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MicroEconomics Study Notes First Exam

1. Chapter 1 a. The Economic Perspective Features: i. Scarcity and Choice - We must decide what we will consume and what we will forego - There is no free lunch - opportunity cost to obtain more of one thing, society forgoes the opportunity of the next best thing. - opportunity cost is present in every decision we make ii. Purposeful Behavior - reflects rational self-interest this is not the same as selfishness - pursuit of things that increase utility - the pleasure, happiness, or satisfaction obtained from consuming - people can make mistakes even though they act purposefully iii. Marginal Analysis - comparison of marginal benefits and costs - *marginal extra, additional or change in. 1. MB = MC optimal 2. MB > MC underallocation 3. MB < MC - overallocation b. Theories, Principals, Models i. Economics relies on the scientific method 1. Observe real-world behavior 2. Formulate a hypothesis 3. Test the hypothesis 4. Accept/Reject the hypothesis 5. If you achieve favorable results, the HYPOTHESIS becomes a THEORY 6. Widely accepted THEORY becomes an ECONOMIC LAW/PRINCIPLE ii. Economic principles are purposeful simplifications the full scope of the economy is too complex to be understood. 1. Generalizations 2. Other things equal assumption ceteris paribus factors other than those being considered are constant 3. Graphical expression iii. Microeconomics vs. Macroeconomics 1. Micro individual customers, workers, households, firms, markets. 2. Macro aggregates collection of units treated as one. - Many topics are rooted in both micro and macro iv. Positive vs. Normative 1. Positive Facts, cause and effect, what is 2. Normative value judgements, what ought to be c. Individuals Economizing Problem i. Economic wants exceed economic means - Consumers have limited income - Unlimited wants our desires can never be fully satisfied.

i. Because of limited income and unlimited wants, we must economize pick what goods and services will maximize our utility. Budget line/constraint below ratio of books to DVDs = Pb/Pdvd == slope

i. Straight-line indicates constant opportunity costs for both goods ii. A change in income will shift the line up and down d. Societys Economizing Problem more resources to education? Criminal sys.? i. Scare Resources including natural, human and manufactured resources. E.g. factories, farm buildings, equipment, tools and machinery, all types of labor, land and minerals. 1. Categories: Factors of production AKA Inputs - Land includes all natural resources - Labor - Capital manufactured aids factories, tools, machine NOT MONEY!! i. Investment the money that pays for the production and accumulation of capital goods ii. Capital goods are not like consumer goods, they satisfy wants indirectly by aiding production of consumer goods. iii. Entrepreneurial Ability the agent whom combines land, labor, and capital to produce a good or service. He is innovative and must take risks to enhance societys standard of living. ii. Production Possibilities Model 1. Assume: - Full employment - Fixed resources - Fixed technology - Two goods 2. More consumer goods more now, more capital goods = much more in the future

3. Law of Increasing Opportunity Costs Economic resources are not completely adaptable to alternative uses. E.g. Land highly suited for for agriculture might not be suited for coal

mining. So if utilizing all of the land for just food production, you could not be as productive. 4. Shape of curve bowed out concave - reflected by the law of increasing opportunity costs 5. Optimal Allocation/output mix MB = MC e. Unemployment, Growth, and the Future i. Unemployment:

ii. If we remove the assumptions that: 1. Technology is fixed, 2. Quantity or supply of resources are fixed, - E.g. rise in population = increase in labor resource 3. Quality of resources is fixed - E.g. add. education and training = increase in labor quality i. Our economy can grow (graphically represented by a shift to the right) AKA larger total output iii. Fallacy of Composition it is false that what is true for one member of a group is true for the entire group - E.g. if 1 person sells their google stock it will have no impact on Googles share price, but if a large group does, it will. iv. Post Hoc Fallacy Just because event A precedes event B, does not imply that event A caused event B. v. Correlation does not mean Causation vi. Present Choices and Future Possibilities 1. Future Goods capital goods, research and education 2. Present Goods consumer goods, food, clothing, entertainment 3. Is Futurevilles choice better than Presentville? No, not necessarily.

