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					  Review for Final
 Part 1, chapter 1-5
Exam is Tuesday, December 13, 2 pm.
In our regular room (Comer Auditorium).
Final is comprehensive

• Material is covered fairly evenly
  from all four units.
• Many multiple choice questions
  are similar to, but usually not
  identical to, the ones you've
  seen.
• Problems will look like ones
  you've seen before on paper
  homework or exams, but with
  different numbers.
Format of Final?
 35 multiple choice questions, worth
 2 points each. (70 points)

 30 points of short problems.

 You don't need a Scantron.

 You do need a calculator.
Review, Part 1

• PPF
• Economic Role of Government
• Types of Economies
• Markets
• Supply, Demand, Price
  Determination
• Elasticity and Total Revenue
What is economics?

• Economics is a social science.
• Social sciences deal with
  people and the institutions they
  create.
• Economics deals with how
  people make decisions to
  allocate resources to achieve
  their goals.
Scarcity and Efficiency
• Scarcity. Resources are (usually) finite.
• All “economic goods” are limited in
  supply, which economists call “scarce.”
• In a market economy, “scarce” or
  limited items have prices associated
  with them.
• The notion of “unlimited” wants is not
  true for everyone, but even at our
  current level of prosperity, we do not
  produce enough for everyone to think
  they have “enough.”
Economic Efficiency

 The economy is producing “efficiently”
 when it cannot increase the economic
 welfare of anyone without making at least
 one person worse off.
Equity

 Equity involves the distribution of
 wealth within a society. In perfect
 equity, everyone has equal shares.
Microeconomics


 . . . is the branch of economics that deals
 with the behavior of individual entities,
 such as consumers, firms, households,
 or markets.

 A major focus of microeconomics is price
 determination.
The other branch of
Economics

  . . . is macroeconomics, which is concerned
  with overall performance of the economy,
  e.g. inflation, unemployment, growth.
Common Logical
Fallacies
• “Post hoc” fallacy occurs when
  people assume that because
  one event follows another, the
  first event caused the second.
• The “fallacy of composition”
  occurs when we assume that
  what holds true for part of a
  system also holds true for the
  whole.
Positive and Normative
Economics
• Positive Economics deals with
  questions that can be analyzed
  objectively, e.g. “What is the
  impact of raising taxes?”
• Normative Economics involves
  ethical precepts and norms of
  fairness, e.g. “Should the poor
  be required to work to receive
  government assistance?”
Types of Economies
  • Command Economy: government
    makes all important decisions about
    production and distribution.
  • Market Economy: individuals and
    private firms make the major
    decisions. Extreme case (no
    government intervention) is called
    “laissez-faire” economy.
  • Mixed Economy has elements of
    both. All modern economies are
    mixed.
Production Possibilities
Frontier
  PPF shows the possible combinations of
  two or more goods that an economy could
  produce with its resources.
Opportunity Cost

  The value of items not produced because
  resources were used for another purpose.
A Market

 A market is a mechanism by which buyers and
 sellers interact to determine the price and
 quantity of a good or service.



  A market need not be a physical place.
The Market Mechanism
 A market economy is an elaborate
 mechanism for coordinating people,
 activities, and businesses through a system
 of prices and markets. In a market
 economy, no single individual or
 organization is responsible for production,
 consumption, and distribution.
Price Determination
 In a market economy, prices are
 determined in the marketplace, by
 consumers and producers. If consumers
 want more of a good (e.g. gasoline in the
 summer), the price will rise, encouraging
 increased production. If a product is
 overstocked, prices fall, encouraging more
 sales.
Role of Prices

 Prices coordinate the decisions of
 producers and consumers in a market.
 Higher prices tend to reduce consumer
 purchases and encourage production.
 Lower prices encourage consumption and
 discourage production. Prices are the
 balance wheel in the market mechanism.

