Notes on

Microeconomics

Prof. Theodore Tolias

(Draft Not for Quotation)
 Agenda
lTheory of Demand and Supply
lElasticity
lApplications
Minimum Wage and Unemployment
Sales Taxes
lPossibilities, Preferences and Consumer
Choices
lThe Theory of the Firm
 The Theory of Demand
l The quantity demanded (Qd) of a good or
service is the amount that consumers plan
to buy during a given time period at a
particular price (p).

l Alinear relationship between P and Qd,

other things remaining equal.
 Mathematically
P = a bQd,

Where:
P = Price of good or service
a = y-intercept or the price where Qd = 0
b = slope of demand curve
Qd = Quantity demanded
Factors That Affect Demand
l The price of the good
l The prices of related goods
l Income
l Expected future prices
l Population
l Preferences
 Movements Along Demand
curve
l Law of Demand

l Change in quantity demanded

l Changes
in the price of the good, cause
movements along the curve, everything
else remaining the same.
 Shifts of the Demand Curve
l Change in Demand

l Decrease in demand - leftward shift

l Increase in demand rightward shift

 Decrease in Demand
l Fall in the price of a
substitute p
l Rise in the price of a
complement
l Income falls (normal
good)
D1
l Expected fall in price
l Population decrease D2

Q
 Increase in Demand
lRise in the price of
a substitute p
lFall
in the price of a
complement
lIncome rises
(normal good) D2

lExpected rise in D1
price
Q
lPopulation Increase
 Theory of Supply
l The quantity supplied (Qs) is the amount of
a good that producers plan to sell in a given
period at a particular price (p).

l Alinear relationship Qs and P, other things

remaining the same.
 Mathematically
P = c + dQs,

Where:
P = Price of good or service
c = y-intercept or the price where Qs = 0
d = slope of supply curve
Qs = Quantity supplied
 Factors That Affect Supply
The price of the good
The prices of factors of production
The prices of other goods produced
Expected future prices
The number of suppliers
Technology
 Movements Along Supply
Curve
l Law of Supply

l Change in Quantity Supplied

l Changesin the price of the good, causes

movements along the curve, everything
else remaining the same.
 Shifts of the Supply Curve
l Change in Supply

l Decrease in Supply Leftward shift

l Increase in Supply Rightward shift

 Decrease in Supply
l Rise in the price of a
p S2
factor of production S1
l Rise in the price of a
substitute in production
l Fall in the price of a
complement in production
l An expected rise in price
of the good
l Fall in the number of firms
Q
 Increase in Supply
lFall in the price of a
factor of production p S1
S2
lFall in the price of a
substitute in production
lRise in the price of a
complement in production
lAn expected fall in price
of the good
lRise in the number of firms
Q
lTechnology
 Price Determination -
Equilibrium
l Theprice at which the quantity demanded
equals the quantity supplied

Qd = Qs
 Diagrammatically
l Prices below the
equilibrium, there is
p
a shortage (excess S
demand) and the
price rises.
l Prices above the
equilibrium there is p*
a surplus (excess
supply) and the D
price falls.
Q* Q
 The Effects in the Change of Demand

l When demand
increases, both the p S
price and the
quantity increase

p2
p1 D2

D1
Q1 Q2 Q
 The Effect of a Change in Supply

l When supply
p S1
increases, the S2
quantity
increases and
the price falls.
p1
p2

