Review

I. Introduction

Here are the percentages of questions by topic on the CLEP exam. Our final exam next week will use a similar distribution, except without as many questions about government policy:

Regulation/Government policy           18%

Inputs to a Firm (espec. labor)            10%

Price Elasticity                                    6%

ATC, AFC, AVC                                  6%

Perfect Competition                            6%

Monopolistic Competition                   6%

Monopolies                                         4%

Demand Curve                                   4%

Returns to Scale                                 4%

Comparative Advantage                     4%

Production Possibilities                      4%

MR                                                     4%

MC                                                     4%

Cartel                                                 2%

Oligopoly                                            2%

Imperfect Competition                        2%

Marginal Utility                                   2%

Cross-Price Elasticity                         2%

Price Discrimination                           2%

Substitutes                                         2%

Complements                                     2%

Inferior Goods                                    2%

Long Run v. Short Run                      2%

That is it: 23 topics. The entire CLEP exam simply asks you to apply these 23 concepts. The top two, government regulation and inputs to a firm, use some of the other concepts. All of the concepts rely heavily on common sense. In fact, many of the questions can answered correctly by carefully applying common sense and logic, even independent of economic principles.

II. Government Regulation

I bet you’re wondering how the CLEP exam can devote 18% of its microeconomic questions to government regulation. I’m wondering the same thing. Question: What should government do to promote commerce? Answer: Nothing. That didn’t take long.

In reality, however, the government plays an enormous role in the economy. It produces goods and services itself. The Post Office is a mammoth example of such a service. Government also regulates the private sector, which means free enterprise. Some of its regulations, such as the antitrust laws, are designed to increase competition and efficiency. The government also redistributes wealth through taxation and welfare programs. Government is big and always there. And it keeps growing bigger.

Occasionally an exam question is designed to highlight the limitations of government. Is it efficient? No. Why not? It often has no competition (e.g., 37-cent letter).

Can we eliminate government? Some say no, because private firms could never survive producing goods or services that have high positive externalities. A private firm could never produce a free public park, for example. The private firm would go bankrupt. Government is necessary, some say, to produce those goods and services that must be available to everyone. Public transportation in New York is made possible by the government. The subway could not survive on only the passenger fare. In a nutshell, private companies cannot produce public goods. Put another way, the use of public goods cannot be withheld from those who do not pay for them.

Most people want government to reduce the negative externalities that occur in a purely free market. If government did not provide garbage service in cities, and everyone had to pay to remove garbage, then before long we’d have rotten garbage filling the streets. The negative externality would be high, and we might beg government to remove the trash.

Likewise with pollution: if companies were allowed to pollute our rivers and streams, then many would. Many did, in fact. This is another negative externality. The companies are not paying for the full cost of their production, so their marginal cost (MC) is artificially lower than it should be. The companies are avoiding the cost of their own pollution. A lower MC means they will produce more goods than if their MC were higher. The term marginal social cost is used by economists to represent the true cost of their activities, including the cost of their pollution. In theory, perhaps there are free market responses to the polluter, such as people asserting property rights in the rivers being damaged. Historically, it has taken government regulation to reduce the negative externality.

Then there are the price floors, supports and ceilings that government imposes from time to time. Do we all know the differences? Price ceilings (or controls) are the easiest: the government says that the good cannot be sold for a higher price. Just as you cannot reach above your ceiling, the price is prohibited from rising above the ceiling that the government sets for it. It would be requiring gas to be sold for no more than $1.50, for example. The quantity supplied will decrease (move down the supply curve), while the quantity demanded will increase (move up the demand curve). Shortages result.

What is a price floor? Just the opposite of a ceiling. We cannot reach below the floor, and a price floor prevents the price from falling below a certain level. It would be a government law that prohibited milk from selling for less than $2 a gallon, for example. It would be intended to help the suppliers, such as dairy farmers. What happens when government imposes a price floor? There is a surplus of the good, as supply exceeds demand.

