Chapter 5: Fundamentals of Economic Analysis

Economics: the study of how people, firms, and societies use their scarce
productive resources to best satisfy their unlimited material wants.
Resources: called factors of production, these are commonly grouped into the four
categories of labor, physical capital, land or natural resources, and entrepreneurial
ability.
Scarcity: the imbalance between limited productive resources and unlimited
human wants. Because economic resources are scarce, the goods and services a
society can produce are also scarce.
Trade-offs: scarce resources imply that individuals, firms, and governments are
constantly faced with difficult choices that involve benefits and costs.
Opportunity cost: the value of the sacrifice made to pursue a course of action.
Marginal: the next unit or increment of an action.
Marginal Benefit (MB): the additional benefit received from the consumption of
the next unit of a good or service.
Marginal Cost (MC): the additional cost incurred from the consumption of the
next unit of a good or service.
Marginal Analysis: making decisions based upon weighing the marginal benefits
and costs of that action. The rational decision maker chooses an action if the MB
MC.
Production Possibilities: different quantities of goods that an economy can
produce with a given amount of scarce resources. Graphically, the trade-off
between the production of two goods is portrayed as a Production Possibility
Curve or Frontier (PPF).
Law of Increasing Costs: the more of a good that is produced, the greater the
opportunity cost of producing the next unit of that good.
Absolute Advantage: exists if a producer can produce more of a good than all
other producers. Comparative Advantage: A producer has comparative
advantage if he can produce a good
at lower opportunity cost than all other producers.
Specialization: When firms focus their resources on production of goods for
which they have comparative advantage, they are said to be specializing.

Productive Efficiency: production of maximum output for a given level of

technology and resources. All points on the PPF are productively efficient.
Allocative Efficiency: production of the combination of goods and services that
provides the most net benefit to society. The optimal quantity of a good is
achieved when the MB MC of the next unit. This only occurs at one point on the
PPF.
Economic Growth: occurs when an economys production possibilities increase.
This can be a result of more resources, better resources, or improvements in
technology.
Market Economy (Capitalism): an economic system based upon the
fundamentals of private property, freedom, self-interest, and prices.

Ch.6 Supply, Demand, Market Equilibrium, Welfare Analysis

Law of Demand: holding all else equal, when the price of a good rises, consumers
decrease their quantity demanded for that good.
All else equal: to predict how a change in one variable affects a second, we hold
all other variables constant. This is also referred to as the ceteris paribus
assumption.
Absolute (or money) prices: the price of a good measured in units of currency.
Relative prices: the number of units of any other good Y that must be sacrificed to
acquire the first good X. Only relative prices matter.
Substitution effect: the change in quantity demanded resulting from a change in
the price of one good relative to the price of other goods.
Income effect: the change in quantity demanded that results from a change in the
consumers purchasing power (or real income).
Demand schedule: a table showing quantity demanded for a good at various
prices.
Demand curve: a graphical depiction of the demand schedule. The demand curve
is downward sloping, reflecting the Law of Demand.
Determinants of demand: the external factors that shift demand to the left or
right.
Normal goods: a good for which higher income increases demand.
Inferior goods: a good for which higher income decreases demand.
Substitute goods: two goods are consumer substitutes if they provide essentially
the same utility to the consumer. A Honda Accord and a Toyota Camry might be
substitutes for many consumers.
Complementary goods: two goods are consumer complements if they provide
more utility when consumed together than when consumed separately. A 35 mm
camera and a roll of film are complementary goods.
Law of Supply: holding all else equal, when the price of a good rises, suppliers
increase their quantity supplied for that good.
Supply schedule: a table showing quantity supplied for a good at various
prices. Supply curve: a graphical depiction of the supply schedule. The supply

curve is upward sloping, reflecting the Law of Supply.

Determinants of supply: one of the external factors that influences supply. When
these variables change, the entire supply curve shifts to the left or right.
Market equilibrium: exists at the only price where the quantity supplied equals
the quantity demanded. Or, it is the only quantity where the price consumers are
willing to pay is exactly the price producers are willing to accept.
Shortage: also known as excess demand, a shortage exists at a market price when
the quantity demanded exceeds the quantity supplied. The price rises to eliminate
a shortage.
Disequilibrium: any price where quantity demanded is not equal to quantity
supplied.
Surplus: also known as excess supply, a surplus exists at a market price when the
quantity supplied exceeds the quantity demanded. The price falls to eliminate a
surplus.
Total welfare: the sum of consumer surplus and producer surplus. The free
market equilibrium provides maximum combined gain to society.
Consumer surplus: the difference between your willingness to pay and the price
you actually pay. It is the area below the demand curve and above the price.
Producer surplus: the difference between the price received and the marginal
cost of producing the good. It is the area above the supply curve and under the
price.
Ch.7 Elasticity, Microeconomic Policy, and Consumer Theory
Elasticity: measures the sensitivity, or responsiveness, of a choice to a change in
an external factor.
Price elasticity of demand (Ed ): measures the sensitivity of consumer quantity
demanded for good X when the price of good X changes.
Price elasticity formula: Ed = (%Qd)/(%P). Ignore the negative sign.
Price elastic demand: Ed > 1 or the (%Qd) > (%P). Consumers are price
sensitive.
Price inelastic demand: Ed < 1 or the (%Qd) < (%P). Consumers are not price
sensitive.

