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Test Review I: Understanding Economic Activity e-mail Walter with
Scarce Resources chapter 2
A. Factors of Production
B. The Production Possibility Frontier (Curve) measures how many of two types of goods can be produced.
Static Model (time is
constant, inputs are fixed)
Characteristics of Market System
A. Economic systems determine what to produce, how to produce, and who will receive production.
B. An economic system must also have the ability to adapt to changing economic environments. For example, America must adapt to changes to September 11?
C. Adam Smith described the beginning of capitalism.
1. His book, The Wealth of Nations, was the first description of capitalism.
2. Published in 1776, it described capitalism as it was practiced in 18th century England.
D. Basic characteristics described by Adam Smith
1. Private property-the right to own resources and bequeath property
2. Freedom of enterprise-own a business
3. Freedom of economic choice-work/not work, spend/not spend
4. Role of self-interest
a. People are by nature economic creatures
b. Self-interest is a fundamental characteristic of people
5. Competitive market system
a. Many buyers and sellers
b. Market participants, buyers and sellers, have little control over price
c. Competition performs the organizing and controlling functions for a market economy
6. Limited government ("Laissez-faire ")
a. Government should let markets be with a hands-off philosophy)
b. Acceptable government involvement has become an important political question in the United States during the last few decades.
E. Modern Capitalism has additional features
1. Complex Market System Setting Prices
2. Importance of Capital Goods and Technology
a. Complexity requires company produce limit their product lines
b. Division of Labor allows specialization by ability ad training.
F. Creative Destruction described by 20th century sociologist/economist Joseph Schumpeter was an important addition to the idea of capitalism.
1. Change involves the creation of improved economic structures based on technology and the destruction of inefficient economic structures.
2. Capitalism allows this destruction to take place.
G. Economic Systems
|IV. Demand and Supply chapter 4|
A market is defined as an institution or mechanism which promotes trade by
buyers (demanders) and sellers (suppliers).
1. Replaced barter which is the direct exchange of goods.
2 Modern market brings money and prices into the circular flow of goods.
B. Demand is willingness to buy.
1. Demand is a schedule of the amounts of goods and services consumers are willing
and able to buy at a set of prices.
2. Total demand is the Horizontal Summation of individual demand.
3. Law of demand:: price and quantity are inversely related and as price goes up,
quantity demanded goes down and vice versa
4. Why more is bought as price drops.
a. Income Effect: as the price of a good drops, consumers feel richer and buy more.
b. Substitution Effect: as the price of a good drops, it becomes cheaper relative to
other goods and consumers buy more
C. What determines demand
1. Tastes or preferences of consumers 2. Number of consumers 3. Incomes of consumers
a. normal (superior) goods such as steak and vacations - more is purchased as income increases.
b inferior goods such as bread and hamburger - less is purchased as income increases.
4. Consumer expectations 5. Price of related goods
a. Substitutes are goods that compete with each other such as hot dogs and hamburgers. If the price of a good increases, the demand for its substitutes will increase.
b. Complements are goods that are purchased together like hot dogs and rolls. If the price of a good increases, the demand for its complement will decrease.
5. ''Ceteris Paribus'' is Latin for all other variables remain the same. So we change one variable at a tome.
D. Changes (shifts) in Demand
D. What determines supply
1. Product costs as affected by technology, resource prices, government involvement with taxes
2. Price of related goods
a. If 2 goods are substitutes, price up for one will increase supply of the other (price of gasoline up,
supply of alternative fuels increases) as companies see more potential profit
b. If 2 goods are complements, price down of one will increase supply of other (price of PC's down,
supply of computer software up) as the expected increase in sales of the first item should increase
sales of the complement.
3. Number of producer and their expectations concerning the above listed variables will affect supply
E. Changes (shifts) in supply
1. A decrease in supply shifts the supply curve to the left
2. An increase in supply shifts the supply curve to the right
F. Equilibrium is where suppliers and demanders agree
on price and quantity as depicted
1. If the price is too high, a surplus results and price must be lowered
2. If the price is too low, a shortage results. This happens with toys every Christmas
(Cabbage Patch Dolls)
3. If they can not agree, as happened with Beta videotape machines, then the curves do not intersect
and the goods are not sold.
