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Microeconomics for E&BE Summary
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This summary contains the readings for the course Microeconomics For E&EB Consumers and Firms.
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MICROECONOMICS2021-2022
Pre-Master Finance
,Table of Contents
Week 1 ........................................................................................................................................ 3
Chapter 1) Adventures in Microeconomics ........................................................................................ 3
1.1. Microeconomics (and What It Can Teach Us about Rosa and Lauren).................................... 3
1.2. This Book (and How Rosa and Lauren Would See It) ............................................................... 3
Chapter 2) Supply and Demand .......................................................................................................... 4
2.1. Markets and Models ................................................................................................................ 4
2.2. Demand .................................................................................................................................... 5
2.3. Supply ....................................................................................................................................... 6
2.4. Market Equilibrium .................................................................................................................. 7
2.5. Elasticity ................................................................................................................................... 9
Chapter 3) Using Supply and Demand to Analyse Markets .............................................................. 11
3.1. Consumer and Producer Surplus: Who Benefits in a Market? .............................................. 11
3.2. Price Regulations.................................................................................................................... 12
3.3. Quantity Regulations.............................................................................................................. 13
3.4. Taxes ...................................................................................................................................... 13
3.5. Subsidies ................................................................................................................................ 15
Week 2 ...................................................................................................................................... 16
Chapter 4) Consumer Behaviour....................................................................................................... 16
4.1. The Consumer’s Preferences and the Concept of Utility ....................................................... 16
4.2. Indifference Curves ................................................................................................................ 17
4.3. The Consumer’s Income and the Budget Constraint ............................................................. 20
4.4. Combining Utility, Income, and Prices: What Will the Consumer Consume? ....................... 21
Week 3 ...................................................................................................................................... 23
Chapter 5) Individual and Market Demand ...................................................................................... 23
5.1. How Income Changes Affect an Individual’s Consumption Choices ...................................... 23
5.2. How Price Changes Affect Consumption Choices .................................................................. 24
5.3. Consumer Responses to Price Changes: Substitution and Income Effects ............................ 25
5.4. The Impact of Changes in Another Good’s Price: Substitutes and Complements ................. 27
5.5. Combining Individual Demand Curves to Obtain the Market Demand Curve ....................... 28
Week 4 ...................................................................................................................................... 30
Chapter 6) Producer Behaviour ........................................................................................................ 30
6.1. The Basics of Production ........................................................................................................ 30
6.2. Production in the Short Run................................................................................................... 31
6.3. Production in the Long Run.................................................................................................... 31
6.4. The Firm’s Cost-Minimization Problem ................................................................................. 32
1
, 6.5. Returns to Scale ..................................................................................................................... 35
6.6. Technological Change ............................................................................................................ 35
6.7. The Firm’s Expansion Path and Total Cost Curve ................................................................... 36
Week 6 ...................................................................................................................................... 37
Chapter 7) Costs ................................................................................................................................ 37
7.1. Costs That Matter for Decision Making: Opportunity Costs .................................................. 37
7.2. Costs That Do Not Matter for Decision Making: Sunk Costs.................................................. 37
7.3. Costs and Cost Curves ............................................................................................................ 38
7.4. Average and Marginal Costs .................................................................................................. 38
7.5. Short-Run and Long-Run Cost Curves .................................................................................... 39
7.6. Economies in the Production Process .................................................................................... 40
Chapter 8) Supply in a Competitive Market (part 1)......................................................................... 41
8.1. Market Structures and Perfect Competition in the Short Run .............................................. 41
8.2. Profit Maximization in a Perfectly Competitive Market ........................................................ 42
Week 7 ...................................................................................................................................... 44
Chapter 8) Supply in a Competitive Market (part 2)......................................................................... 44
8.3. Perfect Competition in the Short Run.................................................................................... 44
8.4. Perfectly Competitive Industries in the Long Run ................................................................. 45
Chapter 9) Market Power and Monopoly ......................................................................................... 47
9.1. Sources of Market Power: Barriers to Entry .......................................................................... 47
9.2. Market Power and Marginal Revenue ................................................................................... 48
9.3. Profit Maximization for a Firm with Market Power ............................................................... 50
9.4. How a Firm with Market Power Reacts to Market Changes .................................................. 51
9.5. The Winners and Losers from Market Power ........................................................................ 52
9.6. Governments and Market Power: Regulation, Antitrust, and Innovation............................. 53
Week 8 ...................................................................................................................................... 55
Chapter 15) General Equilibrium ...................................................................................................... 55
15.1. General Equilibrium Effects in Action .................................................................................. 55
15.2. General Equilibrium: Equity and Efficiency .......................................................................... 56
15.3. Efficiency in Markets: Exchange Efficiency .......................................................................... 58
15.6. Markets, Efficiency, and the Welfare Theorems ................................................................. 59
Chapter 17) Externalities and Public Goods...................................................................................... 60
17.1. Externalities ......................................................................................................................... 60
17.2. Correcting Externalities ........................................................................................................ 61
2
,Week 1
Chapter 1) Adventures in Microeconomics
1.1. Microeconomics (and What It Can Teach Us about Rosa and Lauren)
• Microeconomics is the branch of economics that studies the specific choices made by consumers
and producers.
