Exam 1 Notes

ECON 3332 Intermediate Microeconomics Conceptual Study Guide

1. Supply, Demand, and Market Equilibrium

Key Concepts

• Market forces: How supply and demand interact to determine prices and quantities

• Equilibrium: The natural resting point of a market where quantity supplied equals quantity demanded

• The Invisible Hand: Markets naturally move toward equilibrium without intervention

  • If price is above equilibrium → excess supply → price falls

  • If price is below equilibrium → excess demand → price rises

Elasticity Concepts

• Elasticity interpretation: Measures responsiveness of one variable to changes in another

• Price elasticity factors:

  • Availability of substitutes (more substitutes = more elastic)

  • Necessity vs. luxury (necessities are less elastic)

  • Percentage of income spent (higher percentage = more elastic)

  • Time horizon (longer time = more elastic)

• Cross-price elasticity interpretation:

  • Positive value = substitutes (price of Y↑ → demand for X↑)

  • Negative value = complements (price of Y↑ → demand for X↓)

• Income elasticity interpretation:

  • Normal goods: demand increases with income

  • Inferior goods: demand decreases with income

  • Necessities vs. luxuries: luxuries are more responsive to income changes

2. Production Concepts

Understanding Production

• Production function conceptual meaning: Relationship between inputs and maximum possible output

• Marginal product interpretation: Additional output gained from one more unit of input

• Diminishing marginal returns: Why additional units of one input yield progressively smaller increases in output

• Average product: Output per unit of input

Returns to Scale

• Constant returns to scale: When doubling all inputs doubles output

• Increasing returns to scale: When doubling all inputs more than doubles output

  • Reasons: specialization, dimensional properties, greater coordination

• Decreasing returns to scale: When doubling all inputs less than doubles output

  • Reasons: management challenges, coordination difficulties

Isoquants

• Conceptual meaning: Different combinations of inputs that produce the same output

• Shape: Convex to origin, reflecting substitutability between inputs

• MRTS interpretation: The rate at which one input can be substituted for another while maintaining the same output level

3. Cost Minimization

Conceptual Framework

• Cost minimization problem: Producing a given output at minimal cost

• Isocost line interpretation: Different combinations of inputs that cost the same amount

• Optimal input mix: Occurs where the isoquant is tangent to the isocost line (MRTS = input price ratio)

• Economic interpretation of tangency condition: Marginal product per dollar spent must be equal across all inputs

Input Price Changes

• When wages increase: Isocost line becomes steeper, optimal input mix shifts toward more capital, less labor

• When rent increases: Isocost line becomes flatter, optimal input mix shifts toward more labor, less capital

4. Costs in the Short Run

Time Horizon Effects

• Short run vs. long run: In short run, some inputs are fixed; in long run, all inputs variable

• Why short-run costs are higher: Inability to adjust all inputs means less efficient production

Understanding Cost Categories

• Fixed costs conceptual meaning: Costs that don't change with output level

• Variable costs conceptual meaning: Costs that change with output level

• Relationship between average and marginal costs:

  • When MC < AC, AC is falling

  • When MC > AC, AC is rising

  • AC is minimized when MC = AC

Cost Curve Shapes

• U-shaped average cost curves: Why they occur (interaction between fixed costs and diminishing returns)

• Increasing marginal cost: Results from law of diminishing returns

5. Perfect Competition

Market Structure

• Perfect competition characteristics: Many firms, identical products, price takers, no barriers to entry

• Price-taker concept: Why individual firms cannot influence market price

• Demand curve for perfectly competitive firm: Horizontal at market price

Profit Maximization Logic

• MC = MR rule: Why this maximizes profit

• Short-run shutdown decision: Operate if P > AVC, shut down if P < AVC

• Intuition for shutdown rule: Only variable costs can be avoided by shutting down

Long-Run Dynamics

• Zero economic profit in long run: Why this occurs (free entry/exit)

• Entry and exit mechanism:

  • Positive profit → entry → supply increases → price falls → profit decreases

  • Negative profit → exit → supply decreases → price rises → profit increases

• Distinction between economic and accounting profit: Economic profit includes opportunity costs

6. Monopoly

Market Power Origins

• Sources of monopoly power:

  • Natural monopoly (economies of scale)

  • Government-created monopoly (patents, licenses)

  • Network effects

  • Control of essential resources

  • High barriers to entry

Monopolist Decision-Making

• Downward-sloping demand curve: Why monopolists face this unlike competitive firms

• Price-setting ability: Monopolist chooses point on demand curve

• MR < P for monopolists: Why this occurs (price reduction affects all units)

• Profit maximization reasoning: Set MR = MC, then find corresponding price on demand curve

Market Power Consequences

• Efficiency effects: Deadweight loss from monopoly

• Price vs. marginal cost: Why monopoly price exceeds marginal cost

• Price discrimination: Charging different prices to different customers

• Lerner Index interpretation: Measure of market power (higher index = greater market power)

• Revenue maximization vs. profit maximization: Revenue maximized at unit elastic point, profit maximized where demand is elastic

7. Imperfect Competition

Monopolistic Competition

• Characteristics: Many firms, differentiated products, no barriers to entry

• Short run vs. long run: Can earn economic profit in short run, zero economic profit in long run

• Product differentiation: How firms attempt to gain market power

Oligopoly Dynamics

• Interdependence: Why firms must consider rivals' actions

• Nash Equilibrium concept: Strategy where no firm wants to change given others' strategies

• Collusion instability: Why cartels tend to break down (incentive to cheat)

• Factors affecting collusion stability:

  • Number of firms (fewer = more stable)

  • Ability to detect cheating

  • Punishment mechanisms

  • Time horizon

Strategic Interaction

• Bertrand competition concept: Firms compete on price

  • With identical firms: Results in P = MC (competitive outcome)

  • With different costs: Most efficient firm captures market

• Cournot competition concept: Firms compete on quantity

  • Each firm's best response depends on others' quantities

  • Results in price between competitive and monopoly levels

• Reaction functions: How one firm's optimal choice depends on rivals' choices

Comparison of Market Structures

• Spectrum of market power: Perfect competition → Monopolistic competition → Oligopoly → Monopoly

• Price and output comparisons:

  • Perfect competition: Highest output, lowest price

  • Monopoly: Lowest output, highest price

  • Oligopoly: Intermediate output and price

• Efficiency comparisons: Deadweight loss increases with market power

Important Exam Concepts and Applications

Cost Analysis

• When is it optimal to shut down in the short run?

• How do firms determine the optimal input mix?

• What happens to costs when input prices change?

Market Comparisons

• How does price relate to marginal cost in different market structures?

• How does quantity produced compare across market structures?

• How does profit compare across market structures?

Strategic Decision-Making

• What factors should a firm consider when setting price or quantity?

• How do firms react to competitors' actions?

• When is collusion sustainable?

Elasticity Applications

• How does elasticity affect a firm's pricing strategy?

• Why do monopolists only operate in the elastic portion of the demand curve?

• How do cross-price elasticities inform competitive strategy?