Principles of Microeconomics: Final Exam Study Guide

Chapter 4: Demand, Supply, and Equilibrium

The Meaning of Markets

Markets are institutions or arrangements where buyers and sellers interact to exchange goods and services. Understanding how markets function is fundamental to microeconomics.

• Market: Any structure that allows buyers and sellers to exchange goods, services, or information.

• Types of Markets: Physical (e.g., farmers' markets) or virtual (e.g., online marketplaces).

• Role: Markets determine prices and allocate resources efficiently.

How Do Buyers Behave?

Buyers make decisions based on preferences, income, and the prices of goods and services.

• Rational Choice: Buyers aim to maximize their utility (satisfaction) given their budget constraints.

• Substitution Effect: As the price of a good rises, consumers may switch to substitutes.

Law of Demand, Demand Schedule, and Demand Curve

The law of demand states that, ceteris paribus, as the price of a good increases, the quantity demanded decreases.

• Demand Schedule: A table showing the quantity demanded at different prices.

• Demand Curve: A graphical representation of the demand schedule, typically downward sloping.

$Q_d = f(P)$

The Difference Between Qd and D

• Quantity Demanded (Qd): The specific amount of a good buyers are willing to purchase at a given price.

• Demand (D): The entire relationship between prices and the quantity demanded at each price.

• Movement vs. Shift: A change in price causes movement along the demand curve (change in Qd), while changes in other factors (income, tastes, etc.) shift the demand curve (change in D).

Individual Demand and Market Demand

• Individual Demand: The demand of a single consumer.

• Market Demand: The sum of all individual demands for a good or service.

• Aggregation: Market demand is found by horizontally summing individual demand curves.

How Do Sellers Behave?

Sellers aim to maximize profit by choosing how much to produce and at what price to sell.

• Profit Maximization: Sellers compare marginal cost and marginal revenue to determine output.

Law of Supply, Supply Schedule, and Supply Curve

The law of supply states that, ceteris paribus, as the price of a good increases, the quantity supplied increases.

• Supply Schedule: A table showing the quantity supplied at different prices.

• Supply Curve: A graphical representation of the supply schedule, typically upward sloping.

$Q_s = f(P)$

The Difference Between Qs and S

• Quantity Supplied (Qs): The specific amount of a good sellers are willing to sell at a given price.

• Supply (S): The entire relationship between prices and the quantity supplied at each price.

• Movement vs. Shift: A change in price causes movement along the supply curve (change in Qs), while changes in other factors (input prices, technology, etc.) shift the supply curve (change in S).

Individual Supply and Market Supply

• Individual Supply: The supply of a single producer.

• Market Supply: The sum of all individual supplies for a good or service.

• Aggregation: Market supply is found by horizontally summing individual supply curves.

Market Equilibrium

Market equilibrium occurs where quantity demanded equals quantity supplied.

• Equilibrium Price (P*): The price at which Qd = Qs.

• Equilibrium Quantity (Q*): The quantity bought and sold at equilibrium price.

$Q_d = Q_s$

Two Types of Market Disequilibrium

• Surplus: Qs > Qd at a given price; leads to downward pressure on price.

• Shortage: Qd > Qs at a given price; leads to upward pressure on price.

Changes in Market Equilibrium

• Shifts in Demand or Supply: Changes in non-price determinants shift the curves, leading to new equilibrium prices and quantities.

• Example: An increase in consumer income (for a normal good) shifts demand right, raising both equilibrium price and quantity.

Chapter 6: Sellers and Incentives

Seller’s Problem

Sellers face the problem of how to maximize profit given their production technology and market conditions.

• Profit: The difference between total revenue and total cost.

• Decision Variables: How much to produce, what inputs to use, and at what cost.

Three Pillars of Rational Decision for Producers

• Inputs: Resources used in production (labor, capital, land).

• Costs: The expenses incurred in producing goods or services.

• Optimum Production Level: The output level where profit is maximized, typically where marginal cost equals marginal revenue.

$\text{Profit} = \text{Total Revenue} - \text{Total Cost}$

Law of Diminishing Returns

As more of a variable input is added to a fixed input, the additional output from each new unit of input eventually decreases.

• Marginal Product: The additional output from one more unit of input.

• Implication: Increasing input use increases output at a decreasing rate after a certain point.

Finding the Optimum Quantity and Profit/Loss Area on Graph

• Optimum Quantity: Where marginal cost (MC) equals marginal revenue (MR).

• Profit Area: The area between total revenue and total cost curves above the break-even point.

$\text{Set } MC = MR$

Shutdown or Staying in Business Decisions in Case of Loss

• Shutdown Rule: In the short run, a firm should continue to operate if price covers average variable cost (AVC), even if making a loss.

