ECON 2001 Microeconomics Review: Principles, Consumer and Producer Behavior, Market Structures, and Externalities

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, examining how their decisions influence prices, resource allocation, and the well-being of other agents.

• Economic agents: Individuals, households, firms, governments.

• Scarce resources: Resources for which wants exceed availability.

Three Principles of Economics

Optimization, Equilibrium, and Empiricism

The study of economics is built on three main principles:

• Optimization: Agents choose the best feasible alternative, maximizing net benefits ($\text{Net Benefits} = \text{Benefits} - \text{Costs}$).

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

• Empiricism: Using data and models to understand and predict economic behavior.

Optimization Methods

Total Values and Marginal Analysis

Optimal choices can be determined by:

• Optimization using total values: Choose the alternative with the highest net benefit.

• Optimization using marginal analysis: Compare changes in costs and benefits when moving between alternatives. The optimal choice is where moving toward it increases net benefit, and moving away decreases it.

Markets and Perfect Competition

Market Structure and Price Takers

A market is a group of agents trading goods or services 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 and Demand

Consumers decide how much of each good to buy by solving the buyer's problem:

• Preferences, prices, and budget are key components.

• Optimal bundle is where $\frac{MB_1}{p_1} = \frac{MB_2}{p_2}$ and the budget is exhausted ($I = p_1x_1 + p_2x_2$).

• Demand schedule: Table of quantities demanded at different prices.

• Demand curve: Graphical representation of the demand schedule.

Example: The Buyer's Problem 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

Example: With income $24, milk price $4, cookie price $2, the optimal bundle is where$\frac{MB_{milk}}{p_{milk}} = \frac{MB_{cookie}}{p_{cookie}}$ and the budget is exhausted.

Graphical Depiction: Indifference Curves and Budget Constraint

• Indifference curves ($U_1, U_2, U_3$) represent different utility levels.

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

• Mathematically: $-\frac{MB_1}{MB_2} = -\frac{p_1}{p_2}$ or $\frac{MB_1}{p_1} = \frac{MB_2}{p_2}$.

• Price changes rotate the budget constraint, changing the optimal bundle.

Demand Elasticity

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

• Formula: $\text{Elasticity} = \frac{\%\Delta Q}{\%\Delta P}$

• Arc elasticity: $\text{Arc } \epsilon = \frac{\frac{Q_{D,new} - Q_{D,old}}{\frac{Q_{D,new} + Q_{D,old}}{2}}}{\frac{P_{new} - P_{old}}{\frac{P_{new} + P_{old}}{2}}}$

• Cross-price elasticity: Measures response to price changes of related goods.

• Income elasticity: Measures response to income changes.

Consumer Surplus

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

Producer Behavior

The Firm's Problem

Firms choose output to maximize profit:

• 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): MC = ATC at ATC's minimum; MC = AVC at AVC's minimum.

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

• Average Fixed Cost (AFC): $\text{AFC} = \text{ATC} - \text{AVC}$; AFC approaches zero as output increases.

Firm's Production Decision Rules (Short-run)

• Expand production until $MR = MC$ as long as $P > AVC$.

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

• If $P < AVC$, firm should shut down (short-run decision).

Graphical Summary of Costs and Profits

• MC intersects ATC and AVC at their minimum points.

• Profit: $\Pi = q(P - ATC)$

• Revenue, variable cost, fixed cost, and total cost can be visualized on cost curves.

Supply Curve and Producer Surplus

Firm's Supply Curve

• Shows quantity supplied at different prices.

• Short-run supply curve: vertical at $0 \leq P < AVC$, equals MC at $P \geq AVC$.

Producer Surplus

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

Price Elasticity of Supply

• Formula: $\epsilon = \frac{\%\Delta Q_S}{\%\Delta P}$

• Arc elasticity: $\text{Arc } -\epsilon = \frac{\frac{Q_{S,new} - Q_{S,old}}{\frac{Q_{S,new} + Q_{S,old}}{2}}}{\frac{P_{new} - P_{old}}{\frac{P_{new} + P_{old}}{2}}}$

Interpreting Elasticities

|ε| Value	Type	Interpretation
∞	Perfectly elastic	Small price change leads to infinite quantity change
1	Unit elastic	Equal percentage change in price and quantity
0	Perfectly inelastic	Quantity does not respond to price
0 < |ε| < 1	Inelastic	Quantity responds less than price
1 < |ε| < ∞	Elastic	Quantity responds more than price

Long-Run Market Dynamics

Entry and Exit

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

• Positive profits ($\Pi > 0$) attract entry, increasing supply and lowering price until $\Pi = 0$.

