My version of an AP Microecon study guide!

Unit 1 - Basic Economic Concepts

1.1 - Scarcity

• Economics is the study of how an individual or an organization manages and allocates their resources effieciently. The need to allocate and organize resources comes from the concept of scarcity.

  • The economic problem states that our needs are unlimited and the resources available are scarce.

  • All resources are limited!
    

• Scarcity : unlimited wants, limited resources (ex: land). Where society does not have enough resources to produce the goods and services which everybody needs. As a consumer, we must make choice as to how to allocate resources properly.

Microeconomics vs Macroeconomics

• Microeconomics: Narrows down to individuals and firms, doesn’t focus on the big picture.

• Macroeconomics: Focuses on the ecnomy as a whole, very big picture.

Factors of Production

• These are resources that are scarce, can be broken down into four categories:

  • Land: natural resources and raw material. Ex: water, oil.

  • Labor: physical labor, skills, and effort. Ex: factory workers

  • Capital: tools used to produce a good. Ex: conveyor belts, hammers, tractors, etc.

  • Entrepreneurship: the ability of an individual to run a business Ex: Sal Khan from Khan Academy

Opportunity Costs and Trade-offs

• Trade-offs: The alternative choice which must be given up in order to make a decision. The goods and services which you do not choose are the trade-offs.

• Opportunity costs: The next best alternative if your first choice is not available.

Positive vs Normative Economics

The study of Economics can be broken down into 2 ways:

• Positive Economics: this approach to economics is based on facts and figures.

• Normative Economics: this approach to economics is based on assumptions.
  

1.2 - Resource Allocation and Economic Systems

• 3 big economic questions:

  • What goods and services will be produced? The economy has to decide what goods and services the society needs in order to properly allocate resources.

  • How will goods and services be produced? This deals with how businesses will go about producing these goods and services.

  • For whom will the goods and services be produced? This question decides who will be able to consume these goods and services, to where these resources where will be allocated.

• Types of Economic Systems

  1. Centrally-Planned (Command) Economic System:

     • Here, the government makes all the economic decisions and answers the three questions on its own. They set the prices for goods and services, as well as set wage rates. They do not respond to consumer wants, and innovation is discouraged.

  2. Market Economic System:

     • Economic changes are guided by the changes in price which occur as individuals and sellers interact in the market. There is a lot of competition and a variety of goods and services. However, there will be a wealth disparity in the market.

  3. Mixed Economic System:

     • A system which has characteristics of both command and market system. There are private property rights which are protected, however, the government is able to intervene.

1.3 - Production Possibilities Curve

• Represents the best possible combinations of goods, given a fixed amount of resources.

  • Illustrates the trade-offs that faces an economy, compares only two goods

  • If the PPC is linear, it has a constant opportunity cost, if it is curved, it has increasing opportunity costs

• Economic growth : a rise in output and an increase in standard of living (can be caused by developments in technology, or an increase in resources)

• Productive efficiency : lowest cost possible on the PPC

• Allocative efficiency : the economy allocates resources so consumers are well off as possible, producing what is demanded

• Constant opportunity cost

  • Occurs when oppurtunity cost stays the same as the production of a good increases.

• Increasing opportunity cost

  • When one good is produced more, you give up more of another good.

Determinants of PPC

• The curve can shift upwards or downwards respectively due to certain factors:

  1. Changes in the amount of resources in the economy:

     • This could be due to changes in the labor force because of population changes, acquirement of new territories (ex: land for farming, mining, etc.), or destruction of territories due to weather conditions, etc.

  2. Changes in technology and productivity:

     • This could be due to government schemes to help farmers for instance or could be due to the usage of inefficient production techniques, etc

  3. Trade:

     • This is dependent on new resources being discovered or improved production techniques.

1.4 - Comparative Advantage and Trade

• Absolute Advantage: When a firm as the ability to produce a higher amount of goods or services in a given time, compared to the others.

