Introduction to Microeconomics
I.
II.
How do people and firms make decisions?
A. Consumers max utility based on budget constraint
B. Firms try to max profits
C. Three fundamental questions of microeconomics – All solved with Price
i. What goods and services should be produced?
ii. How to produce?
iii. Who gets them?
Theoretical vs. Empirical Economics
A. Theoretical: the process of building models to explain world
B. Empirical: the process of testing models
i. Also, Positive vs normative (are/should be)
Applying Supply and Demand
I.
II.
III.
Equilibrium: point where suppliers and demanders are both happy
A. Higher price as more is demanded, because that’s how much producers want to make
Labor market equilibrium
A. Wages per hour is y-axis, hours worked is x-axis.
B. Supply is upward sloping because the higher your wages, the more you’re willing to
work.
C. If there is excess supply in the market, the market would lower the price (wage)
i. Minimum wage is a price floor
Costs
A. Efficiency loss: if you prevent a trade where both parties would’ve been better off
B. Allocation inefficiency: (caused by price ceiling) Trades are not being made because of
how resources are allocated
Elasticity
I.
Elasticity: How much do supply and demand respond when price changes?
A. What is the slope of that demand curve?  sensitivity to price
B. Perfectly inelastic demand
1. Demand for good is unchanged regardless of price
2. Vertical demand curve
3. Caused by lack of substitutes
4. If there is a supply shock, only price changes, no change in quantity
C. Perfectly elastic demand
1. Consumers only care about price
2. Horizontal demand curve
3. Caused by infinite substitutes
4. If the price changed, consumers would immediately switch
II.
D. Elasticity Σ = % Δ Q/ % ΔP
E. Revenue = P x Q
1. Δ R/ Δ P = Q +P x (Δ Q/ Δ P)
2. Δ R/ Δ P = Q (1+Σ)
Empirical Economics
A. Distinguish causation from correlation
1. Think about which (price, quantity) affects what
B. Impact of producer tax
Preferences and Utility
I.
II.
III.
Utility Maximization
A. Posit preference, budget constraint then calculate what will you get
B. Three steps
1. Preference assumptions
2. Utility function
3. Budget constraints
Preference Assumptions
A. Completeness: In bundles of goods, you prefer one, but never unsure or both.
B. Transitivity: transitive property
C. Non-satiation: more is always better.
Properties of Indifference Curves (preference maps)
A. Curve showing all combos of consumption along which an individual is indifferent
B. Properties
1. Prefer higher indifference curves: further out the curve, the more you prefer it
2. Indifference curves are always downward sloping
a) Cant violate Non-satiation (Can’t be indifferent to getting more)
3. Cannot cross
a)
b) A and B are on the same curve, indifferent between A and B; A and C
are on the same curve, indifferent between A and C; transitive property,
means indifference between B and C which can’t be true because more
is better (Non-satiation).
C. Utility function: math rep of peoples preferences
IV.
1. u=√(𝑥𝑦)
Marginal utility  diminishing
A. Marginal rate of substitution (MRS) = ΔP/ ΔM = slope of indifference curve
B. ^Is same thing as –Mux /Muy
Budget Constraints
I.
II.
III.
Y= X*Px + Y*Py (X times the price of X)+(Y times the price of Y)
A. Slope = -Px/Py = MRT (Marginal rate of transformation)
Opportunity cost
A. Value of sacrificed alternative
B. Marginal benefits = marginal costs
Budget constraint and indifference curves
A.
i. D is the best point. E would be nice, but not in our budget. A is affordable but
it’s √10, while D is √18
IV.
MB = MC
A. –Px/Py = MRT and –Mux /Muy = MRS
B. Mux/ Px = Muy/ Py
Deriving Demand Curves
I.
Food Stamps: Example) Income $1,000, X spends $600 on other goods, $400 on food; Y
spends $100 other goods, $900 on food. Food stamps is $500.
A.
II.
1. New budget constraint is $1,500 (shift out)
2. Marginal rate of substitution and transformation aren’t the same
3. Person X is unhappier than Person Y
Price elasticities
A. Price elasticity of demand is how demand changes with the price of the item
B. Two effect that determine price elasticity
1. Substitution effect: change in quantity demanded when price increases, holding
utility constant (ΔP/P) / (ΔQ/Q) |u
2. Income effect: change in quantity demanded when income changes, holding
prices constant (ΔQ/Q) / (ΔY/Y) |P
C.
