Exam 1 study guide

Capitalism + governments and institutions

You should understand…

• …the components of the capitalist economic system: private property, markets, and firms
• …what happens when any of these components gets distorted
• …what makes public goods different from regular goods (see public goods game)
• …what institutions are and how they coordinate action
• …what GDP is, what it measures, what it doesn’t measure, what problems there are with it, what alternatives there are for it, and why it continues to be popular
• …the difference between real and nominal values (and why we care)
• …what a price index is
• …what purchasing power parity (PPP) is (and also what the Big Mac Index is)
• …the downsides of capitalism (inequality + environmental damage)
• …why not everything should be a market
• …why large groups suffer from free riding and how they work to behave like small groups
• …how small factions threaten democracy, but also how they enable it
• …how voting can suffer from failures (Condorcet’s paradox)

Important formulas:

$$\text{Real} = \frac{\text{Nominal}}{\text{Price Index / 100}}$$

• Percent change:

$$\text{% change} = \frac{\text{New} - \text{Old}}{\text{Old}}$$

or

$$\text{% change} = \frac{\text{Current} - \text{Previous}}{\text{Previous}}$$

• Compound annual growth rate (CAGR); periodic method (this assumes interest is compounded once a year; this is the harder method and you don’t really need to use it):

$$r = \exp(\frac{\ln(\frac{\text{Price index}_{\text{new}}}{\text{Price index}_{\text{old}}})}{t}) - 1$$

• Compound annual growth rate (CAGR): continuous method (this assumes interest is compounded continuously; this is the easier method and you should generally use this):

$$r = \frac{\ln(\frac{\text{Price index}_{\text{new}}}{\text{Price index}_{\text{old}}})}{t}$$

Guides:

Social interactions, economic outcomes, and incentives

You should understand…

• …that perfectly rational individual behavior can create irrational and inferior social outcomes
• …how to use game theory to analyze social interactions. In particular, you should be able to define the following: game, zero-sum, Pareto efficiency, Nash equilibrium, pure strategy, mixed strategy, dominant strategy
• …what social dilemmas, collective action problems, and tragedies of the commons are
• …the difference between a stag hunt game and a prisoners dilemma game, why that difference is important, and why stag hunts are possibly a better metaphor for social dilemmas
• …what factors prevent individuals from cooperating, such as uneven payoffs, lack of assurance, preference falsification, dishonesty, and selfishness
• …how to fix collective action problems with altruism, repetition and iteration, infinitization, punishment, norms, and institutions
• …how incentives can get crowded out and distorted when extrinsic rewards or punishments replace intrinsic motivation (i.e. don’t marketize important social relationships; pay enough or don’t pay at all)

Guides:

Fairness and efficiency

You should understand…

• …the difference between Pareto efficiency and fairness
• …why Pareto efficiency is not necessarily the best standard for measuring the success of a policy
• …how we can measure fairness with substantive standards, procedural standards, and Rawlsian standards
• …how cultural perceptions of luck and fairness shape public policy
• …how ideas of efficiency and fairness apply to international trade
• …how public policy can be used to change the payoffs in games (e.g. making it more expensive to use water and deplete public goods)
• …what elasticity measures (i.e. what it means for something to be inelastic vs. elastic)
• …why good public policies should be a Nash equilibrium
• …the difference between absolute and comparative advantage and how there can still be gains from trade if a part doesn’t have absolute advantage in a product

Guides:

Work, wellbeing, and scarcity

You should understand…

• …what opportunity costs are and how they influence decision making
• …how to draw a budget line and what budget lines mean
• …how utility is measured and what indifference curves are
• …the difference between the marginal rate of substitution (slope of the indifference curve) and the marginal rate of transformation (slope of the feasible frontier)
• …what it means when marginal product and marginal utility diminish
• …how to find the utility-maximizing level of consumption given preferences and budget constraints
• …the difference between normal and inferior goods
• …what income effects and substitution effects are and how they’re related to government policies

Important formulas:

• All the ways marginal utility (or marginal rate of substitution) can be written:

$$MRS = \frac{dy}{dx} = \frac{\Delta y}{\Delta x} = \frac{\text{Price}_x}{\text{Price}_y} = \frac{MU_x}{MU_y} = \frac{\partial u / \partial x}{\partial u / \partial y}$$

Guides:

The firm

You should understand…

• …how the decision-making structures of firms and markets are different
• …that perfectly complete contracts are difficult (if not impossible) to create
• …what happens when there are incomplete contracts
• …what a principal-agent problem is