Key Concepts in Microeconomics: Definitions and Principles
Key Concepts in Microeconomics
Basic Economic Concepts
1. What is the origin of the term “micro”?
The term “micro” is derived from the Greek word mikros.
2. What is one demerit of socialism?
One demerit of socialism is the lack of individual incentives.
3. What is an economic problem?
An economic problem arises due to the scarcity of resources and unlimited human wants.
4. What is one determinant of market supply?
One determinant of market supply is the price of the product.
Fundamental Principles
1. Scarcity in Economics:
Scarcity in economics refers to the limited availability of resources relative to unlimited wants.
2. Opportunity Cost:
Opportunity cost is the value of the next best alternative forgone when making a choice.
3. Market Demand:
Market demand is the total quantity of a good or service demanded by all consumers at various prices.
4. Price Elasticity of Demand:
Price elasticity of demand is the measure of the responsiveness of quantity demanded to a change in price.
5. What is one determinant of supply?
One determinant of supply is the price of the good.
Market Structures and Consumer Behavior
Laissez-faire is an economic system in which the government does not interfere with the economy. It is based on the idea that economic systems work best when left to themselves.
Two causes for the upward shift of the demand curve are:
- Increase in the income of the consumer
- Increase in the price of a substitute good
Two features of the production possibility frontier are:
- It is downward sloping, indicating that an increase in the production of one good requires a decrease in the production of the other good.
- It is concave to the origin, indicating that the opportunity cost of producing one good increases as more of it is produced.
Two exceptions to the law of demand are:
- Giffen goods: Goods for which the demand increases with an increase in price.
- Veblen goods: Goods for which the demand increases with an increase in price due to their prestige value.
Define the price line.
A price line shows the various combinations of two goods that can be purchased with a given income.
3. Give an example of time utility.
A ripe fruit has more utility than an unripe one.
4. What is the income effect?
The income effect is the change in consumption of a good due to a change in income.
5. What is one point of superiority of indifference curves over Marshallian utility analysis?
Indifference curves can handle multiple goods and income effects.
Consumer Choice and Utility
6. Budget Constraint: The combination of goods a consumer can afford given their income and the prices of goods.
7. What is the difference between Hicksian and Slutsky substitution effects?
The Hicksian substitution effect keeps utility constant, while the Slutsky substitution effect adjusts for purchasing power.
8. What is the diamond-water paradox?
The diamond-water paradox explains why diamonds are more expensive than water despite water being essential for survival.
9. Consumer Choice: The decision-making process by which consumers select goods and services.
10. Consumer Surplus: The difference between what a consumer is willing to pay and what they actually pay.
Two properties of an indifference curve are:
- It is downward sloping, indicating that as the consumer gets more of one good, they are willing to give up some of the other good.
- It is convex to the origin, indicating that the marginal rate of substitution between the two goods decreases as the consumer moves along the indifference curve.
The law of diminishing marginal utility states that:
- As a consumer consumes more units of a good, the marginal utility derived from each additional unit decreases.
- The marginal utility eventually becomes negative if the consumer consumes too much of the good.
Consumer surplus is the difference between the maximum price a consumer is willing to pay for a good and the actual price they pay. For example, if a consumer is willing to pay $10 for a product but actually pays $8, the consumer surplus is $2.
The substitution effect of a price change refers to the change in the quantity demanded of a good due to a change in its price, assuming the consumer’s income and preferences remain constant. It leads to a decrease in the consumption of the good whose price has increased.
Production Costs and Firm Behavior
Cost of Production: The total expenses incurred in producing a good or service.
Shape of Short-Run Industry Supply Curve: Upward sloping.
Average Revenue: Total revenue divided by the quantity sold.
Example of Marginal Cost: The cost of producing one additional unit of a product.
Economies of Scale: Reduction in per-unit costs as production increases.
What is a cost function?
A cost function is a mathematical relationship between the cost of production and the level of output.
Give an example of prime cost.
An example of prime cost is wages paid to workers.
What is implicit cost?
Implicit cost is the opportunity cost of using a resource that is not explicitly paid for.
What is the shape of the short-run industry supply curve?
