Econ for Public Decision-making

John Meynard Keynes

"The long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again."

(1) Elastic Supply & Inelastic Demand. If the supply curve is elastic but the demand curve is inelastic, which party bears the heavier burden of taxation? Buyers or sellers? (2) Inelastic Supply & Elastic Demand. What if it was the other way around? Which party bears more burden if the supply curve is inelastic while the demand curve is elastic? Hint: Elastic = Flat'ish Inelastic = Vertical'ish

(1) Elastic Supply & Inelastic Demand: The price received by sellers falls only slightly while the price paid by buyers rises substantially. Thus, buyers bear most of the burden of tax (Book). (2) Inelastic Supply & Elastic Demand: The sellers suffer more burden of the taxation. In short, the *more inelastic party suffers more*.

What are two reasons a nation can never attain full employment?

*Frictional Unemployment* always exists because people are always changing jobs. These include changes in the economy and the sectorial transitions among composition of industries meeting demands. *Structural Unemployment* results from the fundamental mismatch in the economy, often an outcome of market failures.

Equation used to calculate the national income is called ________, and what is it used for?

*Keynesian Economics* explains the aggregate demand in the short-run macroeconomy. Y = C + I + G + NX

What do you call a market with only one purchaser? And, why is this considered a market failure?

*Monopsony* drives the market value down from the optimal point.

Give an example of *Rational People Think at the Margin*. - 10 Principles of Economics

*Rational people* do the best to save the most money by comparing costs and benefits at the *margin*. For example: Assume that an average airline seat costs $500. If there are ten unsold seats one-hour before take-off, it is rational to sell the empty seats for whatever price offered since the marginal cost is merely the cost of one bag of peanuts and a can of soda. *Marginal change* means that there are small, incremental adjustments to an existing plan of action (Book).

What are the three ways a monopoly can arise? Give an example of each.

- *Governments can create* by giving a single firm the exclusive right to produce some good or service (Book). Prime examples include water, electricity, and transportation. Other examples include patent laws. The laws governing patents have benefits and costs. The benefits of the patent and copyright laws are the increased incentives for innovation while the benefits are offset by the costs of monopoly pricing (Book). - *Natural monopoly* occurs when one producer can produce at a lower cost than other producers. Because of the high fixed cost but a low profit, investment does not make sense. - *Resources* like diamonds owned by DeBeers make up 80% of the world's diamond mines (Book).

Name four solutions to solve the monopoly problem.

- *Price discrimination* - *Anti-trust laws* prevent mergers between two powerful companies. - *Regulate monopoly prices or behavior* of certain goods such as water and electricity, which the goods are inelastic. - *Public ownership of monopoly*: Government can run the monopoly itself. This solution is common in many European countries, where the government owns and operates utilities such as telephone, water, and electric companies. In the United States, the govern- ment runs the Postal Service (Book).

According to the Classical Model of Macroeconomics, inflation can hurt the economy. Why is that? Name as many reasons as you can.

- *Shoeleather costs*: When hyperinflation hits, cash value decreases by the minute, so people want to convert cash into real goods. So, people make more trips to the bank. The term was coined before the invention of the internet. - *Menu costs* increase transactional costs because it costs money to change menus. - *Relative price variability* occurs when prices adjust over different time periods, leading to misallocation of resources - *Tax distortions* occur because we tax in nominal values - *Confusion* occurs because people think in nominal dollars. - *Arbitrary redistribution of wealth* happens because terms of loans are set in place prior to inflations. For example, if you have student loans, then hyperinflation is good because you can pay off student loans in no time. However, this may prevent banks from handing out future loans, which may be required for many business transactions and home purchases, consequently disrupting the fluidity of economic trends. - Hyperinflation spiral

What factors determine the Demand Elasticity?

- Availability of a close substitute (You purchase Ford if Chevy has no rebate). - "Necessity" v. "Luxury" nature of good (Water is a necessary good, whereas humans can live without blood-washed slavery inducing diamonds). - Time Horizon (Generally, goods are more elastic over longer time period). - Elasticity can vary at different points on a demand curve.

Name four instances we talked about in class that causes the demand curve to shift.

- Changes in taste - Change in Income - Prices of Other Goods - Expectation of Goods

List the Assumptions of Classical Macro Theory

- Income always equals Production - Supply creates demand, not the other way around - The economy will always move toward equilibrium - Inflation (usually) has no impact on the real economy (nominal has no impact on real values)

The book mentions three most important Public Goods. What are they?

- National Defense - Basic Research - Fighting Poverty

How can *Trade Make Everyone Better Off*? - 10 Principles of Economics

- People gain from their ability to trade with one another. - Competition results in gains from trading. - Trade allows people to specialize in what they do best. (Lecture). Example: Trade allows each person to specialize in the activities he or she does best, whether it is farming, sewing, or home building. By trading with others, people can buy a greater variety of goods and services at lower cost (Book).

Name some ways in which public policy can influence supply.

- Price Controls - Taxes on Sellers or Intermediate Goods - Subsidies for Sellers or Intermediate Goods - Quotas and production limits.

