Principles of Microeconomics – Exam 1 Review

A comprehensive set of Q&A flashcards covering core microeconomic concepts from scarcity and opportunity cost through demand & supply analysis and government price controls.

What is the basic definition of economics?

A social science concerned with how individuals, institutions, and society make best choices under conditions of scarcity.

What condition forces individuals and society to make choices?

Scarcity – limited resources restrict options and require choices.

What does the phrase “there is no free lunch” illustrate?

Someone always bears a cost; every choice incurs an opportunity cost.

Define opportunity cost.

The value of the next-best alternative that must be sacrificed to obtain something.

What assumption about human behavior underlies ‘purposeful behavior’?

People make decisions with rational self-interest to achieve desired outcomes.

Is rational self-interest the same as selfishness?

No. Rational self-interest can include personal sacrifices for others.

What is marginal analysis?

Comparing the additional (marginal) benefits and marginal costs of a decision.

List the main steps of the scientific method used in economics.

Observation, hypothesis formulation, testing, acceptance/rejection/modification, continued testing.

What is an economic law or principle?

A statement describing regular economic behavior that allows prediction of probable effects.

What does the ‘other-things-equal’ (ceteris paribus) assumption mean?

All variables except those under immediate consideration are held constant.

Differentiate microeconomics and macroeconomics.

Micro studies individual units (consumers, firms); macro looks at the economy as a whole (aggregates, inflation, unemployment).

What are aggregates in macroeconomics?

Combinations of individual economic units treated as one whole, e.g., total consumer spending.

What is positive economics?

The analysis of facts and cause-and-effect relationships without value judgments.

What is normative economics?

Economics that incorporates value judgments about what the economy ‘should’ be like.

State the economizing problem for individuals.

Unlimited economic wants exceed limited economic means, requiring choices.

What does a budget line illustrate?

All possible combinations of two goods a consumer can buy with a given income at specific prices.

How does an increase in income shift the budget line?

Rightward; a decrease shifts it leftward.

Name the four general categories of economic resources (factors of production).

Land, labor, capital, entrepreneurial ability.

Does ‘capital’ in economics refer to money?

No. Capital refers to produced goods used to produce other goods (machinery, tools, software).

What is investment in economic terms?

Spending that pays for the production of new capital goods or intellectual capital.

What does a production possibilities curve (PPC) show?

The maximum combinations of two goods an economy can produce with full employment and fixed resources/technology.

State the law of increasing opportunity costs.

As production of a good increases, the opportunity cost of producing an additional unit rises, giving the PPC a bowed-out shape.

What condition signals the optimal allocation of resources?

Where marginal benefit equals marginal cost.

What do points inside the PPC represent?

Unemployment or inefficient use of resources.

List three sources of economic growth.

Increases in resource supplies, improvements in resource quality, and technological advances.

How do current choices between capital and consumer goods affect future growth?

More capital goods today shift the future PPC outward faster.

Explain international specialization and trade using the PPC.

It lets nations consume beyond their own PPC by focusing on goods they produce efficiently and trading for others.

What is the fallacy of composition?

Assuming what is true for one individual is true for the group.

Define the post hoc fallacy.

Mistakenly assuming that because event A precedes event B, A caused B.

What is an economic system?

A set of institutional arrangements and coordination mechanisms to solve the economizing problem.

Describe laissez-faire capitalism.

An extreme system with minimal government; markets and prices direct economic activity.

Describe a command system.

Government owns most resources and uses a central plan to guide economic activity.

What is the market (mixed) system?

Most property is privately owned, but government plays a significant role; markets coordinate activity through prices.

Give two key features of a market system that encourage cooperation.

Private property and freedom of enterprise and choice.

What is the main motivating force in a market economy?

Self-interest of households and firms.

Why is competition considered a regulatory mechanism?

It diffuses economic power among many buyers and sellers, preventing any one agent from dictating prices.

Explain the division of labor.

Human specialization where workers focus on specific tasks, exploiting abilities, learning by doing, and saving time.

What problem does money solve compared to barter?

It eliminates the need for a double coincidence of wants, acting as a medium of exchange.

State the five fundamental questions faced by any economy.

What goods and services will be produced? How will they be produced? Who will get the output? How will the system accommodate change? How will the system promote progress?

What does consumer sovereignty mean?

Consumers ‘vote’ with their dollars, ultimately determining which products succeed in the market.

Define creative destruction.

Innovation that creates new products and methods, destroying the market positions of firms wedded to old ways.

According to Adam Smith’s ‘invisible hand’, what happens when firms seek profit?

Their self-interest unintentionally promotes society’s interests by producing what people want efficiently.

List two major problems of command economies identified historically.

Coordination difficulties and lack of incentives leading to shortages or surpluses.

Who are residual claimants in a firm?

Owners, because they receive whatever profit (or loss) remains after all inputs are paid.

State the law of demand.

Other things equal, quantity demanded rises when price falls and falls when price rises.

Why does diminishing marginal utility help explain the downward-sloping demand curve?

Each additional unit consumed yields less extra satisfaction, so consumers buy more only at lower prices.

List three primary determinants of demand besides price.

Tastes/preferences, number of buyers, consumer income (plus prices of related goods and expectations).

What is a normal (superior) good?

A good for which demand increases when consumer income rises.

What is an inferior good?

A good for which demand decreases as consumer income rises.

Differentiate substitute and complementary goods.

Demand for substitutes moves in the same direction as the price of the other good; for complements, demand moves opposite to the price of the other good.

What is the network effect on demand?

Product value rises as more people use it, shifting demand rightward.

What is the congestion effect?

Product value falls as more people use it (e.g., crowded roads), shifting demand leftward.

What is the law of supply?

Other things equal, quantity supplied rises when price rises and falls when price falls.

Name four major determinants of supply (other than price).

Resource prices, technology, taxes/subsidies, producer expectations, and number of sellers.

Define market equilibrium price.

The price at which quantity supplied equals quantity demanded; intentions of buyers and sellers match.

What results when price is above equilibrium?

A surplus (excess supply), causing downward pressure on price.

What results when price is below equilibrium?

A shortage (excess demand), causing upward pressure on price.

What is the rationing function of prices?

Prices adjust to assure that resources and goods are distributed to buyers who value them most.

Differentiate productive and allocative efficiency.

Productive efficiency: goods produced at the lowest cost. Allocative efficiency: resources devoted to the mix of goods most desired by society.

What is a price ceiling and its typical market effect?

A government-set maximum legal price; if below equilibrium, it creates shortages (e.g., rent controls).

What is a price floor and its typical market effect?

A government-set minimum price; if above equilibrium, it creates surpluses (e.g., minimum wage, farm supports).