Microeconomics MID TERM Flashcards
microeconomics -
Branch of economics that deals with the behavior of individual economic units—consumers, firms, workers, and investors—as well as the markets that these units comprise
macroeconomics
Branch of economics that deals with aggregate economic variables, such as the level and growth rate of national output, interest rates, unemployment, and inflation
market
Collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products.
market definition
Determination of the buyers, sellers, and range of products that should be included in a particular market.
arbitrage
The practice of buying at a low price at one location and selling at a higher price in another
perfectly competitive market
Market with many buyers and sellers, so that no single buyer or seller has a significant impact on the price
supply curve
Relationship between the quantity of a good that producers are willing to sell and the price of the good
S shows…
The supply curve shows how the quantity of a good offered for sale changes as the price of the good changes. The supply curve is upward sloping: The higher the price, the more firms are able and willing to produce and sell. If production costs fall, firms can produce the same quantity at a lower price or a larger quantity at the same price.
demand curve:
Relationship between the quantity of a good that consumers are willing to buy and the price of the good
THE DEMAND CURVE
The demand curve, labeled D, shows how the quantity of a good demanded by consumers depends on its price. The demand curve is downward-sloping; holding other things equal, consumers will want to purchase more of a good as its price goes down. The quantity demanded may also depend on other variables, such as income, the weather, and the prices of other goods. For most products, the quantity demanded increases when income rises. A higher income level shifts the demand curve to the right (from D to D′).
SHIFTING THE DEMAND CURVE
If the market price were held constant at P1, we would expect to see an increase in the quantity demanded—say, from Q1 to Q2 , as a result of consumers’ higher incomes. Because this increase would occur no matter what the market price, the result would be a shift to the right of the entire demand curve.
substitutes
Two goods for which an increase in the price of one leads to an increase in the quantity demanded of the other
complements
Two goods for which an increase in the price of one leads to a decrease in the quantity demanded of the other.
In economics, market clearing is
the process by which, in an economic market, the supply of whatever is traded is equated to the demand so that there is no leftover supply or demand.
equilibrium (or market clearing) price
Price that equates the quantity supplied to the quantity demanded
market mechanism
Tendency in a free market for price to change until the market clears.
surplus
Situation in which the quantity supplied exceeds the quantity demanded.
shortage
Situation in which the quantity demanded exceeds the quantity supplied.
When the supply curve shifts to the right,
the market clears at a lower price P3 and a larger quantity Q3
When the demand curve shifts to the right,
the market clears at a higher price P3 and a larger quantity Q3
elasticity
Percentage change in one variable resulting from a 1-percent increase in another.
price elasticity of demand
Percentage change in quantity demanded of a good resulting from a 1-percent increase in its price.
infinitely elastic demand
Principle that consumers will buy as much of a good as they can get at a single price, but for any higher price the quantity demanded drops to zero, while for any lower price the quantity demanded increases without limit.
completely inelastic demand
Principle that consumers will buy a fixed quantity of a good regardless of its price.
theory of consumer behavior
Description of how consumers allocate incomes among different goods and services to maximize their wellbeing.
Consumer behavior is best understood in three distinct steps:
- Consumer Preferences
- Budget Constraints
- Consumer Choices
market basket (or bundle)
List with specific quantities of one or more goods.
Completeness:
Preferences are assumed to be complete. In other words, consumers can compare and rank all possible baskets. Thus, for any two market baskets A and B, a consumer will prefer A to B, will prefer B to A, or will be indifferent between the two. By indifferent we mean that a person will be equally satisfied with either basket. Note that these preferences ignore costs. consumer might prefer steak to hamburger but buy hamburger because it is cheaper.
Transitivity:
Preferences are transitive. Transitivity means that if a consumer prefers basket A to basket B and basket B to basket C, then the consumer also prefers A to C. Transitivity is normally regarded as necessary for consumer consistency.
More is better than less:
Goods are assumed to be desirable—i.e., to be good. Consequently, consumers always prefer more of any good to less. In
addition, consumers are never satisfied or satiated; more is always better, even if just a little better.
indifference curve
Curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction.
indifference map
Graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent.
The magnitude of the slope of an indifference curve measures
the consumer’s marginal rate of substitution (MRS) between two goods.
marginal rate of substitution (MRS)
Maximum amount of a good that a consumer is willing to give up in order to obtain one additional unit of another good.