• Negative profits ($\Pi < 0$) cause exit, decreasing supply and raising price until $\Pi = 0$.

Market Efficiency and Distortions

Competitive Equilibrium

• Maximizes total well-being (social surplus).

• Minimizes production costs.

• Maximizes total value of production.

Market Distortions

• Command-based policies, price controls, taxes, externalities.

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

Trade and Comparative Advantage

Production Possibilities and Specialization

• PPC represents efficient production combinations.

• Trade occurs when parties have 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

• Externality: Benefit or cost imposed on third parties not involved in the transaction.

• Negative externality: Spillover cost (e.g., pollution).

• Positive externality: Spillover benefit (e.g., education).

Negative Externality

• Social cost exceeds private cost: $\text{Social Cost} = \text{Private Cost} + \text{External Cost}$

• Marginal External Cost: $\text{MEC} = \text{MSC} - \text{MPC}$

• Firms only consider MPC, not MEC.

Positive Externality

• Social benefit exceeds private benefit: $\text{Social Benefit} = \text{Private Benefit} + \text{External Benefit}$

• Marginal External Benefit: $\text{MEB} = \text{MSB} - \text{MPB}$

• Consumers only consider MPB, not MEB.

Consequences of Externalities

• Negative: Market produces beyond efficient level, generating deadweight loss (DWL).

• Positive: Market produces below efficient level, also generating DWL.

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

Graphical Representation of Negative Externality

• Efficient market: $S = MPC = MSC$, $D = MPB = MSB$.

• Inefficient market: $S = MPC$, $MSC$ above $MPC$.

• External cost per unit: $MEC = MSC - MPC$.

• Deadweight loss and social surplus loss illustrated.

Solutions to Externalities

Private Solutions

• Bargaining (Coase Theorem): Agents negotiate to internalize externality.

• Doing the right thing: Voluntary internalization.

Government Solutions

• Command-and-control: Direct regulation (quantity restrictions).

• Market-based policies: Incentives for internalization (Pigouvian taxes/subsidies).

Factor Markets

Labor Demand and Supply

• Worker's value: $VMP_L$ (Value of Marginal Product of Labor).

• Labor-leisure trade-off determines supply.

• Wage differences arise from human capital, compensating differentials, discrimination, and skill-biased technological change.

Monopoly

Characteristics and Efficiency

• Single seller, high barriers to entry, market power.

• Monopolist faces market demand; can earn positive long-run profits.

• Optimal output: $MR = MC$; price set at consumer's willingness to pay for last unit.

• $P_{monopoly} > P_{perfect competition}$; monopolies are inefficient.

• Efficiency can be restored via price discrimination or regulation.

Natural Monopoly

• Economies of scale: ATC decreases as output increases.

• Monopolist produces where $MR = MC$ and sets price accordingly.

Oligopoly and Monopolistic Competition

Market Structures and Outcomes

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

• Monopolistic competition: Many firms, differentiated products.

• Oligopolies with identical products and costs can achieve $P = MR = MC$ (efficient outcome).

• Monopolistic competition: Long-run profits are zero due to free entry/exit.

Buyer-Side Market Structures

• Monopsony: One buyer.

• Oligopsony: Few buyers.

• Monopsonistic competition: Many buyers, differentiated products.

• Perfect competition: Many sellers, identical products.

Bertrand Competition (Duopoly)

• Two firms, homogeneous products.

• Residual demand for firm A: $D = \begin{cases} 500, & \text{if } P_A < P_B \text{ and } 0 \leq P_A \leq 100 \\ 250, & \text{if } P_A = P_B \text{ and } 0 \leq P_A \leq 100 \\ 0, & \text{if } P_A > P_B \end{cases}$

• Firms compete in prices; lower price wins the market.

Monopolistic Competitor's Problem: Short-run and Long-run

• Short-run: Firms can earn positive profits ($\Pi > 0$).

• Long-run: Entry shifts demand down, becomes more elastic; profits go to zero.

• Markup and deadweight loss exist in monopolistic competition.

Additional info: These notes cover the foundational topics in microeconomics, including principles, consumer and producer behavior, market structures, efficiency, externalities, and factor markets, as outlined in standard college microeconomics courses.