MICRO FINAL YOU'RE GOING TO DO WELL

Substitution Effect

The change in consumption caused by a change in the relative price, holding utility constant.

Income Effect

The change in consumption caused by the change in purchasing power resulting from a price change.

Marginal Utility

The change in utility from consuming an additional unit. MUA is the marginal utility of good "A."

Elasticity of Demand (tax)

The deadweight loss from taxation is lower the less elastic the demand curve is. •If demand is elastic, a tax deters many trades. •If demand is inelastic, there is little deterrence and thus fewer lost gains from trade.

After the development of iron, did the supply or demand for bronze shift? Which way did it shift? Why

The demand for bronze shifted to the left (down) because there was now a good substitute for bronze.

Tax Wedge Equation

Tax wedge = Pbuyers - Psellers = Tax

Given that Maria and Juan find a price suitable to both of them, how much total surplus (i.e., the sum of consumer and producer surplus) would be generated?

$15

If the state where Maria and Juan live instituted a tax on services that included a $5 per haircut tax on stylists and barbers, what is one price that will make both Maria and Juan better off?

$30

Suppose that Maria is willing to pay $40 for a haircut, and her stylist Juan is willing to accept as little as $25 for a haircut. What possible price for the haircut would be beneficial to both Maria and Juan?

$30

Tournament

A compensation scheme in which payment is based on relative performance

Indifference Curve

A curve connecting all combinations of goods, or consumption bundles, that give the consumer the same utility.

Compound Returns

A higher rate of return makes a big difference in the long run. •Rule of 70: If the rate of return of an investment is x%, then the doubling time is 70/x years. •With a return of 2%, an investment will double approximately every 35 years (70/2 = 35). •In the long run, stocks offer higher returns than bonds. • Stocks, however, have the potential for greater losses than do bonds.

Given your answer on the previous question, how much revenue did it raise when it increased its gasoline tax

A little revenue

If DC, Maryland, and Virginia all agreed to raise their gas tax simultaneously, how much revenue could the gas tax raise? Note: These states have heavily populated borders with each other, but they don't have any heavily populated borders with other states

A lot of revenue

Subsidy (definition)

A reverse tax, in which the government gives money to consumers or producers.

How is the increasing price of bronze an incentive? a. Consumers will save more money by conserving bronze. b. Consumers who switch to substitutes can save money. c. Entrepreneurs can profit by developing new alternatives to bronze. d. Entrepreneurs can profit by developing ways to recycle bronze.

All of the above.

Why do you think iron and steel became more common around the same time as the increase in price of bronze?

An increase in the price of bronze encourages innovation to produce substitutes.

Piece Rate

Any payment system that pays workers directly for their output

Prices

Are the key force integrating markets and motivating entrepreneurs. • Create rich connections between markets by conveying important information. • Create an incentive to respond to that information in socially useful ways. • Enable societies to mobilize vast amounts of knowledge toward common ends.

Given your prediction about the change in the price of paper, how would the price of pencils change? (Hint: are paper and pencils complements or substitutes?)

Fall, because demand would shift to the left.

Commodity Tax (definition)

Taxes on goods, such as those on fuel, cigarettes, and liquor

Diminishing Marginal Utility

Each additional unit of a good adds less to utility than the previous unit.

Junk food has been criticized for being unhealthy and too cheap, enticing the poor to adopt unhealthy lifestyles. Suppose that the state of Oklakansas imposes a tax on junk food. For the tax to actually deter people from eating junk food, should junk food demand be elastic or inelastic?

Elastic

Let's take a look at the supply side of junk food. If junk food supply is highly elastic—perhaps because it's not that hard to start selling salads with lowfat dressing instead of mayonnaise- and cheese-laden burgers—will a junk food tax have a bigger effect if supply were inelastic or elastic?

Elastic

Decades ago, Washington, DC, a fairly small city, wanted to raise more revenue by increasing the gas tax. Washington, DC, shares borders with Maryland and Virginia, and it's very easy to cross the borders between these states. How elastic is the demand for gasoline sold at stations within Washington, DC? In other words, if the price of gas in DC rises, but the price in Maryland and Virginia stays the same, will gasoline sales at DC stations fall a little, or will they fall a lot?

Elastic - gasoline sales would fall a lot

If a government is hoping that a small tax can actually discourage a lot of junk food purchases, it should hope for

Elastic supply and elastic demand

suppose new farming techniques drastically increased the productivity of growing wheat. Given this change, how would the price of wheat change?

Fall, because supply would shift to the right.

Fill in the blanks: As long as supply and demand curves have their normal shape (the demand curve has a negative slope while supply curves have appositive slope), if there is a tax, the equilibrium quantity must _______ and the price that sellers receive must _______.