CONVEXITY
Observe that the MRS falls as we move down the indifference curve. The decline in the MRS reflects our fourth assumption regarding consumer preferences: a diminishing marginal rate of substitution. When the MRS diminishes along an indifference curve, the curve is convex.
perfect substitutes
Two goods for which the marginal rate of substitution of one for the other is a constant.
perfect complements
Two goods for which the MRS is zero or infinite; the indifference curves are shaped as right angles.
utility
Numerical score representing the satisfaction that a consumer gets from a given market basket.
utility function
Formula that assigns a level of utility to individual market baskets.
budget constraints
Constraints that consumers face as a result of limited incomes
budget line
All combinations of goods for which the total amount of money spent is equal to income.
A change in income (with prices unchanged) causes the
budget line to shift parallel to the original line (L1).
A change in the price of one good (with income unchanged) causes the
budget line to rotate about one intercept.
The maximizing market basket must satisfy two conditions:
- It must be located on the budget line.
2. It must give the consumer the most preferred combination of goods and services.
Satisfaction is maximized (given the budget constraint) at the point where
MRS = P(F)/P(C)
marginal benefit
Benefit from the consumption of one additional unit of a good
marginal cost
Cost of one additional unit of a good.
satisfaction is maximized when
the marginal benefit—the benefit associated with the consumption of one additional unit of food—is equal to the marginal cost—the cost of the additional unit of food. The marginal benefit is measured by the MRS.
corner solution
Situation in which the marginal rate of substitution for one good in a chosen market basket is not equal to the slope of the budget line.
When a corner solution arises,
the consumer maximizes satisfaction by consuming only one of the two goods.
marginal utility (MU)
Additional satisfaction obtained from consuming one additional unit of a good.
diminishing marginal utility
Principle that as more of a good is consumed, the consumption of additional amounts will yield smaller additions to utility.
equal marginal principle
The principle that utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across all goods.
Our analysis of demand proceeds in six steps:
- We begin by deriving the demand curve for an individual consumer.
- With this foundation, we will examine the effect of a price change in more detail.
- Next, we will see how individual demand curves can be aggregated to determine the market demand curve.
- We will go on to show how market demand curves can be used to measure the benefits that people receive when they consume products, above and beyond the expenditures they make.
- We then describe the effects of network externalities—i.e., what happens when a person’s demand for goods also depends on the demands of other people.
- Finally, we will briefly describe some of the methods that economists use to obtain empirical information about demand.
A reduction in the price of food, with income and the price of clothing fixed, causes
the consumer to choose a different market basket.
price-consumption curve
Curve tracing the utility-maximizing combinations of two goods as the price of one changes.
individual demand curve
Curve relating the quantity of a good that a single consumer will buy to its price.
The individual demand curve has two important properties:
- The level of utility that can be attained changes as we move along the curve.
- At every point on the demand curve, the consumer is maximizing utility by satisfying the condition that the marginal rate of substitution (MRS) of food for clothing equals the ratio of the prices of food and clothing
income-consumption curve
Curve tracing the utility-maximizing combinations of two goods as a consumer’s income changes.
An increase in income, with the prices of all goods fixed, causes
consumers to alter their choice of market baskets.
An increase in a person’s income can lead to:
less consumption of one of the two goods being purchased.
Engel curve
Curve relating the quantity of a good consumed to income.
Two goods are substitutes if
an increase in the price of one leads to an increase in the quantity demanded of the other.
Two goods are complements if
an increase in the price of one good leads to a decrease in the quantity demanded of the other.
Two goods are independent if
a change in the price of one good has no effect on the quantity demanded of the other.
A fall in the price of a good has two effects:
- Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive. This response to a change in the relative prices of goods is called the substitution effect.
- Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power. The change in demand resulting from this change in real purchasing power is called the income effect.
substitution effect
Change in consumption of a good associated with a change in its price, with the level of utility held constant.
income effect
Change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant.
A decrease in the price of food has
an income effect and a substitution effect.
Giffen good
Good whose demand curve slopes upward because the (negative) income effect is larger than the substitution effect.
When food is an inferior good, and when the income effect is large enough to dominate the substitution effect, the demand curve will be
upward-sloping
market demand curve
Curve relating the quantity of a good that all consumers in a market will buy to its price.
The market demand curve is obtained by
summing our three consumers’ demand curves DA, DB, and DC.
Two points should be noted:
- The market demand curve will shift to the right as more consumers enter the market.
- Factors that influence the demands of many consumers will also affect market demand.
The aggregation of individual demands into market becomes important in practice when market demands are built up from the demands of different demographic groups or from consumers located in different areas.
Laikas mohitukui
INELASTIC DEMAND
When demand is inelastic, the quantity demanded is relatively unresponsive to changes in price. As a result, total expenditure on the product increases when the price increases.
