Microeconomics

Chapter 1

Positive analysis = deals with explanation and prediction. Describes relationships of cause
and effect.
Normative analysis = deals with how the world should be.

 consumer theory
Microeconomics
 firm theory

Arbitrage = practice of buying at a low price at one location and selling at a higher price in
another location.

Market price = price prevailing in a competitive market.

Nominal price = absolute price of a good.

Real price = price of a good relative to an aggregate measure of prices.

Consumer price index (CPI) = measure of the aggregate price level.

Producer price index (PCI) = measure of the aggregate price level for intermediate products
and wholesale goods.

 Which price index should you choose to convert nominal prices into real prices?
o Depends on the type of product you are examining.

Chapter 2 – Consumer Behaviour

 Consumer behaviour is best understood in 3 steps:

a) Consumer preferences
b) Budget constraints
- consumers also consider prices
c) Consumer choices
- Given their preferences and limited income, people choose to buy
combinations of goods that maximize their satisfaction.

NOTE – Consumers do not always behave rationally. For example, they buy on impulse,
ignoring their budget constraints. Sometimes consumers are unsure about their preferences
or are swayed by the consumption decisions of friends and neighbours, or even by a change
in their mood. This are of research is called behavioural economics.
CONSUMER PREFERENCES

Market basket = list with specific quantities with one or more goods.

Basic assumptions about preferences:

1. Completeness = consumers can compare and rank all possible baskets

- for any two market baskets A and B, a consumer will prefer A to B, will prefer
B to A, or will be indifferent between the two.

2. Transitivity = if a consumer prefers basket A to basket B and basket B to basket C,

then the consumer also prefers A to C.
3. More is Better than less

 Indifference Curves = all combinations of market baskets that provide a consumer

with the same level of satisfaction

 Indifference Maps = a set of indifference curves showing the market baskets among
which a consumer is indifferent.
 !! Indifference curves do not cross.

marginal rate of substitution (MRS) = Maximum amount of a good that a consumer is willing
to give up in order to obtain one additional unit of another good = the magnitude of the
slope of an indifference curve

- If the MRS is 1/2, the consumer is willing to give up only 1/2 unit of clothing.

perfect substitutes Two goods for which the marginal rate of substitution of one for the
other is a constant.
perfect complements Two goods for which the MrS is zero or infinite; the indifference
curves are shaped as right angles.

Bad = Good for which less is preferred rather than more.

 pizza: amount of pepperoni (like) and anchovies (dislike)

Ex: - air pollution, anchovies on pizza

Neutrals = good that the consumer does not care about

Bliss point/ Satiation point = consumer has one most preferred market basket
Utility = numerical score representing the satisfaction that a consumer gets from a given
market basket

Utility function = formula that assigns a level of utility to individual market baskets.

a) ordinal utility function = Utility function that generates a ranking of market baskets
in order of most to least preferred.
b) cardinal utility function = Utility function describing by how much one market
basket is preferred to another.

BUDGET CONSTRAINTS

= constraints that consumers face because of limited incomes.

Budget line = all combinations of goods for which the total amount of money spent is equal
to income. We are ignoring the possibility of saving.
 a) Price changes

b) Income changes – shifts the budget line to the left/right, but does not change the
slope.

CONSUMER CHOICES
 - It must be located on the budget line
- It must give the consumer the most preferred combination of G&S
- choose goods to maximize the satisfaction they can achieve, given the limited budget
available to them.

NOTE: Satisfaction is maximized when the marginal rate of substitution (of F for C) is equal
to the ratio of the prices (of F to C). If the MRS is less or greater than the price ratio, the
consumer’s satisfaction has not been maximized.

- Satisfaction is maximized when marginal benefit (MB) = marginal cost (MC)

Corner solutions = a situation in which the MRS of one good for another in a chosen market
basket is not equal to the slope of the budget line.
- If an individual chooses to purchase only good X (not good Y) this decision
reflects a corner solution.
- When one of the goods is not consumed, the consumption bundle appears at
the corner of the graph.
- MRS ≥ PIC/PY

marginal utility (MU) = Additional satisfaction obtained from consuming one additional unit
of a good.
MUF/PF = MUC/PC  CHECK BOOK (PG. 118)

- This equation tells us that utility maximization is achieved when the budget is
allocated so that the marginal utility per dollar of expenditure is the same for
each good.

diminishing marginal utility = Principle that as more of a good is consumed, the

consumption of additional amounts will yield smaller additions to utility.

Chapter 4

Demand Analysis Steps

1) Individual Demand

price-consumption curve = Curve tracing the utility-maximizing combinations of two goods

as the price of one changes.

