Microeconomics Study Guide

Introduction and Preliminaries

Economics - study of how a society uses its limited resources to produce, trade, and
consume goods
Macroeconomics - branch of economics that deals with aggregate economic variables
(GDP, interest rates, inflation)
Microeconomics - branch of economics that deals with behavior of individual economic
units (consumers, markets, investors, workers)
Positive Analysis - statements that describe cause and effect, and can be verified gas is $2/gal)
Normative Analysis - statements that examine questions of what ought to be, or
opinions - gas should cost $1/gal
Nominal Price - absolute price of a good or service with regards to the time it is sold
(does not take inflation into account)
Real Price - price relative to an aggregate measure of prices or constant dollar price
(takes inflation into account, relative to overall price level)
Formula:
*in the base year, nominal price = real price
Consumer Price Index (CPI) - measure of aggregate prices, percent changes in CPI
measure inflation rate
The Basics of Supply and Demand
The Supply Curve - relationship between price (Y) of a good and the quantity (X) of the
good that producers are willing to sell
Curve:

Change in Quantity Supplied - movement along the curve caused by change in price
Change in Supply - shift of the curve caused by change something other than price
(i.e. cost of production)
Example:

The Demand Curve - relationship between price (Y) of a good and the quantity (X) of
the good that consumers are willing to buy
Curve:

Change in Quantity Demanded - movement along the curve caused by change in

price
Change in Demand - shift of the curve caused by change something other than price
(i.e. income, preferences)
Example:

The Market Mechanism - tendency in a free market for price to change until market
clears
Market Clears - when quantity demanded = quantity supplied
Market Clearing Price - price at which market clears

Market Equilibrium - no shortage/excess demand, no shortage/excess supply, quantity

supplied = quantity demanded
Excess Supply - market price is above equilibrium, downward pressure on price,
quantity demanded increases and quantity supplied decreases
Excess Demand - market price is below equilibrium, upward pressure on prices,
quantity demanded decreases and quantity supplied increases
Graph:

Normal Good - as income increases, demand increases

Inferior Good - as income increases, demand decreases
Luxury Good - as income increases, demand increases by a lot
Consumer Behavior (Part 1)
Axiom 1 - Completeness (A > B, B > A, or A~B)
Axiom 2 - Transitivity (If A > B and B > C, then A > C); assumes that individuals choices
are internally consistent
Axiom 3 - Continuity (If A > B, then situations close to to A would be preferable to B);
used to analyze individuals responses to small changes in income or prices
Axiom 4 - Strict Monotonicity (If A is greater than B, then A > B); consumer never
satisfied, thinks more is better
Axiom 5 - Strict Convexity; averages preferred to extremes
Indifference Curves - represents all combinations of market baskets that a person is
indifferent to; cannot cross because it would violate axiom of transitivity

Marginal Rate of Substitution (MRS) - measures how a person trades one good for
another, the negative (-) of the slope of the indifference curve at any point on the curve,
ratio of the marginal utility of X to the marginal utility of Y
Calculate: MRS =
Convexity - if indifference curve is convex, then middle points are better than extremes
Perfect Substitutes - MRS is constant
Graph:

Perfect Complements - indifference curves are right angels, MRS is infinity

Graph:

When Goods Are Bads - redefine the commodity (air pollution -> clean air)
Consumer Behavior (Part 2)
Utility Function - formula that assigns a level of utility to individual market baskets (ex.
U(F,C) = F + 2C, where F = food and C = clothing); solving for a variable in utility
function and then finding the derivative, equals MRS
MRS = -dy/dx
Utility - only tells you relative desirability, does not describe intensity of desire
Marginal Utility (MU) - extra utility obtained from slightly more X1; suppose an
individual has utility function in form U = u(x1, x2,...,xa); then MUx1 = du/dx1
Deriving MRS from MU -

ratio of the marginal utility of X to the marginal utility of Y

Example:
Cobb-Douglas Utility The Budget Line - different choices of food/clothing can be calculated that use all
income; written as:

then rearranged to:

Changes in Budget Line - increase/decrease in income -> parallel outward/inward shift

increase/decrease in price of good -> pivot inward/outward
Utility Maximization and Individual Demand
Utility Maximization (Graphical Analysis) - utility is maximized where indifference
curve is tangent to budget constraint
Graph:

Utility Maximization (Analytical Analysis) - at optimal allocation of income the

MRS = Px/Py
Effects of Changes in Income and Prices
Income Consumption Curve (ICC) - traces out the utility maximizing market level
basket for each income level
Positive Slope ICC - quantity increases with income, income elasticity is positive,
normal good
Graph:

Negative Slope ICC - quantity decreases with income, income elasticity is negative,
inferior good
Graph:

Engel Curves - relate the quantity of good consumed to income, can use to determine
if good is normal or inferior
Substitution Effect - change in an items consumption associated with a change in
price of the item, with level of utility held constant
Income Effect - change in an items consumption associated with an increase in
purchasing power, with price of item held constant; income effect is rarely enough to
outweigh substitution effect
Market Demand
Market Demand Curves - curve that relates the quantity of a good that all consumers
in a market buy to the price of the good; curve will shift to the right as more consumers
enter the market
Price Elasticity of Demand - measures percentage of change in the quantity
demanded resulting from a percent change in price
Formula:
Inelastic Demand - Ep is less than 1 in absolute value (its a fraction, essentially),
quantity demanded is relatively unresponsive to change in price, total expenditure (P*Q)
decreases when price increases
Elastic Demand - Ep is greater than 1 in absolute value, quantity demanded is
relatively responsive to change in price, total expenditure (P*Q) decreases when price
increases

Isoelastic Demand - price elasticity of demand is constant along demand curve,

demand curve curves inwards
Consumer Surplus - measures how much better off consumers are; difference
between the maximum amount a consumer is willing to pay for a good and the amount
actually paid
Endogeneity Problem - upwards demand curve, usually a seasonal activity (in summer
time, hotels are more expensive and in more demand)
Empirical Estimation of Demand - assuming only price determines demand: Q = a-bP
Production
Production Technology - how inputs can be transformed into outputs
Inputs: land, labor, capital, raw materials
Outputs: cars, desks, books, etc.
Cost Constraints - firms must consider prices of labor, capital, and other inputs
Input Choices - given input prices and technology, firms choose how much of each
input
Production Function - highest output a firm can produce for every combination of
inputs
Function:
Technology Production Function - if technology increases, more output can be
produced for a given level of inputs
Function:
One Variable Input - short run, capital is fixed and labor is variable; when labor is zero
output is zero, with additional labor output increases up to a certain amount, then begins
to decrease
Average Product of Labor - output per unit of a particular product, measures firms
labor in terms of how much, on average, each worker can product
Formula:

Marginal Product of Labor - additional output produced when labour increased by one
unit; change in output, divided by change in labor, derivative of Q with respect to L
Formula:

Average and Marginal Products - marginal product is positive as long as total output
is increasing, Marginal Product crosses Average Product at its maximum
Graph:

MP > AP: AP is increasing

MP < AP: AP is decreasing
MP = 0: total product (output) is at maximum
Law of Diminishing Returns - as the use of an increase with other inputs fixed, the
result additions to output will eventually decrease (applies only for short run when one
variable input is fixed)
Malthus - predicted that mass hunger as diminishing returns limited agricultural input;
failed because he did not take technology into account
Two Variable Inputs - long run, both labor and capital are variable
Isoquants - curves show all possible combinations of inputs that yield the same output
(similar to indifference curves)
Map:

Marginal Rate of Technical Substitution (MRTS) - negative of the slope of an

isoquant; amount by which the quantity of one input can be reduced when one extra unit
of another input is used, so output remains constant
Formula:

Labor vs Capital - as labor increases to replace capital, labor becomes relatively less
productive, capital becomes relatively more productive, isoquant becomes flatter, MRTS
is diminishing
Graph:

MRTS and Marginal Products - if output is constant, net effect of increasing labor and
decreasing capital must be 0
Formula:

Isoquants: Special Cases - two extremes show possible range of input substitution
Perfect Substitutes - MRTS is constant on all isoquant points, same output can be
produced with a lot of capital/labor, or a balanced mix
Graph:

Perfect Complements - output can only be made with a specific proportion, no

substitute available between inputs
Graph:

Returns to Scale - how a firms decides, in the long run, the best way to increase out,
rate at which output increases as inputs are increased proportionally
*midterm question - distinguish between increasing vs. decreasing returns to scale
1. Increasing returns to scale
Double in input results in more than double the output (isoquants move closer together)
Alpha + beta > 1

