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Slide 01
Microeconomics
- The Economics of Everyday Decisions
- How individuals, firms, and markets allocate scarce resources -- and why the price of everything matters.
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Slide 02
What Is Microeconomics?
- Microeconomics studies the behavior of individual economic agents -- consumers, workers, firms, and investors -- and how their decisions interact through markets to determine prices, quantities, and resource allocation.
- Micro vs. Macro
- Microeconomics asks: Why does a cup of coffee cost $5? Why do software engineers earn more than teachers? How does Uber set surge pricing?
- Macroeconomics asks: Why is unemployment at 4%? Why is inflation rising? What should the Fed do with interest rates?
- Core Assumptions
- Scarcity: Resources are limited; choices involve trade-offs
- Rationality: Agents pursue their self-interest (utility/profit maximization)
- Equilibrium: Markets tend toward a state where supply equals demand
- Ceteris paribus: Analyze one variable at a time, holding others constant
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Slide 03
Supply and Demand: The Foundation
- The most powerful model in economics, proposed by Alfred Marshall in 1890.
- The Law of Demand
- As price rises, quantity demanded falls (and vice versa), holding all else equal. This reflects diminishing marginal utility: the 5th slice of pizza is worth less to you than the 1st.
- Demand curve slopes downward (negative relationship between P and Q).
- The Law of Supply
- As price rises, quantity supplied increases. Higher prices incentivize producers to allocate more resources toward production. This reflects increasing marginal cost.
- Supply curve slopes upward (positive relationship between P and Q).
- Equilibrium: Qd(P*) = Qs(P*)
- The equilibrium price (P*) is where the quantity consumers want to buy exactly equals the quantity producers want to sell. Any other price creates either a surplus (P > P*) or a shortage (P 3 / 23
Slide 04
Shifts vs. Movements
- A critical distinction that trips up every introductory student.
- Movement Along a Curve
- Caused by a change in the good's own price. If coffee goes from $4 to $5, you move along the existing demand curve to a lower quantity demanded. The curve itself does not move.
- Shift of the Entire Curve
- Caused by changes in other factors. Demand shifts when income, preferences, prices of substitutes/complements, or expectations change. Supply shifts when input costs, technology, regulations, or number of producers change.
- Example: A viral TikTok video popularizes matcha lattes. This shifts the demand curve for matcha rightward -- at every price, more people want matcha. The equilibrium price and quantity both rise. This is a demand shift, not a movement along the curve.
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Slide 05
Elasticity: How Responsive Are Markets?
- Elasticity measures the percentage change in one variable in response to a percentage change in another.
- Price Elasticity of Demand = %ΔQd / %ΔP
- Type|E|MeaningExamples
- Perfectly Inelastic0Quantity does not respond to priceInsulin for diabetics
- Inelastic0 < |E| < 1Quantity changes less than priceGasoline, salt, cigarettes
- Unit Elastic1Quantity changes proportionallyTheoretical benchmark
- Elastic|E| > 1Quantity changes more than priceLuxury goods, restaurant meals
- Perfectly Elastic∞Any price increase kills all demandCommodities at world price
- Key insight: When demand is inelastic, raising the price increases total revenue. When elastic, raising the price decreases total revenue. This is why governments tax cigarettes (inelastic) rather than restaurant meals (elastic).
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Slide 06
Consumer Theory: Utility Maximization
- How do consumers decide what to buy? The utility model says they maximize satisfaction subject to their budget.
- Budget Constraint
- If you have $100/week for food and entertainment, every dollar spent on sushi is a dollar not spent on movies. The budget line shows all affordable combinations.
- PxX + PyY = M
- Where M = income, P = prices, X and Y = quantities of goods.
- Indifference Curves
- Each curve connects all bundles of goods that give equal satisfaction. Higher curves = more utility. Curves are convex (reflecting diminishing marginal rate of substitution) and never cross.
- Optimal choice: The bundle where the budget line is tangent to the highest indifference curve. At this point, the marginal rate of substitution equals the price ratio.
