# Exam 1 study guide

## Capitalism + governments and institutions

**You should understand…**

- …the components of the capitalist economic system: private property, markets, and firms
- …what happens when any of these components gets distorted
- …what makes public goods different from regular goods (see public goods game)
- …what institutions are and how they coordinate action
- …what GDP is, what it measures, what it doesn’t measure, what problems there are with it, what alternatives there are for it, and why it continues to be popular
- …the difference between real and nominal values (and why we care)
- …what a price index is
- …what purchasing power parity (PPP) is (and also what the Big Mac Index is)
- …the downsides of capitalism (inequality + environmental damage)
- …why not everything should be a market
- …why large groups suffer from free riding and how they work to behave like small groups
- …how small factions threaten democracy, but also how they enable it
- …how voting can suffer from failures (Condorcet’s paradox)

**Important formulas:**

Adjusting for inflation:

\[ \text{Real} = \frac{\text{Nominal}}{\text{Price Index / 100}} \]

Percent change:

\[ \text{% change} = \frac{\text{New} - \text{Old}}{\text{Old}} \]

or

\[ \text{% change} = \frac{\text{Current} - \text{Previous}}{\text{Previous}} \]

Compound annual growth rate (CAGR); periodic method (this assumes interest is compounded once a year; this is the harder method and you don’t really need to use it):

\[ r = \exp(\frac{\ln(\frac{\text{Price index}_{\text{new}}}{\text{Price index}_{\text{old}}})}{t}) - 1 \]

Compound annual growth rate (CAGR): continuous method (this assumes interest is compounded continuously; this is the easier method and you should generally use this):

\[ r = \frac{\ln(\frac{\text{Price index}_{\text{new}}}{\text{Price index}_{\text{old}}})}{t} \]

**Guides:**

**Other helpful resources:**

## Fairness and efficiency

**You should understand…**

- …the difference between Pareto efficiency and fairness
- …why Pareto efficiency is not necessarily the best standard for measuring the success of a policy
- …how we can measure fairness with substantive standards, procedural standards, and Rawlsian standards
- …how cultural perceptions of luck and fairness shape public policy
- …how ideas of efficiency and fairness apply to international trade
- …how public policy can be used to change the payoffs in games (e.g. making it more expensive to use water and deplete public goods)
- …what elasticity measures (i.e. what it means for something to be inelastic vs. elastic)
- …why good public policies should be a Nash equilibrium
- …the difference between absolute and comparative advantage and how there can still be gains from trade if a part doesn’t have absolute advantage in a product

**Guides:**

## Work, wellbeing, and scarcity

**You should understand…**

- …what opportunity costs are and how they influence decision making
- …how to draw a budget line and what budget lines mean
- …how utility is measured and what indifference curves are
- …the difference between the marginal rate of substitution (slope of the indifference curve) and the marginal rate of transformation (slope of the feasible frontier)
- …what it means when marginal product and marginal utility diminish
- …how to find the utility-maximizing level of consumption given preferences and budget constraints
- …the difference between normal and inferior goods
- …what income effects and substitution effects are and how they’re related to government policies

**Important formulas:**

All the ways marginal utility (or marginal rate of substitution) can be written:

\[ MRS = \frac{dy}{dx} = \frac{\Delta y}{\Delta x} = \frac{\text{Price}_x}{\text{Price}_y} = \frac{MU_x}{MU_y} = \frac{\partial u / \partial x}{\partial u / \partial y} \]

**Guides:**

**Other helpful resources:**

- How to draw income and substitution effects
- Example Income and Subsitution Effects For Normal and Inferior Goods
- Income and Substitution Effects

## The firm

**You should understand…**

- …how the decision-making structures of firms and markets are different
- …that perfectly complete contracts are difficult (if not impossible) to create
- …what happens when there are incomplete contracts
- …what a principal-agent problem is
- …adverse selection
- …moral hazard
- …how firms can use the labor discipline model to induce higher worker effort
- …why involuntary unemployment is necessary