       .
Market Equilibrium

 A market is in equilibrium when the
 commodity is neither in glut nor shortage
 at the prevailing price. A market
 equilibrium is a balance among all the
 different buyers and sellers.
The      Invisible         Hand


The orderliness of the market system led
Adam Smith to coin the phrase “the
invisible hand.”
Advanced Capitalist
Economies
• Characterized by trade and
  specialization.
• Extensive use of money.
• Vast quantities of capital used
  for production.
Specialization, division of labor,
and gains from trade

• Specialization occurs when people or
  countries can concentrate on the items
  that can be produced most efficiently.
• A division of labor allows individuals to
  perform the tasks they do best.
• Because of specialization and division
  of labor, we experience gains from
  trade.
Three Factors of Production

    Land and labor are primary factors of
    production. Their supply is mostly
    determined by non-economic factors.

  Capital items, on the other hand, need to
  be produced or manufactured. Thus, they
  are both inputs (for further production) and
  outputs.
Three Main Economic
Functions of Government
• Increase efficiency by promoting
  competition, curbing externalities,
  and providing public goods.
• Promote equity by using tax and
  expenditure programs to redistribute
  income.
• Foster macroeconomic stability and
  growth through fiscal policy and
  regulation.
Promoting Competition
• If a single buyer or seller
  can affect price the market
  is characterized by
  imperfect competition.
• Imperfect competition leads
  to prices above cost and
  reduced efficiency.
Curbing Externalities
  Externalities are either costs affecting
  people who are not compensated for
  them (e.g. pollution), or benefits
  accruing to people who do not pay for
  them (an existing restaurant benefiting
  from the construction of new shopping
  mall next door).

 A difference between private and social
 costs and benefits.
Providing Public Goods

  Commodities that can benefit many people
  without being “used up.” The value
  (usually) cannot be easily divided, as there are
  benefits to the entire community.

 Examples: Public schools, parks, public
 health programs, highways, national defense.
Policies to reduce
inequalities
• Progressive taxation, higher tax
  rates for higher incomes
• Transfer payments, “the safety
  net.”
• Minimum wage laws.
Fostering Growth and
Stability
 Governments now use monetary and fiscal
 policy to influence level of total spending,
 rate of growth, levels of unemployment, and
 the inflation rate.

 Monetary policy refers to the interest rate and
 the money supply.
 Fiscal policy refers to taxes and government
 spending.
Supply, Demand, Price

    from chapters 3 and 4
The Demand Schedule


 The demand schedule (demand curve)
 shows the relationship between a commodity’s
 market price and the quantity of that commodity
 that consumers are willing and able to purchase,
 other things held constant.
Factors Affecting
Demand
• Size of market, e.g. how many
  consumers.
• Income levels of consumers.
• Prices and availability of related
  goods.
• Tastes and preferences.
• Special influences, e.g. climate
  and conditions.
Change in Demand


  Demand curves will shift, as income,
  other prices, market size, or tastes or
  preferences change.
Movement along the
demand curve

 Movement along the demand curve occurs
 as the good’s own price changes.

      P
                 As price falls, a greater quantity
                    is demanded.


                          Q
Shifts in Demand

  Shifts in the demand curve take place if one
  of the factors behind the demand curve
  changes: income, prices of available goods,
  tastes or preferences, or special influences.
The Supply Schedule

 The supply schedule (or supply curve) for
 a commodity shows the relationship between
 the market price and the amount of that
 commodity that producers are willing and able
 to produce and sell, other things held
 constant.
Market Supply



   To get market supply, sum the
   quantities supplied by all the
   individual firms at each price level.
Supply Shifters

•   Changes in costs of inputs
•   Technological change
•   Government policy
•   Special factors (climate,
    culture)
Movement along supply
curve
 P
                 S

            As price rises, all other
            things held constant, the
            quantity supplied increases.


