Study Guide

Midterm One Study Guide

The Nature and Method of Economics

§       Economics is the study of how people make choices under conditions of scarcity and the results of those choices for society.  Economic analysis of human behavior begins with the assumption that people are rational – that they have well-defined goals and try to achieve them as best they can.  In trying to achieve their goals, people normally face tradeoffs: Because material and human resources are limited, having more of one thing means making do with less of some other good thing.

§       Our focus in this chapter has been how rational people make choices among alternative courses of action.  Our basic tool for analyzing these decisions is cost-benefit analysis.  The cost-benefit principle says that a person should take an action in, and only if, the benefit of that action is at least as great as its cost.  The benefit of an action is defined as the largest dollar amount the person would be will willing to pay in order to take the action.  The cost of an action is defined as the dollar value of everything the person must give up in order to take the action. 

§       Often the question is not whether to pursue an activity but rather how many units of it to pursue.  In these cases, the rational person pursues additional units as long as the marginal benefit of the activity (the benefit from pursuing an additional unit of it) exceeds its marginal cost (the cost of pursuing an additional unit of it).

§       In using the cost-benefit framework, we need not presume that people choose rationally all the time.  Indeed, we identified four common pitfalls that plague decision makers in all walks of life: a tendency to treat small proportional changes as insignificant, a tendency to ignore opportunity costs, a tendency not to ignore sunk costs, and a tendency to confuse average and marginal costs and benefits.

§       Microeconomics is the study of individual choices and of group behavior in individual markets, while macroeconmics is the study of the performance of national economies and of the policies that governments use to try to improve economic performance. 

Core Principles – Scarcity Principle; Cost-Benefit Principle; Not-All-Costs-And-Benefits-Matter Equally Principle

The Economizing Problem

§       One person has an absolute advantage over another in the production of a good ifs he can produce more of that good than the other person.  One person has a comparative advantage over another if the production of a good if she is relatively more efficient than the other person at producing that good, meaning that her opportunity cost of production it is lower than her counterpart’s.  Specialization based on comparative advantage is the basis for economic exchange.  When each person specializes in the task at which he or she is relatively most efficient, the economic pie is maximized, making possible the largest slice for everyone. 

§       At the individual level, comparative advantage may spring from differences in talent or ability or from differences in education, training, and experience.  At the national level, sources of comparative advantage include those innate and learned differences, as well as differences in language, culture, institutions, climate, natural resources, and a host of other factors. 

§       The production possibilities curve is a simple device for summarizing the possible combinations of output that a society can produce if it employs its resources efficiently.  In a simple economy that produces only coffee and nuts, the PPC shows the maximum quantity of coffee production (vertical axis) possible at each level of nut production (horizontal axis). The slope of the PPC at any point represents the opportunity cost of nuts at that point, expressed in pounds of coffee.

§       All production possibilities curves slope downward because of the scarcity principle, which states that the only way a consumer can get more of one good is to settle for less of another.  In economies whose workers have different opportunities cost of producing each good, the slope of the PPC become steeper consumers move downward along the curve.  This change in slope illustrates the principles of increasing opportunity costs (or the low-hanging fruit principle), which states that in expanding the production of any good, a society should first employ those resources that are relatively efficiently at producing that good, only afterward turning to those that are less efficient. 

§       Factors that cause a country’s PPC to shift outward over time include investment in new factories and equipment, population growth, and improvements in knowledge and technology. 

§       The same logic that prompts individuals to specialize in their production and exchange goods with one another also leads nations to specialize and trade with one another.  On both levels, each trading partner can benefit from an exchange, even though one may be more productive than the other, in absolute terms, for each good.  For both individuals and nations, the benefits of exchange tend to be larger the larger are the differences between the trading partners’ opportunity costs.

