EXPLORING ECONOMICS: MICROECONMICS

WEEK 12: REVISION

Week 1: INTRODUCTION: MARKETS AND PRICES
The Themes of Microeconomics
Positive vs. Normative Analysis
Positive questions deal with explanation and prediction, normative questions
with what ought to be.
positive analysis Analysis describing relationships of cause and effect.
Positive analysis is central to microeconomics.
normative analysis Analysis examining questions of what ought to be.
Normative analysis is often supplemented by value judgments. When value
judgments are involved, microeconomics cannot tell us what the best policy
is. However, it can clarify the trade-offs and thereby help to illuminate the
issues and sharpen the debate.
What Is a Market?

Market Definition—The Extent of a Market

extent of a market Boundaries of a market, both geographical and in terms of
range of products produced and sold within it.
For some goods, it makes sense to talk about a market only in terms of very
restrictive geographic boundaries.
We must also think carefully about the range of products to include in a
market.
Market definition is important for two reasons:
A company must understand who its actual and potential competitors are for
the various products that it sells or might sell in the future.
Market definition can be important for public policy decisions.
Week 2: The Basics of Demand and Supply
 11/29/2023 6

2.1 Supply and Demand

The Demand Curve QD = QD(P )
demand curve Relationship between the
quantity of a good that consumers are willing to
buy and the price of the good.

FIGURE 2.2
THE DEMAND CURVE

The demand curve, labeled D, shows how the

quantity of a good demanded by consumers
depends on its price. The demand curve is
downward sloping; holding other things
equal, consumers will want to purchase more
of a good as its price goes down.
2.3 Changes in Market Equilibrium
FIGURE 2.4
NEW EQUILIBRIUM
FOLLOWING SHIFT
IN SUPPLY
When the supply curve
shifts to the right, the
market clears at a
lower price P3 and a
larger quantity Q3.
 If elasticity >1, it is elastic. If
2.4 Elasticities of Supply and Demand elasticity <1, it is inelastic

elasticity Percentage change in one variable resulting from a 1-

percent increase in another.
PRICE ELASTICITY OF DEMAND
price elasticity of demand Percentage change in quantity
demanded of a good resulting from a 1-percent increase in its
price.

E p = (%ΔQ )/(%ΔP )

ΔQ/Q PΔQ
Ep = =
ΔP /P QΔP
(2
.1
)
Week 3: THE CONSUMER THEORY
Three Basic Assumptions about Preferences

1. Completeness
2. Transitivity
3. More is better than less
 Consumer Choice

MAXIMIZING CONSUMER
SATISFACTION
A consumer maximizes satisfaction by
choosing market basket A. At this
point, the budget line and
indifference curve U2 are tangent.
No higher level of satisfaction (e.g.,
market basket D) can be attained.
At A, the point of maximization, the
MRS between the two goods equals
the price ratio. At B, however,
because the MRS [− (−10/10) = 1] is
greater than the price ratio (1/2),
satisfaction is not maximized.
 Choice
Marginal utility (MU) Additional satisfaction obtained from consuming one additional
unit of a good.
Diminishing marginal utility Principle that as more of a good is consumed, the
consumption of additional amounts will yield smaller additions to utility.

0 = MUF (ΔF ) + MUC (ΔC )

- (ΔC /ΔF ) = MUF /MUC
(3.5)

(3.6)
𝑖𝑓 MRS = − (ΔC /ΔF ) MRS = MUF / MUC
Condition to maximize utility: MRS = PF / PC
MUF / MUC = PF / PC
or MUF / PF = MUC / PC (3.
7)
equal marginal principle Principle that utility is maximized when the consumer has
equalized the marginal utility per dollar of expenditure across all goods.
Week 4: THE CONSUMER THEORY -2
Individual Demand
EFFECT OF PRICE CHANGES
A reduction in the price of food, with income
and the price of clothing fixed, causes the
consumer to choose a different market basket.
In panel (a), the baskets that maximize utility
for various prices of food (point A, $2; B, $1; D,
$0.50) trace out the price-consumption curve.
Part (b) gives the demand curve, which relates
the price of food to the quantity demanded.
(Points E, G, and H correspond to points A, B,
and D, respectively).
 Individual Demand
EFFECT OF INCOME CHANGES
In part (a), the baskets that maximize
consumer satisfaction for various incomes
(point A, $10; B, $20; D, $30) trace out the
income-consumption curve.
The shift to the right of the demand curve in
response to the increases in income is shown
in part (b). (Points E, G, and H correspond to
points A, B, and D, respectively.)
income-consumption curve Curve tracing the
utility-maximizing combinations of two goods
as a consumer’s income changes.
Week 5: PRODUCTION
Firms and Their Production Decisions
Production function Function showing the highest output that a firm can
produce for every specified combination of inputs.

