Summary Microeconomics for Premasters 2018-2019 EC2MIP
Utrecht University, Premaster Economics
Chapters 1 t/m 4 and 6 t/m 11 (week 1 till 4)
Chapters 12, 13, 5, 17 and 19 (week 6 till 8)
Week 1
Chapter 1: Preliminaries
Positive analysis - Describes the relationship of cause and effect
Normative analysis - examining questions of what ought to be
Nominal price - Absolute price, unadjusted for inflation
Real price - Price adjusted for inflation
CPI - measures the aggregate price level
PPI - measures the aggregate price level of intermediate and wholesale goods
Real price = CPIold/CPIcurrent/new * nominal pricecurrent
Chapter 2: basics of supply and demand
Substitutes – Two goods for which an increase in price of one will result in an increase of
quantity demanded of the other
Complements – Two goods for which an increase in price of one will result in a decrease of
quantity demanded of the other
Market mechanism – Tendency in a free market for price to change until the market clears
(equilibrium)
Surplus – Q supplied exceeds Q demanded
Shortage – Q demanded exceeds Q supplied
Shifts of the Demand curve Shifts of the supply curve
To the right: P increases, Q increases P decreases, Q increases
To the left: P decreases, Q decreases P increases, Q decreases
Price elasticity of demand Ep:
Ep = %Q/Q / %P/P = P/Q*Q/P (Q/P = slope of the function)
Ep>-1: Elastic demand
Ep<-1: Inelastic demand
Ep=-1: optimum point, max profit
Infinitely elastic demand: (fill in P = 0 in the function)
One price where Q is infinite -> horizontal demand curve
Completely inelastic demand: (fill in Q = 0 in the function)
One Q where P is infinite -> vertical demand curve
Income elasticity of demand Ei
Ei = %Q/Q / %I/I = I/Q*Q/I
Cross price elasticity of demand – change in Q demanded from a change in P of the other
good (substitutes):
Ed = Pm/Qb * (Pm*Qb) / (Qb*Pm) = %Qb/Qb / %Pm/Pm
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,Arc elasticity of demand – Ep over a range of prices:
EP = Q/P * Average P/Average Q
Long run elasticities:
Demand Income Supply
SR: elastic, LR: inelastic SR: inelastic, LR: elastic. SR: inelastic, LR: elastic
Week 2
Chapter 3: consumer behaviour
Three distinct steps:
1. Consumer preferences
2. Budget constraints -> limited income
3. Consumer choices -> maximize satisfaction
Indifference curve – all combinations of market baskets with the same utility
Basic rules and assumptions:
1. Completeness – preferences are complete -> all possible market baskets can be
ranked
2. Transitivity – if A is preferred to B and B is preferred to C than A is preferred to C
3. More is better than less - more is preferred over less (or less over more in case of a
bad good like pollution)
4. Diminishing marginal rate of substitution – slope of the indifference curve increases,
indifference curve is convex
Marginal rate of substitution MRS – maximum of good A given up to obtain one more unit
of good B. it is the value the consumer places on 1 extra good in terms of another
MRS = -X/Y (X is on the horizontal axis, Y on the vertical axsis).
Perfect substitutes – two goods where the MRS is constant. The indifference curve is a
straight line. Max Utility is the total amount the consumer is able to buy from the cheapest
good. This is a Corner Solution -> MRS > or = Px/Py.
Perfect complements – two goods, MRS is zero (horizontal part) or infinite (vertical part),
indifference curve is an angle with two straight lines horizontal and vertical
Ordinal utility - ranking of market baskets most to least preferred
Cardinal Utility – How much one basket is preferred to one other
Budget line: I = Px*Qx + Py*Qy -> Qy = I/Py – (Px/Py) * Qx
When income I changes -> budget line shifts parallel to the original one
When price of one good changes -> B-line rotates inward (P increase) of outward (P
decreases)
Maximum consumer satisfaction - MRS = Px/Py -> where the I-curve and the B-curve are
tangent (point where the slopes are equal)
Marginal benefit MB – benefit from consumption of on additional good
Marginal cost MC – cost of one additional good
Marginal Utility MU – additional satisfaction from consuming one additional good
Diminishing MU – as more of a good is consumed, MU will decrease (additional Utility will
decrease)
2
,Max utility: -Y/X (Ratio of prices) = MUx/MUy = MRS = Px/Py -> MUf/Pf = MUy/Py
Max utility is achieved when the MU per dollar is equal for each good.
