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

Chapter 1: Economics – Foundations and Models

1.1 Three Economic Ideas

Economics is built on three fundamental ideas that help explain how individuals and societies make choices under scarcity.

• 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 and benefits influence the choices people make. Incentives can be monetary or non-monetary.

• Optimal Decisions are Made at the Margin: Most choices involve doing a little more or a little less of something. Economists analyze decisions by comparing marginal benefit and marginal cost.

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

1.2 The Economic Problem Every Society Must Solve

Scarcity forces societies to answer three basic economic questions:

• What goods and services will be produced?

• How will these goods and services be produced?

• Who will receive the goods and services produced?

These questions are answered differently in market economies (where decisions are decentralized) and centrally planned economies (where the government makes decisions).

1.3 Economic Models

Economic models are simplified representations of reality used to analyze real-world economic situations. They help economists make predictions and understand cause-and-effect relationships.

• Assumptions: Models use assumptions to focus on key relationships and ignore less relevant details.

• Testability: Good models generate testable predictions that can be compared with real-world data.

Example: The supply and demand model predicts how prices and quantities change in response to shifts in demand or supply.

1.6 A Preview of Important Economic Terms

• Scarcity: The limited nature of society’s resources.

• Trade-off: The idea that because of scarcity, producing more of one good or service means producing less of another.

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

• Marginal Analysis: Comparing marginal benefits and marginal costs to make decisions.

Appendix: Using Graphs and Formulas

• Graphs: Visual tools to represent economic relationships (e.g., supply and demand curves).

• Formulas: Used to calculate economic variables. For example, opportunity cost can be calculated as:

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

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

2.1 Production Possibilities Frontiers and Opportunity Costs

The Production Possibilities Frontier (PPF) shows the maximum attainable combinations of two products that may be produced with available resources and technology.

• Efficiency: Points on the PPF are efficient; points inside are inefficient; points outside are unattainable.

• Opportunity Cost: The slope of the PPF represents the opportunity cost of one good in terms of the other.

Example: If producing 1 more car means producing 2 fewer computers, the opportunity cost of 1 car is 2 computers.

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

2.2 Comparative Advantage and Trade

Comparative advantage is the ability to produce a good at a lower opportunity cost than another producer. Trade allows individuals or countries to specialize in goods where they have a comparative advantage, increasing overall efficiency and consumption.

• Absolute Advantage: The ability to produce more of a good with the same resources.

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

Example: If Country A can produce wheat at a lower opportunity cost than Country B, Country A should specialize in wheat and trade with Country B.

2.3 The Market System

The market system is a network of buyers and sellers who exchange goods and services. Prices are determined by the interaction of supply and demand, and resources are allocated efficiently through voluntary exchange.

• Households: Supply factors of production (labor, capital, natural resources, entrepreneurship).

• Firms: Demand factors of production and supply goods and services.

• Markets: Facilitate the exchange of goods, services, and resources.

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

3.1 The Demand Side of the Market

Demand shows the relationship between the price of a good and the quantity demanded by consumers, holding other factors constant (ceteris paribus).

• Law of Demand: As price falls, quantity demanded rises, and vice versa (inverse relationship).

• Demand Curve: Downward sloping; shows quantity demanded at each price.

• Determinants of Demand: Income, prices of related goods, tastes, population, and expected future prices.

$Q_d = f(P, I, P_r, T, N, E)$

Where $Q_d$ = quantity demanded, $P$ = price, $I$ = income, $P_r$ = price of related goods, $T$ = tastes, $N$ = number of buyers, $E$ = expectations.

3.2 The Supply Side of the Market

Supply shows the relationship between the price of a good and the quantity supplied by producers, holding other factors constant.

• Law of Supply: As price rises, quantity supplied rises, and vice versa (direct relationship).

• Supply Curve: Upward sloping; shows quantity supplied at each price.

