Microeconomics

Introduction to Economics

   Economics Defined: A way of thinking to understand how societies allocate scarce resources to produce and distribute goods and services.

   Scarcity: The fundamental problem of infinite human wants clashing with finite resources, forcing choices.

   Opportunity Cost: The real cost of any decision is the value of the next best alternative that is forgone.

   Microeconomics vs. Macroeconomics: Micro studies individual actors (firms, consumers); Macro studies the economy as a whole (GDP, inflation, unemployment).

   Market vs. Planned Economy: In a market economy, decisions are decentralized via supply/demand. In a planned economy, a central authority makes all decisions.

Key Economic Thinkers

   Adam Smith:

  Wealth of Nations: National wealth comes from production and trade, not gold.

  Specialization/Division of Labor: Breaking down work into specific tasks boosts productivity.

  Invisible Hand: Individuals pursuing self-interest in a competitive market unintentionally benefit society.

   Thomas Malthus:

  Malthusian Theory: Population grows geometrically, while food supply grows arithmetically, leading to a "Malthusian Catastrophe" of famine and poverty.

   John Maynard Keynes:

  Key Insight: Economies can suffer from insufficient "Aggregate Demand," leading to prolonged unemployment.

  Government Role: Advocated for government intervention (e.g., public works spending) to boost demand and end recessions.

Demand Analysis

   Demand Definition: The want, willingness, and ability to buy a product at a given price.

   Law of Demand: Ceteris Paribus, a lower price leads to a higher quantity demanded (downward-sloping curve).

   Demand Shifters (Move the entire curve):

  Change in number of consumers.

  Change in consumer incomes (Normal vs. Inferior goods).

  Change in tastes and preferences.

  Change in prices of related goods (Substitutes & Complements).

  Change in future price expectations.

   Price Elasticity of Demand (PED):

  Measures responsiveness of quantity demanded to a price change.

  Elastic (|PED| > 1): Quantity changes more than price. Many substitutes. Price cut increases total revenue.

  Inelastic (|PED| < 1): Quantity changes less than price. Few substitutes, necessities. Price cut decreases total revenue.

  Perfectly Inelastic (PED = 0): Vertical demand curve (e.g., essential medicine).

  Perfectly Elastic (PED = ∞): Horizontal demand curve.

   Other Elasticities:

  Income Elasticity: Responsiveness of demand to income changes.

  Cross-Price Elasticity: Responsiveness of demand for good X to a price change in good Y.

   Price Discrimination: Charging different prices to different consumer groups to capture more consumer surplus.

  1st Degree: Charge each consumer their maximum willingness to pay.

  2nd Degree: Quantity discounts (e.g., bulk pricing).

  3rd Degree: Different prices for different market segments (e.g., student discounts).

Supply Analysis

   Law of Supply: Ceteris Paribus, a higher price leads to a higher quantity supplied (upward-sloping curve).

   Supply Shifters (Move the entire curve):

  Change in number of suppliers.

  Change in technology.

  Change in input prices/costs of production.

  Change in taxes and subsidies.

  Change in producer expectations.

Market Equilibrium

   Equilibrium: The price where Quantity Demanded (Qd) equals Quantity Supplied (Qs). The market clears.

   Disequilibrium:

  Shortage (Excess Demand): Price is below equilibrium (Qd > Qs). Upward pressure on price.

  Surplus (Excess Supply): Price is above equilibrium (Qs > Qd). Downward pressure on price.

   Government Intervention:

  Price Floor: A legal minimum price (e.g., minimum wage). Creates a surplus.

  Price Ceiling: A legal maximum price (e.g., rent control). Creates a shortage.

   Welfare Economics:

  Consumer Surplus (CS): Difference between what consumers are willing to pay and the market price.

  Producer Surplus (PS): Difference between the market price and the minimum price producers are willing to accept.

  Social (Total) Surplus: CS + PS. Maximized at the free market equilibrium.

   Pareto Efficiency: A state where no one can be made better off without making someone else worse off. The free market equilibrium is Pareto efficient.

