Principles of

Microeconomics
(Course Handouts for Coursera Course)

Copyright © 2022
Dr. José J. Vázquez

1 THE SCOPE OF ECONOMICS AND 5 MAIN PRINCIPLES....................................

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1.1 What is the Main Economic Problem?...............................................................................4
1.2 Nothing is Free (Opportunity Cost) Principle.....................................................................5
1.3 The Net Marginal Benefit Principle....................................................................................5
1.4 The low hanging fruit principle..........................................................................................6
1.5 Trade is Good Principle......................................................................................................7
1.6 The Invisible Hand Principle...............................................................................................7
1.7 Conclusion.........................................................................................................................8
2 THE SUPPLY AND DEMAND MODEL........................................................................
2.1 Market Equilibrium Intuitively?.........................................................................................9
2.2 Using the Model: a practice example..............................................................................10
2.3 Supply and Demand with Math – a short presentation...................................................12
2.4 Conclusion.......................................................................................................................14
2.5 Appendix A: Supply and Demand with Math – a long presentation................................15
2.5.1 The Demand Schedule.................................................................................................15
2.5.2 Changes in Price of X and Quantity Demanded...........................................................16
2.5.3 Change to Non-price of X determinants of Demand: Income......................................17
2.5.4 Change to Non-price of X determinants of Demand: Buyer’s Preferences...................17
2.5.5 The Supply Schedule....................................................................................................18
2.5.6 Changes in Price of X and Quantity Supplied...............................................................19
2.5.7 Market Equilibrium.....................................................................................................19
2.5.8 Using the Model..........................................................................................................22
2.6 Appendix B: Five Examples on how to use the Model of Supply and Demand................22
2.6.1 Example 1: Increase in Demand..................................................................................22
2.6.2 Example 2: Decrease in Demand.................................................................................23
2.6.3 Example 3: Increase in Supply.....................................................................................24
2.6.4 Example 4: Decrease in Supply....................................................................................24
2.6.5 Example 5: Simultaneous Changes..............................................................................25
2.7 Appendix C: Summary of all Possible Scenarios...............................................................27
3 ELASTICITY...................................................................................................................
3.1 A Working Example: How to reduce smoking?................................................................28
3.2 The Price Elasticity of Demand.........................................................................................29
3.2.1 Definition of the Price Elasticity of Demand................................................................29
3.2.2 Classifying the Price Elasticity of Demand...................................................................30
3.2.3 The mid-point method.................................................................................................32
3.2.4 The price elasticity of demand changes along a linear demand curve........................33
3.2.5 Price Elasticity of Demand and the Demand Equation................................................34
3.2.6 Price elasticity of demand and total revenue..............................................................35
3.3 Three More Elasticities....................................................................................................37
3.3.1 The Income Elasticity of Demand................................................................................37
3.3.2 The Cross-Price Elasticity of Demand..........................................................................37
3.3.3 The Price Elasticity of Supply.......................................................................................38
5 PRODUCTION................................................................................................................
5.1 Inputs Of Production........................................................................................................40
5.2 Fixed Inputs and Variable Inputs......................................................................................41
5.3 The Production Funtion...................................................................................................41
6 THE COSTS OF PRODUCTION..................................................................................

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6.1 Variable Costs and Fixed Costs........................................................................................45
6.2 The Total Cost Curve........................................................................................................45
Marginal Costs.........................................................................................................................47
6.3 Average Costs..................................................................................................................48
6.4 Marginal Costs and Average Costs...................................................................................50
7 COMPETITIVE SUPPLY..............................................................................................
7.1 The Profit Maximizing Rule..............................................................................................52
7.2 The Profit Maximizing Rule in Competitive Markets........................................................53
7.3 Short-run Competitive Supply..........................................................................................55
7.4 Long-run Competitive Supply...........................................................................................56
8 MONOPOLY...................................................................................................................
8.1 Market Structure and Price..............................................................................................58
8.2 Monopoly Output............................................................................................................59
8.3 Welfare Effects of Monopolies........................................................................................60
8.4 Market Power and Price Elasticity of Demand.................................................................61
9 PRICE DISCRIMINATION...........................................................................................
9.1 The Benefits of Price Discrimination................................................................................62
9.2 Different Types of Price Discrimination...........................................................................63
10 GAME THEORY.............................................................................................................
10.1 And Introduction to The Prisoner’s Dilemma Problem....................................................65
10.2 Setting up the game: Players, Rules and Payoffs..............................................................66
10.3 Strategic Moves: What should each player do?...............................................................67
10.4 The Payoff Matrix............................................................................................................68
10.5 Solving the Collude or Defect Game with a Payoff Matrix...............................................69

