Introduction to Microeconomics: Key Concepts and Equations

Rational Decision Making

Individuals make decisions to maximize net benefit, defined as benefits minus economic costs, also known as economic rent.

Technology

A process that transforms inputs (e.g., labor, machinery, energy) into outputs.

Adam Smith

Founder of modern economics, introduced the 'invisible hand,' where individual self-interest can lead to societal benefits through market interactions.

Production and Opportunity Cost

Production functions describe input-output relationships. Opportunity cost is the value of the next best alternative foregone when making a choice.

Specialization and Gains from Trade

Specialization enhances productivity through learning, resource differences, and economies of scale. Trade is driven by absolute and comparative advantages.

Firms, Technology, and Production

Firms select technologies to minimize costs, using fixed-proportions technology (fixed input ratios) or technologies with constant returns to scale (doubling inputs doubles output).

Incentives

Factors that alter marginal costs or benefits, influencing behavior. Innovation rents are profits earned from adopting new technologies.

Economic Models and Equilibrium

Models simplify reality to study decisions. Equilibrium is a stable state that persists unless disrupted by external forces.

Net Benefit (Economic Rent)

Net Benefit = Benefit−Economic Cost

Economic Cost

Economic Cost = Direct Costs + Opportunity Cost

Production Function

Y = f(M, N, E), where Y is output, M is machines, N is number of workers, E is energy.

Cost of Technology

Cost = w · N + p · M, where w is wage rate, N is number of workers, p is price of machines, M is number of machines.

Average Product of Labor (APL)

APL = Y/N, where Y is output, N is number of workers.

Scarcity

Unlimited wants exceed limited resources.

Opportunity Cost

Value of the next best alternative foregone.

Marginal Cost (MC)

Additional cost of a small increase in an activity.

Marginal Benefit (MB)

Additional benefit of a small increase in an activity.

Rationality

Using all available information to achieve goals.

Incentive

Factor influencing behavior by altering marginal costs or benefits.

Fixed-Proportions Technology

Inputs used in fixed ratios.

Constant Returns to Scale

Doubling inputs doubles output.

Absolute Advantage

Higher productivity in producing a good.

Comparative Advantage

Lower opportunity cost of producing a good.

Economic Rent

Net benefit after accounting for opportunity cost.

Invisible Hand

Adam Smith's concept that self-interest can benefit society.

Innovation Rents

Profits from adopting new technology.

Equilibrium

Stable state persisting unless external forces intervene.

Endogenous Variables

Determined within the model.

Exogenous Variables

Determined outside the model.

Ceteris Paribus

Holding all else equal.

Decision Making Under Scarcity

Individuals maximize utility by choosing optimal combinations of consumption and free time within their feasible set.

Income and Substitution Effects

Wage or income changes affect choices via income effect (altered purchasing power) and substitution effect (altered relative prices).

Preferences and Utility

Indifference curves represent combinations of goods yielding equal utility. The Marginal Rate of Substitution (MRS) measures trade-offs between goods.

Marginal Rate of Transformation (MRT)

The rate at which one good is sacrificed for another, equal to the slope of the feasible frontier.

Budget Constraint

c = w(24 −t), where c is consumption, w is wage rate, t is hours of free time.

MRS

Absolute value of the slope of the indifference curve, representing the trade-off between two goods.

MRT

Absolute value of the slope of the budget constraint, showing the trade-off in production or consumption.

Feasible Frontier (Budget Constraint)

Boundary of possible combinations of goods given constraints.

Indifference Curve

Combinations of goods providing equal utility.

Marginal Rate of Substitution (MRS)

Rate of substituting one good for another while maintaining utility.

Income Effect

Change in consumption due to income changes.

Substitution Effect

Change in consumption due to relative price changes.

Utility

Satisfaction from consuming goods or services.

Strategic Interactions

Outcomes depend on the choices of multiple individuals, analyzed using game theory.

Game Theory

Framework for studying strategic decisions, involving players, strategies, and payoffs.

Invisible Hand Game

Shows how self-interest can lead to mutually beneficial outcomes (e.g., farmers choosing crops).

Prisoners' Dilemma

Individual rational choices result in a worse collective outcome (e.g., pest control choices).

Tragedy of the Commons

Overuse of shared resources due to self-interest (e.g., overfishing).

Pareto Criterion

An allocation is Pareto efficient if no one can be better off without making another worse off.

