Microeconomics Principles

It's designed for anyone new to economics, whether you're a high school or college student taking an introductory course, a self-learner exploring the subject for the first time, or someone who wants a refresher on the essentials. The flashcards focus on definitions and key relationships, making them ideal for building a strong conceptual base before moving on to more advanced topics like elasticity, consumer theory, or market structures.

Because the deck is built on pairs of related ideas (like shortage versus surplus, or price floors versus price ceilings), you'll get the most out of it by reviewing regularly rather than cramming. Spacing your study sessions over several days helps the terminology stick in long-term memory. A good tip while you study: try to put each term into your own words or think of a real-world example as you go. That small step turns simple definitions into lasting understanding and makes the connections between concepts much easier to recall later.

Economics is the study of how individuals and societies allocate scarce resources to satisfy unlimited wants. Scarcity is the central problem: because resources are limited while human wants are essentially unbounded, choices must be made. Every choice carries an opportunity cost, defined as the value of the next-best alternative forgone. This single idea underlies nearly all economic reasoning, from a household choosing how to spend its weekly income to a government deciding how to allocate tax revenue.

Microeconomics is the branch of economics that focuses on the decisions of individuals, households, and firms, while macroeconomics studies economy-wide phenomena such as GDP, inflation, and unemployment. The fundamental building blocks of microeconomic analysis are markets, which are any arrangements in which buyers and sellers interact to trade goods and services. In these markets two forces interact: supply, the quantity producers are willing to sell at various prices, and demand, the quantity consumers are willing to buy at various prices. The law of demand holds that, all else equal, as price rises quantity demanded falls, while the law of supply holds that, all else equal, as price rises quantity supplied rises.

The equilibrium price is the price at which quantity supplied equals quantity demanded. When quantity demanded exceeds quantity supplied, a shortage exists and prices tend to rise; when quantity supplied exceeds quantity demanded, a surplus exists and prices tend to fall. Governments can intervene with a price floor, a legally set minimum price above equilibrium such as a minimum wage, or a price ceiling, a maximum price below equilibrium such as rent control. Each policy distorts the market, producing surpluses in the case of price floors and shortages in the case of price ceilings. Welfare effects can be tracked through consumer surplus, the difference between willingness to pay and actual payment, and producer surplus, the difference between what producers receive and the minimum they would accept. Deadweight loss is the reduction in total surplus when a market fails to reach equilibrium.

Elasticity measures the responsiveness of one variable to changes in another. The most common form is price elasticity of demand, calculated as the percentage change in quantity demanded divided by the percentage change in price: \(E_d = \frac{\%\Delta Q_d}{\%\Delta P}\). When the absolute value of this ratio exceeds one, demand is elastic and quantity is highly responsive to price. When it is less than one, demand is inelastic and quantity is relatively unresponsive. The unit elastic case, where the ratio equals one, describes situations in which percentage changes in price and quantity are equal.

Several factors shape elasticity. The availability of substitutes is critical: goods with many close alternatives tend to have more elastic demand than goods without them. Necessities typically display inelastic demand while luxuries display elastic demand. Goods that consume a large share of consumer income tend to have more elastic demand, and demand generally becomes more elastic over longer time horizons as consumers adjust habits and find alternatives. Cross-price elasticity measures the responsiveness of demand for one good to changes in the price of another. Positive cross-price elasticity indicates substitutes, while negative cross-price elasticity indicates complements, goods consumed together.

Income elasticity measures how demand responds to changes in consumer income. A normal good has positive income elasticity, so demand rises with income, while an inferior good has negative income elasticity, so demand falls as income rises. Two special cases defy the law of demand. A Giffen good is a rare inferior good whose demand rises as its own price rises, because a strong income effect outweighs the substitution effect. A Veblen good is a luxury whose demand rises with price because higher prices confer status. These cases reveal that demand is shaped by psychological and social forces in addition to straightforward price comparisons, foreshadowing the economics">behavioral economics discussed in the next chapter.

Consumer theory models how individuals make choices to maximize satisfaction. Utility is the abstract measure of satisfaction from consuming a good or service, and marginal utility is the additional utility gained from consuming one more unit. The law of diminishing marginal utility states that each additional unit consumed adds less utility than the previous one, providing a foundation for understanding downward-sloping demand curves. Utility maximization occurs when consumers allocate spending so that the marginal utility per dollar is equal across all goods purchased.

