Past Exam Solution

Economics Summary

1. What are Economics?

• Scarcity (limited nature of society’s resources)
• Prices (signals that guide allocation of resources, mechanism for rationing scarce resources, determine who produces which good and how much is produced)
• Allocation
• Demand, Customers
• Supply, Sellers
• Trade
• Competition
• Money
• Product→ factors of production: labor, knowledge, land, capital
• Households (own the factors, sell/rent them to firms for income; buy and consume goods and services)
• Firms (buy/hire factors, use them to produce; sell goods and services)
• Income
• Elasticity
• Inflation, Deflation

• Economy: One who manages a household
• Economics: study of how society manages its scarce resources, how decisions what to buy, how much to work, save or spend, how much to produce, how many workers to hire, how to allocate resources are made
• Microeconomics: study of how households and firms make decisions; how they interact in the market
• Macroeconomics: study of economy-wide phenomena, including inflation, unemployment, economic growth

• Consumer Theory (why and in which quantity goods are demanded)
• Firm Theory (under which criteria are goods offered and what influences decisions concerning production progress)
• Price Theory (In which quantity are goods to a specific price sold and what influences the composition of production)
• Distribution Theory (Who decides the allocation)
• Money Theory (Which role play money)
• Finance Theory (What influences does the state have)
• Employment Theory (What influences rate of unemployment)
• Economic Cycle Theory (What influences the whole economy)
• Growth Theory (What are reasons and conditions for economic growth)
• Trade Theory (What happens in special economies)

1. Competition

• Monopoly (only one seller in market, influences price)
• Oligopoly (e.g. duopoly)
• Monopolistic competition
• Competitive market (market with many buyers and many sellers, each has a negligible impact, price determined by interaction of buyers and sellers)
• perfectly competitive market (goods are exactly the same/identical, buyers and sellers are price takers --> can't influence price, at market price: buyers can buy all they want, sellers can sell all they want)

1. Principles of Economics

• #1: People face tradeoffs

• Time -  money
• Environment – production
• Efficiency – equity (getting the most out of scarce resources – distributing prosperity fairly among society’s members)

• #2: The cost of something is what you give up to get it

• Comparing costs and benefits of alternative choices
• Opportunity cost: whatever must be given up to obtain a certain good (e.g. time)

• Relevant cost of decision making

• #3: Rational people think at the margin

• Rational: systematically and purposefully do the best you can to achieve your objectives
• Evaluate costs and benefits of marginal changes (small changes to an existing plan)

• #4: People respond to incentives

• Incentive: something that induces a person to act, e.g. the prospect of a reward or punishment

• #5: Trade can make everyone better off

• People specialize in producing one good or service and exchange it for other good
• Get a better price abroad
• Buy goods more cheaply abroad

• #6: Markets are usually a good way to organize economic activity

• Market: a group of buyers and sellers
• Organize economic activity (what to produce, how to produce, how much to produce, who gets the goods)
• Interaction households – firms
• Led by an invisible hand (works through price system)
• Interaction buyer – seller
• Price reflects good’s value to buyers – costs of producing the good

• #7: Governments can sometimes improve market outcomes

• Enforce property rights
• Market failure: fails to allocate society’s resources efficiently

• Externalities: production or consumption affects bystanders              (e.g. pollution)
• Market power: single buyer/seller has substantial influence on market price (monopoly)

• Governments may alter market outcome to promote equity

• Tax, welfare policies

1. PPF (Production Possibilities Frontier)

• graph shows combination of 2 goods the economy can produce given the available resources and technology
• e.g. computers on x-axis, wheat on y-axis
• point on PPF: efficient; below: not efficient; above: impossible
• opportunity cost is slope of PPF (what society has to give up to gain something --> e.g. 1 computer = 10 tons of wheat)
• PPF changes when more/less resources, technology

1. View of an economist

• positive statements: describe how world is
• normative statements: describe how world should be
• economists use models (Circular-Flow Diagram --> exchange of factors of production and goods/services; PPF --> decision what amount of what good to produce)

1. Demand

• Determined by buyers
• Quantity demanded: amount of goods buyers are willing and able to purchase
• Law of demand (other things equal): when price rises --> quantity demanded falls
• Demand curve sloped downwards; exception: Giffen good: demand increases when price rises
• Market demand: sum of all individual demands for a good/service