Now, how about a price support?   That occurs when the government buys large quantities of good, such food, at prices higher than the competitive equilibrium. The government does this to “support” a higher price, instead of passing a law to require a higher price. A price support is designed to help the firms producing the goods, such as farmers. The rationale is that farmers are politically important and that pure competition is too brutal on their business and their lives, and also that foreign countries engage in the same practices. The effect of a price support is similar to a price floor: it creates a surplus of the good when the support is above the equilibrium price.

When government regulates labor, the analysis is similar to its regulation of price. A price floor is created by the minimum wage: the buyer (an employer) must pay at least a certain amount for a service (labor). The minimum wage creates an oversupply of the service: too many workers. Not all of them will be able to obtain jobs at a wage higher than equilibrium. Unemployment results from a minimum wage that is higher than the equilibrium wage.

III. Test-taking Techniques in Economics.

Good test-taking techniques are particularly important to doing well on an economics exam. Simple questions are often intentionally disguised as something more complicated. It is easy to become confused and misguided in analyzing economic issues. 99% of the public would say that we would be better off if Congress put a price ceiling or cap on gasoline at $1.50 a gallon. It takes a bit more thought to realize that massive shortages would result, and we would all have to spend hours each week waiting in line for gasoline. Some may not be able to obtain gas at all.

The ability to eliminate wrong answers is very important on economics exams. We have already seen questions on the mid-term exam that are best analyzed by eliminating two wrong answers, and then choosing the best answer among the remaining two.

Let’s try the elimination technique on a real CLEP question:

Which of the following is true about the official measure of the poverty-level income for a family of four in the United States?

(A) It is used to determine eligibility for Social Security benefits.

(B) It shows that roughly half of all Americans live in poverty.

(C) It falls when welfare benefits increase.

(D) It is calculated by multiplying the cost of a nutritionally adequate diet by three.

(E) It is not adjusted each year for changes in the cost of living.

Virtually none of you would know the answer to this question at first glance. The question is not really appropriate for a microeconomics exam, but CLEP asks it anyway. Questions about poverty, gaps between the rich and poor, and government programs are always favorites among typical educators. You will see many more questions about these issues than about the invisible hand or the creation of wealth.

So what do we do when faced with this question? Simply give up? Move to the next question and hope it is easier? Blindly guess at an answer? None of the above.

We can narrow the choices, and thereby reduce our risk of error, by eliminating wrong answers. Basic economic principles (or common sense) serve as our guide.

Let’s start with choice (B): It shows that roughly half of all Americans live in poverty. Think about it: declaring half of the country to be poor? Half of your friends in poverty? Half of New Jersey in poverty? Imagine the political effect if that were really true. Who would pay to run government? What would we call the most poor of the poor? The percentage of half is far too high. With common sense, we can eliminate this answer.

Let’s turn to choice (E): It is not adjusted each year for changes in the cost of living. Why wouldn’t it be adjusted? Poverty must be relative to the cost of living. If the cost of living doubled, then the numbers in poverty would increase greatly. But failure to adjust for the cost of living would miss that effect. Again, common sense leads us to eliminate this answer.

Next we can turn to choice (A): It is used to determine eligibility for Social Security benefits. That cannot be true: virtually everyone must pay Social Security taxes, and then receive benefits when they become old. All politicians, rich or poor, defend Social Security.   Social security is not security only if you’re poor. We can eliminate this choice.

We’re left with only two possibilities: (C) and (D). Now our odds are 50% even if we just guess. If you took the CLEP and at least narrowed every difficult question down to two choices, then you would likely pass. But can we do better than a blind guess between these two choices?

Perhaps. Option (D) seems to have the right amount of detail, and fits the question well grammatically. The official measure of the poverty-level income … is calculated by multiplying the cost of a nutritionally adequate diet by three. Option (C) does not fit the question so well: The official measure of the poverty-level income … falls when welfare benefits increase. A measure falls? No, a measure is calculated. Even if you had no idea between (C) and (D), (D) is better grammatically and logically. It’s an educated guess. (D), indeed, is correct.

