**Microeconomics describes the trade-offs that consumers, workers, and firms face, and shows how these trade-offs are best made.

In a centrally planned economy, the government sets prices. In a market economy, prices are determined by the interactions of consumers, workers, and firms.

The theory of the firm begins with a simple assumption – firms try to maximize their profits. The theory of the firm tells us whether a firm’s output level will increase or decrease in response to an increase in wage rates or a decrease in the price of raw materials.

Positive analysis – Analysis describing relationships of cause and effect.

Normative analysis – Analysis examining questions of what ought to be.

Market – Collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products.

Industry – A collection of firms that sell the same or closely related products.

Market definition – Determination of the buyers, sellers, and range of products that should be included in a particular market.

Arbitrage – Practice of buying at a low price at one location and selling at a higher price in another.

Perfectly competitive market – Market with many buyers and sellers, so that no single buyer or seller has a significant impact on price.

Market price – Price prevailing in a competitive market.

Extent of a Market – Boundaries of a market, both geographical and in terms of range of products produced and sold within it.

The supply-demand model combines two important concepts: the supply curve and a demand curve.

Supply curve – Relationship between the quantity of a good that producers are willing to sell and the price of the good.

**The higher the price, the more firms are able and willing to produce and sell. The quantity supplied can also depend on production costs, including wages, interest charges, and the costs of raw materials.

Movements along the supply curve can represent changes in price. Changes in other variables are shown by a shift of the supply curve itself.

Demand curve – Relationship between the quantity of a good that consumers are willing to buy and the price of the good.

Substitutes – Two goods for which an increase in the price of one leads to an increase in the quantity demanded of the other.

Complements – Two goods for which an increase in the price of one leads to a decrease in the quantity demanded of the other.

Equilibrium (market-clearing price) – Price that equates the quantity supplied to the quantity demanded.

Market mechanism – Tendency in a free market for price to change until the market clears.

Surplus – Situation in which the quantity supplied exceeds the quantity demanded.

Shortage – Situation in which the quantity demanded exceeds the quantity supplied.

Elasticity – Percentage change in one variable resulting from a 1% increase in another.

Price Elasticity of Demand – Percentage change in quantity demanded of a good resulting from a 1% increase in its price.

E/^p   =    P ΔQ/  Q ∆P =% ΔQ/   % ∆ P

Infinitely elastic demand – Principle that consumers will buy as much of a good as they can get at a single price, but for any higher price the quantity demanded drops to zero, while for any lower price the quantity demanded increases without limit.

Completely inelastic demand – Principle that consumers will buy a fixed quantity of a good regardless of its price.

**The steeper the slope of the cure, the less elastic demand is.

Income elasticity of demand – Percentage change in the quantity demanded resulting from a 1% increase in income.

E1 =    I ∆Q / Q ∆ I

Cross-price elasticity of demand – Percentage change in the quantity demanded of one good resulting from a 1% increase in the price of another.

EQP=    P∆Q / Q ∆ P

When goods are substitutes, cross-price elasticities will be positive. When goods are complements, cross-price elasticities will be negative.

Price elasticity of supply – Percentage change in quantity supplied resulting from a 1% increase in price.

Point elasticity of demand – Price elasticity at a particular point on the demand curve.

Arc elasticity of demand – Price elasticity calculated over a range of prices.

E  = (   ∆Q ¿( P´ )

^p        ∆ P     Q´

Short-run – one year or less

Long-run – enough time is allowed for consumers or producers to adjust fully to the price change

**For goods which are used daily (coffee, toilet paper, paper, pens), demand is more price elastic in the long run than in the short run.

**For goods which are bought rarely (cars, fridges, houses), demand is less elastic in the long run than in the short run.

Cyclical industries – Industries in which sales tend to magnify cyclical changes in gross domestic product and national income.

**Firms face capacity constraints in the short run and need time to expand capacity by building new production facilities and hiring workers to staff them.

Market basket (bundle) – List with specific quantities of one or more goods.

