Economics 1014 - Test 1

Ration

Since we don't have enough resources to produce all the goods and services we want, we have to have some way to decide who will get what is produced; this means we have to figure out how to ration these scarce resources. Our free market system uses market price as the rationing device.

Demand

The demand for a product shows the relationship between the price of a product and the amount of the product that consumers would be willing and able to purchase at each of those prices.

Substitute Effect

When the price of a product rises, consumers will see that the relative prices of other goods and services they might want to purchase are lower and they will substitute the other goods for this now more expensive good.

Profit

A firm earns a profit whenever it earns more revenue from the production and sale of a product than it spends producing that product. Profit is equal to total revenue earned minus total cost of production. When firms compete, profit also acts a signal that this firm is the more efficient producer of this product

Normal Goods

A good is considered to be a normal good if the demand for the good rises when the person's income rises.

Inferior Goods

A good is considered to be an inferior good if the demand for that good falls when the person's income rises.

Pigovian Tax/Subsidy

A Pigovian Tax is used to fix a market failure that occurs because of a negative externality. The tax should be in the amount of the externality and should be placed on buyers if it is a consumption externality and should be placed on sellers if it is a production externality. A Pigovian Subsidy is used to fix a market failure that occurs because of a positive externality. The subsidy should be in the amount of the externality and should be given to buyers if it is a consumption externality and should be given to sellers if it is a production externality. For example, if every time I smoke a pack of cigarettes I harm people around me by 50 cents, then I should be made to pay a Pigovian tax of 50 cents per pack in order to get me to recognize the full social cost of my smoking so that I will make the best smoking decision from society's point of view.

Change in Quantity Supplied

A change in quantity supplied is said to occur when the price of a product changes and producers respond by desiring to produce a larger or smaller quantity. This is a movement from one point to a second point on a single supply curve. A change in quantity supplied is not the same as a change in supply.

Sunk Cost

A cost is said to be sunk if there is no way to eliminate that cost by any new decision made. Since the sunk cost cannot be changed, it should not be considered in any new cost-benefit analysis. For example, if you paid $7 to get in to see a movie and half-way through the movie you decided the movie was boring, you shouldn't stay to the end just because you already paid the $7. This is a sunk cost because you cannot get it back regardless of whether you stay or go, so it should not impact your mid-movie decision on whether to stay to the end or leave immediately. Think of it this way, if you stay to the end, you will have wasted another hour of your time at a boring movie and you will be out $7; if you leave immediately you will be able to do something more enjoyable with that hour and you will still be out $7. Since you are out $7 in either case, why should it impact your decision?

Market

A market is said to exist for a product whenever there is at least one person who wants to buy the product and at least one person who wants to produce and sell the product.

Monopoly

A monopoly is said to exist if there is only one producer of a product in a particular market. If a monopoly exists, then consumers have no choice but to buy from that producer. This means there is less incentive for the producer to produce efficiently, less incentive to improve product quality or innovate and less incentive to offer good customer service.

Negative Consumption Externality

A negative consumption externality exists whenever a consumer makes a buying (consumption) decision that harms people around him or her and the consumer fails to include this harm in his or her cost/benefit analysis. A negative consumption externality usually results in the private individual choosing to consume more than society would like him or her to consume.

Negative Production Externality

A negative production externality exists whenever a producer makes a selling (production) decision that harms people around him or her and the producer fails to include this harm in his or her cost/benefit analysis. A negative production externality usually results in the private individual choosing to produce more than society would like him or her to produce.

Normative Statement

A normative statement is a statement that is not potentially testable or provable. It is a statement that is based on subjective values. Normative statements often contain ambiguous or subjective words like ought, should, good, bad, fair, and unfair. For example, "We should tax the rich to pay for health care for the poor because this is fair" is a normative statement since there is no way to test whether we should do something and there is not an unambiguous definition of what it means to be fair.

Positive Consumption Externality

A positive consumption externality exists whenever a consumer makes a buying (consumption) decision that benefits people around him or her and the consumer fails to include this benefit in his or her cost/benefit analysis. A positive consumption externality usually results in the private individual choosing to consume less than society would like him or her to consume.