• Variables that may change the demand curve (relation between price and quantity)
• Increase in demand: curve shifts right
• Decrease in demand: curve shifts left

• Income

• Inferior good: Income up, Demand down
• Normal good: Income up, Demand up

• Price of related goods

• Substitutes: Price S up, Demand G up
• Complements: Price C up, Demand G down

• External Factors
• Tastes
• Expectations about the future
• Number of buyers

1. Supply

• Determined by sellers
• Quantity supplied: amount of goods sellers are willing and able to sell
• Law of supply (other things equal): Price up → Supply
• Market supply: sum of the supplies of all sellers for good/service
• Variables that may change the supply curve (relation price and quantity)
• Increase in supply: curve shifts right
• Decrease in supply: curve shifts left

• Input prices (e.g. raw materials): negatively related --> higher input prices, lower supply
• Technology
• Expectations about the future
• Number of sellers

1. Equilibrium

• Forces are in balance

• Point where demand curve and supply curve intersect --> quantity supplied = quantity demanded

• Equilibrium price (market-clearing price) and equilibrium quantity

• Surplus: Quantity supplied > quantity demanded --> excess supply --> downward pressure on price
• Shortage: Quantity supplied < quantity demanded --> excess demand --> upward pressure on price
• Law of supply and demand: price will adjust to bring quantity demanded and quantity supplied in balance --> mostly shortage, surplus are only temporary
• Shift in demand curve

• Decrease: curve shifts to left → lower equilibrium price and quantity
• Increase: curve shifts to right → higher equilibrium price and quantity

• Shift in supply curve

• Decrease: curve shifts to left → higher equilibrium price, lower quantity
• Increase: curve shifts to right → lower equilibrium price, higher quantity

• To calculate equilibrium: set demand and supply equal → solve for P → Plug P in one equation --> solve for Q

1. Elasticity

• How much the price of a good changes, when other factors change (in percent)

• One variable responds to changes in another variable

• Calculated value > 1 → elastic respond
• Calculated value < 1 → inelastic respond
• Price elasticity of demand (how much demand responds to changes in price)

• Percentage change in quantity demanded / percentage change in price
• Midpoint method:

• ((end value – start value) / midpoint) * 100% = percentage of change

• Price elasticity is higher, when close substitutes are available
• Price elasticity is higher for narrowly defined goods than broadly defined ones
• Price elasticity is higher for luxuries than for necessities
• Price elasticity is higher in the long run than in the short run
• 5 cases:

• Perfectly inelastic demand → E=0 (changes in price don’t influence demand)
• Inelastic demand → E<1 (changes in price bigger than changes in demand)
• Unit elastic demand → E=1 (changes in price equal to changes in demand)
• Elastic demand → E>1 (changes in price lower than changes in demand)
• Perfectly elastic demand → E=infinity (changes in price lead to zero demand)

• Income elasticity of demand

• Percentage change in quantity demanded / percentage change in income
• Inferior good: % change demand negative, % change income positive → negative elasticity
• Normal good: % change in demand positive, % change income positive → positive elasticity

• Cross price elasticity of demand

• Percentage change in quantity of G / percentage change in price of S
• Substitutes: % change in G’s quantity positive, % change in S’ price positive        → positive elasticity
• Complementary: % change in G’s quantity negative, % change in S’ price positive → negative elasticity

• Price elasticity of supply

• Percentage change in quantity supplied / percentage change in price
• Measures how much quantity supplied responds to changes in price
• Again: Perfectly inelastic, inelastic, unit elastic, elastic, perfectly elastic
• Price elasticity higher if sellers can change produced quantity easily
• Price elasticity higher in long run than in short run --> can adjust production
• Price elasticity becomes less elastic as quantity supplied rises due to capacity limits

1. Government Policies

• Normally decrease market activity
• Improve market outcomes sometimes --> help the poor, protect seller, buyer or environment
• Other ways to help: rent subsidies, wage subsidies, advertising campaigns, environmental protections