What are some issues with Economic Assumptions about Rationality?

- We operate with rules of thumb with minimal information. - We are *bounded rational* such that we only have limited information and limited capacity to process them. - We have limited time to make decisions. - Information acquisition may be expensive. - People are emotional, which parallels irrationality.

What is *Neoclassical Synthesis*?

...

Friedman/Phelps Model

... is a classical model describing unemployment such that prices and wages are flexible, and actors have rational expectations, and *so the economy will always trend toward the natural rate of unemployment over the long-run*. The authors, Friedman and Phelps, concluded that there is no reason to think that the rate of inflation would, in the long run, be related to the rate of unemployment. In particular, they implied that monetary policymakers face a *vertical* *Phillips curve* in the long run (Book). In other words, no matter how big the inflation, natural rate of unemployment remains the same in the long run.

According to the book, what are the two general types of Public Policy remedies against externalities? Explain what they are.

1. *Command-and-Control* — Behavior control. The government can remedy externalities by making certain behaviors forbidden. For example, it is a crime to dump used engine oil into the city river. In this case, the external costs to society far exceed the benefits enjoyed by the polluter. 2. *Market-Based Policy*. - *Corrective Taxes* induce private decision makers to take account of the social costs that arise from a negative externality. - Pollution Permits

What are the four solutions to Moral Hazards we discussed in class?

1. *Cost Sharing* 2 *Monitoring and re-pricing* 3. *Contracts* 4. *Regulate behavior*

What are some solutions to the *Free Rider problem*?

1. *Make goods excludable* by creating patent laws and placing tolls for roads (Lecture). 2. *Publicly provide private goods* with taxpayer money. However, the book mentions that cost-benefit analysis may not always be easy. For example, how do you define the cost of life when debating over traffic light plan? 3. Provide subsidies

What are the two characteristics of a *Public Good*?

1. *Non-Excludability* An "excludable" good is one which a person can be prevented from using. 2. *Non-Rivalry* A "rival" good is one whereby one person's use diminishes other people's use.

Name the *Four types of Goods* we have discussed in class. Also, briefly mention what defines the goods' identity.

1. *Private Goods* are both excludable and rival in consumption. You have to fight for that last cookie. 2. *Public Goods* are neither excludable nor rival. 3. *Common Resources* are rival but not excludable. 4. *Club Goods* are excludable but not rival.

According to professor, what are the four ways of Public Policy remedies to externalities? Explain what they are.

1. *Regulation* is a "command-and-control" type of policy remedy (i.e. Carbon emission limits for cars). 2. *Assigning property rights* make it easier for the parties to know their boundaries when creating contracts. 3. *Pigovian Taxes* can reduce negative externalities by "internalizing" the full social cost. 4. *Subsidies* can reduce positive externalities by "internalizing" the full social value

How does Keynesian's view differ from the classical model in three ways?

1. *Saving is not investment* Keynes believed that investments are determined not by savings but by economic prospects. In which case, savings will not lead to increase of investments, but instead a reduction of national income. 2. *Questions rationality* - Speculation: People invest not based on value but on timing the market - Animal Spirits: People react spontaneously rather than heard of optimism or pessimism. 3. *Involuntary Unemployment* In the classical model, firms would not want to reduce labor because it is not good for the macro-output. However, many employers do relieve workers to save money.

List five reasons the long run Aggregate Supply Curve shifts.

1. *Shifts arising from the Labor* Increase immigration > increase production > long-term aggregate supply curve shifts right 2. *Shifts from Capital* Ability of capital increase > increase productivity and goods and services supplied > supply curve shifts to the right 3. *Shifts from Natural Resources* 4. *Shifts from Technological Knowledge* Increase of computer use > increase productivity > shift right 5. Expected Price level

What are the four solutions to Adverse Selection?

1. *Signaling* - Offering warranties or Advertising reputation. 2. *Screening* "CarFax.com" assesses the quality of used vehicles so that the consumers can narrow their gauge. 3. *Underwriting* - Pooling risk through employer or group. 4. *Regulation* - California has a lemon law that mandates sellers to replace lemon cars. - Individual mandates was a strategy that was used in Obamacare to redistribute funds from lower risk individuals to those at higher risk (Lecture).

What are the types of Private Solutions to externalities?

1. *Social norms and moral codes of conduct*: These include not littering or teaching children "Do unto others as you ..." 2. *Charitable organizations*: Local volunteer fire station runs on 100% donation made by its community. 3. *Contract between parties*: Coase Theorem.

What are the three theories that posit that the Aggregate-Supply Curve slope in upward direction in the short run?

1. *Sticky-Wage Theory* Curve slope upward because nominal wages are slow to adjust to changing economic conditions. 2. *Sticky-Price Theory* The price of some goods and services adjust slowly in response to the changing economic conditions. Menu cost is an example of that. 3. *Misperceptions Theory* - It is when suppliers change in overall prices are reflection - Suppliers misconceive that their performance is a reflection of their product rather than the result of lack of adjustment to average market increase. In summary, all three theories suggest that output deviates in the short run from its long-run level (the natural state) when the actual price level deviates from the price level that people had expected to prevail (Lecture).