Positive Production Externality

A positive production externality exists whenever a producer makes a selling (production) decision that benefits people around him or her and the producer fails to include this benefit in his or her cost/benefit analysis. A positive production externality usually results in the private individual choosing to produce less than society would like him or her to produce.

Positive Statement

A positive statement is a statement that is potentially testable and provable, even though it might technically be un-testable and even though it might actually be proven to be wrong. It is a statement that doesn't depend on subjective value words. Examples of positive statements include, "An increase in the federal minimum wage will lead to a 10% reduction in jobs for low-skilled workers," "An increase in the federal minimum wage will lead to a 10% increase in jobs for low-skilled workers," and "Higher income tax rates on workers will result in lower tax revenues because workers will work less."

Economic Surplus

Economic surplus refers to the net change in someone's well-being as a result of making a decision. For example, if you are considering buying a car and you are willing to pay $20,000 for the car (actual marginal benefit) but you are able to negotiate a price of $17,000 (actual marginal cost) then you are $3000 better off after you conclude your purchase. This $3000 is your net gain from the decision to buy the car and we call this your economic surplus.

On The Margin

Economists believe people make decisions on the margin, meaning we believe we make decisions one small step at a time (re-evaluating at each new step). For example, if you pay to see a movie and it turns out the movie is bad, you don't have to stay for the entire movie. You should do a new cost/benefit analysis as soon as you decide the movie is bad to decide whether to stay or leave early. Making decisions on the margin also means you can only include costs and benefits above and beyond what you would experience if you didn't make the decision. For example, if you believe you will get a job paying $20,000 per year if you don't attend college and you believe you will get a job paying $50,000 per year if you attend college, then the marginal benefit is $50,000 - $20,000 = $30,000 of extra salary from attending college.

Needs

Economists generally avoid talking about needs since this is such a subjective idea. I may consider a car to be a need, but I can actually survive without it, it just makes my life more comfortable. Instead, economists prefer to talk about very highly valued wants versus less highly valued wants. Things that you might consider to be needs are just very highly valued wants. I want a car and I want some diamond jewelry, but if I have a spare $20,000 to spend, I'm going to choose to buy the car rather than the jewelry because the car is a more highly-valued want and the jewelry is a lower-valued want.

Incentives

If you wish to encourage someone to make a decision, you can offer them an incentive by increasing the benefit they get from making the decision. The U.S. government tries to encourage people to buy homes by offering the incentive of a reduction in personal income taxes for those people paying mortgage interest. Many employers encourage employees to work harder by offering an end-of-year bonus that depends on the worker's yearly productivity. Parents encourage good behavior on the part of their children by offering to buy them ice cream. An incentive can also be used to discourage a decision. In this case, we might call it a disincentive (this is just a negative incentive) and it usually serves to increase the cost of making the decision. The government tries to discourage speeding on the highway by imposing a monetary fine in addition to penalty points on your driving record if you are caught speeding. Parents try to discourage bad behavior on the part of their children by withholding allowance, by restricting access to cell phones and game systems and by grounding them.

Natural Experiments

In the social sciences, where it is difficult to perform controlled experiments, scientists must often rely on natural experiments. A natural experiment occurs when some naturally occurring event provides the scientist a change in an important variable that allows the scientist to observe how people respond to that change. For example, if two neighboring states are very similar in their economies and their population demographics and one state increases its minimum wage while the other state does not, this would be considered a natural experiment. The economic scientist can use the state which has not raised its minimum wage as the control state and the state which has raised its minimum wage as the experimental state. If the only change that has occurred is the change in the minimum wage in the one state, then the economic scientist can compare employment changes in the two states to try to infer the impact of a minimum wage increase.

Jargon

Jargon is the specialized language of a field of study. It allows scientists within that field to more easily and successfully communicate by using words with meanings precise to that field. Jargon can also be used to exclude non-members, so it is also important to explain concepts in every-day language as much as possible.

