AP Microeconomics: Master Notes UNIT 1: FUNDAMENTALS
AP Microeconomics: Master NotesUNIT 1: FUNDAMENTALS OF ECONOMISKey Terms Economics: The study of how limited resources areallocated. Microeconomics: Study of how individuals (firms orhouseholds) make choices and are influenced by economicforces. Macroeconomics: Looks at the economy as a whole,focusing on issues such as growth, unemployment,inflation, and business cycles. Scarcity: material wants are unlimited and economicresources are limited or scarce. Factors of Productiono Land: Any productive resource existing in nature, Ex.water, wind, mineral deposits.o Labor: Physical and mental effort of people. Ex. Teachero Capital: Manufactured goods that can be used in theproduction process Ex. tools, buildings, machinery Human Capital: Knowledge and skills acquiredthrough training and experience Ex. College orTechnical School.o Entrepreneurship: Ability to identify opportunities andorganize production, risk taker. Ex. Elon MuskEconomic Reasoning Given limited resources (SCARCITY), there areopportunity costs for every choice Trade-offs- All the possible options given up when youmake a choice The opportunity cost of an action is the benefit missed bynot choosing the next-best alternative. An action should bechosen only if the expected benefit is greater than theopportunity cost. Implicit Cost: Forgone benefits of any single transactions.Ex. time and effort an owner puts into maintaining acompany, rather than expanding it. Explicit Cost: Expenses that are paid with cash orequivalent. Ex. Wages to workers, electricity bill Individuals attempt to maximize utility by allocating andspending their resources according to their preferences. Individual consumption and production options areexpanded through the market, where goods and servicesare exchanged for mutual benefit.Economic Systems All economic systems must answer three basic economicquestionso What goods and services to produce?o How to produce those goods and services?o Who consumes those goods and services? Types of Economic Systemso Command Minimize imbalance in wealth via the collectiveownership of property Lacks incentives for extra effort, risk taking, andinnovation Wages determined by the gov. Particularly vulnerable to corruption as the gov. playsthe central role in allocating resources; only onepolitical party Economic goal emphasized: Price stability, equity, fullemployment, security Economic goal deemphasized: Efficiency, freedom,growth of consumer goods/serviceso Market Pursuit of individual profit Private individuals control the factors of production Wages determined by negotiations between trade unionsand managers Market forces of supply and demand determine theallocation of resources Gov. can regulate business and provide tax-supportedsocial benefits Economic goal emphasized: Efficiency, freedom, pricestability, growth Economic goal deemphasized: Equity, security, fullemploymento Mixed- Both market and command together, realityProduction Possibilities Model (Curve) Identify the Points on the PPCo The A, B, and C represents: Attainable and efficient withthese resources Allocative vs. Productive Efficiency Productive Efficiency: Products are being producedin the least costly way (any point on the curve) Allocative Efficiency: The products being producesare the ones most desired by society. (optimal pointdepends on the desire of society)o The X represents: Inefficiencyo The Y represents: Not Attainable/Unattainable with theseresourceso Movement from A to B is an increase or decrease inconsumer demand.Production Possibilities Model (Curve) ooooReasons for Economic Growth/ContractionTechnology (Quality of Resources)Land (Quantity of Resources)Population (Quantity of Resources)Education (Quality of Resources)
Production Possibilities Model: Economic GrowthOther Shifts: Contraction to just Butter Increasing Opportunity CostWhy does the graph curve? Resources are not easilyadaptable between products- GUNS VS BUTTER)Explain opportunity cost of curve: The opportunity cost ofthe 4th Butter is small (1 Gun), as we go to the 6th, 7th or 8thbutter, the opportunity of Guns will go up (2 Guns).Increasing Opportunity Cost Graph Constant Opportunity Cost GraphTrade (Absolute and Comparative Advantage) Absolute advantage describes a situation in which anindividual, business, or country can produce more of agood or service than any other producer with the samequantity of resources.o Just because a country has an absolute advantage, itdoesn’t mean that the country necessarily benefits themost from producing that good. Comparative advantage describes a situation in which anindividual, business, or country can produce a good orservice at a lower opportunity cost than another producer.o Countries will benefit from specialization if one countryhas a comparative advantage in one good, and the othercountry has a comparative advantage in the other good. Exampleoooooo Constant Opportunity CostWhy does the graphs curve remain straight? Resourcesare easily adapted between products (PIZZA VSCALZONE)o Explain opportunity cost of the curve: As more calzonesare made, resources that are easily adapted to produceeither good are moved away from pizza and towardcalzones. Opportunity cost for each calzone is constant at2 bicycles.oWhich nation has the absolute advantage in producingcorn? DallasWhich nation has the absolute advantage in kiwi? DallasWhich nation has the comparative advantage in corn?DallasWhich nation has the comparative advantage in kiwi?MontezumaShould Dallas specialize in corn or kiwi? CornShould Montezuma specialize in corn or kiwi? Kiwi
