Microeconomics

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Microeconomics (from Greek prefi( mikro- meaning 5small5 and economics) is a ranch of
economics that studies the ehavior of individuals and small impacting organi0ations in making
decisions on the allocation of limited resources (see scarcity)6
7#8
9ypically, it applies to markets
*here goods or services are ought and sold6 'icroeconomics e(amines ho* these decisions and
ehaviors affect the supply and demand for goods and services, *hich determines prices, and
ho* prices, in turn, determine the :uantity supplied and :uantity demanded of goods and
services6
7!87;8
9his is in contrast to macroeconomics, *hich involves the 5sum total of economic activity,
dealing *ith the issues of gro*th, inflation, and unemployment65
7!8
'icroeconomics also deals
*ith the effects of national economic policies (such as changing ta(ation levels) on the
aforementioned aspects of the economy6
7<8
Particularly in the *ake of the )ucas criti:ue, much of
modern macroeconomic theory has een uilt upon =microfoundations=>i6e6 ased upon asic
assumptions aout micro?level ehavior6
@ne of the goals of microeconomics is to analy0e market mechanisms that estalish relative
prices amongst goods and services and allocation of limited resources amongst many alternative
uses6 'icroeconomics analy0es market failure, *here markets fail to produce efficient results,
and descries the theoretical conditions needed for perfect competition6 &ignificant fields of
study in microeconomics include general e:uilirium, markets under asymmetric information,
choice under uncertainty and economic applications of game theory6 ,lso considered is the
elasticity of products *ithin the market system6
Contents
7hide8
# ,ssumptions and definitions
! 'icroeconomic topics
o !6# Demand, supply, and e:uilirium
o !6! 'easurement of elasticities
o !6; .onsumer demand theory
o !6< 9heory of production
o !6A .osts of production
o !6B Perfect competition
o !6C Perfect monopoly
o !6D @ligopoly
o !6E 'arket structure
o !6#" Game theory
o !6## )aour economics
o !6#! Welfare economics
o !6#; %conomics of information
; @pportunity cost
< ,pplied microeconomics
A Development
o A6# 9raditional marginalism
o A6! /mperfect competition and game theory
o A6; %(ternalities and market failure
o A6< -ehavioral economics
o A6A Great 2ecession and e(ecutive compensation
B 2eferences
C Further reading
D %(ternal links
Assumptions and definitionsedit!
9he fundamentals of 'icroeconomics lies in the analysis of the preference relations6 Preference
relations are defined simply to e a set of different choices that an actor can choose (a k?cell
metric space) that actors can also compare et*een any t*o undles of choices ( completeness of
the relationship6) /n order to analy0e the prolem further, the assumption of transitivity is added
to the mi(6 9hese t*o assumptions of completeness and transitivity that are imposed upon the
preference relations are *hat is termed rationality6 'icroeconomic analysis are conducted
mainly through imposition of additional constraints on the preference relations or even rela(ation
of the aove stated assumptions (most often transitivity) although such rela(ation makes the
prolem much harder to analy0e6
9he supply and demand model descries ho* prices vary as a result of a alance et*een
product availaility at each price (supply) and the desires of those *ith purchasing po*er at each
price (demand)6 9he graph depicts a right?shift in demand from D# to D! along *ith the
conse:uent increase in price and :uantity re:uired to reach a ne* market?clearing e:uilirium
point on the supply curve (&)6
9he theory of supply and demand usually assumes that markets are perfectly competitive6 9his
implies that there are many uyers and sellers in the market and none of them have the capacity
to significantly influence prices of goods and services6 /n many real?life transactions, the
assumption fails ecause some individual uyers or sellers have the aility to influence prices6
Fuite often, a sophisticated analysis is re:uired to understand the demand?supply e:uation of a
good model6 $o*ever, the theory *orks *ell in situations meeting these assumptions6
'ainstream economics does not assume a priori that markets are preferale to other forms of
social organi0ation6 /n fact, much analysis is devoted to cases *here so?called market failures
lead to resource allocation that is suoptimal y some standard (defense spending is the classic
e(ample, profitale to all for use ut not directly profitale for anyone to finance)6 /n such cases,
economists may attempt to find policies that avoid *aste, either directly y government control,
indirectly y regulation that induces market participants to act in a manner consistent *ith
optimal *elfare, or y creating 5missing markets5 to enale efficient trading *here none had
previously e(isted6
9his is studied in the field of collective action and pulic choice theory6 5@ptimal *elfare5
usually takes on a Paretian norm, *hich in its mathematical application of GaldorH$icks method6
9his can diverge from the 3tilitarian goal of ma(imi0ing utility ecause it does not consider the
distriution of goods et*een people6 'arket failure in positive economics (microeconomics) is
limited in implications *ithout mi(ing the elief of the economist and their theory6
9he demand for various commodities y individuals is generally thought of as the outcome of a
utility?ma(imi0ing process, *ith each individual trying to ma(imi0e their o*n utility under a
udget constraint and a given consumption set6
Microeconomic topicsedit!
9he study of microeconomics involves several 5key5 areas:
"emand# supply# and equili$riumedit!
Main article: Supply and demand
&upply and demand is an economic model of price determination in a market6 /t concludes that in
a competitive market, the unit price for a particular good *ill vary until it settles at a point *here
the :uantity demanded y consumers *ill e:ual the :uantity supplied y producers resulting in
an economic e:uilirium for price and :uantity6
Measurement of elasticitiesedit!