Scarcity

Something is considered to be scarce if there is not enough to satisfy everyone's desire for the item. We would say that 'wants' exceed 'availability' or that demand exceeds supply. This scarcity situation means that we need some way to decide who will get the scarce item; we need some way to ration it. We could hold a lottery; we could use a 'first-come-first-served' policy where people wait in line and whoever gets there first gets it; or we could try to give it to the people who want it the most. Our free market system attempts to ration these scarce items by letting people indicate how much they want the item by how much they are willing to pay for them. Think of an auction; people bid on the items being auctioned and as the price is bid up, all drop out of the bidding as the price rises above what they think the item is worth to them until only one bidder is left. This last bidder, the winning bidder, should be the person who wants the item the most. Generally the scarcer the item, the higher the price will be bid up and the less scarce the item, the lower the price. In the free market system, price charged is the rationing device.

Excess Demand

There is an excess demand for a product whenever the price is such that the amount consumers would be willing and able to purchase is greater than the amount that producers would be willing and able to produce. An excess demand generally occurs when the price is set below the market equilibrium price. Excess demand is also referred to as a shortage.

Excess Supply

There is an excess supply of a product whenever the price is such that the amount consumers would be willing and able to purchase is less than the amount that producers would be willing and able to produce. An excess supply generally occurs when the price is set above the market equilibrium price. Excess supply is also referred to as a surplus.

Law of Demand

There is an inverse relationship between the price of a product and the amount of the product that consumers are willing and able to purchase, ceteris paribus. When prices rise, consumers want to buy less; when prices fall, consumers want to buy more.

Invisible Hand

This is a metaphor introduced by Adam Smith in his 1776 treatise, An Inquiry Into the Nature and Causes of the Wealth of Nations. It refers to the way the free market, which operates simply through the unorganized negotiation of buyers and sellers each trying to make themselves as happy as possible, seems to direct resources to their best production use and goods and services to their best consumption use so that we have economic efficiency without any explicit effort on the part of any central authority.

Economic Pie

This is a metaphor used to illustrate the total amount of wealth or economic surplus that can be produced for society through the production and consumption decisions made by sellers and buyers. We are referring to efficiency issues when we discuss the size of the economic pie and we are referring to equity issues when we discuss ways to divide the economic pie.

Command Economy

This is a method of allocating scarce resources without using markets. In a command economy, central planners make the decisions that would be made by the unregulated negotiation of buyers and sellers in a free market system. A command economy is more likely a part of a communist system of government. A free market economy is more likely a part of a democratic system of government.

Utility

This is a theoretical construct used by economists to measure the well-being or happiness people get from making decisions. We use it to measure the amount of economic surplus you receive. It eliminates the need to put this in dollars or yen or euros. It is good for more theoretical studies, but in practical work it is often more useful to use a local currency that makes sense to people. Utility is measured in utils.

Labor Intensive

This type of production process occurs whenever the producer relies heavily on workers (labor) with less reliance on machinery (capital) to produce a product.

Opportunity Cost

To an economist, the true cost of any decision is the value of the next best opportunities sacrificed when you make that decision rather than the actual dollars paid. For example, suppose you live in the hills of southern California and you are ordered to evacuate because of an approaching fire. You are given 30 minutes to grab what you can and leave the area. You are likely to grab sentimental items, such as pictures and family heirlooms, even though they have a low market value because to you they have a high personal value. This means that even though the pictures might only have a dollar value of $20, the opportunity cost to you of leaving them might be thousands of dollars or more.

Simplifying Assumptions

To make our models as easy to use as possible, we use a number of simplifying assumptions in order to take away all the unnecessary complexities so that we can focus just on the parts of the model that are important to help us answer our question. This may make the model less realistic, but since the goal of any model is to make the best predictions possible, we don't need to worry about the realism of these simplifying assumptions.

Bankruptcy

When a firm cannot produce and sell a product efficiently, it is not able to sell for a price high enough to cover all its costs of producing the product and will be driven out of business or go bankrupt. This bankruptcy is a signal to the market that this is not the most economically efficient producer of the product and it is a signal to the owners of the firm that their resources could be more useful to society producing some other product.

Next Best Opportunity

When determining the cost of a decision made, we need to know what choices had to be sacrificed to make this choice. For example, if we are trying to decide how to spend our weekend and we can either stay in town and work, head to Kansas City to shop, or head to Lake of the Ozarks to spend time with friends, then if we decide to stay in town to work, we give up the chance to shop in Kansas City and we give up the chance to spend time with friends at Lake of the Ozarks. The opportunity cost of our decision to stay in town and work, however, cannot be the value of both of the lost opportunities, because we could not have done both of them if we chose not to stay in town. Instead we need to determine which of the two lost opportunities is worth most to us and then that is our next best opportunity. It is the value of this next best opportunity that is the true opportunity cost of our decision to stay in town and work.

