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ECON101 Study Guide

Site: Saylor Academy
Course: ECON101: Principles of Microeconomics
Book: ECON101 Study Guide
Printed by: Guest user
Date: Thursday, 3 April 2025, 9:24 PM

Table of contents

Navigating this Study Guide

Study Guide Structure

In this study guide, the sections in each unit (1a., 1b., etc.) are the learning outcomes of that unit. 

Beneath each learning outcome are:

  • questions for you to answer independently;
  • a brief summary of the learning outcome topic; and
  • and resources related to the learning outcome. 

At the end of each unit, there is also a list of suggested vocabulary words.

 

How to Use this Study Guide

  1. Review the entire course by reading the learning outcome summaries and suggested resources.
  2. Test your understanding of the course information by answering questions related to each unit learning outcome and defining and memorizing the vocabulary words at the end of each unit.

By clicking on the gear button on the top right of the screen, you can print the study guide. Then you can make notes, highlight, and underline as you work.

Through reviewing and completing the study guide, you should gain a deeper understanding of each learning outcome in the course and be better prepared for the final exam!

Unit 1: Introduction to Economics

1a. Explain the economic way of thinking

  • What is economics?
  • What is the tension between scarce resources and unlimited wants?
  • What are scarcity and the market?
  • What is the difference between microeconomics and macroeconomics?
  • What is opportunity cost and the concept of forgone activity and/or forgone time?
  • How does the division of labor and specialization increase production and reduce cost per unit to achieve economies of scale?

Economics is the social science that studies how economic agents (consumers, firms, and the government) make choices so as to administer the allocation of resources in the face of scarcity. Scarcity exists when there is not enough of something (product, service, resource) to satisfy everyone's wants at no cost. Even if the desired item were free, enough would not be available to satisfy its demand.

The concept of opportunity cost is essential to economics. It is the cost of the next best alternative (the choice forgone, or the option you did not choose) to the one you selected. We must often make economic decisions that require choosing between two paths. Perhaps you had to decide whether to enroll in college without the full required tuition and costs in hand. You may have decided to take one or two courses while working part-time. Or you may have decided to take out student loans to study full-time so you could begin your career sooner and hopefully earn a higher salary. Unfortunately, this option requires you to pay off a significant debt after graduation.

What questions help you decide? What do you give up when you choose one path? What do you gain? Given your resource constraints, you should consider the cost of your next best alternative to optimize the return on your time and money. This is an opportunity cost.

Find an example of opportunity cost that works for you in real life and review it a few times. Try to use this same example to review other economic concepts such as scarcity, incentives, marginal cost, marginal benefit, willingness to pay, allocation of resources, etc.

This concept map illustrates how the conflict between scarce resources and unlimited wants gives rise to economic agents' choices. Microeconomics involves the analysis of the consequences of these choices at the economic agents level (consumers, firms, and governments). Macroeconomics, on the other hand, examines the impact of the choices at the national and international levels.


One way to address the tension between scarce resources and unlimited wants is to increase production through the division of labor and specialization. By dividing the labor force into specialized workers, each individual can produce more units with higher quality. As each worker increases production using the same amount of inputs, the company achieves economies of scale: the average cost to produce each unit declines as the production level increases.

You need some basic mathematics skills to complete this course successfully. We have included plenty of resources to help you get ready. 

To review, see

 

1b. Identify how individual economic agents make rational choices and optimize the use of scarce resources by responding to incentives and calculating opportunity costs

  • What is a rational choice? How do economic agents make rational choices?
  • How is the budget constraint related to choices?
  • How do economic agents calculate opportunity costs based on the budget constraint?
  • How does scarcity affect prices?

When facing limited resources, making rational choices is essential. Scarcity prompts economic agents to engage in rational decision-making to allocate resources efficiently. A rational choice means making decisions based on preferences, budget constraints, and available information. You are picking the best option among different choices, considering what you want and what you know to make a smart decision.

Obviously, your budget constraint limits what you can buy. Let's say a Chromebook costs $400 and a holiday weekend $600. The slope of your budget line (representing this budget constraint with Chromebooks in the x-axis and holiday weekends in the y-axis) is $400/$600. It shows how much holiday you give up for each Chromebook. This reasoning should sound familiar: the slope reflects the opportunity cost of a Chromebook. So, the budget constraint's slope illustrates the trade-off and will help guide your choices.

Prices also limit what you can buy. In a capitalist economy, the market distributes scarce resources according to the price system. Prices signal the existence of scarcity.

To review, see:

 

1c. Apply marginal analysis to make optimal choices by identifying whether choices are efficient

  • What are marginal analysis, marginal cost, and marginal benefit?
  • How can you analyze resource allocation based on making decisions at the margin?
  • What is the sunk cost fallacy?

How do you make choices, such as how much food to buy, how many hours to study, how many vacation days to take, and how many hours to work? You probably make adjustments based on small changes rather than make all-or-nothing decisions. People and societies rarely make all-or-nothing choices. 

Marginal analysis examines the cost and benefits of choosing a little more or a little less. Specifically, marginal cost is the increase in total cost that arises from producing one additional unit of a good or service. Marginal benefit, on the other hand, is the increased satisfaction a consumer gains from consuming one additional unit of a good or service. Imagine you are deciding whether to extend your streaming service subscription. As a rational consumer, you will only decide to renew it if the utility you derive from one more unit (one more month) exceeds the extra cost – the marginal cost and marginal benefit. To make smart decisions at the margin, we must shift our focus from past investments to present and future factors. Holding onto past decisions, known as the sunk cost fallacy, can hinder rational decision-making. It may help to think of a personal example to grasp this concept better.

To review, see:

 

1d. Identify basic economic models related to the circular flow of resources and the production possibilities frontier

  • Why do economists need to work with models?
  • What is ceteris paribus, and how do economists use it?
  • What is the circular flow model of production, resources, and money?
  • What is the production possibilities frontier model?

Like other scientists, economists use models to simplify reality to make it easier to analyze. These models often include the ceteris paribus assumption, which holds everything else equal to focus on the impact of just one specific factor. For example, if you want to focus on how the number of hours you study microeconomics impacts your final grade, you would hold other factors that affect your grade constant, such as the quality of your instructor's explanations, the difficulty level of the exam, your prior knowledge of the subject. 

In this course, we introduce simple but powerful economic models. The circular flow model is essential for understanding the fundamental interactions between households and businesses that drive economic activity. It describes how money, resources, and goods and services flow among different sectors of the economy.

This diagram is a simplified version of the circular flow model. It does not include the role the government, financial system, international trade, and international finance play. However, even this simplified version demonstrates the crucial role of trade – the process where individuals and societies exchange goods and services based on their needs and specializations.

What goods or skills do you specialize in and trade with others? For example, do you work in a certain profession because you have skills or talents your employer values and is willing to pay you to do? Do you use the income you earn to purchase goods and services you need from others? Trade is an integral component of every economic analysis.

The production possibilities frontier (PPF) model is another powerful economic model. It helps us visualize all of the potential production combinations of two goods when all of the production factors are completely or fully and efficiently used. The PPF incorporates the economic principles of allocative efficiency, opportunity cost, productive efficiency, and resource scarcity.

The graph below shows a PPF of a basic economy that produces food and clothing. Why are points A, B, and C efficient? At Point D, all of the available resources are not completely used, or they are used inefficiently, i.e., it is inefficient. All the points on the curve or inside the curve are attainable. Points outside the curve are not attainable because additional resources are needed to produce more food and/or clothing.