D. Substitution effect is always negative. Income effect can be either.
Applying Consumer Theory: Labor
I.
The more labor to market, more you consume, less leisure
A.
B.
What determines the slope of a budget constraint?
1. The marginal rate of transformation, which is ratio between prices. Price of
leisure is wage.
2. Slope here is –W/1. Tradeoff is $1
Introduction to Producer Theory
I.
II.
III.
Producer trying to max profits [Profits = Revenues – costs = π = R – c]
A. Efficient production
B. Production function: take input and turn into outputs
1. Labor and Capital  Hours in production and machines/land/building
2. Output (q), so q=f(L,k)
a. q is given firm’s output; Q is market output
C. Variable vs fixed inputs, short run vs. long run
1. SR is period where some inputs are fixed
2. LR is period where all inputs are variable
SR Production
A. Marginal product of labor (MPL) = Δq/ΔL given that k is constant
1. k is always constant in SR
2. How many hours needed to make my good?
3. Diminishing marginal product- each additional worker does less, because in
short run we don’t increase in k
LR Production
A. Trade off L and k. q=√(𝑘 ∗ 𝐿)
1. Same mechanics as utility theory
IV.
Isoquant: parallels to indifference curves. Sets of inputs where production is the same and q
is fixed, and k and L are varied.
A. Slope depends on substitutability of k and L
1.
2.
B. Slope of isoquant: (MRTS) Marginal Rate of Technical Substitution- rate at which you can
substitute one input for another
1. Δk/ ΔL given q is constant
2. Slope is MPL/MPk
V.
3.
Returns to scale
A. All inputs increase of decrease proportionally
B. Constant Returns to Scale: CRS = f(2L,2k) = 2*f(L,k) double inputs means double outputs
C. Increasing Returns to Scale: IRS = f(2L,2k) > 2*f(L,k) or q
D. Decreasing Returns to Scale: DRS =f(2L,2k) < 2*f(L,k) or q
Productivity and Costs
I.
II.
III.
Aggregate production is also about productivity, not just k and L.
A. q=f(k,L) should be Q=A*f(k,L)
π=R–C
A. Total costs = fixed costs + variable costs
B. Marginal Costs (MC) = ΔC/ΔQ
C. Average Costs (AC) =C/Q
D. Cost of producing q C(q)=f(wL+rk)  wage, rental. (Assume all machines are rented)
1. WHY: FC=rk, VC=wL  Short run total costs is rk+wL
2. So MC = ΔC/Δq = w *ΔL/Δq
a. So MC=w/MPL (marginal product of labor)
Long Run: Max Production efficiency = minimizing costs
A. Isoquants are combos of labor capital. Technologically, any choice of labor and capital
makes same q. How do we know which one to choose, which one minimizes costs?
Draw Isocost Lines
1. Isocost lines: represent cost of diff combos of inputs
2. Slope is –w/r, which is the tradeoff between labor and capital determined buy
the prices of those inputs.
B. Economically efficient input combination for given level of output q is determined by
tangency of isoquant to isocost.
C. Slope of isoquant: MRTS = MPL/MPk = w/r  MPL/w = MPk/r  k/L
Competition I
I.
II.
III.
Perfect completion: firms are price takers, not makers, on both the output and input makers
A. Perfect elastic demand for goods and supply of inputs
1.
B. Four conditions for perfect competition
1. Identical products
2. Full infor on all prices
3. Low transaction (shopping) costs
4. Free entry and exit of firms
Firm vs. Market
A. Residual Demand- as price goes up demand goes down
B. D(p) Demand function for market
C. Dr(p) Demand function for firm= D(p) – So(p) [Supply that all other firms in market
provides]
D. q=Q/N  Qo=(n-1)q
Max profits in SR
A. Value of time π(q) = R(q) – C(q)  dR/dq=dC/dq, MR=MC
Competition II
I.
II.
Why would firms stay in business if they’re losing money?
A. They lose less money by selling at lower than profit prices, and as long as PQ ≥VC, they
should keep selling. (or P ≥Avg VC.)
B. SR supply decision making steps  derive the supply curve
1. Set P = MC, which gives q* which is how much the firm will produce.
2. Check that P ≥AvgVC to make sure firm makes some money.
The supply curve IS the marginal cost curve
III.
IV.
