I Economics a Production possibilities curve April 30 2012 1 Graphing lines a Slope 1 m the change in y the change in x a m y2 y1 x2 x1 b Slope intercept form 1 y mx b 2 Percentage change a P 2 P 1 100 P1 b Key principles of economics 1 Opportunity cost a The cost of foregoing the next best opportunity 1 Opportunity cost Cost Gain 2 Marginal principle a Marginal cost b Marginal principle MP 1 The optimal level of an activity max profit occurs when marginal revenue is equal to marginal cost a MP occurs when MR MC 3 Diminishing returns a In any productive activity increasing an input beyond some level will eventually result in diminishing increases in output b Example c Short run d Long run 4 Externalities 1 The period of time in which at least 1 production factor is fixed 1 The period of time in which all production factors are adjusted a Also known as spillovers b Economic costs or benefits not experienced by the economic decision maker 1 Negative externalities a Costs imposed 2 Positive externalities a Benefits imposed 5 Gains from trade a Absolute advantage b Comparative advantage The ability to produce a good using fewer inputs than another producer another producer 1 With trade the countries specialize in the good in which they have comparative The ability to produce a good at a lower opportunity cost than c Law of demand 1 Demand curve slopes downward Decreasing price results in increasing quantity demanded advantage a Example 1 Moving from point A to point B a Demand has not changed b Price decreases c Quantity demanded increases 2 Moving from demand curve 1 to demand curve 2 changes demand a Demand increases 3 Moving from demand curve 1 to demand curve 3 changes demand a Demand decreases 2 Factors that shift demand a Income 1 For a normal good increasing income causes an increase in demand 2 For an inferior good increasing income causes a decrease in demand b Changes in the price of a related good 1 When goods are substitutes the increase in the price of good A will lead to an increase in demand for good B a Substitutes are consumed in an either or fashion 2 When goods are compliments the increase in the price of good A will lead to an decrease in demand for good B a Compliments are consumed together Increasing population increases demand c Population 1 d Taste 1 Increasing taste increases demand e Consumer expectations about future prices 1 2 If consumers receive news that future prices will increase demand increases in the present If consumers receive news that future prices will decrease demand decreases in the present d Law of supply 1 Supply curve slopes upward Increasing price results in increasing quantity supplied a Example a Moving from point A to point B 1 Supply has not changed a Does not change firm behavior 2 Price increases 3 Quantity supplied increases b Moving from supply curve 1 to supply curve 2 changes supply c Moving from supply curve 1 to supply curve 3 changes supply 1 Changes behavior of firms 2 Supply increases 1 Changes behavior of firms 2 Supply decreases b Factors that shift supply 1 Change in variable input prices a An increase in the price of a variable input decreases supply 2 Technological change a Technological advances increases supply 3 Number of firms a An increase in the number of firms increases supply 4 Producer expectations about future prices a b If producers receive news that future prices will increase supply decreases in the present If producers receive news that future prices will decrease supply increases in the present e Market equilibrium 1 A price at which quantity supplied is equal to quantity demanded 2 Surplus a When quantity supplied is greater than quantity demanded 3 Shortage a When quantity demanded is greater than quantity supplied 4 Equilibrium changes a Demand shifts Income 1 2 Changes in the price of a related good 3 Population 4 Tastes 5 Consumer expectations about future prices ambiguous b Supply shifts 1 Change in variable input prices 2 Technological change 3 Number of firms 4 Producer expectations about future prices a Anytime supply and demand are both changing either supply or demand is f Elasticity 1 Elasticity tells how many percent quantity changes by when price increases by 1 2 3 4 If E is 1 demand is elastic If E is 1 demand is unit elastic If E is 1 demand is inelastic 5 Price elasticity of demand a How sensitive quantity demanded is to a change in price 1 Example a Flatter demand curves are more sensitive to changes in price ED Percentage change in quantity demanded Percentage change in price a ED quantity demanded price 1 More elastic b Formula 1 1 ED Q 2 Q 1 Q1 P2 P1 P1 2 ED is always negative c Factors that affect elasticity of demand 1 Necessity vs luxury a Luxuries are more elastic 2 Close substitutes a Goods with close substitutes are more elastic 3 Budget share 4 Time a Large budget shares are more elastic a Goods are more elastic over longer time periods 6 Price elasticity of supply a How sensitive quantity supplied is to a change in price b Formula 1 ES Percentage change in quantity supplied Percentage change in price a ES quantity supplied price 1 ES Q 2 Q 1 Q1 P2 P1 P1 c ES is always positive d Larger ES is more elastic e Factors that affect elasticity of supply 1 Time a Quantity is more elastic over longer time periods 7 Income elasticity a Formula 1 EY Percentage change in quantity Percentage change in income a EY quantity income 1 EY Q 2 Q 1 Q1 Y2 Y1 Y1 b EY can be positive or negative 1 2 If EY 0 there is a normal good If EY 0 there is an inferior good 8 Cross price elasticity a Formula b EPo Percentage change in quantity Good 1 Percentage change in price Good 0 1 EPo quantity price a EPo Q 2 Q 1 Q1 P2 P1 P1 c EPo can be positive or negative 1 2 g Consumer surplus CS If EPo 0 the goods are substitutes If EPo 0 the goods are compliments 1 Extra value received by consumers in excess of price paid 2 The demand curve maps consumer willingness to pay WTP 3 Area under the demand curve and above the price h Producer surplus PS 1 Extra value received by producers in excess of willingness to accept compensation 2 The supply curve maps consumer willingness to accept compensation WTA 3 Area under the price and above the supply curve a The total value created by the market is the sum of producer and consumer surplus a Potential consumer surplus and producer surplus not captured by the market a There is no additional transaction that would benefit a buyer seller or an affected third b Consumer