This is my very extended (60 pages!!) summary for the course 'principles of microeconomics'. I did the pre-master, so for pre-masters there is also a lot of extra content! In this summary, you'll find: (1) a complete summary of the book, (2) supplements from the lectures, (3) supplements from the ...
ECS2601 BMZ ASSESSMENT 4 SEMESTER 2 2024 MASTER In a perfectly competitive industry, the amount of output that a rm decides to sell has no effect on the market price, because… a. the rm’s output...
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Microeconomics
9 th Edition Robert S. Pindyck & Daniel L. Rubinfeld
Microeconomics - 9th Edition Robert S. Pindyck & Daniel L. Rubinfeld 1
,CONTENTS
Contents............................................................................................................................................2
1 Preliminaries..................................................................................................................................7
1.1 The themes of microeconomics......................................................................................................................7
1.1.1 Trade-Offs................................................................................................................................................................7
1.1.2 Prices and markets..................................................................................................................................................7
1.1.3 Theories and models...............................................................................................................................................7
1.1.4 Positive versus Normative analysis..........................................................................................................................8
1.2 What is a market?..........................................................................................................................................8
1.2.1 Defining a market....................................................................................................................................................8
1.2.2 Competitive versus non-competitive markets.........................................................................................................8
1.2.3 Market price............................................................................................................................................................ 8
1.2.4 Market definition – the extent of a market.............................................................................................................9
1.3 Real versus Nominal prices.............................................................................................................................9
1.4 Why study microeconomics?..........................................................................................................................9
2 The basics of supply and demand.................................................................................................10
2.1 Supply and Demand......................................................................................................................................10
2.1.1 The supply curve....................................................................................................................................................10
2.1.2 The Demand curve................................................................................................................................................10
2.2 Changes in the supply and demand curve (2.2+2.3)....................................................................................10
2.4 Elastices of supply and demand...................................................................................................................11
2.2.1 Arc elasticities........................................................................................................................................................11
2.3 Short-run versus Long-run elastices.............................................................................................................11
2.3.1 Demand................................................................................................................................................................. 11
2.3.2 Supply.................................................................................................................................................................... 12
2.7 effects of government intervention - price controls.....................................................................................12
3 Consumer behaviour....................................................................................................................12
3.1 Consumer preferences..................................................................................................................................12
3.1.1 The market basket.................................................................................................................................................12
3.2 budget constraints........................................................................................................................................14
3.2.1 The budget line......................................................................................................................................................14
3.2.2 The effects of changes in income and prices.........................................................................................................14
3.3 Consumer choice...........................................................................................................................................15
3.3.1 Corner solutions....................................................................................................................................................15
3.4 Revealed preference.....................................................................................................................................15
3.5 Marginal utility and consumer choice..........................................................................................................16
4 Individual and market demand.....................................................................................................16
4.1 Individual demand........................................................................................................................................16
4.2 Income and substitution effects...................................................................................................................17
4.2.1 Indicating both effects...........................................................................................................................................17
4.2.2 The Giffen good.....................................................................................................................................................18
4.3 Market demand............................................................................................................................................18
4.3.1 Elasticity of demand..............................................................................................................................................18
Microeconomics - 9th Edition Robert S. Pindyck & Daniel L. Rubinfeld 2
, 4.4 The consumer surplus...................................................................................................................................19
4.5 Network externalities...................................................................................................................................19
5 Uncertainty and Consumer behaviour..........................................................................................19
5.1 Describing risk...............................................................................................................................................19
5.1.1 Probability............................................................................................................................................................. 19
5.1.2 Expected value......................................................................................................................................................20
5.1.3 Variability.............................................................................................................................................................. 20
5.2 Preferences toward risk................................................................................................................................20
5.2.1 Different preferences towards risk........................................................................................................................20
5.3 Reducing Risk................................................................................................................................................21
5.3.1 Insurance............................................................................................................................................................... 22
5.3.2 The value of information.......................................................................................................................................22
5.4 The demand for risky assets.........................................................................................................................22
5.4.1 Risky and Riskless assets........................................................................................................................................22
5.4.2 Asset returns......................................................................................................................................................... 22
5.5 Measures of risk aversion.............................................................................................................................22
5.5.1 Measure of absolute risk aversion.........................................................................................................................22
5.5.3 Measures of Relative Risk Aversion.......................................................................................................................24
6 Production....................................................................................................................................25
6.1 Firms and their production decisions............................................................................................................25