2. Constant returns to scale

Output doubles when all inputs are doubled (isoquants move equally far apart)
Alpha + beta = 1
3. Decreasing returns to scale
Double in input results in less than double the output (isoquants become further apart)
Alpha + beta < 1
The Cost of Production
The Isocost Line - line showing all combinations of L & K that can be purchased for the
same cost (similar to budget line)
Formula:

Slope of Isocost - ratio of wage rate to rental cost of capital, shows rate at wich capital
can be substituted for labor with no change in cost
Cost Minimizing Conditions - minimum cost for a given output will occur when each
dollar of input added to the production process will add an equivalent amount of output
Formulas/Graph:

Short Run: Fixed and Variable Costs - cost of production equals the fixed costs and
variable costs
Formula:
Average Total Cost (ATC) - cost per unit of output, has a fixed component in the short
run
Formula:

Marginal Cost (MC) - the cost of expanding output by one unit, fixed costs have no
impact on MC
Formula:

Cost Curves Graph:

When MC is below AVC, AVC is falling

When MC is above AVC, AVC is rising
When MC is below ATC, ATC is falling
When MC is below ATC, ATC is rising

Economies of Scale - increase in output > increase in costs

Diseconomies of Scale - increase in output < increase in costs
Increasing returns to scale (OUTPUT)
Output more than doubles when inputs are doubled
Economies of Scale (COSTS)
Doubling of output requires less than doubling of costs; measured in terms of cost
output elasticity
What is the difference between increasing returns to scale and economies of scale?

Scale Economy Index (SCI)

Accounting Cost - retrospective view, actual expenses plus depreciation charges for
capital equipment
Economic Cost - forward-looking view, cost to a firm of utilizing economic resources in
production, including opportunity cost

Sunk Cost - expense that cant be recovered and shouldnt influence a firms future
decisions
Fixed cost =/= sunk cost
Fixed cost - cost paid by firm for inputs fixed in the short term (static)
Sunk cost - cost has been incurred and cannot be recovered (dynamic)
What is the difference between a fixed and a sunk cost?

Profit Maximization and Competition Supply

Perfectly Competitive Markets - three basic assumptions
1. price taking - suppliers / consumers
2. product homogeneity (all products are the same)
3. free entry and exit
Profit Maximization (Formulas)
Profit =
Revenue =
Total Cost (C) =
Graph:

Slope of total revenue is marginal revenue

Slope of total cost curve is marginal cost
Profit maximized when MR = MC

The Competitive Firm - demand curve is horizontal line because firm sales have no
effect on market price
Graph(s):

Whole Market - downward sloping demand curve because it shows amount of goods all
consumers will purchase at different prices
Graph(s):

Short Term Production

Why would firm produce at a loss? - may think prices will increase in near future or
shutting down/starting up again could be costly
When should firm shut down?
If AVC < P < ATC, firm should continue producing (can cover all variable costs and
some fixed costs)
If AVC > P < ATC, firm should shut down (cannot cover either variable or fixed costs)
Competitive Firm Short Run Supply Curve - supply curve tells how much output will
be produced at different prices, determines quantity to produce where P = MC, supply
curve is portion of the marginal cost above the AVC curve
Graph:

Why is supply curve upward sloping?

Response of a Firm to a Change in Input Price - how the firms output changes in
response to change in price of input (increase in marginal costs)
Graph:

Industry Supply in the Short Run - shows amount of product the whole market will
produce at given prices, sum of all individual producers in market
Graph:

Elasticity of Market Supply - measures sensitivity of industry output to market price,

percentage change in quantity supplied (Q) in response to 1-percent change in price
When MC increases rapidly in response to increase in output, elasticity is low
When MC increases slowly, supply is relatively elastic
Perfectly Inelastic - short-run supply arises when the industrys plant and equipment
are so fully utilized that new plants must be built to achieve greater output
Perfectly Elastic - short-run supply arises when marginal costs are constant
Producer Surplus in the Short Run - price is greater than MC on all but the last unit of
output, surplus earned on all but the last unit
Producer Surplus - sum over all units produced of the difference between the market
price of the good and the marginal cost of production
Graph(s):

Long-Run Competitive Equilibrium - entry and exit; long run response to short-run
profits is to increase output and profits -> profits will attract other producers -> more
producers increase industry supply which lowers market price -> continues until there
are no more profits to be gained in the market (zero economic benefits)
Graph(s):

3 Conditions for Long Run Competitive Market

1. All firms in industry are maximizing profits
2. Market is in equilibrium
3. No firm has incentive to enter/exit industry (zero economic profits)