Fall; fall

Fill in the blanks: As long as supply and demand curves have their normal shape (the demand curves have a negative slope while supply curves have a positive slope), if there is a tax, the equilibrium quantity must _______ and the price that buyers pay must _______.

Fall; rise

In the opening scene of the classic Eddie Murphy comedy Beverly Hills Cop, Axel Foley, a Detroit police officer, is stopping a cigarette smuggling ring. Of course, smugglers don't pay the tax when the cigarettes cross state lines. Which way do you suspect the smugglers were moving the cigarettes, based on economic theory?

From the low-cost South to the high-tax North.

Risk-Return Trade-Off

Higher returns come at the price of higher risk.

One question that economics students often ask is "In a market with a lot of buyers and sellers, who sets the price of the good?" There are two possible correct answers to this question: "Everyone" and "No one." a. What is meant by "Everyone?"

In a market with many participants, each person's actions push the supply or the demand just a little bit, so everyone has some small influence.

Given your answer to the previous question, what would happen to the price of paper?

Increase, because demand would shift to the right.

How would the price of cookbooks specializing in recipes using wheat flour change?

Increase, because demand would shift to the right.

If the Oklakansas government wants to strongly discourage people from eating junk food, when will it need to set a higher tax rate: When junk food demand is elastic or when it is inelastic?

Inelastic

What does it mean that elasticity equals escape? (This is worth remembering: Elasticity is one of the toughest ideas for most economics students.)

It is easy for market participants to escape to another market if they have elastic demand or supply

One way governments have tried to collect taxes from the wealthy is through the use of luxury taxes, which are exactly what they sound like: taxes on goods that are considered luxuries, like jewelry or expensive cars and real estate. What is true about the demand for luxuries?

It is elastic

Circa 1200 BCE, a decreasing supply of tin due to wars and the breakdown of trade led to a drastic increase in the price of bronze in the Middle East and Greece (tin being necessary for its production). It is around this time that blacksmiths developed iron- and steel-making techniques (as substitutes for bronze). What does the increasing price of bronze signal

It tells people that bronze is getting harder to find and its higher price will signal consumers to conserve it more or seek substitutes.

Suppose that Maria is willing to pay $40 for a haircut, and her stylist Juan is willing to accept as little as $25 for a haircut. If the state where Maria and Juan live instituted a tax on services that included a $5 per haircut tax on stylists and barbers, what will happen to the $15 of economic benefit?

It will stay the same

The process of market creation is most similar to the creation of a country's

Language

Marginal utility per dollar spent formula

MU/P

Total utility will be maximized if

MUa/P=MUb/P

Suppose that Maria is willing to pay $40 for a haircut, and her stylist Juan is willing to accept as little as $25 for a haircut. If a previous $5 tax increases to $20, will the haircut transaction still happen?

No

What is meant by "No one?"

Nobody actually plans for a given price to be the equilibrium price.

Some people with diabetes absolutely need to take insulin on a regular basis to survive. Pharmaceutical companies that make insulin could find a lot of other ways to make some money. If the U.S. government imposes a tax on insulin producers of $10 per cubic centimeter of insulin, payable every month to the U.S. Treasury, who will bear most of the burden of the tax?

People with diabetes

Suppose instead that because of government corruption, the insulin manufacturers convince the U.S. government to pay the insulin makers $10 per cubic centimeter of insulin, payable every month from the U.S. Treasury. Who will get most of the benefit of this subsidy?

People with diabetes

central planning

Problems of information and incentives.

Speculation

The attempt to profit from future price changes.

Losing Your Ticket (Income and Substitution Effects)

Should you buy another ticket? • The relative price of the ticket hasn't changed. •If the ticket cost very little, the income effect is small; most people will buy another ticket. •If the ticket cost a lot, the income effect is larger; people will be less willing to buy another ticket. • The income effect will be greater on poorer people.

Budget Constraint

Shows all the consumption bundles a consumer can afford, given their income and prices.

Passive funds

Simply try to mimic a broad stock market index, such as S&P

Diversification

Spreading out investments to reduce risk

Futures

Standardized contracts to buy or sell specified quantities of a commodity or financial instrument at a specified price, with delivery set at a specified time in the future

Costs of Stock Markets

Stock markets (and other asset markets) can encourage speculative bubbles. • Stock prices rise far higher, and more rapidly, than the fundamental prospects of the company. • Capital is invested in areas in which it is not very valuable. •When the bubble crashes, lower prices mean people feel poorer and spend less. •Workers must move from one sector to another, creating labor adjustment costs.

Suppose you learned that growing political instability in Chile (the largest producer of copper) will greatly reduce the productivity of its mines in two years. Ignoring all other factors, which curve (demand or supply) will shift which way in the market for copper two years from now?

Supply curve will decrease, that is, a shift to the left (up).

