Microeconomics Final Exam Review: Key Concepts and Relationships

Scarcity, Opportunity Cost, and Marginal Analysis

Scarcity and Tradeoffs

Scarcity is the fundamental economic problem arising because resources are limited while human wants are unlimited. This leads to the necessity of making choices and tradeoffs.

• Scarcity: Limited resources (labor, capital, land, entrepreneurship) vs. unlimited wants.

• Tradeoffs: Choosing more of one good requires giving up some of another.

• Opportunity Cost: The value of the next best alternative forgone. Always measured in terms of what is sacrificed.

• Marginal Analysis: Decisions are made by comparing marginal benefit (MB) and marginal cost (MC). Optimal choice occurs where $MB = MC$.

• Positive Economics: Descriptive, testable statements.

• Normative Economics: Prescriptive statements based on value judgments.

The Economic Problem and Production Possibilities

Production Possibilities Curve (PPC)

The PPC illustrates the maximum combinations of two goods that can be produced given fixed resources and technology.

• Efficient Production: Points on the PPC.

• Inefficient Production: Points inside the PPC.

• Unattainable: Points outside the PPC.

• Increasing Opportunity Cost: As production of one good increases, more of the other must be given up due to resource specialization.

• Slope of PPC: Represents the marginal rate of transformation (MRT), which equals opportunity cost.

• Economic Growth: Outward shift of PPC due to increases in labor, capital, technology, or human capital.

Supply and Demand

Market Forces

Supply and demand determine market prices and quantities.

• Law of Demand: As price increases, quantity demanded decreases (ceteris paribus).

• Demand Shifters: Income, tastes, expectations, number of buyers, prices of related goods.

• Normal Good: Demand increases with income.

• Inferior Good: Demand decreases with income.

• Substitutes: Price of one increases demand for the other.

• Complements: Price of one decreases demand for the other.

• Law of Supply: As price increases, quantity supplied increases (ceteris paribus).

• Supply Shifters: Input prices, technology, taxes/subsidies, expectations, number of sellers.

• Market Equilibrium: Quantity demanded equals quantity supplied.

• Shortage: Quantity demanded exceeds quantity supplied.

• Surplus: Quantity supplied exceeds quantity demanded.

Elasticity

Measuring Responsiveness

Elasticity quantifies how much quantity demanded or supplied responds to changes in price, income, or other factors.

• Price Elasticity of Demand (PED): $PED = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in price}}$

• Elastic Demand: $|PED| > 1$ (quantity responds strongly to price changes).

• Inelastic Demand: $|PED| < 1$ (quantity responds weakly to price changes).

• Total Revenue Test: If demand is elastic, price and total revenue move in opposite directions; if inelastic, they move in the same direction.

• Determinants of Elasticity: Substitutes, time horizon, necessity vs luxury, share of income.

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

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

Efficiency and Equity

Market Outcomes

Markets can achieve efficient allocation, but equity concerns how benefits and costs are distributed.

• Consumer Surplus: Area below demand and above price; difference between willingness to pay and market price.

• Producer Surplus: Area above supply and below price; difference between market price and minimum willingness to accept.

• Total Surplus: Sum of consumer and producer surplus; maximized at competitive equilibrium.

• Allocative Efficiency: Occurs when $MB = MC$.

• Equity: Distribution of benefits and costs among participants.

Government Actions in Markets

Price and Quantity Controls

Government interventions can distort market outcomes.

• Price Ceiling: Maximum legal price; binding if below equilibrium, causing shortages.

• Price Floor: Minimum legal price; binding if above equilibrium, causing surpluses.

• Deadweight Loss (DWL): Reduction in total surplus due to market distortion.

Taxes and Tax Incidence

Effects of Taxes

Taxes create a wedge between buyer and seller prices, reduce quantity traded, and generate deadweight loss.

• Tax Wedge: Difference between price buyers pay and price sellers receive.

• Tax Incidence: Distribution of tax burden depends on relative elasticities; the more inelastic side bears more burden.

