Review for the Final Exam

Review for Material Covered on Midterm 1

Production Possibility Frontiers The production possibility frontier shows the
combinations of goods that can be produced if resources are used efficiently. The slope
of the production possibility frontier is called the marginal rate of transformation. You
should be able to calculate the opportunity cost of a good if given either the slope or a
production schedule. You should also be able to draw the changes in a PPF if there is a
change in technology for one good or both goods.
You should also understand comparative advantage, absolute advantage and
Ricardos Theory of Comparative Advantage
Positive / Normative Economics You should be able to tell the difference between a
normative statement and a positive statement.
Opportunity Costs The opportunity cost is the best alternative that we forgo, or give
up, when we make a choice or a decision. Remember the opportunity cost of attending a
movie includes the explicit cost of the movie ticket and the second best alternative use of
the amount of time.

Inward = left outward= right

Demand Curves A demand curve or schedule shows how much consumers would be
willing to buy of a good at various prices. Remember when we draw a demand curve we
hold income, tastes, and the prices of complement and substitute goods constant. The
law of demand states that demand curves should slope downwards.
You should know how an increase or decrease in income affects the demand for a
normal good and an inferior good.
You should know how an increase or decrease in a complement or substitute good
affects demand. demand curve shifts with a complement of the good,
demand curves inward if subs decrease, outward if subs inc.
You should be able to distinguish between a movement along a curve versus a
shift in the curve. Movement= price shift, shift = difference in anything
else(subs ect.)
You should know that the market demand for a private good is found by adding
individual consumer demand curves horizontally. You add up the quantities.
Supply Curves A supply curve or schedule shows how much a firm would be willing
to sell of a good at various prices. Remember when we draw a supply curve we hold
input prices, technology and the prices of other goods they could produce constant. The
law of supply states that supply curves should slope upwards.
You should know how an increase or decrease in input prices affects supply
You should know how an increase or decrease in technology affects supply
increase = outward shift, decrease = inward shift

 You should be able to distinguish between a movement along a curve versus a

shift in the curve movement = change in price of good/service shift= cost of
input changes, inc. = inward shift, dec = outward shifts
Equilibrium is the price and quantity where the demand and supply curves intersect.
Price Ceilings and Price Floors A fixed price below the equilibrium price (price
ceiling) implies shortages. A fixed price above an equilibrium price (price floor) implies
surpluses. You should be able to label a surplus or a shortage in a market on a graph.
If the price ceiling is above the equilibrium price, or if the price floor is below the
equilibrium price, the fixed price is ineffective.
If the price ceiling is set below equilibrium price, then you should be able to draw
consumer surplus, producer surplus, and the deadweight loss that results from the price
ceiling.
Elasticity: On the exam you must use the midpoint formula to receive full credit.
For example to calculate the price elasticity of demand you would use the formula
below:
Q 2 Q1
Q 1 Q2
%Q (Q1 Q2 ) / 2 (Q1 Q2 ) / 2

P2 P1
P1 P2
%P
( P1 P2 ) / 2
( P1 P2 ) / 2
You should be able to draw a perfectly elastic curve or a perfectly inelastic curve. You
should know that the elasticity is not constant across a line. As the price of a good goes
up then the price elasticity also goes up along a downward sloping demand curve.
Perfectly elastic = horizontal perfectly inelastic = vertical
You should also know how price elasticity is related to total revenues.
If you raise price and demand is inelastic, then total revenues will go up.
If you raise price and demand is elastic, then total revenues will go down.
If you lower price and demand is inelastic, then total revenue will go down.
If you lower price and demand is elastic, then total revenue will go up.
Income elasticity = (% Change in quantity demanded)/ (% Change in Income)
If given an income elasticity, you should be able to tell whether the good is a normal
good (and whether it is a necessity or a luxury) or if it is an inferior good.
Negative = inferior, positive= normal, 1=luxury
Cross-price elasticity of demand measures the response of quantity of one good
demanded to a change in the price of another good is defined as:
Cross-price elasticity of demand = (% Change in quantity Y demanded)
(% Change in price of X)

If given a cross-price elasticity of demand you should be able to tell whether the goods
are substitutes or complements.
Negative = complement, positive = substitutes
Nature of Demand You should be able to draw a budget set. You should also know
that an individual maximizes utility when the individuals indifference curve is tangent to
the budget set.

You should know the condition for utility maximization.