This analysis is represented graphically using indifference curves, which depict combinations of two goods yielding the same total utility, with the marginal rate of substitution describing the rate at which a consumer would trade one good for another while maintaining utility. The budget constraint describes the combinations of goods affordable given income and prices. Consumer choice theory combines these tools to predict that consumers maximize utility subject to their budget constraint, sometimes reaching a corner solution in which one good is consumed in zero quantity. When prices change, two effects emerge: the substitution effect captures changes in quantity due to relative price shifts holding utility constant, while the income effect captures changes in purchasing power. The principle of revealed preference holds that preferences can be inferred from observed choices, anchoring empirical work in consumer behavior.

economics">Behavioral economics shows that real people often deviate from the perfectly rational model. Bounded rationality recognizes that decisions are made within cognitive limits. Loss aversion means people feel losses more strongly than equivalent gains, and the endowment effect describes how people value possessions more once they own them. Anchoring occurs when decisions rely too heavily on the first piece of information offered, while mental accounting leads people to treat money differently depending on its source or intended use. The sunk cost fallacy tempts people to let past unrecoverable costs influence current decisions, and hyperbolic discounting describes the tendency to prefer smaller immediate rewards over larger delayed ones. Commitment devices help bind future behavior to overcome present bias, and nudge theory uses subtle design changes to influence behavior without removing choice.

Under uncertainty the expected utility hypothesis describes how rational agents choose among risky prospects, and individuals can be classified as risk averse, preferring a sure outcome over a gamble with equal expected value; risk neutral, indifferent between the two; or risk seeking, preferring the gamble. Insurance pools risk through premiums, but introduces moral hazard, when insured behavior becomes riskier, and adverse selection, when high-risk individuals are disproportionately likely to buy insurance.

A production function describes how outputs arise from inputs. The marginal product of labor is the additional output produced by employing one more worker, and the law of diminishing marginal returns states that adding more of one input while holding others constant eventually yields smaller increases in output. Economists distinguish between the short run, in which at least one input is fixed, and the long run, in which all inputs can vary. This distinction shapes how firms make decisions in response to changing market conditions.

Costs are divided into fixed costs, which do not vary with output such as rent, and variable costs, which do such as raw materials. Marginal cost is the cost of producing one more unit, while average total cost is total cost divided by quantity and average variable cost is variable cost divided by quantity. The profit maximization rule states that firms should produce where marginal revenue equals marginal cost. The firm's break-even point is where total revenue equals total cost, and the short-run shutdown point is where price falls below average variable cost, at which the firm should temporarily cease production. Economic profit deducts total opportunity cost, including implicit costs, from revenue, while accounting profit deducts only explicit costs. Normal profit corresponds to zero economic profit, where revenue covers all costs including opportunity cost. As firms grow, economies of scale describe cost advantages from increased production, diseconomies of scale describe rising average costs from growing too large, and constant returns to scale describe stable average costs. X-inefficiency arises when a lack of competitive pressure allows costs to drift above the minimum achievable level. Barriers to entry are obstacles preventing new firms from entering a market, while barriers to exit are costs preventing firms from leaving.

Market structures range across a spectrum. Perfect competition features many small firms, identical products, free entry and exit, and perfect information; in the long run, firms earn zero economic profit and the long-run supply curve is horizontal at minimum average total cost once entry and exit adjust output. A monopoly is a market with a single seller of a product without close substitutes, sustained by barriers such as patents, control of resources, or government grants, and a natural monopoly arises when a single firm can serve demand at lower cost than multiple firms, as is common for utilities. Monopolies restrict output below competitive levels, generating deadweight loss. Monopolistic competition features many firms selling differentiated products with relatively easy entry, and in the long run produces zero economic profit but at excess capacity. An oligopoly is dominated by a few firms whose strategic interactions are central to outcomes.

Game theory studies strategic interaction among rational agents. In the prisoner's dilemma, individual rationality leads to a worse collective outcome, illustrating how uncooperative behavior can harm all participants. A Nash equilibrium is a set of strategies in which no player can benefit by unilaterally changing their own action. A dominant strategy yields better outcomes regardless of opponents' choices. These concepts are essential for understanding oligopoly behavior and other settings in which outcomes depend on the choices of others.

