AP Microeconomics Course Notes

Assets
asset - provides flow of money/services to its owner
• capital gain - increase in value of asset
o unrealized until asset is sold
• capital loss - decrease in value of asset
• risky asset - random monetary flow, could rise or fall
• riskless asset - pays certain monetary flow, such as bonds
o usually grows slower than risky assets
• return - total monetary flow an asset yields
o includes either capital gain/loss as fraction of its price (given in percentages)
o real return - return after taking into account inflation
o investments should grow faster than inflation, or worthless
o higher expected return usually means
investment portfolio - determines how much to invest in each asset
• R = bR1 + (1-b)R2 = R2 + b(R1-R2)

Asymmetric Information, Insurance

buyer information - seller often knows more about good than buyer
medical insurance - insurance companies need to cover their losses
• patients know more about their health than company
• patients with worse health buy insurance >> insurance costs rise >> patients w/ better health no
longer buy insurance >> health companies screwed
o in response, insurance companies offer insurance at companies, to include
healthy/unhealthy patients
o a sort of bundling w/ the job
• moral hazard - those w/ insurance more susceptible to doing risky things

Budget Constraints
budget line - indicates all combinations where total spent is equal to income
• I = P A A + PB B
• slope = negative ratio of prices of 2 goods
• intercepts on the graph represent how much of each good you could buy if you only bought that
certain good
• income change >> changes vertical/horizontal intercepts, not slope
o increase >> shifts outward; decrease >> shifts inward
o income consumption curve positive >> normal good (quantity increases w/ income)
o income consumption curve negative >> inferior good (less desire w/ increased income,
ex. hamburger vs steak)
• price change >> slope change (or none if both prices change by same rate)
o changes intercept of one of the axes (or both of both prices changed)
o may not change consumption of other good
• purchasing power - determined by income and prices
 • original budget line
• possible income changes
• possible price changes
• both price changes could change in such a way that it appears to be an income change (increase
in purchasing power through either income increase or price decrease)
maximizing basket - must fulfill 2 conditions
• (1) located on budget line - can’t go past budget line, can’t leave income unused
o assuming that satisfaction from goods now exceeds saving income for goods later
o can’t spend more, can’t spend less
• (2) must give consumer more preferred combination of goods
o goes w/ the highest indifference curve
• satisfaction maximized where marginal rate of substitution (MRS) equal to ratio of prices
o marginal benefit = marginal cost
o MRS = PA/PB = -∆ B / ∆ A
o if MRS doesn’t equal PA/PB, than utility can be increased
• corner solutions - when 1 good is not consumed at all.
o in this case, MRS doesn’t necessarily equal price ratio (only holds true when positive
quantities of goods are consumed)
o restrictions can change shape of budget line

• most satisfying basket lies on the intersection between the indifference curve offering the highest
good and the budget line
• indifference curves found through utility function
• can use both the budget line formula and given utility function to find most satisfying basket
Bundling, Advertising
bundling - combining 2 or more products in a sale to gain a pricing advantage
• sometimes customers want 1 product but not the other
• conditions for bundling:
 o heterogeneous customers
o can't price discriminate (and profit at the same time)
o demands negatively correlated
• consumers will buy bundle if the cost of the entire bundle is less than the the sum of the amount
they're willing to pay for both goods individually
o ie. if customer is willing to pay $4 for good A and $6 for good B, then as long as the
bundle costs $10 or less, they'll purchase it
o also, this bundle would also appeal to customer willing to pay $1 for good A and $9 for
good B
• best used when customers each really only want 1 of the goods in the package
• examples of bundling: features in cars (sunroof, anything non-standard), hotel w/ airfare,
premium channels
advertising - only done by firms w/ market power
• no point for price takers to make advertisements
• new demand function Q(P,A)
o quantity demanded not a function of price (P) and amount spent on advertising (A)
• profit = PQ(P,A) - C[Q(P,A)] - A
o revenue = price x quantity demanded
o cost = calculated by quantity
o subtract A for amount spent on advertising (another fixed cost)
• if demand price inelastic and advertising effective >> advertise more
o ie. diamond (Kay's jewelers)
Capital Markets
stock vs flow -
• stock - instantaneous amount owned by a firm
o ie. capital
• flow - variable inputs/outputs
o amount needed/used over a time period
• capital, if not used, can gain interest
o firms calculate how much capital in the future is worth today
o determines whether or not it's a good investment
• future flow of income worth less today than at that time
present discounted value (PDV)
• future dollar value = M(1+R)n
o M = amount of capital now
o R = interest rate
o n = time period (usually in years)
• present value = M / (1+R)n
• stream of payment w/ smallest present value is best
bond - contract where borrower (issuer) pays a stream of income to lender (holder)
• gov't could issue bond where they would pay $100 every year for 10 years
o results in $1000 total after 10 years
o but remember that $100 paid before 10 years can still have time to grow
o lender (bondholder) would pay less than that $1000 in the beginning
o that $1000 has present value of: 100/(1+R) + 100/(1+R)2 + ... 100/(1+R)9 + 100/(1+R)10
net present value = -C + profit1/(1+R) + ... + profitn/(1+R)n
• profit can be negative if firm is operating in a loss
 • risk premium paid in form of higher yield for riskier bonds/stocks (ie. tech stocks) and lower
yield for more stable/dependable bonds (ie. gov't bonds)
Competition vs Collusion
game theory - where firms make strategic decisions
• firms try to get the best possible outcome/payoff
• strategy - plan for going through the game
o optimal strategy - gives the best payoff
• noncooperative game - negotiation between firms not possible
o no binding contracts
• cooperative game - firms negotiate, work together
o have binding contract to dictate how they should behave
o pursued in joint interest to help both sides
cooperative collusion - firms don't react to one another
• find the quantity/price at equilibrium where MR=MC
o no need to find reaction curves
• results in less output and higher profits than Cournot equilibrium
o firms not in competition in this case
• competitive equilibrium >> P = MC >> zero profit
• Cournot equilibrium >> reaction curves set equal
• collusion >> MC = MR >> best outcome

