Econ 2302 MICROECONOMICS Fall 2011
Review for Final Exam
This Review Guide covers the material we studied following Test I. You may
want to review Test I and the earlier material if you feel you need to be more
comfortable with the basics of Supply and Demand, Production Possibility Curves,
Externalities, etc. It would be a good idea to review all the past Tests and Test
Reviews.
I. CONSUMER CHOICE
What is meant by Total Utility? By Marginal Utility?
What is meant by Declining Marginal Utility?
Understand that declining marginal utility underlies a downward sloping demand
curve.
Understand the utility-maximizing rule:
MU good A = MU good B = MU good C = MU good D , etc.
Price A
Price B
Price C Price D
Basically, a consumer maximizes utility when the marginal utility from each
additional dollar spent is equal. It is the Marginal that determines the decision, not
the average. The consideration is the Marginal benefit and the Marginal Cost (or
here the price). Simply put: Each additional dollar should provide the same
additional utility; otherwise one could substitute and improve total utility. When
substitution cannot add to the total utility, the total utility is maximized.
(These concepts can be depicted in indifference curves which are discussed
in the appendix. We did not cover difference curves, and I will not ask about them.
They are a good graphical depiction of maximizing utility, but if you understand the
above Marginal benefit and price concepts, you understand the basic theory.)
II. Supply and Demand Elasticities
What is elasticity? Inelasticity?
Relate Elasticity and Inelasticity to different products: such as luxuries and
necessities. Consider the importance of time to allow for adjustments to price –
generally, the more time available, the greater the elasticity, and vice versa: the
immediate, short term generally forces an inelasticity of demand.
What is relationship of price elasticity to total revenue?
Elastic Demand: P cut, QD up more than proportional; therefore TR
increases. If P increases; QD down more than proportional; therefore TR
falls
Inelastic Demand: P cut, QD rises less than proportional; therefore TR rises.
P increases, QD does not fall proportionally,; therefore TR
rises
Unit Elasticity: P cut, QD rises proportionally, TR remains the same
P rises, QD falls proportionally, therefore TR remains the
same
How is elasticity measured?
The % change in quantity demanded
The % change in Price
If there is more % change in QD than in P, then the Q is sensitive to price, and
the demand curve will reflect that stretch – by being more horizontal.
If there is less % change in QD than in P, there is less sensitivity to price, and
the demand curve will be more vertical (not reflecting stretch.)
Numerically: if the % change in QD/% change in P is > 1 then there is
elasticity
If the % change in QD/ %change in P is < 1 there is inelasticity
Understand the difference between short term and long term elasticity.
Generally Time allows more ability to adjust, and hence time provides more
elasticity.
How does price elasticity affect a firm’s pricing decisions? How might it affect
tax policy?
What is cross elasticity? (Review Complementary goods; competing goods)
The Price change in one good affects the quantity demand for another good.
(A drop in the price of peanut butter might affect the demand for jelly.)
What is income elasticity? (Review Normal and Inferior goods)
If income changes, does the QP change more/less than the income,
III. The Firm: Costs and Output Determination
Understand the meaning and behavior of these costs:
Explicit Costs and Implicit Costs
Variable Cost VC
Fixed Costs FC
Total Costs TC
Average Variable Cost AVC
Average Fixed Cost AFC
Average Total Costs ATC
Marginal Cost MC
IV.
Understand the characteristics of each of the market structures.
Number of firms; nature of the product: differentiated or nondifferentiated; ease or difficulty of entry and exit; ability to influence price,
nature of demand: downward sloping or horizontal (perfectly elastic) etc. To these
also consider why and how firms in each market structure might advertise or
conduct research and development. Know business examples of each of these
market structures.
V
Consider these basics that apply to all firms in any of these market
structures.
A. To maximize the firm’s profit each seeks to produce at a
point where MC = MR.
B. They all have fixed costs and variable costs
C. Eventually marginal costs rise. In the early levels of
production, MC may fall. But eventually they rise because
eventually diminishing returns set in.
D. With the cost of each extra unit of output (MC), the Average
Total cost is being redefined. If lower than ATC, MC pulls the
average down. If higher than ATC, then MC pulls the average
up…..So, MC always crosses the ATC at the minimum ATC.
(Think about my example of your Grade Point Average and
how each marginal course you take redefines the cumulative
grade point average.)
E. The decision to close down or not depends on whether price
covers variable costs or not. If Price is greater than average
variable costs, then the excess pays part of fixed cost,
rendering it advantageous to continue in business even at a
loss. That loss is less than closing the business completely,
since if the business is closed, it would still have to pay the
fixed cost. The firm does not need to lose more than the
Fixed Cost.
VI.
Consider these basics that are different among the market structures
A.. The Nature of the demand and Marginal Revenue.
1. The Perfect Competitor is a market taker since the Perfect
Competitor faces a perfectly elastic demand curve. Depicted by
a horizontal demand curve. The Perfect Competitor can sell
any quantity at the industry price.