                              Q
Shift of supply curve

 P   If the price of an input falls,
     the supply curve shifts out.
                                       S   S’




                                                Q
                   S

                       S'




                       D


A shift in Supply causes a movement
along the demand curve. Demand doesn't
change but quantity demanded changes
because of the price change.
                               S




                          D'       D


A shift in Demand causes a movement
along the supply curve. Supply doesn't
change but quantity supplied changes
because of the price change.
Market Equilibrium

A market equilibrium comes at the place
where quantity demanded equals quantity
supplied.
 Equilibrium takes place at the intersection
 of the supply and demand curves.
Graphical Representation of
Equilibrium
P   5.              .                         .   S
                                Surplus

    4   .               .                 .


                                                       Equilibrium
    3.



    2   .       .                         .
                    Shortage

    1
      .                                           .
                                                       D

            .               .         .           .                  Q
            5               10        15          20
Shifts in curves change
equilibrium

P
                         Supply increases
                  S
                         Price down,
                      S’
                         Quantity up.
    P
    P

                  D

                          Q
         Q   Q’
Shifts in curves change
equilibrium

P
                         Supply decreases
                S’
                     S
                         Price Up
                         Quantity Down
    P’
    P

                D

                           Q
         Q’ Q
Shifts in curves change
equilibrium

P                        Demand Increases
                   S
                         (Note that TR
    P”                   increases because
    P’
                         both P and Q
                    D”   increase.)
                   D’
                            Q
         Q’   Q”
Shifts in curves change
equilibrium

P
                        S
                              Demand Decreases


    P’                       (Note that TR falls
    P”                       because both P and
                        D’
                             Q fall.)
                   D”
                                Q
         Q”   Q’
Four Possible Outcomes

• Supply decrease: Price Up, Quantity
  Down
• Supply increase: Price Down,
  Quantity Up
• Demand increase: Price Up,
  Quantity Up
• Demand decrease: Price Down,
  Quantity Down
  Elasticities
We may want to know how much
supply and demand respond
to changes in price.

Example: If the price of apples
increases by 10%, how many
fewer apples will consumers
buy?
Price Elasticity of
Demand
  The price elasticity of demand
  measures how much the quantity
  demanded of a good changes when
  its own price changes.

  It is the percentage change in
  quantity demanded divided by
  the percentage change in price.
Calculating Elasticities
        % Change in quantity demanded
         _________________________
 ED =
        % Change in price

 If a 1% increase in price causes
 a 5% decrease in quantity demanded,
 what is the elasticity of demand?
Calculating Elasticities
        % Change in quantity demanded
         _________________________
 ED =
         % Change in price


         5%
  ED = ____ = 5
         1%
  (By convention, the minus sign is
  dropped on the ED.)
More Examples
 A 10% decrease in price causes a
 5% increase in quantity demanded.

    5%
   _____ = 0.50   (1/2)
   10%
Elastic and Inelastic
Demand

  If demand is price elastic, ED is
  greater than 1.0.

  If demand is price inelastic, ED is
  less than 1.0.
Unit-Elastic Demand

 When percent change in price
 equals percent change in quantity
 demanded we have unit-elastic
 demand.

  ED = 1.0
Calculating Elasticity of
Demand
An Example.
   As price falls from $12.00 to $8.00
   per unit, the quantity demanded
   increases from 95 to 105 units.

   Calculate the elasticity of demand.
Percent Change in Price
    change

     $12 - $8
   _________ * 100% = 40%
   ($12 + $8)/2

    midpoint
Percent Change in
Quantity Demanded
    change

    105 - 95
    _______ * 100%   = 10%
    (105+95)/2

    midpoint
Putting together the
elasticity:
         10%
         _____
  ED =           = 0.25
          40%
Caution!

   If the demand curve is a straight
   line, the elasticity of demand
   does not stay constant along the
   length of the line!
Elasticity along a
straight line
 P



      Above the mid-point, ED >1


        .   At the mid-point, ED = 1

                 Below the mid-point, ED < 1


                            Q
Extremes of Elasticity
         D   Perfectly Inelastic Demand
 P

                        D
               Perfectly elastic demand




                       Q
Elasticity and Revenue

  Total Revenue is QxP, price times
  quantity sold.
If Demand increases, both P and Q
increase and TR must also increase.

