Key Concepts in Microeconomics: Consumer Theory and Market Welfare

Posted on Dec 10, 2025 in Economics

Four Properties

1.
Higher indifference curves are preferred to lower ones.
2. Indifference curves cannot cross
3. Indifference curves are downward sloping.
4. Indifference curves are bowed inward –convexity-

Tangency Condition


MRS = P1 / P2 ​

Consumer’s Optimal Choice


MU1 / MU2 = P1 / P2 ​

Proportionality Rule


MU1 / P1 = MU2 / P2 ​

Perfect Substitutes:


Indifference curves are straight lines. Optimal choice is at one extreme (all of one good).

Perfect Complements:


Indifference curves are L-shaped. Optimal choice is on the diagonal (fixed proportions).

Income-Consumption Curve (ICC):


Shows how consumption of two goods changes as income changes (prices constant).

Engel Curve:


Shows how quantity of one good changes with income.

Normal Goods:


Quantity ↑ when income ↑.

Inferior Goods:


Quantity ↓ when income ↑.

Substitution Effect (SE):


Change in consumption due to relative price change (utility constant).

Income Effect (IE):


Change in consumption due to change in real income (purchasing power).


CS:


0.5×(Maximum Price−PE​)×QE​ 

PS:


0.5​×(PE​−Minimum Price)×QE

Price Ceiling (When the bar is low): It creates a shortage​ and it also implies some DWL. 

For a tax or tariff:

– DWL is the triangle formed between the old equilibrium quantity and the new quantity after the tax.


– Formula

DWL=0.5×(Tax or Tariff)×(Reduction in Quantity)



Reduction in quantity: ΔQ=QE​−Qnew

For price controls (ceiling or floor):

 – DWL = area of triangle between demand and supply at controlled price.

– DWL=0.5×(Quantity difference)×(Price difference)

Consumer Burden:


Extra amount consumers pay compared to before tax:
Consumer Burden=(PC−PE)×Qnew

Producer Burden:


Loss for producers compared to before tax:
Producer Burden=(PE−PP)×Qnew
Consumer Burden+Producer Burden=Tax Revenue

Where:


Tax Revenue=Tax per unit×Qnew


  • Efficiency vs Equity:


    Efficiency = it takes all opportunities to make some people better off without making other people worse off. ;
    Equity = fairness in resource distribution.

  • Income Distribution:

    Measured using Lorenz curve and Gini coefficient.

  • Lorenz Curve:

    Graph showing cumulative income share vs population share.

  • Gini Coefficient:


    Ratio of area between equality line and Lorenz curve to total area below the line (0 = equality, 1 = inequality).

  • Utilitarianism:

    Maximize total welfare, not necessarily equal distribution.

  • Rawls’ Criterion:

    MAXIMIN principle—maximize welfare of the least advantaged.

  • Income Redistributive Policies:

    Taxes and welfare spending to reduce inequality.

  • Public Sector Role:

    Correct market failures and promote fairness.

  • Typology of Goods:

    Classified by excludability and rivalry (private, public, common, club goods).

  • Free-Rider Problem:

    Non-excludable goods lead to under-provision without government intervention.

  • Externalities:

    Costs or benefits imposed on others without compensation (negative or positive).

  • Pigouvian Tax/Subsidy:

    Tax to reduce negative externalities;
    Subsidy to encourage positive ones.

  • Coase Theorem:

    Private bargaining can solve externalities if property rights and low transaction costs exist.