• reaction curves
• Q = q1+q2
Consumer Behavior, Market Baskets
market baskets (bundles) - group of goods
• how/why consumers decide how much of each good to buy
• assumptions about preferences - consumers often behave erratically, but assumptions must be
made for models
o completeness - all goods are ranked (either above/below, or tied for a rank)
o transitivity - if A preferred to B and B preferred to C, then A preferred to C
o more > less - consumers always want more for less
indifference curve - all combinations of market baskets providing same satisfaction
• matches up market baskets where there’s more of 1 good and less of another from the preferred
basket
• market baskets above/right of curve is preferred to any basket on curve
• must slope downward (or else violates assumption that more > less)
Consumer Surplus
market demand - sum of individual demands
• more consumers enter market >> market demand curve shifts more to the right
 • factors influence consumer demands >> also affect market demands
• if individual demands are all the same, then market demand is just some multiple of the
individual demands
elasticity of demand = (∆ Q/Q) / (∆ P/P) = (P/Q) (∆ Q/∆ P)
• inelastic >> demand relatively unresponsive to price changes
o for goods that people need, willing to pay more for
o consumers may buy less, but ultimately spend the same or more
• elastic >> demand decreases as price goes up
o consumers will buy/spend less
• isoelastic >> elasticity of demand stays constant
• point elasticity of demand = (P/Q) (1/slope)
o instantaneous price elasticity at some point on the demand curve
• arc elasticity = (Pavg/Qavg) (∆ Q/∆ P)
o elasticity over a range of prices
consumer surplus - difference between what consumer is willing to pay and what consumer actually
pays
• calculated by area between demand curve and market price (triangular shape)

• there will always be consumers willing to pay more than equilibrium market price
• there will always be producers willing to sell for less than equilibrium market price
• as a result, a surplus arises
• price floor changes the amount of surplus
• relatively, it increases the supplier surplus, as compared to before

• consumer is indifferent between baskets A, B, or C, since they lie on the same indifference curve
• A, B, C preferred to basket E, not as preferred as basket D
• baskets on an indifference curve have more of 1 good but less of another when compared to
other baskets on the curve

• indifference map - describes preference for all combinations

o set of indifference curves, can’t intersect
• marginal rate of substitution - max amount of 1 good that consumer is willing to give up for 1
extra unit of another good
o calculated w/ respect to vertical axis
o convex indifference curves >> decreasing marginal rate of substitution

• perfect substitute >> linear line graph >> constant marginal rate of substitution
• if 1 good is the same as another, it doesn't matter how many of each you have
• only the total number matters
 • U=A+B

• perfect complement >> need both to gain satisfaction >> right angle graph
• ex. buying left/right shoes
• it doesn't matter how many right shoes you have if you don't have a left shoe to match
• consumer indifferent between a basket containing 1 right and 1 left shoe and another basket
containing 1 right and 15 left shoes
• U = min(A,B)
utility function - assigns numerical values to market baskets
Cost Function
cost function - relates cost to output level for future prediction
• VC = bQ
o linear function, implies constant marginal cost
• VC = bQ + gQ2
o quadratic function, implies linear marginal cost
• VC = bQ + gQ2 + dQ3
o cubic function, implies quadratic (U-shaped) marginal cost
Cobb-Douglas cost/production function - when production in form Q = AKaLb
• C(Q) = wL(Q) + rK(Q)
o use production function and MRTS to find L and K functions in terms of Q
• MRTS = w/r = MPL / MPK
o w/r = (AbKaLb-1) / (AaKa-1Lb) = (bK) / (aL)
o waL = rbK
o L = (rb)K / (wa)
o K = (wa)L / (rb)
o substitute these back into the production function to find both L and K in terms of Q
o no need to use lagrangian method
• substitute L and K functions back into the initial cost function to get final outcome
• note that in short-run, either K or L will be fixed
o leaves the production function in terms of just K or L and makes it easy to solve
o in finding total cost, don't forget to calculate the fixed cost as well
Economies of Scale/Scope, Learning Curve
economies/diseconomies of scale
• input proportions change >> expansion path no longer a straight line
• firm can double output for less than twice the cost >> economies of scale
• firm needs more than twice the cost to double output >> diseconomies of scale
• EC (cost-output elasticity) = MC/AC
o EC < 1 >> economy of scale
o EC > 1 >> diseconomies of scale
 o EC = 1 >> neither economies or diseconomies of scale
economies/diseconomies of scope
• joint output of single firm is greater than output by 2 separate firms >> economies of scope
• joint output of single firm is less than output by 2 separate firms >> diseconomies of scope
o if production of 1 product conflicted w/ production of 2nd when both produced together
jointly
• SC = [C(Q1) + C(Q2) - C(Q1,Q2)] / C(Q1,Q2)
o measures degree of economies of scope
o SC > 0 >> economies of scope
o SC < 0 >> diseconomies of scope
learning curve - long term introduces new information to increase efficiency
• workers/managers can become better adapted to their jobs, more experienced, more efficient >>
long-term average cost can decrease
• learning curve describes relation between output and amount of inputs needed for each output
β
• L = A + BN-
o N = units of output produced
o L = labor input per output unit
o A, B, β constants (where A, B positive and 0 < β < 1)
o larger β >> more important learning effect
• economies of scale moves along the average cost curve, learning curve shifts the average cost
curve downwards