What are the two causes of an inverse relationship in Law of Demand?

1. *Substitution effect*: When prices of beer rise, then consumers can turn around and purchase something similar (i.e. wine). 2. *Income effect*: If the prices of beer rise, then consumers have less power to purchase everything else.

Which five government policies can shift the Aggregate Demand curve?

1. *The Money Supply* The Federal Reserve can shift the aggregate demand curve by increasing the money supply. 2. *Government Purchases* Increasing government purchases (G-up) 3. *Taxes*: Reducing Taxes (C-up) A tax cut will increase disposable income, therefore increasing consumption and GDP. An increase in transfer payments will do the same 4. *Transfers* Increasing Transfers (C-up) 5. *Incentives* Changes in the Incentives (C, I, Nx-up)

Name three factors that causes the Supply curve to shift. Discuss their impact on the curve.

1. Input Prices Increase sugar prices > Ice cream supply curve shifts left 2. Technology Increase ability to produce > Beer supply shifts right 3. Expectations If a firm expects the price of ice cream to rise in the future, it will put some of its current production into storage and supply less to the market today (book).

What are the two causes discussed in class that leads to a deadweight loss?

1. Market Inefficiency such as market failures; externalities. 2. *Government policies* through price control, taxation, and subsidies.

Ten Principles of Economics — List them.

1. People face trade offs 2. Cost of Something is what you give 3. Rational people think at the margin 4. People respond to incentives 5. Everyone benefits from trade 6. Market economy is decentralized decision 7. Government is sometimes good for the economy 8. Production determines standard of living 9. More print money more price 10. Trade-off between inflation and unemployment

What is an *Asymmetric Information*?

A condition in which one party has more information than the other. For example, when a consumer is shopping for a used car, it may be very difficult for him or her to determine if it is a good car or a lemon. By contrast, the seller probably has a better knowledge of the car's quality (Article). Asymmetric information leads to *Adverse selection* and *Moral Hazard*.

What are the three reasons the Aggregate Demand curve slopes downward?

A fall in the price level increases quantity of goods and services demanded (Book). 1. *Wealth Effect*(Reductions in prices increase Consumption): When the price level increases, the real value of wealth falls, and therefore buyers want to purchase less. - Decrease in price raise value of money > encourages spending - Increase spending > larger quantity of goods and services demanded 2. *Interest Rate Effect*(Reductions in prices increase Investment): When the price level increases, people save less, thus interest rates rise and investment falls. 3. *Exchange Rate Effect* (Reductions in prices increase Net Exports): When the price level increases, U.S. exports become relatively more expensive for foreign buyers and they want to purchase less. - Price fall > interest fall > investors convert from U.S. to Foreign investment - Foreign investment conversion > increase of dollar quantity - Increase dollar quantity > depreciation of dollar value - Lower dollar value > more expensive foreign goods (because dollar is worth less now) AND cheaper domestic goods - More expensive foreign goods > decrease demand for foreign good - Lower cost of domestic goods > increase demand for domestic goods - Decrease foreign good and increase domestic goods > increase U.S. export.

You see a relatively flat demand curve and a vertically erected demand curve. Explain these demand curves in terms of elasticity.

A flat demand curve indicates that the demand for that good is elastic. For example, a small increase in price will drastically change the quantity demanded (super elastic) A vertical demand curve suggests that the demand for that good is inelastic. In other words, increase in price does not change quantity demanded (inelastic).

What is the definition of *monopoly*?

A monopoly is the *sole seller* of its product, and its product has *no close substitutes*. A monopoly is a price maker as opposed to a price taker. Monopoly supply curve is downward sloping because they can set the price as they wish. Since they are the sole provider, their demand curve is identical to the demand curve.

What is a *Negative Externality*? Give some examples.

A negative externality occurs when a third party incurs costs without receiving the benefit from the cost causing activities. A negative externality has a social cost larger than what a firm is willing to charge (Lecture). - *Automobile exhaust* creates smog and affects health. - *Cigarette smoking* leads to secondhand smoking. - *Loud stereos* in an apartment building disrupts the neighborhood's peace. (Book & Lecture).

What is a *Positive Externality*? Give some examples.

A positive externality happens when certain activities create benefits to those not involved in the activities. A positive externality has a social value greater than what an individual is willing to pay (Lecture). - *Immunizations*; Small anti-vaccine movement benefits from sane people. - *Restored historic* buildings provide joy to people but not to its residents. - *Research into new technologies* provide knowledge to people, but inventors cannot capture the full benefits. (Book & Lecture).

What is *price ceiling*? Give a public policy example and one societal problem that accompanies with price ceilings. (Chapter 6 - summary)

A price ceiling is a legal maximum on the price of goods and services. A good example is rent control. If the price ceiling is below the equilibrium price, then the quantity demanded exceeds the quantity supplied, which leads to a shortage. Because of the resulting shortage, suppliers sell less than the equilibrium point. Thus, as it would have in taxes, price ceiling creates a deadweight loss (Lecture).

