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Chapter Review Chapter 3: Households and Firms in the Labor and Capital Markets

  1. An increase in the price of a good reduces a person’s demand for that good both because of the income effect (the higher price makes the individual worse off, and because she is worse off, she reduces her consumption) and because of the substitution effect (the good is now more expensive relative to other goods, so she substitutes other goods).

  2. The response of the quantity demanded to changes in price is measured by the price elasticity of demand. If the quantity demanded decreases by more than 1 percent when the price increases by 1 percent, demand is elastic; if the quantity demanded decreases by less than 1 percent when the price increases by 1 percent, demand is inelastic.

  3. An increase in the real interest rate has an ambiguous effect on saving and current consumption. The income effect leads to more current consumption (reduced sav­ ing), but the substitution effect leads to less current consumption (increased saving). The net effect is probably positive but small, making the saving supply relatively inelastic.

  4. A dollar today is worth more than a dollar in the future. That future value in terms of today’s dollar is its present discounted value.

  5. An increase in the real wage has an ambiguous effect on labor supply. Because individuals are better off, the income effect leads to more leisure (less work). But the substitution effect—the increased consumption made possible by working an additional hour—leads to more work. In practice, the two effects probably just offset each other, making labor supply very inelastic.

  6. The typical firm produces at the output at which price equals marginal cost, so long as total revenue equals or exceeds total costs. The typical shape of the market supply curve is relatively horizontal (elastic supply) when output is very low but close to vertical (inelastic supply) as capacity is reached.

  7. General equilibrium analysis stresses that all markets are interrelated. Equilibrium occurs when demand equals supply for every good and service and every input; at that point, the product, labor, and capital markets clear.

  8. The circular flow diagram shows the flow of funds among the various parts of the economy.

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