Microeconomics Midterm Review: Models, Demand, Supply, and Market Equilibrium

Thinking Like an Economist

Economics and Economic Models

Economics studies how individuals, businesses, and governments make choices to achieve their goals, and how these choices interact in markets. Economists use models to simplify and focus on key aspects of economic life.

• Economics: The study of decision-making and interactions in markets.

• Economic Model: A simplified representation of reality, highlighting important concepts for analysis.

• Circular Flow Model: Illustrates the interactions among households, businesses, and government in the economy.

• Inputs: Productive resources such as labor, natural resources, capital equipment, and entrepreneurial ability.

• Input Markets: Where businesses buy inputs from households (e.g., labor market).

• Output Markets: Where businesses sell products and services to households.

• Government: Sets rules and can interact in any aspect of the economy.

• "All Other Things Unchanged" (Ceteris Paribus): Assumption used to isolate the effect of one variable by holding others constant.

Positive vs. Normative Statements:

• Positive Statements: Factual claims that can be tested and verified.

• Normative Statements: Value-based claims that cannot be tested or proven true/false.

Demand: Making Smart Choices

The Law of Demand and Determinants

Demand refers to consumers' willingness and ability to pay for goods and services. The law of demand states that as price rises, quantity demanded falls, all else equal.

• Demand: Willingness and ability to pay for a product or service.

• Law of Demand: If the price of a product rises, quantity demanded decreases, ceteris paribus.

• Change in Demand: Caused by factors other than price (IPPEN: Income, Preferences, Prices of related products, Expected future prices, Number of consumers).

• Change in Quantity Demanded: Caused only by a change in price.

Marginal Choices and Marginal Benefit

• Marginal Benefit: The additional benefit from consuming one more unit; changes with circumstances.

• Diamond/Water Paradox: Water has higher total benefit but lower marginal benefit due to abundance; diamonds are scarce, so marginal benefit is high.

Demand Curve

• Demand Curve: Graphical representation of the relationship between price and quantity demanded.

• Market Demand: Sum of all individual demands for a product or service.

Factors Shifting Demand

• Increase in Demand: Rightward shift; caused by higher preferences, higher price of substitutes, lower price of complements, higher income (for normal goods), lower income (for inferior goods), higher expected future prices, more consumers.

• Decrease in Demand: Leftward shift; opposite changes in the above factors.

Supply: Business Decisions and Opportunity Cost

The Law of Supply and Determinants

Supply is the willingness of businesses to produce goods and services. The law of supply states that as price rises, quantity supplied increases, all else equal.

• Supply: Businesses' willingness to produce a product or service because price covers opportunity costs.

• Law of Supply: If the price of a product rises, quantity supplied increases, ceteris paribus.

• Change in Supply: Caused by factors other than price (PENTEN: Prices of related products produced, Expected future prices, Technology, Prices of inputs, Environment, Number of businesses).

• Change in Quantity Supplied: Caused only by a change in price.

Opportunity Cost and Marginal Cost

• Opportunity Cost: The value of the best alternative forgone.

• Marginal Cost: The additional opportunity cost of increasing quantity supplied; rises as more is supplied due to less productive inputs.

• Sunk Costs: Past expenses that cannot be recovered; do not affect forward-looking decisions.

Supply Curve

• Supply Curve: Shows the relationship between price and quantity supplied.

• Can be read as a supply curve (over and down) or as a marginal cost curve (up and over).

• Market Supply: Sum of all businesses' supply for a product or service.

Factors Shifting Supply

• Increase in Supply: Rightward shift; caused by improved technology, lower price of related products, lower expected future price, more businesses, favorable environment.

• Decrease in Supply: Leftward shift; opposite changes in the above factors.

Coordinating Smart Choices: Demand and Supply Together

Market Equilibrium and Price Signals

Markets coordinate the choices of buyers and sellers through voluntary exchange. Prices result from these interactions and move toward equilibrium, where quantity demanded equals quantity supplied.

• Market: Interaction between buyers and sellers.

• Voluntary Exchange: Both buyer and seller are better off after the transaction.

• Property Rights: Legally enforceable guarantees of ownership.

• Shortage: Quantity demanded exceeds quantity supplied; creates upward pressure on prices.

• Surplus: Quantity supplied exceeds quantity demanded; creates downward pressure on prices.

Equilibrium Price and Quantity

• Equilibrium Price (Market-Clearing Price): The price at which quantity demanded equals quantity supplied.

• Equilibrium Quantity: The quantity bought and sold at the equilibrium price.

• Price signals coordinate smart choices, leading to efficient market outcomes.

Consumer and Producer Surplus

• Consumer Surplus: Difference between what consumers are willing to pay and what they actually pay.

• Producer Surplus: Difference between the price received and the minimum price at which producers are willing to sell.

• Total Surplus: Sum of consumer and producer surplus; maximized at efficient market outcome ($\text{Marginal Benefit} = \text{Marginal Cost}$).

Changes in Demand and Supply

Shifts in demand or supply curves lead to changes in equilibrium price and quantity. Comparative statics is used to analyze the impact of these changes.

• Increase in Demand: Raises equilibrium price and quantity.

• Decrease in Demand: Lowers equilibrium price and quantity.

• Increase in Supply: Lowers equilibrium price, increases equilibrium quantity.

• Decrease in Supply: Raises equilibrium price, decreases equilibrium quantity.

• Simultaneous Shifts: When both demand and supply change, the effect on equilibrium price or quantity depends on the relative size of the shifts.

Comparative Statics

• Comparative Statics: Comparing two equilibrium outcomes to isolate the effect of changing one factor at a time.

• When both demand and supply increase: equilibrium quantity increases, price may rise, fall, or remain constant.

• When both decrease: equilibrium quantity decreases, price may rise, fall, or remain constant.

• When demand increases and supply decreases: price rises, quantity may change in any direction.

• When demand decreases and supply increases: price falls, quantity may change in any direction.

Key Formulas and Equations

• Law of Demand: $Q_d = f(P)$, where $Q_d$ decreases as $P$ increases.

• Law of Supply: $Q_s = f(P)$, where $Q_s$ increases as $P$ increases.

• Equilibrium Condition: $Q_d = Q_s$

• Total Surplus Maximization: $\text{Marginal Benefit} = \text{Marginal Cost}$

Summary Table: Factors Affecting Demand and Supply

Factor	Effect on Demand	Effect on Supply
Price	Movement along demand curve (change in quantity demanded)	Movement along supply curve (change in quantity supplied)
Income	Increase for normal goods, decrease for inferior goods	No direct effect
Preferences	Increase or decrease demand	No direct effect
Prices of Related Products	Substitutes/complements affect demand	Related products produced affect supply
Expected Future Prices	Increase or decrease demand	Increase or decrease supply
Number of Consumers/Businesses	More consumers increase demand	More businesses increase supply
Technology	No direct effect	Improved technology increases supply
Environment	No direct effect	Favorable environment increases supply

Additional info: Academic context and definitions have been expanded for clarity and completeness. The summary table is inferred from standard microeconomic principles.