The theory of consumer behavior begins with three basic assumptions about people’s preferences for one market basket versus another.

1. Completeness – Consumers can compare and rank all possible baskets.
2. Transitivity – If consumer prefers basket A to basket B and basket B to basket C, then consumer also prefers A to C.
3. More is better than less – More is always better, consumers are never satisfied
4. Diminishing marginal rate of substitution – an indifference curve is convex if the MRS diminishes along the curve

Indifference curve – Curve representing all combinations of market baskets that provide a consumer with the same level of satisfaction. Indifference curves cannot intersect.

Indifference map – Graph containing a set of indifference curves showing the market baskets among which a consumer is indifferent.

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.

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.

Utility - numerical score representing the satisfaction that a consumer gets from a given market basket.

Ordinal utility function – Utility function that generates a ranking of market baskets in order of most to least proffered.

Cardinal utility function – Utility function describing by how much one market basket is preferred to another.

Budget constraints – Constraints that consumers face as a result of limited incomes.

Budget line – All combinations of goods for which the total amount of money spent is equal to income.

P_FF + P_CC = I

*We can see how much of y-axis quantity must be given up to consume more of x- axis quantity, by using:

Q_Y = (I/P_Y) – (P_X/P_Y)Q_X

A change in the income, shift the whole budget line to the right or left.

A change in the price, rotates the budget line depending on which price changes.

Consumers will always choose goods to maximize the satisfaction they can achieve, given the limited budget available to them. The maximizing market basket must satisfy two conditions:

1. It must be located on the budget line
2. It must give the consumer the most preferred combination of goods and services

**The basket that maximizes satisfaction must lie on the highest indifference curve that touches the budget line.

Satisfaction is max. at the point: MRS = P_x/P_Y

Marginal benefit – Benefit from the consumption of one additional unit of a good.

Marginal cost – Cost of one additional unit of a good.

Corner Solutions – Situation in which the marginal rate of substitution of one good for another in a chosen market basket is not equal to the slope of the budget line.

If a consumer chooses one market basket over another, and if the chosen market basket is more expensive than the alternative, then the consumer must prefer the chosen market basket.

Marginal utility (MU) – Additional satisfaction obtained from consuming one additional unit of a good.

Diminishing marginal utility – Principle that as more of a good is consumed, the consumption of additional amounts will yield smaller additions to utility.

        MRS = MU_X/MU_Y = P_X/P_Y

 Equal marginal principle = Principle that utility is maximized when the consumer has equalized the marginal utility per dollar of expenditure across all goods.

Cost-of-living index – Ratio of the present cost of a typical bundle of consumer goods and services compared with the cost during a base period.

Ideal cost-of-living index – Cost of attaining a given level of utility at current prices relative to the cost of attaining the same utility at base-year prices.

Laspeyres price index – Amount of money at current year prices that an individual requires to purchase a bundle of goods and services chosen in a base year divided by the cost of purchasing the same bundle at base-year prices.

LI = Px2Qx1 + Py2Qy1 / Px1Qx1 + Py2Py1

Px2 and Py2 = current-year prices.

Q_X1   and    Q_{Y 1}    = base-year quantities

PX 1       and     PY 1      = base-year prices

Paasche index – Amount of money at current-year prices that an individual requires to purchase a current bundle of goods and services divided by the cost of purchasing the same bundle in a base year.

                 PI = PX 2 QX 2+ PY 2 QY 2 /  PX 1 QX 2+ PY 1 QY 2

                   Qx2 and Qy2 = current- year quantities

Fixed-weight index = Cost-of-living index in which the quantities of goods and services remain unchanged.

Chain-weighted price index = Cost-of-living index that accounts for changes in quantities of goods and services.

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

1. Consumers will tend to buy more of the good that has become cheaper and less of those goods that are now relatively more expensive.

2. Because one of the goods is now cheaper, consumers enjoy an increase in real purchasing power.

Substitution effect – Change in consumption of a good associated with a change in its price, with the level of utility held constant.

