Intro to Econ

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Econ 1011 Study Guide

Opportunity Cost

The opportunity cost is the cost of the forgone alternative. (If you have many alternative it is the one which has the highest value)

Total opportunity cost / economic cost = Explicit cost + Implicit cost

Production Possibilities Frontier

- Points inside the PPF vs. outside the PPF
- Shape of the PPF
- Economic growth and PPF

Law of Demand

Other things remaining constant, the quantity demanded of a good rises when the price of the good falls

Income and Substitution Effect

The two concepts are trying to explain the law of demand. Let’s define the ‘price effect’ as the impact of a change in price on quantity demanded. We expect the price effect to have a negative sign, signifying the inverse relationship between P and Q / the downward slope of DD.

When price of a good changes, it does two things (a) makes it relatively expensive or cheaper with respect to other goods in the market, and (b) changes our purchasing power.

The substitution effect is always negative i.e. when price rises then the good becomes relatively expensive and quantity demanded decreases. (Both P and Q go in opposite direction)

The income effect can be negative or positive: when the price of a good rises and if it reduces your purchasing power (in turn reducing the quantity demanded) then income effect will have a negative sign and such goods are called ‘normal goods’.

However, if a decrease in price of a good, increases your purchasing power and you decide to increase quantity demanded then the income effect has a positive sign (both P and Q go in same direction) and such goods are called inferior goods.

Now, inferior goods mess up our calculations. A negative plus a positive number could be either negative (inferior good type 1) or it could be positive (inferior good type 2). The latter are called ‘Giffen goods’ and that they are kind of bizarre because they have a positive price effect. In other words, when price goes up, quantity demanded also goes up (ceteris paribus) - a result that counters the law of demand.

To sum up:
Substitution effect+ Income effect= Total price effect

Normal goods (negative)+ (negative)= (negative) Inferior goods (negative)+ (positive)= ?

Inferior goods - type 1 (negative)+ (small positive)=(negative) Inferior goods - type 2 (negative)+ (big positive)= (positive)

Note: we have said nothing about the price of substitute good changing or income changing. It is tempting to think of income and sub effect in terms of these, but remember that they are explaining what happens to quantity demanded of a good when price of the same good changes.

We can also define income and sub effect for perfect substitutes and perfect complements. (You will learn more about this in intermediate micro though).

Substitution effect+ Income effect= Total price effect

Perfect substitutes (negative)+ 0= (negative) Perfect complements 0+ (negative)=(negative)

DD curve vs DD schedule

Demand curve Curve that shows relationship between price of product and quantity demanded Demand schedule Table showing the same relationship

Determinants of DD

- Price of own good
- Price of other goods (substitutes vs. complements)
- Income (normal vs. inferior goods)
- Tastes and pref
- Expectations (of prices of the product or income)
- Number of buyers

Law of Supply

Other things remaining constant, the quantity supplied of a good rises when the price of the good rises

Determinants of SS

- Price of own good
- Price of inputs
- Technology
- Prices of substitutes in production
- Expectations (about price of the product and cost of production) - Number of sellers

Movement along Curve vs. Shift of Curve

- Price of own goodmovement along DD curve
- Price of other goodsshifts DD curve
- Incomeshifts DD curve
-...
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