Economics Lecture Seven

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Economics Lectures - [1 - 2 - 3 - 4 - 5 - 6 - 7 - 8 - 9 - 10 - 11 - 12 - 13 - 14]

"Real" Price and the CPI

Let's return for a moment to an important concept we mentioned earlier in this course: opportunity cost. Recall what the opportunity cost is: it is the value of the best forgone alternative. Now consider this: the real price of a good is its opportunity cost. When someone buys something for $10, the real cost of that good is the best alternative use of that $10. The real price of watching television for one hour is value of that time if you had spent it in the best way possible. It may seem like the cost of that hour watching television was $0, but in fact the real cost is the best alternative use of that hour. The real price of that hour of television watching is your highest hourly wage if you worked, or your future wages made possible by studying harder now.

Defining the real price of a good in terms of opportunity cost is helpful in avoiding the confusion caused by "inflation". Inflation is the amount that prices increase each year for the same goods. Back in the late 1970s, inflation was more than 10% per year. What cost $10 one year would cost $11 the next year, and over $12 in the third year.

Economists created something called the “Consumer Price Index,” or CPI, to measure changes in basic prices of many goods over time. It looks at the typical purchases by urban (not farming) families and monitors the change in prices of those goods and services from month-to-month. It includes the costs of food, beverages, housing, clothes, transportation, medical care, recreation, education, and even services like haircuts. It then combines all those values into one number. To make it easier to compare, the values are combined in a way that the CPI for the period 1982-84 averaged “100". In January 2004, the CPI was 185.2. You can view all the CPI numbers going back nearly a hundred years on the internet.[1] In July 2009, the CPI was 215.351. Inflation causes it to go higher and higher, as the government prints more and more dollars and cause them to lose their value.

By comparing a change in price of a good to the change in the CPI, you can tell whether the real price of the good is becoming more or less expensive. If the good’s price increases by less than the CPI’s increase, then the good has a real price that is falling.

Now think about this: if inflation is 10% per year for three years, but one particular good keeps the same price during those three years, then its opportunity cost and real price actually decreased. Think about that.


In business, it is the competition that brings out the best service, highest quality goods, and lowest prices. Wal-Mart competes with Target and K-Mart. Federal Express competes with UPS for shipping services. Phone companies compete with either for cell phones and home service. Television stations compete with each other; Fox News competes with CNN. Politicians compete with each other to win elections. The dictionary definition of the "free market," a term was first used in 1907, is "an economic market operating by free competition."[2]

We all think we know what "competition" is, but can we define it precisely? Here's one attempt: "competition is the rivalry by people or companies for achievement, success, customers, attention or praise." We could define competition in other ways, by using other powerful terms developed in this course. For example, we could define competition in terms of efficiency: "competition is the process that most efficiently rewards the best."

When we are a customer, we like competition for our spending money. Competition means companies will be constantly trying to offer a lower price and a better deal than their rivals. That saves us money, as customers, and allows us to obtain better goods and services. Without the competition, we would be stuck with companies charging as much as they like, and providing as poor quality goods and services as they want. Competition rewards hard work; a lack of competition encourages laziness.

The economic definition of competition should include a rivalry for resources in addition to a rivalry for customers, as companies compete with each other for workers too. So let's define competition in economics as the "rivalry for goods, services or resources among different buyers or sellers." Perhaps you can improve further on that definition.

It often helps to look at an ideal case, and that is "perfect competition." How should we define that?

Perfect Competition

Perfect competition is the set of conditions that are ideal for someone benefiting from the competition, such as a consumer of a good who wants the best quality and the lowest price. The conditions for perfect competition are these:

1. Many buyers and sellers. You can't have perfect competition without a lot of competitors! In a classroom situation, two or even five students competing for a good grade may not be enough. If a few get lazy, then all may stop working. But in a large group of students, you can be sure that some are working hard. Similarly, the more gas stations in an area, the more the competition for customers of gasoline.

2. Goods that are perfect substitutes for each other. The ability to substitute one good for the other is what makes the market so perfectly competitive. Pencils are so inexpensive because there are so many perfect substitutes for them, as one brand of pencil substitutes easily for another. Notice that any variance in quality would prevent perfect substitution, and frustrate perfect competition for a particular level of quality; if there were only one brand for a high-quality pencil, then there would not be perfect competition for it.

