Microeconomics: Key Concepts and Formulas

Posted on Mar 10, 2025 in Economics

Key Concepts in Microeconomics

Monopolistic Competition, Oligopoly/Game Theory, Externalities, and Public Goods and Common Pool Resources

Monopolistic Competition:

• Monopoly: Price maker (downward sloping demand curve), creates deadweight loss (DWL), but customers get variety. Scale isn’t efficient (doesn’t minimize average fixed cost (AFC) in the long run (LR)).
• Perfect Competition: Many firms, only earn profit in the short run (SR). In the LR, profit = 0 (due to barriers to entry, competitors are quick to imitate).
• Graph: Is the same as a monopoly when it gets substituted in.

Externalities:

The consumption or production of a good imposes an external cost or benefit on society (those not directly involved in the transaction).

• Consumption: Externality on demand.
• Production: Externality on supply.
• Cost: Negative externality.
• Benefit: Positive externality.

Solutions to Externalities:

• Pigovian Tax or Subsidy:
  • Tax: Equal to the per-unit amount of the negative externality.
  • Subsidy: Equal to the per-unit amount of the positive externality.
  • Example: If the per-unit amount is 50 cents, the Pigovian tax or subsidy would be 50 cents on the producer or consumer.
• Price ceiling and price floor, ban/quota, cap and trade.
• Private Solutions: Coase Theorem: The real problem is with property rights. If there were no transaction costs and contracts were made to enforce it. Example: Pay for how far you drive your car, or get paid to not drive a gas car.
• Social shame/incentives/norms.

When a tax or subsidy is enacted, it will create a double shift. The externality gets internalized in the socially optimal section.

Public Goods and Common Pool Resources:

• Rival: One person’s consumption prevents others from consuming/enjoying the good.
• Excludable: Sellers can prevent use by those who have not paid.
• Free-rider Problem: Public goods end up undersupplied if left to competitive markets.
• Tragedy of the Commons: Common pool resources (CPR) end up overconsumed if left to competitive markets.

Solutions for Public Goods and CPR:

• Government regulation: Poaching bans, monitoring/punishing users with fines.
• Pigovian tax: Make users pay for the external cost of their consumption.
• Assign property rights: Privatize forests, implement tradable quotas/fisheries.
• Public goods provision:
  • Private: Privatize, congestion prices, user fees, crowdfunding, social norms.
  • Government: Government provision and subsidies, moves S private to S social, similar to a positive externality.
• Elinor Ostrom: Monitoring/enforcing is costly for centralized authorities. Users who know each other are more efficient at punishing and monitoring. Civilizations have a high chance of escaping the tragedy of the commons. What tends to work well: a clear distinction of valid users, users help set the rules, shared values and shared space, use is transparent, and leadership is important.

Formulas and Additional Concepts

Exam 2: Formulas, Behavioral Economics, Costs, Perfect Competition, Monopoly

Formulas:

• Net Worth = Assets – Debts
• Net Worth = Savings balance with interest – Credit card balance with interest
• Balance with interest = Initial amount x (1+r), where r is the interest rate
• Profit = Total Revenue (TR) – Total Cost (TC) = (P – ATC) x Q
• Total Revenue = P x Q
• Accounting Profit = Total Revenue – Total Explicit Cost
• Economic Profit = Total Revenue – Total Explicit Costs – Total Implicit Costs
• TC = FC + VC
• Marginal Product of Labor (MPL) = (New Q – Old Q) / (New L – Old L)
• Average Product of Labor = Q / L
• Average Variable Cost (AVC) = VC / Q
• Average Total Cost (ATC) = TC / Q or AFC + AVC
• Marginal Cost (MC) = Change in TC / Change in Q
• Marginal Revenue (MR) = Change in TR / Change in Q

Behavioral Economics:

• Overvaluing Sunk Costs: Placing too much value on something you no longer have control over.
• Undervaluing Opportunity Cost:
  • Time: People underestimate how valuable their time is; factor in hourly wage.
  • Possession: The value of an item that someone is no longer using.
• Time Inconsistency: Changing one’s mind based on the decision.
• Fungibility: The exchangeability of an item.
• Asymmetric Information: When one party (buyers or sellers) has more information than another.
• Adverse Selection: Occurs before the transaction.
• Moral Hazard: Occurs after the transaction.
• Signaling: Party with more information reveals private information.
• Screening: Party is forced to reveal private information.
• Reputation: Crowdsourcing information based on the history of the transaction.
• Statistical Discrimination: Generalizing based on shared experience with a group.
• Regulation: Government forces a party to reveal private information.

Costs:

• Fixed Cost: Does not change as profit increases; present if no profit is produced.
• Variable Cost: Changes as production changes; equals 0 if no product is produced and Q=0.
• Explicit Cost: Everything paid on paper.
• Implicit Cost: Opportunity cost.
• Productivity: How much output you get from your workers; per-unit cost.
• Production Function: Relationship between labor (L) and capital (K); K is constant.
• Marginal Product of Labor: How much each worker contributes.
• Average Product of Labor: How much all the workers produce on average.
• Law of Diminishing Productivity: If one input is fixed, adding additional units will diminish productivity (the idea of specialization).
• Short Run Cost Curves:
  1. MC: Determines Q* and will hit AVC and ATC at the minimum (Nike swoosh).
  2. ATC: Determines profit; will get closer to AVC as AFC continues to decrease.
  3. AVC: Determines the shutdown decision.
  4. AFC: Will approach 0 as quantity increases because the fixed cost does not change.

