ECON 101 Study Guide - Midterm Guide: Efficient-Market Hypothesis, Constant Curvature, Monopolistic Competition
Economics 101
Lori Leachman
Exam 1 Complete Material
• Definition of Economics: study of how individual & society choose among alternative uses of scarce
resources to produce & consume goods & services
o Scarce resources: unlimited wants - not enough resources
▪ Scarcity necessitates choice
o Individuals: con
o sumers, firms, labor - Microeconomics
o Society: consumers, business, government, foreign sector - Macroeconomics
o Resources
▪ Land: raw material (acreage & natural resources from land)
▪ Labor: human input (physical and mental labor (human capital))
▪ Capital: tools, machines, equipment used to produce something else - production
resources
▪ Entrepreneurship: innovation & risk taking (human capital)
o Microeconomics: focus on individuals, firms & their interaction in markets
▪ Individuals are consumers or labor (input resources) - always want max utility
(satisfaction)
▪ Firms combine & process inputs to create outputs - always want max profit
• Bottom line firm - maximizes profit
• Double bottom line firm - maximizes profit & sustainability (environmental)
• Triple bottom - maximizes profit & sustainability & social consciousness
▪ Can maximize
• Profit - revenue minus costs
• Social welfare - social consciousness
• Market share - user base; eyeballs
• Revenue - all money brought in
o Markets - interaction between firms and individuals
▪ Perfect Competition: (construct & ideal; doesn’t really exist)
• No barriers to entry/exit - easy to join market, no large requirements
• Large # of small firms - no one really influences market
• Homogenous product - everyone’s product is the same, no consumer preference
• Price takers - market sets price
▪ Monopolistic Competition: (real competitive markets - ads)
• No barriers to entry/exit
• Large # of small firms
• Heterogeneous Product - product differentiation; branding & ads
• Price setter - ability to set price due to branding
▪ Oligopoly: entertainment, pharmaceutical... etc
• High barriers to entry/exit - copyrights & patenting & large capital requirements
(startup costs); gov. won’t let them exit or merge b/c can lead to monopoly
• Small # of big firms - dominant firms, few large ones that matter
• Heterogeneous product
• Price setter
▪ Monopoly: (one dominant firm)
• High barriers to entry/exit - can sustain large profits/losses
• One dominant firm
• Homogenous product - only one product
• Price setter
o Competition comes from outside industry (electric to solar)
▪ Very high limits - can set high limits
▪ Regulated by government (technically illegal)
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o Returns to Scale of Production - how cost changes as firm gets bigger/smaller
▪ Increasing RTS - as you get bigger, you produce cheaper (per unit cost decreases)
• Technology
• Learning by doing - practicing efficiency
• Leads to oligopoly, monopoly - motivation to become bigger
▪ Decreasing RTS - as you get bigger, you produce expensively (per unit cost increases)
• Service industry - only can have so many with quality services (ex. medical)
• Leads to perfection competition, monopolistic competition - smaller firms
▪ Constant RTS - regardless of size, per unit costs remain the same
• Possibly any industry structure
o Production function
▪ Output (Q) is a function of capital (K) and labor (L)
▪ A three dimensional graph - an S curve
• Positive curvature - increasing RTS (up to Q1)
• Constant curvature - constant RTS (Q1 to Q2)
• Negative curvature - decreasing RTS (Q2 and beyond)
o Size of Q2 relative to market determines how many firms can be in
market structure
▪ Where constant RTS changes to negative RTS - dictates market structure
o Long Run Average Cost Curve (LRAC)
▪ Mirrors production function; looks like a U with a flat middle (constant RTS)
• Conservative Thinking - Classical - Freshwater (comes from University of Chicago)
o Individual self-interest is dominant
o Reliance on markets; markets are self-regulating
o Setting rules/laws of market and enforcing them; monetary policy (supply-oriented)
▪ Dislike discretionary policy
o Say’s Law - supply creates its own demand
o Focus on AS - believe in the EMH (Efficient Market Hypothesis)
▪ EMH - all information is in price; rational expectations & few market failures
(externalities)
o Rational Expectations (uses past information and model to forecast future)
▪ Economic agent is very sophisticated
