AP Microeconomics Exam Review Notes

Unit One: Basic Concepts

• Scarcity: The inability of limited resources to satisfy all wants. If demand exceeds supply at a zero price, the item is scarce, leading to a positive price requiring a trade-off. Scarcity exists because factors of production are scarce.

• Factors of Production: Land, labor, capital, and entrepreneurship.

• Economic Systems:

  • Market-Based Economies: Emphasize private property rights and utilize prices to allocate scarce resources, goods, and services.

  • Command Economies: Government bureaucrats allocate resources, goods, and services.

• Opportunity Cost: The value of the next best alternative not chosen. It represents what is given up when making a choice.

• Production Possibilities Curve (PPC): Illustrates all possible combinations of two goods that can be produced with fixed resources.

  • Linear PPC: Shows constant opportunity costs, indicating resources are perfectly adaptable between producing both goods.

  • Bowed-Out PPC: Shows increasing opportunity costs, indicating resources are not perfectly adaptable; as production of one good increases, the opportunity cost in terms of the other good rises.

  • Productive Efficiency: Any point on the PPC indicates productive efficiency, where resources are fully utilized.

  • Inefficiency: Points within the curve signify inefficiency, indicating idle resources and underutilization (recession and high unemployment in a macro context).

  • Impossibility: Points outside the curve are unattainable due to resource scarcity.

  • Economic Growth: An outward shift of the PPC resulting from an increase in the quality or quantity of resources or increased productivity of those resources.

  • Decrease in Resources: Inward shift of the PPC indicating that the economy cannot produce as much of the two goods due to decrease in the quality or quantity of resources.

• Absolute Advantage: The ability to produce more of a good or the same amount of a good using fewer resources.

  • Output Problem: More production is better.

  • Input Problem: Lower quantities of inputs are better.

• Comparative Advantage: The ability to produce a good at a lower opportunity cost.

  • Output Problem Calculation: Use the "other over" formula: \text{Opportunity cost of A} = \frac{\text{Quantity of B}}{\text{Quantity of A}}

  • Input Problem Calculation: Use the "it over" formula: \text{Opportunity cost of A} = \frac{\text{Quantity of A}}{\text{Quantity of B}}

• Mutually Beneficial Terms of Trade: Fall between the opportunity costs of the involved parties; trade outside this range benefits only one party.

• Marginal Analysis:

  • Marginal: Change in the total.

  • Marginal Benefit: Change in total benefit.

  • Benefit-Maximizing Behavior: Act as long as marginal benefit is greater than or equal to marginal cost. Do not act if marginal benefit is less than marginal cost.

• Utility-Maximizing Combinations:

  • Utility represents the benefit for a consumer.

  • Formula: \frac{\text{Marginal Utility of A}}{\text{Price of A}} = \frac{\text{Marginal Utility of B}}{\text{Price of B}}

  • If one ratio is higher, increase consumption of that item; if lower, decrease consumption.

Unit 2: Supply and Demand

• Law of Demand: Ceteris paribus, consumers buy more at low prices and less at high prices, resulting in a downward-sloping demand curve. A change in price causes movement along the demand curve, affecting quantity demanded only.

• Demand Shifters:

  • Tastes and Preferences

  • Market Size (more consumers increase demand)

  • Prices of Related Goods

    • Substitutes (direct relationship): as the price of one good increases, the demand for the other good increases.

    • Complements (inverse relationship): as the price of one good increases, the demand for the other good decreases.

  • Changes in Income

    • Normal Goods: increased income increases demand.

    • Inferior Goods: increased income decreases demand.

  • Expectations for the Future

• Demand Curve Shifts: Shifts right for an increase in demand and left for a decrease in demand due to factors other than price.

• Reasons for Downward-Sloping Demand:

  • Substitution Effect: As prices increase, consumers buy substitutes.

  • Income Effect: As prices rise, purchasing power decreases, so consumers buy less.

• Law of Supply: There's a direct relationship between price and quantity. At higher prices, producers sell more; at lower prices, they sell less. This creates an upward-sloping supply curve. Price only changes quantity supplied, and such changes are shown as movement along the supply curve.

• Supply Shifters:

  • Input Prices (inverse relationship): as the price of resources increase, the supply curve decreases.

  • Government Tools: taxes (decrease) , subsidies (increase), and regulations (decrease).

  • Number of Sellers (increase in sellers increases supply).

  • Technology (increases supply).

