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 Models: Simplified representations of reality used to analyze economic behavior and predict outcomes.

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

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

• Diminishing Marginal Benefit/Product: The additional benefit or output from consuming or producing one more unit decreases as quantity increases.

Example: Choosing between studying for an exam or working a part-time job involves considering the opportunity cost of each activity.

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 represents producer willingness to sell.

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

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

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

Equation:

• $Q_d = Q_s$

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

Example: An increase in demand for corn due to biofuel policies shifts the demand curve rightward, raising price and quantity.

Consumer Theory

Budget Constraints and Indifference Curves

Consumer theory explores 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 attainable indifference curve.

Example: A consumer chooses between apples and oranges, balancing preferences and budget constraints.

Elasticity

Price Elasticity of Demand

Elasticity measures the responsiveness of quantity demanded or supplied 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 how quantity demanded changes with income.

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

Example: If the price of coffee rises, the quantity demanded falls; the degree of change is measured by elasticity.

Efficiency and Exchange

Consumer and Producer Surplus, Deadweight Loss

Market efficiency is evaluated by the distribution of surplus and the presence of deadweight loss.

• 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 producer surplus and total welfare.

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

Additional info: Table entries are placeholders; actual examples would include specific goods/services/industries.

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: $TC = FC + VC = AC \times Q$

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

  • Average Cost: $AC = \frac{TC}{Q}$

  • Variable Cost: $VC$

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

  • Fixed Cost: $FC$

• Revenue:

  • Total Revenue: $TR = P \times Q$

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

• Profit Maximization: Occurs where $MR = MC$.

Example: A firm increases output until marginal cost equals marginal revenue.

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 and benefit from comparative advantage.

• 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; free trade increases efficiency.

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

Forms of Industrial Organization

Perfect Competition, Monopoly, Monopolistic Competition, Oligopoly

Market structures differ in the number of firms, product differentiation, and barriers to entry.

• Perfect Competition: Many firms, identical products, free entry/exit, price equals marginal cost.

• Monopoly: Single firm, unique product, barriers to entry, price exceeds marginal cost.

• Monopolistic Competition: Many firms, differentiated products, some market power.

• Oligopoly: Few firms, interdependent decisions, potential for collusion.

Example: The airline industry is an oligopoly, while wheat farming is closer to perfect competition.

Game Theory

Strategic Interaction and Nash Equilibrium

Game theory analyzes strategic interactions among firms, especially in oligopolistic markets.

• Game Matrix: Represents payoffs for different strategies.

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

	Advertise	Don't Advertise
Advertise	Hong Tan earns $200, La Jolla earns $200	Hong Tan earns $300, La Jolla earns $100
Don't Advertise	Hong Tan earns $100, La Jolla earns $300	Hong Tan earns $250, La Jolla earns $250

Example: Firms in an oligopoly may choose to advertise or not, with payoffs depending on competitors' choices.

Externalities

Negative and Positive Externalities

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

• Negative Externality: Overproduction, e.g., pollution ($MSC > MPC$).

• Positive Externality: Underproduction, e.g., education ($MSB > MPB$).

• Solutions: Taxes, subsidies, regulation, and property rights (Coase Theorem).

Example: A factory pollutes a river, imposing 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).

• Tragedy of the Commons: Overuse of common resources due to lack of property rights.

Example: Overfishing in international waters leads to resource depletion.

Markets for Factors of Production

Input Markets and Labor

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 employment levels depend on supply and demand for labor.

Example: A firm hires workers up to the point where $MRP = wage$.

Income Inequality and Risk Preferences

Measuring Inequality and Risk Attitudes

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

• Present Value Formula:

$\text{Present Value} = \frac{\text{Payment } T \text{ periods from now}}{(1 + \text{interest rate})^T}$

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

Example: Choosing between a guaranteed payment and a risky lottery depends on individual risk preferences.

Additional info: These notes synthesize and expand upon the provided study sheet, adding definitions, examples, and formulas for clarity and completeness.