Chapter 1:

Economics: the study of how people make choices under conditions of scarcity and the results of those choices for
society

Positive economics: independent of the ethical value system of the economist

Normative economics: reflects the ethical value system of the economist (implicitly, explicitly, or by omission)

Macroeconomics: the study of the performance of national economies and the policies that governments use to try
to improve that performance

Microeconomics: the study of individual choice under conditions of scarcity, and its implication for society

Standard economic theory assumes decision makers are rational

Scarcity: resources available to satisfy boundless needs and wants are limited

Opportunity cost: the net value of the next best alternative that must be foregone in order to undertake the activity

Rationality demands that an individual (or firm or other decision maker) takes an action if, and only if, the extra
benefits (=marginal benefits) from taking that action are at least as great as the extra costs (=marginal costs)

Decision pitfalls:

1. Measuring costs and benefits as proportions rather than absolute money amounts
2. Ignoring opportunity (ie. implicit) costs
3. Failure to ignore sunk costs
○ Sunk costs: costs that are beyond recovery at the moment a decision must be made
4. Failure to understand the distinction between average and marginal costs and benefits
○ Marginal benefit: the increase in benefit that results from carrying out one additional unit of an
activity
○ Average benefit: the total benefit of undertaking n units of activity divided by n
○ Marginal cost: the increase in total cost that results from carrying out one additional unit of an
activity
○ Average cost: the total cost of undertaking n units of an activity divided by n

Economists use the cost-benefit principle as an abstract model of how an idealized rational decision maker would
choose among competing alternatives

Any model is a simplified representation of reality (used to derive predictions and we judge each based on their
accuracy)
Chapter 2:

Absolute advantage: one party has an absolute advantage over another if an hour spent in performing a task earns
more than the other party can earn in an hour at the same task

Comparative advantage: one party has a comparative advantage over another ina task if his or her opportunity cost
of performing a task is lower than the other party’s opportunity cost of performing the same task

Principle of comparative advantage: From a social welfare perspective, it is most efficient when each person or
country specializes, thus concentrating on the activities for which opportunity cost is lowest.

Origin of comparative advantage:

● Sources individual level (micro): inborn talent, education, training, experience

● Sources national level (macro): land, labor, capital, entrepreneurship, knowledge, natural resources, cultural,
legal, and political institutions

Production possibilities curve (PPC): a graph that shows the quantity of a good that can be produced for every
possible level of production of another good

Attainable point: any combination of goods that can be produced using currently available resources

Unattainable point: any combination of goods that cannot be produced using currently available resources

Efficient point: any combination of goods for which currently available resources do not allow an increase in the
production of one good without a reduction in the production of the other

Inefficient point: any combination of goods for which currently available resources enable an increase in the
production of one good without a reduction in the production of the other

Principle of increasing opportunity cost (“low hanging fruit principle): in expanding the production of any good, first
employ those resources with the lowest opportunity costs, and only afterward turn to resources with higher
opportunity cost

With specialization following the low-hanging-fruit principle, total production quantities can be greater than
if specialization occurs the other way around

Production possibility frontier (PPF): the PPC for a multi-person and million person economy

Factors that shift an Economy’s PPF: Increases in productive resources or improvements in knowledge and
technology cause the PPF to shift outwards. They are the main factors that drive economic growth.
Chapter 3:

Market: The market for any good or service consists of all buyers and sellers of that good or service

The demand curve: a schedule or graph showing the quantity of a good that buyers wish to buy at each price

Substitution effect: the change in the quantity demanded of a good that results from a change in price, making the
good more or less expensive relative to other goods that are substitutes

Income effect: the change in the quantity demanded of a good that results from the effect of a change in the good’s
price on consumers’ purchasing power

Buyer’s reservation price: the largest amount of money a buyer would be willing to pay for a unit of a good

The supply curve: a curve or schedule that tells us the quantity of a good that sellers wish to sell at each price

Market Equilibrium: at the intersection of demand and supply where all buyers (consumers) and sellers (producers)
are satisfied with their respective quantities at the prevailing market price. There is no tendency for the system to
change.

Equilibrium price: price at which a good will sell

Equilibrium quantity: quantity supplied and quantity demanded are equal

Excess supply: the amount by which quantity supplied exceeds quantity demanded when the price of a good exceeds
the equilibrium price.

Excess demand: the amount by which quantity demanded exceeds quantity supplied when the price of a god lies
below the equilibrium price.

Price ceiling: a maximum allowable price, specified by law

Price floor: a minimum allowable price specified by law

Change in quantity demanded: a movement along the demand curve that occurs in response to a price change

Change in demand: a shift of the entire demand curve: a demand change at the same price

Change in the quantity supplied: a movement along the supply curve that occurs in response to a price change

Change in supply: a shift of the entire supply curve: a supply change at the same price

Shifts in demand due to: complements, substitutes, income changes

Shifts in supply: based on costs of production

Buyers Surplus: the difference between the buyer’s reservation price and the price actually paid

Buyers reservation price: willingness to pay of the buyer; the maximum amount a buyer will pay

Seller’s surplus: the difference between the price received by the seller and the lowest price she is willing to sell at

Total surplus: is the sum of buyer’s surplus and seller’s surplus

Exactly when is the market equilibrium efficient?