  • Prices of Other Goods Producers Can Produce

  • Producer Expectations

• Effect of Shifts: Supply curve shifts right for an increase and left for a decrease.

• Price Elasticity of Demand: Measures how much a change in price affects quantity demanded.

  • Inelastic Demand: Necessities, few substitutes, or inexpensive items result in a steep demand curve. A large price change leads to a small change in quantity demanded. Consumers are price insensitive.

  • Elastic Demand: Luxury items, many substitutes, or expensive items result in a relatively horizontal demand curve. A small price change causes a large change in quantity demanded.

• Total Revenue Test: Total revenue is calculated by \text{Price} \times \text{Quantity}.

  • Elastic Demand: If price goes down and total revenue goes up (opposite directions).

  • Inelastic Demand: If price goes down and total revenue goes down (same direction).

  • Unit Elastic: No change in total revenue with a change in price.

• Elasticity Coefficients: Calculated using \frac{\text{Percentage Change of Quantity}}{\text{Percentage Change in Price}} .

  • Percentage Change: \frac{\text{New - Old}}{\text{Old}} \times 100

  • Elastic: Absolute value of coefficient is greater than one.

  • Unit Elastic: Absolute value of coefficient equals one.

  • Inelastic: Absolute value of coefficient is less than one.

• Income Elasticity: Measures whether a good is normal or inferior, calculated by \frac{\text{Percentage Change of Quantity}}{\text{Percentage Change of Income}} .

  • Positive Coefficient: Normal good.

  • Negative Coefficient: Inferior good.

• Cross-Price Elasticity: Measures whether goods are substitutes or complements, calculated by \frac{\text{Percentage Change of Quantity}}{\text{Percentage Change in Price of Other Good}} .

  • Positive Coefficient: Substitutes.

  • Negative Coefficient: Complements.

• Market Equilibrium: The intersection of supply and demand curves, where quantity demanded equals quantity supplied. Markets aim for this equilibrium.

  • Surplus: Price above equilibrium, quantity supplied exceeds quantity demanded, and prices fall.

  • Shortage: Price below equilibrium, quantity demanded exceeds quantity supplied, and prices rise.

• Effects of Shifts in Demand/Supply:

  • Increase in Demand: Equilibrium price and quantity increase.

  • Decrease in Demand: Equilibrium price and quantity decrease.

  • Increase in Supply: Price decreases, quantity increases.

  • Decrease in Supply: Price increases, quantity decreases.

• Double Shifts: Graph and analyze conflicting axes to determine the indeterminate variable. For example, with a decrease in supply and an increase in demand, the equilibrium quantity is indeterminate.

• Surplus and Deadweight Loss:

  • Consumer Surplus: Difference between what consumers are willing to pay and what they actually pay. Shown as a triangle above the market price and under the demand curve.

  • Producer Surplus: Difference between the marginal cost of production and the price producers receive. Shown as a triangle below the market price and above the supply curve.

  • Allocative Efficiency: Occurs at equilibrium, maximizing total surplus (consumer + producer surplus), assuming no externalities.

• Deadweight Loss: Results from not reaching equilibrium, indicating inefficiency.
  

• Government Intervention:

  • Binding Price Floor: Set above equilibrium, leading to deadweight loss, increased producer surplus, and surplus quantity.

  • Binding Price Ceiling: Set below equilibrium, leading to deadweight loss, decreased producer surplus, and shortage quantity.

  • Per Unit Tax: Shifts the supply curve vertically by the amount of the tax, creating deadweight loss. The per unit tax is the difference between the price buyers pay (PB) and the price sellers receive (PS).

• Tax Incidence: Less elastic side of the market bears more of the tax burden.

  • Perfectly Elastic Supply: Buyers pay all the tax.

  • Perfectly Inelastic Demand: Buyers pay all the tax.

• International Trade:

  • Domestic demand and supply are compared to world price. If the world price is below the domestic equilibrium, consumers buy at the world price, importing the difference between domestic production and consumption.

  • Tariffs: Raise the world price by the tariff amount, creating tariff revenue but also deadweight loss.

Costs and Perfect Competition

• Law of Diminishing Marginal Returns: As more units of a variable input are added to a fixed input, the marginal product of the variable input eventually decreases.

  • Production Function: Shows the relationship between the quantity of workers and the amount of output. Includes, increasing returns, decreasing returns, and negative returns.

  • Marginal product increases initially, then diminishes, and eventually becomes negative.

• Marginal Cost of Labor: Calculated as the wage divided by the marginal product of labor. The marginal cost curve is an upside-down version of the marginal product curve.

