Finance and Economics Foundations

Question 1

What does the field of Economics concern?

Answer 1

Production, distribution, and consumption of goods and services.

Another way to view economics is that it is about the efficient allocation of scarce resources. When wants and needs exceed the available resources, then scarcity exists.

Question 2

Microeconomics

Answer 2

Microeconomics is the branch of economics that deals with the behavior of individual economic units, including: Consumers Workers Investors Firms …as well as the way these units combine and interact to form Markets

Question 3

Macroeconomics

Answer 3

Macroeconomics deals with the behavior of an entire economy rather than the individual economic units in the economy.

There are three key focus areas in macroeconomics:

Inflation
Unemployment
Economic Growth

Question 4

Positive vs. Normative Analysis

Answer 4

Positive analysis attempts to describe the world as it is. This type of analysis seeks to answer questions about the world, but it does not involve making judgments about whether the answer is good or bad.

Normative analysis attempts to describe the way the world should be, and it often involves value judgments. Normative analysis could involve answering questions like “how much should nations with high per capita GDP contribute to improve GDP in poorer nations” or “would society be better off if the minimum wage was higher.”

Question 5

Real vs. Nominal

Answer 5

To assess the real value of a wage increase, you need to account for the effects of inflation.

The dollar value of the wage increase without including the effect of inflation is a nominal amount.

Many variables that are affected by inflation will be reported in both real and nominal terms. These include GDP, GDP growth, wages, and interest rates.

Question 6

demand-supply model

Answer 6

Demand represents the quantity of the item that these potential buyers would be willing to purchase at different prices. Supply represents the quantity of the item that these potential sellers are willing to provide to the market at different prices.

Question 7

buyer’s reservation price

Answer 7

The highest price that a buyer is willing to pay is called the buyer’s reservation price.

Question 8

sellers reservation price

Answer 8

minimum amount they are willing to accept.

Question 9

mutually beneficial exchange

Answer 9

For an exchange to occur, both parties must benefit. The buyers must value the goods or services at more than the selling price. Similarly, the sellers must value the goods or services at less than the selling price. The intuition here is simple–if one party does not benefit from an exchange, then that party has no incentive to make the exchange.

Question 10

opportunity cost

Answer 10

In economics, the value of the items “given up”

Question 11

Accounting profits

Answer 11

are equal to revenues less explicit costs

Question 12

economic profits

Answer 12

are equal to revenues less explicit and implicit costs.

Question 13

demand

Answer 13

for a good or service represents the amount of that good or service that consumers are willing to buy.

Question 14

quantity

Answer 14

Quantity demanded refers to the specific quantity of a good or service that is demanded at a given price.

Question 15

demand schedule or demand curve relationship

Answer 15

The complete relationship between prices and the quantity that consumers are willing to purchase at each price

Question 16

demand schedule

Answer 16

A demand schedule is a table showing quantity demanded at different prices.

Question 17

demand curve

Answer 17

graphically shows the relationship between quantity demanded and price. Quantity is conventionally plotted on the horizontal axis and price on the vertical axis.

Question 18

law of demand

Answer 18

As the price of a typical good or service increases, the quantity demanded decreases. Graphically, this law corresponds to a downward-sloping demand curve.

Question 19

income effect

Answer 19

When prices rise, the amount of goods or services that a consumer can afford to purchase will decrease. This is equivalent to a reduction in the consumer’s real income, even though actual income has not changed. Conversely, when prices fall, consumers are able to purchase more goods and services. Again, even though actual income is unchanged, the result is equivalent to an increase in the consumers’ real income.

Question 20

substitution effect

Answer 20

As the price of a good rises, consumers will tend to substitute some of their purchases into other goods, because they are now relatively less expensive. Any price change will result in both an income effect and a substitution effect. The combination of these effects results in the downward-sloping shape of the demand curve.

Question 21

supply schedule

Answer 21

A supply schedule is a table showing quantity supplied at different prices.

Question 22

supply curve

Answer 22

graphically shows the relationship between quantity supplied and price.

Question 23

law of supply

Answer 23

As the price of a typical good or service increases, the quantity supplied also increases. Graphically, this law corresponds to an upward-sloping supply curve.

Question 24

Market Equilibrium

Answer 24

In a given market, the desires of the buyers are represented by the demand curve, and the desires of sellers are represented by the supply curve. Buyers want to pay a low price; the higher the price, the fewer items they want to purchase. Sellers have the opposite incentives; they want to receive a high price, and the higher the price, the more they want to sell.

Question 25

invisible hand

Answer 25

individuals acting freely in a competitive marketplace, in the pursuit of their own self-interest, will generate an efficient market equilibrium.

Question 26

price floor

Answer 26

When a price floor is set, the market price is not allowed to fall below the designated level. Common examples of price floors are agricultural subsidies. This is generally intended to help producers, because they should benefit from the higher prices.

Question 27

price ceiling

Answer 27

When a price ceiling is set, the market price is not allowed to rise above the designated level. Common examples of price ceilings are rent controls. This is generally intended to help the consumers because they should benefit from the lower prices.

Question 28

endogenous changes

Answer 28

The supply-demand model describes relationships between quantity and price in the form of supply and demand curves. As prices increase, quantity supplied will generally increase and quantity demanded will generally decrease. Endogenous changes would be represented as movements along the relevant curve.

Question 29

exogenous changes

Answer 29

Changes that arise from factors outside the model. Such factors include everything other than price and quantity that can affect supply or demand. Changes of this type would change the quantity of a good demanded or quantity of a good supplied at every price level. In other words, an exogenous change shifts the entire demand or supply curve.