Effect of Elasticities on Surplus

long-run effects - elasticities can change in the long run
• elasticity - generally the slope of the curves
o will alter the shape of the triangles and areas between the curves and market clearing
price
• change elasticity >> change relative amount of surplus
• demand and supply have same elasticities >> tax split evenly between consumers and producers
o demand grows more elastic >> demand curve gets flatter >> less of tax falls on consumer
o demand grows more inelastic >> demand curve gets steeper >> more of tax falls on
consumer
o same applies for supply curve
 • fraction of tax paid by consumer
• fraction of tax paid by producer

• demand curve gets more elastic

• notice that the equilibrium stays at the same point and tax (pb - ps) remains the same
• everything merely shifts
• fraction of tax paid by consumer now exceeds fraction of tax paid by producer
Elasticity
elasticity - measures how much curves change w/ respect to other curve
• percent change in 1 variable per 1 percent change in other variable, measures sensitivity
• independent to units that price/quantity are measured
• notice that the derivatives are w/ respect to P, not Q
• more elastic >> more reactive to changes
o perfectly elastic >> the smallest change could drive demand to 0
• less elastic >> less reactive to changes
o perfectly inelastic >> consumers willing to pay any price for good (ie drug addiction)
price elasticity of demand - E = %ΔQ / %ΔP = PdQ / QdP = (P/Q) (dQ/dP)
• dQ/dP = partial derivative of Q function w/ respect to P
o for arc elasticity, dQ/dP is a given average change
o normally calculated as point elasticity w/ derivatives
• elasticity of demand - usually negative number
o price increases >> quantity desired decreases, price decreases >> quantity desired
increases
o availability of substitutes - primary determinant of price
o linear demand curve >> elasticity not constant, more elastic up top, near 0 at bottom
• constant elasticity demand function - takes away linear possibility (unrealistic)
o expenditure = Q x P >> d(exp) / dP = Q + P x dQ/dP = Q(1+elasticity)
• income elasticity of demand = I/Q x dQ/dI
 o % that quantity changes w/ % income change
o luxuries = income elastic
o basic necessities = income inelastic
• cross-price elasticity of demand - same as elasticity of demand, but w/ different goods
o negative for complements (ie tires/cars)
o positive for substitutes

• perfectly elastic
• slightest price change will make demand go to 0
• obviously very responsive to price changes

• perfectly inelastic
• demand stays stable for any change in price
• obviously not at all responsive to price changes
Engel Curves
engel - essentially just demand curves, except w/ respect to income
• axes changes to income and just 1 good
• normal good - increased income >> increased consumption
• inferior good - increased income >> decreased consumption
• take demand curve C = (4/5) (I/PC) for instance
o C changes w/ I >> linear relationship
o I is independent variable, C is dependent
o engel curve would be linear line
 • income consumption curve for an inferior good
• consumption of good 1 decreases w/ increasing income by the 3rd budget line >> good 1 is an
inferior good
• consumption of good 2 increases w/ increasing income >> normal good
Income-Substitution Effects
price change effect on consumption - broken down into 2 parts