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1 THE SCOPE OF ECONOMICS
AND 5 MAIN PRINCIPLES
Modern economics is based on a few major principles. Master these principles and you
not only will go a long way to understand everything that comes afterwards in this
course, but also be a much better decision maker in your daily life.

But before you learn these principles you must understand when to apply them, namely
the scope of modern economics.

1.1 What is the Main Economic Problem?

All resources are scarce. This truth drives modern economics, and limits the scope of
study to the following question:

What is the best way for society to distribute a scarce resource?

Three important conclusions follow from this simply question statement. First, the
“what” refers to some kind of distributional scheme. For instance, the capitalist system is
a distributional scheme that relies heavily on the idea of free markets to distribute scarce
resources among members of society. The socialist system, on the other hand, is a
distributional scheme that relies heavily on a central entity (e.g., the Government), to
distribute scarce resources.

Second, the word “best” refers specifically to a situation where society uses all its
resources in their most efficient way. Economists have a pretty straightforward way of
operationalizing this situation:

A situation is efficient when it is impossible to change it without reducing the net

benefits associate with it.

Finally, a “scarce resource” is any resource that exist in a limited quantity. As it turns
out, this definition of scarcity encapsulates pretty much anything we can think of; from
concrete goods such as coal and clean air to more abstract ones such as ideas, time and
romantic relationships. Nothing exists in infinite quantity. Therefore, economics would
have something to say about pretty much anything you can think of.

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1.2 Nothing is Free (Opportunity Cost) Principle

Since no resources exist in unlimited quantity, using any amount of any resource always
mean giving something up. Think about the time you are taking to read this sentence;
oopss; it is now gone. Or the time you are taking to read this new sentence…yeah, that is
now gone too. And, by the time you are done reading this complete section of the book
you probably have given up 10-15 minutes you could have used to do something else,
like reading a book for another one of your courses or spending time with your friends.
Every action you – and any other economic agent – take carries a tradeoff given, that
resources are always in limited quantity. Economists call this trade off an opportunity
cost.

So, from now every time we mention the word “cost” in this course we are really talking
about an opportunity cost, which is the net value of the best alternative. For example,
part of the cost of eating a burger for lunch, is the value you would have received from
eating your next best alternative, a slice of pizza. And part of the cost of attending
college is the salary you could be earning in your best job opportunity.
It is going to take some time, and much practice, for you to start thinking of all costs as
the opportunity lost. But, once you do, you will have an edge over non-economists in
terms of decision making.

1.3 The Net Marginal Benefit Principle

Since economics deal with the way people make decision, we are forced to make some
basic assumptions about the way people make decisions. The simplest assumption we
can make about people’s choices is the following:

A rational economic agent (say a person or a firm), will take an action if, and
only if, that ONE action increases net marginal benefits for that economic agent.

This assumption has two major implications. First, when we evaluate economic actions,
we only consider the consequence of that single action. Economists called this the
marginal change of that action.

Second, no rational economic agent will take an action if the marginal costs of that action
outweigh the marginal benefits of that action. If they did, then the net marginal benefits
will decrease.

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Let’s again consider the first question (above) to demonstrate this principle.

Say you were considering whether to study another hour for the economics exam, instead
of the math exam. Both exams are taking place tomorrow. Further, supposed you knew
you are on average better at solving math problems, compared to economics problems.
So, on average, every hour spent studying math increases your score by more than every
hour studying economics. Does this mean you should spend your next hour studying
math?