Main article: Elasticity (economics)
%lasticity is the measurement of ho* responsive an economic variale is to a change in another
variale6 %lasticity can e :uantified as the ratio of the percentage change in one variale to the
percentage change in another variale, *hen the latter variale has a causal influence on the
former6 /t is a tool for measuring the responsiveness of a variale, or of the function that
determines it, to changes in causative variales in a unitless *ay6 Fre:uently used elasticities
include price elasticity of demand, price elasticity of supply, income elasticity of demand,
elasticity of sustitution et*een factors of production and elasticity of intertemporal
sustitution6
Consumer demand theoryedit!
Main article: Consumer choice
.onsumer demand theory relates preferences for the consumption of oth goods and services to
the consumption e(pendituresI ultimately, this relationship et*een preferences and consumption
e(penditures is used to relate preferences to consumer demand curves6 9he link et*een personal
preferences, consumption and the demand curve is one of the most closely studied relations in
economics6 /t is a *ay of analy0ing ho* consumers may achieve e:uilirium et*een
preferences and e(penditures y ma(imi0ing utility su4ect to consumer udget constraints6
Theory of productionedit!
Main article: Production theory
Production theory is the study of production, or the economic process of converting inputs into
outputs6 Production uses resources to create a good or service that is suitale for use, gift?giving
in a gift economy, or e(change in a market economy6 9his can include manufacturing, storing,
shipping, and packaging6 &ome economists define production roadly as all economic activity
other than consumption6 9hey see every commercial activity other than the final purchase as
some form of production6
Costs of productionedit!
Main article: Cost-of-production theory of value
9he cost?of?production theory of value is the price of an o4ect or condition is determined y the
sum of the cost of the resources that *ent into making it6 9he cost can comprise any of the
factors of production: laour, capital, land6 9echnology can e vie*ed either as a form of fi(ed
capital (e(:plant) or circulating capital (e(:intermediate goods)6
%erfect competitionedit!
Main article: Perfect competition
Perfect competition descries markets such that no participants are large enough to have the
market po*er to set the price of a homogeneous product6 ,n e(ample is %ay6
%erfect monopolyedit!
Main article: monopoly
, monopoly (from Greek monos JKLMN (alone or single) O polein PQRS L (to sell)) e(ists *hen a
single company is the only supplier of a particular commodity6
Oligopolyedit!
Main article: Oligopoly
,n oligopoly is a market form in *hich a market or industry is dominated y a small numer of
sellers (oligopolists)6 @ligopolies can result from various forms of collusion *hich reduce
competition and lead to higher costs for consumers6
7A8
Mar&et structureedit!
9he market structure can have several types of interacting market systems6 Different forms of
markets is a feature of capitalism and advocates of socialism often critici0e markets and aim to
sustitute markets *ith economic planning to varying degrees6 .ompetition is the regulatory
mechanism of the market system6
'onopolistic competition, also called competitive market, *here there is a large numer
of firms, each having a small proportion of the market share and slightly differentiated
products6
@ligopoly, in *hich a market is run y a small numer of firms that together control the
ma4ority of the market share6
Duopoly, a special case of an oligopoly *ith t*o firms6
'onopsony, *hen there is only one uyer in a market6
@ligopsony, a market *here many sellers can e present ut meet only a fe* uyers6
'onopoly, *here there is only one provider of a product or service6
+atural monopoly, a monopoly in *hich economies of scale cause efficiency to increase
continuously *ith the si0e of the firm6 , firm is a natural monopoly if it is ale to serve
the entire market demand at a lo*er cost than any comination of t*o or more smaller,
more speciali0ed firms6
Perfect competition, a theoretical market structure that features no arriers to entry, an
unlimited numer of producers and consumers, and a perfectly elastic demand curve6
%(amples of markets include ut are not limited to: commodity markets, insurance markets,
ond markets, energy markets, flea markets, det markets, stock markets, online auctions, media
e(change markets, real estate market6
'ame theoryedit!
Main article: ame theory
Game theory is a ma4or method used in mathematical economics and usiness for modeling
competing ehaviors of interacting agents6 ,pplications include a *ide array of economic
phenomena and approaches, such as auctions, argaining, mergers T ac:uisitions pricing, fair
division, duopolies, oligopolies, social net*ork formation, agent?ased computational
economics, general e:uilirium, mechanism design,and voting systems, and across such road
areas as e(perimental economics, ehavioral economics, information economics, industrial
organi0ation, and political economy6
La$our economicsedit!
Main article: !a"our economics
)aour economics seeks to understand the functioning and dynamics of the markets for *age
laour6 La$our mar&ets function through the interaction of *orkers and employers6 )aour
economics looks at the suppliers of laour services (*orkers), the demands of laour services
(employers), and attempts to understand the resulting pattern of *ages, employment, and
income6 /n economics, la$our is a measure of the *ork done y human eings6 /t is
conventionally contrasted *ith such other factors of production as land and capital6 9here are
theories *hich have developed a concept called human capital (referring to the skills that
*orkers possess, not necessarily their actual *ork), although there are also counter posing
macro?economic system theories that think human capital is a contradiction in terms6
(elfare economicsedit!
Main article: #elfare economics
Welfare economics is a ranch of economics that uses microeconomic techni:ues to evaluate
*ell?eing from allocation of productive factors as to desiraility and economic efficiency *ithin
an economy, often relative to competitive general e:uilirium6
7B8
/t analy0es social $elfare,
ho*ever measured, in terms of economic activities of the individuals that compose the
theoretical society considered6 ,ccordingly, individuals, *ith associated economic activities, are
the asic units for aggregating to social *elfare, *hether of a group, a community, or a society,
and there is no 5social *elfare5 apart from the 5*elfare5 associated *ith its individual units6
Economics of informationedit!
Main article: %nformation economics
/nformation economics or the economics of information is a ranch of microeconomic theory
that studies ho* information and information systems affect an economy and economic
decisions6 /nformation has special characteristics6 /t is easy to create ut hard to trust6 /t is easy to
spread ut hard to control6 /t influences many decisions6 9hese special characteristics (as
compared *ith other types of goods) complicate many standard economic theories6
7C8
Opportunity costedit!
