SUMMARY REVIEWER the characteristics and behavior of the

market.
Chapter 2: Basics of Supply and demand
Supply-demand analysis
- a basic tool of microeconomics.
- supply and demand curves tell us how Government price controls
much will be produced by firms and
how much will be demanded by - keeps the price below the level that
consumers as a function of price equates supply and demand. A
shortage develops; the quantity
Market mechanism demanded exceeds the quantity
supplied.
- The tendency for supply and demand
to equilibrate so that there is neither Chapter 3: Consumer Behavior
excess demand nor excess supply.
The theory of consumer choice
Equilibrium Price
- rests on the assumption that people
- the price that equates the quantity behave rationally to maximize the
demanded with the quantity supplied satisfaction that they can obtain by
purchasing a particular combination of
Elasticities
goods and services.
- the responsiveness of supply and
2 Parts of consumer choice
demand to changes in price, income,
or other variables. 1. The study of the consumer’s
- Pertain to a time frame. preferences.
2. the analysis of the budget line that
Supply-demand diagrams
constrains consumer choices.
- Used to see how shifts in the supply
Consumer choice
curve and/or demand curve can
explain changes in the market price - Consumers make choices by
and quantity comparing market baskets or bundles
of commodities.
Market-clearing price
Assumptions of preference
- We can calculate by equating the
quantity supplied with the quantity 1. Complete
demanded o consumers can compare all
- can calculate how the market-clearing possible market baskets
price and quantity will change as 2. Transitive
these other variables change. This is a o if they prefer
means of explaining or predicting o basket A to B, and B to C, then
market behavior they prefer A to C)
Simple numerical analyses 3. More of each good is always preferred
to less
- can often be done by fitting linear
supply and demand curves to data on Indifference curves
price and quantity and to estimates of - represent all combinations of goods
elasticities. For many markets, such and services that give the same level
data and estimates are available, and of satisfaction, are downward-sloping
simple “back of the envelope” and cannot intersect one another
calculations can help us understand
Indifference map
 - set of indifference curves that The theory of the consumer approaches
describes consumer preferences
1. Indifference Curve
- Provides and ordinal ranking of all
o uses the ordinal properties of
choices a consumer may make
utility (that is, it allows for the
Marginal Rate of Substitution (MRS) ranking of alternatives)
2. Utility function
- The max amount of A that a person is
o obtains a utility function by
willing to give up to get one extra unit
attaching a number to each
of B
market basket; if basket A is
- The MRS diminishes as we move down
preferred to basket B, A
along an indifference curve. When
generates more utility than B
there is a diminishing MRS,
indifference curves are convex
Budget lines Cardinal properties of the utility function
- represent all combinations of goods for - important when risky choices are
which consumers expend all their analyzed or when comparisons must
income. Budget lines shift outward in be made among individuals.
response to an increase in consumer
income. When the price of one good Marginal rate of utility
(on the horizontal axis) changes while - As more and more of a good is
income and the price of the other consumed, the consumer obtains
good do not, budget lines pivot and smaller and smaller increments of
rotate about a fixed point (on the utility
vertical axis).
Utility maximization
Consumers maximize satisfaction subject to
budget constraints - When the utility function approach is
used and both goods are consumed
- When a consumer maximizes - when the ratio of the marginal utilities
satisfaction by consuming some of of the two goods is equal to the ratio
each of two goods, the marginal rate of the prices
of substitution is equal to the ratio of
the prices of the two goods being Marginal Rate of Substitution
purchased.
- the ratio of the marginal utilities of the
Maximization two goods

- sometimes achieved at a corner Ideal cost-of-living index

solution in which one good is not
- measures the cost of buying, at
consumed. In such cases, the marginal
current prices, a bundle of goods that
rate of substitution need not equal the
generates the same level of utility as
ratio of the prices
was provided by the bundle of goods
The theory of revealed preference consumed at base-year prices

