monopolist’s demand and cost curves give it a profit and nothing disturbs these curves, the monopolist will earn profit in the long run. Price descrimination is the practice of a seller charging different prices for the same product that are not justified by cost differences. Arbitrage is the practice of earning a profit by buying a good at a low price and reselling the good at a higher price. 

A monopolist is characterized by inefficiency because resources are underallocated to the production of its product. Monopoly harms consumers on two fronts. The monopolist charges a higher price and produces a lower output that would result under a perfectly competitive market structure.   

Monopoly is a single seller that faces the entire industry demand curve because it is the only seller. The monopolist sells a unique product, and extremely high barriers to entry protect it from competition. 

Barriers to entry that prevent new firms from entering an industry are: ownership of an essential resource, legal barriers, and economies of scale. Government franchises, licenses, patents, and copyrights are the most obvious legal barriers to entry.

A natural monopoly arises because of the existence of economies of scale in which the long-run average cost curve falls over the full range of output demanded in the market. Economies of scale allow a single firm, rather than several firms, to produce enough output to satisfy the entire market demand at the lowest possible cost. Whichever firm expands first gains a cost advantage and monopoly status, as smaller firms leave the industry because of their high costs. 

A network good is a good that increases in value to each user as the total number of users increases. A price maker firm faces a downward sloping demand curve. It therefore searches its demand curve to find the price-output combination that maximizes its profit or minimizes its losses. The marginal revenue and demand curves are downward sloping for a monopolist. The marginal revenue curve for a monopolist lies below the demand curve, and the total revenue curve reaches its maximum where marginal revenue equals zero. 

Price elasticity of demand corresponds to sections of the marginal revenue curve. When MR is positive, price elasticity of demand is elastic. When MR is equal to zero, price elasticity of demand is unit elastic. When MR equal is negative, price elasticity of demand is inelastic. 

The short run profit maximizing monopolist, like the perfectly competitive firm, locates the profit maximizing price by producing the output where the MR and MC curves intersect. If this price is greater than the average total cost, the firm earns an economic profit. If the price is less than average total cost but greater than average variable cost, the firm loses money but remains in business. Finally, if the price is less than the average variable cost, the monopolist shuts down to minimize losses. 

The long run profit maximizing monopolist earns a profit because of barriers to entry. If demand is low and costs or high, thus creating the prospect of long run losses, the monopolist will leave the industry. 

Price descrimination allows the monopolist to increase profits by charging buyers different prices rather than a single price. Three conditions are necessary for price descrimination: the seller possesses some price setting ability, buyers in different markets must have different price elasticities of demand, and buyers must be prevented from reselling the product at a higher price than the purchase price.

Monopoly disadvantages include the following: a monopolist charges a higher price and produces less output than a perfectly competitive firm. Resource allocation is inefficient because the monopolist produces less than if competition existed. Monopoly produces higher long run profits than if competition existed. Monopoly transfers income from consumers to producers to a greater degree than under perfect competition. 

Because of economies of scale, a single firm in an industry will produce output at a lower pre-unit cost than two or more firms.

As the number of people connected to a network goods system increases, the greater the benefit each person receives from the network goods. The demand and marginal revenue curves of the monopolist are downward sloping in contrast to the horizontal demand and corresponding marginal revenue curves facing the perfectly competitive firm. The marginal revenue curve for a straight line demand curve intersects the quantity axis halfway between the origin and the quantity axis intercept of the demand curve. The monopolist always maximizes profit by producing at a price on the elastic segment of its demand curve. 

If the positions of a monopolist’s demand and cost curves give it a profit and nothing disturbs these curves, the monopolist will earn profit in the long run. A monopolist is characterized by inefficiency because resources are under allocated to the production of its product. Monopoly harms consumers on two fronts. The monopolist charges a higher price and produces a lower output than would result under a perfectly competitive market structure.  

Monopolistic Competition and Oligopoly

Monopolistic competition is a market structure characterized by many small sellers, a differentiated product, and easy market entry or exit. The many-sellers condition is met when each firm is so small relative to the total market that its pricing decisions have a negligible effect on the market price. Product differentiation is the process of creating real or apparent differences between goods and services. A firm can charge higher prices if it makes its products seem unique. Nonprice competition is the situation in which a firm competes using advertising, packaging, product development, better quality, and better service, rather than low prices. 

The demand curve for a monopolistically competitive firm is less elastic, or steeper,  than for a perfectly competitive firm and more elastic, or flatter, than for a monopolist. Oligopoly is a market structure characterized by few large sellers, either a homogenous or a differentiated product, and difficult market entry. Mutual interdependence is a condition in which an action by one firm may cause a reaction from other firms. The few-sellers condition is met when these few firms are so large relative to the total market that they can affect the market price. Buyers in an oligopoly may or may not be indifferent as to which seller’s product they buy. 

Price leadership is a pricing strategy in which a dominant firm sets the price for an industry and the other firms follow. A cartel is a group of firms that formally agree to reduce competition by coordinating the price and output of a product. Game theory is a model of the strategic moves and countermoves of rivals. The payoff matrix demonstrates why a competitive oligopoly tends to result in both rivals using a low-price strategy that does not maximize mutual profits. As long as the benefits exceed the costs, cheating can threaten formal or informal agreements among oligopolists to maximize joint profits.  

Monopolistic competition is a market structure characterized by many small sellers, a differentiated product, and easy entry or exit from the market. Given these characteristics, firms in monopolistic competition have a negligible effect on the market price. 

Product differentiation is a key characteristic of monopolistic competition. It is the process of creating real or apparent differences between products. 

Nonprice competition includes advertising, packaging, product development, better quality, and better service. Under monopolistic competition and oligopoly, firms may compete using nonprice competition, rather than price competition. 

Short run equilibrium for a monopolistic competitor can yield economic losses, zero economic profits, or economic profits. In the long run, monopolistic competitors make zero economic profits.

Comparing monopolistic competition with perfect competition, we find that in the long run the monopolistically competitive firm does not achieve allocative efficiency, charges a higher price, restricts output, and does not produce where average costs are at a minimum. 

Oligopoly is a market structure characterized by few sellers, homogeneous or differentiated products, and difficult market entry. Oligopolies are mutually interdependent because an action by one firm may cause a reaction from other firms.

The nonprice competition model is a theory that might explain oligopolistic behavior. Under this theory, firms use advertising and product differentiation, rather than precise reductions, to compete. 

Price leadership is another theory of pricing behavior under oligopoly. When a dominant firm in an industry raises or lowers its price, other firms follow suit. 

A cartel is a formal agreement among firms to set prices and output quotas. The goal is to maximize joint profits, but firms have an incentive to cheat, which is a constant threat to a cartel. 

Game theory reveals that oligopolies are mutually interdependent in their pricing policies, without collusion, oligopoly prices and mutual profits are lower, and oligopolists have a temptation to cheat on any collusive agreement.

Comparing oligopoly with perfect competition, we find that the oligopolist allocates resources inefficiently, charges a higher price, and restricts output so that price may exceed average cost enabling long run profits.

 The many sellers’ condition is met when each firm is so small relative to the total market that its pricing decisions have a negligible effect on the market price. 

A firm can charge higher prices if it makes its products seem unique.

The demand curve for a monopolistically competitive firm is less elastic than for a perfectly competitive firm and more elastic than for a monopolist.

The few-sellers condition is met when these few firms are so large relative to the total market that they can affect the market price.

Buyers in an oligopoly may or may not be indifferent as to which seller’s product they buy.

The payoff matrix demonstrates why a competitive oligopoly tends to result in both rivals using a low price strategy that does not maximize mutual profits.

As long as the benefits exceed the costs, cheating can threaten formal or informal agreements among oligopolists to maximize joint profits.

GDP

Gross domestic product is the market value of all final goods and services produced in a nation during a period of time.

This is the most reported measurement of an economy. GDP includes only current transactions, meaning final sales. It does not count purely private or public financial transactions. 

A transfer payment is a government payment to individuals not in exchange for goods or services currently produced.

GDP only counts final goods that are sold or produced. Final goods are finished goods or services produced for the ultimate user. Intermediate goods are goods and services used as inputs for the production of final goods.

The circular flow model shows the exchange of money, products, and resources between households and businesses. The upper half represents product markets, in which households exchange money for goods and services produced by firms. The bottom half of the diagram represents the factor markets, in which firms demand the natural resources, labor, capital, and entrepreneurship needed to produce the goods and services sold in the product markets. 

Expenditure approach is the national income accounting method that measures GDP by adding all the spending for final goods during a period of time. This includes

• C - personal consumption
• I  - investment
• G- government spending
• (X-M) - net exports
• Formula for GDP = C+ I + G + (X-M)

Because GDP only counts market transactions, it excludes activities that are unpaid like child rearing. GDP is blind to whether a small fraction of the population consumes most of a country’s GDP or consumption is evenly divided. GDP is a quantitative, rather than a qualitative measure of the output of goods and services. GDP does not directly measure quality of life variables such as leisure time. 

It can be argued that GDP understates national well being because no allowance is made for variables such as leisure time, life expectancy, and other such things.

Underground activities are not counted for GDP because there are no transaction records. If the underground economy is sizable, GDP will understate an economy’s performance by a sizable amount. Since the costs of negative by-products are not deducted, GDP overstates the national well-being.

So far, GDP has been expressed as nominal GDP. Nominal GDP is the value of all final goods based on the prices existing during the time period of production. This adjusted GDP allows meaningful comparison over time when prices are changing. 

Measuring the difference between changes in output and changes in the price level involves making an important distinction between nominal GDP and real GDP. Real GDP is the value of all final goods produced during a given time period based on the prices existing in selected base year. GDP chain price index is a measure that compares changes in the prices of all final goods during a given year relative to the prices of those goods in a base year. This index is also called GDP price index or simply GDP deflator. 

Business and Unemployment

The business cycle is alternating periods of economic growth and contraction. These changes are measured in real GDP. The peak is the phase of the business cycle in which real GDP reaches its maximum after rising during a recovery. A recession is the downturn in the business cycle during which GDP declines and the unemployment rate rises. It is also called a contraction.

The trough is the phase of the business cycle in which real GDP reaches its minimum after falling during a recession. An expansion is an upturn in the business cycle during which real GDP rises. This is also known as a recovery. Economic growth is an expansion in national output measured by the annual percentage increase in a nation’s real GDP.

We value economic growth as one of our nation’s economic goals because it increases our standard of living. Leading indicators are variables that change before real GDP changes. Coincident indicators are variables that change at the same time that real GDP changes. Lagging indicators are variables that change after real GDP changes.

Unemployment rate is the percentage of people in the civilian labor force who are without jobs and are actively seeking jobs. The civilian labor force is the number of people 16 years or older who are employed or who are actively seeking a job, excluding armed forces, homemakers, discouraged workers, and other persons not in the labor force.

A discouraged worker is a person who wants to work but has given up searching for work because they believe there will be no job offers. Frictional unemployment is temporary unemployment caused by the time required of workers to move from one job to another. Structural unemployment is caused by a mismatch of skills of workers out of work and the skills required for existing job opportunities.  

Outsourcing is the practice of a company having its work done by another company in another country. Offshoring is the practice of work for a company being performed by the company’s employees located in another country. 

Cyclical unemployment is caused by the lack of jobs during a recession. Full employment is the situation in which an economy operates at an unemployment rate equal to the sum of the frictional and structural unemployment rates. This is also called the natural rate of unemployment. The GDP gap is the difference between actual real GDP and potential for full employment real GDP. 

The gap between actual and potential real GDP measures the monetary losses of real goods and services to the nation from operating at less than full employment. 

Inflation

Inflation is an increase in the general price level of goods and services in the economy. Deflation is the decrease in the general price level of goods and services in the economy. Inflation is an increase in the overall average level of prices and not an increase in the price of any specific product. The consumer price index measures changes in the average prices of consumer goods and services. 

The base year is a year chosen as a reference point for comparison with some earlier or later year. 

Disinflation is a reduction in the rate of inflation. Nominal income is the actual number of dollars received over a period of time. Real income is the actual number of dollars received adjusted for changes in CPI. People whose nominal income rise faster than the rate of inflation gain purchasing power while people whose nominal incomes do not keep pace with inflation lose purchasing power. 

Wealth is the value of stock or assets owned at some point in time. Nominal interest rate is the actual interest rate without adjustment for the inflation rate. The real interest rate is the nominal interest rate minus the inflation rate. An adjustable rate mortgage is a home loan that adjusts the nominal interest rate to changes in an index rate, such as rates on treasury securities. When the real rate of interest is negative, lenders and savers lose because interest earned does not keep up with the inflation rate. 

Hyperinflation is an extremely rapid rise in the general price level. Wage price spiral is a situation that occurs when increases in nominal wage rates are passed on in higher prices which result in even higher nominal wage rates and prices. Demand-pull inflation is a rise in the general price level resulting from an excess of total spending. Cost-push inflation is an increase in the general price level resulting from an increase in the cost of production. 

Fiscal Policy

Fiscal policy is the use of government spending and taxes to influence the nation’s output, employment, and price level. Discretionary fiscal policy is the deliberate use of changes in government spending or taxes to alter aggregate demand and stabilize the economy.  

The spending multiplier is the change in aggregate demand resulting from initial change in any component of aggregate expenditures, including consumption, investment, government spending, and net exports. In the intermediate segment of the aggregate supply curve, the equilibrium real GDP changes by less than the change in government spending times the spending multiplier. Marginal propensity to consume is the change in consumption spending divided by a given change in income. 

Any initial change in spending by the government, households, firms, or foreigners on our exports creates a chain reaction of further spending which causes a greater cumulative change in aggregate demand. The marginal propensity to save is the change in saving divided by a change in income. A tax cut has a smaller multiplier effect on aggregate demand than an equal increase in government spending. The tax multiplier is the change in aggregate demand resulting from an initial change in taxes. 

Automatic stabilizers are federal expenditures and tax revenues that automatically change levels in order to stabilize an economic expansion or contraction, sometimes referred to as nondiscretionary fiscal policy. Budget surplus is a budget in which government revenues exceed government expenditures in a given time period. A budget deficit is a budget in which government expenditures exceed government revenues in a given time period. 

Automatic stabilizers assist in offsetting a recession when real GDP falls and in offsetting inflation when real GDP expands. Supply-side fiscal policy emphasizes government policies that increase aggregate supply in order to achieve long-run growth in real output, full employment, and a lower price level. A laffer curve is a graph depicting the relationship between tax rates and total tax revenues. 

Money and the Federal Reserve System

Bartering is the direct exchange of one good or service for another good or service, rather than for money. The use of money simplifies and therefore increases market transactions. Money also prevents wasting time that can be devoted to production, thereby promoting economic growth by increasing a nation’s production possibilities. Money is anything that serves as a medium of exchange, unit of account, and store of value. Medium of exchange is the primary function of money to be widely accepted in exchange for goods and services.

A unit of account is when the function of money provides a common measurement on the relative value of goods and services. A store of value is the ability of money to hold value over time. Money is a useful mechanism for transforming income in the present into future purchases. Money is the most liquid form of wealth because it can be spent directly in the marketplace. 

The supply of money must be great enough to meet ordinary transaction needs, but not be so plentiful that it becomes worthless. Commodity money is anything that serves as money while having market value based on the material from which it is made. Fiat money is money accepted by law and not because of its redeemability or tangible value. An item’s ability to serve as money does not depend on its own market value or the backing of precious metal. M1 is the narrowest definition of the money supply. It includes currency and checkable deposits. 

Currency is money including coins and paper money. Checkable deposits are the total money in financial institutions that can be withdrawn by writing a check. M2 is the definition of the money supply that equals M1 plus near monies such as savings deposits and small time deposits of less than $100,000. M1 money is more liquid than M2 money.

The federal reserve system is the 12 federal reserve district banks and other financial institutions within each of the federal reserve districts. The board of governors are the seven members appointed by the president and confirmed by the US senate who serve for one nonrenewable 14 year term. Their responsibility is to supervise and control the money supply and the banking system of the United States. 

The Federal Open Market Committee directs the buying and selling of US government securities which are major instruments for controlling the money supply. The FOMC consists of the seven members of the Board of governors, the president of the New York federal reserve bank, and the presidents of four other Federal reserve district banks. The federal deposit insurance corporation is a government agency established in 1933 to insure customer deposits to a limit if a bank fails. 

The Consumer Financial Protection Bureau is an independent Bureau within the federal reserve that helps consumers make financial decisions. The Monetary Control Act is a law that gave the federal reserve system greater control over nonmember banks and made all financial institutions more competitive.  

Principles of Economics

Economics involves a lot more than money, such as the choices that we all make. An economic agent is a person or group that makes choices. Individuals make choices every day. Groups can also make choices.

The choices that people make are about the allocation of scarce resources. Scarcity exists because people have unlimited desires and the world can not accommodate these desires. So, economics is the study of how everyone allocates their scarce resources.

We study economics to see what people do and what we should do. The study of what people do is called positive economics. The study of what they should do is normative economics.

Economics can be further divided into macroeconomics and microeconomics. Macroeconomics is the study of the economy as a whole. The includes subjects like growth rate and inflation rate. Microeconomics is the study of how individuals or small entities make choices. We need to understand this when we want to understand a small piece of the economy.

The main principles of economics include optimization, equilibrium, and empiricism.

Optimization is about picking the best available option. Optimizing choices involves trade-offs. to gain one thing, you have to give up another. A budget constraint is therefore the set of things that a person can choose to do without breaking their goals. These choices also involve opportunity costs. This is something that you must give up when you make a choice. To do this, we perform a cost-benefit analysis. This is when we want to compare a set of feasible alternatives and pick the best one. We do this so that we can pick the alternative that has the largest net benefit.

Equilibrium is when everyone believes that making a change in their behavior is pointless. Everyone is trying to optimize.

Empiricism is about making choices based on data. We use data to test if theories are correct. People do this to see what is causing things in the world to happen.

The definition of economics states that it is the study of how agents choose to allocate scarce resources and the impact of those resources on society.

The statement that the United States has too many illegal immigrants is a normative statement since it describes what people ought to do.

The statement that the United States saw the unemployment rate peak at 10% in 2009 is a positive statement since it describes what people actually do.

The ethical implications of a hotly debated governmental policy would best be considered a normative question, since it deals with a subjective issue based on personal preferences.

Economics is divided into two broad fields of study: microeconomics and macroeconomics.

Microeconomics studies a small piece of the overall economy, while macroeconomics studies the economy as a whole.

Policy decisions made by the government are analyzed by both microeconomics and macroeconomics.

A policy such as those limiting a firm’s monopoly powers would be studied under microeconomics, since it deals with a small part of the overall economy. 

The three principles of economics include optimization, equilibrium, and empiricism.

Empiricism describes a situation where economists use data to analyze what is happening in the world.

Optimization describes a situation where people weigh costs and benefits when making a decision.

Equilibrium describes a situation where no one would benefit from changing his or her behavior.

Economics, anthropology, psychology, sociology and political science all study human behavior.

Economists differ from these other social sciences because it also addresses the three key concepts of optimization, equilibrium, and empiricism.

Suppose your new year resolution is to get back into shape. 

How would you evaluate your options and choose an optimal one?

Do a cost-benefit analysis to compare the alternatives.

When making your decisions about which activity to choose, you should consider the monetary cost as well as the opportunity costs of the activities.

The goal is to choose the option that offers the greatest net benefit.

During the process of optimization, economists believe that people are considering the feasibility of a choice, given the available information at the time.

The goal of optimization for an individual is to maximize overall well being.

Suppose that you allocate $20 each week for your entertainment budget. 

This money is spent on two items: either renting movies for $1 each or downloading songs at $1 each.

Given this information: which of the following would represent your budget constraint for entertainment?

Amount spent on songs plus the amount spent on movies equals $20.

Your budget constraint for entertainment illustrates the concepts of tradeoffs, since as you increase your purchases of one item, you must decrease your purchases of the other item.

The opportunity cost of an item is a measure of what is given up when you do that activity.

Let’s say you are trying to decide on what to do on Friday at 11 am. 

You rank your possible options from the one you value the most to the one that you value the least in the following order: going to class, sleeping in late, going to work early, getting lunch, going to the gym, and watching tv.

If you decide to go to class, then what do we know about the opportunity cost of your decision?

The opportunity cost would be sleeping in late, since it is your next best option.

Comparing a set of feasible alternatives and picking the best one is an optimization process called cost-benefit analysis.

Free riding occurs when people’s private benefits are out of sync with the public interest.

Which of the following is subject to the free rider problem?

All: neighborhood watch, national security, and public libraries.

Which of the following is more susceptible to the free rider problem? Funded symphonies or public roads.

Use of public roads is more susceptible since even those who don’t pay taxes still benefit, while government funded symphonies can charge for admission, so that everyone who goes pays their share.

For a market to be in equilibrium, three conditions must hold.

The amount produced by sellers must be equal to the amount purchased by buyers.

The costs of making a product must be less than the final price at which the product sells.

Buyers must place a value on the uses of a product that is greater than the cost of buying the product.

Which of the following is true regarding the concept of causation?

It describes how one event can bring about change in another.

Which of the following is not an example of a causal claim?

It rains more often on days you wash your car.

Identify the cause and effect in the following examples.

Lower infant mortality is an effect and an improvement in nutrition is the cause.

A surge in cocoa prices is an effect and a pest attack on cocoa crops is the cause.

Using Data and Models

The scientific method is the name for the ongoing process that economists and other scientists use to develop models of the world. Empirical evidence is facts that are obtained through observations and measurement. This is also called data. Economists try to uncover causal relationships among variables. An experiment can be designed to measure a causal relationship. Economists now actively pursue experiments both in the laboratory and in the field. Economists also determine causality by studying historical data that have been generated by a natural experiment.

A model is a simplified description of reality. Sometimes economists will refer to a model as a theory. These terms are usually used interchangeably. Empirical evidence consists of facts that are obtained through observation and measurement. It is also called data.

The median value is calculated by ordering the numbers from least to greatest and then finding the value halfway through the list. The mean is the sum of all the different values divided by the number of different values. Causation occurs when one thing directly affects another. A variable is a changing factor.

Correlation means that two variables tend to change at the same time. Positive correlation implies that two variables tend to move in the same direction. Negative correlation implies that two variables tend to move in opposite directions. When two variables have movements that are not related, we say that the variables have zero correlation. An omitted variable is something that has been left out of a study that would explain why two variables that are in the study are correlated. Reverse causality occurs when we mix up the direction of cause and effect.

An experiment is a controlled method for investigating causal relationships among variables. Randomization is the assignment of subjects by chance, rather than by choice, to a control group. A natural experiment is an empirical study in which some process has assigned subjects to control and treatment groups in a random or nearly random way.

To say that economists use the scientific method means that they are using an ongoing process to develop models of the world and then test and evaluate those models.

How do economists distinguish between models that work and those that don’t?

They test their models against real-world data.

How does the sample size affect the validity of an empirical argument?

The larger the sample size the better.

Suppose you thought income inequality in the US had increased over time.

Would you expect the ratio of the mean income in the US to the median income to have risen or fallen?

Risen, because means change more with extreme values.

Suppose you have been hired as a management consultant by a major oil company to help it optimally price gasoline at its service stations. During a meeting with your client, the CEO asks if your economic models include all factors that impact gasoline prices. What is your response?

No, the model is a simplified representation of reality.

Your client becomes critical of your sloppy technique of using a model that does not include all factors. How do you reply?

Economic models are meant to be approximations that predict what happens in most circumstances.

He is still unconvinced about the reliability of using economic models to make business decisions. You can answer this concern by sharing that you will confirm the accuracy of the model by testing its predictions with empirical data.

What is meant by randomization in the context of an economic experiment?

Subjects are assigned by chance, rather than by choice, to a group.

As the text explains, it can sometimes be very difficult to sort out the direction of causality.

Causation occurs when there is a logical cause and effect relationship.

Demonstrate causation or correlation with the following examples.

More police officers and lower crime rates is likely to be causation.

More economic growth and higher employment rates is likely to be causation.

The length of women’s skirts and stock market performance is likely to be correlated.

The signaling argument implies that a college student who drops out of school one month before graduation should earn much less than a student who graduates.

The human capital argument implies that a college student who drops out of school one month before graduation should earn almost the same as a student who graduates.

Your client has asked you to plot crude oil prices and gasoline prices on a graph.

The cause, or independent variable, should be plotted on the x-axis.

The effect, or dependent variable, should be plotted on the y-axis.

There is a positive correlation between oil prices and gasoline prices.

Your client has asked you to plot GDP and gasoline prices on a graph.

There is a negative correlation between GDP and gasoline prices.

Suppose you have been hired as a management consultant by a major oil company to help it optimally price gasoline as its service stations. Your client would like your team to perform a study on customers’ gasoline purchasing habits when they notice price increases.

You suggest that the team design and execute an experiment.

Debbie, a member of your team, advocates finding random people and then breaking them up into two groups. Group A would be shown an increase in the price of gas before taking the survey. Group B would be told there was no increase in the price of gas before taking the survey. Troy, another member on your team, recommends finding two groups of people already sorted by whether they have recently noticed an increase in the price of gas.

Debbie’s method is a controlled experiment and Troy’s method is a natural experiment.

Group A is the treatment or test group and Group B is the control group.

A simple economic model predicts that a fall in the price of bus tickets means that more people will take the bus. However, you observe that some people still do not take the bus even after the price of a ticket fell.

Is the model incorrect?

No, because it predicts the outcome of increased bus ridership on average.

How would you test this model?

You should run a natural experiment by analyzing bus ridership and price changes.

Suppose that you are on a date with an economics major, and you want to impress them by talking about economics. Your date challenges you to state your knowledge of positive and normative questions.

You say that positive questions ask what is or what will be.

You also say that normative questions ask what ought to be.

Which of the following examples do you provide as a normative question?

Should welfare be repealed?

Which of the following do you provide as a positive question?

How much is the national debt?

Optimization in Economics

Economists believe that optimization describes most of the choices economic agents make. However, people don’t always make the optimal choice. A large body of economic research attempts to answer the question: when do people succeed in choosing the best feasible option and when do they fail. Using the concept of optimization to describe and predict behavior is an example of positive economic analysis.

Optimization concepts also provide an excellent toolbox for improving decision making that is not already optimal. Optimization using total value has 3 steps: translate all costs and benefits into common units, calculate the total net benefit of each alternative, and pick the alternative with the highest net benefit.

Marginal analysis evaluates the change in net benefits when you switch from one alternative to another. Marginal analysis calculates the consequences of doing one more step of something. Marginal cost is the extra cost generated by moving from one alternative to the next alternative. Optimization using marginal analysis has 3 steps: translate all costs and benefits into common units, calculate the marginal consequences of moving between alternatives, and apply the principle of optimization at the margin by choosing the best alternative with the property that moving to it makes you better off and moving away from it makes you worse off.

Optimization using total value and optimization using marginal analysis yield the same answer.

Economists refer to the best feasible option as the optimal choice. Behavioral economics jointly analyzes the economic and psychological factors that explain human behavior.

Marginal analysis is a cost benefit calculation that studies the difference between one feasible alternative and the next feasible alternative. Marginal cost is the extra cost generated by moving from one feasible alternative to the next feasible alternative.

The principle of optimization at the margin states that an optimal feasible alternative has the property that moving to it makes you better off and moving away from it makes you worse off.

Optimization is the process that describes the choices that governments make.

Optimization in levels examines total net benefits, while optimization in differences analyzes the change in net benefits.

You have been invited to play a 4-hour round of golf that has a value to you of $90. The total price to play the round of golf is $25.

The net benefit of the round of golf is $65.

Now assume that you have a job that pays you $6 per hour. Would you be optimizing to accept the invitation to play golf?

To optimize, you should play golf.

Suppose your total benefit from eating slices of pizza is \(6x-x^{2}\) where x is the number of slices of pizza.

Pizza is sold by the slice and costs $2 per slice, and so the total cost of pizza is 2x.

Using optimization in levels, what is the optimal(most total benefit) amount of pizza for you to eat?

Your net benefit is maximized at 2 slices of pizza.

The reason why is when x=2, \(6(2)-2^{2} = 12 - 4 = 8\). Then the cost is \(2(2)\).

So, the total benefit is \(8-4 = 4 \). Two slices yields the greatest total benefit.

You and your friend have just moved out of your dorm and into a new apartment. Both of you decide that you need to get a couch. He thinks you should get a new one from the furniture store nearby. You feel that, given your budget, it is best to buy a used one. Your other options are to buy one online or get a couch custom-made at the same furniture store.

How would you arrive at an optimal solution here? Assume that your opportunity cost of time is $5 per hour.

The direct costs and the indirect opportunity cost of your time required to shop.

Now suppose that you have a summer job that pays you $15 per hour. How would your analysis change?

With a $15-per-hour summer job, the opportunity cost of your time would increase.

A company mines 390,000 tons of coal per year in a rural county. The coal is worth $77 per ton. The average price for a 2,000 square foot house with three bedrooms more than 20 km away from the mining site in this county is $220000. The average price for a similar, 2000 square foot house with three bedrooms within 4 km of the mine is 2 percent lower.

Using comparative statics, what is the effect of mining on home prices in this county?

Mining changes the price of a 2000 square foot home by $-4400.

There is a proverb “anything worth doing is worth doing well”.

Do you think an economist would agree with this proverb?

No, because the marginal cost of extra effort may be greater than the marginal benefit.

What is the difference between marginal values and average values?

Marginal values show the additional benefit or cost from consuming an additional unit of a good, while average values are the benefit or cost per unit of a good.

Determine whether the following statements better describe optimization using total value or optimization using marginal analysis.

John is attempting to decide on a movie. He determines that the new Batman movie is preferred to the new Spider man movie and that both are preferred to the new Superman movie.

This is optimization using marginal analysis, since he is calculating the change in net benefits between alternatives.

Nikki decided to jog for 3 miles for exercise by reasoning that a 3 mile jog was better than either a 2 mile jog or a 4 mile jog.

This is optimization using marginal analysis, since she is calculating the difference in net benefits between alternatives.

At a yard sale, Reagan calculated that she was willing to pay $200 for a queen bed that was being sold for $100 and she was willing to pay $220 for a king bed that was being sold for $300.

This is optimization using marginal analysis, since she is comparing the net benefits between alternatives.

You are a professor of economics at a university. You have been offered the position of serving as department head, which comes with an annual salary that is $9500 higher than your current salary. However, the position will require you to work 200 additional hours per year. Suppose the next best use of your time is spending it with your family, which has value of $20 per hour.

What is the difference in net benefit from becoming the department head?

\(200*20=4000\)

\(9500-4000=5500\)

To optimize, you should become a department head.

You are considering renting a city apartment with 1000 square feet for $1200 per month. The monthly rent on a larger, 1500 square foot city apartment is $1600.

The marginal cost of renting an apartment with 500 additional square feet is $.80 per square foot per month.

Demand and Supply in Economics

A market is a group of economic agents who are trading a good or service plus the rules and arrangements for trading. If all sellers and all buyers face the same price, it is referred to as the market price. In a perfectly competitive market, sellers all sell an identical good and no one buyer can influence the market. A price-taker is a buyer or seller who accepts the market price. Quantity demanded is the amount of a good that buyers are willing to purchase at a given price. A demand schedule is a table that reports the quantity demanded at different prices, holding all else equal. Holding all else equal implies that everything else in the economy is held constant. The Latin phrase “ceteris paribus” is often used to say this.

The demand curve plots the quantity demanded at different prices. A demand curve plots the demand schedule. Two variables are negatively related if the variables move in opposite directions. The law of demand is when the quantity demanded rises when price falls. Willingness to pay is the highest price that a buyer is willing to pay for an extra unit of a good. Diminished marginal benefit: as you consume more of a good, your willingness to pay for an additional unit declines. The process of adding up individual behaviors is referred to as aggregation.

The market demand curve is the sum of the individual demand curves of all potential buyers. It plots the relationship between the total quantity demanded and the market price, holding all else equal. The demand curve shifts only when the quantity demanded changes at a given price. If a good’s own price changes and its demand curve hasn’t shifted, the own price changes produces a movement along the demand curve.

For a normal good, an increase in income shifts the demand curve to the right, causing buyers to purchase more of a good. For a normal good, a decrease in income shifts the demand curve to the left, causing all buyers to purchase less of the good. For an inferior good, an increase in income shifts the demand curve to the right, causing buyers to purchase more of the good. For an inferior good, a decrease in income shifts the demand curve to the left, causing buyers to purchase less of the good. Two goods are substitutes when a rise in the price of one leads to a rightward shift in the demand curve for the other. Two goods are complements when a fall in the price of one leads to a rightward shift in the demand curve for the other.

