Microeconomics Study Sheet

Economiic IIssues and Conceptts

Economic Is sues and Concepts
Econom c ssues and Concep s

The production possibility curve (PPC) illustrates

maximum combinations of outputs that can be
produced, given a countrys resources and technology.
The opportunity cost of a choice is the benefit of the
next best alternative given up. It is the slope of the PPC.

- For substitutes/complements, the cross elasticity is

positive/negative.
Price
($)

=9
= 2.33

Good X
Unattainable

=1
= 1/2.33
= 1/9

Attainable

D
Quantity
Good Y

= 1:
Total expenditure
is maximized

How Economiistts Worrk

How Economis ts Work
How Econom s s Wo k

Best affordable
point

The slope of a straight line is calculated as the change

in the value of the variable measured on the vertical
axis (y) divided by the change in the value of the
variable measured on the horizontal axis (x):
slope =

Budget line

y
x

> 1:
Price cut
increases total
expenditure

Value of an index in a given period

=

absolute value at given period

100
absolute value in base period

< 1:
Price cut
decreases total
expenditure

Demand,,,Supplly,,,and Prrice
Demand Supply and Priice
Demand Supp y and P ce

The higher the price of a good, the smaller the quantity

demanded (law of demand).
The demand curve is downward sloping.
The higher the price of a good, the higher the quantity
supplied (law of supply).
The supply curve is upward sloping.
Shortage (excess demand): quantity demanded >
quantity supplied
Upward pressure on the price.
Surplus (excess supply): quantity demanded < quantity
supplied
Downward pressure on the price.
The price adjusts until quantity demanded equals
quantity supplied (market equilibrium).

Quantity

Marrketts iin Acttion

Mark ets in Actiion
Ma ke s n Ac on

A price ceiling below equilibrium price results in

shortage (excess supply).
A price floor above equilibrium price results in surplus
(excess demand).
In the long run, rent controls result in a growing
housing shortage.
Farm policies are directed at stabilizing and raising
farm revenues.
Rent
($)

Relative price (-PM/PP) = MRS (budget line tangent to

indifference curve).
The effect of a price change can be divided into
substitution and income effect.
- (Hicksian) Substitution effect (effect of a change in
relative price, holding utility constant).
Increase (decrease) in the consumption of the good
whose price has fallen (risen).
Income effect (effect of a change in income, holding
relative price constant).
Normal good: Income effect reinforces the
substitution effect.
Inferior good: Income and substitution effects work
in opposite directions.
The income-consumption line traces out all utility
maximizing points for different levels of income.
- The price-consumption line traces out all utility
maximizing points for different levels of income.

Prroducerrs iin tthe Shorrt Run

Pro ducers in th e Shortt Run
P oduce s n he Sho Run

Blackmarket price

Price
($)

ConsumerrBehaviiourr
Consumer Behavio ur
Consume Behav ou

Total utility is maximized when all income is spent

and when the utility gained from the last dollar spent on
each product is equal:
MUi = MUj
Pi
Pj
A budget line marks the borderline between affordable
and unaffordable consumption bundles. It depends on
income and prices.
Slope of the budget line: -PM/PP
An indifference curve represents a certain level of
utility. Consumption bundles to the right are preferred,
consumption bundles to the left are not preferred.
MRS (slope of an indifference curve) diminishes as
we move down to the right along an indifference curve.
The best affordable point is the point at which the
budget line is tangent to the indifference curve:

Surplus

Price
ceiling

Shortage

- Short run (SR)

Quantities of at least one of the firms resources is
fixed.
- Long run (LR)
Quantities of all of the firms resources can be
varied, but its technology is fixed.
- Very long run
Quantities of all of the firms resources and its
technology can be varied.
- Economic profits = total revenues opportunity costs.
Total product (TP): Total output produced for various
levels of labour.
Marginal product (MP): Increase in total product
resulting from a one-unit increase in labour. Slope
of the TP curve (TP/L)
Average product (AP): Total product per unit of labor
(TP/L).
Total cost (TC) = Total fixed cost (independent of the
level of output) + Total variable cost (increases as
output increases).
Marginal cost (MC): Increase in total cost resulting
from a one-unit increase in output. Slope of the TC
curve (TC/Q).
Average total cost (ATC): TC per unit of output
(TC/Q).
ATC = AVC (average variable cost) + AFC (average
fixed cost).

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D

Shortage

Quantity

Ellastticiity
Ela stiicitty
E as c y

% change in quantity
% change in price

change in quantity average quantity

=
% change in price average price
=

Quantity

Price
($)

Surplus

S
Price
floor

Q /Q
P / P

- If demand is (in-)elastic, a decrease in price results in

higher (lower) total expenditure (TE). TE doesnt
change due to a price-change for a unit-elastic demand.
- For inferior/normal goods, the income elasticity is
negative/positive.