D
Q1 Q2 Q
 Elasticity
l Elasticity of Demand
measures the responsiveness of the quantity
demanded of a good or service to a change in
its price

the percentage change in the quantity

demanded of a good divided by the percentage
change in its price
 Derivation
Elasticity of demand:
Q
% Q Q P Qave Q Pave
= = or = =
% P P Q P P Qave
Pave
Perfect Inelastic demand Unit Elastic Demand Perfectly Elastic
= 0 =1 =

p D p p

Q Q Q
Elasticity Along a Straight
Line Demand Curve
p

>1

=1

<1

Q
 Elasticity, Total Revenue and
Expenditure
l When demand is Maximum
elastic, a decrease in TR total revenue
price brings an
increase in the total
revenue.
l When demand is
A price cut A price
inelastic, a decrease in increases cut
price brings a total decreases
decrease in the total revenues total
revenues
revenue.
Q
 The Factors That Influence The
Elasticity of Demand
l The closeness of substitutes

l Theproportion of income spent on the

good

l Time elapsed since a price change

 Other Elasticities of
Demand

l Cross price elasticity of demand

l Income elasticity of demand

 Cross Price Elasticity of
Demand
% Q
xy =
% P

Assume Two Goods (X, Y)

if = then goods are perfect substitutes
xy

if > >0 then goods are substitutes

xy

if xy =0 then goods are independent

if xy <0 then goods are complements
 Income Elasticity of
Demand
% Q
I =
% I
if I >1 the good is normal.
Demand is income elastic. %Q > %I
if 1> I >0 the good is normal.
Demand is income inelastic. %Q < %I
if I<0 the good is inferior.
If income increases demand decreases.
 Elasticities of Supply
When the value of the elasticity of supply, , is:

l = the supply is perfectly elastic

l > >1 the supply is elastic
l 1> >0 the supply is inelastic
l =0 the supply is perfectly inelastic
 Applications

l Minimum wage and Unemployment

l Sales taxes- Who pays the tax?

 Minimum wage and
Unemployment
l A price floor - the wage should not fall
below the minimum wage.
l To be effective the price must be set
above the market equilibrium price.
l Creates an excess supply and a rise in
unemployment.
 W

Wmin

W*

Qd Q* Qs Quantity
(millions of hours)
Sales taxes- Who pays the
tax?
l Shifts the supply to the left. Producers and
suppliers share the tax burden.
S2
p
S1
tax
p2

p1
Tax
revenues

Q2 Q1 Q
 Sales tax and Perfectly
Inelastic Demand
l If demand is inelastic the consumer pays the entire tax

p S2

p2 S1
tax
Tax
revenues
p1

Q1 Q
 Sales tax and Perfectly
Elastic Demand
l If demand curve is perfectly elastic the entire tax is
paid by the seller
p S2

S1
tax

p2

Tax
revenues

Q2 Q1 Q
 Additional Applications
l The case of a perfectly inelastic supply
curve

l The case of perfectly elastic supply curve

l Given that the demand for farm products

is highly inelastic examine how farmers
income is affected if the crop is poor
 Possibilities, Preferences,
and Consumer Choices
l Possibilities:
Consumption choices are limited by income
and prices. The limits to households
consumption choices are described by its
budget line.
 Possibilities
The budget equation: I = PyY + PxX

where I= income, Px, Py are the prices of goods

X and Y respectively.

A relative price is the price of one good divided

by the price of another good. It measures the
slope of budget line: Px
Py
 I Px
Solve for Y=
Py Py
X

Y Y Y

X X X
a)budget line for Px, Py, I b) budget line shifts right c) budget line pivots
when income increases to the right when Px
decreases
 Preferences
l A persons preferences can be
represented by a preference map that
consists of a series of indifference curves.

l An indifference curve is a line that shows

combinations of goods among which a
consumer is indifferent.
Y

U2
U1
Uo

X
 Properties of indifference
curves
l For most goods, indifference curves slope
downward and bow towards the origin
(convexity).
l They never intersect.
l The magnitude of the slope of an indifference
curve is called the marginal rate of substitution.
l The marginal rate of substitution diminishes as
a person consumes less of the good measured on
the y-axis and more of the good measured on the
x-axis.
Slope and the Marginal Rate of
Substitution (MRS)
Y