The short-run industry supply curve is upward sloping.
Marginal Revenue: The additional revenue earned from selling one more unit of a good.
Real cost refers to the actual sacrifice made by a producer in terms of resources, time, and effort. Money cost refers to the monetary expenses incurred by a producer in producing a good or service.
Why does the MC curve cut the AC curve at its minimum point?
The MC curve cuts the AC curve at its minimum point because when MC is less than AC, AC falls. When MC is greater than AC, AC rises, and when MC equals AC, AC is at its minimum point.
The profit-maximizing conditions of a firm are:
- MC = MR: The marginal cost of producing an additional unit of the good should be equal to the marginal revenue earned from selling that unit.
- The MC curve cuts the MR curve from below: The marginal cost curve should cut the marginal revenue curve from below, indicating that the firm is producing at the lowest possible cost.
The relationship between total cost, total fixed cost, and total variable cost is: TC = TFC + TVC, where TC = Total Cost, TFC = Total Fixed Cost, and TVC = Total Variable Cost. Graphically, the total cost curve is the sum of the total fixed cost curve and the total variable cost curve.
Firm and Production
Define a firm.
A firm is a business organization that produces goods or services.
Economic Profit: The excess of total revenue over total cost.
Define short run.
The short run is a period of time in which some inputs are fixed.
What is marginal physical product?
Marginal physical product is the additional output produced by one more unit of a variable input.
Write the cost-minimizing equilibrium condition.
MP = Wage Rate
Production Function: The relationship between input quantities and output quantity.
Returns to Scale: The change in output resulting from a proportional change in all inputs.
Choice of Technology: The selection of production methods to maximize efficiency.
Iso-cost Curve: Represents all combinations of inputs that cost the same amount.
Cost-Minimizing Equilibrium Condition: When the marginal rate of technical substitution equals the ratio of input prices.
Two properties of an isoquant are:
- It is downward sloping, indicating that as the quantity of one input increases, the quantity of the other input decreases while keeping the output constant.
- It is convex to the origin, indicating that the marginal rate of technical substitution between the two inputs decreases as the firm moves along the isoquant.
Producer’s Surplus is the difference between the actual price received by a producer and the minimum price they are willing to accept. It represents the excess revenue earned by the producer over their minimum acceptable price.
Choice of technology refers to the decision made by a producer regarding the combination of inputs to be used in the production process. It involves selecting the most efficient method of production, given the available resources and technology.
Market Dynamics and Perfect Competition
Market Price: The price at which goods are bought and sold in the market.
Shape of Long-Run Supply Curve of an Industry: Horizontal or upward sloping, depending on the type of industry.
Supernormal Profit: Profit exceeding the normal profit level.
Why is AR = MR under perfect competition?
Because firms are price takers, the price remains constant for each additional unit sold.
Constant-Cost Industry: An industry where input costs do not change with output levels.
Why is AR = MR under perfect competition?
Because the firm is a price taker and can sell any quantity at the market price.
What is the shape of the long-run industry supply curve?
Horizontal.
What does a constant cost industry mean?
An industry where the cost of production remains constant as output increases.
What is the condition of equilibrium of a firm in the long run under a perfectly competitive market?
P = MC
What is normal price?
The price that equals the firm’s average cost.
Two assumptions of perfect competition are:
- Large number of buyers and sellers: There are many firms producing a homogeneous product, and many buyers purchasing the product.
- Free entry and exit: Firms are free to enter or exit the industry as they wish, and there are no barriers to entry or exit.
The two conditions of equilibrium of a firm under a perfect competition market are:
- MC = MR: The marginal cost of producing an additional unit of the good should be equal to the marginal revenue earned from selling that unit.
- The MC curve cuts the MR curve from below: The marginal cost curve should cut the marginal revenue curve from below, indicating that the firm is producing at the lowest possible cost.
The two basic conditions of equilibrium of a firm under perfect competition are:
- MC = MR
- The MC curve cuts the MR curve from below.
Increasing Cost Industry: An industry where the cost of production increases as the industry expands.
Decreasing Cost Industry: An industry where the cost of production decreases as the industry expands.