3. Perfect knowledge in the market. Fully informed consumers and suppliers are also necessary for perfect competition. If Wendy’s is selling a hamburger at a lower price than McDonald’s or Burger King, but no one knows about Wendy's, then the competition is not going to be perfect. McDonald's and Burger King would be able to continue to sell overpriced hamburgers.

4. Perfect mobility of resources. Put another way, the competitors must have identical costs for their supplies. If one competitor, say a gas station, has higher costs than the others, such as a higher price of gas from its suppliers, then it is not going to be able to be competitive.

(Additionally, there cannot be any price discrimination. You can ignore this point if you do not recall what "price discrimination" is.)

Every Economics exam has questions about "perfect competition," and you will answer them correctly by remembering the above four points and applying them correctly.

Beyond the value of doing well on exams, perfect competition is useful as an ideal against which to analyze imperfections. Understand why a market does not have perfect competition, and then it becomes easier to know how to buy, sell or invest in that market, or how improvements might occur.

An investor in the stock market may want to stay away from companies that are in perfectly competitive markets, because the competition will reduce prices and profits for the companies. But a buyer or consumer prefers a perfectly competitive market because it lowers price and improves quality!

If you are the owner of a firm, do you like competition? No, not when other firms are competing against you, because that competition will cause you to lower your prices and lose profit. But you do want want perfect competition among your suppliers, because that will help keep your costs lower.

Exam tip: On a typical Economics exam, "perfect competition" or "perfectly competitive" will be mentioned in nearly 20% of the questions. When you see that in a question, it means that prices are at their lowest possible point. The competition causes everyone to lower their prices down to their minimum. Profits are zero. If the labor market is perfectly competitive, then everyone is available to work at the lowest possible wage. These is no excess or surplus or "fat" or inefficiencies in a perfectly competitive market.

Example of Perfect Competition: Sports

Let's look at sports and see if it qualifies as "perfect competition":

1. Many buyers and sellers? Yes. There are many teams competing for support of fans, and many fans choosing between different teams to support.

2. Goods that are perfect substitutes? Yes (entertainment services in this case). It's easy to stop rooting for the New York Giants and start rooting for another team, such as the New York Jets, or at least it should be easy!

3. Perfect knowledge in the market? Yes, everyone knows the scores and the ticket prices are published for anyone who is interested.

4. Perfect mobility of resources? Pretty much "yes" again, as each team has tryouts and participates in a massive draft of college players every year.

But wait, you say, there is only one NFL. It looks like there is perfect competition within the NFL, but there is no other league that has perfect competition with the NFL. That is true: the NFL itself has little or no competition. There was a USFL that tried to compete against it many years ago, but it failed. In the 1960s, there was an "AFL" that did successfully compete against the NFL, and they merged to form what we call the NFL today. Now the NFL as a whole has almost no competition.

Consider these two alternatives for picking players for a new football team. The first approach would be to decide who you think would do best for each position based on their family background, their height and weight, an interview, and your intuition. The second approach would be to have tryouts for each position and select the player who did the best at the tryout competitions. Obviously the result would be much better with the second approach, as many players would be surprisingly good (or bad) at certain positions and it would become obvious during the competition. Similarly, use competition for your own benefit to obtain the best.

Benefits of Competition

Free enterprise is based on competition bringing out the best in business and the lowest prices for consumers. If a price is too high or a business too inefficient, then competition is what brings a competitor along to do better.

Opponents of competition say it is wasteful to have multiple people or companies produce the same thing. Or they do not like the way that competition causes someone to lose. Many parents oppose competition in school, because for every winner there is a loser, and that might be their child. Actually, in difficult competitions there can be dozens of losers for every winner. Tournaments, for example, have one winner but many losers.

However, the same people who oppose competition in business or school can be found watching professional sporting events like the Super Bowl, or entertainment competitions like American Idol. If they are having a medical operation, wouldn’t they want the doctor who had the best grades and surgical record? Or if they are flying on an airplane, wouldn’t they want the pilot who did the best in flight school and on the job? If competition there is acceptable, then why not in business and school also?

