# ECON 101 (GATEMAN) MIDTERM EXAM REVIEW SESSION BY COLIS CHENG

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1 ECON 101 (GATEMAN) MIDTERM EXAM REVIEW SESSION BY COLIS CHENG

2 TABLE OF CONTENT I. Exam Tips and Strategies II. Chapter 6 Crash Course III. Chapter 7 Crash Course IV. Chapter 8 Crash Course V. Critical Thinking Moment Practice Problems VI. Sample Article

3 EXAM TIPS AND STRATEGIES 1. Assume Nothing! Gateman s patented catchphrase. What he is trying to emphasize here is detail. Never make any assumptions when answering questions. If something isn t obvious, state it! Detail > Concision 2. Have faith in the scaling gods These exams are designed to have raw averages below passing (< 50%). For the most part, you will generally see about a 20% increase in your raw score after scaling. You don t need to do well on the exam to get a good mark. Just hope your section has a low average >:) 3. Bring a watch This may be a bit obvious but time management is very important. The recommended times that are listed beside the question are HEAVILY suggested. When you pass that recommended time for the question, move on and come back later. If you spend 20 minutes on the first 5 definitions, you won t finish! 4. Don t be surprised if you see content from Midterm 1 From what I recall from my 2 nd midterm last year, Gateman threw in 1 question from midterm 1 content. Don t waste your time rereading it midterm 1 content if you can t. Just make sure you know the basics. This is just a minor detail 5. Don t stress too much You ve done the work, you ve attended the CMP review session, you ll do great! Try to enjoy ECON 101 with Gateman as much as you can. He is an interesting professor and I firmly believe that you cannot graduate as a UBC BCOM without having him at least once!

5 Demand Curves If prices change adjust purchases to equate. When prices change, you need to shift your purchases to equate marginal utility per unit between the 2 goods. This is for a single consumer demand curve Sum of individual demand curves is the market demand curve 6.2 Income and Substitution Effect Substitution Effect If a good s price has fallen, it has become relatively cheaper and you will SUBSTITUTE away from other goods to buy more of the good whose price has fallen. Income Effect If a good s price has fallen, your purchasing power (INCOME) has increased and you can now buy more of that good. If the price of cake falls, you will purchase less ice cream to buy more cake (substitution effect) and you will have more money left over after buying it at the discounted price (income effect) The slope of the demand curve is determined with the income and substitution effects. 3 kinds of goods exist: Normal good, Inferior good, Giffen Good, (Conspicuous Consumption is special) LOOK AT THE GRAPHS IN TEXTBOOK IT IS VERY CONCISE AND CLEAR Normal Goods Substitution effect and income effect move in same direction (downward sloping demand) *think cars, pencil cases, cell phones Inferior Goods - Substitution effect and income effect move in opposite direction but substitution effect is still greater than income effect (downward sloping demand) *think no name brand Giffen Goods - Substitution effect and income effect move in opposite direction but income effect is greater than substitution effect (upward sloping demand) *think Irish potato famine Giffen goods are inferior, but MUST account for a large portion of income to be considered Giffen Conspicuous Consumption Goods These are a special case and don t fall under of the previous 3. These goods get their intrinsic value from their price: snob appeal. But keep in mind, these do not have an upward sloping demand curve because it is not a true Giffen Good.

6 6.3 Consumer Surplus Consumer surplus is a very simple concept. Essentially, it is just the extra intrinsic value you gained because you valued a good higher than the market was selling for. i.e. The boots I really wanted, and would be willing to pay \$700 for, are on sale for \$680. My consumer surplus is \$20. Paradox of Value Water is essential to life but is cheap. Diamonds are shiny clunk rocks yet are so expensive. Why? Water is very plentiful but diamonds are relatively scarce. Therefore, our marginal utilities between these two products differ a lot. That s where the difference in price comes from Think in terms of consumer surplus. Water would have a lot of consumer surplus (low marginal value) but diamonds would have low consumer surplus (high marginal value) Indifference Curves Indifference Curves All points on the indifference curve represent the same amount of utility. Budget lines The trade-off between 2 kinds of goods you can purchase with a given budget. Utility is maximized at the point of tangency between the budget line and indifference curve. *Income-Consumption Line, Price-Consumption Line, Income and Substitution effect are tricky to teach in a large group. If after reading the textbook/gbook, you don t understand come and see me during office hours. I can explain it more efficiently one-on-one.