• prices change >> income, prices both change relatively

• substitution effect - price changes >> relative prices of good changes
o willing to buy more of good that became relatively cheaper
o price change for 1 good relatively effects the other good as well
o utility stays constant, price declines >> demand increases
o causes shift along indifference curve (to point where more of one good bought than
before)
• income effect - price falls >> relative income increases >> increase in real purchasing power
o price held constant (as if income increased), quantity demanded depends on whether
good is inferior/normal
o outward or inward shift to new demand curve
o inferior good >> inward shift >> may or may not overtake substitution effect
o may be large enough to cause demand to slope upward (stop consuming some other good
completely
• substitution effect
• indifference curve
• initial budget line
• new, relative budget line
• though the absolute price of good 2 doesn't change, a price decrease for good 1 makes good 2
relatively more expensive >> new relative budget line
 • income effect
• price decrease for good 1 leads to an overall increase in purchasing power
• new budget line shifts outward from relative budget line found in last step
• negative income effect >> inferior good
• Giffen good - causes demand curve to slope upward due to very large income effect (very rare)
• overall change
• as expected, a price decrease for good 1 leads to more of good 1 and less of good 2 being bought
Intro to Microeconomics
economics - social science studying behavior/interaction
• microeconomics - behavior of individual economic units
o how units interact to form larger units (consumers/owners >> markets/industries)
• about making tradeoffs, choices
• originally about how to allocate resources to increase nation’s wealth (optimization)
• tradeoffs made for best/optimum output (balance between everything)
o use capital or labor? invest in machines or labor?
o lower price >> sell more >> less profit per unit
o higher price >> sell less >> more profit per unit
o making the most out of given limits
• consumer theory - how consumers maximize preferences
o limited income/time, how/when to consume
o job security vs advancement
o labor vs leisure
• producer theory - how firms maximize profits, how/when/what to produce
o statistics/econometrics - tests accuracy of predictions/models
economic variables - stocks vs flows
• flow variables - measured per unit of time (ie income)
o production/consumption - units made/consumed annually
• stock variables - not measured w/ respect to time
o price, wealth, inventories
• expenditure = total price = unit price x consumption
• revenue = unit price x production
• consumption = expenditure / price index
• price index = cost of materials
• nominal price - absolute/current dollar price of good/service when it is sold
• real price - price relative to others in relation to time, corrects for inflation
o consumer price index ( CPI ) - measures aggregate prices altogether, computed from wide
market
o CPI percent changes = rate of inflation
o real price = CPIbase year / CPI current year x nominal price
theories - used to explain observations w/ set of basic rules/assumptions
• used to make predictions
• quality of predictions >> validity of theory
• tested by conducting experiments, comparing data
• imperfect, but gives insight into observations
• models - created from theories
o mathematical representations used to make quantitative predictions
• positive analysis - statements describing cause/effect
o deals w/ explanation/prediction
 • normative analysis - questions what should happen
o tries to find best potential scenario, deals more w/ comparison
Isocost Line
isocost - line showing all combos of labor and capital bought for a given cost
• rental rate - r, given to certain equipment to quantify capital
• C = wL + rK
o MPL/MPK = w/r = MRTS
cost-minimization - finding lowest isocost curve intersecting given isoquant
• found at point of tangency between isoquant and isocost
• expansion path - curve passing through cost minimization points (points of tangency between
isocost and isoquant)
o long-run total cost curve derived from expansion path
o shows combinations of labor/capital that the firm needs at each output level, will increase
if labor/capital increase w/ output
Labor Supply
choice of labor - dependent on utility of leisure and money
• leisure competes w/ income for utility
o wage rate measures price/value of leisure
• u(L,Y)
o L = hours of leisure
o Y = income = wh
o w = wage
o h = hours worked
o L+h = 24
• uL / uY = w at maximum utility
income/substitution
• higher wages >> workers replace hours worked w/ leisure
o substitution effect
o work hours and leisure shift to satisfy initial utility
• higher wages >> workers can purchase more goods
o income effect
o work hours and leisure shift to obtain highest possible utility
• income effect exceeds substitution effect >> backward bending supply curve
*examples to come* monopsony power - only 1 firm to buy up labor (ie. gov't, NASA)
• marginal value (MV) = marginal expenditure (ME)
• monopsonist pays same price for each unit >> average expenditure = supply
Long-Run Output
long-run profit maximization -
• marginal costs change now that firm can adjust more inputs in long run
• economic profit made as long as marginal cost (equal to price) above the average total cost
• zero economic profit - firm earning a normal (competitive) return on investment
o normal return - equal to investing elsewhere (whether in capital or other industry)
• high profit >> other firms enter market (assuming free entry) >> increases output >> drives
down prices >> reduces profit
long-run competitive equilibrium - when no exit/entry
• firms earning zero economic profit >> no incentive to enter or exit
• all firms must be maximizing profit
• quantity supplied by industry equal to quantity demanded by consumers
 • patents act as opportunity cost for firms that have it
o can be sold or kept to produce a positive profit
economic rent - willingness of firms to pay for an input less than the minimum amount
• some firms have natural advantages over others
o land might be beneficial to shipping
o materials might be more readily accessible
• gives firm an edge >> other firms willing to pay for that edge >> economic rent
long-run supply curve - cannot just sum curves like w/ short-run
• in long-run, markets and enter/exit, so no way to tell how many total firms are in the market
• constant-cost industry - horizontal long-run supply curve, very elastic
• unlike short-run, where 1 input held constant, both inputs can vary in the long-run
o use MRTS to relate wages/rent to marginal labor/capital functions (in terms of Q)
o C(Q) = wL(Q) + rK(Q)
• curve generally wider than short-run curve
o MC-MR intersection located farther to the right
Marginal Utility, Consumer Choice
revealed preference - finding preferences based on choices
• instead of making choices based on preferences