UNIT 2: SUPPLY, DEMAND AND CONSUMER CHOICEDemand (CONSUMERS, BUYERS, INDIVIDUALS) Law of Demand: if Price goes , the Quantity goes , or ifPrice goes , the Quantity goes Reasons for Law of Demand (DOWNWARD SLOPINGCURVE)o Substitution Effect: At a higher price, consumers arewilling to and able to look for substitute (COKE orPEPSI). The substitution effect suggest that at a lowerprice, consumers have the incentive to substitute thecheaper good for the more expensive service.o Income Effect: A decline in the price of a good will givemore purchasing power to the consumer and he/she canbuy more now with the same amount of income.o Law of Diminishing Marginal Utility: This law statesthat as we consume additional units of something, thesatisfaction (utility) we derive from each additional unit(marginal unit) grows smaller (diminishes) Changes in Quantity (MOVING ALONG THECURVE)o What changes quantity demanded: A change in the priceof the good/service Changes in Demand (SHIFTING THE CURVE)o What shifts the demand curve?o Change in income: Normal goods: an increase in income leads to arightward shift in the demand curve Income goes , Demand goes Income goes , Demand goes Inferior goods: an increase in income leads to aleftward shift since these are usually low-quality itemspeople will avoid when the have more to spend Income goes , Demand goes Income goes , Demand goes o Change in taste/preferenceso Change in price of complementary goods: the linkage ofproducts’ demand because the work with each other canaffect demand for each (Milk and cookies) Price of A Demand for B goes Price of A Demand for B goes o Change in price of substitutes: When the prices of orpreference for a substitute changes, demand for bothproducts will change. Price of A Demand for B goes Price of A Demand for B goes o Change in number of buyerso Change in price expectation of buyersSupply (SELLERS, FIRMS, PRODUCERS) The Law of Supply: If price goes , the quantity producedgoes or if the price goes , the quantity produced goes Reasons for Law of Supply (UPWARD SLOPINGCURVE)o Opportunity cost: At a higher prices, profit seekingfirms have an incentive to produce more.o Law of Diminishing Marginal Returns: Since theadditional cost of each unit will eventually increase, thefirm must increase the price to increase quantity supplied Changes in Supply (SHIFTING THE CURVE)o What shifts the supply curve?o Price/Availability of inputs (resources)o Number of sellerso Technologyo Government Action: taxes and subsidieso Change price expectationo Expectations of future profitEquilibrium Market Equilibrium: A market is in equilibrium when theprice and quantity are at a level at which supply equalsdemand. The quantity that consumers demand is exactlyequal to the quantity that producers supply.o Equation for Equilibrium: Qd Qs Market Disequilibrium: Quantity demanded doesn’t equalquantity supplied. Creates shortages and surpluseso Shortage: The price is below equilibrium, the amountdemanded will be greater than the amount supplied Equation for Shortage: Qd Qso Surplus: The price is above equilibrium, the amountdemanded will be less than the amount supplied Equation for Surplus: Qd QsDouble Shift in Supply and Demand Double shift rule: If two curves shift at the same time, eitherprice or quantity will be indeterminate. Example below: Demand and supply are increasing, so Priceis INDETERMINATE and Quantity has INCREASEDDouble Shifts in Supply and Demand CurveElasticity Elasticity: Is the responsiveness of consumer to a change inthe price of a product. Equations for elasticity: Be sure to use absolute values and ignore the --------sign;useful for comparing different products. Interpreting elasticityo Inelastic Demand Elasticity coefficient less than 1 Few substitutes and necessities Example: Cancer medicationo Elastic Demand Elastic coefficient greater than 1 Luxury goods and many substitutes Example: Coke
