Comprehensive Microeconomics Review Notes (ECON 2001)

What is Economics?

Definition and Scope

• Economics is the study of how economic agents allocate scarce resources and how these choices affect society.

• Microeconomics focuses on the behavior of individuals, households, firms, and governments, and how their choices influence prices, resource allocation, and overall well-being.

• Economic agents include individuals, households, firms, and governments.

• A resource is scarce when the desire for it exceeds its availability.

Three Principles of Economics

Core Principles

• Optimization: Economic agents select the best feasible alternative, maximizing Net-Benefits (Net-Benefits = Benefits − Costs).

• Equilibrium: A state where all agents are optimizing given available information; no agent can benefit by changing their choice unilaterally.

• Empiricism: Using data and evidence to test economic theories and models.

Optimization Techniques

Total Value vs. Marginal Analysis

• Optimization using total values: Compare total net-benefits of each alternative; choose the highest.

• Optimization using marginal analysis: Compare changes in costs and benefits when moving between alternatives.

• Principle of Optimization at the Margin: The optimal choice is where moving toward it increases well-being and moving away decreases it.

Markets and Competition

Market Structure and Perfect Competition

• A market is a group of agents trading a good or service under specific rules.

• Perfect competition is characterized by:

  • Many buyers and sellers

  • Homogeneous products

  • Free entry and exit

  • All agents are price takers

Consumer Behavior

The Buyer's Problem

• Quantity demanded is the amount a buyer is willing to purchase at a given price.

• Buyers solve their problem by maximizing utility subject to their budget constraint.

• The optimal consumption bundle is where:

$\frac{MB_1}{p_1} = \frac{MB_2}{p_2}$

• and the budget is exhausted:

$I = p_1 x_1 + p_2 x_2$

• Demand schedule: Table showing quantity demanded at various prices.

• Demand curve: Graph plotting the demand schedule.

Example: Marginal Benefit Table

Quantity	MBmilk	MBmilk/pmilk	MBcookie	MBcookie/pcookie
1	5	1.25	10	5
2	2.5	0.625	5	2.5
3	1.67	0.417	3.33	1.667
4	1.25	0.313	2.5	1.25
5	1	0.25	2	1
6	0.83	0.208	1.67	0.833
7	0.71	0.179	1.43	0.714
8	0.63	0.156	1.25	0.625
9	0.56	0.139	1.11	0.556
10	0.5	0.125	1	0.5

Additional info: The optimal bundle is found where the marginal benefit per dollar is equalized across goods and the budget is exhausted.

Graphical Depiction: Indifference Curves and Budget Constraint

• Indifference curves (Uk) represent combinations of goods yielding equal utility.

• The optimal bundle is where the highest attainable indifference curve is tangent to the budget constraint.

• At this point, the slope of the indifference curve equals the slope of the budget constraint:

$-\frac{MB_1}{MB_2} = -\frac{p_1}{p_2} \implies \frac{MB_1}{p_1} = \frac{MB_2}{p_2}$

• A price decrease for a good rotates the budget constraint outward, increasing the quantity demanded for that good.

Elasticity of Demand

• Price elasticity of demand: Measures responsiveness of quantity demanded to price changes.

$\varepsilon = \frac{\%\Delta Q}{\%\Delta P}$

• Arc elasticity:

$\text{arc } \varepsilon = \frac{\left( \frac{Q_{D,\text{new}} - Q_{D,\text{old}}}{\frac{Q_{D,\text{new}} + Q_{D,\text{old}}}{2}} \right)}{\left( \frac{P_{\text{new}} - P_{\text{old}}}{\frac{P_{\text{new}} + P_{\text{old}}}{2}} \right)}$

• Consumer surplus (CS): The difference between willingness to pay (MB) and the price paid.

Producer Behavior

The Firm's Problem

• Firms choose output to maximize profit:

$\Pi = \text{Revenue} - \text{Costs}$

• Short-run: At least one input is fixed.

• Long-run: All inputs are variable.

Cost Relationships

• Marginal Cost (MC): Change in total cost from producing one more unit.

• Average Total Cost (ATC): Total cost divided by quantity.

• Average Variable Cost (AVC): Variable cost divided by quantity.

• Average Fixed Cost (AFC): Fixed cost divided by quantity.

• Key relationships:

  • MC = ATC at ATC's minimum

  • MC = AVC at AVC's minimum

  • If MC < ATC, ATC is decreasing; if MC > ATC, ATC is increasing

  • AFC = ATC − AVC; AFC approaches zero as output increases

Firm's Production Decision (Short-run)

• Produce where MR = MC as long as P > AVC.

• If P = AVC, the firm is indifferent between producing and shutting down.

• If P < AVC, the firm should shut down in the short run.

• The shutdown point is where P = MC = AVC (minimum AVC).

Firm's Supply Curve

• The supply curve shows the quantity a firm will supply at different prices.

• Short-run supply is vertical at P < AVC and equals MC for P ≥ AVC.

• Producer surplus (PS): Difference between market price and willingness to accept.

Price Elasticity of Supply

• Measures responsiveness of quantity supplied to price changes:

$\varepsilon = \frac{\%\Delta Q_S}{\%\Delta P}$

• Arc elasticity formula:

$\text{arc } -\varepsilon = \frac{\left( \frac{Q_{S,\text{new}} - Q_{S,\text{old}}}{\frac{Q_{S,\text{new}} + Q_{S,\text{old}}}{2}} \right)}{\left( \frac{P_{\text{new}} - P_{\text{old}}}{\frac{P_{\text{new}} + P_{\text{old}}}{2}} \right)}$

• Interpretation:

  • |ε| = ∞: Perfectly elastic

  • |ε| = 1: Unit elastic

  • |ε| = 0: Perfectly inelastic

  • 0 < |ε| < 1: Inelastic

  • 1 < |ε| < ∞: Elastic

Market Efficiency and Long-Run Equilibrium

Long-Run Dynamics

• In long-run equilibrium, identical firms earn zero economic profit.