Externalities

Whenever you make a decision, you must consider all the benefits and costs of that decision. If, however, some of the benefits and/or costs of your decision are not felt by you and are not included by you in your cost/benefit analysis, then we say that your decision involves an externality. An externality is a cost or a benefit of your decision that is external to your private cost/benefit analysis. Externalities cause market failures because the best decision for the private individual making the decision will no longer be the best decision for society. For example, I will choose to smoke as long as I believe the benefits I receive from smoking exceed the costs I will pay. Smoking will be the rational decision for me. However, if my smoking harms those around me and I don't consider that harm to others in my private cost/benefit analysis, then I am imposing an external cost on those around me and the social benefits of my smoking might be less than the social costs so that my decision to smoke is not the best decision for society.

Change in Quantity Demanded

A change in quantity demanded is said to occur when the price of a product changes and consumers respond by desiring to buy a larger or smaller quantity. This is a movement from one point to a second point on a single demand curve. A change in quantity demanded is not the same as a change in demand.

Laws

By law, we simply mean the regular and predictable rules for how the world works. In economics we have many of these laws; two of the most important are the law of demand and the law of supply. We'll study these later in the course, but the law of demand is simply an explanation of how consumers make their buying decisions and the law of supply is an explanation of how suppliers make their selling decisions. We call these laws because we believe most, if not all, consumers and producers make their decisions in a very similar way. For example, we believe that all consumers prefer lower prices to higher prices and will be willing to buy more of an item if the price is lowered. On the other hand, we believe that all suppliers prefer to be paid a higher price for their product and will be willing to sell more if the price offered is higher. It is because we believe there is this regular and predictable pattern of behavior that lets us call them laws.

Ceteris Paribus

Ceteris paribus is a Latin term frequently used in economics for "everything else held constant".

Competition

Competition is an important condition for the efficient functioning of free market economies. When firms have to compete, they are forced to work harder at finding low-cost ways of producing, producing quality products, innovating and offering good customer service. If consumers have a choice of firms to buy from, those firms will have to work harder to keep consumers happy.

Inferior Good

These are goods or services that we demand less of when our income rises and more of when our income falls (a negative relationship between income and demand).

Behavioral Economics

This is a field of economics that combines the study of psychology with the study of economics in order to better understand the decision making processes of buyers and sellers engaged in market transactions.

Capital-Intensive

This type of production process occurs whenever the producer relies heavily on machinery (capital) with less reliance on workers (labor) to produce a product.

Wants

We generally believe people have unlimited wants. A want is anything that we feel would make us happy; these are things we would be willing to sacrifice for. Some wants are very highly valued wants, such as food and housing, and some wants are less highly valued wants, such as chia pets and pet clothing. Since we have limited resources, we use those resources to acquire our most highly valued wants first and only get the less highly valued wants if we have enough resources remaining.

Production Efficiency

Part of achieving economic efficiency involves making sure the resources available are used in the best way possible. This means making sure we produce those goods and services people want most and it also means producing in the least wasteful manner.

Consumption Efficiency

Part of making sure we make the best use of our scarce resources involves making sure the goods and services produced with those resources get allocated to the consumers who place the highest value on them. If there is only one doctor available in the emergency room and there are two patients waiting, we would probably want to allocate that doctor to the patient showing symptoms of a heart attack before we allocated the doctor to the patient needing stitches removed. If we have two houses available, one with three bedrooms and one with one bedroom, and we have two families needing a home, one with three kids and one with no kids, we would probably want the bigger home allocated to the family with kids and the smaller home allocated to the family without kids.

