ARE 100A – Intermediate Microeconomics
• Microeconomics – is the study of how individuals and firms make themselves as well off as possible in
a world of scarcity, and the consequences of those individual decisions for markets and the entire
o In studying microeconomics, we examine how individual consumers and firms make decisions
and how the interaction of many individual decisions affects markets.
o Often called price theory. Plays roles in determining market outcomes.
o Explains how the actions of all buyers and sellers determine prices and how prices influence the
decisions and actions of individual buyers and sellers.
1.1 Microeconomics: The Allocation of Scare Resources
• Consumers select the mix of goods and services that make them happy.
• Firms decide which goods to produce, where to produce them, how much to produce to maximize their
profits, and how to produce those levels of output at the lowest cost by using more or less of various
inputs such as labor, capital, materials, and energy.
• Government decision makers decide which goods and services the gov’t will produce and whether to
subsidize, tax, or regulate industries and consumers so as to benefit consumers, firms, or gov’t
a. Which goods and services to produce
b. How to produce
c. Who gets the goods and services
B. Who Makes the Decisions
a. Some countries explicitly by the government
b. Most other countries, how many cars of each type are produce and who gets them are
determined by how much it costs to make cars of a particular quality in the least expensive way
and how much consumers are willing to pay for them.
C. How Prices Determine Allocations
a. Prices link the decision about which goods and services to produce, how to produce them, and
who gets them.
b. Prices influence the decision of individual consumers and firms, and the interactions of these
decisions by consumers, firms, and the gov’t determine price.
c. Market – exchange mechanism that allows buyers to trade with sellers. 1.2 Models – a description of the relationship between 2 or more economic variables. Use to predict how a
change in one variable will affect another variable.
A. Simplifications by Assumption
a. An economic model is a simplification of reality that contains only reality’s most important
b. Economists make many assumptions to simplify their models.
B. Testing Theories
a. Economic theory is the development and use of a model to test hypotheses, which are
predictions about cause and effect.
b. If a prediction does not come true, economists may reject the theory.
c. Economists use a model until it is refuted by evidence or until a better model is developed.
d. A good model makes sharp, clear predictions that are consistent with reality.
C. Maximizing Subject to Constraints
a. Individuals allocate their scare resources so as to make themselves as well off as possible.
b. Consumers pick the bundle of goods that gives them the most possible enjoyment.
c. Firms try to maximize their profits given limited resources and existing technology.
d. Consumers maximize their well-being subject to a budget constraint, which says that their
resources limit how many goods they can buy.
e. Firms maximize profits subject to technological and other constraints.
D. Positive Versus Normative
a. Sometimes only make scientific prediction about the relationship between cause and effect:
Price controls (cause) lead to food shortages and starvation (effect).
i. Positive statement: a testable hypothesis about cause and effect. We only test the truth
of our statement.
b. The gov’t makes a value judgment or normative statement: a conclusion as to whether
something is good or bad.
i. A normative statement cannot be tested because a value judgment cannot be refuted by
evidence. It is a prescription rather than a prediction. A normative statement concerns
what somebody believes should happen; a positive statement concerns what will
ii. A normative conclusion can be drawn without first conducting a positive analysis, a
policy debate will be more informed if positive analyses are conducted first.
iii. Positive economic analysis can be used to predict whether these programs will benefit
poor people but not whether these programs are good or bad. iv. Can’t test value judgments but can test hypothesis.
1.3 Uses of Microeconomic Models
• A major use of microeconomic models by gov’t is to predict the probable impact of a policy.
1. Microeconomics: The Allocationj of Scare Resources. Microeconomics is the study of the allocation of
scare resources. Consumers, firms, and gov’t must make allocation decision. A society faces 3 key
trade-offs: which goods and services to produce, how to produce them, and who gets tem. These
decision are interrelated and depend on the prices that consumers and firms face and on gov’t actions.
Market prices affect the decision of individual consumers and firms, and the ineraction of the decision of
individual consumers and firms determines market prices. The organization of the market, especially
the # of firms in the market and the information consumers and firms have, plays an important role in
determining whether the market price is equal to or higher than the cost of producing an additional unit
2. Models. Models based on economic theories are used to predict the future or to answer questions
about how some changes, such as a tax increase, will affect various sectors of the economy. A good
theory is simple to use and makes clear, testable predictions that are not refuted by evidence. Most
microeconomic models are based on maximizing behavior. Economists use models to construct
positive hypotheses concerning how a cause leads to an effect. These positive questions can be
tested. In contrast, normative statements, which are value judgments, cannot be tested.
3. Uses of Microeconomic Models. Individuals, gov’t and firms used microeconomic models and
predictions to make decisions. For example, to maximize its profits, a firm needs to know consumers’
decision-making criteria, the trade-off between various ways of producing and marketing its product,
gov’t beliefs and how it rivals will react to its actions play a critical role in how the company forms its
Chapter 2: Supply and Demand
• The supply and demand model describes how consumers and suppliers interact to determine the
quantity of a good or service sold in a market and the price at which it is sold.