Inelastic DemandoElastic Demand Elasticity of Demand CoefficientsPerfect Inelastic 0Relatively Inelastic Less than 1Unit Elastic 1Relatively Elastic Greater than 1Perfectly Elastic Undefined Elasticity Varies with Price Range:o More elastic toward to left, less elastic at lower right.o Slope does not measure elasticity—Slope measuresabsolute changes; elasticity measures relative changesoooooElasticity Varies with Price Range Elasticity of Supply: Measures seller’s responsiveness tochanges Es 1 Supply is elastic- Producers are responsive toprice change Es 1 Supply is inelastic- Producers are not responsiveto price change Equation belowTotal Revenue and the Price Elasticity of DemandTotal Revenue: Is the amount paid by buyers andreceived by sellers of a good.o Equation: TR P x Qo Total Revenue Test Elastic Demand (EXAMPLE- Coke/Pepsi) Price increase causes TR to decrease Price decrease causes TR to increase Inelastic Demand (EXAMPLE- CANCER DRUGS) Price increase causes TR to increase Price decrease causes TR to decrease Unit Elastic Price changes and TR remains unchangedoElastic Demand and Total Revenue Graphs ooTypes of ElasticityCross-Price Elasticity: Measures responsiveness of salesto changes in price of another good Substitute Positive sign Complement Negative sign Independent Goods zero Equation belowIncome Elasticity: Measures responsiveness of buyer tochanges in income Normal Good positive sign Inferior Goods negative sign Equation belowInelastic Demand and Total Revenue Graphs
Consumer and Producer Surplus at Market Equilibrium Consumer Surplus: Difference between the price a buyerwould have been ready to pay for a good or service(willingness) and the price that he/she actually pays(market price)o Equation for Consumer Surplus: ½ Quantity x Price Producer Surplus: Difference between the price that aseller actually receives (market price) and the price atwhich he/she would have been ready to supply the good orservice (willingness)o Equation for Producer Surplus: ½ Quantity x Price Total Surplus (SOCIAL WELFARE): The sum of thetotal consumer surplus and the total producer surplus.o Equation for Total Surplus: ½ Quantity x Price CS and PS allows us to access the soundness of economicpoliciesConsumer and Producer Surplus Graph (EFFICENT) Calculate using Consumer and Producer Surplus Grapho Consumer Surplus 1,250o Producer surplus 1,250o Total Surplus (Social Welfare) 2,500Government Effects on Market (DISEQUILIBRIUM ANDINEFFICENTCY) Government Price Floors:o Effective Price Floors, the price is above the equilibriumpriceo Example: Minimum wageo Leads to a surplus, because Qs Qdo Non-effective price floors, the price is below theequilibrium price Government Price Ceilings:o Effective price ceilings, the price is below equilibriumpriceo Example: Rent Control Housingo Provide lower costs for consumerso Leads to a shortage in the market because, Qd Qso Can also result in illegal black market activity- sellinggoods for a higher pricePrice Floor/Surplus GraphPrice Ceiling/Shortage Graph Government TaxesIndirect Tax: Is one place by the government on theproducers of a particular goodo Excise Tax: Tax on producers, but the goal is for them tomake less of the good (Cigarette, alcohol tax)o For every unit made, the producer must payo Consumers will pay the tax indirectly through producerso An indirect tax will be shared by both consumers andproducers.o Creates disequilibrium and inefficiency in the market, theresult is dead weight losso Dead weight loss: Represents the loss of former consumerand producer surplus in excess of the total revenue of thetax. Transactions that would have taken place in themarket if there was not tax.o Tax Incidence: The distribution of the tax burden (WHOACTUALLY PAYS THE TAX)o Tax Incident (WHO PAYS) If demand is perfectly inelastic: Tax burden paid entirelyby consumers If demand is relatively inelastic: Tax burden mostly onconsumers If demand is unit elastic: Tax burden shared betweenconsumer and producer If demand is relatively elastic: Tax burden mostly onproducers If demand is perfectly elastic: Tax burden paid entirelyby producer.o
Tax (EXCISE or INDIRECT) Graph Identify using International Trade GraphConsumer Surplus with no trade: PProducers Surplus with no trade: IDAAmount we import and world price(Pw): KLMN or Q5Q1o Producers Surplus if we trade at world price (Pw): Io Consumer Surplus if we trade at world price (Pw):PABCDEFGHo If government tariff leads to a world price of Pt, howmuch is imported and what is the Consumer Surplus andProducers Surplus: LM or Q4-Q2, PS is I, PC is PABCo If government tariff leads to world price of Pt, what is thedeadweight loss and tariff revenue? DW is EH, TR is FGUtility Maximization and Consumer Behavior Total Utility (TU): This is the total happiness a consumerat a particular level of consumption. Total utility willgenerally increase as total consumption of a particular goodincreases, until the consumer has “had too much” of a good,when total utility will begin to decline. Marginal Utility (MU): This is the increase in total utilityresulting from the consumption of each additional unit of agood. Equation for Marginal Utility (MU): MU ΔTU/ΔQ Reasoning: Since MU measures the change in TU, as longas MU is positive at a particular level of output, TU will beincreasing. But if MU becomes negative, TU will decrease. Law of Diminishing Marginal Utility: The greater thelevels of consumption of a particular good, the les utilityconsumers derive