Basic Principles of Economics

Scarcity and Opportunity Cost

Economics studies how society allocates scarce resources among competing uses. Scarcity means resources are limited relative to wants, leading to the concept of opportunity cost—the value of the next best alternative forgone when making a choice.

• Opportunity Cost Formula:

• Example: If you spend time studying economics, the opportunity cost is the time you could have spent on another activity.

Reading and Understanding Graphs

Production Possibility Frontier (PPF)

The PPF shows the maximum combinations of two goods that can be produced with available resources and technology. It is typically bowed outward due to increasing opportunity costs.

• Equation:

• Intercepts: (when ), (when )

• Slope (MRT):

• Efficiency: Points on the PPF are efficient; points inside are inefficient.

The Market Forces of Supply and Demand

Supply and Demand Model

The Marshallian model describes how prices and quantities are determined in competitive markets through the interaction of supply and demand.

• Demand Function: , where

• Supply Function: , where

• Equilibrium: ; solve for

Equilibrium and Comparative Statics

Market equilibrium occurs where quantity demanded equals quantity supplied. Changes in demand or supply shift the equilibrium price and quantity.

• Equilibrium Price:

• Equilibrium Quantity: Substitute into either function.

Elasticity

Price Elasticity of Demand

Elasticity measures the responsiveness of quantity demanded to a change in price.

• Formula:

• Interpretation: (elastic), (inelastic), (unit elastic)

• Total Revenue Test: If demand is elastic, a price increase decreases total revenue; if inelastic, a price increase increases total revenue.

Consumer Choice and Behavioral Economics

Rationality and Preferences

Consumers are assumed to have rational preferences, which are complete, transitive, and monotonic. Utility functions represent these preferences.

• Utility Function:

• Assumptions: Completeness, Transitivity, Monotonicity

Indifference Curves and Marginal Rate of Substitution (MRS)

Indifference curves show all combinations of goods that provide the same utility. The slope of the indifference curve is the marginal rate of substitution (MRS).

• MRS Formula:

• Diminishing MRS: Indifference curves are convex to the origin.

Budget Constraint

The budget constraint shows all combinations of goods a consumer can afford given prices and income.

• Equation:

• Slope:

Consumer Optimum

The consumer optimum occurs where the highest indifference curve is tangent to the budget constraint, i.e., where .

• Condition:

Introductory Economic Models

Law of Demand

The law of demand states that, all else equal, an increase in price leads to a decrease in quantity demanded, and vice versa. This is due to the substitution and income effects.

• Total Effect:

• Substitution Effect: Always opposite the price change.

• Income Effect: Depends on whether the good is normal or inferior.

Summary Table: Key Microeconomic Concepts