Microeconomics

134 Pages·4.32 MB·English

by  Ahlesten Krister.

KRISTER AHLERSTEN
ESSENTIALS OF
MICROECONOMICS
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Krister Ahlersten
Microeconomics
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Microeconomics
© 2008 Krister Ahlersten & Ventus Publishing ApS
ISBN 978-87-7681-410-6
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Microeconomics Contents
Contents
1 Introduction 10
1.1 Plan 11
2 Supply, Demand, and Market Equilibrium 12
2.1 Demand 12
2.1.1 The Demand Curve 12
2.1.2 When do We Move along the Demand Curve, and When Does It Shift? 13
2.2 Supply 14
2.2.1 The Supply Curve 14
2.3 Equilibrium 16
2.3.1 How to Find the Equilibrium Point Mathematically 17
2.4 Price and Quantity Regulations 17
2.4.1 Minimum Prices 17
2.4.2 Maximum Prices 19
2.4.3 Quantity Regulations 19
3 Consumer Theory 21
3.1 Baskets of Goods and the Budget Line 22
3.2 Preferences 25
3.3 Indifference Curves 26
3.4 Indifference Maps 27
3.5 The Marginal Rate of Substitution 28
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Microeconomics Contents
3.6 Indifference Curves for Perfect Substitutes and Complementary Goods 29
3.7 Utility Maximization: Optimal Consumer Choice 31
3.8 More than Two Goods 32
4 Demand 34
4.1 Individual Demand 34
4.1.1 The Individual Demand Curve 34
4.1.2 The Engel Curve 35
4.2 Market Demand 36
4.3 Elasticity 38
4.3.1 Price Elasticity 38
4.3.2 Income Elasticity 39
4.3.3 Cross-Price Elasticity 40
5 Income and Substitution Effects 41
5.1 Normal Good 42
5.2 Inferior Good 43
6 Choice under Uncertainty 46
6.1 Expected Value 46
6.2 Expected Utility 46
6.3 Risk Preferences 48
6.4 Certainty Equivalence and the Risk Premium 49
6.5 Risk Reduction 50
7 Production 51
7.1 The Profi t Function 51
7.2 The Production Function 52
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Microeconomics Contents
7.2.1 Average and Marginal Product 52
7.2.2 The Law of Diminishing Marginal Returns 53
7.3 Production in the Short Run 54
7.3.1 The Product Curve in the Short Run 54
7.4 Production in the Long Run 57
7.4.1 The Marginal Rate of Technical Substitution 58
7.4.2 The Marginal Rate of Technical Substitution and the Marginal Products 58
7.4.3 Returns to Scale 59
8 Costs 60
8.1 Production Costs in the Short Run 61
8.2 Production Cost in the Long Run 63
8.3 The Relation between Long-Run and Short-Run Average Costs 66
9 Perfect Competition 68
9.1 Introduction 68
9.2 Conditions for Perfect Competition 68
9.3 Profi t Maximizing Production in the Short Run 69
9.3.1 Strategy to Find the Optimal Short-Run Quantity 71
9.3.2 The Firm’s Short-Run Supply Curve 71
9.3.3 The Market’s Short-Run Supply Curve 72
9.4 Short-Run Equilibrium 72
9.5 Long-Run Production 73
9.6 The Long-Run Supply Curve 75
9.7 Properties of the Equilibrium of a Perfectly Competitive Market 76
10 Market Interventions and Welfare Effects 77
10.1 Welfare Analysis 79
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Microeconomics Contents
11 Monopoly 80
11.1 Barriers to Entry 80
11.2 Demand and Marginal Revenue 80
11.3 Profi t Maximum 81
11.4 The Deadweight Loss of a Monopoly 83
11.5 Ways to Reduce Market Power 84
12 Price Discrimination 85
12.1 First Degree Price Discrimination 85
12.2 Second Degree Price Discrimination 87
12.3 Third Degree Price Discrimination 87
13 Game Theory 88
13.1 The Basics of Game Theory 88
13.2 The Prisoner’s Dilemma 89
13.3 Nash Equilibrium 91
13.3.1 Finding the Nash Equilibrium in a Game in Matrix Form 91
13.4 A Monopoly with No Barriers to Entry 92
13.4.1 Finding the Nash Equilibrium for a Game Tree 93
13.5 Backward Induction 94
14 Oligopoly 96
14.1 Kinked Demand Curve 96
14.1.1 How does the Price in the Kinked Demand Curve Arise? 97
14.2 Cournot Duopoly 98
14.3 Stackelberg Duopoly 99
14.4 Bertrand Duopoly 100
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Microeconomics Contents
15 Monopolistic Competition 102
15.1 Conditions for Monopolistic Competition 102
15.2 Market Equilibrium 102
15.2.1 Short Run 102
15.2.2 Long Run 102
16 Labor 104
16.1 The Supply of Labor 105
16.2 The Marginal Revenue Product of Labor 106
16.3 The Firm’s Short-Run Demand for Labor 107
16.3.1 Perfect Competition in both the Input and Output Market 107
16.3.2 Monopoly in the Output Market 108
16.3.3 Monopsony in the Input Market 109
16.3.4 Bilateral Monopoly 110
17 Capital 111
17.1 Present Value 112
17.1.1 Bonds 112
17.1.2 Stocks 113
17.2 Correction for Risk 113
17.2.1 Diversifi able and Nondiversifi able Risk 113
17.3 CAPM: Pricing Assets 115
17.4 Pricing Business Projects 115
18 General Equilibrium 117
18.1 A “Robinson Crusoe” Economy 117
18.2 Effi ciency 117
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Microeconomics Contents
18.3 The Edgeworth Box 117
18.4 Effi cient Consumption in an Exchange Economy 119
18.5 The Two Theorems of Welfare Economics 120
18.6 Effi cient Production 120
18.7 The Transformation Curve 121
18.8 Pareto Optimal Welfare 123
18.8.1 A Defi nition of Pareto Optimal Welfare 124
19 Externalities 125
19.1 Defi nition 126
19.2 The Effect of a Negative Externality 126
19.3 Regulations of Markets with Externalities 127
20 Public Goods 128
20.1 Defi nition of Public and Private Goods 128
20.2 The Aggregate Willingness to Pay 128
20.3 Free Riding 129
21 Asymmetric Information 130
21.1 Adverse selection 130
21.1.1 Insurance 130
21.1.2 Used Cars 130
21.1.3 Signaling and How to Reduce Problems with Adverse Selection 131
21.2 Moral hazard 131
21.2.1 How to Reduce Problems with Moral Hazard 132
22 Key Words 133
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Microeconomics Introduction