• Taxes: Reduce quantity traded and create deadweight loss.

Externalities and Market Failure

External Effects

Externalities occur when market activities affect third parties, leading to inefficient outcomes.

• Externality: Spillover effect affecting third parties.

• Negative Externality: Social cost exceeds private cost; market produces too much.

• Positive Externality: Social benefit exceeds private benefit; market produces too little.

• Marginal Social Cost (MSC): $MSC = MPC + \text{External Cost}$

• Marginal Social Benefit (MSB): $MSB = MPB + \text{External Benefit}$

• Efficient Output: Occurs where $MSC = MSB$.

• Pigouvian Tax: Tax equal to external cost to correct overproduction.

• Pigouvian Subsidy: Subsidy equal to external benefit to correct underproduction.

Public Goods and Common Resources

Types of Goods and Market Failure

Goods are classified by rivalry and excludability, affecting market provision and efficiency.

• Private Goods: Rival and excludable.

• Club Goods: Non-rival and excludable.

• Common Resources: Rival and non-excludable.

• Public Goods: Non-rival and non-excludable.

• Market Failure: Public goods are underprovided due to free riding; common resources are overused (tragedy of the commons).

• Efficient Provision: Occurs where marginal social benefit equals marginal social cost; for public goods, individual demand curves are added vertically.

Production and Cost

Cost Concepts and Relationships

Firms face explicit and implicit costs, and their profit depends on the difference between revenue and costs.

• Explicit Costs: Out-of-pocket costs.

• Implicit Costs: Opportunity costs of owned resources.

• Accounting Cost: Explicit cost.

• Economic Cost: Explicit + implicit cost.

• Accounting Profit: $\text{Total Revenue} - \text{Accounting Cost}$

• Economic Profit: $\text{Total Revenue} - \text{Economic Cost}$

• Short Run: At least one input fixed.

• Long Run: All inputs variable.

• Total Product (TP): Total output produced.

• Marginal Product (MP): Additional output from one more unit of input.

• Average Product (AP): $AP = \frac{TP}{\text{Quantity of input}}$

• Diminishing Marginal Product: MP eventually falls as more variable input is added.

• Cost Relationships:

  • $TC = TFC + TVC$

  • $AFC = \frac{TFC}{Q}$

  • $AVC = \frac{TVC}{Q}$

  • $ATC = \frac{TC}{Q} = AFC + AVC$

  • $MC = \frac{\Delta TC}{\Delta Q}$

• MC intersects AVC and ATC at their minimum points.

• Long-Run Average Cost: Shows economies and diseconomies of scale.

Perfect Competition

Market Structure and Firm Behavior

Perfect competition features many firms, homogeneous products, and free entry/exit. Firms are price takers.

• Characteristics: Many firms, homogeneous product, free entry/exit, perfect information.

• Price Takers: Firms cannot affect market price.

• Firm Demand: $\text{Demand} = \text{Average Revenue} = \text{Marginal Revenue} = \text{Price}$

• Profit Maximization: Choose output where $MR = MC$; since $P = MR$, $P = MC$ at chosen output.

• Economic Profit: $\text{Economic Profit} = (P - ATC) \times Q$

• Short Run: Firms may earn profits, zero profit, or losses.

• Break-even Point: $P = ATC$; economic profit is zero.

• Shutdown Condition: Produce if $P \geq AVC$; shut down if $P < AVC$.

• Long Run: Free entry/exit drives economic profit to zero.

Monopoly

Market Structure and Pricing

Monopoly is characterized by a single firm, barriers to entry, and no close substitutes. The monopolist faces a downward-sloping demand curve.

• Characteristics: Single firm, no close substitutes, significant barriers to entry.

• Demand Curve: Downward-sloping; marginal revenue lies below demand.

• Profit Maximization: Choose output where $MR = MC$; charge price from demand curve at that quantity.

• Comparison: Monopoly produces less and charges higher price than perfect competition.

• Price Discrimination: Charging different prices to different consumers for the same good.