MU X MU Y

PX
PY
If given the prices of two goods, a budget and the total utility derived from each unit, you
should be able to find the utility maximizing bundle.
You should know that any change in price leads to an income and substitution effect. If
the good is a normal good (and we are talking about output markets), the income effect
and substitution effect work in the same direction. These effects provide another
explanation for why demand curves slope downward.
Consumer Surplus If given a graph, you should be able to find the consumer surplus.
Remember (when there is no price ceiling in effect) that the consumer surplus is the area
below the demand curve and above the equilibrium price. The consumer surplus can be
found by calculating the area of this triangle or by calculating it from a demand schedule.
Producer Surplus If given a graph, you should be able to find the producer surplus.
Remember that the producer surplus is the area above the supply curve and below the
equilibrium price. The producer surplus can be found by calculating the area of this
triangle.
Input Markets The input market differs from the output market in many important
ways. The first is that individuals supply labor (sometimes land and capital) to firms and
firms demand these inputs. The second important way that it differs is that the income
and substitution effects work in different directions if leisure is a normal good.
If the substitution effect dominates, the supply curve slopes upward.
If the income effect dominates, the supply curve bends backwards.
Review for Material Covered on Midterm 2
Chapter 6: The Production Process: The Behavior of Profit-Maximizing Firms
Accounting Profit = TR explicit costs
Economic Profit = TR- explicit costs implicit costs
Implicit costs includes opportunity costs
Short Run some factors of production are fixed
Long Run all factors are variable.

A firm produces by combining inputs given available technology. If all other inputs are
fixed at pre-specified quantities, we can relate changes in output to changes in the one
variable input. Each extra unit of input changes output by an amount called the marginal
product (MP).
The principle of diminishing returns says that the MP of this input will eventually
decrease as more of it is used with a fixed amount of other inputs.
Average product (AP) is defined as output divided by the amount of the single input that
is variable in the short run.
The firms will produce using the cheapest technology in order to maximize profits. If
given the prices of inputs, you should know how to determine the cheapest technology.
In the short run, the amount of at least one of the productive inputs is fixed. This means
that in the short run the firm incurs fixed costs whether or not it produces. The other
inputs can be varied yielding costs that increase with output (variable costs).
Chapter 7: Short-Run Costs and Output Decisions
For the exam you should be able to fill out a chart if given some of the costs for a firm.
You should know all of the cost formulas and the relationship between different types of
costs.
Cost Formulas: Total costs at each output in the short run are the sum of fixed and
variable costs (TC = TVC+TFC). For purposes of analyzing how firms behave we use
the following breakdown of costs:
ATC = TC/q,
AVC = TVC/q
AFC = TFC/q.
Marginal cost, MC, is the change in TC as Q increases by one unit. (Since only variable
costs change as output changes in the short run, it is also the change in TVC).
Marginal revenue (MR) is the change in revenue produced by a one-unit increase in
sales.
Perfect competition is defined as a situation in which there are many sellers; each takes
the price as given (faces a horizontal demand curve demand is perfectly elastic); and
there is free entry and exit to and from the market. Each competitors product is assumed
to be identical (homogenous).
We assume that all firms seek to maximize their profits.
Profits = total revenue total costs
Profit Maximization Rule: Firms maximize their profits when Marginal Revenue =
Marginal Cost. This is true for all firms. In perfect competition, P = MR. Therefore, for

perfectly competitive firms P = MC maximizes profits. If there is no point where this

hold exactly true, the firm will produce at the last unit of output where P > MC.
Remember: There are two slight exceptions to this rule.
1) The firm will shut down if P < AVC
2) The firm will produce at the larger quantity if P = MC at two
different quantities.
Perfectly competitive firms have a short-run supply curve. The short-run supply curve is
defined as all points on the MC curve above AVC.
Industry supply curve is the sum of the individual firm supply curves that is, the
marginal cost curves (above AVC) of all the firms in the industry.
Chapter 8: Long-Run Costs and Output Decisions
Long Run all costs are variable. There are no fixed costs in the long run.
Long Run Average Cost Curve: The firms long-run average cost (LRAC) shows the
most efficient way of producing each particular output given complete freedom to vary
inputs.
If LRAC is constant, we say there are constant returns to scale.
If LRAC is increasing with output, there are decreasing returns to scale
If LRAC is decreasing with output, there are increasing returns to scale.
In the long run in a perfectly competitive industry economic profits will be zero. If they
are positive, firms will enter and drive down price until profits equal zero. If profits are
negative, firms leave and prices rise until losses are removed.
You should be able to graph for me either the profits or losses for a perfectly competitive
firm given the market price.
In the long run, profits are zero for a perfectly competitive firm. This means that the
perfectly competitive firm is producing at the point where P =min (ATC). In the long
run, perfectly competitive firms also produce at the min of the LRAC curve.
Chapter 11: General Equilibrium and the Efficiency of Perfect Competition
Efficiency requires P=MC; P is value of output to society, MC is value of inputs needed
to make 1 unit of output. This outcome means that society is pulled toward the point on
the production possibility frontier that yields the highest satisfaction.
Pareto efficiency or Pareto optimality A condition in which no change is possible
that will make some members of society better off without making some other members
of society worse off.
Chapter 12: Monopoly and anti-trust policy
Monopoly, monopolistic competition and oligopoly are examples of imperfect
competition.

