ECON 1 FINAL STUDY GUIDE

Professor Lee Ohanian

Chapter 2: Thinking like an economist

- Economists play two roles:
1. Scientists: try to explain the world
2. Policy advisors: try to improve it
- Circular flow diagram
- Market for goods and services
- Market for factors of production (inputs)

PPF
- A graph: combinations of output that the economy can possibly produce
- Given the available- Factors of production and technology
- Why the PPF might be bowed outward- As the economy shifts resources from beer to
mountain bikes: PPF becomes steeper and the opportunity cost of mountain bikes increases
- The PPF is bowed outward when:
- Different workers have different skills
- Different opportunity costs of producing one good in terms of the other
- There is some other resource, or mix of resources with varying opportunity costs
Positive statements: descriptive
- Attempt to describe the world as it is
- Confirm or refute by examining evidence: “minimum wage laws cause unemployment”
Normative statements; prescriptive
- Attempt to prescribe how the world should be: “the government should raise the minimum
wage”

Chapter 3: Interdependence and the gains from trade

- Trade can make both countries better off
- Exports
- produced in your country and sent to another
- Imports
- produced in another country and sent to us
- Example
- If america produces a computer they lose 10 tons of wheat
 - If japan produces a computer they lose 5 tons of wheat
- US should shift production from computers to wheat
- Japan shifts production from wheat to computers
Comparative advantage:
being able to produce a good at a lower opportunity cost
Absolute advantage:
being able to produce a good with fewer inputs or resources
The gains from trade are based on comparative advantage, not absolute advantage
Trade makes everyone better off and allows specialization in which they have a comparative advantage
- 1 computer takes 200 hours to produce but with this time you could have made 50
wheats
- 1 computer takes US 100 hours to produce but with his time could have made 20
wheats
- US has comparative advantage in computer making (less opportunity cost)

Chapter 4: The Market Forces of Supply and Demand

- Competitive market- Many buyers and many sellers, each has a negligible impact on market
price
Demand
- Quantity demanded
- Amount of a good that buyers are willing and able to purchase (BASED ON PRICE)
- Shown as a movement along demand curve up or down (NOT A SHIFT)
- Law of demand
- When price of a good rises, the quantity demanded of the good falls
- When the price falls, the quantity demanded rises
- Demand Curve shifters
- non-price determinant
- Numbers of buyers
- Increase in # of buyers- Shifts D curve to the right
- Decrease in # of buyers - Shifts curve to the left
- Income
- Normal good, other things constant- An increase in income leads to an
increase in demand shifting D curve to the right
- Inferior good, other things constant (only use this because income is low)- An
increase in income leads to a decrease in demand shifting D curve to the left
- Prices of related goods, substitutes
- An increase in the price of one leads to an increase in the demand for the
other
- Prices of related goods, complements
- An increase in the price of one leads to a decrease in the demand for the other
- Tastes or preferences
- Anything that causes a shift in tastes toward a good will increase demand for
that good and shift its D curve to the right
- Expectations about the future
- Expect an increase in income, increase in current demand
- Expect higher prices, increase in current demand
Supply
- Quantity supplied
- Amount of a good Sellers are willing and able to sell (Based on PRICE)
- Law of supply
- When the price of a good rises, the quantity supplied of the good rises
- When the price falls, the quantity supplied falls
- Supply curve shifters
- Input prices
- Supply is negatively related to prices of inputs
- A fall in input prices makes production more profitable at each output price
- S curve shifts to the right
- Technology
- A cost saving technological improvement has the same effect as a fall in input
prices, shifts S curve to the right
- Number of sellers
- An increase in number of sellers- S curve shifts to the right
- Expectations about future
- If suppliers expect prices in the future to be higher then they wait to sell in
future
- Sellers may adjust supply when their expectations of future prices change (if
good not perishable)
Supply and Demand Together
- Equilibrium price : price where Q supplied = Q demanded
- Markets not in equilibrium: Surplus
- Surplus (excess supply): quantity supplied is greater than quantity demanded
- sellers try to increase sales by cutting price so Q demand to rise and Q supplied falls
- Markets not in equilibrium: Shortage
- Shortage (excess demand): quantity demanded is greater than quantity supplied
- sellers raise the price so that Q demanded falls and Q supplied rises

