Introduction to Microeconomics

Sellers and Incentives

This section introduces the fundamental concepts of microeconomics, focusing on the behavior and incentives of sellers in perfectly competitive markets. Understanding these principles is essential for analyzing how firms make production and pricing decisions.

Perfectly Competitive Market

Characteristics of Perfect Competition

A perfectly competitive market is defined by several key features that ensure no single buyer or seller can influence the market price.

• No market power: No individual buyer or seller is large enough to affect the market price.

• Identical goods: All sellers offer products that are perfect substitutes for one another.

• Free entry and exit: Firms can freely enter or leave the market in response to profit opportunities, which helps maintain competitive pricing.

These conditions ensure that prices are determined by overall market supply and demand, not by individual actions.

The Seller's Problem

Profit Maximization

The primary objective of a seller in a competitive market is to maximize profit. To achieve this, sellers must address three fundamental questions:

• How to make the product?

• What is the cost of making the product?

• How much can the seller get for the product in the market?

Production Decisions

Production Function and Inputs

Production is the process of transforming inputs into outputs. The production function describes the relationship between input quantities and output quantity.

• Physical capital (K): Tools, machines, and structures used in production. Usually considered a fixed factor in the short run.

• Labor (L): The physical and mental effort of workers. Considered a variable factor in the short run.

The marginal product is the change in total output resulting from using one more unit of input:

The law of diminishing returns states that as more units of a variable input are added to fixed inputs, the additional output from each new unit will eventually decrease.

Example: The Wisconsin Cheeseman

This example illustrates the law of diminishing returns using data on cheese production.

Additional info: The marginal product becomes negative when too many workers are added, illustrating overcrowding and inefficiency.

Short-Run Production Function

The short-run production function shows how output changes as more workers are added, holding capital constant. Initially, output increases rapidly, but eventually, additional workers contribute less and may even reduce total output.

• Marginal product can be negative: Overcrowding leads to inefficiency.

Cost of Production

Types of Costs

Firms must consider both variable and fixed costs when making production decisions.

• Variable cost (VC): Costs that change with the level of output (e.g., labor, materials).

• Fixed cost (FC): Costs that do not change with output (e.g., rent, equipment).

• Total cost (TC):

Average and marginal cost measures are essential for decision-making:

• Average Total Cost (ATC):

• Average Variable Cost (AVC):

• Average Fixed Cost (AFC):

• Marginal Cost (MC):

Example: Wisconsin Cheeseman Cost Table

Additional info: This table helps illustrate how costs change as output increases and is used to derive cost curves.

Cost Curves

Cost curves graphically represent the relationship between output and various cost measures. The typical shapes are:

• Marginal Cost (MC): U-shaped, reflecting increasing and then decreasing marginal returns.

• Average Total Cost (ATC): U-shaped, due to spreading fixed costs and then rising variable costs.

• Average Variable Cost (AVC): Also U-shaped, but lower than ATC.

Profit Maximization

Optimal Output Decision

Firms maximize profit by producing the quantity where marginal revenue equals marginal cost:

Profit is calculated as:

At the optimal quantity:

• If , the firm earns economic profit.

• If , the firm incurs economic loss.

• If , the firm breaks even.

Accounting vs. Economic Profits

Definitions

• Accounting Profit:

• Economic Profit:

Implicit costs include opportunity costs. A firm can have an economic loss but still report a positive accounting profit.

Shutdown Conditions

Short-Run Decision

In the short run, a firm should continue operating if the price covers average variable cost, even if it does not cover average total cost. Fixed costs are considered sunk and should not affect the shutdown decision.

• If , continue operating.

• If , shut down.

Supply Curve and Market Supply

From Seller's Problem to Supply Curve

The supply curve shows the relationship between price and quantity supplied. In most cases, quantity supplied increases as price rises, holding other factors constant.

Supply Schedules and Curves

Individual and market supply schedules list quantities supplied at different prices. The market supply curve is the horizontal sum of individual supply curves.

Additional info: Table entries inferred for illustration.

Shifts vs. Movements Along the Supply Curve

• Movement along the curve: Caused only by a change in the product's price.

• Shift of the curve: Caused by changes in input prices, technology, number/scale of sellers, or sellers' expectations about the future.

Entry and Exit Decisions

Long-Run Market Dynamics

Firms enter the market if there is potential for positive economic profit. Conversely, firms exit if they cannot cover their costs in the long run.

Producer Surplus

Definition and Calculation

Producer surplus is the difference between the market price and the minimum price at which a producer is willing to supply a good (as indicated by the supply curve).

Elasticity of Supply

Price Elasticity of Supply

The price elasticity of supply measures how responsive quantity supplied is to changes in market price:

• Elastic supply (): Quantity supplied is very responsive to price changes.

• Inelastic supply (): Quantity supplied changes less than proportionally to price changes.

• Unit-elastic supply (): Quantity supplied changes proportionally to price changes.

Elasticity tends to be higher when firms have more inventory, can hire workers easily, and have a longer time horizon.

Short Run vs. Long Run Production

Adjustment of Inputs

In the short run, some inputs (like capital) are fixed, and firms can only adjust variable inputs (like labor). In the long run, all inputs are variable, allowing firms to fully adjust their production processes.

Economies and Diseconomies of Scale

Returns to Scale

• Economies of Scale: ATC falls as output increases. If inputs double, output more than doubles. Often due to large setup costs.

• Constant Returns to Scale: ATC remains unchanged as output increases. If inputs double, output doubles. Gains from specialization are fully realized.

• Diseconomies of Scale: ATC rises as output increases. If inputs double, output increases by less than double. May result from excessive management layers.