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Review of Topics for the Midterm Examination What is Microeconomics Notion of Scarcity Scarcity There are not enough of the items humans find desirable to satisfy everybody s wants Scarcity is the mother of economics Microeconomics is the study of the allocation of scarce resources Economics is a Social Science economists try to enunciate positive rather than normative statements Economics Social Science conscience thoughts Positive statements We can test it by observing They are classified as either true or false Normative statements There is no observation that can check whether it is true They are value judgements should be avoided Notion of Opportunity Cost Opportunity cost of a good is the highest valued alternative given up to get it Preferences and Constraints preferences are immeasurable constraints may be observed and people take advantage of changes in constraints ConstraintsPreferences tastes i Income budgeting ii Take prices as given iii Time very hard to measure heterogeneous among the population Consumer Behavior and Demand Analysis Postulates of Behavior including Diminishing Marginal Valuation Postulate 1 People have preferences Postulate 2 More is preferred to less Postulate 3 People are willing to substitute one good for another Postulate 4 For all individuals and all goods the marginal value of goods decreases as more of that good is consumed holding other things constant Marginal versus Total Values Marginal value of a good is the amount of other goods we should be willing to give up in order to obtain an incremental marginal amount of that good Total value The maximum amount a consumer would be willing today in terms of other goods forgone in order to have all unite of this good rather than non at all all or nothing choice Total Value Total Expenditure and Consumer Surplus Consumer s Surplus Marginal Willingness to pay Price P1 0 Total Expenditure Q1 Total Expenditure price quantity TR P Q Total Expenditure Total Revenue Quantity Consumer surplus exists when a person buys something with a marginal benefit more than what he paid Total expenditure is what we actually do pay for a given quantity of goods Consumer Surplus Total value Total Expenditure Total Value Total Expenditure The Law of Demand The quantity demanded of any good or the level of any activity pursued varies inversely with the price of that good or activity holding all other things constant Market Demand Curves The Market Demand Curve is the lateral sum of individual demand curves P 10 9 8 7 6 5 4 3 2 1 0 Market Demand A s Demand B s Demand 0 1 2 3 4 6 7 8 9 Q 10 5 Definition of Elasticity in quantity in price of good Q P P Q Q Q P P The Elasticity of demand measures the response in the quantity demanded of some good to a change in the price of that good Elastic versus Inelastic Elastic means a relatively large percentage response in quantity demanded per percent change in the price Inelastic means a small percentage response in quantity demanded to a given percent change in price Calculation of elasticity at a point Relative elasticities of different demand curves In the upper part of the the demand curve where demand is elastic the percent increase in quantity is greater than the percent decrease in price Price falls Quantity increases Total Expenditure increases In the lower part of the demand curve where demand is inelastic the percent increase in quantity is less than the percent decrease in price Total Expenditure decreases 1 or 1Elastic 1 0 or 1Inelastic 1Unit Elastic Relationship of elasticity to the availability of substitute goods P Elastic Unit Elastic Inelastic Q The availability of substitutes is the main factor that affects the elasticity of a demand curve A demand curve for a good becomes relatively more elastic as the number of substitutes for the good increases Diamond Water Paradox Diamond Water Paradox Why are diamonds expensive and water cheap even though water is necessary for life The key to resolving Diamond Water Paradox is that prices represent marginal values not the total values of diamonds and water Because the supply of diamonds is low and the supply of water is great marginal value of diamonds is higher than the marginal value of water but total value of water is higher than the total value of diamonds Relative versus Absolute Price Changes Relative prices A change in Relative prices is a change in one price relative to another Absolute prices A change in the general price level as measured by the CPI Second Law of Demand With the passage of time the response to a change in price becomes absolutely greater Shipping the Good Apples Out product quality and relative prices Reason of this phenomena Law of Demand With a lower relative price the law of demand predicts that proportionally more high quality apples will be consumed although the total amount of apples consumed will still be lower in distant locations than at locations closer to the orchards Exchange and Supply Initial differences in marginal values provide the basis for mutual gains from trade The source of mutual benefits from exchange in the difference in the marginal valuations of a good by different people Calculation of Gains from Trade given information on marginal values and initial endowments Anytime one person values an additional unit of a good more highly than does another person mutually advantageous trade can take place The person with the greater marginal value can always offer to buy a unit at some place below his or her marginal value and above the other person s marginal value The second person will always agree to trade since he or she will gain The trade will then take place absent some legal or other barrier leading to mutual benefits At one price one person would be willing to pay X for another good while the other person will not sell one unless he receives more than X There are no further gains from exchange and so voluntary trading ceases The gain from trade are exhausted Theorems concerning trade Voluntary Exchange is based on mutual benefits The source of the mutual benefits from exchange is the difference in the marginal evaluations of a good by different people Supply Initial endowment minus quantity demanded for own consumption In an exchange economy supply curves are upward sloping because marginal valuation for own consumption is downward sloping Supply curve is the total amount of the good in existence minus the quantity demanded by the present owners at various prices Seller


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UW ECON 200 - Microeconomics

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