ECONOMICS 120EXAM AID

Instructors: Jason Frittaion, Kara Chiki

Some images used from course slides and textbook.

AGENDA

• Intro to Economics and Opportunity Cost

• Trade, PPC, and Comparative Advantag

• Demand, Supply, and Price• Elasticity• Markets in Action (Price Floors and

Ceilings)

CHAPTER 1Opportunity Cost

A Few Qualitative Points• Economics is pretty much the study of motives and

relationships that cause all the interactions of the market.

• The economy is self-organizing through these motives (self-interest, incentives, etc.). When the economy is self-organizing, we consider it to be an open market (constantly striving for efficiency).

• Land, labour, and capital are what produce the goods and services we consume.

• These resources are however limited (scarcity). Therefore we must manage these resources, making decisions among our needs and unlimited wants.

• Opportunity cost illustrates this concept of trade-off.

The Flow of the Economy

• Private property and freedom of contract are enforced through active government policy. Government further try to intervene to correct market failures, provide public goods, and offset externalities.

Opportunity Cost “The foregone benefits of the next best

alternative.”

These costs include explicit costs (out of pocket expenses such as paying for a movie ticket) and implicit costs (foregone earnings such as going to the movies versus working that night)

They DO NOT include sunk costs (unrecoverable costs). These are basically the costs that must be incurred regardless of which course of action is taken.

EXAMPLE # 1

Answer: (b)WHY? If he hires a plumber and chooses to go to work, he will have to pay the plumber $200, which is an out of pocket expense; hence it will be included as an opportunity cost. If he does it himself, his foregone earnings that he could’ve made by working would be his opportunity cost.

EXAMPLE # 2

Answer: (b)WHY? Before the fertilizer was discovered, if the farmer had chosen to plant potatoes(5), he would have to give up the benefit of growing 10 corns. In other words, in order to grow 1 potato, he would have to give up 2 corns. Now that a new fertilizer has been discovered which doubles the per acre yield, in order to grow potatoes(10), he would have to give up the benefit of growing 20 corns. In other words, in order to grow 1 potato, you would have to give up 2 corns again.Same rule applies to the option of growing Corns instead.

CHAPTER 33Trade and Comparative Advantage

• Shows the combinations of goods that can be produced if all resources are fully employed.

• Points inside the PPC are attainable but you are not fully using your resources.

• Points outside are unattainable and can only be attained by new technology or a stronger labour force.

• Slope of the PPC indicates opportunity cost.• PPC has a concave shape because productivity

declines with output.• PPC shifts if technology or resources change.

Production Possibilities Curve

Production Possibility Curve

The negatively sloped boundary shows the combinations that are just attainable when all of society’s resources are efficiently employed.

Trade• Adam Smith proposed trade in terms of absolute

cost.• David Ricardo took it a step further saying that trade

should be based on a comparative level (comparing opportunity costs to other countries).

• By trading, goods can be acquired at lower opportunity costs and specialization can further increase consumption possibilities.

• The terms of trade between two countries (what to price the goods at in terms of the other goods, I.e. 1 pencil sharpener = 3 cans of pop) have to be so that each country is never paying more than the opportunity cost of producing the good domestically.

Comparative Advantage

“The situation that exists when a country can produce a good with less foregone output of

other goods than can another country.”• Comparative advantages reflect opportunity costs

that differ between countries.• Even though a country may have an absolute

advantage in all goods, it cannot have a comparative advantage in all goods.

• The gains from specialization and trade depend on the pattern of comparative, not absolute advantage.

Gains from Trade• Trade allows importing countries to acquire goods at

a lower opportunity cost than if they produced the goods themselves.

• Whenever opportunity costs differ between countries, it is always possible to increase production of products if countries specialize in producing the product they have a comparative advantage in.

• TIP: Whenever calculating OC, put the one you want to find in the bottom (denominator). – I.e. with guns and pillows. If I want to find the OC of

guns in Canada, do: Canadian Pillows Canadian Guns

EXAMPLE # 1Output per Worker

Wheat (kg) Cloth (m)

Canada 25 units 100 units

United States 20 units 40 units

Canada has a comparative advantage in __ and an absolute advantage in __.a) wheat only both goodsb) cloth only neither goodc) cloth only both goodsd) both goods wheat onlye) both goods cloth only

Answer – (c)

Canada

O.C. of Wheat = Foregone cloth production Current output of wheat = 100 m C = 4 m C =

4mC/1kgW 25 kg W 1 kg W

O.C of Cloth = Foregone wheat production Current output of cloth= 25 kg W = 1 kg W =

0.25kgW/1mC 100 m C 4 m C

United States

O.C. of Wheat = Foregone cloth production Current output of wheat = 40 m C = 2 m C =

2mC/1kgW 20 kg W 1 kg W

O.C of Cloth = Foregone wheat production Current output of cloth= 20 kg W = 1 kg W =

0.5kgW/1mC 40 m C 2 m C

EXAMPLE 1 (continued)

We now have calculated the opportunity costs of each country in terms of producing the two products.