2. Since the Perfect Competitor’s demand curve does not
decline, the marginal revenue curve does not decline either.
3. Marginal revenue is equal to Price for the Perfect
Competitor
4. Marginal Revenue is less than Price for the Monopoly,
Monopolistic Competitor, and the Oligopoly. They may sell
more output, but they do so at a lower price. And as Price
declines, Marginal Revenue also falls. Thus MR < P
B. For the Perfect Competitor in the long run P=MR=MC= ATC at its
minimum.
Thus, in the long term break even point, (when all firms entering and
exiting the industry is completed), society is getting the maximum
output, at the minimum average cost, and at a Price that equals marginal
cost.
Price represents the benefit derived for the buyer. Thus, marginal benefit
= marginal cost. This maximizes society’s position.
C. For the other market structures, P > MR =MC and the firm’s maximum
profit output quantity is not at the minimum ATC. Society would be
willing to pay a Price higher that Marginal Cost, but this position is not in
the maximum profit making interest of the firm, who stops at MC =MR,
which is < P.
Understand that this concept is at the heart of antitrust legislation that seeks
to prevent or at least regulate chartered monopolies and oligopolies. This
position is a hotly debated position among economists, business persons,
lawyers, and the issues associated with these concepts fill law libraries.
Understand these concepts so you can enter this discussion.
D. With an understanding of firms in the four market structures, how would
you assess their behavior with advertising decisions? with research and
development decisions? Pricing and output decisions?
VII. Understand these points for each of the markets structures:
F. Profit maximization point
G. The Breakeven point
H. The shut down -- go out of business point
VIII. Understand these concepts and points:
 Monopolies can be resource monopolies; sanctioned
monopolies sustained by copyrights, patents, or
charters; or natural monopolies that exist because a
market can sustain only one firm – a forced division
would cause each to “ride up its cost curve” and be
unable to survive or it might survive at the added
expense to consumers. (e.g. a Cable company; many
utilities)
 Oligopolies have few participants and are best
understood through game theory: the few firms
strategically engage in price and business actions but
avoid the illegal practice of explicit collusion. They
sometimes undertake implicit price leadership
behavior, and actions that can be depicted by kinked or
cornered demand curves. These arise if other firms
match one firm’s reduction in price, but do not match an
increase in price.
 Game theory includes such practices as the Nash
Theorem: a firm’s action must be taken with the
consideration of the opponent’s reaction. Consider
“cornered or kinked demand curves,” price retaliation,
etc.
 Oligopolies are sometimes defined by Market share
concentration, for example, the “four firm concentration
ratio.”
 Oligopolies sometimes are created by mergers,
especially horizontal mergers. (understand how
horizontal and vertical and conglomerate mergers
differ.)




O
Oligopolies that form cartels are in essence trying to
behave as a monopoly. OPEC is an example. (Cartels to
fix price and interfere with commerce are not legal in
the U.S.)
Barriers to entry clearly may arise from controlling a
basic resource, by copyright or patent, or by large
financial requirements. They may also be affected by
“switching costs” and “network effects.”
What is meant by “a normal profit”?
What are “accounting profits” and “economic profits”?
How do they differ?
Consider the importance of this relationship for the Perfect Competitor: In
the Long Term:
MC = P = MR = Minimum Average Cost
This is “Optimal societal allocation of resources.” Marginal benefits =
Marginal Costs. Society receives all the quantity at lowest cost, i.e. cost equal
to alternative opportunity costs. For all other market structures, the
quantity is held back, since MC =MR at the optimum output level is less that
what consumer’s opportunity value is as reflected in the Price consumer is
willing to pay. This is worse in the Monopoly form and hence one reason
society attempts in various ways to regulate or break up monopolies.
OTHER CONCEPTS
O
O
O
O
Brand multiplication to gain market share and use excess capacity
Segmenting the market to capture “consumer surplus”
Balanced and unbalanced Oligopoly
What is the Herfindahl Index? How is it used? Understand the “sum of the
squares” analytical technique.
< 1000 generally no concern with a concentrated industry.
Between
1000—1800 mergers and acquisitions may be questioned, especially if a
proposed merger would result in I ncreases in the H-H Index by 100 or more
> 1800 almost certain concern and perhaps government opposition to the
merger or acquisition if H-H Index increases by 50 or more
IX. Pricing of the Factors of Production:
Land; Labor; capital
Nature of derived demand
Marginal Physical Product (MPP)
Marginal Revenue Product (MRP)
The Least Cost, maximized position exists when:
MPP a = MPP l = MPP k
Pa
Pl
Pk
(Where a = land; l = labor; k = capital; and P = price)
MRP a = MRP l = MRP k
Pa
Pl
Pk
If the above relationships are NOT equal, the firm can substitute among the
factors and improve its resource allocation efficiency. So that If the price of one
factor declines (related to its output), there is substitution to use more of that factor.