Perfect Competition:

Firms will enter when profit is > 0 and leave when profit is < 0.

• When P > ATC > AVC: Firms are profitable and stay in the SR and LR.
• When ATC > P > AVC: Firms should stay in the SR and leave in the LR.
• When ATC > AVC > P: Firms should exit now.

Profit will always return to 0 in the long run.

Monopoly Graph:

Entry Barriers:

1. Control of scarce resources.
2. Economies of scale:
   • Demand: For consumers, bigger is better when users increase.
   • Supply side: One producer can meet all demand at a lower price than other firms.
3. Government intervention: Patents and copyrights, state-owned enterprises (e.g., DMV).
4. Aggressive business tactics: Buying up competition and predatory pricing.

Producer and Consumer Surplus:

• PS = Area below P, above MC.
• CS = Area below D, above P.

When a substitute is introduced, demand gets flatter and more elastic.

Government Responses to Monopolies:

• Public ownership.
• Price control, usually a price ceiling.
• Vertical split: Supply chain.
• Horizontal split: Creating more companies that do the same thing.

Price Discrimination:

Charging different prices based on willingness to pay.

Requirements:

• Market power to change price.
• No arbitrage (profit off resale).
• Segmenting: Charging different groups different prices based on demographics (age, gender, past purchases, location, time).
• Perfect: All pay individual willingness to pay (WTP).
• Indirect: Know group once bought (coupons, quantity discount, punch cards).
• Direct: Know group before purchase (student discount).

Exam 1: Formulas, Opportunity Cost, Utility, Comparative Market, Elasticity, Surplus, Government Actions

Formulas:

• Elasticity of Demand/Supply = (Q2 – Q1) / [(Q2 + Q1) / 2] / (P2 – P1) / [(P2 + P1) / 2]
• Elasticity of Income = (Q2 – Q1) / [(Q2 + Q1) / 2] / (I2 – I1) / [(I2 + I1) / 2]
• Cross-Price Elasticity = (Q2 – Q1) / [(Q2 + Q1) / 2] / (P2 – P1) / [(P2 + P1) / 2]

Key Concepts:

• Scarcity: People’s wants exceed the resources; the resources are “scarce.”
• Opportunity Cost: The value of the next best foregone alternative; what you give up to get something.
• Sunk Cost: A cost that has occurred and cannot be removed; cannot change.
• Marginal Decisions: Comparing the additional benefits of a choice to the additional cost. MB > MC is good; MC > MB is bad.
• Incentives: In rational behavior, people respond to incentives.
• Positive Statements: Fact; the way things are.
• Normative Statements: Opinion; the way things should be.
• Correlation: Two events occur at the same time.
• Causation: One event causes the other.
• Model Assumptions vs. Predictions
• Utility: A measure of how satisfactory is derived from consuming a good.
  • Pro: Universal yardstick.
  • Cons: No way to compare against other people.
• Revealed Preferences: Assume that rational people make choices to maximize their utility.
• Diminishing Marginal Utility: Law of DMU: Eventually, consuming additional units will yield less utility.
• Social Sources of Utility:
  • Inward Preferences: How does it make you feel?
  • Perception of Others: What do others think of you?
  • Altruism: Selfless behavior with no reward.
  • Reciprocity: Doing it for someone else.
• Budget Constraints: Shows all possible combinations of two goods with a given income.

• Income Effect: A change in price affects the consumer’s purchasing power. Example: If the price of coffee decreases, the consumer would be more willing to buy other groceries because they feel richer.
• Substitution Effect: The shift in consumption pattern as the good changes in price. Example: If the price of tea decreases, consumers are more willing to substitute it for coffee because it is cheaper.
• Comparative Market Characteristics: Buyers and sellers are price takers. If sellers try to charge more, nobody buys, but if they try to sell cheaper, other firms copy and they all lose profit.
• Law of Demand: As prices fall, the quantity demanded increases.
• Shifts of Demand: Change in income, tastes/preferences, price of substitute/complement, number of buyers, tax/subsidy on consumers, future expectations.
• Law of Supply: As prices increase, the quantity supplied increases.
• Shifts of Supply: Change in input cost, technology, number of sellers, tax/subsidy on producers, future expectations of price.
• Equilibrium: Where supply and demand meet. When there is a double shift, either P or Q will be ambiguous. When the price is above equilibrium, there is a surplus. When the price is below equilibrium, there is a shortage.
• Elasticity:

• Price Floor: Government policy that sets a minimum price that producers are allowed to accept for a specific good.
• Tax/Subsidy: Golden Rule:
  1. It does not matter who you tax/subsidize.
  2. Only the relative elasticity of S and D matter because a relatively inelastic S and D will just pay more of a tax or subsidy (a tax will always shift S or D left, and a subsidy will always shift S or D right).

Space for more information.