Midterm Economics Study Guide

This document is a comprehensive study guide designed to explain the key topics for your upcoming midterm economics exam. It breaks down each major topic into core definitions, detailed explanations of key concepts, and a set of potential exam questions modeled after the professor's style. The goal is to provide a clear and structured path to help you master the material and prepare effectively.

1.0

Core Macroeconomic Concepts

1.1 Business Cycles

Understanding business cycles is fundamental to macroeconomics. These cycles represent the natural, recurring fluctuations in a country's economic activity over time. They are a central focus for economists and policymakers because they directly impact critical areas like national output, employment levels, and overall economic prosperity.

Definition: A business cycle is defined as the "recurrent ups and downs in the level of economic activity." These fluctuations do not occur at regular intervals but follow a recognizable pattern.

The 4 Phases

Boom/Peak This phase represents the highest level of economic activity and output in a cycle. It marks the end of a period of economic expansion. During a peak, resource utilization, including labor and capital, is high, and unemployment is at a low point. The economy is operating at or near its full capacity, and businesses are generally prosperous.
Recession/Contraction Following the peak, the economy enters a period of recession. This phase is characterized by a general decline in total output, income, and business activity. As economic performance falls, the unemployment rate begins to rise. When the recession becomes particularly severe or prolonged, the economy is said to reach a depression or trough.
Trough/Depression The trough is the lowest point of a business cycle. It marks the end of the recessionary period and the beginning of a recovery. During this phase, unemployment and the amount of idle productive capacity are at their highest levels.
Recovery/Expansion In the recovery or expansion phase, the economy begins to grow again. More resources are employed, total output increases, national income rises, and the unemployment level gradually diminishes. Business activity picks up, and the economy moves toward the next peak.

Business Cycle Visualization

The cycle shows economic fluctuations moving around a Growth trend line, which represents the economy's long-term potential growth path.

Potential Exam Questions

"What is a business cycle? Describe in detail the four primary phases of a business cycle, explaining the economic conditions associated with each."
"Draw a standard business cycle graph, labeling the axes, the growth trend line, and each of the four phases. Explain what is happening to the economy's total output during the 'Recovery/Expansion' phase."

1.2 Unemployment and Its Types

The study of unemployment is strategically important in macroeconomics as it serves as a key indicator of an economy's health. High unemployment signals economic distress, while low unemployment is a sign of prosperity.

Key Definitions

Unemployment: A situation where individuals in the specified labor force age group are without a job but are actively searching for one.
Labor Force: The group of people within a specified age who are either employed or unemployed and actively seeking work.
Full Employment: The economic state where the unemployment rate is equal to the natural rate of unemployment. This implies that cyclical unemployment is zero, but frictional and structural unemployment still exist. Crucially, this means that "full employment" is not zero unemployment.

Formulas

Unemployment Rate = (Total Unemployment / Labor Force) * 100

Natural Level of Unemployment = Frictional Unemployment + Structural Unemployment

Frictional Unemployment

Unavoidable, brief periods. Associated with normal labor market turnover. Includes people voluntarily switching jobs, new graduates entering the labor force, or re-entrants. Example: Construction workers affected by seasonality.

Structural Unemployment

Results from a mismatch between skills/locations of seekers and available jobs. Caused by long-term structural changes like technological advancements or shifts in consumer demand (e.g., obsolete skills).

Cyclical Unemployment

Directly tied to the business cycle. Arises from a deficiency in demand for goods/services, forcing firms to lay off workers. Increases during recessions, decreases during expansions.

Potential Exam Questions

"Define unemployment and labor force. What are the three main types of unemployment? Provide a detailed explanation and an example for each."
"A recent graduate is looking for her first job. What type of unemployment is she experiencing? Explain your reasoning. Is it possible for an economy to have a 0% unemployment rate? Explain why or why not, using the concept of 'full employment'."

