microeconomics - final exam

What is GDP?

Market value of all final goods and services produced in an economy in a given period.

What are the three approaches to measuring GDP?

Production, Income, Expenditure (PIE)

What is GDP per capita?

GDP per capita = GDP ÷ Population

What is disposable income?

Disposable Income = Total Income – Taxes + Government Transfers

Why is GDP per capita not equal to disposable income?

GDP per capita excludes taxes and transfers; disposable income includes them.

What is the 'History’s Hockey Stick'?

A sharp rise in GDP per capita after long stagnation, due to economic transformation.

What are the two key assumptions of the Malthusian model?

• APL ↓ as population ↑

• Population ↑ if APL > subsistence level

What happens when productivity rises in the Malthusian model?

APL ↑ → Population ↑ → APL returns to subsistence level

What is opportunity cost?

Opportunity Cost = Value of the next best alternative foregone

What is economic rent?

Economic Rent = Benefit – (Direct Cost + Opportunity Cost)

What is comparative advantage?

Lower opportunity cost in producing a good compared to others

What is absolute advantage?

Ability to produce more output using the same resources

Why is comparative advantage important?

Specialization based on it increases total output and mutual benefit

Budget Line

Definition:
Represents all combinations of goods where total spending equals income.

Budget Set

Definition:
All affordable combinations of two goods.

Slope of Budget Line

Definition:
Opportunity cost of good X in terms of good Y.

(it’s just the gradient)

Marginal Rate of Transformation (MRT)

Definition:
Rate at which one good can be traded for another in the market.

(just the gradient, again)

Optimal Bundle Condition

Bundle where the highest indifference curve is tangent to the budget line.

Alternative Optimal Bundle Formula

Marginal utility per dollar is equal across goods.

Well-Behaved Preferences

Preferences that are complete, transitive, continuous, monotonic, and convex.

Indifference Curve

Shows all bundles that provide equal utility to the consumer.

Property: Downward sloping, convex to origin (due to diminishing MRS)

Price Change Effect on Budget Line

Price increase pivots budget line inward; decrease pivots outward.

Income Change Effect on Budget Line

Increase shifts line outward (parallel); decrease shifts inward.

Consumption-Leisure Trade-off

Shows trade-off between leisure time (t) and consumption (c)

Hicksian Decomposition

Separates total effect of a price change into substitution and income effects.

Substitution Effect

Change in consumption due to a change in relative prices, holding utility constant.

Income Effect

Change in consumption due to change in purchasing power.

Inferior Good

Demand decreases as income increases.

Giffen Good

Price increase leads to increased demand due to a strong negative income effect.

Condition: Must be an inferior good where income effect > substitution effect.

MRS > MRT?

Consumer values good more than market → consume more of that good.

Perfect complements?

Consumed in fixed ratio (e.g., left & right shoes), L-shaped indifference curves.

Perfect substitutes?

Goods can fully replace each other. Indifference curves are straight lines.

How does a SmartCard (with food-only spending) affect budget constraints?

It creates a kinked budget line because a portion of income is restricted to food, altering the shape of feasible consumption.

What effect does the JobSeeker payment have?

It increases income when not working, shifting the budget line outward at the leisure end, possibly increasing chosen leisure time.

What happens when the wage increases?

• Substitution effect: leisure becomes more expensive → consume less leisure.

• Income effect: higher income → consume more of both leisure and goods.

In a wage increase scenario, how are total effects broken down?

• Substitution effect: from C to B

• Income effect: from A to C

• Total effect: from A to B

What are quasi-linear preferences?

Preferences where one good has linear utility, meaning income changes affect only one good. Income effect on leisure is zero.

Is the substitution effect always negative for price increases?

Yes, generally. A price rise leads to less consumption of the now more expensive good due to convex indifference curves.

Is the income effect always positive for normal goods?

Yes. More income generally leads to more consumption of both goods—unless the good is inferior.

What is Game Theory?

The study of strategic interactions where each player's outcome depends on others' actions.

Define strategic interaction.

A situation where each person's action affects others and vice versa.

What is a strategy in Game Theory?

An action or set of actions a person may choose in a strategic interaction.

List components of a game.

Players, feasible strategies, order of play, information, payoffs.

What is a dominant strategy?

A strategy that yields a better outcome regardless of what others do.

What is a dominated strategy?

A strategy that always yields a worse outcome than another.

What is a Nash Equilibrium?

A set of strategies where no player can benefit by changing theirs unilaterally.

Define Pareto Efficiency.

An outcome where no one can be made better off without making someone else worse off.

Example of a Prisoner's Dilemma game?

Two prisoners decide to stay silent or talk; dominant strategy is to talk.

What is the key dilemma in a Prisoner’s Dilemma?

Mutual cooperation gives better outcome but players choose to undercut.

How can cooperation be sustained in public goods games?

Via altruism/social norms or repeated interactions with future rewards/punishments.

What are institutions in economics?

Institutions are the rules of the game, which include constraints (who can do what, when) and incentives (how actions affect payoffs).

What do institutions affect in economic games?

They affect the allocation outcomes and determine who gets what and why.

What is the Ultimatum Game (Game 1)?

Player 1 proposes a split of $10; Player 2 accepts or rejects. If rejected, both get $0.

What is the Dictator Game (Game 2)?