• To use this model, you need to determine: buyers’ behavior, sellers’ behavior and how buyers’ and
sellers’ actions affect price and quantity.
o Demand: The quantity of a good or service that consumers demand depends on price and other
factors such as consumers’ incomes and the prices of related goods.
o Supply: The quantity of a good or service that firms supply depends on price and other factors
such as the cost of inputs that firms use to produce the good or service.
o Market Equilibrium: The interaction between consumers’ demand curve and firms’ supply
curve determines the market price and quantity of a good or service that is bought and sold.
o Shocking the Equilibrium: Comparative Statics. Changes in a factor that affect demand (such
as consumers’ incomes), supply (such as a rise in the price of inputs), or a new gov’t policy
(such as a new tax), alter the market price and quantity of a good. o Elasticity: Given estimates of summary statistics called elasticity’s, economists can forecast the
effects of changes in taxes and other factors on market price and quantity.
o Effects of a sales tax: How a sales tax increase affects the equilibrium price and the quantity of
a good, and whether the tax falls more heavily on consumers or on suppliers, depend on the
supply and demand curves.
o Quantity supplied need not equal quantity demanded: If the gov’t regulates the prices in a
market, the quantity supplied might not equal the quantity demanded.
o When to use the supply-demand model: the supply and demand model applies only to
• Quantity demanded – the amount of a good that consumers are willing to buy at a given price during a
specified time period. Quantity demanded can exceed the quantity actually sold.
• Potential consumers decide how much of a good or service to buy on the basis of its price, which is
expressed as an amount of money per unit of the good.
o Consumers make purchases based on their taste; however, advertising can influence people’s
Information for misinformation. (False advertising).
o The price of a complement – a good that you like to consume at the same time as the product
you are considering buying – could affect your decision.
o People’s incomes play a major role in determining what and how much of a good or service they
o Gov’t rules and regulations affect people’s purchase decisions.
Sales taxes increase the price that a consumer must spend on a good, and gov’t
imposed limits on the use of a good can affect the demand.
A. The demand Function
a. Shows the correspondence between the quantity demanded price, and other factors that
b. Substitute - a good that might be consumed instead of this good.
c. Demand curve – is a plot of the demand function that shows the quantity demanded at each
possible price, holding constant the other factors that influence purchases.
i. The downward slope of the demand curve shows that, holding other factors that
influence demand constant, consumer demand less of a good when its price is high and
more when the price is low.
ii. A change in price causes a movement along the demand curve. 1. Law of demand: consumers demand more of a good the lower its price, holding
constant tastes, the prices of other goods, and other factors that influence the
amount they consume. (Downward sloping curve).
a. Another way to state the Law of Demand is that this derivative is
negative: a higher price results in a lower quantity demanded.
b. If the demand function is Q = D(p), then the Law of Demand says that
dQ/dp < 0, where dQ/dp is the derivative of the D function with respect to
c. Changes in the quantity demanded in response to an infinitesimal change
in the price.
d. ∆Q = Q – 2 1
e. Slope = dp/dQ = 1/(dQ/dp) It’s a reciprocal of the derivative on the
RISE ∆ p
f. Slope = =
iii. A change in any factor other than the price of the good itself causes a shift of the
demand curve rather than a movement along the demand curve.
B. Summing Demand Functions
a. The total quantity demanded at a given price is the sum of the quantity each consumer demand
at that price.
• Quantity supplied – is the amount of a good that firms want to sell during a given time period at a
given price, holding constant other factors that influence firms; supply decision, such as costs and gov’t
• Firms determine how much of a good to supply on the basis of the price of that good and other factors,
including the costs of production and gov’t rules and regulations.
A. The Supply Function – shows the correspondence between the quantity supplied, price, and other
factors that influence the # of units offered for sale.
a. Supply curve – which shows the quantity supplied at each possible price, holding constant the
other factors that influence firms’ supply decisions.
b. The market supply curve can be upward sloping, vertical, horizontal or downward sloping.
c. A change in a factor other than a product’s price causes a shift of the supply curve. When costs,
gov’t rules, or other variables that affect supply change, the entire supply curve shifts.
B. Summing Supply Functions
a. The total supply curve shows the total quantity of a product produced by all suppliers at each
possible price. C. How Gov’t Import Policies Affect Supply Curves
a. A limit that a gov’t sets on the quantity of a foreign-produced good may be imported is called a
2.3 Market Equilibrium
• The supply and demand curves jointly determine the price and quantity at which goods and services
are bought and sold. The demand curve shows the quantities that consumers want to buy at various
prices, and the supply curve shows the quantities that firms want to sell at various prices.
• When all traders are able to buy or sell as much as they want, we say that the market is in equilibrium:
a situation in which no participant wants to change its behavior.
• A price at which consumers can buy as much as they want and sellers can sells as much as they want
is called an equilibrium price. The quantity that is bought and sold at the equilibrium price is called the
A. Finding the Market Equilibrium
a. The equilibrium is the quantity that firms want to sell and the quantity that consumers want to
buy at the equilibrium price.