ELASTIC DEMAND
When demand is elastic, total expenditure on the product decreases as the price goes up.
isoelastic demand curve
Demand curve with a constant price elasticity
consumer surplus
Difference between what a consumer is willing to pay for a good and the amount actually paid.
CONSUMER SURPLUS
Consumer surplus is the total benefit from the consumption of a product, less the total cost of purchasing it.
CONSUMER SURPLUS GENERALIZED
For the market as a whole, consumer surplus is measured by the area under the demand curve and above the line representing the purchase price of the good.
To examine the ways that people can compare and choose among risky alternatives, we take the following steps:
- In order to compare the riskiness of alternative choices, we need to quantify risk.
- We will examine people’s preferences toward risk.
- We will see how people can sometimes reduce or eliminate risk.
- In some situations, people must choose the amount of risk they wish to bear.
- Sometimes demand for a good is driven partly or entirely by speculation— people buy the good because they think its price will rise.
probability
Likelihood that a given outcome will occur.
expected value
shows us what would be the average payoff of different
scenarios
payoff
Value associated with a possible outcome.
The expected value measures the central tendency—
the payoff or value that we would expect on average
variability
Extent to which possible outcomes of an uncertain event differ
deviation
Extent to which possible outcomes of an uncertain event differ.
standard deviation
Square root of the weighted average of the squares of the deviations of the payoffs associated with each outcome from their expected values
OUTCOME PROBABILITIES FOR TWO JOBS
The distribution of payoffs associated with Job 1 has a greater spread and a greater standard deviation than the distribution of payoffs associated with Job 2. Both distributions are flat because all outcomes are equally likely.
UNEQUAL PROBABILITY OUTCOMES
The distribution of payoffs associated with Job 1 has a greater spread and a greater standard deviation than the distribution of payoffs associated with Job 2. Both distributions are peaked because the extreme payoffs are less likely than those near the middle of the distribution.
expected utility
Sum of the utilities associated with all possible outcomes, weighted by the probability that each outcome will occur.
risk averse
Condition of preferring a certain income to a risky income with the same expected value.
risk loving
Condition of preferring a risky income to a certain income with the same expected value.
risk neutral
Condition of preferring a risky income to a certain income with the same expected value.
risk premium
Maximum amount of money that a risk-averse person will pay to avoid taking a risk.
The risk premium, CF, measures the
amount of income that an individual would give up to leave her indifferent between a risky choice and a certain one.
diversification
Practice of reducing risk by allocating resources to a variety of activities whose outcomes are not closely related.
negatively correlated variables
Variables having a tendency to move in opposite directions.
mutual fund
Organization that pools funds of individual investors to buy a large number of different stocks or other financial assets.
positively correlated variables
Variables having a tendency to move in the same direction.
THE LAW OF LARGE NUMBERS
Insurance companies are firms that offer insurance because they know that when they sell a large number of policies, they face relatively little risk. The ability to avoid risk by operating on a large scale is based on the law of large numbers, which tells us that although single events may be random and largely unpredictable, the average outcome of many similar events can be predicted.
ACTUARIAL FAIRNESS
When the insurance premium is equal to the expected payout
actuarially fair -
Characterizing a situation in which an insurance premium is equal to the expected payout.
value of complete information
Difference between the expected value of a choice when there is complete information and the expected value
when information is incomplete.
asset
Something that provides a flow of money or services to its owner
risky asset
Asset that provides an uncertain flow of money or services to its owner.
riskless (or risk-free) asset
Asset that provides a flow of money or services that is known with certainty (užtikrintumas)
return
Total monetary flow of an asset as a fraction of its price.
real return
Simple (or nominal) return on an asset
expected return
Return that an asset should earn on average.
actual return
Return that an asset earns.
The Trade-Off Between Risk and Return
Let’s denote the risk-free return on the Treasury bill by Rf. Because the return is risk free, the expected and actual returns are the same. In addition, let the expected return from investing in the stock market be Rm and the actual return be rm.
Price of risk
Extra risk that an investor must incur to enjoy a higher expected return.
An investor is dividing her funds between two assets—
Treasury bills, which are risk free, and stocks. To receive a higher expected return, she must incur some risk.
The budget line describes
the trade-off between the expected return and its riskiness, as measured by the standard deviation of the return.
The utility-maximizing investment portfolio is at the point where…
indifference curve U2 is tangent to the budget line.
bubble
An increase in the price of a good based not on the fundamentals of demand or value, but instead on a belief that the price will keep going up.
