Chapter 2: The Basics of Supply and Demand
 Elasticities of Supply and Demand
o Price elasticity of demand = [% Change in Q] / [% Change in P]
o Price elasticity of demand = [P / Q] * [1 / abs(slope of demand
curve)]
o Elasticities pertain to a time frame and can vary between the SR
and LR
Chapter 3: Consumer Behavior
 Marginal Rate of Substitution (MRS) is the absolute value of the slope of
the indifference curve = ratio of the marginal utilities of the two goods
(partial derivatives)
 A consumer chooses quantities of two goods at the point where an
indifference curve is tangent to the budget constraint line
 At optimal consumption bundle, MRS = price ratio of two goods (absolute
value of the slope of the budget constraint)
 MU1 / MU2 = P1 / P2
 Cost of living indexes
o CPI is a Laspeyres index – it measures the change in cost for a
constant market basket of goods chosen in the base year and thus
tends to overstate the rise in prices
o A Paasche index, in contrast, uses a market basket chosen in the
present year and calculates the cost of it in the past year thus
tending to understate the ideal cost of living adjustment
Chapter 4: Individual and Market Demand
 Price-Consumption Curve is the curve traced out by the points
representing a consumer’s consumption choices when the price of one
good is held fixed and the other good’s price changes
 Income-Consumption Curve is analogous to the Price-Consumption Curve
except that income varies while prices remain fixed
 Normal good = consumption increases as income rises
 Inferior good = consumption decreases as income rises
 Engel Curve is a plot of Income (vertical axis) vs. quantity of a good
consumed (horizontal axis)—useful for identifying normal vs. inferior goods
 When the price of one good changes, there is both a substitution and an
income effect
o To find the magnitude of the substitution effect, find a hypothetical
budget constraint with the new price ratio for the two goods (i.e.
parallel to the new budget constraint) but that is tangent to the
original indifference curve (from before the price change)
o The income effect is whatever change in consumption is not
explained by the substitution effect
o When a large negative income effect outweighs the substitution
effect, the good is called a Giffen good
 The market demand curve is the horizontal summation of all individual
demand curves
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Network externality occurs when the quantity of a good demanded by a
typical consumer increases (positive—e.g. bandwagon effect) or decreases
(negative—e.g. snob effect) in response to the growth in purchases of other
consumers
Consumer surplus is the difference between what a consumer is willing to
pay for a good and what he actually pays
When demand is price inelastic, an increase in price will lead to an
increase in expenditure. When demand is price elastic, an increase in
price will lead to a decrease in expenditure
Chapter 5 – Uncertainty and Consumer Behavior
 Risk premium – maximum amount of money a person will pay to avoid
taking a risk. For a risk averse person, the plot of utility vs income is
upward sloping but with diminishing marginal utility. The risk premium is
the difference in income between the expected value of a risky proposition
and income associated with the point on the indifference curve with the
same utility as the expected utility
 Risk can be reduced by diversification, insurance, and additional
information
 Behavioral economics
o Reference points – people dislike losing things that they already
possess more than they like gaining things they don’t have
o Fairness – people often forgo consumption when they think prices
are “unfair” even though they are within the limits of consumer
demand
o Probability – people often misjudge probabilities via the “law of small
numbers” which tends to overstate the probability that certain
events will occur
Chapter 6 - Production
 In the SR one or more inputs are fixed, in the LR all inputs are variable
 Law of Diminishing Marginal Returns – as the use of an input increases in
equal increments (with other inputs fixed), a point will be reached at which
the resulting additions to output decrease
 Isoquants are analogous to indifference curves
 Marginal Rate of Technical Substitution (MRTS) = - (change in K) /
(change in L) for a given level of q or the absolute value of the slope of the
isoquant
 MRTS = MPL / MPK
 Returns to scale
o Increasing returns to scale – output more than doubles when inputs
are doubled
o Likewise for constant and decreasing returns to scale
o Returns to scale need not be constant across all levels of output
Chapter 7 – The Cost of Production
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Isocost lines are the production equivalent of the consumer’s budget
constraint line (TC = wL + rK)
A producer chooses levels of K and L for a given target production quantity
by selecting the point on the isocost line that is tangent to the isoquant, at
this point:
o MRTS = w /r = MPL / MPK
Expansion path plots the combinations of K and L that a firm will choose to
minimize costs at all levels of output
Returns to scale refers only to cases where the ratio of inputs is held
constant. When a firm can, for example, double its output for less than
double the cost, it is said to enjoy economies of scale (conversely, a firm
can suffer from diseconomies of scale)
Economies of scope – a single firm can produce two products more
