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Economic Principles
What is Economics?
It is concerned with what commodities and services to produce, how to produce them and
for whom to produce. It is an allocation system.
How do economists measure improvements in the economy?
They measure social welfare which is determined by consumption levels.
How would you describe the workings of an economic system?
It is concerned with balancing production (or supply) with consumption (or demand)
decisions. These decisions are complex since consumers demand many things that they
themselves do not produce. Exchanges of goods and services occur by using money
earned through the use of human capital. The value of human capital limits the amount
of goods and services consumers can purchase.
What is scarcity?
Resources have alternative uses. If they don’t then they are not scarce. There is a finite
supply of resources.
What is an opportunity cost?
It’s the cost of the best alternative use.
What if there is no scarcity?
Then we have a free good.
What is a model?
A simplification of reality. It is useful to unravel complex behavior to determine
important behavioral relationships in economics.
What does “ceteris paribus” mean?
Holding everything else constant, with the exception of one variable.
What is positive economics?
It is the scientific aspect of economics and deals with objective formulations of behavior.
As the scientific aspect, positive economics is subject to replicability by other economists.
What is normative economics?
It is a value judgment. It implies what ought to be done.
What is the difference between micro and macro economics?
Microeconomics is concerned with decisions that occur at the individual level, a firm or
consumers. Macroeconomics is concerned with the economy as a whole.
What is the difference between a market-based and command economy?
A market based approach allows agents to freely engage in the exchange of goods and
services. The price is a signal that determines how agents behave. A command system
allocates resources based on an authoritative control such as a central government.
What is the role of prices in a market-based system of allocation?
Consumers use prices to determine how much to consume and also how much to work.
Producers use prices to determine what to produce and how much of it. Prices are
adjusted (using an invisible hand under competitive conditions) by changes in the
demand and/or supply of a good or service.
What is demand?
It is a revealed preference. Revealed preferences are observed through purchases made
by consumers. Purchasing decisions answer the what and for whom production
decisions.
What is meant by a competitive market?
A market is where consumers and producers exchange goods or services. In a
competitive market, consumers are allowed to come and go without any barriers, and
producers likewise enter and exit the market based on whether they can make profits or
not.
Who takes responsibility under a command economy?
The government or some central planning unit takes responsibility for production and
distribution decisions. This central planning unit makes all the decisions with respect to
what, how and for whom to produce. There does not exist any entrepreneurship since
individuals do not solve allocation problems.
What is the “invisible hand”?
The competitive market takes control rather than a central planning unit and allows
individual consumers and firms make allocation decisions so as to maximize their own
benefits. In so doing, the continuously solve the problem of the central planning unit of
what, how and for whom to produce.
What is meant by efficiency in economics?
It implies the least-costly method to achieve an objective.
Is there a role for governments in economic decision making?
Yes, some tasks are better performed by central planning units, particularly when public
goods are involved, externalities exist and/or non-competitive market behavior is
observed.
What is a public good?
A good characterized by nonexclusivity and indivisibility.
What is an externality?
The welfare of an individual, household or firm depends on the activity of some other
individual, household or firm. It can be either positive or negative.
What is meant by economic inequality?
The distributional effects of the market system are unfair. Those with higher incomes
have a higher weight is what is produced, irrespective of whether those goods meet the
needs of people with lower incomes. Transfer payments occur when markets produce an
unfair distribution.
Defining Economic Principles
What is Diminishing Marginal Utility?
The amount of benefits or utility derived from consuming a unit of the commodity will be
less than the amount from the previous unit consumed. The total level of utility will
increase however.
What is the difference between marginal, average and total?
Marginal is the extra (last) unit consumed, average is the total number of units consumed
divided by the number of consumers.
What does the equimarginal condition imply?
In the case of income, the equimarginal condition implies that marginal utility of last unit
of income spent on each of the purchased commodities should be identical. You would
continue to spend on items that are relatively cheap in providing utility until their
diminishing marginal utility causes parity with other items
In the case of competitive markets it implies that the marginal benefits should equal the
marginal costs for social welfare to be the greatest.
What are indifference curves?
Illustrates the behavior of individuals when choosing among items to purchase. An
indifference curve illustrates the combinations of two goods that will yield the same
utility to an individual.
What is a budget constraint?
It constraints our insatiable wants. We cannot continue to consume goods and services
without the means to pay for them. Our budget limits the amounts of goods and services
we can purchase.
What does an individual do facing insatiable wants and a budget constraint?
Maximizes his or her utility given the available budget. He or she chooses a bundle of
goods A and B with the highest possible utility given their budget. It’s the point where
the marginal rate of substitution is equal to the marginal rate of transformation (another
equimarginal condition).
What is the marginal rate of substitution?
It is the number of extra units of good A needed to exactly compensate for a unitary loss
in good B, evaluated at a constant level of utility.
What is the marginal rate of transformation?
It is the relative price of good A to good B. It is the slope of the budget line.
What is an individual demand curve?
It is a demand schedule derived from letting an individual choose his maximum utility
under different prices for a good.
What is consumer surplus?
It is a measure of benefits. It is the difference between what the individual is willing to
pay and actually has to pay.
What is market demand?
The aggregation of individual demand schedules. For a private good, it is the horizontal
sum of individual demand schedules. For a public good it is the vertical sum of
individual demand curves.
What is a supply curve?
It is the marginal cost of producing a good or service.
What is producer surplus?
It is revenues that a firm receives above his cost of production. If we aggregate
individual supply curves, the total producer surplus is the industry profit.
What is a market?
It is a mechanism that has producers and consumers participating in the exchange of
goods and services for income. The market uses prices to signal to both consumers and
producers how much to allocate to the production of a good or service.
How are prices determined?
By the interaction of demand and supply.
What is a price-taker?
An individual or firm that cannot influence in isolation the market price.
What is a market-clearing price?
The price at which supply is equal to demand. At a price below this market-clearing
price, there is excess demand (demand exceeds supply). At a price above this marketclearing price, there is excess supply (supply exceeds demand).