Key Formulas & Frameworks
Where C = Consumption, I = Investment, G = Government Spending, X = Exports, M = Imports
Marginal Revenue: MR = ΔTR ÷ ΔQ
Profit Maximization: MR = MC
Where A = area between Lorenz curve and line of equality, B = area below Lorenz curve
Where RR = Required Reserve Ratio
Where π = inflation, πe = expected inflation, u = unemployment, un = natural rate
Where Y = output, A = technology, K = capital, L = labor, α = capital's share of income
Core Concepts
Scarcity
The fundamental economic problem that resources are limited while human wants are unlimited. Every society must decide what to produce, how to produce, and for whom to produce.
Opportunity Cost
The value of the next best alternative forgone when making a choice. If you spend 4 hours studying economics, the opportunity cost is what you could have done with those 4 hours (e.g., working at $15/hr = $60).
Supply and Demand
The model showing how prices and quantities are determined in a market. The law of demand states that as price rises, quantity demanded falls (ceteris paribus). The law of supply states that as price rises, quantity supplied increases.
Market Equilibrium
The point where quantity demanded equals quantity supplied. At equilibrium price P*, there is no shortage or surplus. If price is above P*, a surplus pushes price down; if below P*, a shortage pushes price up.
Elasticity
A measure of responsiveness. Price elasticity of demand measures how much quantity demanded responds to a price change. If |Ed| > 1, demand is elastic; if |Ed| < 1, demand is inelastic; if |Ed| = 1, demand is unit elastic.
Marginal Analysis
Decision-making at the margin — comparing marginal benefit (MB) to marginal cost (MC). Rational agents continue an activity until MB = MC. This underpins consumer choice (MU = P) and firm production (MR = MC).
Market Structures
Four main types: (1) Perfect Competition — many firms, identical products, price takers; (2) Monopolistic Competition — many firms, differentiated products; (3) Oligopoly — few large firms, strategic interdependence; (4) Monopoly — single seller, price maker.
Externalities
Costs or benefits imposed on third parties not involved in a transaction. Negative externalities (pollution) lead to overproduction; positive externalities (education) lead to underproduction. Solutions include Pigouvian taxes, subsidies, and tradable permits.
Game Theory
The study of strategic interaction among rational agents. Key concepts include dominant strategies, Nash equilibrium (no player can benefit by unilaterally changing strategy), and the Prisoner's Dilemma (individual rationality leads to collectively suboptimal outcomes).
Worked Examples & Case Studies
Example 1: Calculating GDP
Problem: A country has the following data (in billions): Consumer Spending = $500, Investment = $200, Government Spending = $300, Exports = $150, Imports = $100.
Solution: GDP = C + I + G + (X − M) = 500 + 200 + 300 + (150 − 100) = 500 + 200 + 300 + 50 = $1,050 billion
Example 2: Price Elasticity of Demand
Problem: When the price of coffee rises from $4 to $5, quantity demanded falls from 200 cups to 160 cups per day. Calculate the price elasticity of demand.
Solution: %ΔQ = (160 − 200) ÷ 200 = −20%. %ΔP = (5 − 4) ÷ 4 = 25%. Ed = −20% ÷ 25% = −0.8. Since |Ed| < 1, demand is inelastic.
Example 3: Profit Maximization
Problem: A firm faces demand P = 100 − 2Q and has total cost TC = 50 + 20Q. Find the profit-maximizing quantity and price.
Solution: TR = P × Q = (100 − 2Q)Q = 100Q − 2Q². MR = dTR/dQ = 100 − 4Q. MC = dTC/dQ = 20. Set MR = MC: 100 − 4Q = 20 → 4Q = 80 → Q* = 20. P* = 100 − 2(20) = $60. Profit = TR − TC = (60 × 20) − (50 + 20 × 20) = 1200 − 450 = $750.
Case Study: The 2008 Financial Crisis
Background: The subprime mortgage crisis triggered a global financial meltdown. Banks had packaged risky mortgages into mortgage-backed securities (MBS) and collateralized debt obligations (CDOs), which received high credit ratings despite underlying risk.
Economic Analysis: Information asymmetry (originator vs. investor), moral hazard (too-big-to-fail), and systemic risk led to market failure. The crisis demonstrated the accelerator effect in reverse — falling housing prices reduced consumption and investment, deepening the recession. Policy responses included TARP ($700B bailout), quantitative easing (Fed balance sheet expansion from $900B to $4.5T), and fiscal stimulus (ARRA, $787B).
Case Study: OPEC and Oil Prices
Background: OPEC (Organization of Petroleum Exporting Countries) controls approximately 40% of global oil production. In 1973, OPEC imposed an oil embargo, causing prices to quadruple from $3 to $12 per barrel.
Economic Analysis: This is a classic case of a cartel restricting supply to raise prices. The price elasticity of oil demand is low in the short run (≈ −0.1), meaning quantity demanded barely responds to price changes — making supply restrictions highly profitable. However, in the long run, elasticity increases as consumers and firms adapt, undermining cartel power.
Practice Problems
Problem 1: If nominal GDP is $12 trillion and the GDP deflator is 120, what is real GDP?
Answer: Real GDP = Nominal GDP ÷ (GDP Deflator ÷ 100) = 12,000 ÷ 1.20 = $10 trillion
Problem 2: The CPI was 240 in 2022 and 252 in 2023. Calculate the inflation rate.
Answer: π = [(252 − 240) ÷ 240] × 100 = 5%
Problem 3: A labor force of 160 million has 8 million unemployed. What is the unemployment rate?
Answer: UR = (8 ÷ 160) × 100 = 5%
Problem 4: If the price of tea rises 10% and the quantity demanded of coffee increases 5%, what is the cross-price elasticity? Are tea and coffee substitutes or complements?
Answer: Exy = 5% ÷ 10% = 0.5. Since Exy > 0, tea and coffee are substitutes.
Problem 5: A monopolist faces demand P = 80 − Q and has MC = 20. Find the profit-maximizing price, quantity, and calculate deadweight loss compared to perfect competition.
Answer: MR = 80 − 2Q. Set MR = MC: 80 − 2Q = 20 → Q* = 30, P* = $50. Competitive: P = MC → 80 − Q = 20 → Qc = 60. DWL = ½ × (60 − 30) × (50 − 20) = ½ × 30 × 30 = $450.
Problem 6: If the required reserve ratio is 10%, what is the money multiplier? How much can the money supply increase from a $1,000 injection?
Answer: m = 1 ÷ 0.10 = 10. ΔMoney Supply = $1,000 × 10 = $10,000.
Problem 7: A consumer has $100 to spend on books ($20 each) and movies ($10 each). Write the budget constraint and find the maximum number of each good they can buy.
Answer: 20B + 10M = 100. Max books (M=0): B = 5. Max movies (B=0): M = 10.
Problem 8: Country A can produce 10 units of wheat or 5 units of cloth per hour. Country B can produce 8 units of wheat or 4 units of cloth per hour. Which country has a comparative advantage in each good?
Answer: Country A's OC of wheat = 5/10 = 0.5 cloth. Country B's OC of wheat = 4/8 = 0.5 cloth. Neither has a comparative advantage — opportunity costs are identical.