Collusion occurs when firms cooperate to fix prices or restrict output, and a cartel is an explicit collusive agreement among firms such as OPEC. Such behavior is typically restricted by antitrust law, exemplified in the United States by the Sherman Act of 1890, which prohibits anticompetitive agreements and monopolization. Market concentration can be measured using the Herfindahl-Hirschman Index, computed as the sum of squared market shares of the firms in the market, with higher values indicating greater concentration. Other strategic behaviors include predatory pricing, in which prices are set below cost to drive out competitors, and price gouging, which involves excessively high prices during emergencies and is often illegal.

Price discrimination is the practice of charging different prices to different buyers for the same product, requiring three conditions: market power, the ability to segment buyers, and prevention of resale. First-degree price discrimination charges each consumer their maximum willingness to pay, capturing all consumer surplus. Second-degree price discrimination prices based on quantity or version, as in bulk discounts. Third-degree price discrimination charges different groups different prices, such as student or senior discounts. Mechanism design is the engineering of rules, auctions, and institutions to achieve desired outcomes. Auction theory analyzes how auction formats allocate resources and reveal value, with the Vickrey auction, a sealed-bid second-price auction in which the highest bidder wins but pays the second-highest bid, encouraging bidders to bid their true valuations. Rent-seeking describes the spending of resources to obtain economic rents, payments to a factor above its opportunity cost, without creating new value, often through lobbying for favorable policies.

Factors of production include labor, capital, land, and entrepreneurship. The marginal revenue product of an input is the additional revenue generated by employing one more unit of it. The labor demand curve is downward-sloping, reflecting that firms hire more workers only when wages fall, while labor supply represents the amount of labor workers are willing to provide at various wages. Human capital refers to the skills, knowledge, and experience that workers accumulate, and human capital theory, developed by Becker, treats education and training as investments that raise future productivity and wages, generating a wage premium for those with more education.

The labor market is shaped by the consumption-leisure tradeoff, as workers balance income against leisure. A higher wage creates two competing effects: the substitution effect makes working more attractive relative to leisure, while the income effect allows workers to afford more leisure. The backward-bending labor supply curve emerges when, at high wages, the income effect dominates and additional income reduces hours worked. A minimum wage set above equilibrium can cause unemployment for low-skill workers, illustrating how price controls apply in factor markets as well as goods markets. Unemployment in microeconomics refers to workers unable to find jobs at the prevailing wage, and it can be frictional, from job search transitions; structural, from skill mismatches; cyclical, from downturns in the business cycle; or related to the natural rate, the level consistent with stable inflation. The Phillips curve describes a relationship between unemployment and inflation, and stagflation refers to the simultaneous occurrence of high inflation and high unemployment.

A labor monopsony is a market with a single buyer, which results in lower wages and employment than a competitive market. Wage discrimination occurs when equal work is rewarded unequally by characteristics such as race or gender, contributing to the gender pay gap, while efficiency wage theory suggests that paying above-market wages increases productivity and reduces turnover. Capital refers to goods used to produce other goods, such as machines and buildings. The interest rate is the price of borrowing money, present value is the current worth of a future sum discounted by that rate, and the time value of money captures the idea that a dollar today is worth more than a dollar tomorrow due to interest and risk. A risk premium is the extra return required to bear additional risk. Intertemporal choice describes decisions involving outcomes across different times, and the marginal propensity to consume captures the fraction of additional income devoted to consumption, with the savings rate capturing what is held back.

Welfare economics evaluates economic outcomes against social welfare criteria. The central efficiency benchmark is Pareto efficiency, an allocation in which no one can be made better off without making someone worse off. A Pareto improvement is a change that benefits someone without harming anyone. Kaldor-Hicks efficiency relaxes this requirement by allowing changes that are potential Pareto improvements in which winners could in principle compensate losers. Allocative efficiency produces the mix of goods consumers most want, while productive efficiency produces at the lowest possible cost. The first welfare theorem states that a competitive equilibrium with no externalities is Pareto efficient, and the second welfare theorem shows that any Pareto-efficient allocation can be achieved through a competitive equilibrium with appropriate lump-sum transfers.