Main article: Opportunity cost
@pportunity cost of an activity (or goods) is e:ual to the est ne(t alternative uses1foregone6
,lthough opportunity cost can e hard to :uantify, the effect of opportunity cost is universal and
very real on the individual level6 /n fact, this principle applies to all decisions, not 4ust economic
ones6
@pportunity cost is one *ay to measure the cost of something6 2ather than merely identifying
and adding the costs of a pro4ect, one may also identify the ne(t est alternative *ay to spend the
same amount of money6 9he forgone profit of this ne&t "est alternative is the opportunity cost of
the original choice6 , common e(ample is a farmer that chooses to farm their land rather than
rent it to neighors, *herein the opportunity cost is the forgone profit from renting6 /n this case,
the farmer may e(pect to generate more profit alone6 9his kind of reasoning is a very important
part of the calculation of discount rates in discounted cash flo* investment valuation
methodologies6 &imilarly, the opportunity cost of attending university is the lost *ages a student
could have earned in the *orkforce, rather than the cost of tuition, ooks, and other re:uisite
items (*hose sum makes up the total cost of attendance)6
+ote that opportunity cost is not the sum of the availale alternatives, ut rather the enefit of the
single, est alternative6 Possile opportunity costs of a city=s decision to uild a hospital on its
vacant land are the loss of the land for a sporting center, or the inaility to use the land for a
parking lot, or the money that could have een made from selling the land, or the loss of any of
the various other possile uses > ut not all of these in aggregate6 9he true opportunity cost
*ould e the forgone profit of the most lucrative of those listed6
@ne :uestion that arises here is ho* to determine a money value for each alternative to facilitate
comparison and assess opportunity cost, *hich may e more or less difficult depending on the
things *e are trying to compare6 For e(ample, many decisions involve environmental impacts
*hose monetary value is difficult to assess ecause of scientific uncertainty6 Ualuing a human
life or the economic impact of an ,rctic oil spill involves making su4ective choices *ith ethical
implications6
/t is imperative to understand that no decision on allocating time is free6 +o matter *hat one
chooses to do, they are al*ays giving something up in return6 ,n e(ample of opportunity cost is
deciding et*een going to a concert and doing home*ork6 /f one decides to go the concert, then
they are giving up valuale time to study, ut if they choose to do home*ork then the cost is
giving up the concert6 ,ny decision in allocating capital is like*ise: there is an opportunity cost
of capital, or a hurdle rate, defined as the e(pected rate one could get y investing in similar
pro4ects on the open market6 @pportunity cost is vital in understanding microeconomics and
decisions that are made6
Applied microeconomicsedit!
3nited &tates .apitol -uilding: meeting place of the 3nited &tates .ongress, *here many ta(
la*s are passed, *hich directly impact economic *elfare6 9his is studied in the su4ect of pulic
economics6
,pplied microeconomics includes a range of speciali0ed areas of study, many of *hich dra* on
methods from other fields6 /ndustrial organi0ation e(amines topics such as the entry and e(it of
firms, innovation, and the role of trademarks6 )aor economics e(amines *ages, employment,
and laor market dynamics6 Financial economics e(amines topics such as the structure of
optimal portfolios, the rate of return to capital, econometric analysis of security returns, and
corporate financial ehavior6 Pulic economics e(amines the design of government ta( and
e(penditure policies and economic effects of these policies (e6g6, social insurance programs)6
Political economy e(amines the role of political institutions in determining policy outcomes6
$ealth economics e(amines the organi0ation of health care systems, including the role of the
health care *orkforce and health insurance programs6 3ran economics, *hich e(amines the
challenges faced y cities, such as spra*l, air and *ater pollution, traffic congestion, and
poverty, dra*s on the fields of uran geography and sociology6 )a* and economics applies
microeconomic principles to the selection and enforcement of competing legal regimes and their
relative efficiencies6 %conomic history e(amines the evolution of the economy and economic
institutions, using methods and techni:ues from the fields of economics, history, geography,
sociology, psychology, and political science6
"e)elopmentedit!
Traditional marginalismedit!