o In contrast, macroeconomics looks at the world through a wider lens and is a description
of the larger, complex system in which consumers and firms operate. Macroeconomics
takes hundreds of millions of individual producers and consumers, and tries to describe
and predict the behaviour and outcome of the combined total of their individual decisions.
• How microeconomics differs from macroeconomics:
1. We incorporate mathematics into our models along with graphs. At its heart, economics
is concerned with resource allocation, so we want to be able to create precise models that
can be solved for optimal quantities.
▪ We often want to know exactly how much of a good a consumer will want to
consume to maximize her happiness (utility) given that she has limited income.
▪ We also want to model how a firm maximizes its profit when choosing its output
level and the amounts of inputs it uses to make that quantity of output.
2. In intermediate microeconomics, the level of analysis is deeper than in principles. We
don’t take relationships such as the law of demand or the law of supply for granted. We
examine the details of why the relationships exist and when they don’t apply.
3. Intermediate microeconomics has a greater policy focus than the principles of
microeconomics course. Understanding the economic behaviour of consumers and
producers is the key to developing appropriate policies.
• Theories and models are explanations of how things work that help us understand and predict
how and why economic entities (consumers, producers, industries, governments, etc.) behave as
they do.
o Use the tools of graphs and mathematics to learn the intricacies of the theories and
models.
o Use the theories and models to look at how people and firms actually behave in real life.
• A+ make the grade: economists often use simplifying assumptions in their models to make the
world an easier place to understand. One of the most important assumptions is ceteris paribus,
which means “all else is equal”. The “all else equal” assumption allows one to focus on the factor
of interest.
o Don’t read more into a scenario than the facts you are given, and don’t drive yourself
crazy by dragging into the problem all kinds of hypothetical situations beyond those
provided in the problem you are analysing.
o The “all else equal” assumption also applies to the goods we are considering. When we
talk about a particular good, we assume that all units of that good are the same; that is,
we hold all the characteristics of the good constant.
1.2. This Book (and How Rosa and Lauren Would See It)
• In microeconomics, we focus in large part on two key economic players: consumers (buyers) and
producers (firms).
• Basic principle for production decisions: they require you to determine whether the costs
(financial, time, or effort) of your decision will bring in enough additional revenue to make your
choice worthwhile.
3
,• In a perfectly competitive market, all firms take the market price as given (they don’t have any
ability to choose the price at which they can sell their products) and decide how much they want
to produce.
o In a perfectly competitive industry, supply reflects the aggregation of the cost curves of
producers, and industry supply combines with market demand to determine price and
quantity movements over both the short and the long run.
• Monopoly → when only one firm supplies a good to a market, the situation differs in several ways
from perfect competition. Key is that the firm now has the ability to choose the price at which it
sells its products. They would produce less than in a competitive market, because limiting the
amount that is produced raises the price at which the product is sold.
• Oligopolies exist when multiple firms interact strategically in the same market. In such markets,
firms have some ability to choose their prices, but their fortunes are determined, in part, by the
actions of the other firms in the market.
• Factors are inputs into production, such as labour, capital, and land.
• Investment decisions are choices that typically involve paying an upfront cost with the hope of
earning a future return.
• Behavioural economics is the study of the intersection of psychology and economics.
• Microeconomics has evolved into a more empirical discipline → using data analysis and
experiments, and not just abstract theory, to explore economic phenomena.
Summary
• Microeconomics relies on theories and models to study the choices made by individuals and
firms. Intermediate microeconomics builds on the principles of microeconomics course by adding
mathematical models to the examination of consumer and producer behaviour. Practicing the
mathematics underlying microeconomic theory is the key to becoming a skilled economist. In
addition, intermediate microeconomics has a strong focus on policy and its effects on behaviour.
• Microeconomics looks at a variety of decisions made by consumers and producers as they interact
in the markets for goods and services, and at the different market structures in which consumers
and producers operate. A wide range of topics deepens our understanding of the microeconomics
of consumer and producer interaction, including risk and uncertainty, the role of information, and
the study of behavioural economics. In recent years, microeconomics has evolved from a discipline
that relied primarily on theory to one based on empirical studies(data analysis and experiments).
