Microeconomics Final Exam Study Guide: Core Concepts, Models, and Applications (Chapters 1–15)

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 choices.

• Scarcity: The fundamental economic problem of having limited resources to meet unlimited wants.

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

• Economic Models: Simplified representations of reality used to analyze economic situations and predict outcomes.

• Correlation vs. Causation: Correlation is a relationship between two variables; causation implies one variable directly affects another.

Example: Choosing to spend time studying economics instead of working a part-time job involves the opportunity cost of lost wages.

Principles of Optimization and Marginal Analysis

Optimization involves making the best possible choice given constraints, often using marginal analysis.

• Marginal Benefit: The additional benefit received from consuming one more unit of a good or service.

• Marginal Cost: The additional cost incurred from producing one more unit of a good or service.

• Diminishing Marginal Product: As more of an input is used, the additional output from each extra unit decreases.

Formula: $MB = MC$ at the optimal point.

Trade, Specialization, and Comparative Advantage

Trade allows individuals and nations to specialize in the production of goods for which they have a comparative advantage, increasing overall efficiency.

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

• Specialization: Focusing resources on the production of specific goods.

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

Demand and Supply

Basic Demand and Supply (Ch. 1–4)

Markets are driven by the interaction of demand and supply, determining equilibrium prices and quantities.

• Demand: The quantity of a good consumers are willing and able to buy at various prices.

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

• Supply: The quantity of a good producers are willing and able to sell at various prices.

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

• Equilibrium: The price ($P^*$) and quantity ($Q^*$) at which demand equals supply.

Formula: $Q_D = Q_S$

Comparative Statics: Analysis of how changes in demand or supply affect equilibrium.

Example: An increase in demand for corn raises both equilibrium price and quantity in the corn market.

Consumer Theory

Budget Line and Indifference Curve (Ch. 5)

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

• Budget Line: Shows all combinations of goods a consumer can afford given income and prices.

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

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

Elasticity

Price Elasticity of Demand (Ch. 5)

Elasticity measures the responsiveness of quantity demanded or supplied to changes in price or other factors.

• Point Elasticity: Measures elasticity at a specific point on the demand curve.

• Arc Elasticity: Measures elasticity between two points on the demand curve.

Formula for Point Elasticity:

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

Formula for Arc Elasticity:

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

• Income Elasticity of Demand: Measures how quantity demanded changes as consumer income changes.

• Cross Price Elasticity: Measures how quantity demanded of one good changes as the price of another good changes.

Efficiency and Exchange

Consumer and Producer Surplus

Surplus measures the benefits to consumers and producers from market transactions.

• Consumer Surplus: The area above the price and below the demand curve.

• Producer Surplus: The area below the price and above the supply curve.

• Total Surplus: The sum of consumer and producer surplus; measures total welfare.

• Deadweight Loss: The loss in total surplus due to market inefficiency, such as taxes or price controls.

Example: A price ceiling below equilibrium creates deadweight loss by reducing the quantity traded.

Table: Price Elasticity of Demand for Different Goods

Price Elasticity of Demand	Goods	Change in Price	Change in Quantity Demanded
Elastic	Items	↑	↓
Inelastic	Items	↑	↓ (small)

Supply in Depth

Cost Minimization and Cost Curves (Ch. 6)

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

• Total Physical Product (TPP): Total output produced by a given amount of input.

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

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

• Cost Curves:

  • Total Cost: $TC = FC + VC = AC \cdot Q$

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

  • Average Cost: $AC = \frac{TC}{Q}$

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

• Revenue: $TR = P \cdot Q$

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

• Profit Maximization: Firms produce where $MR = MC$.

Example: If $MR > MC$, a firm should increase output; if $MR < MC$, decrease output.

Market Structures

Perfect Competition (Ch. 7)

Perfect competition is characterized by many firms selling identical products, with no barriers to entry or exit.