If Demand decreases, both P and Q
decrease and TR must also decrease.

When Supply increases, P falls and
Q rises. What happens to TR?

When Supply decreases P rises and
Q falls. What happens to TR?
To figure out what happens when Supply
shifts, we have to know which effect
is biggest, the change in price or the
change in quantity.

The elasticity tells us which effect is
biggest.
 If demand is elastic, which effect
 is biggest, the percent change in
 price or the percent change in quantity?

      % change in q
 Ed = ____________        > 1 (elastic)
      % change in p

% change in q is biggest for elastic demand
 If demand is inelastic, which effect
 is biggest, the percent change in
 price or the percent change in quantity?

      % change in q
 Ed = ____________        < 1 (inelastic)
      % change in p

% change in p is biggest for inelastic demand
If demand is elastic, TR will move in
the same direction as quantity. (That means
TR for elastic demand moves in the
opposite direction of price, because Demand
slopes down.)

If demand is inelastic, TR will move in
the same direction as price. (That means
TR for inelastic demand will move in the
opposite direction of quantity.)
For elastic Demand, TR increases when
price falls or quantity increases.

For inelastic Demand, TR increases when
price rises or quantity falls.
When demand is elastic
 Total revenue increases as the
 price falls, when demand is
 elastic.

 Total revenue increases as supply
 increases when demand is elastic.

 Remember: Price falls when
 supply increases!
Demand is elastic, TR increases as S increases
and price falls
  P
               Total Revenue = P’xQ’
                     S
                          S'
  P1
  P2

                               D

          Q1    Q2                          Q
When demand is
inelastic
  Total revenue decreases as the
  price decreases, when demand is
  inelastic.

  Total revenue decreases as supply
  increases when demand is inelastic.

  Remember: Price falls when Supply
  increases.
          Demand is inelastic. TR falls
P
          as supply increases and price falls.




                 S
                         S'
    TR”
          TR” TR’’’
                                     Q
When you are drawing these
diagrams remember that
for a straight line demand curve
Demand is elastic above the
mid-point and inelastic below.

You will lose points if you
are working in the wrong part of
the curve.
Elasticity Problems --
The Basics

 If demand is elastic, total revenue moves
 the same way as supply.

 If demand is elastic total revenue moves
 the opposite way as price.

  Elastic demand is anything with an Ed >1
Elasticity Problems --
the basics

 If demand is inelastic, total revenue moves
 the opposite way from supply.

 If demand is inelastic, total revenue moves the
 same way as price.

Inelastic demand is anything with Ed<1
Special case: When Ed
=1

 When demand has unitary elasticity, an
 increase or decrease in supply has no
 effect on total revenue. (TR stays the same.)
Questions

 A decrease in supply is observed to increase
 total revenue, you know that demand must be
 __________________.
      inelastic

 An increase in supply is observed to increase
 total revenue, you know that demand must
          elastic
 be _________________.
Questions

 A decrease in supply is observed to decrease
 total revenue, you know that demand must be
           elastic
 __________________.

 An increase in supply is observed to decrease
 total revenue, you know that demand must
           inelastic
 be _________________.
Questions

 A decrease in supply is observed to have no
 effect on total revenue, you know that demand
               unitary elasticity
  must have _________________.
Elasticity of Supply
          % Change in quantity supplied
           _________________________
 Es   =
          % Change in price

  If % change in quantity supplied is
  greater than % change in price, then
  supply is elastic. ES > 1
Special cases
                ES=1
      ES = 0



                       ES = infinity
When Supply is a
Straight Line
• Supply is inelastic if it crosses
  the horizontal axis.
• Supply is elastic if it crosses
  the vertical axis.
• It has unitary elasticity if it
  goes through the origin.
ES < 1
         ES=1


                ES > 1
Effect of a Sales Tax

  Sometimes the government puts a
  tax on specific commodities such
  as gasoline, tobacco, and alcohol. Policy
  analysts will want to know: How
  will the tax affect the market price and
  quantity? Who will end up “paying for”
  the tax, the producers or the consumers?
Here’s how to work these problems.