- MRS = MUx/MUy = Px/Py
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Slide 07
Income and Substitution Effects
- When a price changes, two distinct forces affect consumer behavior.
- Substitution Effect
- When the price of good X falls, X becomes relatively cheaper compared to other goods. Consumers substitute toward X, buying more of it. This effect always moves opposite to the price change.
- Income Effect
- When the price of X falls, your real purchasing power increases -- you can afford more of everything. For normal goods, this reinforces the substitution effect. For inferior goods (like instant noodles), it works against it.
- Giffen Goods: A theoretical curiosity where the income effect overwhelms the substitution effect. During the 1845 Irish Famine, as potato prices rose, the poorest consumers actually bought more potatoes because the price increase made them too poor to afford meat, forcing them to substitute toward the cheaper staple. Jensen and Miller confirmed this with rice in Hunan province (2008).
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Slide 08
Production and Costs
- Firms transform inputs (labor, capital, materials) into outputs. The production function describes this relationship.
- Short Run vs. Long Run
- In the short run, at least one input is fixed (e.g., factory size). Only variable costs change with output. In the long run, all inputs are variable -- firms can build new plants, enter or exit the industry.
- Diminishing Returns
- As you add more of one input (holding others fixed), the marginal product eventually falls. The 10th worker in a small kitchen adds less output than the 3rd. This is a short-run phenomenon, not a law about technology improving.
- Cost ConceptFormulaMeaning
- Total Cost (TC)FC + VCAll costs of production
- Average Total Cost (ATC)TC / QCost per unit
- Marginal Cost (MC)ΔTC / ΔQCost of one more unit
- Average Variable Cost (AVC)VC / QVariable cost per unit
- Key relationship: MC intersects ATC and AVC at their minimum points. When MC ATC, they are rising.
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Slide 09
Perfect Competition
- The benchmark market structure against which all others are compared.
- Conditions
- Many small buyers and sellers
- Homogeneous (identical) product
- Perfect information
- Free entry and exit
- No firm can influence the market price (price takers)
- Real-world approximations: wheat farming, foreign exchange markets, some commodity markets.
- Profit Maximization
- The firm produces where MR = MC (marginal revenue equals marginal cost). In perfect competition, MR = P (the market price), so the rule becomes P = MC.
- Short-run: firms can earn positive, zero, or negative economic profit. Long-run: free entry/exit drives economic profit to zero. If profit > 0, new firms enter until price falls to min ATC.
- Long-Run Equilibrium: P = MC = min ATC → Economic Profit = 0
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Slide 10
Monopoly: One Seller Dominates
- A single firm controls the entire market supply. The monopolist is a price maker, not a price taker.
- Sources of Monopoly Power
- Legal barriers: Patents (pharmaceuticals), government franchises (utilities)
- Natural monopoly: Economies of scale so large that one firm serves the market more cheaply than two (power grids, water systems)
- Control of key resource: De Beers and diamonds (historically)
- Network effects: The more users, the more valuable the platform (Google search)
- The Monopoly Problem
- A monopolist maximizes profit where MR = MC, but MR
- Price is higher than under competition
- Quantity is lower
- A deadweight loss triangle represents destroyed surplus -- transactions that would benefit both buyer and seller but do not occur
- Example: A patented cancer drug costs $2 to produce but sells for $200. The monopolist captures enormous producer surplus, but some patients who would pay $50 (well above MC) go untreated. That gap is deadweight loss.
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Slide 11
Price Discrimination
- Charging different prices to different consumers for the same product, based on willingness to pay.
- 1st Degree
- Perfect price discrimination. Charge each consumer their maximum willingness to pay. Captures all consumer surplus. Theoretically eliminates deadweight loss but is nearly impossible in practice.
- Closest real example: car dealerships negotiating individual prices.
- 2nd Degree
- Quantity discounts. Different prices per unit for different quantities. Costco bulk pricing, software licensing tiers, airline fare classes. Consumers self-select into categories.