B. Forces that Drive a Market to Equilibrium
a. The ability to buy as much as you want of a good at the market price is indirect evidence that a
market is in equilibrium.
b. Market equilibrium occurs without any explicit coordination between consumers and firms.
c. If the price were not at the equilibrium level, consumers or firms would have an incentive to
change their behavior in a way that would drive the price to the equilibrium level.
d. If the price were initially lower than the equilibrium price, consumers would want to buy more
than suppliers would want to sell.
e. At demand excess, the market would be in disequilibrium meaning that the quantity demanded
would not equal the quantity supplied.
i. There would be excess demand – the amount by which the quantity demanded
exceeds the quantity supplied at a specified price.
f. When there is excess supply, there is a disequilibrium – the amount by which the quantity
supplied is greater than the quantity demanded at a specified price.
i. As long as the price remained above the equilibrium price, some firms would have
unsold pork for example and would want to lower the price to attract addition customers.
g. The equilibrium price is called the market clearing price because it removes from the market all
frustrated buyers and sellers: there is no excess demand or excess supply at the market
2.4 Shocking the Equilibrium Comparative Statics • The equilibrium changes if a shock occurs so that one of the variables we were holding constant
changes causing a shift in either the demand curve or the supply curve.
• Comparative statics is the method economists use to analyze how variables controlled by consumers
and firms – here, price and quantity – react to a change in environmental variables (also called
exogenous variables) that they do not control.
o Such environmental variables include the prices of substitutes, the prices of substitutes and
complements, the income level of consumers, and the prices of inputs.
o An equilibrium at a point in time from before the change – to a static equilibrium after the
A. Comparative Statics with Discrete (relatively large) changes
a. An increase in a price of a factor causes a shift of the supply curve and a movement along the
B. Comparative Statics with Small Changes
a. Use algebra
C. Why the Shapes of Demand and Supply Curves Matter
a. The shapes and position of the demand and supply curves determine by how much a shock
affects the equilibrium price and quantity.
• Elasticity is the percentage change in one variable in response to a given percentage change in
another variable holding other relevant variables constant.
percentagechange∈quantitydemanded ∆Q/Q dQ p
o E = percentagechange∈price = ∆ p/p = dpQ
A. Demand Elasticity
a. Price elasticity of demand is the percentage change in the quantity demanded, Q, in response
to a given percentage change in the price, p, at a particular point on the demand curve.
b. Elasticities along the demand curve
i. On downward sloping liner demand curves that are neither vertical nor horizontal, the
higher the price, the more negative the elasticity of demand. Even though the slope of
the linear demand curve is constant, the elasticity varies along the curve.
ii. At a point where the elasticity of demand is zero, the demand curve is said to be
iii. A point along the demand curve where the elasticity is between 0 and -1 is inelastic.
iv. A midpoint of the linear demand curve is unitary elasticity. v. At prices higher than at the midpoint of the demand curve, the elasticity of demand is
less than negative one E < -1 and this is elastic.
vi. As the price rises, the elasticity gets more and more negative, approaching negative
infinity – perfectly elastic.
vii. Constant – elasticity demand curve the elasticity is the same at every point along the
viii. If the price increases even slightly above p*, demand falls to zero.
ix. Why would a demand curve be horizontal? One reason is that consumers view one good
as identical to another good and do not care which one they buy.
x. A demand curve is vertical for essential goods – goods that people feel they must have
and will pay anything to get.
c. Other Demand Elasticities
i. As people’s incomes increase, their demand curves for products shift. If a demand curve
shifts to the right, a larger quantity is demanded at any given price. If instead the
demand curve shifts to the left, a smaller quantity is demanded at any given price.
ii. Income elasticity of demand is the % change in the quantity demanded in response to
a given % change in income Y.
iii. Goods that consumers view as necessities, such as food, have income elasticities near
zero. Goods that they consider to be luxuries generally have income elasticites greater
iv. Cross-price elasticity of demand is the % change in the quantity demanded in
response to a given % change in the price of another good, p . 0
change∈priceof another good
2. When the cross-price elasticity is negative, the goods are complements.
3. If the cross-price elasticity is positive, the goods are substitutes.
B. Supply Elasticity
a. Price elasticity of supply is the % change in the quantity supplied in response to a given %
change in the price.
b. The key distinction is that the elasticity of supply describes the movement along the supply
curve as price changes, whereas the elasticity of demand describes the movement along the
demand curve as price changes. c. At a point on a supply curve where the elasticity of supply is n = 0, we say that they supply
curve is perfectly inelastic. If 01 the supply curve is
elastic. If n is infinite, the supply curve is perfectly elastic.
d. A supply curve that is vertical at a quantity, Q*, is perfectly inelastic.
e. A supply curve that is horizontal at a price is perfectly, p*, elastic.
C. Long run Vs. Short Run – how long it takes consumers or firms to adjust for a particular good.
a. Demand Elasticites over Time
i. The ease of substitution and storage opportunities.
ii. The short-run demand elasticity for goods that can be stored easily may be more elastic
than the long-run ones.
b. Supply Elasticities over time
i. We would expect a firm’s long-run supply elasticity to be greater than it is in the short
2.7 Quantity Supplied Need Not Equal Quantity Demanded
• We defined the quantity supplied as the amount firms want to sell at a given price, holding constant
other factors that affect supply, such as the price of inputs.