To review, see:

 

Unit 1 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • budget constraint
  • ceteris paribus
  • choice forgone
  • circular flow model
  • division of labor
  • economics
  • economies of scale
  • macroeconomics
  • marginal analysis
  • marginal benefit
  • marginal cost
  • market
  • microeconomics
  • models
  • opportunity cost
  • production possibilities frontier (PPF)
  • rational choice
  • scarcity
  • specialization
  • sunk cost fallacy
  • utility

Unit 2: Supply and Demand

2a. Define demand, supply, and market equilibrium

  • What is the Law of Demand?
  • What is the relationship between the quantity consumers demand and the price of a good?
  • What is the difference between demand and quantity demanded?
  • What is the Law of Supply?
  • What is the relationship between the quantity producers supply and the price of a good?
  • What is the difference between supply and quantity supplied?
  • What are the variables that shift the demand curve?
  • What are the variables that shift the supply curve?
  • What is a market equilibrium?

Demand refers to how consumers behave in the marketplace. Specifically, demand shows the relationship between the quantity demanded and the price. Millennials, for example, are willing to pay premium prices for goods and services. Therefore, their demand differs from that of baby boomers. The quantity demanded is the amount that consumers are willing and able to buy at each price. It is crucial to distinguish between the quantity demanded (the dependent variable) and the demand (the function that shows how the quantity demanded changes with the price). 

Review this figure, which depicts a demand curve for coffee.


Figure: A Demand Schedule and a Demand Curve

This simple diagram shows several important microeconomic relationships: 

  1. There is an inverse relationship between price and quantity demanded. Picture yourself as the consumer to understand why. If you take ceteris paribus, this inverse relationship is the Law of Demand.
  2. When the price changes, there is a movement along the demand curve, but there is no shift. 
  3. As the price goes down and the consumer buys more units, satisfaction (utility) increases.

To ensure you do not confuse a movement along the demand curve with a shift, always consider first what happens to the price. If, at the same price, the quantity demanded changes, that indicates a shift in the demand.

Review how changes to demand determinants (income, price of related goods, preferences, number of consumers, and expectations about prices) shift the demand curve. For example, consider how the rise in Chinese middle-class income affects the demand curve for electronic gadgets. Draw the diagram on your own before reviewing the answer, and remember, graphs are just tools to help you understand and summarize complex economic relations.


Make sure you understand why we consider electronic gadgets normal goods in this context.

To review supply and its determinants, we apply the same methodology as we have just done with demand. Supply refers to how producers (firms) behave in the marketplace. Specifically, supply shows the relationship between the quantity supplied and the price. The quantity supplied is the amount that producers are willing and able to buy at each price. It is crucial to distinguish between the quantity supplied (the dependent variable) and the supply (the function that shows how the quantity supplied changes with the price). 

Review this figure, which depicts a supply curve.


Figure: A Supply Schedule and a Supply Curve

This simple diagram shows several important microeconomics relations: 

  1. There is a positive relationship between price and quantity supplied. As the market price increases, producers are willing to produce and sell more units. If you take ceteris paribus, this inverse relationship is the Law of Supply.
  2. When the price changes, there is a movement along the supply curve, but there is no shift. In our graph example, coffee growers are incentivized to produce more coffee to sell at a higher price. 

To ensure you do not confuse a movement along the demand curve with a shift, always consider first what happens to the price. If, at the same price, the quantity supplied changes, that indicates a shift in the supply.

Review how changes to supply determinants (technological change, cost of production (mainly the price of the factors of production), number of producers, possibility of substitution in production, and expectations about the price) shift the supply curve. Consider how automation that allows for higher efficiency, reduced labor costs, and increased production speed, for example, could affect the supply curve for electronic gadgets. Draw the diagram on your own before reviewing the answer.


Due to the relative emphasis on graph analysis in this unit, students often interpret market equilibrium as just the point where supply and demand intersect. Market equilibrium is more than just a point. Market equilibrium is a situation in which both consumers and producers are satisfied with price and quantity. To reinforce your understanding, review a scenario where, for whatever reason, the price is higher than the equilibrium price. How would you explain the situation at a price of 750 yuan? Is there any adjustment?


What will happen in a competitive market when a change in demand or supply causes a shortage to occur at the original price? Think about the effect of a shortage on the price of the good.

To review, see:

 

2b. Determine the equilibrium in a market under situations that cause shifts in demand and supply that affect changes in prices and quantities

  • What is the effect of a change in demand on market price and quantity?
  • What is the effect of a change in supply on market price and quantity?
  • What is the effect on market price and/or quantity of a change in both supply and demand?

We need analytical tools to examine the effects changes have on market price and quantity since the events that alter supply and demand impact the economy. Follow this four-step process to analyze the impact of daily economic events:

  1. How many events are affecting the market?
  2. Do events affect supply, demand, or both?
  3. Do events increase or decrease demand and supply?
  4. Analyze the impact of P and Q in a diagram. Explain the new equilibrium.

For example, we can apply this thinking process to analyze the impact of the reduced global supply of sugar in November 2023 caused by unfavorable weather in key sugar-exporting countries like India and Thailand. If you follow the steps correctly, your answer should indicate an increase in market price and a reduction in market quantity.


Pay attention to situations where both the supply and demand curves shift. If there is no information about the size of the shift, the impact on price or quantity could be undetermined.

To review, see:

 

2c. Explain how demand and supply behave in the labor and financial markets

  • What is a financial market?
  • What is the difference between debt and equity?
  • What is the relationship between risk and return?
  • Who supplies and borrows funds in the financial market?
  • What is the interest rate?
  • Who supplies and who demands labor?
  • What is the equilibrium wage?

We can use the supply and demand framework to review the financial and labor markets. 

Financial markets are critical for firms and consumers since they allocate and provide financial resources connecting savers and borrowers. Economists examine financial markets in more detail in macroeconomics, but we can explore their basic functions in microeconomics. In a financial market, the interest rate is represented on the y-axis as the price, and the x-axis represents the quantity of financial capital.

The interest rate serves as the price of money, factoring in time. You should also be familiar with various types of financial capital and the ability to distinguish between debt (such as bonds) and equity (shares of a company). 

Labor markets are also critical for firms and individuals. The labor market matches individuals who supply work with employers who demand workers. This matching process is based on the skills, qualifications, and preferences of workers and firms, determining the equilibrium wage. You should understand the representation of the labor market in a diagram, with wages on the y-axis and the quantity of hours worked (or the number of workers) on the x-axis. The demand and supply curves behave like those for goods and services. 

To review, see:

 

Unit 2 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • debt
  • demand
  • equilibrium wage
  • equity
  • financial markets
  • interest rate
  • labor market
  • Law of Demand
  • Law of Supply
  • market equilibrium
  • quantity demanded
  • quantity supplied
  • supply

Unit 3: Elasticity and its Applications

3a. Explain the concept of elasticity as it applies to microeconomics

  • Why is elasticity a fundamental concept in economics?
  • On which variables can we apply an elasticity analysis?
  • Why is elasticity calculated in terms of percentage changes?

Elasticity is a core concept in microeconomics. Thus far, we have focused on understanding the direction (increase or decrease) of changes in the basic microeconomic variables: demand, supply, quantity demanded, quantity supplied, and price. With elasticity, we assess how much (in percentage terms) a variable changes in response to a given percentage change in a related variable. All we need to do is divide the percentage change in the dependent variable by the percentage change in the independent variable. Economists use elasticity to analyze how demand and/or supply react to specific changes in price, income, price of related goods, advertising, taxes, etc.