Laptop and desktop computers are substitutes. Now that the price of laptops has changed, what does this do to the demand for desktop computers

The demand for desktops decreases.

The competitive market equilibrium maximizes gains from trade. Taxes and subsidies, by altering the market outcome, reduce the gains from trade. Does this happen primarily because of the impact of taxes and subsidies on prices, or the impact of taxes and subsidies on quantities?

The impact on quantities

Optimization and Consumer Choices (part 1)

The optimal consumption bundle is on the highest indifference curve but still on the budget constraint. •At this bundle, the slope of the indifference curve (MRS) is equal to the slope of the budget constraint (Ppizza / Pgas): MRS=Ppizza/Pgasoline

In our discussion of taxation, we've acted as if it were effortless to pass and enforce tax laws. But, of course, law enforcement officials including the Internal Revenue Service put a lot of effort into enforcing tax laws. Let's think for a moment about what kind of taxes are easiest to collect, just based on the basic ideas we've covered. Who will make the most effort to escape a tax?

The party who is inelastic

Let's apply the economics of taxation to romantic relationships. Sometimes relationships have taxes. Suppose that you and your boyfriend or girlfriend live one hour apart. Using the tools developed in the chapter, how can you predict which one of you will do most of the driving? That is, which one of you will bear the majority of the relationship tax?

The person with more inelastic demand for the relationship will bear the tax - he or she will do most of the driving.

Let's see if the forces of the market can be as efficient as a benevolent dictator. Since laptop computers are increasingly easy to build and since they allow people to use their computers wherever they like, an all-wise benevolent dictator would probably decree that most people buy laptops rather than desktop computers. This is especially true now that laptops are about as powerful as most desktops. Since it's become much easier to build better laptop computers in recent years, laptop supply has increased. What does this do to the price of laptops?

The price of laptops decreases

Will the price rise or fall as a result of this curve shift?

The price will rise.

Marginal Rate of Substitution

The rate at which the consumer is willing to trade one good for another and remain indifferent.

Consider jewelry. Is a luxury tax more likely to hurt the buyers of jewelry, or the sellers of jewelry?

The sellers

Corporate Culture

The shared collection of values and norms that govern how people interact in an organization

How does the change in desktop demand affect the quantity supplied of desktop computers?

The supply of desktops decreases.

Once it became easier to build good laptops, did "invisible hand" forces push more of society's resources into making laptop and push resources away from making desktops?

Yes

Optimal Consumption Rule

To maximize utility, a consumer should allocate spending so that the marginal utility per dollar is equal for all purchases

Commodity Taxes

With no tax, consumer plus producer surplus is maximized. •With tax, consumer plus producer surplus is smaller and tax revenues are larger. •But tax revenues increase by less than the decrease in producer and consumer surplus. • This creates a deadweight loss—lost gains from trades that do not occur. •Results in reduced gains from trade.

buy and hold

an investment strategy that involves simply buying stock and holding it for a period of years

Active funds

are run by managers who try to pick stocks

Fill in the blanks: When the government taxes an activity, resources such as labor, machines, and bank lending will tend to gravitate _________the activity that is taxed and will tend to gravitate ________ activity that is not taxed.

away from; toward

Technical analysis

is an approach that looks for patterns in stock and asset prices

Who ultimately pays a tax

is determined by the relative elasticities of supply and demand.

Mutual funds

pool money from many customers and invest it in many firms, in return for a fee.

MRS

the slope of the indifference curve

Efficient Markets Hypothesis

the theory that asset prices reflect all publicly available information about the value of an asset

Great Economic Problem

to arrange our scarce resources to satisfy as many of our wants as possible

Fill in the blanks: When the government subsidizes an activity, resources such as labor, machines, and bank lending will tend to gravitate __________ the activity that is subsidized and will tend to gravitate ___________ activity that is not subsidized

toward; away from

Price of Costco Membership (Income and Substitution Effects)

• Costco offers low prices but requires an annual membership fee. • Lower prices move customers to a higher indifference curve. • Paying a membership fee is equivalent to shifting the new budget line back. • The maximum fee a customer will be willing to pay is the amount that would shift the new budget line back to the old indifference curve.

price system

• Each user of oil compares the value in their use with the value in alternative uses .• Each user has an incentive to give up the oil if it has a lower value in their use.

Beating the Market

• For every buyer, there is a seller. • Can't get rich by buying and selling on public information. •Unless an investor is trading on inside information, he or she will not systematically outperform the market. •Insider information quickly becomes public, and opportunities for profit evaporate

Futures Markets

• Futures allow people to speculate without accepting or delivering the goods. • Futures markets are also used to reduce risk. • Airlines can lock in fuel costs by buying oil on the futures market. • Farmers can agree to sell crops at harvest time at a price agreed on today. • Firms can avoid exchange rate risk by buying or selling currency futures

Signal Watching

• Futures prices can be very informative about future events. • Economist Richard Roll found the futures price of orange juice could be used to improve the predictions of the weather service. •Many factors affect futures prices, so they are a noisy signal.

