Microeconomics Midterm Study Guide: Core Principles and Applications

Topic 1: What is Economics?

Basic Principles and Assumptions

• Economics is the study of how individuals and societies allocate scarce resources to satisfy unlimited wants.

• Scarcity means that resources are limited, which forces choices and trade-offs.

• Opportunity cost is the value of the next best alternative forgone when making a decision.

• Economic models rely on assumptions such as rational behavior, ceteris paribus (all else equal), and marginal analysis.

• Pitfalls in economic analysis include confusing correlation with causation, ignoring secondary effects, and failing to consider opportunity costs.

• Positive analysis deals with objective, testable statements ("what is"), while normative analysis involves subjective value judgments ("what ought to be").

• Microeconomics studies individual markets and agents; macroeconomics examines the economy as a whole.

Topic 2: Production Possibilities, Trade, and Comparative Advantage

Economic Systems and the Production Possibilities Curve (PPC)

• Free market economy: Resources are allocated by voluntary exchange in markets.

• Centrally planned economy: The government makes allocation decisions.

• Mixed economy: Combines elements of both market and government decision-making.

• The Production Possibilities Curve (PPC) shows the maximum combinations of two goods that can be produced with available resources and technology.

• Efficient points are on the PPC; inefficient points are inside; unattainable points are outside.

• Productive efficiency means producing on the PPC; allocative efficiency means producing the mix of goods most desired by society.

• The PPC shifts outward with economic growth (more resources, better technology) and inward with resource loss.

• A PPC bows outward if opportunity costs increase as more of one good is produced.

Comparative and Absolute Advantage

• Absolute advantage: The ability to produce more of a good with the same resources.

• Comparative advantage: The ability to produce a good at a lower opportunity cost.

• Trade allows individuals/countries to specialize in goods where they have comparative advantage, increasing total output.

• Calculating comparative advantage: Compare opportunity costs for each producer.

Markets and Incentives

• Private property rights are essential for market efficiency and innovation.

• Free markets reward producers who respond to consumer preferences, leading to higher quality, variety, and lower prices.

• Adam Smith's Invisible Hand: Self-interested actions in markets can lead to socially desirable outcomes.

• I, Pencil illustrates the complexity and coordination achieved by markets without central planning.

Topic 3: Demand, Supply, and Equilibrium

Demand

• The demand curve shows the relationship between price and quantity demanded, holding other factors constant.

• Law of demand: As price falls, quantity demanded rises (and vice versa), ceteris paribus.

• Movement along the demand curve is caused by a change in price; shifts are caused by changes in income, tastes, prices of related goods, expectations, or number of buyers.

Supply

• The supply curve shows the relationship between price and quantity supplied.

• Law of supply: As price rises, quantity supplied rises (and vice versa), ceteris paribus.

• Movement along the supply curve is due to price changes; shifts are caused by changes in input prices, technology, expectations, or number of sellers.

Market Equilibrium

• Equilibrium occurs where the demand and supply curves intersect; at this price, quantity demanded equals quantity supplied.

• If price is above equilibrium, a surplus results; if below equilibrium, a shortage occurs.

• Shifts in demand or supply change equilibrium price and quantity.

Topic 4: Market Efficiency, Price Controls, Taxes

Consumer and Producer Surplus

• Consumer surplus is the area below the demand curve and above the price.

• Producer surplus is the area above the supply curve and below the price.

• Economic surplus (total surplus) is maximized in a competitive market at equilibrium.

Price Controls

• Price floor: A legal minimum price (e.g., minimum wage). If set above equilibrium, it creates a surplus.

• Price ceiling: A legal maximum price (e.g., rent control). If set below equilibrium, it creates a shortage.

• Price controls can reduce total surplus and create deadweight loss (lost gains from trade).

Taxes

• A tax shifts the supply or demand curve, depending on whether it is levied on producers or consumers.

• Taxes create deadweight loss, reduce consumer and producer surplus, and generate government revenue.

• Tax incidence refers to how the burden of a tax is shared between buyers and sellers, depending on elasticity.

Key Formulas

• Deadweight Loss: $DWL = \frac{1}{2} \times (Q_{efficient} - Q_{tax}) \times (P_{buyer} - P_{seller})$

• Government Revenue: $Tax \ Revenue = Tax \ per \ unit \times Quantity \ sold \ after \ tax$

Topic 5: Elasticity and Utility

Elasticity

• Price elasticity of demand measures responsiveness of quantity demanded to price changes.

• Definition: $E_d = \frac{\% \ change \ in \ quantity \ demanded}{\% \ change \ in \ price}$

• Midpoint formula: $E_d = \frac{(Q_2 - Q_1)}{(Q_2 + Q_1)/2} \div \frac{(P_2 - P_1)}{(P_2 + P_1)/2}$

• Perfectly elastic demand: $E_d = \infty$; Perfectly inelastic demand: $E_d = 0$

• Determinants: availability of substitutes, necessity vs. luxury, time horizon, share of income spent.

• Income elasticity of demand: $E_I = \frac{\% \ change \ in \ quantity \ demanded}{\% \ change \ in \ income}$

• If $E_I > 0$, the good is normal; if $E_I < 0$, the good is inferior.

• Price elasticity of supply measures responsiveness of quantity supplied to price changes; more elastic in the long run.

• Total revenue and elasticity: If demand is elastic, raising price lowers total revenue; if inelastic, raising price increases total revenue.

Utility and Consumer Choice

• Total utility is the total satisfaction from consuming a good; marginal utility is the additional satisfaction from one more unit.

• Marginal utility typically diminishes as more of a good is consumed (diminishing marginal utility).

• Optimal consumption rule: $\frac{MU_x}{P_x} = \frac{MU_y}{P_y}$ for goods x and y.

• Given utility and price data, consumers maximize utility by equalizing marginal utility per dollar across goods.

Topic 6: Externalities and Public Goods

Externalities

• Externality: A side effect of production or consumption that affects third parties (can be positive or negative).

• Negative externalities (e.g., pollution) lead to overproduction; positive externalities (e.g., vaccination) lead to underproduction.

• Graphically, externalities cause market outcomes to diverge from the social optimum.

• Private bargaining (Coase Theorem) can internalize externalities if property rights are clear and transaction costs are low.

• When private solutions fail, government can use taxes (Pigouvian tax), subsidies, regulation, or tradable permits.

Types of Goods

• Private goods: Rival and excludable (e.g., food).

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

• Common resources: Rival but non-excludable (e.g., fisheries).

• Club goods: Non-rival but excludable (e.g., cable TV).

• Public goods tend to be underproduced; common resources tend to be overused (tragedy of the commons).

• Mechanisms to correct inefficiencies include government provision, taxes, subsidies, and property rights.

Demand for Private vs. Public Goods

• For private goods, market demand is the horizontal sum of individual demand curves.

• For public goods, market demand is the vertical sum of individual willingness to pay at each quantity.

Topic 7: Government Failure

Limits of Government Intervention

• Government failure occurs when government intervention leads to inefficient outcomes.

• Voting paradox: Collective preferences can be inconsistent, making it hard to discern the public interest.

• Majority voting may not reflect true social preferences due to cycling and strategic voting.

• Rent-seeking: Efforts to gain economic benefits through the political process rather than productive activity.

• Regulatory capture: When regulatory agencies are dominated by the industries they regulate.

• Logrolling: Vote trading among legislators; rational ignorance: Voters remain uninformed when the cost of information exceeds expected benefit.

• Programs with concentrated benefits and dispersed costs are more likely to be enacted, even if not socially optimal.