Business Economics Unit 2 ReviewMicroeconomics: Core Principles

Key Concepts and Definitions

• Scarcity the fundamental economic problem of having limited resources to satisfy unlimited wants and needs
• Opportunity cost the highest-valued alternative that must be given up to engage in an activity or make a choice
  • Calculated by considering the value of the next-best alternative foregone
• Marginal analysis evaluating the additional benefits and costs of an activity to determine the optimal level of that activity
• Positive economics objective analysis of economic behavior and outcomes based on facts and data
• Normative economics subjective analysis of economic behavior and outcomes based on value judgments and opinions
• Microeconomics the study of individual decision-making units (households and firms) and how they interact in markets
• Macroeconomics the study of the economy as a whole, focusing on aggregate variables (GDP, inflation, unemployment)

Supply and Demand Basics

• Supply the quantity of a good or service that producers are willing and able to offer for sale at various prices
  • Determined by factors such as input prices, technology, expectations, and the number of sellers
  • Represented by an upward-sloping supply curve, showing a positive relationship between price and quantity supplied
• Demand the quantity of a good or service that consumers are willing and able to purchase at various prices
  • Influenced by factors like income, preferences, prices of related goods, expectations, and the number of buyers
  • Depicted by a downward-sloping demand curve, illustrating a negative relationship between price and quantity demanded
• Law of supply states that, ceteris paribus (all else equal), a higher price leads to a higher quantity supplied
• Law of demand asserts that, ceteris paribus, a higher price results in a lower quantity demanded
• Determinants of supply factors that shift the supply curve (input prices, technology, expectations, number of sellers)
• Determinants of demand factors that shift the demand curve (income, preferences, prices of related goods, expectations, number of buyers)

Market Equilibrium

• Market equilibrium a situation where the quantity supplied equals the quantity demanded at a given price
  • Occurs at the intersection of the supply and demand curves
  • Represents a price and quantity combination where there is no shortage or surplus
• Equilibrium price the price at which the quantity supplied equals the quantity demanded
  • Also known as the market-clearing price
• Equilibrium quantity the quantity bought and sold at the equilibrium price
• Shortage a situation where the quantity demanded exceeds the quantity supplied at a given price
  • Occurs when the price is below the equilibrium price
  • Creates upward pressure on the price as consumers compete for the limited supply
• Surplus a situation where the quantity supplied exceeds the quantity demanded at a given price
  • Happens when the price is above the equilibrium price
  • Puts downward pressure on the price as producers compete to sell the excess supply
• Price mechanism the process by which changes in supply and demand lead to adjustments in prices and quantities to restore equilibrium

Elasticity and Its Applications

• Elasticity a measure of the responsiveness of one variable to changes in another variable
• Price elasticity of demand measures the responsiveness of quantity demanded to changes in price
  • Calculated as the percentage change in quantity demanded divided by the percentage change in price
  • Elastic demand (|elasticity| > 1) quantity demanded is highly responsive to price changes
  • Inelastic demand (|elasticity| < 1) quantity demanded is relatively unresponsive to price changes
  • Unit elastic demand (|elasticity| = 1) quantity demanded changes proportionally with price changes
• Income elasticity of demand measures the responsiveness of quantity demanded to changes in income
  • Normal goods have positive income elasticity (quantity demanded increases with income)
  • Inferior goods have negative income elasticity (quantity demanded decreases with income)
• Cross-price elasticity of demand measures the responsiveness of quantity demanded of one good to changes in the price of another good
  • Substitutes have positive cross-price elasticity (quantity demanded of one good increases when the price of the other rises)
  • Complements have negative cross-price elasticity (quantity demanded of one good decreases when the price of the other rises)
• Price elasticity of supply measures the responsiveness of quantity supplied to changes in price
  • Elastic supply (elasticity > 1) quantity supplied is highly responsive to price changes
  • Inelastic supply (elasticity < 1) quantity supplied is relatively unresponsive to price changes

