Principles of Microeconomics (Chapters 1-5) Key Terms

Vocabulary terms and definitions generated from Chapters 1 through 5 of Principles of Microeconomics.

Scarcity

The condition in which human wants exceed the limited resources available to satisfy them, forcing individuals and societies to make choices.

Economics

The study of how scarce resources are allocated, human decision-making, and market exchange.

simple: how people decide what to do with limited resources

Opportunity Cost

what you give up when you choose one option instead of another

Division of Labor

The practice of breaking production down into separate, specialized tasks to increase overall output.

Specialization

When workers or firms focus on specific tasks for which they are well-suited, leading to higher productivity.

Economies of Scale

A condition in which the average cost per unit falls as the total level of production rises.

Microeconomics

The branch of economics that focuses on individual decision-makers and markets, including households, workers, and businesses.

Macroeconomics

The branch of economics that focuses on economy-wide issues such as economic growth, unemployment, inflation, and the trade balance.

Traditional Economy

An economic system based largely on customs and long-established practices, typically agricultural, with limited economic development.

Traditional = doing things the way they’ve traditionally been done

Command Economy

An economic system where major economic decisions are made by government authority, including production, prices, and wages.

COMMAND = government commands

Market Economy

An economic system with decentralized economic decisions where private individuals own resources and businesses respond to demand.

Globalization

The trend of increasing economic connections across countries, often measured using exports as a share of GDP.

Budget Constraint

A line showing all combinations of two goods that a person can afford when spending all available income.

Opportunity Set

All affordable combinations of goods that lie on or inside the budget constraint.

Diminishing Marginal Utility

The principle stating that as a person consumes more of a good, the additional satisfaction (utility) obtained from each extra unit declines.

Sunk Cost

A cost incurred in the past that cannot be recovered and should not influence current or future economic decisions.

Production Possibilities Frontier (PPF)

A diagram showing productively efficient combinations of two goods that an economy can produce with its available resources.

Productive Efficiency

When resources are being used fully and efficiently, so you cannot produce more of one good without producing less of another.

On a PPF graph, productive efficiency is shown by points ON the PPF.

Easy memory trick:
ON the PPF = Efficient ✅
INSIDE the PPF = Inefficient ❌

Allocative Efficiency

A state achieved when the particular mix of goods produced represents the specific combination that society most desires.

Comparative Advantage

The ability of a country or entity to produce a good at a lower opportunity cost than another producer.

Lower OC = give up less = comparative advantage

Positive Economics

Economic analysis that describes or explains facts and relationships without making value judgments.

Normative Economics

Economic statements that offer prescriptions or opinions about what ought to be, incorporating value judgments.

Law of Demand

when the price of something changes, people usually change how much they buy in the opposite direction

Easy memory: Expensive = buy less. Cheap = buy more

Substitutes

Goods used in place of one another, where an increase in the price of one leads to an increase in demand for the other.

Complements

Goods commonly used together, where an increase in the price of one leads to a decrease in demand for the other.

Law of Supply

Price and quantity supplied move in the SAME direction.

Why? Higher prices give producers more incentive to sell/produce more.

Market Equilibrium

The situation where quantity demanded equals quantity supplied ($Q_d = Q_s$), establishing market price and quantity.

Price Ceiling

A legal maximum price for a good or service; it is binding when set below the equilibrium price, resulting in a shortage.

Price Floor

FLOOR = minimum = price can’t fall below it.
Binding price floor → ABOVE equilibrium → SURPLUS.

Price Ceiling = LOW price → Buyers want MORE, Sellers offer LESS → SHORTAGE

Consumer Surplus

The maximum price a buyer is willing to pay minus the price actually paid; shown as the area below the demand curve and above market price.

Producer Surplus

The actual price received by a seller minus the minimum price acceptable to them; shown as the area above the supply curve and below market price.

Deadweight Loss

benefits from trades that could have happened but didn’t

Financial Capital

Economic resources measured in monetary terms, supplied by savers/lenders and demanded by borrowers.