6.1.1 What are firms?.....................................................................................................................................................25
6.1.2 The production function........................................................................................................................................25
6.2 Production with one variable input..............................................................................................................26
6.2.1 Average and marginal products.............................................................................................................................26
6.2.2 Law of diminishing marginal returns.....................................................................................................................26
6.2.3 Labour productivity...............................................................................................................................................27
6.3 production with two variable inputs............................................................................................................27
6.3.1 Two special cases..................................................................................................................................................28
6.4 Returns to scale............................................................................................................................................28
7 The cost of production..................................................................................................................28
7.1 Measuring cost: which costs matter?...........................................................................................................29
7.1.1 Economic cost versus accounting costs.................................................................................................................29
7.1.2 Opportunity cost...................................................................................................................................................29
7.1.3 Sunk costs.............................................................................................................................................................. 29
7.1.4 Fixed costs and variable costs................................................................................................................................29
7.1.5 Fixed versus sunk costs..........................................................................................................................................29
7.1.6 Marginal and average cost....................................................................................................................................30
7.2 Cost in the short run....................................................................................................................................30
7.2.1 The determinants of short run cost.......................................................................................................................30
A little recap bonus thing....................................................................................................................................31
7.3 Cost in the long run.......................................................................................................................................32
7.3.1 The user cost of capital..........................................................................................................................................32
7.3.2 The cost-minimizing input choice..........................................................................................................................32
7.3.3 The Isocost line......................................................................................................................................................33
7.3.4 Varying output levels.............................................................................................................................................34
Microeconomics - 9th Edition Robert S. Pindyck & Daniel L. Rubinfeld 3
, 7.4 Long-run versus Short-run cost curves.........................................................................................................34
7.4.1 Inflexibility of short-run production......................................................................................................................34
7.4.2 Long run average cost...........................................................................................................................................34
7.4.3 Economies and diseconomies of scale...................................................................................................................34
8 Profit maximization and competitive supply.................................................................................35
8.1 Perfectly competitive market.......................................................................................................................35
8.2 Profit maximization......................................................................................................................................35
8.3 Marginal revenue, marginal cost and profit maximization..........................................................................35
8.4 Choosing output in the short run..................................................................................................................36
8.5 The competitive firm’s short-run supply curve.............................................................................................36
8.6 The short-run Market supply curve..............................................................................................................37
8.6.1 The producer surplus in the short run...................................................................................................................37
8.7 Choosing output in the long run...................................................................................................................37
8.8 The industry’s long-run supply curve............................................................................................................38
8.8.1 Constant-cost industry..........................................................................................................................................38
8.8.2 Increasing-cost industry........................................................................................................................................38
8.8.3 Decreasing-cost industry.......................................................................................................................................38
8.8.4 Other important notes..........................................................................................................................................38
9 The analysis of competitive markets.............................................................................................38
9.1 The consumer and producer surplus............................................................................................................38
9.1.1 Applying the surplus..............................................................................................................................................38
9.2 The efficiency of a competitive market.........................................................................................................39
10 Market power: Monopoly and Monopsony................................................................................40
10.1 Monopoly....................................................................................................................................................40
10.1.1 When the monopolist should produce................................................................................................................40
10.1.2 A rule of thumb for pricing..................................................................................................................................41
10.1.3 Shifts in the demand curve..................................................................................................................................41
10.2 Monopoly power.........................................................................................................................................42
10.2.1 Determining the demand curve...........................................................................................................................42
10.2.2 Measuring monopoly power...............................................................................................................................42
10.3 Sources of monopoly power.......................................................................................................................43
10.3.1 The elasticity of market demand.........................................................................................................................43
10.3.2 The number of firms............................................................................................................................................43
10.3.3 The interaction among firms...............................................................................................................................43
10.4 The social Costs of monopoly power..........................................................................................................46
10.4.1 Rent seeking........................................................................................................................................................ 47
10.4.2 Price regulation...................................................................................................................................................47
10.4.3 Natural monopoly...............................................................................................................................................47
10.5 Monopsony.................................................................................................................................................47
10.5.1 Monopsony and monopoly compared................................................................................................................48
10.6 Monopsony power......................................................................................................................................48
10.6.1 Bilateral monopoly..............................................................................................................................................48
Microeconomics - 9th Edition Robert S. Pindyck & Daniel L. Rubinfeld 4