- The demand curve has 2 important properties:

a) The level of utility that can be attained changes as we move along the curve
 - The lower the price, the higher the level of utility
b) At every point on the demand curve, the consumer is maximizing utility by satisfying
the condition that the marginal rate of substitution (MRS) (check page 134)

income-consumption curve = Curve tracing the utility-maximizing combinations of two

goods as a consumer’s income changes.

Normal VS Inferior goods

- In order to determine if a good is a normal or an inferior good, we can look at
the income-consumption curve

- When the income-consumption curve has a positive slope (like in the picture
above), Qd increases with income.
- In this case, income elasticity of demand is positive, meaning that we are
dealing with a normal good.

- in the picture below, we are dealing with the income-consumption curve for
an inferior curve. This means that consumption falls when income increases
=> negative income elasticity of demand.
Engel Curves
- income consumption curves can be used to construct Engel Curves.

Engel Curve = Curve relating the quantity of a good consumed to income.

Substitutes VS Complements
- we can examine at the price consumption curves to determine if a good is a
substitute or a complement (page 138)

2) Income and Substitution effects

A fall in the price of a good has two effects:

a) Consumers will tend to buy more of the good that has become cheaper and less of
those goods that are now relatively more expensive. This response to a change in the
relative prices of goods is called the substitution effect.
b) Because one of the goods is now cheaper, consumers enjoy an increase in real
purchasing power. They are better off because they can buy the same amount of the
good for less money, and thus have money left over for ad- ditional purchases. The
change in demand resulting from this change in real purchasing power is called the
income effect.

- Normally these 2 effects occur simultaneously

Substitution Effect = Change in consumption of a good associated with a change in its price,
with the level of utility held constant

- This substitution is marked by a movement along an indifference curve. In

Figure 4.6, the substitution effect can be obtained by drawing a budget line
parallel to the new budget line RT (reflecting the lower relative price of food),
but which is tangent to the original indifference curve U1 (holding the level of
satisfaction constant).

Income effect = Change in consumption of a good resulting from an increase in purchasing

power, with relative prices held constant.

- In figure 4.6, we can see the income effect by moving from the imaginary
budget line that passes through point D to the parallel budget line, RT, which
 passes through B. The consumer chooses market basket B on indifference
curve U2 (because the lower price of food has increased her level of utility).

Total Effect(F1F2) = Substitution Effect(F1E) + Income Effect(EF2)

RECALL!!

- The direction of the substitution effect is always the same. A decline in the
price leads to an increase in the consumption of that good.
- The income effect can move demand in either direction. It depends on
whether the good is normal or inferior.

- A special case is the Giffen Good = good whose demand curve slopes upward
because the income effect is larger than the substitution effect. So demand
rises, as price rises. EX: Bread
 3) Market Demand

Elasticity Of Demand

a) Inelastic Demand < 1

b) Elastic Demand > 1

isoelastic demand curve = Demand curve with a constant price elasticity.

- A special case of the isoelastic demand curve is:

 c) Unit Elasticity of Demand = 1

speculative demand = Demand-driven not by the direct benefits one obtains from owning
or consuming a good but instead by an expectation that the price of the goodwill increase.

4) Consumer Surplus

Consumer Surplus = the difference between what a consumer is willing to pay for a good
and the amount actually paid

= what a consumer is willing to pay – the amount it actually pays

- Consumer surplus has important applications in economics. When added

over many individuals, it measures the aggregate benefit that consumers
obtain from buying goods in a market.

5) Network Externalities
network externality = Situation in which each individual’s demand depends on the
purchases of other individuals.
 a) Positive network externality = if the quantity of a good demanded by a typical
consumer increases in response to the growth in purchases of other consumers.
Ex: word processing such as Microsoft Office. If colleagues or professors use it,
you are more inclined to use it as well.

- Another example is: Bandwagon effect = Positive network externality in

which a consumer wishes to possess a good in part because others do. The
desire to be in style

b) Negative Network Externality = if the quantity demanded decreases

EX: Snob effect = where a consumer wishes to own an exclusive or unique good –
rare works or art

6) * Empirical Estimation of Demand (pg. 159)

Chapter 6 – Production

Firms and production decisions:

- Production decisions:
a) Production technology
- How to transform inputs into outputs?
b) Cost constraints
- Firms must consider the cost of inputs
c) Input choices
- How much of each input to use in producing its output?

Why do firms exist?

- Why couldn’t a product (ex. Cars) be produced by a collection of

individuals who worked independently and contracted with each
other when appropriate?
- This could be possible. However, it would not be so efficient.
 - Firms offer a means of coordination that is extremely important
and would be surely missing if workers operated independently.
- Firms eliminate the need for every worker to negotiate every task
that he or she will perform.
- There is no guarantee that a firm will operate efficiently.