• We defined the quantity demanded as the quantity that consumers want to buy at a given price, if other
factors that affect demand are held constant.
• The quantity that firms want to sell and the quantity that consumers want to buy at a given price need
not equal the actual quantity that is bought and sold.
• If we had defined supplied as the amount firms actually sell at a given price and the quantity demanded
as the amount consumers actually buy, supply would have to equal demand in all markets because we
defined the quantity demanded and the quantity supplied as the same quantity.
• The gov’t may set a price ceiling at p bar so that the price at which goods are sold may be no higher
than p bar. When the gov’t sets a price floor at p bar, the price at which goods are sold may not fall
below p bar.
A. Price Ceiling
a. Legally limits the amount that can be charged for a product.
b. It does not affect market outcomes if it is set above the equilibrium price that would be charged
in the absence of the price control.
c. Were it not for the price controls, market forces would drive up the market price to p ,2where the
excess demand would be eliminated.
d. The gov’t’s price ceiling prevents the adjustment from occurring, which causes a shortage, or
persistent excess demand. e. The supply-and-demand model predicts that a binding price control results in equilibrium with a
f. Without a price control, consumers facing a shortage would try to get more output by offering to
pay more, or firms would raise their prices.
B. Price Floor
a. Example – minimum wage. If the minimum wage binds – exceeds the equilibrium wage, w* - the
minimum wage caused unemployment, which is a persistent excess supply of labor.
2.8 When to use the supply and demand model
• A perfectly competitive market is one in which all firms and consumers are price takers: no market
participant can affect the market price.
o There are a large # of buyers and sellers.
o All firms produce identical products
o All market participants have full information about prices and product characteristics.
o Transaction costs are negligible.
o Firms can easily enter and exit the market.
• When there are many firms and consumers in a market, no single firm or consumer is a large enough
part of the market to affect the price.
• If there is only one seller of a good or service – a monopoly – that seller is a price setter and can affect
the market price.
o Because demand curves slope downward, a monopoly can increase the price it receives by
reducing the amount of a good it supplies.
• Firms are also price setters in an oligopoly – a market with only a small # of firms – or in markets in
which they sell differentiated products, and consumers prefer one product to another.
o Only the supply-and-demand model does not apply to markets with a small # of sellers or
• Transaction costs – the expenses, over and above the price of the product, of finding a trading
partner and making a trade for the product.
Chapter 3: A Consumer’s Constrained Choice
• Individual tastes or preferences determine the amount of pleasure people derive from the goods and
services they consume.
• Consumers face constraints, or limits, on their choices.
• Consumers maximize their well-being or pleasure from consumption subject to the budget and other
constraints they face. • Consumers buy the goods that give them the most pleasure, subject to the constraints that they cannot
spend more money than they have and that they cannot spend it in ways that the gov’t prevents.
A. Properties of Consumer Preferences
a. Consumer chooses between bundles of goods by ranking them. A>B, B>C, so A>C.
b. Completeness: possibility that the consumer cannot decide which bundle is preferable.
c. Transitivity: The consumer has well-defined preferences between any pair of alternatives –
d. More is better: A good is a commodity for which more is preferred to less, at least at some levels
of consumption. Bad is something for which less is preferred to more, such as pollution.
B. Preference Maps
C. Indifference Curves
a. Indifference curve – the set of all bundles of goods that a consumer views as being equally
b. Indifference map – a complete set of indifference curves that summarize a consumer’s tastes.
c. Each indifference curve in an indifference map consists of bundles of goods that provide the
same utility or well-being for a consumer, but the level of well-being differs from one curve to
i. Bundles on indifference curves farther from the origin are preferred to those on
indifference curves closer to the origin.
ii. There is an indifference curve through every possible bundle.
iii. Indifference curves cannot cross.
iv. Indifference curves slope downward.
v. Indifference curves cannot be thick.
3.2 Utility – is a set of numerical values that reflect the relative rankings of various bundles of goods.
A. Utility Function – is the relationship between utility measures and every possible bundle of goods.
B. Ordinal Preferences
a. If we know only consumers’ relative rankings of bundles but not how much more they prefer one
bundle to another, our measure of pleasure is an ordinal measure rather than a cardinal
b. An ordinal measure is one that tells us the relative ranking of two things but does not tell us how
much more one rank is valued than another.
c. A cardinal measure is one by which absolute comparisons between ranks may be made. ($) C. Utility and Indifference Curves
a. An indifference curve consists of all those bundles that correspond to a particular utility
D. Willingness to Substitute Between Goods
a. Depends on the slope of the indifference curve at the consumer’s initial bundle of goods.
b. Marginal rate of substitution – the slope at a point on an indifference curve. It is the maximum
amount of one good that a consumer will sacrifice (trade) to obtain one more unit of another
c. Marginal utility – the extra utility that a consumer gets from consuming the last unit of a good.
d. MRS = = -
E. Curvature of Indifference Curve
a. MRS varies along the indifference curve.
b. Because the indifference curve is convex to the origin, as we move down and to the right along
the indifference curve, the MRS (the slope of the indifference curve) becomes smaller in
c. Diminishing marginal rate of substitution – the MRS approaches zero – becomes flatter or less
d. Straight line:
i. Perfect substitutes – goods that a consumer is completely indifferent as to which to
ii. Slope can be any constant rate.
e. Right Angle:
i. Perfect complements – goods that a consumer is interested in consuming only in fixed
f. Convex Curve:
i. Shows that a consumer views two goods as imperfect substitutes.