Y1 A

Y2 B

Uo

X1 X2 X
 Indifference Between
Combination A and B
Y.MUy = X.MUx,

l where MUy is the marginal utility derived from

the consumption of Y
l where MUx is the marginal utility of the extra
units of X
l To remain indifferent between combination A
and B the losses in terms of satisfaction must
equal the gains
 Rearranging
Y MUx
=
X MUy

Y
is the slope of the indifference curve
X
MUx
and it is equal to the MRS =
MUy
 Best Affordable Point
l The consumers objective is to maximize
utility subject to the budget constraint.

l The best affordable point must be on

the budget line and also on the highest
possible indifference curve.
 Y

Y1 A

X1
X

Point is the best affordable point. Given the budget line, the
consumer chooses to Y1 and X1 quantities. At point A the
slope of the budget line equals the slope of the indifference
curve, i.e. Px MUx
=
Py MUy
 Derivation of the Individual
Demand for good X
l Assume a point on the individuals demand
curve for good X, i.e. point X1 for price
Px.
l Assume that Px decreases (Px1)
l The budget line pivots to the right and
the individual can now move to a higher
indifference curve
The new affordable point for most goods, (normal goods), will
indicate that the consumer will be willing to buy more of X.

Y1 A B

X1 X2
X
New affordable point is B and the utility maximizing
quantity of X is X2.
 Demand curve for Good X
P

Px

Px1

D
X1 X2 X
From the above we notice that every point on the demand curve
represents a maximum utility point for given prices.
A change in income will shift the individual demand to the
right assuming the good is normal.
 Implications of Marginal
Utility Theory
Consumer Surplus
value a consumer places on a good is the
maximum amount that the person would be
willing to pay for it.

For X1 units the consumer would be willing to

pay Px and that for X2 units the price that
would maximize utility is Px1.
 Consumer Surplus
Cont..
l The price that a consumer actually pays to
buy any unit of X is determined in the
market.
l If the market price is below what the
consumer would be willing to pay then we
can say that he/she enjoys a surplus.
l Consumer surplus = the value of a good
minus the market price.
 P

Px2 B

X2 X

The consumer surplus when the market price is Px2 is the area
of the triangle APx2B.

The consumer would be willing to pay higher prices for any

units of X less than X2.

The lower the market price the higher the consumer surplus.
 THE THEORY OF THE FIRM
l The firms objective is to maximize profits given
the market and technology constraints.

l Definition of economic profit:

equal to the firms total revenue minus its
opportunity cost of production.
Opportunity cost measures cost as the value of the
best alternative forgone.
 THE THEORY OF THE FIRM
l The market constraints are the conditions under
which the firm can buy its inputs or sell its
output
i.e. whether it faces competitive or non-competitive
input and output markets.

l The firms technology constraints are the limits

to the quantity of output that can be produced by
using given factors of production.
The firm chooses a technologically and
economically efficient method of production.
 Short-run technology
constraint
l Definitions
Short run: The period for which the capital stock
of the firm remains fixed. In the short run the
total product can increase only if variable
inputs increase.

Marginal product: The additional product

produced by an additional unit of the variable
input.
 Definitions Cont
Average product: the average productivity of the
variable input. Calculated by dividing total output by
the units of the variable input.

The law of diminishing marginal productivity: As more

units of the variable input (labour) are employed total
product increases but at a decreasing rate. This
implies that marginal product of labour first increases
and then decreases.
Relate marginal product (MPL) to
the average product (AP)L
l When MPL exceeds the APL , the APL
increases

l when MPL is less than APL , APL decreases

l when MPL and APL are equal, APL is at its

maximum
AP
MP

MP AP

Labour
units
 Short-run Cost
l A firms total cost is the sum of the costs
of all the inputs it uses in production.
l Total cost (TC) = Fixed cost (FC) +
Variable cost (VC).
l Recall that all costs ,opportunity and
money costs, are included in the total cost
measure.
 Short-run Cost Cont
l Marginalcost (MC) is the extra cost of
producing an additional unit of output

l Since in the short-run additional output

can only be produced by using an
additional unit of the variable input, the
MC is related to the MPL.
 Example
If the marginal product (MPL) is increasing,
the production of an additional unit of
output costs less because of increasing
productivity. However, as the (MPL)
declines MC increases.
The lowest MC corresponds to the highest
(MPL).
 Average Cost
ATC=AFC + AVC

Average fixed cost (AFC) declines as more output

is produced.

