Economics 2545

Front 1

Describe the substitution effect, the income effect, and their relationship :

Back 1

When the price of a good X decreases, the substitution effect will push consumption towards more of good X.
Since the price drops, the income increases, which creates an income effect that can work both ways: either good X is a normal good, and the income effect will push towards more consumption, or it is an inferior good, and the income effect will reduce consumption, sometimes even offsetting the substitution effect (=Giffen good).

Front 2

Explain and describe normal, inferior, Giffen and Veblen goods:

Back 2

A normal good is one for which the income effect is positive, and an inferior good is the opposite.
A Giffen good is an inferior good for which the negative income effect outweighs the positive substitution effect when prices fall. Thus, Giffen goods have an upward-sloping (positive) demand curve.
A Veblen good is a normal good for which an increase in price makes the good more desirable. The consumer gets utility from being seen to consume a good that has high status (Gucci bag). This is a theoretical good, and it must have a a limit, otherwise the price would rise without limit.

Front 3

Define Accounting profit, Economic profit, and normal profit:

Back 3

Accounting profit = total revenues – accounting (explicit) costs. These costs do not include cost of capital, they are the costs that you pay with money (such as interests on debt).
Economic profit (=abnormal profit) = Total revenues – accounting costs – implicit opportunity costs. Implicit opportunity costs include the cost of ownership (for public companies = dividends, and for private they include all the money/value of time that the owner has foregone to create the company).
Normal profits are the accounting profits that make economic profit equal to zero.
Normal profit is the minimum level of profit needed for a company to remain competitive in the market.
economic profit = accounting profit – normal profit = positive If accounting profits exceed implicit opportunity costs and vice versa, and =0 if the firm just meets the investors expectations.

Front 4

Explain the concept of economic rent:

Back 4

Economic rents are "excess returns" above "normal levels" that take place in competitive markets. More specifically, it is "a return in excess of the resource owner's opportunity cost". For example, consider a company that possesses a gold mine. When the price of gold goes up, the economic rent paid to this gold mine will increase, since supply is almost fixed, and it will result in greater economic profit for the firm.

Front 5

Define Marginal Revenue Product (MRP) of labor/capital, and explain how to reach the optimal combination of labor and capital.

Back 5

The optimal combination of labor and capital inputs is reached when the ratio of the marginal product of capital to its cost is equal to the same ratio for labor, which is output per dollar of input cost:

〖MP〗_capital/P_Capital =〖MP〗_Labor/P_Labor

When this condition is met, costs for the associated level of output are at a minimum. If the ratio for capital is greater than the ratio for labor, then the costs can be reduced by employing more capital and less labor and vice-versa.

Front 6

What is the GDP deflator, and how to calculate it?

Back 6

GDP deflator: A price index that can be used to convert nominal GDP into real GDP, taking out the effects of changes in the overall price level.

GDP Deflator=(Nominal GDP in year t)/(Value of year t output at year t_(-5 ) prices)* 100