ECO 20250 - Midterm Exam #1 Review Notes
ECO 20250 - REVIEW for MIDTERM EXAM #1
Chapter 1: Introduction to Microeconomics
Core Concepts:
Scarcity: Resources are limited, necessitating choices.
Tradeoffs: Because of scarcity, choosing one thing means giving up another.
Prices: Mechanisms that allocate scarce resources and reflect values.
Theories and Models: Simplified representations of complex economic phenomena used to understand and predict behavior.
Positive vs. Normative Analysis:
Positive Analysis: Describes objective, factual statements about what is or what will be (e.g., "An increase in price will reduce quantity demanded."). These statements can be tested and confirmed or refuted.
Normative Analysis: Involves subjective value judgments about what ought to be (e.g., "The government should lower taxes."). These statements cannot be proven or disproven.
What is a Market?
A collection of buyers and sellers whose interaction determines the price of a product or set of products.
Types of Markets: Can vary by structure (e.g., perfectly competitive, monopolistic), geographic scope, or product type.
Market Definition: Crucial for understanding competitors, substitutes, and geographic boundaries for policy analysis.
Real vs. Nominal Prices:
Nominal Price (Current Dollar Price): The absolute price of a good, unadjusted for inflation.
Real Price (Constant Dollar Price): The price of a good relative to an aggregate measure of prices, adjusted for inflation to reflect its purchasing power.
How to Convert Nominal Prices to Real Prices:
Using a Price Index (e.g., CPI - Consumer Price Index): Real Price{YearX} = Nominal Price{YearX} \times \frac{CPI{Base Year}}{CPI{Year_X}}
Example: If nominal price in 2020 is 100 and CPI in 2020 is 200, and base year CPI is 100, then real price in 2020 (in base year dollars) is 100 \times \frac{100}{200} = 50.
Using an Inflation Rate to Create a Price Index: If you know the inflation rate, you can construct a price index to deflate nominal prices.
Why Study Microeconomics?
Provides tools for making better business and personal decisions.
Helps understand public policy issues and their implications.
Explains how individual agents (consumers, firms) behave and interact in markets.
Chapter 2: Basics of Supply and Demand
Supply Curve: Shows the quantity of a good that producers are willing to sell at various prices, holding other factors constant (e.g., input prices, technology).
Demand Curve: Shows the quantity of a good that consumers are willing to buy at various prices, holding other factors constant (e.g., income, tastes, prices of related goods).
Variables that Affect Supply and Demand:
Supply: Input prices, technology, government regulations, number of sellers, expectations.
Demand: Income, tastes/preferences, prices of related goods (substitutes, complements), population, expectations.
Calculations and Analysis:
Market Clearing Price and Quantity (Equilibrium): The price and quantity at which the quantity demanded equals the quantity supplied. Graphically, it's the intersection of the supply and demand curves.
To calculate: Set the supply equation equal to the demand equation and solve for price (P), then substitute P back into either equation to find quantity (Q).
Effect of Demand or Supply Shift on Equilibrium: A shift in either curve will lead to a new equilibrium price and quantity. For example, an increase in demand (rightward shift) will increase both equilibrium price and quantity, assuming an upward sloping supply.
Equation of a Demand or Supply Curve: Can often be linear, like QD = a - bP (demand) or QS = c + dP (supply).
Analyzing Graphs: Be able to describe in words how shifts in demand and supply affect market price and quantity (e.g., "An increase in supply, all else equal, will lead to a lower equilibrium price and a higher equilibrium quantity.").
The Market Mechanism:
The tendency in a free market for price to change until the market clears (quantity demanded equals quantity supplied).
Excess Demand (Shortage): When quantity demanded exceeds quantity supplied at a given price. This pushes prices up until equilibrium is restored.
Excess Supply (Surplus): When quantity supplied exceeds quantity demanded at a given price. This pushes prices down until equilibrium is restored.
Elasticities of Supply and Demand: Measures the responsiveness of quantity demanded or supplied to a change in another variable.
Price Elasticity of Demand (EP^D): Percentage change in quantity demanded resulting from a 1% change in price. EP^D = \frac{\%\Delta QD}{\%\Delta P} = \frac{\Delta QD/QD}{\Delta P/P} = \frac{P}{QD} \frac{\Delta Q_D}{\Delta P}
The value is typically negative, but economists often refer to its absolute value.
|E_P^D| > 1 : Demand is elastic (quantity demanded is very responsive).
|E_P^D| < 1 : Demand is inelastic (quantity demanded is not very responsive).
|E_P^D| = 1 : Demand is unit elastic.