What is *price floor*? Give an example. (Chapter 6 - summary)

A price floor is a legal minimum on the price of a good or service. An example is the minimum wage. If the price floor is above the equilibrium price, then the price floor is binding, and the quantity supplied exceeds the quantity demanded. Because of the resulting surplus, buyers' demands for the good or service must in some way be rationed among sellers (Book). In lecture, we posited that minimum wage increases the unemployment rate.

What is *Supply Shock*, and describe its role.

A supply shock is an event that directly impacts a firm's production cost, and thus the prices they charge change (Book). It plays an important role in Phillips Curve because if an economy's aggregate supply shifts left, quantity falls and prices increase. Firms conclude that market has changed and lays off workers to produce fewer amount of goods. Consequently, this forces the Phillips curve to shift toward the right. Example: OPEC increases oil price > increase input price of relative goods > shifts supply curve left > less quantity higher price > less quantity is less workers > higher unemployment

What is *opportunity cost*?

According to Principle #2 — the cost of something is what you give — the *opportunity cost* of an item is what you give up to obtain that item. For example, ask the question, "What did you give up to attend college?" Here, the *opportunity cost* of education could be the income you could have earned, had you not attended school.

Give an example of *Society Faces a Short-run Tradeoff Between Inflation and Unemployment*. - 10 Principles of Economics

According to the book, economists describe short-run effects of monetary injections in *Phillips Curve*: - Increase money > stimulate spending > higher demand - Higher demand > More workers - Hiring > lower unemployment The inverse is also true: - Decrease money > Decrease spending > Lower demand - Lower demand > Fewer jobs - Fewer jobs > Higher unemployment

Describe what an *Adverse Selection* is.

Adverse selection occurs when asymmetric information of the actual value of a product causes only "bad" products or consumers to be selected. This circumstance leads to a "spiral" of price changes and market exists. Think about *Market for Lemons*: Buyer thinks the car is a lemon and offers a price lower than the optimum > Sellers do not sell good cars at the offered low price, so only the bad cars are left on the market > The number of buyers is the same, so the probability of buyers purchasing a lemon increases (negative externality) > At the same time, the average cost of the car is below the market optimum.

What is an allocation issue, and what is one solution we discussed in class to fight it. Also, why should allocation issue be addressed by economists?

Allocation issue is another word for class-inequality where the top 20% make the 50% of the income. Taxes can redistribute the disproportionate growth of the wage gap. Economist should be concerned about allocation issues to: - Protection of capitalism - *Diminishing Marginal Utility* ($1 is worth less to a wealthier person) - Rawlsian "Veil of Ignorance" - Positive externalities - Prevention of concentrated power

What does it mean to *internalize an externality*? Give an example.

Altering incentives so that people take account of the external effects of their actions (Book). For example, social planners can, through taxation, internalize the external costs of pollutants released into the atmosphere. A deadweight loss occurs in the process, but externality has been internalized into the social optimal point.

What is an *Externality*? Give a brief explanation.

An externality is a spillover effect whereby a good or transaction provides benefits or cost to a third party not involved in the transaction (Lecture).

Why is Long-Run Aggregate Supply Vertical?

As in the classical model, aggregate supply is dependent on labor, capital, human capital, natural resources, and technological knowledge. So, the long-run supply is independent of prices. In other words, nominal values ($) do not affect the real values.

Give an example of how *People Respond to Incentives*. - 10 Principles of Economics

As policymakers, it is important to remember that marginal changes in costs or benefits motivate people to respond. For example, a gasoline tax encourages people to take public transportation or live closer to where they work (Book). The decision to choose one alternative over another occurs when that alternative's marginal benefits exceed its marginal costs (Lecture).

How do taxes create deadweight loss?

Before Taxation: A+B+C+D+E+F = Total Gain A+B+C = Consumer Surplus D+E+F = Supplier Surplus After Taxation: C+E = Deadweight Loss B+D = Government Revenue A = New Consumer Surplus F = New Supplier Surplus

What is *Endogenous Growth Theory*?

Both Solow and Endogenous growth theories sought to answer what determines the growth of the economy. Solow found that increasing savings and investment can increase the size of the economy but not its rate. To answer this question, Romer asserted that ideas are the key to growth — *technology*. "Perhaps the most important ideas of all are *meta-ideas*—ideas about how to support the production and transmission of other ideas." - Patent systems - Universities - Crowd Sourcing?

What is *Cap and Trade*? Give an example.

Cap and Trade is an approach that ensures the regulatory target in aggregate but allow the market to achieve the goal efficiently. In other words, the government places a cap (i.e. carbon emission) and allows the free market to engage in trade of permits. The book mentions a good example made by President Obama when it quotes: "I believe that, depending on how it is designed, a carbon tax accomplishes much of the same thing that a cap-and-trade program accomplishes. The danger in a cap-and-trade system is that the permits to emit greenhouse gases are given away for free as opposed to priced at auction. One of the mistakes the Europeans made in setting up a cap-and-trade system was to give too many of those permits away."

