Microeconomics Exam 2 Study Guide: Elasticity, Production & Costs, Market Structures

Elasticity and Revenue

Price Elasticity of Demand

The price elasticity of demand measures how much the quantity demanded of a good responds to a change in its price. It is a key concept for understanding consumer behavior and market dynamics.

• Definition: Price elasticity of demand (Ed) is the percentage change in quantity demanded divided by the percentage change in price.

• Formula: $E_d = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in price}}$

• Point-Slope Method: $E_d = \frac{\Delta Q}{\Delta P} \times \frac{P}{Q}$

• Interpretation: If $|E_d| > 1$, demand is elastic; if $|E_d| < 1$, demand is inelastic; if $|E_d| = 1$, demand is unit elastic.

• Relationship to Total Revenue: When demand is elastic, a price decrease increases total revenue; when inelastic, a price decrease decreases total revenue.

• Maximizing Total Revenue: Total revenue is maximized when demand is unit elastic.

• Marginal Revenue: Marginal revenue is the change in total revenue from selling one more unit.

• Other Elasticities:

  • Income Elasticity of Demand: Measures response of quantity demanded to changes in income.

  • Cross-Price Elasticity of Demand: Measures response of quantity demanded of one good to changes in the price of another good.

  • Elasticity of Supply: Measures response of quantity supplied to changes in price.

Example: If the price of coffee rises by 10% and quantity demanded falls by 20%, $E_d = -2$ (elastic demand).

Production and Cost of Production

Production Function

The production function shows the relationship between inputs and the maximum output that can be produced.

• Short Run vs. Long Run: In the short run, at least one input is fixed; in the long run, all inputs can be varied.

• Marginal Product (MP): The additional output produced by one more unit of input. $MP = \frac{\Delta Q}{\Delta L}$

• Specialization Effect: Increasing returns due to specialization at low levels of input.

• Law of Diminishing Marginal Product: As more units of a variable input are added to fixed inputs, the marginal product eventually decreases.

• Short Run Costs of Production:

  • Fixed Cost (FC): Costs that do not vary with output.

  • Variable Cost (VC): Costs that vary with output.

  • Total Cost (TC): $TC = FC + VC$

  • Average Cost (AC): $AC = \frac{TC}{Q}$

  • Marginal Cost (MC): $MC = \frac{\Delta TC}{\Delta Q}$

• Graphs: Cost curves typically include AVC, ATC, MC, and show relationships between costs and output.

• Long Run Production: All inputs are variable; firms can achieve returns to scale (increasing, constant, or decreasing).

Example: A bakery hires more workers; initially, output rises quickly (specialization), but eventually, adding more workers leads to overcrowding and lower marginal product.

Perfect Competition

Market Structure and Firm Behavior

Perfect competition is a market structure characterized by many firms selling identical products, with no single firm able to influence market price.

• Assumptions: Many buyers and sellers, homogeneous products, free entry and exit, perfect information.

• Price Takers: Individual firms accept the market price; $P = MR$.

• Profit Maximization: Firms maximize profit where $MR = MC$.

• Finding Profit-Maximizing Output: Set $MR = MC$ and solve for $Q$.

• Short Run Equilibrium: Firms may earn profits or losses; supply curve is the portion of MC above AVC.

• Long Run Equilibrium: Entry and exit drive economic profit to zero; $P = MC = ATC$.

• Adjustment to Long Run Equilibrium: Firms enter or exit until profits are zero.

Example: Wheat farmers are price takers; if market price falls below average cost, some exit the market in the long run.

Monopoly

Market Structure and Welfare Effects

A monopoly is a market with a single seller that controls the price and output of a product with no close substitutes.

• Monopoly Equilibrium: The monopolist sets output where $MR = MC$ and price from the demand curve.

• Consumer Surplus: The difference between what consumers are willing to pay and what they actually pay.

• Producer Surplus: The difference between the price received and the minimum price at which producers are willing to sell.

• Deadweight Loss: Monopoly leads to a loss of total surplus due to reduced output and higher prices compared to perfect competition.

• Lerner Index: Measures monopoly power: $L = \frac{P - MC}{P}$

• Pareto Efficiency: An allocation is Pareto efficient if no one can be made better off without making someone else worse off.

Market Structure	Number of Firms	Price Control	Entry Barriers
Perfect Competition	Many	No (Price Taker)	None
Monopoly	One	Yes (Price Maker)	High

Example: A local water utility is a monopoly; it sets prices above marginal cost, resulting in deadweight loss.

Additional info:

• Some topics (e.g., "Delmon", "Gopher shun NCATE") were unclear or possibly miswritten; they were omitted or interpreted as not directly relevant to standard microeconomics curriculum.

• Workbook and textbook sections referenced (Chapters 5, 7, 8, 9, 13) typically cover elasticity, production, costs, perfect competition, and monopoly.