Study Guide Economics Comprehensive Exam 2014 - What is economics? o The study of how society manages its scarce resources o The social science concerned with the efficient use of scarce resources to achieve maximum satisfaction of economic wants - The Basic Economic Problem o There are four interrelated problems involving resource allocation in an economy: 1) Resources are scarce 2) Scarce resources are used to make good and services 3) Scarce resources have alternative uses - Economic Problem (in a nutshell) o The economic problem arises because unlimited wants exceed scarce resources. - Marginal Analysis o In economics, the term marginal means additional - Factors of Production o Definition: another term for economic resources, which are used to produce goods and services and which are in limited supply. o Three main factors of production 1) Land 2) Capital (physical) includes technology and component parts 3) Labor: includes enterprise or entrepreneurship. Both mental (human capital) and physical. - Land o In economics, “land” means any natural resource used in production o Includes the earth’s surface as well as what is beneath it, such as oil and coal, and what is naturally found on it. - Capital o Definition: Any human-made (manufacture) good used to produce other goods and/or services. o Examples: offices, factories, machinery, railways, tools, ect. - Capital vs. Consumer goods o Capital goods are of value for what they can produce o Consumer goods are of value for the satisfaction they can provide to their owners - Labor o Definition: all human effort, both mental and physical. Involved in producing goods and services. o The term “human capital” refers to the education, training, and experience of workers. More human capital = greater capability of producing - Opportunity cost o Definition: the next best alternative forgone - Production Possibilities Curve or Frontier o Definition: a curve that shows the max output of 2 types of products and the combination of these products that can be produces with existing resources and technology.
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Study Guide Economics Comprehensive Exam 2014
What is economics?
o The study of how society manages its scarce resources
o The social science concerned with the efficient use of scarce resources to achieve maximum
satisfaction of economic wants
The Basic Economic Problem
o There are four interrelated problems involving resource allocation in an economy:
1) Resources are scarce
2) Scarce resources are used to make good and services
3) Scarce resources have alternative uses
Economic Problem (in a nutshell)
o The economic problem arises because unlimited wants exceed scarce resources.
Marginal Analysis
o In economics, the term marginal means additional
Factors of Production
o Definition: another term for economic resources, which are used to produce goods and
services and which are in limited supply.
o Three main factors of production
1) Land
2) Capital (physical) includes technology and component parts
3) Labor: includes enterprise or entrepreneurship. Both mental (human capital) and
physical.
Land
o In economics, “land” means any natural resource used in production
o Includes the earth’s surface as well as what is beneath it, such as oil and coal, and what is
naturally found on it.
Capital
o Definition: Any human-made (manufacture) good used to produce other goods and/or
services.
o Examples: offices, factories, machinery, railways, tools, ect.
Capital vs. Consumer goods
o Capital goods are of value for what they can produce
o Consumer goods are of value for the satisfaction they can provide to their owners
Labor
o Definition: all human effort, both mental and physical. Involved in producing goods and
services.
o The term “human capital” refers to the education, training, and experience of workers.
More human capital = greater capability of producing
Opportunity cost
o Definition: the next best alternative forgone
Production Possibilities Curve or Frontier
o Definition: a curve that shows the max output of 2 types of products and the combination of
these products that can be produces with existing resources and technology.
Study Guide Economics Comprehensive Exam 2014
Four Key Assumptions
o Only 2 goods can be produced
o Full employment of resources
o Fixed resources ( ceteris paribus)
o Fixed economy
Per Unit Opportunity Cost
o How much each marginal unit costs:
Utility and Diminishing Marginal Unity:
o Diminishing Marginal Unity: proposition that as a person increases consumption of a good-
while keeping consumption of other goods constant- there is a decline in the marginal utility
(additional satisfaction) the person derives from consuming each additional unit of that
good.
Marginal Analysis Example
o Decision criterion: stop consuming where marginal benefit >= marginal cost
Three Fundamental Questions Concerning Resource Allocation
o Because of the basic economic problem, every economy must answer:
1) What should be produced?
2) How should it be produced?
3) For whom should it be produced?
Centrally Planned Economy
o Definition: An economy in which the government makes the crucial decisions, in which land
and capital are state-owned, and in which resources are allocated by directives.
Market Economy
o Definition: An economy in which consumers determine what is produced, in which
resources are allocated by the price mechanism, and in which land and capital are privately
owned.
Mixed Economy:
o Definition: An economy in which both private and public sectors play an important role.
Advantages of a Market Economy
o Responsive to consumer demand; consumers said to be sovereign
o Choice for consumers, firms, and workers
o Profit motive and competition promote efficiency.
Firms that produce what consumers want at low prices earn high profits.
o High income provides incentive for hard work and risk taking
Demand
o Demand is the willingness and ability to buy a product.
Demand and Price
o Quantity demanded an price are inversely related (i.e. law of demand)
Effects of Price Changes on Demand
o A decline in price leads to an increase in quantity demanded, while an increase in price leads
to the opposite.
Study Guide Economics Comprehensive Exam 2014
Changes in the quantity demanded are caused by price changes and are distinct from
changes in demand.
Quantity Demanded vs. Demand
o Quantity demanded is a specific number of products where demand is just the willingness
and ability to buy a product.
Why does the law of demand occur?
o The substitution effect: if the price goes up for a product, consumers buy less of that
product and more of another substitute product and vice versa.
o The income effect: if the price goes down for a product, the purchasing power increases for
consumers allowing them to purchase more.
o Law of diminishing marginal utility (satisfaction): as you consume more units of any good,
the additional satisfaction from each additional unit will eventually start to decrease. The
more you buy the less satisfaction you get from each unit.
