Microeconomics Study Guide: From Basic Principles to Market Dynamics
Economic Science
What is Economics?
Economics is a science that explains the actions of various actors, such as consumers and entrepreneurs, in response to incentives or signals. It studies the effects of these actions and how society can design incentives compatible with social welfare.
What is the Scientific Method?
The scientific method is a disciplined approach to achieving valid and reliable knowledge. It is a pattern that allows researchers to move from point A to point Z with confidence in obtaining valid knowledge. It is a set of steps designed to protect against subjectivity, reaching the maximum level of analysis for a particular situation.
Why Do Economists Use Models of Reality?
Economists use models of reality to simplify complex economic systems and isolate the effects of specific variables. These models help in understanding economic phenomena and predicting future outcomes.
Difference Between Positive and Normative Statements
- Positive Statement: Describes the world as it is, based on facts and evidence.
- Normative Statement: Prescribes how the world should be, based on values and opinions.
Production Possibility Frontier
The production possibility frontier (PPF) shows the combinations of products an economy can produce given its factors of production and production technology.
Efficiency
Efficiency in economics refers to how well resources are used to produce goods and services. It measures the productivity of a given set of factors in an industry.
Supply, Demand, Equilibrium, and Welfare
Fixed Costs
Fixed costs are expenses that do not vary with the quantity of output produced. These costs remain constant regardless of production levels. Examples include rent payments and manager salaries.
Variable Costs
Variable costs are expenses that change directly with the quantity of output produced. As production levels increase, variable costs rise, and vice versa. Examples include raw materials and labor costs.
Opportunity Cost
Opportunity cost is the value of the next best alternative forgone when making a choice. It represents the potential benefits missed by choosing one option over another.
Assumptions of a Competitive Market
A perfectly competitive market assumes:
- Many buyers and sellers
- Homogeneous products (identical goods or services)
- Price takers (no individual buyer or seller can influence the market price)
What Assumptions Should Be Given for the Free Market to Lead to Economic Efficiency?
For a free market to achieve economic efficiency, it requires:
- Perfect competition
- No externalities (costs or benefits that spill over to third parties)
- Perfect information (buyers and sellers have complete knowledge of market conditions)
Non-Competitive Market Structures
- Monopoly: A single seller dominates the market.
- Oligopoly: A few large sellers control a significant portion of the market.
- Monopolistic Competition: Many sellers offer differentiated products, each with some market power.
Demand Curve
The demand curve illustrates the relationship between the price of a good and the quantity demanded by consumers. It shows how much of a good consumers are willing to buy at different price levels.
Supply Curve
The supply curve depicts the relationship between the price of a good and the quantity supplied by producers. It shows how much of a good producers are willing to sell at different price levels.
Difference Between Movement Along and Shift in the Demand Curve
- Movement Along the Demand Curve: Occurs due to a change in the price of the good itself, while other factors remain constant.
- Shift in the Demand Curve: Happens when factors other than the price of the good change, such as consumer income, preferences, or prices of related goods.
Market Equilibrium
Market equilibrium occurs at the price where the quantity demanded equals the quantity supplied. At this point, there is no shortage or surplus, and the market clears.
Horizontal Supply Curve
A horizontal supply curve indicates perfectly elastic supply, meaning that producers are willing to supply any quantity at a given price. A small change in price leads to an infinite change in quantity supplied.
What Makes the Market Clear?
The market-clearing process is driven by the forces of supply and demand. When there is a surplus (supply exceeds demand), prices tend to fall, encouraging consumers to buy more and producers to supply less. Conversely, when there is a shortage (demand exceeds supply), prices rise, incentivizing producers to supply more and consumers to buy less. This process continues until equilibrium is reached.
Competitive Market Leads to Economic Efficiency Because…
In a competitive market equilibrium, resources are allocated efficiently because the price reflects the marginal cost of production. Consumers who value the good more than the price are willing to buy it, while producers who can produce it at a cost lower than the price are willing to sell it. This ensures that resources are used to produce goods and services that society values most.
Consumer Choice Theory
Consumer choice theory explains how consumers make decisions about what to buy, given their preferences, income, and prices of goods and services. It analyzes how consumers maximize their satisfaction within their budget constraints.
Market Economy
A market economy allocates resources through the decentralized decisions of individuals and firms interacting in markets. Prices serve as signals that guide resource allocation.
Budget Constraint
The budget constraint represents the combinations of goods and services a consumer can afford, given their income and the prices of those goods and services.
Indifference Curves
Indifference curves show different combinations of goods that provide a consumer with the same level of satisfaction. They illustrate consumer preferences and the trade-offs they are willing to make.
Marginal Rate of Substitution (MRS)
The marginal rate of substitution (MRS) measures the rate at which a consumer is willing to trade one good for another while maintaining the same level of satisfaction. It represents the slope of the indifference curve.
Income and Substitution Effects
- Income Effect: The change in consumption due to a change in purchasing power caused by a price change.
- Substitution Effect: The change in consumption due to a change in the relative prices of goods, leading consumers to substitute towards the relatively cheaper good.
Types of Goods
- Normal Good: Demand increases as income increases.
- Inferior Good: Demand decreases as income increases.
- Substitute Good: A good that can be used in place of another good.
- Complementary Good: A good that is consumed together with another good.
Production and Cost Curves
- Production Function: Shows the relationship between inputs (factors of production) and outputs (goods and services produced).
