Microeconomics Study Guide: Core Concepts, Demand & Supply, Elasticity, Efficiency, and Market Structures (Chapters 1-8)

Core Concepts (Ch. 1-4)

Fundamental Principles of Microeconomics

Microeconomics is built on several foundational concepts that help explain how individuals and firms make decisions and interact in markets.

• Scarcity: Limited resources require choices about allocation.

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

• Economic Model: Simplified representations of reality used to analyze economic situations.

• Causation and Correlation: Distinguishing between relationships where one variable causes another versus mere association.

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

• Diminishing Marginal Benefit: As consumption increases, the additional benefit from consuming one more unit decreases.

• Diminishing Marginal Product of an Input: Adding more of one input, holding others constant, eventually yields lower additional output.

• Price Elasticity of Demand and Supply: Measures responsiveness of quantity demanded or supplied to changes in price.

• Long and Short Run: Time frames affecting the flexibility of inputs and costs.

• Perfect Competition, Invisible Hand, and Efficiency: In perfectly competitive markets, resources are allocated efficiently through price signals.

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

• Trade Gains, Frontier, Division of Labor, and Specialization: Specialization and trade allow for greater total output and efficiency.

• Intertemporal Choice: Decisions involving trade-offs across time.

• Trade, Protectionism, Retaliation, and Justification: Examines the effects and arguments for and against trade barriers.

Basic Demand and Supply (Ch. 1-4)

Market Forces and Equilibrium

Demand and supply are the core forces that determine prices and quantities in markets.

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

  • Definition: Relationship between price and quantity demanded.

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

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

  • Definition: Relationship between price and quantity supplied.

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

• Equilibrium: The price and quantity at which demand equals supply.

  • Equation: $Q_d = Q_s$

• Comparative Statics: Analysis of how changes in demand or supply affect equilibrium price and quantity.

Example: Given demand $Q_d = 400 - 2P$ and supply $Q_s = 2P - 20$, solve for equilibrium by setting $Q_d = Q_s$.

Demand / Consumer Theory (Ch. 5)

Understanding Consumer Choices

Consumer theory explains how individuals make choices given their preferences and budget constraints.

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

• Indifference Curve: Represents combinations of goods that provide the same level of satisfaction.

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

• Deriving a Demand Curve: Shows how quantity demanded changes as price changes, holding other factors constant.

• Downward Sloping Demand: As price decreases, quantity demanded increases due to substitution and income effects.

Elasticity (Ch. 5)

Measuring Responsiveness in Markets

Elasticity quantifies how much quantity demanded or supplied responds to changes in price or other factors.

• Price Elasticity of Demand: Percentage change in quantity demanded divided by percentage change in price.

  • Point Elasticity Formula: $\frac{dQ}{dP} \times \frac{P}{Q}$

  • Arc (Average) Elasticity Formula: $\frac{Q_2 - Q_1}{(Q_2 + Q_1)/2} \div \frac{P_2 - P_1}{(P_2 + P_1)/2}$

• Income Elasticity of Demand: Measures responsiveness of demand to changes in income.

• Cross-Price Elasticity of Demand: Measures responsiveness of demand for one good to changes in the price of another good.

• Elasticity and Total Revenue: If demand is elastic, a price increase reduces total revenue; if inelastic, a price increase raises total revenue.

Price Elasticity of Demand	Change in Price	Change in Quantity	Change in Total Revenue
Elastic	↑	↓	↓
Inelastic	↑	↓	↑
Unitary Elastic	↑	↓	No change

Efficiency and Exchange

Surplus and Market Outcomes

Efficiency in markets is measured by the total surplus generated, which is the sum of consumer and producer surplus.

• Consumer Surplus: Difference between what consumers are willing to pay and what they actually pay.

• Producer Surplus: Difference between the price received and the minimum price at which producers are willing to sell.

• Total Surplus: $\text{Consumer Surplus} + \text{Producer Surplus}$

• Deadweight Loss: Loss of total surplus due to market inefficiency, often caused by price controls or taxes.

• Price Floors and Ceilings: Government-imposed limits on prices can create surpluses or shortages and deadweight loss.

Example: If a $2 per unit tax is imposed, calculate the new equilibrium price and quantity, consumer surplus, and producer surplus. Illustrate using a supply and demand diagram.

Supply in Depth (Ch. 6)

Production and Cost Analysis

Understanding the cost structure of firms is essential for analyzing supply decisions.

• Cost Minimization: Firms seek to produce output at the lowest possible cost.

  • Total Physical Product (TPP): Total output produced.

  • Marginal Physical Product (MPP): Additional output from one more unit of input. $MPP = \frac{\Delta TPP}{\Delta Q}$

  • Principle of Diminishing Marginal Product: As more of an input is used, the additional output eventually decreases.

• Cost Curves:

  • Total Cost (TC): $TC = VC + AC \times Q$

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

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

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

• Revenue:

  • Total Revenue (TR): $TR = P \times Q$

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

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

  • If $P > AC$, firm earns profit.

  • If $P = AC$, firm breaks even.

  • If $P < AC$, firm incurs a loss.

The Firm and the Industry (Ch. 7)

Market Structures and Profit Analysis

Firms operate in different market structures, affecting their pricing and output decisions.

• Perfect Competition: Many firms, identical products, free entry and exit.

• Zero Economic Profits: In the long run, entry and exit drive profits to zero ($P = minAC$).

• Positive Economic Profits: In the short run, firms may earn profits if $P > AC$.

• Industry Supply Response: If costs remain constant, supply increases until profits are eliminated.

Example: Graphs illustrate how industry supply and firm cost curves interact to determine profits.

Forms of Industrial Organization – Perfect Competition (Ch. 7)

Characteristics and Outcomes

Perfect competition leads to efficient outcomes but has both advantages and disadvantages.

• Advantages: Efficient allocation of resources, consumer choice, and competitive prices.

• Disadvantages: Firms are price takers, may face losses in the short run, and lack product differentiation.

• Short Run: Firms can earn profits or losses.

• Long Run: Entry and exit ensure only normal profits ($P = minAC$).

Trade (Ch. 8)

International Economics and Policy

Trade allows countries to specialize and benefit from comparative advantage, but also raises questions about protectionism.

• Production Possibilities Frontier (PPF): Shows maximum output combinations given resources and technology.

• Comparative Advantage: Basis for mutually beneficial trade.

• Effects of Opening to Trade: Domestic price may rise or fall, depending on whether the country is an exporter or importer.

• Globalization: Integration of world markets.

• Protectionism: Use of tariffs and quotas to restrict trade.

• Arguments for and against Free Trade: Efficiency gains vs. concerns about jobs and industries.

Additional info: These notes cover the essential topics from chapters 1-8 of a college-level microeconomics course, including definitions, formulas, and applications relevant for exam preparation.