Comprehensive Microeconomics Study Notes: Core Principles, Models, and Applications

Basic Principles of Economics

Introduction to Microeconomics

Microeconomics studies the allocation of scarce resources and the incentives faced by decision-makers, including consumers, producers, and governments. It analyzes how these agents interact in markets to maximize welfare.

• Scarcity: Resources are limited, so choices must be made about their allocation.

• Positive vs. Normative Economics: Positive economics describes the world as it is, while normative economics prescribes how it ought to be.

• Opportunity Cost: The value of the best alternative forgone when making a decision.

• Economic Agents: Consumers, producers, and governments interact in markets, using price signals to allocate goods and services.

• Models: Simplified representations used to highlight key mechanisms, but always context-dependent and with limitations.

Consumer Theory

Utility Maximization and Demand

Consumers aim to maximize their utility (satisfaction) given their budget constraints. They respond to changes in prices and income, and their choices are subject to rationality assumptions.

• Utility: A measure of satisfaction derived from consuming goods and services.

• Budget Constraint: The set of all bundles a consumer can afford given prices and income.

• Diminishing Marginal Utility: The additional satisfaction from consuming one more unit of a good decreases as consumption increases.

• Price Elasticity of Demand: Measures how much quantity demanded responds to a change in price.

Formula:

$\text{Price Elasticity of Demand} = \frac{\%\ \text{Change in Quantity Demanded}}{\%\ \text{Change in Price}}$

• Substitutes: Goods with positive cross-price elasticity.

• Complements: Goods with negative cross-price elasticity.

• Aggregate Demand: Summing individual demands yields the market demand curve.

• Marginal Benefit: The demand curve reflects consumers' willingness to pay for each additional unit.

Producer Theory

Production, Costs, and Supply

Firms are organizations that transform inputs into outputs, aiming to maximize profits by choosing optimal input combinations and output levels.

• Production Function: $q = F(K, L)$, where $K$ is capital and $L$ is labor.

• Isocost Line: Combinations of $K$ and $L$ that cost the same.

• Isoquant: Combinations of $K$ and $L$ that produce the same output.

• Marginal Product (MP): The additional output from using one more unit of an input.

• Diminishing Marginal Product: Additional output from an input decreases as more is used.

• Returns to Scale:

  • Increasing Returns to Scale (IRS): Output increases more than proportionally with inputs.

  • Constant Returns to Scale (CRS): Output increases proportionally with inputs.

  • Decreasing Returns to Scale (DRS): Output increases less than proportionally with inputs.

• Short Run vs. Long Run: In the short run, at least one input is fixed; in the long run, all inputs are variable.

Cost Concepts:

• Total Cost (TC): $TC(q) = FC + VC(q)$

• Fixed Cost (FC): Costs that do not vary with output.

• Variable Cost (VC): Costs that vary with output.

• Average Total Cost (ATC): $ATC = \frac{TC}{q}$

• Average Variable Cost (AVC): $AVC = \frac{VC}{q}$

• Marginal Cost (MC): $MC = \frac{dTC}{dq}$

Economies of Scale: ATC decreases as output increases (IRS). Diseconomies of Scale: ATC increases as output increases (DRS).

Market Structures

Perfect Competition

In perfectly competitive markets, many firms sell identical products, and no single firm can influence the market price. Firms are price takers and maximize profit by choosing output where price equals marginal cost.

• Profit Maximization: $P = MC$

• Short Run: Firms produce if $P \geq AVC_{min}$

• Long Run: Firms enter or exit until $P = ATC_{min}$ and economic profits are zero.

• Market Equilibrium: Quantity supplied equals quantity demanded at the equilibrium price.

• Allocative Efficiency: Goods are allocated to those who value them at least as much as their marginal cost.

Monopoly

A monopoly exists when a single firm is the sole producer of a good with no close substitutes, often due to barriers to entry. The monopolist is a price maker and maximizes profit where marginal revenue equals marginal cost.

• Barriers to Entry: Legal restrictions, control over resources, economies of scale, network effects.

• Profit Maximization: $MR = MC$

• Lerner Index: $L = \frac{P - MC}{P}$ (measures market power)

• Inefficiency: Monopolies create deadweight loss due to reduced output and higher prices compared to perfect competition.

• Price Discrimination:

  • First-degree: Each consumer charged their maximum willingness to pay.

  • Second-degree: Different prices for different quantities or versions.

  • Third-degree: Different prices for different groups.

Monopolistic Competition

Many firms sell differentiated products. Each firm has some market power but free entry and exit drive profits to zero in the long run. Inefficiency remains due to excess capacity.

• Short Run: Firms act as monopolists for their own product.

• Long Run: Entry and exit erode profits, but firms do not produce at minimum ATC.

Oligopoly and Game Theory

Oligopoly markets have a few firms whose decisions are interdependent. Game theory analyzes strategic interactions among firms.

• Game Elements: Players, strategies, payoffs, information.

• Dominant Strategy: Always yields the highest payoff regardless of others' choices.

