Microeconomics

How individual households and firms make choices under scarcity, and how markets aggregate those choices into prices and quantities: supply and demand, elasticity, consumer and producer theory, market structures, game theory, factor markets and market failure. The whole-economy view (GDP, inflation, unemployment, policy) is in macroeconomics. Algebra and graph reading are on math fundamentals and reading graphs.

Core ideas

A production possibilities frontier (PPF) shows the maximum combinations of two goods an economy can make with its resources and technology. Its slope is the opportunity cost of one good in terms of the other.

Comparative advantage

Absolute advantage: producing more with the same inputs. Comparative advantage: producing at a lower opportunity cost. Gains from trade come from comparative, not absolute, advantage (Ricardo, 1817).

Ana has the absolute advantage in both goods, yet Ben has the comparative advantage in coconuts (1 fish versus 2). Ana specializes in fish, Ben in coconuts, and any price between 1 and 2 fish per coconut leaves both better off than self-sufficiency.

Supply and demand

Law of demand: at a higher price, buyers want less (substitution and income effects). Law of supply: at a higher price, sellers offer more (higher marginal cost of extra output is now covered).

A change in the good's own price moves along a curve ("quantity demanded changes"). A change in anything else shifts the curve ("demand changes").

Equilibrium: the price at which $Q_d = Q_s$. Above it there is a surplus and the price falls; below it a shortage and the price rises.

When both curves shift, one of the two outcomes is ambiguous: it depends on which shift is larger.

Solving linear markets

With linear curves, surplus areas are triangles: $\text{CS} = \tfrac12\,Q^*(P_\text{max} - P^*)$, where $P_\text{max}$ is the demand curve's choke price ($Q_d = 0$), and $\text{PS} = \tfrac12\,Q^*(P^* - P_\text{min})$.

Elasticity

Elasticity is the percentage response of one variable to a 1% change in another. It is unit-free, which makes it comparable across goods.

Demand is more elastic with close substitutes, for luxuries, when the good is a large share of the budget, for narrowly defined markets ("Brand X cola" vs "drinks") and over longer time horizons. Supply is more elastic when spare capacity exists, inputs are easy to find, and over longer horizons.

Tax incidence does not depend on who legally pays. The side with the less elastic curve bears more of the tax:

Consumer choice

Consumers maximize utility subject to a budget. Only the ranking of bundles matters (ordinal utility).

A price change has two effects:

Consumer surplus is willingness to pay minus the price actually paid: the area under demand and above the price.

Time and risk

Surplus, welfare and intervention

Total surplus (CS + PS) is maximized at the competitive equilibrium when there are no externalities (the first welfare theorem). Anything that pushes quantity away from $Q^*$ destroys surplus: the lost area is deadweight loss (DWL).

DWL grows with the square of the tax: doubling a tax roughly quadruples its deadweight loss, which is why broad taxes at low rates beat narrow taxes at high rates.

Production and costs

MC crosses AVC and ATC at their minimums because an average falls while the marginal is below it and rises when the marginal is above it (like a test score pulling your average). In the drawn example, AVC bottoms out at 5.5 when $Q = 7.5$ and ATC at about 8.98 when $Q \approx 9.55$.

Sources of economies of scale: specialization, spreading fixed costs (R&D, tooling), bulk buying, network effects. Diseconomies: coordination and management costs. Minimum efficient scale is the smallest output at which long-run ATC is at its minimum; relative to market size it decides how many firms an industry can support.

Market structures

Every profit-maximizing firm produces where marginal revenue equals marginal cost ($MR = MC$), then charges the highest price demand allows at that quantity.

Perfect competition, short run: produce where $P = MC$ if $P \ge \min AVC$; otherwise shut down (lose only the fixed cost). Long run: exit if $P < \min ATC$. The firm's short-run supply curve is its MC curve above min AVC. Long-run equilibrium: $P = MC = \min ATC$, zero economic profit.

Monopoly: with linear demand $P = a - bQ$, revenue is $aQ - bQ^2$ and $MR = a - 2bQ$ (twice as steep as demand). A monopolist never operates on the inelastic part of demand. Its markup follows the Lerner index:

Market concentration is measured by the Herfindahl–Hirschman Index: the sum of squared market shares in percent (monopoly = 10,000). The 2023 US Merger Guidelines treat markets above 1,800 as highly concentrated and presume a merger that raises HHI by more than 100 in such a market substantially lessens competition.

