LECTURE NOTES FOR INTERMEDIATE MICROECONOMICS

PROF. REGINA TREVINO

Lecture Zero:
Mathematical Preliminaries

The following is a very terse review of elementary algebra and calculus. We will use

these concepts in class; nonetheless, this is certainly the most mathematics that you

would need for the course.

0.1. FUNCTIONS

A function is a “black box” which takes numerical input(s) and produces a unique

number as output. The simple one variable function y = f (x) takes each number x and

assigns a unique number y following the rule described in f. Thus, a function describes a

rule like “take each number and add 1”or “take each number and square it” and is written

as y = x+1 and y = x2 respectively.

Given a function y = f (x), the number x is often called the independent variable and

the number y is called the dependent variable. If y depends on several other variables x1,

x2, x3, and so on, the function is written as y = f (x1, x2, x3).

0.2. LINEAR FUNCTIONS

A linear function is a function of the form:

y = a + bx

where a and b are constants. The graph of such function is a straight line.

Linear functions can be expressed explicitly, like y = a + bx . Here we have an explicit

rule that enables us to determine the value of y for each value of x .

Alternatively, linear functions can be expressed implicitly, like ax + by = c . Here the

relationship between the variables x and y is implicitly present. In such cases, we often

like to transform the equation to an explicit function by solving in terms of y .

0.2.1 Solving Linear Equations

When solving linear equations two rules need to be followed (eq stands for equation):

RULE 1eq. A term can be moved from one side of an equation to the other if and only if

its sign is changed to the opposite sign as it crosses the equal sign.

RULE 2eq. Both sides of an equation can be multiplied or divided by the same nonzero

number and the equation is unaltered.

Suppose that we are given the an implicit function like

ax + by = c

where a , b , and c are constants and b ≠ 0 . If we want to solve the equation in terms for

y , we proceed as follows:

STEP 1. Start with ax + by = c .

STEP 2. Move the term ax to the other side of the equation and change its sign (RULE

1eq), that is, by = c − ax .

by c ax
STEP 3. Divide every term in the equation by b (RULE 2eq), that is, = − .
b b b

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c a
Simplifying, this results in the explicit equation y = − x.
b b

0.3 SLOPES AND INTERCEPTS OF LINEAR FUNCTIONS

First let’s define the components of any linear function: its slope and intercepts with the

axes. We will then look at specific linear forms.

The Greek letter ∆ (delta) is typically used to denote change in the value of a variable.

Thus, the notation for a change in the value of the variable x is ∆x (note that this does

not mean ∆ times x ). If, for example, x changes from x1 to x 2 , then the change in x is

expressed as:

∆x = x2 − x1

Suppose then that y is a function of x given by y = f (x) . The rate of change of y

with respect to x is the ratio of ∆y and ∆x and is given by the expression

∆y f ( x 2 ) − f ( x1 )
=
∆x x 2 − x1

This measures how y (dependent variable) changes as x (independent variable)

changes.

The slope of a function is precisely the rate of change of y as x changes, that is,

∆y
slope =
∆x

If y increases whenever x increases, then ∆y will have the same sign as ∆x , and the

slope of the function is positive. If, on the other hand, y decreases whenever x

increases, then, ∆y and ∆x have opposite signs, and the slope of the function is negative.

A fundamental property of a straight line is that its slope is constant.

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The horizontal intercept ( x -intercept) is the point where the graph intersects the

horizontal axis ( x -axis). To find the horizontal intercept we set y = 0 and solve the

resulting equation for x .

The vertical intercept ( y -intercept) is the point where the graph intersects the

vertical axis ( y -axis). To find the vertical intercept we set x = 0 and solve the resulting

equation for y .

0.3.1 Slope-Intercept Form of a Line

The slope-intercept form for a line is given by

y = a + bx (1.1)

where a and b are constants and b ≠ 0 . This is a useful way of expressing a line since

the coefficient of x , b , gives us the slope of the line and the constant a gives us the

vertical intercept of the line.

Now, let’s analyze the components of equation (1.1), that is a and b , in more detail.

Our goal is to understand how the graph of the line changes when either is varied.

THE SIGN OF b. If b is positive, the line is said to be upward sloping. If b is negative

the line is said to be downward sloping.

