Micro Economics

Overview

Read this unit as one connected argument rather than nine separate topics. The consumer chooses to maximise utility subject to a budget; the firm chooses inputs to minimise cost for a given output or to maximise profit given prices; the market aggregates those choices into demand and supply; equilibrium prices reconcile them. When a result changes as you move from one market structure to another, ask which assumption changed: the number of sellers, product differentiation, freedom of entry, or information. When a welfare claim is made, ask whether it is about efficiency, about distribution, or about both, because the two require different criteria. Keep three habits throughout: draw the diagram before writing the algebra, check second-order conditions and corner solutions as well as interior ones, and test every conclusion by asking what happens if an assumption fails. Those habits turn memorised results into reasoning you can reproduce under examination pressure, and they are what distinguish a good answer from a list of definitions.

Theory of consumer behaviour

Consumer theory starts from preferences over bundles of goods. Preferences are assumed to be complete, transitive and, usually, convex, which means the consumer can rank bundles, rankings are consistent, and averages are preferred to extremes. Preferences are represented by a utility function, but only ordinal utility matters for most demand results: any increasing transformation of the utility function represents the same preferences, because what matters is the ranking, not the size of utility numbers. Indifference curves join bundles that give equal utility. They slope downward, because giving up one good must be compensated by more of another to hold utility constant, and they are convex to the origin when marginal rate of substitution diminishes, meaning the consumer gives up less and less of one good to gain an extra unit of another as consumption of that good rises. The budget constraint shows what the consumer can afford: expenditure on goods cannot exceed income, and its slope is the price ratio.

Theory of production and costs

Production theory describes how inputs become output through a production function. In the short run at least one input, typically capital, is fixed, while labour varies; in the long run all inputs vary. Total product rises with the variable input, marginal product is the extra output from one more unit of input, and average product is output per unit of input. The law of variable proportions says marginal product first rises, then falls as more of the variable input is applied to a fixed input, and eventually can become negative. Marginal product crosses average product at its maximum: when marginal exceeds average, average rises; when marginal is below average, average falls. Returns to scale describe the long run: doubling all inputs more than doubles output under increasing returns, exactly doubles it under constant returns, and less than doubles it under decreasing returns, with causes including specialisation, indivisibilities and managerial limits.

Decision making under uncertainty and risk

Many economic choices involve risk: outcomes are uncertain, but probabilities can be assigned. A lottery is a set of outcomes with associated probabilities. Expected value is the probability-weighted average of outcomes, but expected value alone does not describe choice, because people care about the distribution of outcomes, not only its mean. Expected utility theory says a decision maker ranks lotteries by the expected value of a utility function defined over outcomes, not by the utility of the expected value. This distinction is the whole theory. A risk-averse person has a concave utility function, so marginal utility of wealth declines, and the utility of a certain amount exceeds the expected utility of a gamble with the same expected value. Such a person will pay a risk premium to avoid risk and will buy full insurance at an actuarially fair premium, where the premium equals expected loss. A risk-neutral person has a linear utility function and cares only about expected value, while a risk-loving person has a convex utility function and prefers the gamble.

Game theory: non-cooperative games

Game theory studies strategic interaction: situations where each player's payoff depends on the actions of others, so a player must anticipate rivals when choosing. A non-cooperative game is described by players, strategies available to each, and payoffs for every combination of strategies. The normal form displays this as a matrix; the extensive form displays it as a tree showing the order of moves and information at each decision point. A dominant strategy is best whatever others do, and if every player has one, the dominant strategy equilibrium follows immediately. More often, dominance must be applied iteratively, deleting strictly dominated strategies round by round. The central solution concept is Nash equilibrium: a combination of strategies where no player can gain by unilaterally changing strategy, given the strategies of others. Every finite game has at least one Nash equilibrium if mixed strategies, randomisation over pure strategies, are allowed.