• Determinants of Supply: Input prices, technology, number of sellers, expected future prices, and government policies.

$Q_s = f(P, P_i, T, N, E, G)$

Where $Q_s$ = quantity supplied, $P$ = price, $P_i$ = input prices, $T$ = technology, $N$ = number of sellers, $E$ = expectations, $G$ = government policies.

3.3 Market Equilibrium: Putting Demand and Supply Together

Market equilibrium occurs where the quantity demanded equals the quantity supplied. The equilibrium price is where the demand and supply curves intersect.

• Surplus: Occurs when quantity supplied > quantity demanded (price above equilibrium).

• Shortage: Occurs when quantity demanded > quantity supplied (price below equilibrium).

$Q_d = Q_s$

3.4 The Effect of Demand and Supply Shifts on Equilibrium

Changes in demand or supply shift the respective curves, leading to new equilibrium prices and quantities.

• Increase in Demand: Shifts demand curve right; raises equilibrium price and quantity.

• Decrease in Demand: Shifts demand curve left; lowers equilibrium price and quantity.

• Increase in Supply: Shifts supply curve right; lowers equilibrium price, raises equilibrium quantity.

• Decrease in Supply: Shifts supply curve left; raises equilibrium price, lowers equilibrium quantity.

Example: A new technology reduces production costs, shifting the supply curve right and lowering prices.

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

4.1 Consumer Surplus and Producer Surplus

Consumer surplus is the difference between the highest price a consumer is willing to pay and the price actually paid. Producer surplus is the difference between the lowest price a producer is willing to accept and the price actually received.

• Consumer Surplus: Area below the demand curve and above the market price.

• Producer Surplus: Area above the supply curve and below the market price.

$\text{Consumer Surplus} = \int_{0}^{Q^*} [D(Q) - P^*] dQ$

$\text{Producer Surplus} = \int_{0}^{Q^*} [P^* - S(Q)] dQ$

Where $D(Q)$ is the demand function, $S(Q)$ is the supply function, $P^*$ is the equilibrium price, and $Q^*$ is the equilibrium quantity.

4.2 The Efficiency of Competitive Markets

Competitive markets maximize the sum of consumer and producer surplus, achieving economic efficiency. At equilibrium, resources are allocated to their most valued uses.

• Deadweight Loss: The reduction in total surplus that results from market distortions (e.g., taxes, price controls).

Example: A tax on a good reduces the quantity traded, creating deadweight loss.

4.3 Government Intervention in the Market: Price Floors and Price Ceilings

Governments sometimes set price floors (minimum prices) or price ceilings (maximum prices) to achieve social goals, but these can lead to inefficiencies.

• Price Floor: A legally established minimum price (e.g., minimum wage). Can cause surpluses.

• Price Ceiling: A legally established maximum price (e.g., rent control). Can cause shortages.

• Consequences: Non-price rationing, black markets, and reduced product quality.

Example: A price ceiling on apartments leads to a shortage of rental units.

Summary Table: Key Concepts

Concept	Definition	Example/Application
Opportunity Cost	Value of the next best alternative forgone	Choosing to attend college vs. working full-time
Comparative Advantage	Ability to produce at lower opportunity cost	Country A specializes in wheat, Country B in cars
Market Equilibrium	Quantity demanded equals quantity supplied	Intersection of supply and demand curves
Consumer Surplus	Difference between willingness to pay and price paid	Buying a concert ticket for $50 when willing to pay $80
Producer Surplus	Difference between price received and minimum acceptable price	Selling a product for $20 when willing to accept $10
Price Floor	Legal minimum price	Minimum wage laws
Price Ceiling	Legal maximum price	Rent control

Additional info: These notes synthesize the main topics and subtopics from the study guide, expanding on brief points with academic context, definitions, examples, and relevant formulas. Sections and applications marked as "skip" in the guide are omitted. For full mastery, students should practice with graphs and quantitative problems as suggested in the study guide.