Microeconomics Review

Tips for Test

• Two-thirds of your grade comes from the multiple choice section, while the other third comes from the Free Response Questions (FRQ).

• There are roughly 60 multiple choice questions, and you are given about 70 minutes to complete them.

• The FRQ consists of one long question and two short questions, for which you are given roughly 60 minutes to complete them.

• Topics covered:
    - 8%-14% - Basic economic concepts
    - 55%-70% - Nature and functions of product markets
    - 10%-18% - Factor Markets
    - 12%-18% - Market Failure and the role of the government

• Score information:
    - To earn a 5, you must score 80% or higher on the exam.
    - To earn a 4, you must score 60% or higher.
    - To earn a 3, you must score 50% or higher.
    - To earn a 2, you must score 33% or higher.
    - To earn a 1, you must score 0% or higher.

• On multiple choice, pace yourself accordingly and avoid spending too long on one question.

• If in doubt, graph it out.

• There is no penalty for wrong answers, so attempt every question, guessing if necessary.

• Beware of choices that use extreme words like "always", "never", "rarely", or "none", as these are often incorrect.

• Stay positive when considering answer choices, but be cautious of negative phrasing like "not" or "except"; in these cases, choose the negative alternative.

• Read questions carefully, analyze them, and simplify if necessary to avoid confusion.

• The difficulty generally increases in the second half of the test; manage your time to confidently answer easier questions first.

• For FRQs, consistency points are available; even if you make a numeric error, correct steps can earn credit.

• Remember to label graphs clearly with your P’s and Q’s.

• Concise answers are crucial; remember that this is not an English exam, so lengthy essays are unnecessary.

• Always include a graph where required, as it is beneficial.

• Show your work if required by the question, and provide written explanations or direct answers as appropriate.

• Prepare for questions on the four market structures, focusing on perfect competition, monopoly, and monopolistic competition; oligopoly may appear in one of the short questions.

• Any course topic is fair game for the two short questions, so study comprehensively!

What is Economics?

• Economics is a social science focused on how resources are used and optimized.

Macroeconomics vs. Microeconomics

• Macroeconomics: Studies economic issues affecting the nation as a whole.

• Microeconomics: Examines economic issues faced by individuals and businesses within the economy.

Positive vs. Normative Economics

• Positive Economics: Employs the scientific method; involves forming and testing hypotheses.

• Normative Economics: Involves value judgments about how things ought to be.

Resources

• Defined as anything used to produce goods or services.

• Key resource categories include:
    - Land: All natural resources.
    - Labor: Human attributes that contribute to productivity.
    - Capital: Productive equipment/machinery.

Opportunity Cost

• Defined as what is sacrificed to obtain something else.
    - Example: The opportunity cost of studying for 2 hours includes two hours of Netflix that were sacrificed.
    - Formula: $\text{Opportunity Cost of Good X} = \frac{\Delta \text{Good Y}}{\Delta \text{Good X}}$

Production Possibility Curve (PPC)

• Illustrates the combinations of two goods produced with the economy’s resources.

• Key points on the curve include:
    - Points below the curve: possible but inefficient.
    - Points on the curve: possible and efficient.
    - Points above the curve: impossible without resource increase.

• Factors affecting the PPC:
    - Shifts in technology or resources cause curve shifts (right for increases, left for decreases).

• Note: Unemployment shifts the point on the curve without changing the curve itself.

• Types of opportunity costs include constant and increasing opportunity costs:
    - Increasing opportunity costs are more common due to inefficiencies in resource allocation when shifting production focus.

Comparative Advantage and Absolute Advantage

• Comparative Advantage: Refers to specialization improving productivity.

• Absolute Advantage: Exists when one party can produce both goods more efficiently than others.

Important Distinction

• Comparative Advantage is not the same as Absolute Advantage.

• A party cannot possess both advantages in both goods.

Economic Systems

• Market: A mechanism for buyers and sellers to exchange goods/services.

• Law of Supply: An increase in product price results in increased quantity supplied.

• Law of Demand: An increase in product price results in decreased quantity demanded.

Economic Types

• Command Economy: Central government determines production, pricing, and distribution; often associated with communism/socialism.

• Capitalism: Prices in a free market are determined by supply and demand.

• Allocative Efficiency: Optimal deployment of resources ensuring correct product amounts meet consumer demands.

• Mixed Economy: Combines elements of government control and capitalist mechanisms.

Circular Flow Diagram

• Demonstrates household-firm interactions and resource/product flow.

Supply and Demand

• Changes in demand or supply cause shifts in their respective curves, while changes in quantity demanded or supplied only result from price adjustments.

• Market Equilibrium: Condition where quantity demanded equals quantity supplied, determining price and output.

Demand Clarifications

• Demand: Quantity a consumer purchases at a given price.

• The Law of Demand presents an inverse relationship between price and demand.

Effects of Price Changes

• Income Effect: Lower prices increase consumers’ purchasing power.