- shows how the choices that individuals Laspeyres price index

make when prices and income vary
- represents the cost of buying the
can be used to determine their
bundle of goods chosen in the base
preferences. When an individual
year at current prices relative to the
chooses basket A even though he or
cost of buying the same bundle at
she could afford B, we know that A is
base-year prices. The CPI, even with
preferred to B.
chain weighting, overstates the ideal
cost-of-living index.
Paasche index
- measures the cost at current-year
prices of buying a bundle of goods
chosen in the current year divided by
the cost of buying the same bundle at
base-year prices. It thus understates
the ideal cost-of-living index.
Chapter 4: Individual and Market
Demand
Price inelastic demand
Individual consumers’ demand curves for a
- when a 1-percent increase in price
commodity
leads to a less than 1-percent
- can be derived from information about decrease in quantity demanded,
their tastes for all goods and services thereby increasing the consumer’s
and from their budget constraints. expenditure
Engel curves Price elastic demand
- describe the relationship between the - when a 1-percent increase in price
quantity of a good consumed and leads to a more than 1-percent
income, can be useful in showing how decrease in quantity demanded,
consumer expenditures vary with thereby decreasing the consumer’s
income expenditure
substitutes Unit Elastic demand
- if an increase in the price of one leads - when a 1-percent increase in price
to an increase in the quantity leads to a 1-percent decrease in
demanded of the other quantity demanded
complements Consumer surplus
- if an increase in the price of one leads - the difference between the maximum
to a decrease in the quantity amount a consumer is willing to pay
demanded of the other for a good and what he actually pays
for it
2 parts of the effects of price change on the
quantity demanded Speculative demand
1. Substitution effect - driven not by the direct benefits one
o the level of utility remains obtains from owning or consuming a
constant while price changes, good but instead by an expectation
2. Income effect that the price of the good will
o the price remains constant increase.
while the level of utility changes
network externality
Giffen good
- occurs when one person’s demand is
- the quantity demanded may move in affected directly by the purchasing or
the same direction as the price usage decisions of other consumers.
change, thereby generating an
Positive network externality
upward-sloping individual demand
curve - when a typical consumer’s quantity
demanded increases because others
market demand curve
have purchased or are using the
- the horizontal summation of the product or service
individual demand curves of all
Negative network externality
consumers in the market for a good. It
can be used to calculate how much - when quantity demanded increases
people value the consumption of because fewer people own or use the
particular goods and services. product or service.
A number of methods can be used to obtain receipt of the expected return on that
information about consumer demand investment
interview and experimental approaches,
Risk-loving
direct marketing experiments, and the more
indirect statistical approach. The statistical - would prefer a risky investment with a
approach can be very powerful in its given expected return to the certain
application, but it is necessary to determine receipt of that expected return.
the appropriate variables that affect demand
before the statistical work is done. Risk can be reduced by

Chapter 5: Uncertainty and Consumer 1. diversification

Behavior 2. insurance
3. additional information
Risk
The law of large numbers
- uncertainty about the future
- applies when each of the possible - enables insurance companies to
outcomes and its probability of provide insurance for which the
occurrence is known premiums paid equal the expected
value of the losses being insured
The expected value against. We call such insurance
actuarially fair.
- a measure of the central tendency of
the values of risky outcomes Consumer theory
Variability - can be applied to decisions to invest in
risky assets
- frequently measured by the standard
deviation of outcomes, which is the Budget line
square root of the probabilityweighted
average of the squares of the - reflects the price of risk
deviation from the expected value of Consumer’s indifference curves
each possible outcome
- reflect their attitudes toward risk
Facing uncertain choices, consumers
maximize their expected utility The study of behavioral economics

- an average of the utility associated - enriches consumer theory by

with each outcome accounting for reference points,
endowment effects, anchoring,
risk averse fairness considerations, and deviations
- A person who would prefer a certain from the laws of probability
return of a given amount to a risky Chapter 6: Production
investment with the same expected
return production function

risk premium - describes the maximum output that a

firm can produce for each specified
- maximum amount of money that a combination of inputs
risk-averse person would pay to avoid
taking a risk short run

risk neutral - one or more inputs to the production

process are fixed
- A person who is indifferent between a
risky investment and the certain long run
- all inputs are potentially variable
average product of labor Constant returns to scale
- measures output per unit of labor - doubling all inputs leads to doubling
input output
marginal product of labor Increasing returns to scale
- measures the additional output as - output more than doubles when inputs
labor is increased by 1 unit are doubled
law of diminishing marginal returns decreasing returns to scale
- when one or more inputs are fixed, a - output less than doubles
variable input (usually labor) is likely
to have a marginal product that
eventually diminishes as the level of
input increases
Isoquant
Chapter 7: Cost of Production
- a curve that shows all combinations of
inputs that yield a given level of opportunity cost
output. A firm’s production function - the cost associated with the
can be represented by a series of opportunities forgone when the firm
isoquants associated with different uses its resources in its next best
levels of output. alternative
- always slope downward because the
marginal product of all inputs is Economic cost
positive. The shape of each isoquant
- the cost to a firm of utilizing economic
can be described by the marginal rate
resources in production. While
of technical substitution at each point
economic cost and opportunity cost
on the isoquant
are identical concepts, opportunity
Marginal rate of technical substitution of cost is particularly useful in situations
labor for capital when alternatives that are forgone do
not reflect monetary outlays
- the amount by which the input of
capital can be reduced when one extra sunk cost
unit of labor is used so that output
- expenditure that has been made and
remains constant.
cannot be recovered. After it has been
The standard of living that a country can incurred, it should be ignored when
attain for its citizens making future economic decisions.
Because an expenditure that is sunk
- closely related to its level of labor has no alternative use, its opportunity
productivity. cost is zero.
Decreases in the rate of productivity growth short run
in developed countries
- one or more of a firm’s inputs are fixed
- due in part to the lack of growth of
capital investment Total cost