THE SIZE OF b. The size of the slope, b , affects how fast the function increases (if

b > 0 ) or decreases (if b < 0 ), in other words, the magnitude of the slope determines the

line’s steepness. To understand the graphical implication of the size of b let’s look at

Figure 0.1 where we show three linear functions with the same vertical intercept but

different slopes.

Panel A compares upward sloping lines (positive slope) and Panel B downward

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sloping lines (negative slope). As we can see from these graphs the larger the absolute

value of the slope, the steeper the line.

y y
y = 2x
slope=2
10 y=x 10
slope=1
8 8
y =10-½x
slope=-½
6 6
y = ½x
4 slope=½ 4 y =10-x
y=10-2x slope=-1
2 2 slope=-2

2 4 6 8 10 x 2 4 6 8 10 x
A B
Slopes of Different Sizes. Panel A depicts lines with different positive slopes and
panel B depicts lines with different negative slopes. FIGURE 0.1

CHANGING a. If the vertical intercept of the line, a , changes, while the slope b is

unchanged, then the line shifts. Note that since the slope is not changing this is either an

upward or a downward parallel shift. Figure 0.2 depicts linear functions that have the

same slope but different vertical intercepts.

y y
y = 6+½x
slope=½
10 10

8 8
y =10-½x
slope=-½
6 6
y = 2+½x
4
slope=½ 4
y =6-½x
2 2
slope=-½

2 4 6 8 10 x 2 4 6 8 10 x
A B
Different Vertical Intercepts. A change in intercepts produces an upward
or downward parallel shift of the line. FIGURE 0.2

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0.4 SOLVING TWO-VARIABLE SYSTEMS OF LINEAR EQUATIONS

A two-variable system of linear equations is a set of two equations with two unknowns.

The solution to the system of equations is the set of values of the unknowns that

simultaneously satisfy both of the equations. For a linear system of equations, this

solution is typically a unique solution.

One way to solve a system of two equations and two unknowns is as follows:

STEP 1. Start with two equations like these:

y = 2+ x (1.3)
y = 14 − 2 x (1.4)

STEP 2. Take the right-hand side of equation (1.3), that is, 2 + x , and substitute it into

the value of y wherever y appears in the equation (1.4). This leaves us with a

single equation in terms of x :

2 + x = 14 − 2 x (1.5)

STEP 3. Collect like-terms by moving − 2 x and 2 to the opposite sides of equation (1.5)

to get:

x + 2 x = 14 − 2

3 x 12
Simplifying, we get 3 x = 12 . Then, we divide both sides by 3, that is, = ,
3 3

12
and simplifying we find that x = = 4.
3

STEP 4. Plugging the result of x = 4 into equation (1.3) we get y = 2 + 4 = 6 . Hence,

the values x* = 4 and y* = 6 solve the original two equations.

This system is graphed in Figure 0.3. In a system of two linear equations and two

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unknowns, the solution ( x*, y*) represents the intersection of the two lines in a graph.

y = 2+ x
16
14

12 y = 14 –2x
10

6
4
2

2 4 6 8 10 12 14 16 x

Solving a System of Equations. Graph of the functions y = 14 - 2x and y = 2 + x. FIGURE 0.3

0.5 NONLINEAR FUNCTIONS

A function y = f (x) is a nonlinear function if the exponent of x is different from 1. For

example, y = x − 2 or y = 3 + x 2 , are nonlinear functions since the exponents of x are

½ and 2 respectively.

A nonlinear function has the property that its slope changes as the value of x changes.

We will talk about how to calculate slopes of nonlinear functions below, for now let’s

introduce the concepts of concavity and convexity.

The function f (x) is concave if for every pair of points on its graph, the chord

joining these two points lies below the graph. The function f (x) is convex if for every

pair of points on its graph, the chord joining them lies above the graph. Figure 0.4

illustrates both types of functions.

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y y f(x)
f(x)
y2

y2
y1
chord chord

y1

x1 x2 x x1 x2 x
A B
Concave and Convex Functions. Panel A depicts a concave function and panel B
depicts a convex function. FIGURE 0.4

0.6 THE CONCEPT OF A DERIVATIVE

Suppose that y is a function of x given by y = f (x) . As you may recall, the slope of the

function is given by

∆y
slope =
∆x

Now, consider the functions depicted in Figure 0.5. For a linear function, such as the one

in Panel A, the magnitude of the change in x , ∆x , and the change in y , ∆y , has no

impact on the value of the slope. The reason for this is that the slope of a linear function

is constant.

