Microeconomics Study Guide

📖 Core Concepts Microeconomics – studies how individuals and firms allocate scarce resources; focuses on single markets rather than the whole economy. Rational Consumer – has stable, complete, transitive preferences; preferences are continuous (allowing a smooth utility function) and locally non‑satiated (more is never worse). Utility Maximization Problem (UMP) – choose a bundle of goods to maximise utility subject to the budget constraint; the solution yields the Walrasian demand. Demand – relationship between price and the quantity consumers are willing to buy; obeys the law of demand (higher price → lower quantity). Supply – relationship between price and the quantity producers are willing to sell; obeys the law of supply (higher price → higher quantity). Market Equilibrium – point where quantity demanded = quantity supplied; price adjusts via shortages (price ↑) or surpluses (price ↓). Marginal Analysis – the marginal utility (MU) on the demand curve equals the marginal cost (MC) on the supply curve at equilibrium in perfect competition. Costs – Fixed Cost (FC): does not vary with output; Variable Cost (VC): changes with output; Sunk Cost: already incurred, unrecoverable. Short‑run total cost: $TC = FC + VC$. Opportunity Cost – value of the next‑best alternative foregone; depends only on the best alternative, not on the number of alternatives. Market Structures – Perfect Competition: many price‑taking firms, identical product, socially optimal output. Monopoly: single seller, price set above marginal cost; natural monopoly when one firm can produce at lower cost than any set of firms. Monopolistic Competition: many firms, differentiated products, higher average costs than perfect competition. Oligopoly: few dominant firms; strategic interaction modelled with game theory. --- 📌 Must Remember Micro vs. macro: micro = individual markets; macro = aggregate economy (growth, inflation, unemployment). Law of Demand: ↑P → ↓Qd (ceteris paribus). Law of Supply: ↑P → ↑Qs (ceteris paribus). Equilibrium Condition: $Qd(P^) = Qs(P^)$. Short‑run TC Formula: $TC = FC + VC$. Fixed vs. Variable vs. Sunk: FC ≠ VC; sunk costs are unrecoverable FC. Opportunity Cost: value of the best alternative, not the sum of all alternatives. Perfect Competition: price = MC = minimum average total cost. Monopoly Pricing: $P > MC$; can earn economic profit in the long run. Natural Monopoly: lower cost with one firm due to high fixed costs and economies of scale. --- 🔄 Key Processes Utility Maximization (UMP) Write the budget constraint: $p1x1 + p2x2 \le I$. Set up the Lagrangian: $\mathcal{L}=U(x1,x2)+\lambda(I - p1x1 - p2x2)$. First‑order conditions → derive Walrasian demand functions. Finding Market Equilibrium Write demand function $Qd(P)$ and supply function $Qs(P)$. Solve $Qd(P)=Qs(P)$ for the equilibrium price $P^$ and quantity $Q^$. Marginal Analysis for a Competitive Firm Compute marginal cost $MC = \frac{dTC}{dQ}$. Set $P = MC$ to find profit‑maximising output. Short‑Run vs. Long‑Run Supply Decision Short run: some inputs fixed → supply less elastic. Long run: all inputs variable → firm can adjust scale → more elastic supply. Game‑Theoretic Reasoning in Oligopoly Identify players, strategies, payoffs. Look for Nash equilibria (no player can improve by deviating unilaterally). --- 🔍 Key Comparisons Perfect Competition vs. Monopoly Competition: many firms, price taker, $P = MC$. Monopoly: single firm, price setter, $P > MC$. Fixed Cost vs. Variable Cost vs. Sunk Cost FC: unchanged by output, e.g., rent. VC: changes with output, e.g., raw materials. Sunk: already incurred, cannot be recovered (a type of FC). Substitution Effect vs. Income Effect (price ↓) Substitution: good becomes relatively cheaper → quantity ↑. Income: real purchasing power ↑ → quantity ↑ (for normal goods). Short‑Run vs. Long‑Run Supply Elasticity SR: some inputs fixed → steeper supply curve. LR: all inputs variable → flatter (more