Unit elastic demand: Ed 1 meaning the (%Qd) (%P).

Perfectly inelastic: Ed 0. In this special case, the demand curve is vertical and
there is absolutely no response to a price change.
Perfectly elastic: Ed = In this special case, the demand curve is horizontal
meaning consumers have an instantaneous and infinite response to a price change.
Slope and elasticity: in general, the more vertical a goods demand curve, the
more inelastic the demand for that good. The more horizontal a goods demand
curve, the more elastic the demand for that good. Despite this generalization, be
careful as elasticities and slopes are not equivalent measures.
Determinants of elasticity: if a good has more readily available substitutes
(luxuries vs. necessities), it is likely that consumers are more price elastic for that
good. If a high proportion of a consumers income is devoted to a particular good,
consumers are generally more price elastic for that good. When consumers have
more time to adjust to a price change, their response is usually more elastic.
Total Revenue: TR P * Qd. Total Revenue Test: total revenue rises with a
price increase if demand is price inelastic and falls with a price increase if demand
is price elastic.
Elasticity and demand curves: at the midpoint of a linear demand curve, Ed 1.
Above the midpoint demand is elastic and below the midpoint demand is inelastic.
Income elasticity: a measure of how sensitive consumption of good X is to a
change in the consumers income.
Income elasticity formula: EI (% Qd good X)/(% Income).
Luxury: a good for which the income elasticity is greater than one.
Necessity: a good for which the income elasticity is above zero, but less than one.
Values of Income Elasticity: if EI > 1, the good is normal and a luxury. If 1 > EI
> 0, the good is normal and income inelastic (necessity). If EI < 0, the good is
inferior.
Cross-Price Elasticity of Demand: a measure of how sensitive consumption of
good X is to a change in the price of good Y.
Cross-Price elasticity formula: Ex,y (% Qd good X)/(% Price Y).
Values of Cross-Price Elasticity of Demand: If Ex,y > 0, goods X and Y are

substitutes. If Ex,y < 0, goods X and Y are complementary.

Price Elasticity of Supply: measures the sensitivity of quantity supplied for good
X when the price of good X changes.
Price elasticity of supply formula: Es (%Qs)/(%P).
Excise tax: a per unit tax on production results in a vertical shift in the supply
curve by the amount of the tax.
Incidence of Tax: the proportion of the tax paid by consumers in the form of a
higher price for the taxed good is greater if demand for the good is inelastic and
supply is elastic.
Dead Weight Loss: the lost net benefit to society caused by a movement away
from the competitive market equilibrium. Policies like excise taxes create lost
welfare to society.
Subsidy: has the opposite effect of an excise tax, as it lowers the marginal cost of
production, resulting in a downward vertical shift in the supply curve for good X.
Price Floor: a legal minimum price below which the product cannot be sold. If a
floor is installed at some level above the equilibrium price, it creates a permanent
surplus.
Price Ceiling: a legal maximum price above which the product cannot be sold. If
a ceiling is installed at a level below the equilibrium price, it creates a permanent
shortage.
Utility: happiness, benefit, satisfaction, or enjoyment gained from
consumption. Total utility: total happiness received from consumption of a
number of units of a good.
Marginal utility: the incremental happiness received, or lost, when the consumer
increases consumption of a good by one unit.
Utils: a unit of measurement often used to quantify utility. A.k.a. happy
points.
Law of Diminishing Marginal Utility: in a given time period, the marginal
(additional) utility from consumption of more and more of that item falls.
Constrained utility maximization: for a one-good case. Constrained by prices
and income, a consumer stops consuming a good when the price paid for the next
unit is equal to the marginal benefit received.

Utility Maximizing Rule: the consumer maximizes utility when they choose
amounts of goods X and Y, with their limited income, so that the marginal utility
per dollar spent is equal for both goods. Mathematically: MUx /Px MUy Py , or
MUx /MUy Px /Py.
Horizontal summation: the process of adding, at each price, the individual
quantities demanded to find the market demand curve for a good.