The quantity supplied is the amount of a good or service that sellers are willing to sell at a given price. A supply schedule is a table that reports the quantity supplied at different prices, holding all else equal. The supply curve plots the quantity supplied at different prices. A supply curve plots the supply schedule. Two variables are positively related if the variables move in the same direction. The law of supply, in almost all cases, is when the quantity supplied rises when the price rises.

The willingness to accept is the lowest price that a seller is willing to get paid to sell an extra unit of a good. At a particular quantity supplied, willingness to accept is the height of the supply curve. Willingness to accept is the same as the marginal cost of production. The market supply curve is the sum of the individual supply curves of all the potential sellers. It plots the relationship between the total quantity supplied and the market price.

An input is a good or service used to produce another good or service. The supply curve shifts only when the quantity supplied changes at a given price. If a good’s own price changes and it’s supply curve hasn’t shifted, the own price change produces a movement along the supply curve. The competitive equilibrium is the crossing point of the supply curve and the demand curve. The competitive equilibrium price equates quantity supplied and quantity demanded. The competitive equilibrium quantity is the quantity that corresponds to the competitive equilibrium price.

When the market price is above the competitive equilibrium price, quantity supplied exceeds quantity demanded, creating excess supply. When the market price is below the competitive equilibrium price, quantity demanded exceeds quantity supplied, creating excess demand.

A market is a group of economic agents who are trading a good or service plus the rules and arrangements for trading. In a perfectly competitive market, sellers all sell an individual good or service and individual buyers or sellers aren’t powerful enough on their own to affect the market price of that good or service.

Quantity demanded is the amount of a good that buyers are willing to purchase at a given price. A demand schedule is a table that reports the quantity demanded at different prices, holding all else equal. A demand curve plots the demand schedule. The law of demand states that in almost all cases, the quantity demanded rises when the price falls.

The market demand curve is the sum of the individual demand curves of all potential buyers. The quantity demanded is summed at each price. It plots the relationship between the total quantity demanded and the market price.

The demand curve shifts only when the quantity demanded changes at a given price. If a good’s own price changes and its demand curve hasn’t shifted, the own price change produces a movement along the demand curve.

Quantity supplied is the amount of a good or service that sellers are willing to sell at a given price. A supply schedule is a table that reports the quantity supplied at different prices. A supply curve plots the supply schedule. The law of supply states that in almost all cases, the quantity supplied rises when the price rises.

The market supply curve is the sum of the individual supply curves of all potential sellers. The quantity supplied is summed at each price. It plots the relationship between the total quantity supplied and the market price.

The supply curve shifts only when the quantity supplied changes at a given price. If a good’s own price changes and its supply curve hasn’t shifted, the own price change produces a movement along the supply curve.

The competitive equilibrium is the crossing point of the supply curve and the demand curve. The competitive equilibrium price equates quantity supplied and quantity demanded. The competitive equilibrium quantity is the quantity that corresponds to the competitive equilibrium price. When prices are not free to fluctuate, markets fail to equate quantity demanded and quantity supplied.

In a perfectly competitive market, sellers cannot charge more than the market price and cannot pay less than the market price.

In a perfectly competitive market, if one seller chooses to charge a price for its good that is slightly higher than the market price, then it will lose all or almost all of its customers.

Market demand is derived by fixing the price and adding up the quantities that each buyer demands.

Does the shape of the market demand curve differ from the shape of an individual demand curve?

No, they both tend to be downward sloping curves.

The Law of Demand states that as the price of a good increases, the quantity demanded decreases. This can be shown with a downward sloping demand curve or numerically in a table using a demand schedule.

The relationship that exists between these two variables can be described as negatively related.

Which of the following is not one of the five major factors that shifts the demand curve when it changes.

Prices of inputs used to produce the good.

The law of Supply states that as the price of a good increases, the quantity supplied of that good increases. This can be shown in an upward sloping supply curve or numerically in a table using a supply schedule.

The relationship that exists between these two variables can be described as positively related.

As a firm produces more of a good, the cost of producing each additional unit increases. This implies that the marginal cost of producing a good increases as you make more of that good.

The supply curve represents the minimum price sellers are willing to accept to sell an extra unit of a good.

Which of the following is not one of the four major factors that shifts the supply curve when it changes?

The income of consumers.

When one of the four major factors changes, causing an increase in supply, the supply curve shifts rightward.

If firms expect future price increases, how would the supply of smartphones be impacted?

There would be a leftward shift.

Lobsters are plentiful and easy to catch in August but scarce and difficult in November. In addition, vacationers shift the demand for lobsters further to the right in August than in any other month. Given this information, we know that both supply and demand are higher in August than in other months.

Given the supply and demand curves on the right, when the price of a good is $20, we say that the market is in competitive equilibrium. At this price, we know that the quantity supplied is equal to the quantity demanded.

If the only change in the market was that the price increased to $30, then we know that the quantity supplied will be greater than the quantity demanded, resulting in an excess supply, which is also known as a surplus.

Suppose instead that the price of the good dropped below the competitive price to a price of $15 per unit. If this were to occur, then the quantity supplied would be less than the quantity demanded, resulting in an excess demand, which is also known as a shortage.

Suppose a new off campus university apartment complex could rent its rooms on the open market for $900 a month. If instead the university chooses to cap the price of rooms to $500 a month for students, the result would be that quantity demanded would exceed the quantity supplied, resulting in a shortage.

Suppose the university is trying to determine the most efficient way to allocate the rooms such that those who value the rooms the most get them. Which of the following would you suggest as the most efficient?

Auctioning the rooms to the highest bidders.

The five major factors that shift the demand curve when they change are: tastes and preferences, income and wealth, availability and prices of related goods, number and scale of buyers, and buyers beliefs about the future.

The law of supply states that, in most cases, the quantity supplied of a good rises when the price of a good rises. This means we would expect a typical supply curve to be upward sloping.

In a perfectly competitive market, sellers cannot charge more than the market price and buyers cannot pay less than the market price.

In a perfectly competitive market, if one seller chooses to charge a price for its good that is slightly higher than the market price, then it will lose all or almost all of its customers.

Based on what happened at the Richmond event, it is apparent that at a price of $50, the quantity demanded of laptops exceeded the quantity supplied. This resulted in an excess demand for laptops.

Which of the following ways of distributing the laptops would be more efficient?

Auctioning off the laptops to the highest bidders, using a random lottery to decide who gets the laptops, and using flexible prices so those who value the laptop would pay more for it.

The concept of diminishing marginal benefits means that each additional unit consumed is worth less to you than the previous one.

The concept of diminishing marginal benefits holds true for goods that you like a lot.

Suppose you have a flashlight that takes three batteries to power it. If you buy the batteries one at a time, for which purchase will diminishing benefits set in?

When you buy the fourth battery.

Defining Macroeconomic Aggregates In Economics

Income per capita is income per person. It is calculated by dividing a nation’s aggregate income by the number of people in the country.

A recession is a period in which aggregate economic output fails. A worker is officially unemployed if he or she does not have a job, has actively looked for work in the prior 4 weeks, and is currently available for work. The unemployment rate is the factor of the labor force that is unemployed. National income accounts measure the level of aggregate economic activity in a country. The national income and product accounts is the system of national income accounts that is used by the US government. Gross domestic product is the market value of all the final goods and services produced in a country during a given period of time.

Two variables are related by an identity when the two variables are defined in a way that makes them mathematically identical. Factors of production are the inputs to the production process.

Each firm’s value added is the firm’s sales revenue, minus its purchases of intermediate products from other firms.

Consumption is the market value of consumption goods and consumption services that are bought by domestic households. Investment is the market value of new physical capital that is bought by domestic households and domestic firms. Government expenditure is the market value of government purchases of goods and services. Exports are the market value of all domestically produces goods and services that are purchases by households, firms, and governments in foreign countries. Imports are the market value of all foreign-produced goods and services that are sold to domestic households, domestic firms, and the domestic government. The national income accounting identity, \(Y = C + I G + X - M\), decomposes GDP into consumption + investment + government expenditure + exports - imports.

Labor income is any form of payment that compensates people for their work. Capital income is any form of payment that derives from owning physical or financial capital.

Gross national product is the market value of production generated by the factors of production-both capital and labor- possessed or owned by the residents of a particular nation.

Nominal GDP is the total value of production, using current market prices to determine the value of each unit that is produced. Real GDP is the total value of production using market prices from a specific base year to determine the value of each unit that is produced.

Real GDP growth is the growth rate of real GDP. The GDP deflator is 100 times the rate of nominal GDP to real GDP in the same year. It is a measure of how prices of goods and services produced in a country have risen since the base year.

The consumer price index is 100 times the ratio of the cost of buying a basket of consumer goods using target year prices divided by the cost of buying the same basket of consumer goods using base year prices.

The rate of increase in prices is the inflation rate. It is calculated as the year over year percentage increase in a price index.

Macroeconomics is the study of economic aggregates and the economy as a whole. An aggregate is a total. Macroeconomic studies total economic activity.

Gross domestic product is the market value of the final goods and services produced in a country during a particular period of time. GDP is defined in 3 equivalent ways: Production = Expenditure = Income. The circular flow diagram explains these identities and adds a fourth identical way of measuring economic activity: factors of production.

GDP is just a summary measure of economic activity and economic well being. GDP leaves many details out, including depreciation, home production, the underground economy, externalities, inequality, leisure, and cross-border movements of capital and labor. Nevertheless, residents of countries with relatively high levels of GDP per capita report relatively high levels of life satisfaction.

Economists distinguish nominal values from real values. Real GDP measures the market value of economic production holding prices fixed at those of a particular base year. The GDP deflator is a measure of the overall level of prices in the economy. The consumer price index is another measure of the overall level of prices. Both the GDP deflator and the CPI can be used to measure the overall rate at which prices are rising: the inflation rate.

Which of the following news stories would typically be studied in macroeconomics?

1. We believe inflation should rule monetary policy.
2. What if economic growth is no longer possible?
3. Expectations high for March employment.

Production based accounting estimates GDP by computing for each firm the difference between sales revenue and the purchase of intermediate products and then sums this difference across all firms. More formally, we say that production based accounting sums each firm;s value added.

Which of the following will be considered a final good in the calculation of US GDP?

Only the foot massages and defense equipment are final goods. The processors and dress shirts are considered intermediate goods since they are components of a final product or are not yet being purchased by their final user.

Items are classified as final goods if they are the end product in a chain of production.

When government statisticians gather and analyze data on the value added by the firms in the domestic economy, they are measuring GDP using the production based accounting method.

The national income accounting identity associated with the expenditure based accounting method is represented by \(y = c + i + g + x - m \)

Gross private domestic investment less private fixed investment gives inventory investment or changes in business inventory. 

The difference between gross private domestic investment and fixed private represents inventory investment. 

A country’s gross national product would exceed its gross domestic product when the production of domestically owned factors operating abroad exceeds the production of foreign owned factors operating in the US.

Ascot’s GNP is computed from its GDP by adding in the revenue earned by Ascot owned firms that operate in Delwich and subtracting the revenue earned by Delwich owned firms that operate in Ascot. The revenue of those Delwich owned firms operating in Ascot is found as a residual from the given facts about the Delwich economy.

Delwich GNP = Delwich GDP + revenue of Delwich owned firms in Ascot - revenue of ascot owned firms in Delwich.

240 = 210 + revenue of delwich owned firms in Ascot - 60

240 - 210 + 60 = Revenue of Delwich owned firms in Ascot

90 = revenue of Delwich owned firms in Ascot

With this variable the GNP for Ascot can be computed

Ascot GNP = Ascot GDP + revenue of Ascot firms in Delwich - revenue of Delwich firms in Ascot.

Which of the following are not included in GDP but probably should be?

1. The value of externalities
2. Home production

The conversion of nominal median household income into real median household income is done most simply by converting it into current 2020 dollars.

Value in 2020 dollars = price index in 2020 / price index in 1950 then multiply by value in 1950 dollars.

The GDP deflator is calculated by (Nominal GDP / Real GDP) * 100

Suppose for the year 2013 the economy of Uplandia has a nominal GDP of 6500 and a real GDP of 4875. For 2013 this economy’s GDP deflator is 133.3

Now suppose the GDP deflator in 2012 was 121.3.

Uplandia’s year over year inflation rate is 9.9%

 (133.3-121.3)/121.3 = .098 = 9.9% rounded

The intersection of nominal GDP and real GDP in a graph gives the point in time when the GDP deflator has a value of 100, also known as the base period. This is obviously when the nominal GDP and real GDP are equal.

The real GDP is found from the nominal GDP and GDP deflator in the following way:

Real GDP = (Nominal GDP / GDP Deflator) * 100

100 is the value assigned to the base year for index numbers.

National income accounting is a system of accounts designed to measure aggregate economic activity in a country.

What is the key difference between the consumer price index and the gdp deflator?

The two indexes measure price changes for different baskets of products.

Which one of the following is not in the circular flow diagram as one of the three systems of GDP measurement?

Taxes are shown as a flow from the private sector to the public sector.

You decide to cook your own meal rather than eat in a restaurant.

As a result, gdp estimates will decrease.

Aggregate Incomes

The GDP per capita is GDP divided by the total population. Purchasing power parity constructs the cost of a representative basket of commodities in each country and uses these relative costs for comparing income across countries.

GDP per worker is defined as GDP by the number of people in employment. Productivity refers to the value of goods and services that a worker generates for each hour of work.

The one dollar a day per person poverty line is a measure of absolute poverty used by economists and other social scientists to compare the extent of poverty across countries.

Human capital is each person’s stock of skills to produce output or economic value. Physical capital is the stock of all machines and buildings used for production. The physical capital stock of an economy is the value of equipment, structures, and other non-labor inputs used in production. Technology refers to a set of devices and practices that determine how efficiently an economy uses its labor and capital. An aggregate production function describes the relationship between the aggregate GDP of a nation and its factors of production.

Total efficiency units of labor is the product of the total number of workers in the economy and the average human capital of workers. The law of diminishing marginal product states that the marginal contribution of a factor of production to GDP diminishes when we increase the quantity used of that factor of production.

Research and development refers to the activities directed at improving scientific knowledge, generating new innovations, or implementing existing knowledge in production to improve the technology of a firm or an economy.

Efficiency of production refers to the ability of an economy to produce the maximal amount of output from a given amount of factors of production and knowledge.

GDP per capita, defined as aggregate income divided by total population, varies greatly across countries, with some nations have more than 40 times the GDP per capita of other nations.

GDP per capita across countries can be compared using exchange rate based measures, which rely on current exchange rates, or purchasing power parity based measures, which compare estimates of the cost of the representative basket of commodities in each country. The latter tend to be more reliable, as they more appropriately capture differences in relative prices across countries and are not subject to fluctuations resulting from changes in exchange rates. Though GDP per capita omits a wealth of other important information on health, schooling, inequality, and poverty, it provides a good summary of prosperity, and higher GDP per capita is typically correlated with higher life expectancy, better schooling, and lower poverty.

The aggregate production function links the GDP of a nation to its total efficiency units of labor, physical capital stock, technology, and efficiency of production. Greater efficiency units of labor and physical capital, as well as better technology and efficiency of production, increase GDP.

Though the total efficiency units of labor and physical capital stock matter a great deal for GDP, the most determinant of cross-country differences in GDP per worker appears to be differences in technology and the efficiency of production.

Suppose you are comparing the income per capita in the US and Ghana. You try two approaches. In the first approach, you convert the Ghana values into US dollars using the current exchange rate between the US dollar and the Ghanaian cedi. In the second approach, you also convert both values to US dollars using the purchasing power parity adjusted exchange rate. Which approach is likely to give you a more accurate picture of the living standards in both countries?

The second approach, because it takes into account the relative costs for each country.

Suppose that country A has higher real income per capita than country B. Explain why this does not imply that most citizens of country A have higher real income than most citizens of country B.

A higher degree of income inequality in country A may result in most of its citizens having incomes below the average income of country B.

Consider the following illustration in which each country has 10 citizens, labeled #1 through #10. The table gives the dollar real income of each citizen in each country. For country A, the real per capita income is $880, whole for country B the real per capita income is $825.

According to the table, 80 percent of the citizens in country A have incomes of $730 or less, which means only 20 percent of its citizens have an income greater than $730, compared to country B where 70 percent of its citizens have incomes greater than $730.

The following table lists 2012 GDP per capita for four countries. The data are given in the national currencies of the countries. It also lists the price of a big mac in local currency in each country in 2012. The price of a big mac in the US in 2012 was $4.30.

Using the big mac as a representative commodity common to the countries, calculate the purchasing power parity adjustment factor for each country, and then the PPP level of GDP per capita in each country.

To calculate the purchasing power parity adjustment factor, we use the following formula:

PPP-Adjustment factor = US price of big mac / local country price of big mac

The PPP adjustment factors for each country are as follows:

Norway= 4.30 / 41.00 = .105

Poland = 4.30 / 9.10 = .473

Turkey = 4.30 / 6.60 = .652

UK      = 4.30 / 2.49 = 1.727

To calculate the PPP GDP per capita, we use:

= PPP-adjustment factor * Local country per capita GDP

Norway = .105 * 579162 = 60812

Suppose you re given the following information for the country Lusitania:

Population = 288 million

Employment = 120 million

Real GDP in US dollars = 2476 billion

Real Income per capita = real gdp / total population

Real income per worker = real gdp / total workers

Using the information given in both of these tables to compare living standards in Lusitania and Arctica, you should use real income per capita.

Let’s assume the US dollar/mexican peso exchange rate is 1/15 pesos and the price of a big mac in the US is $3. Mexico’s GDP is 16696 billion pesos, and its population is 135 million people.

Assuming the countries have purchasing power parity, the price of a big mac in mexico is 45 pesos. (3 *15)

Mexican income per capita is 124 thousand pesos.

Mexican income per capita in US dollars is (3/15=.0667) = (.0667*124000=8258 Ud dollars)

In a particular study, economists at the world bank ranked some countries on the basis of GNP per capita as well as HDI. They also computed the difference between the ranks to have a comprehensive idea about the performance of these economies. Their observations on Switzerland and China for the year 1999 are given in part a and for Sweden in the years 1999 and 2012 in part b.

Does the information in the table below suggest , in any way, that people in China were better off than the people in Switzerland in 1999? Explain your answer.

The only unambiguous suggestion is that China’s HDI rank was much higher than its per capita income rank, while Switzerland’s HDI rank was lower than its per capita income rank. Without data on the actual rankings, little can be said regarding which people may have been better off.

What does the information in the table below suggest about the relationship between income per capita and HDI in a country?

It suggests that HDI in a prosperous country may be largely unrelated to income per capita.

Productivity is the value of output that a worker generates for each hour of work.

Productivity varies across countries because:

1. Human capital per worker varies substantially from country to country
2. The quantity of physical capital that workers can access varies greatly across countries.
3. The level of technology differs across countries.

Use the following diagram to explain the relationship between a country’s physical capital stock and GDP.

Both the increasing relationship between capital and output and the law of diminishing marginal product.

The aggregate production function, holding total efficiency units of labor constant.

Suppose that from period 1 to period 2, the unemployment rate in the economy increases. Everything else remains unchanged. The total efficiency units of labor will decrease because less workers are employed.

What are the consequences of this increase in unemployment for GDP?

Y1 > Y2

The aggregate production function is expressed as Y=F(K,H) where Y stands for real GDP, k is capital stock, and H is efficiency units of labor.

Suppose the aggregate production function in period 1 Y1 = F(K1,H1) and in period 2 is Y2 = F(K2,H2)

With an increase in unemployment, the efficiency units of labor will fall. This means that real  GDP will also fall, since there is a direct relationship between capital, labor, and aggregate output. This means that Y1 > Y2.

What are the consequences of this decrease in real GDP for real GDP per capita and real GDP per worker?

Real GDP per capita will decrease while the change in real GDP per worker is uncertain.

Suppose that there is technological advance from period 1 to period 2 but, at the same time, a decrease in the physical capital stock. 

Can you say whether real GDP will increase or decrease?

Not really, since the two items have offsetting effects.

Productivity varies across countries because of differences in:

1. Human capital
2. Technology
3. Physical capital

Human capital is each person’s stock of skills to produce output or economic value

Physical capital is the stock of all machines and buildings used for production

Technology are the devices and practices that determine how efficiently an economy uses its labor and capital.

Complete the formula for the aggregate production formula:

Y = F(K,H)

Y stands for real GDP

K is the physical capital stock of the nation

H is the efficiency units of labor used in production

F is best described as a relationship between the variables

What are the two components of technology?

1. A more efficient means of production
2. The knowledge of how to produce new products.

What policies can be used to raise real GDP in a country?

1. Increase technology
2. Raise physical capital
3. Improve efficiency in the allocation of resources

The US is currently a relatively rich country.

How do the following items support US economic strength?

Sam Walton, the founder of Walmart, is an example of the power of entrepreneurship, which creates economic growth.

Your university or college is an example of human capital, which contributes to economic growth.

The nation’s ports are examples of physical capital, which contributes to economic growth.

New developments that enable natural gas and oil fracking are examples of technology which contribute to economic growth.

Economic Growth

Economic growth measures how much real GDP per capita grows over time.

Today’s high levels of GDP per capita in many nations are a result of rapid economic growth over the past two centuries. Sustained economic growth relies on technological progress. There are sizable differences in the historical growth rates of different economies, which are largely responsible for their differences in the levels of real GDP per capita. Economic growth is a powerful tool for poverty reduction.

Economic growth is the increase in GDP per capita of an economy. The growth rate is the change in a quantity, for example, real GDP per capita, between two dates, relative to the baseline quantity. Exponential growth refers to a situation in which the growth process can be described by an approximately constant growth rate of a variable such as real GDP or real GDP per capita.

Catch-up growth refers to a process whereby relatively poorer nations increase their incomes by taking advantage of knowledge and technologies already invented in other, more technologically advanced countries. Sustained growth refers to a process whereby real GDP per capita grows at a positive and relatively steady rate for long periods of time. 

The saving rate designates the fraction of income that is saved. Technological change is the process of new technologies and new goods and services being invented, introduced, and used in the economy, enabling the economy to achieve a higher level of real GDP for given levels of physical capital stock and total efficiency units of labor. 

The subsistence level is the minimum level of income per person that is generally necessary for the individual to obtaIn enough calories, shelter, and clothing to survive. Fertility refers to the number of children per adult or per woman of childbearing age. 

The malthusian cycle refers to the pre-industrial pattern in which increases in aggregate incomes lead to an expanding population, which in turn, reduces income per capita and ultimately puts downward pressure on population. 

The demographic transition refers to the decline in fertility and number of children per family that many societies undergo as they transform from agriculture to industry. The industrial revolution denotes the series of innovations and their implementation in the production process that began at the end of the eighteenth century in Britain. 

Many countries, including the United States, have experienced rapid economic growth over the past 200 years, increasing their real GDP per capita several times over. For example, the current real GDP per capita is about 25 times the U.S. real GDP per capita in 1820. In addition, U.S. growth has been relatively sustained, meaning that GDP per capita has grown relatively steady, with the exception of the great depression and the decade following it.

Economic growth can sometimes take place rapidly due to catch-up growth, whereby relatively poorer nations increase their real GDP per capita by taking advantage of knowledge and technologies already invented in other, more advanced countries.

Economic growth results from an economy increasing its physical capital, raising the human capital of its workers, and improving its technology. Because of the diminishing marginal product of physical capital and limits of how much each worker can invest in his or her human capital before joining the workforce, sustained growth is generally impossible to achieve just by building up human and physical capital. Rather, the most plausible driver of sustained growth is technological progress. Empirical evidence also suggests that technological progress accounts for the bulk of the increase in real GDP per capita in the United States. 

Though the past 200 years have been characterized by sustained economic growth in many parts of the world, the preceding centuries did not experience steady growth. Instead, most economies during these times experienced Malthusian cycles: increases in GDP fueled population growth, which reduced the standard of living and subsequently acted as a check on further population growth by reducing fertility and survival. The world broke out of the Malthusian cycle through the industrial revolution, which started a process of rapid technological progress, underpinning the sustained growth of the past two centuries.

Economic growth has the capacity to significantly reduce poverty, provided that such growth is not associated with increased inequality. 

Catch-up growth is the process by which relatively poorer nations increase their incomes by taking advantage of the knowledge and technologies already invented in other technologically advanced nations.

An example of catch up growth is South Korea, which by 1970 had become poorer relative to the US, but over the last 40 years grew faster than the US, closing the gap that had opened up previously.

Sustained growth is the process where GDP per capita grows at a positive and relatively steady rate for long periods of time.

An example of sustained growth is the US, which demonstrated sustained growth between 1820 and 2007.

The growth equation is defined as:

\(Growth = \frac{Y_{t+1} - Y_t}{Y_t}\)

Using the equation for sustained growth above, explain why a country that has a very low per capita GDP can also have a very high growth rate.

A country with a very low per capita GDP can have a very high growth rate because mathematically, when the denominator is lower, even a small difference in the numerator will result in a large growth rate.

Consider a $100 increase in GDP per capita. In 2012 Niger had a GDP per capita of approximately $800, and the US had a GDP per capita of $50700. Calculate the corresponding growth rates for these two countries.

Niger’s growth rate is 12.50 percent. The US growth rate is .20 percent.

Thus, niger started out with a lower base and had a higher growth rate.

The saving rate in an economy is defined as the fraction of total income that households save.

Factors that help household decide whether to consume or save their incomes are:

1. Interest rate
2. Expectations about taxes
3. Expectations of future income growth

Household saving decisions impact investment in the economy by having a direct impact on investment, as saving is correlated with investment. 

Which factors explain economic growth in the US over the past few decades?

1. Human capital
2. Technology
3. Physical capital

Which factor is the most important contributor to growth in the US?

Technology

A relatively simple method of gauging the change in living standards over time with a country is to compute real GDP per capita.

This is done by dividing each value of real GDP by the associated population.

Real GDP per capita in 2018 =  18437100000000 / 327667595 = 56268

Real GDP per capita in 2023 =  20246400000000 / 336047315 = 60249

From 2018 to 2023 real GDP per capita increased at an average annual rate of 1.38%.

According to the rule of 70, the growth rate computed above, if maintained, would result in a doubling of real GDP per capita in 50.7 years.

Gross government saving reflects the status of the budget; a deficit is negative saving by government while a surplus is positive government saving.

Why was there no sustained economic growth before modern times, that is, before 1800?

The period before modern times was not stagnant, but it was not characterized by sustained growth. One of the possible explanations is the fact that the pace of technological change was much slower than in more recent times. Also, any increases in aggregate income were offset by increases in population, keeping per capita income low.

1. Increases in aggregate income were offset by increases in population, keeping per capita income low.
2. The pace of technological change was much slower than in modern times.

There was no sustained growth in living standards prior to the industrial revolution because:

With output increasing at a decreasing rate, it is not possible to increase living standards, especially as the population continues to grow.

The industrial revolution had a positive impact on living standards:

Because of the introduction of new capital and technology that shifted the production curve upward.

Note that output increases at a decreasing rate, as is also the case with capital. This does not allow for an increase in living standards, especially as the population continues to grow.

Before 1800, a pattern developed showing that increases in aggregate income led to an expanding population, which in turn reduced income per capita and put downward pressure on the population. The pattern is known as the Malthusian cycle.

The Malthusian cycle was common prior to the Industrial Revolution.

What factors explain the dramatic increases in life expectancy that we saw in most countries in the twentieth century?

1. Scientific breakthrough leading to the development of antibiotics and vaccines
2. Innovations in disease control, including the use of DDT against malaria
3. The establishment of simple but effective medical and public health practices

Assume a society consists of two economic groups: one group is rich and the other group is poor. Suppose that 50 percent of the population is rich while the other 50 percent of the population is poor.

Scenario A: the rich have 75000 each while the poor have 3000 each

Scenario B: the rich have 8000 each and the poor have 850 each

If you only care about average income and not about equality, you would prefer Scenario A which has an average income of 39000.

Now suppose that you only care about inequality.

In this case, you would prefer Scenario B, which has a rich to poor ratio of 9.4

Finally, suppose you only care about living standards

In this case, you would prefer Scenario A, because it has lower poverty

To find the average annual rate of return in real GDP per capita:

\[ \frac{X_2023}{X_2018}^{\frac{1}{5} -1 = g \]

The formula for the rule of 70 is:

\[ \text{number of years to double} = \frac{70}{\text{growth rate]} \]

What did Maltheus predict about economic growth?

1. The number of children per family would adjust so that income would remain close to a subsistence level.

Did his predictions come true/

1. No because he failed to account for the demographic transition and the impact of the Industrial Revolution

The saving rate in an economy is defined as the fraction of total income that households save.

Factors that help households decide whether to consumer or save their income are:

1. Expectations about taxes
2. The interest rate
3. Expectations of future income growth

Household saving decisions impact investment in the economy by having

1. A direct impact on investment as saving is correlated with investment

In the 1980’s the saving rate of Japan was extremely high. The savings rate ranged between 30 percent and 32 percent. Since saving leads to investment, is a very high saving rate always good for the economy?

1. No, a high saving rate cannot lead to sustained growth because there is a maximum amount of aggregate income than an economy can achieve by increasing saving, since the economy can never exceed a saving rate of 100 percent.

What factors explain the dramatic increase in life expectancy that we saw in most countries in the 20th century?

1. Scientific breakthroughs leading to the development of antibiotics and vaccines.
2. Innovations in disease control including the use of DDT against malaria
3. The establishment of simple but effective medical and public health practices.

Catch-up growth is the process by which relatively poorer nations increase their incomes by taking advantage of the knowledge and technologies already invented in other technologically advanced nations.

An example of catch up growth is South Korea, which by 1970 had become poorer relative to the US but over the ;ast 40 years grew faster than the US closing the gap that had opened up previously. 

Sustained growth is the process where GDP per capita grows at a positive and relatively steady rate for long periods of time.

An example of sustained growth is the US which demonstrated sustained growth between 1820 and 2007

Ln y(t) = ln y(0) + gt 

Ln y(t) = ln 41365 + 4.72(t)

Why Some Countries Are Poorer Than Others

Proximate causes of prosperity link prosperity and poverty of nations to the levels of inputs, whereas fundamental causes look for the reasons these are such differences in the levels of inputs. 

The geography, culture, and institutions hypotheses advance different fundamental causes of poverty. 

Inclusive and extractive economic institutions affect economic development. 

Creative destruction is integral to economic growth through technological change.

Reversal of fortune evidence provides support for the institution's hypothesis.

Proximate causes of prosperity are high levels of factors such as human capital, physical capital, and technology that result in a high level of real GDP per capita.

Fundamental causes of prosperity are factors that are at the root of the differences in the proximate causes of prosperity. 

The geography hypothesis claims that differences in geography, climate, and ecology are ultimately responsible for the major differences in prosperity observed across the world.

The culture hypothesis claims that different values and culture beliefs fundamentally cause the differences in prosperity around the world.

Institutions are the formal and informal rules governing the organization of a society, including its laws and regulations. 

The institutions hypothesis claims that differences in institutions-that is, in the way societies have organized themselves and shaped the incentives of individuals and businesses-are at the root of the differences in prosperity across the world. 

Private property rights mean that individuals can own businesses and assets and their ownership is secure.

Economic institutions are those aspects of the society’s rules that concern economic transactions. 

Inclusive economic institutions protect private property, uphold law and order, allow and enforce private contracts, and allow free entry into new lines of business and occupations.

Extractive economic institutions do not protect property rights, do not uphold contracts, and interfere with the workings of the markets. They also erect significant entry barriers into businesses and occupations.

Political institutions are the aspects of the society’s rules that concern the allocation of political power and the constraints on the exercise of political power. 

Creative destruction refers to the process by which new technologies replace older ones, new businesses replace established companies, and new skills make old ones redundant.

Political creative destruction refers to the process by which economic growth destabilizes economic regimes and reduces the political power of rulers.

Physical capital, human capital, and technology are proximate causes of prosperity in the sense that, though they determine whether a nation is prosperous, they are themselves determined by other, deeper factors. Put differently, if we want to understand why some nations are poor, we have to ask why they do not sufficiently invest in physical capital or human capital and why they do not adopt the best technologies and organize their production efficiently. 

The fundamental causes of prosperity include factors that potentially influence the physical and human capital investment and technologies of nations and, via this channel, shape their prosperity.

Three leading hypotheses about the fundamental causes of prosperity are geography, culture, and institutions. According to the geography hypothesis, geographic aspects determine whether a nation can be prosperous. According to the culture hypothesis, it is the cultural values of the country’s people that powerfully determine its potential for prosperity. According to the institution's hypothesis, it is the institutions that are central to prosperity.

