Midterm Micro 1
Chapter 1
Economic analysis is based on a set of common principles
o Principles for understanding the economics of how individuals make
choices
Individual choice- the decision by an individual of what to do
which necessarily involves a decision of what not to do.
The principles for understanding the economics of how individuals
make choices are
Resources are scarce
o Resource- anything that can be used to produce
something else
Ex: land, labor, capital
o Resources are scarce- the quantity available isnt
large enough to satisfy all productive uses
Ex: petroleum, lumber, intelligence
The real cost of something is what you must give up to
get it
o The real cost of an item is the opportunity cost
o Opportunity cost- what you must give up in order to
get it
How much? Is a decision at the margin
o You make a trade-off when you compare the costs
with the benefits of doing something
o Making trade-offs at the margin- comparing the
costs and benefits of doing a little bit more of an
activity versus doing a little bit less of another
o Marginal analysis- the study of such decisions
Ex: hiring one more worker, buying one
more CD, etc
People usually take advantage of opportunities to make
themselves better off
o Incentive- anything that offers rewards to people
who change their behavior
Ex: price of gasoline risespeople buy
more fuel efficient cars
o Principles for understanding how individual choices interact
Interaction of choices- my choices affect your choices, and vice
versais a feature of most economic situations.
The set of principles for understanding how individual choices
interact are:
There are gains from trade
o Individuals engage in trade. They provide goods
and services to others and receive goods and
services in return
o The gains from trade are through specialization
Markets move toward equilibrium
o An economic situation is in equilibrium when no
individual would be better off doing something
different
Resources should be used as efficiently as possible to
achieve societys goals
o Economy is efficient if it takes all opportunities to
make some people better off without making others
worse off
o Equity- everyone gets his or her fair share.
Not well-defined as efficient
Markets usually lead to efficiency
o The incentives built into a market economy already
ensure that resources are usually put to good use
o Opportunities to make people better off are not
wasted
When markets dont achieve efficiency, government
intervention can improve societys welfare
o Externalities- Individual actions have side effects
not taken into account by the market
o Principles for understanding economy-wide interaction
One persons spending is anothers income
Overall spending sometimes gets out of line with the
economys productive capacity, leading to recession or
inflation
Governments have the ability to strongly affect overall
spending, an ability they use in an effort to steer the
economy between recession and inflation
Chapter 2
Model- a simplified representation of a real situation that is used to be better
understand real-life situations
o Create a real but simplified economy
o Simulate an economy on a computer
Ex: tax models, money models
Other things equal assumption- means that all other relevant factors remain
unchanged
PPF- illustrates the trade offs facing an economy that produces only two goods;
also opportunity cost, efficiency, and economic growth
Improves our understanding of trade-offs by considering a
simplified economy that produces only two goods
o Through specialization and trade both parties are better off
o Comparative advantage- in producing a good or service if the opportunity
cost of producing the good is lower for that individual than other people
o Absolute advantage- in an activity if he or she can do it better than other
people
Circular-flow diagram- a model that represents the transactions in an economy by
flows around a circle
o Household- a person or group of people that share their income
o Firm- an organization that produces goods and services for sale
Firms sell goods and services that they produce to households in
markets for goods and services
Firms buy the resources they need to producefactors of
productionin factor markets
o Factor markets- where firms buy the resources they need to produce
factors of production
o Income distribution- how total income is divided among the owners of the
various factors of production; determined by the factor markets
Statements
Positive economics- the branch of analysis that describes the way
the economy works
Ex: we should lower taxes to encourage more work
Normative economics- makes prescriptions about the way the
economy should work
Ex: we should lower taxes to encourage more work
o Economists can determine correct answers for positive questions, but
typically not for normative questions, which involve value judgments
Forecast- a simple prediction of the future