• Price ceiling (legal maximum)
• if above equilibrium price: not binding
• if below equilibrium price: binding --> shortage --> sellers must ration the scarce of goods
• reasons: decrease in supply --> protect environment; protect buyers from too high prices
• negative effects: demand exceeds supply
• Price floor (legal minimum)
• if below equilibrium price: not binding
• if above equilibrium price: binding --> surplus --> sellers are unable to sell what they want
• reasons: increase in price --> minimum wage
• negative effects: unemployment
• Taxes (most often reduce size of market)
• Government uses taxes to raise revenues for public projects
• Tax incidence: manner in which the burden of the tax is shared among buyer and seller
• Tax levied on seller: supply curve shifts left --> higher equilibrium price, lower quantity
• Tax levied on buyer: demand curve shifts left --> lower equilibrium price, lower quantity
• Tax --> buyer pays more, seller receives less
• Tax burden: more heavily on the side of the market that is less elastic

1. Market Efficiency

• Welfare economics: how allocation of resources effects economic well-being
• Willingness to pay: maximum amount buyer will pay
• Consumer surplus
• Amount buyer is willing to pay - amount buyer has to pay
• Measures benefits buyers receive from participating in the market
• Area below the demand curve and above the price
• Calculation: ((max. price - equilibrium price)*quantity) / 2
• Cost: value of everything a seller must give up to produce; measure of willingness to sell
• Producer surplus
• Amount seller is paid for good - seller's cost for providing good
• Area below the price and above supply curve
• Calculation: ((price - min. price)*quantity) / 2
• The benevolent social planner: all-knowing, all-powerful, well-intentioned dictator --> wants to maximize economic well-being
• Total surplus = consumer + producer surplus (= value to buyers - cost to sellers)
• Efficiency: resource allocation, maximizing total surplus
• Equality: distributing total surplus uniformly among buyers and sellers

1. Costs of production

• Opportunity costs: what you have to give up
• Explicit costs: input costs that require spending of money
• Implicit costs: input costs that to do not require spending of money
• Total costs: explicit + implicit costs
• Economic profit: total revenue - total cost
• Accounting profit: total revenue - explicit cost
• Production function: relation between input (capital, labor) and output --> gets flatter as production rises
• Marginal Product: slope of production function; increase in output if change of one unit in input --> 1st derivative of production function; marginal product of input decreases as quantity of output increases
• Total cost curve: relation between quantity and total costs; gets steeper as quantity rises
• Fixed costs: costs that do not vary with quantity (e.g. machinery)
• Variable costs: costs that vary with quantity (e.g. labor)
• Total cost: fixed + variable costs
• Average fixed cost: fixed cost / quantity of output --> ~cost per unit --> always declines as output rises
• Average variable cost: variable cost / quantity of output --> ~cost per unit --> typically rises as output increases
• Average total cost: AFC + AVC; U-shaped --> minimum of ATC at bottom of U --> quantity that minimized average total cost
• Marginal cost: increase in total cost arising from an extra unit --> 1st derivative of total cost function, upward sloping
• Relation ATC and MC
• MC < ATC: ATC falling
• MC > ATC: ATC rising
• MC crosses ATC at its minimum
• Costs in short and long run
• Decisions fixed in short run, variable in long run --> greater flexibility in long run
• Long run cost curves: much flatter than short run cost curves
• Short run cost curves: lie on or above long run cost curves
• Economies of scale: long run ATC falls as the quantity increases e.g. increased specialization among workers
• Constant returns to scale: long run ATC stays the same as the level of output changes
• Diseconomies of scale: long run ATC rises as the quantity of output increases e.g. increasing coordination problems