• Comparative Advantage: The ability of a firm to produce a good or service at the lowest oppurtunity cost

• Terms of Trade: people split up the work, and provide each other with a good in return for another. It is also the rate at which one good can be exchanged for another (if the price of a good obtained from trade is less than the opportunity cost of producing it, trade is beneficial)

  • Capital goods: goods that make consumer goods (ex: machinery)

  • Consumer goods : goods that are consumed (ex: food)

1.5 - Cost-Benefit Analysis

• Implicit costs: opportunity costs in terms of making a choice, can include money

• Explicit costs: traditional out of pocket costs (ex: rent)

1.6 - Marginal Analysis and Consumer Choice

• Utility: the measure of personal satisfaction (util is a unit of utility)

• Marginal utility: the change in total utility by consumer one additional unit of that good/service

• Principle of diminishing marginal utility : additional units of a good/service add less total utility than the previous units do

• Marginal utility per dollar : MU good ÷ P good (marginal utility of one unit of the good / price of one unit of the good)

• Optimal consumption rule : to maximize utility, marginal utility per dollar spent on each good = service in consumption bundle, MU 1 ÷ P 1 = MU 2 ÷ P 2

Unit 2 - Supply and Demand

All the basics of Supply and Demand which are the foundation of the majority of concepts moving forward.

2.1 - Demand

• Demand: the quantity which a consumer/buyer are willing and able to buy at different prices

  • Movement on the graph: downward sloping

  • Demand slopes down on the graph due to:

    1. Income effect

    2. Substitution effect

    3. law of diminishing marginal utility

• Law of Demand: As price ↑, demand ↓, and as price ↓, demand ↑

• Determinants of demand:

  • Taste and preferences, related goods, income, buyers, expectations

• Substitutes : good/service that can be used in place of another, when price of one increases, consumers will buy more of the other (ex: coffee and tea)

  • Substitution effect: as the price of a good increases, consumers substitute the good with another that is cheaper

• Complements : goods/services that are consumed together (ex: hamburgers and buns)

• Income effect: as income increases, people will buy more of normal goods, and less of inferior goods

• Normal good : increase in demand when consumer’s income increases (ex: oreos)

• Inferior good : increase in demand when consumer’s income decreases (ex: off brand oreos)

• Diminishing marginal utility: As more units of a product are consumed, the satisfaction/utility it provides tends to decline

  • ex: The more glasses of water you drink, the statisfaction you get from drinking each glass starts to decline because you are forcing yourself to drink each glass

2.2 - Supply

• Supply: different quantities of goods/services which sellers are willing and able to produce at a given price

• Law of supply: as price ↑, quantity supplied also ↑, this is a direct relation.

• The market supply shows the quantity a supplier is willing and able to offer at various prices at a given time

Reasons for the Law of Supply

1. Rising prices give greater opportunities to suppliers to earn a profit

2. With every additional unit, suppliers face an increase in the marginal cost of production

   • Charging higher prices provides them with the easiest way to cover the cost

     • The vice versa is also true; lower prices wouldn’t provide the incentive to motivate the supplier and thus reduces the quantity of product

   • The supply curve shifts upward, and the movement along the supply curve indicates a change in price.

• Shifters of supply :

  1. Resource costs and availability

     • The cost of production (land, labor, capital) has an inverse impact on the supply

     • When the cost of these increases, the supplier decides to produce less of the products since they are unable to afford the production cost

  2. Other goods and services

     • Suppliers who produce more than one product (profit-maximizing firms) have an easier time switching to the production of another product if issues do arise in prices

     • ex: A farmer has land where he is able to produce corn and earn a profit

     • If his land is capable to produce wheat as well, in case the price of wheat increases to that of corn, he would switch to wheat production to earn better

     • The supply curve in this situation for wheat would shift outwards(more supply) and vice versa for corn(reduced supply)

  3. Technology

     • Newer technology causes the cost of production to decline and helps improve the efficiency of the supplier

     • This allows the supplier to produce more, shifting the supply curve outwards(toward right)

       • ex: machines on the production line help reduce unit costs due to which more products are affordable by the supplier

  4. Taxes and Subsidies

     • Taxes are added up to the unit cost of production, thus making it more expensive