from each additional unit of the good. Point of Satiety: The point where marginal utility of a goodis zero.ooo Calculate using Tax GraphBefore Tax PS before tax: EFG CS before tax: ABCDo After Tax Tax per unit: 4 per unit tax (vertical distance betweentwo supply curves) PS after tax: G CS after tax: A Dead weight loss: DF Total tax revenue to gov’t: BCE Total spending by buyers: BCEGH Total revenue to sellers: GH Amount of tax buyers pay: BC Amount of tax sellers pay: E International Tradeo World Trade Price: If the world price of good is lower than the domesticprice, the country will import the good. If the world price of a good is higher than the domesticprice the country will import the good.o Subsidy: tax on importso Quota: a limit on importoTotal Utility and Marginal Utility GraphInternational Trade Graph Graph Explained:Point A: A total utility increases, marginal utilityincreases.o Point B: Point of satiety, total utility is maximized andmarginal utility is zero.o Point C: Consumer Dissatisfaction, total utility starts todiminish and marginal utility becomes negative.o
Maximizing Utility Rule: To maximize your total utility,you should instead consume the combination of good thatmaximizes your marginal utility per dollar spent, so that: Equation: MUgood A/PgoodA MugoodB/PgoodB Calculate Maximizing Utilityo Assume the following You have a budget of 20 that you wish to spendentirely on Good A and Good B. The price of Good A is 5 and the price of Good B is 2.o Calculate the following If you have 20, what combination maximizes yourutility? 2 of Good A and 3 of Good Bo Reasoning (USING THE GRAPH) You should first buy 1st of Good B because MU/P is2.5, you have 18 remaining. You should then buy 2nd of Good B because MU/P is2, you have 16 remaining. You should then buy 1st of Good A because MU/P is 2,you have 11 remaining You should then buy 2nd of Good A because MU/P is1.6, you have 6 remaining. You should then buy 3rd of Good B because MU/P is1.5. NOW based on utility maximizing rule, you should buy2 widgets and 3 robots or where MUgoodA/PgoodA MugoodB/PgoodBQuantityTUMUMU/P(Good A)(Good A)(Good A)12345101824283010864221.61.2.8.4QuantityTU(Good B)MU(Good B)MU/P(Good B)1234559121415543212.521.510.5UNIT 3: COST CURVES AND PERFECTCOMPETITIONCost of Production Profit Maximization: The goal of most firms is tomaximize their profits. To do so, they must produce at alevel of output at which the difference between theirrevenue and their costs is maximized Total Revenue: The amount a firm receives for the sale ofits output or Price x Quantity Total Cost: The market value of the inputs a firm uses inproduction Economic Profit Total Revenue (TR) – Total Cost (TC) Economic Cost or Cost of Production: Payments a firmmust make, or income it must pay to resources suppliers toattract those resources from alternative uses. This wouldmean all the opportunity costs.Economic Profit vs Accounting Profit Explicit Costs: Payment to outsiders for labor, materials,service, fuel Implicit Costs: Cost of self-owned, self-employedresources. The opportunity cost that firms “pay” for usingtheir own resources. Accounting Profit Equation: Total Revenue – AccountingCost (EXPLICIT ONLY) Economic Profit Equation: Total Revenue- EconomicCosts (Explicit Implicit) Accounting profit must be larger than economic profitbecause there is always an opportunity cost. FOR MICROECONOMICS ALL COST WILL BEECONOMIC COSTS Normal Profit: Is zero economic profit. Minimum level ofprofit needed just to keep an entrepreneur operating in hiscurrent market. If firms are not covering their costs theymay shut down. It’s important to understand that if a firm ears zeroeconomic profit they are still making money.Short Run v. Long Run Costs of Production Short Run—Fixed Planto Period of time to brief for firms to alter its plant capacityo Output can be varied by adding larger or smaller amountsof labor, material, and other resources.o Exiting plant capacity can be used more or less intensively Long Run----Variable Planto Period of time extensive enough to change the quantity ofall resources employed, including plant capacityo Enough time for existing firms to dissolve and exit theindustry or for new firms to form and enter the industryProduction Function: The production function shows the relationship betweeninputs and outputs in both the short-run and the long-run Inputs: Resources used to make outputs also called factors Outputs: Finished product Marginal Production (MP): The increase in output thatarises from an additional unit of that input (each additionalworker)o Equation: MP Change in Total Product/Change inInputs Average Production (AP): Total production/quantityproduced Diminishing Marginal Returns or (Produc
AP Microeconomics: Master Notes UNIT 1: FUNDAMENTALS OF ECONOMIS Key Terms Economics: The study of how limited resources are allocated. growth of consumer goods/services Microeconomics: Study of how individuals (firms o
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