.lassic duopoly model of .ournot: reaction functions of oth firms are derived y imposing
profit ma(imi0ation, the +ash e:uilirium is given y intersection of 2# and 2!6 ,t e:uilirium
no firm has a rational self?interest in changing produced :uantities6
9he modern field of microeconomics arose as an effort of neoclassical economics school of
thought to put economic ideas into mathematical mode6 ,n early attempt *as made y ,ntoine
,ugustine .ournot in 'esearches on the Mathematical Principles of the (heory of #ealth
7D8

(#D;D) in descriing a spring *ater duopoly that no* ears his name6 )ater, William &tanley
Jevons=s (heory of Political Economy
7E8
(#DC#), .arl 'enger=s Principles of %conomics
7#"8
(#DC#),
and )Von Walras=s Elements of Pure Economics: Or the theory of social $ealth (#DC<HCC)
7##8
gave
*ay to *hat *as called the 'arginal 2evolution6 &ome common ideas ehind those *orks *ere
models or arguments characteri0ed y rational economic agents ma(imi0ing utility under a
udget constrain6 9his arose as a necessity of arguing against the laour theory of value
associated *ith classical economists such as ,dam &mith, David 2icardo and Garl 'ar(6 Walras
also *ent as far as developing the concept of general e:uilirium of an economy6
,lfred 'arshall=s te(took, Principles of Economics
7#!8
*as pulished in #DE" and ecame the
dominant te(took in %ngland for a generation6 $is main point *as that Jevons *ent too far in
emphasi0ing utility as an attempt to e(plain prices over costs of production6 /n the ook he
*rites:
59here are fe* *riters of modern times *ho have approached as near to the rilliant originality
of 2icardo as Jevons has done6 -ut he appears to have 4udged oth 2icardo and 'ill harshly, and
to have attriuted to them doctrines narro*er and less scientific than those they really held6 ,lso,
his desire to emphasi0e an aspect of value to *hich they had given insufficient prominence, *as
proaly in some measure accountale for his saying, 52epeated reflection and in:uiry have led
me to the some*hat novel opinion that value depends entirely upon utility65 (9heory, p6 #) 9his
statement seems to e no less one?sided and fragmentary, and much more misleading, than that
into *hich 2icardo often glided *ith careless revity, as to the dependence of value on cost of
productionI ut *hich he never regarded as more than a part of a larger doctrine, the rest of
*hich he had tried to e(plain6 5
/n the same appendi(
7#;8
he further states:
5Perhaps Jevons= antagonism to 2icardo and 'ill *ould have een less if he had not himself
fallen into the hait of speaking of relations *hich really e(ist only et*een demand price and
value as though they held et*een utility and valueI and if he had emphasi0ed as .ournot had
done, and as the use of mathematical forms might have een e(pected to lead him to do, that
fundamental symmetry of the general relations in *hich demand and supply stand to value,
*hich coe(ists *ith striking differences in the details of those relations6 We must not indeed
forget that, at the time at *hich he *rote, the demand side of the theory of value had een much
neglectedI and that he did e(cellent service y calling attention to it and developing it6 9here are
fe* thinkers *hose claims on our gratitude are as high and as various as those of Jevons: ut that
must not lead us to accept hastily his criticisms on his great predecessors65
'arshall=s diagram: &&= is the supply curve, DD= is the demand curve and , is the e:uilirium
'arshall=s idea of solving the controversy *as that the demand curve could e derived y
aggregating individual consumer demand curves, *hich *ere themselves ased on the consumer
prolem of ma(imi0ing utility6 9he supply curve could e derived y superimposing a
representative firm supply curves for the factors of production and then market e:uilirium
*ould e given y the intersection of demand and supply curves6 $e also introduced the notion
of different market periods: mainly short run and long run6 9his set of ideas gave *ay to *hat
economists call perfect competition, no* found in the standard microeconomics te(ts, even
though 'arshall himself had stated:
7#<8
59he process of sustitution, of *hich *e have een discussing the tendencies, is one form of
competitionI and it may e *ell to insist again that *e do not assume that competition is perfect6
Perfect competition re:uires a perfect kno*ledge of the state of the marketI and though no great
departure from the actual facts of life is involved in assuming this kno*ledge on the part of
dealers *hen *e are considering the course of usiness in )omard &treet, the &tock %(change,
or in a *holesale Produce 'arketI it *ould e an altogether unreasonale assumption to make
*hen *e are e(amining the causes that govern the supply of laour in any of the lo*er grades of
industry6 For if a man had sufficient aility to kno* everything aout the market for his laour,
he *ould have too much to remain long in a lo* grade6 9he older economists, in constant contact
as they *ere *ith the actual facts of usiness life, must have kno*n this *ell enoughI ut partly
for revity and simplicity, partly ecause the term 5free competition5 had ecome almost a
catch*ord, partly ecause they had not sufficiently classified and conditioned their doctrines,
they often seemed to imply that they did assume this perfect kno*ledge6 5
@ne of 'arshall=s diagrams for monopoly: DD= is the demand curve, &&= the supply curve, FF= is
the monopoly revenue curve and :; the ma(imum revenue point6 .ournot had already
considered the mathematics of monopoly in the 'athematical Principles of the 9heory of Wealth
ut he dra* no diagram
,n early formulation of the concept of production functions is due to Johann $einrich von
9hWnen,
7#A8
*hich presented an e(ponential version of it6 9he standard .oHDouglas production
function found in microeconomics te(tooks refers to a collaorative paper et*een .harles
.o and Paul Douglas pulished in #E!D in *hich they analy0ed 36&6 manufacturing data using
this function as the asis of a regression analysis for estimating the relationship et*een inputs
(laour and capital) and output (product):
7#B8
this discussion takes place through the concept of
marginal productivity6 9he mathematical form of the .oHDouglas function can e found in the
prior *ork of Wicksell, 9hWnen, and 9urgot6
Jaco Uiner presented an early procedure for constructing cost curves in his X.ost .urves and
&upply .urvesY (#E;#),
7#C8
the paper *as an attempt to reconcile t*o streams of thought *hen
dealing *ith this issue at the time: the idea that supplies of factors of production *ere given and
independent of rate of remuneration (,ustrian &chool) or dependent on rate of remuneration
(%nglish &chool, that is follo*ers of 'arshall)6 Uiner argued that, X9he differences et*een the
t*o schools *ould not affect :ualitatively the character of the findings,Y more specifically,
X666that this concern is not of sufficient importance to ring aout any change in the prices of the
factors as a result of a change in its output6Y
/n Uiner=s terminology>no* considered standard>the short run is a period long enough to
permit any desired output change that is technologically possile *ithout altering the scale of the
plant>ut is not long enough to ad4ust the scale of the plant6 $e aritrarily assumes that all
factors can, for the short run, e classified in t*o groups: those necessarily fi(ed in amount, and
those freely variale6 Scale of plant is the si0e of the group of factors that are fi(ed in amount in
the short?run, and each scale is :uantitatively indicated y the amount of output that can e
produced at the lo*est average cost possile at that scale6 .osts associated *ith the fi(ed factors
are fi&ed costs6 9hose associated *ith the variale factors are direct costs6 +ote that fi(ed costs
are fi(ed only in their aggregate amounts, and vary *ith output in their amount per unit, *hile
direct costs vary in their aggregate amount as output varies, as *ell as in their amount per unit6
9he spreading of overhead is therefore a short?run phenomenon and not to e confused *ith the
long?run6
$e e(plains that if the la* of diminishing returns holds that output per unit of variale factor
falls as total output rises, and that if the prices of the factors remain constant>then average
direct costs increase *ith output6 ,lso, if atomistic competition prevails>that is, the individual
firm output *on=t affect product prices>then the individual firm short?run supply curve e:uals
the short run marginal cost curve6 /n the long run, the supply curve for industry can e
constructed y summing individual marginal cost curves ascissas6 $e also e(plains that:
/nternal economies of scale are primarily a long?run phenomenon and are due either to
reductions in the technical coefficients of production (technical economiesZincreasing
productivity y improved organi0ation or methods of production) or to discounts
resulting from larger si0e (pecuniary economies)6
/nternal diseconomies of scale can e avoided y increasing industry output y increasing
the numer of plants *ithout increasing the scale of the plant6
%(ternal economies of scale are also either technical or pecunary, ut in this case are due
to the aggregate ehavior of the industry, and refer to the si0e of output of the industry as
a *hole6
%(ternal diseconomies of scale may occur if as industry output rises the unit price of
factors and materials rises as *ell due to increasing competition for inputs *ith other
industries6
/t should e made clear that these long?run results only hold if producer are rational actors, that is
ale to optimi0e their production so as to have an optimal scale of plant6
Imperfect competition and game theoryedit!