To review, see:

 

3b. Discuss price elasticity of demand and understand how to measure it

  • What is the price elasticity of demand?
  • What is the formula used to calculate the price elasticity of demand?
  • Why do we take absolute value to calculate the price elasticity of demand?
  • What is the interpretation of an elasticity result that is, for example, lower than one?
  • Do all consumers have the same price elasticity of demand?
  • What goods and services would you expect to have a lower price elasticity of demand, necessities, or luxuries? 

Let's apply the concept of elasticity to the quantitative analysis of the relationship between various microeconomic variables. One of the most widely used elasticities is the price elasticity of demand (PED), which measures the percentage change in the quantity demanded of a good in response to a given percentage change in its price.

Mathematically:

PED = | (ΔQ/Q) / (ΔP/P) | = | % change in Qd / % change in P |

The interpretation of the result is as important as the calculation itself. You do not need to memorize the possible results and their meaning. Make sure you understand what the numbers mean. For example, if the elasticity is positive or greater than one, the upper part of the fraction is higher than the bottom part. Therefore, the quantity demanded reacts more than the change in price itself. If the elasticity is negative, the upper part of the fraction is lower than the bottom part. Therefore, the quantity demanded reacts less than the change in price itself. This rationale allows you to interpret the results.

To review, see:

 

3c. Give examples of income elasticity of demand and cross price elasticity of demand and understand their results

  • What is the income elasticity of demand?
  • What is the cross price elasticity of demand?
  • Do we take absolute value to calculate income elasticity of demand?
  • How do you interpret negative cross price elasticity results?
  • How do we use income elasticity of demand to classify goods as normal or inferior?

Let's expand on the analysis of demand elasticities by incorporating the income elasticity of demand (IED) and the cross-price elasticity of demand.

Income elasticity of demand quantifies the percentage change in quantity demanded relative to a given percentage change in income. We refrain from calculating absolute values to differentiate betweeninferior goods (negative results) and normal goods (positive results). As we did for the PED, we use the values one and minus one to assess whether demand is income elastic or inelastic.

Mathematically:

IED = (ΔQ/Q) / (ΔIncome/Income)

IED = % change in Qd / % change in Income

Cross price elasticity of demand (XED) measures how much the quantity demanded of a good or service changes (in percentage) relative to a given percentage change in the price of another good or service. As with price elasticity of demand, we refrain from calculating absolute values because we need to interpret both positive and negative values. 

XED = % change in Qy / % change in Px

For example, if we analyze the cross-price elasticity between olive oil and sunflower oil, a positive value implies that consumers tend to substitute olive oil with sunflower oil when the price of olive oil rises. This indicates that olive oil and sunflower oil are substitutes. 

Again, rather than rely on rote memorization, focus on understanding the interpretation and analysis of the results. This approach will significantly enhance your understanding of microeconomics. Can you create your own example and interpretation of a negative value for the cross price elasticity of demand?

To review, see:

 

3d. Explain price elasticity of supply and its applications

  • What is the price elasticity of supply?
  • How do we interpret the results of the price elasticity of supply?
  • What factors affect the price elasticity of supply?
  • Do we need to take absolute value to calculate the price elasticity of supply? 

The price elasticity of supply shows how producers adjust their output in response to price changes.

Mathematically:

PES = % change in Qs / % change in P

A result higher than one (change in quantity supplied is higher than the change in price) suggests that producers can readily increase or decrease production in response to price changes. You can apply a similar reasoning to understand the implications of results lower than one, including zero.

To review, see:

 

3e. Predict how elasticity affects revenue and pricing decisions

  • What is the relationship between total revenues and the price elasticity of demand?
  • What is the relationship between total revenues and price elasticity of supply?
  • Facing a demand that is price elastic, should a firm increase the price to optimize total revenue?

You have probably gathered that businesses must understand elasticity! Pricing strategies significantly impact revenues and profits. Since we multiply price by the number of units sold to determine revenues, the responsiveness of sales to price changes directly influences revenue.

Rather than providing a comprehensive table of elasticity-revenue relationships, this unit empowers you to analyze any situation. Let's revisit the key steps:

  1. Interpret the elasticity result – determine whether the change in quantity is higher or lower than the price (or income) change;
  2. Remember the total revenue formula – revenue equals price multiplied by quantity and
  3. Analyze revenue's direction – identify whether revenue increases or decreases. Account for the inverse relationship between price and quantity demanded.

For example, the price elasticity of demand for oranges is approximately 0.6. This indicates that if the price of oranges increases by a specific percentage, ceteris paribus, the quantity demanded will decrease by a lower percentage. What would occur to total revenues? They would rise because the change in price exceeds the change in the quantity demanded.

To review, see:

 

3f. Discuss how tax incidence relates to the model of demand and supply and to elasticity

  • What is tax incidence?
  • What is the tax burden?
  • What is the effect of a tax levied on a product with a demand that is perfectly price elastic?

Tax incidence determines who ultimately bears the cost of a tax, considering both the direct and indirect consequences of the tax. Tax incidence involves analyzing how the tax burden is distributed between buyers and sellers in the market. The tax burden, also known as the tax share, refers to the actual economic cost of the tax borne by an individual or entity. For example, firms pay the government a tax on their sales. However, firms can pass the entire or partial amount of tax along to the consumer. The amount the consumer supports of this tax burden and the amount the firm assumes depends on the relative price elasticity of demand and the price elasticity of supply. Understanding elasticity is essential for policymakers to assess the impact of tax policies.

The price elasticity of supply and demand also determine the amount of revenue the government receives from the tax. For example, a tax on a product with highly inelastic demand (such as alcoholic beverages or cigarettes) will generate more tax revenue than a tax on a product with relatively elastic demand (a product with many close substitutes). 

Be sure to review the two videos on the relationship between taxation and the two polar cases of price elasticity of demand. 

To review, see:

 

Unit 3 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • cross price elasticity of demand (XED)
  • elasticity
  • income elasticity of demand
  • price elasticity of demand (PED)
  • price elasticity of supply
  • tax burden
  • tax incidence

Unit 4: Markets and Individual Maximizing Behavior

4a. Explain how the maximization assumption helps us understand the behavior of consumers and firms

  • What principle drives consumer behavior?
  • What principle drives producer behavior?
  • What are consumer surplus and producer surplus?
  • What is the relationship between consumer surplus and value?
  • What is the relationship between producer surplus and the supply curve?
  • How does demand represent marginal benefit, and how does supply represent marginal cost?

Let's revisit the familiar demand and supply framework to examine the concept of efficiency. By closely observing the equilibrium between demand and supply, we notice it is impossible to enhance consumer satisfaction without simultaneously impacting producers. Similarly, firms cannot increase their revenue without affecting consumer satisfaction. The equilibrium involves efficiency! (Hint: consider a price above or below the equilibrium and analyze the situation for consumers and producers in terms of efficiency).

Consumer surplus, producer surplus, and the resulting total surplus are valuable tools for assessing market efficiency. They are based on the fact that consumers seek to maximize their utility while firms act to maximize their economic profit. Consumer surplus is defined as the difference between the total amount that consumers are willing and able to pay for a good or service and the total amount that they actually do pay. This measure reflects the extra benefit consumers receive from purchasing a good or service at a market price that is lower than the maximum price they are willing to pay. Producer surplus, on the other hand, is the difference between the total amount that producers receive for a good or service and their total cost of producing it. It represents the additional benefit producers gain by selling a product at a market price that is higher than the minimum price at which they are willing to sell.

