Microeconomics Final Exam Review: Key Concepts and Models

Introduction to Economics

Scarcity and Choice

Economics studies how individuals and societies allocate limited resources to satisfy unlimited wants. Scarcity is the fundamental economic problem, leading to the necessity of making choices and tradeoffs.

• Scarcity: Resources (labor, capital, land, entrepreneurship) are limited, but human wants are unlimited.

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

• Opportunity Cost: The value of the next best alternative forgone when making a choice.

• Marginal Analysis: Decisions are made by comparing marginal benefit (MB) and marginal cost (MC). The optimal choice is where MB = MC.

• Positive Economics: Descriptive, testable statements about how the world works.

• Normative Economics: Prescriptive statements based on value judgments about what ought to be.

The Economic Problem

Production Possibilities and Economic Growth

The Production Possibilities Curve (PPC) illustrates the tradeoffs and opportunity costs of producing different combinations of goods with limited resources.

• Production Possibilities Curve (PPC): Shows maximum combinations of two goods that can be produced with fixed resources and technology.

• Efficient Production: Points on the PPC; Inefficient: Points inside; Unattainable: Points outside.

• 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), equal to opportunity cost.

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

Demand and Supply

Market Forces and Equilibrium

Markets allocate resources through the interaction of demand and supply, determining 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 increase in one raises demand for the other; Complements: Price decrease in one raises 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 supplied; Surplus: Quantity supplied exceeds demanded.

Elasticity

Measuring Responsiveness

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

• 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 together.

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

• Cross-Price Elasticity: $CPE = \frac{\%\ \text{change in quantity demanded of Good A}}{\%\ \text{change in price of Good B}}$

• Income Elasticity: $IE = \frac{\%\ \text{change in quantity demanded}}{\%\ \text{change in income}}$

Efficiency and Equity

Market Outcomes and Welfare

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

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

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

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

• Allocative Efficiency: Occurs when marginal benefit equals marginal cost ($MB = MC$).

• Equity (Fairness): Concerns the distribution of benefits and costs among participants.

Government Actions in Markets

Price and Quantity Controls

Government interventions such as price ceilings and floors can distort market outcomes, leading to inefficiency.

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

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

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

Taxes and Market Outcomes

Tax Incidence and Efficiency

Taxes create a wedge between the price buyers pay and the price sellers receive, affecting market equilibrium and efficiency.

• Tax Wedge: The difference between buyer and seller prices due to a tax.

• Tax Incidence: The distribution of the tax burden depends on the relative elasticities of demand and supply.

• Burden of Tax: The more inelastic side of the market bears a larger share of the tax.

• Taxes: Reduce quantity traded and create deadweight loss.

Market Failure: Externalities

Spillover Effects and Policy Solutions

Externalities occur when market activities affect third parties not directly involved in the transaction, leading to inefficiency.

• Externality: A spillover effect of a market activity on a third party.

• 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: Where $MSC = MSB$.

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

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

Public Goods and Common Resources

Types of Goods and Market Failure

Goods are classified by rivalry and excludability, affecting how markets provide them and the potential for market failure.

• Rivalry: One person's use reduces availability for others.

• Excludability: Ability to prevent non-payers from using the good.

Type of Good	Rival?	Excludable?
Private Good	Yes	Yes
Club Good	No	Yes
Common Resource	Yes	No
Public Good	No	No

• Public Goods: Non-rival and non-excludable; underprovided due to free riding.

• Efficient Provision: Where marginal social benefit equals marginal social cost; sum individual demand curves vertically.

• Common Resources: Rival and non-excludable; tend to be overused (Tragedy of the Commons).

Production and Cost

Short-Run and Long-Run Costs

Firms face various costs in production, which influence their output and pricing decisions.

• Explicit Costs: Out-of-pocket payments by the firm.

• Implicit Costs: Opportunity costs of using resources owned by the firm.

• 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 is fixed; Long Run: All inputs are 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 of a variable input is added to fixed inputs.

• Total Cost (TC): $TC = TFC + TVC$

• Average Fixed Cost (AFC): $AFC = \frac{TFC}{Q}$

• Average Variable Cost (AVC): $AVC = \frac{TVC}{Q}$

• Average Total Cost (ATC): $ATC = \frac{TC}{Q} = AFC + AVC$

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

• 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 is characterized by many firms, identical products, and free entry and exit, leading to efficient outcomes.

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

• Price Takers: Firms accept the market price; cannot influence it.

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

• Profit Maximization: Choose output where $MR = MC$; in perfect competition, $P = MR$, so $P = MC$ at optimal output.

• Economic Profit: $(P - ATC) \times Q$

• Short Run: Firms may earn profits, break even, or incur losses.

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

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

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

Monopoly

Market Power and Pricing

A monopoly is a market with a single seller and significant barriers to entry, resulting in market power and potential inefficiency.

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

• Downward-Sloping Demand: Monopolist faces the market demand curve; marginal revenue (MR) lies below demand.

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

• Compared to Perfect Competition: Monopoly produces less and charges a higher price.

• Price Discrimination: Charging different prices to different consumers for the same good; increases profit if resale is limited.

• Natural Monopoly: One firm can supply the market at lower cost due to economies of scale.

• Regulation: Marginal Cost Pricing: $P = MC$ (efficient, may require subsidy); Average Cost Pricing: $P = ATC$ (zero profit, less efficient).

• Two-Part Tariff: Fixed fee plus per-unit price; helps cover fixed costs.

• Economic Profit: $(P^* - ATC^*) \times Q^*$

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

• Deadweight Loss: Monopoly price exceeds marginal cost, creating inefficiency.

Monopolistic Competition

Differentiation and Market Outcomes

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

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

• Product Differentiation: Products are similar but not identical (e.g., restaurants, clothing brands).

• Firm Demand: Downward-sloping; MR lies below demand.

• Short Run: Firms may earn profits, break even, or incur losses.

• Long Run: Entry/exit drives economic profit to zero; price equals ATC.

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

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

• Benefits: Product variety and consumer choice.

• Advertising: Used to differentiate products and affect demand elasticity.

Oligopoly and Game Theory

Strategic Behavior and Market Outcomes

Oligopoly is a market with a few interdependent firms, analyzed using game theory to understand strategic interactions.

• Oligopoly: Few firms, mutual interdependence.

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

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

• Normal Form: Payoff matrix for simultaneous games; Extensive Form: Game tree for sequential games.

• Dominant Strategy: Best regardless of others' choices.

• Nash Equilibrium: No player can improve by unilaterally changing strategy.

• Prisoner's Dilemma: Incentives lead to non-cooperative, inefficient outcome.

• Cartel: Firms collude to act like a monopoly; often unstable due to incentives to cheat.

• Models: Cournot: Compete on quantity; Bertrand: Compete on price; Stackelberg: Sequential moves.

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

Key Graphs and Relationships

• Supply and demand shifts: Distinguish movement along vs. shift of a curve.

• Price controls: Identify shortages, surpluses, and deadweight loss.

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

• Externality graphs: Private vs. social cost/benefit.

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

• Market structure graphs: Identify profit-maximizing output, profit/loss, shutdown, and long-run equilibrium.

• Game theory: Dominant strategies, Nash equilibrium, incentives in cartels.

Study Advice

• Know precise definitions.

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

• Read and interpret graphs carefully.

• Identify market structure before analyzing firm behavior.

• For profit maximization, use $MR = MC$.

• In perfect competition, $P = MR$; in monopoly/monopolistic competition, $MR$ lies below demand.

• In game theory, analyze best responses and Nash equilibrium.