Econ 201: Introduction to Microeconomics – Midterm Review Study Guide

The Principles and Practice of Economics

What Economics Studies

Economics is the study of how individuals, firms, and societies allocate scarce resources to satisfy unlimited wants. It analyzes decision-making, resource allocation, and the consequences of choices.

• Microeconomics focuses on individual agents (consumers, firms) and markets.

• Macroeconomics studies aggregate outcomes (national income, inflation, unemployment).

Positive vs. Normative Statements

• Positive statements describe what is or can be tested (e.g., "Increasing the minimum wage will increase unemployment").

• Normative statements express value judgments (e.g., "The government should increase the minimum wage").

Three Principles of Economics

• Optimization: Making the best possible choice given constraints.

• Equilibrium: A situation where no agent has an incentive to change their behavior.

• Empiricism: Using data to test economic theories.

Cost-Benefit Analysis

Cost-benefit analysis compares the costs and benefits of an action to determine if it is worthwhile.

• Opportunity cost: The value of the next best alternative foregone.

• Formula: $\text{Net Benefit} = \text{Total Benefit} - \text{Total Cost}$

Free Rider Problem

The free rider problem occurs when individuals benefit from resources, goods, or services without paying for them, leading to under-provision of public goods.

• Example: National defense is a public good; individuals cannot be excluded from its benefits.

Economic Science: Using Data and Models to Understand the World

Scientific Method in Economics

Economists use the scientific method to develop models, test hypotheses, and analyze data.

• Steps: Observation, hypothesis formation, testing, and revision.

• Models: Simplified representations of reality to explain economic phenomena.

Correlation vs. Causation

• Correlation: Two variables move together, but one does not necessarily cause the other.

• Causation: One variable directly affects another.

• Example: Ice cream sales and drowning incidents are correlated due to seasonality, not causation.

Observational vs. Experimental Data

• Observational data: Collected without intervention; harder to establish causality due to confounding factors.

• Experimental data: Generated by controlled experiments; allows for clearer causal inference.

Consumers and Incentives

Indifference Curves and Preferences

Indifference curves represent combinations of goods that provide equal satisfaction to consumers.

• Substitutes: Indifference curves are less curved; consumers are willing to trade one good for another.

• Complements: Indifference curves are more curved; goods are consumed together.

Budget Constraints

The budget constraint shows all combinations of goods a consumer can afford given prices and income.

• Formula: $P_x X + P_y Y = I$

• Changes: Price or income changes shift or rotate the budget line.

Consumer Choice and Marginal Analysis

• Marginal benefit per dollar: Consumers allocate spending to maximize utility.

• Optimal choice: $\frac{MU_x}{P_x} = \frac{MU_y}{P_y}$

Demand Curves

• Individual demand: Shows quantity demanded at each price for one consumer.

• Aggregate demand: Sum of individual demands.

Shifts vs. Movements Along Demand Curve

• Shift: Caused by changes in income, tastes, prices of related goods.

• Movement: Caused by change in price of the good itself.

Consumer Surplus

• Definition: The difference between what consumers are willing to pay and what they actually pay.

• Formula: $\text{Consumer Surplus} = \int_{0}^{Q^*} D(p) dp - P^* Q^*$

Elasticity of Demand

• Price elasticity: $\varepsilon = \frac{\% \text{ change in quantity}}{\% \text{ change in price}}$

• Income elasticity: $\varepsilon_I = \frac{\% \text{ change in quantity}}{\% \text{ change in income}}$

• Cross-price elasticity: $\varepsilon_{xy} = \frac{\% \text{ change in quantity of x}}{\% \text{ change in price of y}}$

Elasticity and Seller Revenue

• Elastic demand: Price increase lowers revenue.

• Inelastic demand: Price increase raises revenue.

Perfectly Elastic and Inelastic Demand

• Perfectly elastic: Horizontal demand curve; $\varepsilon = \infty$

• Perfectly inelastic: Vertical demand curve; $\varepsilon = 0$

Sellers and Incentives

Production Function and Returns to Scale

The production function shows the relationship between input factors and output.

• Economies of scale: Output increases more than proportionally with inputs.

• Constant returns: Output increases proportionally.