Usury Laws

Laws imposing an upper limit on interest rates charged by lenders, serving as a price ceiling in financial markets.

Price Elasticity of Demand

A measure of the responsiveness of quantity demanded to a price change, calculated as $E_d = \frac{\% \Delta Q_d}{\% \Delta P}$.

Midpoint Method

A formula used to calculate percentage changes relative to the average of initial and final values: $\% \Delta Q = \frac{Q_2 - Q_1}{(Q_2 + Q_1) / 2}$.

Elastic Demand

Consumers are very responsive to a change in price.

• Elasticity > 1

• A small % change in price causes a larger % change in quantity demanded

Example: Price increases 10%, and people buy 20% less → demand is elastic.

Inelastic Demand

A condition where the absolute value of demand elasticity is less than 1 ($|E_d| < 1$), meaning quantity demanded changes by a smaller percentage than price.

Tax Incidence

The manner in which the economic burden of a tax is split between consumers and producers.

Income Elasticity of Demand

The percentage change in quantity demanded divided by percentage change in income; positive for normal goods and negative for inferior goods.

Cross-Price Elasticity of Demand

The percentage change in quantity demanded of Good A divided by percentage change in price of Good B; positive for substitutes and negative for complements.

Tradeoff

occurs when getting more of one good means giving up something else. Examples are environmental protection vs. production, efficiency vs. equality, and leisure vs. income. Which does not determine what choice is better.

Theory/Model

simplified representation of how variables interact

Goods and Service Market

A market where households buy goods and services from firms

Households = buyers

Firms = sellers

Households receive goods and services

Households pay money to firms

labor/factor market

The Job market:

Workers SUPPLY the work 👷 → Firms DEMAND the work 🏢

• Households provide work/labor to firms

• Firms pay households wages, salaries, and benefits

Real-world economies

mixed systems containing elements of market, command and traditional systems

market economies generally rely…

rely more on voluntary exchange and generally have fewer controls.

Heavily regulated markets

more government rules/control can create incentives for underground or black markets.

The slope of the budget constraint

tradeoff between the two goods.

Marginal

Additional or incremental — the effect of doing or getting one more unit

Rational decision making

Compare the marginal benefit (MB) of doing one more unit with the marginal cost (MC).

• MB > MC → Do it

• MB < MC → Don’t do it

• MB = MC → Optimal/efficient point

The key is to compare the extra benefit and extra cost rather than automatically comparing total benefits and total costs.

Utility

satisfaction or happiness a person receives from consuming goods and services.

PPF slope downward

Because of scarcity and tradeoffs. Producing more of one good requires giving up some of the other good

slope of the PPF represent

Opportunity cost — how much of one good must be given up to produce more of the other.

point ON the PPF mean

Productively efficient ✅

Resources are being fully and efficiently used. You cannot produce more of one good without producing less of the other.

An increase in productive capacity, such as:

• Technological improvements

• More productive resources

An outward shift means the economy can produce more than it could before, making some previously infeasible combinations possible.

Market

 Interaction of buyers and sellers

Market structure

Describes how a market is organized

Examples mentioned in the study guide include competitive (perfectly competitive) markets and monopolies.

demand curve shifts

when something OTHER than the product’s own price changes how much consumers want to buy.

Shift RIGHT → Demand increases ➡
People want to buy more at every price.

Shift LEFT → Demand decreases ⬅
People want to buy less at every price.

Things that can shift demand include income, tastes/preferences, number of buyers, expectations, and prices of related goods

Quantity supplied

the amount sellers are willing and able to produce and sell at a particular price

Supply Shift

When a factor other than the good’s own price changes quantity supplied at every price.

Natural Conditions

Natural conditions affect production.

Good conditions → supply increases

Bad conditions → supply decreases

Input Prices

Inputs are production costs like labor, materials, and machinery.