Visualizing concepts through diagrams facilitates a deeper understanding of their relationships and applications. Take, for instance, the market for smart speakers shown in the diagram below. How much is consumer surplus (CS), and what does it mean? How much is producer surplus (PS), and what does it mean? Why is a quantity of 10,000 units of smart speakers at a price of $200 per unit an efficient combination? Can consumer surplus increase without decreasing producer surplus? Can smart speaker producers sell the product at a price below $100?


To review, see:

 

4b. Apply the concept of consumer surplus, producer surplus, and total surplus to understand the efficient or equitable allocation of resources when there is a change in demand or supply

  • How is consumer surplus affected by a shift in demand or supply?
  • How is producer surplus affected by a shift in demand or supply?
  • How is total surplus (social surplus) affected by market events?

We know the market is dynamically influenced by events that affect demand, supply, or both. We also know how these events affect market prices and quantities (Units 2 and 3). But do we know how they impact efficiency? Yes! We just need to review how shifts in demand, supply, or both impact total surplus (i.e., social surplus) by incorporating the consumer and producer surplus triangles into our demand and supply shift analysis. 

This diagram illustrates an increase in demand and allows us to assess the impact on total surplus and revisit concepts and relationships from previous units.


While the resulting increase in price might have led you to think that consumer surplus has decreased, note that the consumer willingness to pay has also increased (from A to E). The diagram shows that both consumer surplus and producer surplus have increased, leading to a larger total surplus. 

The efficiency analysis based on changes to consumer and/or producer surplus is very useful for assessing the impact of adopting tax policies, price controls, foreign trade tariffs, etc. 

To review, see:

 

4c. Apply efficiency analysis to understand the effects of the adoption of price controls

  • What is a price control?
  • What are the different types of price controls?
  • What are the benefits of price controls? Who benefits?
  • What problems do price controls cause? Who is hurt?
  • How do price controls affect market efficiency?
  • What is a deadweight loss?

Free markets create an equilibrium at the point where demand and supply intersect. What happens in a market when the government considers the free market equilibrium price "too high" or "too low"? Governments may implement price controls to attempt to influence the market. For example, in May 2023, UK ministers were reportedly working with supermarkets to voluntarily cap the price of essential food items to alleviate the nation's rising cost of living (with a price ceiling).

The diagram below illustrates the potential excess of demand that a price ceiling could introduce to the milk market. While the deadweight loss (economic inefficiency that results when the allocation of resources is not optimal, such as when supply and demand are not in equilibrium) is not explicitly depicted in the diagram, we can determine it by comparing consumer surplus and producer surplus before and after the implementation of the price control.


Another instance of price controls is the adoption of a minimum wage (a price floor) by governments that consider the wage rate for important jobs "too low", such as when workers do not earn enough to rise above the poverty level. Governments may require businesses to pay a minimum wage to their workers. 

To review, see:

 

4d. Explain how consumers and firms use marginal benefit and marginal cost to make rational choices

  • What is the marginal decision rule?
  • What steps do economic agents follow to determine optimal outcomes?
  • What is the value of marginal benefit with respect to marginal cost at the optimal level of consumption or production?

To analyze how market participants (consumers and firms) make decisions, we start with the basic assumption that they are driven by rational self-interest and seek to maximize utility (consumers) and profits (firms).

According to the marginal decision rule, consumers and firms compare the marginal benefit or marginal cost of adding one more unit to consumption or production. If the marginal benefit of the next unit exceeds the marginal cost, they should add more units.


Figure: The Benefits and Costs of Studying Economics

To review, see:

 

4e. Explain how market failures are caused by externalities and public goods and identify the role of government intervention in alleviating them

  • What are some examples of market failure?
  • What are some examples of a public good?
  • What are some examples of a free rider?
  • What are negative and positive externalities, and what are some examples of each?
  • What government policies are used to correct negative externalities?
  • What is the concept of the tragedy of the commons?

The free market equilibrium is the most efficient point in the market in terms of optimizing total surplus. However, from a society's point of view, the market equilibrium may not always be the best. Sometimes, externalities, public goods, asymmetric information, and market power generate additional costs or benefits that are not considered in the interaction between demand and supply and its resulting equilibrium.

In the presence of market failures like externalities and public goods, markets may fail to allocate resources effectively. Externalities arise when consumption or production has an unintended effect (positive or negative) on a third party. The pleasant piano music played by your neighbor's son is an example of a positive externality, whereas the unpleasant smoke emanating from the restaurant downstairs represents a negative externality.

Public goods, like national defense, are non-rivalrous and non-excludable, meaning everyone benefits without paying, leading to underproduction. Government intervention, such as taxes or subsidies, can address market failures.

The tragedy of the commons refers to a situation where a shared resource is overused and depleted because individuals, acting in their self-interest, exploit the resource without considering the long-term consequences for the collective (the free rider problem). While some public goods are common resources, not all public goods are.

To review, see:

 

4f. Apply marginal benefit and marginal cost analysis to show how society can achieve efficient solutions to environmental problems

  • What are some negative externalities that pollution creates?
  • What government policies are used to correct negative externalities?
  • How do policymakers use marginal analysis to tackle environmental problems?

Many economic activities generate environmental problems, such as pollution, which results in external costs that market prices do not take into account. Economists' assessments of the marginal benefit and marginal cost of economic activities that impact the environment can help governments make informed decisions regarding resource allocation for environmental control.

For example, governments may implement a pollution tax, raising costs for businesses that pollute. When determining the potential structure of this tax, policymakers should compare the marginal cost of the tax (such as the additional deadweight loss the tax caused) to its marginal benefit (the additional reduction in polluting activities).

Governments can also provide funding to encourage businesses to develop and use clean technologies. To determine the appropriate funding level, policymakers should weigh the marginal cost of the subsidy (the additional government financial outlay) against its marginal benefit (additional benefit society receives from clean technologies, such as health benefits, clean rivers, etc.).

To review, see:

 

4g. Explain how the Lorenz curve and Gini coefficient give insight into a country's distribution of income and income inequality

  • What is income inequality?
  • Why has income inequality increased around the world?
  • How do we measure income inequality using the quintile distribution?
  • How do we measure income inequality using the Lorenz curve?
  • How do we measure income inequality using the Gini coefficient?

Income inequality (the uneven distribution of income and economic resources among individuals, households, or different groups within a society) is a growing problem in many countries, including the United States. Shifts in wage distribution and changes in households' composition partially explain the increase in inequality.

Common methods used to measure income inequality include: 

  • Quintile distribution: This method divides all households into five equal groups, called quintiles, based on their income. The first quintile contains the poorest 20 percent of households, the second quintile contains the next 20 percent, and so on. Economists calculate the share of income each quintile receives.
  • Lorenz curve: This curve on a graph shows the cumulative share of the population on the horizontal axis and the cumulative percentage of total income received on the vertical axis. The closer the Lorenz curve is to the 45-degree line, the more equal the income distribution.
  • Gini coefficient: This is a number between zero and one that measures the overall level of income inequality. A Gini coefficient of zero indicates perfect equality; a Gini coefficient of one indicates perfect inequality.

