Microecon Exam 1 Review

ECO 211: Introductory Microeconomics Review Sheet—Exam 1 Fall 2007 Exam will cover material in text chapters 1through 6. The exam will have both multiple-choice questions and “essay” and/or “problem-solving” questions. You should be familiar with Krugman’s essays, “The Accidental Theorist” and “In Praise of Cheap Labor.” You will not need to know these articles I detail. But you should know what the topic of each essay is and what point(s) Krugman is making. I. Introduction A lot of economic jargon was introduced at the beginning of the course; e.g., efficiency, equity, scarcity, opportunity cost, normative and positive analysis, comparative advantage, etc., etc. While you will not be asked to give exact definitions for these terms, you should know what they mean and understand their importance. You should be familiar with the methodology of economic analysis (“scientific method”) and the value of model-building. You should be able to work with Production Possibilities Frontiers: Know what they represent, how efficiency, inefficiency and growth can be demonstrated with a PPF. Be able to explain why the slope of the PPF represents opportunity costs. Be able to explain what a “bowed-out” frontier represents (increasing costs). II. Comparative Advantage An important principle of economics is that there are Gains to Trade. Chapter 3 introduces one of the most fundamental ideas in economics which highlights one source of gains to trade (Usually referred to as the “Law of Comparative Advantage” or the “Principle of Comparative Advantage): individuals (and/or countries) should specialize in the production of the good in which they have the comparative advantage and trade for other goods. 

Be prepared to identify absolute advantage when provided with productivity information.

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Be prepared to calculate opportunity costs and identify comparative advantage given the same information.

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Be able to create (graph) a Production Possibilities Frontier (PPF) and interpret it.

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Be able to use information opportunity costs to discuss patterns of trade (who trades what) and to discuss at what prices trade can take place.

III. Supply and Demand (Chapter 4) Know the definitions of Supply and Demand. Know the determinants of supply and demand (the factors that can shift a supply or demand curve). Be able to find the market equilibrium in a supply and demand graph and be able to explain why this is an equilibrium. Be able to perform “comparative-statics” exercises using supply and demand analysis. You should be able to do this type of analysis both verbally and graphically. Here is a table listing the effects of changes in supply and demand on equilibrium price and quantity:

S U P

No Change in Supply

P L

Increase in Supply

Y

Decrease in Supply

DEMAND No Change in Increase in Demand Demand Price ↑ Quantity↑ Price ?? Price ↓ Quantity ↑ Quantity ↑ Price ↑ Quantity ↓

Price ↑ Quantity ??

Decrease in Demand Price ↓ Quantity ↓ Price ↓ Quantity ?? Price ?? Quantity ↓

Your textbook suggests a 3-step procedure (page 78) that may be useful for correctly performing these types of exercises: 1. Decide whether the event shifts the supply or demand curve (or perhaps both) 2. Decide which direction the curve(s) shift. 3. Use a supply and demand diagram to see how the shift(s) change equilibrium price and quantity. IV. Elasticity You should know what elasticity is: a measure of responsiveness. More formally, you should know the definition of Price Elasticity of Demand:

ED = You should know categories of Elasticity: • • •

Relatively Elastic: Relatively Inelastic: Unit Elastic:

ED > 1 ED < 1 ED = 1

%∆Q D %∆P

You should know the relationship between Elasticity and Total Revenue: • •

When demand is elastic, raising price will lower total revenue, lowering price will increase total revenue. When demand is inelastic raising price will increase total revenue, lower price will decrease total revenue.

You should also be able to explain why these relationships hold. You should be able to use and discuss the determinants of price elasticity of demand. • Availability of substitutes • Percent of total budget spent on the good. • Time frame •

You should be familiar with the idea of price elasticity of supply You should be familiar with other types of elasticity: Income Elasticity of Demand: E D =

% ∆Q D % ∆I

You should know that Normal Goods have positive income elasticity and Inferior Goods have negative income elasticity. Cross-Price Elasticity: E D =

% ∆Q D x (The percentage change in demand for good x caused by a % ∆Py

1% change in the price of good y) You should know that Complements have negative cross-price elasticity and Substitutes have positive cross-price elasticity. V. Taxes and Price Controls • You should know what a Price Ceiling is and what a Price Floor is. You should know what it

means for these to be “effective” price controls.

• Be able to explain the impact of price controls on market outcomes. For example, effective price

ceilings cause shortages and effective price floors cause surpluses.

• You should be able to give examples of each type of price control and be able to discuss the

“winners and losers” from such policies.

• Be able to analyze the effect of an excise tax on equilibrium. • Know that the economic incidence of the tax is independent of the legal incidence. • Know who pays the tax and how the burden is determined (determined by the elasticities of

supply and demand).

• Be able to show the impact of a tax and the distribution of the tax burden on a supply and

demand graph.