Higher input costs → supply decreases ⬅

Lower input costs → supply increases ➡

technology affect supply

Technology that makes production more efficient → increases supply ➡

Government Policies

Government policies can change production costs, causing supply to increase or decrease.

price ABOVE equilibrium

quantity supplied exceeds quantity demanded (Qs > Qd), creating a surplus/excess supply

price BELOW equilibrium

quantity demanded exceeds quantity supplied (Qd > Qs), creating a shortage/excess demand

Four-Step Process for Market Changes

Draw or identify the original demand and supply model and equilibrium.

Decide whether the event affects demand, supply, or both.

Determine the direction of the shift: right for an increase and left for a decrease.

Compare the new equilibrium with the original equilibrium to determine the change in price and quantity.

Labor Market Basics

Workers SUPPLY labor

Employers DEMAND labor

Price of Labor

The wage or salary paid to workers

Law of Labor Demand

From the employer’s perspective:

• Wage ↑ → Quantity of labor demanded ↓

• Wage ↓ → Quantity of labor demanded ↑

Law of Labor Supply

From the worker’s perspective:

Wage ↑ → Quantity of labor supplied ↑

Wage ↓ → Quantity of labor supplied ↓

Labor-Market Equilibrium

Labor supplied = Labor demanded

At the equilibrium wage, employers can find workers and workers can find jobs.

labor-demand shifters

Labor demand can shift because of changes in:

• Demand for the output workers produce

• Education and training

• Technology

• Number of companies

• Government regulations

• Price or availability of other inputs

Remember: These factors change how many workers employers want to hire at every wage.

Technology

Technology replaces some jobs but creates/increases demand for others

• Decrease in demand for workers

• Increase demand for workers whose skills are needed tech wise

Minimum wage is a price floor

it is illegal to pay below the specified hourly wage, binding when it is ABOVE the equilibrium wage, the quantity of labor supplied exceeds the quantity of labor demanded

unemployment

excess supply of labor

Savings

supply of financial capital

Lenders/savers

People who supply funds (money) in order to earn a return, such as interest.

Borrowing

Taking money now that you promise to pay back later

Demand for financial capital, and Households/businesses demand funds for uses such as mortgages, credit, and business investment

financial-market equilibrium

the quantity of funds supplied equals the quantity of funds demanded

Intertemporal decision making

deciding when to consume: now or in the future.

Elasticity

how responsive one variable is to a change in another variable and is based on percentage changes, allowing responsiveness to be compared across goods or situations with different units

Perfectly elastic demand or supply

Buyers or sellers are extremely responsive to price changes. Shown as a horizontal line

Perfectly inelastic demand or supply

Quantity does not change at all, even when the price changes, shown as a vertical line

Perfectly inelastic = VERTICAL = quantity won’t budge

Price elasticity of supply

Measures how much sellers/producers change the quantity they supply when the price changes.

Supply elasticity

is not negative because price and quantity supplied move in the same direction under the law of supply

Total revenue

Price × Quantity sold

demand is elastic

decreasing the price increases total revenue because quantity demanded responds proportionally more than price falls

demand is inelastic

Consumers don't reduce the quantity they buy very much when the price increases.

Inelastic = people keep buying → higher price = more revenue

unit elastic demand

The percentage change in price equals the percentage change in quantity demanded.

Elasticity = 1

Because the changes balance each other, total revenue stays about the same.

Unit elastic = EQUAL changes = 1

excise tax

creates a wedge between the price consumers pay and the price producers receive

demand is more inelastic than supply

consumers bear most of the tax burden

supply is more inelastic than demand

sellers/producers bear most of the tax burden

Equivalent study-guide shortcut

Who bears more of the tax burden based on demand elasticity?

Back:

• Demand more ELASTIC → Producers bear more

• Demand more INELASTIC → Consumers bear more

Easy memory trick: The more inelastic side gets stuck with more of the tax.

So if consumers can easily change what they buy → producers bear more.
If consumers keep buying even when the price rises → consumers bear more