     • Due to this, heavily taxed products are produced in less quantity by suppliers (supply curve shifts left)

     • Subsidies are the opposite of taxes and help reduce price per unit

     • This allows suppliers to produce more of the product(supply curve shifts right)

  5. Expectation

     • If suppliers expect prices to increase in the future, they would hold back supply for the current time with the future goal of earning more profit later (and vice versa)

  6. Number of sellers

     • As the number of sellers increases in the market, the supply automatically increases

     • This allows consumers more choices at a lower price due to an increase in competition

2.3 - Price Elasticity of Demand

• Equation : %∆Qd / %∆P

  • 0 = perfectly elastic, <1 = inelastic, =1 unit elastic, >1 = elastic

• Midpoint formula : Qd2-Qd1 / (Q2d+Qd1) / 2 , replace with Qd with price for price

• Inelastic demand : TR correlates direct with price

• Elastic demand = TR correlates inversely with price

• Elasticity: how much the Q is affected by P.

  • Elastic demand means that the goods are affected by a change in price.

  • Inelastic demand means that goods are not affected by a change in price.

• Characteristics of Elastic Demand:

  • Flat, quantity is sensitive to price change, substitutes, luxury items, large portion of income, not needed immediately. Is equal to >1.

• Characteristics of Inelastic Demand:

  • Steep, few substitutes, required now, small portion of income, is equal to <1

• Shapes of elasticity/inelasticity

  • Perfectly elastic: infinity

  • Relatively elastic: >1

  • Unit elastic: 1

  • Relatively inelastic: <1

  • Perfectly inelastic: 0

2.4 - Price Elasticity of Supply

• PES: measures how sensitive are sellers to price changes on goods

  • Equation : %∆Qs / %∆P

  • 0 = perfectly elastic, <1 = inelastic, =1 unit elastic, >1 = elastic

  • Inelastic : unable to respond to price change

  • Elastic : short run

  • Extremely elastic : long run

• Characteristics of Inelastic Supply:

  • Difficult production, high costs, hard to change to alternative, high barriers to entry, <1

• Characteristics of Elastic Supply:

  • Easy production, low cost, easy to switch to, low barriers to entry, >1

2.5 - Other Elasticities

• Cross price elasticity of demand : %∆Qd of Good A / %∆P of good B

• Negative = compliments (inferior good), positive = substitutes (normal good)

• Income elasticity of demand : %∆Qd / %∆income

• 1 = income elastic, <1 = income inelastic, negative = inferior, positive = normal

2.6 - Market Equilibrium, Consumer and Producer Surplus

• Equilibrium : occurs when no one is better off doing something else

  • Equilibrium: Price = Quantity

  • Price below the equilibrium is shortage

    

• Consumer surplus : price consumers are willing to pay - actual price

• Producer surplus : actual price -price the producer is willing to sell for

• Demand increase : price and quantity increase

• Demand decrease : price and quantity decrease

• Supply increase : price decreases, quantity increases

• Supply decrease : price increases, quantity decreases

• Double shift : either price or quantity will be unknown. This rule states that when there is a simultaneous shift in both demand and supply, either price or quantity would stay indeterminate

• Deadweight loss (DWL) : transactions that should occur, but don’t because of government intervention (calculate the area: triangle formula, ½ (base x height)

  

2.7 - Market Disequilibrium and Changes in Equilibrium

• Market Disequilibrium:

  • Shortage : Qs < Qd, price is lower than equilibrium

  • Surplus : Qs > Qd, price is above equilibrium
    

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2.8 - Government Intervention in Markets

• Price floor : minimum price a supplier can charge, price is set above equilibrium (causes shortage)

  

• Price ceiling : maximum price a supplier can charge, price is set below equilibrium (causes surplus)

  

• Quota: limit of a quantity that can be bought or sold (known as quantity control)

• License: gives an owner the right to supply a good/service

• Demand price: the price at which consumers will demand that quantity

• Supply price: the price at which producers will supply that quantity

2.9 - International Trade and Public Policy

• Quota rent: difference between demand price and supply price

• Tariffs: tax placed on a good that is imported or exported

• Import quota: restriction on the quantity of a good that can be imported

  

Unit 3 - Production, Cost, and the Perfect Competition Model

3.1 - The Production Function

• Production function : relation between the quantity of inputs a firm uses and the quantity of output it produces.