Chapter 2) Supply and Demand
2.1. Markets and Models
• We follow the economist’s standard approach: Simplify the problem until it becomes
manageable.
• The supply and demand model represents the economist’s best attempt to capture many of the
key elements of real-world markets in a simple enough way that we can analyse it.
o Supply is the combined amount of a good that all producers in a market are willing to sell
o Demand is the combined amount of a good that all consumers are willing to buy.
• A market is defined by the specific product being bought and sold (e.g., oranges or Bitcoin), a
particular location (a mall, a city, or the Internet), and a point in time (January 4th).
o Search costs → the buyers in a market should be able to find the sellers in that market
and vice versa, however, it might take some work to make that connection.
o The kind of markets discussed in the book tend to be broadly defined, as broader markets
are often of more interest and result in more data to analyse. However, defining markets
too broadly can make the assumptions of the supply and demand model less realistic.
4
,• There are four basic assumptions that underpin the supply and demand model:
1. We restrict our focus to supply and demand in a single market → we look at how supply
and demand interact in just one market to determine how much of a good or service is
sold and at what price it is sold.
2. All goods bought and sold in the market are identical → the goods need to be
homogeneous, so that the consumer is just as happy with any one unit of the good.
▪ Commodities are goods that are traded in markets where consumers view
different varieties of the good as essentially interchangeable.
3. All goods sold in the market sell for the same price, and everyone has the same
information → implies that there are no special or secret deals for particular buyers and
no quantity discounts. Same information is provided about prices, quality etc.
4. There are many buyers and sellers in the market → No one consumer or producer has a
noticeable impact on anything that occurs in the market and on the price level in
particular.
• This model is not completely realistic. However, a strength of this model is that when some (or
even most) of the specific assumptions of the model fail, it still manages to provide a good
description of how markets work.
2.2. Demand
• There are all sorts of factors that influence demand:
o Price: few consumers would buy a product such as tomato for a very high price.
o The number of consumers: all else equal, the more people there are in a market, the
greater the quantity of the good desired.
o Consumer income or wealth: as a consumer becomes richer, he/she will buy more of
most goods. Sometimes, however, when a consumer becomes richer, he/she will buy less
of a particular good, and buys more expensive ones. E.g., the consumer might buy a car
and stop taking public transportation.
o Consumer tastes: a change in consumer preferences or tastes will change the amount of
goods the consumer wants to purchase. Taste changes can be driven by all sorts of forces,
such as bad news coverage (e.g., salmonella), or popular advertising campaigns.
o Prices of other goods: the prices of substitutes and complements both affect how much
of a good consumers want to buy, but they have oppositive effects.
▪ Substitutes are goods that can be used in place of another good → when the price
of a substitute good falls, consumers will want to buy more of that substitute and
less of the initial good.
▪ Complements are goods that are often purchased and used in combination with
a certain good → when the price of a complement falls, consumers will want to
buy more of it and also more of the initial good.
• The demand curve is the relationship between the quantity of a good that consumers demand
and the good’s price, holding all other factors constant. Price is on the vertical axis and quantity
demanded is on the horizontal axis.
o A demand curve is drawn under the assumption that there is no change in any of the other
factors – such as consumers’ incomes, tastes, or the prices of other goods – that might
also affect how much of a good consumers buy at any given price.
o Demand curves usually slope downward → all else equal, the lower the price of a good,
the greater the amount of it consumers will buy.
o Mathematical representation of the demand curve:
5
, ▪ We can represent a demand curve mathematically by an equation in the form:
𝑄 = 𝑏 − 𝑎𝑃, in which Q is the quantity demanded, and P is the price.
▪ Demand choke price is the price at which quantity demanded is zero; the vertical
intercept of the inverse demand curve. It is the price at which no consumer is
willing to buy a good.
▪ Inverse demand curve is a demand curve written in the form of price as a function
of quantity demanded: 𝑃 = 𝑐 − 𝑑𝑄
• it is sometimes easier to work with inverse demand curve in part because
demand curves are drawn with price on the vertical axis and quantity on
the horizontal.
o There are other shifts in demand curves → when one of the other (nonprice) factors that
affect demand changes, the change affects the quantity of goods consumers want to buy
at every price. The changes in the quantity demanded at every price that occur when
nonprice factors change illustrate an essential distinction:
▪ Changes in quantity demanded are reflected in movements along a given
demand curve that occurs as a result of a change in the good’s price.
▪ Changes in demand are reflected in a shift of the entire demand curve caused by
a change in a determinant of demand other than the good’s own price.
o We treat prices differently than other factors that influence demand because price is a
factor that also directly influences the supply of the good, so it is the critical element tying
together supply and demand.
