Essential Microeconomics Concepts & Market Structures
Understanding Core Microeconomics Principles
Microeconomics focuses on individual decision-makers and their interactions within an economy. The central challenge is the economizing problem: how to allocate scarce resources to best satisfy unlimited wants. This always involves a clear goal, specific constraints, and the necessity of making choices.
Fundamental Economic Concepts
- People Face Tradeoffs: Decisions require giving up one thing for another.
- Opportunity Cost: The value of the next best alternative that must be forgone when making a choice.
- Marginal Analysis: Decisions are made by comparing the additional benefits and additional costs of a choice.
Positive vs. Normative Economics
- Positive Economics: Describes “what is”; statements that can be verified or disproven.
- Normative Economics: Describes “what ought to be”; statements that involve value judgments and cannot be empirically tested.
Four Factors of Production
- Labor
- Land
- Capital
- Entrepreneurship
Production Possibilities Frontier (PPF)
The Production Possibilities Frontier (PPF) illustrates the maximum possible output combinations of two goods or services an economy can achieve when all resources are fully and efficiently employed. Points on the frontier are productively efficient and clearly demonstrate the concepts of tradeoffs and opportunity cost.
Characteristics of a Market System
- Freedom of Enterprise and Choice
- Private Property Rights
- Self-Interest as a Driving Force
- Competition Among Buyers and Sellers
- Prices as a Guiding Mechanism for Resource Allocation
Key Economic Laws
Law of Diminishing Marginal Utility
The Law of Diminishing Marginal Utility states that as additional units of a good are consumed, the additional satisfaction (utility) derived from each subsequent unit tends to decline.
Law of Diminishing Returns
The Law of Diminishing Returns asserts that as additional units of a variable resource are added to fixed amounts of other resources, the extra output (marginal product) will eventually decline.
Market Dynamics: Demand and Supply
Determinants of Demand (Demand Shifters)
- Tastes and Preferences of Consumers
- Income of Consumers (Normal vs. Inferior Goods)
- Prices of Related Goods (Substitutes and Complements)
- Number of Buyers in the Market
- Expectations of Future Prices or Incomes
Determinants of Supply (Supply Shifters)
- Resource Costs (Input Prices)
- Taxes and Subsidies
- Number of Sellers in the Market
- Technology
- Expectations of Future Prices
Market Equilibrium and Price Controls
- Shortage: A situation where quantity demanded exceeds quantity supplied at a given price.
- Surplus: A situation where quantity supplied exceeds quantity demanded at a given price.
Price Ceilings
A Price Ceiling is a maximum legal price. If set below the equilibrium price (P*), it creates a shortage. If set above P*, it has no effect.
Price Floors
A Price Floor is a minimum legal price. If set above the equilibrium price (P*), it creates a surplus. If set below P*, it has no effect.
Elasticity
Calculating Elasticity of Demand/Supply
Elasticity is measured as the percentage change in Quantity divided by the percentage change in Price. The midpoint formula is often used for precision:
Elasticity = [(Q2 - Q1) / ((Q2 + Q1) / 2)] / [(P2 - P1) / ((P2 + P1) / 2)]
Determinants of Price Elasticity of Demand
- Availability of Close Substitutes
- Necessity vs. Luxury Status of the Good
- Time Horizon (Short Run vs. Long Run)
- Definition of the Market (Broad vs. Narrow)
Production Costs
Key Cost Definitions
- Marginal Cost (MC): The extra cost incurred from producing one more unit of output.
- Total Cost (TC): The sum of Total Fixed Cost (TFC) and Total Variable Cost (TVC).
- Average Fixed Cost (AFC): Total Fixed Cost (TFC) divided by Quantity (Q).
- Average Variable Cost (AVC): Total Variable Cost (TVC) divided by Quantity (Q).
- Average Total Cost (ATC): Total Cost (TC) divided by Quantity (Q), or AFC + AVC.
Shifters of Cost Curves
- Changes in Resource Prices (both fixed and variable inputs)
- Changes in Technology that increase productivity of all resources (shifts curves downward)
Market Structures
Market structure is determined by:
- The Number of Firms in the Industry
- The Uniqueness or Differentiation of the Product
- The Ease of Entry and Exit for New Firms
Perfectly Competitive Markets
Characteristics:
- Many Sellers and Many Buyers
- Identical (Homogeneous) Product
- Easy Entry and Exit for Firms
In perfect competition, firms are price takers. Their primary goal is to maximize profits, achieved through marginal analysis.
Profit Maximization Rule: Price (P) = Marginal Revenue (MR) = Marginal Cost (MC). A firm should continue to produce even if incurring a loss in the short run, as long as Price is greater than Average Variable Cost (P > AVC).
Monopoly
Characteristics:
- One Single Seller
- The Firm is a Price Maker
- Significant Barriers to Entry (e.g., economies of scale, legal barriers, ownership of essential resources)
A monopolist must lower the price to increase the quantity sold. Output is produced where Marginal Revenue (MR) = Marginal Cost (MC), and the price is then set at the corresponding point on the demand curve.
Potential Benefits of Monopoly:
- Lower average costs can sometimes be achieved due to economies of scale.
- Encourages innovation through protected profits.
Monopolistic Competition
Characteristics:
- Many Firms
- Differentiated Product (each firm has a slight monopoly over its specific product)
- Demand is Fairly Elastic
- Free Entry and Exit for Firms
Ways to Differentiate Products:
- Advertising and Branding
- Customer Service
- Product Quality and Features
- Location
Graphically, monopolistic competition resembles a monopolist, but the demand curve is more elastic. Output is determined where MR=MC. This market structure typically results in neither allocative efficiency (P ≠ MC) nor productive efficiency.
Oligopoly
Characteristics:
- Few Large Producers
- Products can be Identical or Differentiated
- Mutual Interdependence among firms (actions of one firm significantly impact others)
- Significant Barriers to Entry
Obstacles to Collusion (Firms secretly cooperating to fix prices or output):
- Incentive to Cheat on Agreements
- Large Number of Firms (harder to coordinate)
- Differences in Demand or Cost Structures
- Economic Recession (increases incentive to cheat)
- Potential Entry of New Firms
- Antitrust Laws and Regulations
Public and Private Goods
- Public Good: Characterized by non-excludable and non-rival consumption (e.g., lighthouse, national defense).
- Private Good: Characterized by excludable and rival consumption (e.g., candy bar, laptop).
Efficiency and Externalities
Why Perfect Competition is Preferred to Monopoly (3 Reasons)
- Allocative Efficiency: Resources are allocated to produce the goods and services most desired by society (P = MC).
- Productive Efficiency: Goods are produced in the least costly way (P = minimum ATC).
- Freedom of Choice: Consumers have a wider array of choices due to many sellers.
Externalities
Externalities are the impacts of a consumer’s or producer’s action on a third party not directly involved in the transaction. They can be positive or negative, and related to either production or consumption.
Examples of Externalities:
- Negative Production (NP): Pollution from a factory.
- Positive Production (PP): Research and development leading to new technologies.
- Negative Consumption (NC): Secondhand smoke from smoking.
- Positive Consumption (PC): Immunizations preventing the spread of disease.