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Econ 2000 1 Study Guide For Final Exam The Ten Key Elements of Economics Section This section accompanies pages 5 39 in your Common Sense Economics textbook Scarcity is the concept that there is not enough of a good freely available from nature so that people can have as much as they would like This is an objective term very different from poverty One should learn to ration Rationing is allocating scare goods to those who want time In a market economy price is used to ration goods Scarcity leads to competitive behavior There are three types of resources human resources human capital physical resources physical capital and natural resources Capital is human made resources used to produce other goods and services Twelve key elements of economic thinking 1 Incentives matter A People respond to changing incentives in a predictable way B What is rational for one person is not rational for everyone C Utility The subjective benefit or satisfaction a person expects from a choice or course of action 2 No such thing as a free lunch because resources are scarce tradeoffs must be made A Opportunity Cost The highest valued alternative that must be sacrificed when choosing an option 3 Decisions are made at the margin A Know how to identify the marginal costs and the marginal benefits of making a decision Marginal describes the effect of a change in the current situation B Understand the law of diminishing marginal utility and its implications The law of diminishing marginal utility as consumption increases the marginal utility derived from addition consumption will eventually decline Ex The more times you eat chipotle the less satisfaction you will get from eating it C Understand the concept of the cost benefit analysis and economic efficiency You should only do those things where the marginal benefits outweigh the marginal costs No action that has more cost than benefit should be taken D People will rationally choose not to become fully informed when making decisions They don t want all the details 4 Voluntary trade promotes economic progress A Know how trade creates value by putting goods into the hands of those who want them the most Voluntary trade is better than coerced trade It moves goods from people that value them less to people who value them more Coercion is when someone will devote resources to make you worse off if you don t comply B Trade makes larger output and consumption levels possible through specialization The Law of Comparative Advantage individuals economies and nations should produce that which they can make at a lower opportunity cost and trade for everything else 1 C Voluntary trade makes it possible to produce things at a lower cost per unit buy in bulk through mass production techniques 5 Transaction costs are an obstacle to trade Transaction costs are the time effort and other resources needed to search out and complete an exchange Middleman reduce transaction costs A middleman is a person who buys and sells goods or services or arranges trades He reduces transaction costs 6 Prices bring the choices of buyers and sellers into balance know how a market equilibrium is created supply and demand section Sellers want to sell high while buyers want to buy low Market prices bring these two conflicting forces into balance 7 Profits direct businesses toward activities that increase wealth A Understand the definitions of profits and losses and their economic role in creating a prosperous society Profit an excess of sales revenue relative to the opportunity cost of production Profit only occurs when the value of the good is greater than the value of the resources used for its production Loss a deficit of sales revenue relative to the opportunity cost of production Losses are penalties imposed on those who produce goods that are valued less than the resources required for their production 8 People Earn Income by Helping Others A Entrepreneurs who create things make everybody better off by expanding the pie rather than taking a slice of it 9 Production not just jobs provides the source of high living standards Know that destruction and jobs that don t produce useful goods and services do not add to economic growth 10 Economic progress comes primarily through trade investment better ways of doing things and sound economic institutions A Investment makes us richer but costs in terms of current consumption B Improvements in technology spur economic progress creative destruction replacing old products and production methods by innovative new ones that consumers judge to be superior C Improvements in economic organization can promote growth private property rights competition personal and economic freedom 11 The invisible hand and the role of prices A The invisible hand the tendency for people while pursuing their own interests to promote the economic well being of society B Understand how prices communicate information and promote market order Prices communicate information to decision makers Prices coordinate the actions of market participants Prices motivate economic players 12 Secondary effects Long term consequences are often ignored A Secondary effect the indirect impact of an event or policy that may not be easily and immediately observable Know the four pitfalls to avoid in economic thinking 1 Violation of the ceteris paribus principle Ceteris paribus other things constant 2 The belief that good intentions equal desirable outcomes A The Nirvana Fallacy The logical error of comparing the actual situation with its idealized counterpart rather than the actual alternative 2 3 The fallacy of composition the fallacious belief that what is true for one is true for all 4 The belief that association is causation Supply and Demand Section This section corresponds with the additional reading entitled Supply and Demand Basics and Supply and Demand Applications and Extensions located on blackboard Supply and Demand Basics Understand the law of demand and why demand curves are downward sloping Law of demand there is an inverse relationship between the price of a good and the quantity that buyers are willing to purchase Downward sloping demand curve As price increases quantity demanded decreases The height of the demand curve at any quantity shows the maximum price that consumers are willing to pay for an additional unit When consumers have more of the good they value it less Know how to find and calculate consumer surplus Consumer surplus the difference between the maximum amount

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