/n #E!E $arold $otelling pulished 5&taility in .ompetition5 addressing the prolem of
instaility in the classic .ournout model: -ertrand critici0ed it for lacking e:uilirium for prices
as independent variales and %dge*orth constructed a dual monopoly model *ith correlated
demand *ith also lacked staility6 $otteling proposed that demand typically varied continuously
for relative prices, not discontinuously as suggested y the later authors6
7#D8
Follo*ing &raffa he argued for 5the e(istence *ith reference to each seller of groups *ho *ill
deal *ith him instead of his competitors in spite of difference in price5, he also noticed that
traditional models that presumed the uni:ueness of price in the market only made sense if the
commodity *as standardi0ed and the market *as a point: akin to a temperature model in physics,
discontinuity in heat transfer (price changes) inside a ody (market) *ould lead to instaility6 9o
sho* the point he uilt a model of market located over a line *ith t*o sellers in each e(treme of
the line, in this case ma(imi0ing profit for oth sellers leads to a stale e:uilirium6 From this
model also follo*s that if a seller is to choose the location of his store so as to ma(imi0e his
profit, he *ill place his store the closest to his competitor: 5the sharper competition *ith his rival
is offset y the greater numer of uyers he has an advantage56 $e also argues that clustering of
stores is *asteful from the point of vie* of transportation costs and that pulic interest *ould
dictate more spatial dispersion6
, ne* impetus *as given to the field *hen around #E;; Joan 2oinson and %d*ard $6
.hamerlin, pulished respectively, (he Economics of %mperfect Competition (#E;;) and (he
(heory of Monopolistic Competition (#E;;), introducing models of imperfect competition6
7#E87!"8

,lthough the monopoly case *as already e(posed in 'arshall=s Principles of %conomics and
.ournot had already constructed models of duopoly and monopoly in #D;D, a *hole ne* set of
models gre* out of this ne* literature6 /n particular the monopolistic competition model results
in a non efficient e:uilirium6 .hamerlin defined monopolistic competition as, 5666challenge to
traditional vie*point of economics that competition and monopoly are alternatives and that
individual prices are to e e(plained in terms of one or the other65 $e continues, 5-y contrast it is
held that most economic situations are composite of oth competition and monopoly, and that,
*herever this is the case, a false vie* is given y neglecting either one of the t*o forces and
regarding the situation as made up entirely of the other65
7!#8
&tackelerg competition represented as an e(tensive form game *ith /nfinite action space6
)ater, some market models *ere uilt using game theory, particularly regarding oligopolies6 ,
good e(ample of ho* microeconomics started to incorporate game theory, is the &tackelerg
competition model pulished in #E;<,
7!!8
*hich can e characteri0ed as a dynamic game *ith a
leader and a follo*er, and then e solved to find a +ash %:uilirium6
William -aumol provided in his #ECC paper the current formal definition of a natural monopoly
*here Xan industry in *hich multiform production is more costly than production y a
monopolyY (p6 D#"):
7!;8
mathematically this e:uivalent to suadditivity of the cost function6 $e
then sets out to prove #! propositions related to strict economies of scale, ray average costs, ray
concavity and transray conve(ity: in particular strictly declining ray average cost implies strict
declining ray suadditivity, gloal economies of scale are sufficient ut not necessary for strict
ray suadditivity6
/n #ED! paper
7!<8
-aumol defined a contestale market as a market *here 5entry is asolutely free
and e(it asolutely costless5, freedom of entry in &tigler sense: the incument has no cost
discrimination against entrants6 $e states that a contestale market *ill never have an economic
profit greater than 0ero *hen in e:uilirium and the e:uilirium *ill also e efficient6 ,ccording
to -aumol this e:uilirium emerges endogenously due to the nature of contestale markets, that
is the only industry structure that survives in the long run is the one *hich minimi0es total costs6
9his is in contrast to the older theory of industry structure since not only industry structure is not
e(ogenously given, ut e:uilirium is reached *ithout add hoc hypothesis on the ehavior of
firms, say using reaction functions in a duopoly6 $e concludes the paper commenting that
regulators that seek to impede entry and1or e(it of firms *ould do etter to not interfere if the
market in :uestion resemles a contestale market6
Externalities and mar&et failureedit!