A monopoly usually arises due to barriers to entry. You should know all of the barriers
to entry mentioned in your textbook.
In monopoly, the firm supplies goods to the entire market and the firm faces a downward
sloping demand curve. This means that (unlike the perfect competitor who could sell as
much as he wanted at a given price), the monopolist must lower price to increase sales.
This leads to a divergence between P and marginal revenue. Profits are maximized at the
output level where marginal revenue equals marginal cost MR=MC, and price is read off
the demand curve at that output level. The monopolist is thus a price maker. The
monopolist can earn supernormal or excess profits in the long run by effectively
preventing entry.
The monopoly produces less output and charges higher prices than would be the case
under perfect competition (P>MR = MC); it has thus misallocated resources. It is
therefore inefficient.
Rent seeking: A monopolist is said to be rent-seeking when it uses some of its profits
in the current period to help maintain its monopoly.
Natural monopoly - If the monopoly comes about naturally due to a declining average
cost curve over a wide-range of output, then this monopoly may be more efficient than a
group of competitive firms. The classic examples of natural monopolies over the years
have been public utilities: the telephone company, the electric company and the gas
company. The basic idea was that huge fixed costs to develop transmission lines and
distribution pipes meant large economies of scale. These monopolies are usually
regulated by the government.
Patents: Patents are a legal barrier to entry.
Price Discrimination means that different customers pay different prices for the same
good. Examples include student tickets to the movies, senior citizen discounts, and even
different prices on airline tickets.
Chapter 13: Monopolistic Competition and Oligopoly
Monopolistically competitive firms differentiate their product and thus have similar, but
not identical products as in perfect competition. This leads to an individual demand
curve that is downward sloping for each firm in the industry. Price and output for each
firm are determined in the same way as the monopoly case by equating MR = MC and
setting the price from the demand curve at that output. However, in the long run for a
monopolistically competitive firm economic profits = zero. Profits are zero in the long
run since there are no barriers to entry. Monopolistically competitive firms may still be
inefficient because they do not realize all of the possible economies of scale.
Oligopoly a few firms are large enough to affect price.
You should understand the basics of game theory. Make sure that you understand how to
solve for a Nash equilibrium.

If oligopolistic firms could collude and form a cartel, they would produce the monopoly
output. An example of a cartel is OPEC.
Perfectly contestable market: A market where there are no barriers to entry and
therefore the firms in the market act as if they were perfectly competitive.

Review for Final Third of the Class

Chapter 16: Externalities, Public Goods, Imperfect Information and Social Choice
Some potential causes for market failure are:
1) imperfect market structure (oligopoly, monopoly)
2) existence of public goods
3) the presence of external costs and benefits (externalities)
4) imperfect information
Some people believe that the government should only intervene if there is market failure.
The question raised in this chapter is when should the government intervene in the
market.
Externality is a cost or benefit imposed or bestowed on an individual or group that is
outside, or external to, the transaction in other words, something that affects a third
party. Classic example: pollution.
If the externality is internalized, then the firm sets marginal social cost equal to the
price.
If a negative externality is not internalized, then the firm sets marginal cost equal to price
and this leads to over-production of the good.
There are several approaches to solving the problem of externalities:
1) Government imposed taxes and subsidies: You should tax a negative externality. The
tax should be equal to the damages of each successive unit of output produced by the
firm. You should subsidize a positive externality.
2) Private bargaining and negotiation: This is the Coase theorem. Coase argued that
private bargains and negotiations are likely to lead to an efficient solution in many social
damage cases without any government involvement at all. You should be familiar with
the conditions necessary for the Coase theorem to hold.
3) legal rules and procedures or direct government regulation
4) Sale or auctioning of rights to impose externalities This solution establishes a
market for the externality and provides an efficient outcome.
Pure public goods are non-rival and non-excludable. Example: national defense

