Econ Final Exam

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Entrepreneurship

Entrepreneurship refers to the risk-taking behavior of individuals who are willing to try to come up with new and better products and/or production methods.

Fixed Cost (FC)

Fixed cost refers to the amount a producer has to pay for fixed inputs, inputs that cannot be varied when more or less is produced. Because fixed inputs cannot be varied, the cost of these inputs also does not vary; these costs are fixed and cannot be increased or decreased.

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.

Market Failure

Market failure is said to occur whenever the market fails to give us the most economically efficient use of resources. In this case, the market outcome fails to give us the greatest economic surplus for society. Some reasons for market failure include imperfect market information, externalities and imperfect market competition.

Market Supply

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

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.

Technology

Technology refers to the manner in which inputs can be combined to produce goods and services. Electricity, mass communication methods, improving computer technology and the internet have all been improvements in technology that have made countries better able to produce goods and services; a shift out of the production possibilities frontier.

Consumption Possibilities Frontier (CPF)

The Consumption Possibilities Frontier refers to the line or curve on a graph that represents all the possible maximum combinations of goods and services that a country can consume. If a country remains self-sufficient, its CPF is identical to its Production Possibilities Frontier (PPF). If a country specializes in its comparative advantage and trades with other countries doing the same, the country's CPF will be able to exceed its PPF.

Explicit Costs

The explicit costs of production are those costs that involve actual dollars lost to the producer, either through direct payment to workers, suppliers, the government and so on or through the loss of value (depreciation) of property/equipment used in the production process.

Substitution 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.

Land

When we refer to a country's land resource we are referring not only to the physical space but also to the resources that come from the land: water, timber, metals, minerals and energy.

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.

Teamwork and Specialization

A firm is experiencing the benefits of teamwork and specialization if by hiring more workers those workers are able to divide up the jobs and get increased efficiency so that the marginal productivity of labor rises.

Fixed Input

A fixed input is used to produce a product but cannot be changed in size or quantity regardless of the level of production; the same amount of this input is used regardless of the production level.

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.

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.

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.

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.

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.

Complement

Complementary goods are goods that are used together. In this case, when the price of one good rises, it causes a reduction in the demand of the other good. Examples of complementary goods may include beer and pretzels, peanut butter and jelly, cars and gasoline, and paper and pens.

Price Floor

This is a legally set minimum price for the market.

Pigovian Taxes/Subsidies

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 Demand

A change in demand is said to occur when a consumer's entire demand for a product rises (shifts right) or falls (shifts left) as a result of a change in some variable other than the price of the product. Variables that can change and cause a change in demand include income, price of related products, and taste for the product. A change in demand is not the same as a change in the quantity demanded.

Change in the 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.

Change in the 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.

Change in Supply

A change in supply is said to occur when a producer's entire supply of a product rises (shifts right) or falls (shifts left) as a result of a change in some variable other than the price of the product. Variables that can change and cause a change in supply include wages, tax rates, and government regulations. A change in supply is not the same as a change in the quantity supplied.

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?

Absolute Advantage

A country is said to have the absolute advantage in the production of a good or service if that country can produce a larger number of units of that good or service than can another country, using equivalent amounts of resources and technology. For example, if country A can produce 1000 cars per month with 20 workers and country be can produce 1200 cars per month with 20 workers, then country B would be said to have the absolute advantage in car production.

Comparative Advantage

A country is said to have the comparative advantage in the production of a good or service if that country can produce a unit of that good or service at a lower opportunity cost. For example, if country A can produce an additional car by moving resources away from bike production and this means a sacrifice of 200 bikes while country B can produce an additional car by moving resources away from bike production and this means a sacrifice of 300 bikes, then country A would be said to have the comparative advantage in car production because it has the lower opportunity cost of producing cars.

Labor

A country's labor input refers to its workers and the skills and knowledge (human capital) possessed by its workers.

Perfectly Price Elastic

A good is said to be perfectly price elastic if consumers or producers are infinitely responsive to price changes. Consumers are perfectly price elastic if quantity demanded changes by an infinite amount when price changes and producers are perfectly price elastic if quantity supplied changes by an infinite amount when price changes. The demand and supply curves will be horizontal if demand and supply are perfectly price elastic.

