Midterm 2 Study Guide
Midterm 2 Study Guide
Chapter 5: Consumers and Incentives
Key Concepts to Focus On:
The Buyer’s Problem
Understand the three main components that influence consumer decisions:
Tastes and Preferences: This refers to what the consumer likes, which shapes their choices in purchasing goods.
Prices of Goods and Services: The cost of the goods impacts consumer choices; consumers will evaluate if the pricing is within their budget.
Budget: The total amount of money available for spending affects the range of goods and services a consumer can purchase.
The consumer's problem is to decide what to buy in order to maximize their benefit given the prices and the budget they face.
Budget Constraint and Opportunity Cost
Familiarize yourself with the concept of the budget set: this represents the limited combinations of goods a consumer can purchase with their income.
Budget constraint: This defines the combinations of goods that exhaust the income available to a consumer. It is crucial to differentiate it from the budget set, which may include combinations that do not use all income.
Understand opportunity cost: This is the value of the next best alternative that is given up when making a decision. An example includes giving up buying a sweater to afford more jeans.
Marginal Benefit and Consumer Choice
Learn about marginal benefit: The additional satisfaction or benefit (measured in dollars) a consumer derives from consuming one more unit of a good.
To maximize TOTAL benefit, consumers should equate the MARGINAL benefit per dollar spent across different goods, known as the equilibrium condition.
Know the principle of diminishing marginal benefit: This indicates that as the quantity of a good consumed increases, the additional benefit received from each extra unit diminishes.
Consumer Surplus
Consumer surplus is defined as the difference between what a consumer is willing to pay for a good and what they actually pay for it.
Be capable of computing consumer surplus from graphical representations or numerical data provided.
Elasticities
Price elasticity of demand: This measures how much the quantity demanded changes when the price of a good changes.
Elastic demand: Refers to large changes in quantity demanded for small price changes.
Inelastic demand: Refers to small changes in quantity demanded for large price changes.
Cross-price elasticity of demand: Evaluates how the demand for one good changes in response to a price change in another good.
Substitute goods: Exhibit positive cross-price elasticity.
Complementary goods: Exhibit negative cross-price elasticity.
Income elasticity of demand: Measures how demand for a good changes as consumer income changes.
Normal goods: Show positive income elasticity.
Inferior goods: Show negative income elasticity.
Budget Sets and Graphs
Review the mechanisms by which changes in prices or income shift the budget constraint.
Interpret the budget line effectively and understand the implications of price or income changes on it, resulting in inward and outward shifts.
Maximizing Consumer Benefit
Understand how consumers allocate their budgets to maximize benefit by equating the marginal benefit per dollar spent across all goods they purchase.
Engage in practice problems to resolve scenarios calculating the optimal quantities of goods under varying budget constraints.
Law of Demand
Review the Law of Demand principles: as price increases, the quantity demanded decreases, and vice versa, holding constant other factors affecting quantity demanded like income, tastes, and expectations.
Familiarize yourself with how shifts in demand are represented visually on a demand curve.
Things to Practice:
Calculating marginal benefits from provided tables of data.
Comparing marginal benefit per dollar spent across different goods to evaluate consumer spending adjustments.
Computing consumer surplus from graphical depictions or numerical values.
Calculating price elasticity of demand, cross-price elasticity, and income elasticity, while interpreting their implications.
Analyzing the effects of price or income changes on the budget constraint and resulting consumer choices.
Chapter 6: Sellers and Incentives
Key Concepts to Focus On:
Perfectly Competitive Markets
Understand the three key characteristics of perfectly competitive markets:
Many buyers and sellers: No single participant can influence the market price significantly.
Identical products: Goods and services offered in this market are homogeneous or commodities.
Free entry and exit: Firms can enter or leave the market without barriers, impacting long-run equilibrium.
In this market structure, sellers are price takers, meaning they must accept the market price rather than setting their own prices.
The Seller’s Problem
To maximize profits, sellers must solve the following three key problems:
Production decision: Determining the method of producing goods using available inputs.
Cost management: Assessing what it costs to produce goods, considering short-run versus long-run costs.
Output decision: Deciding the optimal production level to maximize profit.
Short-Run vs Long-Run
Short-run: At least one factor of production (such as capital) remains fixed, while firms can adjust certain inputs (e.g., labor).
Long-run: All inputs, including capital, are variable, allowing for more flexible adjustments by firms.
Marginal Product of Labor
Marginal product is defined as the additional output generated by employing one more unit of labor. Initially, marginal product can increase due to specialization, but declining returns can occur due to the law of diminishing marginal returns.
Be familiar with negative marginal product, where increasing the number of workers actually decreases total output.
Costs of Production
Total cost (TC): Represents the sum of variable costs (VC) (costs that change with production levels) and fixed costs (FC) (costs that remain unchanged with production levels).
Understand the distinctions between average total cost (ATC), average variable cost (AVC), and marginal cost (MC).
Marginal cost (MC): The change in total cost that arises from producing an additional unit of output. This is critical for determining the profit-maximizing output level.
Recognize that fixed costs are unavoidable in the short run, while variable costs fluctuate with production levels.