2.0

Theory of Consumer Behavior

2.1 Ordinal Utility Theory and Its Assumptions

Ordinal Utility Theory provides a framework for how consumers make choices. Unlike the Cardinal Utility approach (measuring satisfaction in "utils"), Ordinal Utility argues consumers only need to rank their preferences.

Definition: In the ordinal approach, "utility is not measurable in cardinal numbers rather the consumer can rank or order the utility he derives from different goods and services."

Core Assumptions

Rational Consumers: Consumers consistently act to maximize satisfaction given limited income and market prices.
Ordinal Utility: Consumers can rank bundles as better, worse, or equally good without quantifying "how much" better.
Diminishing Marginal Rate of Substitution (MRS): The rate at which a consumer is willing to trade one good for another while maintaining satisfaction. As a consumer has more of a good, they are willing to give up progressively less of another good to get one more unit of it.
Consistency (Transitivity): If a consumer prefers bundle X to Y, and Y to Z, they must prefer X to Z.

2.2 Indifference Curves

Indifference Curve: A curve showing "different combinations of two goods which yield the same utility to the consumer."

Indifference Map: A set of indifference curves. Each curve represents a different utility level.

4 Essential Properties

Negative slope: Downward sloping left to right. To gain more of one good while keeping utility constant, you must give up some of the other good.
Convex to the origin: Reflects Diminishing MRS. The curve becomes flatter as you move down because you are willing to give up fewer units of the vertical good to get more of the horizontal one.
Higher is better: Higher curves represent bundles with more commodities. Rational consumers prefer more to less.
Never cross: Intersection violates transitivity. If they crossed at A, then A=B and A=C, implying B=C. But if B is on a higher curve than C, B must be preferred. This contradiction proves they cannot cross.

Indifference Map

Potential Exam Questions

"What are the core assumptions of the ordinal utility theory? Please explain each in detail."
"Define an indifference curve. Draw a standard indifference curve and explain why it is downward sloping and convex to the origin, relating these properties to consumer preferences."

3.0

Theory of Costs

A firm's costs are a critical determinant of its production and pricing decisions. In the short run, at least one input is fixed.

3.1 Cost Components

TFC (Total Fixed Cost): Costs that do not change with output (e.g., rent). Paid even if output is zero.
TVC (Total Variable Cost): Costs that vary directly with output (e.g., raw materials, wages).
TC (Total Cost): TFC + TVC.
AFC (Avg Fixed Cost): TFC / Q. Declines continuously as output increases.
AVC (Avg Variable Cost): TVC / Q. U-shaped.
AC/ATC (Average Cost): TC / Q or AFC + AVC. U-shaped.
MC (Marginal Cost): Additional cost for one extra unit. dTC/dQ.

Production & Costs Link

The U-shape results from the law of diminishing returns.

MC = w / MPL

AVC = w / APL

MC and MPL are mirror images. When MPL is max, MC is min.

Short-Run Cost Curves

Relationship Rules:

MC intersects AVC and AC at their minimum points.
If MC < AC, Average falls. If MC > AC, Average rises.
Vertical distance between AC and AVC is AFC (which shrinks as Q increases).

Potential Exam Questions

"Define AFC, AVC, AC, and MC. Explain why the short-run MC, AVC, and AC curves are typically U-shaped."
"Draw a single graph showing the typical shapes and relationships of the AFC, AVC, AC, and MC curves. Be sure to label the axes and all curves correctly. Explain why the MC curve must intersect the AC curve at the AC curve's minimum point."

4.0

Market Structures

4.1 Perfect Competition

Characterized by a complete absence of rivalry. A theoretical model.

Large Number of Sellers/Buyers: No single entity influences price. Firms are "Price Takers".
Homogeneous Product: Identical products. Perfect substitutes.
Perfect Mobility: Labor/capital move freely seeking highest returns.
Free Entry/Exit: No barriers (legal/financial).
Perfect Knowledge: Complete information on prices/costs.
No Govt Interference: Free enterprise policy.

