Comprehensive Microeconomics Final Exam Study Guide

Economics: Foundations and Models

Three Key Economic Ideas

• Rationality: Economists assume individuals make decisions by comparing costs and benefits, aiming to maximize their well-being.

• Response to Incentives: Behavior changes 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 alternatives 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, total surplus can be increased by producing more.

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 negotiation can resolve externalities.

• Command-and-Control Policies: Direct regulation (e.g., pollution limits).

• Market-Based Policies: Taxes or tradable permits create incentives to reduce negative externalities (e.g., carbon tax).

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 changes.

• Inelastic Demand: Quantity demanded changes little with price changes.

• Perfectly Inelastic: Vertical demand curve; quantity does not change with price.

• Perfectly Elastic: Horizontal demand curve; quantity drops to zero with any price increase.

Formula:

$\text{Price Elasticity of Demand} = \frac{\% \text{ change in quantity demanded}}{\% \text{ change in price}}$

• Example: If PED = -0.8, a 1% increase in price causes a 0.8% decrease in quantity demanded.

Determinants of Elasticity

• Availability of close substitutes (more substitutes = more elastic demand).

• Narrowly defined goods are more elastic (e.g., Starbucks vs. coffee).

• More time to adjust = more elastic demand (long run vs. short run).

Elasticity and Revenue

• If demand is elastic, increasing price reduces total revenue.

• If demand is inelastic, increasing price increases total revenue.

Price Elasticity of Supply

• Measures responsiveness of quantity supplied to price changes.

• Supply is generally more elastic in the long run.

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

• Adding more of a variable input (e.g., labor) increases output, 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 the ATC and AVC curves at their minimum points.

Formulas:

$\text{MC} = \frac{\Delta \text{Total Cost}}{\Delta \text{Quantity}}$

$\text{ATC} = \frac{\text{Total Cost}}{\text{Quantity}}$

$\text{AVC} = \frac{\text{Total Variable Cost}}{\text{Quantity}}$

$\text{AFC} = \frac{\text{Total Fixed Cost}}{\text{Quantity}}$

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 marginal revenue equals marginal cost.

$\text{Profit Maximization:} \quad MR = MC$

Shutdown Decision

• A firm should shut down in the short run if price is less than average variable cost.

$\text{Shutdown if:} \quad P < AVC$

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 (e.g., restaurants).

Firm Behavior

• Downward-sloping demand curve; must lower price to sell more.

• Maximize profit where marginal revenue equals marginal cost.

Long Run Outcome

• Entry of new firms eliminates profits; zero economic profit in the long run.

Consumer Benefits

• Consumers benefit from a 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 (often insurmountable) barriers are necessary for monopoly power.

Pricing and Output

• The monopolist faces the market demand curve.

• Must lower price to sell additional units.

Profit Maximization

• Produce where marginal revenue equals marginal cost; charge the corresponding price on the demand curve.

Efficiency

• Monopolies are inefficient: 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., marginal revenue equals marginal cost).

• Apply economic reasoning, not just memorization.

• Distinguish between similar concepts (e.g., shifts vs. movements, elasticity vs. slope).