- Cost Curves: Illustrate the costs of production at different output levels.
Economies of Scale
Economies of scale occur when the average cost of production decreases as the quantity of output increases. This can happen due to factors such as specialization, bulk purchasing, and technological advancements.
Elasticity
Elasticity measures the responsiveness of one variable to changes in another variable. For example, price elasticity of demand measures how much the quantity demanded changes in response to a change in price.
Perfectly Elastic and Inelastic Demand
- Perfectly Elastic Demand: Quantity demanded changes infinitely in response to a small change in price (horizontal demand curve).
- Perfectly Inelastic Demand: Quantity demanded does not change at all in response to a change in price (vertical demand curve).
Price Elasticity of Demand
Price elasticity of demand measures the sensitivity of quantity demanded to changes in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.
Market Structures and Competition
Monopoly
A monopoly exists when a single firm controls the entire market for a particular good or service. Monopolies can arise due to barriers to entry, such as patents, control over essential resources, or government regulations.
Why the Government Cares When There is a Monopoly
Governments often intervene in monopolistic markets to promote competition and protect consumers from potential abuses of market power. Monopolies can lead to higher prices, reduced output, and less innovation compared to competitive markets.
Natural Monopoly
A natural monopoly occurs when a single firm can supply the entire market at a lower cost than multiple firms. This typically happens in industries with high fixed costs, such as utilities.
Oligopoly
An oligopoly is a market structure characterized by a few large firms that dominate the market. These firms often engage in strategic behavior, such as price fixing, collusion, and advertising wars.
Monopolistically Competitive Market
In monopolistic competition, many firms offer differentiated products, each with some degree of market power. Firms compete on factors such as price, product quality, and advertising.
Game Theory
Game theory is a branch of economics that studies strategic interactions between rational agents. It analyzes how individuals or firms make decisions when their outcomes depend on the choices of others.
Nash Equilibrium
A Nash equilibrium is a situation in a game where no player can improve their outcome by unilaterally changing their strategy, given the strategies chosen by the other players.
Prisoner’s Dilemma
The prisoner’s dilemma is a classic game theory scenario that illustrates the difficulties of cooperation even when it is mutually beneficial. In this game, two individuals acting in their self-interest end up with a worse outcome than if they had cooperated.
Other Game Theory Concepts
- Game of Chicken: A game of brinksmanship where two players engage in a dangerous activity, and the first one to back down is considered the”chicken”
- Battle of the Sexes: A game where two players have different preferences but want to coordinate their actions.
- Matching Pennies: A zero-sum game where one player’s gain is the other player’s loss.
Externalities, Public Goods, and Property Rights
Externality
An externality occurs when the actions of one party have an impact on the well-being of a third party not directly involved in the transaction. Externalities can be positive (beneficial) or negative (harmful).
Pigouvian Tax
A Pigouvian tax is a tax levied on goods or activities that create negative externalities. The tax aims to internalize the external costs, leading to a more socially optimal level of production or consumption.
Coase Theorem
The Coase Theorem states that if property rights are well-defined and transaction costs are low, private bargaining can lead to an efficient allocation of resources, even in the presence of externalities.
Tradable Permits
Tradable permits, also known as cap-and-trade systems, are market-based mechanisms for controlling pollution. The government sets a cap on the total amount of pollution allowed, and firms can buy and sell permits that allow them to emit a certain amount of pollution.
Public Goods
Public goods are goods that are non-excludable (it is difficult to prevent people from using them) and non-rivalrous (one person’s use does not diminish another person’s use). Examples include national defense, street lighting, and public parks.
Free-Rider Problem
The free-rider problem arises when individuals can benefit from a public good without contributing to its cost. This can lead to under-provision of public goods.
Tragedy of the Commons
The tragedy of the commons describes a situation where a shared resource is overused and depleted because individuals acting in their self-interest do not consider the long-term consequences of their actions.
Property Rights
Property rights define who owns and has the right to use resources. Clear property rights are essential for efficient resource allocation and economic growth.
Poverty, Income Distribution, Growth, and Institutions
Institutions
Institutions are the rules, norms, and organizations that shape human behavior and interactions. They play a crucial role in economic development by providing a framework for cooperation, reducing uncertainty, and enforcing contracts.
Poverty and Income Inequality
Poverty and income inequality are significant social and economic issues. Poverty refers to a state of deprivation, while income inequality measures the disparity in income distribution within a society.
Gini Index and Lorenz Curve
- Gini Index: A statistical measure of income inequality, ranging from 0 (perfect equality) to 1 (perfect inequality).
- Lorenz Curve: A graphical representation of income distribution, showing the cumulative share of income earned by different segments of the population.
Efficiency-Equity Trade-off
The efficiency-equity trade-off refers to the potential conflict between maximizing economic efficiency and promoting social equity. Some policies that enhance efficiency may exacerbate inequality, and vice versa.
Redistribution
Redistribution policies aim to reduce income inequality by transferring income or wealth from higher-income individuals to lower-income individuals. Examples include progressive taxation, social welfare programs, and minimum wage laws.
Utilitarianism, Liberalism, and Libertarianism
- Utilitarianism: A moral philosophy that emphasizes maximizing overall happiness or well-being.
- Liberalism: A political philosophy that emphasizes individual rights, liberty, and limited government.
- Libertarianism: A political philosophy that advocates for minimal government intervention in the economy and individual lives.