According to the table, it is clear that Canada has a comparative adv. in cloth only and US has a comparative adv. in wheat only.

Opportunity Costs

Wheat (kg) Cloth (m)

Canada 4 0.25

United States 2 0.5

CHAPTER 3Demand & Supply

Demand and Supply

Quantity Demanded: total amount of any particular good or service that consumers wish to purchase in some time period at a certain price.

Quantity Supplied: total amount of any particular good or service that suppliers wish to supply in some time period at a certain price.

Demand

Supply

Price

Quantity

Pe

Qe

Factors of Demand• Change in the price of a substitute good

• Direct relationship (I.e. Pepsi prices increases, Coke Demand (increases)

• Change in the price of a complementary good•Inverse relationship (I.e. Pillow prices rise, pillowcase demand falls)

• Change in consumer income•Direct relationship (I.e. minimum wage increases, demand for beer increases)

• Change in population • Direct relationship (every fall, the population of Waterloo increases by about 30,000 students, demand for eating out increases)

• Change in tastes and Preferences• Direct Relationship (The people of Waterloo generally become more health conscious, the demand for health food increases)

• Future expectations• Direct Relationship (Y2K example: the public thinks some crazy stuff is gonna go down, therefore the demand for canned soup sky rockets now )

Factors of Supply• Price of an input

• Inverse Relationship: the price of yarn goes up, therefore the supply of Kara’s hand knitted mittens goes down

• Technology• Direct relationship: new technology is discovered in

regards to getting the caramel inside of the chocolate, therefore the supply of Caramilk bars goes up

• (They no longer get in this way… http://www.youtube.com/watch?v=q8GOyuEELWc)

• # of Suppliers• Direct relationship: the number of restaurants being built

in Waterloo goes up, therefore the supply increases

Demand and SupplyKey Points TO KEEP IN MIND:• Both quantity demanded and quantity supplied represent

flows of those goods over a time period (not a stock of goods).• For the time being, we are assuming markets to be perfectly

competitive (many buyers and sellers who have no appreciable influence over prices – the market determines prices). Therefore, market forces cause price to always move towards EQUILIBRIUM (where Qd = Qs).

• A change in a good’s price (P) causes a– Movement along a demand or supply curve and a change

in quantity demanded or supplied• A change in any of the factors of demand or supply (Price not

being one of them) causes– Shift of a demand/supply curve

Four Laws of Demand and Supply

1. An increase in demand causes an increase in both the equilibrium price and the equilibrium quantity exchanged.

2. A decrease in demand causes a decrease in both the equilibrium price and quantity exchanged.

(when demand shifts, P and Q move in the same direction!)

Four Laws of Demand and Supply Continued….

3. An increase in supply causes a decrease in the equilibrium price and an increase the equilibrium quantity exchanged.

4. A decrease in supply causes an increase the equilibrium price and a decrease quantity exchanged.

(when Supply shifts, P and Q move in opposite directions!)

Laws Sum Up

If…– D Pe Qe

– D Pe Qe

– S Pe Qe – S Pe Qe

Practice Questions

1. Canadian Wine: Early frost destroys a large percentage of the grape crop in BC.

2. Wood Burning Stoves: The price of heating oil and natural gas triples.

3. Beer: Population of drinking age increase also, brewery unions negotiate a large increase in wages.

More examples!• Which of the following will shift the supply curve for good X

leftward?a) a decrease in wages of workers employed to produce Xb) an increase in the cost of machinery used to produce Xc) a technological improvement in the production of Xd) a situation where quantity demanded exceeds quantity suppliede) all of the above

ANSWER: b) An increase in the cost of machinery used to produce X is one of the factors mentioned earlier that shift the supply curve. If it costs firms more to make a product, they will decrease their production and the supply curve will shift the to left.

End of Chapter 3!

Any questions? Any at all?Sweet…

CHAPTER 4Elasticity

Price Elasticity of Demand

The price elasticity of demand is the measure of responsiveness of quantity of a product demanded to a change in that product’s price.

Percentage changes are measured using the average price and quantity so that η is the same for a price rise or a price fall.

η along a Linear Demand Curve

A linear demand has a constant slope but a non-constant elasticity.

Elasticity of Demand/SupplyInelastic Demand: a situation in which, for a given

percentage change in price, there is a smaller percentage change in quantity demanded; elasticity is less than one.

Ex: Pace Maker, certain drugs…

Elastic Demand: the situation in which for a given percentage change in price there is a greater percentage change in quantity demanded.

Ex: blue ink pen

These same concepts can be applied to supply curves.

Determinants of η • η depends on the ability and willingness of buyers

to substitute between products.• η is higher..

– In long-run than in the short-run • If you give buyers more time, individuals will

substitute away – hence higher elasticity

– The more narrowly defined a good is (I.e. Pepsi is more elastic than pop in general).