Factors of production = inputs that go into the production process.

a) Labor
b) Capital
c) Materials

The Production Function = function showing the highest output that a firm can
produce for every specified combination of inputs.

q = F(K, L)

- The production function describes what is technically feasible

when the firm operates efficiently – when the firm uses
- The equation applies to a given technology – to a given state of
knowledge about the various methods that might be used to
transform inputs into outputs. As technology advances, a firm can
obtain more output from the same amount of inputs.

Short run = period of time in which quantities of one or more production factors cannot be
changed.

Fixed input = production factor that cannot be varied.

Long run = amount of time needed to make all production inputs variable.

Production with one variable input (Labor)

Average product (APL ) = output per unit of a particular input (ex. Average product per
labour)

APL = t. output/ t. input of labour = q/L

- The average product of labour measures the productivity of the firm’s

workforce in terms of how much output a worker produces on average.
Marginal product (MPL ) = the additional output produced as the labor is increased by one
unit.

Marginal product of labor = Change in output/ change in labor input = ∆q/∆L

Law of diminishing marginal returns = principle that as the use of an input
increases with other inputs fixed, the resulting additions to output will
eventually decrease.

- When the labor input is small (and capital is fixed), extra labor
adds considerably to output, often because workers are allowed to
devote themselves to specialized tasks
- The law of diminishing marginal returns applies: when. There are
too many workers, some workers become ineffective and the MPL
falls.
 - This law usually applies in the short run, when at least one input is
fixed
- Do not confuse the law of diminishing marginal returns with
possible changes in the quality of labour as labour inputs are
increased (ex. Most qualified labour is highered first). This is not
the case with this law. It is assumed that labour inputs are of equal
quality.
- Diminishing marginal returns result from the limitations on the use
of other fixed inputs (machinery)

Labor Productivity = average product of labour for an entire industry or for the
economy.

- Is important because it determines the real standard of living that a

country can achieve for its citizens.

Production with two variable inputs

- Capital and labor are variable

Isoquants

= curve showing all possible combinations of inputs that yield the same output

Isoquant map = graph combining several isoquants used to describe a

production function.

- Reading the levels of output from each isoquant as labor is

increased, we note that each additional unit of labor generates less
and less additional output
- There are also diminishing marginal returns to capital when labour
remains constant.
Substitution among inputs

Marginal rate of technical substitution (MRTS) = amount by which the quantity

of one input can be reduced when one extra unit of another input is used, so that
output remains constant

Ex: The MRTS of labour for capital is the amount by which the input of capital
can be reduced when one extra unit of labour is used, so that output remains
constant

MRTS = - change in capital input/ change in labour input = - ∆K/∆L ( for a

fixed level of quantity)

- The MRTS is the slope of the isoquant

- The MRTS falls as we move down along an isoquant. (diminishing
MRTS). This tells us that the productivity of any one input is
limited. Production needs a balanced mix of both inputs.

Additional output from increased use of labor = (MPL)(∆L)

Reduction in output from decreased use of capital = (MPK)(∆K)

Production function – special cases

Fixed-proportions production function = production function with L- shaped

isoquants, so that only one combination of labour and capital can be used to
produce each level of output
Returns to Scale

Returns to scale = which output increases as inputs are increased

proportionately

a) Increasing returns to scale = when the output increases by a larger

proportion than the increase in inputs during the production process.
b) Constant returns to scale = when an increase in inputs (capital, labour)
causes the same proportional increase in output.
c) Decreasing returns to scale = when the output increases by a smaller
proportion than the increase in inputs during the production process.

- Returns to scale do not need to be constant across all levels of

output. At lower levels, the firm could have increasing returns to
scale, but constant and eventually decreasing returns at higher
levels of output.
Chapter 7 – The Cost of Production

Measuring Cost: Which Costs Matter

Economic VS Accounting cost

Accounting Cost = Actual expenses plus depreciation charges for capital

equipment

Economic Cost = cost to a firm of utilizing economic resources in production

Opportunity Cost = next best alternative forgone/ Cost associated with

opportunities forgone when a firm’s resources are not put to their best
alternative use

- As long as we account for and measure all of the firm’s resources

properly, we will find that: Economic Cost = Opportunity Cost

Ex: if a firm owns the building in which it is operating under, does this mean
that the cost of office space is zero? A manager or an accountant might say yes.
However, an economist says that there is an opportunity cost involved because
you could have leased the office space and put this resource to an alternative
use.

- While economic cost and opportunity cost both describe the same
thing, the concept of opportunity cost is particularly useful in
 situations where alternatives that are forgone do not reflect
monetary outlays.