- Example: Spotify Free vs. Premium ($0 vs. $10.99/month).
- 3rd Degree
- Group pricing. Different prices for identifiable groups with different elasticities. Student discounts, senior pricing, regional pricing for software. Most common form.
- Example: movie tickets -- $15 adult, $10 student, $8 senior.
- Price discrimination requires: (1) market power, (2) ability to segment consumers, and (3) prevention of resale (arbitrage).
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Slide 12
Oligopoly and Game Theory
- When a few large firms dominate a market, each firm's decisions depend on what it expects rivals to do. This is the domain of game theory.
- The Prisoner's Dilemma
- Two firms choosing whether to set high or low prices:
- Firm B: High PFirm B: Low P
- Firm A: High PBoth earn $10MA: $2M, B: $15M
- Firm A: Low PA: $15M, B: $2MBoth earn $5M
- Nash Equilibrium: Both choose Low Price ($5M each), even though both would prefer High Price ($10M each). Individual rationality produces collective irrationality.
- Real-World Oligopolies
- Airlines: 4 carriers control 80% of US domestic flights
- Wireless: AT&T, Verizon, T-Mobile hold 98% of US subscribers
- Tech: Google (92% search), Apple/Google (99% mobile OS)
- OPEC: Cartel of oil-producing nations attempting to coordinate output to keep prices high
- Collusion (explicit price-fixing) is illegal under antitrust law. But tacit coordination -- matching competitors' prices without explicit agreement -- is legal and common.
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Slide 13
Monopolistic Competition
- The most common market structure in everyday life: many firms selling differentiated products.
- Characteristics
- Many sellers (but not as many as perfect competition)
- Differentiated products (branding, quality, location)
- Some price-setting power (downward-sloping demand)
- Free entry and exit in the long run
- Examples: restaurants, clothing brands, hair salons, craft breweries, coffee shops.
- Long-Run Outcome
- Free entry eliminates economic profit, just as in perfect competition. But unlike perfect competition, firms produce at a point where ATC is not minimized -- there is excess capacity.
- The trade-off: consumers pay slightly higher prices but gain product variety and innovation. Is having 47 varieties of toothpaste wasteful or wonderful? Economists disagree.
- "The monopolistically competitive firm is like a small monopolist -- a monopolist in its own niche." -- Edward Chamberlin, "The Theory of Monopolistic Competition" (1933)
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Slide 14
Labor Markets
- In labor markets, firms demand labor and workers supply it. Your wage is (approximately) the value of what you produce.
- Marginal Revenue Product
- A profit-maximizing firm hires workers until the marginal revenue product of labor (MRPL) equals the wage (W).
- MRPL = MPL × MR = W
- If an additional worker produces 10 widgets/hour and each widget sells for $5, that worker's MRP is $50/hour. The firm will hire this worker only if the wage is at or below $50/hour.
- Why Wages Differ
- Human capital: Education and training increase productivity (college premium: ~80% in the US)
- Compensating differentials: Dangerous or unpleasant jobs pay more (oil rig workers, sewage engineers)
- Discrimination: Gender and racial wage gaps persist even after controlling for qualifications
- Monopsony: When one employer dominates (e.g., single hospital in a rural area), wages are depressed below MRP
- Winner-take-all markets: Small talent differences yield huge pay gaps (athletes, CEOs, tech founders)
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Slide 15
Market Failure: Externalities
- Markets fail when the price does not reflect the full social cost or benefit of an activity.
- Negative Externalities
- A cost imposed on third parties not involved in the transaction. The market overproduces the good because producers do not bear the full cost.
- Factory pollution affecting downstream communities
- Cigarette smoke harming bystanders
- Carbon emissions driving climate change
- Antibiotic overuse creating resistant bacteria
- Positive Externalities
- A benefit enjoyed by third parties. The market underproduces the good because consumers do not capture the full social benefit.
