Introduction to Microeconomics

"There are three kinds of economics: Greek-letter, up-and-down, and airport." Paul Krugman

Graphs

Supply and Demand: This graph will show up throughout the course, so spend the time
mastering it. The graph is a visual representation of a market where prices are determined. In a
market are two groups of participants the suppliers and demanders. The key is to remember is
that the two curves are graphical representations of two groups. The supply curve captures the
behavior of those supplying goods to the market, and the curve slopes upward because as the
price increases suppliers would like to sell more to make more money. The demand curve,
meanwhile, represents those who are buyers in the market and it slopes downward because buyers
reduce their demand as the price rises. When anything else changes that affects one of the
participants then one of these curves shifts to reflect the impact of the shock on the participants
and the market. Most of the questions you will deal with will involve explaining or predicting
changes in price or quantity as a result of some shock, and when trying to solve those problems I
strongly suggest that you use that Cookbook Approach just play by the rules and you will be
OK.


Here is where to start with a modified S&D graph that has the determinants of Supply and
Demand. For example, in the demand curve you see income, which means that if there is a
change in income or wealth - then this will affect demand and shift the curve. If income
increases you would expect demand to increase and this would be a shift to the right of the
Demand curve. In the supply curve you see productivity so if there is an increase in productivity
then supply will increase and we show this by the Supply curve shifting to the right.



Example 1: How would you best capture the "story" behind the following headline "oil prices fall
on news of higher Iraqi oil shipments." What curve(s) would shift? Following the Cookbook
Approach, the market is oil and the buyers are people (you and me) and the sellers are companies
and countries. This is a story about Iraq, which is a supplier of oil, and this is a story about a
reduction in supply. You would show this as an inward shift in the supply curve and this would
drive up the equilibrium price (P) and reduce output / sales (Q).

Example 2: How would you best capture the "story" behind the following headline " high end car
sales down as stock market slides." What curve(s) would shift? Following the Cookbook
Approach, the market is high end cars and the buyers are wealthy people and the sellers are high
end car companies. This is a story about stock prices falling that will reduce the wealth / income
of high-income individuals and this will decrease demand. You would show this as an inward
shift in the demand curve and this would drive down the equilibrium price (P) and reduce sales
(Q).

Formulas, Equations, and Definitions to Remember


Present Value
Elasticity
Production and Cost: Output
Revenue and Profit: Output
Inputs

Present Value Equation
Describes the relationship between the values at two points in time. Actually it can be
thought of as an equation with four unknowns, and all you need to do is solve for the one
unknown. Below is the equation where future value (FV) is the unknown.
FV = PV*(1 + g)
T

Where:
PV = Present Value ( value at beginning of the period)
FV = Future Value ( value at the end of the period)
g = Average growth rate per period
T = Number of time periods
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Elasticity

The formulas for demand and supply elasticities are:
Income elasticity of demand
o definition: responsiveness of demand to income change
o formula: e
y
= %!Q/%!Y
Cross-price elasticity of demand
o definition: responsiveness of demand (good A) to change in price of another good (price
of B)
o formula: e
c
= %!Q
A
/%!P
B

Own-Price elasticity of demand
o definition: responsiveness of demand to price change
o formula: e
p
= %!Q/%!P
o possibilities
! inelastic: unresponsive = | e
p
| < 1
! elastic: responsive | e
p
| > 1
! unitary elastic: | e
p
| = 1
Own-Price elasticity of supply
o definition: responsiveness of supply to price change
o formula: e
ps
= %!Q
s
/%!P/
Relationship between price elasticity and revenue
!R = Q*(1+e
p
)*!P
!R = P*(1+1/e
p
)*!Q
or in percentage terms
%!R = (1+e
p
)*%!P
%!R =(1+1/e
p
)*%!Q

