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

Principles and Practice of Economics

Positive vs. Normative Statements

Economists distinguish between statements that describe the world as it is (positive statements) and those that prescribe how it should be (normative statements).

• Positive Statement: Factual, testable claims (e.g., "Increasing the minimum wage will reduce employment among teenagers.")

• Normative Statement: Value-based, subjective claims (e.g., "The government should increase the minimum wage.")

• Example: "Unemployment is currently 5%." (positive); "Unemployment should be lower." (normative)

Core Components of the Economic Approach

Economics relies on four foundational concepts to analyze decision-making:

• Stable Preferences: Individuals have consistent tastes and priorities.

• Optimization: People make choices to maximize their well-being given constraints.

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

• Empiricism: Economic theories are tested using real-world data.

• Example: Choosing the best combination of goods within a budget constraint.

Economic Science: Using Data and Models

Opportunity Cost vs. Sunk Cost

Understanding costs is crucial for rational decision-making.

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

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

• Example: If you paid $100 for a concert ticket but decide not to go, the $100 is a sunk cost.

Cost-Benefit Analysis

Economists use cost-benefit analysis to evaluate decisions.

• Net Benefit: Total benefit minus total cost.

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

• Formula:

$\text{Net Benefit} = \text{Total Benefit} - \text{Total Cost}$

$\text{Marginal Net Benefit} = \text{Marginal Benefit} - \text{Marginal Cost}$

Optimization Methods

Optimal choices can be determined using two approaches:

• Optimization in Levels: Compare total net benefits across options.

• Optimization in Differences: Compare marginal net benefits for incremental changes.

• Example: Deciding how many hours to work based on marginal benefit and marginal cost.

Marginal Analysis and "Bang-for-the-Buck" Rule

Marginal analysis helps allocate resources efficiently.

• Bang-for-the-Buck Rule: Allocate time or money where the marginal benefit per dollar is highest.

• Formula:

$\frac{MU_1}{P_1} = \frac{MU_2}{P_2}$

where $MU$ is marginal utility and $P$ is price.

Correlation vs. Causation

Empirical analysis must distinguish between correlation and causation.

• Correlation: Two variables move together.

• Causation: One variable directly affects another.

• Common Pitfalls: Reverse causality, omitted variables, selection bias.

• Example: Ice cream sales and drowning incidents are correlated, but not causally related.

Optimization: Trying to Do the Best You Can

Constructing Demand and Supply Curves

Demand and supply curves represent the behavior of buyers and sellers.

• Demand Curve: Shows the relationship between price and quantity demanded; reflects marginal willingness to pay (WTP).

• Supply Curve: Shows the relationship between price and quantity supplied; reflects marginal willingness to accept (WTA).

• Market Demand/Supply: Horizontal sum of individual curves.

• Example: If two consumers are willing to buy 3 and 2 units at $5, market demand at $5 is 5 units.

Equilibrium Price and Quantity

Markets reach equilibrium where demand equals supply.

• Algebraic Solution:

$Q_d = Q_s$

where $Q_d$ is quantity demanded and $Q_s$ is quantity supplied.

• Graphical Solution: Intersection of demand and supply curves.

• Example: If $Q_d = 100 - 2P$ and $Q_s = 20 + 3P$, solve for $P$ and $Q$ at equilibrium.

Consumer Surplus, Producer Surplus, and Total Surplus

Surplus measures the benefits to buyers and sellers.

• Consumer Surplus: Difference between WTP and price paid.

• Producer Surplus: Difference between price received and WTA.

• Total Surplus: Sum of consumer and producer surplus.

• Formula:

$\text{Total Surplus} = \text{Consumer Surplus} + \text{Producer Surplus}$

Demand, Supply, and Equilibrium

Law of Demand and Law of Supply

Demand curves slope downward and supply curves slope upward under ceteris paribus conditions.

• Law of Demand: As price decreases, quantity demanded increases.

• Law of Supply: As price increases, quantity supplied increases.

• Example: A decrease in the price of apples leads to higher quantity demanded.

Shifts vs. Movements Along Curves

Changes in price cause movements along curves; changes in other factors cause shifts.

• Movement Along Curve: Caused by price change.

• Shift of Curve: Caused by changes in preferences, income, prices of other goods, number of buyers/sellers, expectations.

• Example: An increase in income shifts the demand curve for normal goods to the right.

Factors Affecting Demand and Supply

Several factors can shift demand and supply curves.

• Demand: Preferences, income, prices of related goods, number of buyers, expectations.

• Supply: Input costs, technology, number of sellers, expectations.

• Example: A technological improvement shifts the supply curve to the right.

Consumers and Incentives

Elasticity Concepts

Elasticity measures responsiveness of quantity to changes in price, income, or other goods' prices.

