Chapters 1 & 2: Preliminaries and The Basics of Supply and Demand

Market Structures and Definitions

Understanding market structures and definitions is fundamental to microeconomics. Markets can be classified based on the number of buyers and sellers, and the nature of competition.

• Perfectly Competitive Markets: Many buyers and sellers, homogeneous products, no single participant can influence price.

• Monopoly Markets: Single seller dominates, can set prices, barriers to entry exist.

• Extent of a Market: Refers to the boundaries of a market, defined by geography and product characteristics.

Real vs. Nominal Prices

Prices can be measured in nominal terms (current dollars) or real terms (adjusted for inflation).

• Nominal Price: The price in current dollars.

• Real Price: The price adjusted for inflation, often using a price index.

Supply and Demand Curves

Supply and demand curves illustrate the relationship between price and quantity supplied/demanded.

• Shifts in Supply or Demand: Changes in factors other than price (e.g., income, tastes, input costs) shift the curves.

• Market Equilibrium: The intersection of supply and demand curves determines equilibrium price and quantity.

• Simultaneous Shifts: Both curves can shift, affecting equilibrium in complex ways.

Substitutes and Complements

• Substitutes: Goods that can replace each other (e.g., tea and coffee).

• Complements: Goods consumed together (e.g., printers and ink cartridges).

Price Controls

• Price Ceiling: Maximum legal price (e.g., rent control).

• Price Floor: Minimum legal price (e.g., minimum wage).

Elasticity

Elasticity measures responsiveness of quantity demanded or supplied to changes in price, income, or other goods' prices.

• Price Elasticity of Demand:

• Income Elasticity:

• Cross-Price Elasticity:

• Long-run vs. Short-run Elasticity: Elasticity is often higher in the long run as consumers have more time to adjust.

Chapter 3: Consumer Behavior

Preferences and Indifference Curves

Consumer preferences are modeled using indifference curves, which represent combinations of goods yielding equal satisfaction.

• Assumptions: Completeness, transitivity, more is better, convexity.

• Indifference Curves: Cannot cross; crossing would violate transitivity and consistency.

• Convexity: Implies diminishing marginal rate of substitution (MRS).

Marginal Rate of Substitution (MRS)

• Definition: The rate at which a consumer is willing to trade one good for another while maintaining the same utility.

• Formula:

• At Utility Maximization:

• Diminishing MRS: As more of one good is consumed, the willingness to trade decreases, leading to convex indifference curves.

Special Cases: Perfect Substitutes and Complements

• Perfect Substitutes: Indifference curves are straight lines; consumer is willing to substitute goods at a constant rate.

• Perfect Complements: Indifference curves are L-shaped; goods are consumed in fixed proportions.

Utility: Ordinal vs. Cardinal

• Ordinal Utility: Ranks bundles; actual numbers are not meaningful.

• Cardinal Utility: Assigns meaningful numbers; rarely used in microeconomics.

Budget Constraints

• Budget Line: Shows all combinations of goods a consumer can afford.

• Slope of Budget Line:

• Effects of Price/Income Changes: Budget line shifts or rotates.

Consumer Choice and Utility Maximization

• Optimal Bundle: Where indifference curve is tangent to budget line.

• Condition:

• Corner Solution: Consumer spends all income on one good.

Revealed Preference

• Definition: Preferences inferred from observed choices.

• Graphical Analysis: Shows how choices reveal underlying preferences.

Chapter 4: Individual and Market Demand

Individual Demand and Price-Consumption Curve

• Derivation: Demand curve is derived from price-consumption curve by varying price and observing optimal bundles.

• Income-Consumption Curve: Shows how demand changes with income.

Normal vs. Inferior Goods

• Normal Goods: Demand increases as income rises.

• Inferior Goods: Demand decreases as income rises.

Engel Curves

• Definition: Graphs showing relationship between income and quantity demanded.

• Shape: Upward sloping for normal goods, downward for inferior goods.

Income and Substitution Effects

• Substitution Effect: Change in consumption due to relative price change, holding utility constant.

• Income Effect: Change in consumption due to change in purchasing power.

Market Demand

• Definition: Sum of individual demands.

• Effects: Market demand increases as more consumers enter.

Consumer Surplus

• Definition: Difference between what consumers are willing to pay and what they actually pay.

• Formula:

• Graphical Representation: Area under demand curve above price.

Network Externalities

• Snob Effect: Demand decreases as more people own the good.

• Bandwagon Effect: Demand increases as more people own the good.

• Pure Price Effect: Change in demand due to price alone.

Chapter 5: Uncertainty and Consumer Behavior

Probability and Expected Value

• Objective Probability: Based on known frequencies.

• Subjective Probability: Based on personal belief.

• Expected Value: Weighted average of possible outcomes.

Variance and Standard Deviation

• Variance: Measures spread of possible outcomes.

• Standard Deviation: Square root of variance.

• Tradeoff: Higher expected value may come with higher risk (variance).

Expected Utility and Risk Preferences

• Expected Utility: Weighted average of utility from each outcome.

• Diminishing Marginal Utility: As wealth increases, additional utility from extra wealth decreases.

• Risk Aversion: Prefers certain outcomes over risky ones with same expected value.

• Utility Functions:

  • Risk Averse: Concave utility function.

  • Risk Seeking: Convex utility function.

  • Risk Neutral: Linear utility function.

Risk Premium

• Definition: Amount a risk-averse person is willing to pay to avoid risk.

• Graphical Representation: Difference between expected value and certainty equivalent.

Risk Aversion and Indifference Curves

• Indifference Curves: Show combinations of risk and return yielding same utility.

• More Risk Averse: Indifference curves are steeper.

Reducing Risk: Diversification and Insurance

• Diversification: Spreading investments across negatively correlated assets reduces risk.

• Mutual Fund: Investment vehicle pooling funds to diversify holdings.

• Insurance: Transfers risk to insurer.

• Law of Large Numbers: Predicts average outcomes over many trials.

• Actuarially Fair Insurance: Premium equals expected payout.

Chapter 19: Behavioral Economics

Bubbles and Information Cascades

• Bubbles: Occur when asset prices exceed fundamental values due to speculation.

• Information Cascades: Individuals follow others' actions, sometimes ignoring their own information.

Behavioral Biases

• Reference Point Behavior:

  • Endowment Effect: Value owned items more highly.

  • Loss Aversion: Losses are felt more strongly than gains.

  • Framing: Decisions influenced by how choices are presented.

  • Opt-in/Opt-out: Participation rates affected by default options.

• Fairness Behavior:

  • Spite: Willingness to reduce others' welfare at own cost.

  • Ultimatum Game: Demonstrates fairness and rejection of unfair offers.

• Decision Biases:

  • Anchoring: Relying too heavily on initial information.

  • Social Information: Decisions influenced by others' actions.

  • Rules of Thumb/Status Quo: Preference for existing state.

  • Law of Small Numbers: Overestimating representativeness of small samples.