Perfectly Price Inelastic

A good is said to be perfectly price inelastic if consumers or producers are not at all responsive to price changes. Consumers are perfectly price inelastic if quantity demanded does not change at all when price changes and producers are perfectly price inelastic if quantity supplied does not change at all when price changes. The demand and supply curves will be vertical if demand and supply are perfectly price inelastic.

Price Elastic

A good is said to be price elastic if consumers or producers are very responsive to price changes. Consumers are price elastic if quantity demanded changes more than price changes and producers are price elastic if quantity supplied changes more than price changes.

Price Inelastic

A good is said to be price inelastic if consumers or producers are not very responsive to price changes. Consumers are price inelastic if quantity demanded changes less than price changes and producers are price inelastic if quantity supplied changes less than price changes.

Duopoly

A market is said to be duopolistic if there are only two producers of a product. This is a special case of oligopoly.

Imperfect Competition

A market is said to be imperfectly competitive if it is neither perfectly competitive nor monopolistic. Imperfectly competitive markets that are closer to the perfect competition extreme are called monopolistic competition and imperfectly competitive markets that are closer to the monopoly extreme are called oligopolistic.

Monopoly

A market is said to be monopolistic if there is only one large producer of a product with no good substitutes and where there are insurmountable barriers to entry,

Monopolistic Competition

A market is said to be monopolistically competitive when it is imperfectly competitive but is closer to the perfect competition extreme than to the monopoly extreme. A monopolistically competitive market has a fairly large number of fairly small firms producing a similar product with few barriers to entry.

Oligopoly

A market is said to be oligopolistic when it is imperfectly competitive but is closer to the monopoly extreme than to the perfect competition extreme. An oligopolistic market has a fairly small number of fairly large firms producing a similar product with significant barriers to entry.

Perfect Competition

A market is said to be perfectly competitive if no single firm has any individual control over the market price. This will only happen if there is a very large number of very small firms each producing a product that is identical in the eyes of consumers and where there are no barriers to entry or exit.

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.

Market Shock

A market shock is said to hit a market whenever something causes a change in market demand (either increase or decrease) and/or causes a change in market supply (either increase or decrease). Market shocks generally cause changes in the market equilibrium price and quantity bought and sold.

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.

Natural Monopoly

A natural monopoly exists whenever the production process involves such large fixed costs and small variable/marginal costs that the market can only support one producer. Production by one single producer allows the cost of production to be divided among a very large production level, bringing the break-even price down.

Average Cost Pricing Regulation

A natural monopoly is allowed to operate as a monopolist but may be regulated by governmental authorities to prevent the charging of monopoly prices. A monopolist subject to average cost pricing regulation is allowed to charge no more than its average total cost of production (ATC).

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.

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."

Binding Price Ceiling

A price ceiling is a legally imposed highest price that can be charged for a product. This price ceiling is binding if it is set below the market equilibrium price because this will keep the price from getting to equilibrium and will cause changes in the quantity buyers and/or sellers wish to buy and sell.

Binding Price Floor

A price floor is a legally imposed lowest price that can be charged for a product. This price floor is binding if it is set above the market equilibrium price because this will keep the price from getting to equilibrium and will cause changes in the quantity buyers and/or sellers wish to buy and sell.

Price Maker

A producer is said to be a price maker if it has some control over the market price. It will not have to simply charge the market equilibrium price.

Price Taker

A producer is said to be a price taker if it has no control over the market price. It will have to simply take the market equilibrium price.

Below Normal Rate of Return

A producer is said to be earning a below normal rate of return if that producer is earning a negative economic profit; the producer is earning an economic loss. This will mean that the producer is earning less accounting profit at this venture than he/she could earn at his/her next best opportunity.

Normal Rate of Return

A producer is said to be earning a normal rate of return if that producer is earning a zero economic profit. This will mean that the producer is earning exactly as much accounting profit at this venture as he/she could earn at his/her next best opportunity.

Above Normal Rate of Return

A producer is said to be earning an above normal rate of return if that producer is earning a positive economic profit. This will mean that the producer is earning more accounting profit at this venture than he/she could earn at his/her next best opportunity.

Long-Run Production Decision

A producer is said to be in the long-run when it is making production decisions that involve only variable inputs.

Short-Run Production Decision

A producer is said to be in the short-run when it is making production decisions that involve at least one fixed input.