Social Preferences

Altruism, reciprocity, or fairness can influence decisions, mitigating social dilemmas.

Public Goods Game

Decisions on contributing to non-excludable, non-rivalrous goods, often leading to free-riding.

Ultimatum Game

Involves splitting resources, highlighting fairness (e.g., splitting $100).

Multiple Equilibria and Assurance Games

Coordination problems with multiple stable outcomes (e.g., driving conventions).

Payoffs

Numerical values representing outcomes in a game.

Nash Equilibrium

No player can improve their payoff by unilaterally changing their strategy.

Dominant Strategy

Best strategy regardless of others' actions.

Pareto Efficiency

No improvement possible without harming another.

Social Dilemma

Individual rationality leads to collective inefficiency.

Firm and Customers

Large firms benefit from economies of scale, producing at lower average costs.

Price Setting

Firms with market power set prices to maximize profits, unlike price-taking firms.

Demand and Willingness to Pay (WTP)

Consumers purchase if price is at or below their WTP, shown by a downward-sloping demand curve.

Differentiated Products

Products vary in characteristics, affecting competition and demand elasticity.

Costs and Returns to Scale

Include fixed costs (unchanging with output) and variable costs (changing with output). Economies of scale reduce average costs.

Average and Marginal Costs

Average cost is total cost per unit; marginal cost is the cost of one additional unit.

Elasticity of Demand

Measures responsiveness of quantity demanded to price changes (elastic: ε > 1, inelastic: ε < 1).

Profit Maximization

Achieved where marginal revenue equals marginal cost (MR = MC).

Gains from Trade and Surplus

Consumer surplus (benefit above price paid) and producer surplus (benefit above cost) measure trade benefits.

Market Power and Monopoly

Firms with few substitutes set higher prices. Monopolies are single sellers; natural monopolies have lower costs than multiple firms.

Welfare Impacts and Deadweight Loss

Inefficiencies (e.g., under-production) cause deadweight loss, reducing total surplus.

Total Revenue

R = P × Q, where P is price, Q is quantity.

Total Cost

C(Q) = FC + VC(Q), where FC is fixed costs, VC(Q) is variable costs.

Profit

π = R − C, or π = P × Q − C(Q).

Price Elasticity of Demand

ε = −%∆Q / %∆P, where %∆Q is percentage change in quantity, %∆P is percentage change in price.

Firm

Organization producing goods or services.

Willingness to Pay (WTP)

Maximum price a consumer will pay.

Fixed Costs (FC)

Costs invariant with output.

Variable Costs (VC)

Costs varying with output.

Average Cost (AC)

Total cost per unit of output.

Economies of Scale

Cost advantages from increased production.

Returns to Scale

Output response to proportional input increases.

Consumer Surplus

Benefit from paying less than WTP.

Producer Surplus

Benefit from selling above cost.

Market Power

Ability to set prices due to limited competition.

Monopoly

Single seller with no close substitutes.

Natural Monopoly

Single firm produces at lower costs than multiple firms.

Deadweight Loss

Loss of surplus due to inefficiency.

Supply and Demand

Buyers and sellers interact to set prices and quantities, reaching equilibrium where supply equals demand.

Competitive Equilibrium

In perfect competition, many price-taking buyers and sellers maximize gains from trade, achieving Pareto efficiency.

Price-Taking Firms

Accept market price, producing where price equals marginal cost (P = MC).

Gains from Trade

Measured by consumer surplus (benefit above price paid) and producer surplus (benefit above cost).

Market Efficiency

Competitive equilibrium maximizes total surplus, assuming no externalities.

Changes in Demand and Supply

Non-price factors (e.g., income, technology) shift curves, altering equilibrium; price changes cause movement along curves.

Government Intervention

Price controls (floors, ceilings) and taxes create inefficiencies like shortages, surpluses, or deadweight loss.

Tax Incidence and Elasticity

Tax burden depends on demand and supply elasticity; less elastic side bears more burden.

Law of One Price

Identical goods sell at a single price in competitive markets with perfect information.

Demand Function

e.g., WTP = 20 −0.5Q = P, where WTP is willingness to pay, Q is quantity, P is price.

Supply Function

e.g., WTA = 2 + 0.25Q, where WTA is willingness to accept, Q is quantity.

Market Clearing

Qd = Qs, where Qd is quantity demanded, Qs is quantity supplied.

Total Surplus

Sum of consumer and producer surplus.

External Effects/Externalities

Costs or benefits affecting non-market participants.