Microeconomics Exam 1 Review: Core Concepts and Applications

Scarcity, Choice, and Opportunity Cost

Scarcity and Tradeoffs

Scarcity is a fundamental concept in economics, arising because resources are limited while human wants are unlimited. This condition forces individuals and societies to make choices about how to allocate resources efficiently.

• Scarcity: The basic economic problem that resources (labor, capital, land, entrepreneurship) are limited, but desires are infinite.

• Tradeoffs: Choosing more of one good or service requires giving up some amount of another due to scarcity.

Opportunity Cost

• Definition: The value of the next best alternative forgone when a choice is made.

• Measurement: Always measured in terms of the alternative given up, not just monetary cost.

• Example: If a student spends time studying economics instead of working, the opportunity cost is the wage they could have earned.

Marginal Analysis

• Marginal Benefit (MB): The additional benefit from consuming or producing one more unit.

• Marginal Cost (MC): The additional cost from consuming or producing one more unit.

• Optimal Choice: Occurs where MB = MC.

• Equation:

$MB = MC$

Positive vs. Normative Economics

• Positive Economics: Descriptive statements that can be tested with data ("what is").

• Normative Economics: Prescriptive statements based on value judgments ("what ought to be").

The Economic Problem and Production Possibilities

Production Possibilities Curve (PPC)

The PPC illustrates the maximum combinations of two goods that can be produced with fixed resources and technology.

• Efficient Production: Points on the PPC represent full and efficient use of resources.

• Inefficient Production: Points inside the PPC indicate underutilization of resources.

• Unattainable Points: Points outside the PPC cannot be reached with current resources and technology.

Increasing Opportunity Cost

• As production of one good increases, larger amounts of the other good must be given up due to resource specialization.

• Slope of PPC: Represents the marginal rate of transformation (MRT), which equals the opportunity cost.

• Equation:

$MRT = \frac{\Delta \text{Good Y}}{\Delta \text{Good X}}$

Economic Growth

• Outward shift of the PPC, caused by increases in labor, capital, technology, or human capital.

• Example: Technological innovation allows more goods to be produced with the same resources.

Demand and Supply

Law of Demand

• As price increases, quantity demanded decreases, ceteris paribus (holding other factors constant).

• Demand Shifters: Income, tastes, expectations, number of buyers, prices of related goods.

• Normal Good: Demand increases as income rises.

• Inferior Good: Demand decreases as income rises.

• Substitutes: An increase in the price of one good increases demand for another.

• Complements: A decrease in the price of one good increases demand for its complement.

Law of Supply

• As price increases, quantity supplied increases, ceteris paribus.

• Supply Shifters: Input prices, technology, taxes/subsidies, expectations, number of sellers.

Market Equilibrium

• Occurs where quantity demanded equals quantity supplied.

• Shortage: Quantity demanded exceeds quantity supplied (price below equilibrium).

• Surplus: Quantity supplied exceeds quantity demanded (price above equilibrium).

Elasticity

Price Elasticity of Demand (PED)

• Definition: Measures the responsiveness of quantity demanded to a change in price.

• Formula:

$PED = \frac{\%\ \text{Change in Quantity Demanded}}{\%\ \text{Change in Price}}$

• Elastic Demand: $|PED| > 1$ (quantity demanded responds strongly to price changes).

• Inelastic Demand: $|PED| < 1$ (quantity demanded responds weakly to price changes).

Total Revenue Test

• If demand is elastic, price and total revenue move in opposite directions.

• If demand is inelastic, price and total revenue move in the same direction.

Determinants of Elasticity

• Availability of substitutes

• Time horizon

• Necessity vs. luxury

• Share of income spent on the good

Cross-Price and Income Elasticity

• Cross-Price Elasticity: Responsiveness of demand for one good to the price change of another.

• Income Elasticity: Responsiveness of demand to changes in income.

Efficiency and Fairness of Markets

Consumer and Producer Surplus

• Consumer Surplus: Difference between willingness to pay and market price; area below demand curve and above price.

• Producer Surplus: Difference between market price and minimum willingness to accept; area above supply curve and below price.

• Total Surplus: Sum of consumer and producer surplus; maximized at competitive equilibrium.

Allocative Efficiency and Equity

• Allocative Efficiency: Occurs when marginal benefit equals marginal cost.

• Equation:

$MB = MC$

• Equity (Fairness): Concerns the distribution of benefits and costs among market participants.

Government Actions in Markets: Price and Quantity Controls

Price Ceilings and Price Floors

• Price Ceiling: Maximum legal price; binding if set below equilibrium, causing shortages.

• Price Floor: Minimum legal price; binding if set above equilibrium, causing surpluses.

Deadweight Loss (DWL)

• Reduction in total surplus due to market distortions such as price controls.

Taxes and Market Outcomes

Tax Wedge and Incidence

• Tax Wedge: The difference between the price buyers pay and the price sellers receive due to a tax.

• Tax Incidence: The distribution of the tax burden between buyers and sellers depends on the relative elasticities of demand and supply.

• The more inelastic side of the market bears a larger share of the tax burden.

• Taxes reduce the quantity traded and create deadweight loss.

Market Failure: Externalities

Externalities and Social Efficiency

• Externality: A spillover effect of a market activity that affects third parties.

• Negative Externality: Social cost exceeds private cost; market produces too much.

• Positive Externality: Social benefit exceeds private benefit; market produces too little.

Marginal Social Cost and Benefit

• Marginal Social Cost (MSC): $MSC = MPC + \text{External Cost}$

• Marginal Social Benefit (MSB): $MSB = MPB + \text{External Benefit}$

• Efficient output occurs where $MSC = MSB$.

Pigouvian Taxes and Subsidies

• Pigouvian Tax: A tax equal to the external cost to correct overproduction from negative externalities.

• Pigouvian Subsidy: A subsidy equal to the external benefit to correct underproduction from positive externalities.