2.3. Supply
• Factors that can determine supply:
o Price: if a producer expects to be able to sell goods at a high price, they will bring loads of
them. If they expect the price to be very low, a much smaller quantity will be made
available.
o Suppliers’ costs of production: suppliers’ production costs will change when input prices
and production technology change. If the prices of the inputs change, the suppliers’ costs
will change and will influence the quantity of goods supplied to the market.
▪ Changes in production technology, the processes used to make, distribute, and
sell a good, will change the costs of production. The more efficient these
processes are, the lower the costs to sellers of providing goods.
o The number of sellers: more producers will raise the available supply.
o Sellers’ outside options: Doing business in markets for other goods or in other markets
for goods can affect suppliers’ willingness to supply goods at a particular market.
• Supply curves show the relationship between the quantity supplied of a good and the good’s
price, holding all other factors constant. They capture the idea that factors influencing supply can
be divided into two sets: (1) price and (2) everything else.
o The supply curve often slopes upward → holding everything else equal, producers are
willing to supply more of a good as its price rises. Many firms experience increasing costs
of production as their output rises, in this case they need to earn higher price in the
market in order to induce them to produce more output.
o Mathematical representation of the supply curve
▪ The supply choke price is the price at which no firm is willing to produce a good
and quantity supplied is zero; the vertical intercept of the inverse supply curve.
▪ The inverse supply curve is a supply curve written in the form of price as a
function of quantity supplied.
6
, o Changes in quantity supplied at every price illustrate a distinction:
▪ Changes in quantity supplied are reflected in movements along the supply curve
that occurs as a result of a change in the good’s price.
▪ Changes in supply are reflected in shifts of the entire supply curve caused by a
change in a determinant of supply other than the good’s own price.
2.4. Market Equilibrium
• The true power of the supply and demand model emerges when we combine demand and supply
curves.
• Market equilibrium 𝐸 is the point where the demand and supply curves cross.
• Equilibrium price 𝑃𝑒 is the only price at which quantity supplied equals quantity demanded.
• Equilibrium quantity 𝑄𝑒
• These quantities can be mathematically determined by using the equations for the demand and
supply curves.
o At market equilibrium, quantity demanded equals quantity supplied: 𝑄𝑒 = 𝑄 𝐷 = 𝑄 𝑆
o We could also use the fact that the price given by the inverse demand and supply curves
is the same at the market equilibrium quantity.
• A+ make the grade: solving for the market equilibrium is one of the most common exam questions
in microeconomics classes. A simple trick to ensure that you obtain the right answer is to take the
equilibrium price that you get and plug it into both the demand and supply curves. If you don’t
arrive at the same answer when you substitute the equilibrium price into the supply and demand
equations, you will know immediately that you made a math error.
• When a market is in equilibrium, the quantity demanded by consumers and the quantity supplied
by producers are equal at the market price. However, this is not always the case:
o Excess supply: With a price higher than the equilibrium price, call it 𝑃ℎ𝑖𝑔ℎ instead of 𝑃𝑒 ,
𝑆 𝐷
the quantity supplied (𝑄ℎ𝑖𝑔ℎ ), is greater than the quantity demanded (𝑄ℎ𝑖𝑔ℎ ). The excess
𝑆 𝐷
quantity for sale equals 𝑄ℎ𝑖𝑔ℎ − 𝑄ℎ𝑖𝑔ℎ , the horizontal distance between the demand and
supply curves at 𝑃ℎ𝑖𝑔ℎ .
▪ Producers want to sell at this high price, but not all producers can find willing
buyers at that price, i.e. price is too high to sell all the goods.
▪ To eliminate this excess supply, producers need to attract more buyers, and to do
this sellers must lower their prices. As price falls, quantity demanded rises and
quantity supplies falls until the market reaches equilibrium at point 𝐸.
o Excess demand: with a price lower than the equilibrium price, 𝑃𝑙𝑜𝑤 , consumers demand
𝐷
a lot of the good when it’s that cheap (𝑄𝑙𝑜𝑤 ), but that amount is more than producers are
𝑆
willing to supply (𝑄𝑙𝑜𝑤 ).
▪ to eliminate this excess demand, buyers who cannot find the good available for
sale will bid up the price and enterprising producers will be more than willing to
raise their prices. As price rises, quantity demanded falls and quantity supplied
rises until the market reaches equilibrium at point 𝐸.
o Keep in mind that in the real world equilibrium is a bit mysterious.
• As mentioned earlier, demand and supply curves hold constant everything else besides price that
might affect quantities demanded and supplied. Therefore, the market equilibrium will only hold
as no other factors change. If any other factor changes, there will be a new market equilibrium
because either the demand or supply curve or both curves will have shifted.
o Distinguishing between shifts in a demand or supply curve and movements along those
curves is of great importance.
7
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