• Short-Run Costs: Include both fixed costs (costs that do not change with the quantity produced) and variable costs (costs that increase as more output is produced).

• Total Costs: Fixed costs plus variable costs.

• Average and Marginal Cost Curves: Average variable cost (TVC/Q), average total cost (TC/Q), and marginal cost intersect at their minimum points.

• Shifting Cost Curves:

  • Fixed Costs: Will only cause the ATC curve to move.

  • Variable Costs: Affect average total cost (ATC), average variable cost (AVC), and marginal cost (MC).

• Long-Run Costs: All costs are variable in the long run.

• Long-Run Average Total Cost Curve:

  • Economies of Scale: Downward sloping; doubling inputs causes more than double output (increasing returns to scale).

  • Constant Returns to Scale: Horizontal portion; doubling inputs causes exactly double output.

  • Diseconomies of Scale: Upward sloping; doubling inputs causes less than double output (decreasing returns to scale).

• Types of Profit:

  • Accounting Profit: Total revenue minus explicit costs (direct money out of pocket).

  • Economic Profit: Total revenue minus explicit and implicit costs (opportunity costs lost).

  • Normal Profit: Occurs when economic profit is zero; accounting profit equals implicit cost.

• Firm Decisions: Firms produce where marginal revenue (MR) equals marginal cost (MC) to maximize profit.

• Perfectly Competitive Markets:

  • Qualities: Many firms, identical products, low barriers to entry, and zero economic profits in the long run. Firms are price takers.

  • Long-Run Equilibrium: ATC is tangent to the marginal revenue and demand curve at the profit-maximizing quantity, so there is zero economic profit.

  • Economic Profit: Attracts new entrants, increasing supply, driving down price, and lowering marginal revenue until firms break even.

  • Economic Losses: Causes firms to exit, decreasing supply, driving up price, until firms break even.

  • Firm's Supply Curve: The marginal cost curve above the minimum of average variable cost. If price falls below the minimum of AVC, the firm shuts down temporarily.

Imperfect Competition

• Includes monopolies, oligopolies, and monopolistic competition.

• Firms often lower prices to sell more, causing marginal revenue to fall faster than price. Imperfectly competitive firms are not allocatively efficient because they price above marginal cost, leading to deadweight loss.

• Monopoly:

  • Qualities: One seller, high barriers to entry, unique good, and price seekers. Has influence over price.

  • Graph: Can earn economic profits in the long run due to barriers to entry. Can be breaking even, or earning economic losses.

  • Efficiency: Not allocatively efficient (deadweight loss) or productively efficient (ATC downward sloping at profit-maximizing quantity).

  • Pricing: Charges higher prices and produces lower quantities than perfectly competitive markets.

  • Perfect Price Discrimination: The marginal revenue curve merges with the demand curve; the firm charges every price along the demand curve until the price of the last unit produced.

• Monopolistic Competition:

  • Qualities: Many sellers, low barriers to entry, differentiated products, and some impact on price.

  • Graph: Looks like a monopoly graph, but firms break even in the long run because the ATC is tangent to the demand curve at the profit-maximizing quantity.

  • Entry/Exit: Economic profits attract new firms, shifting demand to the left until firms break even. Economic losses cause firm exits, increasing demand until firms break even.

• Oligopolies:

  • Qualities: Few sellers, high barriers to entry, differentiated or homogeneous products, and some impact on price.

  • Game Theory: Uses a payoff matrix to understand interdependent strategic behavior between firms.

  • Collusion: The best outcome for both firms, acting like a monopoly.

  • Dominant Strategy: A strategy one player will take regardless of the other player's actions.

  • Nash Equilibrium: The most likely outcome; if either firm changes their decision, they will lose profit.

Factor Markets

• Key Factors: Land (rent), labor (wages), and capital (interest).

• Labor Demand: The marginal revenue product (MRP) of labor. \text{MRP} = \text{Marginal Revenue (Price)} \times \text{Marginal Product of Labor} . The sum of all MRPs constitutes market demand for labor. Businesses are demanders in factor markets.

• Labor Supply: Households' willingness to work; higher wages increase willingness. The supply of labor shifts with the number of workers, their availability, population, age, value of leisure time, etc.

• Market Equilibrium: Intersection of labor demand and supply determines equilibrium wage and quantity of labor.

• Perfectly Competitive Factor Market: The market sets the wage, which becomes the supply curve or marginal resource cost (MRC) for the firm. The firm hires where \text{MRP} = \text{MRC (also called Marginal Factor Cost)}

• Monopsony:

  • Qualities: One buyer of labor in the market with an upward-sloping supply curve.