Quantity

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Because of initially increasing returns and eventually
decreasing returns, the average total cost curve is
u-shaped
MP & AP
(units)

Point of diminishing
marginal return

Point of diminishing
average returns

MP

AP

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marginal revenue = average revenue = market price.

MR = AR = p
Short run economic profits (losses) induce firms to
enter (exit) the industry. Industry supply increases
(decreases), the market price falls (rises) and in the
long run, economic profits return to zero.
Shutdown point: p = AVCMIN
The marginal cost curve above the shutdown point
traces out the firms short run supply curve.
The short run industry supply is simply the sum of the
quantities supplied by all firms at each given price.
Long run equilibrium
- Economic profits are zero.

Labour
Price

Prroducerrs iin tthe Long Run

Pro ducers in th e Long Run
P oduce s n he Long Run

($)

In the long run, all factors are variable (plant size is

variable).
The long run average cost curve traces out the lowest
attainable average total cost at each output when both
capital and labour inputs can be varied.
Profit maximization is equivalent to cost minimization.
- Firms choose the combination of capital and labour
such that MPK = MPL

pK

Economic profit

Diminishing returns occur for any given quantity of

capital (labour) as the quantity of labour (capital)
increases.
MPK (MPL) decreases as more capital (labour) is
employed.
Economies of scale
- Fall in ATC as firms scale of production increases.
(increasing returns to scale).
Diseconomies of scale
- Rise in ATC as firms scale of production increases.
(decreasing returns to scale)..
Constant returns to scale
- Constant ATC as firms scale of production increases.
(constant returns to scale).
Minimum efficient scale
- Smallest quantity of output at which LRAC reaches its
lowest level.
Isoquant
- Whole set of technically efficient factor combinations
for producing a given level of output.
Marginal rate of substitution between two factors is
equal to the ratio of their marginal products.
- Slope of an isoquant at a particular point.
Isocost line shows alternative combinations of factors
that a firm can buy for given total cost.
- Slope = - (factor price ratio).
Cost minimization

($)

P* = TC*

D
Quantity

In oligopoly, firms are aware of interdependence

among the decisions made by the various firms in the
industy strategic behaviour.
Barriers to entry ensure that economic profits can
persist in the long run.

Economiic Efffiiciiency and Publlic Pollicy

Economic Efffic ie ncy and Publiic Poliicy
Econom c E c ency and Pub c Po cy

Quantity

pL

Price

Monopolly
Monopoly
Monopo y

A single price monopolist maximizes profit by producing

the output level at which marginal revenue = marginal
cost.
Note that marginal revenue < market price.
Compared to perfect competition, equilibrium output
is lower and equilibrium price is higher
(inefficient). Efficiency loss (deadweight loss).

Productive efficiency requires that total cost in an

industry is minimized.
Allocative efficiency p = MC for each product.
Industries in which firms have a certain degree of
market power result in allocative distortion
(inefficiency), because p > MC.
There exists income distortion when profits/losses
occur.
Imposing marginal cost pricing on a natural monopoly
results in allocative efficiency, but the monopolist
generally incurs economic profits or losses.
Imposing average cost pricing on a natural monopoly
results in zero economic profits, but the outcome is
generally allocatively inefficient.
Price
($)

Price
($)

MC

ATC
Economic
profit

ATC
Loss with MC pricing

MC
M

D
Quantity

Price-discriminating monopoly: Producer charges

different prices for different units of the same product for
reasons not associated with differences in cost.
A (perfectly) price discriminating monopolist
converts consumer surplus into profit by charging each
buyer the maximum amount that he is willing to pay.
The outcome is efficient, with smaller consumer
surplus and larger producer surplus.
Monopoly profits can persist in the long run if there
are effective barriers to entry.
Cartels as monopolies: Organization of producers
who agree to cooperate and act as a single seller.
Cartels are unstable due to incentive to cheat for each
firm.

D
Quantity
Price
($)
MC

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pL MPL
=
pK MPK
Cost
($)

IImperrfecttCompettittion
Im perffect Competiitiion
mpe ec Compe on

AT
Minimum
efficient
scale
Economies
of scale

Constant
returns to scale

AT
Diseconomies
of scale

Output

Compettittive Marrketts
Competiitiive Mark ets
Compe ve Ma ke s

The profit maximizing output level is the quantity at

which
marginal revenue = marginal cost. (MR = MC)

In monopolistic competition there may be economic

profits in the short run. Each firm supplies its
differentiated product to a small segment of the
market. However, free entry/exit assures that in the
long run, economic profits are zero (at the quantity
where MC = MR, p = ATC).

ATC

Profit with MC pricing

D
Quantity

FacttorrPrriciing and FacttorrMobiiliity

Facto r Priicin g and Facto r Mobillitty
Fac o P c ng and Fac o Mob y

Factors of production are capital, land, an labour.