/n #E;C, X9he +ature of the FirmY *as pulished y .oase introducing the notion of transaction
costs (the term itself *as coined in the fifties), *hich e(plained *hy firms have an advantage
over a group of independent contractors *orking *ith each other6
7!A8
9he idea *as that there *ere
transaction costs in the use of the market: search and information costs, argaining costs, etc6,
*hich give an advantage to a firm that can internali0e the production process re:uired to deliver
a certain good to the market6 , related result *as pulished y .oase in his X9he Prolem of
&ocial .ostY (#EB"), *hich analyses solutions of the prolem of e(ternalities through argaining,
7!B8
in *hich he first descries a cattle herd invading a farmer=s crop and then discusses four legal
cases: Sturges v )ridgman, Cooke v *or"es, )ryant v !e+ever, and )ass v regory6 $e then
states:
5/n earlier sections, *hen dealing *ith the prolem of rearrangement of legal rights through the
market, it *as argued that such a rearrangement *ould e made through the market *henever
this *ould lead to an increase in the value of production6 -ut this assumed costless market
transactions6 @nce the costs of carrying out market transactions are taken into account it is clear
that such rearrangement of rights *ill only e undertaken *hen the increase in the value of
production conse:uent upon the rearrangement is greater than the costs *hich *ould e involved
in ringing it aout6 When it is less, the granting of an in4unction (or the kno*ledge that it *ould
e granted) or the liaility to pay damages may result in an activity eing discontinued (or may
prevent its eing started) *hich *ould e undertaken if market transactions *ere costless6 /n
these conditions the initial delimitation of legal rights does have an effect on the efficiency *ith
*hich the economic system operates6 @ne arrangement of rights may ring aout a greater value
of production than any other6 -ut unless this is the arrangement of rights estalished y the legal
system, the costs of reaching the same result y altering and comining rights through the market
may e so great that this optimal arrangement of rights, and the greater value of production
*hich it *ould ring, may never e achieved65
9his then ecomes relevant in conte(t of regulations6 $e argues against the Pigovian tradition:
7!C8
56669he prolem *hich *e face in dealing *ith actions *hich have harmful effects is not simply
one of restraining those responsile for them6 What has to e decided is *hether the gain from
preventing the harm is greater than the loss *hich *ould e suffered else*here as a result of
stopping the action *hich produces the harm6 /n a *orld in *hich there are costs of rearranging
the rights estalished y the legal system, the courts, in cases relating to nuisance, are, in effect,
making a decision on the economic prolem and determining ho* resources are to e employed6
/t *as argued that the courts are conscious of this and that they often make, although not al*ays
in a very e(plicit fashion, a comparison et*een *hat *ould e gained and *hat lost y
preventing actions *hich have harmful effects6 -ut the delimitation of rights is also the result of
statutory enactments6 $ere *e also find evidence of an appreciation of the reciprocal nature of
the prolem6 While statutory enactments add to the list of nuisances, action is also taken to
legali0e *hat *ould other*ise e nuisances under the common la*6 9he kind of situation *hich
economists are prone to consider as re:uiring Government action is, in fact, often the result of
Government action6 &uch action is not necessarily un*ise6 -ut there is a real danger that
e(tensive Government intervention in the economic system may lead to the protection of those
responsile for harmful eing carried too far65
9his period also marks the eginning of mathematical modeling of pulic goods *ith
&amuelson=s X9he Pure 9heory of Pulic %(penditureY (#EA<), in it he gives a set of e:uations
for efficient provision of pulic goods (he called them collective consumption goods), no* kno*
as the &amuelson condition6
7!D8
$e then gives a description of *hat is kno* called the free rider
prolem:
5$o*ever no decentrali0ed pricing system can serve to determine optimally these levels of
collective consumption6 @ther kinds of 5voting5 or 5signaling5 *ould have to e tried6 -ut, and
this is the point sensed y Wicksell ut perhaps not fully appreciated y )indahl, no* it is in the
selfish interest of each person to give false signals, to pretend to have less interest in a given
collective consumption activity than he has, etc65
3sed cars market: due to presence of fundamental asymmetrical information et*een seller and
uyer the market e:uilirium is not efficientI in the language of economists it is a market failure
,round the #EC"s the study of market failures again came into focus *ith the study of
information asymmetry6 /n particular three authors emerged from this period: ,kerlof, &pence,
and &tiglit06 ,kerlof considered the prolem of ad :uality cars driving good :uality cars out of
the market in his classic X9he 'arket for )emonsY (#EC") ecause of the presence of
asymmetrical information et*een uyers and sellers6
7!E8
&pence e(plained that signaling *as
fundamental in the laour market, ecause since employers can=t kno* eforehand *hich
candidate is the most productive, a college degree ecomes a signaling device that a firm uses to
select ne* personnel6
7;"8
, synthesi0ing paper of this era is X%(ternalities in %conomies *ith
/mperfect /nformation and /ncomplete 'arketsY y &tiglit0 and Green*ald:
7;#8
the asic model
consists of households that ma(imi0e a utility function, firms that ma(imi0e profit>and a
government that produces nothing, collects ta(es, and distriutes the proceeds6 ,n initial
e:uilirium *ith no ta(es is assumed to e(ist, a vector ( of household consumption and vector 0
of other variales that affect household utilities (e(ternalities) are defined, a vector P of profits is
defined along *ith a vector % of households e(penditures6 &ince the envelope theorem holds, if
the initial non ta(ed e:uilirium is Pareto optimal then it follo*s that the dot products [
(et*een P and the time derivative of 0) and - (et*een % and the time derivative of 0) must
e:ual each other6 9hey state:
5%(cept in the special case (*hich is unlikely to hold generically) *here [ and - e(actly cancel
each other out, the e(istence of these e(ternalities *ill make the initial e:uilirium inefficient
and guarantee the e(istence of *elfare?improving ta( measures65
@ne application of this result is to the already mentioned 'arket for )emons, *hich deals *ith
adverse selection: households uy from a pool of goods *ith heterogeneous :uality considering
only average :uality, since in general the e:uilirium is not efficient, any ta( that raises average
:uality is eneficial (in the sense of optimal ta(ation)6 @ther applications *ere considered y the
authors, such as ta( distortions, signaling, screening, moral ha0ard, incomplete markets, :ueue
rationing, unemployment and rationing e:uilirium6
Beha)ioral economicsedit!
