Microeconomics: Core Principles, Markets, and Applications – Study Guide

Chapter 1 – Foundations of Economics

Positive vs. Normative Economics

Economics distinguishes between statements of fact and statements of opinion or value judgment.

• Positive Economics: Describes and explains economic phenomena as they are. These statements can be tested and validated or refuted. Example: “The unemployment rate is 4%.”

• Normative Economics: Involves value judgments about what the economy should be like or what particular policy actions should be recommended. These statements cannot be tested scientifically. Example: “The government should raise the minimum wage.”

• Tip: Words like should, ought, or better signal normative statements.

Core Economic Principles

• Scarcity Requires Choice: Resources (time, money, labor, land) are limited, so choices must be made about their use.

• Opportunity Cost: The value of the next best alternative forgone when making a choice. Example: Studying for an exam instead of working means the opportunity cost is the wages not earned.

• Rationality: Individuals make decisions to maximize their benefit given constraints. Rational does not mean perfect, but rather choosing the option with the highest benefit relative to cost.

• Incentives Matter: People respond to rewards and penalties. Example: Higher wages attract more workers; taxes on cigarettes reduce smoking.

• Marginal Decisions: Choices are made at the margin, weighing additional benefits against additional costs. Example: Deciding whether to study one more hour involves comparing the marginal benefit (better grade) to the marginal cost (less leisure).

Other Economic Tools

• Ceteris Paribus: Latin for “all else held constant.” Used to isolate the effect of one variable.

• Secondary Effects: Economic actions often have unintended consequences. Example: Minimum wage increases may lead to higher wages but also fewer jobs.

• Association vs. Causation: Just because two variables move together does not mean one causes the other. Example: Ice cream sales and drowning both rise in summer, but heat is the underlying cause.

Three Economic Questions

• What to produce?

• How to produce?

• For whom to produce?

Market vs. Centrally Planned Economies

• Market Economy: Decisions made by individuals and firms; prices guide behavior. Pros: Efficiency, innovation, responsiveness. Cons: Inequality, possible market failures.

• Centrally Planned Economy: Government makes production decisions. Pros: Can reduce inequality, prioritize social goals. Cons: Inefficiency, poor information, less innovation.

Chapter 2 – Trade-offs, Opportunity Cost, and the PPF

Opportunity Cost

Every choice involves a trade-off due to scarcity. The opportunity cost is the value of the next best alternative forgone.

• Example: If you can produce 10 pizzas or 5 computers, the opportunity cost of 1 computer is 2 pizzas, and the opportunity cost of 1 pizza is 0.5 computer.

Production Possibilities Frontier (PPF)

The PPF is a graph showing the maximum combinations of two goods an economy can produce given its resources and technology.

• Points on the curve: Efficient (full use of resources)

• Inside the curve: Inefficient (unemployment/wasted resources)

• Outside the curve: Impossible with current resources

• Shape: Usually bowed outward (concave) due to increasing opportunity cost and resource specialization.

Law of Increasing Opportunity Cost

• As production of one good increases, the opportunity cost of producing additional units rises because resources are not equally suited to all activities.

Shifts and Rotations of the PPF

• Outward Shift: Economic growth (more resources or better technology).

• Inward Shift: Resource loss (war, disaster).

• Rotation: Biased growth (improvement in production of one good only).

Absolute vs. Comparative Advantage

• Absolute Advantage: Ability to produce more output with the same resources.

• Comparative Advantage: Ability to produce a good at a lower opportunity cost. This determines the basis for trade.

• Law of Comparative Advantage: Even if one party is better at everything, both can benefit from trade by specializing according to comparative advantage.

Chapter 3 – Markets: Demand and Supply

What is a Market?

A market is any arrangement where buyers and sellers interact to exchange goods and services, with prices coordinating decisions.

Demand

• Law of Demand: As price increases, quantity demanded decreases (and vice versa). Demand curves slope downward.

• Substitution Effect: Higher prices lead consumers to substitute other goods.

• Income Effect: Higher prices reduce purchasing power.

• Market Demand: The horizontal sum of all individual demand curves.

Supply

• Law of Supply: As price increases, quantity supplied increases. Supply curves slope upward.

• Market Supply: The horizontal sum of all individual supply curves.