- Vaccination (herd immunity protects unvaccinated)
- Education (more-educated citizens generate economic growth, lower crime)
- R&D (knowledge spillovers to other firms)
- Beekeeping (pollination benefits nearby farmers)
- Social Cost = Private Cost + External Cost
- Pigouvian taxes (taxing negative externalities) or subsidies (for positive ones) can align private incentives with social welfare. The carbon tax is the textbook Pigouvian solution to climate change.
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Slide 16
The Coase Theorem
- Ronald Coase (1960) proposed a radical alternative to government intervention for externalities.
- "If property rights are well-defined and transaction costs are sufficiently low, private bargaining will lead to an efficient allocation of resources regardless of the initial assignment of property rights." -- Ronald Coase, "The Problem of Social Cost" (1960)
- Classic Example: A factory pollutes a river, harming a fishery. Coase argued that if the factory and fishery can bargain costlessly, they will reach an efficient outcome regardless of who holds the legal right. If the fishery has the right to clean water, the factory will pay to pollute only if the value of production exceeds the damage. If the factory has the right to pollute, the fishery will pay the factory to reduce emissions only if the fish are worth more than the factory's output.
- The catch: Transaction costs are rarely zero. When thousands of people are affected (air pollution, climate change), bargaining is impractical. This is why Coasean solutions work for neighbor disputes but not for global externalities.
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Slide 17
Public Goods and the Free-Rider Problem
- Defining Public Goods
- ExcludableNon-Excludable
- RivalPrivate goods (food, clothing)Common resources (fish in the ocean)
- Non-RivalClub goods (cable TV, toll roads)Public goods (national defense, lighthouses)
- The Free-Rider Problem
- Because public goods are non-excludable, individuals can enjoy the benefit without paying. Rational self-interest leads everyone to free-ride, so the good is undersupplied by the market.
- National defense is the classic example: you cannot exclude non-paying citizens from protection. Private markets will not provide it efficiently; government provision (funded by taxes) is the standard solution.
- Tragedy of the Commons: Garrett Hardin (1968) showed that common resources (non-excludable but rival) are overexploited. Each fisherman has an incentive to catch one more fish, but collectively they deplete the stock. Solutions: privatization, regulation, or community governance (Elinor Ostrom won the 2009 Nobel for documenting the latter).
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Slide 18
Information Asymmetry
- When one party in a transaction knows more than the other, markets can break down entirely.
- Adverse Selection
- George Akerlof's "Market for Lemons" (1970, Nobel 2001): In the used car market, sellers know whether their car is a "peach" or a "lemon," but buyers cannot tell. Buyers offer a price reflecting average quality, which drives good-car sellers out. The market "unravels" until only lemons remain.
- Insurance: Sick people are more likely to buy health insurance. If insurers cannot distinguish risk levels, premiums rise, healthy people drop out, and the pool worsens -- the "death spiral."
- Moral Hazard
- After a transaction, one party changes behavior because they do not bear the full consequences. Having fire insurance may make you less careful about fire prevention. Having a bailout guarantee may make banks take excessive risks.
- Solutions: Deductibles, co-pays, monitoring, performance pay, warranties, and regulations all attempt to realign incentives when information is asymmetric.
- Michael Spence (Nobel 2001) showed that education can serve as a "signal" -- even if college teaches nothing useful, completing a degree signals discipline and ability to employers.
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Slide 19
Behavioral Economics: When Rationality Fails
- Starting in the 1970s, Daniel Kahneman and Amos Tversky documented systematic deviations from rational choice theory.
- Loss Aversion
- Losses hurt roughly twice as much as equivalent gains feel good. People reject a 50-50 gamble to win $110 or lose $100, even though the expected value is positive ($5).
- Anchoring
- Initial information disproportionately influences judgment. Showing a "was $200, now $100" tag makes $100 feel like a bargain, even if the item was never worth $200.
