Microeconomics Exam 1 Review: Foundations, Models, and Trade-offs

Economics: Foundations and Models

Definition and Scope of Economics

Economics is the study of the choices people make to attain their goals, given their scarce resources. Scarcity means that resources are limited and cannot satisfy all human wants, necessitating choices and trade-offs.

• Scarcity: The fundamental economic problem of having limited resources to meet unlimited wants.

• Example: Choosing to attend a review session instead of another activity.

Resources of Production

Production of goods and services requires four key resources, also known as factors of production:

• Labor: The number and quality of workers available.

• Land: All natural resources (e.g., dirt, water, oil, air).

• Capital: Tools, factories, and equipment used to produce other goods.

• Entrepreneurship: The abilities of individuals willing to take risks and develop new products.

Microeconomics vs. Macroeconomics

Distinguishing Microeconomics

Microeconomics focuses on specific markets and individual choices, such as how taxes affect supply and demand for a particular product. In contrast, macroeconomics examines broader economic trends and policies, including inflation and unemployment.

• Microeconomics: Studies how households and firms make choices, interact in markets, and how government influences these choices.

• Macroeconomics: Studies the economy as a whole, including aggregate phenomena like inflation and unemployment.

Economic Models

Purpose and Construction of Models

Economists use models to analyze human behavior, economic events, and government policies. Models are simplified versions of reality that focus on positive outcomes (what is happening) rather than normative outcomes (what ought to happen).

• Positive Analysis: Concerned with factual statements and objective analysis.

• Normative Analysis: Concerned with value judgments and what should be.

• Assumption of Rationality: Economic models generally assume people are rational, meaning they make the best decisions possible with the information available.

Circular Flow Model

Basic Structure

The circular flow diagram is a simplified economic model showing the flow of resources, goods, and money between households and firms. It omits elements such as government, financial systems, and foreign buyers/sellers.

• Households: Provide factors of production to firms and receive income.

• Firms: Produce goods and services and pay households for resources.

Productive and Allocative Efficiency

Productive Efficiency

Productive efficiency occurs when a firm uses the most cost-effective production techniques and achieves the lowest possible cost per unit of output. This is typically driven by competition.

• Key Point: Achieving the lowest cost per unit through optimal resource use.

Allocative Efficiency

Allocative efficiency is achieved when resources are allocated where they are most valued by consumers, typically when the price of a product matches its marginal cost of production. This arises from voluntary exchange in markets.

• Key Point: Ensuring that goods and services are distributed according to consumer preferences.

Marginal Benefit and Marginal Cost

Decision-Making at the Margin

Optimal decisions are made by comparing the marginal benefit (additional revenue or satisfaction) and marginal cost (additional cost) of an action. The activity should continue up to the point where marginal benefit equals marginal cost.

• Formula: $MB = MC$

• Example: Apple considers the cost and revenue of producing 300,000 more iPhones.

Positive vs. Normative Statements

Definitions and Examples

• Positive Statement: Describes what is, can be tested or validated (e.g., "The U.S. minimum wage increased in 2009.").

• Normative Statement: Describes what ought to be, based on opinions or values (e.g., "The government should raise the minimum wage to $10.").

Production Possibilities Frontier (PPF) and Opportunity Cost

PPF Definition and Properties

The production possibilities frontier (PPF) is a curve showing the maximum attainable combinations of two goods that can be produced with available resources and current technology. The PPF is a positive tool, concerned with "what is."

• Points on the PPF: Attainable and efficient.

• Points below the PPF: Attainable but inefficient.

• Points above the PPF: Unattainable with current resources.

Opportunity Cost

Opportunity cost is the highest-valued alternative that must be given up to engage in an activity. It is illustrated by movements along the PPF, where producing more of one good requires sacrificing some of another.

• Law of Increasing Opportunity Cost: The PPF is bowed outward because opportunity cost increases as more resources are allocated to one good.

Economic Growth and Shifts in the PPF

Economic growth occurs when more resources become available, shifting the PPF outward and allowing greater production of goods and services.

• Cause of PPF Shift: Increase in a country's resources.

Tables: Production Choices and Opportunity Cost

Tables are used to illustrate opportunity cost and absolute/comparative advantage.

Choice	Gasoline-Powered F-150s Produced per Day	Lightnings Produced per Day
A	60	0
B	40	20
C	20	40
D	0	60

Additional info: Table illustrates trade-offs and opportunity cost between producing gasoline-powered and electric vehicles.

Combination	Banjos	Saxophones
A	0	10
B	1	9
C	2	7
D	3	4
E	4	0

Additional info: Table shows opportunity cost of producing additional banjos in terms of saxophones forgone.

Absolute and Comparative Advantage

Definitions

• Absolute Advantage: The ability to produce more of a good than another entity with the same resources.

• Comparative Advantage: The ability to produce a good at a lower opportunity cost than another entity.

Practice Table: Absolute Advantage

	Papers	Lectures
Shaun	8	10
Bryan	4	2

Example: Shaun has the absolute advantage in writing papers because 8 papers is greater than 4 papers.

Basis for Trade

Trade is based on comparative advantage, allowing individuals, firms, or countries to specialize in what they do best and trade for other goods and services, increasing overall consumption and welfare.