perfect substitutes - can be divided into fixed cost and

variable cost
- the proportions of inputs to be used
are fixed (a fixed proportions marginal cost
production function).
 - the additional variable cost associated - when a firm can double its output at
with each additional unit of output less than twice the cost.
Correspondingly, there are
average variable cost
diseconomies of scale when a doubling
- total variable cost divided by the of output requires more than twice the
number of units of output cost. Scale economies and
diseconomies apply even when input
In the short run, when not all inputs are proportions are variable; returns to
variable, the presence of diminishing returns scale apply only when input
determines the shape of the cost curves. In proportions are fixed.
particular, there is an inverse relationship
between the marginal product of a single Economies of scope
variable input and the marginal cost of
- arise when the firm can produce any
production. The average variable cost and
combination of the two outputs more
average total cost curves are U-shaped. The
cheaply than could two independent
short-run marginal cost curve increases
firms that each produced a single
beyond a certain point, and cuts both
output
average cost curves from below at their
minimum points. The degree of economies of scope
In the long run, all inputs to the production - measured by the percentage reduction
process are variable. As a result, the choice in cost when one firm produces two
of inputs depends both on the relative costs products relative to the cost of
of the factors of production and on the extent producing them individually.
to which the firm can substitute among
inputs in its production process. The cost-
minimizing input choice is made by finding Learning curve
the point of tangency between the isoquant
representing the level of desired output and - shows how much the input needed to
an isocost line. produce a given output falls as the
cumulative output of the firm
expansion path increases.
- shows how its cost-minimizing input Cost functions
choices vary as the scale or output of
its operation increases. As a result, the - relate the cost of production to the
expansion path provides useful firm’s level of output. The functions
information relevant for long-run can be measured in both the short run
planning decisions. and the long run by using either data
for firms in an industry at a given time
long-run average cost curve or data for an industry over time. A
number of functional relationships,
- the envelope of the firm’s short-run
including linear, quadratic, and cubic,
average cost curves, and it reflects the
can be used to represent cost
presence or absence of returns to
functions.
scale. When there are increasing
returns to scale initially and then Chapter 7: Cost of Production
decreasing returns to scale, the long-
run average cost curve is U-shaped, Managers
and the envelope does not include all - can operate in accordance with a
points of minimum short-run average complex set of objectives and under
cost various constraints. However, we can
economies of scale assume that firms act as if they are
maximizing long-run profit
Many markets may approximate perfect In the long run, profit-maximizing
competition in that one or more firms act as competitive firms choose the output at which
if they face a nearly horizontal demand price is equal to long-run marginal cost
curve. In general, the number of firms in an
Conditions of a short-run competitive
industry is not always a good indicator of the
equilibrium
extent to which that industry is competitive.
1. when firms maximize profit
Because a firm in a competitive market
2. when all firms earn zero economic
accounts for a small share of total industry
profit, so that there is no incentive to
output, it makes its output choice under the
enter or exit the industry
assumption that its production decision will
3. when the quantity of the product
have no effect on the price of the product. In
demanded is equal to the quantity
this case, the demand curve and the
supplied
marginal revenue curve are identical.
Horizontal long-run supply curve for a firm
short run
- industry is a constant-cost industry in
- a competitive firm maximizes its profit
which the increased demand for inputs
by choosing an output at which price
to production (associated with an
is equal to (short-run) marginal cost.
increased demand for the product) has
- Price must, however, be greater than
no effect on the market price of the
or equal to the firm’s minimum
inputs
average variable cost of production.
Vertical long-run supply curve for a firm
The short-run market supply curve
- where the increased demand for
- horizontal summation of the supply
inputs causes the market price of
curves of the firms in an industry. It
some or all inputs to rise
can be characterized by the elasticity
of supply: the percentage change in
quantity supplied in response to a
percentage change in price
producer surplus for a firm
- the difference between its revenue
and the minimum cost that would be
necessary to produce the profit-
maximizing output. In both the short
run and the long run, producer surplus
is the area under the horizontal price
line and above the marginal cost of
production.
Economic rent
- the payment for a scarce factor of
production less the minimum amount
necessary to hire that factor. In the
long run in a competitive market,
producer surplus is equal to the
economic rent generated by all scarce
factors of production