• Exit Decision: In the long run, if price is less than average total cost (ATC), the firm should exit the market.

Difference Between Accounting and Economic Profit

• Accounting Profit: Total revenue minus explicit costs.

• Economic Profit: Total revenue minus both explicit and implicit (opportunity) costs.

$\text{Economic Profit} = \text{Total Revenue} - (\text{Explicit Costs} + \text{Implicit Costs})$

Producer Surplus

Producer surplus is the difference between the price a seller receives and the minimum price they are willing to accept.

• Graphically: The area above the supply curve and below the market price.

Competitive Equilibrium in the Long Run (Firm Entries and Exits)

• Entry: New firms enter when existing firms earn economic profit, increasing supply and lowering price.

• Exit: Firms exit when incurring losses, decreasing supply and raising price.

• Long-Run Equilibrium: Firms earn zero economic profit; price equals minimum ATC.

Chapter 8: Trade

Production Possibilities Curve (PPC)

The PPC shows the maximum combinations of two goods that can be produced with available resources and technology.

• Shape: Typically bowed outward due to increasing opportunity costs.

Efficient, Possible, and Impossible Points on PPC

• Efficient Points: On the PPC; all resources fully utilized.

• Possible Points: On or inside the PPC; feasible with current resources.

• Impossible Points: Outside the PPC; unattainable with current resources.

Calculating the Opportunity Cost on PPC

• Opportunity Cost: The value of the next best alternative foregone.

• Calculation: Slope of the PPC at a given point.

$\text{Opportunity Cost of Good X} = \frac{\text{Loss of Good Y}}{\text{Gain of Good X}}$

Comparative Advantage Theory

Comparative advantage exists when a producer can produce a good at a lower opportunity cost than others.

• Basis for Trade: Specialization according to comparative advantage increases total output.

Acceptable Terms of Trade for International Trade

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

• Acceptable Range: Between the opportunity costs of the two trading partners.

Trade Between States and Expansion of PPC

• Gains from Trade: Allow consumption beyond the PPC.

• Expansion: Trade and specialization can shift the PPC outward over time.

Determinants of Trade Between Countries

• Comparative Advantage: Determines whether a country is an exporter or importer of a good.

• Example: If Denmark has a lower opportunity cost for cheese, it will export cheese.

Chapter 9: Externalities and Public Goods

Externalities (Negative and Positive)

Externalities are costs or benefits from an economic activity that affect third parties not directly involved in the transaction.

• Negative Externality: Imposes costs (e.g., pollution).

• Positive Externality: Confers benefits (e.g., education).

Pecuniary Externalities

• Pecuniary Externality: Occurs when a market transaction affects others through prices rather than direct resource allocation (e.g., increased demand for housing raises prices for others).

Private Solutions to Externalities

• Coase Theorem: If property rights are well-defined and transaction costs are low, private bargaining can solve externality problems.

• Negotiation: Parties can reach mutually beneficial agreements.

Government Solutions to Externalities

• Taxes and Subsidies: Corrective (Pigovian) taxes for negative externalities; subsidies for positive externalities.

• Regulation: Direct controls on behavior (e.g., emission limits).

• Tradable Permits: Allow firms to buy and sell rights to emit pollutants.

Public Goods and the Characteristics of Four Types of Goods

Goods are classified based on excludability and rivalry in consumption.

Type of Good	Excludable?	Rival?	Example
Private Goods	Yes	Yes	Food, clothing
Public Goods	No	No	National defense, street lighting
Common Pool Resources	No	Yes	Fisheries, groundwater
Club Goods	Yes	No	Cable TV, private parks

Free Rider Problem

• Free Rider: Someone who benefits from a good without paying for it.

• Problem: Leads to under-provision of public goods.

Common Pool Resource Goods and Tragedy of the Commons

• Common Pool Resources: Goods that are rival but not excludable.

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

Chapter 12: Monopoly

Key Characteristics of Monopoly

• Single Seller: Only one firm supplies the product.

• No Close Substitutes: The product is unique.

• Price Maker: The monopolist can set the price.

Barriers to Entry

• Legal Barriers: Patents, copyrights, government licenses.

• Natural Barriers: Economies of scale, control of key resources.

Profit Maximization in Monopoly

• Rule: Produce where marginal revenue equals marginal cost (MR = MC).

• Price: Set above marginal cost, leading to higher profits.

$MR = MC$

The Inefficiencies of Monopoly

• Deadweight Loss: Monopoly pricing leads to reduced output and loss of total surplus.

• Allocative Inefficiency: Price exceeds marginal cost.

Price Discrimination

• Definition: Charging different prices to different consumers for the same good.

• Types: First-degree (perfect), second-degree (by quantity), third-degree (by group).

• Example: Student discounts, airline tickets.