3.3 Budget Constraint
• Budget line or budget constraint – the bundles of goods that can be bought if a consumer’s
entire budget is spend on those goods at given prices.
• The slope of the budge line the marginal rate of transformation (MRT) – the trade-off the market
imposes on the consumer in terms of the amount of one good the consumer must give up to obtain
more of the other good.
3.4 Constrained Consumer Choice • Consumers maximize their well-being subject to their budget constraints.
• We have to determine the bundle of goods that maximizes an individual’s well-being subject to the
person’s budget constraint.
A. The Consumer’s Optimal Bundle
a. We want to determine which bundle within the opportunity set gives the consumer the highest
level of utility.
b. Bundles that lie on indifference curves above the constraint, are not in opportunity set.
c. For any bundle inside the constraint there is another bundle on the constraint with more of at
least one of the two goods and hence she prefers that bundle.
d. The optimal bundle – the consumer’s optimum – must lie on the budget line and be on an
indifference curve that does not cross it.
i. The interior solution, in which the optimal bundle has positive quantities of both goods
and lies between the ends of the budget line.
ii. Corner solution, occurs when the optimal bundle is at one end of the budget line, where
the budget line forms a corner with one of the axes.
e. Optimal Bundles on Convex Sections of Indifference Curves
i. If indifference curves are smooth, optimal bundles lie either on convex sections of
indifference curves or at the point where the budget constraint hits an axis.
ii. Consumers with straight-line indifference curves buy only the cheapest good. If
consumers are to buy more than a single good, indifference curves must have convex
f. Buying where more is better
i. We do not observe consumers optimizing their well-being at bundles where indifference
curves are concave or that consumers are satiated.
ii. Indifference curves are convex and that consumers prefer more less in the ranges of
goods that we actually observe.
B. Maximizing utility subject to a constraint using calculus.
a. See Class Notes
C. Minimizing Expenditure
a. The rule for minimizing expenditure while achieving a given level of utility is to choose the
lowers expenditure such that the budget line touches – is tangent to – the relevant indifference
b. Maximizing utility subject to a budget constraint or minimizing the expenditure subject to
maintaining a given level of utility – yields the same optimal values. c. Expenditure function – the relationship showing the minimal expenditures necessary to
achieve a specific utility level for a given set of prices.
3.5 Behavioral Economics – adds insights from psychology and empirical research on human cognition
and emotional biases to the rational economic model to better predict economic decision making.
A. Tests of Transitivity
B. Endowment Effect – which occurs when people place a higher value on a good if they own it than they
do if they are considering buying it.
a. Rather than rely on income to buy some mix of two goods, an individual who was endowed with
several units of one good could sell some of them and use that money to buy units of another
a. People are more likely to consider information if it is presented in a way that grabs their
attention or if it takes relatively little thought or calculation to understand.
b. Bounded rationality – people have a limited capacity to anticipate, solve complex problems, or
enumerate all options.
Chapter 4: Demand
4.1 Deriving Demand Curves
• An increase in the price of a good – holding people’s tastes, their incomes, and the prices of other
goods constant – causes a movement along the demand curve for the good.
A. System of Demand Equations
a. Constant Elasticity of Substitution
i. Depends on both goods’ prices and the consumer’s income
i. Depends on consumer’s income and each good’s own price, but no on the price of the
c. Perfect Substitutes
i. Demand curves depend on the consumer’s income and the prices of both goods if the
goods are perfect substitutes.
B. Graphical Interpretation.
a. See Notes
4.2 Effects of an Increase in Income
• An increase in an individual’s income, holding tastes and prices constant, causes a shift of the demand
curve. • An increase in income causes a parallel shift of the budget constraint away from the origin, prompting a
consumer to choose a new optimal bundle with more of some or all of the goods.
A. How Income Changes Shift Demand Curves
a. See Class Notes
B. Consumer Theory and Income Elastic ties
a. Income elasticities tell us how much the quantity demanded of a product changes as income
b. Income Elasticity
i. Is the % change in the quantity demanded of a product in response to a given % change
ii. change∈income = ∆Y
iii. Normal good – if more of it is demanded as income rises.
iv. Inferior good – if less of it is demanded as income rises.
c. Income-consumption curves and income elasticites
i. The shape of the income-consumption curve for two goods tells us the sign of their
income elasticities: whether the income elasticites for those goods are positive or
4.3 Effects of a Price Increase
• Substitution effect – the change in the quantity of a good that a consumer demands when the good’s
price rises, holding other prices and the consumer’s utility constant.
o If the consumer’s utility is held constant as the price of a good increases, the consumer
substitutes other goods that are now relatively cheaper for this now more expensive good.