4.2 Oligopoly

Dominated by a few large firms.

Few Dominant Firms: Produce significant portion of output.
Interdependence: The most distinguishing characteristic. Decisions of one firm directly affect others (e.g., Ford discounts affect GM). Risk of price wars.
Entry Barriers: Considerable obstacles (scale, patents, brand).
Homogeneous or Differentiated: Can be "Pure" (steel) or "Differentiated" (cars).
Non-Price Competition: Advertising, service, quality (to avoid price wars).

Feature	Perfect Competition	Monopolistic Comp	Oligopoly	Monopoly
Firms	Very Large Number	Relatively Many	Few Dominant	One (Single)
Product	Homogeneous (Identical)	Differentiated	Homogeneous/Diff	Unique (No substitutes)
Control Over Price	None (Price Taker)	Limited	Significant (Interdependent)	Price Maker
Barriers to Entry	Free Entry/Exit	None	Considerable Obstacles	Blocked
Non-Price Comp	None	Extensive	High	Public Image/Goodwill

Potential Exam Questions

"What are the core assumptions of a perfectly competitive market? Explain why a firm in this market is considered a 'price taker'."
"Compare and contrast the characteristics of a perfectly competitive market and an oligopoly market with respect to the number of firms, type of product, and conditions of entry."
"Create a table that summarizes the key features of the four main market models: perfect competition, monopolistic competition, oligopoly, and monopoly."

5.0

Special Topics & Problem Solving

5.1 Externalities

An externality is a cost or benefit arising from an economic transaction that affects a third party not directly involved. These "spillover" effects can be negative or positive.

Negative Externalities: Harm/cost suffered by a third party. Example: A factory polluting a river. The factory profits, but the community bears the health/cleanup costs. In profit maximization, firms often ignore these external costs.

Note: Course material defines the problem but does not detail government solutions (taxes/regulations).

5.2 How to Approach Cost and Profit Problems

Walkthrough: Maximizing Profit

Perfect Competition

Goal: Find quantity (q) that maximizes profit (π), where π = TR - TC.
Golden Rule: Produce where Marginal Revenue (MR) = Marginal Cost (MC).

Example Problem:
Price (P) = $10
Total Cost (TC) = 2 + 10q - 4q² + q³

Find MR: In perfect competition, MR = P. So, MR = 10.
Find MC: Derivative of TC. MC = 10 - 8q + 3q².
Set MR = MC: 10 = 10 - 8q + 3q² -> 0 = -8q + 3q² -> q(-8 + 3q) = 0. Solutions: q=0 or q=8/3.
Second Order Condition: Ensure MC is rising (slope positive). Slope of MC = -8 + 6q. At q=8/3, slope is +8 (Rising). This is max profit.
Calculate Profit: TR - TC at q=8/3. TR ≈ 26.67, TC ≈ 19.19. Profit ≈ $7.48.

Shutdown Point: Firm shuts down in short run if Price < Min AVC.
1. Find TVC (10q - 4q² + q³).
2. Find AVC (TVC/q = 10 - 4q + q²).
3. Minimize AVC (derivative = 0 -> -4 + 2q = 0 -> q=2).
4. Calculate Min AVC at q=2: 10 - 8 + 4 = $6.
Shutdown if Price < $6.

Interactive Summary

Step 1: MR & MC

MR = 10

MC = 10 - 8q + 3q²

Step 2: Solve

q = 8/3

Confirmed by 2nd order condition.

Potential Exam Questions

"A firm in a perfectly competitive market faces a price of 4 birr. Its total cost function is given by TC = (1/3)Q³ - 5Q² + 20Q + 50. What level of output should the firm produce to maximize its profit? What is the firm's total profit or loss at this output level?"

Quiz

MC = w / MPL. They are mirror images. As marginal product of labor (MPL) rises, marginal cost (MC) falls. When diminishing returns set in (MPL falls), MC rises.