• if consumer chooses more expensive basket over another, then chosen market basket is more
preferred
• creates a more defined indifference curve >> more rankings
• changing budget lines >> more defined preference area
marginal utility (MU) - measures additional satisfaction from an additional unit of good
• generally diminishes as more good is consumed
o ex. the 4th or 5th hamburgers aren't quite as satisfying as the 1st
• same utility on all points of indifference curve
• MU increase w/ 1 good >> MU decrease w/ other good
• MUA/MUB = MRS = PA/PB
• marginal utility is same for each good >> utility maximization (equal marginal principle)
• UA / PA = U B / PB
o PA/PB = UA/UB = MRS
o now you can find the MRS even if price isn't given (or is a variable in your calculations
instead of constant)
In buying goods x and y, a consumer has utility function U = 1.5x + 2y and an income of $60, where
good x costs $2, and good y costs $3. Find the MRS and the amount of each the consumer would buy if
he wanted to maximize his utility
• budget constraint >> I = Pxx + Pyy
o 60 = 2x + 3y
• MRS = Ux/Uy
o Uy = 2
o Ux = 1.5
o MRS = 1.5/2 = 0.75
• note that in this case, Px/Py = 2/3, different from the MRS
o this indicates a corner solution, where the maximum amount possible of 1 good is
consumed
• consumer will buy 30 of good x
o gives utility of 45
o buying 20 of good y gives utility of 40
 o no other combination gives a higher utility
cost-of-living indexes - ratio of present cost to past cost
• accounts for inflation, price growth (ie CPI )
• ideal cost-of-living index - cost of a given level of utility now compared to before
• Lasapeyres index - amount of money needed to purchase past market basket now divided by
cost before
o deals w/ purchases as opposed to preferences
o usually overstates true cost-of-living index
o assumes that consumers don’t change consumption patterns
• Paasche index - like Lasapeyres index, but deals w/ current market baskets (opposed to past)
o will understate true cost-of-living index
o assumes that consumers used current habits in the past
• chain-weighted index - unlike fixed-weight index (Laspeyres/Paasche)
o accounts for changes in quantities of goods
Market Equilibrium, Shifts
equilibrium (market-clearing price/quantity) - no shortage/excess demand/supply
• everyone can buy/sell at current price >> intersection of demand/supply curves
• market price above equilibrium >> surplus supply >> inventories pile up
o price must be cut to re-establish equilibrium, make consumers consume, increase demand
• market price below equilibrium >> excess demand >> not enough to go around
o price must go up to re-establish equilibrium (ie reselling hybrid cars) >> arbitrage
• prices determined by relative supply/demand
o comparative static analysis - compares new/old equilibrium
o comparative dynamic analysis - traces changes over time
• raw materials price falls >> suppliers produce more >> surplus >> prices lowered to reach new
equilibrium
o travel down demand curve to new intersection
• income increases >> consumers want to buy more >> shortage >> prices raised to reach new
equilibrium
o travel up supply curve to new intersection
• equilibrium never shifts as much as demand/supply curves
o other curve dampens overall effect
changes in supply/demand - can act together in real world to change equilibrium
• increases in classroom costs >> decrease in supply
• increase in people wanting to go to college >> increase in demand
• demand shifts outward, supply shifts inward >> intersection rises in price more drastically
• w/ curve shifts, curve shape still stays the same
Given equations for the demand and supply curves, set them equal to each other to find the equilibrium
point.
• Given:
o Qsupply = 100 + 5Psupply
o Qdemand = 200 - 20Pdemand
• at equilibrium, Qsupply = Qdemand, and Psupply = Pdemand
• 100 + 5Psupply = 200 - 20Pdemand
o 100 + 5P = 200 - 20P
o 25P = 100
o P=4
o Q = 100 + 5P = 120
 • equilibrium at P=4, Q=120
Monopolistic Price Competition
short-run vs long-run
• few firms in the beginning >> economic profits
• more firms enter in long run >> price = marginal cost
o each firm's output/price decreases
o overall industry output increases
Cournot equilibrium - firms make decision all at the same time
• found at the intersection of the 2 firm's reaction curves
o gives respective quantities produced by the 2 firms (in duopoly case)
• identical firms (identical cost functions) >> same output from each firm
o q1 = q2
o plug into reaction functions to find how much each firm produces
Bertrand model - prices decided by firms simultaneously
• assume the good to be homogeneous
• follows rules of competitive equilibrium
o P = MC
• homogeneous good >> consumer only cares about price
o firm charges too much >> can't sell anything
o will assume that other firms behave the same way >> act as if in a competitive
equilibrium
Monopoly Power
price-maker - monopoly offers only 1 source for a given good
• firms in competitive market take the price of the market
o can't charge higher than market price or else will lose all profit
• monopoly forms the entire supply curve in forming a market equilibrium
• will still maximize profits where MR = MC
• monopoly promotes barriers to entry
o no longer a monopoly if free entry was possible
• average revenue = P(q)
o P(q) given by market demand
o no other competition to decide price
• marginal revenue = d[P(q)q]/dq
equilibrium price
• find quantity that needs to be produced from MR=MC
• plug that quantity into the market demand function to find market price
• multiplant production - monopoly has different plants w/ different production
o use total marginal product to find total quantity that needs to be produced
o use the price (not market price) that corresponds to total quantity and the marginal cost
functions for each individual plant to find how much each will produce
 • demand
• marginal revenue
• marginal cost
• p* = market price
• q = quantity at the intersection of marginal revenue and cost
• MR = P + P(1/Edemand)
• more elastic >> price mark-up decreases (p*-p decreases)
monopolistic competition - products still distinct but possibly substitutes
• ie. soda brands
• product differentiation - firms try to differentiate their product from that of other firms
o otherwise, each firm bound by prices set by other firms
• each firm now faces a different demand curve
Monopsony
single buyer - takes advantage of sellers
• oligopsony - market w/ only a few buyers
• monopsony power - lets buyer pay less than market price for a good
• marginal value - additional benefit from purchasing another good
• marginal expenditure - additional cost from purchasing another good
o E = expenditure = P(q)q
o but P(q) in this case set by supply curve, not demand curve
o AE = avg expenditure = P(q)
• quantity bought found at intersection of demand curve and marginal expenditure
o price found by dropping down to corresponding price on supply curve