## Firms and markets

**You should understand…**

- …how demand curves are derived from consumer willingness to pay
- …the difference between fixed costs and variable costs
- …how to calculate total cost, total revenue, average fixed costs, average variable costs, marginal cost, marginal revenue, and maximum profit
- …that maximum profit occurs where marginal revenue is equal to marginal cost (\(MR = MC\))
- …that socially optimal quantity occurs when the demand is equal to the marginal cost (\(\text{demand} = MC\))
- …how to calculate elasticity of demand (\(-\frac{\Delta Q}{\Delta P} \times \frac{P}{Q}\))
- …what elasticity measures and why it is important in public policy and administration
- …how a single demand curve can have an overall elasticity
*and*different elasticities at each point - …economies of scale, diseconomies of scale, economies of agglomeration, network effects, and the difference between short-run and long-run costs
- …that market equilibria (i.e. optimal price and quantity) occur at the intersection of supply and demand curves
- …how government-imposed price floors and price ceilings distort market-clearing equilibria
- …and be able to identify the differences between changes in supply/demand and changes in quantity supplied/demanded
- …what consumer and producer surplus represent
- …the relationship between elasticity of supply and/or demand and the size of consumer and producer surplus
- …how taxes impose deadweight loss on society
- …how the burden of taxes depends on the elasticity of supply and/or demand
- …why governments tax and the philosophical and ethical principles behind who should bear the burden of taxes
- …the difference between price-taking and price-making
- …how firms try to gain market power, including monopolies, branding, cost controls, regulation, and switching costs
- …why firms try to gain market power
- …why firms want to price discriminate
- …the consequences of monopolistic production (lower Q and higher P than what would happen under perfect competition; deadweight loss)
- …how governments can regulate monopolies
- …why natural monopolies exist and how governments can induce them to produce at socially optimal levels
- …how firms need to be somewhat anti-competitive and anti-capitalist in order to maximize profits, innovate, and (essentially) be more competitive and capitalist

**Guides**

**Important formulas:**

Demand:

\[ P = aQ + b \]

Total cost:

\[ \begin{aligned} TC = TFC + TVC \\ \text{or a formula using } Q \text{, like} \\ TC = aQ^2 + b \end{aligned} \]

Average cost:

\[ AC = \frac{TC}{Q} \]

Marginal cost:

\[ \begin{aligned} MC &= \frac{\Delta TC}{\Delta Q} \\ &\text{or} \\ MC &= \text{First derivative of TC} \\ &= 2aQ \text{ (if } TC = aQ^2 + b) \end{aligned} \]

Total revenue:

\[ \begin{aligned} TR &= PQ \\ &\text{or} \\ TR &= (aQ + b)Q \\ &= aQ^2 + bQ \end{aligned} \]

Average revenue:

\[ AR = \frac{TR}{Q} \]

Marginal revenue:

\[ \begin{aligned} MR &= \frac{\Delta TR}{\Delta Q} \\ &\text{or} \\ MR &= \text{First derivative of TR} \\ &= 2aQ + b \text{ (if } TR = aQ^2 + bQ) \end{aligned} \]

Maximum profit:

\[ max(\pi): MC = MR \]

Price elasticity of demand (see this guide of how to get to \(- \frac{\Delta Q}{\Delta P} \times \frac{P}{Q}\)):

\[ \varepsilon = -\frac{\% \text{ change in quantity demand}}{\% \text{ change in price}} = - \frac{\Delta Q}{\Delta P} \times \frac{P}{Q} \]

**Important graphs:**

Consumer surplus, producer surplus, tax revenues, tax burdens, and deadweight loss (use algebra and geometry to figure out the areas of the triangles (\(\frac{1}{2} \times b \times h\)) and rectangles (\(l \times w\))):

**Helpful resources:**

- Derivatives of Exponential Functions (how to calculate derivatives quickly)
- Jason Welker, “Natural Monopoly and the Need for Government Regulation”

## Social interactions, economic outcomes, and incentives

You should understand…Guides:Other helpful resources: