Microeconomics Flashcards

Production Possibilities Frontier (PPF) and Opportunity Cost

• Definition of Production Possibilities Frontier (PPF): A curve showing the maximum production output possible for an entity given its available resources and current technology.

• Shape and Curvature of the PPF:

  • The PPF usually bows outward (concave to the origin).

  • This outward curvature occurs because resources are not equally suited at making all types of goods.

  • To produce more of one good, an economy must shift resources away from producing another good. The resources transferred first are those best suited for the new output, but as production increases further, increasingly ill-suited resources must be transferred, increasing the cost of additional units.

• Numerical Schedule (Tandem Bikes vs. Beer):

  • Combination A: $0$ Tandem Bikes, $15$ Cases of Beer

  • Combination B: $1$ Tandem Bike, $14$ Cases of Beer

  • Combination C: $2$ Tandem Bikes, $12$ Cases of Beer

  • Combination D: $3$ Tandem Bikes, $9$ Cases of Beer

  • Combination E: $4$ Tandem Bikes, $5$ Cases of Beer

  • Combination F: $5$ Tandem Bikes, $0$ Cases of Beer

• Production Regions on the PPF Graph:

  • Feasible but Inefficient: Any point inside the frontier (shaded pink region). Resources are either underutilized, unemployed, or allocated inefficiently.

  • Efficient: Any point directly on the PPF curve (blue line and plotted points A through F). All resources are fully and optimally utilized.

  • Infeasible Production: Any point outside the frontier (shaded red region). Output combinations that cannot be attained with currently available resources and technology.

• Slope and Opportunity Cost:

  • The slope of the PPF represents the opportunity cost of producing Good X in terms of Good Y.

  • Opportunity cost of Good X is how much of Good Y must be given up to obtain one additional unit of Good X.

  • Opportunity Cost Formula:         $OC_x = \frac{\Delta y}{\Delta x} = \frac{\text{y/hr}}{\text{x/hr}} = \frac{\text{hrs/x}}{\text{hrs/y}}$

• Shifts vs. Rotations of the PPF:

  • $PPF_0$: Represents the original frontier.

  • Shifts of the PPF: Technological development or increased total economic resources shift the entire PPF outward ($PPF_1$). Conversely, resource depletion or widespread destruction shifts the PPF inward.

  • Rotations of the PPF: Education, training, or sector-specific technological advances in a single product rotate the curve outward along that specific product's axis.

    • Beer Training: Increases maximum potential beer output while leaving maximum bike capacity unchanged, rotating the top of the curve outward along the vertical (beer) axis.

    • Bike Training: Increases maximum potential bike output while leaving maximum beer capacity unchanged, rotating the right side of the curve outward along the horizontal (tandem bikes) axis.

Market Equilibrium Mechanics and Disequilibrium

• Fundamental Market Definitions:

  • Quantity Demanded ($Q_D$): A specific point on the demand curve; the exact amount of a good or service that customers are willing and able to buy at a particular price.

  • Quantity Supplied ($Q_S$): A specific point on the supply curve; the exact amount of a good or service that sellers are willing and able to sell at a particular price.

  • Demand: The entire relationship between price and quantity demanded across all price levels.

  • Demand Schedule: A tabular representation showing the specific relationship between price and quantity demanded.

  • Market Demand: The horizontal summation of all individual consumer demand curves in a given market. To find market demand algebraically, isolate quantity ($Q$) on one side of each individual demand equation and sum them together.

  • Competitive Market: A market structure in which there are so many buyers and sellers that no single individual or firm has the power to influence the market price.

• Economic Principles Governing Demand:

  • Law of Demand: As price rises, quantity demanded falls. This inverse relationship is driven by three underlying factors:

    1. Substitution Effect: When the price of a good rises, buyers switch to buying relatively cheaper substitute goods.

    2. Income Effect: A higher price reduces buyers' purchasing power, rendering them unable to afford as many units.

    3. Diminishing Marginal Benefit: Each additional unit consumed provides progressively less extra satisfaction or utility; therefore, buyers are only willing to purchase more if the price falls.

  • Law of Supply: As price rises, quantity supplied increases, because higher market prices make additional production more profitable.