Accounting Profit

A producer's accounting profit is the difference between the revenue earned by the producer when selling his/her product and the accounting costs incurred in producing that product. Accounting profit is the payment to the producer him- or herself; it is the money remaining to the producer from the revenue earned after paying all the other production expenses. Accounting profit measures the financial viability of the production process.

Economic Profit

A producer's economic profit is the difference between the revenue earned by the producer when selling his/her product and the economic costs incurred in producing that product. Economic profit measures the economic efficiency of the production process.

Subsidy

A subsidy occurs when someone (usually the government) provides a buyer or a seller with a payment when a product is bought and sold. For example, if the government wishes to encourage the purchase of hybrid vehicles, it might pay hybrid car buyers $1000 when the buyer purchases a hybrid vehicle from a car seller.

Tax

A tax occurs when someone (usually the government) makes a buyer or a seller pay additional money to it when a product is bought and sold. For example, car drivers pay a tax to the government whenever they purchase gasoline at a gas station.

Tax Wedge

A tax wedge occurs when the government imposes a tax on a market, forcing the buyer's price (the money coming directly from the buyer's pocket) to differ from the seller's price (the money going directly into the seller's pocket). The tax wedge is equal to the amount of the tax per unit.

Variable Inputs

A variable input is an input (labor, supplies, utilities, etc.) that is used to produce a product where more can be used if the producer wants to produce more and less can be used if the producer wants to produce less.

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.

Capital

Capital refers to things that are man-made (such as machinery, tools, and factories) that can then be used to help produce more goods and services.

Ceteris Paribus

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

Depreciation

Depreciation refers to the loss of value a piece of property/equipment incurs while being used in the production process. If you buy a machine at the beginning of the year for $10,000 and can sell it for no more than $8,000 at the end of the year, then it has lost $2,000 of its value over the year; it has depreciated by $2,000.

Economic Efficiency

Economic efficiency occurs when resources are used in their best use for society. This means they are used in a way that gets the most economic surplus for society. Sometimes we refer to this as maximizing the size of the economic pie. This also means we are producing efficiently (not wasting any resources when we produce) and consuming efficiently (sending our produced goods and services to those consumers who value them the most).

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.)

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.

Human Capital

Human capital refers to the skills and knowledge workers possess. These skills and knowledge help the worker to be more productive. As such, human capital is part of a country's bundle of production resources and a country can increase its ability to produce goods and services (shift out its production possibilities frontier) by providing more education and training to its workers.

Resources Identical in Production

If a country's resources are identical in production there are no specialists. This would mean that everyone in the country is equally skilled at surgery, equally skilled at book-keeping, equally skilled at dancing, and so on. This would give rise to a straight-line production possibilities frontier with a constant opportunity cost.

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.

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.)

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.

Interest

Interest is the payment someone with money earns when that money is loaned out to another and the payment someone makes when that money is borrowed.

Labor Force

Labor force refers to the number of individuals in a country who are counted as both willing and able to work, regardless of whether they are currently working. This means the worker must be eligible to work (at least 16 years of age, not institutionalized, and legally in the country) and willing to work (either currently working or actively seeking employment). A university student with part-time employment would be considered part of the labor force, a university student without employment but actively seeking employment would be considered part of the labor force, but a university student without employment and not seeking employment would not be considered part of the labor force.

Marginal Cost (MC)

Marginal cost refers to the change in the cost of production that a producer incurs when he/she marginally increases or decreases production level. Marginal cost involves the change in the total cost of production divided by the change in the level of production (MC=∆TC/∆Q). Because fixed cost of production never changes, then the only reason cost of production changes is because variable cost changes. For this reason, we can also calculate marginal cost by dividing the change in variable cost of production by the change in the level of production (MC=∆VC/∆Q).

Marginal Revenue (MR)

Marginal revenue refers to the change in the amount of revenue that a producer earns when he/she marginally increases or decreases production level. Marginal revenue involves the change in total revenue earned divided by the change in the level of production (MR=∆TR/∆Q).

Market Demand

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

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.

Price Discrimination

Price discrimination occurs when a producer is able to charge more than one price for its product; charging different prices to different consumers by setting the price charged according to each consumer's personal willingness-to-pay or reservation price.