  • Also related to how firms produce goods using the factors of production (land, labor, capital, and entrepreneurship)

• Key Vocab:

  • Fixed input : an input whose quantity doesn’t change

  • Variable input : an input whose quantity can change

    • Long run : time period in which all inputs can be variable

    • Short run : time period in which at least 1 input is fixed

  • Marginal product : change in overall output when input changes

  • Marginal product of labor (MPL) : ∆Q / ∆L

  • Diminishing marginal returns : as input increases, the output of each input will be less than the previous input

  • Output : quantity produced

  • Rental rate : price of capital

  • Capital : goods that are used to produce goods/services

3.2 - Short-Run Production Costs

• The short run is the period in which at least one of our inputs are fixed.

• The long run looks into costs which aim to minimize our costs.

• This can be measured by:

  • Fixed cost : cost that doesn’t change with amount of output produced (ex: oven)

  • Variable cost : cost that changes with amount of output produced

  • Total cost : fixed cost + variable cost

  • Marginal cost : cost difference of one additional unit of output (∆TC / ∆Q)

  • Average fixed cost (AFC) : FC / Q

  • Average variable cost (AVC) : VC / Q

  • Average total cost (ATC) : TC / Q

3.3 - Long-Run Production Costs

• In the long run, all inputs are variable

  • Long run average total cost (LRATC) : same as short run ATC, but bigger

  • Economies of scale : LRATC declines as output increases

  • Diseconomies of scale : LRATC increases as output increases

  • Constant returns to scale : output increase directly in proportion to an increase in all inputs (ex: input doubles, output also doubles)

3.4 - Types of Profit

• Profit is the excess revenue that a business gets to keep.

  • Economic profit : revenue - (explicit cost + implicit cost)

  • Accounting profit : revenue - explicit cost

  • Implicit cost : not an actual cost, a cost that you could’ve been earning (ex: if you own a restaurant, the implicit cost would be the salary you would have earned as being a chef working in a different restaurant)

  • Marginal Revenue: additional revenue gained by producing one more unit

3.5 - Profit Maximization

• The profit maximising point for a firm is where it aims to increase revenue due to costs possibly being high as well.

  • MR = MC

  • If you cannot have MR=MC, MR>MC

• The firms aim to produce where MR = MC due to the fact that all profits are earned without overshooting and gathering additional costs.

• These calculations help a firm understand how much it must produce in order to maximize their profits.

3.6 - Firms’ Short-Run Decision to Produce and Long-Run Decisions to Enter or Exit a Market

• Firms need to be able to know when to enter the market, as well as when to end production (entry and exit)
  

• Short Run:

  • Shutdown rule : as long as P > AVC, continue to produce

  • If AVC > P : shutdown

  • Firms can make profit or losses

• Long Run :

  • Exit rule : if P < ATC, exit the market

  • Firms make normal profit ($0), unless monopoly or oligopoly

• Shut down rule: a firm should not produce unless it can cover its variable costs. If it is not able to do so, firms are better off producing nothing. However, this only tends to happen in perfect competition)

  • Perfect competition occurs when P<AVC at MR = MC)

  • As a result, this leads to long term adjustments in the long run where equalities in the market make a normal profit

3.7 Perfect Competition

• In perfect competition, many identical firms are competing at a constant market price. This market has low barriers, meaning any firm is able to enter and exit the market in the long run.

  • Firms in this market are price takers, who are firms which cannot charge a higher price than the equilibrium price. This means that they have no market power.

• Long run will have normal profit

• Short run can have either profit or loss

Unit 4 - Imperfect Competition

4.1 - Introduction to Imperfectly Competitive Markets

• Firms are able to make an increased profit in the long run if there is less competition since firms are considered to be price makers. There are stricter barriers to entry in imperfect competition (Governmental, economies of scale, geography, etc.)