- Present Bias
- People overweight immediate rewards versus future ones. This explains why we under-save for retirement, overeat, and procrastinate -- even when we know better.
- Nudge Theory (Thaler & Sunstein, 2008): Instead of mandating behavior, design "choice architectures" that make good decisions the default. Auto-enrollment in 401(k) plans increased participation from 49% to 86% at one firm.
- Kahneman won the Nobel in Economics in 2002; Thaler in 2017. Neither is an economist by training -- Kahneman is a psychologist.
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Slide 20
Welfare Economics and Efficiency
- How do economists evaluate whether a market outcome is "good"?
- Consumer and Producer Surplus
- Consumer surplus: The difference between what consumers are willing to pay and what they actually pay. Graphically, the area below the demand curve and above the price.
- Producer surplus: The difference between the price received and the minimum price producers would accept. Area above the supply curve and below the price.
- Total surplus = CS + PS is maximized at the competitive equilibrium.
- Pareto Efficiency
- An allocation is Pareto efficient if no one can be made better off without making someone else worse off. The First Welfare Theorem states that competitive equilibria are Pareto efficient (under certain conditions).
- Limitation: Pareto efficiency says nothing about fairness. An economy where one person owns everything and everyone else starves can be Pareto efficient -- you cannot help the poor without taking from the rich.
- "Efficiency is about the size of the pie. Equity is about how the pie is divided. Economics can tell you about the first; it can only illuminate the trade-offs of the second." -- Arthur Okun, "Equality and Efficiency: The Big Tradeoff" (1975)
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Slide 21
Government Intervention: Taxes, Subsidies, and Price Controls
- Taxes
- A tax creates a wedge between the price buyers pay and sellers receive. The tax burden falls more heavily on the side with more inelastic demand/supply. A $1 tax on cigarettes is mostly paid by consumers (inelastic demand), regardless of whether the law places the tax on buyers or sellers.
- Deadweight loss: Every tax (except on perfectly inelastic goods) reduces total surplus by discouraging some mutually beneficial trades.
- Price Controls
- Price ceiling (max price, e.g., rent control): If set below equilibrium, creates a shortage. NYC rent control has contributed to a vacancy rate below 3% while neighboring uncontrolled buildings have higher rents.
- Price floor (min price, e.g., minimum wage): If set above equilibrium, creates a surplus (unemployment). Debate rages: Card & Krueger (1994) found modest minimum wage increases did not reduce employment in NJ fast food -- challenging the simple textbook model.
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Slide 22
International Trade and Comparative Advantage
- David Ricardo's 1817 insight remains the most powerful argument for free trade.
- Ricardo's Example: England is better at making cloth; Portugal is better at making wine. Even if Portugal were better at both (absolute advantage), trade is still mutually beneficial if each country specializes in the good where its opportunity cost is lower (comparative advantage). Portugal gives up less wine to make cloth, so it should specialize in wine and trade for cloth.
- Gains from Trade
- Specialization increases total output
- Consumers access cheaper goods and greater variety
- Competition drives innovation
- Economies of scale in export industries
- Costs of Trade
- Workers in import-competing industries lose jobs
- Income inequality may widen (Stolper-Samuelson theorem)
- Adjustment costs are real and can last decades
- The "China Shock" (Autor, Dorn, Hanson 2013): US communities exposed to Chinese imports suffered persistent job losses
- Trade creates net gains but also losers. The political challenge is compensating the losers -- something economists recommend but governments rarely do adequately.
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Slide 23
Why Microeconomics Matters
- Every policy debate -- healthcare, climate, housing, tech regulation, minimum wage -- is ultimately a question about how markets work, when they fail, and what to do about it. Microeconomics provides the analytical toolkit.
- Nobel Prizes for microeconomic theory since 2000
- $16T
- Estimated annual US GDP shaped by micro-level decisions
- ∞
- Trade-offs you will face in your lifetime
- "Economics is the study of mankind in the ordinary business of life." -- Alfred Marshall, "Principles of Economics" (1890)
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