EC 205 1st EditionExam # 1 Study Guide Econ 205 Midterm Review1. What is economics?a. Economics is the study of how people allocate their limited resources to satisfy their nearly unlimited wants. Economics is the study of how people make decisions, and we can make predictions about behavior.2. What is scarcity and who supported this idea?a. Scarcity illustrates that resources are limited and economists can be wrong. Thomas Malthus said that population growth would lead to starvation and cultivation would not be able to keep pace, but he did not account for increases in technology and productivity.3. What is the difference between micro and macroeconomics?a. Microeconomics is the study of individual units that make up the economy, such as labor economics, industrial organization, or agricultural economics. Macroeconomics is the study of the workings of the economy as a whole, including unemployment, fiscal policy, interest rates, money supply, and inflation.4. What are the five foundations of economics? Explain each.a. Incentives- factors that motivate one to act and to make a decision. Economists assume that people are rational and will do whatever is in their best interest. Direct incentives are easy to recognize, while indirect are murky, and have unintended consequences. An example of an indirect incentive is welfare, because it leads some people to not like working a minimum wage job, when they make more money taking the benefits of welfare. Patents and copyrights guarantee inventors a specific amount of time for which they can exclusively sell their work. An example is a brand-name drug. Positive incentives are things like tax breaks for charitable contributions, negative incentives are speeding tickets to encourage safe driving. b. Trade-Offs- the idea that every decision incurs a cost. An example is the idea of there’s no such thing as free lunch. We have scarcity of all resources. Examples oftrade-offs are pollution and income levels in China. There are costs of industrialization, and the developed nations are richer and able to afford reducing pollution.c. Opportunity Costs- the highest valued alternative that must be sacrificed for something else. Example: studying or going out on a Saturday? Opportunity costsneed not be constant across individuals. An example is: do we need $100? Does Bill Gates? We choose what to do based on what gives us the largest benefit, orthe lowest opportunity cost. Trade-offs and opportunity cost are different because opportunity cost is the actual thing lost in the trade-off.d. Marginal Thinking- economists like to make decisions at the margin, a “per unit” way of thinking. e. Trade- trade adds value by bringing two parties together who gain from having a transaction. An example is if I can produce shoes for a cost of $50 and can sell them to you for $75, a trade should take place. Trade is the voluntary exchange between two parties, like buyers and sellers. Trade adds value, both sides are better because of the transaction. See pages 1-24 of the textbook for more notes and examples.5. What is a PPF?a. A Production Possibilities Frontier is a linear or curved concave graph that is an economic model, which illustrates the combinations of outputs that a society canproduce if all of its resources are being used effectively. Society and individuals face trade-offs. Anything on the PPF line if producing efficiently, and under is possible, but inefficient. Outside the line is unattainable. 6. What decides our points on a PPF?a. It is based on the tastes and preferences of consumers.7. What is Ceteris Paribus?a. The economic term for holding things constant. We assume the levels of resources and technology were constant. However, technology can change due to innovations.8. What are Exogenous Variables?a. Technology and resources, the variables controlled for a model. An example would be the goods being traded, such as shirts and cars. Note: if the technology of one good changes, the opportunity cost will change. If there is a change in technology or resources, there will be the same ratio, only more efficient. 9. What is constant opportunity cost? Non-Constant?a. No matter at what point we locate the trade-off between two goods, cost is the same due to a constant slope.b. Non-Constant: Law of Increasing Relative Cost- opportunity cost of producing a good rises as society produces more of it. 10. Other applications of the PPF model?a. Consumption- expenditure on goods and services now. Consuming now means less investment, production will not be able to grow as fast in the future.b. Investment- savings that can be used to create new capital goods.c. Capital Goods- help in the production of new goods and services in the future. Examples of capital goods are machinery and education, both cause economic growth. Example of U.S. vs China: China focuses more on capital goods, which means more savings and longer work hours. The United States focuses more on consumption goods, which means more leisure and instant gratification. Use of capital goods raises savings, raises investments, and raises growth rate of the economy. 11. What is absolute advantage and how can it be applied?a. A person/country has absolute advantage in the production of a good if that person/country has the ability to produce more with the same quantity of resources than another person/country can produce. But, both sides can still benefit from trade.12. What is comparative advantage?a. The use of slope to see which person/country has lower opportunity costs and should produce a certain good.Note: if the points of trade are outside the PPF graph, it leads to growth for both countries. 13. When will trade take place between two countries?a. Trade will take place between two countries as long as the terms of trade are between both countries’ opportunity costs. 14. Why does trade create value?a. Trade and growth rest on the idea of specialization.b. Focusing on what we do best allows us to maximize all aspects of our economy,c. We are efficiently using our scarce resources.15. What is a market?a. A market is a place where buyers and sellers interact, allocating products and resources with little or no government intervention.16. What are competitive markets?a. There are so many buyers and sellers that each cannot influence the price at which a good is sold or how much of a good is produced. Buyers and sellers take prices and quantities as given, because of similar goods and