o Long run oriented
• Liberal Thinking - Keynesian - Saltwater (along east coast)
o Social welfare is dominant
o Markets are imperfect; lots of sources of market failure
o Set rules and proactively regulate economy and engage in discretionary policy; fiscal policy
o Problems with imperfect information
o Focus on AD
o Adaptive Expectations (does not forecast future; bases decisions solely on past information)
▪ Economic agent is less sophisticated
o Short run oriented
• Sources of Market Failure (ignored by Classicals)
o Externalities - by products
▪ Negative: pollution and second hand smoking; push costs onto others - taxes
▪ Positive: public health care, vaccination, education - subsides
o Public goods - pricing public goods that are collectively consumed; cannot assign price; no firm
wants to produce
o Information problems
▪ people can be ignorant & biased to perfect information
▪ asymmetric information (not everyone has same information)
▪ interpretive biases - people read & interpret things differently (wording... etc)
o Concentration of power
o Growing inequality
o Inadequate demand
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• Macroeconomics - study of entire economic system, focus on how gov. uses discretionary policy
o Discretionary - policy that can change whenever gov. wants
o Fiscal policy - taxes, spending, budget - short term
▪ Done by executive & legislative branches - lot of politics
▪ Full employment, economic growth, price stability, optimal external balance
o Monetary policy - interest rates, money supply - affect inflation
▪ Done by Federal Reserve (Central Bank)
▪ Price stability, economic growth, full employment, optimal external balance
• Government Objectives & Goals
o Full employment (around 4.5%) - maintain frictional level of unemployment; not zero
o Price stability - little/no inflation (less than or equal to 2%)
▪ Inflation - persistent upward movement in price level (price of all goods)
▪ Deflation - downward movement in price level - very problematic - debt burden
▪ Disinflation - smaller and smaller inflation rates
o Economic Growth - measured by real GDP (gross domestic product)
o Optimal External Balance
▪ BP = balance of payments = (x - m) + (Ad - FA)
• x - m = trade balance; goods & services trade
o x = exports, m = imports
• Ad - FA = money flow; financial account
o Ad = domestic assets that foreigners buy (i.e. stocks purchased by
foreigners), FA = foreign assets that we buy (real estate in other
countries)
• If Ad - FA > 0 (borrowing from world; outflow) < 0 (lending to world; inflow)
• If x - m > 0 (trade surplus) < 0 (trade deficit)
• BP = 0 = deficit and borrowing = 0 (U.S.) - LONG RUN ALWAYS
• Optimal for US (industrial country) - trade surplus and lending to world
o Currently the opposite
• Optimal for developing country - imports capital goods - trade deficit and
borrowing from world - build up capital to produce in future (investments)
• Four Sectors of Economy
o C: Consumption - single largest spending component (65-70%)
o I: Investment - 2 parts: business spending & inventory investment (disequilibrium) (10-15%)
o G: Government - consolidated government and includes federal, state, local gov. (30%)
o Xn: Net Exports - less than 0 (we import more than export)
• Economic Assumptions
o Rationality: people prefer more to less of good
o Efficiency: people want most for least cost
o Nothing is free: everything has a cost
▪ Direct cost: what you pay
▪ Transaction costs: time/info/subscription/transfer costs/fees
▪ Opportunity costs: costs of next best alternative; what you give up
▪ Optimal decision making takes on board all costs
o The best economic decisions are made with marginal analysis (reconsidering at all steps)
o Risk = prob of bad event * cost if the event occurs
• Demand: all price & quantity combos consumers are willing & able to purchase (effective demand)
o Law of Demand: inverse relationship between price and quantity demanded
▪ Substitution effect: if price is cheaper than alternatives/substitutes, people buy more
▪ Income effect: if price is cheaper, real income (buying power) increases and you buy
more
▪ If demand is upwards slowing, due to ill-behaved income effect
o Change in price: move along demand curve - change in quantity demanded
• Price elasticity of Demand: sensitivity of changes in quantity demanded due to price changes - Ep
o Ep = % change in Qd / % changes in P
o Ep = 1; UNIT ELASTIC
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