Sources of growth
o Increase in factors of production and resources
o Improved technology
Chapter 3 Supply and Demand
Competitive market- has many buyers and sellers on the same good or service
Supply and demand model- a model of how a competitive market works
o 5 key elements
1. Demand Curve
Shows how much of a good or service consumers want to
buy at any given price
The graphical representation of the demand schedule
o Demand schedule- how much a good or service
consumers will want to buy at different prices
A change in population generates a change in demand
o Shifts to the right
2. Supply Curve
Shows how much of a good or service people are willing to
sell at a given price
3. Demand and Supply curve shifts
o Movement along curve is different than a shift
Increase in demand is a shift to the right
Decrease in demand is a shift to the left
Demand can change suddenly due to
1. Substitutes- two goods are substitutes if a fall in the
price of one of the goods makes consumers less
willing to buy the other good (price of A increases
demand of B increases)
2. Complements-two goods are complements if a fall
in the price of one good makes people more willing
to buy the other good (price of A increases demand
of B decreases)
3. Change in Income
Normal goods- when a rise in income
increases the demand for a good- the normal
case- we say that the good is a normal good
Inferior goods- when a rise in income
decreases the demand for a good, it is an
inferior good
4. Changes in Tastes
Everyone wants a phone with
internet now
5. Changes in Expectations
If you think a better item is coming out you
will wait for it
Supply can change suddenly due to
1.
Changes in input goods
a. Input- a good that is used to produce
another good
2.
Changes in the prices of related goods and
services
3.
Changes in technology
a. Firms can produce more for a less price,
shift to the right
4.
Changes in expectations
a. May increase supply, shift to the left
5.
Changes in the number of producers
a. Supply will increase and go up, shift to
the right
4. Market equilibrium
Equilibrium- in a competitive market; when the quantity
demanded of a good equals the quantity supplied of that
good
o Equilibrium price- the price at which this takes
place
Every buyer finds a seller and vice versa
o Equilibrium quantity- the quantity of the good
brought and sold at that price
Firms can sell exactly the amount that individuals want to
buy
5. Changes in the market equilibrium
Surplus
o When the quantity supplied exceeds the quantity
demanded
Occur when the price is above its
equilibrium level
Shortage
o When the quantity demanded exceeds the quantity
supplied
Occur when the price is below its
equilibrium level
Change after the equilibrium occurred
o Change in demand
Leads to a movement along the supply curve
due to a higher price and higher equilibrium
quantity
o Change in supply
A decrease in supply leads to a movement
along the demand curve due to a higher
equilibrium price and lower equilibrium
quantity
Chapter 6 Elasticity
Elasticity- the sensitivity of the quantity demanded when we change the price of a
good or service
o Price elasticity of demand- the ratio of the percent change in the quantity
demanded to the percent change in the quantity demanded to the percent
change in the price as we move along the demand curve, dropping the
minus sign
price elasticity of demand= % change in quantity demanded/
% change in price
% Change= change in quantity demanded or
price/initial quantity or price demanded x100
o Midpoint Method- using averages or midpoints of the values to calculate
elasticity of demand
Inelastic demand- when price elasticity is below 1
o Increase in price= increased total revenue
Price effect is stronger than quantity effect
o Perfectly inelastic- when the quantity demanded does not respond at all to
changes in price
Curve is vertical
Elastic demand- when price elasticity is greater than 1
o Increase in price= reduced total revenue
Quantity effect is stronger than the price effect
o Perfectly elastic- When any price increase will cause the quantity
demanded to drop to zero
Curve is horizontal
Unit elastic demand- when price elasticity equals 1
o Increase in price= no change in total revenue
Sales effect and the price effect offset each other
Total revenue- the total value of sales of a good or service
Total revenue= price x quantity sold
o Price effect- after a price increase, each unit sold sells at a higher price,
which tends to a raise in revenue.
o Quantity effect- after price a increase, fewer units are sold, which tends to
lower revenue
Price elasticity of demand is determined by
o Whether close substitutes are available
o Whether the good is a necessity or luxury
o Share of income spent on the good
o Time
Cross-
price elasticity of
demand- between
the two goods measures the effect of the change in one goods price on the quantity
demanded of the other good.