Market structures and equilibria

Market structure is defined by the number and size of firms, product differentiation, barriers to entry and exit, and information. Perfect competition has many small firms selling an identical product with free entry and perfect information. Each firm is a price taker facing a horizontal demand curve at the market price, so marginal revenue equals price. Profit maximisation requires marginal revenue equal to marginal cost, hence price equals marginal cost. In the short run a firm may earn profit or loss, but it shuts down if price falls below average variable cost, because then it loses more by operating than by closing. In the long run free entry and exit drive economic profit to zero: price equals minimum long-run average cost, firms produce at efficient scale, and the outcome is both productively and allocatively efficient. A monopoly has a single seller protected by barriers such as control of a resource, economies of scale, patents or legal restrictions.

Factor pricing

Factor pricing applies demand and supply to inputs: labour, capital, land and entrepreneurship. In a competitive product and factor market, a profit-maximising firm hires labour up to the point where the wage equals the value of marginal product of labour, the marginal product multiplied by product price. This gives the firm's labour demand curve, which slopes downward because marginal product diminishes. Market labour demand aggregates firm demands, and labour supply reflects workers trading off income against leisure. A rise in the wage has a substitution effect, encouraging work over leisure, and an income effect, encouraging leisure as a normal good, so the individual labour supply curve can bend backward at high wages. In an imperfectly competitive product market, the relevant concept is marginal revenue product, marginal product multiplied by marginal revenue, which is lower than value of marginal product, so the firm hires less at any wage.

General equilibrium analysis

Partial equilibrium studies one market holding other prices fixed; general equilibrium studies all markets simultaneously, asking whether a set of prices exists at which every market clears and what properties that allocation has. In an exchange economy with two consumers and two goods, the Edgeworth box represents all feasible allocations, with each consumer's origin at opposite corners. Indifference curves of the two consumers are drawn in the same box, and the contract curve joins all points where their indifference curves are tangent, so no mutually beneficial trade remains. Those points are Pareto efficient for the exchange economy: neither consumer can be made better off without making the other worse off. The core is the set of Pareto efficient allocations that no coalition can block by trading among itself. Walras law states that the sum of excess demands across all markets, valued at current prices, is zero, so if all but one market clear, the last must clear too. This is why general equilibrium analysis can focus on relative prices: only relative prices matter, and one price can be normalised.

Efficiency criteria and welfare economics

Welfare economics judges allocations, not just describes them. Pareto efficiency is the weakest standard: an allocation is Pareto optimal if no one can be made better off without making someone else worse off. The Pareto criterion itself can only rank a change as an improvement if it harms no one, which rules out almost all real policies that create both winners and losers. Compensation criteria were designed to handle that case. The Kaldor-Hicks criterion calls a change an improvement if winners could in principle compensate losers and still remain better off, whether or not compensation is actually paid. The Scitovsky criterion adds the reverse test to avoid contradictions where a change and its reversal both pass, and the double test requires passing in both directions. These criteria smuggle in a distributional judgement whenever compensation is hypothetical, because a change that passes Kaldor-Hicks can still leave losers worse off in fact, and should be described honestly as a potential rather than an actual Pareto improvement.

Asymmetric information

Asymmetric information means one party to a transaction knows more than the other, and it can undermine markets that would work perfectly with symmetric information. Adverse selection is hidden information before a contract is signed: the party with private information selects into the contract in a way that harms the uninformed party. The market for used cars illustrates the logic: sellers know quality, buyers do not, so buyers offer a price reflecting average quality, owners of good cars withdraw, average quality falls, price falls further, and in the extreme only the worst cars remain, a market unraveling. Insurance markets show the same pattern: high-risk individuals are more likely to buy cover at a pooled premium, raising claims and premiums, which drives low-risk individuals out. Credit markets respond with rationing rather than ever higher interest rates, because higher rates worsen the borrower pool and encourage riskier projects. Moral hazard is hidden action after a contract is signed: an insured party takes less care, or a borrower takes more risk, because the cost of bad outcomes is borne by someone else.

Market structures compared

Income and substitution effects when price falls

Welfare criteria compared