BackComprehensive Microeconomics Final Exam Study Guide
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Economics: Foundations and Models
Three Key Economic Ideas
Rationality: Economists assume individuals make decisions by comparing costs and benefits, aiming to maximize their utility.
Response to Incentives: Individuals change their behavior when costs or benefits change. For example, higher prices typically reduce quantity demanded, while higher wages increase labor supply.
Scarcity and Trade-Offs
Scarcity: Resources are limited, but human wants are unlimited, necessitating choices.
Trade-Offs: Every choice involves giving up something else due to scarcity. This applies to all individuals, regardless of wealth.
Opportunity Cost: The value of the next best alternative forgone when making a decision.
Trade-Offs and Comparative Advantage
Production Possibilities Frontier (PPF)
The PPF shows the maximum combinations of goods an economy can produce with given resources and technology.
Efficient Points: On the curve.
Inefficient Points: Inside the curve.
Unattainable Points: Outside the curve.
Moving along the PPF illustrates opportunity cost. A bowed-out PPF indicates increasing opportunity costs.
An outward shift of the PPF represents economic growth.
Comparative Advantage
A producer has a comparative advantage if they can produce a good at a lower opportunity cost than others.
Trade allows specialization based on comparative advantage, benefiting all parties—even if one has an absolute advantage in all goods.
Demand and Supply
Market Equilibrium
Equilibrium: Occurs where quantity demanded equals quantity supplied.
Shortage: Price below equilibrium; upward pressure on price.
Surplus: Price above equilibrium; downward pressure on price.
Shifts in Demand and Supply
Movement Along a Curve: Caused by price changes.
Shift of a Curve: Caused by external factors (e.g., income, tastes, technology).
Double Shifters: When both demand and supply shift, the effect on price and quantity depends on the magnitude and direction of each shift.
Key Relationships:
If both price and quantity decrease, demand has decreased.
If price decreases and quantity increases, supply has increased.
Efficiency, Price Controls, and Taxes
Consumer and Producer Surplus
Consumer Surplus: The difference between the maximum price a consumer is willing to pay and the actual price paid.
Producer Surplus: The difference between the price received and the cost of production.
Economic Efficiency
An outcome is efficient when marginal benefit equals marginal cost.
If output is below this level, marginal benefit exceeds marginal cost—more should be produced.
Price Controls
Price Ceiling: Maximum legal price (e.g., rent control); leads to shortages.
Price Floor: Minimum legal price; leads to surpluses.
Identify who benefits and who is harmed by these policies.
Taxes
Taxes create a wedge between the price buyers pay and the price sellers receive.
The burden of a tax (tax incidence) falls more on the side of the market that is less elastic (less responsive to price changes).
Externalities and Public Goods
Externalities
Externality: When a third party is affected by a transaction.
Negative Externality: Leads to overproduction (e.g., pollution).
Positive Externality: Leads to underproduction (e.g., education).
Private Solutions and Government Policy
Coase Theorem: If property rights are well defined and transaction costs are low, private negotiations can resolve externalities.
Command-and-Control Policies: Direct regulation (e.g., pollution limits).
Market-Based Policies: Use incentives (e.g., taxes or tradable permits).
Four Categories of Goods
Type of Good | Rival? | Excludable? | Example |
|---|---|---|---|
Private Good | Yes | Yes | Bread |
Public Good | No | No | National defense |
Common Resource | Yes | No | Public pasture land |
Quasi-Public Good | No | Yes | Cable TV |
Common resources often lead to overuse ("tragedy of the commons").
Elasticity
Price Elasticity of Demand
Elasticity: Measures responsiveness of quantity demanded to price changes.
Elastic Demand: Quantity demanded changes significantly with price.
Inelastic Demand: Quantity demanded changes little with price.
Perfectly Inelastic: Vertical demand curve.
Perfectly Elastic: Horizontal demand curve.
Formula:
Example: If PED = -0.8, a 1% increase in price causes a 0.8% decrease in quantity demanded.
Determinants of Elasticity
Elasticity is higher when:
Close substitutes are available
The good is narrowly defined
Consumers have more time to adjust (long run)
Elasticity and Revenue
If demand is elastic, increasing price reduces total revenue.
If demand is inelastic, increasing price increases total revenue.
Firms can estimate elasticity by adjusting price and observing revenue changes.
Price Elasticity of Supply
Measures responsiveness of quantity supplied to price changes.
Supply is generally more elastic in the long run.
Formula:
International Trade
Trade and Tariffs
Tariff: A tax on imports; raises prices and reduces trade.
Gains from Trade
Trade allows countries to specialize based on comparative advantage, resulting in lower prices, greater variety, and increased welfare.
Mutually beneficial trade is possible even if one country has an absolute advantage in all goods.
Production and Costs
Positive Technological Change
Occurs when a firm can produce more output with the same inputs.
Production and Diminishing Returns
As more units of labor are added, output increases but at a decreasing rate (law of diminishing marginal returns).
This explains why average total cost (ATC) and marginal cost (MC) curves are U-shaped in the short run.
Cost Concepts
Marginal Cost (MC): Additional cost of producing one more unit.
Average Total Cost (ATC): Total cost divided by output.
Average Variable Cost (AVC): Variable cost divided by output.
Average Fixed Cost (AFC): Fixed cost divided by output.
The MC curve intersects ATC and AVC at their minimum points.
Long Run Costs
All inputs are variable; firms can adjust scale to minimize costs.
The long run average cost curve shows the lowest average cost for each output level.
Perfect Competition
Market Structure
Many buyers and sellers
Identical products
No barriers to entry
Profit Maximization
Firms maximize profit where:
Shutdown Decision
A firm should shut down in the short run if price is less than average variable cost (P < AVC).
Long Run Equilibrium
Firms earn zero economic profit (break even).
Price equals minimum average total cost.
Monopolistic Competition
Key Features
Many firms
Differentiated products
Some control over price
Low entry barriers
Firm Behavior
Firms face downward-sloping demand curves and must lower price to sell more units.
Profit maximization occurs where MR = MC.
Long Run Outcome
Entry of new firms eliminates profits, resulting in zero economic profit in the long run.
Consumer Benefits
Consumers benefit from a greater variety of products tailored to their tastes.
Oligopoly
Market Characteristics
Few firms dominate the market.
Firms are interdependent; one firm's decisions affect others.
Game Theory
A dominant strategy is optimal regardless of competitors' actions.
Firms must anticipate rivals' responses when making decisions.
Monopoly
Barriers to Entry
High barriers are necessary to maintain monopoly power (e.g., patents, resource ownership).
Pricing and Output
The monopolist faces the market demand curve and must lower price to sell more units.
Profit Maximization
Monopolist produces where MR = MC and charges the corresponding price on the demand curve.
Profit-maximizing price exceeds marginal cost.
Efficiency
Monopolies are inefficient because price exceeds marginal cost, resulting in deadweight loss.
Final Exam Strategy
Be comfortable interpreting graphs (cost curves, demand and supply, market structures).
Understand key decision rules (e.g., MR = MC).
Apply economic reasoning rather than memorization.
Distinguish between similar concepts (e.g., shifts vs. movements, elasticity vs. slope).