Question 30

How Demand and Supply Effects Market equilibrium

Answer 30

If an economic change causes demand at every price to increase, the demand curve will shift to the right. The resulting intersection of the demand and supply curves would show a both a higher price and quantity for the good at equilibrium. On the other hand, if the demand curve shifted to the left, equilibrium price and quantity would both drop. If an economic change causes supply at every price to increase, the supply curve will shift to the right. In that case the resulting intersection of the demand and supply curves would show a lower price and a higher quantity at equilibrium. If the supply curve shifted to the left instead, the equilibrium price would increase and the quantity would drop.

Question 31

Factors causing exogenous changes

Answer 31

There are many factors that could affect the demand curve such as the price of complement goods, the price of substitute goods, consumer income, quality, and seasonality.

Question 32

Complements

Answer 32

are defined as goods that are generally consumed together.

Question 33

Substitutes

Answer 33

Substitutes are the opposite of complements, a substitute good is generally consumed instead of another good.

Question 34

normal good

Answer 34

if demand for a good increases with increasing consumer income

Question 35

inferior good

Answer 35

if demand decreases with increasing consumer income

Question 36

Factors that affect the supply curve

Answer 36

input prices, changes in production technology, and taxes.

Question 37

If demand increases and supply increases . .

Answer 37

quantity increases, price ambiguous

Question 38

If demanded decreases and supply increases . . .

Answer 38

Price decreases; change in Quantity is ambiguous

Question 39

If demand and supply decreases

Answer 39

Quantity decreases; change in Price is ambiguous

Question 40

Demand increases and supply decreases

Answer 40

Price increases; change in Quantity is ambiguous

Question 41

Elasticity

Answer 41

Price elasticity of demand measures the responsiveness of demand to a change in price.

Question 42

High Price elasticity

Answer 42

consumers are very sensitive to price changes, and a small change in price will result in a relatively large change in quantity.

Question 43

low elasticity

Answer 43

then consumers are not very sensitive, and a price change will have relatively little effect on demand.

Question 44

categories of elasticity

Answer 44

if | Ed | the absolute value of E sub d> 1, then demand is considered elastic if | Ed | the absolute value of E sub d< 1, then demand is considered inelastic if | Ed | the absolute value of E sub d= 1, then demand is considered unit elastic

Question 45

factors affecting price elasticity

Answer 45

1) Basic necessities will have a lower elasticity than luxury items. 2) Goods with few substitutes will have a lower elasticity than goods with many substitutes. 3) Goods will tend to have lower elasticity in the short-run than in the long-run.

Question 46

price elasticity of demand and total revenue

Answer 46

1) When demand is inelastic, an increase in price will result in a proportionately smaller decrease in quantity, so total revenue will be increased. 2) When demand is unit elastic, an increase in price will result in a proportional decrease in quantity, so total revenue will be unchanged. 3) When demand is elastic, a small increase in price will result in a proportionately larger decrease in quantity, so total revenue will be lowered.

Question 47

Marginal analysis

Answer 47

The idea behind marginal analysis is that the most relevant factors in a decision are marginal changes; that is, the incremental changes that will occur as a result of the decision. For example, in order to evaluate a decision, it is necessary to compare its marginal benefits with its marginal costs. If its marginal benefits exceed its marginal costs, then the decision should be accepted. If not, then the decision should be rejected.

Question 48

Competitive markets

Answer 48

1) There are many buyers and sellers in the market. 2) There is free entry and exit in the market. It is possible for new firms to enter the market at any time, and existing firms are able to exit the industry without incurring significant costs. 3) The good or service should be homogeneous. From a buyer's perspective, the good or service is the same regardless of which particular firm manufactures it. Perfectly competitive markets are rare in the real world, because free entry and exit and homogeneous products are not that common. The most common examples of competitive markets are commodity markets, such as wheat or steel. Although these markets may not exactly meet the assumptions of perfect competition, they do behave in ways that are consistent with the theory. For example, an individual wheat farmer likely has very little control over the market price of wheat. As a result of these characteristics, buyers and sellers in a competitive market have very little power to affect the market price, so the participants are price-takers.

Question 49

surplus

Answer 49

most buyers would pay more than the selling price for a good or service, while most sellers would provide the good or service at less than the selling price.

Question 50

consumer surplus

Answer 50

Consumer surplus equals the difference between the buyers' reservation prices and the actual amount paid. In other words, consumer surplus is the welfare received by the buyer of a good. area under the demand curve, above price ``` line curve (triangle) - 1/2 (base x height) steps (put into rectangle) - add rectangles ```

Question 51

producer surplus

Answer 51

Producer surplus equals the difference between the sellers' reservation prices and the market price.

Question 52

Market Efficiency

Answer 52

a market is efficient if the sum of producer and consumer surplus is greatest at the equilibrium price and quantity.

Question 53

allocative Efficiency

Answer 53

Allocative efficiency occurs when the good or service is offered at the lowest feasible price to consumers.

Question 54

productive efficiency

Answer 54

Productive efficiency occurs when a firm is producing at its lowest average cost.

Question 55

internal rate of return

Answer 55

the discount rate that results in a net present value of zero.

Question 56

perpetuity

Answer 56

is an investment that makes a series of payments at fixed intervals for an infinite period of time.

Question 57

FV Function

Answer 57

future value of a single payment in Excel

Question 58

PV function

Answer 58

present value of a single payment. Use Excel to find the amount that must be deposited in the CD today to be worth $60,000 in 3 years.

Question 59

rates of return

Answer 59

new - old / old

Question 60

AAR

Answer 60

average of the returns each period.