Average variable cost (AVC): Initially decreases

because average product increases, and starts
increasing when the average product decreases.
The lowest average cost corresponds to the
highest average product.
Relate MC and AVC to MPL
and APL
AP
MP

AP
MP
Labour units
MC
AVC AVC
MC

Output units
 The shape of Short-run
Average Cost Curves
AC
MC
AVC AVC
MC
AC

Output units

It is U-shaped because as output increases, it

combines the influences of falling fixed cost and
eventually diminishing returns.
 Output and costs in the
Long run
l Long-run cost is the cost of production
when all inputs have been adjusted to
their economically efficient level

l When a firm increases all inputs

proportionally, it experiences returns to
scale
 Definitions
Constant returns to scale: % increase in firms
output = % increase in firms inputs

Increasing returns to scale (economies of scale): %

increase in firms output > % increase in firms
inputs

Decreasing returns to scale (diseconomies of scale):

% increase in firms output < % increase in firms
inputs
 Output and Costs in the
Long run Cont
l There is a set of short-run cost curves for each
different plant size and one least-cost plant size.
l The larger the output, the larger the plant size and
the lower the average cost.
l The long-run average cost traces the relationship
between the lowest attainable average cost and
output when both capital and labour inputs are
varied.
 AVC
MC
AC LRAC

AC2
AC1

Economies Diseconomies
of scale of scale

Output
units

Shape of LRAC: With economies of scale it declines, while

with diseconomies of scale it increases.

 Perfect Competition
l In perfect competition, a firm is a price taker
and its marginal revenue (MR) equals the market
price (P).
l If price exceeds AVC, a firm maximizes profit
by producing the output at which marginal cost
(MC) = MR.
l Since in perfect competition MR=P the profit
maximizing output level is found by MC=P.
 Short Run
l The firm makes economic profits when
P>AC,
l Breaks even when P=AC
l Loses part of its return on capital if
P<AC.
l The lowest price at which the firm
produces is equal to the AVC.
The supply curve of the firm: Corresponds to the portion of the
MC curve above the AVC.
AVC MC
MC
AC AC
C AVC
P1
P=AR=MR
A B
P2 D

Output units

lP1ABC represents short-run economic profits when market price is P1.

lThe existence of economic profits attracts new entrants into the industry.
lThe increase in supply, everything else being the same, drives the price down to P2
lAt point D the firm breaks even. Thus, in the long run economic profits are zero.
 Allocative Efficiency
P
S

A
P*
B

D
Q* Q
lConsumers efficiency is achieved at all points on the demand curve.
lProducers efficiency is achieved at all points on the supply.
l Exchange efficiency is achieved at the quantity Q* and P* where the
sum of consumer surplus (area A) and producers surplus (area B), is
maximized.
 MONOPOLY
l The demand curve facing the monopoly is
the industry demand curve.

l The marginal revenue for the monopolist is

less than the price and it declines as
output increases.
 P

MC
AC
Pm

profits

MR
Qm Q

l The monopolist maximizes profits where MC=MR.

l Sets price Pm according to the demand curve. Pm is greater than
MC.
l Since there is no possibility of entry the monopolist can enjoy
economic profit even in the long run.
 Compare Monopoly to Perfect Competition
P
MC=S

Pm
Pc

MR D
Qm Qc Q

Perfect Competition Monopoly

l Qc is produced at price Pc
l consumer surplus = a+b+c
l Qm is produced at price Pm
l consumer surplus = a
l Area b producer surplus
l Areas c+d deadweight loss or loss
in social welfare