It also helps to think about the purpose of a question. These are not trick questions, and you do not want to outsmart yourself. Don’t be too cute in eliminating wrong answers. Don’t reach for the answer that you least expected initially. The purpose of this question is to ask about how poverty-level income is calculated. Answer (D) most directly relates to that purpose. It makes for a good guess if you did not otherwise know. You won’t always be able to guess the right answers, but by increasing your chances you can significantly increase your overall score.

Let’s try one more real CLEP question, this time relating to labor:

Assume that both input and product markets are competitive. If capital is fixed and the product price increases, in the short run firms will increase production by increasing:

(A) capital until marginal revenue equals the product price

(B) capital until the average product of capital equals the price of capital

(C) labor until the value of the marginal product of labor equals the wage rate

(D) labor until the marginal product of labor equals the wage rate

(E) labor until the ratio of product price to the marginal product of labor equals the wage rate

Whew! This looks far too difficult! Should we just give up right now?

Read the question again, and a third time. Capital is fixed, according to the question. So capital cannot be increased. Answers (A) and (B) can be eliminated that easily. Sounds too obvious, but many students miss this. They fail to read and understand the question.

Only labor can be increased, which is possible under answers (C), (D) and (E). We could just guess at this point, with a 33% chance of being correct. Those are good odds on a difficult question like this. But we can improve our chances even more.

(C) and (D) look similar so let’s turn to (E) first. It says to increase labor until the ratio of product price to the marginal product of labor equals the wage rate. At first glance, it seems awkward and contrived. If in a hurry, you may want to limit this immediately. When do we ever divide product price by marginal product? That’s dividing P by marginal Q, which isn’t done.

The marginal product of labor is the additional units (product) produced due to an additional unit of labor. Remember MP? The term does not include revenue or price, so it only gives you the quantity. We need to multiply that quantity by product price to obtain revenue, what the firm owner cares the most about. Choice (E) makes no sense by dividing terms that should be multiplied together. We can eliminate it.

Back to (C) and (D). The only difference between the two is the term value of in (C). Should we go for it? Think about what marginal product is. It is a quantity, not a dollar amount. Yet we are comparing it to wage rate, which would be in dollars. We need to insert value of to convert a quantity into equivalent dollars. (C) is the correct choice.

Remember that on these exams you don’t have to be correct every time. Batters who achieve hits only one-third of the time are elected to the Baseball Hall of Fame. You want to strive to do a bit better on these exams, but you don’t have be successful on every single question. You simply want to maximize your average.

IV. Review

Knowing and understanding basic concepts are the key to mastering economics exams. Return to page one of this lecture and make sure you understand every concept listed. Return to the lecture in which they were discussed and explained, and reexamine the homework as you have difficulties. Don’t worry about the most difficult concepts discussed in the course, such as the Giffen good. Instead, master the basics and be prepared to apply them logically to the final exam.

Efficiency is a basic economic concept that underlies many of the concepts on page one. In the long run, for example, a company’s production is at its most efficient level. All costs are optimized. In the long run, every cost is a variable cost that can be adjusted to attain maximum output for minimum input (I misstated this orally at the end of last Tuesday’s class). In the long run, the firm can vary its output by varying all its factors of production, including its plant scale.

The efficient level of production for a company is somewhere on its production possibilities curve. Where would an inefficient level be represented graphically? At a point where production is less than an amount on the curve. This would be a point inside the curve, closer to the origin. If there is a technological improvement that enhances efficiency, then the entire curve shifts outward. All production can increase and a new curve represents the possibilities.

Like many fields, it is often helpful for the student to find something easy to understand and then relate difficult ideas to that concept. Which concept are you most comfortable with? Perfect competition? Elasticity? MR=MC? Monopolies? In perfect competition, economic profits are squeezed to zero. P=MC. P=ATC. From there, you can understand monopolies better. A monopoly must be something other than perfect competition. Economic profits are greater than zero; economic rent exists. P>MC. P>ATC. But in both competition and monopolies, MR=MC.

Here is a final puzzle to leave you with. What is the impact on quantity of a price ceiling in a competitive industry compared to a price ceiling in a monopoly? If you can answer that correctly, then you have gone a long way to mastering this material. Hint: In which one (competitive v. monopoly) can a clever price ceiling actually increase quantity? Think about it.