vii. International Trade - Specialize in the production of items that it has the lowest opportunity cost and then trade with other nations that specialize in something i. Increases the quantity of capital/consumer goods for society 2. Chapter 2 a. Economic Systems set of institutional arrangements and a coordinating mechanism i. Who owns the factors of production? ii. What method is used to motivate, coordinate and direct economic activity? b. Command System AKA Socialism, Communism i. Government owns property and businesses and makes almost all decisions through central planning board ii. Very small amount of private ownership and markets c. Market System AKA Capitalism i. Private ownership of resources property rights: 1. Property owners can pass on their property when they die 2. Legally bound - Helps ensure that only mutually agreeable transactions take place 3. Includes intellectual property patents, copyrights - These rights remove fear that property will be stolen/taken - Encourage exchange knowing who is the legitimate owner - Encourage improvement or maintenance - Relieve people of the burden to protect their property ii. Self-interest the motivating force of the various economic units iii. Markets and prices coordinate/direct economic activity decisions made by business and individuals is highly coordinated 1. *market a place where buyers and sellers come together to buy and sell goods, services, and resources. 2. Society dictates what should be produced iv. Competition exists because goods are produced by whoever is willing, requires: 1. 2 or more buyers and 2 more sellers acting independently in a product/resource market 2. Freedom of sellers and buyers to enter or leave markets - Diffuses business economic power none may dictate price v. Government plays a role much smaller than in the command system 1. it promotes stability and growth 2. provides certain goods that would otherwise be underproduced 3. modifies the distribution of income vi. Different then pure capitalism (laissez-faire capitalism) where governments role is limited even further. vii. Market economies rely heavily on specialization because it is more efficient to do so. 1. Human specialization AKA the Division of Labor contributes to societys output:

- Makes use of different abilities - Fosters learning by doing - Saves time multitasking gets confusing and slows people down 2. Geographic specialization viii. Use of money a medium for exchange better than barter because that requires a coincidence of wants ix. Freedom of Enterprise and Choice 1. Enterprise free to obtain resources to produce their choice of goods 2. Choice owners can employ/dispose of their property as they see fit - Allow consumers to buy the goods and services that best satisfy their wants x. Reemphasis of the 3 most important merits of a market system 1. Efficiency encourages adoption of the latest and most efficient production techniques 2. Incentives- encourages skill acquisition, hard work and innovation. 3. Freedom coordinates market activity without coercion (like a command system) d. The Five Fundamental Questions that all economic systems must address i. What goods will be produced? 1. The ones that produce a continuing profit = TotRev > TotCost 2. Consumer Sovereignty consumers are in command because they spend their income (dollar votes) on goods in the market. ii. How will they be produce the goods/output? 1. In a way that minimizes cost/unit of output least input(resources) at the lowest prices and most efficient = cheaper 2. Competition eliminates high cost producers iii. Who will get the goods/output? 1. Consumer willingness 2. Consumer income iv. How will the system accommodate change? 1. It can respond through changes in price and profits dictated by consumers v. How will the system promote progress? And increase the standard of living? 1. Tech Advance - Rival firms must follow the lead of the innovative firms in order to stay competitive, or suffer creative destruction creation of new products destroys the firms that continue old production methods 2. Capital Accumulation e. The Invisible Hand i. Adam Smith 1776 Wealth of Nations 1. Firms and resource suppliers, through self-interest, in a competitive market, will simultaneously promote public and social interest - E.g. Businesses reducing cost = using the least resources - E.g. Businesses new products improve societys well-being f. The Demise of the Command Systems i. The Coordination problem 1. Set realistic targets for production, supply the factor inputs, but many outputs were used by other industries as inputs, so if even one would fail, it would cause a chain reaction of problems.