Give me a short definition of the Classical macroeconomics

Classical macroeconomics is what the size of the economy should look like in the long run. It holds that, in the long run, a nation's economy is determined by its productive capacity. Y = A f(L + K + H + N)

How do *corrective taxes* differ from most other taxes?

Corrective taxes, such as Pigovian taxes, are unlike most other taxes because: 1. Most taxes distort incentives *away* from the social optimum, resulting in a deadweight loss. 2. Corrective taxes account for the presence of negative externalities and thereby move the allocation of resources *closer* to the social optimum. Thus, while corrective taxes raise government revenue, they also enhance economic efficiency (Book).

What is the lecture definition of *Deadweight Loss*?

Deadweight loss is the reduction of total welfare if supply and demand do not meet at their equilibrium Deadweight loss is the "gains from trade" that don't occur.

What is the effect in the production function if we reduced the spending on the Department of Education?

Decrease in H.

What is the effect in the production function if we enacted an immigration reform that reduces both legal and illegal immigration?

Decreased L.

How can policymakers avoid diminishing returns?

Double every element in the production function.

What is Price Elasticity?

Elasticity is the steepness of demand curve. It measures the responsiveness of quantity demanded or quantity supplied to a change in one of its determinants. In equation: %∆ in quantity demanded/ %∆ in price. Elastic = very price sensitive (Diamonds, free peas, Chevy cars). Inelastic = price insensitive (Salt, match, gas).

True or False: Positive Externalities are good for the economy.

False. Positive Externalities are bad for the economy because it creates a deadweight loss (Lecture).

Why does market failure occur in *Market for Lemon*?

First, when assessing the value of a used car, consumers will assume the chance of purchasing a bad car, and therefore be willing to pay less. Second, sellers who have information about the quality of the car will not sell the good vehicle at a lower price. Consequently, only lemons are left on the market for the same number of consumers (Lecture). The market failures are: (1) Optimal price of the good decreased. (2) The probability of consumer purchase of lemons increased. This is the social cost of negative externality. The government can remedy the market failure through regulation. For example, in California, the lemon seller must replace the vehicle or refund the purchase.

What happens to the Demand Curve when Income changes?

For a Normal Good, higher income increases demand. For an Inferior Good, high income decreases demand.

What are the six (6) causes of Market Failures we have talked about in class?

From the Lecture: - *Externalities* - *Public Goods* (and common resources and club goods) - *Monopolies* (and oligopolies, monopsonies, cartels, etc.) - *Information asymmetry* (including adverse selection and moral hazard) - *Irrationality* (or bounded rationality) - *Undesired resource allocation* (i.e. inequality)

What is *GDP*?

Gross Domestic Product is a the most common measurement used to estimate the national income, which is reflected as *aggregate demand* (Lecture). The textbook definition of GDP is ... the market value of all final goods and services produced within a country in a given period of time.

What is *Multiplier Effect*?

Higher spending increases income (and expected income) which increases spending and creates a positive feedback cycle.

How does elasticity of demand influence the cost and quantity of supply through a subsidy?

If the demand curve is inelastic (vertical), then the subsidy is influenced by price; the government pays more for a smaller quantity. If the demand curve is elastic (flat), then the quantity of subsidy has a strong effect on quantity; government provides more with fractional costs compared to an inelastic demand curve.

What happens to the Demand Curve when prices of *other* goods change? In other words, what happens to the quantity of demand when prices of related goods change?

If the price of *Perfect Substitutes* increase, demand goes up. For example, if the price of Coors light increases, Bud light demand increases (Lecture). If the price of *Perfect Compliments* increase, demand goes down. For example, increase in gas price leads to lower demand in gas-inefficient cars (Lecture).

How do expectations influence the Demand Curve?

If you expect to earn a higher income next month, you may choose to save less now and spend more of your current income (Book).

What are the two Information-related market failures we have talked about in class?

Imperfect Information Asymmetric Information - Adverse Selection - Moral Hazards

What are complements?

In Supply and Demand, complements are often pairs of goods that are used together, such as gasoline and automobiles, computers and software, and peanut butter and jelly.

What is a substitute?

In Supply and Demand, substitutes are often pairs of goods that are used in place of each other, such as hot dogs and hamburgers, sweaters and sweatshirts, and movie tickets and DVD rentals.

Why do Monopolies Cause Market Failures?

In a competitive market, prices equal to marginal cost of production. However, in a monopoly, the sole seller sets prices to maximize profits. As a result, monopolies can *price their goods above the optimal* price, and this leads to the creation of a deadweight loss (Lecture).

Why are externalities considered a market failure?

In an ideal market, the equilibrium quantity equals the socially optimal quantity. With an externality, the equilibrium prices does not reflect the "true price" and so the optimal quantity is not produced (Lecture).

In taxation, which elasticity type creates a bigger deadweight loss? Elastic or Inelastic?

In both Supply and Demand curve, elastic curve type suffers more deadweight loss than an inelastic one (Book). Logically, it makes sense because the operational definition of inelastic goods is that people consume the goods regardless of the set price.