Competition, in fact, yields enormous benefits for the losers as well as the winners. Competition is a great motivator. It is also an essential part of the “invisible hand” that channels work and supplies towards their most useful purposes. Competition increases efficiency. Competition encourages innovation. It allows to people to do what was thought to be impossible. Whenever we are beaten by a competitor, and all of us experience that many times, we are left to ask ourselves why our competitor was better than we were. Next time, we can do better.

The U.S. Constitution itself can be understood as system using competition for power to prevent anyone from becoming too powerful. It established three separate branches of government to serve as checks and balances on each other. No individual or branch can grab too much power because the system protects and promotes competition.

Competition is also a great way to motivate yourself. Few like to work or study. But people dislike losing even more. Look around at achievements by others and then ask yourself: why not me? Sometimes, the achievers are those who overcome the greatest obstacles. At a local grocery store, the fastest checkout clerk has only one good arm. Yet he is more efficient than all the other clerks who have two good arms. Frequently the best athlete is the one with less God-given skills than others. Rather, the best athlete is often the one who tries the hardest, both in practice and in the game. The same is often true for the best student and the best business.

Businesses themselves often dislike competition because it can reduce their ability to earn profits. To protect consumers, federal laws limit the ability of businesses to reduce competition. This is known as "antitrust law": it makes anti-competitive behavior by businesses illegal.

Competition and Innovation

Perfect competition helps being out innovation, as participants seek a clever way to outdo the others. Competition can often motivate and bring out the best in everyone.

Consider the remarkable, true story of Dick Fosbury.

Dick Fosbury was a skinny young man having apparently little athletic ability. But the benefit of perfect competition is that it brings out the best, and the best is not always the person who others expect to win.

Fosbury's athletic event was the high jump, and he was determined to do his very best and win, no matter what anyone else said. Trouble was, he was such a poor jumper that he could "clear" (leap over) only about 5' 3" high. This was, nowhere near what was needed to win any competitions. Not giving up, he worked tirelessly, trying all known techniques for jumping over a bar. Still, he could not improve to the jumping height he needed to win.

He did not give up. The high jump event, like most sports events, is perfectly competitive. There are (1) many participants, (2) athletes who serve as perfect "substitutes" for each other, (3) perfect knowledge in the market (everyone knows what the rules and conditions are), and (4) perfect mobility of resources (everyone has the same access to training opportunities).

Motivated by the opportunity of perfect competition, Fosbury developed a revolutionary style of high jumping. He jumped back-first over the high bar. Though lacking in athletic gifts enjoyed by his competitors, this young man improved his jumping ability by a foot, and then even more. He began to win.

His peculiar style attracted mockery and name-calling, as people derided his technique as the "flop". But he showed he did have a special characteristic that others lacked: he did not allow the mockery to bother him. He continued to jump in the direction opposite to all his competitors. With his unique invention of jumping back-first, he won the national college high jump event. But experts still considered his success to be a fluke and his approach to be a joke. They still refused to take Fosbury or his "flop" seriously.

When it came time for the Olympics in 1968, no one considered the young man to have a chance, and competitors with superior athletic ability were favorites to win the high jump event. But remember that this is perfect competition, and it does not matter what the experts say.

During the 1968 Olympics, the whole world was riveted to the television screen as Dick Fosbury flawlessly cleared every height as the bar was raised again and again. When the bar was finally raised to an Olympic record height of 7' 4 1/4", only this young man and his "flop" were able to jump over it. He won the gold medal.

Immediately everyone else, including those who had mercilessly mocked him, began praising and imitating his style. To this day it is known as the "Fosbury Flop."[3] Nearly every high-jumper today uses this technique.

Review: Cost Measures

Let's pause for a moment and review some concepts from the last class. Imagine you are the owner of a firm. You want to understand all your costs. There are seven basic types of costs for a firm, also known as "cost measures":

  • marginal cost (MC)
  • total cost (TC)
  • average total cost (ATC)
  • fixed cost (FC, which is also the total fixed cost because there is nothing to sum up)
  • average fixed cost (AFC)
  • total variable cost (TVC)
  • average variable cost (AVC)

The average of a type of cost is simply the total of that cost divided by the output (number of units) produced by the firm, also known as "Q". Stated another way, the average of a type of cost is the total cost per unit produced by the firm.