Chapter 5: Elasticity and Its Application

- Elasticity - Measure of the responsiveness of Qd or Qs to a change in one of its determinants
- Price elasticity of demand- How much the quantity demanded of a good responds to a
change in the price of that good . It measures the price sensitivity of buyers’ demand
- Price elasticity of demand= percentage change in Qd / percentage change in P
- Method of computing the percentage change: = (end value - start value) / (start value)
x 100 %
- Price elasticity of demand = (Q2-Q1) / ((Q2+Q1)/2) / (P2-P1)/((P2+P1)/2)
- Determinants
- Price elasticity is higher when close substitutes are available
- Price elasticity is higher for narrowly defined goods than for broadly defined
ones
- Price elasticity is higher for luxuries than for necessities
- Price elasticity is higher in the long run
Variety of demand curves for price elasticity : (The flatter the demand curve the higher the
price elasticity of demand)
- Demand is elastic - > 1
- Demand is inelastic - < 1
- Demand has unit elasticity -= 1
- Demand is perfectly inelastic - = 0 vertical
- Demand is perfectly elastic - = infinity horizontal
Price elasticity and total revenue
- Total revenue = P x Q
- Price increase has two effects on revenue
- Higher revenue : because of the higher P
- Lower revenue: you sell fewer units (lower Q)
- For a price increase, if demand is elastic
- Elasticity > 1
- TR decreases: the fall in revenue from lower Q > the increase in revenue from higher
P
- For a price increase, if demand is inelastic
- Elasticity < 1
- TR increases: the fall in revenue from lower Q < the increase in revenue from higher
P
Price elasticity of supply
- How much the quantity supplied of a good responds to a change in the price of that good
- Percentage change in Qs / percentage change in P
- Measures sellers price sensitivity
Variety of supply curves for price elasticity (The flatter the supply curve, the greater the price
elasticity of supply)
- Supply is unit elastic = 1
- Supply is elastic > 1
- Supply is inelastic < 1
- Supply is perfectly inelastic = 0 Vertical
- Supply is perfectly elastic = infinity horizontal
Supply elasticity is a measure of the responsiveness of an industry or a producer to changes in
demand for its product.
- When supply is inelastic, an increase in demand has a bigger impact on price than on quantity
- When supply is elastic, an increase in demand has a bigger impact on quantity than on price
- Supply often becomes less elastic as Q rises, due to capacity limits
- Greater price elasticity of supply - The more easily sellers can change the quantity they
produce
- Price elasticity of supply is greater in the long run than in the short run
Other elasticities of demand
- Income elasticity of demand - How much the quantity demanded of a good responds to a
change in consumers income
- % change in Qd / % change in income
- Normal goods: income elasticity > 0
- Inferior goods: income elasticity < 0
 - Cross price elasticity of demand - How much the Qd of one good responds to a change in
the price of another good
- % change in Qd of the first good/ % change in price of the second good
- Substitutes : cross-price elasticity > 0
- Complements : cross-price elasticity < 0