Summarize the article, "Animal Spirits: A Q&A With George Akerlof."

In classical macroeconomics, there exists an assumption that people make rational choices by thinking at the margin. The article talks about how one Nobel Laureate macroeconomist incorporated irrationalities in the long run model. Preceding the market collapse in 2007, there were high animal spirits among people, overconfidence, an irrationality. "We understand that with animal spirits, people will incautiously buy inadequately backed securities if they are overconfident. Insurance is regulated so that if your house burns down, the insurance company will have the money to pay. The same should be the case of other financial assets: they should be regulated so that people's expectations will be met regarding whether or not they will be paid off. The mortgage market is only one financial market where people showed overconfidence. There was a much greater need for regulation of financial markets."

Fill in the blank: In the long run, aggregate supply curve runs in __________ direction. In the short run, aggregate supply curve runs in __________ direction.

In the long run, the aggregate supply curve is *vertical*. In the short run, the aggregate supply curve is *upward sloping*.

What is the effect in the production function if we increased the infrastructure spending (assume paid for)?

Increase in K.

What is the effect in the production function if we replace corporate income tax with business consumption tax (assume deficit neutral)a?

Increase in K.

What is the effect in the production function if we De-regulate oil exploration and drilling?

Increase in N.

What happens to the Demand Curve when Tastes for goods change?

Increase in taste raises the demand curve. Conversely, decrease in taste decrease the demand curve

What is the effect on the production function if we reduced the individual income tax rates (assume unpaid for)?

Increased L . Decreased K.

What is *Tragedy of the Commons*? Provide an example.

It illustrates why common resources are used more than desirable from the society's standpoint. When one family's flock of sheep grazes on the common land to a point where the land becomes barren, it reduces the quality of the land available for other families (Book).

What is a *Pigovian Tax*? Could you give an example?

It is one of the government's solutions to externalities. The Pigovian tax aims to reduce negative externalities by imposing a tax equal to the value of a negative externality. For example, suppose that factories dump 500 tons of glop into a river every year. The EPA levies $50,000 tax for each ton to compensate for the loss of negative social costs incurred​ through 500 tons of glop (Book).

What is *natural-rate hypothesis*?

It is the claim that unemployment eventually returns to its normal, or natural, rate, regardless of inflation (Book).

What is *Laffer Curve*? Draw an example and explain it.

Laffer curve shows the point at which tax revenue first rises and then falls (Book). In other words, government revenue increases until it reaches a point where people are just not willing to work at a particulartax rate (Lecture).

What can you say about the Aggregate Suppy curve in short run and long run?

Long-run aggregate supply is vertical Short-run aggregate supply is upward sloping

Give an example of why *Markets Are Usually a Good Way to Organize Economic Activity*. - 10 Principles of Economics

Market economy allocates resources through the *decentralized decisions* of many firms and households (Lecture). Firms decide whom to hire and what to make. Households decide which firms to work for and what to buy with their incomes. Consequently, the *invisible hand* leads them to desirable market outcomes (Book).

Draw a monopolist's demand curve in relation to a competitive firm's.

Monopolist's demand curve is downward sloping because a monopolist can charge whatever price and still be able to sell. In a way, a monopolist is the market of itself. Therefore, its demand curve reflect a downward slope (Book).

What are the two types of *Moral Hazard*?

Moral Hazard is a "principle-agent" problem where, absent perfect information, an agent does not act as a principle desires. It often happens when the agent is shielded from risk (Lecture). There are two types of moral hazard: 1. *Ex-Ante* Moral Hazard involves riskier *behavior*. Ex) Driving more recklessly after purchasing car insurance. 2. *Ex-Post* Moral Hazard involves higher utilization of a principles' *resources*. Ex) Purchasing more expensive health procedures once covered by health insurance.

Why is Moral Hazard an Informational Issue?

Moral hazards are informational issue because not all party possess same information (Lecture). The employment relationship is the classic example. The employer is the principal, and the worker is the agent. The moral-hazard problem is the temptation of imperfectly monitored workers to neglect their responsibilities (Book).

How do economists measure the size of the economy in the *Long-Term*?

Most economists rely on *Classical Economics*. Remember that in the Long-Term, the size of the economy is determined by our capacity to produce; production; *aggregate supply*.

How do economists measure the size of the economy in *Short-Term*?

Most economists rely on *Keynesian Economics*. It determines what we buy in terms of national expenditures. Y = C + I + G + NX Y = *Income* C = *Consumption* I = *Investment* includes purchases of goods (such as capital equipment, structures, and inventories) used to produce other goods (Book). G = *Government* NX = *Net Exports* is exports minus imports.

Speaking in terms of the Supply and Demand curve, what are some of the main differences between a positive externality and a negative externality?

Negative externalities lead markets to produce a larger quantity than is socially desirable. Quantity > Socially Optimal Positive externalities lead markets to produce a smaller quantity than is socially desirable. Quantity < Socially Optimal

What is *Oligopoly*? Why is this a market failure?