Scientific Method

The Scientific Method is a way of organizing the process used by scientists to better understand the world. This method is used in all the sciences, including economics. It generally consists of the following steps: 1. Observe the world around us, 2. Make hypotheses about the world based on these observations, (These hypotheses are often then developed into mathematical/graphical models of the world.), 3. Make predictions about the world based on these hypotheses, 4. Test the hypotheses using the models and data collected from the world around us, and 5. Revise the hypotheses and models as needed if the predictions are not accurate. This would then require additional testing until the predictions are accurate

Market Equilibrium Price

The market equilibrium price is the one price that exists in a market so that the quantity demanded is exactly equal to the quantity supplied

Market Equilibrium Quantity

The market equilibrium quantity is the quantity bought and sold at the market equilibrium price

Supply

The supply of a product shows the relationship between the price of a product and the amount of the product that producers would be willing and able to produce and sell at each of those prices.

Law of Supply

There is a positive relationship between the price of a product and the amount of the product that producers are willing and able to produce, ceteris paribus. When prices rise, producers want to produce more; when prices fall, producers want to produce less.

Income Effect

According to the income effect, consumers feel poorer as prices rise because their income cannot buy as much it previously was able to buy. Because of this, they will have to reduce their purchase of the product with the rising price in order to keep the income going to purchase other goods and services at its original level.

Rational

An individual is said to be rational if he or she makes decisions in a consistent manner. Economists generally assume people are rational. This is an important assumption, because without it, it would become impossible to model how people make decisions. If you make decisions randomly, without any rhyme or reason, there would be no way to predict or explain your decisions. In addition, we generally assume people make decisions in order to make themselves as well-off as possible (maximize economic surplus). This means we only do things if we expect the benefits to exceed the costs.

Choice

Because of our limited resources, each of us is forced to choose among the many things we want. A student may only have enough time to take 4 courses a semester but may have 6 courses he or she would like to take. This student must choose among the 6 desired courses for the 4 he or she has the time to take. A business owner may want to open a satellite office in two new markets but may only have the money to move into one new market. The business owner must make a choice between the two new markets because of the limited money.

Adam Smith

Born in Scotland in the 18th century, Adam Smith is generally considered to be the founder of modern economics. He authored the seminal economic text entitled An Inquiry Into the Nature and Causes of the Wealth of Nations (usually shortened to just The Wealth of Nations), which was published in 1776.

Economic Efficiency

Economic efficiency refers to making the absolute best use of our scarce resources. If we guarantee that we are producing the best goods and services in the best manner (production efficiency) and we also guarantee that we are sending those goods and services to the consumers who most value them (consumption efficiency) then we will have maximized the amount of economic surplus earned by our society and we will have achieved economic efficiency. We sometimes refer to this as maximizing the size of the economic pie. (This is also sometimes referred to as allocative efficiency because it involves allocating resources to producing the best goods and services and it involves allocating those goods and services to the people who most value them.)

Cost-Benefit Analysis

In order to make a good decision, we have to consider all marginal costs as well as all marginal benefits we would expect to experience as a result of any decision we might make. We then weigh the benefits against the costs and, if we are rational, only if we expect the benefits to exceed the costs do we proceed with the decision. (If we expect the benefits to exactly equal the costs we are technically indifferent; our decision could rationally go either way.)

Market Demand

Market demand for a product is the summation of all of the individual consumer demands for a product.

Market Supply

Market supply of a product is the summation of all of the individual producer supplies of a product.

Resource

Resources are the inputs used to produce goods and services. This includes land resources, such as oil, steel and timber; capital inputs, such as factories, delivery vans and hammers; and labor inputs, such as waiters, pharmacists and improv comics.

Equity

Societies that want to make sure the wealth produced is equitably shared (divide the pie more evenly) often find that they have to accept some reduction in the size of the economic pie. Attempts to increase equity generally result in reductions in efficiency. We might be willing to put up with some reduction in the size of the economic pie if we like having the pie shared more equally, but if attempts to increase equity result in large wealth reductions, we might be better off with a less evenly divided pie. In fact, even the people with the smallest shares might be better off with the less evenly divided pie if the efficiency impact of equity programs is very large.

Efficiency

Societies that want to maximize economic surplus (make the economic pie as big as possible) need to concentrate on allocating resources to where they are most useful to society.

Substitute

Substitutes are goods that are used in replacement for the other. In this case, when the price of one good rises, it causes an increase in the demand for the other good. Examples of substitutes might include Coke and Pepsi, gas-powered cars and electric cars, and pens and pencils.