Chapter 6: Supply, Demand, and Government Policies

- Price controls
- Price ceiling: legal maximum on the price at which a good can be sold
- Rent control laws; Specify the max amount of rent that can be charged
- A price ceiling above the equilibrium price is not binding
- The Price ceiling is binding if it is lower than equilibrium price, causes a
shortage
- Demand will be higher for new price so causes shortage
- In the long run, supply and demand of rental apartments are more price
elastic so the shortage is larger
- Shortages and Rationing
- Sellers must ration the goods among buyers
- Rationing
- inefficient and can be unfair; People waste their time waiting in line
to buy good, Unfair that people who know seller can buy good
- Another issue: illegal markets (black markets)
- You might be able to buy rationed good if you don't have it or buy more of
good by paying price premium
- Price floor: legal minimum the price at which a good can be sold
- Minimum wage laws; An employee cannot be payed less than a certain
amount
- Prevents price from falling below a certain level
- If it is below the equilibrium price so it is not binding
- Price floor is above equilibrium price and is binding and causes a surplus
(i.e. unemployment) (people want to work more)
- When minimum wages rise in the US - It reduces jobs for low skilled workers
- Taxes: government can make buyers or sellers pay a specific amount on each one
- Sales taxes affect the market
- Government uses taxes
- To raise revenue for public projects; Roads, schools, and national
defense
- Tax incidence
- Manner in which the burden of a tax is shared among participants in a
market; government can make buyer or the seller pay the tax
- Hence, a tax on buyers shifts the D curve down by the amount of the
tax
- How the burden of a tax is shared among market participants
- Just because tax is levied on consumers does not mean it won't hurt
sellers as well
 - In fact, it does hurt sellers because consumer demand shifts
downwards; this puts downward pressure on price of pizzas; price of
pizzas fall so sellers pay some of this tax
- Difference between price paid by consumers and price received by sellers = a
tax wedge
- The outcome is the same in both cases; The effects on P and Q, and
the tax incidence are the same whether the tax is imposed on buyers
or sellers!
- A tax drives a wedge between the price buyers pay and the price
sellers receive
- Other ways of helping those in need; believe these as better ways as they don't interfere in
market process of supply and demand
- Rent subsidies
- Wage subsidies (earned income tax credit) (offered to workers as a tax refund)
How elasticities of supply and demand affects price paid by buyer, price received by seller, and how
incidence of tax is determined
- The difference between price received by seller and price paid by buyer = the size of the tax
- Tax incidence = difference between the new price paid - original price for the buyer and the
new pierce received- original price for the seller
- Demand elasticity is low because D is steep; buyer pays most of the tax
- They are not that sensitive to changes in the price
- If Demand elasticity is more elastic than supply
- Buyers more price sensitive than sellers, Sellers bear more of the tax
- Vice-versa ; whoever has steeper curve, less elasticity so will bare more of the tax

Chapter 7: Consumers, Producers, and the Efficiency of Markets

Welfare economics
- Combinations of benefits received by producers and consumers= welfare
- Studies how the allocation of resources affects economic well-being
- Supply curve shows private costs
- Demand curve shows private value
Willingness to pay
- Maximum the buyer will pay for the good; how much they value the good
- Quantity demanded depends on who has willingness to pay at each level of price
Consumer surplus
- Consumer surplus = willingness to pay - the amount the buyer actually pays
- The CS is the area under the demand curve measured from top of curve to the market price
and then move to Q demanded at that price
- CS is the benefit consumers gain by being able to buy the good at that price
- Reasons for fall of CS
- Buyers leaving the market
- Remaining buyers paying higher P
Producer Surplus
- Cost- value of everything a seller must give up to produce a good
- Measure of willingness to sell; if the price > cost
- At different prices there are different Q supplied
 - Producer surplus = amount a seller is paid for a good - the seller's cost of providing the good
- Total PS equals the area above the supply curve under the price from 0 to Q
- Reasons for fall in pS
- Sellers leaving market
- Remaining sellers getting lower P
Market efficiency = CS + PS
- Total surplus = value to buyers (max consumers will pay) - cost to sellers (cost to suppliers)
- Measures society's well being to see if market allocation is efficient
- Efficient allocation of resources maximizes total surplus
- 1. Goods are consumed by buyers who value them most highly
- 2. Goods are produced byt he producers with the lowest costs
- 3. Raising or lowering the Q of a good would not increase total surplus
- Market is efficient if there is no other allocation that creates better economic well being
- Adam smith's invisible hand - guides everyone in the market to the best outcome; free markets
Market failures; this is when resources are not allocated efficiently
- Market power - a single buyer or seller control market prices; markets are inefficient
- Externalities - decisions of buyers and sellers affect people who are not participants in the
market at all
Total surplus
- The two triangles of CS and PS together
- Equilibrium of S and D maximize total surplus