• demand
• supply, avg expenditure, P(q)
• marginal expenditure
 • p* = market price
degree of monopsony power - depends on # of buyers, interaction between buyers
• fewer buyers >> supply becomes less elastic >> more monopsony power
• buyers compete less >> more monopsony power
• more elastic supply >> markdown (p-p*) will be less
surplus - works out just opposite of monopoly
• deadweight loss from smaller quantity desired by buyer(s)
• producer surplus lost >> increase in consumer surplus
Multiple Inputs
substition effect - comes into play
• could cause MPRL to shift more than for a single factor
o wage decrease >> more labor demanded >> increases MPK >> firm buys more
machinery >> increases MPL >> firms buys even more labor
• wage rate decrease >> more labor >> more output >> more units of good in the market >> price
would decrease
o wage hardly ever changes w/o affecting market price
input supply - no limit in competitive purchase market
• firms can buy as much of each input as they want at market price
• firm will not affect market price of input
• input supply perfectly elastic >> price (wage/rental) stays constant
Network Externalities
network externalities - when person’s demand depends on someone else’s demands
• positive network externality - to be in style, be like everyone else (bandwagon effect)
o marketing to make good popular (not banking on low costs, good quality)
o makes consumer willing to spend more on good only because others do
o relatively more elastic than neutral network externality
o general urge to match up to standards of everyone else
• consistency - quantity consumed by individual must be on demand curve associated w/ other
consumers’ demands
o forms aggregate demand curve (points of consistency where individual demand matches
demand of others)
o assume that others will behave like you >> personal choices can affect others to make
choices that come full-circle
bandwagon effect - more often for children's toys
• more items initially bought if consumers think a large number of other consumers already have it
• more people buy product >> larger bandwagon effect
• more people own a product >> higher intrinsic value
o firms will produce more goods/services for that particular product
o ex. ipod
• makes market demand more elastic
• individual demand function will have some component proportional to overall market demand
o yindividual = C + kymarket
If the individual demand function is y = 2 - P/30 - Y/30, where P is the price and Y is the market
demand, then find the market demand for 30 consumers.
• Y = 30y in this case
o need to solve for y in terms of P first, and then find Y
• y = 2 - P/30 - Y/30 = 2 - P/30 - (30y)/30 = 2 - P/30 - y
o 2y = 2 - P/30
 o y = 1 - P/60
• Y = 30y = 30(1 - P/60)
o Y = 30 - P/2
snob effect - negative network externality, desire to own exclusive goods
• more people own a product >> no longer unique
• less items initially bought if consumers think a large number of other consumers already have it
• makes market demand less elastic
• individual demand function will also have some component proportional to negative overall
market demand
o yindividual = C - kymarket
Oligopoly
small number of competitors - each has more than negligible effect on the market
• possible product differentiation, barrier to entry (patent, technology, economies of scale)
• decisions based on what competitors are doing
o must decide how to react to competitors' actions
o figure out how own actions will affect competitors' reactions
• equilibrium - all firms doing the best they can >> prices/quantities set
o all firms assume that everyone is taking competitors' actions into account
o nash equilibrium - each competitor doing the best based on what its rivals are doing
Stackelberg equilibrium - leader-follower interaction
• 1 firm makes production decisions before all others
• Q = q1 + q2
• follower's decision depends on what the leader does
o q2 = f(q1) >> reaction function
o follower will seek to maximize profits
• profit maximization where derivative of profit equation equal to 0
o revenue2 = p(Q)q2 = p(q1+q2)q2
o derive w/ respect to q2 in order to solve for reaction function
• leader makes decision based on the follower's reaction function
o revenue1 = p(q1+q2)q1 = p[q1+f(q1)]q1
o derive to find best decision for leader in the market
One Variable Input
firm decisions - based of benefits on incremental or average basis
• total output - can actually decrease after too many workers are employed
o too many workers >> workers get in each others' way, entrepeneurship decreases
• average product of labor (APL) = Q/L
o output per unit of labor
o slope of line from origin to point on total product curve
• marginal product of labor (MPL) = ∆ Q/∆ L
o derivative of the production function w/ respect to labor
o additional output produced w/ increase in labor by 1 unit
• marginal output less than 0 >> decreasing total output
• marginal output less than average output >> decreasing average output
o marginal output intersects average output at max average output
 • graph not drawn to scale
• total output curve
• average product of labor curve
• marginal product of labor curve
• when marginal product curve crosses the x-axis (becomes negative), total output curve reaches a
maximum
• at intersection of marginal product and average product, average product is at a maximum
law of diminishing marginal returns - additions from input to output gradually decrease
• increasing input has more effect on output early on than later
• small labor force >> adding labor affects output considerably
o more workers assigned to specialized tasks, etc
• larger labor force after adding labor >> adding additional labor doesn't affect output as much as
before
o too many workers >> less efficient, more willing to slack
• technology improvements >> shifts total output curve >> increases labor productivity as a whole
o note however, that diminishing marginal returns still exist
o existence of a max total ouput proves existence of diminishing marginal returns
o increasing labor productivity >> increases capital flow >> increases standard of living

