Detailed notes for EC102 Economics B - Microeconomics (Michaelmas Term) by a student that achieved 93% in the exam. The notes have been broken down by each week to make it easier to follow with on-going lectures, and equally when it comes to revising for the exam.
EC102 Micro week 1 – Introduction (slides 1-23) & Monopolistic Behaviour (slides 23-72)
Introduction
Microeconomics starts at the level of individuals and asks how people pursue their own individual
goals. We try to have models and predictions and to understand how individuals make decisions.
Start at the individual level but we put it in the societal context – trying to understand what happens
in society.
Positive and normative economics
Two types on analysis in economics:
Positive economics – what do people do? We care about understanding how people behave and
making predictions about how they behave. For example, with Brexit, how will people behave after
Brexit (such as the leaders, companies, consumers, governments etc.)?
It relates to things we can observe in the data and make predictions about.
Normative economics – what should people do? What should the government do? Implies that
we’re imposing some notion of welfare when we’re making such statements.
Positive analysis is objective, but sometimes the way you model/explain a situation involves you
saying these are the important aspects of the situation. Sometimes, choosing these aspects colour
the way you see things.
Normative analysis is subjective as it is based on a particular notion of welfare.
Economic principles
Economics combines empiricism (looking at data and asking how people actually behave) with
theorising (writing down models, theories and explanations that predict how people will behave in
certain situations).
We use data to inform our theories, and we use the theories to look at the data.
Two very important principles:
1. Optimisation – people decide what to do by weighing all the known pros and cons of the
different options and picking the best option: they have a well-defined preference, and they
look at what is available to them and they choose the option that maximises their goal. We
call this rationality.
2. Equilibrium – unique to economics: focus on situations in which things stabilise to the point
where everybody is optimising and nobody can find anything to do that will better their
situation. Therefore, this is a situation in which everyone is simultaneously optimising, which
means that no individual thinks that he/she has another course of available action that is
better for them.
The demand and supply curves correspond to optimisation, and the equilibrium point is where there
is no consumer who would like to buy more and no supplier who would like to produce more.
Therefore, everything is in equilibrium.
,Monopolistic Behaviour
Monopoly is a market structure where there is only one firm in the industry. Why? Many reasons,
and these reasons are put into one term called barriers to entry.
One form is by law (e.g. drug company being given a patent so that only that company can produce
it for that number of years). Another example is natural (e.g. some industries such as utilities only
have room for one firm due to infrastructure and returns to scale).
A monopoly cannot influence the demand curve, and so the price at which a monopolist can sell its
product depends on the quantity (or vice versa).
P(q) tells us the relationship between quantity demanded and price → for any price, how much
quantity is demanded (or vice versa).
Degrees of monopolistic behaviour
Simple monopoly – a monopolist who can only choose one price for all consumers.
There are different types of ways in which a monopolist can discriminate in order to increase
revenue and/or profits:
a) First degree – a fully discriminating monopolist that has the ability to charge a different price
for each person. However, this is difficult to do in reality due to arbitrage (where those that
are charged a lower price sell at a higher price to those that would have been charged at
least this or even more by the monopoly and so are willing to pay).
b) Second degree – able to sell different quantities of output at different prices e.g. discount to
those who bulk buy, different sized tins etc.
c) Third degree – able to sell at different prices to different consumer groups e.g. males
charged more at clubs
Simple monopolist
Monopoly chooses the quantity to produce, q → price is determined by the demand function P(q)
Revenue, R(q) = P(q) x q
Profit = R(q) – C(q) where C(q) is the cost of producing q
Revenue curve shown is for a linear demand curve and is an inverted U
shape because, to sell more output, the monopolist has to lower the
price. This has 2 opposing effects on total revenue:
i) Lower price increases the quantity demanded, so the firm
sells more (marginal units)
ii) Reduces revenue from units that would have been sold if the price was higher (infra-
marginal units)
These effects are shown on the demand curve. If the
blue rectangle is bigger, revenue increases. If the red
rectangle is bigger, revenue decreases.
,Marginal Revenue
What is the effect on revenue if the monopolist wants to produce a little bit more?
This is the derivative of the revenue function with respect to q → by how much would the revenue
increase for a small increase in q
Mathematically, the marginal revenue is ΔR(q)/Δq.
For a linear function, p(q) = a – bq
R(q) = p(q).q = aq – bq2
MR(q) = ΔR(q)/Δq → therefore, MR(q) = a – 2bq
Note that for a monopoly, price is a function of quantity, because a
monopolist cannot set both: they set a quantity and the price is determined
by this quantity.
Therefore, the marginal revenue function has the same intercept, but a slope twice as big as a linear
demand function.
The optimal point for a monopolist to produce is where marginal revenue (MR) = marginal cost
(MC), with the price determined by the demand curve at that quantity. MR = MC is the optimal point
because after this point, any additional unit would result in MC being greater than MR, and thus
these units would incur a loss.
However, a discriminating monopoly can increase profits and producer surplus further at the
expense of consumer surplus.
, EC102 Micro week 2 – Price setting and consumer theory (slides 72-120)
The microfoundations of consumer demand
Demand is a relationship between the price and the quantity that the aggregate people will demand
at that price.
Measuring demand is tricky because there’s many different prices.
A consumption bundle is the set of things that a consumer buys in a period of time.
We assume that people have well-defined preferences and will choose goods/services that maximise
these preferences (utility).
The budget line tells us the set of things that the consumer can achieve, since they have a limited
amount of money → trade-offs.
Theory of optimal consumption
Preferences – how you feel about different consumption bundles
A rational economic agent will always consume a consumption bundle that optimises her
preferences given the amount of money in her wallet and the prices of the good available.
We assume that a rational consumer will not save the money but spend all of their budget, as this is
where they will gain the most utility.
Indifference curves are lines of equal preferences. Note that each indifference curve is not a shift of
a lower/higher indifference curve, but its own curve.
The optimal consumption bundle is where the slope of the indifference curve is tangent to the slope
of the budget line → slope of the budget line = slope of the indifference curve (i.e. exchange rate in
market = exchange rate in preferences).
The exchange rate in the market is the ratio of prices of the bundle of goods, which is the negative
slope of the budget line.
The exchange rate in preferences is the ratio of marginal utility, which is the negative slope of the
indifference curve.
Therefore: - MUx/MUy = - Px/Py i.e. MUx/Px = MUy/Py
Note that it is not (change in y/change in x) as we are used to in maths.
Assumptions for this model:
a) The consumer knows the different goods they can buy
b) The consumer knows the prices of each good
c) The consumer has a fixed amount of income they want to spend on the goods
d) The consumer has well-defined preferences
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