Chapter 8: Application: The Costs of Taxation

- Government and taxes impact welfare
- Deadweight loss is the loss of welfare composed of both consumer and producer surplus
- When demand and or supply curves are really elastic this will mean there are good substitutes
around; people tend to leave the market; when this happens we see deadweight loss
- Highly elastic - changing taxes a little means enormous change in tax revenue
- A tax
- Drives a wedge between the price buyers pay and the price sellers receive
- Part of the tax is paid by buyers and part by sellers
- Irrelevant who the tax is firstly levied on
- Tax raises the price for buyers and lowers the price sellers receive
- Reduces the quantity bought and sold
- What determines who is hurt by the tax depends upon the demand and supply curves
The effects of a tax
- Price paid by buyer is the Pb (higher price shown on vertical axis)
- Prince paid to sellers is the low Ps (low on the vertical axis)
- When the gov imposes a tax the Quantity produced and sold is Qt that is quite a bit less than
the free equilibrium amount of Qe.
- Size of Ps to Pb is the size of the tax
- If the tax is smaller price paid by buyers would be lower than Pb, price received by sellers
higher than Ps, and so the Qt would be higher than the prior
- Without a tax, CS=A + B + C (this is above price equilibrium and below the demand curve)
- PS = D + E + F (this is above the supply curve and below the price equilibrium)
- Total surplus = A + B + C + D + E + F
 - C + E is the deadweight loss - the fall in total surplus that results from a market distortion
such as a tax
- Qe - Qt = units not sold because of the tax (this is the deadweight loss)
- By imposing the tax
- CS declined to solely the top of the triangle of just A (Lose B to the government)
- PS declined to solely bottom of triangle of F (lose D to the government for tax
revenue)
- Tax revenue = B + D
- The tax reduces the total surplus by C + E (this is the deadweight loss)
Determinants of deadweight loss
- More elasticities of supply and demand
- More elastic supply curve -> larger deadweight loss
- More elastic demand curve -> larger deadweight loss
- Elasticities make a big difference
DWL and elasticity of supply
- Inelastic is upward sloping and close to straight up and down
- Its harder for firms to leave the market when the tax reduces Ps; so tax only reduces
quantity produced a little, small DWL
- Elastic is upward sloping but close to horizontal
- The more elastic the supply, the easier for firms to leave the market when tax reduces
Ps
- The greater the quantity of production falls ; the greater the DWL triangle
DWL and elasticity of demand
- Inelastic is downward sloping close to vertical
- Harder for consumers to leave the market when the tax raises Pb; so the tax only
reduces Q a little and DWL is small
- Elastic is downward sloping, close to horizontal
- The more elastic, the easier for buyers to leave the market when the tax increases
Pb(more substitutes), greater the DWL
Easiest place to make most tax revenue is with goods with inelastic supply or demand
Bigger the government, more taxes needed
- Big government
- Provides more services, requires higher taxes, which cause DWLs
- The larger the DWL from taxation the greater the argument for smaller government
(they don't like ASL because it's inefficient; society giving up benefits it could have)
- So they tax items they don't generate big DWL; these are the inelastic items
- They tax labor income
A tax has a DWL because it causes consumers to buy less and producers to sell less, thus shrinking
the market below the level that maximizes total surplus

Effects of changing the size of the tax

- As the tax increases, deadweight loss increases even more rapidly than the size of the tax
- Tax revenue - increases at first then decreases (Higher tax reduce the size of the market)
produces produce less and consumers buy less
DWL and the size of the tax
- Doubling the tax causes the DWL to more than double
 - Raising tax rates is harmful - causes a large loss of benefits
- When tax is small, increasing it causes tax revenue to rise
- When tax is already large, increasing it causes tax revenue to fall
Revenue and the size of the tax
- The laffer curve shows the relationship between the size of the tax and tax revenue
- As tax grows, producers begin to not want to make it and buyers will lose buying interest
- When tax is small revenue initially rises until the tax gets to large and then declines to no tax
revenue