Supply and Demand: An Introduction

§       Eighteenth-century economics tried to explain differences in the prices of goods by focusing on differences in their cost of production.  But this approach cannot explain why a conveniently located house sells for more than one that is less conveniently located.  Early nineteenth-century economists tried to explain price differences by focusing on differences in what buyers were willing to pay.  But this approach cannot explain why the price of a lifesaving appendectomy is less than that of a surgical facelift. 

§       Alfred Marshall’s model of supply and demand explains why neither cost of production nor value to the purchaser (as measured by willingness to pay) is, by itself, sufficient to explain why some goods are cheaper and others are expensive.  To explain variations in price, we must examine the interaction of cost and willingness to pay.  As we’ve seen in this chapter, goods differ in price because of the differences in their respective supply and demand curves. 

§       The demand curve is a downward-sloping line that tells what quantity buyers will demand at any given price.  The supply curve is an upward sloping line that tells what quantity sellers will offer at any given price.  Market equilibrium occurs when the quantity buyers demand at the market price is exactly the same as the quantity that sellers offer.  The equilibrium price-quantity pair is the one that which the demand and supply curve intersect.  In equilibrium, market prices measures both the value of the last unit sold to buyers and the cost of the resources required to produce it. 

§       When the price of a good lies above its equilibrium value, there is an excess supply of that good.  Excess supply motivates sellers to cut their prices, and price continues to fall until the equilibrium price is reached.  When price lies below its equilibrium, there is excess demand.  With excess demand, frustrated buyers are motivated to offer higher prices, and the upward pressure on prices persists until equilibrium is reached.  A remarkable feature of the market system is that, relying only a tendency of people to respond in self-interested way to market price signals, it somehow manages to coordinate the actions of literally billions of buyers and sellers worldwide.  When excess demand or excess supply occurs, it tends to be small and brief, except in markets where regulations prevent full adjustment of prices. 

§       The efficiency of markets in allocating resources does not eliminate social concerns about how goods and services are distributed among different people.  For example, we often lament the fact many buyers enter the market with too little income to buy even the most basic goods and services.  Concern for the well-being of the poor has motivated many governments to intervene in a variety of ways to alter the outcomes of market forces.  Sometimes these interventions take the form of laws that peg prices below their equilibrium levels.  Such laws almost invariably generate harmful, if unintended, consequences.  Programs like rent-control laws, for example, lead to severe housing shortages, black marketeering, and a rapid deterioration of the relationship between landlords and tenants. 

§       If the difficulty is that the poor have too little money, the best solution is to discover ways of boosting their incomes directly.  The law of supply and demand cannot be repealed by the legislature.  But legislatures do have the capacity to alter underlying forces that govern the shape and position of supply and demand schedules. 

§       The basic supply and demand model is a primary tool of the economic naturalist.  Changes in the equilibrium price of a good, and in the amount of it traded in the marketplace, can be predicted on the basis of shifts in its supply or demand curves.  The following four rules hold for any good with a downward-sloping demand curve and an upward-sloping supply curve:

§         An increase in demand will lead to an increase in equilibrium price and quantity.

§         A reduction in demand will lead to a reduction in equilibrium price and quantity. 

§         An increase in supply will lead to a reduction in equilibrium price and an increase in equilibrium quantity. 

§         A decrease in supply will lead to an increase in equilibrium price and a reduction in equilibrium quantity. 

§       Incomes, tastes, population, expectations, and the prices of substitutes and complements are among the factors that shift demand schedules.  Supply schedules, in turn, are primarily governed by such shifts as technology, input prices, expectations, the number of sellers, and especially for agricultural products, the weather.

§       When the supply and demand curves for a good reflect all significant costs and benefits associated with the production and consumption for that good, the market equilibrium price will guide people to produce and consume the quantity of the good that result in the largest possible economic surplus.  This conclusion, however, does not apply if others, beside buyers, benefit from the good (as when someone benefits from his neighbor’s purchase of a vaccination against measles), or if others besides sellers bear costs because of the good (as when its production generates pollution).  In such cases, market equilibrium does not result in the greatest gain for all.