ECO 105

Study Guide for Exam 1

The Principles of Economics

Know what each of the ten principles stated in Chapter 1 of your text means. Make sure you understand each principle.

• What makes a problem an economic problem?
• Define opportunity cost and recognize what constitutes opportunity cost in a problem.
• What is marginal thinking? Be able to use it to answer questions.
• How do people respond to incentives?
• Why does trade make everyone better off?
• Explain why informational problems make markets generally superior to centralized economic planning.
• What does a nation’s standard of living depend on? Why?

Production Possibilities – and Other Stuff

You should be comfortable working with the PPF model.

• What is the relationship of opportunity cost to slope of the PPF?
• What is the economic difference between a concave PPF and a linear PPF?
• Why do economists believe that concave PPFs are typical?
• What factors cause the PPF to expand (shift or rotate) over time?

Other stuff to know:

• What is the difference between microeconomics and macroeconomics?
• What is the difference between a normative statement and a positive statement?
• Why are assumptions important in economic analysis?

Absolute and Comparative Advantage

This is a particularly important topic.

• Define absolute advantage and comparative advantage.
• How do you determine which person in an example has a comparative advantage in which good?
• What determines which good a person (or country) should specialize in?
• How does specializing according to comparative advantage and then trading make both parties better off?
• Why might one trader prefer a particular mutually beneficial trading ratio to an alternative mutually beneficial trading ratio?

Markets, Demand, and Supply

You should have a general conception of what a market is and what a market does. Mankiw’s definition is weak; check your notes. In particular, you should understand what is meant by the phrase, "A market is an institution that brings buyers and sellers together."

• What is the difference between demand and quantity demanded? Be able to apply your knowledge to specific problems.
• What is the difference between supply and quantity supplied? Be able to apply your knowledge to specific problems.
• What does ceteris paribus mean? Why do economists use it?
• How does a demand curve shift in response to a change in
  • income (normal or inferior good)
  • prices of other goods (complements and substitutes)
  • tastes
  • expectations?
• How does a supply curve shift in response to a change in
  • input prices
  • technology
  • expectations?
• Be able to shift the demand or supply curve appropriately, showing the change in equilibrium price and quantity.
• How does a market tend to eliminate either excess demand (a shortage) or excess supply (a surplus)?
• How do market prices allocate resources to their highest-valued uses?
• How do prices convey information on consumer desires or resource scarcities to producers or demanders?

Price Ceilings and Floors

Sometimes governments intervene in markets, forcing prices away from their equilibrium market levels.

• What does a price floor look like in a demand/supply diagram?
• What does a price ceiling look like in a demand/supply diagram?
• How do price floors or ceilings affect quantity demanded and quantity supplied?
  • For example, what are the effects on Qd and Qs of a minimum wage? Of a rent ceiling?
• How do price ceilings or floors affect the behavior of buyers or sellers who are adversely affected by price controls?
  • For example, how would dairy farmers react to a government program of buying and storing large quantities of cheese?
  • How do landlords react to rent controls?
• In what ways do price ceilings and floors benefit some market participants while harming others?
  • For example, how do rent controls have different effects on renters who already have apartements and prospective renters seekings apartments?
• When government levies a tax on the price of a good, does it matter whether the tax is levied on the buyer or on the seller?
  • For example, when you buy something in a store, sales tax is added on. The customer pays. Would it make any difference if the state required sellers to pay the tax?
  • Can the government determine who really pays a tax?

Consumer and Producer Surplus

The concepts of consumer and producer surplus are extremely useful in evaluating how different policies affect the welfare of consumers and producers. You should understand thoroughly what consumer surplus and producer surplus are, including the idea of subjective value (on the demand side) and opportunity cost (on the supply side).

• What areas in a demand/supply diagram represent consumer and produce surplus?
• Use the demand/supply model to determine how consumer surplus and producer surplus are affected by
  • an increase or decrease in demand for the product (caused, say, by a change in tastes).
  • an increase or decrease in supply of the product (caused by a change in opportunity cost of production).
  • the imposition of a price ceiling or a price floor.
• What is market efficiency?
• Why is market efficiency maximized at the market-clearing price/quantity equilibrium?
• What are the effects on market efficiency of government price controls?
• Why is market efficiency a positive concept, while equity is a normative concept?
• Why do interventions in markets to promote equity nearly always reduce efficiency?

We will go over the study guide, and any other questions you might have, during the review sessions in exam ssweek.