Microeconomics Exam 1 Study Guide: Foundations, Trade-offs, Markets, Efficiency, and Elasticity

Chapter 1: Economics – Foundations and Models

Scarcity and the Economic Problem

Scarcity is the fundamental economic problem of having seemingly unlimited human wants in a world of limited resources. Economics studies how individuals and societies allocate these scarce resources to satisfy their needs and wants.

• Scarcity: The condition that arises because resources are limited while wants are unlimited.

• Economics: The study of how people make choices to satisfy their wants given the existence of scarcity.

Three Economic Ideas

• Rational Choices: Individuals use all available information to achieve their goals and make decisions that provide them with the greatest benefit.

• Incentives: Factors that motivate individuals and firms to make decisions in their best interest.

• Choices on the Margin: Most decisions involve doing a little more or a little less of something, known as marginal analysis.

Trade-offs and Opportunity Costs

• Trade-offs: To obtain more of one thing, society must forgo the opportunity of getting the next best thing.

• Opportunity Cost: The highest-valued alternative that must be given up to engage in an activity.

Types of Economic Systems

• Centrally Planned Economy: The government decides how economic resources will be allocated.

• Market Economy: Decisions of households and firms interacting in markets allocate resources.

• Mixed Economy: Most economic decisions result from the interaction of buyers and sellers, but governments play a significant role in the allocation of resources.

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

Production Possibilities Frontier (PPF)

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

• Graph Interpretation: Points on the PPF are efficient, inside are inefficient, and outside are unattainable.

• Bowed Out vs. Straight Line: A bowed-out PPF reflects increasing opportunity costs, while a straight line indicates constant opportunity costs.

• Law of Increasing Marginal Opportunity Cost: As more of one good is produced, the opportunity cost of producing that good increases.

Economic Growth

• Total Growth: Outward shift of the PPF, indicating an increase in resources or technological improvement.

• Sector-Specific Growth: PPF shifts outward more for one good than another, reflecting growth in a specific sector.

Absolute and Comparative Advantage

• Absolute Advantage: The ability to produce more of a good or service than competitors using the same amount of resources.

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

• Calculating Opportunity Cost: For each good, opportunity cost is what is given up to produce one more unit of that good.

Example: If Country A can produce 10 cars or 20 computers, the opportunity cost of 1 car is 2 computers.

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

Competitive Market and Quantity Demanded

• Competitive Market: Many buyers and sellers, none of whom can influence the market price.

• Quantity Demanded (Qd): The amount of a good that buyers are willing and able to purchase at a given price.

• Law of Demand: As the price of a good falls, the quantity demanded rises, ceteris paribus.

• Demand Shifters: Factors other than price that shift the demand curve (e.g., income, tastes, prices of related goods, expectations, number of buyers).

Quantity Supplied and Law of Supply

• Quantity Supplied (Qs): The amount of a good that sellers are willing and able to sell at a given price.

• Law of Supply: As the price of a good rises, the quantity supplied increases, ceteris paribus.

• Supply Shifters: Factors that shift the supply curve (e.g., input prices, technology, expectations, number of sellers).

Market Equilibrium and Double Shifters

• Market Equilibrium: The point where quantity demanded equals quantity supplied; determines the equilibrium price and quantity.

• Double Shifters: When both demand and supply curves shift, the effect on equilibrium price and quantity depends on the magnitude and direction of each shift.

Chapter 4: Economic Efficiency, Government Price Setting, and Taxes

Consumer and Producer Surplus

• Consumer Surplus: The difference between the highest price a consumer is willing to pay and the price actually paid.

• Producer Surplus: The difference between the lowest price a firm would accept and the price it actually receives.

• Marginal Benefit: The additional benefit to a consumer from consuming one more unit of a good.

• Marginal Cost: The additional cost to a producer from producing one more unit of a good.

Total Economic Surplus

• Total Surplus: The sum of consumer and producer surplus; a measure of the overall benefit to society from market transactions.

Government Interventions: Price Ceilings and Price Floors

• Price Ceiling: A legally established maximum price; if set below equilibrium, causes a shortage (Qd > Qs).

• Price Floor: A legally established minimum price; if set above equilibrium, causes a surplus (Qs > Qd).

• Non-binding: If the ceiling is above or the floor is below equilibrium, it has no effect.

Tax Incidence and Deadweight Loss

• Tax Incidence: The division of the burden of a tax between buyers and sellers.

• Price Received by Seller: The price after tax is deducted.

• Price Paid by Buyer: The price including the tax.

• Market Clearing Price: The equilibrium price before tax.

• Tax Size: The amount of the tax per unit.

• Tax Revenue: The total amount of money collected from the tax ($Tax\ Revenue = Tax\ Size \times Quantity\ Sold$).

• Deadweight Loss (DWL): The reduction in total surplus resulting from a market distortion, such as a tax.

Chapter 6: Elasticity – The Responsiveness of Demand and Supply

Price Elasticity of Demand

• Definition: Measures how much quantity demanded responds to a change in price.

• Equation:

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

• Midpoint Method: Used to calculate percentage changes between two points:

$\%\ Change\ in\ Quantity = \frac{Q_2 - Q_1}{(Q_2 + Q_1)/2} \times 100$

$\%\ Change\ in\ Price = \frac{P_2 - P_1}{(P_2 + P_1)/2} \times 100$

• Interpretation:

  • Elastic (>1): Quantity demanded changes more than price.

  • Inelastic (<1): Quantity demanded changes less than price.

  • Unit Elastic (=1): Quantity demanded changes exactly as price changes.

Determinants of Price Elasticity of Demand

• Availability of close substitutes

• Necessities vs. luxuries

• Definition of the market

• Time horizon

• Share of a good in a consumer's budget

Example: Gasoline tends to be inelastic in the short run but more elastic in the long run.

Price Elasticity of Supply

• Definition: Measures how much quantity supplied responds to a change in price.

• Equation:

$Price\ Elasticity\ of\ Supply = \frac{\%\ Change\ in\ Quantity\ Supplied}{\%\ Change\ in\ Price}$

Cross-Price Elasticity and Income Elasticity

• Cross-Price Elasticity: Measures the responsiveness of demand for one good to a change in the price of another good.

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

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

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

Example: If the cross-price elasticity between tea and coffee is positive, they are substitutes; if negative, they are complements.

Additional info: These notes expand on the study guide by providing definitions, formulas, and examples for each topic. For graphs and calculations, refer to your textbook or class materials for visual aids.