A market failure is a situation in which free markets allocate resources inefficiently, arising from externalities, public goods, market power, or asymmetric information. Externalities are costs or benefits imposed on third parties not involved in a transaction. A negative externality such as pollution imposes costs on others, while a positive externality such as vaccinations confers benefits. The socially optimal output occurs where social marginal benefit equals social marginal cost. A Pigouvian tax corrects a negative externality by internalizing its cost, aligning private and social incentives. The Coase theorem holds that with well-defined property rights and low or zero transaction costs, parties can bargain to efficient outcomes regardless of the initial assignment of rights. Public goods are non-rivalrous and non-excludable, like national defense, leading to the free-rider problem in which individuals benefit without paying. The tragedy of the commons describes how shared resources are overused when individuals act in self-interest. A Lindahl tax ties each person's payment to their marginal benefit from a public good, attempting to align contributions with benefits.

Asymmetric information occurs when one party in a transaction has more information than the other. Moral hazard arises when a party takes more risk because costs fall on others, as when insured individuals behave more riskily, and adverse selection occurs when asymmetric information leads to undesirable participation, as when high-risk individuals disproportionately buy insurance. Signaling involves actions taken to convey information, such as diplomas signaling ability, while screening involves an uninformed party inducing the informed party to reveal information. The principal-agent problem arises when an agent acts on behalf of a principal with different incentives, while the median voter theorem suggests that majority-rule voting tends to reflect the median voter's preference.

Government failure occurs when government intervention causes inefficiency or worse outcomes than markets would have produced, and regulatory capture describes how regulators may come to serve industry interests rather than the public. Partial equilibrium analyzes a single market in isolation, while general equilibrium considers the state in which all markets clear simultaneously, recognizing that interventions in one market spill over into others.

Comparative advantage explains why countries, individuals, and firms benefit from specialization and trade. A producer has an absolute advantage when it can produce more of a good with the same inputs, but comparative advantage, the ability to produce a good at a lower opportunity cost, is what drives mutually beneficial trade, as David Ricardo famously demonstrated. When each party specializes in what it produces at lower opportunity cost and exchanges with others, both sides realize gains from trade. The production possibilities frontier (PPF) depicts the combinations of two goods an economy can produce given its resources and technology. Points inside the PPF represent inefficient use of resources, while points outside are unattainable with current resources. The concave shape of the PPF reflects increasing opportunity costs as more of one good is produced. Trade barriers such as tariffs (taxes on imports), quotas (quantity limits), and concerns about dumping (selling exports below cost to gain market share) reduce these gains. The law of one price states that identical goods should sell for the same price in different markets, absent transaction costs, and arbitrage is the practice of profiting from price differences across markets.

The Edgeworth box is a diagram showing all possible allocations of two goods between two consumers, and the contract curve is the locus of Pareto-efficient allocations within it. Economic inequality is measured using tools such as the Lorenz curve, which graphs cumulative shares of income against cumulative shares of households, and the Gini coefficient, a summary measure ranging from zero (perfect equality) to one (perfect inequality). Wealth inequality concerns the unequal distribution of assets. Policy responses include a poverty line that defines income thresholds below which households are considered poor, universal basic income that provides regular cash transfers to all citizens regardless of work, microfinance that extends small loans to poor entrepreneurs lacking access to traditional banking, and conditional cash transfers that provide cash contingent on actions such as school attendance. The concept of consumer sovereignty holds that consumers determine what is produced through their purchases, while producer sovereignty emphasizes that firms may shape outcomes through advertising and supply decisions. Informationally efficient markets are those in which prices fully reflect available information.

Economic analysis is shaped by different schools of thought and methodologies. Positive statements describe what is, while normative statements express value-laden judgments about what ought to be. Methodological individualism explains economic phenomena through individual actions. Adam Smith's invisible hand describes how self-interest can lead to socially beneficial outcomes through markets, supporting a laissez-faire approach of minimal government intervention. Keynesian economics emphasizes aggregate demand and government's role in stabilizing the economy. Monetarism, associated with Friedman, highlights the role of the money supply in inflation and growth. Austrian economics emphasizes methodological individualism and free markets. Creative destruction, a concept from Schumpeter, describes how innovation destroys old industries while creating new ones.

Valuation methods bridge theory and empirics. Willingness to pay is the maximum a consumer would pay for a good, while willingness to accept is the minimum a seller would accept to part with it. Contingent valuation uses survey methods to estimate willingness to pay for non-market goods such as environmental amenities, and hedonic pricing decomposes observed prices into contributions from individual attributes. These techniques extend the surplus measures from the foundations chapter into areas where market prices are absent or incomplete, while the dependency ratio summarizes the demographic balance between working-age and non-working-age populations that conditions much of labor market analysis.