Signal Wrapped in an Incentive

• Prices are incentives, signals, and predictions. •When a price rises, buyers are encouraged to use less or substitute. •It is also a signal to suppliers to provide more. • Price signals and the accompanying profits and losses tell entrepreneurs what areas of the economy consumers want expanded and what areas they want contracted.

Markets Link to One Another

• Shifts in supply and demand in one market ripple across the worldwide market. • Entrepreneurs are constantly looking for ways to lower costs. • These cost-cutting measures link markets that seem like they are a world away.

Nudges

• Small changes in how a choice is presented, or "framed," can matter a great deal. • Supermarkets know that 80% lean beef sells better than 20% fat beef. • Planning where, when, and how choices are made is sometimes called "choice architecture." • Sometimes nudging is considered a form of manipulation. • Small changes or "nudges" can improve decisions.

Benefits of Stock Markets

• Stock markets have uses beyond investment. •New stock and bond issues are an important means of raising capital for capital investment. •A well-functioning stock market helps companies get going or expand. •Market prices give the public a daily report on how well a company is run. • Stock markets are a way of transferring company control from less competent people to more competent people.

Elasticity of Supply (tax)

• The deadweight loss from taxation is lower the less elastic the supply curve is. •If supply is elastic, a tax deters many trades. •If supply is inelastic, there is little deterrence and thus fewer lost gains from trade.

The Demand Curve (Marginal Utility)

• The optimal consumption rule provides a foundation for demand curves. •An increase in price (PA ) means apples (A) now provide less utility per dollar: MUa/pa is greater then MUo/Po the consumer will buy fewer apples and more oranges. •When price increases, consumers buy less; this is consistent with a downward-sloping demand curve.M

No-Free-Lunch Principle

• There is a systematic trade-off between return and risk. • To get higher returns, you need to bear higher risk. • The expected returns on different assets, adjusted for risk, should be equal. •Assets that provide additional enjoyment (art, real estate) generally underperform the stock market.

Solving the Great Economic Problem

•A buyer compares the value of the good to its opportunity cost (market price). •Because markets are linked, the price reflects information about many other markets. • The market collapses all relevant information into a single number—the price. • The buyer is deciding whether their use is more valuable than the billions of other uses that are presently unsatisfied.

Optimization and Consumer Choice (part 2)

•A change in price causes consumers to change their consumption bundle. •A drop in the price of one good can cause an increase in the consumption of both goods. • This is because a change in price has two effects: • the income effect, and • the substitution effect

Subsidies

•A subsidy creates a deadweight loss because some nonbeneficial trades occur. • The supply curve tells us the cost of producing. • The demand curve tells us the value to buyers. • Producing goods for which the cost exceeds the value creates waste. •Whoever bears the burden of a tax receives the benefit of a subsidy.

Wage Subsidy

•A subsidy might be beneficial if it increased something of importance. • Edmund Phelps suggested wage subsidies to increase employment of low-wage workers. •Offsetting benefits include: • Lower welfare payments • Reduced crime • Reduced drug dependency • Reduced culture of rational defeatism

Tax Wedge

•A tax drives a tax wedge between the price paid by buyers and the price received by sellers. • We can use the tax wedge to simplify our analysis.

tournament risks

•A tournament insulates rewards from environment risk due to outside factors that are common to all the players. •It adds ability risk; someone else's ability is not under a player's control. • Tournaments work best when environment risk is more important than ability risk . • They can be structured to reduce ability risk. • Tournaments can discourage cooperation.

Labor Supply (Income and Substitution Effects)

•A worker's response to a change in wages also depends on the income and substitution effects. • Income effect (IE): when the wage (income) falls, the demand for normal goods (including leisure) also falls. • Substitution effect (SE): when the wage falls, workers substitute work for leisure. •If IE > SE: ↓wage → ↓leisure, ↑ work •If IE < SE: ↓wage → ↑leisure, ↓ work

Tournament theory

•One way to tie rewards more closely to what a worker controls is pay based on relative performance. • Since every worker faces the same conditions, factors that a worker doesn't control no longer influence rewards. 22-12 ▪ Factors a worker does control (like effort) become more important.

Elasticity of tax wedge

•We can use the wedge shortcut to show that who pays a tax is determined by the relative elasticities of demand and supply. • Elasticity measures how responsive quantities demanded (or supplied) are to price changes. •When demand is more elastic than supply, demanders pay less of the tax than sellers. •When supply is more elastic than demand, suppliers pay less of the tax than buyers.