Income effect – Change in consumption of a good resulting from an increase in purchasing power, with relative prices held constant.

                       Total Effect = Substitution Effect + Income Effect

Inferior good – A good that has a negative income effect.

Giffen good – Good whose demand curve slopes upward because the (negative) income effect is larger than the substitution effect.

Market demand curve – Curve relating the quantity of a good that all consumers in a market will buy to its price.

Two points should be noted as result of this:

1. The market demand curve will shift to the right as more consumers enter the market.
2. Factors that influence the demands of many consumers will also affect market demand.

Elasticity of Demand = E_{p =     ∆Q / Q}

                                                ∆ P/ P

Isoelastic demand curve – Demand curve with a constant price elasticity.

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 good will increase.

Consumer surplus – Difference between what consumer is willing to pay for a good and the amount actually paid.

Network externality – Situation in which each individual’s demand depends on the purchases of other individuals.

Bandwagon effect – Positive network externality in which a consumer wishes to process a good in part because others do.

Snob effect – Negative network externality in which a consumer wishes to own an exclusive or unique good.

Factors of production – Inputs into the production process (eg. Labor, capital, and materials).

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

                                                           q = F(K, L)

**As technology becomes more advanced the production function changes, since more can be produced in less time.

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

Long run – Amount of time needed to make all production inputs variable.

Fixed input – Production factor that cannot be varied.

Average product of labor = Output/labor input = q/L

Marginal product of labor = change in output/change in labor input =    Δq / Δ L

When the marginal product is greater than the average product, the average product is increasing.

When the marginal product is less than the average product, the average product is decreasing.

**The average product of labor is given by the slope of the line drawn from the origin to the corresponding point on the total product curve.

The 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.

Labor productivity – Average product of labor for an entire industry or for the economy as a whole. (it determines the real standard of living that country can provide)

Stock of capital – Total amount of capital available for use in production.

Technological change – Development of new technologies allowing factors of production to be used more effectively.

Isoquant – Curve showing all possible combinations of inputs that yield the same output.

Isoquant map – Graph combining a number of isoquants, used to describe a production function.

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.

MRTS = -    Δ K / Δ L    = (MP_L)/(MP_K) >>>> (for a fixed level of q) MP = marginal product of…

Fixed-proportions production function – Production function with L-shaped isoquants, so that only one combination of labor and capital can be used to produce each level of output.

Returns to scale – Rate at which output increases as inputs are increased proportionately.

Increasing returns to scale – Situation in which output more than doubles when all inputs are doubled. (on a graph isoquants get closer and closer as you move to the right)

Constant returns to scale – Situation in which output doubles when all inputs are doubled.

Decreasing returns to scale – Situation in which output less than doubles when all inputs are doubled. (on a graph isoquants get further and further apart when you move to the right)

Accounting cost – Actual expenses plus depreciation charges for capital equipment.

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

Opportunity cost – Cost associated with opportunities forgone when a firm’s resources are not put to their best alternative use.

Economic cost = Opportunity cost (if we measure all of firm’s resources properly)

Sunk cost – Expenditure that has been made and cannot be recovered.

Total cost – Total economic cost of production, consisting of fixed and variable costs. Fixed costs – Cost that does not vary with the level of output and that can be eliminated only by shutting down

Variable cost – Cost that varies as output varies

Amortization – Policy of treating a one-time expenditure as an annual cost spread out over some number of years.

Marginal cost (MC) or incremental cost – Increase in cost resulting from the production of one extra unit of output.

MC =     ΔVC = ΔTC

                 Δq      Δq

Average total cost = (FC+AC)/q

Average fixed cost = FC/q

Average variable cost = VC/q

MC = w/MP_L

In the short run, there are both fixed and variable costs. Variable costs change with output.