• Substitute Effect: An increase in one good's price boosts demand for substitutes.

Determinants of Demand - SPICE Mnemonic

• S: Substitute Goods

• P: Preferences/Population

• I: Income

• C: Complementary Goods

• E: Expectations

• Substitute Goods: Direct relationship where price increase of one leads to demand increase of another.

• Preferences: Direct relation; as preference grows, demand increases.

• Population: More consumers result in higher demand.

• Income:
    - Normal Good: Increased income raises demand.
    - Inferior Good: Increased income reduces demand.

• Complementary Goods: Price rise of one leads to demand drop of the other (inverse relation).

• Expectations: Anticipated price increases lead to current demand increases (direct relationship).

Supply Dynamics

• Supply: Quantity produced at a specific price; characterized by a direct relationship per the Law of Supply.

Determinants of Supply - COTTEEN

• C: Cost of Inputs

• O: Opportunity cost of Alternatives

• T: Technologies

• T: Taxes and Subsidies

• E: Expectations

• N: Number of Sellers

• Cost of Inputs: Price increase leads to decreased supply (inverse relation).

• Opportunity Cost: Firms choose outputs for maximum profit.

• Technology: Improved technology raises supply.

• Taxes and Subsidies: Tax increase decreases supply; subsidies raise it.

• Expectations: Future price increases lead to current supply decreases (inverse relationship).

• Number of Sellers: More competition drives supply up (direct relation).

Market State Definitions

• Surplus: Occurs above equilibrium when supply exceeds demand.

• Shortage: Occurs below equilibrium when demand exceeds supply.

• Ceteris Paribus: Assumes all other conditions remain constant; useful for analysis.

• Price Ceiling: Maximum legal price imposed by government.

• Price Floor: Minimum legal price set by government.

Elasticity and Taxation

• Total Revenue (TR) Test:
    $TR = P \times Q$

• Types of Elasticities:
    - Unit Elastic: Price increase matches quantity decrease; TR remains constant.
    - Elastic Demand: Price increase results in more than proportionate quantity decrease, reducing TR.
    - Inelastic Demand: Price increase results in less than proportionate quantity decrease, increasing TR.
  

Formulae

• Price Elasticity of Demand:
    $\text{Price Elasticity of Demand} = \frac{\%\Delta Q_d}{\%\Delta P}$

• Price Elasticity of Supply:
    $\text{Price Elasticity of Supply} = \frac{\%\Delta Q_s}{\%\Delta P}$

Elasticity Coefficient Values

• Perfectly Inelastic: 0

• Relatively Inelastic: <1

• Unit Elastic: 1

• Relatively Elastic: >1

• Perfectly Elastic: Infinity

Cross-Price Elasticity of Demand

• Indicates percentage demand change for one good due to price change of another.

• Negative indicates complementary goods; positive indicates substitute goods.

• Formula:
    $\text{Cross-Price Elasticity} = \frac{\%\Delta Q_d \text{ of Good Y}}{\%\Delta P \text{ of Good X}}$

Periods of Adjustment

• Short Run: Supply lacks full adjustment to demand changes; leads to price rises.

• Long Run: More choices available, yielding greater consumer sensitivity to price changes; demand becomes more elastic.

Necessities and Income Elasticity

• Necessities often exhibit inelastic demand regardless of price.

• Income Elasticity of Demand: Reflects how quantity demanded shifts with consumer income.

• Positive sign indicates a normal good; negative sign indicates an inferior good.

• Formula:
    $\text{Income Elasticity} = \frac{\%\Delta \text{Consumption}}{\%\Delta \text{Income}}$

Supply, Costs, and Production

• Accounting Profit: Total revenues minus explicit costs.

• Average Fixed Cost (AFC):
    $\text{AFC} = \frac{\text{Total Fixed Cost}}{\text{Output}}$

• Average Product (AP):
    $\text{AP} = \frac{\text{Total Output}}{\text{Variable Input}}$

• Average Total Cost (ATC): Sum of Average Variable Costs (AVC) and AFC.

• Average Variable Cost (AVC):
    $\text{AVC} = \frac{\text{Total Variable Cost}}{\text{Output}}$

• Diseconomies of Scale: Increasing output leads to higher long-run average total cost.

• Economic Profit: Total revenues minus both explicit and implicit costs.

• Excise Tax: Tax imposed on specific products per unit sold.

• Fixed Costs: Constant costs that don’t change with quantity in the short run.

• Law of Diminishing Marginal Returns: Increasing output leads to diminishing returns.

• Long Run: Time frame where supply fully adjusts to demand changes.

• Lump-Sum Tax: Tax of a fixed amount per firm, affecting average fixed and total costs.

• Marginal Cost (MC):
    $MC = \frac{\Delta \text{Total Cost}}{\Delta ext{Output}}$

• Marginal Product (MP): Increase in output from adding one more input.
    $MP = \frac{\text{Change in Output}}{\text{Change in Input}}$

• Normal Profit: Revenue that neither benefits nor harms the entrepreneur.