To review, see:

 

4h. Distinguish between relative and absolute measures of poverty and explain the major factors that cause and prevent poverty in the United States

  • What is the poverty line?
  • What is the difference between poverty and income inequality?
  • What is the difference between the absolute and the relative income tests?
  • What are the poverty rate and the poverty trap?
  • Can governments avoid the poverty trap?

Poverty and income inequality are related yet distinct economic concepts. We determine poverty by the number of individuals who fall below a specific income threshold (the poverty line). Using the poverty line, we can distinguish between absolute and relative income tests. An absolute income test sets a specific income level and defines a person as poor if their income falls below that level. For a relative income test, people are considered poor when their income falls at the bottom of the income distribution.

The poverty rate measures the percentage of the population that is below the poverty line in any given year. The concept of a poverty line raises many tricky questions. For example, should there be a national poverty line in a country as vast as the United States? Should the government adjust the poverty line to account for the value of non-cash assistance programs such as Medicaid and food aid?

While government assistance programs and subsidies may seem like an effective way to address poverty, they can inadvertently create a poverty trap. This occurs when the additional earnings from working are offset by reductions in government support, disincentivizing individuals from seeking employment. Review the measures suggested in the readings to avoid the poverty trap.

To review, see:

 

4i. Illustrate how discrimination in the labor market affects the labor demand and labor supply curves

  • What is the wage rate?
  • What is employment discrimination?
  • Why does discrimination persist?
  • How can we identify employment discrimination in the labor market diagram?

In Unit 2, we introduced the concept and functioning of the labor market. With workers supplying labor and firms demanding labor, the labor market functions in the same way as any other market for goods or services, with the price on the y-axis determined by the wage rate (the amount of compensation individuals receive in exchange for performing labor or services).

Even at the equilibrium point, an efficient labor market can discriminate against specific sectors of society. Employment discrimination occurs when workers with the same skill levels receive different pay or have different job opportunities due to their gender, race, or religion. Make sure you review Gary Becker's model of discrimination in the workplace and the relevant diagram.

To review, see:

 

Unit 4 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • absolute income test
  • consumer surplus
  • deadweight loss
  • employment discrimination
  • externalities
  • free rider problem
  • Gini coefficient
  • income inequality
  • Lorenz curve
  • marginal decision rule
  • negative externality
  • positive externality
  • poverty
  • poverty line
  • poverty rate
  • poverty trap
  • price ceiling
  • price control
  • price floor
  • producer surplus
  • public good
  • quintile distribution
  • relative income test
  • tragedy of the commons
  • wage rate

Unit 5: Introduction to Consumer Choice

5a. Explain consumer preferences using concepts related to utility, including total utility and marginal utility

  • What is marginal utility?
  • How do consumers choose between two goods?
  • Why is marginal utility diminishing?
  • What does the law of diminishing marginal utility indicate?

The theory of consumer choice seeks to understand how consumers allocate their limited income to maximize their utility. Consumers' choices are affected by preferences, budget restrictions, and the prices of goods and services. As individuals seek to maximize their utility, it is essential to remember that marginal utility (the benefit per unit of a good or service) diminishes while total utility increases with consumption. 

To review, see:

 

5b. Analyze a household's budget line and describe how it changes when prices or incomes change

  • What is a consumer's budget line?
  • How does the budget line limit consumer choices?
  • How does a price change affect the budget line?
  • How does an income change affect the budget line?

We explored the concept of the budget line and the relevant diagram in Unit 1. Here, we review the budget line in the context of consumer choice theory and analyze the effect of price changes and income changes on the budget line.

Review this monthly budget line below for a consumer who buys pizzas and books. If books are $15 per unit and pizzas are $10 per unit, how much income does the consumer have? Recall that we assume the consumer maximizes their utility by spending their entire income (that is, without saving).


What would happen if the price of pizzas goes up? We can apply the Law of Demand from Unit 2. The decrease in the quantity demanded that results is represented by an inward rotation of the budget line. We can use the same process to analyze the impact of a change in income. What is the impact of an increase in income on the budget line?


To review, see:

 

5c. Use indifference curves to explain the principle of diminishing marginal rate of substitution

  • What is an indifference map and an indifference curve?
  • What is the marginal rate of substitution?
  • Why does the marginal rate of substitution decrease as we move downward in an indifference curve?
  • How is the optimal consumer choice obtained using an indifference map and the budget line?

Let's analyze the same consumer from the previous section who spent their entire budget on books and pizzas. We are familiar with their budget line, but we want to review the satisfaction they obtain from consuming a given combination of pizzas and books and the rate at which they are willing to exchange books for pizzas. This information is contained in the indifference map and in each indifference curve.


What has to happen for the consumer to be able to move from Indifference Curve 1 to Indifference Curve 2? Does the consumer prefer to consume five books and two pizzas or four books and four pizzas? Why is the marginal rate of substitution (MRS) – the rate that the consumer is willing to give up one good in exchange for an additional unit of another good while keeping their level of satisfaction or utility constant – diminishing?

Imagine you only have two books. Wouldn't you demand a larger number of pizzas to give up one book than if you had, let's say, ten books? This is what the MRS measures and why it decreases along a given indifference curve.

To find the optimal consumer choice, we look for the equilibrium between the highest possible indifference curve and the budget line. Make sure you spend some time reviewing why A is the optimal consumer choice and what it means. Due to the abstract nature of this section, make sure that you review all the resources thoroughly. 


To review, see:

 

5d. Derive a demand curve from an indifference map by analyzing the quantity of the good consumed at different prices

  • What is a demand curve in the framework of optimal consumer choices?
  • How is the demand curve connected to the budget line and the indifference curves?
  • Why does a decrease in price result in an increase in the quantity demanded?

The demand curve, which we introduced in Unit 2 as a simple relationship between price and quantity, is formally derived from the optimal consumer choice (consumer equilibrium) you recently reviewed.

Consumer equilibrium displays the optimal combination of goods and services a consumer can afford to buy given their preferences (illustrated by indifference curves) in terms of the prices of goods and their income (illustrated by the budget line). In turn, the demand curve presents the connection between prices and the quantity demanded of goods and services. It is obvious, therefore, that there is a connection between consumer equilibrium and the demand curve.

To establish this link, we only need to change the price of the good measured on the x-axis within the consumer equilibrium framework. Changing the price rotates the budget line, leading to a new quantity demanded. This is precisely what the demand curve illustrates – it represents the connection between the market price and the quantity demanded of a good or service. In this sense, each consumer equilibrium point at different prices (tangency between an indifference curve and a budget line) is a point of the demand curve.

To review, see:

 

Unit 5 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • budget line
  • demand curve
  • indifference curve
  • indifference map
  • marginal rate of substitution (MRS)
  • marginal utility
  • optimal consumer choice
  • theory of consumer choice

Unit 6: The Producer

6a. Analyze the behavior of the producer

  • Why do firms exist?
  • What is the difference between accounting profit and economic profit?
  • What are opportunity costs in the context of a company's production decisions?
  • What is the difference between the short and the long run in microeconomics?

Understanding producer behavior is a bit more complex than that of consumers. It helps to keep a simple guiding question in mind: once producers have decided what they want to produce and how they are going to produce it, how do they decide how many units to produce? What factors affect this decision? Whenever you feel a dark cloud of abstract concepts looming over you, go back to basic questions like this one.

When analyzing the producer's decision regarding how many units to produce, consider the timeframe. In microeconomics, the timeframe is straightforward: if the firm can only alter the number of workers employed during the production process, it is the short run. If the firm can adjust all of the factors of production, it is in the long run. This distinction frames Burger King's decision whether to hire another employee (short run) or open another restaurant (long run). 