Production and Cost

short-run production concepts

Total (physical) product
o Definition: amount of output obtained from given amount of input
o Graph: vertical axis (units of output) : horizontal axis (units of input)
Average (physical) product:
o Definition: amount of output obtained per unit of input
o Formula: Output / Input
o Graph: vertical axis (average product) : horizontal axis (units of input)
Marginal (physical) product:
o Definition: additional output obtained by 1 more unit of input
o Formula: !Output / !Input
o Graph: vertical axis (marginal product) : horizontal axis (units of input)
! Diminishing marginal product: as input use expands the marginal product begins
to decline
short run cost concepts

Total Cost (TC):
o Definition: all costs of production (Fixed costs plus variable cost)
o Formula: Fixed Cost + Variable Cost (TC = FC + VC)
o Graph: vertical axis (Total cost) : horizontal axis (Output)
Fixed Cost (FC):
o Definition: all costs of production (Fixed costs plus variable cost)
o Formula: Fixed cost
o Graph: vertical axis (Fixed cost) : horizontal axis (Output)
Sunk Cost (SC):
o Definition: costs of resources that have already been incurred and will not change
regardless of any current or future decisions
Variable Cost (VC):
o Definition: costs of production that vary with output
o Formula: Variable cost
o Graph: vertical axis (Variable cost) : horizontal axis (Output)
Average Cost (AC):
o Definition: costs per unit of output
o Formula: Total cost / Output (AC = TC/Q)
o Graph: vertical axis (Average cost) : horizontal axis (Output)
Marginal Cost (MC):
o Definition: additional costs of producing more output
o Formula: ! Total cost / ! Output
o Graph: vertical axis (Marginal cost) : horizontal axis (Output)
Average Variable Cost
o Formula: Variable cost / Output (AVC = VC/Q)
Average Fixed Cost
o Formula: Fixed cost / Output (AFC = FC/Q)

long run production and cost concepts

decreasing returns to scale: if we double all inputs and output less than doubles
constant returns to scale: if we double all inputs and output doubles
increasing returns to scale: if we double all inputs and output more than doubles
increasing cost industry: as we expand output, average cost rises
constant cost industry: as we expand output, average cost remains constant
decreasing cost industry: as we expand output, average cost falls

Revenue and profit relationships

Total Revenue: relationship between sales revenue and output = relationship between sales
revenue and output =
o Definition: relationship between sales revenue and output
o Formula: Price * Quantity (P x Q)
o Graphs: vertical axis (Revenue) : horizontal axis (Output)
Average Revenue:
o Definition: amount of revenue obtained per unit of output
o Formula: Revenue / Output (TR/Q)
o Graphs: vertical axis (Average Revenue) : horizontal axis (Output)
Marginal Revenue:
o Definition: additional revenue from selling more unit of output
o Formula: D Revenue / ! Output (!TR / !Q)
o Graphs: vertical axis (Marginal Revenue) : horizontal axis (Output)
Total Profit:
o Definition: relationship between profit and output
o Formula: Total Revenue - Total Cost (TR - TC)
o Graphs: vertical axis (Profit) : horizontal axis (Output)
Marginal Profit: Marginal profit
o Definition: additional profit obtained by producing and selling 1 more unit of output
o Formula: D Profit / D Output (DP / D Q)
o Alternative formula: MP = MR - MC
o Graphs: vertical axis (Marginal Profit) : horizontal axis (Output)

Logic of Profit Maximization: implications of decision to raise output

1. Profit = Revenue - Cost
2. Revenue: depends on demand
3. Cost: depends on input use and costs
4. Marginal revenue (MR) is the additional revenue
of the decision
5. Marginal Cost (MC) is the additional cost of the
decision
6. Marginal Profit (MP) = MR - MC is the
additional profit of the decision
7. MP > 0 means that the decision will increase
profit
8. MP < 0 means that the decision will decrease
profit
9. MR = MC (MP = 0) means the maximum profit
choice
10. Since FC does not affect MC, then FC does not
affect optimal choice

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Inputs
Optimal input choice rules for profit maximizer

Short run
MRP
A
= MR
X
* MP
A
= P
A


Long run
MRP
A
/P
A
= MRP
B
/P
B

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