• Income effect – the change in the quantity of a good a consumer demands because of a change in
income, holding prices constant.
o An increase in price reduces a consumer’s buying power, effectively reducing the consumer’s
income or opportunity set and causing the consumer to buy less of at least some goods.
o A doubling of the price of all the goods the consumer buys is equivalent to a drop in the
consumer’s income to half its original level.
o Even a rise in the price of only one good reduces a consumer’s ability to buy the same amount
of all goods previously purchased.
A. Income and Substitution Effects with a Normal Good a. Total effect = substitution effect + income effect
b. The substitution effect is the change in the quantity demanded from a compensated change in
c. The income effect is the change in the quantity of a good a consumer demands because of a
change in income, holding prices constant.
d. The total effect from the price change is the sum of the substitution and income effects, as the
e. Because indifference curves are convex to the origin, the substitution effect is unambiguous:
less of a good is consumed when its price rises.
f. A consumer always substitutes a less-expensive good for a more expensive one, if we hold the
consumer’s utility constant.
g. The substitution effect causes a movement along an indifference curve.
h. The income effect causes a shift to another indifference curve due to a change in the
consumer’s opportunity set.
i. The direction of the income effect depends on the income elasticity.
B. Income and Substitution Effects with an Inferior Good
a. If a good is inferior, the income effect and the substitution effect move in opposite directions.
b. For most inferior goods, the income effect is smaller than the substitution effect. So the total
effect moves in the same direction as the substitution effect, but the total effect is smaller
c. Giffen good – is a decrease in its price causes the quantity demanded to fall.
i. The demand for a giffen good has an upward slope.
C. Compensated Demand Curve
a. We can derive a compensated demand curve, which shows how the quantity demanded
changes as the price rises, holding utility constant, so that the change in the quantity demanded
reflects only the pure substitution effect form a price change.
4.4 Cost-of-Living Adjustment
• Which raise prices or incomes in proportion to an index of inflation
A. Inflation Indexes
a. Prices of most goods rise over time. The increase in the overall price level inflation.
b. The actual price of a good is called the nominal price.
c. The price adjusted for inflation is the real price.
d. Gov’t measure the cost of a standard bundle of goods, or market basket, to compare prices over
time.(Consumer Price Index) – tells us how prices rose on average. i. Each month, the gov’t reports how much it costs to buy the bundle of goods that an
average consumer purchased in a base year. We can determine how much the overall
price level has increased.
ii. Example: CPI for 2010 / CPI for 1955 x price of good = __________
B. Effects of Inflation Adjustments
a. A CPI adjustment of prices in a long-term contract overcompensates for inflation
b. CPI Adjustment
c. True Cost of living adjustment
i. An inflation index that holds utility constant over time.
d. Size of the CPI Substitution Bias
i. CPI has an upward bias in the sense that an individual’s utility rises if we increase the
person’s income by the same percentage by which the CPI rises.
ii. There is not substitution bias if all prices increases at the same rate so that relative
prices remain constant.
4.5 Revealed Preference
• If we observe a consumer’s choice at many different prices and income levels, we can derive the
consumer’s indifference curves using the theory of revealed preference.
A. Recovering Preferences
a. A consumer chooses the best bundle that the consumer can afford.
B. Substitution Effect is negative
a. This result stems from utility maximization, given that indifference curves are convex to the
b. The theory of revealed preference provides an alternative justification without appealing to
unobservable indifference curves or utility functions.
Chapter 5: Consumer Welfare and Policy Analysis
5.1 Consumer Welfare
• Want to know how much consumers are helped or harmed by shocks that affect the equilibrium price
and quantity of goods and services.
• Price change when new inventions reduce costs or when a gov’t imposes a tax on subsidy. Quantities
change when a gov’t sets a quota. To determine how these changes affect consumers, we need a
measure of consumers’ welfare. If we knew that levels of utility associated with the original indifference
curve at the new indifference curve, we could measure the impact of the tax in terms of the change in
the consumer’s utility level.
• We measure consumer welfare in terms of dollars. • Consumer welfare from a good is the benefit a consumer gets from consuming that good in excess of
• Consumer surplus is easy to calculate using the uncompensated demand function and is a good, but
not exact, measure of the true value of a consumer’s welfare.