Equilibrium

• Occurs where quantity demanded equals quantity supplied.

• Equilibrium Price: The price at which the market clears.

• Shortage: Price below equilibrium; quantity demanded exceeds quantity supplied; price rises.

• Surplus: Price above equilibrium; quantity supplied exceeds quantity demanded; price falls.

Shifts vs. Movements

• Movement along a curve: Caused by a change in price.

• Shift of a curve: Caused by changes in non-price factors (income, tastes, expectations, number of buyers/sellers, input costs, technology, taxes/subsidies).

Summary Table: Effects of Shifts

Case	Price	Quantity
Demand increases	Up	Up
Supply increases	Down	Up
Demand decreases	Down	Down
Supply decreases	Up	Down
Both increase	Ambiguous	Up
Both decrease	Ambiguous	Down

Chapter 4 – Economic Efficiency, Price Controls, and Taxes

Consumer and Producer Surplus

• Consumer Surplus: Willingness to pay minus price paid; area below demand curve and above price.

• Producer Surplus: Price received minus cost of production; area above supply curve and below price.

• Total Surplus: Sum of consumer and producer surplus; measures total gains from trade.

Economic Efficiency

• Market is efficient when goods go to those who value them most and are produced at lowest cost.

• At equilibrium: marginal benefit equals marginal cost; total surplus is maximized; no deadweight loss.

Price Controls

• Price Ceiling: Legal maximum price. If set below equilibrium (binding), causes shortages, black markets, and reduced quality. Example: Rent control.

• Price Floor: Legal minimum price. If set above equilibrium (binding), causes surpluses and waste. Example: Minimum wage.

Taxes

• Taxes create a wedge between price buyers pay and price sellers receive, reducing quantity traded.

• Tax Incidence: The burden of a tax falls more on the side of the market that is more inelastic.

• Deadweight Loss: Loss of total surplus due to market distortion (taxes or price controls).

Chapter 6 – Elasticity: Responsiveness of Demand and Supply

Price Elasticity of Demand (PED)

• Definition: Measures how much quantity demanded responds to a change in price.

• Formula: $PED = \frac{\%\ Change\ in\ Quantity\ Demanded}{\%\ Change\ in\ Price}$

• Elasticity is usually negative (law of demand), but we use the absolute value.

• Elastic: PED > 1 (very responsive)

• Inelastic: PED < 1 (not very responsive)

• Unit Elastic: PED = 1 (proportional response)

Determinants of Demand Elasticity

• Availability of substitutes (more substitutes = more elastic)

• Necessity vs. luxury (necessities = inelastic, luxuries = elastic)

• Share of income (expensive goods = more elastic)

• Time horizon (longer time = more elastic)

Elasticity and Total Revenue

• Total Revenue (TR): $TR = P \times Q$

• If demand is elastic, price increase lowers TR; if inelastic, price increase raises TR.

Other Elasticities

• Cross-Price Elasticity of Demand (XED): $XED = \frac{\%\ Change\ in\ Quantity\ of\ Good\ A}{\%\ Change\ in\ Price\ of\ Good\ B}$ Positive for substitutes, negative for complements.

• Income Elasticity of Demand (YED): $YED = \frac{\%\ Change\ in\ Quantity\ Demanded}{\%\ Change\ in\ Income}$ Positive for normal goods, negative for inferior goods.

• Price Elasticity of Supply (PES): $PES = \frac{\%\ Change\ in\ Quantity\ Supplied}{\%\ Change\ in\ Price}$ More elastic in the long run and when production can be easily scaled.

Chapter 10 – Consumer Choice and Behavioral Economics

Utility

• Utility: Satisfaction or happiness from consuming goods/services.

• Total Utility (TU): Total satisfaction from consumption.

• Marginal Utility (MU): Extra satisfaction from one more unit.

Law of Diminishing Marginal Utility

• As more of a good is consumed, marginal utility decreases.

• Explains why demand curves slope downward.

Optimal Choice Rule

• Consumers maximize utility by equalizing marginal utility per dollar across goods and spending all income.

• Formula: $\frac{MU_A}{P_A} = \frac{MU_B}{P_B}$

• If not equal, shift spending toward the good with higher MU per dollar.