Inclusive economic institutions are those that provide secure property rights, establish a judiciary system that allows and facilitates private contracting and financial transactions, and maintain relatively free entry into different businesses and occupations. In contrast, extractive economic institutions create insecure property rights, a partial judicial system, and entry barriers that protect the businesses and incomes of a small segment of society at the expense of the rest. According to the institution's hypothesis, inclusive economic institutions tend to generate prosperity, while extractive economic institutions do not.

Though the inequalities in GDP per capita around the world have multiple causes, the evidence from the economic experiences of former European colonies suggests that institutional factors, and not geography, are central to explaining these disparities. In fact, the major patterns cannot be explained by geographic factors.

Foreign aid can be useful to temporarily alleviate extreme poverty or manage crises but is unlikely to be a solution to poor economic development in many parts of the world. This is because aid largely fails to address the institutional roots of poverty.

According to the geography hypothesis, incomes in poor countries are unlikely to be changed, because ecology is largely out of their control.

The culture hypothesis states societal values are responsible for differences in prosperity.

In the context of this chapter, what is meant by an institution?

Regulations

Which of the following is one of the three important elements that define institutions?

They are determined by individuals.

The institution hypothesis explains the difference in prosperity among nations is due to the way societies shape incentives.

Proximate causes of Borundo’s lack of prosperity are:

1. The workforce is not skilled
2. School enrollment is low

Fundamental causes of Borundo’s lack of prosperity are:

1. The geography is not favorable
2. There are few constraints to the exercise of power
3. The farmers have limited incentives to increase output

To say that private property rights are well enforced in an economy means that individuals can securely hold assets.

Private property rights foster economic development by providing incentives to borrow money

The return to entrepreneurship curve shows the number of entrepreneurs with at least a particular level of returns.

The opportunity cost of entrepreneurship is the value to a potential entrepreneur of her best alternate activity.

Parts of the world that were relatively more prosperous 500 years ago have experienced a reversal of fortune and are relatively poorer today. What factors could explain this?

1. The establishment of inclusive institutions by European colonialists in areas previously not well developed. 
2. The establishment in those previously prosperous places of extractive institutions by European colonialists.

Would Zimbabwe be considered to have extractive or inclusive institutions?

Extractive institutions, because it doesn’t protect property.

Why would a government undertake policies that would adversely affect the lives of its citizens?

To maintain its power.

The equilibrium number of entrepreneurs is where the return-to-entrepreneurship curve equals the cost-of-entrepreneurship curve.

\(R=C\)

\(900-100N = 100+150N\)

\(800=250N\)

\(N = 3.2 \text{thousand}\)

The equilibrium returns to entrepreneurship is then that level of returns at the equilibrium number of entrepreneurs.

\(R=900-100N\)

\(R=900-100(3.2)\)

\(R=900-320\)

\(R=$580 \text{thousand}\)

With the license fee, the cost of entrepreneurship becomes:

\(C=100+150N + 50\)

\(C=150+150N\)

The equilibrium number of entrepreneurs is where the return to entrepreneurship curve equals the cost of entrepreneurship curve with the license fee included.

\(R=C\)

\(900-100N=150+150N\)

\(750=250N\)

\(N=3 \text{thousand}\)

The equilibrium returns to entrepreneurship is then that level of returns at the equilibrium number of entrepreneurs:

\(R=900-100N\)

\(R=900-100(3)\)

\(R=900-300\)

\(R=$600 \text{thousand}\)

Suppose a country has well developed private property rights for entrepreneurs, but a large fraction of the population does not have access to education and thus cannot become entrepreneurs and would have low productivity as workers. Would you say this country has inclusive or extractive economic institutions?

1. Extractive institutions because barriers block access to education

Could the country achieve a high level of economic development?

1. No, the country’s extractive institutions limit prosperity

Based on the information in the chapter, and perhaps your own reading, explain why foreign aid designed to spur investment usually does not work.

1. It is frequently diverted to corrupt officials

The geography hypothesis states climate is responsible for differences in prosperity.

Unlike extractive economic institutions, inclusive economic institutions promote open markets

Employment and Unemployment in Economics

Potential workers fall into three categories: employed, unemployed, and not in the labor force. 

The level of employment and the level of wages are determined by firms’ labor demand, workers labor supply, and various wage rigidities. 

Frictional unemployment arises because it takes time for an unemployed worker to learn about the condition of the labor market and find a new job.

Structural unemployment arises because wage rigidities prevent the quantity of labor demanded from matching the quantity of labor supplied. 

Cyclical unemployment is the difference between the unemployment rate and its long term average.

Potential workers include everyone in the general population with three exceptions: children under 16 years of age, people on active duty in the military, and people who are living in institutions where the residents have restricted personal mobility, like long term medical care facilities or prisons. 

A person holding a full time or part time job is employed.

A worker is unemployed if she does not have a job, has actively looked for work in the prior four weeks, and is currently available for work.

The labor force is the sum of all employed and unemployed workers.

The unemployment rate is the percentage of the labor force that is unemployed.

The labor force participation rate is the percentage of potential workers who are in the labor force. 

The value of the marginal product of labor is the contribution of an additional worker to a firm’s revenues.

The labor demand curve depicts the relationship between the quantity of labor demanded and the wage. The value of the marginal product of labor is also the labor demand curve because they both show how the quantity of labor demanded varies with the wage.

The labor supply curve represents the relationship between the quantity of labor supplied and the wage.

The competitive equilibrium wage is the market clearing wage. At this wage, every worker who wants a job can find one: the quantity of labor demanded matches the quantity of labor supplied.

Job search refers to the activities that workers undertake to find appropriate jobs.

Frictional unemployment refers to the unemployment that arises because workers have imperfect information about available jobs and need to engage in a time consuming process of job search.

Wage rigidity refers to the condition in which the market wage is held above the competitive equilibrium level that would clear the labor market.

Structural unemployment arises when the quantity of labor supplied persistently exceeds the quantity of labor demanded. 

Collective bargaining refers to the contract between firms and labor unions.

Efficiency wages are wages above the lowest pay that workers would accept: employers use them to increase motivation and productivity. 

Downward wage rigidity arises when workers resist a cut in their wage and firms respond to this resistance by holding nominal wages fixed.

The natural rate of unemployment is the rate of unemployment around which a healthy economy fluctuates.

The long run rate of unemployment is the average historical rate of unemployment.

Cyclical unemployment is the deviation of the actual unemployment rate from the long run rate of unemployment.

Potential workers are defined as the civilian non-institutional population ages 16 and older. Those holding a paid full time or part time job are classified as employed, while those without a paid job who have actively looked for work are unemployed. Potential workers who are employed and unemployed make up the labor force, while the rest of the potential workers are classified as out of the labor force. The unemployment rate is the percentage of the labor force that is unemployed.

The unemployment rate fluctuates significantly over time. It is higher during and in the immediate aftermath of recessions.

Employment is determined by labor demand and labor supply. The labor demand curve is downward-sloping because of the diminishing marginal product of labor and profit maximization by firms. In contrast, the labor supply curve tends to be upward-sloping because higher wages generally encourage workers to supply even more hours to the labor market.

The competitive labor market equilibrium is given by the intersection of the labor demand and labor supply curves. The competitive equilibrium wage is also called the market clearing wage.

In a competitive labor market equilibrium in which all workers know the market clearing wage, there will be very little unemployment because every worker willing to work at the market clearing wage can find a job. Workers who are not willing to work at the market clearing wage will stop searching and will therefore not be counted as unemployed.

Frictional unemployment exists because workers need time to learn about the condition of the labrador market, and search for a job that suits them. Even in a healthy labor market, there will always be some unemployed workers in the process of changing jobs, or finding a new job after losing their previous one, or finding their first job after entry into the labor market.

Structural unemployment results when the market wage is above the market clearing level, causing the quantity of labor supplied to be greater than the quantity of labor demanded. This is often referred to as wage rigidity. It can result from institutional features of the labor market like minimum wage legislation or collective bargaining. More importantly, it can result from efficiency wages or from downward wage rigidity. Efficiency wages arise when employers pay wages higher than the market clearing wage to increase worker productivity. Downward wage rigidity arises because of the unwillingness of workers to accept wage cuts, which prevents wages from immediately falling in response to a leftward shift of the labor demand curve.

The most important cause of unemployment fluctuations is a shifting labor demand curve. When wages are flexible, a shift to the left of the labor demand curve reduces both employment and wages but does not increase unemployment because the labor market clears. When wages are rigid, the same leftward shift creates a larger decline in employment because the wage does not decline and unemployment increases.

The natural state of unemployment is the rate of unemployment around which a healthy economy fluctuates. The long run rate of unemployment is the average historical rate of unemployment, which tends to be higher than the natural rate of unemployment due to the presence of structural unemployment. Cyclical unemployment is the difference between the current rate of unemployment and the long run rate of unemployment. Cyclical unemployment is positive in recessions and negative in economic booms. 

Explain whether each of these individuals will be counted as a part of the labor force.

Alex is a full time student that volunteers on the weekends at an animal shelter.

John recently retired after working for the same company for 30 years.

We know that Alex is not in the labor force, and we know that John is not in the labor force.

The fact that unemployment is lower among workers with a relatively higher level of education can be explained in part by the principle of optimization.

What other reasons might explain why unemployment is lower among workers with a relatively higher level of education?

1. More educated workers have a higher opportunity cost of time
2. Workers with a higher level of education are in greater demand by firms
3. More educated workers have more human capital

In February 2014, the US added 175000 jobs to the economy. Given this information, what can we say about the unemployment rate of the country?

1. It may increase, decrease, or not change depending on how many people started searching for jobs during the month.

\[\text{Unemployment Rate} = 100% * \frac{\text{Unemployed}}{\text{Labor Force}} \]

When employed individuals become unemployed, the civilian labor force

1. Does not change

Given that the unemployment level of men exceeds the unemployment level of women, it follows that the unemployment rate for men will be higher than the unemployment rate for women. 

1. This claim is false

Suppose that a deep and prolonged recession induces some job seekers to discontinue their job search efforts due to the belief that no jobs are available for them. These individuals are known as:

1. Discouraged workers

An increase in discouraged workers, all else constant, will cause the unemployment rates computed above to decrease

The value of the marginal product of labor is the:

1. Market value of a worker’s additional output for a firm

An additional worker gives $80 more revenue a day so the marginal product of labor is:

1. $80

The value of the marginal product of labor is the market value of each worker, or marginal product. To find the value of the marginal product of labor, you can multiply the additional output produced by each hour of labor times the value of the good being produced.

The labor supply curve shows that the quantity of labor supplied will decrease as:

1.  wages decrease

This results in a labor supply curve that is:

1. Upward sloping

The labor supply curve is derived from the concept that:

1. As wages increase, the opportunity cost of leisure increases, leading people to work more hours

Which of the following is an example of what economists refer to as job search?

1. A person who applies for a high paying job but does not qualify, so she begins searching for an appropriate position
2. People that engage in the job hunt by sending out resumes
3. An individual that engages in the job hunt by determining who is hiring and how much they pay

What type of unemployment does job search lead to?

1. Frictional unemployment

Which of the following is true regarding wage rigidity?

1. Wage rigidity occurs when wages are held fixed above the competitive equilibrium level that clears the labor market.

Which of the following is not one of the factors that can increase wage rigidity in the labor market?

1. An increase in the time needed to search for available jobs

An economy’s natural rate of unemployment reflects the combined effect of frictional and:

1. Structural unemployment

Whenever the economy’s actual rate of unemployment falls below its natural rate as was the case in May 2023, it can be deduced that:

1. Potential real gdp falls below actual real gdp for that period

Recall that the natural rate of unemployment is assumed to represent the sum of frictional and structural unemployment. The third type of unemployment, cyclical unemployment, is caused by a business cycle contraction.

The cyclical rate of unemployment can be estimated by subtracting the natural rate of unemployment from the actual rate of unemployment.

\[ \text{cyclical rate} = 3.7 - 4.4 = -0.7 \]

Be sure to convert 2% to decimal before multiplying by the cyclical unemployment rate. This result is then multiplied by the value of potential real gdp to obtain the answer.

Given the cyclical unemployment rate recorded above, this translates into actual real gdp deviating from potential real gdp by:

\[ -1 * (-.07 * .02) * 20541.3 = $287.6 \text{billion} \]

Credit Markets

The credit market matches borrowers and savers.

The credit market equilibrium determines the real interest rates.

Banks and other financial intermediaries have three key functions: identifying profitable lending opportunities, using short run deposits to make long run investments, and managing the amount and distribution of risk.

Banks become insolvent when the value of their liabilities exceeds the values of their assets.

Debtors, or borrowers, are economic agents who borrow funds.

Credit refers to the loans that the debtor receives.

The interest rate is the annual cost of a 1$ loan.

The real interest rate is the nominal interest rate minus the inflation rate.

The credit demand curve is the schedule that reports the relationship between the quantity of credit demanded and the real interest rate.

The credit supply curve is the schedule that reports the relationship between the quantity of credit supplied and the real interest rate.

The credit market is where borrowers obtain funds from savers.

Securities are financial contracts. They may allocate ownership rights of a company or promise payments to lenders. 

Financial intermediaries channel funds from suppliers of financial capital to users of financial capital. 

Bank reserves consist of vault cash and reserves held at the federal reserve bank. 

Demand deposits are funds that depositors can access on demand by withdrawing money from the bank, writing checks, or using their debit cards.

Stockholders’ equity is the difference between a bank’s total assets and its total liabilities.

Maturity refers to the time until debt must be repaid.

Maturity transformation is the process by which banks take short maturity liabilities and invest in long maturity assets.

A bank becomes insolvent when the value of the bank’s assets is less than the value of its liabilities.

A bank is solvent when the value of the bank’s assets is greater than the value of its liabilities. 

A bank run occurs when a bank experiences an extraordinarily large volume of withdrawals driven by a concern that the bank will run out of liquid assets with which to pay withdrawals.

Credit is essential for the efficient allocation of resources in the economy. Credit allows firms to borrow for investment or households to borrow to purchase a home.

The relevant price in the credit market is the real interest rate rather than the nominal interest rate. The real interest rate adjusts the price of borrowing or lending for the effects of inflation, thus reflecting the economic trade-off between the present or the future that borrowers and savers face.

Firms, households, and governments use the credit market for borrowing. The credit demand curve summarizes the relationship between the quantity of credit demanded by borrowers and the real interest rate. The credit demand curve results from the optimizing behavior of these borrowers.

The credit supply curve summarizes the relationship between the quantity of credit supplied and the real interest rate and also results from optimizing behavior, this time of savers. Savers trade off consumption today for consumption in the future, taking into account the reward for delaying consumption-the real interest rate.

The intersection of the credit demand curve and the credit supply curve is the credit market equilibrium. At the equilibrium real interest rate, the quantity of credit demanded is equal to the quantity of credit supplied.

Saving and borrowing in the credit market are intermediated by banks and other financial intermediaries. Banks play three key roles in the economy. They find credit worth borrowers and channel savings of depositors to them. They transform the maturity structure in the economy by collecting money from savers in the form of short term demand deposits and investing money in long term projects. They manage risk by holding a diversified portfolio and by transferring risk from depositors to stockholders.

Governments provide deposit insurance that reduces the likelihood of bank runs, and governments intervene to save failing banks in order to avert widespread crises. The US economy has experienced four major waves of bank failures since 1900. 

Firms, households, and governments use the credit market for borrowing. The credit demand curve shows the relationship between the quantity of credit demanded and the real interest rate.    The credit demand curve slopes downward because:

1.  a higher real interest rate reduces a borrowing firm’s profit and hence its willingness to borrow.

A shift in the credit demand curve can be caused by:

1. Changes in household preferences or expectations
2. Changes in perceived business opportunities for firms
3. Changes in government policy

Households and firms with savings lend money to banks and other financial institutions. The credit supply curve shows the relationship between the quantity of credit supplied and the real interest rate. The credit supply curve slopes upward because a:

1. Higher real interest rate induces more investment and higher real interest rate discourages current consumption

A shift in the credit supply curve can be caused by:

1. An aging population that is ill prepared for retirement
2. A heightened desire on the part of firms to internally fund their future activities
3. An elevated perception on the part of households that the future may hold many rainy days

Optimizing economic agents use the real interest rate when thinking about the economic costs and returns of a loan. Suppose the rate paid by banks on savings accounts is 0.3 percent at a time when inflation is around 1.3 percent. For the saver, the real rate of interest on his or her savings is:

1. -1.00 percent

If banks expect that the rate of inflation in the long run will be 4.3 percent and they want a real return of 5.5 percent on a certain category of loans, then the nominal rate they should charge borrowers on those loans is:

1. 9.80 percent

If the economy experiences an unexpectedly low rate of inflation, the group that would tend to benefit is:

1. Creditors, people or institutions that are owed money

If the economy experiences an unexpectedly high rate of inflation, the group that would tend to benefit is:

1. Debtors, people or businesses who owe money

If \(\pi\) denotes the rate of inflation and \( i \) denotes the nominal rate of interest, then the amount a borrower repays in a year on a one dollar loan is:

1. 1 + i

The inflation adjusted purchasing power of the originally borrowed dollar is:

1. 1 + \(\pi\)

The inflation adjusted purchasing power of the originally borrowed dollar is subtracted from the amount a borrower repays in a year on a one dollar loan. The result is:

1. Real price of the loan
2. Real interest rate
3. Inflation adjusted cost of the loan

The figure on the right shows the credit market in equilibrium with the real interest rate at 5 percent and the flow of credit equal to 50 billion. 

Now suppose that households feel less pressure to save. With this situation, at the previously determined equilibrium real interest rate,

1. We will find a credit shortage
2. Causing the real interest rate to increase

When equilibrium is restored in the credit market the flow of credit will be:

1. Higher

The figure on the right shows the credit market in equilibrium with the real interest rate at 5 percent and the flow of credit equal to 25 billion.

Now suppose that government budget deficits fall dramatically.

With this situation at the previously determined equilibrium real interest rate:

1. We will find a credit surplus
2. Causing the real rate to decrease

When equilibrium is restored in the credit market the flow of credit will be:

1. Lower

Assets:

1. Reserves
2. Cash equivalents
3. Long term investments

Liabilities and Stockholder Equity

1. Demand deposits
2. Short term borrowing
3. Long term debt
4. Stockholder equity

Which of the following are functions banks perform as financial intermediaries in the economy:

1. Identify profitable lending opportunities
2. Manage risk through diversification strategies
3. Transform short term liabilities into long term assets

What is deposit insurance?

1. A program implemented in most countries to protect bank depositors, in full or in part, from losses caused by a bank’s inability to pay its withdrawals

Excluding cases where banks had accumulated a lot of non deposit liabilities that are not covered by fdic insurance, would analysts generally agree that deposit insurance has been successful in preventing bank runs?

1. Yes, since bank runs and bank failures have been relatively rare since the advent of deposit insurance

Banks that practice narrow banking match the maturity of their investments with the term of the deposits that they collect from the public. In other words, narrow banks take short maturity deposits and invest in assets that carry a low level of risk and are also of short term maturity, like short term government debt. Suppose that all fdic insured banks decide to adopt narrow banking. How would narrow banking reduce the level of risk in the banking system?

1. It would reduce risk in the banking system by reducing the likelihood of bank runs and liquidity problems for banks.

 If narrow banking would reduce systemic risk, why does society allow banks to practice maturity transformation?

1. Banks still practice maturity transformation simply because it is generally very profitable to do so, and it enables society to undertake significant long term investment.

Based on the information given in this chapter, which of the following factors could explain why asset prices fluctuate?

1. There are psychological factors and biases that can produce excessive reactions to booms and busts
2. Fluctuations reflect the rational appraisals by investors of new information relevant to asset profitability 

When a bank experiences withdrawals of deposits and short term loans by firms and other banks, the situation is described as:

1. An institutional bank run

When large firms and the general banking community lose confidence in a weak bank, fdic insurance is:

1. Incapable of alleviating the situation

What is the shadow banking system?

1. Nonbank financial institutions that behave like banks in many respects
2. A group of several thousand disparate nonbank financial intermediaries
3. Financial institutions that make loans from funds raised by means other than by accepting deposits

Maturity transformation is the process by which banks:

1. Transform short term liabilities into long term investments

Firms, households, and governments use the credit market for borrowing. The credit demand curve shows the relationship between the quantity demanded and the real interest rate. The credit demand curve slopes downward because:

1. A lower real interest rate raises a borrowing firm’s profit and hence its willingness to borrow

A shift in the credit demand curve can be caused by:

1. Changes in government policy
2. Changes in perceived business opportunities for firms
3. Changes in household preferences or expectations

Monetary System

Money has three key roles: serving as a medium of exchange, a store of value, and a unit of account.

The quantity theory of money describes the relationships among the money supply, velocity, prices, and real GDP.

The Federal Reserve, the US central bank, has a dual mandate-low inflation and maximum employment.

The federal reserve holds the reserves of private banks.

The Federal Reserve’s management of private bank reserves enables the Fed to do three things: set a key short term interest rate, influence the money supply and the interest rate, and influence the long term real interest rate.

Money is the asset that people use to make and receive payments when buying and selling goods and services.

A medium of exchange is an asset that can be traded for goods and services.

A store of value is an asset that enables people to transfer purchasing power into the future.

A unit of account is a universal yardstick that is used for expressing the worth of different goods and services.

Fiat money refers to something that is used as legal tender by government decree and is not backed by a physical commodity like gold or silver.

The money supply adds together currency in circulation, checking accounts, saving accounts, travelers’ checks, and money market accounts. It is sometimes referred to as M2.

The quantity theory of money assumes that the growth rate of the money supply and the growth rate of the nominal GDP are the same over the long run.

The deflation rate is the rate of decrease of a price index.

Government revenue obtained from printing currency is called seigniorage.

The real wage is the nominal wage divided by a price index, like the consumer price index.

The central bank is the government institution that monitors financial institutions, controls key interest rates, and indirectly controls the money supply. The activities constitute monetary policy.

The Federal Reserve bank is the name of the central bank in the US.

Liquidity refers to funds available for immediate repayment. To express the same concept in a slightly different way, funds are liquid if they are immediately available for payment.

The federal funds market refers to the market where banks obtain overnight loans of reserves from one another.

The federal funds rate is the interest rate that banks charge each other for overnight loans in the federal funds market. The funds being lent are reserves at the Federal Reserve Bank.

Private banks that hold reserves at the Federal Reserve, including reserves that they have borrowed, are paid interest on those hold reserves. This is called interest on reserves, and this interest rate is set by the Federal Reserve.

The point where the supply and demand curves cross in the federal funds market is the federal funds market equilibrium. 

If the Federal Reserve wishes to increase the level of reserves that private banks hold, it offers to buy government bonds from the private banks, and in return it gives the private banks more electronic reserves. If the Federal Reserve wishes to decrease the level of reserves, it offers to sell government bonds to the private banks and in return the private banks give back some of their reserves. By buying or selling government bonds, the Federal Reserve shifts the vertical supply curve in the federal funds market and thereby controls the level of reserves. These transactions are referred to as open market transactions.

The long term real interest rate is the long term nominal interest rate minus the long term inflation rate.

The realized real interest rate is the nominal interest rate minus the realized rate of inflation.

The expected real interest rate is the nominal interest rate minus the expected rate of inflation.

Economic agents’ inflation expectations are their beliefs about future inflation rates.

Money plays a vital role in our lives. It makes a range of economic transactions possible, simultaneously serving as a medium of exchange that can be traded for goods and services, a store of value that enables us to save and transfer purchasing power into the future, and a common unit of account that expresses the price of different goods and services. 

The money supply is the quantity of money that individuals can immediately use in transactions. The money supply is defined as the sum of currency in circulation and the balances of most bank accounts at private banks. This measure of the money supply is referred to as M2. This measure excludes all forms of bank reserves. Specifically, the money supply excludes bank reserves of private banks on deposit at the Federal Reserve.

The quantity theory of money links the money supply to nominal GDP, which is the value of total output in the economy measured at current prices. The quantity theory of money implies that the long term inflation rate equals the long run growth rate of the money supply minus the long run growth rate of real GDP.

At a fixed growth rate of real GDP, faster growth of the money supply leads to inflation and hyperinflation. Inflationary growth in the money supply generates social costs that firms incur as they make frequent price changes and price controls that create supply disruptions, shortages, and inefficient queuing. Moderate growth in the money supply generates certain benefits for society including seigniorage. Moderate inflation also enables employers to lower real wages without cutting nominal wages. Moderate inflation also makes it easier for the Federal Reserve to lower the real interest rate. Lower real wages and lower real interest rates stimulate growth of real GDP.

Central banks, such as the Federal Reserve bank in the US, attempt to keep inflation at a low and stable level and also try to maximize the sustainable level of employment.

The Federal Reserve regulates banks, implements interbank payments, and attempts to influence macroeconomic fluctuations.

The Federal Reserve holds the reserve of private banks. The management of these private bank reserves is one of the most important roles that the Federal Reserve plays. It’s management of private bank reserves enables it to influence interest rates, the inflation rate, and the level of employment.

The Federal Reserve has many policy levers that enable it to influence the market for bank reserves, the federal funds rate, including shifting the quantity of reserves supplied, which is referred to as open market operations and changing the interest on reserves which shifts the demand curve for reserves.

How does fiat money differ from commodities like gold and silver that were used as money?

1. Fiat money is intrinsically worthless whereas gold and silver have intrinsic value

If fiat money is intrinsically worthless, then why is it valuable?

1. Fiat money is used as legal tender by government decree and other people will accept it as payment for transactions

Barter is a method of exchange whereby goods and services are traded directly for other goods and services without the use of money or any other medium of exchange. Suppose you need to get your house painted. You register with a barter website and want to offer your car cleaning services to someone who will paint your house in return. What are the problems you are likely to encounter?

1. It may take a lot of time to negotiate and finally settle on a deal that you both find fair
2. You might find it difficult to find someone who needs you to wash his car and is willing to paint your house in return
3. It might be difficult to agree on how many car washes is equivalent to painting a house

Some barter websites allow the use of barter dollars. The registration fee that you pay to a barter website gets converted into barter dollars that can be exchanged with other users to buy goods and services. Would the use of barter dollars resolve the problems you identified above?

1. Yes, because you could both pay and be paid in barter dollars

Money makes a variety of economic transactions possible. In the following three situations, determine whether money is involved in the transaction. In prison camps during World War II, and in some prisons today, cigarettes circulate among prisoners. For example, today a cell phone might cost 600 cigarettes, whereas a magazine might cost two cigarettes. Which functions of money are cigarettes fulfilling in this case?

1. Unit of account
2. Store of value
3. Medium of exchange

Over the last 50 years, credit cards have become an increasingly popular way for people to purchase goods and services. Are credit cards themselves money?

1. No, because credit cards are not assets

Almost every day, many people sign their names to little pieces of paper called checks, which are then accepted in exchange for goods and services. Do these checks constitute money?

1. No, because checks simply represent a means of access to money, not money itself.

The m1 money stock is the sum of three components. Which of the four components in the table are part of m1?

1. Currency component of m1 
2. Demand deposits
3. Other checkable deposits

Based on the data above, what is 61 percent of m1?

1. Other checkable deposits

The graph to the right shows the m1 money supply measured at two different intervals: weekly and monthly. Use the graph to determine which of the following statements is true.

1. M1 fluctuates quite a bit from week to week, but is fairly stable month to month

The most recent observations of these variables are:

1. M2-20852.4
2. Retail money market funds=144.7
3. Small denomination time deposits=797.2

Subtracting the last two from m2 yields an m1 equal to 18610.5

Other liquid deposits 11327.8 and demand deposits 5030.5 are components of m1

If consumers were to shift funds from checking accounts to saving accounts, which of the following is true?

Recall that m1 is a component of m2; thus, a change in any component of m1, such as checking accounts, is also a change in m2. On the other hand, m2 has components, such as saving accounts, that are not a part of m1.

1. The movement of funds from checking accounts, a component of m1, to saving accounts decreases m1 but leaves m2 unchanged.

Recall the discussion in the chapter about the quantity theory of money. The quantity theory of money assumes that:

1. The ratio of money supply to nominal gdp is exactly constant

This implies that if the money supply grows by 10 percent, then nominal gdp needs to grow by:

1.  10 percent.

It follows that the growth rate of money supply and the growth rate of nominal gdp will be the same. In this case, inflation is:

1. Equal to the gap between the growth rate of money supply and the growth rate of real gdp

If the growth rate of money supply is larger than the growth rate of real gdp, the inflation rate is:

1. Positive

Are the predictions of the quantity theory of money borne out by historical data?

1. Yes, the long run data show a one to one growth rate of money supply and inflation

According to the quantity theory of money, what must the growth rate of the money supply be given the following information?

The growth rate of real gdp is 2.3%

The growth rate of nominal gdp is 5.1%

The nominal interest rate is 3.2%

The real interest rate is 0.4%

The money supply, m2, is $11438 in billions

So, according to the quantity theory of money, the growth rate of the money supply must be:

1. 5.1%

The quantity theory of money states that the ratio of the money supply to nominal gdp is constant over the long run. If the ratio of two variables is constant, then the growth rates of the numerator and denominator must be the same. In this case, the growth rates of the money supply and nominal gdp must be equal.

Growth rate of money supply = growth rate of nominal gdp

Growth rate of nominal gdp = inflation rate + growth rate of real gdp

Growth rate of money supply = inflation rate + growth rate of real gdp

Inflation rate = growth rate of money supply - growth rate of real gdp

According to the quantity theory of money, what is the inflation rate?

1. Inflation rate = 5.1% - 2.3% = 2.8%

The sum of m2 and real gdp represents the gross wealth of the US, this claim is:

1. False

Assuming annual compounding, the average annual rate of change in a variable is found using:

\[ \frac{x_2023}{x_2013}^\frac{1}{10} -1 = g \]

Then multiply g by 100 to get a percent

So: 

\[ \frac{21077}{10501}^{1/10} -1 * 100 = 7.22% \]

\[ \frac{20283}{16442}^{1/10} -1 * 100 = 2.12% \]

On the assumption that velocity was constant during this period, it may be deduced that the average annual inflation rate was:

1. 5.1%

However, because actual annual inflation averaged 2.61%, it can be concluded that velocity during this period must have:

1. Decreased

Suppose the government decided that it will print new notes to fund its fiscal deficit as well as all its ongoing expenditure. What would the effects of such a policy be?

1. Printing paper money has a small direct cost and so gives the government money to spend

Identify a possible problem with this policy

1. Printing too much money may lead to a high rate of inflation, reducing the amount of goods and services that the government can purchase with the newly printed notes

When the nominal wage increases, workers know that their buying power is unambiguously higher. This claim is:

1. False

To calculate the real average hourly wage for each time period, divide the nominal average hourly wage by the cpi and multiply by 100

\[ \frac{24.98}{256.4} * 100 = 9.74 \]

\[ \frac{28.75}{304.1} * 100 = 9.45 \]

Over the three year interval under examination, the average hourly nominal wage changed by 15.1% and the real average hourly wage changed by:

1. -3.0%

The change in the real average hourly wage indicates that individuals have, since may 2020, experienced what in their standard of living?

1. A decline

An open market operation is:

1. An exchange between a private bank and the federal reserve where the fed buys or sells government bonds to private banks

The federal reserve conducts open market operations when it wants to:

1. Influence the federal funds rate

When the fed buys government bonds from private banks, it:

1. Increases the electronic reserves that banks hold

From 2001 to 2006 Japan’s central bank, the bank of Japan engaged in a monetary policy program called quantitative easing. The BOJ increased the quantity of reserves that commercial banks held with the central bank by buying assets from these commercial banks.

With the quantitative easing policy, the supply curve for reserves:

1. Shifts right

The overnight call rate:

1. Decreases

The demand for reserves:

1. Stays the same

How would you best describe how each investor is forming their expectation of inflation?

1. Sean is forming his inflation expectations using adaptive expectations. He is looking at the recent past to form his opinions of the future. River, on the other hand, is forming her inflation expectations using rational expectations. She is using all of the information available to her, such as the recent economic recovery and her belief of the fed’s actions, to form her opinions

What are possible criticisms of the way each investor is forming their expectations?

1. Sean is not maximally rational, and River can not be as good at understanding how the economy works as she thinks she is.

Which of the following are included in bank reserves for private banks?

1. Deposits at the central bank
2. Vault cash

What is liquidity?