• Economic Functions of Market Prices:

  1. Signals: Prices convey information to buyers and sellers about relative scarcity and market conditions.

  2. Incentives: Higher prices reward production expansion; lower prices encourage consumption.

  3. Rationing: Prices allocate scarce goods to buyers who value them most highly.

• Producer/Buyer Misalignment and Disequilibrium Dynamics:

  • Excess Supply (Surplus) ($P > P^*$):

    • Sellers want to sell output at quantity $Q_S$ at price $P$, but buyers are only willing to buy quantity $Q_D$ at price $P$.

    • Since trades require a willing buyer, $Q_{\text{transacted}} = Q_D$.

    • Because $Q_D < Q_S$, $Q_{\text{transacted}} < Q_S$, creating an excess supply (surplus).

    • Natural Convergence: Unsold goods create an incentive for suppliers to lower prices. At lower prices, suppliers produce less and consumers demand more, pushing the market toward equilibrium ($P^<em>, Q^</em>$).

  • Excess Demand (Shortage) ($P < P^*$):

    • Buyers want to purchase quantity $Q_D$ at price $P$, but sellers are only willing to supply quantity $Q_S$ at price $P$.

    • Since trades require a willing seller, $Q_{\text{transacted}} = Q_S$.

    • Because $Q_S < Q_D$, $Q_{\text{transacted}} < Q_D$, creating an excess demand (shortage).

    • Natural Convergence: Competition among buyers for scarce goods encourages sellers to raise prices. Higher prices reduce quantity demanded and increase quantity supplied until equilibrium ($P^<em>, Q^</em>$) is restored.

Determinants of Demand and Supply Shifts

• Distinction Between Movements and Shifts:

  • Change in Own Price: Causes a movement along an existing supply or demand curve, changing the quantity demanded ($Q_D$) or quantity supplied ($Q_S$).

  • Change in Non-Price Factors: Causes a shift of the entire supply or demand curve, establishing a new quantity traded at every price point.

• Determinants of Demand Shifts (Acronym: PEPTIC):

  1. Prices of Related Goods:

     • Substitutes: An increase in the price of Good Y increases demand for Good X (shifts demand right). Cross-price elasticity $E_{XY} > 0$. Example: Coke and Pepsi.

     • Complements: An increase in the price of Good Y decreases demand for Good X (shifts demand left). Cross-price elasticity $E_{XY} < 0$. Example: Printers and ink.

  2. Expectations: Expecting future prices to rise increases current demand (shifts right); expecting future price drops decreases current demand (shifts left).

  3. Preferences and Tastes: Favorable shifts in consumer tastes increase demand (shifts right).

  4. Income:

     • Normal Goods: Income increases $\rightarrow$ Demand shifts right ($E_I > 0$).

     • Inferior Goods: Income increases $\rightarrow$ Demand shifts left ($E_I < 0$). Examples: Instant ramen, bus rides, store-brand goods.

  5. Congestion / Network Effects: Positive network effects increase demand as consumer usage expands.

  6. Type and Number of Buyers: An increase in total buyers in the market shifts market demand to the right.

• Determinants of Supply Shifts:

  1. Input Prices (wages, raw materials, energy): Higher input costs increase marginal production costs, shifting supply to the left. Lower input costs shift supply to the right.

  2. Technology and Productivity: Improvements in production technology lower unit production costs, shifting supply to the right.

  3. Prices of Related Outputs (Substitutes in production): If the market price of an alternative product rises (e.g., Android chargers vs. iPhone chargers), firms shift production capacity to the alternative good, decreasing supply of the current good (shifts left).

  4. Expectations: If sellers expect higher future market prices, they hold back current inventory, decreasing supply today (shifts left). Expecting lower future prices encourages selling more immediately (shifts right).

  5. Number of Sellers: Entry of new firms increases market supply (shifts right); exit of firms decreases supply (shifts left).

  6. Taxes, Subsidies, and Government Regulation: Excise taxes increase production costs (shifting supply left); government subsidies offset costs (shifting supply right).

Welfare Economics, Taxes, Subsidies, and Deadweight Loss

• Surplus Definitions:

  • Consumer Surplus (CS): The net gain to consumers, calculated as the difference between maximum willingness to pay (demand curve) and actual market price paid.