Market Failures

   Externalities: Costs or benefits imposed on third parties not involved in a transaction.

  Negative Externality (e.g., pollution): Social cost > Private cost. The market overproduces. Solution: Tax.

  Positive Externality (e.g., education): Social benefit > Private benefit. The market underproduces. Solution: Subsidy.

   Monopoly: A single seller with market power, leading to higher prices, lower output, and a reduction in social surplus (Deadweight Loss).

Applications

   Tax Incidence: The burden of a tax depends on the relative elasticity of supply and demand. The more inelastic side bears more of the tax burden.

   Cost Changes: How cost increases (e.g., taxes) or decreases (e.g., technology) affect price and quantity depends on the elasticity of demand.

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Costs, Market Structures, and Strategy

Costs of Production

   Short Run vs. Long Run:

  Short Run: At least one input is fixed (e.g., capital). The Law of Diminishing Returns applies: adding more variable inputs (labor) to a fixed input yields smaller output gains.

  Long Run: All inputs are variable. Firms experience Returns to Scale:

       Economies of Scale: Output increases more than costs; falling Long-Run Average Cost (LRAC).

       Diseconomies of Scale: Costs increase more than output; rising LRAC.

       Constant Returns to Scale: Costs and output rise proportionally.

   Cost Types:

  Fixed Costs (FC): Don't vary with output (rent).

  Variable Costs (VC): Vary with output (raw materials).

  Total Cost (TC): FC + VC.

  Marginal Cost (MC): The cost of producing one more unit.

  Average Total Cost (ATC): TC / Output.

   Profit Maximization Rule: Produce where Marginal Revenue (MR) = Marginal Cost (MC).

Perfect Competition

   Characteristics: Many firms, identical products, no barriers to entry, perfect information.

   Firm's Demand: Perfectly elastic (horizontal) at the market price. Therefore, P = MR.

   Long-Run Outcome: Firms make zero economic profit (earn only "normal profit"). They are both:

  Productively Efficient: P = min ATC.

  Allocatively Efficient: P = MC.

Monopoly

   Characteristics: Single seller, no close substitutes, high barriers to entry.

   Firm's Demand: Faces the downward-sloping market demand curve. Therefore, P > MR.

   Outcome: Produces less output at a higher price than a competitive market. Creates a Deadweight Loss. It is neither productively nor allocatively efficient.

   Natural Monopoly: Exists when one firm can supply the entire market at a lower cost than multiple firms (e.g., utilities). Often regulated.

Monopolistic Competition

   Characteristics: Many firms, differentiated products, free entry and exit (e.g., restaurants, clothing brands).

   Outcome: In the long run, firms make zero economic profit. However, they operate with:

  Excess Capacity: Not producing at minimum ATC.

  Markup: P > MC.

  Therefore, they are not efficient.

Oligopoly

   Characteristics: A few large, interdependent firms, high barriers to entry (e.g., telecoms, automakers).

   Key Feature: Strategic Interdependence. Each firm's decisions depend on its rivals' actions.

   Concentration Measures:

  N-Firm Concentration Ratio: % of market share held by the top N firms.

  Herfindahl-Hirschman Index (HHI): Sum of squared market shares; higher HHI means more concentration.

   Cartels & Collusion: Firms have an incentive to collude and act like a monopoly, but this is often illegal and unstable due to the incentive to cheat.

   Models of Oligopoly Behavior:

  Kinked Demand Curve: Explains price rigidity. Assumes rivals will match price cuts but not price increases.

  Game Theory:

       Prisoner's Dilemma: Shows why cooperation is difficult. Each firm's dominant strategy is to cheat, leading to a worse collective outcome.

       Nash Equilibrium: A situation where each firm chooses its best strategy given the strategies of its rivals.

Business Strategies

   Product Differentiation: Key in monopolistic competition to make products seem unique.

   Advertising: Used to shift the demand curve and build brand loyalty.

   Innovation: Continuous product development is necessary to maintain a competitive edge and economic profits.

   Mergers & Acquisitions: Can be used to achieve Minimum Efficient Scale (MES) and gain cost advantages over rivals.