• If profits are positive, new firms enter, increasing supply and lowering price until profits are zero.

• If profits are negative, firms exit, decreasing supply and raising price until profits are zero.

Market Efficiency

• Competitive equilibrium maximizes total well-being (social surplus).

• Efficient allocation of goods, production, and resources.

• Market distortions (e.g., taxes, price controls, externalities) can reduce efficiency.

• Trade-off exists between efficiency (maximizing surplus) and equity (fairness).

Trade and Comparative Advantage

Production Possibilities and Gains from Trade

• The production possibilities curve (PPC) shows efficient production combinations.

• Trade occurs when parties have comparative advantage in different goods.

• Each party specializes in their comparative advantage; terms of trade must lie between opportunity costs.

• Trade creates winners and losers:

  • Exporters: Sellers win, buyers lose

  • Importers: Buyers win, sellers lose

Externalities

Definition and Types

• Externalities are costs or benefits imposed on third parties not directly involved in a transaction.

• Negative externality: Market activity imposes a cost (e.g., pollution).

• Positive externality: Market activity provides a benefit (e.g., education).

Measuring Externalities

• Negative externality:

$\text{Social Cost} = \text{Private Cost} + \text{External Cost}$

$\text{Marginal Social Cost (MSC)} = \text{Marginal Private Cost (MPC)} + \text{Marginal External Cost (MEC)}$

• If MEC = 0, then MSC = MPC (no externality).

• Firms typically consider only MPC, not MEC.

• Positive externality:

$\text{Social Benefit} = \text{Private Benefit} + \text{External Benefit}$

$\text{Marginal Social Benefit (MSB)} = \text{Marginal Private Benefit (MPB)} + \text{Marginal External Benefit (MEB)}$

• If MEB = 0, then MSB = MPB (no externality).

• Consumers typically consider only MPB, not MEB.

Consequences and Solutions

• Negative externalities: Market produces more than efficient quantity; deadweight loss (DWL) results.

• Positive externalities: Market produces less than efficient quantity; DWL results.

• Efficient outcome: $P = MB = MC$ or $P = MSB = MSC$.

Graphical Representation of Negative Externality

• Without externality: Supply = MPC = MSC; Demand = MPB = MSB.

• With negative externality: MSC > MPC; market quantity exceeds efficient quantity.

• Deadweight loss and external cost are created by overproduction.

Private and Government Solutions

• Private solutions: Bargaining (Coase Theorem), social norms.

• Government solutions:

  • Command-and-control (direct regulation, quantity restrictions)

  • Market-based policies (Pigouvian taxes/subsidies to internalize externalities)

Markets for Factors of Production

Labor Markets

• Value of Marginal Product of Labor (VMPL): The additional value a worker adds to the firm.

• Labor-leisure trade-off: Workers allocate time between labor and leisure.

• Wage differences arise from:

  • Human capital

  • Compensating wage differentials

  • Discrimination

  • Skill-biased technological change

Monopoly

Monopoly Market Structure

• A monopoly is a market with a single seller and high barriers to entry.

• The monopolist faces the market demand curve and can set prices.

• Profit maximization: Choose output where MR = MC, set price from demand curve.

• Monopoly price is higher and quantity lower than in perfect competition.

• Monopolies are inefficient; total surplus is not maximized.

• Efficiency can be improved by price discrimination or regulation.

Natural Monopoly and Economies of Scale

• A natural monopoly arises when a single firm can supply the market at lower cost due to economies of scale.

• Average total cost (ATC) declines over the relevant range of output.

Oligopoly and Monopolistic Competition

Market Structures

• Oligopoly: Few firms; actions of one affect others.

• Monopolistic competition: Many firms, differentiated products, free entry and exit.

• Oligopolies with identical products and costs can achieve competitive outcomes (P = MR = MC).

• Monopolistic competition yields zero long-run profit due to entry/exit.

• Buyer-side market structures: Monopsony (1 buyer), Oligopsony (few buyers), etc.

Bertrand Competition (Duopoly with Homogeneous Products)

• Two firms compete by setting prices; the lower-priced firm captures the market.

• Residual demand for each firm depends on relative prices.

Firm A Price (PA) vs. Firm B Price (PB)	Firm A's Demand
PA < PB	500
PA = PB	250
PA > PB	0

Monopolistic Competition: Short-run and Long-run

• Short-run: Firms can earn positive profit if demand is high.

• Long-run: Entry of new firms shifts demand left and makes it more elastic; profits are driven to zero.

• Markup and deadweight loss persist due to product differentiation.

Summary Table: Market Structures

Market Structure	Number of Firms	Product Type	Entry/Exit	Long-run Profit
Perfect Competition	Many	Identical	Free	Zero
Monopoly	One	Unique	Blocked	Positive
Oligopoly	Few	Identical or Differentiated	Barriers	Possible
Monopolistic Competition	Many	Differentiated	Free	Zero

Additional info: These notes cover the foundational topics in microeconomics, including consumer and producer theory, market structures, externalities, and factor markets, as outlined in a typical college-level microeconomics course.