Non-rival means that my consumption of the good does not affect your consumption of
the good. An example of a rival good would be a hamburger. If I eat the hamburger, you
cant eat the hamburger, too.
A good is non-excludable if it is difficult to exclude people who do not pay.
You should know that public goods tend to be underprovided. They are underprovided
because it is difficult to exclude people who do not pay. This is called the free-rider
problem.
You should be familiar with Samuelsons argument for the optimal level of a public
good. At the optimal level, societys total willingness to pay per unit is equal to the
marginal cost of producing the good. You should sum up every individuals willingness
to pay to obtain societys willingness to pay. The market demand for a public good is
equal to the vertical sum of individuals demand curves.
The optimal level of provision for public goods - is the level at which society's total
willingness to pay per unit is equal to the marginal cost of producing the good.
Tiebout hypothesis is that an efficient mix of public goods is produced when local land
and housing prices and taxes come to reflect consumer preferences just as they do in the
market for private goods.
Mixed Goods: Goods that are part public goods and part private goods. Education is an
example.
Social Choice: The problem of deciding what society wants. The process of adding up
individual preferences to make a choice for society as a whole.
Impossibility Theorem A proposition demonstrated by Kenneth Arrow showing that no system of aggregating
individual preferences into social decisions will always yield consistent, nonarbitrary
results.
Transitivity: If A is preferred to B and B is preferred to C then if it satisfies transitivity
then A must be preferred to C.
Voting paradox: A simple demonstration of how majority-rule voting can lead to
seemingly contradictory and inconsistent results. A commonly cited illustration of the
kind of inconsistency described in the impossibility theorem.
CHAPTER 17: Uncertainty and Asymmetric Information:
Payoff: The amount that comes from a possible outcome or result

Expected value: The sum of the payoffs associated with each possible outcome of a
situation weighted by its probability of occurring.
Fair game: A game whose expected value is zero
Diminishing marginal utility: The more of any one good consumed in a given period, the
less incremental satisfaction is generated by consuming a marginal or incremental
satisfaction is generated by consuming a marginal or incremental unit of the same good.
Expected utility: The sum of the utilities coming from all possible outcomes of a deal
weighted by the probability of each occurring.
Risk-averse: Refers to a person's preference of a certain payoff over an uncertain one
with the same expected value.
Risk-neutral: Refers to a person's willingness to take a bet with an expected value of
zero.
Risk-loving: Refers to a person's preference for an uncertain deal over a certain deal with
an equal expected value.
Risk premium: The maximum price a risk averse person will pay to avoid taking a risk.
Asymmetric Information: One of the parties to a transaction has information relevant to
the transaction that the other party does not have.
Adverse selection: The problem of adverse selection can occur when a buyer or seller
enters an exchange with another party who has more information. The classic case of
adverse selection is the used car market.
Moral hazard: Moral hazard occurs when a person changes their behavior due to a
contract. For example, a person who has insurance over car theft may be less careful in
locking their doors. A person wearing a seat belt may be more likely to speed than
someone who does not wear a seat belt.
Precise definition: A moral hazard problem arises when one party to a contract passes
the cost of its behavior on to the other party to the contract.
CHAPTER 18: INCOME DISTRIBUTION AND POVERTY
You should know that households derive their incomes from 1) wages or salaries, 2)
from property 3) from the government.
You should be able to recognize that the minimum wage is a price floor and that it creates
a surplus of workers wanting work (unemployment).
Transfer payments: Payments by government to people who do not supply goods or
services in exchange.

You should know how to draw a Lorenz curve. You should know how to compare
Lorenz curves.
You should know the definition of the Gini coefficient and how to interpret a Gini
coefficient.
In the past few decades, income inequality has increased. The reasons for this potentially
are: skill biased technological change, increased numbers of low-skilled immigrants, and
trade.
You should know some of the arguments for and against redistribution.
Poverty Line: the officially established income level that distinguishes the poor from the
nonpoor. It is set at three times the cost of the Department of Agriculture's minimum
food budget.
You should know what it means if an individual receives an in-kind benefit.
Social Security You should be able to recall how the social security system is funded.
It is mostly funded as a pay-as-you go system. Workers today pay for todays retirees.
Chapter 19: Public Finance: The Economics of Taxation
Every tax has two parts. The first part is the base and the second part is the rate.
Proportional tax: A tax whose burden is the same proportion of income for all
households.
Progressive tax: A tax whose burden, expressed as a percentage of income, increases as
income increases.
Regressive tax: A tax whose burden, expressed as a percentage of income falls as income
increases.
Average tax rate: Total amount of tax paid divided by total income
Marginal tax rate: the tax rate paid on any additional income earned.
Tax Equity:
Benefits-received principle: A theory of fairness holding that taxpayers should contribute
to government in proportion to the benefits they receive from public expenditures.
Ability-to-pay principle: A theory of taxation holding that citizens should bear tax
burdens in line with their ability to pay taxes.

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Tax shifting: Occurs when households can alter their behavior and do something to avoid
paying a tax.
Excess burden: The amount by which the burden of a tax exceeds the total revenue
collected. Also called deadweight loss.
Principle of neutrality: All else equal, taxes that are neutral with respect to economic
decisions (that is, taxes that do not distort economic decisions are gnerally preferable to
taxes that distort economic decisions. Taxes that are not neutral impose excess burdens.

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