This is not the case, however, for nonlinear functions. With a nonlinear function like

that in Panel B, the slope varies along the function, and as a result, the magnitude of ∆x

and ∆y affect the value of the slope. If we were to use the formula ∆y / ∆x to calculate

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the slope of the function between points ( x1, y1 ) and ( x2 , y2 ) what we would get is the

slope of the line segment that connects points M and N. This is not the same as the slope

of the function at either point M or point N.

y y

y2 N

y2 ∆y Δy
slope = M ∆y
∆x slope =
Δy y1 ∆x
Δx
y1

Δx

x1 x2 x x1 x2 x
A B
Linear and Nonlinear Functions. Panel A depicts a linear function and
panel B depicts a nonlinear function. FIGURE 0.5

However, if we make ∆x smaller and smaller then, the slope will approximate the

value of the slope of a line drawn tangent to the function at point M. The precise

mathematical measure to evaluate the slope of a function when ∆x is an infinitesimally

small value is the derivative. We will expand on the graphical interpretation of the

derivative. First let’s review some useful rules.

0.6.1 Notation of Derivatives

The derivative of the function y = f (x) with respect to x is typically denoted by f ' ( x )

and is read “f prime of x ”.

0.6.2 Rules of Differentiation

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When we find the derivative of a function, we differentiate the function. Here are the

basic rules of differentiation (d is for derivative).

RULE 1d. If f ( x) = c , where c is a constant, then f ' (x ) = 0 .

A derivative always indicates a rate of change and, by definition, a constant never

changes, so the derivative of a constant is always zero.

Examples:

1. If f ( x) = 3 , find f ' ( x) .

SOLUTION: f ' ( x) = 0 .

2. If f ( x) = 16 2 , find f ' ( x) .

SOLUTION: f ' ( x) = 0 .

RULE 2d. If f ( x) = x a where a is any number, then f ' ( x) = ax a −1 .

The first step is to multiply x by the exponent a , that is, bring a down to multiply x .

Then, subtract 1 from the exponent so that x is now raised to the power of a − 1 .

Examples:

1. If f ( x) = x3 , find f ' ( x) .

SOLUTION: f ' ( x) = 3x 3−1 = 3x 2 .

2. If f ( x) = x 2 , find f ' ( x) .

SOLUTION: f ' ( x) = 2 x 2−1 = 2 x 1 = 2 x .

RULE 3d. If f ( x) = cg ( x) , where c is a constant, then f ' ( x) = cg ' ( x) .

In this case, c is multiplying g (x) , which is a function of x , so the constant c will

continue to multiply the derivative g ' ( x) . The derivative of g (x) is taken according to

RULE 2d.

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Examples:

1. If f ( x) = 4 x3 , find f ' ( x) .

SOLUTION: ( )
f ' ( x) = 4 3 x 2 = 12 x 2 .

2. If f ( x) = 2 x , find f ' ( x) .

SOLUTION: ( )
f ' ( x) = 2 x 0 = 2(1) = 2 .

RULE 4d. If f ( x) = g ( x) + h( x) , then f ' ( x) = g ' ( x) + h' ( x) and

if f ( x) = g ( x) − h( x) , then f ' ( x) = g ' ( x) − h' ( x) .

The derivative of the sum (difference) of two or more functions equals the sum

(difference) of their respective derivatives.

Examples:

1. If g ( x) = 4 x , h( x) = x 2 and f ( x) = g ( x) + h( x) , find f ' ( x) .

SOLUTION: f ' ( x ) = g ' ( x ) + h' ( x ) = 4 + 2 x .

2. If g ( x) = 12 x , h( x) = 2 x 4 and f ( x) = g ( x) − h( x) , find f ' ( x) .

SOLUTION: f ' ( x) = g ' ( x) + h' ( x) = 12 − 8 x 3 .

RULE 5d. If f ( x) = a + bx , then f ' ( x) = b . [Follows from RULE 1d and RULE 2d].

Note that this is the equation of a line and b is the slope.

Examples:

1. If f ( x) = 4 x + 3 , find f ' ( x) .

SOLUTION: f ' ( x) = 4 .

