Download AP Econ Midterm Review 2016

Microeconomics Midterm Review
CH 1: TEN PRINCIPLES OF ECONOMICS
Economy: one who manages household
Scarcity: means that society had limited resources and therefore cannot produce all the
goods and services people wish to have.
Economics: the study of how society manages its scarce resources
1. People face tradeoffs
a. Efficiency: the property of society getting the most it can from its scarce
resources
b. Equity: the property of distributing economic prosperity fairly among the
members of society
2. The cost of something is what you give up to get it
a. Opportunity cost: of an item is what you give up to get that item.
3. Rational people think at the margin
a. Marginal changes: small incremental changes to a plan of action
4. People respond to incentives
5. Trade can make everyone better off
6. Markets are usually a good way to organize economic activity
a. Market economy: an economy that allocates resources through decentralized
decisions of many firms and households as they interact in markets for goods
and services
b. Adam Smith’s invisible hand
7. Governments can sometimes improve market outcomes
a. Market failure: refers to a situation in which a market left on its own fails to
allocate resources efficiently
b. Externality: the impact of one person’s actions on the well-being of a
bystander
c. Market power: the ability of a single economic actor (or group of) to have
substantial influence on market prices
8. A country’s standard of living depends on its ability to produce goods and services
a. Productivity: the amount of goods and services generated from each hour of a
worker’s time.
9. Prices rise when the government prints too much money
a. Inflation: an increase of overall level of prices
10. Society faces a short run tradeoff between inflation and unemployment
a. Philips curve: a curve which depicts this tradeoff as a result of sticky prices
CH 2: THINKING LIKE AN ECONOMIST
Positive statements: claims that attempt to
describe the world as it is
Normative: claims that attempt to claim
the world as it should be.
Reasons for disagreement:
Validity of alternative positive theories
about how the world works and they have
different values
CH 3: INTERDEPENDENCE AND THE GAINS FROM TRADE
Absolute advantage: comparison among producers of a good according to their
productivity
Comparative advantage: the comparison among producers of a good according to their
opportunity cost
Trade can benefit everybody because it allows people to specialize in activities in which
they have a comparative advantage.
CH 4: THE MARKET FORCES OF SUPPLY AND DEMAND
Market: a group of buyers and sellers of a particular good or service
Competitive market: many buyers and sellers so that each has a negligible impact on
price
What determines quantity demanded?
 Price
o Law of demand: all thing equal when the price of a good rises the quantity
demanded falls
 Income
o Normal good: demands increases as income increases
o Inferior good: demand decreases as income increases
 Prices of related goods (substitutes and complements)
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Tastes
Expectations
Demand curve: downward sloping line relating price and quantity demanded
Ceteris paribus: other things being equal
What determines the quantity supplied?
 Price
o Law of supply: ceteris paribus quantity supplied of a good rises when
the price of a good rises
 Input prices
 Technology
 Expectations
Supply curve: a graph of relationship between the price of a good and the quantity
supplied
Equilibrium: a situation in which supply and demand are brought into balance
Equilibrium price is sometimes called market-clearing price
Surplus: q supplied is greater than q demanded
Shortage: q demanded is greater than q supplied
Law of supply and demand: the claim that the price of any good adjusts to bring the
supply and demand for that good into balance
When the price is the only determinant which changes there is movement along that
curve and it is said that there has been a change in the quantity supplied/demanded of that
factor not a change in supply/demand
If both supply and demand shift in the same direction price is ambiguous; if supply and
demand are opposite in shift quantity is ambiguous
CH 5: ELASTICITY AND ITS APPLICATION
Elasticity: a measure of how responsive quantity demanded/supplied is to one of its
determinants
What determines price elasticity of demand?
 Necessities versus luxuries
 Availability of a close substitute
 Definition of the market (narrow def equals more elastic)
 Time horizon (tend to be more elastic over long periods of time)
Computing: ▲QD/▲P
Unit elasticity: if the elasticity is exactly one, so that Q moves the same amount
proportionately as price
Perfectly inelastic: elasticity of zero
Total revenue: P × Q
 When a demand curve is inelastic a price increase generally increases the total
revenue (positive relationship)
 When a demand curve is elastic, a price increase reduced total revenue and a price
decrease increases total revenue
 In unit elastic demand a price change does not affect the total revenue
Income elasticity of demand: measure how the Q demanded changes as consumer income
changes
Compute: ▲QD/ ▲income (normal goods have positive income elasticity, whereas
inferior goods have negative income elasticity)
Cross price elasticity: ▲in q demanded of good #1/ ▲ change in price of good #2
If cross price is negative the two goods are complements, if positive they are substitutes
Elasticity of Quantity Supplied:
Depends on flexibility of sellers to change amount of good they produce and time period
(short run inelastic)
Perfectly elastic: curve is horizontal
Perfectly inelastic: curve is vertical
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When demand is inelastic and there is an increase in supply the effect is a
substantial decrease in the price and proportionately smaller quantity supplied
In the short run, when supply and demand are inelastic a shift in supply leads to a
large increase in price
In the long run, when supply and demand are elastic, a shift in supply leads to a
small increase in price.