2. Unreliable success indicator - A market system uses profit as a success indicator, the command system used quantity, so managers would often sacrifice quality to meet quotas. ii. The Incentive Problem 1. Managers had no incentive to adjust production when shortages and surpluses arose because they were rewarded for meeting their quantity quotas. 2. There were no fluctuations in price so there was no signal as to the demand. 3. Entrepreneurship was lacking and central planning did not reward innovation g. The Circular Flow Model i. Resource/Products flow counter-clockwise ii. Monetary flows are clockwise iii. Businesses/Households 1. Businesses fall into 3 categories - Sole proprietorship 1 owner - Partnership 2 or more owners - Corporation independent legal entity owners bear no responsibility

3. Chapter 3 Demand, Supply and Market Equilibrium a. Markets i. bring together buyers and sellers ii. do not have to be a physical place iii. include demand, supply, price and quantity b. Demand schedule or curve that shows the various amounts of a product consumers will purchase at possible prices during a specified period of time. i. Law of demand all other things equal, as price falls, quantity demanded rises - a negative inverse relationship = MB 1. 3 reasons why quantity demanded goes up as price goes down - Common sense price deters or attracts consumers to buy - Diminishing marginal Utility with each successive purchase, consumers experience less utility, therefore consumers will only buy additional units of a product if the price is low - The Income/Substitution Effect i. lower price increases purchasing power of a consumers income ii. Substitute the lower priced product for the more expensive ones 1. Chicken instead of pork, fish, etc.

ii. Total quantity demanded = horizontal summing iii. Determinants of demand (demand shifters) 1. Consumers tastes 2. Consumers income - Inferior good income falls, demand inc - inverse - Normal good (superior goods) income increase, demand inc - direct 3. Consumers expectations 4. Prices of related goods - Substitute increase in price of 1 good, increase in demand of the substitute - Complement demand of 1 good increase, demand of the comp increases - Independent goods unrelated, the majority of goods 5. # of buyers in the market iv. Increase in demand = right shift, Decrease in demand = left shift

1. c. Supply i. Law of supply increase price, increase quantity supplied direct relationship positive = MC ii. Market supply total quantity supplied = horizontal summing

1. iii. Determinants of supply 1. Resource prices 2. Technology 3. Taxes and Subsidies tax = cost, subsidy = tax in reverse 4. Price of other goods alternative/substitute goods similar to the ones they are producing already 5. Producer Expectations 6. # of sellers d. Application Government set prices i. Price ceiling sets the max legal price a seller may charge for a product or service 1. E.g. rent controls, usury laws 2. For the ceiling price to be effective, it must be below equilibrium price 3. You end up with a shortage Qs <Qd 4. Consumers can obtain some essential good they could not afford at equilibrium

- Black market people paying more than the price ceiling ii. Price floor a min price fixed by the gov. 1. E.g. min wage, agricultural products 2. Above equilibrium price 3. You end up with a surplus Qs > Qd 4. Fix problems with insufficient income for households or businesses iii. Negative side effects 1. Rationing function 2. Distorted resource allocations 4. Chapter 5 Market failures: Public goods and externalities a. Market failure overview government may play a role in fixing the failure i. Demand-side market failure 1. E.g. public fireworks, there is no way to exclude people who havent paid for them ii. Supply-side market failure a firm does not have to pay the full cost for its output 1. E.g. coal-burning plant releasing pollution in the air, cost goes unaccounted for b. InEfficient markets i. Consumer surplus = max price consumer would pay max price they actually pay

ii. 1. Inverse relationship between Consumer Surplus and Price iii. Producer surplus = actual price producer receives min acceptable price consumer could pay to cover ALL production cost of a single unit