Supply and Price
o Definition of supply: the willingness and ability to sell a product.
o Quantity supplied and price are directly related (i.e. law of supply)
Higher price= increase quantity supplied
Firms earn greater profits with higher prices because they are able to cover costs more
easily.
Effect of Price Change on Supply:
o A decline in price leads to a decrease in quantity supplied, while a rise in price leads to the
opposite.
Changes in quantity supplied are caused by price changes and are distinct from
changes in supply.
Equilibrium Price
o Definition: The price where quantity demanded and quantity supplied are equal; sometimes
called the market clearing price.
o Simply the point where demand and supply curves intercept.
Disequilibrium
o Definition: a situation where quantity demanded and quantity supplied are not equal
o Surplus: quantity supplied exceeds quantity demanded.
o Shortage: quantity demanded exceeds quantity supplied.
Causes of Changes in Demand
o Disposable income
o Prices of related products
o Tastes and preferences
Advertising
Seasonal factors (e.g. weather)
o Number of consumers
population
o Expectations about future prices
Study Guide Economics Comprehensive Exam 2014
Disposable Income
o Definition: The income after taxes have been deducted.
o An increase in disposable income raises consumers purchasing power
Normal good: product whose demand increases when income increases and vice versa.
Inferior good: product whose demand decreases when income increases and vice versa.
Prices of Related Products
o Changes in demand can be caused by changes in prices of a substitute of a complementary
good.
Substitute: products that can be used in place of another
Complement: a product that is used in conjunction with another.
Tastes and Preferences: Advertising
o A successful ad campaign will increase demand for a product.
Causes of Change in Supply
o Costs of production
Prices and availability of inputs
- Productivity
- Weather conditions
- Disasters and wars
- Discovery or depletion of resources
Improvements in technology
Opportunity cost of alternative production
o Number of sellers
Expectations about future profits
o Government action
Taxes
Subsidies
Changes in Costs of Production
o If it costs more to produce a product, suppliers will want a higher price for it.
o Two basic reasons for change in costs:
A change in the price of any of the factors of production
A change in productivity of factors of production
Taxes and Subsidies
o Increases in taxes are like increases in cots and so will reduce supply; opposite true of tax
decreases.
o A subsidy given to producers (or consumers) provides a financial incentive for them to
supply more (or purchase more); opposite true if subsidy deceases.
MB >= MC
Consumer Surplus
o Definition: an economic measurement of consumer satisfaction, which is calculated by
taking the difference between what consumers are willing to pay for a good relative to its
market price.
Study Guide Economics Comprehensive Exam 2014
o CS= max. willingness to pay- price
= MB/MU-MC
Producer Surplus
o Definition: an economic measure of the difference between the amount that a produce
receives for a good and the minimum amount that a producer is willing to accept of a good.
o PS= price- min willingness to accept
= MB/MU-MC
Consumer/ Producer Surplus
o Consumer surplus: area of triangle about equilibrium price and below the demand curve
with a length equal to that equilibrium supply
o Producer surplus: area of triangle below price and above supply curve with a length equal to
the equilibrium quantity.
Price Elasticity of Demand (PED)
o Definition: the sensitivity of quantity demanded to a change in price
o
Magnitude of PED
o Elastic Demand: PED greater than one (in absolute value)
o Inelastic Demand: PED between zero and one (in absolute value)
Factors Determining Degree of Elasticity
o Availability of substitutes (lots of substitutes – inelastic; monopoly- elastic)
o Other factors:
Proportion of income spend on product (little- inelastic; large-elastic)
Necessity or luxury (necessity- inelastic; luxury- elastic)
Addictiveness (inelastic)
Whether purchase can be postponed ( elastic- long postponement)
Market definition
Time period under consideration
o PED may also change over time (e.g. luxury items become necessities)
Other Degrees of Elasticity
o Perfectly elastic demand: when a change in price caused a complete change in QD.
o Perfectly inelastic demand: when QD doesn’t change when price changes.
o Unit elasticity of demand: when percent change in price results in equal percent change in
QD. PED= -1
Price Elasticity of Supply (PES)
o Definition: The sensitivity of quantity supplied to change in price
o
Magnitude of PES
o Elastic Supply: PES greater than one
o Inelastic Supply: PES between zero and one
Study Guide Economics Comprehensive Exam 2014
Perfectly Elastic Supply: when a change in price causes a complete change in quantity supplied:
PES= infinity
Perfectly Inelastic Supply: when quantity supplied doesn’t change when price changes; PES=0
Unit Elasticity of Supply: when the percent change in price results in an equal percent change in
quantity supplied; PES=1
What factors of production are employed
o Influenced by:
The product produced
Factor productivity
Relative cost
Substitutable Factors
o When they are substitutes, a rise in productivity or fall in cost of one may result in a change
in the combination of resources.
o Example: a fall in price of capital might lead to replacement of workers with machines.
Complementary Factors
o When they are compliments, a rise in productivity or fall in cost of one may increase use of
all factors.
o Example: a fall in cost of aircraft may cause an airline to fly to more destinations, increasing
employment of pilots and cabin crew.
Influence on Demand for Capital
o The QD of capital obviously depends on price
o Demand is a function of:
The price of other factors of production when substitutable or complementary