Review the distinction between accounting profit (the difference between a firm's total revenue and its explicit costs like materials and labor)and economic profit (found by subtracting explicit and implicit costs from total revenue) because profit maximization guides producer behavior. For example, consider the economist who quits their corporate job (earning $60,000 a year) to start a small business that earns $40,000 a year in accounting profits. A positive accounting profit indicates that the business can cover its costs and earn positive profits. However, the –$20,000 economic profit (accounting profit minus the opportunity cost of the salary forgone) may convince the economist to close their new business and return to earning a corporate salary (if it is still available).

To review, see:

 

6b. Compare the costs of production in the short run to the costs of production in the long run

  • What are fixed costs, variable costs, and total costs?
  • What are average total cost, marginal cost, and average variable cost? How are they computed and represented?
  • How do costs change when we increase or decrease output?
  • What is the long-run average total cost, and how is it represented graphically?
  • Can you identify economies of scale, diseconomies of scale and constant returns to scale in a diagram?

Short-Run Costs

Each firm's cost structure is unique due to its different production processes. However, all firms display certain common features. These features differ in the short and long run. Why? (hint: review the previous section). 

Here is a summary of the main properties of the short-run cost structure to help you review the relevant definitions and/or properties. Make sure you can explain the reasons behind each graphical representation (output is on the horizontal axis, and the relevant costs are on the vertical axis).

  1. Fixed costs do not change with the level of output. The fixed cost curve is a horizontal line.
  2. Variable costs change with the level of output. The variable cost curve is an upward-sloping curve. 
  3. Marginal cost represents the additional cost of producing one more unit of output. The marginal cost curve is U-shaped.
  4. Average fixed cost is the fixed cost per unit of output. The average fixed cost curve is a downward-sloping curve that shows how average fixed costs decrease as output increases.
  5. Average variable cost is the variable cost per unit of output. The average variable cost curve is U-shaped. It shows how average variable costs first decrease and then increase as output increases. Why?
  6. Average total cost is the total cost per unit of output. The average total cost curve is U-shaped. The explanation is the same as the one you just reviewed for the average variable cost curve.

Long-Run Costs

The long run is a time period where all costs are variable since the firm can adjust all its factors of production. It is specific to each firm. For example, Inditex might be able to open a new Zara store in Madrid more quickly than a local restaurant could open a new location in a nearby town.

The diagram below illustrates the long-run cost curve of a company producing CDs. Note that the long-run average total cost curve (LRAC) envelopes its short-run cost average total cost curves.


Figure: Relationship between Short-Run and Long-Run Average Total Costs

We derive the LRAC by taking the lowest average total cost curve at each level of output. The graph displays the average total cost curves for 20, 30, 40, and 50 units of capital (the four smaller yellow curves). When the firm produces 10,000 CDs per week, it can minimize the cost per CD by producing 20 units of capital (point A). What about when it produces 20,000 CDs per week?

Keep in mind that it takes time to move from one point to another along the LRAC. Each point represents the lowest average cost after all possible adjustments are made. With this long-run framework, the firm can determine the optimal scale of production and take advantage of economies of scale (the downward-sloping section of the LRAC in the diagram above). 

To review, see:

 

6c. Compute the relationship between different cost functions

  • What is the relationship between marginal cost and average total cost?
  • What is the relationship between the marginal cost curve and average variable cost?
  • What specific calculations define each type of cost?
  • What is the relationship between the production function and costs?

Consider an ice cream shop that rents an ice cream machine and has contracted two employees to work on an hourly basis (at $10 per hour). The cost to rent the storefront and lease the ice cream machine is fixed: the business manager must pay these fixed costs regardless of how many ice cream cones he produces or sells. How do fixed costs behave when we increase the number of ice cream cones produced?

Since the business manager has contracted their employees to work on an hourly basis, the number of work hours will vary with the production level (number of ice cream cones produced and sold). This cost is variable, not fixed. We can see in the table below that greater production quantities are associated with more hours worked.

Ice Cream cones

Fixed Cost

Average Fixed Cost

Variable Cost

Average Variable Cost

Total Cost

Average Total Cost

Marginal Cost

0

$1,000

-

$0

-

$1,000

-

-

1

$1,000

$200

$10

$10

$1,010

$1010

$10

5

$1,000

$200

$10

$2

$1,010

$202

$0

10

$1,000

$100

$30

$3

$1,030

$103

$20

15

$1,000

$67

$60

$4

$1,060

$71

$30

20

$1,000

$50

$100

$5

$1,100

$55

$40


How do we calculate marginal cost from total cost, and how do we interpret an increasing marginal cost? Again, consider the effect on worker productivity as you add additional employees in a crowded space and as you ask employees to work extra long hours.

Review the relationship between the production functions and costs by revisiting the diagram below, where we measure the quantity produced on the vertical axis of the total product curve and on the horizontal axis of the total cost curve.


Key Takeaways from 8.1 Production Choices and Costs: The Short Run

To review, see:

 

6d. Identify the production function in the short run as well as the long run

  • What is the short-run production function?
  • What is the Law of Diminishing Marginal Returns?
  • Why do diminishing marginal returns affect the short-run production function?
  • What optimization rule do companies follow to decide how many employees to hire?
  • What is the long-run production function?
  • What is the difference between diminishing marginal returns and negative returns?
  • What is the relationship between returns to scale and economies/diseconomies of scale?

A production function is the relationship between a company's factors of production and its output. The ice cream shop from the previous section uses inputs: fixed resources (the shop and the ice cream machine) and variable resources (employees, sugar, cream, cones) to produce the output: ice cream cones. This is a short-run production function. Why?

This figure presents an example of a company that produces jackets. The table above the graph indicates output levels per day for Acme Clothing Company at various quantities of labor per day, assuming the short run. We plot these values on the graph as a total product curve.


Figure: Acme Clothing's Total Product Curve

As we move from points A, B, and C to D, the slope of the production function rises, indicating increased worker productivity. What could cause an increase in labor productivity? (Hint: we talked about workers' specialization in Unit 1).

However, as we continue adding more employees past point D, labor productivity declines (diminishing marginal product) until it reaches point H. After point H, additional labor will actually lead to negative returns in production. Do these negative returns make sense? Make sure you understand the difference between points H and I. 

What we see after point D is the Law of Diminishing Marginal Returns, which states that the marginal product of any variable factor of production eventually declines, assuming the quantities of other factors of production are unchanged. At this point, you should be able to explain why the marginal product will eventually decline. 

In the long run, when firms can freely adjust all factors of production, the constraint of fixed capital becomes irrelevant. We use the long-run production function to analyze this scenario. The long-run production function illustrates the maximum output that a firm can produce given its available resources and technology when all factors of production are variable. 

The long-run production function can show three different returns to scale:

  • Increasing returns to scale: Inputs increased by a certain percentage result in output increase by a larger percentage.
  • Decreasing returns to scale: Inputs increased by a certain percentage result in output increase by a smaller percentage.
  • Constant returns to scale: Inputs increased by a certain percentage result in a proportional increase in output.

You should now be able to match the different returns to scale with the economies and diseconomies of scale we reviewed previously. 