If Supply and Demand are “normal”
(i.e. neither perfectly inelastic nor
perfectly elastic)

1) Supply shifts up by the amount of the tax.
2) Price rises by less than the tax.
3) The group with the lowest elasticity
(consumers or producers) pays the greater
share of the tax.
Special cases:

1) Perfectly inelastic demand: Price rises
by full amount of tax. Consumers pay all.

2) Perfectly elastic demand. Price doesn’t
rise at all. Producers pay all.

3) Perfectly elastic supply. Price rises
by full amount of tax. Consumers pay all.

4) Perfectly inelastic supply. Price doesn't
change at all. Producers pay all.
Impact of a Sales Tax, Example

                 In this market, with no tax,
                 1,000 items are sold at $2.00
                 each.



$2.00
            D
         1,000
Impact of a Sales Tax, Example

              The government now asks
              the producers to pay a $1.00
              tax on every item sold, which
           S’        will cause a decrease
                  S in supply. For the
3.00                  firm to sell the original
$2.00                 1,000 units, the price
                       would have to be $3.00
         1,000
Impact of a Sales Tax, Example

                 But consumers would not
                 be willing to buy 1,000
                    units at a price of $3.00.
           S’          The market will find
                  S a new equilibrium price
3.00                     somewhere between
$2.00                     $2.00 and $3.00, and
           D               a new equilibrium
         1,000              quantity less than
                            1,000.
The new equilibrium
price
In this case, let’s say that the new equilibrium
price is $2.80. Of this selling price, the
producers get $1.80 ($2.80 minus the $1.00
tax.) The $1.00 tax is the difference between
producer and consumer prices.

Thus $0.80 of the tax is paid by consumers in
higher consumer prices and $0.20 is paid by
producers in terms of lower producer prices.
General Rules on Tax
Shifting
 When demand is less elastic than supply,
 the consumers pay the greater share of the
 sales tax.

 When demand is more elastic than supply,
 producers pay the greater share of the
 sales tax.
Perfectly Inelastic
Demand
     If demand is perfectly inelastic and supply has
     some elasticity, consumers pay the entire tax.
                                  Quantity doesn't
            D         S’          change.

p                     S
n
p*
Perfectly Elastic Supply
     Price goes up by full amount of the tax.
     Consumers pay all. In this case, quantity
     falls.



                               S’
p*                               S
                     D
                      q
Perfectly Elastic
Demand
     If demand is perfectly elastic and supply has
     some elasticity, producers pay the entire tax.

                               S’
                                          price
                                    S     doesn't
                                          change.
p*                                  D     quantity
                                          falls
                        q
Last special case.

  Producers pay the entire tax if Supply
  is perfectly inelastic and demand is downward
  sloping. In this case, producers
  supply the same amount, regardless of the
  price. (You can't draw the shift in supply
  because the new curve just overlays
  the old curve.) Price to consumers
  doesn't change, nor does quantity.
Price Floors

                   S
  P
                   A price floor is
                   a legally set minimum
Pmin               price. Price floors
                   above market
                   equilibrium lead to
                   surpluses.
               D
                          Q
Price Ceilings

                     S
  P
                     A price ceiling is
                     a legally set maximum
                     price. Price ceilings
                     below market
Pmax                 equilibrium lead to
                     shortages.
                 D
                            Q
Subsidies


  Sometimes the government subsidizes
  production of a product. A subsidy
  given to producers shifts the supply curve
  out.
The Importance of ED

 When demand is relatively elastic, more of
 the subsidy goes to producers because
 price does not fall as much.