Player 1 decides the split of $10; Player 2 has no say and must accept.

How does power differ in Game 1 vs Game 2?

Player 2 has greater bargaining power in Game 1 due to the ability to reject offers.

What is structural power?

It's the value of a person’s next best alternative. It limits and defines what each person can get.

What is bargaining power?

It determines what each player gets between their minimum and maximum possible outcome.

What is the Pareto Criterion?

Allocation A Pareto dominates B if at least one person is better off and no one is worse off. A Pareto-efficient allocation cannot be dominated.

Does Pareto efficiency guarantee fairness?

No, it only means no one can be made better off without making someone else worse off.

What is procedural fairness?

It evaluates how outcomes are generated—e.g., was the process voluntary, discriminatory, or forced?

What is outcome-based fairness?

It judges what people got—e.g., income, happiness, distribution of goods.

What is Rawlsian fairness?

It uses the "veil of ignorance": decide what's fair without knowing your role.

Which game is more efficient: one with accepted unfair offers or rejected fair ones?

The one with accepted unfair offers is efficient but may not be fair.

What are the three institutional cases discussed?

1. Forced labor

2. Take-it-or-leave-it contract

3. Bargaining in a democracy

What is Pareto efficiency?

A state where no one can be made better off without making someone else worse off.

Is Pareto efficiency always fair?

No, an outcome can be efficient but still unfair (e.g., all surplus going to one person).

What does the Gini coefficient measure?

Income inequality. Ranges from 0 (perfect equality) to 1 (perfect inequality).

What is joint surplus?

Total economic rent from trade, split depending on bargaining power.

What is the trade-off between efficiency and fairness?

More fair outcomes may be less efficient; negotiations or laws may balance both.

gini coefficient formula?

• List incomes → e.g. Angela = 15, Bruno = 31

• Average difference = ∣31−15∣ = 16

• Average income = (15+31)/2=23

• Gini = 0.5×16/23=≈0.35

What is a reservation wage?

The lowest wage at which a person is willing to accept a job.

How is employment rent calculated?

Employment rent = Value of current job − Value of reservation option.

What factors determine the value of a current job?

Wage earned minus the cost of effort.

What factors affect the reservation option's value?

Unemployment benefits, time to find a new job, and utility from free time or job search anxiety.

What is the formula for the no-shirking wage?

• s = Expected number of weeks before being caught shirking.

• h = Total expected time in job if working hard.

What is asymmetric information in labour markets?

Employers can't perfectly observe how much effort workers exert.

Why do firms offer wages higher than the reservation wage?

To discourage shirking by increasing the cost of losing the job (employment rent).

What is an isoprofit curve?

A curve showing all combinations of wage (w) and employment (N) that give the same profit.

What is the profit formula when wages are the only input cost?

Profit = (Revenue per worker − Wage) × Number of workers

Where does a firm set wages to maximize profit?

Where the isoprofit curve is tangent to the no-shirking wage curve.

How is profit calculated?

Profit = Total Revenue − Total Cost

What is Average Cost (AC)?

Average cost = Total cost ÷ Number of items made

(when profit = 0, since you’re breaking even)

What is Marginal Cost (MC)?

Marginal cost = Cost to make one more item (not the sale amount!)

If it costs $14,000 to make one extra car, then
MC = $14,000

What is a Fixed Cost?

Fixed cost = Cost that doesn’t change no matter how much you make

Example:
Rent for your factory = $80,000 whether you make 0 or 100 items.

What is a Variable Cost?

Variable cost = Cost that increases when you make more stuff

Example:
If each car costs $14,000 to build, then making 2 cars = $28,000

What is Elasticity?

Elasticity = How much people change what they buy when price changes

• Elastic: Big change (e.g. cheaper chocolate → buy a lot more)

• Inelastic: Small change (e.g. petrol → still need it even if price goes up)

Zero Profit Condition

Profit is zero when price = average cost

Example:
If it costs $300 to make something, and you sell it for $300,
→ Profit = $0

How Do Firms Maximize Profit?

They pick the best price and quantity where they sell the most and make the most money

They look at:

• What people will pay (demand curve)

• What it costs them (costs)

• Try to land on the best combo

What is a competitive market?

A market with many buyers and sellers of the same good/service, where no single buyer or seller can influence the price.

What is the law of demand?

price of good decreases, demand increases (vice versa)

What is the difference between demand and quantity demanded?

Demand refers to the entire demand curve, while quantity demanded refers to a specific point on that curve at a given price (a given point).

What are complements?

Goods that are typically consumed together. An increase in the price of one decreases the demand for the other.

What are substitutes?

Goods that can replace each other. An increase in the price of one increases the demand for the other.

What are normal goods?

Goods for which demand increases as consumer income increases.

What are inferior goods?

Goods for which demand decreases as consumer income increases.

What causes a shift in the demand curve?

Changes in income, tastes, expectations, number of consumers, and prices of related goods.

What is the law of supply?

price of good increases, quantity supplied increases (vice versa)

Higher prices → More people want to sell → Quantity supplied rises

What causes a shift in the supply curve?

Changes in input prices, technology, expectations, number of producers, and prices of related goods.

What is market equilibrium?

The point where quantity demanded equals quantity supplied.

What is consumer surplus?

The difference between what a consumer is willing to pay and what they actually pay.