**There are only variable costs in long run.

User cost of capital = Annual cost of owning and using a capital asset, equal to economic depreciation plus forgone interest = Economic depreciation + Interest Rate

 r = depreciation rate + interest rate

Rental rate – Cost per year of renting one unit of capital.

Isocost line – Graph showing all possible combinations of labor and capital that can be purchased for a given total cost.

                                                      C = wL + rK

When a firm minimizes the cost of producing a particular output, the following condition holds:

                MP_L/w = MP_K/r

 Expansion path – Curve passing through points of tangency between a firm’s isocost lines and its isoquants.

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.

LMC<LAC then LAC will fall

LMC>LAC then LAC will rise

LMC=LAC then min. of LAC

Economies of scale – Situation in which output can be doubled for less than a doubling cost.

Diseconomies of scale – Situation in which a doubling of output requires more than a doubling cost.

Price taker – Firm that has no influence over market price and thus takes the price as given.

Product homogeneity – Products in a market are perfectly substitutable with one another.

Free entry (or exit) – Condition under which there are no special costs that make it difficult for a firm to enter (or exit) an industry.

Cooperative – Association of businesses or people jointly owned and operated by members for mutual benefits.

Condominium – A housing unit that is individually owned but provides access to common facilities that are paid for and controlled jointly by an association of owners.

Profit – Difference between revenue and total cost

Marginal revenue – Change in revenue resulting from a one-unit increase in output.

MR(q) = MC(q) = P (in the short run, the competitive firm maximizes its profit by choosing an output q at which MC=P)

**If a firm is producing any output, it should produce at the level at which marginal revenue equals marginal cost.

The firm’s supply curve is the portion of the marginal cost curve for which marginal cost is greater than average variable cost.

The short-run industry supply curve is the summation of the supply curves of the individual firms.

Elasticity of supply = E_S = ( ΔQ / Q ¿ /( ΔP / P ¿

Perfectly inelastic supply = arises when the industry’s plant and equipment are so fully utilized that greater output can be achieved only if new plants are built Perfectly elastic supply = arises when marginal is constant

Producer surplus = Sum over all units produced by a firm of differences between the market price of a good and the marginal cost of production. (area under the price and above the marginal cost)

Producer surplus = R – VC

Profit =    π    = R – VC – FC

**The long-run output of a profit-maximizing competitive firm is the point at which long-run marginal cost equals the price.

Zero economic profit – A firm is earning a normal return on its investment – ex. it is doing as well as it could by investing its money elsewhere.

**In a market with entry and exit, a firm enters when it can earn a positive long-run profit and exits when it faces the prospect of a long-run loss.

Long-run competitive equilibrium – All firms in an industry are (1) maximizing profit, (2) no firm has an incentive to enter or exit, and (3) price is such that quantity supplied equals quantity demanded.

Economic rent – Amount that firms are willing to pay for an input less the minimum amount necessary to obtain it.

Constant-cost industry – Industry whose long-run supply curve is horizontal at a price that is equal to the long-run minimum average cost of production.

Increasing-cost industry – Industry whose long-run supply curve is upward sloping.

Decreasing-cost industry – Industry whose long-run supply curve is downward sloping.

Monopoly – Market with only one seller.

Monopsony – Market with only one buyer.

Market power – Ability of a seller or buyer to affect the price of a good.

Marginal revenue – Change in revenue resulting from a one-unit increase in output.

           D

          1/ E_¿

P =       ¿

            1+¿

            MC

              ¿ 

MR =    ∆ R = ∆P×Q

             ΔQ      ΔQ

**A monopolistic market has no supply curve.

Lerner Index of Monopoly Power – Measure of monopoly power calculated as excess of price over marginal cost as a fraction of price.

       L = (P – MC)/P = - 1/E_D

**The less elastic a demand curve, the more monopoly a firm has.

Three factors determine a firm’s elasticity of demand:

1. The elasticity of market demand – the market demand limits the potential for monopoly power
2. The number of firms in the market – If there are many firms, it is unlikely that any one firm will be able to affect price
3. The interaction among firms

Barrier to entry – Condition that impedes entry by new competitors

Rent seeking – Spending money in socially unproductive efforts to acquire, maintain, or exercise monopoly.

