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 decision-making processes of individuals, households, firms, and governments, and the resulting effects on prices, resource allocation, and overall well-being.

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

• Scarce resources: Resources for which wants exceed availability.

Three Principles of Economics

Core Principles

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

• Equilibrium: A state where all agents are optimizing, and no one can benefit by changing their choice unilaterally.

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

Optimization Techniques

Total Value vs. Marginal Analysis

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

• Optimization using marginal analysis: Compare the change in costs and benefits when moving from one alternative to another. The Principle of Optimization at the Margin states that the optimal choice is where moving toward it increases net benefit, and moving away decreases it.

Markets and Market Structures

Definition of a Market

A market is a group of economic agents trading a good or service, governed by rules and arrangements for trading.

• Perfect Competition: Many buyers and sellers, homogeneous products, free entry and exit, and all agents are price takers.

Consumer Behavior

The Buyer's Problem

Consumers decide how much of each good to buy by maximizing utility subject to their budget constraint.

• Quantity Demanded: Amount a buyer is willing to purchase at a given price.

• Preferences, prices, and budget are the three components of the buyer’s problem.

• Demand Schedule: Table showing quantity demanded at different prices.

• Demand Curve: Graphical representation of the demand schedule.

Mathematical Condition for Optimal Consumption

• Optimal bundle is where the marginal benefit per dollar is equalized across goods and the budget is exhausted:

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

Budget constraint: $I = p_1 x_1 + p_2 x_2$

Example Table: Marginal Benefit per Dollar

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

Graphical Depiction

• Indifference curves (U1, U2, U3) represent different utility levels.

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

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

Elasticity of Demand

• Price Elasticity of Demand: Measures responsiveness of quantity demanded to price changes.

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

• Arc Elasticity:

$\text{arc } \varepsilon = \frac{\left( \frac{Q_D^{new} - Q_D^{old}}{\frac{Q_D^{new} + Q_D^{old}}{2}} \right)}{\left( \frac{P^{new} - P^{old}}{\frac{P^{new} + P^{old}}{2}} \right)}$

• 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 Functions and Relationships

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

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

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

• Average Fixed Cost (AFC): $AFC = ATC - AVC$

• MC intersects ATC and AVC at their minimum points.

• If MC < ATC or AVC, those averages are decreasing; if MC > ATC or AVC, they are increasing.

Short-run Production Decision

• 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.

• Shutdown point: Minimum of AVC curve.

Graphical Summary

• Profit: $\Pi = q(P - ATC)$

• At $q^*$, $MR = MC$ and $P$ is given by the market.

Firm's Supply Curve

• Short-run supply is vertical at $0$ for $P < AVC$ and equals MC for $P \geq AVC$.

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

Price Elasticity of Supply

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

• Arc elasticity:

$\text{arc } -\varepsilon = \frac{\left( \frac{Q_S^{new} - Q_S^{old}}{\frac{Q_S^{new} + Q_S^{old}}{2}} \right)}{\left( \frac{P^{new} - P^{old}}{\frac{P^{new} + P^{old}}{2}} \right)}$

• Interpretation:

  • |ε| = ∞: Perfectly elastic

  • |ε| = 1: Unit elastic

  • |ε| = 0: Perfectly inelastic

  • 0 < |ε| < 1: Inelastic

  • 1 < |ε| < ∞: Elastic

Long-Run Market Dynamics

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

• If $\Pi > 0$, new firms enter, supply increases, price falls until $\Pi = 0$.

• If $\Pi < 0$, firms exit, supply decreases, price rises until $\Pi = 0$.

Market Efficiency and Social Surplus

• Competitive equilibrium maximizes total well-being and allocates resources efficiently.

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

• Social surplus: Total value of trade in a market.

Trade and Comparative Advantage

• Production Possibilities Curve (PPC): Shows efficient production combinations.

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

• Terms of trade must lie between opportunity costs for both parties to benefit.

• Trade creates winners and losers (exporters vs. importers).

Externalities

Definition and Types

• Externality: A cost or benefit imposed on third parties not directly involved in a transaction.

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

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

Measuring Externalities

• Negative externality: $\text{Social Cost} = \text{Private Cost} + \text{External Cost}$

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

• Positive externality: $\text{Social Benefit} = \text{Private Benefit} + \text{External Benefit}$

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

Consequences and Efficiency

• With negative externalities, markets overproduce; with positive, they underproduce.

• Efficient outcome: $P = MSB = MSC$

• Deadweight loss (DWL) arises from inefficient market outcomes.

Graphical Representation

• Without externality: $S = MPC = MSC$, $D = MPB = MSB$

• With negative externality: $S = MPC$, $MSC$ above $MPC$

• Efficient quantity is where $MSC$ intersects $D$

Solutions to Externalities

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

• Government solutions: Command-and-control (regulation), market-based policies (Pigouvian taxes/subsidies).

Factor Markets

• Labor demand: Determined by the value of the marginal product of labor (VMPL).

• Labor supply: Determined by the labor-leisure tradeoff.

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

Market Structures

Monopoly

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

• Monopolist sets output where $MR = MC$ and price from demand curve.

• $P_{monopoly} > P_{perfect\ competition}$

• Monopolies are inefficient; can be addressed by price discrimination or regulation.

Natural Monopoly

• Characterized by economies of scale; ATC declines over the relevant range of output.

Oligopoly and Monopolistic Competition

• Oligopoly: Few firms, interdependent decisions.

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

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

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

Other Market Structures

• Monopsony: One buyer.

• Oligopsony: Few buyers.

Bertrand Competition (Duopoly with Homogeneous Products)

• Firms compete in prices; the lower-priced firm captures the market.

• Residual demand for each firm depends on relative prices.

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

• Short-run: Firms can earn positive profit ($\Pi > 0$), attracting entry.

• Long-run: Entry shifts demand left and makes it more elastic, driving profit to zero.

• Markup and deadweight loss persist in long-run equilibrium.

Summary Table: Key Market Structures

Structure	# Sellers	Product Type	Entry Barriers	Long-run Profit	Efficiency
Perfect Competition	Many	Identical	None	Zero	Efficient
Monopoly	One	Unique	High	Positive	Inefficient
Oligopoly	Few	Identical/Diff.	Some	Possible	Varies
Monopolistic Competition	Many	Differentiated	Low	Zero	Inefficient

Additional info: Some explanations and formulas have been expanded for clarity and completeness, and tables have been reconstructed for study purposes.