Microeconomics Study Guide: Demand, Supply, Equilibrium, and Market Structures

Markets and Market Structures

The Meaning of Markets

A market is any arrangement that allows buyers and sellers to exchange goods, services, or resources. Markets can take many forms, from physical locations to digital platforms.

• Types of Markets:

  • Competitive markets: Many buyers and sellers, with prices determined by supply and demand.

  • Monopoly: One seller dominates the market.

  • Oligopoly: Few sellers, often with significant market power.

  • Monopolistic competition: Many sellers offering differentiated products.

• Market price (equilibrium price): The price at which quantity demanded equals quantity supplied.

Demand, Supply, and Equilibrium

How Do Buyers Behave?

• Buyers aim to maximize utility (satisfaction) given limited income.

• Their willingness to buy depends on:

  • Price of the good

  • Income

  • Tastes/preferences

  • Expectations

  • Prices of related goods (substitutes and complements)

Law of Demand, Demand Schedule, and Demand Curve

• Law of Demand: As the price of a good decreases, the quantity demanded increases (ceteris paribus).

• Demand Schedule: Table showing the relationship between price and quantity demanded.

• Demand Curve: Graphical representation — downward sloping from left to right.

The Difference Between Qd and D

• Quantity Demanded (Qd): Movement along the demand curve caused by a price change.

• Demand (D): A shift of the entire demand curve caused by factors other than price (income, preferences, etc.).

Individual Demand and Market Demand

• Individual Demand: The demand of one consumer.

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

How Do Sellers Behave?

• Sellers aim to maximize profits.

• They consider production costs and market price.

• Profit maximization occurs when producing until marginal cost = marginal revenue.

Law of Supply, Supply Schedule, and Supply Curve

• Law of Supply: As price increases, quantity supplied increases (direct relationship).

• Supply Schedule: Table showing price and quantity supplied.

• Supply Curve: Upward sloping graph showing producers' willingness to sell at each price.

The Difference Between Qs and S

• Quantity Supplied (Qs): Movement along the supply curve caused by a price change.

• Supply (S): Shift of the supply curve caused by input costs, technology, taxes, or number of sellers.

Individual Supply and Market Supply

• Individual Supply: Supply from one firm.

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

Market Equilibrium

• Occurs where Qd = Qs.

• The equilibrium price (P*) and equilibrium quantity (Q*) are determined at this intersection.

Two Types of Market Disequilibrium

1. Surplus (Excess Supply): Price is above equilibrium — Qs > Qd — downward pressure on price.

2. Shortage (Excess Demand): Price is below equilibrium — Qd > Qs — upward pressure on price.

Changes in Market Equilibrium

• Demand shift: Increases (curve right) → higher P and Q; Decreases (curve left) → lower P and Q.

• Supply shift: Increases (curve right) → lower P and higher Q; Decreases (curve left) → higher P and lower Q.

Consumer and Producer Surplus

Consumer Surplus

• The difference between what consumers are willing to pay and what they actually pay.

• Represents the benefit to consumers from participating in the market.

• On a graph: area below demand curve and above price line.

Elasticity

Demand Elasticities

Elasticity measures responsiveness of quantity demanded to a change in a determinant (like price, income, or other goods' prices).

1. Price Elasticity of Demand (PED)

• Formula: $PED = \frac{\%\ \text{change in } Q_d}{\%\ \text{change in Price}}$

• Elastic (|PED| > 1): Qd responds strongly to price change.

• Inelastic (|PED| < 1): Qd responds little to price change.

• Unit Elastic (|PED| = 1): Qd changes proportionally to price.

• Elastic demand: Flatter curve; inelastic = steeper curve.

2. Cross-Price Elasticity of Demand (XED)

• Formula: $XED = \frac{\%\ \text{change in Qd of Good A}}{\%\ \text{change in Price of Good B}}$

• Positive: Substitutes (e.g., Coke and Pepsi).

• Negative: Complements (e.g., coffee and cream).

3. Income Elasticity of Demand (YED)

• Formula: $YED = \frac{\%\ \text{change in Qd}}{\%\ \text{change in income}}$

• Positive: Normal goods (YED > 0).

• Negative: Inferior goods (YED < 0).

Producer Theory

Seller's Problem

• Production: Turning inputs into outputs.

• Cost: The relationship between production and cost (fixed + variable).

• Revenue: Price × Quantity sold.

• Goal: Maximize profit = Total Revenue – Total Cost.

Law of Diminishing Returns

• As more of a variable input (e.g., labor) is added to a fixed input (e.g., machinery), the marginal product eventually declines.

• Example: Each additional worker adds less output after a certain point.

Finding Optimum Quantity and Profit/Loss Area on Graph

• Optimum quantity occurs where MC = MR.

• Profit: (Price – ATC) × Quantity

• If P > ATC → Profit

• If P < ATC → Loss

Shutdown or Staying in Business Decisions

• Short run: Stay open if P ≥ AVC (covering variable costs).

• Shut down if P < AVC.

• Long run: Exit if P < ATC (cannot cover total costs).

Producer Surplus

• The difference between the market price and the minimum price producers are willing to accept.

• On a graph: area above supply curve and below price line.

Competitive Equilibrium in the Long Run

• Firms enter when P > ATC → market supply increases → price falls → profit = 0.

• Firms exit when P < ATC → market supply decreases → price rises → profit = 0.

• Long-run equilibrium: Zero economic profit, efficient allocation of resources.

Perfect Competition and the Invisible Hand

The Problem of Allocation of Scarce Resources

• The economy faces limited resources but unlimited wants.

• Markets allocate resources efficiently through prices: goods go to those who value them most, production goes to lowest-cost producers.

Price Controls

• Price Ceiling: Maximum legal price (e.g., rent control). Binding if set below equilibrium price → causes shortage.

• Price Floor: Minimum legal price (e.g., minimum wage). Binding if set above equilibrium price → causes surplus.

Social Surplus and Deadweight Loss

• Social Surplus = Consumer Surplus + Producer Surplus

• Deadweight Loss (DWL): Total surplus lost due to inefficiency (caused by price controls, taxes, monopoly).

Monopoly

Key Characteristics of Monopoly

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

• Downward-sloping demand curve.

Barriers to Entry

1. Legal barriers: Patents, copyrights, government franchises.

2. Control of key resources.

3. Natural monopoly: High fixed costs make one firm most efficient.

4. Network effects: Value increases with number of users.

Profit Maximization in Monopoly

• Produce where MR = MC, but charge price on demand curve at that quantity.

• Since P > MC, monopoly results in allocative inefficiency.

The Inefficiencies of Monopoly

• Deadweight loss due to underproduction.

• Higher prices, lower output than competition.

• Reduced consumer surplus, possible rent-seeking behavior.

Price Discrimination

• Selling the same product at different prices to different consumers.

• Conditions:

  1. Market power

  2. Ability to segment groups

  3. No resale between groups

• Types:

  1. First-degree: Perfect (each consumer pays their max WTP).

  2. Second-degree: Based on quantity (bulk discounts).

  3. Third-degree: Based on group (student, senior discounts).

• Increases profits and can reduce DWL.