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 choices people make as they cope with scarcity and the incentives that influence those choices.

• 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 people's decisions and behavior.

• Optimal decisions are made at the margin: The best decisions are made by comparing the additional (marginal) benefit to the additional (marginal) cost.

• 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 that shows the maximum attainable combinations of two goods that can be produced with available resources and technology.

• Points on the PPF: Efficient production; all resources are fully utilized.

• Points inside the PPF: Inefficient production; some resources are underutilized.

• 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 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, incurring an opportunity cost.

• Formula: $ Opportunity\ Cost = \frac{Loss\ in\ Good\ A}{Gain\ in\ Good\ B} $

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

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 computer output without reducing car production.

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 make 10 cars or 20 computers; Country B can make 8 cars or 16 computers. Both have the same opportunity cost, but if the ratios differ, comparative advantage can be identified.

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 PPFs by specializing and exchanging goods.

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

Calculating Opportunity Cost and 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: If Country A gives up 2 computers for 1 car, and Country B gives up 4 computers for 1 car, Country A has the comparative advantage in cars.

Chapter 3: Where Prices Come From: The Interaction of Demand and Supply

Demand: 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: Higher income increases demand for normal goods, decreases 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.

• Example: If the price of coffee rises, demand for tea (a substitute) may increase.

Types of Goods

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

• 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).

Surplus vs. 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 market price is set above equilibrium, a surplus results; if below, a shortage occurs.

Chapter 6: Elasticity: The Responsiveness of Demand and Supply

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: $ Price\ Elasticity\ of\ Demand = \frac{\%\ Change\ in\ Quantity\ Demanded}{\%\ Change\ in\ Price} $

• Inelastic demand: Elasticity < 1 (quantity demanded changes less than price).

• Elastic demand: Elasticity > 1 (quantity demanded changes more than price).

• Unit elastic: Elasticity = 1 (quantity demanded changes exactly as price changes).

• Example: If a 10% increase in price leads to a 5% decrease in quantity demanded, elasticity = 0.5 (inelastic).

Midpoint Formula for Elasticity

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

• Use: Provides a consistent measure of elasticity between two points on a demand curve.

Determinants of Price Elasticity of Demand

• Availability of substitutes: More substitutes = more elastic demand (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.

• Example: Demand for gasoline is more elastic in the long run as consumers can switch to fuel-efficient cars.

Elasticity and Revenue

• Total revenue: $ Total\ Revenue = Price \times Quantity $

• 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: $ Cross\text{-}Price\ Elasticity = \frac{\%\ Change\ in\ Quantity\ Demanded\ of\ Good\ A}{\%\ Change\ in\ Price\ of\ Good\ B} $

• Interpretation: Positive value = substitutes; negative value = complements; zero = unrelated goods.

• Example: If the price of tea rises and demand for coffee increases, the goods are substitutes.

Income Elasticity of Demand

• Definition: Measures how quantity demanded changes as consumer income changes.

• Formula: $ Income\ Elasticity = \frac{\%\ Change\ in\ Quantity\ Demanded}{\%\ Change\ in\ Income} $

• Normal goods: Positive income elasticity (demand increases as income rises).

• Inferior goods: Negative income elasticity (demand decreases as income rises).

• Example: As income rises, demand for restaurant meals (normal good) increases, while demand for instant noodles (inferior good) decreases.