Consumer Behavior and Utility

• Utility the satisfaction or benefit a consumer derives from consuming a good or service
  • Measured in utils, which are subjective units of satisfaction
• Marginal utility the additional satisfaction gained from consuming one more unit of a good or service
  • Diminishes as more units are consumed (law of diminishing marginal utility)
• Total utility the overall satisfaction derived from consuming a given quantity of a good or service
  • Calculated by summing the marginal utilities of all units consumed
• Consumer equilibrium the point at which a consumer maximizes total utility subject to a budget constraint
  • Occurs when the marginal utility per dollar spent is equal across all goods consumed
• Indifference curve a graphical representation of different combinations of two goods that provide a consumer with the same level of utility
  • Downward-sloping and convex to the origin
  • Do not intersect, as each curve represents a different level of utility
• Budget constraint a line showing all combinations of two goods a consumer can afford given their income and the prices of the goods
  • Slope equals the negative of the price ratio of the two goods
• Consumer optimum the point where the budget constraint is tangent to the highest possible indifference curve
  • Represents the utility-maximizing combination of goods given the consumer's income and prices

Production and Costs

• Production the process of transforming inputs (factors of production) into outputs (goods and services)
• Short run a time period in which at least one input is fixed (usually capital)
• Long run a time period in which all inputs can be varied
• Total product (TP) the total output produced by a firm using a given amount of inputs
• Marginal product (MP) the additional output produced by employing one more unit of a variable input, holding other inputs constant
  • Calculated as the change in total product divided by the change in the variable input
• Average product (AP) the output per unit of a variable input, holding other inputs constant
  • Calculated as total product divided by the quantity of the variable input
• Law of diminishing marginal returns states that as more units of a variable input are added to a fixed input, marginal product eventually declines
• Fixed costs (FC) costs that do not vary with the level of output in the short run (rent, insurance, salaries)
• Variable costs (VC) costs that change with the level of output (raw materials, hourly wages, utilities)
• Total cost (TC) the sum of fixed costs and variable costs at each level of output
• Marginal cost (MC) the additional cost of producing one more unit of output
  • Calculated as the change in total cost divided by the change in output
• Average fixed cost (AFC) fixed cost per unit of output, found by dividing fixed cost by the quantity of output
• Average variable cost (AVC) variable cost per unit of output, calculated by dividing variable cost by the quantity of output
• Average total cost (ATC) total cost per unit of output, found by dividing total cost by the quantity of output or by adding average fixed cost and average variable cost

Market Structures

• Perfect competition a market structure characterized by many buyers and sellers, homogeneous products, free entry and exit, perfect information, and no market power
  • Firms are price takers, facing a perfectly elastic demand curve
  • Long-run equilibrium occurs where price equals minimum average total cost
• Monopoly a market structure with a single seller, unique product, high barriers to entry, and significant market power
  • Faces a downward-sloping demand curve and can set price or quantity, but not both
  • Produces less output and charges a higher price compared to perfect competition
• Monopolistic competition a market structure with many sellers, differentiated products, low barriers to entry and exit, and some market power
  • Firms face a downward-sloping demand curve but have limited ability to set prices
  • Long-run equilibrium occurs where price equals average total cost, but firms operate with excess capacity
• Oligopoly a market structure with few sellers, interdependent decision-making, high barriers to entry, and significant market power
  • Firms engage in strategic behavior, considering the actions and reactions of rivals
  • Outcomes can range from collusion (joint profit maximization) to competition (price wars)
• Price discrimination the practice of charging different prices to different consumers for the same product or service
  • Requires market power, ability to segment the market, and prevention of resale
  • Can increase profits by capturing more consumer surplus

Real-World Applications

• Minimum wage a legally mandated lower bound on the wage rate that employers can pay their workers
  • Creates a price floor in the labor market, potentially leading to unemployment if set above the equilibrium wage
• Price controls government-imposed restrictions on the prices that can be charged for goods or services
  • Price ceilings (rent control) set a maximum price below the equilibrium price, causing shortages
  • Price floors (agricultural price supports) set a minimum price above the equilibrium price, resulting in surpluses
• Taxes and subsidies government policies that can shift the supply or demand curves in a market
  • Taxes (excise tax on cigarettes) shift the supply curve to the left, raising the price and reducing the quantity
  • Subsidies (renewable energy subsidies) shift the supply curve to the right, lowering the price and increasing the quantity
• Externalities costs or benefits of an activity that affect third parties not directly involved in the activity
  • Negative externalities (pollution) impose costs on society, leading to overproduction compared to the socially optimal level
  • Positive externalities (education) generate benefits for society, resulting in underproduction compared to the socially optimal level
• Public goods goods that are non-excludable (cannot prevent non-payers from consuming) and non-rivalrous (consumption by one does not reduce availability for others)
  • Examples include national defense, public parks, and lighthouses
  • Often underprovided by private markets due to the free-rider problem, requiring government provision or funding