Chapter 10: Externalities

- Externalities
- When an action taken by one party affects people who don't participate in that action
Externality : one type of market failure
- In absence of market failures, the competitive market is usually a good way to organize
economic activity
- Self interested buyers and sellers neglect the external costs or benefits behind their actions;
market outcome inefficient
- Negative externality - impact on the bystander is adverse
- Example: air pollution, dog barking, noise pollution
- Market for gasoline- negative externality
- Additional cost on society for using gasoline is $1
- Social cost is $1 more than supply or private cost curve
- Social cost curve = private cost plus external cost imposed on society
- Socially optimal Q
- At any Q higher, then the social cost is higher than the value to society
- Taxes could be implemented to highlight the fact there is a negative
externality
- Make them pay the social cost instead of the private cost
- Internalizing the externality
- Altering incentives so people take into account the effects of their external
actions
- If consumers pay social costs; market equilibrium = social optimum
- External cost = value of the negative impact on bystanders
- Positive externality - impact on the bystander is beneficial
- Example: being vaccinated, going to college etc
- The social value = the private value + external benefit
- Socially optimal Q maximizes welfare
- At any lower Q, the social value exceeds their cost
- At any higher Q, the cost of the last unit exceeds its social value
- Gov provides a subsidy (negative tax) that the government pays you to do something
- Offers subsidy to consumers if they will provide positive externality (getting
vaccinated)
To remedy the problem
- Tax goods with negative externalities
- Subsidize goods with positive externalities
Another approach: Regulation
Command and control policies
- Regulate behavior directly
- Example: limits on quantity of pollution, requirement for firms to adopt new tech for
less emission
Market based policies
- Changes incentives so that private decision makers can solve problem independently
- Corrective taxes
- Induce private decision makers to take into account the social costs that come from
negative externalities
- These raise revenue for the government, place a price on the right to pollute, reduce
pollution at a lower cost, enhance economic efficiency
- Subsidies
- Tradable pollution permits
A pollution tax is efficient
- Firms with low pollution costs will reduce pollution to reduce their tax burden
- If firms with high pollution costs have greater willingness to pay tax
Regulation requiring all firms to reduce pollution by a specific amount
- Is not efficient
Corrective taxes are better for the environment
- Corrective tax gives firms incentive to continue reducing pollution as long as the cost of doing
so is less than the tax
- In contrast, firms have no incentive for further reduction beyond the level specified in a
regulation
- The gas tax (example of corrective tax)
- Targets congestion, accidents, pollution
Public policies toward externalities:
Tradable pollution permits system
- Reduces pollution at lower cost than regulation
- Firms with low cost of rescuing pollution do so and sell their unused permits
- Firms with high cost of reducing pollution buy permits
- Result: pollution reduction is concentrated among those firms with lowest costs
Pollution permits or corrective taxes
- Firms pay for their pollution
- Corrective taxes: pay to the government
- Pollution permits: pay to buy permits
- Internalize the externality
Clean environment is a normal good
- Positive income elasticity - rich countries can afford cleaner environment, more environmental
protection
Private solutions to externalities
- Moral codes and social sanctions
- Charities
- Interested parties can enter into a contrast
- The coase theorem - if private parties can bargain without cost over the allocation of
resources, they can solve the problem of externalities
- Interested parties can reach a bahrain; everyone is better off
 - Why they don't work
- High transaction costs
- Stubbornness
- Coordination problems

Chapter 11: Public Goods and Common Resources

- We consume many goods without paying
Excludability
- Property of a good whereby a person can be prevented from using it
- Example: fish tacos, wireless internet
Rivalry in consumption
- Property of a good whereby one person’s use diminishes other peoples use
- Example: fish tacos
Different types of goods
- Private goods
- Excludable and rival in consumption
- Food
- Public goods
- Not excludable and nonrival in consumption
- National defense
- Common resources
- Rival in consumption and not excludable
- Fish in the ocean
- Club goods
- Excludable and nonrival in consumption
- Cable TV
Public goods and common resources
- Externalities arise because something of value has no price attached
- Congestion is a form of externality
- Private decisions about consumption and production can lead to an inefficient outcome
- Public policy can sometimes help here
Public goods
- Examples: national defense, basic research, anti poverty programs financed by taxes (welfare
system, food stamps)
- Free rider - person who receives benefit of a good but avoids paying for it
- Free rider problem - public goods are not excludable (either way you can receive the good),
prevents the private market from supplying the goods, market failure
Remedy for the free rider problem
- If benefits of a public good exceeds its costs - government has the power to tax
- Government provides public good of national defense and enforces taxes to pay for it
- Measuring benefit is difficult: Cost-benefit analysis
- Compare costs and benefits to society of providing the public good
- Rough approximations due to no price signals
Common resources
- Examples - clean air, congested roads, fish and other wildlife
- Cannot prevent free riders from using because they are not excludable
 - They are rival in consumption; role of the government is ensuring they are not overused
- Tragedy of the commons
- Shows why common resources are used more than desirable
- Social and private incentives differ - private incentives (using land for free) outweigh
social incentives (using it carefully)
- Arises because of negative externality ; people neglect the external cost resulting in
overuse of the land
- Policy options to prevent overconsumption
- Regulate the use of the resource
- Impost a corrective tax to internalize the externality (hunting and fishing licenses,
entrance fees for parks)
- If the resource is land, convert to a private good by dividing and selling parcels to
individuals
Importance of property rights
- Market fails to allocate resources efficiently - because property rights are not well established,
item of value has no owner with authority to control it
- The government can help define property rights and unleash market forces
- Regulate private behavior
- Use tax revenue to supply a good that the market fails to supply