1. Funds that are available for immediate payment

This implies that if the money supply grows by 10 percent, then nominal gdp needs to grow by

1. 10 percent

It follows that the growth of money supply and the growth of nominal gdp will be the same. In this case, inflation is:

1. Equal to the gap between the growth rate of money supply and the growth rate of real gdp

If the growth rate of money supply is larger than the growth rate of real gdp, the inflation rate is:

1. positive

Are the predictions of the quantity theory of money borne out by historical data?

1. Yes, the long run data show a one for one growth rate of money supply and inflation

Hyperinflation is most likely caused by:

1. Large budget deficits financed by printing more money

Short-Run Fluctuations

Recessions are periods in which real GDP falls.

Economic fluctuations have three key features; co-movement, limited predictability, and persistence.

Economic fluctuations occur because of technology shocks, changing sentiments, and monetary factors.

Economic shocks are amplified by downward wage rigidity and multipliers.

Economic booms are periods of expansions of GDP, associated with increasing employment and declining unemployment.

Three key factors contributed to the 2007-2009 recession: a collapsing housing bubble, fall in household wealth, and a financial crisis. The recession was accompanied by both a demand shock and a financial shock.

One key factor initiated the 2020 recession: a coronavirus pandemic. The pandemic led consumers to reduce their demand for goods and services because of both their concerns about their own household finances and their effort to avoid being infected by the coronavirus. The pandemic led firms to cut back their activities, both because consumers were reducing demand for goods and services and because firms found it costly or even impossible to operate safely during the pandemic.

Short run changes in the growth of GDP are referred to as economic fluctuations or business cycles.

Economic expansions are the periods between recessions. Accordingly, an economic expansion begins at the end of one recession and continues until the start of the next recession.

The Great Depression refers to the severe contraction that started in 1929, reaching a low point for real GDP in 1933. The period of below trend real GDP did not end until the buildup to World War II in the late 1930’s. 

Although there is no consensus on the definition, the term depression is typically used to describe a prolonged recession with an unemployment rate of 20 percent or more.

Real business cycle theory is the school of thought that emphasizes the role of changes in technology in causing economic fluctuations.

Animal spirits are psychological factors that lead to changes in the mood of consumers or businesses, thereby affecting consumption, investment and GDP.

Sentiments include changes in expectations about future economic activity, changes in uncertainty facing firms and households, and fluctuations in animal spirits. Changes in sentiments lead to changes in household consumption and firm investment.

Multipliers are economic mechanisms that amplify the initial impact of a shock.

A self-fulfilling prophecy is a situation in which the expectations of an event induce actions that lead to that event.

Aggregate demand is the economy’s overall demand for the goods and services that firms produce. Aggregate demand derives the hiring decisions of firms and consequently determines the labor demand curve.

Actual wages are also called nominal wages, which distinguishes them from wages adjusted for inflation, or real wages. To calculate real wages, economists divide nominal wages by a measure of overall prices.

The phillips curve describes the empirical relationship between employment growth and inflation, showing that employment growth tends to produce more inflation, especially when an economy is near full employment.

All economies experience economic fluctuations. The growth rate of GDP fluctuates from year to year. During recessions, real GDP contracts and unemployment increases. On rare occasions, a recession turns into a depression, like the great depression. From 1929 to 1933, real GDP declined by 26 percent, and the rate of unemployment rose from 3 percent to 25 percent. 

Economic fluctuations have three key properties. 

Co-movement is when consumption, investment, GDP, and employment generally fall and rise together. Unemployment moves in the opposite direction. 

Limited predictability of turning points: Economic fluctuations are not pendulum-like with regular up and down cycles. It is difficult to predict in advance when an economy will enter a recession and when a recession will end. 

Persistence: When the economy is growing, it will probably keep going the following quarter. Likewise, when the economy is contracting-when growth is negative-the economy will probably keep contracting the following quarter.

When the labor demand curve shifts to the left, employment and real GDP fall. When the labor demand curve shifts to the right, employment and real GDP rise.

Many factors explain fluctuations in economic activity.

Technology shocks: Changes’ in firms productivity translate into shifts in the demand curve for labor, causing fluctuations in employment and real GDP. The recession of 2020 was caused by the covid-19 pandemic, which is an example of a productivity shock.

Keynesian factors: Changes in sentiments, including changes in expectations, uncertainty, and animal spirits, influence firm and household behavior. If a firm becomes pessimistic, its demand curve for labor shifts to the left. If a firms’ customers become pessimistic, they reduce their purchases, decreasing demand for the firm’s products and shifting the firm's labor demand curve to the left. An initial shift in the labor demand curve creates a cascading chain of events, multiplying or amplifying the impact of the initial shock. For example, when firms lay off workers in response to a shock, the laid off workers cut their own consumption, reducing the demand for the products of other firms. Financial factors create additional multiplier effects. Defaults, bankruptcies, and declines in asset prices lead banks to scale back their lending to firms and households, generating another round of adverse shifts in the labor demand curve. 

Monetary and financial factors: A fall in the price level is contractionary because firms face downward wage rigidities-that is, they are unable or unwilling to cut wages. Employment declines by more than it would have with flexible wages. In addition, monetary contractions cause the real interest rate to rise, reducing investment. Finally, financial crises reduce the credit available to firms and households. All these channels will shift the labor demand curve to the left, reducing employment and real GDP.

Economic booms tend to increase employment and reduce unemployment as the labor demand curve of the economy shifts to the right and the multiplier effects increase employment further. Economic expansions may generate inflation if the economy is already near the level of full employment. Economic booms also have a dark side because if they reverse, the economy can overshoot and sink into a recession.

Multiplier effects help us understand the recession of 2007-2009. Between the late 1990’s and 2006, the US housing market experienced a bubble. This bubble burst in 2006, and real housing prices fell by approximately 40 percent. The construction industry, which had been booming until then, began a sharp contraction.

Falling housing prices-and by implication falling wealth-led households to cut their consumption. Firms, seeing the demand for their products decline, reduced their labor demand, starting a spiral of layoffs and further reductions in household consumption. The collapse in housing prices also led to mortgage defaults and foreclosures. The defaults and foreclosures generated huge losses for many banks, which either failed or sharply cut lending, further worsening the recession.

The recession of 2020 was caused by the covid-19 pandemic, which reduced the productivity of economic exchange. Because of the risk of infection,households were less willing to demand goods and services, and many industries could not both profitably and safely supply goods and services.

The first documented US infection occurred in January 2020. The US recession and stock market crash started in February, anticipating an initial large wave of infections and deaths from March to May. During this first wave of infections, large parts of the economy closed down, causing a leftward shift in the demand for labor and a spike in unemployment that was far sharper than any previously recorded in US history.

The unemployment rate peaked at 14.8 percent in April, only two months after the recession started. Once the first wave of infections began to decline, many people returned to work, though the virus was still not under control. The US unemployment rate began to fall in May, just three months after the recession started.

Economic fluctuations are:

1. Short run changes in the growth of gdp

Recessions are periods in which the economy:

1. Contracts

Economic expansions are defined as the periods:

1. Between recessions

An economic expansion begins:

1. At the end of a recession

In the US, recessions are usually defined as:

1. Two consecutive quarters of negative growth in real gdp

The average weekly hours worked by manufacturing workers is likely to be:

1. Positively correlated with real gdp

The average number of initial applications for unemployment insurance is likely to be:

1. Negatively correlated with real gdp

The amount of new orders for capital goods unrelated to defense is likely to be:

1. Positively correlated with real gdp

The amount of new building permits for residential buildings is likely to be:

1. Positively correlated with real gdp

The S&P 500 stock index is likely to be:

1. Positively correlated with real gdp

Consumer sentiment is likely to be:

1. Positively correlated with real gdp

Early theories of business cycles assumed that economic fluctuations had a pendulum like structure with systematic swings in economic growth. Which property of economic fluctuations do these early theories contradict?

1. Limited predictability

Using your answer above, how does a pendulum like structure contradict this property in economic fluctuations?

1. Pendulums swing in an easily measured rhythm that would make predicting fluctuations simple

A variable identified as real is one that is measure in:

1. Base year dollars

Nominal variables are measured in current dollars while real variables are measured in base year dollars.

To compute the gdp deflator, divide nominal gdp by real gdp and multiply by 100. To calculate the percent that real gdp is below real potential gdp, use the following formula:

\[ \frac{\text{real gdp - real potential gdp}}{\text{real potential gdp}} * 100 \]

The gdp deflator is:

\[ \frac{26529.8}{20282.8} * 100 = 130.80 \]

Relative to potential real gdp, real gdp is:

1. .84% below potential real gdp

\[ \frac{20282.8 - 20453.7}{20453.7} * 100 = -0.84 = 0.84 \]

The concept of multipliers was one of the key elements of John Maynard Keyne’s theory of fluctuations. A multiplier is:

1. An economic mechanism that causes an initial shock to be amplified by follow on effects

An example of a multiplier is when:

1. An increase in business confidence causes firms to increase production and hire employees, leading to an increase in household spending, causing firms to further increase production and employment
2. A drop in consumer confidence reduces household spending, causing firms to cut production and lay off employees, leading to a greater reduction in household spending

Assume labor supply and labor demand are described by the following equation:

\[ L^{S} = 5 * w \text{Labor Supply} \]

\[ L^{D} = 110 - .5 * w \text{Labor Demand} \]

Where w = wage expressed in dollars per hour and \(L^{S}\) and \(L^{D}\) are expressed in millions of workers.

We find the equilibrium wage and level of employment by setting labor supply equal to labor demand:

\[ 5 * \text{w} = 110 - .5 * \text{w} \]

\[ 5.5 * \text{w} = 110 \]

Plug the equilibrium wage into either the supply or demand equation and solve for the level of unemployment

\[ L^{S} = 5 * \text{w} = 5 * 20 = 100 \]

\[ L^{D} = 110 - .5 * \text{w} = 110 - .5 * 20 = 110 -10 = 100 \]

Assume that there is a shock to the economy, such that the labor demand curve is now described by the equation:

\[ L^{D} = 55 - .5 \text{w} \]

If wages were flexible, the new equilibrium would be:

We find the equilibrium wage and level of employment by setting labor supply equal to labor demand.

\[ 5 * \text{w} = 55 * \text{w} \]

\[ 5.5 * \text{w} = 55 \]

\[ \text{w} = 10 \]

Plug the equilibrium wage into either the supply or demand equation and solve for the level of employment.

\[ L^{S} = 5 * w = 5 * 10 = 50 \]

\[ L^{D} = 55 - .5 * w = 55 - .5 * 10 = 55 -5 = 50 \]

If an economic shock decreases labor demand, equilibrium employment:

1. Falls

Real gdp will:

1. Fall

If wages are flexible, the decrease in employment and real gdp will be:

1. Smaller than

When workers are laid off, what happens to physical capital?

1. Physical capital becomes less productive, leading firms to reduce capacity utilization

Okun’s Law states that:

1. When growth in real gdp is above 2%, unemployment drops and when it is below 2%, unemployment increases

 According to real business cycle theory, the economic impact of changing input prices is similar to the economic impact from:

1. Technology changes

If oil, which is a major input to most production processes, abruptly jumps in price, the impact on the economy would be similar to:

1. A productivity decrease, with a resultant decrease in gdp

How would Keynes concept of animal spirits explain the creation of a housing bubble?

1. People believed that a house was a worthwhile investment, which led to an increased demand for housing and thus pushed prices up. This confirmed to people that housing was a worthwhile investment, which led to more demand, resulting in an upward spiral driven by optimism

The national income identity shows that:

1.  Output is a function of consumption, investment, government spending, and net exports

The recession of 2007-2009 affected the components of the national identity by primarily affecting:

1. The C and I components through a reduction in consumer wealth and a drop in housing construction

Real business cycle theory:

1. Emphasizes the role of changing productivity and technology in causing economic fluctuations

What does it mean to say that an economic fluctuation involves the co-movement of many aggregate macroeconomic variables?

1. These variables grow or contract together during booms and recessions

Which of the following variables exhibit co-movement during an economic expansion?

1. Investment and consumption
2. Real gdp and employment

Countercyclical Macroeconomic Policies

Countercyclical policies attempt to reduce the severity of economic fluctuations and smooth the growth rates of employment, GDP, and prices.

Countercyclical monetary policy reduces economic fluctuations by manipulating bank reserves and interest rates.

Expansionary monetary policy increases bank reserves and decreases interest rates. Contractionary monetary policy decreases bank reserves and increases interest rates.

Countercyclical fiscal policy reduces fluctuations by manipulating government expenditures and taxes.

Expansionary fiscal policy increases government expenditure and decreases taxes. Contractionary monetary policy decreases government expenditures and increases taxes.

Some countercyclical policies are conducted jointly by the monetary authority and the fiscal authority. Such hybrid policies stimulate economic activity by extending credit or other financing to banks and other firms.

Countercyclical policies attempt to reduce the intensity of economic fluctuations and smooth the growth rates of employment, GDP, and prices.

Countercyclical monetary policy, which is conducted by the central bank in the US, attempts to reduce economic fluctuations by manipulating bank reserves and interest rates.

Countercyclical fiscal policy, which is passed by the legislative branch and signed into law by the executive branch, aims to reduce economic fluctuations by manipulating government expenditures and taxes.

Expansionary monetary policy increases the quantity of bank reserves and lowers interest rates.

Quantitative easing is achieved when the central bank creates a large quantity of bank reserves to buy long term bonds, simultaneously increasing the quantity of bank reserves and pushing down the interest rate on long term bonds.

The Federal Reserve acts as a lender of last resort during times of crisis, providing loans to banks and other firms when standard financing channels become unavailable.

Contractionary monetary policy slows down growth in bank reserves, raising interest rates, reduces borrowing, slows down growth in the money supply, and reduces the rate of inflation.

Expansionary fiscal policy uses higher government expenditure and lower taxes to increase the growth rate of real GDP.

Contractionary fiscal policy uses lower government expenditure and higher taxes to reduce the growth rate of real GDP.

Automatic stabilizers are components of the government budget that automatically adjust to smooth out economic fluctuations.

If a 1$ change in government expenditure causes a $m change in GDP, then the government expenditure multiplier is m.

Crowding out occurs when rising government expenditure partially or even fully displaces expenditures by households and firms.

If a 1$ reduction in taxation causes an $m increase in GDP, then the government taxation multiplier is m.

Countercyclical policies attempt to reduce the intensity of economic fluctuations and smoothe the growth rates of employment, GDP, and prices.

Countercyclical monetary policy, which is conducted by the central bank, attempts to reduce economic fluctuations by manipulating bank reserves and interest rates.

Open market operations refer to the Federal Reserve’s transactions with private banks to increase or reduce bank reserves held on deposit at the Federal Reserve. Open market operations and interest on reserves influence the federal funds rate. An increase in the supply of bank reserves lowers the federal funds rate. A decrease in interest on reserves also lowers the federal funds rate.

Expansionary monetary policy increases the quantity of bank reserves and lowers interest rates, shifting the labor demand curve to the right and increasing the growth rate of GDP.

Contractionary monetary policy slows down the growth in bank reserves and increases interest rates, shifting the labor demand curve to the left and reducing the growth rate of GDP. Contractionary monetary policy is used when inflation is well above the Federal Reserve’s long run target of 2 percent or when the economy is growing excessively quickly.

Countercyclical fiscal policy, which is passed by the legislative branch and signed into law by the executive branch, reduces economic fluctuations by manipulating government expenditures and taxes.

Countercyclical fiscal policies might be automatic or discretionary. Automatic stabilizers are components of the government budget, like taxes owed, that automatically adjust to smooth out economic fluctuations.

Expansionary fiscal policy uses higher government spending and lower taxes to increase GDP, shifting the labor demand curve to the right. Crowding out occurs when rising government expenditure partially or even fully displaces expenditures by households and firms.

Countercyclical fiscal policy uses lower government spending and higher taxes to reduce GDP, shifting the labor demand curve to the left.

What are the similarities and differences between monetary and fiscal policies?

Monetary and fiscal policies both seek to reduce the intensity of economic fluctuations, and both cause the labor demand curve to shift.

They differ in the ways that they work to reduce economic fluctuations and in the entities that exert control over them. Monetary policy works through interest rate changes and is conducted by the central bank, while fiscal policy works through the manipulation of government spending and taxes and is under the control of the legislative and executive branches of the national government.

1. The manner or ways in which they work- Different
2. The aspect of the labor market they impact - Similar
3. The result of their implementation seeks to achieve - Similar
4. The entities or authorities that oversee them - Different

Former chairman of the Federal Reserve Alan Greenspan used the term irrational exuberance in 1996 to describe the high levels of optimism among stock market investors at the time. Stock market indexes, such as the S&P, were at an all time high, and the stock market kept rapidly rising in the late 1990’s, generating what came to be recognized as a bubble in technology stocks. Some commentators believed that the Fed should have intervened to slow the expansion of the economy at that time. 

Why would central banks ever want to clamp down when the economy is growing rapidly?

1. To prevent inflationary forces from gathering momentum 
2. To block the formation of unsustainable speculative asset bubbles

What policies could the government and the central bank use to achieve the goal of slowing down the economic expansion?

1. The government could raise taxes and reduce expenditures, while the central bank could raise interest rates

 According to the figure, a recession impacts employment less severely when wages exhibit downward:

1. Flexibility

Quantitative easing is:

1. A variation on the central bank’s traditional manner of conducting open market operations
2. The central banks purchase of long term bonds in the open market
3. An attempt by the central bank to more directly impact long term interest rates

Central banks undertake quantitative easing programmed to:

1. Work around the problems when short term nominal interest rates approach zero
2. More forcefully and directly impact the interest rates relevant for investment decisions

According to the Taylor Rule, the Federal Reserve should lower the federal funds rate when the:

1. Fed’s long run target for the federal funds rate falls
2. Output gap falls
3. Fed’s inflation rate target rises
4. Inflation rate falls

The Fed’s decision results in an increase in Treasury bonds of 90 billion and an increase in Other bonds of 50 billion. This is balanced by an increase in reserves of 90 billion plus 50 billion.

The Fed’s purchases of Treasury securities of 90 billion and agency mortgage backed securities of 50 billion causes Bank of America’s Bonds and other investment holdings to decrease by 140 billion. The Fed pays BOA for these bonds by increasing their reserves by 140 billion.

When is the output gap, defined as the percent difference between gdp and potential gdp, positive?

1. When actual real gdp rises above potential gdp
2. When the economy’s capacity to produce is exceeded by its actual production
3. When the economy experiences an inflationary boom

According to the Taylor rule, should the Fed raise or lower the federal funds rate when the output gap is positive?

1. It should raise the federal funds rate

Suppose the Fed conducts an open market purchase. Such as action would be called for if the economy faced the possibility of:

1. Recession

The Fed’s open market purchase impacts the federal funds market shown on the right by shifting the:

1. Supply of reserves

Following the Fed’s successful open market purchase, the process that ensues is given by:

1. Short term interest rates fall, Long term interest rates fall, Demand for goods and services increases, Labor demand shifts right

Suppose the Fed commits itself to the use of the Taylor rule to set the federal funds rate.

\[ \text{Federal funds rate} = \text{Long - run target} + 1.5 (\text{inflation rate - inflation target}) + .5 \text{Output gap} \]

Suppose the Fed has set the long run target for the federal funds rate at 1.5 percent and its target for inflation at 3 percent.

If the economy is currently hitting the Fed’s inflation target and gdp exactly equals the trend gdp, then the Fed will set the federal funds rate at:

Set the actual inflation rotate equal to its target and the output gap equal to 0 and solve the following expression for the federal funds rate.

Since the actual inflation rate equals the target and the economy has no output gap, the federal funds rate should be set equal to its long run target of 1.5 percent

1.   \( 1.5 + 1.5(3-3) + .5(0) = 1.5 \text{percent} \)

Now suppose the economy heats up, causing the actual inflation rate to increase to 4 percent and the economy to rise 2.5 percent above trend gdp. In this case the Fed will seek to set the federal funds rate at:

Substitute the actual inflation rate of 4 percent and the output gap of 2.5 percent into the following expression for the federal funds rate.

\[ \text{Federal funds rate} = 1.5 + 1.5(\text{inflation rate -3}) + .5(\text{Output gap}) = 4.25 \]

To achieve its target for the federal funds rate, the Fed may:

1. Increase the reserve requirement
2. Increase the interest rate paid on reserves deposited at the Fed
3. Sell treasury bonds in the open market
4. Decrease lending from the discount window

Two economists estimate the government taxation multiplier and come up with different results. One estimates the multiplier at .8, while the other comes up with an estimate of 1.2. Explain why these estimates are different in terms of the assumptions that each economist is making.

1. Compared to the first economist, the second ecomist must be assuming either a larger induced increase in consumption, a smaller crowding out effect, or both.

What do these estimates imply about the consequences of government taxation?

1. The multiplier of .8 would result in a smaller increase in gdp from a tax cut than the multiplier of 1.2

If the current value of gdp is 20.86 trillion and the government is planning to make transfers to people of 1.4 trillion, the percentage increase in gdp using the multiplier estimate of the first economist is:

The predicted change in gdp using the first economist’s multiplier is:

1. \( 1.4 \text{trillion} * .8 = 1.12 \text{trillion} \)

When added to the current value of gdp, the first economists projected level of gdp becomes 21.98 trillion. The percentage increase in gdp using this economists estimate is found as:

1. \( \frac{21.98 - 20.86}{20.86} * 100 = 5.37 \text{percent} \)

Suppose traditional monetary and fiscal policy has only had limited success in promoting higher employment. Governments sometimes seek to directly stimulate hiring by the private sector by engineering a shift in the labor:

1. Demand curve

Suppose the government enacts a stimulus program composed of 500 billion of new government spending and 200 billion of tax cuts for an economy producing a gdp of 15000 billion. If all the new spending occurs in the current year and the government expenditure multiplier is 1.5, the expenditure portion of the stimulus package will add:

Combine the government expenditure and the government expenditure multiplier to determine the change in gdp attributable to the program’s expenditure. Then divide this amount by the economy’s gdp to get the percentage increase. 

1. The government expenditure of 500 billion when magnified by the government expenditure multiplier(1.5) yields a change in gdp of 750 billion. Dividing this amount by the economy’s gdp of 15000 billion gives a percentage increase of 5 percent.

If the government taxation multiplier is .8, the tax cut portion of the stimulus package will add:

1. The tax cut of 200 billion when magnified by the taxation multiplier(.8) yields a change in gdp of 160 billion. Dividing this amount by the economy’s gdp of 15000 billion gives a percentage increase of 1.07 percent

As a result of the stimulus program, the economy;s gdp was increased by:

1. Simply add the percentage increase to gdp from each component of the stimulus program. = 6.07 percent

If the economy’s actual growth was -4 percent, then without the stimulus package, growth would have been:

1. Since the economy grew by -4 percent with the program in place, its growth without the program would obviously been less. To get this otherwise rate of growth, subtract the contribution of the stimulus program. So, with the stimulus program in place, the economy realized a growth rate of -4 percent. Since the stimulus package contributed 6.07 percent to this realized rate, its absence would have resulted in a growth rate of \( -4 - 6.07 = =10.07 \text{percent}  \)

Cazenovia is in the midst of a bad recession, and its congress has placed economic recovery at the top of its political agenda. Different expansionary fiscal policies are currently being examined, but the members of congress are aware of the problems associated with large, sustained government deficits and will not accept any proposal that increases the deficit by more than 2 million.

After lengthy discussion, these are the final proposals:

1. Spend 2 million on highways
2. Reduce taxes by 2 million

Assume the economy is characterized by the following fout equations in the short run:

1. \(Y = C + I + G + NX \)
2. \( C = C_0 + C_y(Y-T) \)
3. \( I = I_0 \) a constant
4. \( NX = 0 \)

Where \(C_) = 50\) and \( C_y = .6 \)

Using the government expenditure multiplier from the simple model presented in the chapter, the plan to spend 2 million oh highways will increase Y by:

1. To derive the government expenditure multiplier, you must substitute the expression for consumption \( C=C_)+C_y(Y-T)\) into the expression \(Y=C+I+G+NX\) and solve the result for Y. Then let \( \delta C_)=\delta T=\delta I=\delta NX=0\) to establish the relationship between \(\delta Y \text{and} \delta G \)

Rearranging terms yields:

\[ Y = \frac{1}{1-C_y} (C_0-C_yT+I_0+G) \]

The letting \(\delta C_0=\delta T=\delta I=\delta NX=0\) you find:

\[ \delta Y = \frac{1}{1-C_y} * \delta G \]

Substituting the values \(C_y=.6\) and \(\delta G=2\) gives the \(\delta Y\) (gdp increase) of 5 million.

Using the government taxation multiplier from the simple model presented in this chapter, the plan to reduce taxes by 2 million will increase gdp by:

1. To derive the government expenditure multiplier, you must substitute the expression for consumption \(C=C_0 + C_y(Y-T)\) into the expression for gdp \(Y=C+I+G+NX\) and solve the result for Y. Then let \(\delta C_0=\delta G=\delta I=\delta NX=0\) to establish the relationship between \(\delta Y \text{and} \delta T\), noting that a tax reduction has \(\delta T<0\). 

Then letting \(\delta C_0=\delta G=\delta I=\delta NX=0\) you find:

\[ \delta Y = \frac{-C_y}{1 - C_y} * \delta T \]

Substituting the values \(C_y=.6\) and \(\delta T = -2\) gives the \(\delta Y\) (gdp increase) of 3 million.

The plan that appears to be the most effective in achieving congress’s goal is to:

1. Spend 2 million on highways

What could explain why a decrease in taxes could lead to a less than one for one increase in output?

1. As a result of diminishing returns to current consumption, consumers may choose to spread the extra spending over the long term rather than consuming the proceeds of a tax cut all at once
2. Consumers may choose to save much of the tax cut in anticipation of having to pay higher taxes in the future

How do expansionary policies differ from contractionary policies?

1. Expansionary policies seek to shift the labor demand curve to the right, while contractionary policies seek to shift it to the left
2. Expansionary policies seek to increase economic growth and increase employment, while contractionary policies seek to reduce the risk of excessive price inflation
3. Expansionary policies seek to reduce the severity of recessions, while contractionary policies seek to slow down the economy when it grows too fast

Macroeconomics and International Trade

International trade enables countries to focus on activities in which they have a competitive advantage.

The current account includes international flows from exports, imports, factor payments, and transfers.

If a country runs a current account deficit, it pays for this by giving its trading partners financial IOUs.If a country runs a current account surplus, it receives financial IOUs from its trading partners.

The world has become more globalized over the past several decades.

Gains from specialization are the economic gains that society can obtain by having some individuals, regions, or countries specialize in the production of certain goods and services. 

A producer has an absolute advantage in producing a good or service if the producer can produce more units per hour than other producers can.

A producer has a comparative advantage in producing a good or service when the producer has a lower opportunity cost per unit produced compared to other producers.

A closed economy does not trade with the rest of the world.

An open economy trades freely with the rest of the world.

Net exports are the value of a country’s exports minus the value of its imports. Net exports are also known as the trade balance.

A trade surplus is an excess of exports over imports and is thus the name given to the trade balance when it is positive.

A trade deficit is an excess of imports and is thus the name given to the trade balance when it is negative.

The current account is the sum of net exports, net factor payments from abroad, and net transfers from abroad.

The financial account is the increase in domestic assets held by foreigners minus the increase  in foreign assets held domestically.

Net capital outflows are the difference between investment by the home country in foreign countries and foreign investment in the home country. 

Foreign direct investment refers to investments by foreign individuals and companies in domestic firms and businesses. To qualify as foreign direct investment, these flows need to generate a large foreign ownership stake in the domestic business. 

The process of globalization has produced a highly interconnected world.

International trade enables us to exploit specialization and comparative advantage. Comparative advantage arises when a person or country has a lower opportunity cost of production than another person or country.

Globalization and international trade improve the well-being of most people, but many other people are made worse off, especially low-skilled workers in developed countries who lose their jobs to foreign producers.

A country runs a current account deficit when it has a negative sum of net exports, net payments from abroad for factor payments, and net transfers from abroad. When this happens, there needs to be a corresponding flow of funds in the financial account that pays for the current account deficit. This implied a net increase in domestic assets held by foreigners and a net increase in foreign assets by domestic residents.

A rapid process of globalization has been under way for several decades, increasing the total volume of international trade. Consequently, consumers and workers around the world can now take better advantage of the gains from international trade. Nevertheless, continued progress in globalization is not guaranteed. In fact, an anti-globalization backlash is now occurring, and some trade agreements have been abandoned or renegotiated. 

Globalization also makes the enormous inequities across nations more visible. We purchase goods and services produced and assembled by workers, sometimes even children, earning a small fraction of the wages of workers in developed countries. The working conditions in factories in the developing world are far worse than those of most low paid factory workers in foreign countries. Their alternative opportunities for employment are usually worse than these factory jobs in the traded goods sector.

Open Economy Macroeconomics

The nominal exchange rate is the rate at which one country’s currency can be exchanged for the currency of another country.

In a flexible exchange rate system, the nominal exchange rate is determined by supply and demand in the foreign exchange market.

Fixed or managed exchange rates are controlled by the government.

The real exchange rate is the ratio of the prices of a basket of goods and services in two countries and thus influences net exports from one country to the other.

A decline in net exports reduces labor demand, lowers GDP, and causes unemployment.

The nominal exchange rate is the price of one country’s currency in units of another country’s currency.

If the government does not intervene in the foreign exchange market, then the country has a flexible exchange rate, which is also referred to as a floating exchange rate.

If the government fixes a value for the exchange rate and intervenes to maintain that value, then the country has a fixed exchange rate.

If the government intervenes actively to influence the exchange rate, then the country has a managed exchange rate.

The real exchange rate is defined as the ratio of the dollar price of a basket of goods and services in the US, divided by the dollar price of the same basket of goods and services in a foreign country.

The nominal exchange rate is the number of units of foreign currency per unit of domestic currency. The real exchange rate, in contrast, gives the ratio of the dollar price of a basket of goods and services purchased in the US to the dollar price of the same basket purchased in a foreign country.

The nominal exchange rate is determined by the supply and demand for a currency in the foreign exchange market. When a Chinese producer sells goods to a US firm and receives dollars, the Chinese firm converts the dollars to the Chinese currency in the foreign exchange market. This is equivalent to demanding yuan and supplying dollars in the foreign exchange market. In contrast, a Chinese firm that imports from the US would be doing the opposite in the foreign exchange market: supplying yuan and demanding dollars with which it will pay its US trading partners.

When a country has a flexible exchange rate, changes in the supply and demand for a currency lead to fluctuations in the nominal exchange rate. Many countries, however, manage or fix exchange rates and therefore peg their currencies to another currency, such as the dollar. Under managed or fixed exchange rates, fluctuations in the supply and demand for the currency do not necessarily lead to corresponding fluctuations in the exchange rate.

Though managed or fixed exchange rate systems might appear more stable at first, when the exchange rates they generate are out of line with market forces, these systems can lead to sudden changes in the exchange rate. In the process, they create huge profit opportunities, like the one exploited by the financier George Soros in 1992, when he bet that the British pound would be allowed to depreciate.

The real exchange rate is a key price for the economy in part because it determines net exports. A real exchange rate greater than 1 implies that US goods and services are more expensive than foreign goods and services. Thus, a real exchange rate above 1 discourages exports and encourages imports, reducing net exports.

A fall in net exports lowers GDP and shifts the labor demand curve to the left.

Domestic interest rates influence the real exchange rate. A fall in domestic interest rates reduces the appeal of domestic assets to investors, lowering both nominal and the real exchange rates. The resulting rise in net exports shifts the labor demand curve to the right and increases GDP.

Principles of Economics

Economists Study the choices that people make. To understand these choices, they focus on the costs and benefits involved. Economics is the study of people’s choices. The first principle of economics is that people try to optimize. They try to choose the best available option. The second principle of economics is that economic systems tend to be in equilibrium. This is a situation in which nobody would benefit by changing their own behavior. The third principle of economics is empiricism. This is analysis that uses data. Economists use data to test theories and to determine what is causing things to happen in the world. 

Economics involves far more than money because it is the study of all human behavior. Choice is the unifying feature of all the things that economists study. Economists think of almost all human behavior as the outcome of choices. 

An economic agent is an individual or a group that makes choices. The second important concept to understand is that economics studies the allocation of scarce resources. Scarce resources are things that people want, where the quantity that people want exceeds the quantity that is available. Scarcity exists because people have unlimited wants in a world of limited resources. 

Economics is the study of how agents choose to allocate scarce resources and how those choices affect society. Economists study the original choice and its multiple consequences for other people in the world. 

Positive economics describes what people actually do. Normative economics recommends what people and society ought to do. 

