Microeconomics Study Notes: Surplus, Elasticity, Utility, and Costs of Production

Consumer and Producer Surplus; Price Ceilings and Floors

Consumer Surplus

Consumer surplus is the difference between the amount a buyer is willing to pay for a good and the amount they actually pay. It is represented graphically as the area below the demand curve and above the price level.

• Definition: The extra benefit consumers receive when they pay less than what they are willing to pay.

• Example: If a buyer is willing to pay $10 for a product but buys it for $7, the consumer surplus is $3.

Producer Surplus

Producer surplus is the difference between the amount a seller receives for a good and the seller's cost of providing it. It is shown as the area above the supply curve and below the price.

• Definition: The extra benefit producers receive when they sell at a price higher than their minimum acceptable price.

• Example: If a seller is willing to sell a product for $5 but sells it for $8, the producer surplus is $3.

Total Surplus and Market Efficiency

• Total surplus = consumer surplus + producer surplus.

• Efficiency: Total surplus is maximized at the market equilibrium.

Price Ceilings and Price Floors

• Price ceiling: A legal maximum price for a good or service. If set below equilibrium, it causes shortages and rationing.

• Example: Rent control in cities.

• Price floor: A legal minimum price for a good or service. If set above equilibrium, it causes surpluses.

• Example: Minimum wage laws.

Additional info: Price controls can lead to black markets and inefficiencies in allocation.

Elasticity

Price Elasticity of Demand

Price elasticity of demand measures the responsiveness of quantity demanded to changes in price. It is calculated as the percentage change in quantity demanded divided by the percentage change in price.

• Formula: $E_p = \frac{\% \Delta Q_d}{\% \Delta P}$

• Example: If price increases by 10% and quantity demanded decreases by 2%, $E_p = -0.2$.

• Interpretation: A negative value indicates the inverse relationship between price and quantity demanded.

• Relative quantities: Elasticity is measured using average values for accuracy.

Cross Price Elasticity of Demand

Cross price elasticity of demand measures the responsiveness of demand for one good to changes in the price of another good.

• Formula: $E_{xy} = \frac{\% \Delta Q_x}{\% \Delta P_y}$

• Interpretation: Positive value: goods are substitutes; negative value: goods are complements.

Income Elasticity of Demand

Income elasticity of demand measures the responsiveness of quantity demanded to changes in consumer income.

• Formula: $E_I = \frac{\% \Delta Q_d}{\% \Delta I}$

• Interpretation: Positive value: normal good; negative value: inferior good.

Additional info: Elasticity affects total revenue and market outcomes. For example, if demand is elastic, a price increase reduces total revenue.

Consumer Choice and Utility

Utility and Utility Analysis

Utility is the satisfaction or benefit derived from consuming a good or service. Economists use utility analysis to understand consumer decision-making.

• Total utility: The total satisfaction received from consuming a certain quantity of goods.

• Marginal utility: The additional satisfaction from consuming one more unit of a good.

• Law of diminishing marginal utility: As more units of a good are consumed, the additional satisfaction from each extra unit decreases.

• Example: The first slice of pizza gives more satisfaction than the fifth.

Consumer Optimum

The consumer optimum is the combination of goods and services that maximizes total utility given a budget constraint.

• Occurs when the marginal utility per dollar spent is equal across all goods: $\frac{MU_A}{P_A} = \frac{MU_B}{P_B}$

• Consumers allocate their budget so that the last dollar spent on each good yields the same marginal utility.

Price Changes and Substitution Effect

• When the price of a good decreases, consumers buy more of it (income and substitution effects).

• Substitution effect: Consumers switch to relatively cheaper goods.

• Income effect: A price change affects the purchasing power of income.

Additional info: These effects explain changes in consumer behavior in response to price changes.

The Costs of Production

Types of Costs

• Total revenue (TR): The amount a firm receives from selling its output. $TR = P \times Q$

• Total costs (TC): The market value of all inputs used in production.

• Profit: $\text{Profit} = \text{Total Revenue} - \text{Total Costs}$

• Explicit costs: Direct, out-of-pocket payments for inputs.

• Implicit costs: Opportunity costs of using resources owned by the firm.

• Economic profit: $\text{Economic Profit} = \text{Total Revenue} - (\text{Explicit Costs} + \text{Implicit Costs})$

• Accounting profit: $\text{Accounting Profit} = \text{Total Revenue} - \text{Explicit Costs}$

Short Run and Long Run

• Short run: At least one input is fixed.

• Long run: All inputs are variable.

Production Function and Marginal Product

• Production function: Relationship between inputs and output.

• Marginal product: The additional output from one more unit of input.

• Law of diminishing marginal product: As more of a variable input is added, the marginal product eventually decreases.

Cost Measures

• Fixed costs (FC): Costs that do not vary with output.

• Variable costs (VC): Costs that vary with output.

• Total cost (TC): $TC = FC + VC$

• Average total cost (ATC): $ATC = \frac{TC}{Q}$

• Average fixed cost (AFC): $AFC = \frac{FC}{Q}$

• Average variable cost (AVC): $AVC = \frac{VC}{Q}$

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

Cost Curves and Scale

• ATC is typically U-shaped due to spreading fixed costs and diminishing marginal returns.

• Minimum efficient scale: The lowest output level at which long-run average costs are minimized.

• Diseconomies of scale: When increasing output raises average costs.

Additional info: Firms seek to operate at minimum efficient scale to maximize profitability.

Cost Type	Definition	Formula
Fixed Cost (FC)	Does not vary with output	-
Variable Cost (VC)	Varies with output	-
Total Cost (TC)	Sum of fixed and variable costs	$TC = FC + VC$
Average Total Cost (ATC)	Cost per unit of output	$ATC = \frac{TC}{Q}$
Average Fixed Cost (AFC)	Fixed cost per unit of output	$AFC = \frac{FC}{Q}$
Average Variable Cost (AVC)	Variable cost per unit of output	$AVC = \frac{VC}{Q}$
Marginal Cost (MC)	Cost of producing one more unit	$MC = \frac{\Delta TC}{\Delta Q}$