Profit Maximization
A firm maximizes profit by producing the quantity at which marginal cost (MC) equals marginal revenue (MR). For perfectly competitive firms, it holds that MR = Price (P).
Analyzing profit scenarios:
If price > ATC, the firm earns economic profits.
If ATC > Price > AVC, the firm faces losses yet should continue production in the short run.
If price < AVC, a firm should halt production in the short run to mitigate losses.
The critical relationship revealed is that the MC curve symbolizes the supply curve for a producer in a competitive market.
In a perfectly competitive market, producers are price takers; they cannot influence the price and can only opt for how much to produce at the given price.
For profit maximization, firms produce the output quantity where MC = P.
At any market price level, firms will offer quantities where MC equals the price. Conclusively, the upward increase in the marginal cost curve above AVC represents the supply curve for producers, indicating production levels at varying prices.
Shutdown Point: A firm will not provide output under pricing below AVC, as it won’t cover variable costs, making the marginal cost curve above AVC represent the firm’s supply curve in the short-run.
Supply and Elasticity of Supply
Elasticity of supply measures the responsiveness of quantity supplied concerning price changes.
Elastic supply: Significant changes in quantity supplied for small price changes.
Inelastic supply: Minimal change in quantity supplied for substantial price variations.
The supply curve maintains close ties to the firm’s marginal cost curve beyond AVC.
Producer Surplus
Producer surplus quantifies the difference between the market price and the minimum price a firm is willing to accept, essentially representing additional profit above the firm's minimal acceptance price (marginal cost).
Economies of Scale
Economies of scale: As firms increase production, the average total cost (ATC) decreases because fixed costs become spread over a larger output.
Diseconomies of scale: Increasing production beyond a certain point may raise ATC, typically due to managerial inefficiencies.
Constant returns to scale: ATC remains unchanged even as output increases.
Long-Run Competitive Equilibrium
In the long run, should firms gain economic profits, the market sees new entry (increasing supply leading to lower prices until profits reach zero).
Conversely, losses prompt exit from the market, reducing supply and raising prices until remaining firms break even.
Things to Practice:
Graph Interpretation: Understand how to read cost curves (MC, ATC, AVC) and identify profit-maximizing output levels.
Marginal Cost and Profit Maximization: Engage in practice for calculating marginal cost and determining output levels that maximize profits.
Shutdown Decision: Apply the shutdown rule in real scenarios (produce if P > minimum AVC; shut down if P < minimum AVC).
Elasticity Calculations: Practice determining price elasticity of supply with various market examples.
Producer Surplus Calculation: Develop skills in calculating producer surplus with graphs or data analysis.
Chapter 7: Perfect Competition and the Invisible Hand
Key Concepts to Focus On:
The Invisible Hand and Market Efficiency
Understand Adam Smith's concept of the invisible hand, which suggests that individuals pursuing their self-interest, in competition, naturally leads to an effective allocation of resources within a free market.
The invisible hand drives the market towards maximizing social surplus—the combined benefit of consumer and producer surplus, thereby ensuring resource allocation conforms to the best use.
Pareto efficiency is reached when no individual can be improved without detriment to another. In a perfectly competitive equilibrium, resources are allocated efficiently.
Perfect Competition and Market Dynamics
Know the defining characteristics of a perfectly competitive market:
Many buyers and sellers: No single actor can sway market price significantly.
Homogeneous products: Goods available from diverse sellers are identical (referred to as commodities).
Free entry and exit: Firms can freely join or exit the market, influencing equilibrium over the long term.
Within these markets, firms become price takers and must comply with market equilibrium pricing.
Equilibrium Adjustments and Supply Curve Shifts
In the short run, firms incurring losses will exit, resulting in reduced market supply, which shifts the supply curve left, leading to price increases until the remaining firms break even.
In contrast, if firms realize economic profits, new entrants will increase supply, shifting the supply curve rightward, decreasing prices, and driving profits to zero.
Marginal Cost and Supply Curve
The marginal cost (MC) curve, situated above the average variable cost (AVC), signifies the supply curve for firms operating in a competitive marketplace.
Firms strategize to produce to the quantity satisfying MC = Price (P), satisfying profit-maximizing conditions.
The supply curve reflects the willingness of firms to supply additional units, provided that the price surpasses the marginal cost of production.
Price and Market Surplus
At the equilibrium price, the quantity demanded equates to the quantity supplied, which results in maximizing social surplus.
Instead, if prices descend below equilibrium, a shortage manifests, leading to inefficient resource allocation and deadweight loss, characterized by the decrease in total surplus resulting from market interruptions like price controls or taxes.
Deadweight loss: It signifies the loss of potential social surplus due to market inefficiencies.
Reservation Values and Market Transactions
The reservation value is understood as the minimum price a seller is ready to accept, or the maximum a buyer is willing to pay for a commodity.
Trading occurs in competitive markets when the buyer's reservation value meets or exceeds that of the seller, ensuring mutually beneficial exchanges.
Efficiency vs. Equity
Efficiency pertains to the maximization of total production or enlarging the economic