, 11.2.1 First-degree price discrimination.........................................................................................................................49
11.2.2 Second-degree price discrimination....................................................................................................................49
11.2.3 Third-degree price discrimination.......................................................................................................................49
11.3 Intertemporal price discrimination and peak-load pricing.........................................................................50
11.4 The two-part tariff......................................................................................................................................50
11.4.1 Single consumer..................................................................................................................................................51
11.4.2 Two consumers...................................................................................................................................................51
11.4.3 Many consumers.................................................................................................................................................51
12 Monopolistic competition and Oligopoly....................................................................................51
12.1 Monopolistic competition...........................................................................................................................51
12.1.1 Defining the monopolistic market.......................................................................................................................51
12.1.2 How the market works: the equilibrium in the short and long run......................................................................52
12.1.3 How to measure the efficiency of the market.....................................................................................................52
12.2 Oligopoly.....................................................................................................................................................52
12.2.1 Finding the equilibrium in an Oligopolistic Market..............................................................................................53
12.2.2 The Cournot model..............................................................................................................................................53
12.2.3 How to translate this into a linear demand curve................................................................................................54
12.2.4 What if there is a first-mover advantage? – The stackelberg model...................................................................55
12.3 Price competition........................................................................................................................................56
A recap of the three important models..............................................................................................................56
12.4 Implications of the prisoner’s dilemma for Oligopolistic pricing................................................................56
12.4.1 The dominant firm model....................................................................................................................................57
13 Game theory and competitive strategy.......................................................................................57
13.1 Gaming and strategic decisions..................................................................................................................57
13.1.1 Some important terminology..............................................................................................................................57
13.2 Dominant strategies...................................................................................................................................58
13.3 Dominated strategies.................................................................................................................................58
13.3.1 iterated eliminations of strictly dominated strategies (IESDS).............................................................................58
13.4 Nash equilibrium revisited..........................................................................................................................58
13.4.1 Finding the nash equilibrium in a game...............................................................................................................58
13.4.2 Maximin strategies..............................................................................................................................................58
13.4.3 Mixed strategies..................................................................................................................................................58
13.5 Repeated games.........................................................................................................................................59
13.5.1 The tit-for-tat strategy.........................................................................................................................................59
13.6 Sequential games.......................................................................................................................................59
13.6.1 The extensive form of a game.............................................................................................................................59
17 Markets with asymmetric information.......................................................................................60
13.7 Quality Uncertainty and the Market for Lemons.......................................................................................60
13.7.1 The market for used cars.....................................................................................................................................61
13.7.2 Implications of Asymmetric information.............................................................................................................61
13.7.3 The importance of reputation and standardization.............................................................................................61
13.8 Market Signalling.......................................................................................................................................62
13.8.1 A simple model of job market signalling..............................................................................................................62
13.9 Moral Hazard..............................................................................................................................................63
13.10 The principal-agent problem....................................................................................................................63
Microeconomics - 9th Edition Robert S. Pindyck & Daniel L. Rubinfeld 5
, 13.10.1 Incentives in the principal-agent framework.....................................................................................................63
17.6 Asymmetric Information in labour markets: Efficiency wage theory.........................................................64
Shirking or work morale - The impact of regulating.........................................................................65
19 Behavioural economics...............................................................................................................65
13.11 Reference points and consumer behaviour..............................................................................................66
13.11.1 Endowment.......................................................................................................................................................66
13.11.2 Loss aversion.....................................................................................................................................................66
13.11.3 Framing............................................................................................................................................................. 66
13.11.4 Salience............................................................................................................................................................. 66
13.12 Fairness.....................................................................................................................................................66
13.13 Rules of thumb and biases in decision making.........................................................................................67
13.13.1 Anchoring.......................................................................................................................................................... 67
13.13.2 Rules of Thumb..................................................................................................................................................67
13.13.3 The law of small numbers..................................................................................................................................67
13.13.4 Overconfidence.................................................................................................................................................67
13.14 Bubbles.....................................................................................................................................................67
13.14.1 Informational cascades......................................................................................................................................68
13.15 Behavioural economics and public policy.................................................................................................68
14 Handy overviews........................................................................................................................69
Microeconomics - 9th Edition Robert S. Pindyck & Daniel L. Rubinfeld 6
,1 PRELIMINARIES
It is important to note that there is a specific methodology applied to the field or reasoning of
microeconomics. We assume that everybody is an actor on its own and that this actor acts based
upon its rationality. This is referred to as the methodological individualism.
1.1THE THEMES OF MICROECONOMICS
1.1.1 Trade-Offs
The basic assumption of microeconomics is that everybody has limits. Yet we all want the best, so we
want to make the best of these limits. These limits in fact all relate to limits in resource (the are thus
scarce). In fancy English, microeconomics is in that case about the allocation of scarce resources. We
go on exploring these trade-offs.