Game theory and oligopoly

The prisoner's dilemma: payoffs (row, column), higher is better.

Defect is dominant for both, so (defect, defect) is the unique Nash equilibrium, although (cooperate, cooperate) is better for both. This is the logic of cartels breaking down, arms races, overfishing and advertising wars.

With $n$ identical Cournot firms facing $P = a - bQ$ and constant marginal cost $c$, each produces $q = \dfrac{a - c}{(n + 1)b}$.

Factor markets

Firms hire an input until the extra revenue it brings equals its price.

Monopsony, a single (or dominant) buyer of labor, pays less than MRP and hires fewer workers than a competitive market, because hiring one more worker raises the wage for all. In that model a minimum wage set between the monopsony wage and the competitive wage can raise both pay and employment, which is one reason empirical studies of moderate minimum wages often find small employment effects.

Economic rent is payment above what is needed to keep a factor in its current use (a star's pay above their next-best job). Taxing pure rent causes no deadweight loss.

Market failure

The Coase theorem: if property rights are clear and transaction costs are low, private bargaining reaches the efficient outcome whoever holds the rights (the allocation of rights changes who pays, not what is produced). With many parties or high transaction costs, it breaks down, which is why pollution needs policy.

Government failure is also real: regulatory capture, rent seeking, lobbying for concentrated benefits with dispersed costs, and imperfect information on the policymaker's side.

Behavioral economics

Worked examples

Equilibrium, surplus and a tax

Demand $Q_d = 100 - 2P$, supply $Q_s = -20 + 4P$.

Choke price $P_\text{max} = 50$, lowest supply price $P_\text{min} = 5$:

Now a tax of 6 per unit is levied on sellers, so supply becomes $Q_s = -20 + 4(P_b - 6)$:

Buyers pay 4 of the 6 and sellers 2: supply's slope in $Q$-per-$P$ (4) is twice demand's (2), so the less responsive side, demand, carries two thirds.

Elasticity and revenue

A café raises a coffee from 4 to 6 and daily sales fall from 120 to 90. Midpoint elasticity:

Inelastic, so revenue rises: $4 \times 120 = 480$ becomes $6 \times 90 = 540$.

Monopoly vs competition

Demand $P = 100 - Q$, constant $MC = 20$, no fixed cost.

Check with Lerner: at $Q = 40$, $\lvert E_d \rvert = 1 \cdot 60/40 = 1.5$ and $(60 - 20)/60 = 2/3 = 1/1.5$. Two Cournot firms would each produce $80/3 \approx 26.7$, for $Q \approx 53.3$ and $P \approx 46.7$: between the two.

Utility maximization

$U = x^{0.5} y^{0.5}$, income 100, $p_x = 2$, $p_y = 5$. Cobb–Douglas spends half the budget on each good: $x = 50/2 = 25$, $y = 50/5 = 10$. Check: $MRS = y/x = 10/25 = 0.4 = p_x/p_y$.

Shut down or stay open?

Using the cost curves drawn above ($\min AVC = 5.5$, $\min ATC \approx 8.98$) in a competitive market:

References

• OpenStax: Principles of Microeconomics 3e (opens in a new tab): free introductory textbook, source of the standard definitions used here
• CORE Econ: The Economy 2.0 (opens in a new tab): free, modern, data-driven introduction
• Marginal Revolution University (opens in a new tab): short videos on every principles topic
• Hal R. Varian, Intermediate Microeconomics: A Modern Approach, 9th ed. (W. W. Norton, 2014): consumer and producer theory with calculus
• N. Gregory Mankiw, Principles of Economics (Cengage): the standard principles text
• Akerlof (1970), The Market for "Lemons" (opens in a new tab), Quarterly Journal of Economics 84(3): adverse selection
• Coase (1960), The Problem of Social Cost (opens in a new tab), Journal of Law and Economics 3: bargaining and externalities
• Kahneman and Tversky (1979), Prospect Theory (opens in a new tab), Econometrica 47(2): loss aversion and reference dependence
• US DOJ and FTC: 2023 Merger Guidelines (opens in a new tab): HHI thresholds
• Macroeconomics: the companion sheet