1. Competition

• Competitive market: many buyers and sellers, identical products, price takers, firms can freely enter or exit market
• Demand = Horizontal Line = Price
• Revenues of a competitive firm
• Profit: total revenue (P * Q) - total cost
• Average revenue: TR / quantity
• Marginal revenue: change in TR from an additional unit sold
• --> Average revenue = P = Marginal revenue
• Profit Maximization --> MR = MC = P
• if MR > MC: increase output
• if MR < MC: decrease output
• MC: quantity of the good firm is willing to supply at any price --> supply curve
• Shutdown: short run decision to stop producing (during specific period, due to current market conditions) --> firm still has to pay fixed costs
• Shutdown if TR < VC (P < AVC)
• Exit: long run decision to leave market --> firm doesn't have to pay any costs
• Exit if TR < TC
• Enter if TR > TC
• Sunk costs: has already been committed, can't be recovered
• Measuring profits
• If P > ATC --> Profit (Profit = (P-ATC)*Q))
• If P < ATC --> Loss
• Market Supply: quantity supplied by all firms added together
• Short run: fixed number of firms, supply quantity where P = MC
• Long run: firms can enter/exit market; ends when firms make zero economic profit (P=ATC) --> MC = ATC: efficient scale, Economic profit = 0, Accounting profit > 0
• Long run supply curve: perfectly elastic --> horizontal at minimum ATC
• Positive economic profit in short run --> firms enter market in long run --> supply curve shifts right --> price decreases back to minimum ATC --> quantity increases (more firms) --> efficient scale

1. Monopoly

• only one firm, price maker
• Barriers to enter: monopoly resources (key resource owned by single firm), government regulation (gives a single firm right to produce e.g. patent and copyright laws), production process (single firm can produce output at a lower cost than many firms together)
• Natural monopoly: single firm can supply good or service to entire market, economies of scale over relevant range of output
• Downward sloping demand
• Monopolist revenue
• MR < P --> MR curve below demand curve
• Increase in quantity sold: higher output --> increase in total revenue; lower price --> decrease in revenue
• Maximize profit: MR = MC --> charge price of demand curve
• Welfare cost of monopolies: produce less than socially efficient quantity of output --> deadweight loss (triangle between demand curve and MC curve)
• Price Discrimination: sell same good at different prices to different customers e.g. movie tickets, quantity discounts
• Rational strategy to increase profit
• Ability to separate customers according to willingness to pay
• Can raise economic welfare
• Perfect price discrimination: charge each customer a different price --> monopolist gets entire surplus --> no deadweight loss
• Without price discrimination: Single price > MC --> consumer and producer surplus --> deadweight loss
• How to increase competition?
• Prevent mergers
• Break up companies
• Regulate monopolies e.g. price
• Public ownership

1. Consumer choice

• Consumer: household
• Purpose: best possible satisfaction of needs, given limited resources
• Assumption: buys best combination of goods that he can barely afford --> what combinations?
• Budget constraint: the limit the consumer can afford, shows trade-off between goods              --> slope: rate at which the consumer can trade one good for the other --> relative price of the two goods
• Indifference curve: shows consumption bundles that give same level of satisfaction --> combination of two goods on same curve                                                                                          --> slope: marginal rate of substitution (rate at which consumer is willing to trade one good for another)
• Quantity of good A at x-axis, quantity of good B at y-axis
• Higher indifference curves are preferred (more goods)
• Indifference curves are downward sloping
• Indifference curves don't cross
• Indifference curves are bowed inward
• Perfect substitutes: straight line indifference curve --> marginal rate constant
• Perfect complements: right-angle indifference curves
• Optimum: Indifference curve and budget constraint cross --> best combination of goods available to consumer --> slope of indifference curve = slope of budget constraint --> marginal rate of substitution = relative price
• Higher income: consumer can afford more --> shifts budget constraint upwards --> new optimum
• Price of one good falls: rotates budget constraint outward --> steeper slope --> change in relative price
• Income effect: change in consumption --> consumer moves to higher or lower indifference curve
• Substitution effect: change in consumption --> consumer moves along indifference curve to new point with new marginal rate of substitution

1. Presentations

• Berlin is the Case (iPhone cases, competitive market, fixed costs ~2000€, VC: 7€ per case, demand more elastic than supply)
• Cupstomized (Cupcake shop in Neukölln, possiblity to create own cupcake, competitive market, demand more elastic than supply, profit ~2000€)
• Apple juice (Organic apple juice, sell in Berlin, competitive market, demand more elastic than supply)
• Cigarettes (demand more inelastic than supply, high taxes, fixed costs ~10000€, VC: 1500000 per month for 600 million cigarettes, competitive market)
• Döner (competitive market, annual revenue: 220,000€, demand more elastic than supply)
• Glühwein (Christmas: competitive market, after christmas: monopoly, demand more elastic than supply)