4. Rationing function of price makes for an efficient allocation of resources.
When competitive forces of supply and demand result in an equilibrium, a rationing function of
goods produce to consumers has occurred.
|G. How changes in supply and demand affect equilibrium price and quantity|
| D up and S up equally
D up causes P up
and Q up
|D up and S down equally
D up causes P up
and Q up
D down and S up equally
|D down and S down
D down causes P down and Q down
S down causes P up and Q down
Result is P same and Q down
H. Government Imposed Price Ceilings and Floors
1. A price ceiling keeps prices from rising (rent control) helping renters but often resulting in a
shortage of housing as investors seek higher returns elsewhere.
2. A price floor keeps prices from falling (farm price supports) helps farmers though a surplus
often results as more of supported crops are produced.
Key Economic Questions Society Must Answer
A. What to produce?
1. Which goods
a. Those that can be sold at a profit, consumers vote with dollars
b. Accounting Profit: The amount by which total revenue exceeds
accounting costs (rents, wages, and interest)
c. Normal Profit
1. Amount received for enterprise
2. Considered by economists to be a cost
d. Economic Profit
1. The amount by which total revenues exceed all "Factor" costs.
2. Some think of it as a surplus.
3. Expanding industries have economic profit.
a) Bill Gates, founder of Microsoft, has earned many billions of dollars.
b) So has Sam Walton of Wal-Mart
2. How many goods
a. Level of demand and efficiency of supply determine output.
b. Society determines total demand (who works, how often and
for how many years).
c. Success of economic system determines efficiency of supply.
B. How to produce?
1. Companies must be competitive
2. Competition is the "Invisible Hand" assuring
a. High quality goods are produced.
b. Efficient production methods are employed.
c. Prices and profits are reasonable.
d. For more read Adam Smith and the invisible hand by Helen Joyce of
3. Technology and innovation are instrumental to success.
C. Who will receive production?
1. Those willing and able to pay
2. Function of income, savings, and attitude toward debt financing
D. How will the economy adapt to changing environments?
1. Today's economic environment is changing more rapidly because
of the communication revolution.
2. Magnitude of these changes is similar to that which occurred in the
last quarter of the 19th century.
3. Companies and individuals must "adapt or be gone."
4. Capitalism allows creative destruction to work.
5. Recently technology has changed rapidly and people are being
a. Normally, political forces would attempt to slow creative destruction.
b. But, the 1990's was the decade of free enterprise so creative
destructions moved on.
c. Perhaps the next recession will slow down the free market
E. Market system evaluated
1. Advantages are resources allocated efficiently, economic freedoms (enterprise,
a. Too dependent upon competition eroded by monopoly power resulting in waste
and inefficiency result because of monopoly power exercised by business,
unions, governments, and interest groups.
b. Inequitable distribution of income (economic survival of the fittest)
c. Market failure occurs
1. Not all costs (pollution) and benefits (public health) are properly accounted for.
2. Why? because measuring their cost and benefits in dollars is difficult and
d. Political process sometimes interferes with creative destruction.
A. Provide a proper legal atmosphere (rules) for capitalism
B. Insure competition
1. Antitrust laws protect against abuse of monopoly power.
2. Natural (justifiable) monopolies such as AT&T were allowed because
duplicating high-cost fixed investments is illogical.
3. The emphasis on free markets discussed in chapter 3 has resulted in some natural
monopolies being broken into smaller companies which had to compete against
new companies touting new technologies.
C. Provide for an equitable distribution of income
1. Transfer payments where a government moves general revenue to a
specific group, i.e., Aid to Families with Dependent Children, students...
2. Market Intervention (affecting supply and demand)
a. Minimum wage decreases supply raising price and lowering quantity.
b. Excise taxes on alcohol, cigarettes, jewelry, etc., deceases supply.
c. Farm price supports, aid to small business and education increases supply.
D. Adjust for market failures
1. Adjust for spillovers (externalities)
a. Effects of a market system often spillover onto non-participants who are
external to the market transaction.
b. Both costs and benefits result.
1. Pollution hurts (costs) society so government tries to affect the supply of,
and demand for, pollution causing products such as automobiles.
For automobiles, they lower supply by requiring catalytic converters and
they lower demand with high excise taxes.
2. An educated workforce benefits society so government increases demand
(aid to students) and supply (aid to colleges).
Currently, our addiction to gasoline is high, as has global
E. Affecting total economic activity
Market System Participant
C. Federal government
Ease of Formation
Length of Life
Unlimited, personal assets at risk
|Once as personal income|
Two or More Owners
Unlimited, personal assets at risk
Once as personal income
Company is a legalentity
Limited to investment
Twice as income & dividends
E. Taxation philosophies
G. Types of tax rates