,symmetric value function in prospect theory: ig losses have a much igger psychological
impact than ig gains
Gahneman and 9versky pulished a paper in #ECE critici0ing the very idea of the rational
economic agent6
7;!8
9he main point is that there is an asymmetry in the psychology of the
economic agent that gives a much higher value to losses than to gains6 9his article is usually
regarded as the eginning of ehavioral economics and has conse:uences particularly regarding
the *orld of finance6 9he authors summed the idea in the astract as follo*s:
5666/n particular, people under*eight outcomes that are merely proale in comparison *ith
outcomes that are otained *ith certainty6 9his tendency, called certainty effect, contriutes to
risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses6
/n addition, people generally discard components that are shared y all prospects under
consideration6 9his tendency, called the isolation effect, leads to inconsistent preferences *hen
the same choice is presented in different forms65
'reat *ecession and executi)e compensationedit!
'ore recently, the Great 2ecession and the ongoing controversy on e(ecutive compensation
rought the principalHagent prolem again to the center of deate, in particular regarding
corporate governance and prolems *ith incentive structures 6
7;;8
*eferencesedit!
#6 +ump up , 'archant, 'ary ,6I &nell, William '6 5'acroeconomic and /nternational Policy
9erms56 3niversity of Gentucky6 2etrieved !""C?"A?"<6
!6 \ Jump up to:
a

b
5%conomics Glossary56 'onroe .ounty Women=s Disaility +et*ork6 2etrieved
!""D?"!?!!6
;6 +ump up , 5&ocial &tudies &tandards Glossary56 +e* 'e(ico Pulic %ducation Department6
,rchived from the original on !""C?"D?"D6 2etrieved !""D?"!?!!6
<6 +ump up , 5Glossary56 %.@+#""6 2etrieved !""D?"!?!!6
A6 +ump up , http:11***6ftc6gov1c1edu1pus1consumer1general10gen"#6shtm
B6 +ump up , ,eardorff-s lossary of %nternational Economics (!""B)6 5Welfare economics65
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#"6 +ump up , .6'enger,Principles of %conomics, #DC# http:11mises6org1ete(ts1menger1principles6asp
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#;6 +ump up , ,6'arshall, Principles of %conomics, #DE", ,PP%+D/a /:2/.,2D@=& 9$%@2_ @F
U,)3% http:11***6econli6org1lirary1'arshall1marPB<6html
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P2%)/'/+,2_ &32U%_ @F D/&92/-39/@+, .@+9/+3%D6
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5ational6konomie6 ; volumes6 Jena, Germany: Fischer6
#B6 +ump up , .o, .6 W6I Douglas, P6 $6 (#E!D)6 5, 9heory of Production56 .merican Economic
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#C6 +ump up , Uiner, Jaco (#E;#)6 5.osts .urves and &upply .urves56 7eitschrift f8r
5ational6konomie / (#): !;H<B6 doi:#"6#""C1-F"#;#B!EE6 2eprinted in %mmett, 26 -6, ed6 (!""!)6 (he
Chicago (radition in Economics/ 9:;<=9;>? 06 2outledge6 pp6 #E!H!#A6
#D6 +ump up , $otteling, $6 (#E!E)6 5&taility in .ompetition56 (he Economic 3ournal /1 (#A;): <#H
AC6 J&9@2 !!!<!#<6
#E6 +ump up , 2oinson, J6 (#E;;)6 (he Economics of %mperfect Competition6 )ondon: 'acmillan6
@.). !C"<""6
!"6 +ump up , .hamerlin, %6 $6 (#E;;)6 (he (heory of Monopolistic Competition6 $arvard
%conomic &tudies /.6 .amridge: $arvard 3niversity Press6 @.). #"EEBC<6
!#6 +ump up , .hamerlin, %6 $6 (#E;C)6 5'onopolistic or /mperfect .ompetition`56 (he @uarterly
3ournal of Economics 2- (<): AACHAD"6 doi:#"6!;"C1#DD#BCE6
!!6 +ump up , &tackelerg, $6 F6 von (#E;<)6 Marktform und leichge$icht6 -erlin: J6 &pringer6
@.). A"<BD!!6
!;6 +ump up , -aumol, William J6 (#ECC)6 5@n the Proper .ost 9ests for +atural 'onopoly in a
'ultiproduct /ndustry56 .merican Economic 'evie$ 03 (A): D"EHD!!6 J&9@2 #D!D"BA6
!<6 +ump up , -aumol W6, .ontestale 'arkets: ,n 3prising in the 9heory of /ndustry &tructure,
,merican %conomic 2evie* vol C! pp6 #?#A #ED!
