Microeconomics Study Sheet

- For substitutes/complements, the cross elasticity is

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The production possibility curve (PPC) illustrates Total utility is maximized when all income is spent
maximum combinations of outputs that can be Price and when the utility gained from the last dollar spent on
produced, given a country’s resources and technology. ($) each product is equal:
η=9
The opportunity cost of a choice is the benefit of the MUi = MUj
next best alternative given up. It is the slope of the PPC. Pi Pj
η = 2.33 A budget line marks the borderline between affordable
Good X
and unaffordable consumption bundles. It depends on
Unattainable
η=1
income and prices.
Slope of the budget line: -PM/PP
η = 1/2.33 An indifference curve represents a certain level of
utility. Consumption bundles to the right are preferred,
Attainable η = 1/9 consumption bundles to the left are not preferred.
D → MRS (slope of an indifference curve) diminishes as
Quantity we move down to the right along an indifference curve.
The best affordable point is the point at which the
budget line is tangent to the indifference curve:
Good Y η = 1:
Total expenditure
H
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Best affordable
The slope of a straight line is calculated as the change point
in the value of the variable measured on the vertical
axis (∆y) divided by the change in the value of the
variable measured on the horizontal axis (∆x): Budget line
∆y
slope = η > 1: η < 1:
∆x Price cut Price cut
Value of an index in a given period increases total decreases total
Relative price (-PM/PP) = MRS (budget line tangent to
expenditure expenditure
absolute value at given period indifference curve).
= × 100 The effect of a price change can be divided into
absolute value in base period
substitution and income effect.
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The higher the price of a good, the smaller the quantity Quantity relative price, holding utility constant).
demanded (law of demand). → Increase (decrease) in the consumption of the good
→ The demand curve is downward sloping. M
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A whose price has fallen (risen).
The higher the price of a good, the higher the quantity A price ceiling below equilibrium price results in Income effect (effect of a change in income, holding
supplied (law of supply). shortage (excess supply). relative price constant).
→ The supply curve is upward sloping. A price floor above equilibrium price results in surplus → Normal good: Income effect reinforces the
Shortage (excess demand): quantity demanded > (excess demand). substitution effect.
quantity supplied In the long run, rent controls result in a growing → Inferior good: Income and substitution effects work
→ Upward pressure on the price. housing shortage. in opposite directions.
Surplus (excess supply): quantity demanded < quantity Farm policies are directed at stabilizing and raising The income-consumption line traces out all utility
supplied farm revenues. maximizing points for different levels of income.
→ Downward pressure on the price. - The price-consumption line traces out all utility
The price adjusts until quantity demanded equals maximizing points for different levels of income.
Rent
quantity supplied (market equilibrium). ($)
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- Short run (SR)
Blackmarket price S → Quantities of at least one of the firm’s resources is
Price S fixed.
($) - Long run (LR)
Surplus Price
ceiling → Quantities of all of the firm’s resources can be
Shortage
varied, but its technology is fixed.

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Shortage
D
D

Quantity
- Very long run
→ Quantities of all of the firm’s resources and its
technology can be varied.
- Economic profits = total revenues – opportunity costs.
Quantity Price Total product (TP): Total output produced for various
($) levels of labour.
EEElllaaassstttiiiccciiitttyyy Marginal product (MP): Increase in total product
η=
% change in quantity resulting from a one-unit increase in labour. → Slope
% change in price
Surplus S of the TP curve (∆TP/∆L)
change in quantity average quantity Price Average product (AP): Total product per unit of labor
=
% change in price average price floor (TP/L).
∆Q /Q Total cost (TC) = Total fixed cost (independent of the
=
∆P / P level of output) + Total variable cost (increases as
- If demand is (in-)elastic, a decrease in price results in D
output increases).
higher (lower) total expenditure (TE). TE doesn’t Marginal cost (MC): Increase in total cost resulting
change due to a price-change for a unit-elastic demand. from a one-unit increase in output. → Slope of the TC
Quantity curve (∆TC/∆Q).
- For inferior/normal goods, the income elasticity is
negative/positive. Average total cost (ATC): TC per unit of output
(TC/Q).
ATC = AVC (average variable cost) + AFC (average
fixed cost).