ATC = TC / Q, where ATC is the abbreviation for "average total cost," and TC is the abbreviation for "total cost," and Q is output.
AFC = FC / Q, where AFC is the abbreviation for "average fixed cost," and FC is the abbreviation for "fixed cost," and Q is output.

We can also relate the different costs by using simple reasoning. The total cost is, of course, all the costs added together. It is the sum of the fixed cost plus the variable cost:


Exam questions can require manipulation of the above equations. For example, a question can give you the total cost as $1000 and the fixed cost as $700, and then ask you what the total variable cost is. Simply use the equation above:

TC = FC + TVC, and thus TVC = TC - FC, and hence TVC - $1000 - $700 = $300

Next suppose a question states that the total cost (TC) is a function of output (Q) as follows:

TC = 5Q + 200

The question may then ask, what is the fixed cost (FC)? The answer requires realizing that the fixed cost is defined as the cost when the output (Q) is 0. Plug in 0 into the above equation and solve for FC:

FC = TC(when Q=0) = 5*0 + 200 = $200

Often an exam question will give you a table of units produced in the first column, and total costs for each level of output in the second column, and then ask you to use the table to calculate all seven of the above costs. Here is a simple guide:

  • FC is the cost when Q=0
  • AFC is FC/Q, and the question will give you Q
  • TC is the total cost for each Q, and the question will give you Q
  • ATC is TC/Q
  • TVC is TC - FC
  • AVC is TVC/Q
  • MC is the cost to produce one more good

In perfect competition, firms sell more and more Q until MR (marginal revenue) falls to the level of MC (marginal cost). Stated another way, firms sell at the point where MR = MC. Do not confuse MC with AVC; these are different concepts and it is tricky to relate one to the other. When MC is greater than AVC, then AVC increases as output increases; when MC is less than AVC, then ACV decreases as output increases.

Master the above and you will both ace exams and be able to run a successful business. Experienced business managers state that profitability is achieved primarily by reducing expenses. This has certainly been true for Wal-Mart. It is constantly driving costs down with its suppliers. Remember: a penny saved is a penny earned. Actually, due to taxes, saving a penny is sometimes worth more than a penny earned.

Honors Only: Applying Cost Measures to Perfect Competition

When there is perfect competition, what can we learn from the cost measures? By applying logic to the assumption that there is perfect competition, we can learn a great deal.

Example Question: Suppose the price of a widget produced by a firm in perfect competition is less than the minimum average variable cost (AVC) in the market. What will the firm do next in the short run?

Answer: Realize that the question is asking about the short run, so building a new factory or changing fixed costs is not possible. There is not enough time. Instead, the question is asking what can be done as a "quick fix" to the problem. What is the problem? The problem is that the sales price is LESS than the lowest average variable cost (AVC). A firm is losing money when the price, or marginal revenue, is less than marginal cost. A firm does not want to sell anything at less than marginal cost, because it loses money on it.

Now let's read the question again carefully, which is so important in Economics. The question says that the price (which is marginal revenue (MR)) is less than the MINIMUM AVC. That means that MR is ALWAYS less than AVC, for all output Q.

So let's compare the profit or loss of the firm at two points: when Q=0 (and thus AVC=0), and when Q>0 (and, as stated in the question, P<AVC, and thus MR<AVC). The firm loses money for Q>0, because it is spending more on AVC than it is bringing in as price or marginal revenue. The firm can reduce its loss by making Q=0. In other words, the firm is better off by completely shutting down.

Easy Question: What is the firm's profit or loss when Q=0 in this problem? This is an honors homework problem.

Hard Question: Prove mathematically that MC>MR for all Q>0 in this problem. This is the most challenging honors homework problem so far in this course.

