Microeconomics Study Sheet
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The production possibility curve (PPC) illustrates
maximum combinations of outputs that can be
produced, given a country’s resources and technology.
The opportunity cost of a choice is the benefit of the
next best alternative given up. It is the slope of the PPC.
- For substitutes/complements, the cross elasticity is
positive/negative.
Price
($)
η=9
η = 2.33
Good X
Unattainable
η=1
η = 1/2.33
η = 1/9
Attainable
D
Quantity
η = 1:
Total expenditure
is maximized
Good Y
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Best affordable
point
The slope of a straight line is calculated as the change
in the value of the variable measured on the vertical
axis (∆y) divided by the change in the value of the
variable measured on the horizontal axis (∆x):
slope =
Budget line
∆y
∆x
η > 1:
Price cut
increases total
expenditure
Value of an index in a given period
=
absolute value at given period
× 100
absolute value in base period
η < 1:
Price cut
decreases total
expenditure
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The higher the price of a good, the smaller the quantity
demanded (law of demand).
→ The demand curve is downward sloping.
The higher the price of a good, the higher the quantity
supplied (law of supply).
→ The supply curve is upward sloping.
Shortage (excess demand): quantity demanded >
quantity supplied
→ Upward pressure on the price.
Surplus (excess supply): quantity demanded < quantity
supplied
→ Downward pressure on the price.
The price adjusts until quantity demanded equals
quantity supplied (market equilibrium).
Quantity
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A price ceiling below equilibrium price results in
shortage (excess supply).
A price floor above equilibrium price results in surplus
(excess demand).
In the long run, rent controls result in a growing
housing shortage.
Farm policies are directed at stabilizing and raising
farm revenues.
Rent
($)
Relative price (-PM/PP) = MRS (budget line tangent to
indifference curve).
The effect of a price change can be divided into
substitution and income effect.
- (Hicksian) Substitution effect (effect of a change in
relative price, holding utility constant).
→ Increase (decrease) in the consumption of the good
whose price has fallen (risen).
Income effect (effect of a change in income, holding
relative price constant).
→ Normal good: Income effect reinforces the
substitution effect.
→ Inferior good: Income and substitution effects work
in opposite directions.
The income-consumption line traces out all utility
maximizing points for different levels of income.
- The price-consumption line traces out all utility
maximizing points for different levels of income.
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Blackmarket price
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Total utility is maximized when all income is spent
and when the utility gained from the last dollar spent on
each product is equal:
MUi = MUj
Pi
Pj
A budget line marks the borderline between affordable
and unaffordable consumption bundles. It depends on
income and prices.
Slope of the budget line: -PM/PP
An indifference curve represents a certain level of
utility. Consumption bundles to the right are preferred,
consumption bundles to the left are not preferred.
→ MRS (slope of an indifference curve) diminishes as
we move down to the right along an indifference curve.
The best affordable point is the point at which the
budget line is tangent to the indifference curve:
Surplus
Price
ceiling
Shortage
- Short run (SR)
→ Quantities of at least one of the firm’s resources is
fixed.
- Long run (LR)
→ Quantities of all of the firm’s resources can be
varied, but its technology is fixed.
- Very long run
→ Quantities of all of the firm’s resources and its
technology can be varied.
- Economic profits = total revenues – opportunity costs.
Total product (TP): Total output produced for various
levels of labour.
Marginal product (MP): Increase in total product
resulting from a one-unit increase in labour. → Slope
of the TP curve (∆TP/∆L)
Average product (AP): Total product per unit of labor
(TP/L).
Total cost (TC) = Total fixed cost (independent of the
level of output) + Total variable cost (increases as
output increases).
Marginal cost (MC): Increase in total cost resulting
from a one-unit increase in output. → Slope of the TC
curve (∆TC/∆Q).
Average total cost (ATC): TC per unit of output
(TC/Q).
ATC = AVC (average variable cost) + AFC (average
fixed cost).
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D
Shortage
D
Quantity
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η=
% change in quantity
% change in price
change in quantity average quantity
=
% change in price average price
=
Quantity
Price
($)
Surplus
S
Price
floor
∆Q /Q
∆P / P
- If demand is (in-)elastic, a decrease in price results in
higher (lower) total expenditure (TE). TE doesn’t
change due to a price-change for a unit-elastic demand.