Chapter 4: individual and market demand
Price consumption curve – tracing utility maximized combinations for two goods when the
price of one good changes -> a curved line
Income consumption curve – tracing utility maximized combinations for two goods as
income changes -> straight line
Engel curve – relates the Q of a good consumed to income
In case of an inferior good:
Inferior good
Normal good
Substitution effect – change in consumption good A resulting in a price change where utility
is equal -> Move Along the I-curve
Income effect – change in consumption good A as income/purchasing power changes where
price is equal -> Move to the new I- and B-curve
1. Draw a new imaginary budget line parallel to the new one to find the point on the
old indifference curve -> gives you the substitution effect
2. Move from this point to the new point on the new I-curve -> gives you the income
effect
Inferior good – positive sub effect, neg income effect (or the other way around), a negative
income effect can be larger than a positive sub effect.
Giffen good – D-curve slope upward, Pa decrease = Qa decrease and increases Qb->
negative income effect, positive substitution effect.
Isoelastic Demand curve - Ep of demand is constant
Unit elastic demand – Ep = -1 at every price
Consumer surplus – difference between what the consumer is willing to pay and the market
price actually paid. CS = ½ * (Pmax – Pcurrent) * Qcurrent
Network externality – each individual demand depends on the purchases of others
Bandwagon effect – positive network externality where a consumer wishes to possess a
good in part because others do
Snob effect – negative network externality where a consumer wishes to own an exclusive or
unique good.
Week 3
Chapter 6: Production
Production decisions:
1. Production technology: inputs to output
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, 2. Cost constraints: prices of inputs
3. Input choices (factors of production -> inputs)
Production function – showing the highest output that can be produced with every
combination of inputs -> Q =F(L,K)
Short run – one or more inputs are fixed
Long run – amount of time needed to make all inputs variable
Production with one variable L
Average product – output per unit of particular input -> AP = Q/L
Marginal product – additional output produced as input is increased by one unit ->
MP = Q/L. When:
- MP > AP: AP is increasing
- MP < AP: AP is decreasing
- AP is at is max when AP = MP
- Max total production: AP > MP where MP is close to zero
Law of diminishing marginal returns – as input increases with other inputs fixed, resulting
additions to output will eventually decrease
Labor productivity – AP of labor for an entire industry or the economy as a whole
Production with two variables L and K
Isoquant – curve with all possible combinations of inputs that yield the same output
Marginal rate of technical substitution MRTS – amount by which the quantity of one input
can be reduced when one extra input of another is used -> output remains constant.
MRTS = K/L (for a fixed level of output Q)
Diminishing MRTS – productivity of any one input is limited. Adding more and more of one
input will eventually decrease productivity of output.
Additional output from an increase in L: MPL/L
Additional output from an increase in K: MPk/K
Max output - MPL/L + MPk/K = 0 and thus -> MPL/MPK = -K/L = MRTS
Fixed-proportions production function – similar to perfect complements -> only one
combination of inputs for each output
Perfect substitutes of inputs – MRTS is constant -> use the cheapest input (total use of K or
L)
Returns to scale – rate at which output increases as inputs are increased proportionally:
- Increasing returns to scale: output more than doubles as all inputs are doubled Ed >1
- Constant returns to scale: output doubles as all inputs are doubled Ed = 1
- Decreasing returns to scale: output less than doubles as all inputs are doubled Ed < 1
Chapter 7: The cost of production
Accounting cost – actual expenses plus depreciation charges on capital equipment
Economic cost – cost to a firm of utilizing economic resources in production
Opportunity cost – cost associated with opportunities forgone when a firm’s resources are
not put in their best alternative use -> economic cost = opportunity cost
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