o Goods are substitutes when the cross price of elasticity of demand is
positive
o Goods are compliments when the cross price of elasticity of demand is
negative
Income elasticity of demand- the percent change in the quantity of a good
demanded when a consumers income changes divided by the percent change in
the consumers income
o Normal good
When the income of elasticity of demand is positive
The quantity demanded at any given price increases with income
o Inferior good
When the income of elasticity of demand is negative
The quantity demanded at any given price decreases as income
increases
Price elasticity of supply- measure of the responsiveness of the quantity of a good
supplied to the price of that good
o Perfectly inelastic supply
Price elasticity of supply= 0
Changes in the price of the good have no effect on the
quantity supplied; vertical line
o Perfectly elastic supply
Price elasticity of supply= infinity
When a tiny increase or reduction in the price will lead to a
large change in quantity supplied; horizontal line
o Factors that change the price elasticity of supply
The availability of inputs- the price elasticity of supply tends to be
large when inputs are readily available and can be shifted into and
out of production at a relatively low cost. It tends to be small when
inputs are difficult to obtain
Time- the price of supply tends to grow larger as producers have
more time to respond to a price change. This means that the longrun price of elasticity of supply is often higher than the short run
elasticity
Chapter 4 Consumer and Producer Surplus
Willingness to pay- the maximum price a person would pay for that good
Individual consumer surplus- the net gain to an individual buyer from the
purchase of a good
o Individual consumer surplus= willingness to pay price paid
Consumer surplus- often used to refer to both individual and total consumer
surplus
Total consumer surplus- the sum of the individual consumer surpluses of all
the buyers of a good
Individual Producer surplus- the net gain to a seller from selling a good
o Cost- the lowest price at which the seller is willing to sell the good
Total producer surplus- a market is the sum of the individual producer
surpluses of all the sellers of a good
o Changes in Producer Surplus
When the price of a good rises, producer surplus increases
through two channels:
The gains of those who would have supplied the good
even at the original, lower price and
The gains of those who are induced to supply the good
by the higher price
Total Surplus- generated in a market is the total net gain to consumers and
producers from trading in the market. It is the sum of the producer and the
consumer surplus
o The concepts of consumer surplus and producer surplus can help us
understand why markets are an effective way to organize economic
activity
o The maximum total surplus is achieved at market equilibrium
Why Markets typically work so well
o Property Rights- the rights of owners of valuable items, whether
resources or goods, to dispose of those items as they choose
o Economic signal- any piece of information that helps people make
better economic decisions
o A Caveat
Its important to realize that although the market equilibrium
maximizes the total surplus, this does not mean that it is the
best outcome for every individual consumer and producer
But in the market equilibrium there is no way to make some
people better off w/o making others worse
o A few words of caution
Inefficient- if there are missed opportunities
Market failure- occurs and the market produces inefficient
outcome
3 Sources
o Attempts to capture more resources that produce
inefficiencies
o Side effects from certain transactions, and
o Problems in the nature of the goods themselves
Chapter 5 Market Strikes Back
Why Governments Control Prices
o The market price moves to the level t which the quantity supplied equals
the quantity demanded
BUT this equilibrium price does not necessarily please either
buyers or sellers
THEREFORE, the government intervenes to regulate prices by
imposing price controls
Price controls- legal restrictions on how high or low a
market price may go
o Price ceiling- the maximum price sellers are
allowed to charge for a good or service
Causes a shortage in goods
But makes goods cheaper
Causes Inefficiency
Inefficiently low quantity
o Deadweight loss- the loss in
total surplus that occurs whenever
an action or policy reduces the
quantity transacted below the
efficient market equilibrium
quantity
