Principles of Microeconomics Lecture Notes

ECON 1051: Principles of Microeconomics

Instructor

  • Andres Cuadros-Meñaca, PhD

  • University of Northern Iowa

  • Wilson College of Business

Roadmap

  • Objectives

  • Allocation Methods and Efficiency

  • Value, Price, and Consumer Surplus

  • Cost, Price, and Producer Surplus

  • Are Markets Efficient?

  • Market Failure

Objectives

  • Upon completing this section, you will be able to:

    • Define and explain the features of an efficient allocation.

    • Define consumer surplus.

    • Define producer surplus.

    • Evaluate the efficiency of alternative methods of allocating resources.

Allocation Methods and Efficiency

  • In market allocations of scarce resources, recipients are those willing to pay the market price.

  • Most scarce resources are allocated by market price.

    • General implication: markets efficiently distribute goods and services in many cases.

  • Allocative Efficiency:

    • Definition: A situation where the quantities of goods and services produced align with what people value most highly.

Marginal Benefit

  • Definition: The benefit a person receives from consuming one more unit of a good or service.

  • Determinants: Individual preferences shape marginal benefit.

    • The marginal benefit corresponds to the amount people are willing to forgo for an additional unit of a good.

  • Principle of Decreasing Marginal Benefit: As consumption of a good increases, the marginal benefit decreases.

Example of Marginal Benefit

  1. At Point A (2,000 pizzas/day):

    • Willing to give up 15 units of other goods.

  2. At Point B (4,000 pizzas/day):

    • Willing to give up 10 units of other goods.

  3. At Point C (6,000 pizzas/day):

    • Willing to give up 5 units of other goods.

Marginal Cost

  • Definition: The opportunity cost of producing one more unit of a good or service.

  • The marginal cost increases with the level of production.

  • Marginal Cost Curve: Illustrates what must be sacrificed to produce an additional pizza.

Example of Marginal Cost

  1. At Point A (2,000 pizzas/day):

    • Must give up 5 units of other goods.

  2. At Point B (4,000 pizzas/day):

    • Must give up 10 units of other goods.

  3. At Point C (6,000 pizzas/day):

    • Must give up 15 units of other goods.

Efficient Allocation

  • Finding efficient allocation involves comparing marginal benefit to marginal cost.

Value, Price, and Consumer Surplus

  • Demand and Marginal Benefit:

    • Buyers differentiate between value (what they gain) and price (what they spend).

    • Value is quantified as the marginal benefit, reflecting the maximum price a consumer is willing to pay for an additional unit.

Consumer Behavior

  • A consumer will purchase one more unit if its price does not exceed the perceived value.

  • The demand curve represents the value consumers place on each unit of a good, functioning as a marginal benefit curve.

Demand Curve Insights

  • Displays quantity demanded at varying prices while other conditions remain constant.

  • Indicates the maximum price consumers are prepared to pay for the last unit.

Consumer Surplus

  • Definition: The difference between the marginal benefit received from a good or service and the price paid, aggregated over all units consumed.

Example of Consumer Surplus

  1. Market price for pizza: $10.

  2. Weekly sales: 10,000 pizzas, total expenditure: $100,000.

  3. Willingness to pay for the 5,000th pizza: $15, therefore:

    • Consumer surplus for that pizza: $5.

  4. Total consumer surplus from 10,000 pizzas: Area of the corresponding triangle = $50,000.

  5. Total benefit from pizzas: $150,000 (total spending + consumer surplus).

Cost, Price, and Producer Surplus

  • Sellers differentiate between cost (sacrificed resources to produce) and price (revenue from sales).

  • Marginal Cost Defined: The cost incurred to produce an additional unit of goods.

Producer Decision-Making

  • A seller will produce an additional unit if the selling price is greater than or equal to its marginal cost.

  • Supply Curve: Illustrates marginal cost for sellers.

Example of Producer Surplus

  1. Market price for pizza: $10.

  2. Marginal cost for 5,000th pizza: $6, leading to:

    • Producer surplus for that pizza: $4.

  3. Total producer surplus from selling 10,000 pizzas: Area of corresponding triangle = $40,000.

  4. Total revenue equation: Total revenue = Selling price × Quantity = $100,000 - Producer surplus = $40,000.

Are Markets Efficient?

  • Market Characteristics:

    • When demand is perfectly inelastic, market dynamics involve:

    • Market Equilibrium: Intersection of demand and supply.

    • Marginal Cost and Benefit Curves: Their intersection indicates efficiency.

    • Efficiency Sign: Quantity is efficient when marginal cost equals marginal benefit.

    • In a competitive market:

    • Demand curve reflects buyers’ marginal benefit.

    • Supply curve reflects sellers’ marginal cost.

    • Competitive equilibrium maximizes total surplus, demonstrating efficient resource allocation.

    • Total Surplus: The aggregate of consumer and producer surplus maximizes at competitive equilibrium.

The Invisible Hand

  • Concept introduced by Adam Smith in The Wealth of Nations (1776):

    • Competitive markets effectively allocate resources to their highest-value uses.

    • Each market participant, unintentionally guided by personal interests, advances collective societal goals.

Market Failure

  • Definition: A scenario wherein the market output is inefficient.

  • Inefficiency causes:

    • Underproduction

    • Overproduction

Implications of Underproduction

  • When production falls below the efficient quantity, a deadweight loss occurs, representing total surplus reduction due to inefficiency.

    • Example:

    • Efficient quantity: 10,000 pizzas; production at 5,000 pizzas/day leads to surplus loss due to reduced total surplus.

Implications of Overproduction

  • Producing above the efficient quantity leads to another form of inefficiency with resultant deadweight loss.

    • Example:

    • Efficient quantity again at 10,000 pizzas; production at 15,000 pizzas incurs a surplus loss, defined by the excess production.

Sources of Market Failure

  • While markets excel at resource allocation, inefficiencies arise from several barriers:

    • Price and quantity controls

    • Taxes and subsidies

    • Externalities

    • Public goods and common resources

    • Market monopolies

Conclusion

  • No single method allocates resources perfectly; however, markets combined with other mechanisms achieve remarkable efficiency overall.

References

  • Gregory Mankiw, Principles of Microeconomics, Tenth Edition, Cengage, 2024.

  • Robin Bade and Michael Parkin, Foundations of Microeconomics, Ninth Edition, Pearson Education Inc., 2021.