Substitution and Income Effects

• Substitution Effect: When a good becomes cheaper, consumers buy more of it relative to others.

• Income Effect: Lower prices increase purchasing power, allowing more consumption.

Social Influences and Sunk Costs

• Celebrity endorsements, network externalities, and fairness can affect demand.

• Sunk Cost Fallacy: Rational decisions should ignore costs that cannot be recovered.

Chapter 11 – Technology, Production, and Costs

Short Run vs. Long Run

• Short Run: At least one input is fixed (e.g., capital).

• Long Run: All inputs are variable; firms can fully adjust production.

Types of Costs

• Fixed Costs (FC): Do not change with output (e.g., rent).

• Variable Costs (VC): Change with output (e.g., labor, materials).

• Total Cost (TC): $TC = FC + VC$

• Average Fixed Cost (AFC): $AFC = \frac{FC}{Q}$ (always falls as output increases)

• Average Total Cost (ATC): $ATC = \frac{TC}{Q} = AFC + AVC$

Marginal Concepts

• Marginal Product of Labor (MPL): Extra output from one more worker.

• Law of Diminishing Returns: Adding more of a variable input to a fixed input eventually decreases marginal product.

• Marginal Cost (MC): Cost of producing one more unit. Relationship: When MPL falls, MC rises.

Shapes of Cost Curves

• MC, AVC, and ATC are U-shaped; MC intersects AVC and ATC at their minimums.

• AFC always slopes downward.

Implicit vs. Explicit Costs

• Explicit Costs: Actual monetary payments (e.g., wages, rent).

• Implicit Costs: Opportunity costs of using own resources (e.g., owner’s time).

Accounting vs. Economic Profit

• Accounting Profit: Revenue minus explicit costs.

• Economic Profit: Revenue minus explicit and implicit costs (always less than accounting profit).

Long Run Average Cost (LRAC)

• LRAC is typically U-shaped due to economies and diseconomies of scale.

• Economies of Scale: Cost per unit falls as output increases (specialization, bulk buying).

• Diseconomies of Scale: Cost per unit rises as firm becomes too large (management issues).

Chapter 12 – Perfect Competition

Characteristics

• Many buyers and sellers, identical products, free entry/exit, perfect information, firms are price takers.

Market vs. Firm Graphs

• Market: Downward-sloping demand, upward-sloping supply; determines equilibrium price.

• Firm: Faces perfectly elastic (horizontal) demand at market price.

Marginal Revenue (MR)

• For a competitive firm, $MR = P$ (price taker).

Profit Maximization

• Produce where $MR = MC$ (with MC rising).

• Profit Formula: $Profit = (P - ATC) \times Q$

• Shutdown Rule (Short Run): Shut down if $P < AVC$.

Supply Curves

• Firm’s supply curve is MC above AVC.

• Market supply is the sum of all firms’ supply curves.

Entry and Exit (Long Run)

• Profits attract entry (supply increases, price falls); losses cause exit (supply decreases, price rises).

• Long Run Equilibrium: $P = MR = MC = ATC$ (zero economic profit).

• Allocative Efficiency: $P = MC$ (resources used efficiently).

Chapter 15 – Monopoly and Antitrust Policy

Characteristics of Monopoly

• Single seller, no close substitutes, high barriers to entry, price maker.

Barriers to Entry

• Government restrictions (licenses, patents)

• Control of key resources

• Network externalities

• Natural monopoly (economies of scale)

Demand and Marginal Revenue

• Monopoly faces downward-sloping demand; MR lies below demand.

• To sell more, must lower price for all units; thus, $MR < P$.

Profit Maximization

• Produce where $MR = MC$; price is found on demand curve at that quantity.

• Profit Formula: $Profit = (P - ATC) \times Q$

• Shutdown Rule: Shut down if $P < AVC$.

• Monopoly is inefficient: $P > MC$; deadweight loss exists.

Comparison: Monopoly vs. Perfect Competition

Feature	Perfect Competition	Monopoly
Firms	Many	One
Price	= MC	> MC
Efficiency	Efficient	Inefficient
MR	= P	< P

Antitrust Laws & Enforcement

• Sherman and Clayton Acts regulate monopolies.