7 CHAPTER 7 CRASH COURSE PRODUCERS IN THE SHORT RUN 7.1 What Are Firms? Not entirely relevant. Read for pleasure 7.2 Production, Costs, and Profits A production function Q=f(L,K) Describes all the output of a firm. The number of output Q you produce is a function of how much/how you use a given set of labour and capital. Economic and Accounting Profits Accounting Profit = Revenue Explicit Costs Very simple. These are the things you can find on an income statement. Explicit costs include things like rent, depreciation, salaries, etc. Economic Profit = Revenue Explicit Costs Implicit Costs Economic Profit = Accounting Profit Implicit Costs Economic profit takes into account opportunity costs. Time is money! What kind of money are you forgoing by staying in business? The opportunity costs, costs of time, are your implicit costs. Opportunity Cost of Financial Capital is the opportunity cost of owning a piece of capital. i.e. the costs of interest for owning a certain piece of equipment. The economic profit (profit including opportunity costs) will tell you how viable it is to stay or leave a certain market. Very crucial market indicator Profit (Π) = Total Revenue Total Cost *Crucial and basic formula Fixed factors An input whose quantity can t be changed Variable factors An input whole quantity can be changed You sell lemonade. The lemonade stand is a fixed factor. The cups you use to sell the lemonade is the variable factor The Short Run You incur fixed factors alongside your variable factors The Long Run All of your factors are variable. No more fixed factors are

8 considered The Very Long Run Such a long time that even technology changes and overall production becomes easier. *Keep in mind that the short run, long run, and very long run are not counted based on time, but based on the variability of factors. The short run may be several years; the long run may be a few months. It all depends on your situation! 7.3 Production in the Short Run Total Product (TP) - The total amount of product produced with a given amount of labour. Average Product (AP) The total amount of product produced divided by the amount of labour used to produce it. It is a measure of approximately how much output each unit of input makes. AP = TP L Marginal Product (MP) The amount of change in total output produced by employing an additional unit of labour. MP = ΔTP ΔL Diminishing marginal product states that each increase to your amount of variable input to an unchanging amount of a fixed input will lead to declining increases in output *DO NOT UNDER ANY CIRCUMSTANCE CONFUSE THIS WITH DIMINISHING MARGINAL RETURNS TO LABOUR >:( Product Curve Relationships Notice that at the peak of the marginal product curve, there is an inflection point on the total product curve. This is to reflect the fact that at THE POINT OF DIMINAL MARGINAL PRODUCT your production slows down a bit. Furthermore, the MP crosses the AP at the AP s highest point. This is known as THE POINT OF DIMINSIHING AVERAGE PRODUCT. This is a sign of how production changes as you continue to increase your variable factor without changes to fixed factors. NOTICE: THE AP CURVE SLOPES UPWARD AS LONG AT THE MP IS OVER IT.

9 THIS IS CONCEPTUALLY VERY IMPORTANT AND YOU NEED TO REMEMBER THIS 7.4 Costs in the Short Run Costs in the short run can be split largely into fixed costs, variable costs, and the sum total costs. The following are equations for all key costs Total Cost (TC) = Total Fixed Costs + Total Variable Costs Total Fixed Cost (TFC) The total amount of overhead costs required to operate. Think of the costs it takes to own your factory. Total Variable Cost (TVC) Total cost of all variable factors Average Total Cost (ATC) = Total cost divided by the number of output produced Average Fixed Cost (AFC) = Fixed cost divided by the number of output produced Average Variable Cost (AVC) = Variable Cost divided by the number of output produced Marginal Cost (MC) = Change in total costs divided by change in output. Cost Curve Relationships: TC curve is simply the TVC curve vertically shifted by the same amount as the TFC MC curve intersects ATC curve and AVC curve at their lowest point. The u-shape of the cost curves is a results of the diminishing average product when you first begin business, everything is fantastic. You produce more goods and your average total costs are declining. However,

10 eventually, you reach the minimum of your ATC, at which point you see minimum returns and later diminishing returns are realized and AC begins to rise. Cost Curve Shifts Changes in the price of variable factors will vertically shift all cost. For example, and increase in the price of a variable cost would shift the MC and ATC up. However, this shift is not applied with an increase in the price of a fixed factor. If there was an increase in the price of your fixed factor, ATC would shift up, MC would remain in the same position. (Only fixed costs changed, there was no change in marginal costs) CHAPTER 8 CRASH COURSE PRODUCERS IN THE LONG RUN (like the short run, only long!) 8.1 The Long Run: No Fixed Factors The equation MPK pk = MPL pl Represents the marginal product of an input divided by price. To maximize production for a firm, this equality must be maintained. However, when these are not equal, thus leads to the possibility of innovation, ways to substitute to reduce your costs. Changes in prevailing market prices will challenge firms to adjust this ratio to achieve efficient production. That being said, the PRINCIPLE OF SUBSTITION defines that methods of production will change if relative input prices change. LONG RUN IS THE PERIOD OF TIME IN WHICH THERE ARE NO LONGER FIXED FACTORS. EVERYTHING IS VARIABLE Key Graphs: Economies of Scales You just started production in your company and you are experiencing decreasing costs (producing in bulk) Constant Cost/Constant Returns to Scale The minimum of the long run average total cost curve. All economies of scale have been realized and soon you will experience

