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 between spending time studying or working at a job due to limited hours in a day.

Three Key Economic Ideas

• People are rational: Individuals use all available information to achieve their goals and make decisions that provide them with the greatest benefit or satisfaction.

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

• Optimal decisions are made at the margin: Most choices involve doing a little more or a little less of something, rather than making all-or-nothing decisions.

• Example: Deciding whether to study one more hour for an exam by weighing the additional benefit (higher grade) against the additional 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 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 one good given up to produce more of the other.

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

• 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: Reflects increasing opportunity costs; resources are not perfectly adaptable between goods.

• Linear PPF: Reflects constant opportunity costs; resources are perfectly adaptable between goods.

• Example: If the opportunity cost of producing cars increases as more cars are produced, the PPF is bowed out.

Comparative Advantage vs. Absolute Advantage

• Absolute advantage: The ability to produce more of a good with the same amount of resources as 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 (1 car = 2 computers), so neither has a comparative advantage.

Specialization and Trade

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

• Basis for trade: Comparative advantage allows all parties to benefit from trade by obtaining goods at a lower opportunity cost than if they produced them themselves.

• Example: If Country A has a comparative advantage in cars and Country B in computers, both benefit by specializing and trading.

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 vs. Quantity Demanded

• Increase/decrease in demand: The entire demand curve shifts due to changes in non-price factors (e.g., income, tastes).

• Increase/decrease in quantity demanded: Movement along the demand curve due to a change in the price of the good itself.

• 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.

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).

Surplus vs. Shortage

• Surplus: Quantity supplied exceeds quantity demanded at a given price; leads to downward pressure on price.

• Shortage: Quantity demanded exceeds quantity supplied at a given price; leads to upward pressure on price.

• Example: If the 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: $\text{Price Elasticity of Demand} = \frac{\%\ \text{Change in Quantity Demanded}}{\%\ \text{Change in Price}}$

• Elastic: Elasticity > 1 (quantity demanded changes by a larger percentage than price)

• Inelastic: Elasticity < 1 (quantity demanded changes by a smaller percentage than price)

• Unit elastic: Elasticity = 1 (quantity demanded changes by the same percentage as price)

Midpoint Formula

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

• Example: If price rises from $10 to $12 and quantity falls from 100 to 80, elasticity is calculated using the midpoint formula.

Determinants of Price Elasticity

• 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 broadly defined markets (e.g., food).

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

• Share of budget: Goods that take a large share of income tend to have more elastic demand.

Elasticity and Revenue

• Total revenue: $\text{Total Revenue} = \text{Price} \times \text{Quantity}$

• Elastic demand: Price increase decreases total revenue; price decrease increases total revenue.

• Inelastic demand: Price increase increases total revenue; price decrease decreases total revenue.

• Unit elastic: Total revenue remains unchanged when price changes.

Cross-Price Elasticity of Demand

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

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

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

• Interpretation:

  • Positive: Normal good (demand increases as income increases).

  • Negative: Inferior good (demand decreases as income increases).

Product Categories by Elasticity

• Brand vs. product category: Demand for a specific brand (e.g., Coca-Cola) is more elastic than for the product category (e.g., soft drinks) as a whole.

• Example: If the price of Coca-Cola rises, consumers can switch to Pepsi, making demand for Coca-Cola elastic.