Study guide 2

Chapter 4

Negative Externalities: Costs that affect a third party not involved in an economic
transaction. Example: Pollution from a factory that harms nearby residents.

Positive Externalities: Benefits received by a third party from an economic transaction.

Example: Vaccinations, which help prevent the spread of disease to others.

Pigovian Taxes: Taxes imposed on activities that generate negative externalities,

designed to reduce the harmful impact. Named after economist Arthur Pigou.

Consumer Surplus: The difference between what consumers are willing to pay for a
good or service and what they actually pay, representing the extra benefit they receive.

Deadweight Loss: The loss of economic efficiency when the equilibrium outcome is not
achieved, often due to taxes, subsidies, or market distortions.

What will happen to consumers surplus if price decrease? If price increase? Other
things equal, a decrease in the market price caused by a change in supply will increase
consumer surplus.

What is an example of asymmetric information and what problem does it cause?

Sellers who possess private information can cause market failure. that can be remedied
with the provision of information. E.g when owners of defective cars have more
information about the condition of their vehicles than potential buyers this is an example
of asymmetric information

When do we have a correctly allocated amount of resources? when the marginal benefit
of an output equals the marginal cost

When do we have a consumer surplus? consumer surplus arises in the market because
the market price is below what some consumers are willing to pay for the product

in a market where negative externalities exist the equilibrium will not be efficient
because too many resources will be allocated towards producing the good

if the deregulated industry ends up generating substantial negative externalities

correcting the industry with regulation is the best option

What will happen if we put a fee on polluting firms? It will shift the supply curve of the
firm to the left
Chapter 5

Market Failure: A situation where the free market, on its own, fails to allocate resources
efficiently, leading to outcomes that are not socially optimal. Examples include
externalities, public goods, and monopolies.

Government Failure: Occurs when government intervention intended to correct a

market failure leads to a more inefficient or undesirable outcome than the market would
have produced on its own. This can happen due to poor policy design, unintended
consequences, or mismanagement.

What is the Coase theorem? The Coase Theorem is an economic theory that suggests
that if property rights are well-defined and transaction costs are low, private parties can
negotiate and resolve externalities on their own, without the need for government
intervention.

what are interest groups? interest groups are made-up of people who share strong
preference for the particular public good and they use advertisements mailing and direct
persuasion to convicts other of the merits of their cause

What is the median voter model? that the person representing the middle position on an
issue will most likely win an election

Chapter 7

Utility: The satisfaction or pleasure a consumer derives from consuming a good or

service. It reflects how much value or benefit a person gets from their choices.

Total Utility: The total amount of satisfaction or benefit a person gains from consuming
a certain quantity of goods or services. It sums up the utility received from all units
consumed.

Marginal Utility: The additional satisfaction or benefit a consumer gains from

consuming one more unit of a good or service. It's the change in total utility from an
additional unit consumed.

The Law of Diminishing Utility states that as a person consumes more of a good or
service, the marginal utility (additional satisfaction) gained from each additional unit
decreases.
In other words, the more you consume of something, the less satisfaction you get from
each extra unit. For example, the first slice of pizza may bring a lot of satisfaction, but
by the third or fourth slice, the additional enjoyment you get from eating more starts to
diminish.

When do we have utility maximization? What happens when the utility per price of two
products is equal?

When the marginal utility per price (MU/P) of two products is equal, it means the
consumer has achieved optimal consumption between the two goods. At this point,
the consumer is maximizing their total utility given their budget. In other words, for each
dollar spent, the consumer is getting the same level of satisfaction from both goods, and
they have no incentive to change the quantity of either product consumed. This balance
reflects the condition for utility maximization in economics.

What happens to the price when the price increases? increasing the price of the product
a will decrease the marginal utility per dollar

Chapter 8

Behavioral Economics: A field of economics that studies how psychological,

emotional, and cognitive factors influence people's economic decisions, often
challenging the assumption that individuals act rationally. It integrates insights from
psychology to explain why people may make seemingly irrational choices.

Heuristics: Mental shortcuts or rules of thumb that people use to make decisions
quickly and with minimal effort. While heuristics help simplify complex decision-making,
they can sometimes lead to biases or errors.

Availability Heuristic: People judge the likelihood of an event based on how easily
examples come to mind. For instance, after seeing news about airplane crashes,
individuals may overestimate the risk of flying.

Anchoring Heuristic: People rely heavily on the first piece of information they
encounter (the "anchor") when making decisions. For example, if a car is initially priced
at $30,000, any discount will seem like a good deal, even if the final price is still high.

Overconfidence Bias: This is the tendency for individuals to overestimate their own
abilities, knowledge, or the accuracy of their predictions. People with this bias tend to be
more confident in their judgments or decisions than is justified by the facts. For
example, an investor may be overly confident in their stock-picking skills and take
unnecessary risks, believing they are more likely to succeed than the average investor.
Hindsight Bias: The tendency for people to believe, after an event has occurred, that
they "knew it all along" or that the event was more predictable than it actually was. This
bias makes it seem as though past events were obvious and inevitable. For example,
after a stock market crash, people might claim they saw it coming or that it was obvious
the market was going to fall, even though the event was unpredictable beforehand.

Status Quo Bias: The preference for keeping things the same or sticking with the
current situation, rather than making changes. People with this bias tend to resist
change, even when switching to a new option might be more beneficial. For example
person might stick with their current insurance plan or phone provider, even if there is a
better or cheaper alternative, simply because they prefer avoiding change.

What are some consequences of heuristics that we use in behavioral economics? That
it is is sometimes difficult for people to correct detrimental behaviors or routines, people
may be vulnerable to others who understand their hardware tendencies, people make
behavioral changes if they expose to situation where heuristics kicks in and start driving
their decision

How does loss aversion affect decision-making in behavioral economics? Loss

aversion is the tendency for people to prefer avoiding losses over acquiring equivalent
gains. It means that the pain of losing is psychologically more impactful than the
pleasure of gaining. As a result, individuals might avoid risks or opportunities, even
when the potential benefits outweigh the losses. For example, people might hold onto
losing investments too long, fearing the realization of the loss.