11 increasing costs. Changes in costs are equivalent to changes in output. Diseconomies of Scale You have reached the point in business where output is far beyond what it was initially. In order to produce at such highly demanded volumes, your firm begins to experience increase costs. For a firm, all short-run average total costs can be contained within a large, long-run average cost curve. Each short run average cost represents a particular plant size. Jacob Viner made a giant mistake when working on this relationship between long-run and short-run costs. 8.2 The Very Long Run: Changes in Technology Faced with increase in the price of an input, firms may either substitute away or innovate away from the input or do both over different time horizons Isoquants and Isocosts Isoquants (the curved lines) each curve represent a particular level of output and that level of output is dependent on its placing along the x and y axis (capital and labour) Isocosts (the straight line) each present alternative factor combinations that all require the same amount of cost. To minimize costs, you must find the point where the isocost is tangent (not crossing) the isoquant given your level of cost and output.

12 CRITICAL THINKING MOMENT EXAMPLE PROBLEMS Colis wants you to define the following five (5) terms precisely and concisely: 5 minutes Principle of Substitution Methods of production will change if the prices of relative inputs change using more of relatively cheap inputs and less of relatively expensive inputs Paradox of Value A good that is very plentiful will have a low price and will be consumed to the point where everyone places a low value on it. A product that is relatively scarce will have a high market price and consumption of it will stop at the point where consumers place a high value on the last unit consumed. Isoquant A curve that shows all the combinations of inputs that yield the same level of production. Halo Effect The bias by customers toward certain products because of a favorable experience with other related products or campaigns Sunk Cost A cost that has been incurred and cannot be recovered. No money back after purchase.

14 You watch from afar as you see Colis and his best friend Robert G get into a heated debate over the short-run cost curves. Colis believes that a change in a fixed factor will cause the marginal cost curve AND the average total cost curve to shift up. Robert G believes that he is wrong and claims that only one of the curves shift. Who is right and who is stupid? In a well-labelled diagram explain and provide your rationale. It is true that an increase in fixed costs will lead to an increase in average total costs. However, the marginal cost curve will not shift. For example, pretend you produce chairs. If the price of renting your factory increases, the per unit price (marginal cost) of producing the chairs will not change. Therefore, when fixed costs increase, the average total cost curve will increase and shift up but marginal cost curve (MC) does not shift. In conclusion, Colis is stupid.

15 Analysis Answer the following two LONG ANSWER questions 20 minutes You have an isoquant defined by K = You also have the L following isocosts: K = - L+2 K = - L+4 K = - L+7 State the appropriate isocost and define quantity of labour and capital needed to minimize costs. A graph is provided for rough work and will be for marks. SHOW ALL WORK This is relatively simple question, mostly math based. Sketch out the isoquant and graph the 3 isocosts. After sketching, find the isocost that lies tangent to you your particular isoquant. At this point (1,3) your total cost is minimized while producing the particular output set by your isoquant.

16 Who was Jacob Viner and what critical mistake/assumptions did he make? With a well labelled diagram explain. Jacob Viner was a Canadian economist credited in helping build the relationships between short run costs and average costs. However, he made a serious mistake upon publishing his findings. He instructed his draftsman to connect all the minimum points of the short run average costs curves instead of building a long run average cost curve that would lie tangent to each of the short run curves. Each short run average cost curve is tangent at some point to the long run average costs but may not necessarily be the minimum point.

17 Sample Article FINLAND PLANNING TO TEST THE EFFECTS OF PAYING A BASIC INCOME BY RAINE TIESSALO Bloomberg News Published Thursday, Aug. 25, :34PM EDT Last updated Thursday, Aug. 25, :02PM EDT Finland is pushing ahead with a plan to test the effects of paying a basic income as it seeks to protect state finances and move more people into the labour market. The Social Insurance Institution of Finland, known as Kela, will be responsible for carrying out the experiment that would start in 2017 and include 2,000 randomly selected welfare recipients, according to a statement released Thursday. The level of basic income would be 560 a month (\$816 Canadian), tax free and mandatory for those picked. RELATED: Basic income has its appeal, but it also has a very basic problem The objective of the legislative proposal is to carry out a basic income experiment in order to assess whether basic income can be used to reform social security, specifically to reduce incentive traps relating to working, the Social Affairs and Health Ministry said. To asses the effect of a basic income, the participants will be held up against a control group, the ministry said. The target group won t include people receiving old-age pension benefits or students. The level of the lowest basic income to be tested will correspond with the level of labour market subsidy and basic daily allowance. The idea of a basic income, or paying everyone a stipend, has gained traction in recent years. It was rejected in a referendum in Switzerland as recently as June, where the suggested amount was 2,500 francs (\$3,338) for an adult and a quarter of that sum for a child. It has also drawn interest in Canada and the Netherlands. Finnish authorities were clear on one thing as they embark on their study: An experiment means that, at this point, basic income will not be paid to the whole population.

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