Descriptions of what people actually do are objective statements about the world. These statements can be confirmed or tested with data. 

Normative economics advises individuals and society on their choices. It is almost always dependent on subjective statements, which means that normative analysis depends at least in part on opinions. 

Economics is also divided into two other ways. Macroeconomics and microeconomics. Microeconomics is the study of how individuals, households, firms, and governments make choices. This leads to the study of how those choices affect prices, the allocation of resources, and the well-being of other agents. 

Macroeconomics is the study of the economy as a whole. They like to study economy-wide situations like growth of gdp or unemployment. 

Economists emphasize three key concepts. They are optimization, equilibrium, and empiricism. Optimization is about picking the best feasible option. Economists believe that people’s goal of optimization explains most choices that people make. Equilibrium holds that economic systems tend to be in equilibrium. This is a situation in which no agent would benefit personally by changing their behavior. The economic system is in equilibrium when each agent cannot do any better by picking another course of action. In other words, equilibrium is a situation in which everyone is optimizing at the same time. Empiricism is evidence-based analysis. It is analysis that uses data. 

All optimization problems involve trade-offs. Trade-offs arise when some benefits must be given up in order to gain others. Economists use budget constraints to describe trade-offs. A budget constraint is the set of things that a person can choose to do without breaking his budget. Budget constraints are useful economic tools, because they quantify trade-offs. When economists talk about the choices that people make, the economist always takes into account the budget constraint. It’s important to identify the feasible options and the trade-offs and a budget constraint gives us that information. 

We face trade-offs whenever we allocate our time. When we do one thing, something else gets squeezed out. This is an opportunity cost. Evaluating trade-offs can be difficult because so many options are under consideration. Economists tend to focus on the best alternative activity. This best alternate activity is another definition of the opportunity cost. This is what an optimizer is giving up when he allocates his time to something. 

Cost-benefit analysis is a calculation that identifies the best option by summing benefits and subtracting costs, with both benefits and costs denominated in a common unit of measurement. Cost-benefit analysis is used to identify the alternative that has the greatest net-benefit. To an economist, cost-benefit analysis and optimization are the same thing. When you pick the option with the greatest benefits, you are optimizing. So, cost-benefit analysis is useful for normative economic analysis. 

In most economic situations, you aren’t the only one trying to optimize. Other people’s behavior will influence what you decide to do. Economists think of the world as a large number of economic agents who are interacting and influencing one another’s efforts at optimization. In equilibrium, both the sellers and the buyers are optimizing. Nobody would benefit by changing their behavior. 

People’s private benefits are sometimes out of sync with the public interest. This is the free-rider problem. Equilibrium analysis helps us predict the behavior of interacting economic agents and understand why free riding occurs.  

Economists test their ideas with data. We refer to such evidence-based analysis as empirical analysis or empiricism. Economists use data to determine whether our theories about human behavior match up with actual human behavior. Economists are also interested in understanding what is causing things to happen in the world. 

The definition of economics states that it is the study of how:

1. Agents choose to allocate scarce resources and the impact of those choices on society

The statement that the US saw the unemployment rate peak at 10 percent in 2009 is a:

1. Positive statement

Since it describes what people:

1. Actually do

The statement that the US is too aggressive in increasing money supply is a:

1. Normative statement

Since it describes what people:

1. Ought to do

The ethical implications of a hotly debated government policy would be best considered:

1. Normative question, since it deals with a subjective issue based on personal preferences

Economics is divided into two broad fields of study, microeconomics and macroeconomics. Microeconomics studies:

1. A small piece of the economy

While macroeconomics studies:

1. The economy as a whole

Policy decisions made by the government are analyzed by:

1. Both micro and macro

A policy such as pollution regulations on steel parts would be studied under:

1. Microeconomics

Since it deals with a:

1. Small part of the overall economy

  The three principles of economics include optimization, equi;ibrium, and empiricism.

Optimization describes where:

1. People weight costs and benefits when making a decision

Equilibrium describes a situation where:

1. No one would benefit from changing their behavior

Empiricism describes a situation where:

1. Economists use data to analyze what is happening in the world

Economics, anthropology, psychology, sociology, and political science all study human behavior. Economics differs from these other social sciences because it also addresses three key concepts:

1. Optimization, equilibrium, and empiricism

Suppose your new year resolution is to get back into shape. How would you evaluate your options and choose an optimal one?

1. Do a cost-benefit analysis to compare the alternatives

When making your decision about which activity to choose, you should consider the monetary:

1. As well as the opportunity cost of the activities.

The goal is to choose the option that offers the greatest:

1. Net benefit

During the process of optimization, economists believe that people are considering:

1. The feasibility of a choice, given the information available at the time

Suppose that you allocate $20 each week for your entertainment budget. This money is spent on two items, renting or buying music. Which of the following would represent your budget constraint for entertainment?

1. Amount spent on itunes + amount spent at redbox = 20

Your budget constraint for entertainment illustrates the concept of:

1. Trade-offs

Since as you increase your purchases of one item, you must:

1. Decrease your purchases of the other item

The opportunity cost of an activity is a measure of:

1. What is given up when you do that activity

If you decide to go to class, then what do we know about the opportunity cost of your decision?

1. The opportunity cost would be sleeping in late since it was your next best option

Comparing a set of feasible alternatives and picking the best one is an optimization process called:

1. Cost-benefit analysis

When deciding whether to install visible countdown timers for pedestrians at crosswalks, which of the following would be considered in the cost-benefit analysis?

1. The value of pedestrians lives saved by having the timers to assist in crossing the street
2. The cost in terms of dollars of installing these new timers all over the city
3. The higher maintenance bill associated with fixing these more complex signals when they break down
4. The value of the lives lost by drivers who watch the countdown timers and try to make it through a light

Free riding occurs when:

1. People’s private benefits are out of sync with the public interest

Which of the following is subject to the free rider problem?

1. National security
2. Neighborhood watch
3. Public libraries

Which of the following is more susceptible to the free rider problem: government symphonies or city wide pest control?

1. City wide pest control since even those who don't pay taxes still benefit

For a market to be in equilibrium three conditions must hold.

The amount produced by sellers must be:

1. Equal to the amount purchased by buyers

The costs of making a product must be:

1. Less than the final price at which the final product sells

Buyers must place a value on the uses of the product that is:

1. Greater than the cost of buying the product

Which of the following is true regarding the concept of causation?

1. It describes how one event can bring about change in another

Which of the following is not an example of a causal claim?

1. It rains more often on days you wash your car

Identify the cause and effect in the following examples:

1. Low infant mortality is an effect and an improvement in nutrition is the cause

A surge in cocoa prices is an effect and a pest attack on the cocoa crop is the cause

In which of the following areas will taking an economics course help benefit you?

1. It will help you analyze and predict human behavior in a variety of situations
2. It will instill the concept that what activity is given up by a decision plays an important role when making choices.
3. It will give you the logic behind using cost-benefit analysis when evaluating decisions

Which of these statements, if true, would help you conclude that there is indeed a cause and effect relationship between the vaccine and autism in children?

1. The survey was conducted on a large group whose members were randomly selected
2. The mmr vaccine contains thimerosal, a preservative that is known to increase the risk of autism.

Free riding occurs because:

1. People sometimes pursue their own interests and don’t contribute voluntarily to the public interest

Which of the following could be considered an economic  agent?

1. Students
2. Criminals
3. Workers
4. Firms

Scarcity is the situation of having unlimited wants in a world of limited resources

Which of the following are considered scarce resources?

1. Time
2. Gas
3. Mechanical pencils
4. Gold

In which of the following examples is the cause and the effect hard to untangle?

1. The relationship between dense forests and heavy rain

Which of the following statements is not a correct explanation of empiricism?

1. It has nothing to do with optimization and equilibrium
2. It cannot be monitored

Economic Methods

A model is a simplified description of reality. Economists use data to evaluate the accuracy of models and understand how the world works. Correlation does not imply causality. Experiments help economists measure cause and effect. Economic research focuses on questions that are important to society and can be answered with models and data. 

Empiricism uses data to analyze the world. It is at the heart of all scientific analysis. The scientific method is the name for the ongoing process that economists, other social scientists, and natural scientists use to develop models of the world and evaluate those models by testing them with data. 

Testing models with data help separate good models from bad models. A model is a simplified description of reality. Sometimes a model is also called a theory. Because models are simplified, they are not perfect replicas of reality. 

Scientific models are used to make predictions that can be checked with empirical evidence. Empirical evidence is a fact that can be obtained through observation and measurement. Empirical evidence is also known as data. A model’s prediction is known as an hypothesis. A model is only an approximation and accordingly, understand that the model is not exactly correct. A model also makes predictions that can be tested with data. 

The man, or average, is the sum of all the different values divided by the number of values and is a commonly used technique for summarizing data. 

Causation occurs when one thing directly affects another. Scientists refer to a changing factor, like temperature, as a variable. Scientists say that causation occurs when one variable causes another variable to change. Correlation means that two variables tend to change at the same time. As one variable changes, the other changes as well. When two variables are correlated, it suggests that causation may be possible and further investigation is warranted. 

Correlations are divided into three categories, positive, negative, and zero correlation. Positive correlation implies that two variables tend to move in the same direction. Negative correlation implies that the two variables tend to move in opposite directions. When two variables are not related, we say they have zero correlation. 

An omitted variable is something that has been left out of a study. Reverse causality is another problem that plagues our effort to distinguish correlation and causation. It occurs when we mix up the direction of cause and effect. 

One method of determining cause and effect is to run an experiment. An experiment is a controlled method of investigating causal relationships among variables. To run an experiment, researchers usually create a treatment group and a control group. Randomization is the assignment of subjects by chance, rather than by choice to a group. The treatment group and the control group are treated identically except along one dimension that they are testing for. 

A natural experiment is an empirical study in which some process has assigned subjects to control and treatment groups in a random or nearly random way. Natural experiments are a useful source of data in empirical economics. In many problems, they help us separate correlation from causation.    

Good economic questions address topics that are important to individual economic agents and to our society. Good economic questions can be answered.

To say that economists use the scientific method means that they are using

1.  An ongoing process to develop models of the world and then test and evaluate those models

How do economists distinguish between models that work and those that don’t?

1. They test their models against real world data

How does the sample size affect the validity of an empirical argument?

1. The larger the sample size the better

Suppose country A had 5 families. Their incomes are 10000,19000,30000,39000,and 49000.

Country A’s median income is 30000

Its mean income is 29400

Suppose country B also has 5 families. Their incomes are 10000,19000,30000,39000, and 151000.

Country B’s median income is 30000

Its mean income is 49800

Country B has greater income inequality

Suppose you thought income inequality in the US had increased over time. Would you expect the ratio of the mean income in the US to the median income has risen or fallen?

1. Risen, because means change more with extreme values

Suppose you have just been hired as a management consultant by a major oil company to help it optimally price gasoline at its service stations. During a meeting with your client, the ceo asks if your economic models include all factors that impact gasoline prices. What is your response to this question?

1. No, the model is a simplified representation of reality

Your client becomes critical of your sloppy technique of using a model that does not include all factors. What is the most appropriate reply to this criticism?

1. Economic models are meant to be approximations that predict what happens in most circumstances.

He is still unconvinced about the reliability of using economic models to make business decisions. You can answer this concern by sharing that you will confirm the accuracy of the model by:

1. Testing its predictions with empirical data

What is meant by randomization in the context of an economic experiment?

1. Subjects are assigned by chance, rather than by choice, to a group

Causation occurs when there is:

1. A logical cause and effect relationship

Demonstrate causation or correlation with the following examples:

1. More police officers and lower crime rates is likely to be causation
2. More economic growth and higher employment levels is likely to be causation
3. The length of women’s skirts and stock market performance is likely to be correlation

In general, people with more education earn higher salaries. Economists have offered two explanations of this relationship.

1. The signaling argument implies that a college student who drops out of school one month before graduation should earn much less than a student who graduates.
2. The human capital argument implies that a college student who drops out of school one month before graduation should earn almost the same as a student who graduates

Some people go to a new gym because it just happened to open up right next to where they live. People who live farther away do not go to this gym.

Using the concept of a natural experiment, which of the following statements is true?

1. This is a good natural experiment

A simple economic model predicts that a fall in the price of bus tickets means that more people will take the bus. This isn’t always the case. Is the model incorrect?

1. No, because it predicts the outcome of increased bus ridership on average

How would you test this model?

1. You should run a natural experiment by analyzing bus ridership and price changes

Your client has asked you to plot crude oil prices and gasoline prices on a graph. The cause or independent variable should be plotted on the:

1. X-axis

The effect or dependent variable should be plotted on the:

1. Y-axis

There is a positive correlation between oil prices and gasoline prices

Your client has asked you to plot gdp and gasoline prices on a graph.

1. There is a negative correlation between gdp and gasoline prices

Suppose you have been hired as a management consultant by a major oil company to help it optimally price gasoline at its service stations. Your client would like your team to perform a study on customers’ gasoline purchasing habits when they notice price increases. You suggest that the team:

1. Design and execute an experiment

Debbie’s method is a controlled experiment and Troy’s method is a natural experiment

Group A is the treatment group and Group B is the control group

Suppose that you are on a date with an economics major, and you want to impress them by talking about economics. Your date challenges you to state your knowledge of positive and normative questions.

1. You say that positive questions ask what is and normative questions ask what ought to be

Which of the following examples do you provide as a normative question?

1. Should welfare be repealed

Which of the following do you provide as a positive question?

1. How much is the national debt?

Optimizing Your Decisions

When an economic agent chooses the best feasible option, he is optimizing. Optimization using total value calculates the total value of each feasible option and then picks the option with the highest total value. Optimization using marginal analysis calculates the change in total value when a person switches from one feasible option to another, and then uses these marginal comparisons to choose the option with the highest total value. Optimization using total value and optimization using marginal analysis give identical answers.

Economists use optimization to predict most of the choices that people, households, businesses, and governments make. Optimization is often quite complex. 

Behavioral economics explains why people optimize in some situations and fail to optimize in others. When people have self-control problems, optimization is not a good description of behavior. 

In normal cost-benefit analysis, the decision maker finds the alternative with the highest value of net benefit, which is benefit minus cost. 

Optimizing using total value has three steps:

1. Translate all costs and benefits into common units, like dollars per month
2. Calculate the total net benefit of each alternative
3. Pick the alternative with the highest net benefit

Optimization using marginal analysis is often faster to implement than optimization using total value, because optimization using marginal analysis focuses only on the ways that alternatives differ. Optimization using marginal analysis breaks an optimization problem down by thinking about how costs and benefits change as you hypothetically move from one alternative to another. 

Economists use the word marginal to indicate a difference between alternatives, usually a difference that represents one step or more.  A cost-benefit calculation that focuses on the difference between one feasible alternative and the next feasible alternative is called marginal analysis. Marginal analysis compares the consequences of doing one step more of something. 

Marginal analysis forces us to focus on what is changing when we compare alternatives. Since marginal analysis always picks out the same optimum as minimization of total cost, you can use whichever method is easier for the particular problem that you are analyzing. However, economists mostly use marginal analysis. Optimization at the margin is simple because you can ignore everything about two alternatives that are being compared except the particular attributes that are different. Marginal analysis reminds you to exclude information that is not relevant to your decision. 

To sum up, marginal analysis has three key steps:

1. Translate all costs and benefits into common units, like dollars per month
2. Calculate the marginal consequences of moving between alternatives
3. Apply the Principle of Optimization at the Margin by choosing the best alternative with the property that moving to it makes you better off and moving away from it makes you worse off.

Marginal analysis can be used to solve any optimization problem. Marginal analysis is most commonly used when there is clear sequence of feasible alternatives. 

Demand, Supply, and Equilibrium

In a perfectly competitive market, sellers all sell an identical good or service. Any individual buyer or seller isn’t powerful enough on his own to affect the market price of that good or service. The demand curve plots the relationship between the market price and the quantity of a good demanded by buyers. The supply curve plots the relationship between the market price and the quantity of a good supplied by sellers. The competitive equilibrium price equates the quantity demanded and the quantity supplied. When prices are not free to fluctuate, markets fail to equate quantity demanded and quantity supplied. 

A market is a group of economic agents who are trading a good or service plus the rules and arrangements for trading. 

If all sellers and all buyers face the same price, that price is referred to as the market price. This implies that buyers and sellers are all price-takers. They accept the market price and can’t bargain for a better price. 

At a given price, the amount of the good or service that buyers are willing to purchase is called the quantity demanded. A table that reports the quantity demanded at different prices is called a demand schedule. Plotting a demand schedule is called a demand curve. The demand curve has an important property which is that the price of gasoline and the quantity demanded are negatively related. They move in opposite directions. When one goes up, the other goes down. 

Almost all goods have demand curves that exhibit this fundamental negative relationship, which economists call the law of demand. The law of demand says that the quantity demanded rises when the prices fall. Diminishing marginal benefit is when you consume more of a good, your willingness to pay for an additional unit declines.  

Though almost all individual demand curves are downward sloping, that is all they have in common. The demand of all buyers in a market is the market demand curve. It is the sum of the individual demand curves of all potential buyers. The market demand curve plots the relationship between the total quantity demanded and the market price. 

The demand curve shifts when these 5 major factors change:

1. Tastes and preferences
2. Income and wealth
3. Availability and prices of related goods
4. Number and scale of buyers
5. Buyer’s beliefs about the future

A change in tastes or preferences is simply a change in what we personally like or value. This would be a leftward shift in demand because a lower quantity demanded for a given price of oil corresponds to a leftward movement on the x-axis. 

The demand curve shifts only when the quantity demanded changes at a given price. If a good’s own price changes and its demand curve hasn’t shifted, the own price change produces a movement along the demand curve. It helps to remember that if the quantity demanded changes at a given price, then the demand curve has shifted. 

A change in income or wealth affects your ability to pay for goods and services. For a normal good, an increase in income shifts the demand curve to the right, causing buyers to purchase more of the good. If rising income shifts the demand curve for a good to the left, then the good is called an inferior good. 

Even if the price of oil hasn’t changed, a change in the availability and prices of related goods will also influence demand for oil products, thereby shifting the demand curve for oil. Two goods are said to be substitutes when a rise in the price of one leads to a rightward shift in the demand curve for the other. Two goods are said to be complements when a fall in the price of one good leads to a rightward shift in the demand curve for the other good. 

When the number of buyers increases, the demand curve shifts right. When the number of buyers decreases, the demand curve shifts left. The scale of the buyers’ purchasing behavior also matters. 

Changes in buyer’s beliefs about the future also influence the demand curve.  

The interaction of buyers and sellers in a marketplace determines the market price. We want to analyze the relationship between the price of a good and the amount of the good that sellers are willing to sell or supply. At a given price, the amount of that good or service that sellers are willing to supply is called the quantity supplied. 

A supply schedule is a table that reports the quantity supplied at different prices. The supply schedule shows that Exxon increases the quantity of oil supplied as the price of oil increases. So, a supply curve plots the supply schedule table. The supply curve of oil shows that the price of oil and the quantity supplied are positively related. This means that the variables move in the same direction. When one variable goes up, the other goes up too. In almost all cases, quantity supplied and price are positively related, which economists call the law of supply.

For an optimizing firm, the height of the supply curve is the firm’s marginal cost. A firm;s willingness to accept is the lowest price that a seller is willing to get paid to sell an extra unit of a good. For an optimizing firm, willingness to accept is the same as the marginal cost of production. 

When we studied buyers, we summed up their individual demand curves to obtain a market demand curve. We do the same thing for sellers. Adding up the quantity supplied world the same way as adding up the quantity demanded. We add up quantities at a particular price. We then repeat this at every possible price to plot the market supply curve. The market supply curve plots the relationship between the total quantity supplied and the market price. 

Aggregating the individual supply curves of thousands of oil producers yields a market supply curve. Recall that the supply curve describes the relationship between price and quantity supplied. There are four major types of variables that are held fixed when a supply curve is constructed. The supply curve shifts when these variables change:

1. Prince inputs used to produce a good 
2. Technology used to produce the good
3. Number and scale of buyers
4. Sellers’ beliefs about the future

Changes in the prices of inputs shift the supply curve. An input is a good or service used to produce another good or service. The supply curve shifts only when the quantity supplied changes at a given price. If a good’s own price changes and its supply curve hasn’t shifted, the own price change produces a movement along the supply curve. 

Changes in technology also shift the supply curve. 

Changes in the number of sellers also shift the supply curve. Finally, changes in seller’s beliefs about the future shift the supply curve. 

Competitive markets converge to the price at which quantity supplied and quantity demanded are the same. 

Demand curves slope down and supply curves slope up. 

Economists refer to the crossing point of the two curves as the competitive equilibrium. This is also called the market clearing price. 

The price at the crossing point is the competitive equilibrium price.

The quantity at the crossing point is the competitive equilibrium quantity.

At the competitive equilibrium price, the quantity demanded is equal to the quantity supplied. 

In a perfectly competitive market, sellers:

1. Cannot charge more than the market price and buyers cannot pay less than the market price

In a perfectly competitive market, if one seller chooses to charge a price for its good that is slightly higher than the market price, then it will:

1. Lose all or almost all of its customers

Market demand is derived by:

1. Fixing the price and adding up the quantities that each buyer demands

Does the shape of the market demand curve differ from the shape of the individual demand curve:

1. No, they both tend to be downward sloping curves

There is an inverse relationship between the quantity demanded of books and their price. 

The law of demand states that as the price of a good increases, the quantity demanded decreases. This can be shown with a downward sloping demand curve or numerically in a table using a demand schedule. The relationship that exists between these two variables can be described as negatively related.

Which of the following is not one of the five major factors that shifts the demand curve when it changes?

1. Prices of inputs used to produce the good

When one of the five major factors changes, causing an increase in demand, the demands curve shifts rightward

If the price of a complementary good increases, how would the demand for a normal good be impacted?

1. This is a left shift line parallel but left of the original

The law of supply states that as the price of a good increases, the quantity supplied of that good increases. This can be shown graphically with an upward sloping supply curve or numerically in a table using a supply schedule.

The relationship that exists between these two variables can be described as positively related.

As a firm produces more of a good, the cost of producing each additional unit increases. This implies that the marginal cost of producing a good increases as you make more of that good.

The supply curve represents:

1. The minimum price sellers are willing to accept to sell an extra unit of a good

Which of the following is not one of the four major factors that shifts the supply curve when it changes?

1. Price of the good itself

When one of the four major factors changes, causing an increase in supply, the supply curve shifts rightward.

If firms expected future price increases. How would the supply of smartphones be impacted?

1. Supply would contract. Draw a line parallel but leftward of the original line.

Land in Sonoma, CA, can be used to either grow grapes for pinot noir wine or to grow apples. Given this information, what is the relationship between pinot noir and apples?

1. They share a common input

If the demand for pinot noir suddenly shifts sharply to the right, we would expect to see an increase in the demand for land in Sonoma, which would increase the equilibrium price of land.

Since both pinot noir wine and apples use the same land in Sonoma, CA, a sharp increase in demand for pinot noir wine will result in a higher price for apples and a lower price equilibrium quantity. 

Lobsters are plentiful and easy to catch in August but scarce and difficult to catch in November. Given this information:

1. Both supply and demand are higher in August than in other months

When comparing the equilibriums in the lobster market for August and November, the equilibrium quantity is:

1. Lower, higher, lower, or unchanged

Given the supply and demand curves on the right, when the price of the goods is $20, we say that the market is in competitive equilibrium. At this price, we know that the quantity supplied is equal to the quantity demanded.

If the only change in the market was that the price increases to $20, then we know that the quantity sup[plied will be greater than the quantity demanded, resulting in an excess supply, which is known as a surplus.

Suppose instead that the price of the good dropped below the competitive equilibrium price to a price of $15 per unit. If this were to occur, then the quantity supplied would be less than the quantity demanded, resulting in an excess demand, which is also known as s shortage.

Suppose conditions arise in the sugar market that would lead to a competitive equilibrium price that is below 18.75 cents per pound. In this situation, sugar mills:

1. Not sell to private buyers at this lower price and will sell to the government instead, which will drive up the domestic price until it reaches 18.75 cents per pound.

Suppose a new off campus university apartment complex could rent its rooms on the open market for 900 a month. If instead, the university chooses to cap the price of rooms to 500 a month for students, the result would be that:

1. Quantity demanded would exceed the quantity demanded, resulting in a shortage

Suppose the university is trying to determine the most efficient way to allocate the rooms such that those who value the rooms the most get them. Which of the following would you suggest as the most efficient?

1. Auctioning the rooms to the highest bidders

Consumers and Incentives

The buyer’s problem has three parts: what you like, prices, and your budget. An optimizing buyer makes decisions at the margin. An individual’s demand curve reflects an ability and willingness to pay for a good or service. Consumer surplus is the difference between what a buyer is willing to pay for a good and what the buyer actually pays. Elasticity measures a variable’s responsiveness to changes in another variable.

First, as a buyer, you want to buy goods and services that you like, because you prefer to buy what tastes good, sounds good, or looks good. You must also consider prices of the various goods and services that interest you. 

The benefits that you receive from consuming goods and services are a direct result of your tastes and preferences. When it comes to the buyer’s problem, economists assume that the consumer attempts to maximize the benefits from consumption. 

Prices are the most important incentives that economists study. They allow us to formally define the relative cost of goods. 

The final ingredient of the buyer’s problem is what you can buy. The budget set is the set of all possible bundles of goods and services that a consumer can purchase with his income. 

An optimizing buyer makes decisions at the margin. 

A decrease in the price of either good will cause the budget constraint to pivot outward. When a price changes, the opportunity cost changes. This will cause the buyer to change the optimal quantities consumed. 

With an understanding of how to spend optimally, we can begin to construct demand curves. An individual’s willingness to pay measured over different quantities of the same good makes up the individual’s demand curve. The demand curve isolates the contribution that a good’s own price makes toward determining the quantity demanded in a given time period.

The quantity demanded refers to the amount of a good that buyers are willing to purchase at a particular price. A demand curve maps how quantity demanded responds to price changes. 

The demand curve shows how the quantity demanded depends on the price of the good. The demand curve is downward sloping. Every point on your demand curve represents a unique price and quantity level. 

We have learned we should recognize the incentives that we face and make decisions based on marginal analysis. That is, we should consider the marginal benefits and marginal costs in our decision making. In markets, the process of optimal decision making by consumers often yields total benefits well above the price we pay for goods. Economists give these market-created benefits a name, consumer-surplus. Consumer surplus is the difference between the willingness to pay and the price paid for the good. 

When price increases, consumer surplus decreases. The higher the price, the smaller the difference between the willingness to pay and the market price. Furthermore, the higher the price, the lower the quantity demanded. 

If we want to know how responsive quantity demanded is to a change in price, we want to know about price elasticity. Elasticity measures the sensitivity of one economic variable to a change in another. In other words, it tells us how much one variable changes when another variable changes. More precisely, elasticity is a ratio of percentage changes in variables. 

Elasticity is an important concept because it takes into account not only the direction of change but also the size of the change. The different types are:

1. Price elasticity of demand
2. Cross-price elasticity of demand
3. Income elasticity of demand

We know from the law of demand that when the price of a good increases, the quantity demanded generally falls. However, we do not know how much quantity demanded falls. The price elasticity of demand measures the percentage change in quantity demanded of a good resulting from a percentage change in the good’s price. 

The distinction between whether a good has a price elasticity of demand greater than or less than 1 is very important. A price elasticity of 1 says that if the price is increased by 20% then quantity demanded decreases by 20%. 20/20=1. So, if price elasticity is greater than 1, price increases hurt revenue.

Elasticity is much different than the slope of a line. Even though the slope is the same over the entire demand curve, the elasticity varies over the slope of the line. This is because the ratio of price to quantity changes as we move along the demand curve. 

Next, elasticities tend to vary over ranges of the demand curve. They are different at the top, middle, and bottom of the curve. 

Another measure that economists often calculate is arc elasticity. The arc elasticity achieves a stable elasticity regardless of the starting point by using the average price and quantity in the calculation. 

Goods with a price elasticity of demand greater than 1 have elastic demand. The percentage change in quantity demanded is greater than the percentage change in price. Peanut butter is an example.

Goods with a price elasticity of demand equal to 1 have unit elastic demand. 1 percent price change affects quantity demanded by 1 percent. So, in this example, a price increase does not affect revenue. Wine is a good with this characteristic. 

Goods with a price elasticity of demand less than 1 have inelastic demand. When the price elasticity of demand is less than 1, the percentage change in quantity demanded is less than the percentage change in price. Cigarettes are such a good. 

Demand can also be perfectly inelastic, which means that quantity demanded is completely unaffected by price. An example of this is insulin, you just have to have it. 

Economists have pinpointed three primary reasons for elasticity differences:

1. Closeness of substitutes
2. Budget share spent on the good
3. Available time to adjust

Economists are interested in much more than merely how changes in a good’s price affect consumers. Another type of inelasticity that economists consider is how quantity demanded for one good changes when the price of a substitute or complement good changes. This is called the cross-price elasticity of demand. It is a measurement of the percentage change in quantity demanded of a good due to a percentage change in another good’s price. 

If a cross-price elasticity is negative, then the two goods are complements. Two goods are complements when the fall in the price of one leads to a right shift in the demand curve for another. 

If a cross-price elasticity is positive, then the two goods are substitutes. Two goods are substitutes when the rise in the price of one leads to a right shift in the demand curve for the other. 

A third type of elasticity measurement has to do with how changes in income affect consumption patterns. The income elasticity of demand informs us of the percentage change in quantity demanded of a good due to a percentage change in the consumer’s income. 

A good is normal if the quantity demanded is directly related to income. When income rises, consumers buy more of a normal good.

A good is inferior if the quantity demanded is inversely related to income. When income rises, consumers buy less of an inferior good. 

Which of the following are necessary ingredients to the buyer’s problem?

1. Prices of goods and services
2. Amount of money the consumer has to spend
3. Consumers tastes and preferences

Akio consumes two goods, books and video games. His income is $40, the price of a video game is $8 and the price of a book is $4.

Suppose Akio’s parents give him $24 for his birthday. 

Use his income, the monetary gift from his parents, and the price data to find the maximum amounts of each good that he could purchase. These will give you the endpoints of the budget constraint, from which you can sketch the budget set. 

1. 8 video games
2. 16 books

Now suppose Akio’s parents had given him three video games for his birthday instead of giving him $24. Akio is a very polite young man and would never return a gift that his parents had given him for cash.

The budget constraint is simply a subset of the budget set; graphically, it is the outer edge of the budget set that separates affordable bundles from unaffordable bundles. 

Based on your preceding answers, which of the following applies:

1. He could be indifferent between a gift of $24 and a gift of three video games.
2. Akio could prefer a gift of three video games.

Hanna has $420 to spend on movies and concerts. Suppose the price of a movie ticket is $14 and the price of a concert ticket is $70.

1. 30 movie tickets
2. 6 concert tickets

Suppose the price of concert tickets drops to $60.

1. 30 movie tickets
2. 7 concert tickets

Now suppose Hanna has $840 to spend rather than 4420. How will this change affect hann’s budget line?

1. It shifts outward in a parallel fashion

Given the information about Hanna’s income and the prices for concerts and movies, we are unable to determine where on the budget line hanna would choose to consume because:

1. Hanna’s tastes regarding movies and concerts are unknown to us

Charley spends all of his income on soft drinks and pizza. Suppose he is currently buying these products in amounts such that his marginal benefit from an additional soft drink is $180 and his marginal benefit from an additional slice of pizza is $80. If the price of a soft drink is $4 and the price of a slice of pizza is $3, is Charley maximizing his total benefits?

1. No, he should shift consumption toward soft drinks and away from pizza to maximize his total benefits.

The demand curve shows:

1. How the quantity demanded responds to changes in the price of the good

Everything else the same, as the price of the good increases, quantity demanded:

1. Decreases

According to economists, the process of optimal decision making by consumers typically yields total benefits well above the amount paid for the goods. 

These market-created benefits are referred to as:

1. Consumer surplus

Using the graph to the right, they are represented by area:

1. B

Suppose now that the market price falls. According to the graph, the excess of total benefits over the total amount spent by consumers will:

1. Increase

The price of rice in a small country is currently $9 per pound. In order to help low-income people afford an adequate diet, the government introduces a subsidy of $3 per pound of rice. Using the graph on the right, show the area representing the increase in consumer surplus as a result of the subsidy. Assume that the full amount of the subsidy is passed to consumers. To do this, you must create a single area by combining two shapes, rectangle and triangle

The formula for the area of a triangle is:

1. Base * height

The formula for the area of a triangle is:

1. (base*height)*½

The sum of these will measure the increase in consumer surplus:

1. (60) + 15=75

Now using the rectangle drawing tool, show the cost of the subsidy in the graph to the right. The hatched area measures the increase in consumer surplus derived above.

