Principles of Microeconomics: Midterm Study Guide (Chapters 1-6)

Midterm Exam Overview

Exam Logistics

• Date: February 12th, Thursday, during class time (in person).

• Chapters Covered: Acemoglu, Laibson, List Chapters 1-6 (including appendices).

• Format: Multiple-choice, short-answer, and long-answer questions.

• Allowed Materials: Pen, pencil, eraser, ruler, simple standard function calculator (not scientific).

• Preparation Tips:

  • Start studying early.

  • Review class notes and note shortcuts/tricks.

  • Redo poll questions, discussion questions, quizzes, and problem sets.

  • Practice end-of-chapter problems and past midterms (for additional practice).

  • Work in groups and compare answers.

  • Ensure adequate rest before the exam.

Core Learning Outcomes

1. Economic Reasoning and Classification

• Positive vs. Normative Statements:

  • Positive statements describe facts or cause-effect relationships ("what is").

  • Normative statements express value judgments or opinions ("what ought to be").

  • Example: "Increasing the minimum wage will reduce employment" (positive); "The government should increase the minimum wage" (normative).

• Four Core Components of Economic Approach:

  • Stable Preferences: Individuals have consistent tastes over time.

  • Optimization: Agents make the best choices given constraints.

  • Equilibrium: Markets reach a state where no agent can improve their outcome by changing behavior.

  • Empiricism: Use of data and evidence to test economic theories.

2. Opportunity Cost, Sunk Cost, and Cost-Benefit Analysis

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

• Sunk Cost: Costs that have already been incurred and cannot be recovered; should not affect future decisions.

• Cost-Benefit Analysis: Comparing the costs and benefits of alternatives to make optimal choices.

• Net Benefits: $\text{Net Benefit} = \text{Total Benefit} - \text{Total Cost}$

• Marginal Net Benefit: The change in net benefit from one additional unit of activity.

• Optimization Methods:

  • Optimization in Levels: Choose the option with the highest net benefit.

  • Optimization in Differences: Choose the option where the marginal benefit equals marginal cost.

• Marginal Analysis (Bang-for-the-Buck Rule): Allocate resources so that the marginal benefit per dollar is equal across activities.

• Example: Choosing between studying and working based on marginal benefit per hour.

3. Empirical Methods and Causality

• Correlation vs. Causation: Correlation does not imply causation due to possible reverse causality, omitted variables, or selection bias.

• Selection Bias: When the sample is not representative, leading to incorrect conclusions.

• Internal Validity: The extent to which a study accurately establishes a causal relationship.

• External Validity: The extent to which results generalize to other settings.

• Example: Analyzing whether a new teaching method causes higher test scores, accounting for selection bias.

4. Demand and Supply Analysis

• Individual and Market Demand:

  • Constructed from willingness-to-pay (WTP) schedules.

  • Market Demand: Horizontal sum of individual demand curves.

• Individual and Market Supply:

  • Constructed from willingness-to-accept (WTA) schedules.

  • Market Supply: Horizontal sum of individual supply curves.

• Equilibrium: The intersection of demand and supply curves determines equilibrium price and quantity.

• Consumer Surplus: $\text{Consumer Surplus} = \text{WTP} - \text{Price}$

• Producer Surplus: $\text{Producer Surplus} = \text{Price} - \text{WTA}$

• Total Surplus: Sum of consumer and producer surplus.

• Law of Demand: Demand curves slope downward; as price decreases, quantity demanded increases (ceteris paribus).

• Law of Supply: Supply curves slope upward; as price increases, quantity supplied increases (ceteris paribus).

• Competitive Markets: Many buyers and sellers, no individual can influence price.

• Adjustment to Equilibrium: Excess demand leads to price increases; excess supply leads to price decreases.

• Movements vs. Shifts:

  • Movement: Change in quantity demanded/supplied due to price change.

  • Shift: Change in demand/supply due to factors other than price (e.g., income, preferences, input costs).

• Example: Analyzing Uber surge pricing using equilibrium analysis.

5. Elasticity Concepts

• Price Elasticity of Demand: Measures responsiveness of quantity demanded to price changes.