Recall that the basic theory of consumer demand is based on three assumptions:
(1) consumers have clear preferences for some goods over others;
(2) consumers face budget constraints; and
(3) given their preferences, limited incomes, and the prices of different goods, consumers choose to buy combinations of goods that maximize their satisfaction.
reference point
The point from which an individual makes a consumption decision.
endowment effect
Tendency of individuals to value an item more when they own it than when they do not.
● loss aversion
Tendency for individuals to prefer avoiding losses over acquiring gains.
framing
Tendency to rely on the context in which a choice is described when making a decision.
anchoring
Tendency to rely heavily on one or two pieces of information when making a decision.
law of small numbers
Tendency to overstate the probability that a certain event will occur when faced with relatively little information.
factors of production
Inputs into the production process
production function
Function showing the highest output that a firm can produce for every specified combination of inputs.
short run
Period of time in which quantities of one or more production factors cannot be changed.
fixed input
Production factor that cannot be varied.
long run
Amount of time needed to make all production inputs variable.
average product
Output per unit of a particular input.
marginal product
Additional output produced as an input is increased by one unit.
Average product of labor =
Output/labor input = q/L
Marginal product of labor =
Change in output/change in labor input = Δq/ΔL
law of diminishing marginal returns
Principle that as the use of an input increases with other inputs fixed, the resulting additions to output will eventually decrease.
law of diminishing marginal returns
Principle that as the use of an input increases with other inputs fixed, the resulting additions to output will eventually decrease.
labor productivity
Average product of labor for an entire industry or for the economy as a whole.
stock of capital
Total amount of capital available for use in production
technological change
Development of new technologies allowing factors of production to be used more effectively.
isoquants
Curve showing all possible combinations of inputs that yield the same output.
isoquant map
Graph combining a number of isoquants, used to describe a production function
A set of isoquants, or isoquant map, describes the…
firm’s production function.
Input Flexibility
Isoquants show the flexibility that firms have when making production decisions: They can usually obtain a particular output by substituting one input for another. It is important for managers to understand the nature of this flexibility.
marginal rate of technical substitution (MRTS)
Amount by which the quantity of one input can be reduced when one extra unit of another input is used, so that output remains constant.
MRTS =
−Change in capital input/change in labor input = − ∆𝐾Τ∆𝐿 (for a fixed level of q)
the case of perfect substitutes and the fixed proportions production function, sometimes called
a Leonitief production function.
fixed-proportions production function
Production function with L-shaped isoquants, so that only one combination of labor and capital can be used to produce each level of output.
The fixed-proportions production function describes situations in which
methods of production are limited.
When the isoquants are straight lines, the MRTS is
constant.
When the isoquants are Lshaped,
only one combination of labor and capital can be used to produce a given output
returns to scale
Rate at which output increases as inputs are increased proportionately
increasing returns to scale
Situation in which output more than doubles when all inputs are doubled.
constant returns to scale
Situation in which output doubles when all inputs are doubled.
decreasing returns to scale
Situation in which output less than doubles when all inputs are doubled.
accounting cost
Actual expenses plus depreciation charges for capital equipment.
economic cost
Cost to a firm of utilizing economic resources in production
opportunity cost
Cost associated with opportunities forgone when a firm’s resources are not put to their best alternative use.
Economic cost =
Opportunity cost
sunk cost
Expenditure that has been made and cannot be recovered.
total cost (TC or C)
Total economic cost of production, consisting of fixed and variable costs.
fixed cost (FC)
Cost that does not vary with the level of output and that can be eliminated only by shutting down.
variable cost (VC)
Cost that varies as output varies.
marginal cost (MC)
Increase in cost resulting from the production of one extra unit of output.
MC =
∆VC/∆𝑞 = ∆TC/∆q
average total cost (ATC)
Firm’s total cost divided by its level of output.
average fixed cost (AFC
Fixed cost divided by the level of output.
average variable cost (AVC)
Variable cost divided by the level of output.
user cost of capital
Annual cost of owning and using a capital asset, equal to economic depreciation plus forgone interest.
User Cost of Capital =
Economic Depreciation + (InterestRate)(Value of Capital)
We can also express the user cost of capital as a rate per dollar of capital:
𝑟 = Depreciation rate + Interest rate
rental rate
Cost per year of renting one unit of capital.
isocost line
Graph showing all possible combinations of labor and capital that can be purchased for a given total cost.
Isocost curves describe the
combination of inputs to production that cost the same amount to the firm.
When the price of labor increases, the isocost curves become:
steeper.
expansion path
Curve passing through points of tangency between a firm’s isocost lines and its isoquants.
