Microeconomics — Practice Q&A
Q: What's the difference between a movement along the demand curve and a shift of the demand curve?
A: A movement along the demand curve is caused solely by a change in the good's own price, holding all other factors constant — it's a change in quantity demanded at different points on the same curve. A shift of the entire demand curve is caused by a change in a non-price factor (income, consumer tastes, prices of related goods, expectations), producing a new demand curve entirely — at every price level, quantity demanded is now different than before. Confusing these two is one of the most common introductory-microeconomics errors.
Q: Why does a firm continue operating in the short run even if it isn't covering its total costs?
A: A firm's shutdown decision in the short run depends on whether revenue covers variable costs, not total costs — because fixed costs are sunk in the short run regardless of whether the firm produces or not. As long as revenue exceeds variable costs, continuing to operate contributes something toward covering fixed costs, which is better than shutting down and covering none of them. Only when revenue falls below variable costs does shutting down become the better choice.
Q: Why does a monopolist restrict output below the competitive level, and what economic problem does this create?
A: A monopolist faces the entire market demand curve, meaning producing more output requires lowering price on all units sold, not just the marginal unit — this makes it profit-maximizing to restrict output and charge a higher price than a competitive market would produce. This creates deadweight loss: some transactions that would benefit both buyer and seller (buyers willing to pay more than the marginal cost of production, but less than the monopoly price) simply don't happen, representing a measurable reduction in total economic welfare relative to the competitive outcome.
Q: How does price elasticity of demand affect a firm's pricing strategy?
A: A firm facing inelastic demand (few substitutes, or the good is a necessity) can raise prices with relatively little quantity loss, generally increasing total revenue. A firm facing elastic demand (many close substitutes available) faces the opposite tradeoff — raising price triggers a proportionally larger quantity decline, generally reducing total revenue. This is why firms selling goods with few substitutes have meaningfully more pricing power than firms in highly competitive, substitute-rich markets.
Q: What's the connection between game theory and oligopoly?
A: In oligopoly, each firm's optimal decision depends on what its rivals do, creating genuine strategic interdependence rather than simple independent optimization — this is exactly the kind of situation game theory analyzes. Concepts like the prisoner's dilemma illustrate why oligopolists might find it individually rational to compete aggressively even when coordinated restraint would benefit all firms collectively, explaining both why cartels sometimes form and why they're often unstable even when collusion would be mutually beneficial.
Q: What are externalities, and why do they justify government intervention in an otherwise efficient market framework?
A: Externalities are costs or benefits of a transaction that affect third parties not directly involved in that transaction — pollution from a factory affecting nearby residents is a classic negative externality. Because these costs aren't reflected in the market price the factory and its customers actually pay, the market produces more of the polluting good than is socially optimal. This is the core economic justification for interventions like pollution taxes — not simply on fairness grounds, but because the intervention corrects a specific, identifiable market failure where prices don't reflect true social cost.