Obstacles to Reducing Costs

Can you think of obstacles to controlling and reducing costs in a business? Here are three reasons why costs increase more than you might expect as an owner of a firm:

1. In the short run, you have diminishing marginal productivity. Additional employees are not likely to be as productive as your first employees, for example. Diminishing marginal productivity results in higher average variable costs (AVC), because AVC = TVC/Q and your TVC (total variable costs) are increasing faster than your output Q when there is diminishing marginal productivity.

2. In the long run, you may have decreasing returns to scale. Note the difference between returns to scale, which is a "long run" concept, and marginal productivity, which is a "short run" issue. In the long run, the bigger you become, the more difficult it is to manage all your "inputs" (workers and inventory and every supply and service you need to run your company). Waste can easily increase beyond expectations.

3. In the long run, your firm may also see rising prices for your inputs. Your suppliers increase their prices periodically. Inflation can hit you hard as the CPI increases from year to year. (Recall that the "CPI" is the "consumer price index," a measure of inflation.) Scarce resources may become even scarcer, unless you can find substitutes for them.

It's not easy to run a business, which is why 9 out of every 10 new businesses fail, and even most success businesses eventually fail also. But if you can control and reduce your costs, as Wal-Mart does, then you can succeed.

Gresham's Law

In Economics we often learn powerful concepts that seem surprising at first, or which we would not think of otherwise. Opportunity cost is one. The Coase theorem is another. The Law of Diminishing Marginal Utility is a third. Returns to scale is a fourth. The list seems never-ending, and perhaps a student in this course will discover a new Economics insight that will be taught to future students. Appreciating any one of these key concepts can yield enormous benefits to you the rest of your life, both with business and beyond.

Here is another surprising discovery in Economics: "bad money drives out good." If there are two types of money in an economy, then people will prefer using the weaker type when they buy goods and will want to save or hoard the better type. Before long the weaker, or "bad", form of money dominates the marketplace as everyone tries to get rid of it. The better form of money is saved up and rarely makes it to the market.

Imagine if people used both gold, which is a strong form of money, and paper dollars, which is weaker than gold because it loses value in inflation. Which would they use when buying groceries or other goods? People would prefer to pay with the weaker dollars and save the gold at home. Everyone would prefer to use the weaker money in transactions. A visitor would see mostly dollars in circulation, and very little gold. Hence the "bad money drives out the good." A cheap form of money tends to drive the better form of money out of circulation in the market.

In 19th century America, both silver and gold were accepted currency (as in 19th century America). But silver was a weaker form of money, and thus people preferred to buy things in silver rather than gold. People wanted to save the gold for themselves and get rid of the silver. The result is that the cheaper currency (silver) would be used more often to pay debts and buy things, and the gold would be driven out of the market. "Bad money drives out good."

Gresham's Law is named after Sir Thomas Gresham, who was the Master of the Mint (a government agency that prints or coins money) under Queen Elizabeth I in the 1500s.

A Brief History of U.S. Money

On July 6, 1785 -- two years before the Constitutional Convention drafted the U.S. Constitution -- our young nation unanimously selected the dollar to be the monetary unit. This was the first time in history that a country selected a decimal system (rather than a fractional system) for its money. The name "dollar" came from the name of a Spanish silver coin called the dollar, which was used during the Revolutionary War and later as a basis for the "greenbacks" (the first "green" dollar bills) that were first issued during the Civil War, to pay for the Union side's expenses.

From 1785 to 1974 -- nearly 200 years -- our dollar was backed by gold or silver or both, and some politicians (such as Congressman and former presidential candidate Ron Paul) urge that we return to the "gold standard" for the dollar in order to guard against inflation. Gold is in limited supply in the world, and inflation can be controlled by tying the dollar to something in limited supply. That way more and more dollars could not be printed by the government, which decreases their value.

We used a system of "bimetallism" from 1792 to 1873, by which the dollar was "backed" (could be traded in for) gold or silver. A ratio of 15:1 was first used; someone received 15 times as much silver as gold for a dollar. In 1834 this was adjusted to 16:1 as more silver was discovered. Led by Republicans after the Civil War, Congress gradually phased out the use of silver because it was considered to be a cheap, inflationary form of money, and in 1900 an entirely gold standard was adopted. Recall from history how William Jennings Bryan made his famous "Cross of Gold" speech (in favor of retaining silver as a standard and thereby avoid being "crucified" on gold) in obtaining the Democratic nomination for president in 1896. Bryan then lost to Republican William McKinley in the general election.