  • Common barriers to entry: control of scarce resources, legal barriers, high startup costs

4.2 - Monopolies

• Monopoly: market structure where there is only one firm producing a product

  • Only producer of a good, has no close substitutes

  • On the graph, there is a downward sloping demand curve

• Quantity is produced : at MR = MC

  • Price is : MR=MC, up to demand

• Supply curve : where MC > AVC

  • Allocatively efficient due to them producing at MR=MC

  • Productively inefficient because they don’t produce at the minimum of the ATC

• Natural monopoly: has large fixed costs, and long economies of scale, has downward sloping ATC curve

• Natural monopoly production point : MR=MC

• Government will correct by forcing them to set price : at D=ATC

  

4.3 - Price Discrimination

• Price discrimination occurs in specific industries as consumers pay a different price for the same good.

  • To be able to price discriminate, you need market power

• Imperfect price discrimination : charging consumers different prices based on the buyer’s willingness to pay

• Perfect price discrimination : charges all consumers the maximum they are willing to pay, no deadweight loss, produce at P=MC

  • Example : resellers, coupons, bulk buying (costco), etc.

    

• In price discrimination, there is no deadweight loss and no consumer surplus as well, only producer surplus.

4.4 - Monopolistic Competition

• Monopolistic competition: is another term for imperfect competition, and occurs when many companies offer competing products which are similar but not perfect substitutes.

  • Characteristics:

    • Combines features of both a monopoly and perfect competition

    • Many sellers and differentiated products

    • Will use advertising to make demand more inelastic + differentiate product

    • Makes profit in short run, normal profit in long run

    • Allocatively inefficient (P does not equal MC)

    • Productively inefficient (does not produce at minimum of ATC until long run)

    • Downwards sloping demand curve

    • Produce at MR = MC, price is MR = MC up to demand

    

  • Long Run

    • Normal profit in long run

    • Short run profits will attract new firms to join, which decreases the demand until the demand Curve is tangent to ATC, causing normal profits in long run

    • In long run, they produce in region where economies of scales exist, because they produce in declining portion of ATC

    

4.5 - Oligopoly and Game theory

• Oligopoly Characteristics

  • Small number of firms, standard or differentiated product

  • Interdependent : all the actions that a firm takes will affect the other firms in the oligopoly

  • Cartels : a group that agrees to control the price and output of a product (often form in oligopoly)

  • Collusion : firms working together to maximize profit

• Game Theory

  • Payoff matrix : represents the payoff to each player to show combinations of given strategies

    • Dominant strategy : the strategy that has a better payoff regardless of what strategy the opponent chooses

    • Nash equilibrium : point where both players can’t do better than the other

Unit 5 - Factor Markets

5.1 - Introduction to Factor Markets

• Factor markets: is a resource for companies to buy what they need to produce their goods and services

• Derived demand : the demand from a resource is derived by product demand (ex: an increase in the demand of movie tickets increases the demand for movie theater workers)

• Marginal revenue product (MRP) : the additional revenue that is generated by an additional resource/worker

• Marginal factor cost (MFC) : the additional cost of an additional resource/worker

• Least cost rule : marginal product of labor/price of labor = marginal product of capital/price of capital (MPL / PL = MPK / PK)

  • Buy more of the one with a higher sum, and less of the one with a smaller sum (to explain, as you increase, diminishing marginal returns kicks in)

5.2 - Changes in Factor Demand and Factor Supply

• These factors determine the supply and demand of these quantities

5.3 - Profit-Maximising Behaviour in Perfectly Competitive Factor Markets

• Market curve : standard supply and demand curve

• Equilibrium wage in the market : establishes the wage that firms will pay workers

• MRP=MFC

• Firms will not hire if MFC>MRP, as they will be at a loss

5.3 - Monopsonistic Markets

• Many sellers, one buyer

• Monopsonies pay a lower wage and hire less than perfect competition

  • This market is an example of Imperfect competition

• MRP=MFC

• MFC > supply

  