CH 6: SUPPLY, DEMAND , AND GOVERNMENT POLICIES
Price ceiling: legal maximum, price is not allowed to rise above this point. It is binding if
it is below the equilibrium price. This will result in a shortage. Leads to discrimination in
allocating scarce goods to large number of potential buyers, real life example is rent
control
Price floor: legal minimum, price
is not allowed to drop below this
point. It is binding if it is above
the equilibrium price. This will
result in a surplus and will result
in use of bias to distribute
demand. Real life example is
minimum wage
Tax incidence: a study of who
bears the burden of taxation
A tax on buyer shifts the demand
curve downward by the size of the
tax.
Taxes discourage market activity.
When a good is taxed, the Q is
smaller in the new equilibrium.
Buyers and sellers share the
burden of tax…. Buyers pay more and sellers receive less.
Payroll tax places wedge between wage firms pay and wage workers receive.
When supply is more elastic than demand the incidence of tax falls more heavily on
consumers than on producers
When demand is more elastic than supply the incidence of the tax falls more heavily on
producers than on consumers
The tax burden falls more heavily on the inelastic part.
CH 7: CONSUMERS , PRODUCERS AND THE EFFICIENCY OF THE MARKET
Welfare economics: the study of how the
allocation of resources affects economic wellbeing
Each buyer’s maximum is his or her willingness to
pay
Consumer surplus: buyer’s willingness to pay
minus the actual price paid.
Producer surplus: amount seller is paid minus the
cost of production
Market outcome insight:
1. Free markets allocate the supply of goods to
buyers who value the good most highly, as
measured by their willingness to pay.
2. Free markets allocate the demand for goods to
the sellers that can produce at the lowest cost.
3. Free markets produce the quantity of goods
that maximizes the sum of consumer and
producer surplus.
CH 8: APPLICATION : THE COSTS OF TAXATION
When supply/demand is inelastic the DWL is
small
When supply/demand is large the DWL is large.
Laffer curve:
Supply-side economics: is a school of
macroeconomic thought that argues that economic
growth can be most effectively created using incentives for
people to produce (supply) goods and services, such as adjusting
income tax and capital gains tax rates
CH 10: EXTERNALITIES
Externality: arises when a person engages in an activity, which
influences the well-being of the bystander and yet neither pays
nor receives compensation for that effect.
Internalizing and externality: altering incentives so that people take account of the
external effects of their actions
Qoptimum is the socially optimal quantity; in a negative externality, the Qmarket is
larger than the optimum. Social cost exceeds private cost
Positive externality called a technology spillover
Qoptimum is larger than Qmarket for a positive externality; the social value is higher
than the private value.
Negative externalities in production or consumption lead markets to produce a larger
quantity than is socially desirable.
Positive externalities in production or consumption lead to a quantity that is less than the
socially desirable level.
Coarse theorem: the proposition that if private parties can bargain without cost over the
allocation of resources, they can solve the problem of externalities on their own
CH 13: THE COSTS OF PRODUCTION
profit= total revenue – total cost
explicit costs: require an outlay of money by the firm.
Economic profit: measured as total revenue – total cost which includes all implicit and
explicit costs
Accounting profit: measured as total revenue – total costs (only implicit costs)
The production function: relationship between quantity of input and quantity of output
(input on x-axis)
Marginal product: the increase in output that arises from an additional unit of input
Diminishing marginal product: the property whereby the marginal product of an input
declines as the quantity of the input increases
Total cost curve: shows relationship between total cost and output; gets steeper as the
amount produced rises (output on the x-axis) because of DMPL.
Fixed costs: do not vary with the amount of output produced
Variable costs: vary with the amount of output produced.
Average total cost: total cost divided by the quantity of output produced
Average variable cost: total variable cost divided by quantity of output; tells cost of a
typical unit of output if total cost is divided equally over all the units produced
Marginal cost: the increase in total cost that arises from an extra unit of production
▲TC/ ▲Q tells increase in total cost that arises from the additional production of a unit.
1. Marginal cost rises with the quantity of output
2. The ATC curve is u shaped
3. MC curve crosses ATC at its minimum (efficient scale)
Economies of scale: the property whereby long-run ATC falls as the quantity of output
increases
Diseconomies of scale: the property whereby long-run ATC rises as the quantity of
output increase
Constant returns to scale: the property whereby long-run ATC curve stays the same as the
quantity of output increases
CH 14: FIRMS IN COMPETITIVE MARKETS
Competitive market- price takers
1) There are many buyers and sellers
2) The goods offered are largely the same
3) Firms can freely enter/exit
4) P=AR=MR
5) Profit maximization occurs where P=MC or MR=MC
6) Firms MC curve determines the quantity of the good the firm is willing to supply at
any price, it behaves as the supply
7) Firm’s short run supply curve is portion of MC curve that lies above the AVC curve.