Collusion

Producers are said to be colluding when they act together to eliminate or reduce the competition that exists between them. This is done to increase the selling price of their products and increase firm profits. Collusion between producers is generally illegal in the United States.

Ration

Products need to be rationed because our limited resources mean we cannot produce enough goods and services for everyone, so we need to figure out a way to determine who will get those things that are produced. Rationing is figuring out who will get these limited products. In the free market system the market uses price to ration.

Rent-Control Policy

Rent control policies are a form of price ceiling. They are imposed by governments to keep down the price of housing.

Resource Misallocation (RM)

Resource misallocation occurs when resources do not get used in their best place. This means these resources are not being used in a way to produce the most economic surplus for society.

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.

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.

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.

Fair Labor Standards Act (FLSA)

The Fair Labor Standards Act (FSLA) was passed by the U.S. Congress during the Great Depression. This legislation established the first national minimum work age (16 years; with some exceptions), overtime pay for more than 40 hours of work per week for wage workers, and a minimum wage for many workers. This legislation, with amendments added over the intervening years, is still in effect. Amendments have increased the number of workers covered by the minimum wage rules and have increased the minimum wage level.

Production Possibilities Frontier (PPF)

The Production Possibilities Frontier refers to the line or curve on a graph that represents all the possible maximum combinations of goods and services that a country can produce given its current set of resources and technology. To produce on the PPF means a country is using all available resources and technology and is making no production mistakes; this means it is producing at maximum economic efficiency.

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.

Absolute Value

The absolute value of a number is essentially just the number without a sign. For example, the absolute value of 2 is written as |2| and is equal to 2 while the absolute value of -2 is written as |-2| and is equal to 2.

Average Fixed Cost (AFC)

The average fixed cost of producing a product refers to the share of fixed cost that can be attributed to each unit of production. Average fixed cost equals fixed cost divided by the number of units produced.

Average Productivity of Labor (APL)

The average productivity of labor refers to the amount of output produced by a worker on average. It can be found by dividing the total amount produced by the number of workers hired (APL=Q/L).

Average Total Cost (ATC)

The average total cost of producing a product refers to the share of total cost that can be attributed to each unit of production. Average total cost equals total cost divided by the number of units produced. It can also be calculated by adding average fixed cost to average variable cost (ATC=AFC+AVC).

Average Variable Cost (AVC)

The average variable cost of producing a product refers to the share of variable cost that can be attributed to each unit of production. Average variable cost equals variable cost divided by the number of units produced.

Cross-Price Elasticity of Demand

The cross-price elasticity of demand measures the relationship between two goods or services. It the two goods are complements, the cross-price of elasticity will be negative and if the two goods are substitutes, the cross-price of elasticity will be positive. If there is a strong relationship between the two goods, the cross-price of elasticity will be a large number in absolute value and if there is only a weak relationship between the two goods, the cross-price of elasticity will be a small number in absolute value.

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.

Implicit Costs

The implicit costs of production are those costs that are not actually dollars paid by the producer or lost through depreciation of property/equipment but are simply dollars that the producer lost the opportunity to earn because of the production process. Implicit costs are generally incurred as a result of the producer using his/her own personal resources in the production process and would most typically include lost earnings, lost interest and lost rent.

Income Elasticity of Demand

The income elasticity of demand measures the impact of a consumer's income on his or her demand for a product. If the product is a normal good, the income elasticity of demand will be a positive number; if the product is an inferior good, the income elasticity of demand will be a negative number. If income has a strong impact on the consumer's demand for the product, the income elasticity of demand will be a large number in absolute value; if income has a weak impact on the consumer's demand for the product, the income elasticity of demand will be a small number in absolute value.

Marginal Productivity of Labor (MPL)

The marginal productivity of labor refers to the increase in production a producer will experience when it hires a marginal unit of labor (MPL=∆Q/∆L).

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.

Point-Slope Formula

The point-slope formula is a form of the price elasticity of demand equation that allows us to find the price elasticity of demand at any particular price/quantity point on the demand curve and a form of the price elasticity of supply equation that allows us to find the price elasticity of supply at any particular price/quantity point on the supply curve.