To review, see:

 

Unit 6 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • accounting profit
  • average fixed cost
  • average total cost
  • average variable cost
  • economic profit
  • fixed costs
  • Law of Diminishing Marginal Returns
  • long-run production function
  • long run
  • marginal cost
  • production function
  • short run
  • total cost curve
  • total product curve
  • variable costs

Unit 7: Market Structure: Competitive and Non-Competitive Markets

7a. Explain the assumptions made about and the differences between perfectly competitive markets, non-competitive markets, and imperfectly competitive markets

  • What is a market structure?
  • How many companies can exist in each of the four types of markets?
  • What market structures display barriers to entry?
  • What market structures are characterized by differentiated products?
  • Under what market structures can companies sustain positive economic profit in the long run?

Producers must consider the market structure when determining their best output level and pricing strategies. This includes assessing the competitive landscape, including the number of rivals, product similarity, and the ability to influence market prices. These are fundamental factors to address when making crucial decisions. The market structure holds the key to answering these questions.

The table below summarizes the distinctions between the four primary market structures. Note that mixed or hybrid structures, which encompass a mixture of characteristics, exist in addition to these four structures (perfect competition, monopoly, oligopoly, and monopolistic competition).

Market Structure

Number of Companies

Barriers to Entry

Nature of Product

Control Over Prices

Positive Economic Profit in the Long Run

Perfect Competition

Many or Infinite

No

Homogeneous

No

No

Monopoly

One

Yes

Unique

Yes

Yes

Oligopoly

Few

Yes

Homogenous or Differentiated

Some

Yes

Monopolistic Competition

Many

Few

Differentiated

Little

No

To review, see:

 

7b. Discuss the characteristics of the model of perfect competition in the short-run and the long-run

  • What is perfect competition?
  • How is the demand curve for the firm different from the market demand curve under perfect competition?
  • What sequence of events indicates a market change that will cause existing companies to earn a positive economic profit under a perfectly competitive market structure?
  • What sequence of events indicates a market change that will cause existing companies to experience negative economic profit under a perfectly competitive market structure?
  • Why do companies experience zero economic profit in the long run under perfect competition?
  • Why are consumers and firms price takers under a perfectly competitive market structure?
  • Identify the firm's economic profit level in a perfectly competitive market diagram.

With perfect competition, a market is characterized by a large number of firms and consumers, making it impossible for any single one of them to influence the market price. Firms have the freedom to enter and exit the market, and the products offered are homogenous. This homogeneity of products leads to a perfectly elastic demand curve for the firm while the market demand curve itself slopes downward (as you have already learned in Unit 2).

Market demand shifts directly influence total revenues (price times quantity sold) and economic profit levels. For example, if consumer demand increases, causing prices and quantities to increase, the profit level of each company will also increase. The higher the economic profit potential, the more attractive it becomes for businesses to enter the market.

Free from entry barriers, firms will enter the market, causing the supply curve to shift downward. This process of entry and exit continues until economic profits reach zero, establishing the long-run equilibrium. 

It may seem counterintuitive that firms continue to operate in the long run, even when economic profits are zero. To understand this concept, it is essential to recall the calculation for economic profit: accounting profit minus opportunity costs. A company that makes zero economic profit is covering its costs, paying its workers, and doing the best it can without a better alternative use of its resources. In this situation, the company will remain in business.

Review the graphs below, which illustrate the dynamics that result from short-run economic profit or loss outcomes.


Figure: Eliminating Economic Profits in the Long Run

In Panel (b), a single company's profit is shown by the shaded area. Entry continues until companies in the industry are operating at the lowest point on their respective average total cost curves and economic profits fall to zero.


Figure: Eliminating Economic Losses in the Long Run

Note that in these graphs, (Q) is the quantity supplied in the market, and (q) is the quantity supplied by one typical company.

To review, see:

 

7c. Describe the characteristics of the model of monopoly and how a monopolist maximizes profit

  • What is a monopoly?
  • What is a natural monopoly?
  • What is the profit-maximizing rule?
  • What is the profit-maximizing output and price for a monopoly?
  • How is the monopoly's demand curve different from the marginal revenue curve?
  • How can you display the economic profit level of a monopoly graphically?
  • What are the effects of monopoly on consumer and producer surplus?
  • Why are firms operating under monopolies less efficient than firms operating under perfect competition?
  • Can a monopoly experience negative economic profit?
  • What is price discrimination?
  • Can you name some real-world examples of price discrimination and a natural monopoly?

A monopoly appears when one firm, protected from competition by barriers to entry, produces products or services without close substitutes. While the monopolist has full (or almost full) market power, it still faces a downward-sloping demand curve. Because the monopoly's position can remain unchallenged for a long period of time, positive economic profit is possible in the long run. A natural monopoly occurs when a single firm can supply a good or service to an entire market at a lower cost than two or more firms could due to economies of scale.

Follow these steps to determine the monopoly's profit-maximizing price and output:

  1. Determine demand, marginal revenue, and marginal cost curves.
  2. Choose the output level where the marginal revenue and marginal cost curves intersect.
  3. Determine the price from the demand curve for the quantity found in step two. Remember that the demand curve illustrates how much the consumer is willing to pay for a specific quantity.

Once we have determined the monopoly company's price (Pm) and output (Qm), we can find its economic profit level by calculating the area in the green rectangle in the graph below [(P – ATC) * Q].


Figure: Computing Monopoly Profit

Monopoly analysis is straightforward once you understand this diagram and the principles behind it. It helps explain the inefficiency of monopolies compared to perfectly competitive markets, the ability of monopolies to engage in price discrimination (setting prices based on consumer willingness to pay), and the government's role in regulating monopolies.

To review, see:

 

7d. Analyze how monopolistic competition affects the short-run equilibrium and the long-run equilibrium

  • What are the main features of a monopolistically competitive market structure? 
  • What is the optimization rule for monopolistically competitive firms?
  • How do monopolistically competitive firms compare with perfectly competitive firms?
  • How do monopolistically competitive firms compare with monopoly firms?
  • Why and how is the economic profit of monopolistically competitive firms reduced to $0 in the long run?

Monopolistic competition lies in the middle of the market structure spectrum: between perfect competition and a monopoly. In this type of structure, we see many producers, as in perfect competition, and fierce competition drives long-run economic profits to zero. However, companies in monopolistic competition produce differentiated products and have the ability to exert some market power. They have some control over prices, and limited barriers protect them from other companies that want to enter their market.

The graphical analysis for a monopolistically competitive company in the short run resembles that of a monopoly company.


Figure: Short-Run Equilibrium in Monopolistic Competition

As you review this chart, examine the intersection of the marginal revenue curve MR1 and the marginal cost curve MC to see that the profit-maximizing quantity is 2,150 units per week. Reading up to the average total cost curve ATC, we see the cost per unit equals $9.20. The price, given on the demand curve D1, is $10.40, so the profit per unit is $1.20. Total profit per week equals $1.20 times 2,150, or $2,580 (area of the shaded rectangle).

When companies in monopolistic competition make positive economic profits in the short run, new companies enter the market to produce similar products. This is the same process that takes place under perfect competition. It is always a good idea to review the long-run dynamics in perfect competition while studying the long-run equilibrium in monopolistic competition.


Figure: Monopolistic Competition in the Long Run

In the diagram above, positive economic profits in the industry attract new firms. As new firms enter in the long run, the demand curve D1 and marginal revenue curve MR1 facing a typical firm will shift to the left to D2 and MR2. Eventually, this shift produces a profit-maximizing solution at zero economic profit, where D2 is tangent to the average total cost curve ATC (point A). The long-run equilibrium solution here is an output of 2,000 units per week at a price of $10 per unit.