• Market concentration measured by HHI (Herfindahl-Hirschman Index): $HHI = \sum (market\ share)^2$

• Barriers to entry and cost efficiencies are considered in merger evaluations.

Chapter 13 – Monopolistic Competition

Characteristics

• Many firms, differentiated products, free entry/exit, some price control, non-price competition (ads, branding).

Demand and Marginal Revenue

• Each firm faces a downward-sloping demand curve; MR is below demand.

Profit Maximization

• Produce where $MR = MC$; price is set from demand curve.

• Profit Formula: $Profit = (P - ATC) \times Q$

• Shutdown Rule: Shut down if $P < AVC$.

Long Run Equilibrium

• Entry and exit drive economic profit to zero: $P = ATC$ (but $P > MC$).

• Firms do not produce at minimum ATC; excess capacity and deadweight loss exist.

Positive Effects of Differentiation

• Variety for consumers

• Innovation

• Non-price competition (service, branding)

Chapter 14 – Oligopoly and Game Theory

Characteristics of Oligopoly

• Few large firms, products may be identical or differentiated, strategic interdependence, barriers to entry.

Game Theory Basics

• Outcomes depend on decisions of multiple players (firms).

• Dominant Strategy: Best choice regardless of rivals’ actions.

• Prisoner’s Dilemma: Rational self-interest leads to worse collective outcome.

• Nash Equilibrium: No player wants to change strategy given others’ choices; stable but not always optimal.

• Repeated Games: Cooperation more likely over time; firms can punish cheating.

• Sequential Games: One player moves first; backward induction used to determine optimal strategies.

• Subgame-Perfect Nash Equilibrium (SPNE): Nash equilibrium optimal in every part of the game.

• Entry Deterrence: Incumbents may set low prices or build excess capacity to discourage entry.

• Bargaining: Outcomes depend on outside options, patience, and bargaining power.

Chapter 5 – Externalities, Environmental Policy, and Public Goods

Public Goods

• Non-excludable: Cannot prevent people from using it.

• Non-rival: One person’s use does not reduce availability for others.

• Examples: National defense, street lighting, public parks.

• Demand for Public Goods: Vertically sum individual demand curves (everyone consumes the same quantity).

Socially Optimal Output

• Produce where marginal social benefit (MSB) equals marginal social cost (MSC): $MSB = MSC$

Market Failure: Free Rider Problem

• People benefit without paying; private markets under-produce public goods.

Externalities

• Externality: When a decision affects third parties not involved in the transaction.

• Negative Externalities: Harm to third parties (e.g., pollution).

• Positive Externalities: Benefits to third parties (e.g., education).

• Private vs. Social Costs: $MSC = MPC + external\ cost$ $MSB = MPB + external\ benefit$

• Negative externality: $MSC > MPC$ (overproduction); positive externality: $MSB > MPB$ (underproduction).

Solutions to Externalities

• Private Solutions (Coase Theorem): If property rights are well-defined and transaction costs are low, private bargaining can solve externalities.

• Government Intervention:

  • Taxes (Pigovian taxes) for negative externalities (set equal to marginal external cost).

  • Subsidies for positive externalities.

  • Tradable permits (cap-and-trade) for pollution control.

• Optimal Pollution Reduction: $MSC = MSB$ (marginal cost of reduction equals marginal benefit).

Chapter 16 – The Markets for Labor and Other Factors of Production

Labor Demand

• Derived from demand for the firm’s output.

• Marginal Revenue Product of Labor (MRP): $MRP = MR \times MPL$

• Firms hire where $MRP = W$ (wage).

• Labor demand curve is downward sloping due to diminishing marginal product.

Labor Supply

• Individuals choose between work (income) and leisure (free time).

• Substitution Effect: Higher wage increases work (leisure is more expensive).

• Income Effect: Higher wage increases leisure (can afford more leisure).

• At high wages, labor supply may bend backward (income effect dominates).

Labor Market Equilibrium

• Occurs where labor demand equals labor supply; determines equilibrium wage and employment.

Shifts in Labor Demand and Supply

• Labor Demand: Increases with higher output demand, productivity, or output prices.

• Labor Supply: Increases with population growth, immigration, or higher participation.

Explaining Wage Differences

• Differences in demand and supply for skills, compensating differentials (risk, unpleasantness), discrimination, and labor unions.