2. If f ( x) = 500 − 100 x , find f ' ( x) .

SOLUTION: f ' ( x) = −100 .

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0.7 PARTIAL DERIVATIVES

Suppose that y is a function that depends on two variables, x and z , so that

y = f ( x, z ) . Then, the partial derivative of f ( x, z ) with respect to x is just the

derivative of the function with respect to x , holding z fixed. Similarly, the partial

derivative with respect to z holds x fixed. Partial derivatives follow the same rules as

ordinary derivatives.

The notation is slightly different. We can no longer use f ' ( x, z ) because it would not

be clear with respect to which variable we are differentiating. The notation for partial

∂f ( x, z )
derivatives involves the use of the symbol ∂ . In this case, we use to indicate the
∂x

∂f ( x, z )
partial derivative of f with respect to x and to indicate the partial derivate of
∂z

f with respect to z .

Examples:

∂f ( x, z )
1. If f ( x, z ) = 4 x 2 + 3 zx , find
∂x

SOLUTION

∂f ( x, z )
= 8 x + 3 z . (Treat the variable z as if it was a constant).
∂x

∂f ( x, z )
2. If f ( x) = −5 x 2 + xz 3 + z , find .
∂z

SOLUTION

∂f ( x, z )
∂z
( )
= 0 + x 3 z 2 + 1 = 3 xz 2 + 1 . (Treat the variable x as if it was a constant).

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Lecture One:
What is Microeconomics? The Demand and Supply Model, Elasticities.

1.1 WHAT IS MICROECONOMICS?

ends in a market economy. Two key concepts:

Scarcity: The economy has only a limited amount of resources. If resources weren’t

scarce, allocating them would not be a problem.

Choice: Microeconomics studies how individuals and firms make choices in an

environment of limited resources.

We begin by developing the competitive model of supply and demand. Competitive

means that market participants are small, i.e., they are price takers. These tools allow us

to describe the determination of prices and the allocation of resources in a market

economy.

1.2 THE DEMAND

purchase. It depends on:

1. The price of the good.

2. The price of related goods.

3. Income.

4. Tastes.

We can denote the quantity demanded Q d of a good as

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Q d = D ( p , pa , I )

where D( ) represents the demand function, p is the price of the good, pa is the price

of alternative goods, and I is income.

One very simple but useful demand function is the linear representation of the

demand function: demand is linear if Qd is a linear function of prices, income, and other

variables that influence demand. The following equation is an example of a linear

demand function:

Q d ( p, p a , I ) = α 0 + α 1 p + α 2 I + α 3 p a

where the α i s are fixed numbers.

1.2.1 The Demand Curve

The demand curve is the graphical representation of the demand function. We know that

the demand function for a good is given by

Q d = D ( p , pa , I )

It is convenient, however, to graph Q d as simply a function of its own price, p , with the

understanding that pa and I are being held constant.

Thus, a demand curve, like that of Figure 1.1, shows the relation between the price of

a good and the quantity of a good, assuming all other determinants of the demand remain

unchanged. Generally, a higher price for the good, other things equal, leads consumers to

demand a smaller quantity of the good. (“Other things equal” is typically referred to as

the ceteris paribus assumption).

Note that in the demand and supply model, for historical rather than good economic

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reasons, the independent variable, price, is graphed in the vertical axis and the dependent

variable, quantity, in the horizontal axis.

price

Demand curve

Quantity

Linear Demand Curve. FIGURE 1.1

The change in the price of another good, p a , can shift the demand curve either in or

out:

• Two goods are substitutes if, when the price of good A rises, demand for good B

rises.

• Two goods are complements if, when the price of good A rises, demand for good B

falls.

A change in income, I, can also shift the demand curve either in or out:

• A good is normal if, when income rises, the demand for this good rises.

• A good is inferior if, when income rises, the demand for this good falls.

1.3 THE SUPPLY

Supply indicates the quantity of a particular good that producers/suppliers are willing to

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sell. It depends on:

1. The price of the good.

2. The price of related goods (inputs and other outputs).

3. Technology.

We can denote the quantity supplied Q s of a good as

Q s = S ( p, p m , tech)

where S ( ) represents the supply function, pm is the price of the materials used to

produce the goods (i.e., the price of the inputs of production), and tech is some set of

technological conditions.