To review, see:

 

7e. Describe the characteristics of an oligopoly and how it compares to other competitive and non-competitive models

  • What are oligopoly, cartel, collusion, and the prisoner's dilemma?
  • How is game theory used to study strategic behavior in oligopolies?
  • What is a dominant strategy?
  • Define Nash Equilibrium and how it is determined.

An oligopoly lies between a monopoly and perfect competition on the market spectrum.

Oligopolies have the following features:

  • There are a few competing and mutually interdependent firms. The quantity supplied by each firm is a large share of the market.
  • There are enough barriers to entry to prevent other firms from entering the market.
  • Each firm has enough market power to prevent it from being a price-taker, but there is enough rivalry between firms to prevent it from considering the market demand as its own market demand.
  • Each firm's strategies regarding pricing and quantities have an impact on the profitability of other firms.
  • Each firm realizes that its competitors might react to its strategies (output, price, or both). Firms typically engage in strategic behavior, which involves constant vigilance.

Oligopoly firms face the temptation to act as if they were a monopoly by acting together to control output and keep prices high. This is called collusion. A cartel is a formal agreement between firms to engage in collusion.

The Prisoner's Dilemma (a game theory scenario where two individuals acting in their own self-interest do not produce the optimal outcome, leading both to worse results than if they had cooperated) is a type of game theory that offers an interesting framework for analyzing strategic behavior among oligopoly companies. The Nash Equilibrium exists where each player's choice is the best response to what the other player has chosen, and none of the players has an incentive to change their choice in equilibrium. We need these analytical tools because of the complexity inherent to oligopolistic markets.

Examples of strategic behavior include a company that may try to outspend its competitors' advertising budgets when deciding how much to allocate to advertising next year. Another company may decide to pre-emptively invest in a large amount of capital to communicate a credible threat to its opponents to capture market share.

To review, see:

 

7f. Explain how the United States has used regulations to protect consumers and limit the effects of imperfect competition via antitrust policies

  • What are antitrust laws?
  • Why would policymakers implement regulations for the approval of mergers?
  • What are restrictive practices? Can you give some examples?
  • What are concentration ratios? How are they calculated and interpreted?
  • What is the Herfindahl-Hirschman Index? 

Real-world markets generally fall under the category of imperfect competition. When imperfect competition or actions taken by firms, such as mergers or acquisitions, lead to decreased competition, governments implement measures to ensure that the market continues to function efficiently. 

The United States uses antitrust laws and other regulations to protect consumers from the effects of imperfect competition.

Some examples of antitrust laws include:

  • Regulations for approving mergers and acquisitions. These regulations are complex as they require the calculation of the degree of market power by using tools such as the Herfindahl-Hirschman Index (HHI).
  • Rules against restrictive practices such as exclusive dealing agreements, tying sales, and bundling practices.
  • Regulations to prevent collusion.
  • Natural monopoly regulations.

To review, see:

 

Unit 7 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • antitrust laws
  • cartel
  • collusion
  • game theory
  • imperfect competition
  • market structure
  • monopolistic competition
  • monopoly
  • Nash Equilibrium
  • natural monopoly
  • oligopoly
  • perfect competition
  • price discrimination
  • prisoner's dilemma

Unit 8: The Role of the Government in a Market Economy

8a. Explain how government intervention can solve market failures of public goods

  • What is market failure?
  • What are public goods? Can you give examples of some?
  • Why is it difficult for private companies to provide public goods?
  • What is the free rider problem of public goods?

As we have introduced in Units 2 and 4, markets are not always efficient and can lead to market failure. When markets fail, the allocation of resources is not optimal, and there is a loss of social welfare. One of the causes of market failures is the existence of public goods. Public goods have two fundamental characteristics: non-excludability and non-rivalry. Non-excludability means that it's not possible to prevent people from using a good or service once it's provided. Non-rivalry means that one person's use of a good or service does not reduce its availability to others.

Due to the free rider problem of public goods, private firms are not incentivized to market public goods. Consequently, the government often intervenes through government spending on public goods financed through taxesand by charging small fees for the use of public goods.

To review, see:

 

8b. Explain how governments redistribute income through transfer payments

  • What is the relationship between income distribution and efficiency?
  • What are the factors that contribute to a skewed income distribution?
  • What is the difference between means-tested and non-means-tested transfer payments?

The efficiency of resource allocation in a private market hinges on the initial income distribution. A skewed distribution raises concerns about equitable resource allocation. Various elements, including luck, inherited wealth, unequal talent distribution, and market fluctuations, contribute to an unequal income distribution. 

Because most consider helping the poor a public good, most governments around the world make some effort to redistribute income through two types of programs: means-tested and non-means-tested transfer payments. Means-tested transfer payments are based on the recipients' income levels, such as Medicaid in the United States. The non-means-tested transfer payments are allocated to specific groups of individuals based on criteria other than income. Examples include Social Security, Medicare, and unemployment benefits.

To review, see:

 

8c. Differentiate between regressive, proportional, and progressive taxes

  • How do governments pay for the goods and services they provide?
  • What is the most important source of government revenue?
  • What is the ability-to-pay principle?
  • What is the difference between proportional, progressive, and regressive tax systems?

Governments need a source of revenue to provide public goods, services, and resources to lower-income sections of the population. In most countries, taxes are the main source of government revenue. Hence, policymakers need to decide on the type of tax system to adopt. Most tax systems link the amount of taxes people pay to the amount of income they receive (based on the ability-to-pay principle).

In this regard, we can distinguish between the following tax systems:

  • Proportional tax – tax is a fixed percentage of income.
  • Progressive tax – the government takes a higher percentage of income for higher incomes (as income rises).
  • Regressive tax – the government takes a higher percentage of income for lower incomes (as income falls).

To review, see:

 

8d. Explain public choice theory and public interest theory

  • What are the main choices that should be made in the public sector realm?
  • What are the main features of public choice theory and public interest theory?

How choices should be made in the public sector is the subject of intense academic and political debates. There are two main competing perspectives: public choice theory and public interest theory.

The basis of public interest theory lies in the belief that policymakers should work to identify and implement solutions that maximize the overall well-being of society. In contrast, public choice theory suggests that public sector individuals are driven by self-interest rather than a collective goal of maximizing net benefits for society. 

To review, see:

 

8e. Explain the Coase theorem and the conditions needed for private bargaining to achieve efficiency

  • Who was Ronald Coase?
  • Why do we study the Coase theorem?
  • What are the conditions that need to be met for the Coase theorem to apply?

The Coase Theorem argues private bargaining can result in an efficient allocation of resources when certain conditions are met, even in the presence of externalities. For example, if property rights are clearly defined and transaction costs are low, the parties affected by externalities can negotiate and reach an optimal outcome without the need for government intervention.

Property rights are considered to be clearly defined if ownership and control over resources are comprehensibly established. Transaction costs, which are the costs associated with conducting and enforcing agreements, must be low to facilitate efficient bargaining. 

To review, see:

 

Unit 8 Vocabulary

Be sure you understand these terms as you study for the final exam. Try to think of the reason why each term is included.

  • ability-to-pay principle
  • Coase Theorem
  • income distribution
  • market failure
  • means-tested
  • non-excludability
  • non-means-tested
  • non-rivalry
  • progressive tax
  • proportional tax
  • public choice theory
  • public interest theory
  • regressive tax