Unit 6 - Market Failure and the Role of Government

6.1 Socially Efficient and Inefficient Market Outcomes

• Socially efficienct is when resources are allocated effectively

• MSB=MSC

• Allocatively Efficient Points

  • Perfectly competitive market : S=D, MB=MC

  • Perfectly competitive firm : P=MC

  • Perfectly competitive labor market : W=MRP (total economic surplus : MSC=MSB)

• Causes of Market Failure

  • Market power (imperfectly competitive markets)

  • Asymmetric information (lack of info provided by buyers and sellers)

  • Positive and negative externalities

  • Insufficient production of public goods

• Government policies used to get rid of DWL

  • Taxes

  • Subsidies

  • Reguations

  • Public prodivions

• Market failure : exists when firms produce where MPB=MPC, S=D

• The government tries to get them to produce where MSC =MSB

6.2: Externalities

• Externality : when external cost/benefit is placed on members of society who did not pay for them

• MSB does not equal MSC

• Negative externality : when someone uses a product, it decreases the benefit of others (ex: smoking), MSC > MPC (correct with per unit tax)

• Positive externality : when one uses a product, others benefit  (ex: education) MSC < MPC (correct with subsidy)

6.3: Public and Private Goods

• Rivalrous good : if someone consumers a product, others cannot (ex: food, shoes)

  • Nonrivalrous : national defense, fireworks, etc

  • Somewhere in middle : schools, roads, etc

• Excludable good : non payers can be prevented from enjoying the benefits (ex: food, school, etc)

  • Nonexcludable : national defense, air, etc

• Public goods : underproduced due to freeloader problem (ex: national defense, law enforcement, etc)

• Freeloader problem : people can enjoy the benefit of a good/service without paying

• Government will provide subsidies to producers

• Private goods : goods produced by private markets, can be excludable

6.4: The Effects of Government Intervention in Different Market Structures

• Causes of inefficient markets

  • Market power

  • Externalities

  • Nonrival and nonexcludable goods (public goods)

• Forms of government intervention

  • Taxes

  • Subsidies

  • Price floors/ceilings

  • Regulation

• Per unit subsidy : gives benefits per unit

  • Perfect competition : MC, ATC, AVC decreases, price doesn’t change (price taker)

  • Monopolistic competition : MC, ATC, price decreases (price maker where MR=MC)

• Lump sum subsidy : gives benefit no matter how many units

• Taxes will always shift supply curve to the left in long run, profits decrease

• Per unit tax : increase MC, ATC, and AVC

  • Perfect competition : MC, ATC, AVC increases, price doesn’t change (price taker)

  • Monopolistic competition : MC, ATC, price increases (price maker where MR=MC)

• Lump sum tax : only increase ATC

• won’t change output level

• Non price regulation : works like taxes, they ensure competition/environmental protection/health and safety

• Antitrust policy : promote competition and prevents monopolies

• Antitrust laws

  • Lawsuits

  • Price controls

  • Subsidies

• Price ceiling : sets minimum price

  • Perfect competition : causes shortage

  • Monopolistic competition : becomes MR curve, price and output decreases

• Price floor : sets maximum price

  • Perfect competition : leads to surplus

  • Monopsony : wages go up and workers go up

6.5: Inequality

• Income distribution : measures % of income that goes to individuals in different percentiles/brackets

• In a system with perfect equality, everyone would receive equal shares of income

• Income : wages, rent, interest, profit

• Lorenz curve : measures the distribution of income equality  (you want to be as close of possible to the perfect equality line as possible)

  

• Gini coefficient : A/(A+B)

  • Closer to 0, more equality

  • Closer to 1, more inequality

• Causes of income inequality

  • Supply + demand in labor market

  • Human capital

  • Discrimination

  • Inheritance

  • Bargaining power

• Policies to address inequality

  • Taxes + transfers

  • Minimum wage laws

  • Anti-poverty program

  • Income protection program

  • Scholarships

• Taxes :

  • Proportional : everyone pays the same percentage of their income (no impact on income distribution)

  • Progressive : taxes are higher % on people earning a higher income (reduces income inequality)

  • Regressive : taxes are lower % on people earning a higher income (increases income inequality)