• Diseconomies of scale: Output increases less than proportionally.

Marginal Product and Diminishing Returns

• Marginal product: Additional output from one more unit of input.

• Diminishing returns: Marginal product decreases as input increases.

Profit Maximization

• Marginal analysis: Firms maximize profit where $MR = MC$.

• Graphical solution: Intersection of marginal revenue and marginal cost curves.

Cost Concepts

• Average total cost (ATC): $ATC = \frac{TC}{Q}$

• Average variable cost (AVC): $AVC = \frac{VC}{Q}$

• Average fixed cost (AFC): $AFC = \frac{FC}{Q}$

• Marginal cost (MC): $MC = \frac{\Delta TC}{\Delta Q}$

• Sunk cost: Costs already incurred and cannot be recovered.

Short-Run vs. Long-Run Costs

• Short-run: Some inputs are fixed.

• Long-run: All inputs are variable.

Economic vs. Accounting Profit

• Economic profit: Includes implicit costs.

• Accounting profit: Excludes implicit costs.

• Formula: $\text{Economic Profit} = \text{Total Revenue} - (\text{Explicit Costs} + \text{Implicit Costs})$

Shutdown Rules

• Short-run: Shutdown if $P < AVC$

• Long-run: Exit if $P < ATC$

Entry and Exit Decisions

• Short-run: Firms may operate at a loss if $P > AVC$ but $P < ATC$

• Long-run: Firms exit if losses persist.

Supply Curves

• Individual supply: Quantity supplied at each price by one firm.

• Aggregate supply: Sum of individual supplies.

Producer Surplus

• Definition: Difference between price received and minimum price willing to accept.

• Formula: $\text{Producer Surplus} = P^* Q^* - \int_{0}^{Q^*} S(p) dp$

Elasticity of Supply

• Price elasticity: $\varepsilon_s = \frac{\% \text{ change in quantity supplied}}{\% \text{ change in price}}$

• Perfectly elastic: Horizontal supply curve; $\varepsilon_s = \infty$

• Perfectly inelastic: Vertical supply curve; $\varepsilon_s = 0$

Perfect Competition and the Invisible Hand

Competitive Markets

• Definition: Many buyers and sellers, homogeneous products, free entry and exit.

Equilibrium Price and Quantity

• Determined by: Intersection of supply and demand curves.

• Formula: $Q_d(P^*) = Q_s(P^*)$

Pareto Efficiency

• Definition: No one can be made better off without making someone else worse off.

Economic Shocks and Social Surplus

• Social surplus: Sum of consumer and producer surplus.

• Shocks: Changes in supply or demand affect equilibrium and surplus.

Price Controls and Deadweight Loss

• Price ceiling: Maximum legal price; can cause shortages.

• Price floor: Minimum legal price; can cause surpluses.

• Deadweight loss: Loss of total surplus due to inefficiency.

Tax Incidence

• Definition: Distribution of tax burden between buyers and sellers.

• Formula: $\text{Tax Incidence on Buyers} = \frac{\varepsilon_s}{\varepsilon_s + \varepsilon_d}$

• Formula: $\text{Tax Incidence on Sellers} = \frac{\varepsilon_d}{\varepsilon_s + \varepsilon_d}$

Effects of Taxes and Subsidies

• Taxes: Reduce consumer and producer surplus, create government revenue, and deadweight loss.

• Subsidies: Increase surpluses, cost government money, may create inefficiency.

Equity vs. Efficiency

• Equity: Fairness in distribution.

• Efficiency: Maximizing total surplus.

• Trade-off: Policies may improve equity but reduce efficiency.

Market vs. Command Economy

• Market economy: Prices allocate resources.

• Command economy: Central authority allocates resources.

Consumer Sovereignty and Paternalism

• Consumer sovereignty: Consumers decide what is produced.

• Paternalism: Government intervenes to protect consumers.

• Examples: Bans on harmful products (paternalism), free choice in markets (sovereignty).

Arguments and Government Failure

• Arguments for sovereignty: Freedom, efficiency.

• Arguments for paternalism: Protection, correcting irrational behavior.

• Government failure: Inefficiency due to poor policy, bureaucracy, or unintended consequences.