According to the graph, the cost of the subsidy is:

The cost of the subsidy is the per unit subsidy*the number of units consumed after the subsidy takes effect.

1. 30*3=90

From the analysis, the cost of the subsidy(90) exceeds the increase in consumer surplus(75) by $15

The price elasticity of demand shows the percentage change in the quantity demanded of a good due to

1. A percentage change in the good’s price

In the market for sneakers, suppose Green’s price elasticity of demand is 0.2, smith’s price elasticity is 1.2, and the price elasticity of all the other consumers is greater than 0.2 but less than 1.2. Could the market price elasticity be less than 0.2 or greater than 1.2?

1. No, it must be between 0.2 and 1.2

Which of the following shows the arc elasticity method of calculating the price elasticity of demand?

1. \( \frac{\frac{Q_2-Q_1}{(Q_2+Q_1)/2}}{\frac{P_2-P_1}{(P_2+P_1)/2}}}

Consider the following statement: given that bacon and eggs are complementary good, if the price of eggs decreases the demand for both goods will rise. Is this an accurate statement?

1. It is somewhat inaccurate. The decrease in the price of eggs will increase the quantity demanded for eggs. It will, however, as the statement claims, increase the demand for bacon.

Consider the following demand schedule for bags.

13 60

15 56

17 48

The price elasticity of demand measures the percentage change in quantity demanded of a good resulting from a percentage change in the good’s price.

Using the midpoint formula:

Percentage change in price= \( \frac{(15-13)}{(15+13)/2}=14.3 \) percent

Percentage change in quantity = \( \frac{(56-60)}{(56+60)/2} = -6.9 \) percent

Price elasticity of demand = \( \frac{-6.9}{14.3} = -0.5 \) 

When the price of bags rises from 13 to 15, the price elasticity of demand is approximately:

1. -0.5

When the price of bags increases from 15 to 17, the total expenditure will:

1. Decrease

Because the price elasticity of demand is:

1. Relatively elastic

Jonathan works at a convenience store and makes note of changes to sales after the price of liquid soap unexpectedly increases by 15%. He notices that the sale of shampoo decreases by 3 percent and the sale of lotion increases by 10 percent. 

The cross-price elasticity of demand is a measurement of the percentage change in quantity demanded of a good due to a percentage change in the price of another good.

The cross-price elasticity between liquid soap and shampoo is negative.

(-3 percent / 15 percent) = -0.2

The cross-price elasticity of demand between liquid soap and shampoo is:

1. -0.2

Based on the cross-price elasticity of demand, we can infer that liquid soap and lotion are substitutes

Three years after graduating from college, you get a promotion and a 12 percent raise. Your consumption habits change accordingly. Suppose your consumption of frozen hot dogs has reduced by 4 percent.

The income elasticity of demand is the percentage change in quantity demanded of a good due to an increase in the consumer’s income.  

In the given scenario, the income elasticity of demand is:

\( \frac{-4 \text{percent}}{12 \text{percent}} = -0.33 \)

Your income elasticity of demand is:

1. -0.33

Thus, we can say that a frozen hot dog is an inferior good

Suppose your consumption of pork chops has increased by 8 percent. Your income elasticity of demand is:

1. 8/12=.67

Thus, we can say that a pork chop is a normal good

Suppose your consumption of sockeye salmon has increased by 20 percent. Your income elasticity of demand is:

1. 20/12=1.67

Thus we can say that sockeye salmon is a:

1. Luxury good

Suppose that Hershey’s increases the price of its chocolate ice cream syrup by 15 percent. In response, the quantity demanded of Nesquik chocolate syrup rises by 11 percent and the quantity demanded of Breyer’s vanilla ice cream falls by 5 percent.

The cross-price elasticity of demand measures the percentage change in quantity demanded of a good due to a percentage change in another good’s price.

If a cross-price elasticity is negative, then the two goods are complements. Alternatively, if a cross-price elasticity is positive, then the two goods are substitutes.

The cross-price elasticity of demand between Hershey’s syrup and nequik’s syrup is:

1. Positive

Implying these two goods are:

1. Substitutes

The cross-price elasticity of demand between Hershey’s syrup and Breyer’s ice cream is:

1. Negative

Implying these two goods are:

1.  complements

Suppose that incomes rise by 9 percent given the price change cited above. As a result, Hershey’s experiences a 5 percent increase in sales volume. Given this information, hershey’s syrup is a:

1. Normal good

For this exercise, assume there are only two goods. 

The substitution effect of a decrease in the price of one good always:

1. decreases

The amount of that good in the individual’s new consumption choice and:

1. Increases the amount of the other good

The associated income effect of a decrease in the price of one good:

1. Will always decrease the quantity of that good and:
2. Will always decrease the quantity of the other good, but the

Quantities of the two goods in the new consumption choice cannot simultaneously:

1. Increase as a result of the income effect

If an individual only consumes goods x and y and is currently maximizing her total benefits, which of the following must be true?

1. All of the above
2. The equal bang for the buck rule is adhered to
3. mbx/px = mby/py
4. The marginal benefits per dollar spent are the same for both good
5. No other consumption choice can make total benefits greater

Sellers and Incentives

In much the same way that consumers choose the optimal bundle of goods and services to maximize their net benefits, sellers choose what to produce and how much to produce to maximize their net benefits: profits.

The seller’s problem has three parts:

1. Production
2. Costs
3. Revenues

An optimizing seller makes decisions at the margin. The supply curve reflects a willingness to sell a good or service at various price levels. Producer surplus is the difference between the market price and the marginal cost curve. Sellers enter and exit markets based on profit opportunities.  

Three conditions characterize perfectly competitive markets are:

1. No buyer or seller is big enough to influence the market price
2. Sellers in the market produce identical goods
3. Their is free entry and exit in the market

Just as a consumer can buy as much as he wants at the market price, sellers are price-takers in that they can sell as much as they want at the market price. The rationale behind this assumption is that an individual seller tends to only sell a tiny fraction of the total amount of a good produced. Because the seller’s output is small relative to that of the market, the individual choice of how much to produce isn’t going to be important for market outcomes. But the combined effect of many seller’s decisions will affect the market price. 

The three elements of the seller’s problem are:

1. Making the goods
2. Cost of doing business
3. Rewards of doing business

A firm is a business entity that produces and sells goods or services. Every firm faces the decision of how to combine inputs to create outputs. Production is the process by which the transformation of inputs (such as labor and machines), to outputs (such as goods and services) occurs. The relationship between the quantity of inputs used and the quantity of outputs produced is called the production function. 

Physical capital is any good, including machines and buildings, used for production. 

Economists refer to the short run as a period of time when only some of a firm’s inputs can be varied. Alternatively, the long run is defined as a period of time wherein a firm can change any input. This means that physical capital is a fixed factor of production or an input that cannot change in the short run. That labor is a variable factor of production or an input that can change in the short run. Marginal product is the additional amount of output obtained from adding one more unit of input, such as a worker. The marginal product increases with the addition of the first few workers. This happens because workers specialize in a particular portion of their jobs. In specialization, workers develop specific skill sets to increase total productivity. 

The marginal product eventually decreases with successive additions of workers. This is the same as diminishing returns of additional workers. Adding too many workers can decrease overall production. It will depend on the environment and place. 

The cost of production is what the firm must pay for its inputs. 

\[ \text{total cost} = \text{variable cost} + \text{fixed cost} \]

Total cost is the sum of variable and fixed costs. Variable costs are those costs associated with variable factors of production. A fixed cost is a cost associated with a fixed factor of production, such as equipment. It does not change with production in the short run. 

The average total cost is total cost divided by total output. 

The average variable cost is the total variable cost divided by total output. 

Average fixed cost is the total fixed cost divided by the total output.

Marginal cost is the change in total cost associated with producing one more unit of output. 

\[ \text{marginal cost} = \frac{ \text{change in total cost}}{ \text{change in output}} \]

A firm makes money from selling goods. The revenue of a firm is the amount of money it brings in from the sale of its outputs. Revenue is determined by the price of its goods sold times the number of units sold.

\[ \text{total revenue} = \text{price} * \text{quantity sold} \]

Recall that in perfectly competitive markets, sellers can sell all they want at the market price. This means they are price-takers. The price of a unit sold comes from the intersection of the market demand curve and the market supply curve. So, the intersection of market supply and market demand gives the equilibrium price. 

Marginal revenue is the change in total revenue associated with producing one more unit of output. In a perfectly competitive market, marginal revenue is equal to the market price. Therefore, the marginal revenue curve is equivalent to the demand curve  facing sellers. 

The profits of a firm are the difference between total revenues and total costs.

\[ \text{profits} = \text{total revenues} - \text{total costs} \]

If a firm can produce another unit of output at a marginal cost that is less than the market price, it should do so, because it can make a profit on producing that unit. 

With this marginal decision making in mind, its straightforward to see how a firm maximizes its profits. It should expand production until:

\[ \text{marginal revenue} = \text{marginal cost} \]

This is the same as producing where price equals marginal cost, because marginal revenue equals price in a perfectly competitive market. 

We can compute total profits by taking the difference between price and average total cost at the point of production and multiplying that difference by the total quantity produced. 

Accounting profits are equal to revenues minus explicit costs. Explicit costs are the sorts of line item expenditures that accountants carefully tally and report, like wages or equipment costs. Economic profits are equal to total revenues minus both explicit and implicit costs.  

The mr=mc rule is powerful because we can determine in the short run how a competitive firm changes its output when the market price changes. 

When considering how responsive the firm is to price changes, we can use elasticity measures. For sellers, the most important measure that economists use is called the price elasticity of supply. This is the measure of how responsive the quantity supplied is to price changes.

Price elasticity of supply = percentage change in quantity supplied / percentage change in price

The price elasticity of supply will tend to be positive, because as price increases, firms tend to increase their quantity supplied.

An elastic supply means that quantity supplied is quite responsive to price changes. Any given percentage change in price leads to a larger percentage change in quantity supplied. In a perfectly elastic supply curve, a very small change in price leads to an infinite change in quantity supplied.  

Alternatively. An inelastic supply means that any given percentage change in price causes a smaller percentage change in quantity supplied. In this case, at every different price, the same quantity is supplied. 

Much like demand elasticities, the size of supply elasticities is determined by several factors. Key determinants include whether the firm has excess inventories. Likewise, how long the firm has to respond to price changes is important, the longer the time to respond, is the more elastic the supply will be. Finally, if workers are readily available, then supply will be more elastic because the firm can respond to price increases by quickly hiring workers. 

A shutdown is a short run decision to not produce anything during a specific time period. Sunk costs are a special type of cost that, once they have been committed, can never be recovered. One of the important things to remember about sunk costs is that once they are committed, they shouldn’t affect current or future production decisions. They can’t affect the relative costs and benefits of current and future production decisions. 

The short run supply curve is the portion of its marginal cost curve that lies above average variable cost. If the market price lies at a point on its marginal cost curve that lies below the minimum of the average variable cost curve, then the firm should shut down. Otherwise, it should produce. 

Producer surplus is computed by taking the difference between the market price and the marginal cost curve. Graphically, producer surplus is the area above the marginal cost curve and below the equilibrium price line. In this way, it is distinct from economic profits. 

A consumer’s surplus arises from being willing to pay above the market price, a producer’s surplus arises from selling units at a price that is above the marginal cost. Similar to consumer surplus, we can add up the seller’s producer surplus to obtain the total producer surplus in the market. We do this by measuring the area above the marginal cost curve that is below the equilibrium price line to compute producer surplus for the entire market. 

There are several ways in which producer surplus can increase or decrease. For example, if a shift in the market demand curve causes a higher equilibrium market price, then producer surplus increases, because the area above the supply curve and below the equilibrium price line gets larger. 

Firms often think about more than just each day’s production. Many businesses issue quarterly reports that discuss the firm’s long term outlook. 

The long run is defined as a period of time in which all factors of production are variable. In the long run, there are no fixed factors of production, because even machines and buildings can be retrofitted, purchased, expanded, or sold. Because of this fact, there are important differences between a firm’s short and long run supply curves. 

In the short run, if it wants to change production, it can only do so by hiring or laying off workers. This is because only labor is variable in the short run. In the long run, the firm searches for the optimal combination of workers and building size. Also in the long run, the firm is able to combine workers and physical capital to achieve the minimal average total cost for each output level. This difference causes the short run cost curves to be above the long run cost curve. 

Economies of scale occur over the daily output range and such an effect might occur because as the scale of the plant gets bigger, workers have more opportunities to specialize. When average total cost does not change with the level of output, the plant experiences constant returns to scale. Diseconomies of scale occur when average total cost increases as output rises and this might happen because management teams begin to get spread too thin or duplication of tasks occurs.

An exit is a long run decision to leave the market. Exit if price is less than average total cost or if total revenue is less than total cost. 

The long run supply curve is the portion of its marginal cost curve that lies above the average total cost. 

Total profit in the long run is computed exactly like its short run profit. Total revenue minus total cost. Profit equals the difference between price and average total cost multiplies by the quantity sold. Accordingly, when computing producer surplus in the long run, we take the difference between market price and the seller’s long run marginal cost curve. 

Much like the short and long run analyses for the individual firm, at the industry level there are critical distinctions between the short run and the long run. The primary difference is that even though the number of firms in the industry is fixed in the short run, in the long run, firms can enter or exit the industry in response to changes in profitability. This is because in the long run, they have the ability to change both labor and physical capital.

If there is free entry into the industry, which means entry is unfettered by any special legal or technical barriers, the entry process continues until the last entrant drives the market price down to the minimum average total cost. 

The market supply curve is the summation of individual firms’ supply curves, adding new firms causes the industry to provide higher quality at any given price. 

We know that the market price in a perfectly competitive industry is determined by the intersection of the market demand and market supply curves. A shift to the right of the market supply supply curve lowers the market price. Atr this point, the market reaches an equilibrium, because no more firms will enter. Firms will keep entering the market as long as the new price remains above the minimum average total cost. A new entry into the market will further shift the market supply to the right and lower the market price even more. They will keep doing this until it is no longer profitable to enter the market. 

Free exit from the market means their exit is unfettered by any special legal or technical barrier. The firms that exit first will be the ones with the highest cost. 

Notice that regardless of initial demand or supply shifts and accompanying price changes in the market, entry or exit causes the market to reach the minimum of the long run average total cost curve. That is, the equilibrium quantity in the market might change due to market demand and supply shifts., but the equilibrium price always returns to the minimum of the long run average total cost. 

Even though the industry’s short run supply curve is upward sloping, the industry’s long run supply curve is horizontal at the long run minimum average total cost level. Price always returns to the minimum average total cost, and because average total cost does not change, price always remains the same in the long run. This is because variations in long run industry output are absorbed by firm entry and exit, causing long run quantity to change while equilibrium price remains the same. 

The second long run outcome achieved with free entry and exit is that firms in a perfectly competitive market earn zero economic profits in equilibrium. Economic profits serve as an important signal as to whether firms are better off in this industry or in some other industry. If economic profits are positive, then entry occurs until economic profits fall to zero. If economic profits are negative, exit occurs until these profits rise to zero. Free entry and exit forces price to the minimum average total cost, and therefore economic profits are zero in the long run equilibrium. 

However, economic profits are not the same as accounting profits. As a business owner, when economic profits are zero, it simply means that you cannot earn more money if you take your talents to a different industry. You are being paid at least your opportunity cost of time. 

Sellers optimize by solving the seller’s problem, which dictates that decisions are made on the margin. Expand production until marginal cost equals marginal revenue.

Short and long run supply curves provide an indication of seller’s willingness to sell at various price levels. 

The difference between price and the marginal cost curve is producer surplus.

Free entry and exit cause long run economic profits to equal zero in a perfectly competitive market. 

With an understanding of decision making rules from the seller’s problem and the forces of free entry and exit, we can not only better understand hot ro run our own business but also better predict how sellers will respond to incentives.

 In a perfectly competitive market, a seller:

1. Cannot choose to raise the price of its goods since all sellers in the market produce identical goods, so raising the price would result in losing all its customers.

All firms in a perfectly competitive market are said to be:

1. Price takers

The marginal cost curve intersects the average total cost curve at its minimum point. Graphically, the marginal cost curve should start below the average total cost curve, intersect it at the average total cost’s lowest point, and then remain above the average total cost.

When the average total cost curve is decreasing, we know that the marginal cost curve is below the average total cost curve, and when the average total cost curve is increasing, we know that marginal cost is above the average total cost curve. 

What is the difference between accounting profit and economic profit?

1. Economic profit subtracts both explicit and implicit costs from total revenue. While accounting profit only subtracts explicit costs.

Is it possible for accounting profit to be positive and economic profit to be negative?

1. Yes, this could occur if explicit costs were modest and implicit costs were high

Under which of the following examples is it likely that the accounting profit is positive and the economic profit is negative?

1. If you open an amusement park in the middle of new york city

Fixing up old houses requires plumbing and carpentry. Jack can fix up three houses in a year if he does all of the carpentry and plumbing himself. His wage is 100,000 per year. Average total cost is the total cost divided by the total output. Jack’s average total cost of fixing up three old houses is:

1. (100000/3) = 33,333

George is an excellent plumber and Harriet is an excellent carpenter. George can do all of the plumbing and Harriet can do all of the carpentry to fix up eight houses per year. Each earns a wage of 100000 per year. If george and Harriet work together and fix up eight old houses each year, their average cost is:

1. (200000/8) = 25000

This problem tells us that one of the sources of economies of scale is:

1. Specialization. Economies of scale occur when average total cost falls as the quantity produced increases.

Which of the following equations calculates the profits of a firm?

1. Total revenues - total costs

When comparing the accounting profit with economic profit, it must be true that the accounting profit is:

1. Greater than or equal to economic profit

The graph to the right shows the average total cost, average variable cost, marginal cost, and marginal revenue curves for a firm in a perfectly competitive market. In order to maximize profits, this firm should produce approximately:

1. 11 units of output

Calculate the price of elasticity of supply in the following examples, then determine if supply is relatively elastic or inelastic, or perfectly elastic or inelastic. 

When the price of a pen increased from 3 to 4, the quantity supplied by a firm increased from 100 to 150 pens. The price elasticity of supply is:

1. (q2-q1) / (q2+q1)/2 all over (p2-p1) / (p2+p1)/2 = (150-100) / (150 + 100)/2 all over (4.00 - 3.00) / (4.00 + 3.00)/2 = 50 / 125 all over (1.00) / (3.50) = .4 / .29 = 1.38

In this case, the price elasticity of supply is:

1. Relatively elastic

When the price of bottled water increased from 2.00 to 2.25, the quantity supplied by a firm increased from 200 to 216 bottles. The price elasticity of supply is:

1. .65

In this case, the price elasticity of supply is:

1. Relatively inelastic

Even though the price of an acre of land increased from 6000 to 10000, the quantity supplied did not change. The price elasticity of supply is:

1. 0

In this case, the price elasticity of supply is:

1. Perfectly inelastic

The ISS is a habitable satellite launched by NASA. In 2009, NASA was considering shutting down the ISS within the next 5-6 years. Among those who were opposed to this idea of de-orbiting the ISS was senator Bill Nelson who was quoted as saying, if we’ve spent a hundred billion dollars, i don’t think we should shut it down in 2015. 

The hundred billion dollars is known as a:

1. Sunk cost

Given this information, the senator’s comment is:

1. Flawed

Since these types of costs:

1. Should not affect current and future decisions

You are planning to build an apartment building. Your market research department estimates that your revenues will be 800000. Your engineering department estimates the cost will be 600000. You started construction and spent 200000 to build the foundation when the recession began. This causes the market research department to revise its revenue estimates downward to 399950. Should you complete the apartment building?

1. No, the remaining cost to build is 400000 and you only expect to earn 399950. You will ignore the 200000 since it is a sunk cost

Producer surplus is the difference between the:

1. Price consumers pay and the supply curve

The graph on the right shows the long run average total cost curve for a  perfectly competitive firm. Refer to points a,b, and c and identify where the firm would experience economies of scale, constant returns to scale, and diseconomies of scale.

1. Point a = economies of scale since the average total cost curve is decreasing as the quantity produced is rising.
2. B = constant returns to scale since the slope is constant
3. C = Diseconomies of scale since since the average total cost curve is increasing as the quantity produced is rising

A firm is experiencing economies of scale when its:

1. Average total cost declines as more output is produced

The table below shows the long run total costs of three different firms.

Do firms 1 and 2 experience economies of scale or diseconomies of scale?

1. Firm 1 is experiencing economies of scale and firm 2 is experiencing diseconomies of scale.

Minimum efficient scale is the lowest level of output where long run average total cost is minimized. Firm 3’s minimum efficient scale occurs when the output is:

1. 3 units

You are one of 5 identical firms that sell widgets. Each day, you have a fixed cost of $9 to operate. The marginal cost of your first widget is $1, second is $2, third $3, fourth $7, and for the fifth it is $8. You have a capacity constraint of 5 and you can only produce a whole number of widgets. The average variable cost for a firm that produces 2 widgets is:

1. (2+1)/2 = 1.50

The market level quantity supplied given the market price of a widget is 2.50 is:

1. Each firm will supply two widgets as the marginal cost of the third widget will be greater than the market price. Since there are 5 firms, the total market level quantity supplied is 2*5 = 10 widgets

Suppose the market level demand is fixed at 18. In other words, there is perfectly inelastic demand. In the short run, the equilibrium price will be:

1. For the market supply to be 18, each firm must be willing to supply either 3 or 4 widgets. At a market price of $7, firms will be willing to supply 4 widgets as the marginal cost will be equal to the price.

If firms are perfectly competitive, the equilibrium price in the long run will be

1. In the long run, price will be driven to the minimum average total cost. At q=2, average total cost is $6, at Q=4. average total cost is $5.50. Therefore, in the long run, the equilibrium price will be $5.

Click on the table icon that shows fixed costs, variable costs, and total costs for different output levels. Then use this data to help fill in missing information

0 - - -

1 16 5 21

2 8 8 16

3 5.33 10.33 15.66

Using the same table, what is the marginal cost of the third unit produces?

1. 15

The graph on the right shows the cost curves for a random firm competing in a perfectly competitive market. Given the shape of the curves label each curve:

1. Marginal cost, average total cost, average variable cost

Which of the following statements regarding producer surplus are not true?

1. It is not possible to calculate the total producer surplus in the market
2. It is the area below the marginal cost curve
3. It is the difference between total cost and total revenue

When the market price(p) is 3.50, the total producer surplus equals:

1. 375

If the equilibrium market price(p) changes to 3.00, the total producer surplus would:

1. Decrease

Assume that the market for chocolates is perfectly competitive. Which of the following statements would be true in this case?

1. Jill starts to produce chocolates today but the addition of her supply into the market does not decrease the market price

Consider a market where there are many firms with different cost structures. When determining which firms enter the market first, we look at:

1. Average total cost

The last firm to enter earns:

1. Zero economic profits

If demand shifts to the left(decreases), the last firm that entered:

1. Earns negative economic profits and so exits the market

The graph on the right shows the long run average cost curve and marginal cost curve for a firm in a perfectly competitive market. Based on the graph to the right, the long run supply curve is:

1. Segment bc, since at prices below B the firm would shut down in the long run

The graph on the right shows the short run cost curves and three possible marginal revenue curves for a perfectly competitive firm.

If the firm were facing mr1, then we know that this firm should:

1. Keep producing, since it is making a profit at the profit maximizing output

If the firm were facing mr2, then we know that his firm should:

1. Keep producing, even though it is incurring a loss it is less than the fixed costs that must be paid if it shuts down

If the firm were facing mr3, then we know that his firm should:

1. Shut down, since it is incurring a loss that is greater than the fixed costs that must be paid if it shuts down

Assume that a perfectly competitive market in a long run equilibrium with firms earning zero profit experiences a sudden increase in demand for its good.

1. As a result, in the long run, the rise in marginal revenue will cause firms to enter the market. 

How does a change in the number of firms in the market impact the market equilibrium?

1. Put a point above the current equilibrium point
2. Draw a curve shifted to the right

Perfect Competition

The invisible hand efficiently allocates goods and services to buyers and sellers. The invisible hand leads to efficient production and industry. The invisible hand allocates resources efficiently across industries. Prices direct the invisible hand. There are trade-offs between making the economic pie as possible and dividing the pieces equally. 

A reservation value is the price at which a person is indifferent between making the trade and not doing so. 

When we plot the demand and supply schedules, we end up with stepwise curves because each individual only demands or supplies one unit. 

The equilibrium price is determined by the intersection of the market demand and market supply curves. 

Social surplus is the sum of consumer surplus and producer surplus. It represents the total value from trade in the market. For social surplus to be maximized, the highest-value buyers are making a purchase and the lowest-cost sellers are selling. In this way, buyers and sellers as distinct groups are doing as well as they possibly can, they are optimizing.

We now know that the competitive market equilibrium is efficient in the sense that mutually advantageous trades take place. In this way, there are no unexploited gains to trade. Accordingly, the competitive market equilibrium maximizes social surplus.

The pareto efficient asks if we can make any individual better off without harming someone else, and the answer is no. An outcome is pareto efficient if no individual can be made better off without making someone else worse off. As it turns out, besides maximizing social surplus, the competitive market equilibrium is also pareto efficient.

So we can say that in a perfectly competitive market, the first distinct function of the equilibrium price is that it efficiently allocates goods and services to buyers and sellers.

So, we can say that in a competitive market, the second distinct function of the equilibrium price is that it efficiently allocates the production of goods in an industry. 

Entry in a market stops when the market price decreases all the way down to where the marginal cost curve intersects the average total cost curve. Once the price reaches the minimum of the average total cost curve, we are in equilibrium because p=mc=atc, which means that there is zero economic profit and therefore no reason for more firms to enter.

This example shows what happens when positive economic profits exist in an industry, resources flow to that industry because of the profits available, This behavior causes resources to flow from less productive uses to more productive uses. 

Such shifting of resources leads to a very important outcome, in a perfectly competitive market equilibrium, production occurs at the point of minimum average total cost. Because resources leave those industries in which price cannot cover their costs of production and enter those industries where price can cover their costs of production, the total value of production is maximized in equilibrium. 

This reasoning leads to a third distinct function of equilibrium prices in a competitive market, they allocate scarce resources across industries in an optimal manner. This is because the industry equilibrium is where p=atc=mc, and this happens only at the minimum point of the average total cost curve. 

What we know so far is that when the right market conditions are in place, self-interest and social interest, as measured by special surplus, are perfectly aligned. Price incentives lead economic agents to act in this manner. Market prices act as the most important piece of information, leading high-value buyers to buy and low-cost-sellers to sell. The flow of labor and physical capital to sectors with the highest rewards cause the production to be at just the right level in a competitive market equilibrium. 

A price control is a government restriction on the price a firm can charge for a good or service. 

Economists call the decrease in social surplus that results from a market distortion a deadweight loss. 

The coordination problem of bringing agents together to trade is a difficult one for central planners. After you have solved the coordination problem, you need to think about how to tackle the incentive problem, or aligning the interests of the economic agents. 

A market economy has features that are remarkable at providing price signals that guide resources in a way that maximizes social surplus and makes the economy efficient. Market forces tend to eliminate waste. 

Equity is concerned with how the economic pie is allocated to the various economic agents. 

In a double oral auction, both bids and asks are orally stated. 

Bilateral negotiations are when a single buyer and a single seller confront each other with bids and asks, rather than yelling out the offers to a group. 

When the strong assumptions of a perfectly competitive market are in place, markets align the interests of self-interested agents and society as a whole. In this way, the market harmonizes individuals and society so that in their pursuit of individual gain, self-interested people promote the well-being of society as a whole.

The remarkable tendency of individual self-interest to promote the well-being of society as a whole is orchestrated by the invisible hand.

The invisible hand efficiently allocates goods and services to buyers and sellers, leads to efficient production within an industry, and allocates resources efficiently across industries.

The invisible hand is guided by prices. Prices incentivize buyers and sellers, who in turn maximize social surplus, the sum of consumer surplus and producer surplus, by simply looking out for themselves.

We can measure the progress of an economy by measuring social surplus, or how big the economic pie is. But we can also measure progress by considering questions of equity, or how the economic pie is distributed among economic agents. 

The diagram on the right shows the demand and supply for jeans. Calculate consumer surplus, producer surplus, and social surplus in the market.

Consumer surplus is measured by the area under the demand curve and above the equilibrium price line.

Producer surplus is above the supply line and below the equilibrium line.

Social surplus is the sum of consumer and producer surplus.

Consumer surplus is:

1. (20*140) / 2 = 1400

Producer surplus is:

1. (30*140) / 2 = 2100

Social surplus is:

1. 1400 + 2100 = 3500

 There are four consumers willing to pay the following amounts for an electric car: 60000, 40000, 80000, 20000

There are four firms that can produce electric cars at the following costs: 20000, 80000, 30000, 40000

Each firm can produce at most one car. Suppose the market for electric cars is competitive.

Why is the equilibrium price in this market 40000?

1. All of the above
2. At this price,, the quantity demanded(three cars) equals the quantity supplied(three cars)
3. At this price, three consumers are willing to buy an electric car and three firms are willing to sell an electric car
4. At 40000, three consumers have reservation values equal to or above 40000 and three firms have reservation values equal to or below 40000

Which firms will produce an electric car if the price is 40000?

1. A,C, D

Which consumers will buy an electric car when the price is 40000?

1. 1, 2, 3

Complete the table by calculating consumer surplus, producer surplus, and social surplus when the market price is 40000.

Consumer surplus is the difference between the buyers reservation values and what the buyers actually pay.

Producer surplus is the difference between the price and the seller’s reservation values.

Social surplus is the sum of the consumer and producer surplus

1. Consumer surplus = 60000
2. Producer surplus = 30000
3. Social surplus = 90000

Sara and Jim are going to lunch together and rank the restaurant options in the following way.

An outcome is pareto efficient if no individual can be made better off without making someone else worse off.

Which of the following restaurant choices are pareto efficient for Sara and Jim?

1. In this scenario, the pareto efficient outcomes occur when both Sara and Jim choose Naf Naf and Blaze. As there is no other allocation or bundle of restaurants which is preferred over Naf Naf and Blaze, both are ranked the highest.

Social surplus is the 

1. Total value from trade in a market

Social surplus is maximized when the

1. All of the above
2. Buyers and sellers as distinct groups are doing as well as they possibly can
3. Competitive market is in equilibrium
4. Highest value buyers are making a purchase and the lowest-cost sellers are selling

The figure on the right displays the market for video game consoles where nine buyers are interacting with nine sellers.

According to this figure the equilibrium price is:

1. 500

The equilibrium quantity is:

1. 5

When the market is in equilibrium, social surplus is:

1. (900-100)+(800-200)+(700-300)+(600-400) = 2000

If the number of consoles is restricted to two less than the equilibrium quantity, social surplus is:

1. (900-100)+(800-200)+(700-300) = 1800

Alternatively, if the government mandated that one more video game console than the equilibrium be transacted, social surplus is now:

1. 1800

From this analysis, it can be concluded that a market in competitive equilibrium:

1. Maximizes social surplus

The diagrams shown below depict the cost curves of two plants owned by a firm producing video games.

From the positions the curves hold in each graph, it can be deduced that the older, less efficient facility is:

1. Beta(atc is higher)

If video games are produced in a competitive market and the current price is 70, production in Alpha is:

1. 70 thousand and production in beta is 60 thousand units. (See where mc line crosses required price to get quantity)

If management sought to transfer 10 thousand units of Beta’s production to Alpha, the firm;s overall profits would:

1. Decrease, since for those 10 thousand units mc_beta<mc_alpha

The figure on the right shows the typical firm in a perfectly competitive industry. Equilibrium in the market is currently yielding a price of 30.

At this price, the typical firm earns a:

1. Negative economic profit (equilibrium price is less than average total cost)

As a consequence of the current short run conditions in this industry, it may be expected that firms will:

1. Leave this market

As this movement occurs, economic profits for the typical firm will:

1. Approach zero

How will the invisible hand move corn prices in response to each of the following:

A weather pattern that produces a bumper corn crop:

1. Decrease corn prices by shifting the supply curve for corn rightward

A rise in the price of wheat(substitute for corn):

1. This will increase corn prices by shifting the demand curve for corn rightward

A change in consumer tastes away from corn dogs toward hot dogs:

1. This will decrease corn prices by shifting the demand curve for corn leftward

A decrease in the number of demanders in the corn market:

1. This will decrease corn prices by shifting the demand curve for corn leftward

The tables below show the reservation values of buyers and sellers in the market for used iphones.