Again, assume initially that all variables are constant except p. Under some general

conditions which we’ll see later, quantity supplied rises when price increases. Figure 1.2

depicts a typical supply curve.

Changes in the state of technology, and the price of inputs and other outputs, shift the

supply function. When the supply function shifts outward, producers are willing to

produce more of the good at each price.

price

Supply curve

Quantity

Linear Supply Curve FIGURE 1.2

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1.4 MARKET EQUILIBRIUM

Equilibrium is a state of affairs that will persist because no one has any incentive to

change his or her behavior. In the equilibrium of the supply and demand model, Qd = QS.

Why? Because if Qd > QS, there will be a shortage of the good, and so firms will raise

their prices to increase their profits. If Qd < QS, inventories are increasing, and so firms

will eventually lower their prices to sell their stock. Thus, in equilibrium, we should

expect that price is such that Qd = QS.

Graphically, the market equilibrium occurs at the point where the supply and demand

intersect, as illustrated by Figure 1.3. At the equilibrium price, p*, the amount that

suppliers want to sell equals the amount that consumers want to buy. This amount is the

equilibrium quantity, Q*,: the amount actually traded. The equilibrium price is also

called the market clearing price because at this price there is neither an excess supply nor

an excess demand. At any other price there is a discrepancy between the amount

demanded and the amount supplied.

Supply curve

p*

Demand curve

Q*

Market Equilibrium.
FIGURE 1.3

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When the demand or supply functions shift, the market equilibrium changes. Prices

adjust to generate a new equilibrium in which supply and demand are in balance.

1.5 ELASTICITIES

The amount by which consumers will change their demand, or by which producers will

change their supply, as a response to a change in the price of a good, varies substantially

from good to good and from market to market. The slope of the supply and demand

curves is essential to understanding and predicting the market equilibrium. Using the

mathematical concept of slope is, however, problematic since the slope of a function

depends upon the units of measurement. That is, the slope of a demand curve in pesos is

not the same as the slope of the same curve in dollars. As such, economists rely on a

related but more robust concept of elasticity.

Simply put, elasticity is just a slope which has had the units of measurement

normalized to unity. Rather than using the idea of change in quantity over change in

price, for example, the price elasticity of demand uses the percentage change in quantity

divided by the percentage change in price. This is independent of the units of

measurement. There is a second fundamental reason why elasticities are preferred over

slopes — the former have a powerful connection to revenue that will serve us well.

1.5.1 Price Elasticity of Demand

The price elasticity of demand measures the responsiveness of the quantity demanded to

a price change. In general, the price elasticity of demand is calculated as the percentage

change in quantity divided by the percentage change in price:

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%∆Q ∆Q P
εd = = ⋅ .
%∆P ∆P Q

The notation Δ (Greek letter Delta) denotes change in values.

However, we can be more precise in this estimation if we know the magnitude of the

price change. The price elasticity of demand is calculated as follows:

∂Q P
εd = × .
∂P Q

Because demand is always downward sloping, this elasticity is always negative. The

reason again is that when P goes up, Q goes down, so ∆Q/∆P is always negative

[ ∂ Q / ∂ P is always negative].

Generally, when we say that an elasticity is “large,” we will be referring to its

absolute value. Hence, a larger elasticity means that the good under consideration is

more sensitive to changes in price.

Where does the price elasticity of demand come from?

1. Number of substitutes. Demand also becomes more elastic when more/better

substitutes are available

2. Share of income spent. We expect demand to be more inelastic if the average

consumer spends a small fraction of her income on the product. When you buy a car

you visit multiple dealers, but not for a cup of coffee.

3. Long time horizon. The longer the time horizon over which the price change is

active, the more time the consumer has to respond. The consumer’s reaction to a price

change should be more pronounced the longer the interval of time the consumer has

to respond.

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1.5.2 Other Important Demand Elasticities

We began our study of Microeconomics noting that demand depends upon several factors

besides price. Demand also depends upon consumer income, I, and the price of other

related goods, p a . As such, we should be able to calculate similar elasticities for these

variables as well.

Cross-Price Elasticity of Demand

Because we need to now discuss two types of goods, we use the notation x and y to

denote the quantities of each good, and we use px and py, to denote the respective prices.