Oligopoly is when few groups gather together and behave monopolistically. So, oligopolies produce deadweight loss by raising prices above the market optimal.

Misperception Theory

One of the three theories that explain why the aggregate supply curve slopes upward in the short run. - Suppliers have misconceived that their performance is a result of their product rather than the result of lack of adjustment to average market increase (Lecture). In other words, suppliers erroneously conclude that changes in one product reflect the changes of the overall goods in the market. Misconceived, suppliers may produce less quantity of goods. For example, wheat farmers may notice a fall in the price of wheat before they notice a fall in the prices of the many items. They may infer from this observation that the reward to producing wheat is temporarily low, and they may respond by reducing the quantity of wheat they supply (Book). The slope is upward because the decrease in the price of wheat has led to decreased production of the production of goods produced in the short run.

Sticky-Wage Theory

One of the three theories that explain why the aggregate supply curve slopes upward in the short run. Curve slope upward because nominal wages are slow to adjust to changing economic conditions.

Sticky-Price Theory

One of the three theories that explain why the aggregate supply curve slopes upward in the short run. The price of some goods and services adjust slowly in response to the changing economic conditions. For example, when a menu cost does not reflect an unexpected fall in the price level, it leaves some firms with higher-than-desired prices. This depresses sales, which induces firms to reduce the quantity of goods and services they produce.

What is *Crowding Out*?

Opposite of multiplier effect. Higher spending also leads to more borrowing, which pushes up interest rates, crowds out investment, and reduces long-term growth (Lecture).

What is *Phillips Curve*?

Phillips curve illustrates the relationship between unemployment and inflation. Remember that according to Friedman and Phelps, Phillips curve is aligned vertically in the long run.

Law of Demand

Price and Demand have *inverse* relationship; when the price of goods rise, demand of the goods fall.

Law of Supply

Price and Demand have a *direct* relationship; if the price of goods or services rise, then the suppliers would want to increase the the quantity of their goods.

What is *price discrimination*? Give some examples of them.

Price discrimination is the business practice of selling the same good at different prices to different customers. - Movie tickets - Airline Prices - Discount Coupons

What does it mean when the book says, *Standard of Living Depends on Its Ability to Produce Goods and Services*? - 10 Principles of Economics

Production is based on capital, labor, human, natural resources, and technology Y = A f(L + K + H + N) Book example: If you are stranded on an island, you cannot consume more than what you can produce. So, your standard of living is determined by how usefully survival tools are utilized to sustain a livelihood.

Why are Public Goods Problematic? Give an example.

Public goods create a *Free Rider*, which is a person who receives the benefit of a good but does not pay for it, thereby reducing the production for goods or services. For example, lighthouses are neither excludable nor rival in consumption. Once built, each captain has an incentive to free ride without paying for the service. So, private markets usually fail to provide lighthouses (Book).

What does the Classical Model say about unemployment?

Pure Classical Model says that wages and prices are perfectly flexible, and so the economy is always operating at full employment. A *full employment* means that the unemployment rate is driven only by structural and frictional unemployment (Lecture). In other words, changes in *nominal* values do not influence *real* values.

Give an example of Income Elasticity of Demand

Quantity demanded of good responds to a change in consumers' income.a Necessities, such as food and clothing, tend to have small income elasticities (inelastic). Luxuries, such as caviar and diamonds, tend to have large income elasticities (elastic).

Why is the Aggregate Supply Curve vertical in the long run?

Real variables are not dependent on nominal variables, so in the long run, real goods (supply) is not influenced by the nominal goods (price level $$). To understand better, try drawing this out., and you will see that increasing the price will not increase the supply level, resulting in a vertical line instead of a slope.

Who is *Romer* and why is s/he significant?

Romer, of U.C. Berkeley, expanded on Solow's model in describing what determines the growth of economy (short-run to long-run). To answer this question, Romer asserted that ideas are the key to growth — *technology*. "Perhaps the most important ideas of all are *meta-ideas*—ideas about how to support the production and transmission of other ideas." - Patent systems - Universities - Crowd Sourcing?

What is a shortage? And, where in the Supply and Demand curve is it drawn?

Shortage is a situation in which quantity demanded is greater than quantity supplied. Thus, it is always drawn on the bottom of the equilibrium point.

Draw a competitive firm's demand curve in relation to a monopolist's.

Since competitive firms are *price takers*, they cannot sell at a higher price than the market would offer, therefore a competitive firm's demand curve is horizontal (Book). In other words, if the seller prices their merchandise above a certain price, then the sellers cannot sell due to competition. So, we get a flat line.

Slowly Inhale.

Slowly exhale.

What is a surplus? And, where in the Supply and Demand curve is it drawn?

Surplus is a situation in which quantity supplied is greater the quantity demanded. Therefore, It is always drawn on the top of the equilibrium point.

Define *tax incidence* as mentioned in Chapter 6 summary.

Tax incidence refers to how the burden of tax is distributed among the people making up the economy.

What determines the elasticity of the Supply Curve?

