Microeconomics Exam 1 Study Guide: Principles, Models, and Applications

Principles of Microeconomics

Rationality and Economic Decision-Making

Microeconomics assumes that individuals and firms act rationally, making decisions to maximize their utility or profit based on available information.

• Rational Agents: Economic agents use all available information to make choices that achieve their goals.

• Marginal Analysis: Decisions are made by comparing marginal benefits and marginal costs.

• Incentives: Agents respond to incentives, adjusting their behavior when costs or benefits change.

• Opportunity Cost: Every choice involves an opportunity cost, which is the value of the next best alternative forgone.

Example: Choosing to spend time studying for an exam rather than working a part-time job involves the opportunity cost of lost wages.

Scarcity and the Economic Problem

Definition and Implications

Scarcity refers to the limited nature of society's resources, which forces individuals and societies to make choices about how to allocate them.

• Wants vs. Resources: Human wants are unlimited, but resources are limited.

• Scarcity Forces Choices: Societies must decide what to produce, how to produce, and for whom to produce.

• Fundamental Questions:

  1. What goods and services will be produced?

  2. How will goods and services be produced?

  3. Who will receive the goods and services?

Example: A government must decide whether to allocate more resources to healthcare or education.

Production Possibilities Frontier (PPF)

Concept and Applications

The Production Possibilities Frontier (PPF) illustrates the maximum attainable combinations of two goods that can be produced with available resources and technology.

• Efficiency: Points on the PPF represent efficient production levels; points inside are inefficient, and points outside are unattainable.

• Opportunity Cost: Moving along the PPF involves shifting resources from one good to another, demonstrating opportunity cost.

• Increasing Marginal Opportunity Cost: As more of one good is produced, larger and larger amounts of the other good must be given up.

Equation:

$\text{Opportunity Cost of Good A} = \frac{\text{Units of Good B forgone}}{\text{Units of Good A gained}}$

Example: If producing 1 more unit of oranges requires giving up 2 units of apples, the opportunity cost of oranges is 2 apples.

Comparative and Absolute Advantage

Definitions and Trade Implications

Comparative advantage and absolute advantage are key concepts in understanding trade between individuals or nations.

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

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

• Basis for Trade: Comparative advantage, not absolute advantage, determines the potential gains from trade.

Example: If the US can produce 2 units of food or 1 unit of clothing, and Japan can produce 3 units of food or 9 units of clothing, each country should specialize in the good for which it has a comparative advantage.

Country	Food (units)	Clothing (units)
US	2	1
Japan	3	9

Additional info: Opportunity cost calculations can be used to determine which country should specialize in which good.

Market Equilibrium and Supply & Demand

Market Forces and Price Determination

Markets reach equilibrium where the quantity supplied equals the quantity demanded, determining the market price and quantity.

• Law of Demand: The quantity demanded of a product is inversely related to its price.

• Law of Supply: The quantity supplied of a product is directly related to its price.

• Equilibrium: The intersection of supply and demand curves determines the equilibrium price and quantity.

• Shifts: Changes in factors such as income, tastes, or prices of related goods can shift demand or supply curves, affecting equilibrium.

Equation:

$Q_d = a - bP$

$Q_s = c + dP$

Equilibrium occurs where $Q_d = Q_s$.

Example: If the price of peanut butter increases, the quantity demanded may decrease, shifting the demand curve left.

Microeconomics vs. Macroeconomics

Scope and Focus

Microeconomics examines individual markets and decision-makers, while macroeconomics studies the economy as a whole.

• Microeconomics: Focuses on households, firms, and individual markets.

• Macroeconomics: Focuses on aggregate measures such as GDP, inflation, and unemployment.

Example: Analyzing the effect of a price change on the demand for coffee is microeconomics; studying national unemployment rates is macroeconomics.

Economic Models and Analysis

Positive vs. Normative Analysis

Economists use models to simplify reality and analyze economic phenomena. Analysis can be positive (describing what is) or normative (prescribing what ought to be).

• Positive Analysis: Objective, fact-based analysis (e.g., "A rise in price reduces quantity demanded").

• Normative Analysis: Subjective, value-based judgments (e.g., "The government should lower taxes").

• Model Development: Steps include formulating hypotheses, using data to test them, and revising models as needed.

Example: Using supply and demand models to predict the effect of a tax on market equilibrium.

Key Terms and Concepts

• Equity: The fair distribution of economic benefits.

• Efficiency: Achieving maximum output with given resources.

• Market Equilibrium: The point where supply equals demand.

• Marginal: Refers to the additional or extra unit.

• Complementary Goods: Goods that are consumed together (e.g., hot dogs and buns).

• Inferior Goods: Goods for which demand decreases as income increases.

Tables and Figures

Production Table Example

Used to determine absolute and comparative advantage.

	US	Japan
Food	2	3
Clothing	1	9

Additional info: Use opportunity cost calculations to determine comparative advantage.

Supply Table Example

Used to analyze market equilibrium at different prices.

Price	Supply
$3.50
$2.50
$1.50

Additional info: At higher prices, supply typically exceeds demand, leading to surplus; at lower prices, demand may exceed supply, leading to shortage.

Application: Exam Practice Questions

• Identify absolute and comparative advantage using production tables.

• Draw and interpret supply and demand curves to find market equilibrium.

• Analyze the effects of changes in price, income, and related goods on market outcomes.

Additional info: Practice drawing and labeling PPFs, supply and demand curves, and calculating opportunity costs for exam preparation.