ECON 101 (GATEMAN) MIDTERM EXAM REVIEW SESSION

BY COLIS CHENG

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

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 2nd 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!

CHAPTER 6 CRASH COURSE – CONSUMER THEORY

6.1 Marginal Utility and Consumer Choice

Utility is defined as a unit of satisfaction

total utility is your total satisfaction given the number of goods you

have consumed

Diminishing marginal returns –

The hypothesis stating that the amount of marginal utility (utility you gain from a

successive unit of consumption) you gain from each subsequent unit of consumption

adds less and less to total utility

You are craving ice cream and so you buy a

cone and eat one. You are very satisfied with

your first ice cream. For some reason you eat

29 more ice cream cones. Is your level of

satisfaction from the 30th cone going to the

same as your satisfaction from the 1st cone?

Probably not. I really hope not….

A common mistake I often see is that students

don’t understand the difference between

marginal and total utility. With each given unit of consumption, your

total utility will increase (until you get to a certain point), but your

marginal utility will decrease. Get this right conceptually.

Maximizing Utility-

All purchases are based on trade-offs. In this example you have 2 goods to choose

from. To maximize utility, adjust your purchases so your marginal utility per dollar

is the same between both goods.

𝑀𝑈1

𝑝1=

𝑀𝑈2

𝑝2

If you purchase fewer units of “good 1”, your MU1 will increase while your MU2 will

decrease because you are buying more of “good 2”. Make adjustments to equate to

maximize utility.

If prices change, adjust purchases to equate marginal utility per dollar.

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.

6.3 – 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.

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

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.

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,

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

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.

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.

Analysis - Please answer the following three SHORT ANSWER

questions. 15 minutes

Is the price elasticity of a Giffen good positive or negative? Explain

Elasticity is essentially the inverse of slope (i.e. instead of rise vs

run, it is run vs rise). It is calculated by the percentage change in

quantity divided by the percentage change in price. A Giffen good is

a special situation where the income and substitution effect work in

opposite directions but the income effect is significantly stronger

than the substitution effect, leading to an upward sloping demand.

This is the case when a product that accounts for a large portion of a

consumer’s income increases in price. Unlike conspicuous

consumption goods, Giffen goods actually have upward demand

curves. Thus, Giffen goods have a positive price elasticity, as an

increase in price leads to an increase in quantity demanded.

Your friend is studying for her ECON 101 midterm but does not

understand why the demand curve is downward sloping. Being a

student of Prof. G you are smart. Explain why this is true with the

law of marginal returns and the income and substitution effects.

The law of marginal returns and the income-substitution effects

explain the same thing. Recall 𝑀𝑈1

𝑝1=

𝑀𝑈2

𝑝2 maximizes utility. When p1

increases (p2 constant), there is an imbalance. Your marginal utility

per dollar for good 1 decreases and you must offset this by

purchasing less of good 1. Money saved will lead to more

consumption of good 2 and your marginal utility per dollar of good 2

also decreases. Constantly readjusting your purchases, the marginal

utility per dollar will eventually equate. For the income-substitution

effect: When the price of a good increases you substitute away from

it and purchase more of other goods. When the price of a good

increases, your relative income will decrease and you will purchase

less of that good.

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.

Analysis – Answer the following two LONG ANSWER questions

20 minutes

You have an isoquant defined by 𝐾 =1

𝐿+ 2. You also have the

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.

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.

Sample Article

FINLAND PLANNING TO TEST THE

EFFECTS OF PAYING A BASIC INCOME

BY RAINE TIESSALO Bloomberg News Published Thursday, Aug. 25, 2016 4:34PM EDT Last updated Thursday, Aug. 25, 2016 10:02PM 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.”