Price Elasticity of Supply (EP^S): Percentage change in quantity supplied resulting from a 1% change in price.
EP^S = \frac{\%\Delta QS}{\%\Delta P} = \frac{\Delta QS/QS}{\Delta P/P} = \frac{P}{QS} \frac{\Delta Q_S}{\Delta P}Extreme Cases of Demand Elasticity:
Infinitely Elastic Demand: Consumers will buy an unlimited amount at a single price, but nothing at all if the price rises even slightly. The demand curve is horizontal (E_P^D = -\infty).
Completely Inelastic Demand: Consumers will buy a fixed quantity regardless of the price. The demand curve is vertical (E_P^D = 0).
Elasticity Along a Linear Demand Curve: For a linear demand curve, elasticity is not constant; it becomes more elastic at higher prices and less elastic at lower prices.
Income Elasticity of Demand (EI^D): Percentage change in quantity demanded resulting from a 1% change in income. EI^D = \frac{\%\Delta Q_D}{\%\Delta I}
Normal Goods: Have a positive income elasticity (E_I^D > 0). Consumers buy more as income rises.
Inferior Goods: Have a negative income elasticity (E_I^D < 0). Consumers buy less as income rises.
Cross-Price Elasticity of Demand (E{PM}^D): Percentage change in quantity demanded of good X resulting from a 1% change in the price of good Y. E{PM}^D = \frac{\%\Delta QX}{\%\Delta PY}
Substitutes: Have a positive cross-price elasticity (E{PM}^D > 0). An increase in the price of Y increases demand for X.
Complements: Have a negative cross-price elasticity (E{PM}^D < 0). An increase in the price of Y decreases demand for X.
Short-run vs. Long-run Elasticities:
Demand: For many goods, demand is more price-elastic in the long run than in the short run (e.g., consumers have more time to find substitutes or change consumption habits). For durable goods, demand can be more elastic in the short run as consumers defer purchases.
Supply: Supply is typically more price-elastic in the long run than in the short run, as firms have more time to adjust production capacity.
Effects of Price Controls:
Government-imposed limits on prices, such as price ceilings (maximum prices) or price floors (minimum prices).
Price Ceiling: If set below the equilibrium price, it creates a shortage (quantity demanded > quantity supplied).
Price Floor: If set above the equilibrium price, it creates a surplus (quantity supplied > quantity demanded).
Chapter 3: Consumer Behavior
Consumer Preferences: How consumers rank different bundles of goods.
Assumptions about Consumer Preferences:
Completeness: Consumers can compare and rank all possible bundles of goods. For any two bundles A and B, a consumer can state if A is preferred to B, B is preferred to A, or if they are indifferent between A and B.
Transitivity: If a consumer prefers bundle A to B, and B to C, then they must prefer A to C. This ensures consistency in preferences.
More is Better (Non-satiation): Consumers always prefer more of a good to less. This means goods are desirable, and consumers are never satisfied.
Indifference Curves: A curve representing all bundles of goods that provide a consumer with the same level of satisfaction (utility).
Why they slope downward: To maintain the same level of utility, if you have less of one good, you must have more of another. This is due to the "more is better" assumption.
Why they are convex to the origin: Reflects the principle of diminishing Marginal Rate of Substitution (MRS). As you consume more of one good, you are willing to give up less and less of the other good to obtain an additional unit of the first.
Marginal Rate of Substitution (MRS): The absolute value of the slope of the indifference curve. It measures the maximum amount of one good a consumer is willing to give up to obtain one additional unit of another good, while remaining equally satisfied.
Extreme Cases of Indifference Curves:
Perfect Substitutes: Two goods for which the MRS of one for the other is constant. Indifference curves are straight lines (e.g., green apples and red apples for some people).
Perfect Complements: Two goods for which the MRS is zero or infinite; the goods must be consumed in fixed proportions. Indifference curves are L-shaped (e.g., left shoes and right shoes).
Indifference Maps: A set of indifference curves describing a person's preferences for all combinations of two goods. Indifference curves in a map do not cross because crossing would imply a contradiction of the transitivity assumption and "more is better."