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Because of initially increasing returns and eventually marginal revenue = average revenue = market price. Price
decreasing returns, the average total cost curve is MR = AR = p ($)
u-shaped Short run economic profits (losses) induce firms to
MP & AP enter (exit) the industry. Industry supply increases
Point of diminishing
(units) marginal return (decreases), the market price falls (rises) and in the
long run, economic profits return to zero. P* = TC*
Point of diminishing Shutdown point: p = AVCMIN
average returns
The marginal cost curve above the shutdown point
traces out the firm’s short run supply curve.
The short run industry supply is simply the sum of the M D
AP quantities supplied by all firms at each given price.
MP Quantity
Long run equilibrium
- Economic profits are zero. In oligopoly, firms are aware of interdependence
Labour
among the decisions made by the various firms in the
Price industy → strategic behaviour.
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In the long run, all factors are variable (“plant size is persist in the long run.
Economic profit
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The long run average cost curve traces out the lowest Productive efficiency requires that total cost in an
attainable average total cost at each output when both industry is minimized.
capital and labour inputs can be varied. Allocative efficiency → p = MC for each product.
Profit maximization is equivalent to cost minimization. Industries in which firms have a certain degree of
- Firms choose the combination of capital and labour market power result in allocative distortion
such that MPK = MPL Quantity (inefficiency), because p > MC.
pK pL There exists income distortion when profits/losses
Diminishing returns occur for any given quantity of Mooonnnooopppooolllyyy
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capital (labour) as the quantity of labour (capital) A single price monopolist maximizes profit by producing Imposing marginal cost pricing on a natural monopoly
increases. the output level at which marginal revenue = marginal results in allocative efficiency, but the monopolist
→ MPK (MPL) decreases as more capital (labour) is cost. generally incurs economic profits or losses.
employed. → Note that marginal revenue < market price. Imposing average cost pricing on a natural monopoly
Economies of scale → Compared to perfect competition, equilibrium output results in zero economic profits, but the outcome is
- Fall in ATC as firm’s scale of production increases. is lower and equilibrium price is higher generally allocatively inefficient.
Price
(increasing returns to scale). (inefficient). Efficiency loss (deadweight loss).
Diseconomies of scale Price ($)
- Rise in ATC as firm’s scale of production increases. ($) MC
(decreasing returns to scale)..
Constant returns to scale
- Constant ATC as firm’s scale of production increases. ATC
(constant returns to scale). Economic
Minimum efficient scale profit
ATC
- Smallest quantity of output at which LRAC reaches its Loss with MC pricing
lowest level. MC
Isoquant D
M
- Whole set of technically efficient factor combinations
Quantity
for producing a given level of output. D
Marginal rate of substitution between two factors is Price-discriminating monopoly: Producer charges
equal to the ratio of their marginal products. different prices for different units of the same product for Quantity
- Slope of an isoquant at a particular point. reasons not associated with differences in cost. Price
Isocost line shows alternative combinations of factors A (perfectly) price discriminating monopolist ($)
that a firm can buy for given total cost. converts consumer surplus into profit by charging each MC
- Slope = - (factor price ratio). buyer the maximum amount that he is willing to pay.
Cost minimization → The outcome is efficient, with smaller consumer

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pL MPL
=
pK MPK
surplus and larger producer surplus.
Monopoly profits can persist in the long run if there
are effective barriers to entry.
ATC

Cost
Cartels as monopolies: Organization of producers
($) Profit with MC pricing
who agree to cooperate and act as a single seller.
Cartels are unstable due to incentive to cheat for each
firm.
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Minimum AT
efficient In monopolistic competition there may be economic
Quantity
scale profits in the short run. Each firm supplies its
Economies
of scale Constant
Diseconomies
of scale
differentiated product to a small segment of the
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returns to scale market. However, free entry/exit assures that in the
Factors of production are capital, land, an labour.
long run, economic profits are zero (at the quantity
Factor demand is derived from the demand of the final
where MC = MR, p = ATC).
Output good or service that the factor produces.
A profit maximizing firm hires up the point where:
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Cooom M marginal cost(MC) = Marginal revenue product
(MRP) = MR*MP
The profit maximizing output level is the quantity at
Total factor income = factor price * level of employment.
which
= transfer earnings + economic rent.
marginal revenue = marginal cost. (MR = MC)