To move from the expansion path to the cost curve, we follow three steps:
- Choose an output level represented by an isoquant. Then find the point of tangency of that isoquant with an isocost line.
- From the chosen isocost line, determine the minimum cost of producing the output level that has been selected.
- Graph the output-cost combination.
long-run average cost curve (LAC)
Curve relating average cost of production to output when all inputs, including capital, are variable.
short-run average cost curve (SAC)
Curve relating average cost of production to output when level of capital is fixed.
● long-run marginal cost curve (LMC)
Curve showing the change in longrun total cost as output is increased incrementally by 1 unit.
economies of scale
Situation in which output can be doubled for less than a doubling of cost.
diseconomies of scale
Situation in which a doubling of output requires more than a doubling of cost.
Increasing Returns to Scale:
Output more than doubles when the quantities of all inputs are doubled.
Economies of Scale:
A doubling of output requires less than a doubling of cost.
economies of scope
Situation in which joint output of a single firm is greater than output that could be achieved by two different firms when each produces a single product.
The product transformation curve describes the
different combinations of two outputs that can be produced with a fixed amount of production inputs.
price taker
Firm that has no influence over market price and thus takes the price as given.
When the products of all of the firms in a market are perfectly substitutable with one another—that is, when they are
homogeneous
homogeneous—
—no firm can raise the price of its product above the price of other firms without losing most or all of its business.
when products are heterogeneous,
each firm has the opportunity to raise its price above that of its competitors without losing all of its sales.
free entry (or exit)
Condition under which there are no special costs that make it difficult for a firm to enter (or exit) an industry
cooperative
Association of businesses or people jointly owned and operated by members for mutual benefit.
condominium
A housing unit that is individually owned but provides access to common facilities that are paid for and controlled jointly by an association of owners.
profit
Difference between total revenue and total cost
marginal revenue
Change in revenue resulting from a one-unit increase in output.
A perfectly competitive firm should choose its output so that marginal cost equals price:
MC(q) = MR = P
A competitive firm should shut down if
price is below AVC.
The short-run industry supply curve is the summation of
the supply curves of the individual firms.
producer surplus
Sum over all units produced by a firm of differences between the market price of a good and the marginal cost of production.
The producer surplus for a firm is measured by the yellow area below the market price and above
the marginal cost curve
Producer surplus =
PS = R − VC
Profit =
π = R − VC − FC
The producer surplus for a market is the area
below the market price and above the market supply curve
The firm maximizes its profit by choosing the output at which price equals
long-run marginal cost LMC
The long-run output of a profit-maximizing competitive firm is the point at which
long-run marginal cost equals the price.
zero economic profit
A firm is earning a normal return on its investment— i.e., it is doing as well as it could by investing its money elsewhere.
In a market with entry and exit, a firm enters when
it can earn a positive longrun profit and exits when it faces the prospect of a long-run loss.
long-run competitive equilibrium
All firms in an industry are maximizing profit, no firm has an incentive to enter or exit, and price is such that quantity supplied equals quantity demanded.
When a firm earns zero economic profit,
it has no incentive to exit the industry. Likewise, other firms have no special incentive to enter.
A long-run competitive equilibrium occurs when three conditions hold:
- All firms in the industry are maximizing profit.
- No firm has an incentive either to enter or exit the industry because all firms are earning zero economic profit.
- The price of the product is such that the quantity supplied by the industry is equal to the quantity demanded by consumers.
economic rent
Amount that firms are willing to pay for an input less the minimum amount necessary to obtain it.
welfare effects
Gains and losses to consumers and producers.
deadweight loss
Net loss of total (consumer plus producer) surplus.
economic efficiency
Maximization of aggregate consumer and producer surplus.
market failure
Situation in which an unregulated competitive market is inefficient because prices fail to provide proper signals to consumers and producers.
There are two important instances in which market failure can occur:
- Externalities
2. Lack of Information
externality
Action taken by either a producer or a consumer which affects other producers or consumers but is not accounted for by the market price.
price support
Price set by government above free-market level and maintained by governmental purchases of excess supply.
import quota
Limit on the quantity of a good that can be imported.
tariff
Tax on an imported good.
Specific tax
Tax of a certain amount of money per unit sold.
subsidy
Payment reducing the buyer’s price below the seller’s price
What happens to the level of utility moving downward along the demand curve?
As the price of a good falls, the budget line pivots outward, and the consumer is able to move to a higher indifference curve. Therefore the level of utility increases.
Producer surplus is
the difference between total revenue and total variable cost
