Economics Study Guide

📖 Core Concepts Economics – the social science of how societies produce, distribute, and consume goods & services. Micro vs. Macro – micro studies individual agents & markets; macro studies whole‑economy aggregates (GDP, unemployment, inflation). Positive vs. Normative – positive describes “what is”; normative prescribes “what ought to be.” Rational vs. Behavioural – rational agents maximise utility given constraints; behavioural economics adds psychology and systematic deviations. Opportunity Cost – value of the best alternative forgone when a choice is made. Pareto (Allocative) Efficiency – no one can be made better off without making someone else worse off. Production‑Possibility Frontier (PPF) – shows max feasible output combos; slope = opportunity cost. Comparative Advantage – lower real opportunity cost in producing a good → basis for gains from trade. Market Failure – when markets do not allocate resources efficiently (public goods, externalities, information asymmetry, natural monopoly). Money Functions – medium of exchange, unit of account, store of value, standard of deferred payment. Fiscal vs. Monetary Policy – fiscal: government spending/taxes; monetary: central‑bank interest rate & money supply. --- 📌 Must Remember Law of Demand: ↑price → ↓quantity demanded (ceteris paribus). Law of Supply: ↑price → ↑quantity supplied. Equilibrium: quantity demanded = quantity supplied; shortage → price ↑, surplus → price ↓. Comparative Advantage Formula: Country A has CA in good X if OPC_A,X < OPC_B,X. Key Keynesian Insight: Sticky wages/prices → unemployment can persist; fiscal stimulus can boost AD. Monetarist Rule: “Money supply growth ≈ inflation target” (Friedman). Okun’s Law: 3 % ↑output ≈ 1 % ↓unemployment. Fiscal Multiplier: ΔY = k·ΔG (or ΔT); k > 1 when idle resources exist. Crowding‑Out: ↑G can ↓ private I if interest rates rise. Ricardian Equivalence: Consumers offset government deficits by saving → fiscal policy neutral. Gini Coefficient: 0 = perfect equality, 1 = perfect inequality. Market Structures: Perfect competition (price taker), Monopoly (price maker), Oligopoly (few firms, strategic interaction), Monopolistic competition (product differentiation), Monopsony (single buyer). --- 🔄 Key Processes Deriving a Supply‑Demand Equilibrium Plot supply (↑price → ↑Q) and demand (↑price → ↓Q). Intersection = equilibrium price P⁎ and quantity Q⁎. Calculating Opportunity Cost on the PPF Slope = ΔGood B / ΔGood A (negative). Opportunity cost of one more unit of A = |slope| units of B. IS‑LM Model (Keynesian Short‑Run) IS curve: equilibrium in goods market (Y = C(Y‑T) + I(r) + G). LM curve: equilibrium in money market (M/P = L(Y, r)). Intersection gives equilibrium output Y⁎ and interest rate r⁎. Fiscal Policy Transmission ΔG ↑ → AD ↑ → Y ↑ → (possible multiplier effect) → lower unemployment. Monetary Transmission Central bank cuts policy rate → lower borrowing cost → I ↑ & C ↑ → AD ↑ → Y ↑, price pressure later. --- 🔍 Key Comparisons Positive vs. Normative Economics – Positive: “Higher minimum wage raises labor costs.” Normative: “Minimum wage should be increased to improve living standards.” Rational vs. Behavioural Economics – Rational: Consumers maximise utility; Behavioural: Consumers exhibit loss aversion, framing effects. Perfect Competition vs. Monopoly – Competition: Many firms, price = MC; Monopoly: Single firm, price > MC, deadweight loss. Fiscal Policy vs. Monetary Policy – Fiscal: Direct changes in G/T; Monetary: Indirect via interest rates & money supply. Public Goods vs. Private Goods – Public: Non‑excludable & non‑rival (e.g., national defense); Private: Excludable & rival (e.g., pizza). --- ⚠️ Common Misunderstandings “Comparative advantage = absolute advantage.” → Wrong; a country can have CA even if it is less efficient in both goods. “Price controls always help consumers.” → Price ceilings cause shortages; price floors cause surpluses. “Higher unemployment always means low inflation.” → Phillips curve relationship can break down (e.g., stagflation). “All externalities are negative.” → Externalities can be positive (e.g., education spillovers). “Monetary policy can instantly boost output.” – Transmission lag; effects appear after months. --- 🧠 Mental Models / Intuition “Marginal Thinking” – Compare the additional benefit of one more unit vs. its additional cost; act only if MB > MC. “The Invisible Hand” – In competitive markets, self‑interest can lead to efficient outcomes, but only when no market failures exist. “Sunk Cost Fallacy” – Ignore costs that cannot be recovered; decisions should be based on future marginal costs/benefits. “Sticky Prices = Short‑Run Rigidities” – Wages & prices adjust slowly → output gaps can persist. --- 🚩 Exceptions & Edge Cases Natural Monopoly – Extreme economies of scale → single‑firm efficient; price regulation may be needed. Monopolistic Competition – Firms have some price power → excess capacity (producing below minimum ATC). Liquidity Trap – When nominal interest rates at zero, monetary policy loses potency; fiscal stimulus becomes crucial. Pure Uncertainty – No probability distribution → risk‑based models (expected utility) may not apply. --- 📍 When to Use Which Use IS‑LM for short‑run analysis of fiscal vs. monetary shocks in a closed economy. Apply the PPF when evaluating trade‑off between two goods or sectors (e.g., guns vs. butter). Choose a Monopoly model when a single firm controls the market (e.g., utilities). Employ Game Theory for oligopolistic strategic interactions (price wars, collusion). Invoke Externality analysis when a transaction imposes costs/benefits on third parties (pollution, vaccination). --- 👀 Patterns to Recognize Shift vs. Move: Changes in determinants → shift of curve; price/quantity changes along a curve → move. Sticky‑price environments → policy effectiveness depends on expectations (e.g., New Keynesian). Positive correlation between investment and growth → look for capital accumulation in growth models. “Too much” of a factor → diminishing marginal returns – appears in production functions and cost curves. --- 🗂️ Exam Traps Confusing Comparative with Absolute Advantage – answer choices may state “higher productivity” = CA (incorrect). Mistaking a shift for a movement: A rise in income shifts demand, not moves along it. Assuming all monopolies are inefficient: Natural monopolies can be efficient; the trap is ignoring scale economies. Equating “price stickiness” with “price rigidity” in all markets: Stickiness is usually short‑run; long‑run markets may still clear. Over‑applying the “law of one price” to differentiated products – monopolistic competition violates it. ---