ECON 111 Midterm Review: Supply, Demand, Elasticity and Market Efficiency

Terms in this set (29)

1. Opportunity costThe value of the next best alternative given up when a choice is made. For example, the opportunity cost of attending class may be the wages you could have earned working.
2. Why is a production possibilities frontier usually bowed outward?Because of increasing opportunity cost: resources are not equally suited to producing both goods, so producing more of one good requires giving up ever larger amounts of the other.
3. Absolute advantage vs comparative advantageAbsolute advantage: producing more of a good with the same resources. Comparative advantage: producing a good at a lower opportunity cost. Trade gains come from comparative advantage.
4. Mini-problem: In one hour, A makes 10 shirts or 5 hats; B makes 6 shirts or 2 hats. Who has comparative advantage in hats?A. A's opportunity cost of a hat is 2 shirts, while B's is 3 shirts. B has comparative advantage in shirts (1/3 hat per shirt vs A's 1/2 hat).
5. Law of demandOther things equal, as the price of a good rises, the quantity demanded falls, giving a downward-sloping demand curve.
6. Change in quantity demanded vs change in demandA change in the good's own price causes a movement along the demand curve (change in quantity demanded). A change in any other factor shifts the whole curve (change in demand).
7. List the main factors that shift a demand curveConsumer income, prices of related goods (substitutes and complements), tastes, expectations about future prices, and the number of buyers (population).
8. Normal good vs inferior goodDemand for a normal good rises when income rises. Demand for an inferior good falls when income rises, such as instant noodles or bus rides for some consumers.
9. Substitutes vs complementsSubstitutes: a price rise in one increases demand for the other (coffee and tea). Complements: a price rise in one decreases demand for the other (printers and ink).
10. What happens when the price is above equilibrium? Below?Above equilibrium: quantity supplied exceeds quantity demanded, creating a surplus that pushes price down. Below: a shortage pushes price up.
11. Demand and supply both increase. What happens to equilibrium price and quantity?Equilibrium quantity rises for sure. The effect on price is ambiguous: it depends on which curve shifts by more.
12. Price elasticity of demand formula (midpoint method)Ed = (percent change in quantity demanded) / (percent change in price), using the average of the old and new values as the base for each percent change. Usually reported as an absolute value.
13. Elastic vs inelastic demand and total revenueElastic (Ed > 1): a price increase lowers total revenue. Inelastic (Ed < 1): a price increase raises total revenue. Unit elastic (Ed = 1): total revenue does not change.
14. Mini-problem: price rises 10 percent and quantity demanded falls 20 percent. Elasticity and revenue effect?Ed = 20/10 = 2, so demand is elastic and total revenue falls.
15. What makes demand more price elastic?Many close substitutes, the good being a luxury rather than a necessity, a large share of the budget, a narrowly defined market, and a longer time to adjust.
16. Income elasticity of demand: what do the signs mean?Positive: normal good (greater than 1 is a luxury). Negative: inferior good. It equals percent change in quantity demanded divided by percent change in income.
17. Cross-price elasticity of demand: what do the signs mean?Positive: the goods are substitutes. Negative: the goods are complements. Close to zero: unrelated goods.
18. Consumer surplusThe difference between what buyers are willing to pay and what they actually pay. On a graph, it is the area below the demand curve and above the price.
19. Producer surplusThe difference between the price sellers receive and their cost (the minimum they would accept). On a graph, it is the area above the supply curve and below the price.
20. Effect of a binding price ceilingSet below equilibrium, it creates a shortage because quantity demanded exceeds quantity supplied. Rent control is the classic example, often leading to waiting lists and lower quality.
21. Effect of a binding price floorSet above equilibrium, it creates a surplus because quantity supplied exceeds quantity demanded. A minimum wage above the market wage can create unemployment in that labour market.
22. Deadweight lossThe loss of total surplus when the quantity traded differs from the efficient quantity, for example due to a tax, price control or market power. It is the triangle between supply and demand over the lost units.
23. Tax incidence: who bears more of a tax burden?Whichever side of the market is less elastic. The statutory payer does not matter; if demand is very inelastic, buyers bear most of the tax through a higher price.
24. Utility-maximizing rule for a consumerAllocate the budget so that the marginal utility per dollar is equal across goods: MUx/Px = MUy/Py.
25. Substitution effect vs income effect of a price fallSubstitution effect: the good becomes relatively cheaper, so consumers buy more of it. Income effect: purchasing power rises, which increases demand for normal goods and decreases it for inferior goods.
26. Positive vs normative statementsPositive statements describe how the world is and can be tested with evidence. Normative statements say how the world should be and involve value judgments.
27. Negative externality and a policy fixA cost imposed on third parties, such as pollution. The market overproduces because private cost is below social cost. A Pigouvian tax equal to the external cost can restore the efficient quantity.
28. What defines a public good, and why is it underprovided by markets?It is non-rival (one person's use does not reduce another's) and non-excludable (people cannot be prevented from using it). Free riders can benefit without paying, so private firms underprovide it.
29. When is a competitive market allocatively efficient?When it produces the quantity where marginal benefit (demand) equals marginal cost (supply), which maximizes total surplus.