• Natural Monopoly: One firm supplies entire market at lower cost due to economies of scale.

• Regulation:

  • Marginal Cost Pricing: $P = MC$ (allocatively efficient, may require subsidy).

  • Average Cost Pricing: $P = ATC$ (covers costs, but price above MC).

  • Two-Part Tariff: Fixed fee plus per-unit price.

• Economic Profit: $\text{Economic Profit} = (P^* - ATC^*) \times Q^*$

• Shutdown Condition: Operate if $P \geq AVC$; shut down if $P < AVC$.

• Deadweight Loss: Monopoly price exceeds MC, creating inefficiency.

Monopolistic Competition

Market Structure and Product Differentiation

Monopolistic competition features many firms, differentiated products, and free entry/exit.

• Characteristics: Many firms, differentiated products, free entry/exit.

• Product Differentiation: Similar but not identical products (e.g., restaurants, clothing brands).

• Firm Demand: Downward-sloping; marginal revenue below demand.

• Profit Maximization: Output where $MR = MC$; price from demand curve.

• Short Run: Firms may earn profit, zero profit, or losses.

• Long Run: Free entry/exit drives economic profit to zero; price equals average total cost.

• Excess Capacity: Firms produce below efficient scale in long-run equilibrium.

• Efficiency: Price exceeds marginal cost; not perfectly efficient.

• Benefits: Product variety and consumer choice.

• Advertising: Used to differentiate products and shift demand.

Oligopoly and Game Theory

Strategic Behavior and Market Outcomes

Oligopoly involves a few firms with mutual interdependence, often analyzed using game theory.

• Oligopoly: Small number of firms, strategic interdependence.

• Game Theory: Study of strategic situations; includes players, strategies, payoffs.

• Payoff Matrix: Table showing payoffs for different strategy combinations.

• Normal Form: Payoff matrix for simultaneous-move games.

• Extensive Form: Game tree for sequential games.

• Dominant Strategy: Best regardless of other players' choices.

• Nash Equilibrium: No player can improve by changing only their own strategy.

• Prisoner's Dilemma: Incentives lead to non-cooperative outcome; cooperation would be better.

• Cartel: Firms coordinate price/output to increase joint profits; often unstable due to incentive to cheat.

• Models:

  • Cournot: Firms compete by choosing quantities.

  • Bertrand: Firms compete by choosing prices.

  • Stackelberg: One firm moves first, another responds.

• Market Outcomes: Oligopoly prices/output between monopoly and perfect competition; entry increases competitiveness.

Key Graphs and Relationships

Graphical Analysis

Understanding graphs is essential for analyzing market structures and outcomes.

• Supply and Demand Shifts: Distinguish movement along vs. shift of a curve.

• Price Ceilings/Floors: Identify shortages, surpluses, deadweight loss.

• Tax Graphs: Identify tax wedge, buyer/seller price, tax revenue, deadweight loss.

• Externality Graphs: Distinguish private vs. social cost/benefit.

• Cost Curves: Relationships among MC, AVC, ATC, AFC, MP, AP.

• Perfect Competition Graph: Profit-maximizing quantity, profit/loss, shutdown, long-run equilibrium.

• Monopoly Graph: Demand, marginal revenue, marginal cost, price, quantity, profit/loss, deadweight loss.

• Monopolistic Competition Graph: Short-run profit/loss, long-run zero economic profit.

• Game Theory Matrices: Dominant strategies, Nash equilibrium, prisoner’s dilemma, cartel incentives.

Final Exam Study Advice

Preparation Strategies

• Know precise definitions.

• Practice directional reasoning: Effects of curve shifts, taxes, entry/exit, elasticity changes.

• Read graphs carefully.

• Identify market structure for firm graphs.

• Profit maximization: Firms choose output where $MR = MC$.

• Perfect Competition: $P = MR$.

• Monopoly/Monopolistic Competition: $MR$ lies below demand.

• Game Theory: Analyze one player’s best response at a time.

• Nash Equilibrium: Check if any player can improve by changing only their own strategy.