Inefficient Allocation to Customers
o People who want the good
and are willing to pay might
not get it
Wasted Resources
o People expend money, effort
and time to cope with
shortages of the good
Inefficiently low quality
o Sellers offer low-quality
goods at a low price
Black markets
o Selling goods illegally
o Price floor- the minimum price buyers are required
to pay for a good or service
Minimum wage- a legal floor on the wage
rate, which is the market price of labor
Just like price ceilings, price floors are
intended to help some people but generate
predictable and undesirable side effects
How a Price floor causes inefficiency
Deadweight loss
Inefficient allocation of sales among
sellers
Wasted resources
Inefficiently high quality
Temptation to break the law
o Controlling Quantities
Quantity control- an upper limit on the
quantity of some good that can be bought or
sold
AKA quota
Quota limit- the amount of the good that can
be legally transacted
License- gives its owner the right to supply a
good
Demand price- of a given quantity is the
price at which consumers will demand that
quantity
Supply price- of a given quantity is the price
at which producers will supply that quantity
Wedge- the area in between the demand
price and the supply price
The price paid by buyers ends up
being higher than that received by
sellers
Quota rent- the difference between the
demand and supply price at the quota limit
Costs of quantity controls
Deadweight loss because some
mutually beneficial transactions
dont occur
Incentives for illegal activities
Chapter 7 Taxes
Excise Tax- the tax on sales of a good or service
o Raise the price paid by buyers
o Reduce the price received by sellers
Tax Incidence
o Incidence- the measure of a tax of who really pays it
o The wedge between the demand price and supply price becomes the
governments tax revenue
o When price elasticity of demand is high and the price elasticity of supply
is low; burden falls on producers
o When price elasticity of supply is higher than the price elasticity of
demand; burden falls on consumers
o Elasticity determines the incidence of an excise tax
Revenue collected by an excise tax is equal to the area of the rectangle
o With Height of the wedge between the supply and demand curves
o With Width the quantity transacted under the tax
Tax rate- the amount of tax people are required to pay per unit of whatever is
being taxed
o Raising the taxes doesnt guarantee an increased revenue
A tax reduces consumer and producer surplus
o Consumer surplus
A fall in the price of a good generates a gain in consumer surplus
A price increase causes a loss to consumers
o Producer surplus
The fall in the price received by producers lead to a fall in
producer surplus
o A TAX REDUCES BOTH, THE CS AND THE PS
The Deadweight loss of a Tax
o The revenue the government collects is
Revenue= tax per unit sold (T) X quantity sold (QT)
o Deadweight loss of tax represents the total surplus lost to society because
of the tax
Cost of Collecting Taxes
o Administrative costs- of a tax are the resources used by government to
collect the tax and by taxpayers to pay it
o Total inefficiency caused by a tax is the sum of its deadweight loss and its
administrative costs
If the good is inelastic and is taxed
The deadweight loss is less
If the good is elastic and is taxed
The deadweight loss is more
Tax Fairness and Tax Efficiency
o Two Priciniples
Benefits principle- those who benefit from public spending should
bear the burden of the tax that pays for that spending
Ability-to-pay principle- tax fairness, those with greater ability to
pay a tax should pay more tax
Lump-sum tax- the same for everyone, regardless of any actions
people take
o Well designed systems have a trade-off between equity and efficiency
The system can be made more efficient only by making it less fair,
and vice versa
o Federal Tax Philosophy
Income tax- Uses the ability to pay principle
o Some people pay negative income tax if they are
poor
FICA- Pays for social security and medicare systems
Most pay 7.65% of earnings to FICA
Understanding the Tax system
o Tax base- the measure or value that determines how much tax an
individual pays
o Tax structure- how the tax depends on the tax base
o Proportional tax- same percentage paid for everyone
Types of taxes
o Check slide 11 in ch 7 part 2
Progressive tax- takes a larger share of high income tax payers
o Ex: federal tax
Regressive tax- takes a smaller share of the income of high income taxpayers than
of low income taxpayers