A.
B. Definition of firm’s supply curve: the marginal cost curve above P ≥AvgVC
Steps to get to SR market equilibrium
A. Each firm chooses amount of capital- cost function for capital and FC
B. Add up firm supply curves to get market supply curve
C. Intersect market supply with market demand to get equilibrium price
In a perfectly competitive LR equilibrium, all firms make zero profit, bc if theres any profit to
be made a new firm will enter and take it away. Firms must be cost minimizing.
A. Why LR Supply upward sloping in reality ?
1. Could be barriers to entry/exit, even in long run.
Competition III
I.
II.
A corporation is a separation of owners and control.
Expected value = P(win)V(win)+P(lose)V(lose)
Principles of Welfare Economics
I.
II.
Monopoly I
I.
Marginal Revenue = Marginal Costs. In competitive market, MR is P. But in a monopoly, they
no longer face a perfectly elastic D curve, so their residual demand = total demand. (q=Q)
A.
B.
C. Also assume cannot vary in prices, cant charge one person a different price
D. MR= B-C or, P2-(P1-P2) Q1
E.
II.
1. Price charged is 24-Q
Marginal Revenue is 24-2Q
Market Power: how much of the ability to charge P>MC
A. MR = MC/P = 1+1/Σ
B. Define markup as percent markup (P-MC)/P = -1/Σ
1. The lower the elasticity, the more the monopoly can markup price. They still
lose money (less people want to buy) by marking up, but they have that option.
C.
1. Perfect competition: Consumer Surplus = A+B+C
2. Monopoly: Consumer Surplus = A
3. PC: Producer Surplus = D+E
4. M: Producer Surplus =D+E+B
5. Deadweight loss = C+E
Monopoly II
I.
II.
How Monopolies Arise
A. Cost Advantages: Natural monopolies – barriers to entry, economically efficient for a
monopoly
B. Government actions: Unnatural, such as patents. Encourages firms to research to profit,
so they don’t worry as much about competition.
Contestable market: there is a natural monopoly, but no strong barrier to entry or market
power. Not a huge fixed cost.
A. To keep monopoly power, firm must keep prices low and close to MC so that others are
discouraged to enter due to low profits.
Oligopoly I
I.
II.
Small number of firms in market with barriers to entry (ex: automobiles)
A. Can be cooperative  cartel  oligopoly to monopoly, but it is difficult to coop
B. Or uncooperative  more common- today’s focus
Game Theory: tool for theoretical economics, think of oligopoly firms as in a game
A. Equilibrium concept: how do we determine when the game’s over?
1. Nash Equilibrium: point where no firm wants to change its strategy given what
the other firms are doing.
2. Strategy: Prisoner’s Dilemma, something you can’t use Nash for
B. Cournot Equilibrium: Instead of 2 choices like in Prisoner’s Dilemma, firms have a variety
of choices of how much product they’ll make.
1. We choose the Q for each firm such that holding all other firms’ Q constant,
they are maxing profits.
2. Steps to solve
a. Compute residual Demand
b. Develop a marginal revenue function, which is f(other firms’ Q)
c. Do steps a and b for all firms.
d. N equations in N unknowns, then solve.
Oligopoly II
I.
II.
The notion was that each firm develops a best response curve. Each firm says, based on
what the other firm's going to do, here is my best level of production. Here's my profit
maximizing level of production.
And each firm having developed a curve, there's an equilibrium where those curves
intersect because at that point both firms are happy. You've achieved your Nash equilibrium
because at that point both firms are satisfied with the strategy they're playing given what
the other firm's playing. So that point of intersection, both firms' best response are
consistent with each other. And that's we developed last time graphically
a. price equals marginal cost in perfect competition.
Factor Markets
I.
Competitive Factor Markets: lots of workers selling their labor, like a blue collar market,
assume perfectly elastic flat labor supply curve
A. SR- capital is fixed. Profit max causes downward sloping labor demand curve
1.
2. What’s marginal benefit of hiring another worker? Another unit of labor (worker)
raises your output by marginal product of labor, this is quantity. Marginal
revenues x marginal product of labor = benefit to the firm. Wage.
3. For perfectly competitive output market, P*MPL =W
B. Monopsony: When one firm is only demander in input market
1.
a. Not perfectly competitive
b. MRPL=60-L given L=W/2
2. Expenditure on labor: E=W(L)*L