Factor demand is derived from the demand of the final
good or service that the factor produces.
A profit maximizing firm hires up the point where:
marginal cost(MC) = Marginal revenue product
(MRP) = MR*MP
Total factor income = factor price * level of employment.
= transfer earnings + economic rent.

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is equal to the economys capital stock.
- Accumulation of capital leads to a decrease in the
equilibrium interest rate.
- Technological improvements lead to an increase in
the equilibrium interest rate.
Present value of a single future payment PV =
MRP/(1 + i)t
Present value of a stream of payments that continues
forever PV = MRP/i
Hotellings rule: The socially optimal rate of extraction
of any non-renewable resource is such that its price
increases at a rate equal to the interest rate.

Wage
($)

Unaffordable

Transfer
earning
D

Price
($)

Elastic
demand

S + tax

S
tax rev.
Excess burden

MarrkettFaiilurres///GoverrnmenttIIntterrventtion
Mark et Faillure s G overn ment In te rv entiion
Ma ke Fa u es Gove nmen n e ven on

Rent
($)

Markets fail to achieve allocative efficiency in presence

of market power, externalities, public goods,
asymmetric information, and missing markets.
With a positive externality, a competitive market will
produce too little of the good.
With a negative externality, a competitive market will
produce too much of the good.
MSC: Marginal social cost MSC = external cost
imposed on the beach resort).
Coase theorem: If property rights exist and
transaction costs are low, private transactions are
efficient, regardless of who has the property right.
Non-rivalrous goods: consumption by one person does
not reduce consumption by another person.
Marginal cost of an additional user is zero.
To reach allocative efficiency, the price should be
zero.
Non-excludable goods: impossible/extremely costly to
prevent someone from consuming a good.
Public goods (those which are non-rivalrous and nonexcldable) give rise to free-rider problem

S
Unaffordable

Econ. rent

D
Wage

($)

Unaffordable

Econ.
rent

Transfer

earning

Cost &
benefit
($)

LabourrMarrketts
Labour Mark ets
Labou Ma ke s

Wage differentials in competitive markets may result

from differences in working conditions, in inherited skill,
in human capital, or from some form of discrimination.
Two general cases that give rise to noncompetitive
labor markets are the presence of a union (monopoly
in selling labor) and / or of a monopsony (single buyer
of labor).
A binding minimum wage reduces employment in
competitive labor markets; however, it may lead to an
increase in employment in case employers have some
monopsony power.
Monopsony: a single buyer in the market
Wage
rate
($/h)

MC

Competitive
eqm.

Price
($)

Inelastic
demand
S + tax
S

tax rev.

Excess burden

Quantity

The Gaiins ffrom IIntterrnattionallTrrade

The Gain s frrom In te rn atiional Tra de
The Ga ns om n e na ona T ade

Gains from trade arise from different opportunity costs.

Specialization in the activity in which opportunity
costs are lowest.
Countries export goods for which they have a
comparative advantage.
Countries import goods for which they have a
comparative disadvantage.
Terms of trade: Ratio of the (average) price of a
countrys exports to the (average) price of its imports.
Index of Export Prices
Terms of Trade =
100
Index of Import Prices
Good X

D = MB

Country A

Quantity

EnviironmenttallPollicy
Envirronmenta l Poliicy
Env onmen a Po cy

Consumption
possibilities
with trade

Profit maximizing firms produce too much relative to the

allocatively efficient level of output if MC < MSC (due
to negative externality).
The allocatively efficient level of pollution is the level
where MC of further pollution abatement = MB of
pollution reduction.
Policies used to regulate pollution are direct controls,
emissions taxes, and tradable pollution permits.

Taxattion and Publlic Expendiiturre

Taxatiion and Publiic Expenditture
Taxa on and Pub c Expend u e

w2

w1

External
cost

Quantity

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MC

w0

Efficient
outcome

Profit

Competitve
eqm
Monopsony
eqm

qM

qPC

MRP = D

Labour

Capiitalland NatturrallResourrces
Capittal and Natu ra l Resourc es
Cap a and Na u a Resou ces

Profit maximizing firms purchase new capital up to the

point where the present value of the stream of future
MRPs is equal to the purchase price of that unit.
The interest rate is determined in the capital market
and adjusts such that the quantity of capital demanded

The most important taxes in Canada are personal

income tax, corporate income tax, excise and sales
taxes, and property taxes.
Progressive tax: marginal tax rate increases as income
increases.
Proportional tax: marginal tax rate is the same for all
levels of income.
Regressive tax: marginal tax rate decreases as income
increases.
Efficiency and equity are often competing goals.

without trade;

Good Y
Good X

Country B

Consumption
possibilities
with trade

without trade;
Good Y

Law of one price: When a product which can be

cheaply transported is traded throughout the entire
world, it will tend to have a single world price.

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