A. Willingness to Pay
a. The inverse demand curve reflects a consumer’s marginal willingness to pay: the maximum
amount of consumer will spend for an extra unit.
b. The consumer’s marginal willingness to pay for a product is the marginal value the consumer
places buying one more unit.
c. Consumer surplus: the monetary difference between the maximum amount that a consumer is
willing to pay for the quantity of the good purchased and what the good actually costs.
i. It’s the dollar-value measure of the extra pleasure the consumer receives from the
transaction beyond its price.
d. Measuring consumer surplus
i. Marginal willingness to pay minus what you pay to obtain the good.
ii. The extra value that a consumer gets from buying the desired # of units of a good in
excess of the amount paid
iii. The amount that a consumer would be willing to pay for the right to buy as many units as
desired as the specified price, and
iv. The area under the consumer’s inverse demand curve and above the market price up to
the quantity of the product the consumer buys.
v. Market surplus is the area under the market inverse demand curve above the market
price up to the quantity consumers buy.
vi. Individual and market consumer surplus are practical and convenient measures of
e. Effect of a price change on consumer surplus
i. If the price of a good rises, purchasers of that good lose consumer surplus.
5.2 Expenditure Function and Consumer Welfare
• Our desired consumer surplus measure is the income that we would need to give a consumer to offset
the harm of an increase in price.
• An uncompensated demand curve, as the price rises, the change in the quantity that the consumer
buys reflects both a substitution and an income effect.
• A compensated demand curve is constructed to answer the question of how much less of a product a
consumer would purchase in response to a price increase if the consumer is given extra income to
offset the price increase so as to hold the consumer’s utility constant. Along a compensated demand curve, as the price rises, the change in the quantity demanded by the consumer reflects a pure
• Compensating variation (CV) – is the amount of money one would have to give a consumer to offset
completely the harm from a price increase – to keep the consumer on the original indifference curve.
• Equivalent variation (EV) – is the amount of money one would have to take from a consumer to harm
the consumer by as much as the price increase. Moves to a lower indifference curve.
A. Indifference Curve Analysis
a. Compensating Variation
i. The amount of money that would fully compensate.
b. Equivalent Variation
i. The amount of income that would lower utility by the same amount as the price increase.
c. The key distinction between these 2 measures is that the equivalent variation is calculated by
using the new, lower utility level, whereas the compensating variation is based on the original
B. Comparing the 3 welfare measures
a. If the good is a normal good |CV| > |∆CS| > |EV|
b. If the good is an inferior good |CV|< |∆CS| < |EV|
c. The smaller the income elasticity or the smaller the budget share, the closer the substitution
elasticity is to the total elasticity, and the closer the compensated and uncompensated demand
curves are. The smaller the income elasticity or budget share, the closer the 3 welfare
measures are to each other.
5.3 Market Consumer Surplus
A. Loss of Market consumer surplus from a higher price
B. Markets in which Consumer Surplus Losses are Large
a. As the price of a good increases, consumer surplus falls the greater the initial revenue spent on the
good and the less elastic the demand curve at the equilibrium
b. The effect of a price change depends on both revenue and the demand elasticity.
5.4 Effects of Gov’t Policies on Consumer Welfare
• If the gov’t imposes a quota, which reduces the # of units that a consumer buys, or provides a
consumer with a certain amount of a good (such as food), the gov’t creates a kink in the consumer’s
• If the gov’t subsidizes the price of a good (such as a child care subsidy) or provides cash to the
consumer, it causes a rotation or a parallel shift of the budget line.
A. Quotas a. Consumer’s welfare is reduced if they cannot buy as many units of a good as they want.
B. Food Stamps
a. May not be sold, though a black market for them exists.
b. Why cash is preferred to food stamps
i. Poor people who receive cash have more choices than those who receive a comparable
amount of food stamps.
ii. Only food can be obtained with food stamps.
c. Why we give food stamps
i. They fear that cash might be spend on booze or drugs.
d. Child care
5.5 Deriving labor supply curves
A. Labor-Leisure Choice
a. People choose between working to earn money to buy goods and services and consuming leisure:
all their time spent not working for pay.
C. Income and Substitution Effects
a. An increase in the wage causes both income and substitution effects, which alter an individual’s
demand for leisure and supply of hours worked.
b. When leisure is a normal good, the substitution and income effects work in opposite directions.
c. Leisure as a inferior good, both substitution effect and income effect would work in the same
D. Shape of the labor supply curve
E. Income Tax Rates and the Labor Supply Curve
a. We can tell from the shape of the labor supply curve whether an increase eint he income tax
rate – a % of earnings – will cause a substantial reduction in the hours of work.
Chapter 6: Firms and Production
• A decision must be made as to how a firm is owned and managed.
• The firms must decide how to produce
• If a firm wants to expand output, it must decide how to do so in the short run and the long run.
• Given its ability change its output level, a firm must decide how large to grow.
• Economic theory explains how firms make decisions about production processes, types of inputs to
use, and the volume of output to produce. 6.1 The Ownership and Management of Firms
• A firm is an organization that converts inputs such as labor, materials, and capital into outputs, the
goods and services that it sells.
A. Private, Public and Nonprofit Firms
a. The private sector (for-profit private sector) consists of firms owned by individuals or other non-
governmental entities and whose owners try to earn a profit. Contributes the most to the gross
b. The public sector consists of firms and organizations that are owned by gov’ts or gov’t agencies.
The gov’t produces less than 1/5 of the total GDP in most developed countries.
c. The not-for-profit sector consists of organizations that are neither gov’t owned nor intended to
earn a profit. Organizations in this sector typically pursue social or public interest objectives.
