Microeconomics Final Exam Study Guide: Core Concepts, Models, and Applications

Core Concepts in Microeconomics

Scarcity, Opportunity Cost, and Economic Models

Microeconomics begins with the study of how individuals and firms make choices under conditions of scarcity. Scarcity refers to the limited nature of resources, which necessitates trade-offs and the concept of opportunity cost—the value of the next best alternative forgone.

• Scarcity: Limited resources relative to unlimited wants.

• Opportunity Cost: The cost of forgoing the next best alternative when making a decision.

• Economic Model: Simplified representations of economic processes, often using graphs and equations.

• Correlation and Causation: Distinguishing between relationships and direct cause-effect links in data.

• Principle of Optimization at the Margin: Decisions are made by comparing marginal benefits and marginal costs.

• Diminishing Marginal Benefit/Product: As more of a good is consumed or produced, the additional benefit or output from each extra unit typically decreases.

Example: Choosing between studying for an exam or working a part-time job involves opportunity cost.

Basic Demand and Supply

Determinants and Equilibrium

Markets are driven by the forces of demand and supply. Demand reflects consumer willingness to buy at various prices, while supply reflects producer willingness to sell.

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

• Determinants of Supply: Input prices, technology, expectations, number of sellers.

• Equilibrium: The price and quantity where quantity demanded equals quantity supplied.

Equilibrium Equation:

$Q_d = Q_s$

Example: If the price of corn increases, the quantity supplied rises and the quantity demanded falls until equilibrium is reached.

Comparative Statics

Comparative statics analyze the effects of changes in demand or supply on market outcomes.

• Example: An increase in demand for corn shifts the demand curve right, raising equilibrium price and quantity.

Consumer Theory

Budget Line and Indifference Curve

Consumer theory examines how individuals allocate their income among different goods to maximize utility.

• Budget Line: Shows all combinations of goods a consumer can afford.

• Indifference Curve: Represents combinations of goods that provide equal satisfaction.

• Optimal Purchase Rule: Consumers maximize utility where the budget line is tangent to the highest indifference curve.

Example: A consumer chooses between apples and oranges given their prices and budget.

Elasticity

Price Elasticity of Demand

Elasticity measures how much quantity demanded or supplied responds to changes in price or other factors.

• Point Elasticity Formula:

$\frac{\Delta Q}{\Delta P} \times \frac{P}{Q}$

• Arc Elasticity Formula:

$\frac{Q_2 - Q_1}{P_2 - P_1} \times \frac{P_2 + P_1}{Q_2 + Q_1}$

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

• Cross Price Elasticity: Measures responsiveness of demand for one good to changes in the price of another.

Example: If the price of coffee rises by 10% and quantity demanded falls by 20%, the price elasticity is -2.

Efficiency and Exchange

Consumer and Producer Surplus; Deadweight Loss

Market efficiency is evaluated by measuring consumer and producer surplus, and identifying deadweight loss from market distortions.

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

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

• Deadweight Loss: Loss of total surplus due to market inefficiency (e.g., price controls, taxes).

Example: A price ceiling below equilibrium creates deadweight loss by reducing total surplus.

Price Elasticity of Demand	Elastic	Inelastic	Unitary Elastic
Items	Box 1	Box 2	Box 3
Services	Box 1	Box 2	Box 3

Additional info: Table illustrates classification of goods/services by elasticity.

Supply In-Depth

Cost Minimization and Cost Curves

Firms seek to minimize costs and maximize profits by analyzing production and cost functions.

• Total Physical Product (TPP): Total output produced.

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

• Cost Curves:

  • Total Cost: $TC = FC + VC$

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

  • Average Cost: $AC = \frac{TC}{Q}$

  • Average Variable Cost: $AVC = \frac{VC}{Q}$

  • Fixed Cost: $FC$

• Revenue: $TR = P \times Q$

• Marginal Revenue: $MR = \frac{\Delta TR}{\Delta Q}$

• Profit Maximization: Occurs where $MR = MC$

Example: If marginal cost is less than marginal revenue, a firm should increase output.

Plotting the Firm and the Industry

Zero and Positive Economic Profits

Graphical analysis shows how firms and industries reach equilibrium and respond to changes in costs and demand.

• Zero Economic Profits: Occur when price equals average cost ($P = AC$).

• Positive Economic Profits: Occur when price exceeds average cost ($P > AC$).

Example: In perfect competition, entry and exit drive profits to zero in the long run.

International Trade

Production Possibilities and Comparative Advantage

Trade allows countries to specialize according to comparative advantage, increasing overall efficiency.

• Production Possibilities Frontier (PPF): Shows maximum output combinations.

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

• Trade Barriers: Tariffs and quotas restrict trade.

Example: If Country A can produce wheat more efficiently than Country B, it should specialize and trade.

Forms of Industrial Organization

Perfect Competition

Perfect competition features many firms, identical products, and free entry/exit.

• Short-run: Firms may earn profits or losses.

• Long-run: Entry/exit drives profits to zero ($P = min AC$).

Monopoly

Monopoly exists when a single firm dominates the market, facing the market demand curve.

• Profit Maximization: Monopoly sets output where $MR = MC$.

• Price exceeds marginal cost: $P > MC$

• Deadweight Loss: Monopoly reduces total surplus compared to perfect competition.

Monopolistic Competition

Monopolistic competition features many firms selling differentiated products with some market power.

• Free entry/exit: Drives profits to zero in the long run.

• Downward-sloping demand: Each firm faces its own demand curve.

Oligopoly

Oligopoly is a market with a few large firms, often interdependent in pricing and output decisions.

• Game Theory: Used to analyze strategic interactions.

• Herfindahl-Hirschman Index: Measures market concentration.

• Collusion: Firms may cooperate to set prices.

Other Topics

Game Theory

Game theory studies strategic decision-making among interdependent agents.

• Nash Equilibrium: Situation where no player can improve their outcome by changing strategy unilaterally.

• Payoff Matrix: Table showing outcomes for each strategy combination.

	Confess	Don't Confess
YOU	5,5	2,10
Cores	5,5	10,2

Additional info: Table illustrates a classic prisoner's dilemma.

Externalities

Negative and Positive Externalities

Externalities occur when market transactions affect third parties not directly involved.

• Negative Externality: Social cost exceeds private cost (e.g., pollution).

• Positive Externality: Social benefit exceeds private benefit (e.g., education).

• Solutions: Taxes, subsidies, regulation, Coase theorem.

Example: A factory polluting a river imposes costs on nearby residents.

Types of Goods and Public Resources

Public Goods and Common Pool Resources

Goods are classified by excludability and rivalry in consumption.

• Public Goods: Non-excludable and non-rival (e.g., national defense).

• Common Pool Resources: Non-excludable but rival (e.g., fisheries).

• Free Rider Problem: Individuals benefit without paying.

Example: Street lighting is a public good; overfishing is a common pool resource problem.

Markets for Factors of Production

Input Markets

Firms demand inputs such as labor and capital to produce goods and services.

• Marginal Revenue Product (MRP): Additional revenue from hiring one more unit of input.

• Labor Market: Wage determination and supply/demand for labor.

Example: If hiring another worker increases output and revenue, the firm will hire until MRP equals wage.

Income Inequality and Risk Preferences

Income Inequality and Risk

Microeconomics examines the distribution of income and how individuals make decisions under uncertainty.

• Present Value: $PV = \frac{Payment}{(1 + r)^t}$

• Risk Preferences: Risk averse, risk seeking, risk neutral.

Example: Choosing between a guaranteed $100 or a lottery with a 50% chance of $200.