● When all costs of producing the good or service are borne directly by the seller (reflected in the supply curve)
● When all benefits from the good or service accrue directly to buyers (reflected in the demand curve)

Inefficient market equilibrium:

● When costs of production fall on people other than those who sell the good or service, the market
equilibrium is inefficient
● When some benefits from the good or service accrue to people who did not buy the good or service, the
market equilibrium is inefficient

Determinants of demand price elasticity:

● Substitution possibilities: if there are substitutes and price increases, people will likely switch to close
substitutes
● Budget share
● Time: consumers change purchasing patterns over time

Cross-Price Elasticity of Demand: The percentage change in quantity demanded of one good in response to a 1%
change in the price of another good

Substitute goods: cross price elasticity of demand is positive

Complement goods: cross price elasticity of demand is negative

Income elasticity of demand: the percentage change in quantity demanded in response to a 1% change in income

Normal goods: income elasticity of demand is positive

Inferior goods: income elasticity of demand is negative

Price elasticity of supply: the percentage change in the quantity supplied that occurs in response to a 1% change in
price

Perfectly inelastic supply: supply is perfectly inelastic with respect to price if elasticity is zero

Perfectly elastic supply: supply is perfectly elastic with respect to price if elasticity is infinite
Chapter 4

Utility: the satisfaction people derive from their consumption activities

Marginal utility: the additional utility gained from consuming an additional unit of a good

The Law of Diminishing Marginal Utility: the tendency for the additional utility gained from consuming an extra unit
of a good to diminish as consumption increases beyond some point

The rational spending rule: spending should be allocated across goods so that the marginal utility per euro is the
same for each good

Preference ordering: identifies an individual’s preferences over various possible bundles of goods that might be
consumer

Assumptions about preferences:

1. Preferences are “complete”

2. Preferences are “ordinal”
3. Preferences are “transitive”
4. The individual’s utility is “increasing” in any good → more is better
5. Preferences are continuous
6. Preferences display a “diminishing marginal rate of substitution”

Indifference Curve: a smoothly convex curve the informs about combinations of two goods between which the
individual is indifferent (same utility)

The further out an indifference curve is, the higher the consumer’s utility from the bundles of A and B on the
curve

Marginal Rate of Substitution (MRS): between two goods gives the slope of the indifference curve

Consumer rationality: implies the consumer will allocate spending so that MRS equals relative price:

When individual demand curves are identical, the market demand curve (b) is derived by multiplying each quantity
on the individual demand curve (a) by the number of consumers in the market

Consumer surplus: the difference between a buyer’s (consumer’s) reservation price for a product and the (market)
price actually paid
Chapter 5:

Producer surplus: the difference between the seller’s reservation price and the market price

Factors of production: inputs used in the production of a good or service

Short run: a period of time sufficient try short for at least some of the firm’s factors of production to be fixed

Long run: a period of time sufficient length for all the firm’s factors of production to become variable

Variable factor of production: an input whose quantity can be altered in the short run

Law of diminishing returns: increased production of the good eventually requires ever-larger increases in the
variable factor when’s omen actors of production are fixed

Fixed cost (FC): the sum of all payments made to the firm’s fixed factors of production / the payments that have to
be made for the service of an input regardless of whether and how much production actually takes place

Variable cost (VC): the sum of all payments made to the variable factors of production

Total cost (TC): the sum of fixed and variable cost

Marginal cost (MC): the change in total cost divided by the corresponding change in output

Average total cost (ATC): total cost divided by total output

Average variable cost (AVC): variable cost divided by total output

Average fixed cost (AFC): fixed cost divided by total output

Profit: total revenue a firm receives from the sale of its products minus all costs (explicit and implicit) of production

Profit-maximizing firm: a firm whose primary goal is to maximize profits

Price-taker: a firm that has no influence over the price at which it sells its product

The perfectly competitive market: a market in which all individual suppliers are price-takers

Imperfectly competitive firm: a firm that has at least some influence over the price at which it sells its product

A profitable firm: a firm whose total revenue exceeds its total cost
Chapter 6

(Pareto) Efficiency: a situation where no further transaction is possible that will help some without harming other
people

if there are still transactions possible that will either help everyone or some without harming others is NOT
Pareto efficient

Observation on efficiency: when the unit price is above or below the equilibrium price, the quantity exchanged will
be lower than the market equilibrium quantity

Any policy that reduces total economic surplus is a missed opportunity to make everyone better off

Deadweight loss: the reduction in total economic surplus that results from the adoption of a policy

Demand elasticity and deadweight loss

● Elasticity determines the burden the buyers and sellers face because of tax that they have to bear
● A more elastic curve means the buyers have to bear less of the burden of the tax
Chapter 7

Invisible Hand Theory: Adam Smith’s theory that the actions of independent self-interested buyers and sellers will
often result in the most efficient allocation of resources

Explicit costs: the actual payments a firm makes to its factors of production and other suppliers

Implicit costs: the opportunity costs of the resources utilized by the firm

Accounting profit: total revenue minus explicit costs

Economic profit: total revenue minus explicit costs minus implicit costs

Normal profit: accounting profit minus economic profit

Rationing function of prices: to distribute scarce goods to those consumers who value them the most

Allocation function of prices: to direct resources away from overcrowded markets and toward markets that are
underserved

Efficiency: The market outcome is efficient in the long run

Fairness: the market is fair

Free entry and exit must exist for the allocative function of price to operate

Entry and exit barriers:

● An entry barrier is any force that prevents firms from entering a market
○ Entry barriers can be caused by legal constraints and unique market characteristics

● Exit barriers are frequently caused by political responses to declining demand or rising costs
○ Exit barriers can indirectly induce entry barriers by making new meds hesitate to enter

The Distinction Between Equilibrium and a Social Optimum

● The Equilibrium Principle means that there are no unexploited opportunities available in markets that are in
equilibrium
● The market equilibrium does not imply that the resulting allocation is necessarily best from the point of view
of society as a whole
● An equilibrium will not be socially optimal when the cost and benefit for individuals differs from society as a
whole