Perfectly Competitive Markets

price taking - firms take market price as given
• individual firms sell sufficiently small part of total market output
• firms can't decide what market price is in a perfectly competitive situation
• consumers also act as price takers
• individual decisions do not affect the outcome of the whole
product homogeneity - firms produce nearly identical products
• products essentially perfect substitutes for each other >> very elastic
 • commodities - homogeneous materials such as raw metals, oil, gasoline, vegetables, fruit
o consumers don't really care what specific firm made which
• name brands (ie. Nike, Adidas, Bluebell) not taken into consideration in perfectly competitive
situations
• helps ensure a single market price
free entry/exit - no costs for new firm to enter/exit industry
• lets consumers switch from 1 supplier to another
• firms can enter if it sees profit, exit if losing profit
• medical, high-tech firms not perfectly competitive
o need research, patents, investment (entry costs) to sell in market
• large number of firms or hight elasticity can lead to high competition
profit maximization - price fixed, so cost needs to be minimized
• dominates most decisions w/ small firms
• larger firm >> owners have less contact w/ managers >> managers have more leeway to act on
their own
o managers may be more focused on short-run than long-run
profit - difference between total revenue and total cost
• p(q) = R(q) - C(q)
o R(q) = Pq
o profit maximized where difference between revenue and cost is greatest
• marginal revenue - slope of revenue curve, change in revenue after one-unit increase in output
• MR(q) = MC(q) = P
o marginal gain in revenue equals marginal gain in cost at max profit
• firms in a large market >> face horizontal demand curve
o market demand still downward sloping, but market is so elastic for each firm (price taker)
that individual firms face a different demand curve
o marginal revenue, average revenue, price all equal on demand curve for individual firms
• output rule - if firm produces anything, it should produce at the level where marginal revenue
equals marginal cost

Price Discrimination
capturing consumer surplus - in competitive market, only 1 price set
• some consumers willing to pay more than that set price
• firm would make more money if they could charge people closest to what they're willing to pay
1st degree price discrimination - charging each consumer a different price
• results in no consumer surplus
• each consumer charged exactly what he/she is willing to pay
• marginal revenue no longer comes into play in deciding market price
• aka perfect price discrimination >> clearly no possible
o firms can't possibly know what each person is willing to pay
2nd degree price discrimination - charges different price for different quantities
• willingness to buy decreases as quantity increases
• firms may offer bulk sales at a lower per-unit price
3rd degree price discrimination - divides consumers into groups
• each group gets charged a different price
o ie. movie tickets for children, adults, students, seniors
• marginal revenue should be equal for each group
• MR1 = MR2 = MC
• P1 / P2 = (1+E2) / (1+E1)
 • possible where it's not profitable to sell to a certain group
intertemporal price discrimination - charging different prices at different times
• divides consumers into those who must have the good immediately and those who are willing to
wait (elastic/inelastic division)
• peak-load pricing - increasing prices when marginal costs get higher due to limits in capacity
(ie. electricity during summer, heating during winter)

Price Supports
agricultural policy - US uses price supports to control domestic market
• gov't sets price at level higher than that of free-market
• gov't buys up any excess quantity that consumers don't buy
• consumers must buy goods at higher price than if there was a free-market
• gov't must spend money to buy up excess quantity of goods
o taxes on consumers/public support this, so ultimately the cost falls on the population
o gov't may try to resell the quantity they buy
• producers sell more >> gain more revenue
o benefit w/o loss
• more efficient to just pay the farmers directly
o this method would still force gov't to pay, but consumers wouldn't be affected
• in this method, note that there are essentially 2 consumers (the public and the gov't)
o maximizes the producer surplus by enhancing their market

• consumer surplus decreases by A+B

• producer surplus increases by A+B+C
• government pays B+C+D
• net effect = producer surplus - consumer deficit - gov't cost = (A+B+C) - (A+B) - (B+C+D) =
loss of B+D
• as with most changes, society worse off as a whole

Price/Income Consumption Curves

demand functions - calculated from budget line and utility function
• MRS calculated by partial derivatives of utility or given prices
• usually changes w/ respect to price/income of itself or other good
• only depends on own price >> independent good
• remember that demand functions slope downward
Find the demand functions for food and clothing if a consumer's utility function for the 2 was U =
C0.8F0.2
• budget constraint >> I = PCC + PFF
o C = (I-PFF) / PC
 o F = (I-PCC) / PF
o need to get rid of F to find C demand function
o need to get rid of C to find F demand function
• MRS = UC / UF = PC / PF
o UC = 0.8C-0.2F0.2
o UF = 0.2C0.8F-0.8
o MRS = (0.8C-0.2F0.2) / (0.2C0.8F-0.8) = 4(F/C)
• 4F/C = PC / PF
o 4FPF = CPC
• substitute that back into the budget constraint equations
o C = (I-[CPC/4])/PC = I/PC - C/4
o 5/4 C = I/PC >> C = (4/5) (I/PC)
o F = (I-[4FPF]) / PF = I/PF - 4F
o 5F = I/PF >> F = (1/5) (I/PF)

price-consumption curve
• connects points of equal utility on budget lines formed by changing prices

income-consumption curve
• connects points of equal utility on budget lines formed by changing income

Probability, Expected Value, Variability

measuring risk - must know all possible outcomes, probability of each outcome
• sum of probabilities = 1
• objective interpretation - based on past events/experiments
• subjective interpretation - based on educated guess about future
• expected value, variability >> characterize payoff/risk
• expected income (value) = sum of product of probability and payoffs
o probability of each case can change based on personal skills/tendencies
 o expected values same >> variability not always the same
o E(X) = probability1(X1) + probability2(X2) + ...
• deviations - difference between expected and actual payoff
o based on deviations from the mean
o standard deviation - measures risk, equal to square root of average of squares of
deviations
o Ö(probability1(deviation1)2 + probability2(deviation2)2)
o people generally want less risk