• Own Price Elasticity of Demand: Percentage change in quantity demanded per percentage change in price.

• Cross Price Elasticity: Response of demand for one good to price change in another.

• Income Elasticity: Response of demand to income changes.

• Own Price Elasticity of Supply: Response of supply to price changes.

• Formula (Point Elasticity):

$\text{Elasticity} = \frac{\%\ \text{change in quantity}}{\%\ \text{change in price}}$

• Arc Elasticity: Uses average values for larger changes.

• Classification: Elastic (>1), Inelastic (<1), Unit Elastic (=1), Substitutes (positive cross elasticity), Complements (negative cross elasticity), Normal (positive income elasticity), Inferior (negative income elasticity).

• Example: If price rises by 10% and quantity falls by 20%, elasticity is 2 (elastic).

Budget Constraints and Optimal Bundles

Consumers face budget constraints when making choices.

• Budget Constraint: All combinations of goods affordable given prices and income.

• Graph: Linear boundary between feasible and infeasible bundles.

• Opportunity Cost: Slope of budget line reflects opportunity cost of one good in terms of another.

• Formula:

$P_x X + P_y Y = I$

where $P_x$ and $P_y$ are prices, $X$ and $Y$ are quantities, $I$ is income.

• Optimal Bundle: Point where indifference curve is tangent to budget line.

Properties of Preferences and Indifference Curves

Well-behaved preferences have specific properties.

• Completeness: Consumers can rank all bundles.

• Transitivity: Consistent rankings across bundles.

• Monotonicity: More is preferred to less.

• Strict Convexity: Mixtures are preferred to extremes.

• Indifference Curve: Shows combinations of goods yielding equal satisfaction.

• Marginal Rate of Substitution (MRS): Rate at which a consumer is willing to trade one good for another.

• Formula:

$MRS = \frac{MU_x}{MU_y}$

where $MU_x$ and $MU_y$ are marginal utilities of goods $x$ and $y$.

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

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

Substitution and Income Effects

A price change affects consumption through two channels:

• Substitution Effect: Change in consumption due to relative price change.

• Income Effect: Change in consumption due to change in purchasing power.

• Normal Good: Consumption increases with income.

• Inferior Good: Consumption decreases with income.

Sellers and Incentives

Production and Cost Concepts

Firms analyze production and costs to maximize profit.

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

• Total Cost (TC): Sum of all costs.

• Average Cost (AC): Cost per unit output.

• Marginal Cost (MC): Cost of producing one more unit.

• Formulas:

$AC = \frac{TC}{Q}$

$MC = \frac{\Delta TC}{\Delta Q}$

• Cost Curves: TC, VC, FC, ATC, AVC, AFC, MC curves.

• MC intersects AVC and ATC at their minimum points.

Profit Maximization

Firms maximize profit by equating marginal cost and marginal revenue.

• Output-Based Condition:

$MC = MR = p$

• Input-Based Condition:

$p = wMPL = rMPK$

where $w$ is wage, $MPL$ is marginal product of labor, $r$ is rental rate, $MPK$ is marginal product of capital.

• Isocost Lines: Combinations of inputs with equal cost.

• Isoquants: Combinations of inputs yielding equal output.

• Optimal Input Mix: Where isoquant is tangent to isocost line.

Short-Run and Long-Run Supply Curves

Supply curves reflect firms' profit-maximizing behavior.

• Short-Run Supply: Portion of MC curve above AVC.

• Long-Run Supply: Portion of MC curve above ATC.

• Example: Firm produces if price > AVC in short run, price > ATC in long run.

Economies and Diseconomies of Scale

Scale affects average costs.

• Economies of Scale: AC decreases as output increases.

• Diseconomies of Scale: AC increases as output increases.

• Example: Large factories may achieve lower per-unit costs, but very large firms may face coordination problems.

Summary Table: Key Microeconomic Concepts

Concept	Definition	Formula	Example/Application
Opportunity Cost	Value of next best alternative foregone	N/A	Choosing work over leisure
Elasticity	Responsiveness of quantity to price/income	$\frac{\%\ \text{change in quantity}}{\%\ \text{change in price}}$	Price elasticity of demand for gasoline
Consumer Surplus	WTP minus price paid	N/A	Buying a product below maximum WTP
Producer Surplus	Price received minus WTA	N/A	Selling a product above minimum WTA
Marginal Cost	Cost of one more unit	$MC = \frac{\Delta TC}{\Delta Q}$	Cost to produce one extra widget
Profit Maximization	Set MC = MR	$MC = MR = p$	Optimal output for a competitive firm

Additional info: These notes expand on the study guide's learning outcomes, providing definitions, formulas, and examples for key microeconomics concepts covered in Chapters 1-6.