Utility: A numerical score representing the satisfaction that a consumer gets from a given market basket.
Utility Functions: A formula that assigns a level of utility to each market basket (U(X,Y)).
How Utility Relates to Indifference Curves: All points on the same indifference curve yield the same utility level. Higher indifference curves represent higher levels of utility.
Ordinal Ranking vs. Cardinal Ranking:
Ordinal Ranking: Orders baskets of goods by preference from most to least preferred (e.g., U1 > U2 > U_3). The magnitude of the utility difference does not matter, only the ranking.
Cardinal Ranking: Assigns actual numerical values to utility, allowing for comparisons of the intensity of preferences (e.g., basket A gives twice as much utility as basket B). Microeconomics primarily uses ordinal utility.
Budget Constraints: The limits consumers face as a result of limited incomes.
Equation of the Budget Line: Represents all combinations of goods for which the total amount of money spent is equal to income.
PX X + PY Y = I where PX and PY are prices of goods X and Y, and I is income.Relation to the Graph of the Budget Line: The budget line is a straight line, with the intercepts representing the maximum amount of each good that can be purchased if all income is spent on that good (I/PX on the X-axis, I/PY on the Y-axis).
Slope of Budget Line: The negative of the ratio of the prices of the two goods (Slope = -PX/PY). This represents the rate at which a consumer can trade one good for another in the market.
Effect of a Change in Income: A change in income causes a parallel shift of the budget line. An increase in income shifts it outward; a decrease shifts it inward.
Effect of a Change in Price of One Good: A change in the price of one good causes the budget line to pivot. If P_X decreases, the X-intercept moves outward, but the Y-intercept remains the same, making the line flatter.
Consumer Choice: How consumers select the optimal bundle of goods given their preferences and budget constraint.
Optimal Choice (Interior Solution): The point on the budget line that provides the greatest utility, meaning it is preferred to all other points on the budget line.
At the optimal choice, the slope of the budget line equals the slope of the indifference curve: MRS = PX/PY.
This means the rate at which a consumer is willing to trade one good for another (MRS) is equal to the rate at which they can trade them in the market (price ratio).
Corner Solution: Occurs when a consumer chooses to consume only one of the two goods, where the optimal consumption bundle is at one of the axes.
In this case, the MRS might not equal the price ratio. Instead, the MRS for the consumed good must be greater than or equal to the price ratio if the consumer is not forced to consume the other good (MRS \ge PX/PY if only X is consumed, or MRS \le PX/PY if only Y is consumed).
Implies that a consumer is unwilling to give up enough of the consumed good to obtain a tiny amount of the other good at the market price.
Example: Spending all money on college if there's a constraint on expenditure.
Revealed Preferences: The idea that choices a consumer makes when facing different budget lines can tell us the shape of their indifference curves.
By observing actual choices, we can infer preferences, relying on the assumptions of "more is better" and transitivity. If consumer chooses bundle A when B is affordable, A is (revealed) preferred to B.
Marginal Utility (MU): The additional satisfaction obtained from consuming one extra unit of a good.
Principle of Diminishing Marginal Utility: As more units of a good are consumed, the additional utility gained from each successive unit decreases.
MRS and Marginal Utility: The Marginal Rate of Substitution can also be expressed as the ratio of the marginal utilities:
MRS = \frac{MUX}{MUY} (the amount of Y given up for an additional X while maintaining utility).Optimal Choice in terms of Marginal Utility: At the optimal choice, the ratio of the marginal utilities equals the ratio of the prices:
\frac{MUX}{MUY} = \frac{PX}{PY}
This can be rearranged to:
\frac{MUX}{PX} = \frac{MUY}{PY}
This means that utility is maximized when the marginal utility per dollar of expenditure is the same for all goods. The consumer is getting the same amount of extra satisfaction from the last dollar spent on each good.
Chapter 4: Individual and Market Demand
Effect of Price Change on Optimal Choice:
Price-Consumption Curve (PCC): Traces the utility-maximizing combinations of two goods as the price of one good changes. By connecting the optimal points at different prices, this curve can be derived.
Slopes upward for complements: As price of one good falls, the demand for the complementary good increases (e.g., price of coffee falls, more coffee is bought, more milk is bought).
