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Chapter Review Chapter 2: The Price System

  1. The basic competitive model consists of rational, self-interested individuals and profit-maximizing firms, interacting in competitive markets.

  2. The profit motive and private property provide incentives for rational individuals and firms to work hard and efficiently.

  3. Society often faces choices between efficiency, which requires incentives that enable people or firms to receive different benefits depending on their performance, and equality, which entails people receiving more or less equal benefits.

  4. The price system in a market economy is one way of allocating goods and services. Other methods include rationing by queue, by lottery, and by coupon.

  5. An opportunity set illustrates what choices are possible. Budget constraints and time constraints define individuals’ opportunity sets. Both show the trade-offs of how much of one thing a person must give up to get more of another.

  6. A production possibilities curve defines a firm or society’s opportunity set, representing the possible combinations of goods that the firm or society can produce.

  7. The opportunity cost is the cost of using any resource. It is measured by looking at the next-best use to which that resource could be put.

  8. A sunk cost is a past expenditure that cannot be recovered, no matter what choice is made in the present. Thus, rational decision makers ignore them.

  9. Most economic decisions concentrate on choices at the margin, where the marginal (or extra) cost of a course of action is compared with its extra benefits.

  10. The market demand curve gives the total quantity of a good demanded by all individuals in an economy at each price. As the price rises, demand falls, both because each person demands less of the good and because some people exit the market.

  11. The market supply curve gives the total quantity of a good that all firms in the economy are willing to produce at each price. As the price rises, supply rises, both because each firm supplies more of the good and because some additional firms enter the market.

  12. The law of supply and demand says that in competitive markets, the equilibrium price is that price at which quantity demanded equals quantity supplied. It is represented on a graph by the intersection of the demand and supply curves.

  13. A demand curve shows only the relationship between quantity demanded and price. Changes in tastes, in demographic factors, in income, in the prices of other goods, in information, in the availability of credit, or in expectations are reflected in a shift of the entire demand curve.

  14. A supply curve shows only the relationship between quantity supplied and price. Changes in factors such as technology, the prices of inputs, the natural environment, expectations, or the availability of credit are reflected in a shift of the entire supply curve.

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