  • Producer Surplus (PS): The net gain to producers, calculated as the difference between actual price received and minimum cost of production (supply curve).

  • Total Surplus (TS): The sum of net economic benefits generated by the market.

  • Total Surplus Formula:         $TS = CS + PS - DWL$

• Deadweight Loss (DWL):

  • The loss of total economic surplus that occurs when a market operates away from its competitive equilibrium quantity ($Q^*$).

  • Represents uncaptured mutually beneficial economic transactions.

  • Production efficiency occurs when a market produces where Marginal Social Benefit equals Marginal Social Cost ($MSB = MSC$).

• Economic Impact of Taxes:

  • An excise tax creates a financial wedge between the price paid by buyers ($P_B$) and the price received by sellers ($P_S$).

  • Price Equation:         $P_B = P_S + \text{Tax}$

  • Total Tax Revenue Collected:         $\text{Tax Revenue} = \text{Tax Amount} \times Q_{\text{tax}}$

  • Tax Burden Division (Incidence):

    • Buyer Tax Burden: $P_B - P^*$

    • Seller Tax Burden: $P^* - P_S$

    • The actual burden of a tax depends on the relative elasticities of supply and demand, not on which party is legally designated to pay the tax.

  • Welfare Effect: Taxes suppress production below $Q^*$, creating a Deadweight Loss (DWL) from underproduction.

• Economic Impact of Subsidies:

  • A subsidy acts as a negative tax, raising the price received by sellers ($P_S$) above the price paid by consumers ($P_B$).

  • Total Subsidy Cost to Government:         $\text{Government Subsidy Cost} = \text{Subsidy Amount} \times Q_{\text{subsidy}}$

  • Welfare Effect: Subsidies force production past the social equilibrium $Q^*$, creating Deadweight Loss (DWL) from overproduction because units are produced where $MC > MB$.

• Goods Sold at Misaligned Price and Quantity ($P_1, Q_1$):

  • When transactions take place at arbitrary or regulated price and quantity levels ($P_1, Q_1 eq P^<em>, Q^</em>$), total economic surplus is curtailed and deadweight loss is created.

Price Elasticity of Demand and Supply

• Price Elasticity of Demand ($E_D^P$):

  • Measures the responsiveness of quantity demanded to changes in price.

  • Standard Formula:         $E_D^P = \frac{\% \Delta Q}{\% \Delta P}$

  • Midpoint Method (% Change Formula):         $\% \Delta = \frac{\text{New} - \text{Old}}{\frac{\text{New} + \text{Old}}{2}}$

• Elasticity Classifications:

  • Elastic: $|E_D^P| > 1$ (Quantity demanded changes by a greater percentage than price).

  • Unit Elastic: $|E_D^P| = 1$ (Quantity demanded changes by the exact same percentage as price).

  • Inelastic: $|E_D^P| < 1$ (Quantity demanded changes by a smaller percentage than price).

• Extreme Cases:

  • Perfectly Elastic Demand ($E = \infty$): Graphically represented as a horizontal line at price $P^<em>$. Sellers can sell any quantity at $P^</em>$, but zero quantity at any price above $P^*$.

  • Perfectly Inelastic Demand ($E = 0$): Graphically represented as a vertical line at quantity $Q^*$. Consumers will pay any price to obtain the given fixed quantity.

• Slope vs. Elasticity on a Linear Demand Curve:

  • Flatter curves (slope closer to 0) are relatively more elastic; a small change in price (small $\Delta P$) leads to a large change in quantity (large $\Delta Q$).

  • Steeper curves are relatively more inelastic.

  • Along a single downward-sloping linear demand curve, elasticity varies continuously:

    • Upper Section: Elastic ($|E_D^P| > 1$).

    • Midpoint: Unit Elastic ($|E_D^P| = 1$).

    • Lower Section: Inelastic ($|E_D^P| < 1$).

• Total Revenue (TR) and Elasticity Link:

  • Total Revenue Equation:         $TR = P \times Q$

  • Total Revenue reaches its absolute maximum at the midpoint of the demand curve, where demand is unit elastic ($E_D^P = -1$).

  • Elastic Region: Lowering price increases Total Revenue; raising price decreases Total Revenue.