• Nash Equilibrium: No player can improve their payoff by unilaterally changing strategy.

• Mixed Strategy Nash Equilibrium: Players randomize over strategies.

• Subgame Perfect Equilibrium: Nash equilibrium in every stage of a dynamic game (found by backward induction).

Oligopoly Models

• Bertrand Competition: Firms compete by setting prices; equilibrium price equals marginal cost.

• Cournot Competition: Firms compete by setting quantities; equilibrium output is between monopoly and perfect competition.

• Stackelberg Competition: Firms choose output sequentially; first mover has an advantage.

• Cartels: Firms collude to set monopoly price/quantity, but such arrangements are unstable due to incentives to cheat.

Welfare, Surplus, and Policy

Consumer and Producer Surplus

Economic welfare is measured by consumer and producer surplus.

• Consumer Surplus: Difference between willingness to pay and price paid.

• Producer Surplus: Difference between price received and willingness to accept (cost).

Taxes, Subsidies, and Price Controls

• Taxes: Shift supply or demand, create deadweight loss, and the burden depends on elasticities.

• Subsidies: Increase supply or demand, can also create inefficiencies.

• Price Ceilings/Floors: Legal maximum/minimum prices; can cause shortages, surpluses, and black markets.

Tax Incidence: The division of the tax burden between buyers and sellers depends on the relative elasticities of supply and demand, not on whom the tax is levied.

Externalities and Public Goods

Externalities

Externalities occur when an agent's actions affect others' welfare outside of market transactions. They can be positive or negative, in consumption or production.

• Marginal Social Cost (MSC): $MSC = MPC + MEC$

• Marginal Social Benefit (MSB): $MSB = MPB + MEB$

• Pareto Inefficiency: Externalities lead to outcomes where it is possible to make someone better off without making others worse off.

Policy Solutions:

• Coasian Bargaining: Assign property rights and let parties negotiate (Coase Theorem).

• Regulations/Quotas: Directly limit or mandate behavior.

• Pigovian Taxes/Subsidies: Taxes or subsidies to internalize externalities.

• Price Controls: Set maximum or minimum prices.

Public Goods

• Non-Rival: One person's consumption does not reduce availability for others.

• Non-Excludable: Impossible or costly to prevent non-payers from consuming.

• Market Failure: Public goods are underprovided due to free-riding and the tragedy of the commons.

• Solutions: Voluntary provision, government provision, or policy interventions.

Asymmetric Information

Moral Hazard and Adverse Selection

Asymmetric information arises when one party has more or better information than another, leading to inefficiencies.

• Moral Hazard: When an agent's actions are unobservable and not perfectly contractible, leading to suboptimal effort.

• Principal-Agent Problem: The principal must design contracts to induce the agent to act in the principal's interest, subject to:

  • Individual Rationality (IR): Agent's utility must be at least as high as their outside option.

  • Incentive Compatibility (IC): Agent prefers the desired action over alternatives.

• Adverse Selection: Occurs when one party cannot distinguish between high and low quality (e.g., 'lemons' problem in used car markets).

• Market Collapse: If too many low-quality goods, high-quality sellers exit, reducing market efficiency.

• Solutions: Screening, signaling, guarantees, and information provision.

Intertemporal Choice and Investment

Present Value and Discounting

Intertemporal decisions involve trade-offs between present and future consumption, using interest rates to discount future values.

• Compound Interest: Interest is earned on both the initial principal and accumulated interest.

• Net Present Value (NPV): The present value of benefits minus costs; projects with positive NPV should be undertaken.

Formulas:

• NPV of Annuity: $NPV = \sum_{t=1}^{n} \frac{CF_t}{(1 + r)^t}$

• NPV of Perpetuity: $NPV = \frac{CF}{r}$

• NPV of Growing Perpetuity: $NPV = \frac{CF}{r - g}$

Cost-Benefit Analysis (CBA): Evaluates projects by comparing discounted benefits and costs, following the Kaldor-Hicks criterion (if total benefits exceed costs, the project is justified).

• Steps in CBA:

  1. Identify all projects to evaluate.

  2. Determine the affected population.

  3. Predict all impacts.

  4. Monetize impacts (using shadow prices if necessary).

  5. Conduct scenario and sensitivity analysis.

  6. Make recommendations.

• Potential Issues: Strategic errors, omission, measurement, forecasting, and valuation errors.

Summary Table: Market Structures Comparison

Market Structure	Number of Firms	Product Type	Entry Barriers	Market Power	Efficiency
Perfect Competition	Many	Homogeneous	None	None (Price Taker)	Allocative & Productive
Monopoly	One	Unique	High	High (Price Maker)	Neither
Monopolistic Competition	Many	Differentiated	Low	Some	Not Productive
Oligopoly	Few	Homogeneous or Differentiated	Medium to High	Some to High	Varies

Additional info: Some explanations and formulas have been expanded for clarity and completeness. Students should practice graphing key models (e.g., supply and demand, cost curves, monopoly deadweight loss) and solving for equilibrium in different market structures.