  • $\text{Price Elasticity of Demand} = \frac{\% \text{Change in Quantity Demanded}}{\% \text{Change in Price}}$

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

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

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

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

• Price Elasticity of Supply: Measures responsiveness of quantity supplied to price changes.

• Elasticity vs. Slope: Elasticity is a relative measure; slope is absolute.

• Classification of Goods:

  • Elastic: Elasticity > 1

  • Inelastic: Elasticity < 1

  • Unit Elastic: Elasticity = 1

  • Substitutes: Positive cross-price elasticity

  • Complements: Negative cross-price elasticity

  • Normal Goods: Positive income elasticity

  • Inferior Goods: Negative income elasticity

  • Necessities: Income elasticity < 1

  • Luxuries: Income elasticity > 1

• Revenue Implications: Elasticity determines whether price increases raise or lower total revenue.

• Example: Predicting revenue changes for a firm after a price change.

6. Consumer Choice and Preferences

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

  • Equation: $P_x X + P_y Y \leq I$

  • Graph: Slope is $-\frac{P_x}{P_y}$

• Opportunity Cost: Relative price reflects opportunity cost of one good in terms of another.

• Preference Properties:

  • Completeness: Consumers can rank all bundles.

  • Transitivity: Preferences are consistent across comparisons.

  • Monotonicity: More is preferred to less.

  • Strict Convexity: Mixtures of bundles are preferred to extremes.

• Indifference Curves: Graphically represent bundles with equal utility.

  • Marginal Rate of Substitution (MRS): $\text{MRS} = \frac{MU_x}{MU_y}$

  • Tangency Condition: $\text{MRS} = \frac{P_x}{P_y}$

• Equal Marginal Utility per Dollar Rule: $\frac{MU_x}{P_x} = \frac{MU_y}{P_y}$

• Optimization: Choose the bundle where budget constraint is tangent to indifference curve.

• Substitution and Income Effects: Decompose total effect of price change into substitution (change in relative price) and income (change in purchasing power).

• Normal vs. Inferior Goods: Normal goods increase with income; inferior goods decrease.

• Example: Analyzing optimal consumption of apples and oranges given prices and income.

7. Firm Production and Cost Analysis

• Marginal Product: Additional output from one more unit of input; typically diminishes as input increases.

• Cost Concepts:

  • Total Cost (TC): $TC = FC + VC$

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

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

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

  • Average Fixed Cost (AFC): $AFC = \frac{FC}{Q}$

• Cost Curves: MC intersects AVC and ATC at their minimum points.

• Profit Maximization:

  • Output Condition: $MC = MR = p$

  • Input Condition: $\frac{w}{MPL} = \frac{r}{MPK}$

• Isocost Lines and Isoquants: Graphical tools for finding optimal input mix.

• Short-run and Long-run Supply Curves: Derived from MC curve.

• Profit and Loss Analysis: Use cost and revenue curves to determine profitability.

• Firm Decisions: Produce, shut down, or exit based on prices and costs.

• Economies of Scale: Average cost decreases as output increases; diseconomies occur when average cost increases.

• Example: Determining optimal output for a bakery given cost and revenue data.

Summary Table: Key Concepts and Formulas

Concept	Definition	Formula (LaTeX)	Example/Application
Net Benefit	Total benefit minus total cost	$\text{Net Benefit} = \text{Total Benefit} - \text{Total Cost}$	Choosing between two job offers
Consumer Surplus	WTP minus price paid	$\text{Consumer Surplus} = \text{WTP} - \text{Price}$	Buying a concert ticket below maximum WTP
Producer Surplus	Price received minus WTA	$\text{Producer Surplus} = \text{Price} - \text{WTA}$	Selling a product above minimum acceptable price
Price Elasticity of Demand	Responsiveness of quantity demanded to price	$\frac{\% \text{Change in Quantity Demanded}}{\% \text{Change in Price}}$	Predicting sales after a price change
Budget Constraint	All affordable bundles given prices and income	$P_x X + P_y Y \leq I$	Choosing groceries with a fixed budget
Marginal Rate of Substitution (MRS)	Rate at which consumer is willing to trade one good for another	$\text{MRS} = \frac{MU_x}{MU_y}$	Trading apples for oranges
Profit Maximization (Output)	Optimal output where MC equals MR	$MC = MR = p$	Setting production level for maximum profit