  • Inelastic Region: Raising price increases Total Revenue; lowering price decreases Total Revenue.

• Market Adjustments and Policy Selection:

  • Steep Curve (Inelastic): Prices adjust significantly while quantities remain relatively fixed.

  • Shallow Curve (Elastic): Quantities adjust significantly while prices remain relatively stable.

Income and Cross-Price Elasticity

• Income Elasticity of Demand ($E_I$):

  • Measures how quantity demanded responds to changes in consumer income.

  • Formula:         $E_I = \frac{\% \Delta Q}{\% \Delta \text{Income}}$

  • Classification Criteria:

    • Inferior Goods ($E_I < 0$): Demand falls as income rises (e.g., instant ramen, bus rides, store-brand goods).

    • Normal Goods ($E_I > 0$): Demand rises as income rises.

      • Necessity Goods ($0 < E_I < 1$): Demand rises less than proportionally with income (e.g., basic groceries, electricity).

      • Luxury Goods ($E_I > 1$): Demand rises more than proportionally with income (e.g., vacations, designer goods, new cars).

• Cross-Price Elasticity of Demand ($E_{XY}$):

  • Measures how the quantity demanded of Good X changes when the price of Good Y changes.

  • Formula:         $E_{XY} = \frac{\% \Delta Q_X}{\% \Delta P_Y}$

  • Classification Criteria:

    • Substitutes ($E_{XY} > 0$): An increase in $P_Y$ leads to an increase in $Q_X$ (consumers substitute away from Y to X; e.g., Coke and Pepsi).

    • Complements ($E_{XY} < 0$): An increase in $P_Y$ leads to a decrease in $Q_X$ (goods are consumed jointly; e.g., printers and ink).

    • Independent Goods ($E_{XY} = 0$): Changes in $P_Y$ have no effect on $Q_X$.

Determinants of Elasticity for Demand and Supply

• Determinants of Demand Price Elasticity:

  1. Availability of Close Substitutes: Goods with many substitutes have more elastic demand. For example, demand for a specific brand of red cars is highly elastic because other car colors and models are close substitutes; however, overall demand for all cars is much less elastic due to fewer overall transport substitutes.

  2. Passage of Time: Demand becomes increasingly elastic over longer time horizons. For instance, when gasoline costs rise, consumers cannot adjust immediately, but over time they can relocate closer to work or purchase electric vehicles.

  3. Luxuries versus Necessities: Luxury items have highly elastic demand, whereas necessities have inelastic demand. Life-saving medication is highly inelastic, while bakery apple pies are elastic because apples and bakery items are non-essential.

  4. Definition of the Market: Narrowly defined markets (e.g., sweet crisp apples) have higher price elasticity than broadly defined markets (e.g., all food).

  5. Willingness to Engage in Search: The more willing consumers are to spend time searching for alternative deals, the higher the price elasticity of demand.

• Determinants of Supply Price Elasticity:

  1. Availability of Inputs: Increased availability of critical inputs makes production easier to expand, increasing the elasticity of supply.

  2. Inventories: Firms carrying larger stockpiles or inventory on hand can react swiftly to price increases, making supply more elastic.

  3. Extra Capacity: Higher excess production capacity within existing facilities leads to greater price elasticity of supply.

  4. Ease of Entry and Exit: Markets with low entry and exit barriers display significantly more elastic supply.

  5. Time Horizon: Supply is considerably more elastic over long time horizons than short ones.

Market Efficiency, Market Failures, and Externalities

• Value vs. Price:

  • Value: The total private benefit or utility a consumer derives from a good or service.

  • Price: The monetary sum required to acquire the good or service.

• Economic Analysis and Principles:

  • Positive Analysis: Objective description and explanation of economic phenomena, predicting what is or what will happen.

  • Normative Analysis: Value-based judgments describing what should or ought to happen.

  • Efficiency-Equity Trade-off: Interventions designed to make economic outcomes fairer or more equal (equity) often reduce total economic output or efficiency.

  • Pareto Efficiency: Achieved when no individual can be made better off without making at least one other person worse off.

• Causes of Market Failure:

  • A market failure occurs when private market allocation produces an inefficient equilibrium output, failing to maximize total surplus.