Chapter 13: The Costs of Production

- Profit = total revenue - total cost
- Total revenue - the amount the firm receives from the sale of its output (TR+ P x Q)
- Total cost - the market value of the inputs a firm uses in production
Costs: Explicit vs Implicit
- The cost of something is what you give up to get it
- Explicit costs
- Requires an outlay of money (wages to workers)
- Implicit costs
- No cash outlay (opportunity cost of the owners time)
- Total cost = explicit + implicit costs
Economic profit vs. accounting profit
- Accounting profit = total revenue - total explicit costs
- Economic profit = total revenue - total costs (explicit and implicit costs)
Production function - recipe for how businesses produce the stuff we buy from them given the inputs
they use
- Relationship between
- Quantity of inputs used to make a good and the quantity of output of that goods
- Gets flatter as production rises
- The more we produce, the production function tends to flatten out
Marginal product
- Increase in output that arises from an additional unit of input added into existing factors
- Slope of the production function
- Marginal product of labor
- MPL = change in quantity / change in labor
Diminishing MPL
 - Marginal product on an input declines as the quantity of the input increases
- The production function gets smaller as we add more labor and slope decreases
- As more workers are added the average worker has less resources to work with and will be
less productive; so, MPL diminishes as labor rises whether the fixed input is land or capital
Marginal cost
- Marginal cost is the increase in total cost arising from an extra unit of production
- MC = change in total cost / change in quantity
- Increase in total cost from producing an additional unit of output
- MC increases as production increases; productivity of workers falls so MC is rising
Comparing MC with marginal revenue is important to see how much to produce
Fixed and variable costs
- Fixed costs do not vary with the quantity of output produced (equipment, rent)
- Variable costs vary with the quantity of output produced (wages)
- Total cost = fixed + variable costs
- Average fixed cost = fixed cost / # units produced
- Declines with units produced
- Average variable cost = variable cost / # of units produced
- Declines but then starts to rise
- Average total cost = total cost / the quantity of output
- As Q rises, initially falls, then AVC pulls ATC up
Average total cost and marginal cost
- When MC is less than ATC, ATC is falling
- When MC is greater than ATC, ATC is rising
- The marginal cost curve crosses average total cost curve at the average total cost curves
minimum npoint; where these are equal is the point where marginal cost is no longer pulling
down or pushing up ATC; the efficient level of production
Costs in the short and long run
Short run
- Some inputs are fixed
- The costs of these are fixed costs
Long run
- All inputs are variable (firms can build more factories or sell old ones)
- No fixed costs
- Long run is the amount of time for every production input to be able to be changed
- Average total cost at any Q is cost per unit using the most efficient mix of inputs for that Q
LRATC
- Firms can change to a different factory size in the long run but not in the short run
- Firm will say how big of a factory is in their interest in the long run
- When your looking at where you want to be in the long run that maximizes long run average
total cost, you pick point on curve that corresponds to minimum of production level you want
to be at
How average total cost changes
Average total cost changes as scale of production changes
Economies of scale : Average total cost falls as Q increases
- As output rises costs lower
- Workers can become more specialized
 - More common when Q is low
Constant returns to scale : Average total cost stays same as Q increases
- In the US we thin production reflects constant returns to scale; as we expand scales of
production, ATC stays the same
Diseconomies of scale: Average total costs rises as Q increases
- As businesses get super big they may lose control over certain aspects
- Less control and less focus
- Common when Q is high