Natural monopoly – Firm that can produce the entire output of the market at a cost lower than what it would be if there were several firms.

Rate-of-return regulation – Maximum price allowed by a regulatory agency is based on the (expected) rate of return that a firm will earn.

Price discrimination – Practice of charging different prices to different consumers for similar goods.

First-Degree Price Discrimination – Practice of charging each customer her reservation price (maximum price that a customer is willing to pay)

Second-Degree Price Discrimination – Practice of charging different prices per unit for different quantities of the same good or service.

Third-Degree Price Discrimination – Practice of dividing consumers into two or more groups with separate demand curves and charging different prices to each group.

Variable profit –Sum of profits on each incremental unit produced by a firm; ex. profit ignoring fixed costs.

Block pricing – Practice of charging different prices for different quantities or “block” of a good.

Profit maximization = MR₁ = MR₂ = MC

                                                       1

                                                  1+1 / E_¿

                                                         ¿

Determining relative prices:             ¿ 1

                                               P2                ¿

Intertemporal price discrimination – Practice of separating consumers with different demand functions into different groups by charging different prices at different points in time.

Peak-load pricing – Practice of charging higher prices during peak periods when capacity constraints cause marginal costs to be high.

Two-part tariff – Form of pricing in which consumers are charged both an entry and a usage fee.

• Single consumer: Usage fee should be set equal to MC and entry fee equal to the consumer surplus for each customers.
• Two consumers: Set the usage fee above MC and then set entry fee equal to the remaining consumer surplus of the consumer with the smaller demand.
• More consumers: A lower entry fee means more entrants and more sale However, as entry fee becomes smaller and the nr. Of entrants larger, the profit derived from entry fee falls.

Monopolistic competition – Market in which firms can enter freely, each producing its own brand or version of a differentiated product.

Oligopoly – Market in which only a few firms compete with one another, and entry by new firms is impeded.

Cartel – Market in which some or all firms explicitly collude, coordinating prices and output levels to maximize joint profits.

Nash equilibrium – Set of strategies or actions in which each firm does the best it can given its competitors’ actions.

Duopoly – Market in which two firms compete with each other.

Cournot model – Oligopoly model in which firms produce a homogenous good, each firm treats the output of its competitors as fixed, and all firms decide simultaneously how much to produce.

Reaction curve – Relationship between a firm’s profit-maximizing output and the amount it thinks its competitors will produce.

Cournot equilibrium – Equilibrium in the Cournot model in which each firms correctly assumes how much its competitor will produce and sets its own production level accordingly.

Noncooperative game – Game in which negotiation and enforcement of binding contracts are not possible.

Payoff matrix – Table showing profit (or payoff) to each firm given its decision and the decision of its competitor.

Prisoners’ dilemma – Game theory example in which two prisoners must decide separately whether to confess to a crime; if a prisoner confesses, he will receive a lighter sentence and his accomplice will receive a heavier one, but if neither confesses, sentences will be lighter than if both confess.

Price rigidity – Characteristic of oligopolistic markets by which firms are reluctant to change prices even if costs or demands change.

Kinked demand curve model – Oligopoly model in which each firm faces a demand curve kinked at the currently prevailing price: at higher prices demand is very elastic, whereas at lower prices it is inelastic.

Price signaling – Form of implicit collusion in which a firm announces a price increase in the hope that other firms will follow suit.

Price leadership – Pattern of pricing in which one firm regularly announces price changes that other firms then match.

Dominant firm – Firm with a large share of total sales that sets price to maximize profits, taking into account the supply response of smaller firms.

Game – Situation in which participants make strategic decisions that take into account such other’s actions and responses.

Optimal strategy – Strategy that maximizes a player’s expected payoff.

Cooperative game – Game in which participants can negotiate binding contracts that allow them to plan joint strategies.