8) Sunk cost: cost which cannot be recuperated
9) Firm’s long run supply curve is portion of MC that lies above the ATC curve.
10) Market’s long run supply curve might slope upward because
a. Some resource used in production may be available only in limited quantity
b. Firms may have different costs
CH 15: MONOPOLY
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Price maker
Fundamental cause of a monopoly is barriers to entry which arise because of:
o A key resource being owned by a single firm
o The government gives a single firm the exclusive rights to produce some
good or service
o The costs of production make a single producer more efficient than a large
number of producers (natural monopoly): has a downward sloping ATC
curve
When a monopoly increases the amount it sells two things occur:
o The output effect: elastic
o The price effect: inelastic
MR=MC is the profit maximizing level (pt a)
Produces on demand curve directly above this
curve (pt b)
P>MC=MR
Where P = MC is the socially (allocative efficient)
efficient level of output
Minimum of ATC curve is productively efficient
Fair market price is where average revenue (price)
is equal to ATC
Faces market demand curve because it is the only
seller in the market. If it wants to sell more it must
lower the price
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Since P>MR, MR will always be below the demand curve because to sell more in
a monopoly you must decrease the price; will always start at the same point as the
demand curve.
A monopoly can set any price It wants; however, it is not guaranteed to sell at any
price.
Monopoly cannot have unlimited profits because it is constrained by the demand
curve
Monopoly produces less than the socially efficient level of output
Is monopoly’s profit a social cost?
o No, transfer of consumer surplus to producer surplus does not affect total
surplus… it is not an economist’s job to decide whether or not producers
are less deserving of this surplus.
o Exception: if to maintain a monopoly there are additional costs in a
country
Public Policy towards Monopolies
o Trying to make monopolized industries more competitive
 Antitrust laws: collection of statutes aimed at curbing monopoly
power
 Sherman- 1890
 Clayton act- 1914
 Sometimes merges prove social benefit (synergies)
o By regulating the behavior of the monopolies
 Problem because natural monopolies have declining ATC so they
would be operating at a loss, government has to provide subsidies
 Problem because monopolies have no incentive to operate with
minimal costs so the government lets them keep some profit.
o By turning some private monopolies into public enterprises
 May have social cost because falure to maintain low cost will
result in loss for taxpayers
o By doing nothing at all
Price discrimination-have to have market power
o Selling the same good at two different prices
o When 2 demographics interested at different prices
o Rational strategy for profit maximizing firm
o Arbitrage: the process of buying a good in one market at a low price and
selling it at another higher price in another market
o Price discrimination can raise economic welfare
In the long run a monopoly will not necessarily have:
o Productive efficiency
o Social/allocative efficiency
o Fair market price
Why is there no supply curve?
o Supply tells quantity a firm chooses to supply at any price but monopoly is
a price maker so it sets price and quantity together; therefore, market
demand will determine how much monopoly will supply
CH 16: OLIGOPOLY
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Imperfect competition: not price takers
Oligopoly: a market structure where only a few sellers offer similar or identical
products
Cartel: when firms cooperate and behave like a cartel
Collusion: agreement among firms in a market about quantities to produce and
prices to charge
Nash equilibrium: a situation in which economic actors interacting with one
another choose the best strategy given the strategies that the other firms have
chosen
As the number of sellers in an oligopoly grows larger, an oligopolistic market
looks more and more like a competitive market. The marginal cost approaches
marginal cost and the quantity produced approaches socially efficient level
The more firms the less likely to cooperate
The larger the oligopoly the less magnitude of price effect
Game theory: study of how people behave in strategic situations
Prisoner’s dilemma: a particular game that illustrates why cooperation is difficult
to maintain even if it is mutually beneficial
Dominant strategy: best strategy for a player to follow regardless of strategies
pursued by other players
Cooperation sometimes works because of long term effects
Public policy
o Resale price maintenance: business practices that appear to reduce
competition but may have legitimate purposes
o Predatory pricing: anti-competitive pricing
o Tying: offering two products together (hidden price bundle)
“zero sum game”: in which players interests are in direct conflict
“non-zero sum game”: players interst are not in direct conflict can be mutually
inclusive
Concentration ratio: percentage of total output produced and sold by industry’s
largest firms if 4 largest control 40% or more then it’s an oligopoly
Herfindahl index: sum of the (% of the market share: squared)
Price leaders: implicit understanding by which oligopolies can coordinate prices
without engaging in outright collusion based on formal agreement. Practice in
which dominant firm initiates price changes.
Oligopoly characteristics:
o Barriers to entry
o Products can be differentiated or identical
o An oligopoly can achieve long run economic profits
o Usually don’t produce at productively efficient level
o P > MC not allocatively efficient
o Faces kinked demand curve model because of competition. A price
increase will not result in the flow of competition, a decrease in price will.