Microeconomics Midterm 2: Study Guide and Key Concepts

Market Forces of Supply and Demand

Price Ceilings and Market Shortages

Price ceilings are government-imposed limits on how high a price can be charged for a product. They are typically set below the equilibrium price to make goods more affordable but can lead to shortages.

• Price Ceiling: A legal maximum on the price at which a good can be sold.

• Shortage: Occurs when the quantity demanded exceeds the quantity supplied at the controlled price.

• Example: Imposing a price ceiling on bottled water during a natural disaster can create a shortage if the ceiling is below the equilibrium price.

Graphical Analysis: The supply and demand curves intersect at the equilibrium. A price ceiling set below this point creates excess demand (shortage).

Taxes and Deadweight Loss

Effects of Taxes on Markets

Taxes imposed on goods affect both consumers and producers, leading to changes in equilibrium price and quantity, and creating deadweight loss.

• Tax Incidence: The manner in which the burden of a tax is shared among participants in a market.

• Deadweight Loss: The reduction in total surplus that results from a market distortion, such as a tax.

• Formula for Deadweight Loss:

$\text{Deadweight Loss} = \frac{1}{2} \times (\text{Tax}) \times (\text{Reduction in Quantity Traded})$

• Example: A $5 tax in a card trading market can create deadweight loss by reducing the number of trades below the efficient level.

Costs of Production

Short-Run Cost Curves

Firms face various costs in production, which are categorized as fixed, variable, and total costs. These costs are used to derive average and marginal cost curves.

• Total Cost (TC): The sum of fixed and variable costs at each level of output.

• Fixed Cost (FC): Costs that do not vary with the quantity of output produced.

• Variable Cost (VC): Costs that vary with the quantity of output produced.

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

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

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

Key Point: The marginal cost curve intersects the average total cost and average variable cost curves at their minimum points.

Consumer and Producer Surplus

Measuring Surplus and Government Revenue

Consumer surplus and producer surplus are measures of economic welfare. Taxes and subsidies affect these surpluses and create government revenue or expenditure.

• Consumer Surplus: The difference between what buyers are willing to pay and what they actually pay.

• Producer Surplus: The difference between the price sellers receive and their minimum acceptable price.

• Government Revenue from Tax: $\text{Tax Revenue} = \text{Tax} \times \text{Quantity Sold after Tax}$

Externalities and Government Intervention

Negative Externalities and Subsidies

Externalities occur when a third party is affected by a market transaction. Negative externalities (e.g., pollution) can be corrected by taxes or subsidies.

• Negative Externality: A cost imposed on others outside the market transaction.

• Subsidy: A government payment to encourage or support a certain economic activity.

• Example: A $3 negative externality can be offset by a $3 subsidy to consumers, affecting market equilibrium and deadweight loss.

Perfect Competition and Long-Run Equilibrium

Firm and Market Equilibrium

In perfect competition, firms are price takers and can freely enter or exit the market. Long-run equilibrium occurs when firms earn zero economic profit.

• Long-Run Equilibrium: Occurs when $P = MC = ATC$ and firms earn zero economic profit.

• Entry and Exit: If firms earn positive profit, new firms enter; if negative, firms exit until profit is zero.

• Example: The long-run equilibrium number of firms is determined by market demand and the cost structure of firms.

Tables and Data Interpretation

Cost and Supply Tables

Tables are used to organize cost data and derive supply schedules for individual firms and the market.

Quantity	Total Cost	Fixed Cost	Variable Cost	Marginal Cost	Average Total Cost	Average Variable Cost
0	30	30	0	-	-	-
1	50	30	20	20	50	20
2	68	30	38	18	34	19
3	90	30	60	22	30	20
4	120	30	90	30	30	22.5

Additional info: Some values are inferred for illustration; actual exam may require calculation.

Price	Quantity Supplied (Individual Firm)
0	0
4	0
8	1
10	2
15	3
22	4

Additional info: Table shows how supply increases as price rises, based on marginal cost.

Key Equations and Concepts

• Equilibrium Price and Quantity: Set $Q_D = Q_S$ and solve for $P$ and $Q$.

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

• Average Total Cost: $ATC = \frac{TC}{Q}$

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

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