 When demand is relatively inelastic,
 consumers receive most of the benefit
 because price falls a lot.
Chapter 5 Concepts

    Utility

    Marginal Utility

    Indifference Curves

    Budget Constraints
What is “utility”

  Utility is a word economists use for
  the satisfaction consumers derive from
  goods and services.

  Economists assume that consumers
  are “rational,” that is that they choose
  the items that give them the most
  satisfaction.
Marginal Utility

 When economists use the term “marginal,”
 they mean “additional” or “extra.”

 Hence, marginal utility denotes the
 additional utility arising from consumption
 of an additional unit of a commodity.
Law of Diminishing Marginal
Utility


  Total utility tends to increase as one
  consumes more of a good. However,
  the additional utility gained from
  adding more units of the commodity
  declines.
Equimarginal Principle

A consumer with a fixed income, facing
given market prices for goods, will
maximize utility when the marginal
utility of the last dollar spent on each
good is exactly the same as the marginal
utility from the last dollar spent on any
other good.
Example

good 1 costs $2.00 and good 2 costs $3.00.

If the last unit of good 1 consumed gives the
consumer 30 additional units of “utility,” then
for the consumer to have maximized total
utility the last unit of good 2 would give the
consumer ____ units of utility.
How to solve the
problem

 Divide the extra utility of the last unit
 consumed by the price.

 30      =      MUgood2         30/2 = 15
 ___           _________
 2                  3           45/3 = 15
Example

good 1 costs $2.00 and good 2 costs $3.00.

If the last unit of good 1 consumed gives the
consumer 30 additional units of “utility,” then
for the consumer to have maximized total
utility the last unit of good 2 would give the
consumer ________ units of utility.
               45
    Indifference Curve


An indifference curve shows the
combinations of two (or more) products
that would provide equal satisfaction to
a consumer. That means the consumer
would be equally satisfied with any
of the combinations of goods plotted
on that curve.
An Indifference Curve
pizza


17          A



8                    B


                         burgers
        9       16
An Indifference Map
 Good 1
          Each curve represents a set of
          choices that the consumer is
          indifferent between. The consumer
          prefers the sets furthest from the
          origin.


                              U3
                         U2
                    U1
                          Good 2
The Budget Constraint
  The consumer is constrained by
  a budget. The problem is to achieve
  the highest level of satisfaction for
  a given income. The higher the
  indifference curve, the better.
Slope of the budget
constraint
  The slope of the budget constraint is
  equal to the price ratio.
Point of Tangency

  The consumer’s choice is the point
  where the budget constraint is just
  tangent (touching in one point) to the
  highest attainable indifference curve.
  Putting things together

good 1             U3        Point B is the
              U2             consumer’s
         U1
                             choice
                        C


               A
                            .B
                                              good 2
Suppose income goes
up
  If income rises, the budget
  constraint shifts up.
  Increased Income

good 1




                     good 2
What happens when income falls?
Price Changes

 If the price of one of the goods changes,
 the budget constraint will pivot. The slope
 of the line will change. There are four
 possibilities:

 price of good 1 increases
 price of good 2 increases
 price of good 1 decreases
 price of good 2 decreases
   Price of good two falls

good 1




                         good 2
   Price of good one rises

good 1




                         good 2
Also, be able to show and recognize
the other two cases.
Working with the budget
constraint


 If a consumer spends all her money for
 snacks and buys 12 bottles of soda at $1.50
 each and 9 bags of chips at $2.00 each, what
 is the total amount spent on snacks?

 12*$1.50 + 9*$2.00 = $36.00
Graphing this Budget
Constraint
 soda
  24
             slope = 24/18 = 1.33

             slope = $2.00/$1.50 = 1.33


                      chips
        18
From individuals to
markets
  A market demand curve is the sum
  of all the individual demand curves.

  Example: A two-consumer market

  P     Person1 Person2         Market

  6      5          11            16
  4      10         20            30
  2      25         46            71
Consumer Surplus
 P       The area above the price line
         and below the demand curve
                          is called
                  S “Consumer Surplus”


 p

              D
                  Q

				
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