q = F (K, L) (6.1)

Production functions describe what is technically feasible when the firm

operates efficiently—that is, when the firm uses each combination of inputs
as effectively as possible.
The Short Run versus the Long Run
Short run Period of time in which quantities of one or more production
factors cannot be changed.
Fixed input Production factor that cannot be varied.
Long run Amount of time needed to make all production inputs variable
 The Slopes of the Product Curve

FIGURE 6.1
PRODUCTION WITH ONE VARIABLE
INPUT
The total output curve in (a) shows the
output produced for different amounts of
labor input.
At point A in (a), with 3 units of labor, the
marginal product is 29 because the tangent
to the total product curve has a slope of 29.
The average product of labor, however, is 23,
which is the slope of the line from the origin
to point A. Also, the marginal product of
labor reaches its maximum at this point.
At point B, with 5 units of labor, the marginal
product of labor has dropped to 24 and is
equal to the average product of labor.
Production with Two Variable Inputs

FIGURE 6.5
PRODUCTION WITH TWO
VARIABLE INPUTS
A set of isoquants, or isoquant
map, describes the firm’s
production function.
Output increases as we move
from isoquant q1 (at which 55
units per year are produced at
points such as A and D), to
isoquant q2 (75 units per year at
points such as B), and to isoquant
q3 (90 units per year at points such
as C and E).
Marginal Rate of Technical Substitution (MRTS)

Substitution Among Inputs

MRTS: amount by which the quantity of one input can be
reduced when one extra unit of another input is used, so that
output remains constant.

∆𝐾
MRTS = - ;
∆L

(6.
2)
Week 6: PRODUCTION COST
Measuring Cost: Which Costs
Matter?
• Economic Cost versus Accounting Cost

Accounting cost Actual expenses plus depreciation charges for

capital equipment.
Economic cost Cost to a firm of utilizing economic resources in
production.
Opportunity cost Cost associated with opportunities forgone
when a firm’s resources are not put to their best alternative use.

Economic cost = Opportunity cost

 Economists vs. Accountants
How an economist How an accountant
views a firm views a firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

23
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Average costs
Fixed cost FC
AFC = =
Quantity Q

Variable cost VC
AVC = =
Quantity Q

Total cost TC
ATC = =
Quantity Q
24
Marginal cost

(change in total cost) TC

MC = =
(change in quantity) Q

25
 Cost in the Short Run
FIGURE 7.1
COST CURVES FOR A FIRM
In (a) total cost TC is the vertical sum
of fixed cost FC and variable cost VC.

In (b) average total cost ATC is the

sum of average variable cost AVC and
average fixed cost AFC.
Marginal cost MC crosses the average
variable cost and average total cost
curves at their minimum points.
Choosing Inputs

FIGURE 7.3
PRODUCING A GIVEN OUTPUT AT MINIMUM COST

Isocost curves describe the combination

of inputs to production that cost the same
amount to the firm.
Isocost curve C1 is tangent to isoquant q1
at A and shows that output q1 can be
produced at minimum cost with labor
input L1 and capital input K1.
Cost Minimizing Condition
Recall that in our analysis of production technology, we showed that the marginal rate of
technical substitution of labor for capital (MRTS) is the negative of the slope of the isoquant and
is equal to the ratio of the marginal products of labor and capital:

MRTS = − ΔK ΔL = MPL MPK (7.3)

It follows that when a firm minimizes the cost of producing a particular

output, the following condition holds:

MPL MPK = w r
We can rewrite this condition slightly as follows:

MPL w = MPK r (7.4)

Week 7: PROFIT MAXIMIZATION & COMPETITIVE
SUPPLY
Three Basic Assumptions of Perfect Competition

• Perfect competition exists when

1. Many firms sell an identical product (homogeneous) to many

buyers.