elastic) supply curve. Monopolistic Competition vs. Perfect Competition Product differentiation → downward‑sloping demand for each firm. Higher average costs, not socially optimal output. --- ⚠️ Common Misunderstandings Sunk vs. Fixed Cost: Not all fixed costs are sunk; sunk costs cannot be recovered, while other fixed costs (e.g., rent) could be avoided by shutting down. Opportunity Cost Includes All Alternatives: It only reflects the next‑best alternative, not the sum of all forgone options. Monopoly Is Always Inefficient: Natural monopolies can achieve lower total cost than multiple firms; regulation may be needed, not outright inefficiency. Law of Demand Violated by Giffen Goods: Outline does not cover Giffen; assume standard downward‑sloping demand unless otherwise stated. Equilibrium Means “Maximum” Profit: In perfect competition it yields zero economic profit; in monopoly profit can be positive. --- 🧠 Mental Models / Intuition Budget Line as a “Shopping Fence”: The consumer can only purchase bundles on or inside the line; moving along it trades one good for another. Marginal Decision Rule: Keep buying/selling one more unit as long as the marginal benefit (MU or MR) exceeds the marginal cost (MC). Supply‑Demand Interaction as a “Tug‑of‑War”: Prices move toward the point where the two forces balance (equilibrium). Game Theory as “Chess”: Each firm anticipates rivals’ moves; a Nash equilibrium is a “stable board position” where no player wants to move. --- 🚩 Exceptions & Edge Cases Natural Monopoly: One firm can supply the entire market at lower cost than multiple firms → price regulation may be required. Market Failure: Occurs when free markets do not allocate resources efficiently (e.g., externalities, public goods). Perfect Competition Assumptions: Many small firms, identical products, perfect information; any violation (e.g., product differentiation) moves the market toward monopolistic competition. Short‑Run Fixed Inputs: If a supposedly “fixed” input can be varied (e.g., overtime labor), the short‑run supply curve becomes more elastic than textbook. --- 📍 When to Use Which Marginal Analysis → when evaluating one more unit (price setting, output decision). Utility Maximization (UMP) → for consumer‑choice questions involving budget constraints. Short‑Run Supply Curve → when at least one input is fixed (e.g., plant size). Long‑Run Supply Curve → when all inputs can be adjusted (entry/exit decisions). Game Theory → any oligopolistic scenario (duopoly, cartel, strategic pricing). Cost‑of‑Production Theory → to compute firm‑level supply decisions in competitive markets. --- 👀 Patterns to Recognize Price ↑ → Shortage? Check if price is below equilibrium (shortage → upward pressure). Fixed Cost Present, Variable Cost Zero: Indicates a purely sunk situation (e.g., a licensing fee). Demand Curve Shift vs. Movement Along Curve: Shift → change in non‑price factor (income, tastes). Movement → price change. Profit‑Maximising Condition: Perfect competition: $P = MC$. Monopoly: $MR = MC$ (price then set above MC). Game‑Theoretic Equilibrium: Look for mutual best‑responses; if each firm’s best response is the other’s strategy, you have a Nash equilibrium. --- 🗂️ Exam Traps Confusing Sunk with Variable Cost: A sunk cost is already incurred and cannot affect current decisions; variable cost does affect marginal decisions. Assuming Monopoly Price Equals MC: Monopoly sets $P > MC$; the profit‑maximising rule is $MR = MC$, not $P = MC$. Mixing Up Substitution and Income Effects: Both move quantity in the same direction when price falls for a normal good, but they stem from different mechanisms. Choosing the Wrong Time Horizon: Applying short‑run cost concepts (fixed inputs) to a long‑run problem leads to incorrect elasticity conclusions. Treating Any Market Failure as Government Failure: The outline defines market failure as inefficient outcomes without implying that government intervention always improves welfare. ---