B. The Ownership of For-Profit Firms
a. The legal structure of a firm determines who is liable for its debts.
b. Sole-proprietorship: are firms owned by a single individual who is personally liable for the firm’s
c. General partnership: (partnerships) are businesses jointly owned and controlled by two or
more people who are personally liable for the firm’s debts. The owners operate under a
partnership agreement. If any partner leaves, the partnership agreement ends and a new
partnerships agreement is created if the firm is to continue operations.
d. Corporation: are owned by shareholders in proportion to the # of shares or amount of stock they
hold. The owners are not personally liable for the firm’s debts; they have limited liability: The
personal assets of corporate owner4s cannot be taken to pay a corporation’s debts even if it
goes into bankruptcy. The most that the shareholders can lose is the amount they paid for their
i. The purpose of limiting liability was to allow firms to raise funds and grow beyond what
was possible when owners risked personal assets on any firm in which they invested.
ii. Large firms tend to be corporations, whereas smaller firms are often sole proprietor
C. The Management of Firms
a. In a small firm, the owner usually manages the firm’s operations. In larger firms, typically
corporations and larger partnerships, a manager or a management team usually runs the
b. What is in the best interest of the owners may not be in the best interest of managers or other
i. The owner replaces the manager if the manager pursues personal objectives rather than
the firm’s objectives. ii. In a corporation, the board of directors is responsible for ensuring that the manager
stays on track.
D. What Owners Want
a. Economists usually assume that a firm’s owners try to maximize profit.
b. A firms profit ∏ is the difference between its revenue, R, which is what it earns from selling a
good, and its cost, C, which is what it pays for labor, materials and other inputs
i. ∏ = R – C
c. Revenue is p, the price, times q, the firms quantity
i. R = pq
d. A firm engages in efficient production (achieve technological efficiency) if it cannot produce
its current level of output with fewer inputs, given its existing knowledge about technology and
how to organize production.
i. A firm produces efficiently if, given the quantity of inputs used, no more output can be
produced using existing knowledge.
ii. If a firm does not produce efficiently, it cannot maximize its profit – so efficient production
is necessary condition for maximizing profit.
iii. It will not maximize its profit if that output level is too high or too low or if it uses an
excessively expensive production process.
iv. Efficient production alone is not a sufficient condition to ensure that a firm’s profit is
• A firm uses a technology or production process to transform input or factors of production into outputs.
o Capital Services (K): Use of long-lived inputs such as land, buildings (such as factories and
stores), and equipment (such as machines and trucks).
o Labor services (L): Hours of work provided by managers, skilled workers (such as architects,
economists, engineers, and plumbers), and less skilled workers (such as custodians,
construction laborers, and assembly-line workers).
o Materials (M): Natural resources and raw goods (such as oil, water, and wheat) are processed
products (such as aluminum, plastic, paper and steel) are typically consumed in producing, or
incorporated in making, the final product.
A. Production Functions
a. Firms can transform inputs into outputs in many different ways.
b. The various ways that a firm can transform inputs into outputs are summarized in the production
function: the relationship between the quantities of inputs used and the maximum quantity of
output that can be produced, given current knowledge about technology and organization. a. q = f(L, K)
b. q = units of output
c. L = units of labor services
d. K = units of capital
i. The production function shows only the maximum amount of output that can be
produced from given levels of labor and capital, because the production function
includes efficient production processes only.
B. Time and the Variability of Inputs
a. A firm can more easily adjust its input in the long run than in the short run.
i. A firm can vary the amount of materials and relatively unskilled labor it uses
comparatively quickly, but it takes more time to find and hire skilled workers, order new
equipment, or build a new manufacturing plant.
ii. The more time a firm has to adjust its inputs, the more factors of production it can alter.
iii. The short run is a period of time so brief that at least one factor or production cannot be
1. A factor that a firm cannot vary practically in the short run is called a fixed input.
2. Variable input is a factor of production whose quantity the firm can change
readily during the relevant time period.
iv. The long run is a long enough period of time that all inputs can be varied.
1. There are no fixed inputs in the long run – all factors of production are variable
v. The time it takes for all inputs to be variable depends on the factors a firm uses.
6.3 Short-Run Production: One Variable and One Fixed Input
• In the short-run, we assume that capital is a fixed input and that labor is a variable input, so the firm can
increase output only by increasing the amount of labor it uses.
o q = f(L, Kbar)
o q = output
o utL = workers
o Kbar = fixed # of units of capital
• The short-run production function is also referred to as the total product of labor – the amount of
output (or total product) that a given amount of labor can produce holding the quantity of other inputs
fixed. • Marginal product of labor (MP ) L is the change in total output resulting from using an extra unit of
labor, holding other factors (capital) constant.
∂q ∂f (L,K)
o MP =L ∂L = ∂L
• Average product of labor (AP ) L is the ratio of output to the # of workers used to produce that output
o AP L
A. Interpretation of Graphs
• As the # of workers rises further, output may not increase by as much per worker because workers