Definitely not! How good you are on average at solving problems does not tell you
anything about the costs and benefits of the next hour. For instance, suppose you have
already studied a lot for math, say 6 hours, and nothing for econ. Clearly, in this situation
studying the next hour for math may not generate a large increase in your score, since
you may be reaching the limits of how much you can actually do for math. So, putting
the next hour for economic is most likely going to give you much more return for your
time, in terms of higher score.

Notice that one problem of using averages to make decisions is that they include events
that already took place, and you have no way of changing. Economists call this type of
events sunk costs. For instance, suppose you purchase a brand-new tractor to improve
the efficiency of your farm. Can you increase the price of the corn you sell in order to
pay for the large investment costs of purchasing the new tractor? Of course, you cannot!
If you did no buyer will buy corn from you, since they could probably buy it from your
next-door farmer; after all, corn is usually the same no matter where you buy it.
Unfortunately for you, the money you spent buying the tractor is gone and you can’t get
back, so no point in considering it when deciding what to do about the next bushel of
corn you sell.

The net marginal principle will take you some time to master. In the meantime, just try
to remember these two rules when making a decision about what do. First, never make
decisions based solely on AVERAGES. And second, never make decisions based on
things that have already taken place, and hence you have no way of changing.
Economists call this type of error the sunk cost fallacy.

1.4 The low hanging fruit principle

Since all resources are in limited quantity, the opportunity cost of using them will
eventually increase as you consume more of them. I call this the low-hanging fruit
principle, since it means it is always cheaper to pick the low hanging fruit from a tree
than the ones at the top. For instance, considering the way you would study for an exam
that is taking place tomorrow.

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The first few hours of studying will provide you with a large return in terms of your
grade, since you will master the most basic concepts pretty quickly. Yet, as you continue
to spend more and more hours studying your productivity will begin to decrease to the
point where you will probably say something like this: “I did all I could; any more hours
studying is not going to make a difference”. In economics jargon, what you are saying is
that the most limited resource you need to perform in your exam tomorrow, intelligence,
is reaching its capacity. So, using any more of that resource to study for that particular
exam will be very expensive.

Notice that the cost of the time you use for your math exam is the score you sacrifice by
not studying for another exam, say economics. In other words, what we are saying here
is that the opportunity cost of studying for any exam will tend to eventually increase as
you continue to study for it.

And, again, since all resources are limited, the same principle applies to all of them. The
cost of producing a bushel of corn will increase as the farmer produces more corn. and
the cost of providing national security in a country will increase as the country becomes
more secure.

1.5 Trade is Good Principle

Since resources are limited, no two resources can ever be the same, and hence the
opportunity costs of using those resources to produce goods and services cannot be the
same. This simple truth has great implications for a society where no two single
individuals share exactly the same preferences. It means society’s welfare will
ALWAYS increase when any two economic agents trade goods and/or services with each
other. For instance, one implication of your decision to attend college could be that you
do not have time left to make your own clothe. Yet, that does not mean you would have
to go around everywhere naked, right? You are probably going to trade something you
have with somebody in exchange for getting clothe to wear.

1.6 The Invisible Hand Principle

Every time a trade takes place two economic agents improve their situation: the buyer
and the seller. Therefore, stand to reason society’s welfare will increase proportionally
with the number of trades; more trades mean more happiness for society. Yet, the main
question is: how can we organize society in a way that maximizes the number of trades?
As it turns out, the best way to organize society is by letting people to freely do whatever
it is that maximizes their own individual welfare.

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1.7 Conclusion

These basic principles are all you need to apply the economic way of thinking to pretty
much any decision you need to make as an individual, or to analyze the decisions any
other individuals or group of individuals. My goal is that in mastering them you will be
able to see the world around you in a whole new way. The rest of this course gives you
an opportunity to do that for a host of interesting questions (applications), I have selected
for you.

So, enjoy the journey!