Slopes downward for substitutes: As price of one good falls, the demand for the substitute good decreases (e.g., price of beef falls, more beef is bought, less chicken is bought).
Derivation of the Individual Demand Curve: The individual demand curve for a good can be derived directly from the price-consumption curve. By plotting the price of one good against the quantity demanded of that good (from the PCC points), you get the individual demand curve.
Effect of Income Change on Optimal Choice:
Income-Consumption Curve (ICC): Traces the utility-maximizing combinations of two goods as income changes. Also known as the Engel Curve for a pair of goods.
Positive slope: Both goods are normal goods (as income increases, consumption of both goods increases).
Negative slope: One good is an inferior good (as income increases, consumption of one good increases, while consumption of the other (inferior) good decreases).
Derivation of a Shift in the Individual Demand Curve: An income-consumption curve (or the income changes it represents) directly derives shifts in the individual demand curve. For a normal good, an increase in income shifts the demand curve to the right; for an inferior good, it shifts it to the left.
Engel Curves: Relate the quantity of a good consumed to an individual's income, holding prices constant. Derived from the ICC, it plots income on the vertical axis and quantity of a good on the horizontal axis.
Income and Substitution Effects of a Price Change: When the price of a good falls, its real price goes down, making consumers feel richer (income effect), and it becomes relatively cheaper compared to other goods (substitution effect).
Substitution Effect: The change in consumption of a good associated with a change in its price, with the level of utility held constant. It shows how a consumer would react to the price change if their real income were compensated to keep them on the initial indifference curve. Graphically, it's shown by rolling the budget line along the same indifference curve until it is parallel to the new budget line (reflecting the new price ratio, but on the original utility level).
Income Effect: The change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant. It represents the impact of the change in real income (purchasing power) on consumption. Graphically, it's shown by a parallel shift from the tangency point on the old indifference curve to the new equilibrium on the higher indifference curve (allowing utility to vary but keeping the new relative prices constant).
Total Effect: Sum of Substitution Effect and Income Effect (Total \ Effect = Substitution \ Effect + Income \ Effect).
Income Effect characteristics:
May be negative for an inferior good (as purchasing power increases, less of the inferior good is consumed).
Is almost never larger than the positive substitution effect (except for Giffen goods, which are rare and where the income effect for an inferior good is so strong it outweighs the substitution effect, leading to an upward-sloping demand curve).
Market Demand: The horizontal sum of all individual demand curves.
To obtain the market demand curve, sum the quantities demanded by all individuals at each price level.
Demand Elasticity and Total Expenditure: The relationship between price elasticity and changes in total expenditure (or total revenue for firms).
Inelastic Market Demand (|E_P^D| < 1): If demand is inelastic, a percentage increase in quantity demanded is less than the percentage decrease in price. Therefore, total expenditure on the good increases when price increases, and decreases when price decreases.
Elastic Market Demand (|E_P^D| > 1): If demand is elastic, the percentage increase in quantity demanded is greater than the percentage decrease in price. Therefore, total expenditure on the good decreases when price increases, and increases when price decreases.
Unit Elastic Market Demand (|E_P^D| = 1): Total expenditure remains unchanged with a change in price.
The Trick! For elastic goods, price and total expenditure move in opposite directions; for inelastic goods, price and total expenditure move in the same direction.
Consumer Surplus: The difference between the maximum amount a consumer is willing to pay for a good and the actual amount they pay.
Calculation: Graphically, it is the area of the triangle under the demand curve and above the market price line.
Measurement: Can be measured for an individual consumer (using their individual demand curve) or for all consumers in a market (using the market demand curve).
Network Externalities: When the demand of different consumers are interdependent; a consumer's demand is influenced by the purchases of other consumers.
Can be positive or negative.
Bandwagon Effect (Positive Network Externality): Occurs when a consumer's demand for a good increases because other people are also consuming it. This makes the demand curve more elastic (or less inelastic) and shifts it outward.
Snob Effect (Negative Network Externality): Occurs when a consumer's demand for a good decreases because many other people are consuming it. Consumers desire to own exclusive or unique goods. This effect makes the demand curve less elastic (or more inelastic) and shifts it inward.
Congestion Effect (Negative Network Externality): Similar to the snob effect, but typically refers to goods/services becoming less valuable as more people use them (e.g., crowded roads, overused public services).