• Short-run: Firms may earn positive or negative profits; $P$ can be above or below $AC$.

• Long-run: Entry and exit drive profits to zero; $P = min AC$.

Example: Agricultural markets often approximate perfect competition.

Monopoly (Ch. 12)

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

• Profit Maximization: Monopolist produces where $MR = MC$.

• Price: Monopolist sets price above marginal cost, leading to deadweight loss.

Example: Utility companies often operate as monopolies.

Monopolistic Competition (Ch. 14)

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

• Entry and Exit: Free entry and exit in the long run.

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

• Long-run Equilibrium: Firms earn zero economic profit; $P = AC$.

Example: Restaurants and clothing brands are examples of monopolistic competition.

Oligopoly (Ch. 14)

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

• Duopoly: Two firms dominate the market.

• Collusion: Firms may cooperate to set prices, but this is often illegal.

• Game Theory: Used to analyze strategic interactions among firms.

Example: The automobile industry is an example of an oligopoly.

Game Theory and Strategic Play

Nash Equilibrium (Ch. 13)

Game theory studies strategic interactions where the outcome depends on the actions of all participants.

• Nash Equilibrium: A situation where no player can improve their payoff by changing their strategy unilaterally.

• Dominant Strategy: A strategy that yields the highest payoff regardless of what others do.

Example Table: Advertising Dilemma

	Advertise	Don't Advertise
Advertise	5,5	7,3
Don't Advertise	3,7	6,6

Additional info: Nash equilibrium occurs where both players choose strategies such that neither can improve their outcome by changing alone.

Externalities and Public Goods

Externalities (Ch. 9)

Externalities are costs or benefits that affect third parties not directly involved in a transaction.

• Negative Externality: Overproduction occurs when social cost exceeds private cost ($MSC > MPC$).

• Positive Externality: Underproduction occurs when social benefit exceeds private benefit ($MSB > MPB$).

• Solutions: Taxes, subsidies, regulation, and the Coase Theorem.

Example: Pollution from factories is a negative externality; education is a positive externality.

Public Goods and Common Pool Resources (Ch. 9)

Public goods are non-excludable and non-rivalrous, while common pool resources are rivalrous but non-excludable.

• Public Good: Clean air, national defense.

• Common Pool Resource: Fisheries, forests.

• Free Rider Problem: Individuals benefit without paying, leading to underprovision of public goods.

Markets for Factors of Production

Input Markets (Ch. 11)

Input markets determine the allocation and pricing of resources such as labor and capital.

• Marginal Revenue Product of Labor (MRPL): The additional revenue generated by employing one more unit of labor.

• Wage Determination: Wages are set where MRPL equals the wage rate.

Example: Firms hire workers up to the point where the wage equals the MRPL.

Trade-offs Involving Time and Risk

Time Preferences and Risk (Ch. 15)

Economic decisions often involve trade-offs between present and future benefits, as well as risk preferences.

• Future Value: $FV = Principle \times (1 + r)^t$

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

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

Example: Choosing between a guaranteed payment now or a risky investment with higher expected return.

Additional Topics

Information Economics (Ch. 16)

Information asymmetry can lead to market failures such as adverse selection and moral hazard.

• Adverse Selection: Occurs when one party has more information than another, leading to inefficient outcomes.

• Moral Hazard: Occurs when one party takes risks because they do not bear the full consequences.

Auctions and Bargaining (Ch. 17)

Auctions are mechanisms for allocating goods and resources, while bargaining involves negotiation between parties.

• Types of Auctions: English, Dutch, sealed-bid, Vickrey.

• Bargaining: Strategic negotiation to reach mutually beneficial agreements.

Social Economics (Ch. 18)

Social economics studies the impact of social norms, fairness, and altruism on economic behavior.

• Fairness: Individuals may sacrifice personal gain for equitable outcomes.

• Altruism: Acting to benefit others, sometimes at a personal cost.