• Per-Unit Tax: Tax on each unit produced, affecting variable costs and MC.

• Short Run: Time frame where supply doesn’t fully adjust to demand.

• Total Costs (TC): Sum of fixed and variable costs.
    $TC = \text{Total Variable Costs} + \text{Total Fixed Costs}$

• Variable Costs: Costs that rise with production.

Product Markets

• Monopolistic Competition: Medium-sized firms differentiate products via innovation and marketing.

• Monopoly: A single firm dominates the market with no close substitutes.

• Oligopoly: Few sellers are interdependent in price control.

• Perfect Competition: Many sellers provide a homogeneous product, ensuring infinite elasticity for prices.

Market Structure Characteristics

• Price Takers: Firms without power to control prices must accept market price.

• Price Makers: Firms with market power control prices above marginal costs for profit maximization.

Perfect Competition

• Economic Efficiency: Resources allocated to productive uses that satisfy demand.

• Profit-Maximizing Criterion:
    $\text{Marginal Revenue} = \text{Marginal Cost}$

• Shut-Down Point: If the price drops below average variable cost, firms should cease operations.

• Demand Function:
    $\text{Price} = \text{Marginal Revenue}$

• Socially Optimal Price:
    $\text{Price} = \text{Marginal Cost}$

• Long-Run Condition:
    $\text{Price} = \text{Minimum Average Cost}$

• Formula for profit/loss:
    $( ext{Price} - ext{Average Total Cost}) imes ext{Output}$

Monopoly

• Herfindahl Index: Measures market concentration via the sum of squared market shares.

• Natural Monopolies: Enjoy cost advantages allowing lower pricing than competitors.

• Price Discrimination: Charge different prices to different consumers for the same product.

• Socially Optimal Pricing: Government sets prices to ensure allocative efficiency.

• Fair-Return Pricing: Regulation allows monopoly to break even and earn normal profits.

• Unregulated Monopoly: Operates at a profit-maximizing quantity, leading to underproduction and overpricing.

• Regulated Pricing at Fair-Return Price:
    $\text{Price} = \text{Average Total Cost}$

• Regulated Pricing at Socially Optimal Price:
    $\text{Price} = \text{Marginal Cost}$

Imperfect Competition

• Cartel: Group of firms collaborating not to compete.

• Collusion: Usually illegal agreements on pricing and production.

• Dominant Strategy: Player’s optimal choice irrespective of rivals' actions.

• Game Theory: Examines tactical decisions firms make like players in a game.

• Prisoner’s Dilemma: Each party’s individual rational choice leads to a worse outcome than mutual cooperation.

Monopolistic Competition Characteristics

• Easy market entry

• Product differentiation

• Combines advertising with non-price competition

• Inefficiencies like excess capacity

• Exists with many buyers/sellers

• Long-run equilibrium attained

• Allocatively inefficient as price exceeds marginal cost

• Common market structure in the U.S.

Nash Equilibrium

• Outcome where all players select the best strategy considering rivals’ choices, reaching the same payoff matrix cell.

Oligopoly Characteristics

• High barriers to entry

• Differentiated products

• Interdependent firms influence price control

• Allocative inefficiency due to price exceeding marginal cost

• Price-making capabilities

• Collusive actions often present

• Competitive behavior influenced by rivals

Resource Markets

• Derived Demand: The need for resources stems from product demand.

• In perfectly competitive labor markets, firms act as price takers due to wage rates being constant.

• Marginal Revenue Product: Represents labor demand.

• Marginal Factor Cost: Represents labor costs.

• Monopsony: A labor market where one buyer exists.

Shifters of Labor Demand

• Product demand changes

• Productivity variations

• Price alterations of alternate resources

Least Cost Rule

• A firm should align labor and capital ratios as such:
    $\frac{MP_l}{P_l} = \frac{MP_k}{P_k}$

Market Failure and Externalities

• Coase Theorem: Suggests private parties can resolve externality issues without government intervention.

• Free-Rider Problem: Public goods provision arises since individuals benefit without payment.

• Gini Coefficient: Income inequality measure ranging from 0 (equal distribution) to 1 (all income to one entity).

• Lorenz Curve: Illustrates total income by household distribution.

• Marginal Social Benefit: Societal gain from product consumption.

• Marginal Social Cost: Societal expense from additional good production.

Types of Externalities

• Negative Externality: A third party shoulders costs, resulting in overproduction.

• Positive Externality: Benefits arise for third parties involved, leading to underproduction.

Goods Types

• Private Goods: Exclusively consumed; consumption by one excludes others.

• Public Goods: Non-exclusive in consumption; one person’s usage does not exclude others.

• Progressive Tax: Rate increases with higher income levels.

• Proportional Tax: Uniform rate irrespective of income.

• Regressive Tax: Tax burden reduces as income increases.