Microeconomics Midterm 2: Key Concepts and Applications

Consumer Choice and Demand

Budget Constraints and Indifference Curves

Consumer choice theory examines how individuals allocate their income among different goods to maximize utility. The budget constraint represents all combinations of goods a consumer can afford, while indifference curves show combinations that provide equal satisfaction.

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

• Indifference Curve: A curve representing all combinations of goods that yield the same utility to the consumer.

• Effects of Price and Income Changes: A decrease in the price of a good pivots the budget line outward, increasing the affordable quantity. An increase in income shifts the budget line outward in a parallel fashion.

• Normal vs. Inferior Goods: For normal goods, demand increases with income; for inferior goods, demand decreases as income rises.

• Example: If the price of apples falls and income rises, the budget line shifts and pivots, affecting the optimal consumption bundle.

Utility Maximization

Marginal Utility and the Optimal Consumption Rule

Consumers maximize utility by equating the marginal utility per dollar spent across all goods.

• Marginal Utility (MU): The additional satisfaction from consuming one more unit of a good.

• Optimal Consumption Rule:

  • For goods A, B, and C with prices $P_A$, $P_B$, $P_C$ and marginal utilities $MU_A$, $MU_B$, $MU_C$:

  • $\frac{MU_A}{P_A} = \frac{MU_B}{P_B} = \frac{MU_C}{P_C}$

• Budget Constraint: $P_A Q_A + P_B Q_B + P_C Q_C = \text{Income}$

• Example: If Sara's income is $54, and the prices of goods A, B, and C are $4, $6, and $4 respectively, she should allocate her spending so that the marginal utility per dollar is equalized across all goods.

Production and Costs

Production Functions and Marginal Product

Firms transform inputs into outputs using a production function. Key concepts include total product, average product, and marginal product.

• Total Product (TP): Total output produced by a given amount of input.

• Average Product (AP): Output per unit of input: $AP = \frac{TP}{L}$

• Marginal Product (MP): Additional output from one more unit of input: $MP = \frac{\Delta TP}{\Delta L}$

• Law of Diminishing Returns: As more of a variable input is added to fixed inputs, the marginal product eventually declines.

• Example Table:

Labor	TP (or q)	AP	MP
1	5	5	-
2	6	3	1
3	12	4	6
4	22	5.5	10
5	5	1	-

Additional info: Table values inferred for illustration; actual exam values may differ.

Cost Concepts

Firms face various costs in production, including fixed, variable, average, and marginal costs.

• Total Cost (TC): $TC = FC + VC$

• Average Cost (AC): $AC = \frac{TC}{Q}$

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

• Marginal Cost (MC): $MC = \frac{\Delta TC}{\Delta Q}$

• Relationship: MC intersects AC and AVC at their minimum points.

• Example: If the price of labor is $210 per unit, and the marginal cost of producing the 18th unit is $30, the firm uses this information to make production decisions.

Perfect Competition

Short-Run and Long-Run Decisions

In perfect competition, firms are price takers and maximize profit where marginal cost equals market price.

• Profit Maximization: $P = MC$

• Shutdown Rule: In the short run, a firm shuts down if $P < AVC$.

• Entry and Exit: In the long run, firms enter if $P > AC$ and exit if $P < AC$.

• Example: If the market price is $30 and the firm's AC at the profit-maximizing output is $26, the firm earns a profit per unit of $4.

Monopoly and Pricing Strategies

Monopoly Profit Maximization

A monopolist maximizes profit by producing where marginal revenue equals marginal cost ($MR = MC$), charging the highest price consumers are willing to pay for that quantity.

• Profit: $\text{Profit} = (P - AC) \times Q$

• Deadweight Loss: The loss of total surplus due to monopoly pricing above marginal cost.

• Uniform Pricing: Charging the same price to all consumers.

• Price Discrimination: Charging different prices to different consumers based on willingness to pay.

• Types of Price Discrimination:

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

  • Second-degree: Price varies by quantity purchased (block pricing).

  • Third-degree: Different prices for different groups (e.g., student discounts).

• Example Table:

Unit	AC
17	500
18	600
19	700
20	800
21	900
22	1000

Additional info: Table values from exam; used to determine if a firm should accept a special order based on marginal cost and price offered.

Natural Monopoly and Regulation

Pricing Rules and Regulation

A natural monopoly occurs when a single firm can supply the entire market at lower cost than multiple firms. Regulation may require pricing at average cost or marginal cost.

• Average Cost Pricing: $P = AC$; ensures normal profit but may require a subsidy if $P < MC$.

• Marginal Cost Pricing: $P = MC$; efficient but may result in losses, requiring a subsidy.

• Deadweight Loss: The loss in total surplus when output is below the socially optimal level.

• Example: If a natural monopoly is unregulated, it sets $MR = MC$ and may earn economic profit and create deadweight loss.

International and Domestic Markets

Price Discrimination Across Markets

Firms may charge different prices in different markets based on demand elasticity and market separation.

• Table Example: A publisher sets different prices for domestic and international markets to maximize profit.

Domestic Market	International Market
Price: $14	Price: $17
Quantity: 8	Quantity: 6
MR: 2	MR: 2
MC: 2	MC: 2

Additional info: Table values inferred for illustration; actual exam values may differ.

Key Formulas and Relationships

• Marginal Product of Labor: $MP_L = \frac{\Delta Q}{\Delta L}$

• Average Product of Labor: $AP_L = \frac{Q}{L}$

• Total Cost: $TC = FC + VC$

• Average Cost: $AC = \frac{TC}{Q}$

• Marginal Cost: $MC = \frac{\Delta TC}{\Delta Q}$

• Profit: $\text{Profit} = TR - TC$

• Revenue: $TR = P \times Q$

• Marginal Revenue: $MR = \frac{\Delta TR}{\Delta Q}$