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 Microeconomics Study Sheet
Wage is equal to the economy’s capital stock. Price Elastic
- Accumulation of capital leads to a decrease in the ($) demand S + tax
($)
equilibrium interest rate.
- Technological improvements lead to an increase in
S the equilibrium interest rate. S
Unaffordable Present value of a single future payment PV =
tax rev.
MRP/(1 + i)t
Transfer
Present value of a stream of payments that continues
earning forever PV = MRP/i Excess burden D
D Hotelling’s rule: The socially optimal rate of extraction
of any non-renewable resource is such that its price
increases at a rate equal to the interest rate.
Rent M
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($) Markets fail to achieve allocative efficiency in presence
S of market power, externalities, public goods, Price
Inelastic
($)
asymmetric information, and missing markets. demand
Unaffordable With a positive externality, a competitive market will S + tax
produce too little of the good.
Econ. rent With a negative externality, a competitive market will tax rev. S
produce too much of the good.
MSC: Marginal social cost MSC = external cost
imposed on the beach resort).
D Coase theorem: If property rights exist and
Excess burden D
transaction costs are low, private transactions are
Wage
efficient, regardless of who has the property right.
($) S Non-rivalrous goods: consumption by one person does
not reduce consumption by another person.
→ Marginal cost of an additional user is zero. Quantity
Unaffordable
→ To reach allocative efficiency, the price should be
Econ. zero.
Non-excludable goods: impossible/extremely costly to
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prevent someone from consuming a good. T G m T
Public goods (those which are non-rivalrous and non- Gains from trade arise from different opportunity costs.
Transfer excldable) give rise to free-rider problem → Specialization in the activity in which opportunity
D Cost & costs are lowest.
earning
benefit
Countries export goods for which they have a
($)
comparative advantage.
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M Efficient Countries import goods for which they have a
outcome comparative disadvantage.
Wage differentials in competitive markets may result External
from differences in working conditions, in inherited skill, cost
Terms of trade: Ratio of the (average) price of a
MC
in human capital, or from some form of discrimination. country’s exports to the (average) price of its imports.
Index of Export Prices
Two general cases that give rise to noncompetitive Terms of Trade = × 100
labor markets are the presence of a union (monopoly Competitive Index of Import Prices
eqm.
in selling labor) and / or of a monopsony (single buyer
of labor). D = MB Good X Country A
A binding minimum wage reduces employment in
Quantity
competitive labor markets; however, it may lead to an
increase in employment in case employers have some
monopsony power.
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Profit maximizing firms produce too much relative to the possibilities
Monopsony: a single buyer in the market … with trade
Wage allocatively efficient level of output if MC < MSC (due
rate to negative externality).
($/h) The allocatively efficient level of pollution is the level

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MC
S
where MC of further pollution abatement = MB of
pollution reduction.
Policies used to regulate pollution are direct controls,
… without trade;
emissions taxes, and tradable pollution permits.
Good Y
w2
Profit
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w0 Competitve The most important taxes in Canada are personal
eqm income tax, corporate income tax, excise and sales
w1 taxes, and property taxes. Consumption
Monopsony
Progressive tax: marginal tax rate increases as income possibilities …
eqm MRP = D with trade
increases.
Proportional tax: marginal tax rate is the same for all
levels of income.
qM qPC Labour Regressive tax: marginal tax rate decreases as income
increases.
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R Efficiency and equity are often competing goals.
… without trade;

Profit maximizing firms purchase new capital up to the

Good Y
point where the present value of the stream of future
MRPs is equal to the purchase price of that unit. Law of one price: When a product which can be
The interest rate is determined in the capital market cheaply transported is traded throughout the entire
and adjusts such that the quantity of capital demanded world, it will tend to have a single world price.

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