Suppose the minimum price is given as 55, which of the following is true in the market for used iphones?

1. Madeline and Katie will each be willing to buy an iphone. (their reservation values are both above 55)

At a price of 55 per iphone, the consumer surplus is:

1. 20. (70-55)+(60-55) = 20

At the price of 55, two iphones will be purchased, but there are five willing sellers.

Based on this information, the highest possible producer surplus is:

1. Producer surplus will be maxed if tom and mary are able to sell the iphones. The highest possible producer surplus will be 45+35=80

At a price of 55 per iphone, the lowest possible producer surplus is:

1. Producer surplus will be at a minimum if Phil and Adam are able to sell the iphones. The lowest possible producer surplus will be 5+15=20 (or sellers that are closest to 55 but under)

The equilibrium rent in a town is 500 per month and the equilibrium number of apartments is 100. The city now passes a rent control law that sets the maximum rent at 400. Complete the table:

Consumer surplus is measured by the area below the demand curve and above the equilibrium price line.

Producer surplus is found as the area above the supply curve and below the equilibrium price line.

Social surplus is simply the sum of both.

Before rent control:

1. Consumer surplus = A+B
2. Producer surplus = C+D+F
3. Social surplus = A+B+C+D+F

After rent control:

1. Consumer surplus = A+C
2. Producer surplus = F
3. Social surplus = A+C+F

Now show the change in consumer surplus, producer surplus, and social surplus.

1. Consumer surplus = c-b
2. Producer surplus = -(c+d)
3. Social surplus = -(d+b)

Assess each change from the before value to after value as positive, negative, or unclear

1. Consumer surplus = unclear
2. Producer surplus = negative
3. Social surplus = negative

A non-market price imposition is a:

1. Price control

In the figure on the right, the imposition of price p_c results in a:

1. Surplus (price control line is above the equilibrium line)

If the imposed price p_c were removed, market forces would rectify the mismatch between the quantity demanded and quantity supplied by pushing the price:

1. Downward (the existence of a surplus causes downward pressure on price)

This price adjustment would eliminate the mismatch by:

1. Incentivizing

When economists speak of a deadweight loss, they are referring to:

1. Decrease in social surplus

Consider the figure on the right that shows a market with a government-imposed price control at P_c

At this price, the transacted level of the product is:

1. Q2 (When the government imposes a price at P_c, the quantity demanded determines the amount actually transacted in the market. Since the price control line is above the equilibrium line, we know we will have a surplus and a surplus will lower the price. Thats why it has to be Q2)

Since this market is prevented from attaining equilibrium, the result is a deadweight loss, which is measured by area;

1. C+e

Imagine you are a buyer in a double oral auction with a reservation value of 17 and there is a seller asking for 12. If you accept this offer, you will gain:

1. 5

If you are the only buyer, and you know that the lowest ask price is 2, should you accept this offer?

1. Both a and c are correct
2. Yes, accepting an offer from any other seller will reduce your surplus
3. Yes, since you will gain 15

Assume there are two industries in our economy, the production of pizza and the production of calzones. Each of these products is produced in a similar way with similar ingredients and requires similar skills.

If the market price of pizza in this competitive market is below the average total cost curve and the price of calzones is above the average total cost curve:

1. Firms currently making pizza will switch to making calzones

When firms switch from making pizza to calzones, the price of pizza will:

1. Increase

The price of calzones will:

1. Decrease

Social surplus is the:

1. Total value from trade in a market

Social surplus is maximized when the:

1. All of the above
2. Buyers and sellers as distinct groups are doing as well as they possibly can
3. Highest-value buyers are making a purchase and the lowest cost sellers are selling
4. Competitive markets is in equilibrium

Two manufacturing plants operate at acme corp, plant a and plant b

If plant a uses older technology than plant b, it is likely to have:

1. Higher marginal cost than plant b

In this case, plant a requires a market price that is:

1. Higher than plant b to produce

At the market price, plant a will produce:

1. Less than plant b

Will earn:

1. Lower economic profit

When economists speak of a deadweight loss, they are referring to:

1. Decrease in social surplus caused by a market distortion

Consider the figure on the right that shows a market with a government-imposed price control lower than the market equilibrium

At this price, the transacted level of the products is:

1. Q1

Since this market is prevented from attaining equilibrium, the result is a deadweight loss, which is measures by area:

1. B+D

Imagine you are a buyer in a double oral auction with a reservation value of 14 and there is a seller asking for 8.

If you accept this offer,m you will gain:

1. 6

If you are the only buyer, and you know that the lowest asking price is 2, should you accept this offer?

1. Both are correct
2. Yes, since you will gain 12
3. Yes, accepting an offer from any other seller will reduce your surplus

Trade

The production possibilities curve tells us how much we can produce from existing resources and technology. The basis for trade is comparative advantage. Specialization is based on comparative advantage, not absolute, advantage. There are winners and losers in trading states and countries. The winners from trade can more than compensate the losers. Important arguments against free trade exist. 

A production possibilities curve shows the relationship between the maximum production of one good for a given level of production of another good.

Comparative advantage is the ability of an individual, firm, or country to produce a certain good at a lower opportunity cost than other producers.

Absolute advantage is the ability of an individual, firm, or country to produce more of a certain good than other competing producers, given the same amount of resources. 

The terms of trade is the negotiated exchange  rate of goods for goods. 

An export is any good that is produced domestically but sold abroad.

An import is any good that is produced abroad but sold domestically. 

A net importer means that imports are worth more than exports over a given time period.

Free trade is the ability to trade without hindrance or encouragement from the government.

A world price is the prevailing price of a good on the world market. 

Globalization is the shift toward more open, integrated economies that participate in foreign trade and investment.

Protectionism is the idea that free trade can be harmful and government intervention is necessary to control trade.

The North American free trade agreement is the agreement signed by Canada, Mexico, and the United States to create a trilateral trade bloc and reduce trade barriers among the three countries.

Free trade always benefits both trading partners overall. However, within any trading country, some individuals may be made worse off by trade. The losses potentially arise from reduced consumer or producer surplus, lost jobs, or lower wages.

The underlying motivation for trade relies on one simple principle: we can all be better off by trading with one another, because trade allows total production to be maximized.

\[ \text{opportunity cost} = \frac{\text{loss}{gains}} \]

Comparative advantage revolves around the notion of figuring out what you are relatively good at doing. The key to determining who has a comparative advantage is to compare individual opportunity costs. 

We can draw two conclusions about what happens when a country opens itself to trade and becomes an exporter of goods and services:

1. Sellers win
2. Buyers lose

We can also draw two conclusions about what happens when a country opens itself to trade and becomes an importer of goods and services.

1. Sellers lose
2. Buyers Win

The factors that contribute most to comparative advantage at the country level are:

1. Natural resources
2. Stocks of human made resources
3. Technology
4. Education
5. Relative abundance of labor and physical capital
6. Climate

Arguments against free trade are:

1. National security concerns
2. Fear of the effects of globalization on a nation’s culture
3. Environmental and resource concerns
4. Infant industry arguments
5. Potential negative effects on local wages and jobs

People and countries are dependent on one another for goods and services. Although there are potential costs to this interdependency, the gains associated with taking advantage of specialization in the production of goods and services can be considerable.

Specialization and trade, which are driven by comparative advantage, not only allow us to consume beyond our individual ppc, but also lead to a wider variety of goods and services.

Whereas comparative advantage revolves around measuring production relative to the opportunity costs that you and the other person incur, absolute advantage relates to production per unit of inputs.

When a country opens up to trade, there are winners and losers. The gains from trade are larger than the losses. One key to avoiding protests about free trade, like the one in Seattle, is to develop policies that everyone can reap the gains from trade.

Empirically, the data do not reveal the sweeping job losses for US workers that trade critics cite. There is certainly a displacement of workers due to trade, but many workers soon find other jobs. Likewise, the supposed negative effect of trade on wages is difficult to find in the data. Beyond lost jobs, however, those against free trade often cite national security concerns, loss of cultural identity, environmental and resource concerns, and infant industry arguments.

The figure at right shows a ppc for Joe. he can spend his time making pizza or chocolate cakes.

For Joe, which production points are attainable?

1. A,b,d,e (anything on the ppc line or inside of it)

For Joe, which production points are efficient?

1. A,b (efficient points are those on the line)

Joe decides to go to baking school and learns to make chocolate cakes faster.

1. Draw a line with the same number of pizzas but more cakes and line goes through c)

Consider the figure on the right. The blue line shows how many units of goods A and B a worker in Taiwan can produce, and the tan line shows the number of units of goods A and B that a worker in Korea can produce. Does this figure indicate anything about either worker having a comparative or absolute advantage in either good?

1. According to the figure, Korea has an absolute advantage in the production of good A and Korea has an absolute advantage in the production of good B.

Considering comparative advantage:

1. Taiwan has a comparative advantage in the production of good A and Korea has a comparative advantage in the production of good B.

Justin has 5 days in a work week, each day he can create either 2 android apps or 1 apple app. Pallas also has 5 days to work and each day she can produce either 2 android apps or 3 apple apps.

Justin has a comparative advantage in the production of:

1. Android apps

Which of the following statements explains why Justin has a comparative advantage in the production of android apps?

1. His opportunity cost of producing an android app is less than pallas’s opportunity cost of producing an android app.

Pallas has a comparative advantage in the production of:

1. Apple apps

Which of the following statements explains why Pallas has a comparative advantage in the production of apple apps?

1. Her opportunity cost of producing an apple app is less than justin’s opportunity cost of producing an Apple app.

Suppose a country has 100 westerners and 100 easterners. A westerner can produce either 6 units of food or 2 units of national defense. An easterner can produce either 2 units of food or 1 unit of national defense. 

According to the data:

1. Easterners have a comparative advantage in the production of defense

Suppose this country has decided it wants to produce 60 units of defense.

In this case, the country will have more food to consume if the:

1. Easterners produced these 60 units of defense

You should have anticipated this answer because:

1. The easterners have a comparative advantage in the production of defense

Now suppose this country institutes a draft and chooses people for the military randomly. Suppose further it drafts 20 westerners and 20 easterners.

If the country chooses to have a military draft, it will produce:

1. If the country uses 20 westerners and 20 easterners to produce defense, then 80 westerners and 80 easterners will be available to produce food. In this case, food production will be (80*6) + (80 * 2) = 640 units of food

Compare the cost in terms of foregone food production under a draft to the cost under a volunteer army where the country pays the easterners enough to persuade them to become soldiers.

The cost of defense measured in terms of foregone food production is:

1. Higher with a draft than with a volunteer army

The figure at right shows a ppc for Joe. He can spend his time making pizzas or chocolate cakes. Using the information in the figure, calculates Joe’s opportunity cost of producing one pizza and his opportunity cost of producing one chocolate cake. Remember that the opportunity cost is how much of one good must be given up to produce one more unit of the other good. 

Joe’s opportunity cost of producing one pizza:

1. 15 cakes / 30 pizzas = 0.5 cakes per pizza

Joe’s opportunity cost of producing one chocolate cake is:

1. 2 pizzas

Joe’s friend Samantha also makes pizza and chocolate cakes. The figure at right shows the ppc for Samantha. Using the information in the figure, calculate Samantha’s opportunity cost of producing one pizza and her opportunity cost of producing one chocolate cake.

Samantha’s opportunity cost of producing one pizza is:

1. 2 chocolate cakes

Samantha’s opportunity cost of producing one chocolate cake is:

1. 0.5 pizzas

Comparative advantage is the ability to produce a certain good at a lower opportunity cost than other producers.

Who has the comparative advantage in the production of pizza and chocolate cake:

1. Joe has a comparative advantage in pizza and Samantha has a comparative advantage in chocolate cake

Samantha’s little brother Rahul is also able to make pizzas or chocolate cake, and he is equally good at each. His opportunity cost of producing either pizza or chocolate cake is one unit of the other good. 

Use the line drawing tool, draw an example of Rahul’s ppc curve.

1. I did a 20 unit pizza to 20 unit chocolate cake line

Suppose Joe has a comparative advantage in making pizzas and Samantha has a comparative advantage in making chocolate cakes. Both individuals will specialize and trade if the exchange rate is favorable. Using the information in the table below, determine whether or not each person will trade at the terms of trade offered.

1. If the terms of trade is 1 cake for 1 pizza Joe will make the trade and Samantha will make the trade.

The terms of trade at 1 cake for 1 pizza:

1. Favors Samantha

Using the opportunity cost of pizza column, a terms of trade of:

1. (2.0-0.5)/2 + .5 = 1.25 cakes per pizza

If the terms of trade is 2.5 pizzas for 1 cake:

1. Joe will not make the trade and Samantha will make the trade

Nearway:

1. 2.00 coconuts and 0.50 fish

Farway:

1. 1.50 coconuts and 0.67 fish

Which nation has an absolute advantage in the production of each good?

1. Farway has an absolute advantage in the production of Fish
2. Farway has an absolute advantage in the production of coconuts

Which nation has a comparative advantage in the production of each good?

1. Farway has a comparative advantage in the production of fish
2. Nearwy has a comparative advantage in the production of coconuts

Assume that nearway and Farway completely specialize according to their comparative advantage and decide to trade. Fill in the blanks:

1. 100 150 200 225
2. 0 300 400 0
3. 0 100 160 0
4. 100 200 240 160
5. 0 50 40 -65

The terms of trade are:

1. 160 coconuts / 100 fish = 1.60 coconuts per fish

Who benefits from trade?

1. Both nations benefit from trade

Which nation received the better deal in this trade?

1. Nearway received the better deal

Would Nearway and Farway wever trade trade 120 coconuts for 40 fish?

1. No, because while Farway gains from this trade, nearway does not

The diagram on the right shows the market for tennis shoes in the US. If the US does not trade with other countries, what are the equilibrium price and quantity of tennis shoes?

1. Price is 61 and quantity is 35 million

Suppose the US opens to free trade with other countries and the world price is 40 per pair of tennis shoes. What are the quantity demanded, quantity supplied by domestic producers, and the quantity of inputs?

1. Quantity demanded is 70 million
2. Quantity supplied by domestic producers is 25 million
3. Quantity of imports is 45 million

Domestic producers complain and convince the government to impose a 7 tariff per pair of shoes. What are the equilibrium price, quantity demanded, quantity supplied by domestic producers, and the quantity of imports?

1. Equilibrium price is 47
2. Quantity demanded is 65 million
3. Quantity supplied by domestic producers is 30 million
4. Quantity of imports is 35 million

Figure 1 on the right shows the world market for tennis shoes and figure 2 shows the US market for tennis shoes without trade. Suppose the US opens to free trade with other countries.

The price of tennis shoes in the US is:

1.  25

Draw the world price line on figure 2 to help determine whether the US is an importer or an exporter.

1. Draw horizontal line above the equilibrium point

With trade, the US is an:

1.  Exporter

The figure on the right shows the US market for tennis shoes where the US is an importer. The US currently has a tariff on imported tennis shoes

Draw a new price line without the tariff

1. Horizontal line below equilibrium point

When the tariff is eliminated, what happens to the quantity supplied by domestic producers?

1. Decreases

When the tariff is eliminated, what happens to the quantity demanded by domestic producers?

1. Increases

When the tariff is eliminated, what is the impact on domestic producers, foreign products, and domestic producers?

1. Foreign producers and domestic producers win. Domestic producers lose

Externalities and Public Goods

An externality occurs when there is a spillover from one person’s actions to a bystander. If left alone, people will generally not account for how their actions affect other, whether positive or negative. They are called market failures because of the negative effects. 

There are important cases in which free markets fail to maximize social surplus. Three such cases are:

1. Externalities
2. Public goods
3. Common pool resources

One common link among these three examples is that there is a difference between the private benefits and costs and the social benefits and costs. Government can play a role in improving market outcomes in such cases.

The market demand curve shows consumers’ willingness and ability to pay for electricity, and the market supply curve reflects producers’ marginal costs of generating it. It is at the equilibrium point where these two lines intersect that the invisible hand most efficiently allocates resources, the point at which social good is maxed.

The downward sloping demand curve meets the upward sloping supply curve. To determine the equilibrium price and equilibrium quantity of electricity.  

In economic terms, the power plant imposes an externality on the public as a by-product of producing electricity. An externality occurs when an economic activity has either a spillover cost to or a spillover benefit for a bystander. 

When there are negative externalities present, this market outcome is no longer efficient. This is because negative externalities impose an additional cost on society that is not explicitly recognized by the buyers and sellers in the market. To arrive at the efficient production level, we need to recognize both the firm's marginal cost and the marginal external costs of production. Together, they sum to the marginal social cost of production. 

Negative externalities lead to external costs of production that the private firm will not account for when making decisions. If we take the marginal external cost into account, a higher equilibrium price and a lower equilibrium quantity result.

Taking into account the extra costs imposed on society by the plant’s pollution, we can see that optimal quantity is less than market quantity because when a negative externality must be accounted for, a smaller quantity of electricity should be generated since it is now more costly to produce each unit. 

Deadweight loss is a decrease in social surplus that results from a market distortion.

Positive externalities occur when an economic activity has a spillover benefit that is not considered when people make their decisions. As with negative externalities, they are all around us. 

Pecuniary externalities exist when market transactions affect other people, but only through the market price. They act only through prices. Remember that negative and positive externalities lead to wrong equilibrium quantities. They do so because they create an external cost or external benefit that is not reflected in the market price. Pecuniary externalities don’t create these effects. Precisely because their impact is completely embodied in prices, the market price correctly reflects the society's wider impact of market transactions. 

When there are negative externalities present, free markets produce and consume too much. When there are positive externalities present, free markets produce and consume too little. 

When individuals or companies take into account the full costs and benefits of their actions because of some public or private incentive, economists say that they are internalizing the externalities. When the external effects of their actions are internalized, the general result is that the market equilibrium moves toward higher social well-being. 

The insight that negotiation leads to the socially efficient outcome regardless of who has the legal property right is called the Coase Theorem. The theorem’s implication is powerful, private bargaining will lead to an efficient allocation of resources. This means that the person who values the ownership the most will match his preferences. 

Governments respond to externalities in two main ways:

1. Command control policies in which the government directly regulates the allocation of resources.
2. Market based policies in which the government provides incentives for private organizations to internalize the externality.

Under command and control regulation, policymakers either directly restrict the level of production or mandate the use of certain technologies. However, this type of regulation action typically provides few incentives for producers to search for more cost effective ways to reduce pollution. 

A market based approach internalizes externalities by harnessing the power of market forces. The most prominent market based approaches to deal with externalities are corrective taxes and subsidies. 

A corrective or Pigoivian tax is designed to induce agents who produce negative externalities to reduce quantity toward the socially optimal level. 

As a social planner, you understand that you must internalize externalities. One solution is to tax each unit of production by the amount of the negative externality. Such a tax allows the externality to be internalized, resulting in a more efficient outcome. 

The same reasoning that holds for negative externalities also applies to positive externalities, the government can use corrective subsidies to internalize the externality. A corrective subsidy is designed to induce agents who produce positive externalities to increase quantity toward the socially optimal level.

In sum, externalities potentially drive a wedge between social benefits and costs and private benefits and costs. This wedge creates a distortion and deadweight loss if the quantity levels of the free market equilibrium diverge from those of the social optimum. Corrective taxes and subsidies can cause agents to internalize their externalities. 

Public goods:

1. No one can prevent others from consumption
2. One person’s consumption doesn’t prevent another person’s consumption

Private goods are excludable, meaning that people can be kept from consuming them if they have not paid for them. Public goods are non-excludable, meaning that once such goods are produced, it is not possible to exclude people from using them.

Private goods are rival in consumption, meaning that they cannot be consumed by more than one person at a time. Public goods are non rival in consumption, meaning that one person’s consumption does not preclude consumption by others. 

To summarize, we can say that private goods are excludable and rival in consumption and public goods are non excludable and nonrival in consumption. 

Ordinary private goods are both highly excludable and highly rival in consumption. 

Goods that are highly excludable but nonrival in consumption are called club goods or artificially scarce goods. 

Common pool resource goods are nonexcludable but rival in consumption.

Public goods are nonrival and nonexcludable in nature. 

What makes public goods different from private goods is precisely their nonrival and nonexcludable nature. 

Public goods need to be valued on the marginal benefit that a single unit of the good provides to society. For this reason, market demand curves for public goods are added along the vertical axis, producing a total willingness to pay for each unit of the public good. 

Private provision of public goods refers to any situation in which private citizens make contributions to the production or maintenance of a public good. This usually happens through donations of time and money. 

Common pool resource goods are nonexcludable so anyone can consume as much as they can. However, they are rival goods. 

Tragedy of the commons occurs when a common resource is used too much. 

The three major examples of when the invisible hand fails are externalities, public goods, and common pool resources. In each case, free markets typically do not maximize social surplus.

Externalities can occur in many shapes and sizes. They can be either positive or negative and can occur in consumption or production. The solution to externalities can come is meant by the tragedy of the commons through private or public means. The key to each is internalizing the externality. In doing so, we can align private and social incentives to maximize overall well-being.

Public goods, which can be provided publicly or privately, are nonrival in consumption and are nonexcludable. This means that once they are provided, no one can be excluded, and all agents can consume them at the same time.

Common pool resource goods are not excludable but are rival. This leads to an important negative externality that one person imposes on all others. Once the bluegil is taken out of the stream, no one else can catch it. Therefore, solutions to common pool resource problems mirror solutions to externalities.

A key link between externalities, public goods, and common pool resources is that there is a difference between the private benefit and costs and the social benefits and costs. 

Which of the following is not an externality?

1. Jordan has lung cancer from smoking cigarettes

Consider the private market for these pesticides shown in the graph on the right. It shows the equilibrium level of pesticides that will be produced in the private, unregulated market for these pesticides. This outcome:

1. Is not socially efficient

In the graph, how would you account for the pesticides effect on honeybees?

1. Draw line that has lower price and quantity, so shifted left. Draw new equilibrium point lower on supply curve.

This outcome:

1. Is socially efficient

You have just been appointed as the county commissioner of hazard county. After your first day of work, you realize that many people talked to you about externalities all day. Based on your conversations today and your economic experience, you conclude that when externalities are present:

1. The free market outcome is not efficient

Furthermore, you conclude that when there are negative externalities present, markets:

1. Produce too much

When there are positive externalities, markets:

1. Produce too little 

The coase theorem states that:

1. Private bargaining will result in an efficient allocation of resources

The coase theorem will breakdown when:

1. There are a large number of agents
2. When property rights are not clearly defined
3. Transaction costs are too high

Jones and Smith live in the same building. HJones loves to play his opera recordings so loudly that Smith can hear them. Smith hates opera. Jones receives 100 worth of benefits from his music and Smith suffers 60 worth of damages. From an efficiency perspective, Jones:

1. Should be allowed to play his opera music

Suppose the building does not have any rules about noise. Jones and Smith can bargain at zero cost. According to the coase theorem:

1. Jones will pay 0 to Smith to compensate for the negative externality

According to the coase theorem:

1. Jones will pay 60 to Smith to compensate for the negative externality

There is a road between the suburbs and downtown. The road is congested at rush hour. If 169 people use the road at rush hour, the trip takes 36 minutes. If one additional person enters the road, everyone has to slow down and the trip now takes 37 minutes. People value their time at 6 per hour or .10 per minute. For simplicity, Ignore all of the costs of using the road other than the cost of time. The total social cost of 169 people using the road art rush hour is:

1. 169*36*.10 = 608.40

The marginal social cost of one additional person is:

1. New social cost - original social cost
2. New social cost = 170*37*.10 = 629
3. Original social cost = 169*36*.10 = 608.40
4. Marginal social cost = 629-608.40 = 20.6

The efficient toll on this one additional person is:

1. 169 * (37 min - 36 min) * .10 = 16.9

The toll at noon should be:

1. 0

A three person city is considering a fireworks display. Anne is willing to pay 50 to see the fireworks, Bob is willing to pay 15, and Charlie is willing to pay 15. The cost of the fireworks is 60. In terms of efficiency, the fireworks display:

1. Should be offered

Who will provide the display on their own?

1. No one

Who will vote in favor of the display?

1. One person

You are the Hazard county commissioner. Dwight’s neighbors bring a complaint before you that Dwight’s hog farm is creating a terrible odor, and they are demanding government action.

You respond to the neighbor’s complaints by putting a tax on DSwight’s hog production.

Taxing Dwight’s hog production is an example of:

1. Pigouvian taxation

Using the graph to the right, answer the following questions.

Before the tax goes into effect, Dwight will produce 5 thousand hogs and will sell them for a price of:

1.  5 per pound.

The efficient tax is:

1. 2.36 per pound

After the tax goes into effect, Dwight will produce:

1. 3.79 thousand hogs and sell them for a price of 6.21 per pound

As a result of the tax:

1. Supply decreases, price increases, and the negative externality decreases

Classify the following goods and services as private goods, common pool resources, club goods, or public goods.

1. Health insurance is a private good
2. Radio spectrum is a common pool resource
3. A video on youtube is a public good
4. A mosquito control program in a city is a public good
5. A library’s collection of ebooks is a club good

Three roommates share an apartment. It is really cold outside and they are considering turning up the thermostat in the as[artment by 1,2,3 or 4 degrees. Their individual marginal benefits from making it warmer in the apartment are as follows:

1 10 8 6

2 8 6 4

3 6 4 2

4 4 2 0

They know that each time they raise the temperature in the apartment by 1 degree, their heating bill goes up by 10.

To maximize social benefit, they should raise the temperature by:

1. 3 degrees

You are the county commissioner of Hazard County. Recently a severe wave of storms swept across Hazard County, spawning several tornadoes and creating a wide path of mayhem. The citizens of Hazard County are demanding that you do something to protect them.

You decide to install some early warning tornado sirens. However, there is no money left in the county budget, so you ask each citizen to donate some money to build the system. Many citizens donate money to help build the warning system, However, Ms Nancy is wealthy. Decides she is not going to donate.

The early warning sirens are an example of a:

1. Public good

Nancy represents a:

1. Free rider

Public goods are:

1. Low in rivalry and low in excludable

What approach would be the least effective way to deal with free riders:

1. Exclude citizens from benefiting from the good or service

Assume that only three citizens are willing to donate to build the sirens. Their demand curves for tornado sirens are below.

1. Draw a demand curve from y=1- to x=5 then draw equilibrium point where it crosses the supply curve

Taxes and Regulation

Government regulation can be a double edged sword. Well-designed regulation can improve societal outcomes but poorly designed regulation stifles economic efficiency. 

In the US, governments tax citizens to correct market failures and externalities, raise revenues, redistribute funds, and finance operations. 

Through direct regulation and price controls, governments can intervene to influence market outcomes.

Although government intervention sometimes creates inefficiencies, it often results in improving social well being.

Weighing the trade-offs between equity and efficiency is one task of an economist.

It is up to each individual to decide when and where government intervention makes the most sense. 

When government tax revenues fall below spending. The government runs a budget deficit. When the converse happens and tax revenues exceed spending, the government is running a budget surplus. Total government spending and tax revenues have increased over the past several decades. 

The largest component of federal government revenues comes from the individual income tax, followed by social insurance tax receipts. Corporate income tax, excise taxes, and other sources of income make up a smaller percentage of federal receipts.

Individual income taxes represent the largest portion, around 47% in 2013.

Payroll taxes represent about a third of the federal government’s receipts. A payroll tax, also known as social insurance tax, is a tax on your wages that employers are required to withhold from employees’ pay. On your paystub, these are often listed as Federal Insurance Contribution Act, or FICA taxes.

Corporate income tax provides 10 percent of the overall pie. Corporate income tax is generated from taxing profits earned by corporations.

All other taxes make up the remaining 9 percent. This includes excise taxes, which are taxes paid when purchasing specific goods such as alcohol, tobacco, and gasoline.

State and local governments receive a much smaller fraction of their tax revenues from individual incomes taxes than does the federal government. Instead, property taxes, income taxes, and transfers from the federal government account for the bulk of their revenues.

Four main factors influence government taxation and spending decisions:

1. Raising revenues
2. Redistributing funds via transfer payments
3. Financing operations
4. Correcting market failures and externalities

Most taxation in our economy is intended to raise revenues for the funding of public goods such as national defense, public education, police protection, and infrastructure projects. The federal government spends most of its money on national defense and social security. The two biggest items of spending for state governments are education and public welfare. 

The second major objective of government taxation and spending is redistribution. Market outcomes can be quite inequitable, with high levels of inequality and poverty coexisting alongside huge fortunes for a few. Governments in all advanced economies use transfer payments and the tax system to limit the extent of such inequality and the economic hardships that poorer households in the society suffer.  Transfer payments refer to payments from the government to certain groups, such as the elderly or the unemployed. Social security is the largest transfer program and was introduced by Roosevelt in 1935 to provide economic security to the elderly, disabled, widows, and fatherless children. Medicare, introduced by Lynbdon Johnson in 1965, provides health insurance to Americans aged 65 and older and makes up another l;arge part of federal spending. 

Public welfare makes up a significant part of state and local budgets. This consists of transfer and vendor payments made to private purveyors for medical, burials, and other services provided under welfare programs.

A progressive tax system is one in which tax rates increase with taxable base incomes, so that the rich pay higher tax rates than the less well to do. To understand this system more precisely, we need to distinguish between average and marginal tax rates. The average tax rate faced by a household is the total tax paid divided by total income earned. The marginal tax rate refers to how much of the last dollar earned the household pays in taxes. 

The alternatives to the progressive tax system are the proportional and regressive tax systems. In a proportional tax system, households pay the same percentage of their incomes in taxes regardless of their income level. In a regressive tax system, the marginal tax and average tax rates decline with income so that low income households pay a greater percentage of income in taxes than do high income households. 

As a result of transfer programs and progressive taxation, the post tax income distribution in the US is more equal than the pre tax income distribution. 

Governments also tax to pay for their own operations, including the salaries of presidents, members of congress, and other politicians, and for the sizable bureaucracy in charge of the day to day running of government operations and services. 

The government sometimes imposes taxes to correct market failures or externalities. Though important in principle, this use of taxation is far less prevalent than the three reasons discussed above.

The term tax incidence refers to how the burden of the tax is distributed across various agents in the economy. The incidence on producers is the portion of tax revenue that lies above the pre-tax equilibrium price, is given by the same green triangle. 

The deadweight loss of taxation is the loss in total surplus or the decline in consumer and producer surpluses not made up by the increase in tax revenues. The deadweight losses of taxation imply that for every dollar of tax raised, the cost is greater than a dollar. 

In competitive markets, tax incidence and equilibrium prices and quantities are independent of whether the tax is imposed on consumers or producers. 

The fact that the incidence of the tax is identical for buyers and sellers in the examples above is due to how we drew the market demand and market supply curves. So, that means buyers and sellers are equally sensitive to price changes at the original equilibrium. 

Externalities and various market failures can have significant social costs. The main tool that governments use to deal with externalities and other sources of market failures is regulation. Regulation refers to actions by the federal or local government directed at influencing market outcomes, such as the quantity traded of a good or service, its price, or its quality of safety. 

A common form of government intervention in markets is direct regulation. Direct regulation refers to direct actions by the government to control the amount of a certain activity. 

A price ceiling is a cap on the price of a market good or service. One important example is rent control. A price ceiling causes a shortage.

Sometimes the government steps in to impose a minimum price on a  product or service. The result is a price floor, which represents a lower limit on the price of the product or service. A good example of a price floor is the minimum wage.  A price floor causes a surplus. 

Every government program needs bureaucrats to monitor its implementation and these people have to be paid. However, they are taken out of productive sectors of the economy. In this way, the allocation of time and talent of individuals to bureaucracy is an important cost of government. This cost is increased by the fact that bureaucracies don’t function efficiently. 

Equally as important as the deadweight losses associated with government intervention and the inefficiencies of bureaucracies is the corruption that large governments engender. Corruption refers to the misuse of public funds or the distortion of the allocation of resources for personal gain. 

The underground economy, or black market, includes activities where income taxes are not paid, as well as illegal activities such as drug dealing and prostitution. In modern economies, black markets cover an array of activities and are generally found in areas where the benefits of such activities are the highest. 

Problems of an underground economy are:

1. When it involves goods and services that have been legally banned, the underground economy undermines the ban.
2. When underground transactions occur in markets for legal goods and services in order to avoid taxes or regulation, they put legitimate businesses at a disadvantage. 
3. To compensate for the lost revenue, governments must levy higher taxes
4. Criminals spend vast resources trying to evade the law, which are not effective uses of society’s resources.

