Microeconomics Final Exam Study Guide: Key Concepts and Practice Problems

Absolute and Comparative Advantage

Definitions and Applications

Understanding absolute and comparative advantage is fundamental to analyzing trade between individuals or countries. These concepts help determine who should specialize in producing which goods to maximize overall efficiency.

• Absolute Advantage: The ability of a producer to produce more of a good using the same amount of resources compared to another producer.

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

• Terms of Trade: The rate at which one good is exchanged for another between two parties.

Example: If Jackie can produce 40 bowls of salad or 200 breadsticks, and Erick can produce 50 bowls of salad or 100 breadsticks, Jackie has an absolute advantage in breadsticks, while Erick has a comparative advantage in salad.

	Bowls of Salad	Breadsticks
Jackie	40	200
Erick	50	100

*Additional info: Opportunity cost calculations determine comparative advantage.*

Demand, Supply, and Elasticity

Market Equilibrium and Elasticity Concepts

Markets reach equilibrium where quantity demanded equals quantity supplied. Elasticity measures how responsive quantity demanded or supplied is to changes in price or other factors.

• Demand Function: Shows the relationship between price and quantity demanded. Example: $Q_D = 25 - 1.5P$

• Supply Function: Shows the relationship between price and quantity supplied. Example: $Q_S = 2P$

• Price Elasticity of Demand: Measures the percentage change in quantity demanded resulting from a 1% change in price. Formula: $E_d = \frac{\% \Delta Q}{\% \Delta P}$

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

Example: If the price of pillows increases by 1%, and the quantity demanded decreases by 0.44%, the price elasticity of demand is -0.44. *Additional info: Normal goods have positive income elasticity; inferior goods have negative income elasticity.*

Government Actions in Markets

Taxes and Market Outcomes

Government interventions such as taxes affect market equilibrium, consumer surplus, producer surplus, and can create deadweight loss.

• Tax Incidence: Refers to how the burden of a tax is shared between buyers and sellers.

• Deadweight Loss (DWL): The reduction in total surplus resulting from a market distortion, such as a tax.

Example: Imposing a $10 tax on imported cigarettes shifts the supply curve, reducing equilibrium quantity and creating deadweight loss.$DWL = \frac{1}{2} \times (\text{Tax}) \times (\text{Reduction in Quantity})$ *Additional info: The division of tax burden depends on the relative elasticities of demand and supply.*

Consumer Choice and Utility

Indifference Curves and Marginal Rate of Substitution

Consumers allocate their budgets to maximize utility, represented by indifference curves. The marginal rate of substitution (MRS) indicates the rate at which a consumer is willing to trade one good for another.

• Indifference Curve: Shows combinations of goods that provide the same level of utility.

• Marginal Rate of Substitution (MRS): The amount of one good a consumer is willing to give up to obtain one more unit of another good, keeping utility constant. $MRS = -\frac{\Delta y}{\Delta x}$

• Budget Constraint: Represents all combinations of goods a consumer can afford given their income and prices.

Cups of Coffee Purchased	Croissants Purchased	MRS (Coffee for Croissants)	Total Utility
0.25	4	0.25	12
1	2	0.125	12
2	1.41	0.125	12
4	1	0.0625	12

Example: If coffee costs $1 and croissants $18, and the consumer has $12 to spend, the optimal bundle is where the budget line is tangent to the highest indifference curve. *Additional info: The slope of the budget line is$-\frac{P_{coffee}}{P_{croissant}}$.*

Production, Costs, and Market Structures

Perfect Competition and Monopoly

Firms operate in different market structures, affecting output, pricing, and efficiency. Perfect competition leads to efficient outcomes, while monopoly can create inefficiency and deadweight loss.

• Perfect Competition: Many firms, identical products, free entry and exit. Firms are price takers.

• Monopoly: Single firm supplies the market, can set prices above marginal cost, leading to deadweight loss.

• Marginal Cost (MC): The increase in total cost from producing one more unit. $MC = \frac{\Delta TC}{\Delta Q}$

• Marginal Revenue (MR): The increase in total revenue from selling one more unit.

Example: For a monopoly, the firm sets output where $MR = MC$ and price from the demand curve. Deadweight loss is the lost surplus due to reduced output. *Additional info: Consumer surplus (CS) and producer surplus (PS) are maximized in perfect competition.*

Game Theory and Oligopoly

Strategic Interaction and Nash Equilibrium

Oligopoly markets feature a few firms whose decisions affect each other. Game theory analyzes strategic choices, including collusion and competition.

• Payoff Matrix: Table showing the outcomes for each combination of strategies.

• Dominant Strategy: A strategy that yields the highest payoff regardless of the opponent's action.

• Nash Equilibrium: A set of strategies where no player can benefit by changing their strategy unilaterally.

• Subgame Perfect Nash Equilibrium: A refinement of Nash Equilibrium for dynamic games.

	Firm B: $200/ticket	Firm B: $150/ticket
Firm A: $200/ticket	$1,700/$1,700	$1,150/$2,000
Firm A: $150/ticket	$2,000/$1,150	$1,000/$1,000

Example: If both firms have a dominant strategy to set the lower price, the Nash Equilibrium is both setting the lower price. *Additional info: Collusion can lead to higher profits but may be unstable due to incentives to undercut.*

Externalities and Public Goods

Market Failure and Social Cost

Externalities occur when market transactions affect third parties. Public goods are non-excludable and non-rivalrous, often requiring government intervention.

• Negative Externality: A cost imposed on others, such as pollution.

• Marginal Social Cost (MSC): The total cost to society of producing one more unit, including external costs. $MSC = MC + \text{External Cost}$

• Deadweight Loss from Externality: The loss in total surplus due to overproduction or underproduction caused by the externality.

Example: Street cleaning services reduce negative externalities from pollution, and the efficient quantity is where $MSC = MB$ (marginal benefit). *Additional info: Government can correct externalities through taxes, subsidies, or regulation.*