Sunk Cost = Expenditure that has been made and cannot be recovered. – R&D
research

- A sunk cost is usually visible., but after it has been incurred it

should always be ignored when making future economic decisions.

Prospective cost = Cost that may be avoided is action is taken.

Total Cost (TC or C) = Total economic cost of production consisting of fixed

and variable costs.

Fixed Cost (FC) = Cost that does not vary with the level of output and that can
be eliminated only by shutting down.

Variable Cost (VC) = Cost that varies with output.

 - Over a very short time horizon, most costs are fixed.
- Over longer periods (a couple of years), many costs become
variable

Fixed VS Sunk Costs

- Sunk costs are costs that have been incurred and cannot be
recovered
- Fixed costs can be avoided if the firm shits down a plant or goes
out of business
- Fixed costs affect the firm’s decision going forward, whereas sunk
costs do not.
Amortization = policy of treating a one=time expenditure as an annual cost
spread out over some number of years.

Marginal Cost (MC)/ Incremental Cost = increase in cost resulting from the
production of one extra unit of output

MC = ∆VC/∆q = ∆TC/∆q

Average total cost (ATC) = TC/q

Average fixed cost (AFC) = FC/q

Average variable cost (AVC) = VC/q

Cost In the Short Run

Determinants of Short-Run Cost

MC= ∆VC/∆q = w∆L/∆q

Marginal Cost = Change in Variable Cost/ Change in Quantity

= Wage x Change in Labor / Change in quantity

 MC = w/MPL

Marginal Cost = Wage / Marginal Product of Labour

- This equation states that when there is only one variable input, the
marginal cost is equal to the price of the input divided by its
marginal product
- See page 246
Shapes of the Cost Curves

Cost in the Long Run

- In the long run, a firm is more flexible. It can expand its capacity,
labour force, change the design of its products

User Cost of Capital = Economic Depreciation + (Interest Rate) (Value of

Capital)  (page252)

The Isocost Line

Isocost line = graph showing all possible combinations of labour and capital that
can be purchased for a given total cost
 - An isoquant shows all combinations of factors that produce a
certain output. An isocost show all combinations of factors that
cost the same amount.

w- unit price of labour

r – rental price of capital

L – amount of labour

K – amount of capital

C – total cost of producing a given output

C = wL + rK

Or

K = C/r – (w/r)L
Cost Minimization with Varying output Levels

Expansion path = curve passing through points of tangency between a firm’s

isocost lines and its isoquants.
How to go from the expansion path to the long run total cost curve?

Long-run total cost curve = the minimum lon-run cost of producing each level
of output

Steps
1. Choose an output level represented by an isoquant in Figure 7.6 (a). Then

find the point of tangency of that isoquant with an isocost line.

2. From the chosen isocost line, determine the minimum cost of producing the output level that has
been selected.
3. Graph the output-cost combination in Figure 7.6 (b).

Long-Run VS Short-Run Cost Curves

long-run average cost curve (LAC) = Curve relating average cost of production
to output when all inputs, including capital, are variable.

short-run average cost curve (SAC) = Curve relating average cost of production
to output when level of capital is fixed.
long-run marginal cost curve (LMC) = Curve showing the change in long-run
total cost as output is increased incrementally by 1 unit.

Economies and Diseconomies of Scale

- as output increases, the firm’s average cost of producing that

output is likely to decline, up to a point. Why?
a) Workers can specialize on the activities that they are most
productive at.
b) Scale can provide flexibility. Managers can organize the
production process more effectively
c) Firms begin to have more negotiating power as they scale up.
Thus, they are able to aquire some production inputs at lower
costs.

- As output increases further, costs can start to increase again. Why?

a) At least in the short run, factory space and machinery may make
it more difficult for workers to do their jobs efficiently
b) Managing a larger firm can become more complex and
inefficient.

Economies of Scale = cost advantages reaped by companies when production

becomes efficient

Diseconomies of Scale = cost disadvantages that economic actors accrue due to

an increase in organizational size or in output, resulting in the production of
goods and services at increased per-unit costs.

Production with 2 outputs – Economies of Scope

Product transformation curve = curve showing the various combinations of 2

different outputs (products) that can be produced with a given set of inputs.
- Say we have a company that produces 2 products (joint production)
- If curve Q1 were a straight line, joint production would entail no
gains (or losses)
Economies of Scope = situation in which joint output of a single firm is greater
than output that could be achieved by two different firms when each produces a
single product

Diseconomies of Scope = situation in which joint output of a single firm is less

than could be achieved by separate firms when each produces a single product.

Degree of Economies of Scope (SC) = % of cost savings resulting when 2 or

more products are produced jointly rather than individually.

Cost of producing output q1 …

- The larger the value of SC, the larger the economies of scope