http:11econ6ucdenver6edu1eckman1research1readings1aumol?contestale6pdf
!A6 +ump up , .oase, 26 $6 (#E;C)6 59he +ature of the Firm56 Economica 4 (#B): ;DBH<"A6
doi:#"6####146#<BD?";;A6#E;C6t""""!6(6
!B6 +ump up , .oase, 26 $6 (#EB")6 59he Prolem of &ocial .ost56 3ournal of !a$ and Economics /:
#H<<6 J&9@2 C!<D#"6
!C6 +ump up , Pigou, ,rthur .ecil (#E!")6 (he Economics of #elfare6
!D6 +ump up , &amuelson, P6 (#EA<)6 59he Pure 9heory of Pulic %(penditure56 'evie$ of
Economics and Statistics /0 (<): ;DCH;DE6 J&9@2 #E!ADEA6
!E6 +ump up , ,kerlof, George ,6 (#EC")6 59he 'arket for c)emonsd: Fuality 3ncertainty and the
'arket 'echanism56 @uarterly 3ournal of Economics .4 (;): <DDHA""6 doi:#"6!;"C1#DCE<;#6
;"6 +ump up , &pence, ,6 '6 (#EC;)6 5Jo 'arket &ignaling56 @uarterly 3ournal of Economics .3
(;): ;AAH;C<6 J&9@2 #DD!"#"6
;#6 +ump up , Green*ald, -ruceI &tiglit0, Joseph %6 (#EDB)6 5%(ternalities in %conomics *ith
/ncomplete 'arket /nformation56 @uarterly 3ournal of Economics -5- (!): !!EH!B<6 doi:#"6!;"C1#DE###<6
;!6 +ump up , Gahneman, D6I 9versky, ,6 (#ECE)6 5Prospect 9heory: ,n ,nalysis of Decision 3nder
2isk56 Econometrica 43 (!): !B;H!E!6 J&9@2 #E#<#DA6
;;6 +ump up , 5%conomist Joseph &tiglit0: Put .orporate .riminals in Jail56 ,aily *inance6 @ctoer
!!, !"#"6
6urther readingedit!
-ade, 2oinI 'ichael Parkin (!""#)6 *oundations of Microeconomics6 ,ddison Wesley
Paperack #st %dition6
-ouman, John: Principles of 'icroeconomics H free fully comprehensive Principles of
'icroeconomics and 'acroeconomics te(ts6 .olumia, 'aryland, !"##
.olander, David6 Microeconomics1 'cGra*?$ill Paperack, Cth %dition: !""D6
Dunne, 9imothy, J6 -radford Jensen, and 'ark J6 2oerts (!""E)6 Producer ,ynamics: 5e$
Evidence from Micro ,ata6 3niversity of .hicago Press6 /&-+ ECD?"?!!B?#C!AB?E6
%aton, -6 .urtisI %aton, Diane F6I and Douglas W6 ,llen6 Microeconomics6 Prentice $all, Ath
%dition: !""!6
Frank, 2oert $6I Microeconomics and )ehavior6 'cGra*?$ill1/r*in, Bth %dition: !""B6
Friedman, 'ilton6 Price (heory1 ,ldine 9ransaction: #ECB
$agendorf, Glaus: )aour Ualues and the 9heory of the Firm6 Part /: 9he .ompetitive Firm6
Paris: %32@D@&I !""E6
$arnerger, ,rnold .6 (!""D)6 5'icroeconomics56 /n David 26 $enderson (ed6)6 Concise
Encyclopedia of Economics (!nd ed6)6 /ndianapolis: )irary of %conomics and )ierty6
/&-+ ECD?"DBAECBBAD6 @.). !;CCE<!BC6
$icks, John 26 Aalue and Capital6 .larendon Press6 7#E;E8 #E<B, !nd ed6
$irshleifer, Jack6, Gla0er, ,mihai, and $irshleifer, David, Price theory and applications:
,ecisions/ markets/ and information1 .amridge 3niversity Press, Cth %dition: !""A6
Jehle, Geoffrey ,6I and Philip J6 2eny6 .dvanced Microeconomic (heory1 ,ddison Wesley
Paperack, !nd %dition: !"""6
Gat0, 'ichael )6I and $arvey &6 2osen6 Microeconomics6 'cGra*?$ill1/r*in, ;rd %dition: #EEC6
Greps, David '6 . Course in Microeconomic (heory6 Princeton 3niversity Press: #EE"
)andsurg, &teven6 Price (heory and .pplications6 &outh?Western .ollege Pu, Ath %dition:
!""#6
'anki*, +6 Gregory6 Principles of Microeconomics6 &outh?Western Pu, !nd %dition: !"""6
'as?.olell, ,ndreuI Whinston, 'ichael D6I and Jerry 26 Green6 Microeconomic (heory6 @(ford
3niversity Press, 3&: #EEA6
'cGuigan, James 26I 'oyer, 26 .harlesI and Frederick $6 $arris6 Managerial Economics:
.pplications/ Strategy and (actics6 &outh?Western %ducational Pulishing, Eth %dition: !""#6
+icholson, Walter6 Microeconomic (heory: )asic Principles and E&tensions1 &outh?Western
.ollege Pu, Dth %dition: !""#6
Perloff, Jeffrey '6 Microeconomics6 Pearson H ,ddison Wesley, <th %dition: !""C6
Perloff, Jeffrey '6 Microeconomics: (heory and .pplications $ith Calculus6 Pearson H ,ddison
Wesley, #st %dition: !""C
Pindyck, 2oert &6I and Daniel )6 2uinfeld6 Microeconomics1 Prentice $all, Cth %dition: !""D6
2uffin, 2oy J6I and Paul 26 Gregory6 Principles of Microeconomics6 ,ddison Wesley, Cth %dition:
!"""6
Uarian, $al 26 (#EDC)6 5microeconomics,5 (he 5e$ Palgrave: . ,ictionary of Economics, v6 ;,
pp6 <B#HB;6
Uarian, $al 26 %ntermediate Microeconomics: . Modern .pproach6 W6 W6 +orton T .ompany,
Dth %dition: !""E6
Uarian, $al 26 Microeconomic .nalysis6 W6 W6 +orton T .ompany, ;rd %dition: #EE!6