Noncooperative game – Game in which negotiation and enforcement of binding contracts are not possible.

Dominant strategy – Strategy that is optimal no matter what an opponent does.

Equilibrium in dominant strategies – Outcome of a game in which each firm is doing the best it can regardless of what its competitors are doing.

Dominant Strategies: I’m doing the best I can no matter what you do.

                                  You’re doing the best you can no matter what I do.

Nash Equilibrium: I’m doing the best I can given what you are doing.

                              You’re doing the best you can given what I am doing.

Random: If a tax is introduced, then supply and demand prices are no longer equal:

                                                  P_S = P_D – t

Partial equilibrium analysis – Determination of equilibrium prices and quantities in a market independent of effects from other markets.

General equilibrium analysis – Simultaneous determination of the prices and quantities in all relevant markets, taking feedback effects into account.

Technical efficiency – Condition under which firms combine inputs to produce a given output as inexpesively as possible.

Marginal rate of technical substitution of labor for capital: MRTS_LK = w/r

 Production possibilities frontier – Curve showing the combinations of two goods that can be produced with fixed quantities of inputs.

Marginal rate of transformation – Amount of one good that must be given up to produce one additional unit of a second good.

MRT = MC_X/MC_Y = MRS = P_X/P_Y

Comparative advantage – Situation in which Country 1 has an advantage over Country 2 in producing a good because the cost of producing the good in 1, relative to the cost of producing other goods in 1, is lower than the cost of producing the good in 2, relative to the cost of producing other goods in 2.

Absolute advantage – Situation in which Country 1 has a advantage over Country 2 in producing a good because the cost of producing the good in 1 is lower than the cost of producing it in 2.

Asymmetric information – Situation in which a buyer and a seller possess different information about a transaction.

The lemons problem: With asymmetric information, low-quality goods can drive high-quality goods out of the market.

Adverse selection – Form of market failure resulting when products of different qualities are sold at a single price because of asymmetric information, so that too much of the low-quality product and too little of the high-quality product are sold.

ü  1.Left Entry Mode

ü  In the left entry mode,the data is entered from the left side of the display unit. 2.Right Entry Mode

ü  In the right entry mode,the first entry to be displayed is entered on the right most display.

Market signaling – Process by which sellers send signals to buyers conveying information about product quality.

Moral hazard – When a party whose actions are unobserved can affect the probability or magnitude of a payment associated with an event. (ex. if my home is fully insured against theft, I may be less diligent about blocking doors when I leave, and I may choose to install an alarm system)

Externality – Action by either a producer or a consumer which affects other producers or consumers, but is not accounted for in the market price.

Marginal external cost – Increase in cost imposed externally as one or more firms increase output by one unit.

Marginal social cost – Sum of the marginal cost of production and the marginal external cost.

                                      MSC = MC + MEC

Marginal external benefit – Increased benefit that accrues to other parties as a firm increases output by one unit.

Marginal social benefit – Sum of the marginal private benefit plus the marginal external benefit.

                                          MSB = D + MEB

Emissions standard – Legal limit on the amount of pollutants that a firm can emit.

Emissions fee – Charge levied on each unit of a firm’s emissions.

Tradeable emissions permits – System of marketable permits, allocated among firms, specifying the maximum level of emissions that can be generated.

Property rights – Legal rules stating what people or firms may do with their property.

Case theorem – Principle that when parties can bargain without cost and to their mutual advantage, the resulting outcome will be efficient regardless of how property rights are specified.

Common property resource – Resource to which anyone has free access

Public good – Nonexclusive and nonrival good: The marginal cost of provision to an additional consumer is zero and people cannot be excluded from consuming it.

Nonrival good = Good for which the marginal cost of its provision to an additional consumer is zero.

Nonexclusive good – Good that people cannot be excluded from consuming, so that it is difficult or impossible to charge for its use.

Free Rider – Consumer or producer who does not pay for a nonexclusive good in the expectation that others will.