The cross elasticity of demand for good x with respect to the price of good y is simply

the percentage change in demand for good x divided by the percentage change in the

price of good y. The formula for the cross price elasticity between x and y is:

∂Q dx Py
ε x, y = × .
∂ Py Q x

Note that we do not know whether the sign should be negative of positive. If an

increase in the price of good y leads to a reduction in the demand of good x, we say that

the goods are complements (e.g., tires and gasoline).

If an increase in the price of good y leads to an increase in the demand of good x, we

say that the goods are substitutes (e.g., think of Rioja and Cabernet wines). Hence, when

the cross-price elasticity is negative, the goods are complements; when the cross-price

elasticity is positive, the goods are substitutes.

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Income Elasticity of Demand

The income elasticity is defined as the percentage change in quantity divided by the

percentage change in income. Since each consumer typically has a different level of

income, to be precise this elasticity makes sense only if we restrict our analysis to an

individual consumer’s demand and study how demand varies as we change the

consumer’s income. The income elasticity formula is:

∂Q I
εI = × .
∂I Q

Again, as in the case of the cross-price elasticity, we do not know the sign of this

elasticity because the effect of income depends upon the good under study. For example,

if an increase in income leads to an increase in consumption, we say that the good is

normal (food is typically a normal good). If the income elasticity is not only positive, but

also greater than one, we say that the good is a luxury good (restaurant meals,

automobiles, and housing are all typically luxury goods). If an increase in income leads to

a reduction in demand— that is, the income elasticity is negative―we say that the good

is inferior. Low quality goods are typically inferior goods.

1.5.3 Price Elasticity of Supply

The price elasticity of supply measures the responsiveness of the quantity supplied to a

price change. The point price elasticity of supply is the derivative of the supply curve

with respect to price, times price over quantity.

∂ QS P
εS = × .
∂P Q

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1.6 PRICE ELASTICITY AND TOTAL REVENUE

We now turn to the most important characteristic of demand elasticity which is its

connection with total revenue. First, we will make a distinction between demand price

elasticities above and below −1. There are three cases:

 When the absolute value of the elasticity is greater than 1 (i.e., ε d < −1 ), we say

that demand is elastic; this indicates that consumers are price sensitive.

 When the absolute value of the elasticity is less than 1 (i.e., − 1 < ε d < 0 ), we say

that demand is inelastic; this indicates that consumers are price insensitive.

 In the rare instance in which the absolute value of the elasticity is equal to 1 (i.e.,

ε d = −1 ), we say that demand is unit elastic.

The revenue that a firm makes on the sales of its goods is given by the quantity sold

times the price per unit. Assuming that all units are sold at the same price per unit,

revenue, denoted by R, is given by the simple expression

R = p×Q.

In a world with no taxes, the revenues the firm takes in is equal to the expenditures that

consumers make, so we will use the terms revenue and consumer expenditures

interchangeably.

In general, we do not know what happens to revenue when price increases because

there are two effects. A higher price implies more revenue, holding quantity purchased

constant. But a higher price implies quantity purchased will decline. Nonetheless, if we

know the elasticity, we can say something very precise about which effect dominates:

• A demand curve for which −1 < εd < 0 is inelastic, and revenue increases when price

increases, and vice versa.

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• A demand curve for which εd < −1 is elastic, and revenue falls when price increases.

• If εd = −1, the good is said to be unit elastic, and there is no change in total

expenditure for a change in price.

%∆Q
Recall that ε d = , so the intuition is that if the demand is inelastic, a price
%∆P

increase will lead to a percentage reduction in quantity, which is smaller than the

percentage increase in price ( %∆P > %∆Q) . Hence, the revenue will increase more from

the price change, than it will decrease from the quantity change so on net, revenue

increases. A similar intuition applies to the case where demand is elastic.

Special Cases of Demand Curves

There are a few useful special cases of demand curves which economists often refer.

 Perfectly elastic demand curve: horizontal demand curves: ε d = −∞ .

 Perfectly inelastic demand curve: vertical demand curves: ε d = 0 .

p
 Linear demand curves: Qd = a − bp implies ε d = −b ⋅ .
Q

Slope versus Elasticity

p
Because ε d = ( slope) ⋅ , one might be tempted to say that flatter demand curves must
Q

have larger elasticities. This is only true, however, if one holds the ratio p/Q fixed. Hence,

for two demand curves that intersect at a point, the flatter curve will have a higher price

elasticity (in absolute value).

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