The equity-efficiency-trade-off refers to the balance between ensuring an equitable allocation of resources and increasing social surplus or total output. Most would agree that equity and efficiency are the two most important goals for government policy. 

The trade-off between equity and efficiency represents the nub of the conflict between those who support big government and those who call for smaller government. The government can often achieve greater social equality but only at the expense of greater inefficiencies. When social inequality is very high, there may be no conflict between equity and efficiency. 

Equity and efficiency are two opposites. To have one means you lose the other. 

All developed nations seek to achieve some degree of equality in their society. The welfare state refers to the set of insurance, regulation, and transfer programs utilized to create a safety net, reduce poverty, and redistribute income from the rich to the poor. The welfare state is even more expansive in Europe. Despite deadweight losses associated with their systems, many European nations choose to promote some degree of equality in income. 

Consumer sovereignty is the view that choices made by a consumer reflect his or her true preferences, and outsiders, including the government, should not interfere with these choices. 

At the other end of the spectrum is paternalism. Paternalism is the view that consumers do not always know what is best for them, and the government should encourage or induce them to change their actions. This approach gives the government an active hand in designing choices to help individuals make the right decision. 

The social security system in the US, which forces individuals to save for old age, was born out of paternalism. Laws that ban substance abuse are also motivated by paternalism. 

As we have shown, a major efficiency loss of taxation is deadweight loss. So, the debate on the reach of the government should hinge on the effect of its actions, the larger the deadweight loss, the worse the policy.  

The government typically operates in a slow moving manner. A significant drag on the economy can result if regulators cannot move swiftly in response to changing market conditions. 

Governments can play an important role in ensuring that markets are competitive, efficient, and equitable. Key roles of the government include taxation to raise funds to provide public goods, such as national defense, policing, and infrastructure investments that would not be provided adequately by the market. The use of tax and transfer programs to achieve a more equitable distribution of resources in society and the use of taxes and subsidies as well as regulation to correct market failures. 

The costs of government interventions must be compared carefully with their benefits. Economics is most useful not as a value judgment on whether the government is good or bad, but for understanding what sorts of activities require government intervention. 

The primary types of tax systems are:

1. Progressive
2. Proportional
3. Regressive

An example of a progressive tax is the:

1. Income tax

An example of a regressive tax is the:

1. Social security tax

An example of a proportional tax is the:

1. Medicare tax

Tax incidence refers to:

1. Who bears the burden of a tax

Is the entire burden of the tax always borne by those on whom is is imposed?:

1. Not necessarily, since the burden of the tax depends on price elasticity. Tax incidence depends on the relative elasticities of market supply and demand

The following table gives the federal income tax rates for a single individual. The total tax payable for an individual who earns 500,000 a year is:

1. 8925*10% +
2. (36250-8925)*15% +
3. (87850-36250)*25% +
4. (183250-87850)*28% +
5. (398350-183250)*33% +
6. (400000-398350)*35% +
7. (500000-400000)*39.6& +
8. = 155763.75

The marginal tax rate is:

1. The marginal tax rate refers to how much of a household’s marginal dollar earned is paid out in tax. Since the last dollar earned is 500000, the individual’s marginal tax rate is 39.60%

The average tax rate is:

1. 31.15 % or 155763.75 / 500000 = 31.15 percent

Many people have argued that an income tax should be marriage neutral, that is, two people should pay the same total tax whether they are married or they are single. Suppose Amanda earns nothing, Ben earns 60000, and Cathy and Dylan each earn 30000. They are all single.

Amanda pays no taxes because she has no income. If they all live in a country that has a progressive income tax, which will be higher: the tax that Ben pays or the sum of the taxes Cathy and Dylan pay?

1. The tax that Ben pays because high-income individuals pay higher income taxes

Amanda marries Ben and Cathy marries Dylan. This country taxes married couples based on a family’s total income.

Amanda and Ben will pay the same tax as Cathy and Dylan because

1. The couple have the same family income

Is the income tax in this country marriage neutral?

1. No, because Cathy and Dylan pay higher taxes when married than before marriage.

Which of the following is a cost associated with government intervention in an economic system?

1. Corruption

Given that there are costs involved with government intervention in an economy, governments still choose to intervene in markets to:

1. Reduce poverty

How would you depict the trade-off between equity and efficiency on a graph?

1. Inequality on one axis and social surplus on the other with a positively-shaped function

A government would want to be on this curve when:

1. There is no correct answer to this question, as the answer depends on a government’s value judgments. 

Paternalism is the view that:

1. People do not always know what is best for them, and government should encourage them to make the right choices

Consumer sovereignty suggests that:

1. Government should not interfere with consumer choices

Why are there two different views on the effect of taxation on labor supply in the US?

1. All of the above
2. The effect of a tax on labor supply depends on the amount of deadweight loss created by the tax
3. It depends on normative questions such as how much to tax or how much government intervention is necessary
4. The effect of a tax on labor supply depends on the elasticity of labor supply

Suppose a government generates its revenue using a lump sum income tax of 10000 per person regardless of income. Calculate the average and marginal income tax rates for individuals with each income level shown in the table below

50,000 20.00% 0%

75,000 13.33% 0

100,000 10.00% 0

125,000 8.00% 0

150,000 6.67% 0

This lump sum income tax is a regressive tax

The two most important goals for government policy involve a trade-off between:

1. Equity and efficiency

The graph shows the market for good A. The equilibrium price and quantity is P_m and Q respectively. Suppose the government imposes a price control that reduces producer surplus. Determine the type of price control and show it on the graph.

1. The price control is a price ceiling

Draw a price control and label is price control

1. Draw horizontal line below equilibrium point

There is a possibility of forming a black market by the seller, if there is a:

1. Price control

If a price floor is set below the free market equilibrium price, then the quantity demanded:

1. Remains unaffected

Which of the following are examples of inefficiencies created by government intervention?

1. Creating a large workforce of professionals who review whether the financial reports of companies are true and fair
2. An increase in the price of alcohol due to higher taxes imposed by the government
3. Quality deterioration in a market after government implements a price control

Which of the following is not a result of corruption?

1. Selling goods at a price that does not include taxes

Markets for Factors of Production

The three main factors of production are labor, physical capital, and land. Firms derive the demand for labor by determining the value of marginal product of labor. The supply of labor is determined by trading off the marginal benefit from labor given earnings against the marginal cost, the value of forgone leisure.

Wage inequality can be attributed to differences in human capital, differences in compensating wages, and discrimination in the job market. In addition to labor, a producer must derive the demand for physical capital and land to achieve its production objectives. 

The market for labor is of particular importance in the economy because it affects all of us. The market for labor is composed of suppliers and demanders. Workers produce goods and services and therefore are known as factors of production. Remember that a factor of production is used in the production of other goods.

Markets for factors of production are somewhat different from markets for goods and services that we consume, because the demand for factors of production is delivered from the demand for final goods and services. 

Although firms tend to use many factors of production, the main factors that we will focus on are labor, machines, and land.

In the market for labor, the roles of demander and supplier are reversed: businesses are buyers of labor and individual workers are suppliers of labor.

All firms rely on labor as a major factor of production. Workers operate machines and often perform tasks more efficiently than machines. 

The law of diminishing returns states that the marginal productivity of an additional unit of labor eventually decreases as we increase the number of workers. 

The value of marginal product of labor is the contribution of an additional worker to a firm’s revenues. 

We have now seen two ways to maximize profits.

1. Choose the total quantity of production in order to maximize profits, so expand production until marginal cost=price
2. Optimally choosing its labor by expanding its workforce until the marginal product of labor * price = vmpl=wage

To construct the market supply curve, we need to aggregate the individual labor supply curves. To do this, we horizontally sum the individual labor supply curves. 

The substitution effect implies that when the price of leisure increases, people will substitute working for relaxing. 

There are several key determinants of where the labor demand curve will be situated. Two important factors are:

1. Price of the good that the firm is producing
2. Technology of the firm

A labor saving technology is a type of technology that substitutes for existing labor inputs, reducing the marginal product of labor. Labor-complementary technologies are those that complement existing labor inputs, increasing the marginal product of labor.

Shifts in labor supply also affect equilibrium wage and employment levels. We discuss three main factors that shift labor supply:

1. Population changes
2. Changes in worker preferences and tastes
3. Opportunity costs

There are three important features of the labor market that may give rise to differences in wages across workers:

1. Differences in human capital
2. Differences in compensating wages
3. Discrimination in the job market

One explanation for the wage difference is that people have very different levels of skills and therefore different levels of productivity. Economists refer to each person’s stock of skills for producing output or economic value as human capital. Differences in human capital result in differences in wages.

The wage differences that are used to attract workers to otherwise undesirable occupations are known as compensating wage differentials. Wage differentials based on risk and unpleasantness are important factors to consider when examining wage differences across jobs, but there are also reasons we may see workers in the same job getting paid differently. 

A third major factor in determining wages in the labor market is the nature and extent of discrimination that is present. Economists have pinpointed two major theories for why employers might discriminate, taste-based and statistical discrimination. 

Taste-based discrimination occurs when people’s preferences cause them to discriminate against a certain group. It is important to note that wages can be different between groups not only because an employer has a taste for discrimination but also because of other factors like human capital. 

Statistical discrimination occurs when employers use an observable variable to help determine whether the person will be a good employee. 

Technology can be either labor saving or labor complementary. It can also be skill saving or skill complementary. Skill biased technological changes increase the productivity of skilled workers relative to that of unskilled workers. The primary technological change over this time period has been advances in computing power. 

Despite our focus so far on labor as an input to production, there are other factors equally important to the production process. 

Recall that the value to a firm of adding each consecutive unit of labor is given by multiplying the output price and the marginal product of labor.

Physical capital is any good, including machines and buildings, used for production. A firm will expand its physical capital until it is not worthwhile to do so. The value of marginal product of physical capital is the contribution of an additional unit of physical capital to a firm’s revenues.

The same is true for uses of land. Land includes the solid surface of the earth where structures are built and natural resources. 

Although the economic framework for deciding how much of the three inputs to use is identical, labor has one major difference from physical capital and land: both physical capital and land can be either rented or owned, whereas labor cannot be owned. When rented, the firm must pay the rental price of physical capital, and to use land it must pay the rental price of land. By rental price, we mean the price of using a good for a specific period of time. 

Producers determine the optimal mix of labor, physical capital, and land when making production decisions. Markets for these factors of production operate in much the same way that markets for final goods and services function. Firms expand their use until marginal benefits equal marginal costs. Determining the demand for labor centers on the concept of the value of marginal product of labor, which is the contribution an additional worker makes to the firm’s revenues.

When making decisions on how to spend our time, we face opportunity costs. There is a trade-off between labor, which comprises activities that earn money, and leisure, which is time spent on activities other than earning money. The opportunity cost for one hour of leisure is the income that we would have earned by working for that one hour.

Large wage differences exist across people and jobs. The differences stem from three main sources: human capital differences, compensating wage differentials, and discrimination. As with labor, firms expand their use of physical capital until the value of the marginal product equals the price of physical capital, and they likewise use land until the value of the marginal product of land equals the price of land. 

Suppose that at your firm the relationship between output produced and the number of workers you hire is as in the following table.

1. Marginal product = 18, 14, 10, 9, 5, 4

Is the relationship between output and labor consistent with the law of diminishing returns?

1. Yes, the marginal product declines as successive units of labor are hired

Suppose your firm is a perfect competitor in the output market and the labor market.

If the price of output is $7 and the wage rate is $28, your firm should hire:

1. 6 workers

If the price output falls to $2 and the wage remains $28, your firm should hire:

1. 2 workers

Consider a businessman that owns three different coffee shops with production functions shown below. Fill in the blanks.

1 100 100 20 20 40 40

2 130 30 40 20 70 30

3 140 10 60 20 100 30

4 140 0 80 20 110 10

Suppose there are 8 workers available and the businessman’s goal is to maximize total coffee production.

Using this information, he should assign:

1. 2 workers to arabica alley
2. 3 workers to barista bar
3. 3 workers to coffee cafe
4. Total production will be 290 cups

Suppose the businessman believes in letting the labor market help in achieving optimal outcomes. Again, there are 8 eager workers.

The equilibrium wage he will set would be:

1. $20

At this wage the total production of coffee would:

1. Equal to the amount you found in the previous question

You run a factory that uses pottery wheels to make pots. You can hire anywhere between 1 and 3 skilled artisans, and you can rent 1 or 2 pottery wheels. Pots sell for 100 each. The total production of your factory is shown in the following table.

Workers

1 2 3

Machines 1 10 13 15

2 12 16 19

Suppose you rent one machine and hire one worker.

You would be willing to pay:

1. 300 to hire a second worker. Consider the value of the marginal product of labor

Suppose you rent one machine and hire one worker

You would be willing to pay a rental rate up to:

1. 200 to acquire a 2nd machine

Suppose the wage is 275. If you have one pottery wheel,. The number of workers you would want to hire is:

1. 2

Pottery wheels are:

1. Labor complementary

A production function shows:

1. The number of workers employed and the corresponding output levels that will be produced

According to the law of diminishing returns:

1. The marginal productivity of an additional unit of labor eventually decreases as the quantity of labor increases

Using the 3 point curved line tool, add a production function to the graph

1. Start the line at 0,0 and gently slope upwards until it covers most of worker numbers

The value of marginal product of labor is:

1. A and C.
2. Given by the marginal product of labor times the price of the firm’s output
3. The contribution of an additional worker to a firm’s revenues

Complete the following table. Assume that the selling price of the firm’s output is 5 per unit

Workers employed Marginal Product VMPL

1 24 120

2 20 100

3 16 80

4 12 60

5 8 40

When the firm’s VMPL is plotted in a diagram with the quantity of labor measured along the horizontal axis, the resulting curve will be:

When plotted, the vmpl is a downward sloping curve, which is the firm’s demand curve for labor

1. Downward sloping and demand curve for labor

The following table gives the value of marginal product of labor for a competitive firm.

Workers VMPL

1 180

2 150

3 120

4 90

5 60

6 30

Because this firm is competitive and haS NO CONTROL OVER ITS PRODUCTS’S PRICE, THE DECLINING VALUES FOR VMPL ARE A RESULT OF DIMINISHING:

1. Marginal productivity

When the vmpl is plotted in a diagram with the number of workers measured along the horizontal axis, the resulting curve is the firm’s:

1. Demand for labor

Draw the firm’s demand for labor curve

1. Draw a downward sloping demand curve
2. Draw a horizontal line at 90 dollars

According to the diagram, the profit maximizing level of employment for this firm is:

1. 4 workers

How does the labor-leisure trade-off determine the supply of labor?

1. An increase in the wage rate is an increase in the opportunity cost of leisure, and can therefore be expected to reduce the amount of leisure one wishes to consume. Choosing less leisure is equivalent to supplying more labor, thus yielding a positive relationship between the wage rate and the amount of labor supplied

How do labor saving technologies differ from labor complementary technologies:

1. All of the above
2. Labor-saving technologies substitute for existing labor inputs, while labor-complementary technologies augment existing labor inputs
3. Labor-saving technologies decrease the marginal product of labor, while labor-complementary technologies increase the marginal product of labor
4. Labor-saving technologies result in lower wages and less employment, while labor-complementary technologies result in higher wages and more employment

Complete the following table by identifying the two types of technological change

Gps location devices in delivery trucks:

1. Labor-complementary technology

Radio frequency identification tags in grocery stores

1. Labor-saving technology

For a long time, your firm has been paying its workers a wage of 20 per hour and your employees have been happy to work 40 hours per week at this wage. Business is suddenly booming and your firm would really like your workers to agree to a 50 hour work week in order to meet this new demand for your product. You are considering two strategies:

You would raise the wage for all hours worked from 20 to 22 per hour

You would leave the wage for the first 40 hours per week at 20 but offer 30 per hour for hours worked above 40 hours.

Both strategies have the same cost of 1100 if a worker chooses to work 50 hours.

Which strategy is more likely to lead your employees to agree to a 50 hour work week?

1. Strategy 2, because the marginal cost of not working increases significantly after 40 hours of work

The patient protection and affordable care act requires all employers with at least 50 full time equivalent workers to offer health insurance to their full time employees or pay a fine of up to 2000 per employee. Some people have argued that ACA will lower employment. This problem looks at an important issue in this debate.

Suppose the government passes a law that requires firms to offer health insurance to their workers. The cost of the insurance is equal to 2 for each hour an employee works.

How will this law affect firms’ demand for labor?

1. Demand for labor will shift down by 2

Suppose workers consider two dollars of health insurance paid by firms to be the equivalent of 2 in wages. How will this law affect the supply curve of labor?

1. Supply of labor will shift down by 2

Consider an industry where the equilibrium wage is 15 per hour and 100 workers are employed.

How will this law affect the equilibrium quantity of labor in this labor market?

How will it affect the equilibrium wage in this industry?

1. D2 = below D1
2. S2 = below S1

According to your graph, the equilibrium wage:

1. Falls

The equilibrium quantity:

1. Stays the same

Now suppose workers consider a dollar of health insurance paid by firms to be worth less than 2 in wages.

How will this law affect the equilibrium quantity of labor in this labor market?

How will it affect the equilibrium wage in this industry?

1. The equilibrium wage and quantity both decline, with the wage declining less than in the previous case where workers consider the insurance to be the equivalent of 2 in wages

The figure on the right shows the market for labor in a given industry.

The demand curve is downward-sloping because marginal productivity:

1. Falls, as more workers are employed

While the supply curve is upward-sloping since an increase in the wage increases the opportunity cost of:

1. Leisure

Now suppose that the price of the product being produced increases, all else constant.

Using the line drawing tool, show the impact of this event.

Note that a price change does not impact the supply curve

1. Demand curve with higher equilibrium price

According to the graph, the consequence of the change in price is a:

1. Higher market wage
2. Higher level of employment

Technologies that substitute for existing labor inputs are known as:

1. Labor-saving technologies

With this type of technological change, the marginal productivity of existing labor inputs will:

1. Decrease

Using the line drawing tool, show the impact of this new technology

1. Draw demand curve with lower equilibrium point

The consequence for workers will be a wage rate that is:

1. Lower

Hours of employment that are:

1. Lower

Occurs when people’s preferences cause them to discriminate against a certain group:

1. Taste-based discrimination

Occurs when expectations cause people to discriminate against a certain group

1. Statistical discrimination

The owner of a company that manufactures  automobile parts states that it will not hire gay or lesbian employees. This is an example of:

1. Taste-based discrimination

Which of the following is not an important determinant of wage inequality within an economy?

1. Differences in connections to influential people

Human capital is the:

1. A db B
2. Experience that people derive from spending more time on a job
3. Skills and knowledge that people obtain by furthering their schooling

Compensating wages are the wage premiums:

1. Paid to attract workers to occupations to otherwise undesirable jobs

When it comes to determining the appropriate quantity of physical capital to use, the firm employs a decision rule that is conceptually:

1. Identical to, the approach it takes in choosing the number of workers to hire

A firm will employ physical capital until:

1. The value of marginal product of capital equals the rental price of capital

The following table gives the value of marginal product of capital for a competitive firm

Machines VMPK

1 120

2 100

3 80

4 60

5 40

6 20

If the rental price of capital is 80 per machine, this firm will employ:

1. 3 machines

Two major theories for why employers might discriminate are:

1. Taste based and statistical discrimination

Suppose an employer avoids hiring youthful workers because she worries that their skill level makes them unproductive. In this case, the employer is practicing:

1. Statistical discrimination

If an employer’s discrimination signals that she is willing to forego profits, the she is engaging in:

1. Taste based discrimination

A production function shows:

1. The number of workers employed and the corresponding output levels that will be produced

According to the law of diminishing returns:

1. The marginal productivity of an additional unit of labor eventually decreases as the quantity of labor increases

The figure on the right shows the market for labor in a given industry.

The demand curve slopes downward because:

1. Marginal productivity falls as more workers are employed

The supply curve slopes upward since the opportunity cost of leisure:

1. Rises following an increase in the wage

Using the line drawing tool, show the impact of this event.

1. Draw supply curve to left of equilibrium supply

According to the graph, the consequence of the change in attitudes is a:

1. Higher market wage and a lower level of employment

Suppose you decide to start a business printing t-shirts. The table below summarizes the number of machines you will need to print t-shirts for a given level of output as well as the marginal product of each additional machine. Assume the equilibrium price of t-shirts is 7.

Calculate the value of marginal product of capital.

Output Machines Marginal product VMPK

60 1 60 420

135 2 75 525

217 3 82 574

290 4 73 511

358 5 68 476

If the rental price of capital is 511 permachine, you will employ:

1. 4 machines

Monopoly Market Structures

A company with market power behaves quite differently from the way that a competitive firm behaves. Compared to competitive firms, monopolists produce less and charge more. They make themselves better off, with the potential of earning economic profits in both the short run and the long run. But their gain will come at the cost of making consumers worse off and decreasing social surplus. 

Monopoly represents an extreme market structure with a single seller. Monopolies arise both naturally and through government protection. Monopolists are price-makers and produce at the point where marginal revenue equals marginal cost. The monopolist profits by producing a lower quantity and charging a higher price than perfectly competitive sellers. The result is a deadweight loss. Efficiency can be established in a monopoly through first-degree price discrimination or government intervention. 

Studying perfectly competitive markets provided important insights into how agents interact in markets and how markets equilibrate. But it proves to be a special type of market. A more common market situation is one in which a firm is not simply a price-taker, but a price-maker, a seller that sets the price of a good. Such a firm has the ability to set the price of the good because it has market power. The most extreme form of market power is a monopoly.

A monopoly is an industry structure in which only one seller provides a good or service that has no close substitutes. In this way, a monopolist is not concerned with the behavior of other sellers. The price chosen by the monopolist is the one that makes the company the highest profit. 

The ability of a company to control a market, to gain market power, relies on barriers to entry. Barriers to entry are obstacles that prevent potential competitors from entering the market. As such, they provide the seller protection against competition. Barriers to entry range from complete exclusion of market entrants to prevention of a new firm from entering and competing on an equal footing with the incumbent firm. 

Two types of market power arise from barriers to entry, legal market power and natural market power. 

A firm has legal market power when it obtains market power through barriers to entry created not by the firm itself but by the government. These barriers can take the form of patents and copyrights that are issued to innovative companies. With a patent, the government grants an individual or company the sole right to produce and sell a good or service. With a copyright, the government grants an individual or company an exclusive right to intellectual property. 

A second common source of barriers to entry occur naturally rather than by design. Natural market power occurs when a firm obtains market power through barriers to entry created by the firm itself. There are two main types:

1. The monopolist owns or controls a key resource for production
2. There are economies of scale in production over the relevant range of output

Key resources are those materials that are essential for the production of a good or service. The most basic way for a firm to develop market power naturally is to control the entire supply of such resources. 

Another key resource is individual expertise. Network externalities occur when a product;s value increases as more consumers begin to use it. Monopolies also form because it is practical for both producers and consumers. Natural monopolies are characterized by substantial fixed costs and economies of scale. 

For goods and services that have economies of scale over the relevant range of output, it is efficient for a single firm to serve the entire market, because it can do so at a lower cost than any larger number of firms could. We denote such cases as natural monopolies, because they arise naturally. A natural monopoly arises because the economies of scale of a single firm make it efficient to have only one provider of a good or service. Often such firms are the first suppliers in a given market, and the cost advantages they achieve through producing a large number of goods preclude would-be competitors from entering the market. Examples of natural monopolies include providers of clean drinking water, natural gas, and electricity. 

In contrast to monopolies that arise through legal means, natural monopolies emerge when unique cost conditions characterize their industry. Because of these conditions, natural monopolists worry less about potential market entrants than do monopolies that arise through legal means.

The monopolist’s problem shares two important similarities with the perfectly competitive seller’s problem. First, the monopolist must understand how inputs combine to make outputs. Second, the monopolist must know the costs of production. 

We do find one important difference between the perfectly competitive seller’s decision problem and the monopolist’s decision problem. To maximize profits, the perfectly competitive firm expands production until marginal cost equals price, where price is determined by the intersection of the market demand and market supply curves. 

  This situation represents the major difference between the perfectly competitive firm’s decision problem and the monopolist’s decision problem. Because the monopolist is the sole market supplier, it faces the market demand curve, which is downward-sloping. Unlike the perfectly competitive firm, the monopolist can increase price and not lose all of its business. In fact, the market demand curve tells us exactly the trade-off the monopolist faces when it changes its price. 

High fixed costs are typical for industries that spend large amounts of money on researching and developing products, such as pharmaceutical companies. In such instances, it is not uncommon for marginal cost to be constant over large ranges of output, because mass production of the product leads to each additional unit of production to have a constant additional cost per unit. 

A perfectly competitive firm must consider both marginal cost and marginal revenue when making its production decision. A monopolist is no different. This reasoning shows that your profit-maximizing level of output produced is given by the intersection of the marginal revenue and marginal cost curves. 

Your pricing decision as a monopolist is critically linked to the nature of the market demand curve. Price is set at a level higher than marginal costs for a monopolist, whereas price is equal to marginal cost for a perfectly competitive firm. 

In perfectly competitive markets, entry causes long-run economic profits to be zero. For a monopoly, economic profits remain. This is because there is no threat of entry from competitors because of barriers to entry. Therefore, no new entrants threaten to increase supply and push the price down to eliminate economic profits. 

Monopolists, unlike sellers in competitive markets, do not have a supply curve. To create a supply curve under perfect competition, it is necessary for firms to be price-takers, whose production is based on the given market price. Under this assumption, we simply determine the quantity at which the marginal cost of producing the last unit of a good is equal to the market price. Thus, in a competitive market, a supply curve shows all price and quantity combinations at which firms will produce. 

Monopolists, as price-makers, do not vary their production based on market price because they set the price. It makes no sense to ask how much of a good a monopolist will produce at a given price. Like sellers in competitive markets, monopolists will produce at the point where their marginal revenue is equal to their marginal cost. Marginal revenue depends on the negatively sloped demand curve that the monopolist faces. Because a monopolist’s production decision is based on demand, it cannot be depicted as an independent supply curve. 

Previously, we learned that the invisible hand creates harmony between individual and social interests. A firm that exercises market power causes a reallocation of resources toward itself, thereby sacrificing social surplus. 

Price discrimination occurs when firms charge different consumers different prices for the same good or service. First-degree price discrimination is where consumers are charged the maximum price they are willing to pay. Second-degree price discrimination is where consumers are charged different prices based on characteristics of their purchase, such as the quantity they purchase. Third-degree price discrimination is when different groups are charged different prices based on their own attributes, such as age, gender, or location.

In practice, perfect price discrimination is difficult to achieve for two reasons. First, it is hard to charge every consumer a unique price. Second, it is challenging to know every consumer’s willingness to pay. Therefore, other forms of price discrimination are more prevalent in practice. 

A monopoly is an industry structure in which only one firm provides a good or service that has no close substitutes. Monopolies arise because of barriers to entry, which take two forms: legal and natural. In the legal form, the government creates the barrier, as with a patent or copyright. In the natural form, control of key resources or achieving economies of scale can result in a natural monopoly. 

Barriers to entry permit the monopolist to exercise market power when making quantity and pricing decisions. The optimal action of the monopolist is to set price > marginal revenue = marginal cost. This differs from a competitive industry, where price=marginal cost=marginal revenue.

In equilibrium, monopoly leads to less quantity and higher prices compared to a perfectly competitive market equilibrium. In this way, because consumers are standing by ready to purchase from the monopolist for a price greater than marginal cost, social surplus is not maximized, leading to a deadweight loss.

Monopolies may sometimes be appropriate, and understanding whether a firm is occupying a monopoly status appropriately is a major concern of US lawmakers. Even though there are costs to allowing firms to have monopoly power, the extra profit might translate into better and more productive research and development for new products, medicines, and technologies. 

Which of the following are properties of a monopoly?

1. There are high barriers to entry
2. Price-maker
3. There is only one seller

Natural monopolies are characterized by substantial fixed costs and economies of scale. To see this, at a low quantity level the average total cost is very high, and as quantities increases the average total cost decreases, approaching marginal cost. 

All firms, regardless of market structure, must consider their average total cost when determining profitability. Show the average total cost curve for a natural monopoly.

1. Draw line starting from top left and curving down towards bottom right

When comparing the graph of your average total cost curve for a natural monopoly with that of a firm in perfect competition, we see that?

1. A natural monopoly has a downward-sloping average total cost curve, while a firm in perfect competition has a u-shaped curve

Which of the following is not one of the sources of natural market power?

1. Production of a luxury good

Which of the following best describes network externalities?

1. They occur when a product’s value increases as more customers begin to use it

The graph on the right shows the average total cost curve for a firm.

How would the cost differ if the market consisted of only one large firm compared to a market with many small firms?

1. Draw points at the units asked for on the atc line

Using the graph, a firm with that type of cost curve is best suited to be:

1. A natural monopoly, since it faces economies of scale and can produce at a lower cost if done by one firm

Which of the following best describes the relationship between price, marginal revenue, and total revenue for a monopolist?

Is it always true that when marginal revenue is falling, total revenue is falling? If the revenue from the last unit sold is positive, it will still add to total revenue. So, whether marginal revenue is rising or falling, as long as it is positive, it should add to total revenue. 

The marginal revenue curve for a monopolist is downward-sloping. If the revenue from the last unit sold is positive, it will still add to total revenue. Similarly, if the revenue from the last unit sold is negative, it will lower total revenue.

1. When marginal revenue is positive, total revenue is rising, and when marginal revenue is negative, total revenue is falling

Given the following demand and marginal revenue curves for a monopolist, graph the resulting total revenue curve on the graph to the right.

1. Draw inverse U shape, starting at 0,0 vertex at 5=mr quantity and ending at 10 quantity

The graph on the right shows the market demand curve for a good. Use the graph to find total revenue and marginal revenue at the given output levels.

If the price is 4, then total revenue is:

Price * quantity

1. 8 thousand

If the price is 3, then total revenue is:

1. 9 thousand

If the price is lowered from 4 to 3, then the change in total revenue is:

1. 1 thousand

Suppose a monopolist faces the linear demand curve P=a-bq

Where a is the point where the demand curve touches the y-axis and b represents the slope of the demand curve.

Given this equation, which of the following represents the monopolist’s marginal revenue?

1. mr=a-2bq

Given the linear demand curve for a monopoly on the graph to the right, find this monopolist’s marginal revenue curve?

1. Draw line that starts at same point on y-xis as demand curve, end on x-axis halfway of total quantity on x-axis.

Suppose as creative college students you and your friends develop software that for a small fee helps students choose courses based on professor’s ratings and grade distributions, and it becomes an instant hit around campus. You decide to patent your software and license its use to a large tech firm who agrees to pay you 5 percent of all revenue earned. For example, if the tech firm sells 200 subscriptions at 1- each, it will have revenue of 2000, meaning you will earn 5 percent of that total or 100.

The tech firm’s goal is to maximize profits, while your goal as a license holder is to maximize total revenue. Given this information, what do we know about the price of the good?

1. You prefer P1, but the tech firm prefers P2

You are a monopolist facing the demand schedule below. You produce a good at a constant marginal cost of 4 per unit. Fill the marginal revenue column:

The total revenue of a firm is calculated by multiplying the quantity of goods sold by the price of the goods. Marginal revenue is the change in total revenue associated with producing and selling one additional unit of output.

1 14 14

2 12 10

3 10 6

4 8 2

The profit-maximizing output for you is:

A monopolist should continue production as long as marginal revenue is greater than marginal cost.

1. 3 units because at 3, marginal revenue is 6, which is more than the marginal cost of 4

Suppose there is a fixed cost of 10. The maximum profit you can earn is:

A monopolist should continue production as long as marginal revenue is greater than marginal cost.

1. The maximum profit the monopolist can earn is at the profit-maximizing output of 3 units. The profit earned at this output is 30-(3*4)=8

Which of the following equations calculates economic profits for a monopoly?

1. Profits=(p-atc)*Q

The graph on the right illustrates the demand, marginal revenue, marginal cost, and average total cost curves for a monopoly.

Use these curves to show a firm’s profits.

A monopolist finds its profit-maximizing quantity where marginal revenue equals marginal cost and then sets its price for that quantity to the maximum amount that consumers would be willing to pay.

The graph on the right shows the demand, marginal revenue, and marginal cost curves in a monopoly market.

Suppose you are a monopolist and you have two customers, A and B. Each will buy either zero or one unit of the good you produce. A is willing to pay up to 55 for your product, B is willing to pay up to 20. You produce this good at a constant average and marginal cost of 8. If you could not engage in third-degree discrimination, what price would you charge?

1. $55