1 Introduction

Economics is often defined as something along the lines of “the study of how
Economics: The study of
society manages its scarce resources.” The starting point of most such studies how society manages its
is that individuals allocate their resources such that they themselves will get scarce resources

the highest possible level of utility. An individual has an idea of what the con-

sequences of different actions will be, and she chooses that action she believes

will produce the best result for her. She is, in other words, selfish and rational.

Note that she is also forward-looking. She acts so that she in the future will get
the highest possible level of utility, independently of what she has already

done. That she is selfish does not have to mean that she is an egoist. However,
it does mean that she will only voluntarily share with others if she believes that

she thereby will maximize her own utility. We often call this simplification of

human beings Homo Economicus.
Homo Economicus: A
The resources that we are talking about here could be labor, capital (such as model of human beings. She
is assumed to maximize her
machines), and raw materials. That they are scarce means there are not enough
own utility.
resources to produce everything we want. That, in turn, means that one has to Resources: Labor, capital
and raw materials. The
weight different things against each other. To get more of one thing, one has to
things we use to produce
give up something else. If you, e.g., want to sleep an extra hour, it is impossi- goods and services.
ble to do so without giving up something else, such as an hour of studying.

There is, consequently, a sort of a hidden cost to sleeping longer. This type of
cost is called opportunity cost (or alternative cost). A classical saying in
Opportunity/alternative
economics is that “there is no such thing as a free lunch.” This means that,
cost: The (hidden) cost of
even if you do not actually pay for the lunch, you always have to give up at choosing one alternative
instead of another.
least the time when you could have done something else. That is, you always

have to pay the opportunity cost.
When we study microeconomics, it is primarily individual human beings and Microeconomics: The
study of the economic
individual firms, agents, that we study. This is in contrast to macroeconomics,
behavior of individual
where one studies whole economies, and questions such as unemployment and human beings and firms.
inflation. Agent: An entity that is
capable of making a deci-
sion, e.g. a human being or
Roughly speaking, there are three types of decisions that need to be made in an
a firm.
economy: Which goods and services to produce, how to produce them, and Macroeconomics: The
who should get them. Often in economic models, the prices of goods (or ser- study of whole economies.
vices, labor, capital, etc.) automatically coordinate these decisions in a market.
A market is any mechanism where buyers and sellers meet. That could be, for
Market: Meeting place
example, a market square, a stock exchange, or a computer network where one where buyers and sellers are
can buy and sell things. able to trade with each
other.
Microeconomics is often based on models. We try to describe a real phenome-
Model: A simplified
non as simply as possible by only highlighting a few central features. Many description of reality.
economic models can be used for predictions and can therefore be tested
against reality. Such models are called positive. The opposite kind of models,
Positive economics: A
models that are about values, is called normative. For example, to decide testable economic model.
Normative economics: An
about an economic policy one would first use positive economics to make as-
economic model that
sessments about the consequences of different alternatives. Then one would includes values (and there-
use one’s opinions about what is desirable and what is not to choose between fore is not testable).
the different alternatives. That is then a normative decision.

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