Microeconomics Exam 1 Review: Foundations, PPF, Demand & Supply, and Elasticity

Chapter 1: Foundations of Economics

Definition of Economics and Scarcity

Economics is the study of how individuals, firms, and societies allocate limited resources to satisfy unlimited wants. Scarcity means that resources (such as time, money, labor, and raw materials) are limited, so choices must be made about their use.

• Scarcity: The fundamental economic problem of having seemingly unlimited human wants in a world of limited resources.

• Economics: The social science that studies the production, distribution, and consumption of goods and services.

• Example: Choosing how to spend your time between studying and working a part-time job.

Three Key Economic Ideas

• People are rational: Individuals use all available information to achieve their goals and make decisions that maximize their benefit.

• People respond to incentives: Changes in costs or benefits will influence the actions of individuals and firms.

• Optimal decisions are made at the margin: The best decisions are made by considering the additional (marginal) benefit and the additional (marginal) cost of an action.

• Example: Deciding whether to study one more hour for an exam by weighing the extra benefit (higher grade) against the extra cost (less leisure time).

Chapter 2: Trade-offs, Comparative Advantage, and the Market System

Production Possibility Frontier (PPF)

The Production Possibility Frontier (PPF) is a curve showing the maximum attainable combinations of two products that may be produced with available resources and current technology.

• Points inside the PPF: Attainable but inefficient (resources are underutilized).

• Points on the PPF: Attainable and efficient (all resources are fully utilized).

• Points outside the PPF: Unattainable with current resources and technology.

• Example: A country can produce either 100 cars or 200 computers, or a combination along the PPF.

Opportunity Cost and Movement Along the PPF

Opportunity cost is the value of the next best alternative foregone when making a choice. Moving along the PPF involves shifting resources from one good to another, and the opportunity cost is the amount of the other good that must be given up.

• Formula: $Opportunity\ Cost = \frac{\text{Loss\ in\ Good\ Y}}{\text{Gain\ in\ Good\ X}}$

• Example: If moving from point A to B on the PPF means producing 10 more cars but 20 fewer computers, the opportunity cost of 10 cars is 20 computers, or 2 computers per car.

Impact of Technology on the PPF

• Technological improvement: Shifts the PPF outward, allowing more of both goods to be produced.

• Example: A new manufacturing process increases car production without reducing computer output, shifting the PPF outward for cars.

Bowed Out vs. Linear PPF

• Bowed out (concave) PPF: Opportunity cost increases as more of one good is produced (resources are not perfectly adaptable).

• Linear PPF: Opportunity cost is constant (resources are perfectly adaptable between goods).

• Example: If the PPF is bowed out, producing more cars means giving up increasingly more computers.

Comparative Advantage vs. Absolute Advantage

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

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

• Example: Country A can produce 10 cars or 20 computers; Country B can produce 8 cars or 16 computers. Both have the same opportunity cost, but if the ratios differ, comparative advantage exists.

Specialization and Trade

• Specialization: When individuals or countries focus on producing goods for which they have a comparative advantage.

• Basis for trade: Trade allows all parties to consume beyond their own PPF by specializing and exchanging goods.

• Example: If Country A specializes in cars and Country B in computers, both can trade to achieve higher consumption levels.

Calculating Opportunity Cost and Identifying Comparative Advantage

• Calculate the opportunity cost for each producer for each good.

• The producer with the lower opportunity cost for a good has the comparative advantage in that good.

• Example Table:

Country	Cars Produced	Computers Produced	Opportunity Cost of 1 Car	Comparative Advantage
A	10	20	2 Computers	Computers (if lower OC)
B	8	16	2 Computers	Neither (if same OC)

Additional info: In real problems, opportunity costs will differ, allowing identification of comparative advantage.

Chapter 3: Demand, Supply, and Market Equilibrium

Change in Demand vs. Change in Quantity Demanded

• Change in demand: The entire demand curve shifts due to factors other than price (e.g., income, tastes).

• Change in quantity demanded: Movement along the demand curve due to a change in the good's own price.

• Example: A rise in consumer income shifts the demand curve for normal goods to the right (increase in demand).

Determinants of Demand (Demand Shifters)

• Income: Increases in income raise demand for normal goods and lower demand for inferior goods.

• Prices of related goods: Substitutes (increase in price of one increases demand for the other), complements (increase in price of one decreases demand for the other).

• Tastes and preferences: Changes can increase or decrease demand.

• Population and demographics: More consumers increase demand.

• Expectations: Expected future prices or income can shift demand today.

Types of Goods

• Substitute goods: Goods that can replace each other (e.g., tea and coffee).

• Complement goods: Goods that are used together (e.g., printers and ink cartridges).

• Normal goods: Demand increases as income increases (e.g., organic food).

• Inferior goods: Demand decreases as income increases (e.g., instant noodles).

Market Equilibrium: Surplus and Shortage

• Surplus: Quantity supplied exceeds quantity demanded at a given price (price is above equilibrium).

• Shortage: Quantity demanded exceeds quantity supplied at a given price (price is below equilibrium).

• Example: If the price of apples is set above equilibrium, there will be a surplus of apples.

Chapter 6: Elasticity

Price Elasticity of Demand

Price elasticity of demand measures how much the quantity demanded of a good responds to a change in its price.

• Formula: $E_d = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in price}}$

• Elastic demand: $|E_d| > 1$ (quantity demanded changes more than price)

• Inelastic demand: $|E_d| < 1$ (quantity demanded changes less than price)

• Unit elastic: $|E_d| = 1$ (quantity demanded changes exactly as much as price)

Midpoint Formula for Elasticity

• Formula: $E_d = \frac{(Q_2 - Q_1)}{(Q_2 + Q_1)/2} \div \frac{(P_2 - P_1)}{(P_2 + P_1)/2}$

• Example: If price rises from $10 to $12 and quantity falls from 100 to 80, plug into the formula to calculate elasticity.

Determinants of Price Elasticity of Demand

• Availability of substitutes: More substitutes make demand more elastic (most important determinant).

• Necessity vs. luxury: Necessities tend to be inelastic; luxuries more elastic.

• Definition of the market: Narrowly defined markets (e.g., specific brands) are more elastic than broad categories.

• Time horizon: Demand is more elastic over the long run.

Elasticity and Revenue

• Total revenue: $TR = P \times Q$

• Elastic demand: Price increase leads to a decrease in total revenue.

• Inelastic demand: Price increase leads to an increase in total revenue.

• Example: If a company raises prices and sees revenue fall, demand is elastic.

Cross-Price Elasticity of Demand

• Definition: Measures the responsiveness of demand for one good to a change in the price of another good.

• Formula: $E_{xy} = \frac{\%\ \text{change in quantity demanded of Good X}}{\%\ \text{change in price of Good Y}}$

• Interpretation:

  • Positive: Goods are substitutes.

  • Negative: Goods are complements.

  • Zero: Goods are unrelated.

Income Elasticity of Demand

• Definition: Measures the responsiveness of demand to changes in income.

• Formula: $E_I = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in income}}$

• Interpretation:

  • Positive: Normal good.

  • Negative: Inferior good.

Product Categories by Elasticity

• Brand-specific goods: More elastic (e.g., Coca-Cola vs. all soft drinks).

• Broad product categories: Less elastic (e.g., food in general).

Additional info: Elasticity concepts are crucial for understanding consumer behavior, pricing strategies, and market outcomes.