  • Primary Causes:

    1. Externalities: Uncompensated third-party effects arising from private transactions.

       • Negative Externalities: Unintended external costs imposed on third parties (e.g., second-hand smoke, pollution).

       • Positive Externalities: Unintended external benefits conferred on third parties (e.g., vaccinations establishing herd immunity).

    2. Public Goods: Non-rivalrous and non-excludable goods that suffer from free-rider problems where individuals consume without paying (e.g., national defense).

    3. Common-Property Resources: Rivalrous but non-excludable resources that suffer from overconsumption and degradation (e.g., open-ocean fisheries, clean air).

    4. Market Power: Monopoly or oligopoly power where sellers restrict output and set price above marginal cost ($P > MC$).

    5. Imperfect/Asymmetric Information: Situations where one party possesses superior information relative to another (e.g., used car sales).

    6. Irrationality: Cognitive biases preventing rational choice.

    7. Government Regulations: Imposed constraints such as price controls or statutory quotas (strict upper limits on transaction volumes).

• Marginal Social Cost and Benefit Framework:

  • Marginal Private Benefit (MPB): Extra value a consumer receives per additional unit; defines the private demand curve.

  • Marginal Private Cost (MPC): Extra cost incurred by a supplier per additional unit; defines the private supply curve.

  • Marginal External Cost (MEC): Additional uncompensated cost imposed on society per unit.

  • Marginal External Benefit (MEB): Additional uncompensated benefit enjoyed by society per unit.

  • Marginal Social Cost (MSC):         $MSC = MPC + MEC$

  • Marginal Social Benefit (MSB):         $MSB = MPB + MEB$

  • Market vs. Social Efficiency: Private markets produce where $MPC = MPB$. Social efficiency requires producing where $MSC = MSB$.

• Government Corrective Instruments:

  • Pigouvian Tax: A tax levied on an activity producing negative externalities, set equal to $MEC$, internalizing the externality and shifting production down to $Q_{\text{optimal}}$.

  • Pigouvian Subsidy: A subsidy granted to an activity producing positive externalities, set equal to $MEB$, expanding production up to $Q_{\text{optimal}}$.

The Coase Theorem and Private Solutions

• The Coase Theorem: In the absence of transaction costs, private bargaining between affected parties will reach an economically efficient outcome regardless of how legal property rights are initially assigned.

• Barriers to Private Bargaining (Why Bargaining Fails in Practice):

  1. Large Numbers of Affected Parties: When externalities impact millions (e.g., regional air pollution), coordination and communication costs make bargaining impossible.

  2. Free-Rider Problem: Individuals withhold payment for collective bargaining, expecting others to finance the solution.

  3. Identification and Property Right Ambiguity: Inventions or pollutants cannot easily be traced to specific actors, or legal boundaries are unclear.

  4. Bargaining Frictions: High legal expenses, holdout tactics, and asymmetric information (disagreements over valuation) disrupt private deals.

Core Foundations: Choice, Advantage, and Specialization

• The Interdependence Principle: Individual decision-making depends fundamentally on four interconnected factors:

  1. Choices between alternative internal options.

  2. Choices made by other individuals in the market.

  3. Developments across other related markets.

  4. Expectations regarding future events.

• The Marginal Principle:

  • Decision-makers should continue engaging in an economic activity as long as Marginal Benefit exceeds or equals Marginal Cost ($MB \ge MC$).

  • Optimal choice occurs exactly where $MB = MC$.

• Absolute vs. Comparative Advantage:

  • Absolute Advantage: The ability of an individual or entity to produce more total output using the same input volume, or to produce a given output volume using fewer inputs.

  • Comparative Advantage: The ability to produce a good at a lower opportunity cost than potential trade competitors.

  • Specialization Rule: Entities achieve maximal economic efficiency by specializing strictly in the production of goods in which they hold a comparative advantage.

• Terms of Trade (Price Range for Specialization):

  • When two parties agree to specialize and trade, the mutually beneficial exchange price for Good X must settle strictly between the opportunity costs of the two parties:         $\text{Opportunity Cost}_{\text{Party 1}} < \text{Price of X} < \text{Opportunity Cost}_{\text{Party 2}}$