Price Elasticity of Demand

The price elasticity of demand measures how responsive consumers of a particular good or service are to changes in the price of that same good or service. The price elasticity of demand is always negative because of the negative relationship between price and quantity demanded. When consumers are very responsive to price changes, the price elasticity of demand will be a large number in absolute value; when consumers are not very responsive to price changes, the price elasticity of demand will be a small number in absolute value.

Price Elasticity of Supply

The price elasticity of supply measures the change in the quantity that producers will choose to supply when there is a change in the price that producers can receive for selling their product

Short-Run Production Function

The short-run production function illustrates the relationship between the amount of variable labor input used by a producer and the amount of output that can be generated by that input.

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.

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.

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).

Normal Good

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

Inputs to Production

These are the things used to produce goods and services. Examples would include workers (labor), machinery and tools (capital), a location, timber, steel, fuel (land) and the ideas and risk taking of individuals who start businesses and come up with new product ideas (entrepreneurs).

Goods

These are things that are produced by an economy that can be physically touched. Examples of goods would be cars, TVs, MP3 players, airplanes, apples, bread, books, shoes, and so on.

Services

These are things that are produced by an economy that cannot be physically touched. Examples of services would be care provided by a doctor, actors performing a play for an audience, book keeping provided for a business by an accountant, and so on.

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.

Price Ceiling

This is a legally set maximum price for the market.

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.

Positive Sum Game

This is terminology from the field of game theory. It refers to any kind of strategic bargaining situation where all 'players' in the game can be made better off. This would be because some outcomes have a greater total payoff so if players can negotiate to get to that outcome, they can all be made better off. The production possibilities frontier model shows that specialization and free trade is a positive sum game where all countries can be made better off relative to where they would be without free trade.

Zero Sum Game

This is terminology from the field of game theory. It refers to any kind of strategic bargaining situation where there is a fixed amount of payoff. This means that the only way one 'player' can be made better off is for at least one other 'player' to be made worse off. Many opponents of free trade may think of free trade, at least at the international level, as a zero-sum game.

Consumer Surplus (CS)

This is the amount of economic surplus earned by buyers when they purchase and consume a product. This is the difference between the buyer's reservation price and the price the consumer actually pays.

Producer Surplus (PS)

This is the amount of economic surplus earned by sellers when they produce and sell a product. This is the difference between the price received by the seller for the product and the seller's reservation price.

Buyer's Price (Pb)

This is the amount of money that comes directly from the buyer's pocket. This price is generally the same as the seller's price, although the two prices will differ if the government imposes taxes or subsidies on the market.

Seller's Price (Ps)

This is the amount of money that goes directly into the seller's pocket. This price is generally the same as the buyer's price, although the two prices will differ if the government imposes taxes or subsidies on the market.

Consumer's Reservation Price

This is the highest price a consumer is willing to pay for a product.

Producer's Reservation Price

This is the lowest price a seller is willing to accept for the production and sale of a product.

Deadweight Loss (DWL)

This is the reduction in economic surplus that results from the misallocation of resources.

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.

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.

Accounting Cost

To calculate profit, an accountant only considers the explicit costs of production. For this reason, we sometimes refer to the sum of the explicit costs as the accounting cost of production.

Economic Cost

To calculate profit, an economist considers all opportunity costs of production, both the explicit costs and the implicit costs. For this reason, we sometimes refer to the sum of the explicit costs and the implicit costs as the economic cost of production.

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.

Total Cost (TC)

Total cost refers to the amount a producer has to pay for all inputs, both those that are fixed as well as those that are variable (TC=FC+VC).

Total Revenue (TR)

Total revenue refers to the full amount a producer is able to earn when he/she produces and sells a product. This revenue will depend on the price charged per unit sold and the number of units sold [TR=(Price Charged) x(Quantity Sold)].

Variable Cost (VC)

Variable cost refers to the amount a producer has to pay for variable inputs, inputs that can be varied when more or less is produced. Because variable inputs can be varied, the cost of these inputs also varies; a producer uses fewer or these inputs and pays less variable cost when he/she chooses a low level of production and a producer uses more of these inputs and pays more variable cost when he/she chooses a higher level of production.

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.

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.

Crowding of Fixed Inputs

When a producer reaches a production level where there are too many variable inputs (usually labor) assigned to too few fixed inputs the marginal productivity of labor will begin to fall; we say the producer is experiencing crowding of his/her fixed inputs.

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.


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