The lower price increases the quantity demanded of that product, which in turn
raises the demand for all the factors. We describe these as the substitution effect
and the output effect. They represent cross-currents, exerting increases and
decreases in demand for a factor. The relative magnitudes of the forces will
determine whether the price of that factor increases or decreases. (A practical
example: the lower cost of computers may (1) induce a firm to add more
computers in place of labor; but (2) the possible lower cost of the product being
made may increase the Quantity demanded for that product, which in turn raises the
demand for computer-trained experts.
X. ECONOMICS OF INFORMATION
 What is meant by asymmetric information? Adverse
selection? Moral hazard? How can Insurance
Companies, et. al. use co-pay and deductibles to offset
the negative effects of these?
 What is an “efficiency wage”? When is it appropriate?
XI. What is meant by Rival and Non-Rival goods? By excludeable and nonexcludeable goods? By a “freerider”? What are Public Goods and Private Goods?
Why are Public Goods underproduced by the private sector in a free market
economy?
XII. TAXES AND INCOME DISTRIBUTION

Understand what is meant by Progressive, Regressive,
and Proportional taxes. Know how the classify: U.S.





income tax, sales taxes, social security tax, gasoline tax,
etc.
I expect much more discussion of the use of a
consumption tax in the U.S. What is meant by a
consumption tax.
Understand these tax principles: Ability to pay
principle; Benefit principle; “Sin taxes” to discourage
use of “demerit goods.”
Understand why the party on whom the tax is levied is
not always the party who bears the incidence of the tax.
(Taxes are generally shifted to the consumer or the
supplier who has the greater inelasticy. E.g. smokers
will bear the incidence of a cigarette tax.
Understand the Lorenz curve and how it can be used to
depict inequality of income distribution. Also
understand what is depicted by a Gini Coefficient.
Understand how elasticities and inelasticities of
demand affect tax incidence. Basically, the more
inelastic the demand (or supply) the less likelihood of
shifting the burden of the tax. Elasticity holds the
bargaining power. The party that bears the ultimate
cost, is said to bear “the incidence” of the tax.
XIII. Income Inequality and Poverty
 What does a Lorenz Curve Depict?
 What is meant by a Gini Coefficient?
 What are the trends in income distribution?
XIV. International Economic Concepts
Imports and Exports and Net Exports
Trade deficits and trade surpluses
Changes in Net Foreign Investment (and understand why net foreign investment
will equal Net Exports -- NX), for example:
If we have a surplus in our trade balance, we will, ceteris paribus,
Increase our foreign investment. Thus both + +
If we have a negative in our trade balance, foreigners invest here, and
When netted, the U.S. foreign investment decreases.
Exchange rate determination (We no longer use the gold standard to back currency
or to set exchange rates. Both now are based on fundamental supply and demand –
free market forces, so the value of the dollar is based on its purchasing power.)
What affects the Appreciation and Depreciation of a currency?
What is meant by Capital Flight? (Large financial capital outflows often caused by
political or economic crises.)
How would financing a budget deficit affect exchange rates, trade, and net foreign
investment. (Basically: to fund the deficit, we must borrow. We borrow by selling
bonds. The Bond price declines and the interest rate increases. To buy the bonds,
foreigners must buy the dollar since bonds are so denominated. So the dollar
strengthens. The stronger dollar makes our exports more expensive and our
imports less expensive. This affects the trade balance and in turn affects our net
foreign investment: Net exports decline and U.S. Net Foreign Investment also
declines.
Understand how Net Exports are related to Net Foreign Investment.
(For example in recent years, the U.S. trade deficit has been negative. I.E. our X < M.
So foreigners build up dollars which they invest in the U.S. – in part buying our
bonds and increasing their portion of our national debt. So, THEIR foreign
investment increases. Netted against OUR foreign investment, the U.S. net foreign
investment declines. In short, the Trade deficit and the U.S. Net Foreign Investment
move together—a decline in the U.S. trade balance leads to a decline in U.S. net
foreign investment. Conversely, A surplus in our trade balance, gives us currencies
to increase our net foreign investment.
The above is clearly summarized in the Balance of Payments.
O
Current Account
-- The trade balance: Goods (tangibles) and Services (intangibles)
-- Private Transfers (e.g. Guest workers in the U.S. send
money home; or foreign students here receive money from
outside the U.S.)
-- Repatriated Interest and earnings from investments
-- Tourism
O
Capital Account: Buying and selling assets such as
-- Real estate
-- Direct investment
-- Portfolio investment
-- U.S. Bonds
O
Official Government transfers
O
Balancing (Errors and Omissions)
__________________________________
The Balance of Payments will balance (sum to zero)
Thus, if our current account balance is negative, these money outflows
will return to us as a positive in our capital account.
Understand the issues associated with Free Trade:
 A traditional definition relying on the absence of tariffs,
taxes, or quotas versus a more expansive definition

relying of “a level playing field” which accounts for
differences in production costs associated with
environmental, OSHA, EEO, and other social welfare
factors.
What are the basic arguments for and against free
trade?
What are some similarities and some differences between NAFTA and the European
Union? What is the Eurozone?