cheaply than two firms each producing one product (also diseconomies of
scope)
Learning curve shows how the input needed to produce a given output
falls as the cumulative output of the firm increases
Chapter 8 – Profit Maximization and Competitive Supply
 Perfect Competition
o Price taking
o Product homogeneity
o Free entry and exit
 For all firms, competitive or not, profit is maximized when MC = MR
 For a firm in a perfectly competitive market, profit maximization occurs
when MC = MR = P
 A competitive firm’s SR supply curve is the portion of the MC curve that
lies above the minimum of the AVC curve
 Industry supply in the SR is the horizontal summation of the firms’
individual supply (MC) curves
 LR supply curve is horizontal for a competitive constant cost industry. For
increasing/decreasing cost industries, the LR supply curve is sloped
Chapter 9 – The Analysis of Competitive Markets
 Deadweight loss – net loss of total (consumer plus producer) surplus
 Economic efficiency – the maximization of aggregate consumer and
producer surplus
 The share of a tax borne by consumers depends on the shapes of the
supply and demand curves and, in particular, on the relative Elasticities of
supply and demand
Chapter 10 – Market Power: Monopoly and Monopsony
 For a monopolist, the MR curve is derived from the market demand curve
 Monopolist chooses output level where MR = MC
 A monopolist has no supply curve
 A multi-plant firm will choose output levels such that MC1 = MC2 . . . = MR
 Lerner Index of Monopoly Power (L) = (P – MC) / P
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The less elastic the firm’s demand curve, the more monopoly power it has
Monopoly power depends on
o The elasticity of market demand
o The number of firms in the market
o The interaction of among the firms
Monopoly power results in a deadweight loss
Rent seeking – spending money in socially unproductive efforts to acquire,
maintain or exercise monopoly power
When a firm has monopoly power, price regulation can reduce or eliminate
the deadweight loss
A natural monopoly is a firm that can produce the entire output of the
market at a cost lower that what it would be if there were several firms
A monopsonist buys goods at the level where Marginal Expenditure (ME)
is equal to Marginal Value (MV). For the monopsonist, the ME curve lies
above the market supply curve
Chapter 11 – Pricing with Market Power
 Pricing strategies for firms with market power are tactics for capturing
consumer surplus and transferring it to producers
 Price discrimination
o First degree – charging each consumer his reservation price (i.e.
capturing 100% of consumer surplus by making the MR curve equal
to the demand [AR] curve)
o Second degree – charging different unit prices for different
quantities of a good
o Third degree – dividing consumers into several groups with separate
demand curves (MR1 = MR2 = MC)
 Intertemporal price discrimination divides consumers into
high and low demand groups
Chapter 12 – Monopolistic Competition and Oligopoly
 Monopolistic Competition
o Firms compete by selling differentiated products that are highly
substitutable
o Free entry and exit
o In the LR, a firm’s demand curve will be tangent to its AC curve
(and downward sloping) implying zero economic profit in the LR
o Two sources of inefficiency
 Deadweight loss
 Excess capacity since the firm’s demand curve does not
intersect the AC curve at its minimum (as in Perfect
Competition)
o Oligopoly
 Oligopolistic markets stabilize in Nash Equilibria where each
firm is doing the best it can given what its competitors are
doing
 Cournot model
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Firms compete via output levels simultaneously
Reaction curves plot q1 vs. q2 for each firm where the
curves chart the profit-maximizing level of output for
one firm assuming a fixed level of output for the other
 Nash equilibrium is the intersection of their reaction
curves
Stackelberg Model
 Similar to Cournot insofar as firms compete on output
 One firm sets its own output first and the second firm
has to react
 First-mover chooses output level on the second firm’s
reaction curve that maximizes the first firm’s profit
 First-mover advantage
Chapter 16 – General Equilibrium and Economic Efficiency
 An allocation of goods is efficient only if the goods are distributed so that
the MRS between any pair of goods is the same for all consumers
(otherwise, they could be made better off by trading)
 See page 606-7 for summary of efficiency
 Reasons for market failure
o Market power
o Incomplete information
o Externalities
o Public goods
Chapter 18 – Externalities and Public Goods
 An externality occurs when a producer or consumer affects the production
or consumption activities of others in a manner that is not directly reflected
in the market
 For a negative externality, the efficient level of output is found by adding
the Marginal External Cost (MEC) to the firm or market’s MC or supply
curve to obtain the Marginal Social Cost curve. The intersection of the
MSC and the demand curve provides the efficient level of output
 In the case of a positive externality, add the Marginal External Benefit to
the demand curve to find the Marginal Social Benefit curve
 Ways of correcting market failures
o Emissions fees
o Emissions standards
o Tradable emissions permits
 Demand curve for a public good is the vertical summation of individuals’
demand curves
 The free-rider problem makes it difficult or impossible for markets to
efficiently provide public goods