- For inferior/normal goods, the income elasticity is
negative/positive.
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Because of initially increasing returns and eventually
decreasing returns, the average total cost curve is
u-shaped
MP & AP
(units)
Point of diminishing
marginal return
Point of diminishing
average returns
AP
MP
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marginal revenue = average revenue = market price.
MR = AR = p
Short run economic profits (losses) induce firms to
enter (exit) the industry. Industry supply increases
(decreases), the market price falls (rises) and in the
long run, economic profits return to zero.
Shutdown point: p = AVCMIN
The marginal cost curve above the shutdown point
traces out the firm’s short run supply curve.
The short run industry supply is simply the sum of the
quantities supplied by all firms at each given price.
Long run equilibrium
- Economic profits are zero.
Labour
Price
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In the long run, all factors are variable (“plant size is
variable”).
The long run average cost curve traces out the lowest
attainable average total cost at each output when both
capital and labour inputs can be varied.
Profit maximization is equivalent to cost minimization.
- Firms choose the combination of capital and labour
such that MPK = MPL
pK
Economic profit
Diminishing returns occur for any given quantity of
capital (labour) as the quantity of labour (capital)
increases.
→ MPK (MPL) decreases as more capital (labour) is
employed.
Economies of scale
- Fall in ATC as firm’s scale of production increases.
(increasing returns to scale).
Diseconomies of scale
- Rise in ATC as firm’s scale of production increases.
(decreasing returns to scale)..
Constant returns to scale
- Constant ATC as firm’s scale of production increases.
(constant returns to scale).
Minimum efficient scale
- Smallest quantity of output at which LRAC reaches its
lowest level.
Isoquant
- Whole set of technically efficient factor combinations
for producing a given level of output.
Marginal rate of substitution between two factors is
equal to the ratio of their marginal products.
- Slope of an isoquant at a particular point.
Isocost line shows alternative combinations of factors
that a firm can buy for given total cost.
- Slope = - (factor price ratio).
Cost minimization
($)
P* = TC*
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Quantity
In oligopoly, firms are aware of interdependence
among the decisions made by the various firms in the
industy → strategic behaviour.
Barriers to entry ensure that economic profits can
persist in the long run.
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Quantity
pL
Price
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A single price monopolist maximizes profit by producing
the output level at which marginal revenue = marginal
cost.
→ Note that marginal revenue < market price.
→ Compared to perfect competition, equilibrium output
is lower and equilibrium price is higher
(inefficient). Efficiency loss (deadweight loss).
Productive efficiency requires that total cost in an
industry is minimized.
Allocative efficiency → p = MC for each product.
Industries in which firms have a certain degree of
market power result in allocative distortion
(inefficiency), because p > MC.
There exists income distortion when profits/losses
occur.
Imposing marginal cost pricing on a natural monopoly
results in allocative efficiency, but the monopolist
generally incurs economic profits or losses.
Imposing average cost pricing on a natural monopoly
results in zero economic profits, but the outcome is
generally allocatively inefficient.
Price
($)
Price
MC
($)
ATC
Economic
profit
ATC
Loss with MC pricing
MC
M
D
Quantity
Price-discriminating monopoly: Producer charges
different prices for different units of the same product for
reasons not associated with differences in cost.
A (perfectly) price discriminating monopolist
converts consumer surplus into profit by charging each
buyer the maximum amount that he is willing to pay.
→ The outcome is efficient, with smaller consumer
surplus and larger producer surplus.
Monopoly profits can persist in the long run if there
are effective barriers to entry.
Cartels as monopolies: Organization of producers
who agree to cooperate and act as a single seller.
Cartels are unstable due to incentive to cheat for each
firm.
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Quantity
Price
($)
MC
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pL MPL
=
pK MPK
Cost
($)
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Minimum
efficient
scale
Economies
of scale
Constant
returns to scale
AT
Diseconomies
of scale
Output
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The profit maximizing output level is the quantity at
which
marginal revenue = marginal cost. (MR = MC)
In monopolistic competition there may be economic
profits in the short run. Each firm supplies its
differentiated product to a small segment of the
market. However, free entry/exit assures that in the
long run, economic profits are zero (at the quantity
where MC = MR, p = ATC).
