SECTION 1 of 3 Economic Methodology 1 Ceteris Paribus means other things remaining constant conclusions about the effect of a variable require other things to remain unchanged 2 Cause and Effect Relationships CORRELATION tendency for the values of two variables to move in a predictable and related way It DOES NOT imply causation FOUR observed explanation for any correlation EX We observe that cities with more police have higher crime rates i Cause and Effect More police cause higher crime rates ii Reverse Causation More crimes cause cities to hire more police iii Omitted Variables Larger cities have both more police and higher crime rates iv Spurious Correlation Police and crime are unrelated Scarcity and Marginal Analysis 1 Scarcity 2 Marginal Analysis Arises because the available resources are insufficient to satisfy wants Scarce resources are still scarce at any price no matter how high or how low Scarcity makes us have to make CHOICES and OPPORTUNITY COST arises from the choices we make The thing highest alternative forgone in our decision is Opp Cost Marginal Benefit the additional benefit that a person receives from one more unit of the activity It decreases as you do more of an activity Marginal Cost additional opportunity cost of one more unit of the activity It increases as Basic economic decision rule Marginal benefit equals marginal cost MB MC It is the most you do more of an activity economically efficient Production Possibilities and Comparative Advantage 1 Explain and illustrate the concepts of scarcity production efficiency and tradeoff using the production possibilities frontier The production possibilities frontier PPF describes the limits to what can be produced by using all the available resources efficiently Points inside and on the PPF are attainable Points outside the PPF are unattainable Production at any point on the PPF achieves production efficiency Production at a point inside the PPF is inefficient When production is efficient on the PPF people face a tradeoff If production is at a point inside the PPF there is a free lunch 2 Calculate opportunity cost Along the PPF the opportunity cost of X the item on the x axis is the decrease in Y the item on the y axis divided by the increase in X The opportunity cost of Y is the inverse of the opportunity cost of X The opportunity cost of producing a good increases as the quantity of the good produced increases possibilities 3 Explain what makes production possibilities expand Technological change and increases in capital and human capital expand production The opportunity cost of economic growth is the decrease in current consumption 4 Explain how people gain from specialization and trade A person has a comparative advantage in an activity if he or she can perform that activity at a lower opportunity cost than someone else People gain by increasing the production of the item in which they have a comparative advantage and trading Demand and Supply 1 Distinguish between quantity demanded and demand and explain what determines demand Other things remaining the same the quantity demanded increases as the price falls and decreases as the price rises the law of demand The demand for a good is influenced by the prices of related goods expected future prices income expected future income and credit the number of buyers and preferences A change in any of these influences changes the demand for the good 2 Distinguish between quantity supplied and supply and explain what determines supply Other things remaining the same the quantity supplied increases as the price rises and decreases as the price falls the law of supply The supply of a good is influenced by the prices of related goods prices of resources and other inputs expectations about future prices the number of sellers and productivity A change in any of these influences changes the supply of the good 3 Explain how demand and supply determine price and quantity in a market and explain the effects of changes in demand and supply The law of market forces brings market equilibrium the equilibrium price and equilibrium quantity at which buyers and sellers trade The price adjusts to maintain market equilibrium to keep the quantity demanded equal to the quantity supplied A surplus brings a fall in the price to restore market equilibrium a shortage brings a rise in the price to restore market equilibrium Market equilibrium responds to changes in demand and supply An increase in demand increases both the price and the quantity a decrease in demand decreases both the price and the quantity An increase in supply increases the quantity but decreases the price and a decrease in supply decreases the quantity but increases the price SECTION 2 of 3 Elasticities of Demand and Supply 1 Define explain the factors that influence and calculate the PRICE ELASTICITY OF DEMAND The demand for a good is ELASTIC if when its price changes the percentage change in the quantity demanded exceeds the percentage change in price The demand for a good is INELASTIC if when its price changes the percentage change in the quantity demanded is less than the percentage change in price The price elasticity of demand for a good depends on how easy it is to find substitutes for the good and on the proportion of income spent on it Price elasticity of demand equals the percentage change in the quantity demanded divided by the percentage change in price If demand is elastic a rise in price leads to a decrease in total revenue If demand is unit elastic a rise in price leaves total revenue unchanged And if demand is inelastic a rise in price leads to an increase in total revenue 2 Define explain the factors that influence and calculate the PRICE ELASTICITY OF SUPPLY The supply of a good is elastic if when its price changes the percentage change in the quantity supplied exceeds the percentage change in price The supply of a good is inelastic if when its price changes the percentage change in the quantity supplied is less than the percentage change in price The main influences on the price elasticity of supply are the flexibility of production possibilities and storage possibilities 3 Define and explain the factors that influence the CROSS ELASTICITY of demand and the income elasticity of demand Cross elasticity of demand shows how the demand for a good changes when the price of one of its substitutes or complements changes Cross elasticity is positive for substitutes and negative for complements Income elasticity
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