The Elasticity of Supply is Determined by the Ability of a Seller to Change the Amount of a Good Produced. These include: - Complexity of Production. - *Time Horizon* (i.e. Milk must be sold by a certain time vs. Gold is stable). - *Excess capacity* (U.S. produces more grain than it can consume). - *Inventories* (How big is your storage? How much storage allowed in Amazon prime shipping center? etc.).

Summarize the article, "Understanding Say's Law of Markets."

The article is the author's attempt to fix the misunderstanding of the Say's Law of Markets, which often is interpreted that supply creates demand. He argues that when Say says supply creates demand, creation of one supply leads to the desire of another supply, and thus this creates demand — a desire for goods other than which one supplies.

Give an example of *People face Trade-Offs*. Hint: Guns and Butter - 10 Principles of Economics

The more a society spends on national defense — guns, the less it can spend on consumer goods to raise the standard of living at home — butter (Book).

What is the main difference between macroeconomics and microeconomics?

The primary goal of macroeconomic policy is to help maximize *national income*. Whereas, micro focuses on individuals and single entities.

What is *Production function*, and what does it measure?

The production function measures the *aggregate supply level*, which determines the long-term economic trend(s) of a nation. Y = A f(L + K + H + N) Whereas: *A*: Technology *L*: Labor *K*: Physical *H*: Human *N*: Natural

What is *catch up effect*?

The property whereby countries that start off poor tend to grow more rapidly than countries that start off rich. This is due to *diminishing returns*.

What is *Coase Theorem*?

The proposition that if private parties can bargain without cost over the allocation of resources, they can solve the problem of externalities on their own so long as: - Property rights are well defined (though it doesn't matter to whom) - There are no (or practically no) *transaction costs*. Transaction costs include lawyers, translators, etc.

What is *potential output*? And, what is another name for it?

The quantity of output associated with the LRAS curve is known as "potential output" or "the natural rate of output." (Lecture)

What does the book mean by *Efficiency vs. Equality* in *People face Trade-Offs*? - 10 Principles of Economics

When government policies are designed, efficiency and equality often conflict. *Efficiency*: Size of the economic pie. *Equality*: How the pie is proportioned among members of the society. Example: Welfare system tries to help the members of society who are most in need by asking some of the financially successful to contribute more than others. While achieving greater equality, these policies reduce efficiency through deadweight loss and decreasing incentives (Book).

What are some ways in which *Governments Sometimes Improve Market Outcomes*? - 10 Principles of Economics

When the market breaks down through *market failure* or *externality*, then governments can intervene to promote *efficiency* and *equity*. These include enacting intellectual property rights laws, limiting *market power* (monopoly), providing subsidies, enacting regulations to protect the environment and health of its citizens (Lecture).

What is *diminishing returns*?

With the exception of available technology (A), each component has diminishing returns to scale. In other words, increasing the inputs will increase the total production by only a small amount. For example, doubling labor supply, all else equal, will NOT double the size of the economy (Lecture).

Technology

Y = *A* f(L + K + H + N) Society's understanding of how best to produce goods and services Technology increase returns of all other areas of the production and, therefore, increases the size of the economy.

What is *Labor Capital* and its determinants?

Y = A f(*L* + K + H + N) Labor Capital is the *total person-hours worked* in an economy. The determinants of labor capital are: - *Number of people* such as population size, birth rate, death rate, immigration. - *Culture* that sets the social norm for how many hours a person should work per day. - *Government Incentives* - Unemployment insurance - *Income and wage rate*

Physical Capital and the three determinants

Y = A f(L + *K* + H + N) Produce factors like equipment and structures. Produce is determined by *Investments*, which is what a nation has to be invested to create K. Investments are determined by *Savings*: Any money not used (money in the bank or purchasing stocks or bonds). Therefore, *Saving+ > Investments+ > Produce+*

Human Capital and its determinants

Y = A f(L + K + *H* + N) Knowledge that has the potential to be utilized for work. - Education, Apprenticeships, Vocational Schools, On-hand, Self-study

Natural Resources and its types

Y = A f(L + K + H + *N*) 1. Renewable: Tree, water, solar, wind 2. Non-renewable = Oil, Diamond, Gold

List four reasons the Aggregate Demand curve shifts in the short-run.

Y = C + I + G + Nx 1. *Shift from consumption* - Taxes: Lower taxes lead to higher spending, so the aggregate demand curve shifts to the right. In contrast, when the taxes increase, demand curve shifts to the left. 2. *Shift from changes in investment* - Investing in technology shift the demand to the right. - Investment tax credit encourages investment and shifts demand to the right. 3. *Shifts from government purchases* - Congress decides to purchase new weapons > shifts right. 4. *Shift from Changes in Net Exports* - U.S. good export increase > shift right - U.S. good export decrease > shift left

What is *Solow Growth Model*?

∆K = sY - dK Capital = Income(savings rate) - Capital(depreciation) High capital needs equivalent savings to replace it, but it also creates more savings by increasing the national income. *Key point*: Increasing savings and investment can, therefore, increase the *size* of the economy, but not the *rate* of growth. The same principle applies on other capital goods.