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vi. Equilibrium Max willingness to pay = min. price acceptable to meet production costs vii. Economic efficiency is market equilibrium consists of: 1. Productive efficiency competition forces suppliers to use the best combination of resources and technologies to produce the product at the lowest cost 2. Allocative efficiency - optimal allocation where MB = MC - max willingness to pay = min price acceptable to meet production costs - total surplus (THE SUM OF CONSUMER AND PRODUCER SURPLUS) is at a max. viii. Efficiency losses (AKA deadweight losses)

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x. c. Public Goods underreporting how much consumers are willing to pay i. Private good goods offered for sale in stores, internet, etc. 1. Rivalry when 1 person buys and consumes a product, it is no longer available to another person. 2. Excludability sellers can keep people who do not pay for a product from gaining its benefits. 3. Firms can make a profit selling private goods ii. Public good 1. Nonrivalry e.g. everyone can obtain the benefit of street lighting simultaneously, it does not disappear after one person has used the street lighting to see 2. Nonexcludability e.g. the street lighting cannot be limited only to people who pay for it - These 2 characteristics create a free-rider problem reduces demand 3. 3 ways public goods may be provided: - Profits are generated by a closely related private good - Private philanthropy - Government provision 4. Optimal quantity government has to try to guess this using surveys or public votes 5. Collective willingness to pay (demand) curve = vertical sum of prices 6. Cost-benefit analysis is used to determine whether to produce a public good

iii. Quasi-public good 1. A good provided by the government that could be produced in a way that excludability is possible iv. The Reallocation process process to free up resources from private goods to public goods 1. Reduces demand for private goods by levying taxes on households and businesses, tax proceeds are then spent on the public good d. Externalities a benefit or cost to someone other than the immediate buyer/seller i. Negative e.g. cost of breathing polluted air 1. Supply-side market failure supply curve shift right 2. Overproduction 3. Overallocation ii. Positive e.g. having everyone else inoculated from some disease 1. Demand-side market failure demand curve shift left 2. Underproduction 3. Underallocation

iii. e. Government Intervention i. To combat Negative externalities: 1. Direct control e.g. uniform emission standards 2. Specific Taxes raise the marginal cost of producing ii. To combat Positive externalities: 1. Subsidy to buyers 2. Subsidy to producer (tax in reverse) 3. Government provision when positive externalities are too large, product provided for free to everyone. f. Optimal reduction of an externality MB=MC 5. Chapter 23 (473-481) a. Basis for trade nations can gain by specializing in the products they can produce with the greatest relative efficiency and by trading for the other goods they cannot produce as efficiently. i. Trade deficit Imports exceed exports US deficit in goods ii. Trade surplus Exports exceed imports US surplus in services iii. Canada is the biggest US trading partner iv. Trade deficit with China b. Comparative advantage can produce a product at a lower opportunity cost i. Specialization and international trade increase the productivity and output ii. Absolute advantage is pointless to look at if a nation can produce more a product given the same amount of resources 6. Chapter 16

a. Government in the circular flow model i. Finances expenditures through taxes it receives from both households and businesses ii. Government purchases resources and products iii. Government provides Goods and services

b. c. Government purchases i. Exhaustive products purchased directly utilize resources and create output 1. E.g. a missle - Physicist labor - Steel, explosives utilized d. Transfer payments i. NonExhaustive no utilization of resources and do not create output. 1. E.g. welfare, social security - No contribution to output in return for money e. Government must borrow to finance these transfer payments during an economic downturn f. Levels of government i. Federal ii. State iii. Local 1. 3 sources of revenue - Taxes - Borrowing - Proprietary income from public utilities and state lotteries g. Taxes i. Progressive tax average rates increase as income increases. Takes a larger %proportion of inc. 1. E.g. federal income tax ii. Regressive tax average rates decrease as income increases. Takes a smaller %proportion of inc. NOT larger amount. 1. E.g. sales tax, property tax 2. Think about the proportion of income, is it larger for poor families? iii. Proportional tax (AKA flat tax) average rate stays the same regardless of income. 1. Corporate Income Tax iv.