Basic Microeconomic Concepts
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Market Model – Supply and Demand
A supply curve shows the willingness to supply by sellers
- As prices increase, sellers will be willing to supply more
- Hence, the supply curve in a market is typically upward sloping
- A positive relationship between price and quantity supplied
A demand curve shows the willingness to pay by buyers
- As price increases, buyers respond by cutting down their demand for the product
- Hence, the demand curve for a ‘normal’ good is typically downward sloping
- A negative relationship between price and quantity demanded
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Market equilibrium when quantity demanded equals the quantity supplied (No surplus or shortage)
In the above diagram, the price and quantity which ensures an equilibrium is P* and Q*
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Economic Decision Making – Maximising Utility and Profit
In microeconomics, the most important principle is Marginal Benefit = Marginal Cost (MB = MC)
Suppose you consume an ice-cream cone, which is sold for $2 per unit
The first ice-cream cone gives you a benefit (or pleasure) worth $5, as you were craving ice-cream
Your net benefit from the initial consumption of an ice-cream is $5 (benefit) – $2 (cost) = $3
Now suppose you are considering have an extra ice-cream cone – should you buy an additional?
From a second ice-cream cone, you get a benefit worth $3.50, which still exceeds the cost of $2
The net benefit this time is $3.50 – $2 = $1.50, which is still positive
Suppose you are contemplating having more, and a third gives you a benefit worth $2.50
The net benefit this time is much smaller at $2.50 – $2 = $0.50, although it is still positive
Suppose you proceed to buy a fourth ice-cream, and the benefit is worth $0.50
You should not proceed since the net additional benefit (marginal benefit) is $0.50 – $2 = -$1.50,
which is negative, so you should stop at the third ice-cream cone
As long as the marginal (or extra) benefit exceeds the marginal (or extra) cost, you should keep on
doing what you are doing until MB = MC
Once MB = MC, or the marginal benefit from continuing further is likely to be less than the marginal
cost, you should stop doing it – you’ve already maximised the cumulative net benefit
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The cumulative net benefit is at a maximum at the third unit of ice-cream
The maximum cumulative net benefit occurs at MB = MC (or very close to it because ice-creams are
not divisible i.e. you cannot buy 3.5 ice-creams)
In the above example, a fundamental assumption is that the additional benefit is diminishing as the
individual consumes more of the same good (principle of ‘Diminishing Marginal Benefit/Utility’)
In the labour market, households (or workers constituting households) supply labour hours, and
firms (or entrepreneurs) demand workers (labour hours) to produce output
The quantity supplied or demanded can be measured in hours (or number of labour units)
The price of labour is the wage rate, say, W dollars per hour
The dollar wages we observe are the nominal wage
The wages adjusted for the purchasing power or price level (P) are called the real wage, W/P
We assume in economics that people are ‘rational’, and are therefore concerned with the real wage
That is, we assume that workers are not fooled by money illusion
What’s the use of getting paid $1 million dollars if you only buy a burger with all of the money!?
We also need to know how a ‘rational’ or profit-maximising firm makes it decisions of hiring workers
The principle that MB = MC for the maximum benefit can be applied in many contexts
For firms, maximum profit can be obtained by setting Marginal Revenue (MR, firm’s MB) = MC
As long as the extra revenue exceeds the extra cost of producing an extra unit of output, the firm
should keep increasing its output until the marginal benefit / revenue is equal to the marginal cost
Firms will try to hire workers until the MB of hiring an additional unit of labour equals the MC of it
Assume that the wage rate is constant and already given (say by the minimum wage) and that all
workers are identical (roughly the same in productivity and attributes)
Then, the MC of hiring an additional unit of labour will be the wage rate
What about the marginal benefit?
The marginal benefit of hiring an additional unit of labour (worker) can be measured by the extra
(or marginal) contribution (or product) brought by the worker
The MB of hiring an additional unit of labour therefore becomes the Marginal Product of the last
hired unit of labour (or worker)
Profit maximising firms will therefore equate MPL (marginal product of labour) to w (the wage rate)
That is, MPL = w
Note that MPL is a real quantity, or a real variable
Hence, here w is also a real wage, not the money wage
Therefore, the wage rate equated to MPL is also a real wage, which is given by w = W/P
Where W = nominal or money wage, and P = the price level such as the CPI
Production Function
Suppose that output can be expressed as 𝑌 = 𝐴𝐾 𝛼 𝐿1−𝛼 (the Cobb-Douglas production function)
Output (Y) is a multiplicative function of capital (K) and labour (L) for a given technology (A), where
the parameters ‘alpha’ and ‘1-alpha’ measure capital’s and labour’s share of output, respectively
Marginal product of labour as 𝑀𝑃𝐿 = ∆𝑌/∆𝐿 = 𝑑𝑌/𝑑𝐿 = (1 − 𝛼)𝐴𝐾 𝛼 𝐿1−𝛼 = (1 − 𝛼)𝑌/𝐿
Noting that Y/L is the average product of labour (𝐴𝑃𝐿 )
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In ECON1002, we use the MB = MC principle in nominal (or dollar) terms, rather than in real terms
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The law of diminishing returns say that
when you keep increasing one input
holding another input constant, output
increases but at a decreasing rate
Production function is concave down
This implies that the marginal (extra)
productivity of the input, measured by
the slope of the production function,
is decreasing as output is increasing
The marginal productivity from point a to
point b can be measured by the change in
output over the change in input (∆𝑌/∆𝐿)
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