But gold eventually lost out also, and was removed as the standard in 1974. Now the U.S. dollar is backed by nothing but a belief that it will continue to have value. The dollar is sometimes called "fiat money" because it cannot be traded in for anything like gold. One might say the dollar is backed by the American economy, or the U.S. Constitution and our political system. Most of the U.S. dollars in the world today are actually being held and used in foreign countries.

As of July 31, 2000, the total amount of dollars in the world was worth $539,890,223,079 (that's over $539 trillion), of which the largest denomination (type of bill) was the $100 bill: $364,724,397,100 worth.

Applying Gresham's Law beyond Economics

Recall back to the beginning of this course when I mentioned that our learning would extend beyond money. Gresham's Law is an example of that. It has significance far beyond money and economics. Let's pause for a moment and consider the implications.

What happens when something "bad", such as a serious crime, happens in a neighborhood? It tends to decrease the value of the homes and drive out the "good", as people move away. Similarly, what happens when someone arrives in a group and starts to use lots of profanity. It tends to lower the quality of the conversation. Before long, other people are using profanity in the group while some people, perhaps disgusted, leave the group altogether. The "bad" drives out the "good".

In public schools, as students wear unattractive clothing like Goth it tends to cause other people to dress worse; as students start to goof off and stop working it becomes contagious and others start to imitate them. Again, the "bad" drives out the "good".

Even on a personal level, the "bad" can drive out the "good". Watch television a while and you may find that your mind becomes sluggish and dull, with a poor attention span. The "bad" of television drives out the "good" in your mind. Spend the same amount of time reading the Bible, and you may discover that your mind becomes sharp and quick and focused. Many great minds, such as Isaac Newton, read the Bible daily and found it brought their level of thinking to new heights. Does the "good" of the Bible drive out the "bad"?

Once we realize that the "bad" drives out the "good", it becomes possible to anticipate and correct it. The "bad" can be prohibited, excluded, or cut off immediately as it occurs. Conversely, the "good" (such as prayer) can be encouraged and promoted.

The converse of Gresham's Law is this: the "good" drives out the "bad". It seems to work. No one hears profanity in church, or is afraid of being robbed there. The greatest achievers in world history would read the Bible daily. Even before Christianity, Alexander the Great slept with a copy of the masterpiece book the Iliad under his pillow. Napoleon, Stonewall Jackson, George Washington, and other successful military leaders made an effort to have the "good" of the Bible drive out the ugly side of war.

Discussing the Bible is an effective way to drive out the falsehoods of atheism in all its different forms. You'll find that atheistic college professors, many public school students, and liberals are amazingly ignorant of the Bible, and will stop talking or even disappear if the Bible is introduced into a discussion! The "good" does seem to drive out the "bad".

Consumer Surplus, Revisited

Recall that the "consumer surplus" is the extra amount the consumer would have paid for a good, but saved because the sales price was lower. If you were willing to pay $20 to see a new movie but it cost you only $12, then your consumer surplus for that transaction is $8. The consumer surplus is an important example of how the free market and supply and demand bring wealth to a society: you are $8 wealthier because the free market lowered the price to $12.

There is a famous graphical description of the consumer surplus that shows up repeatedly on exams. It is worth learning and remembering:

Consumer and Producer Surplus.png

The equilibrium is where the supply and demand curves intersect: P=$5 and Q=500 units. From there a dotted line can be drawn horizontally to the y-axis (Price). The demand curve above that line represents the people who are willing to pay more than $5 for the good. Some are willing to pay $6, $7, $8, $9 and even $10, as well as prices in between. But they can buy the good for only $5 because that is the free market price. Thus they obtain benefit as their "consumer surplus" the amount above $5 that they did not have to pay, and can hold on to as savings. The total consumer surplus is the sum of all the individual consumer surpluses, which is the entire area above the P=$5 line and below the demand curve. It is equal to the area inside the triangle formed by the P=$5 line, the slanted demand curve above it, and y-axis on the left side.