ATC
Profit with MC pricing
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Factors of production are capital, land, an labour.
Factor demand is derived from the demand of the final
good or service that the factor produces.
A profit maximizing firm hires up the point where:
marginal cost(MC) = Marginal revenue product
(MRP) = MR*MP
Total factor income = factor price * level of employment.
= transfer earnings + economic rent.
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is equal to the economy’s capital stock.
- Accumulation of capital leads to a decrease in the
equilibrium interest rate.
- Technological improvements lead to an increase in
the equilibrium interest rate.
Present value of a single future payment PV =
MRP/(1 + i)t
Present value of a stream of payments that continues
forever PV = MRP/i
Hotelling’s rule: The socially optimal rate of extraction
of any non-renewable resource is such that its price
increases at a rate equal to the interest rate.
Wage
($)
S
Unaffordable
Transfer
earning
D
Price
($)
Elastic
demand
S + tax
S
tax rev.
Excess burden
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Rent
($)
Markets fail to achieve allocative efficiency in presence
of market power, externalities, public goods,
asymmetric information, and missing markets.
With a positive externality, a competitive market will
produce too little of the good.
With a negative externality, a competitive market will
produce too much of the good.
MSC: Marginal social cost MSC = external cost
imposed on the beach resort).
Coase theorem: If property rights exist and
transaction costs are low, private transactions are
efficient, regardless of who has the property right.
Non-rivalrous goods: consumption by one person does
not reduce consumption by another person.
→ Marginal cost of an additional user is zero.
→ To reach allocative efficiency, the price should be
zero.
Non-excludable goods: impossible/extremely costly to
prevent someone from consuming a good.
Public goods (those which are non-rivalrous and nonexcldable) give rise to free-rider problem
S
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Econ. rent
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Wage
S
($)
Unaffordable
Econ.
rent
Transfer
D
earning
Cost &
benefit
($)
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Wage differentials in competitive markets may result
from differences in working conditions, in inherited skill,
in human capital, or from some form of discrimination.
Two general cases that give rise to noncompetitive
labor markets are the presence of a union (monopoly
in selling labor) and / or of a monopsony (single buyer
of labor).
A binding minimum wage reduces employment in
competitive labor markets; however, it may lead to an
increase in employment in case employers have some
monopsony power.
Monopsony: a single buyer in the market
Wage
rate
($/h)
External
cost
MC
Competitive
eqm.
Quantity
Price
($)
S + tax
tax rev.
S
Excess burden
D
Quantity
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Gains from trade arise from different opportunity costs.
→ Specialization in the activity in which opportunity
costs are lowest.
Countries export goods for which they have a
comparative advantage.
Countries import goods for which they have a
comparative disadvantage.
Terms of trade: Ratio of the (average) price of a
country’s exports to the (average) price of its imports.
Index of Export Prices
Terms of Trade =
× 100
Index of Import Prices
Good X
D = MB
Inelastic
demand
Country A
Quantity
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Consumption
possibilities
… with trade
Profit maximizing firms produce too much relative to the
allocatively efficient level of output if MC < MSC (due
to negative externality).
The allocatively efficient level of pollution is the level
where MC of further pollution abatement = MB of
pollution reduction.
Policies used to regulate pollution are direct controls,
emissions taxes, and tradable pollution permits.
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MC
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eqm
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outcome
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eqm
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qPC
MRP = D
Labour
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Profit maximizing firms purchase new capital up to the
point where the present value of the stream of future
MRPs is equal to the purchase price of that unit.
The interest rate is determined in the capital market
and adjusts such that the quantity of capital demanded
The most important taxes in Canada are personal
income tax, corporate income tax, excise and sales
taxes, and property taxes.
Progressive tax: marginal tax rate increases as income
increases.
Proportional tax: marginal tax rate is the same for all
levels of income.
Regressive tax: marginal tax rate decreases as income
increases.
Efficiency and equity are often competing goals.
… without trade;
Good Y
Good X
Country B
Consumption
possibilities …
with trade
… without trade;
Good Y
Law of one price: When a product which can be
cheaply transported is traded throughout the entire
world, it will tend to have a single world price.
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