2. Firm that has no influence over market price and thus takes the
price as given.

3. There are no restrictions on entry into (or exit from) the market. No
barriers to entry.
 Marginal Revenue, Marginal Cost, and Profit
Maximization
Profit. Difference between total revenue and
total cost.
Π=R -C
Marginal Revenue Change in revenue
resulting from a one-unit increase in
output.
FIGURE 8.1
PROFIT MAXIMIZATON IN THE SHORT RUN

A firm chooses output q*, so that profit,

the difference AB between revenue R
and cost C, is maximized.
At that output, marginal revenue (the
slope of the revenue curve) is equal to
marginal cost (the slope of the cost
curve).
MR = MC
A competitive firm making a positive profit

FIGURE 8.3

In the short run, the

competitive firm maximizes its
profit by choosing an output q*
at which MC = MR = P.
The profit of the firm is
measured by the rectangle
ABCD.

q*
Week 9: MONOPOLY
 The Monopolist’s Output Decision

FIGURE 10.2
PROFIT IS MAXIMIZED WHEN
MR = MC
If the firm produces Q1—it
sacrifices some profit because
the extra revenue that could be
earned from producing the units
between Q1 and Q* exceeds
the cost of producing them.
Similarly, expanding output from
Q* to Q2 would reduce profit
because the additional cost
would exceed the additional
revenue.
A Rule of Thumb for Pricing

(Q/P)(ΔP/ΔQ) is the reciprocal of the elasticity of demand, 1/Ed, measured at the profit-
maximizing output, and
MR = P + P (1 Ed )
Now, because the firm’s objective is to maximize profit, we can set marginal revenue equal to marginal
cost:

P + P (1 Ed ) = MC

which can be rearranged to give us

P − MC = − 1 (10.1)

P Ed
Equivalently, we can rearrange this equation to express price directly as a markup over
marginal cost:

P = MC
(10.2)

1+ (1 Ed )
Measuring Monopoly Power

Remember the important distinction between a perfectly competitive firm and a firm
with monopoly power: For the competitive firm, price equals marginal cost; for the
firm with monopoly power, price exceeds marginal cost.
Lerner Index of Monopoly Power Measure of monopoly power calculated as excess of
price over marginal cost as a fraction of price.
Mathematically:

L = (P − MC) P
This index of monopoly power can also be expressed in terms of the elasticity of demand facing
the firm. (10.4)

L = (P − MC ) P = −1 Ed
Week 10: EXTERNALITIES
NEGATIVE EXTERNALITIES: POLLUTION

Private Costs and Social Costs

Marginal private cost is the cost of producing an additional unit of a good
or service that is borne by the producer of that good or service.
Marginal external cost is the cost of producing an additional unit of a
good or service that falls on people other than the producer.

© 2015 Pearson
NEGATIVE EXTERNALITIES: POLLUTION

Marginal social cost is the marginal cost incurred by the entire society—
by the producer and by everyone else on whom the cost falls.
Marginal social cost (MSC) is the sum of marginal private cost (MC) and
marginal external cost (MEC).

MSC = MC + MEC

© 2015 Pearson
EXTERNAL COST

FIGURE 18.1 EXTERNAL COST

In (a), a profit-maximizing firm produces at q1, where price is equal to MC.
The efficient output is q*, at which price equals MSC.
In (b), the industry’s competitive output is Q1, at the intersection of industry supply MC and demand D.
The aggregate social cost is as the shaded triangle between MSCI, D, and output Q1.

Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved
Week 11: GAME THEORY
13.3 The Nash Equilibrium Revisited (1 of 8)
Dominant Strategies: I’m doing the best I can no matter what you do.
You’re doing the best you can no matter what I do.
Nash Equilibrium: I’m doing the best I can given what you are doing.
You’re doing the best you can given what I am doing.

TABLE 13.3 PRODUCT CHOICE PROBLEM

FIRM 2

CRISPY SWEET

CRISPY –5, –5 10, 10

FIRM 1
SWEET 10, 10 –5, –5

In this game, each firm is indifferent about which product it produces—so long as it does not
introduce the same product as its competitor. The strategy set given by the bottom left-hand
corner of the payoff matrix is stable and constitutes a Nash equilibrium: Given the strategy of its
opponent, each firm is doing the best it can and has no incentive to deviate.

Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved
THE END

Copyright © 2016, 2012, 2009 Pearson Education, Inc. All Rights Reserved