For Honors only: There is an analogous "producer surplus" for the seller, which is the amount he obtained by selling at a price higher than what he would have been willing to sell for the first few units. The supply curve illustrates that the supplier would have been able to make a few units to sell at only $1, $2, $3 and $4, as well as prices in between. But he was able to sell those units at the higher equilibrium price of $5, so he earned more money on those units than he would have otherwise. He has a "producer surplus" that is the area above the supply curve but below the P=$5 line. It is shown as the area within the lower triangle above.

Consumer surplus is one way that the free market brings enormous wealth to a society. There is a question about it on this week's homework.

Exam Tips

Here are a summary of the concepts we have learned so far, with an approximate weighting to indicate how many questions about each would appear on a quiz or exam. We should have another quiz later this month (I'll announce it once it is prepared):

  • 10%: The basics (defining economics, also scarcity and opportunity cost)
  • 20%: Supply and demand, including price controls (price ceilings and floors)
  • 15%: Elasticity
  • 15%: Utility, indifference curves
  • 30%: Decisions by a firm (cost measures, marginal product, short and long run, returns to scale, MR=MC)
  • 10%: Miscellaneous, including consumer surplus, efficiency, transaction costs, Coase theorem, Gresham's Law

On any multiple choice exam, you can improve your score significantly by improving your test-taking skills. This includes:

  • reading the question carefully, and rereading if necessary; never miss a question due to misreading it
  • eliminating incorrect answers before choosing the correct one
  • not leaving any questions unanswered if no points are deducted for wrong answers (neither the CLEP exam nor my exams deduct for wrong answers)
  • preferring answers that are worded in a way that fits the question, as a key fits a lock
  • disfavoring answers that have sweeping or broad terms in them, like ALWAYS and NEVER
  • avoiding changing answers away from your first impression, unless you have a good reason to do so.

Many questions on a multiple-choice exam can be answered correctly even though you didn't know the right answer beforehand, if you follow the above test-taking skills. One of my former students was told he would not have to take a particular exam in college, and he did not study for it, but was then surprised when the teacher made him take it anyway. Using these test-taking skills that he learned in my courses, he obtained the highest score -- higher than many students who studied many hours for the exam.


Read and, if necessary, reread the above lecture. Answer 6 out of the following 7 questions:

1. Identify the four elements of perfect competition.

2. Describe how you might use competition, perhaps even competing with yourself, to motivate yourself to achieve more.

3. Write the equations for TC, FC, ATC, and AFC, and give an example of how they would be used.

4. Do you think the converse of Gresham's Law is true with respect to speech and conversation? Specifically, does good speech or conversation (such as discussing the Bible) drive out bad speech? Explain.

5. Explain the difference between total cost, average cost, and marginal cost.

6. Suppose you decide you could profitably set the price for a homeschool dinner event at $15 per ticket, and it would have attracted 150 people. You also determine that 50 out of the 150 people who would have attended would have paid $20 per ticket and 10 out of the 150 would have paid $25 per ticket, and 5 out of the 150 would have paid $30 per ticket, because they would have enjoyed and benefited so much from it. However, this homeschool dinner event was never held because no one "got around to it." What is the loss in wealth or consumer surplus due to the fact that the event was not held?

7. Explain what the "CPI" is, and why the real price of a good is decreasing if its price remains constant while the CPI increases from year-to-year. An example of this might be the real price of laptop computers from 2012 to 2013.


Answer any 3 out of the following 4 questions:

8. Explain what the Producer Surplus is, and provide an example.

9. Suppose the underlying labor market is perfectly competitive, but there is a minimum wage above the market rate. Then suppose that the supply of labor increases. Explain what the result is and why.

10. What is the firm's profit or loss when Q=0 in the honors discussion above? (Answer simply in terms of another cost measure.) Is the firm profitable?

11. (Challenging, with extra credit) Prove mathematically that MC>MR for all Q>0 in the honors discussion above. (Hint: define MC in terms of the change in AVC, and then regroup the terms and draw conclusions about them to show MC>MR).


  2. Merriam-Webster's Collegiate Dictionary (10th Ed. 1994).