• Smaller categories have more substitutes – hence higher elasticity

– The larger the share of a consumer’s budget it represents (I.e. 20% change in car prices vs. 20% change in coffee prices)

Elasticity and Consumer Spending

• Consumer Spending = P x QD

• If demand is elastic then..– P and consumer spending are inversely related

• If demand is inelastic then..– P and consumer spending are directly related

• If demand is unit elastic then..– Spending is unaffected by price changes

Elasticity and Spending

Example!!

• If demand is inelastic then will a drought result in higher(increased spending) or lower(decreased spending) revenues for sellers collectively?

Decrease in Supply and Total Expenditure

Inelastic Demand

Elastic Demand

S 1S 2

With a decrease in supply S2 is still considered in the inelastic portion of the demand curve (S1 to S2) and thus total expenditure will increase (price is increasing, spending increases).

With a larger decrease in supply, that overshoots the equilibrium past the point of unit-elasticity, the supply curve intersects the elastic portion of the demand curve whereby price increases but total expenditure begins to decrease. Making it possible for total expenditure from S1 to S3 to decrease (or increase if not overshot by too much).

S3

Q1Q2Q3

P

Q

Again, remember:

More Elasticity ProblemsWhat is the elasticity in the following cases:1. As the price of CDs fell, product revenue rose.

P decreased, Revenue(spending) increased – when P and total consumer spending are inversely related, we know that the demand is price ELASTIC

2. I gotta have coffee no matter what the price Gotta have it – INELASTIC (prices go up but people don’t stop buying -> price and total spending move up together.

3. I spend $50/day on gas regardless of the price Spending stays constant – hence UNIT ELASTIC

Cross Price Elasticity of Demand

ηxy = % change in quantity demanded of good x

% change in price of good y

ηxy > 0 if x and y are substitutes (coke/pepsi)

ηxy < 0 if x and y are complements (gas/car)

Income Elasticity of Demand

ηY = % change in quantity demanded of good x

% change in incomeηY > 0 for normal goods

income increases, demand increasesηY < 0 for inferior goods

income increase, demand decreases

Example!• Coffee is a normal good. A decrease in income will

a) Increase the equilibrium price of coffee and increase the equilibrium quantity of coffee

b) Increase the equilibrium price of coffee and decrease the equilibrium quantity of coffee

c) Decrease the equilibrium price of coffee and decrease the equilibrium quantity of coffee

d) Decrease the equilibrium price of coffee and increase the quantity supplied of coffee

e) Cause none of the aboveANSWER: c) The definition of a normal good is that with income increases, the demand for that good also increases. The same pattern is applied to when income decreases. Decreased income decreases the demand for coffee (resulting in a leftward shift of D). The shift in the demand curve causes equilibrium price and quantity to move in same direction. So it’s a) or c). We know income directly relates to demand for normal goods, therefore P and Q decrease along with it.

Example!• If turnips are an inferior good, then ceteris paribus, an increase in

the price of turnips will causea) A decrease in the demand for turnipsb) An increase in the demand for turnipsc) A decrease in the supply of turnipsd) An increase in the supply of turnipse) None of the above

ANSWER: e) This question attempts to trick students. Any change in the price of a good is already taken into account by your graph (Price is on the y axis). The demand and supply curves formed represent all the quantities demanded and supplied at each price (so a change in one is just a movement along the already existing curves).

Price Elasticity of Supply ηs = % change in quantity supplied

% change in priceDeterminants of ηs - ηs is higher..

• in the long-run than in the short run • If inputs can be easily re-allocated

– I.e. the easier a farmer can switch between growing wheat and corn, the more responsive they will be to changes in wheat or corn prices. So if wheat prices drop, they switch to corn and reduce wheat supply.

• if costs per unit rise slowly with output– If I own a pillow factory, and I acknowledge that the cost of making pillows is

rising slowly then I can make the conscientious decision to change my production to something else.

CHAPTER 5Markets in Action

(Price Ceilings and Price Floors)

Price Floor• A price floor is a minimum permissible price (ex.

minimum wage)• An effective price floor..

– Is set above the equilibrium price– Results in fewer units being sold– Makes buyers worse off, some sellers better off & other

sellers worse off– Causes excess supply

Price Ceiling

• A price ceiling is a maximum permissible price (ex. Rent controls, tuition fees, human organs)

• An effective price ceiling..– Is set below the equilibrium price– Results in fewer units being sold– Makes sellers worse off, some buyers better off & other

buyers worse off– Causes excess demand– Excess demand can be

allocated by black markets

Example!

• A price floor set below the equilibrium price results ina) excess supplyb) excess demandc) the same equilibrium price prevailingd) an increase in supplye) a decrease in demand

ANSWER: c) the same equilibrium price prevailing. This is because a price floor is only an effective measure if it is set ABOVE the equilibrium price. Otherwise, the existing equilibrium price and quantity will prevail.

THE END

QUESTIONS?!