  • Marginal Resource Cost (MRC): Greater than the supply because hiring more workers requires raising wages for all workers hired. The firm hires where \text{MRC} = \text{MRP} , but pays a wage from the supply curve.

  • Compared to a perfectly competitive market, monopsonies pay lower wages, leading to deadweight loss.

• Least Cost Combinations of Labor/Capital: \frac{\text{Marginal Product of Labor}}{\text{Price of Labor}} = \frac{\text{Marginal Product of Capital}}{\text{Price of Capital}}

  • If one ratio is higher, use more of that resource.

Market Failures

• Socially/Allocatively Efficiency: Marginal Social Benefit (MSB) equals Marginal Social Cost (MSC) at the market quantity. Under or overproduction creates deadweight loss.

• Market w/o Externalities: Equilibrium is allocatively efficient, and a perfectly competitive firm is allocatively efficient because price equals marginal cost. Monopolies have deadweight loss and are inefficient because price is greater than marginal cost.

• Types of Externalities:

  • Occur when costs or benefits affect those not involved in the production or consumption of a good or service. Lead to deadweight loss.

    • Production: Positive (e.g., safety training) or negative (e.g., pollution).

    • Consumption: Positive (e.g., vaccinations) or negative (e.g., cigarettes).

• Negative Externalities in Production: The Marginal Social Cost (MSC) is greater than the Marginal Private Cost (MPC), which is the supply curve. The gap between the two is equal to the marginal external cost, and there is deadweight loss from overproduction.

• Negative Externalities in Consumption: The Marginal Private Benefit (MPB) is greater than the Marginal Social Benefit (MSB). The negative external cost is subtracted from the MPB to derive MSB. There is deadweight loss from overproduction.

• Correcting Negative Externalities: A per-unit tax shifts the supply curve left to approach the socially optimal quantity (QO). Making the tax equal to the external cost aligns the new supply curve with MSC. A tax can also be levied on consumers, which shifts the demand curve to the left.

• Positive Externalities in Consumption: The Marginal Social Benefit (MSB) is higher than the Marginal Private Benefit (MPB). Deadweight loss results from underproduction.

• Positive Externalities in Production: The Marginal Social Cost (MSC) is less than the Marginal Private Cost (MPC) or supply curve. Deadweight loss is from underproduction.

• Correcting Positive Externalities: A per-unit subsidy shifts the demand curve vertically. When the subsidy is equal to the external benefit, the new demand curve equals MSB, eliminating deadweight loss. The subsidy also can be given to producers shifting the supply curve to the right.

• Classifying Goods:

  • Rival: Consumed goods which can't be consumed again (e.g. donut).

  • Non-Rival: Not diminished in quantity/availability when consumed ( ex. digital streaming music).

  • Excludable: Possible to prevent consumption (e.g., a sponsor in an indoor arena).

  • Non-Excludable: Not Possible to prevent consumption (e.g., public fireworks display). Suffer from the free rider problem, leading to underproduction.

• Public Goods: Non-rival and non-excludable (e.g., national defense).

• Government controls on firms:

  • A lump sum tax or subsidy shifts the Average Total Cost (ATC) curve but does not alter the quantity a firm produces, since the marginal cost doesn't move.

  • A per unit tax or subsidy will move the marginal cost and the average total cost accordingly.

• Natural Monopolies: Often regulated by the government. The average total cost curve is downward sloping. If unregulated, they overprice and underproduce causing deadweight loss.

  • Allocative Efficiency: Government sets a price ceiling where marginal cost equals demand. Then the firm is given a lump sum subsidy equal to it's economic losses.

  • Fair Return Price Ceiling: Government sets a price ceiling where average total cost meets the demand. There will still be some deadweight loss, but it will be producing more and the price will then be lower.

• Anti-Trust Legislation: The government may pass to encourage copetition and prevent collusion.

• Lorenz Curve: Shows income distribution. The closer to the line of equality, the more equal the income distribution and the further away, the less equal the distribution.

• The government may categorize taxes by the percentage of income from those who pay:

  • Regressive Taxes: Lower percentage of income from the rich. Sales taxes are regressive.

  • Progressive Taxes: United States income taxes are a prime example. They have a higher percentage of income from the wealthy and set marginal tax rates that increase as income increases.

  • Proportional Taxes: The same percentage of income for rich and poor alike.