1.1.1.1Consumers
The consumer has a trade-off which mainly concerns its income. They have to optimize their well-
being, based on their income. The optimal well-being is achieved by buying some goods while not
buying the other goods.
1.1.1.2Workers
People who work also have to make trade-offs, or decisions in which one eliminates the other. The
book illustrates two examples: To work or not to work (can you get more well-being by doing
something else?), where to work (what type of job benefits you the most) and how long to work
(leisure-time versus work-time).
1.1.1.3Firms
A firm, or a company, cannot produce everything and thus has to choose what to make in order to
gain the most profit. When it decided that, it also must decide how much it should produce by how
many people in order to, again, maximize its profit.
1.1.2 Prices and markets
Prices are very important to microeconomics, as it is the way of measuring things. We can calculate
the ‘price’ of hiring someone or the ‘price’ of working overtime. Next to that, microeconomics also
looks at how these prices are determined in the first place. These prices are ‘generated’ by an
interaction of suppliers and demanders. Both of them meet in so-called ‘markets.
1.1.3 Theories and models
This is of course quite straightforward. To make matters explainable, we create theories of observed
phenomena. These phenomena are observed, meaning that it lies in the past. As economists, we
however also want to be able to predict. This is done via models. In fancy English, this is a
mathematical representation, based on economic theory, of a firm, a market or some other entity. A
model lets us predict for example whether the profit grows after a specific decision.
Theories and models are not perfect and will never be. This is why we constantly need to test these
against the actual observations. Some of them might work under one circumstance, but not under
the other. These are important things to remember or notice when using a theory.
Microeconomics - 9th Edition Robert S. Pindyck & Daniel L. Rubinfeld 7
, 1.1.4 Positive versus Normative analysis
This is where things get a bit tacky. As on one hand in microeconomics we test what is the
mathematical best but also test what is ‘ought to be’ the best, there are two different approaches (or
names) to these analyses. Simply put:
Positive analysis is a mathematical representation of what is best, assuming everybody acts with a
rational mindset and we do not account for norms or values.
Normative analysis is more of an analysis in which we assume norms and values, in which we ask
ourselves what is ought to be. Normative analysis is thus used more for policymaking. It does not ask
whether tax on oil is good (positively speaking it is bad 😉) but asks how high the tax should be.
1.2WHAT IS A MARKET?
1.2.1 Defining a market
Let’s be fair, the word ‘market’ is not new and is used a lot by many instances. Economists use it a lot
too, so it is important to know what it means exactly and that everybody uses the same definition.
In a market, people meet. We divide these people in buyers and sellers. It is important to note that
someone can be a seller in market A, but a buyer in market B. The interactions between these two
groups, form a market. The market is thus a collection that through their actual or potential
interactions determine the price of (a) product(s).
But who are these players? Who do you include in ‘your market’? Determining who is part of the
market – who you include – is called the ‘market definition’. This is important as in your market there
could be a lot of actors. Even those who do not actually buy something, but intend to buy, can
influence the price of a commodity.
Another issue or phenomenon which occurs in and between markets, is so-called ‘arbitrage’. This
phenomenon entails the buying of a product in one cheap place and selling it (with a big profit) on
another market. You could for example buy something cheap on AliExpress and then sell it again via
Marktplaats.nl for a price twice as high.
1.2.2 Competitive versus non-competitive markets
A perfectly competitive market has many buyers and sellers, so that no single buyer or seller has a
significant impact on the price. That is of course an unreachable ideal. You are able to distinguish
some sort of spectrum:
CLose to perfectly competitive Competitive enough to be treated Treated as competitive for Noncompetitive
as if perfectly competitive analysis purposes
Agricultural markets have many Natural resources are produced When only a few are key players, Individual firms can impact the
buyers and sellers, with no actor by a few dozen, yet one is not yet there is strong competition price significantly (like a
having significant impact able to significantly impact the making the market competitive monopolY)
price nonetheless
1.2.3 Market price
The market price is determined by the interaction between demand and supply. In a perfectly
competitive market, price is determined at the point/equilibrium where the two meet. In not-so-
perfectly-competitive markets, firms might not offer all the same prices. This could have to do with
pricing based upon winning customers or trying to maximize profit for a specific price. Of course, in
all markets, prices can rise and fall (sometimes dramatically).
Microeconomics - 9th Edition Robert S. Pindyck & Daniel L. Rubinfeld 8
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