Product Function, Isoquants

factors of production - inputs that firm uses to produce
• mainly divided into labor, materials, capital
o capital - not just money, but also equipment, buildings, machinery
production function - shows highest output for combo of inputs
• Q = F(K,L)
o K = capital, L = labor (materials left out of function for simplicity)
o multiple combinations of K, L can produce any given Q
o function will change w/ technology changes (allowing production to occure more
efficiently)
• possible for firm to produce less than maximum efficiency, but function assumes that firm
produces as much as possible
• inputs, outputs measured as flow variables (changing w/ time)
isoquant - like indifference curve, shows all input combos for a given output
• certain amount of capital can replace labor, and vice versa
• isoquant map - several isoquants combined on a single graph, like an indifference map
• input flexibility - ability to choose different combinations, depending on their situation

short run vs long run - not based on a set amount of time

• different for each firm and situation

• short run - firm can only change a few of its inputs
o firm can increase labor (add hours), buy more materials
o machinery, other tools cannot be changed as quickly
o always a fixed input (unchangeable) in place
• long run - firm can change all inputs
o more time >> more flexibility
Quotas and Tariffs
limiting production - effectively changes the supply curve
• like w/ a price ceiling, limits the available supply
o remember that price floors don't necessarily limit the supply (especially for stupid
companies)
o ie. number of alcohol licenses, New York taxi medallions
• ultimately helps the producers
o sort of like a combination of a price ceiling (limits supply for sure) and price floor (leads
to an additional producer surplus for the most part)

• consumer surplus loses A+B

• producer surplus increases by A, decreases by C
• net change = loss of B+C (deadweight)
import restrictions - either w/ tariff (tax) or quota, serves to help domestic market
• w/o quotas, domestic consumers would buy solely/mostly from abroad instead of domestic
markets
• to keep domestic markets alive, consumer surplus must suffer
• domestic markets want the quota to be 0, or for tariffs to be so high that foreign producers won't
interfere w/ domestic market
o decreases competition, increases price >> increases revenue
o all at the expense of the consumer
• main difference between tariff and quota is that gov't earns money through a tariff and can
channel that to the consumers
o of course, politically, it may be better for the gov't to use quotas than tariffs

• domestic supply curve

 • pw = world (foreign) market price
• p* = market price w/ quota
• p* - pw = tariff that could replace the quota
• Q1 - Q2 = quota, note what happens when this goes to 0
• consumer surplus decreases by A+B+C+D
• domestic producer surplus increases by A
• if gov't used tariffs, it would get back C worth of revenue

• what happens w/ no quota at all

• consumer surplus increases dramatically >> consumption increases
• producer surplus very small, nonexistent if world price less than lowest domestic price

Reducing Risk
diversification - putting resources into different risky situations
• can't lose on all investments
• invesments not too closely correlated >> eliminates some risk
• negatively correlated - good results for 1 investment means bad results for another investment
• positively correlated - investments moving in the same direction, in response to economic
changes
insurance - uses risk premiums
• insurance cost = expected loss
• law of large numbers - aility to avoid risk by operating on a large scale
• if insurance premium = expected payout, then actuarially fair
o insurance companies need to profit >> charge more than expected losses
Dan has a wealth utility function of U = lnw. He currently has $1200, but there's a 1/8 chance that his
car will blow up and he'll lose $1000. However, he could pay insurance 30 cents on the dollar to cover
his potential losses. How much insurance should he pay?
• you want to maximize expected utility
• x = amount he covers w/ insurance
o he'll pay 0.3x for the insurance
• if his car doesn't blow up, he'll have w = 1200 - 0.3x
• if his car does blow up, he'll have w = (1200-1000) - 0.3x + x
o gets back the x amount he covers
o be sure to include the 0.3x amount that he still paid
• EU = (7/8) ln(1200 - 0.3x) + (1/8) ln(200 + 0.7x)
o d(EU)/dx = 0 = (-2.1/8) / (1200 - 0.3x) + (0.7/8) / (200 + 0.7x)
o (2.1/8) / (1200 - 0.3x) = (0.7/8) / (200 + 0.7x)
 o 2.1 / (1200 - 0.3x) = 0.7 / (200 + 0.7x)
o 420 + 1.47x = 840 - 0.21x
o 1.68x = 420
o x = $250
value of complete information - difference between expected value of choice w/ and w/o complete
information
• calculates how much firm would pay for extra information/predictions for sales
• also dependent on whether firm is risk averse/neutral/loving

Risk Preferences
expected utility - sum of utilities of all possible incomes weighted by probability
• E(u) = (probabilty1)(utility1) + (probability2)(utility2)...
• different expected values/risks >> depends on individual
o find utility/happiness obtained by risk
• risk averse - person always prefers given income compared to risky income
o risk >> diminishing marginal utility of income
o 1st earned dollar not as attractive as 2nd
• risk-loving - prefers uncertain income to certain
• no preference between certain/uncertain income >> risk neutral (usually never possible)
o has constant marginal utility of income

• risk averse
• risk loving
• risk neutral
risk premium - max money person willing to give up to avoid risk
• variability increase >> risk premium increase
• difference in value between certain value and expected value at the same utility

• marginal utility
• expected value curve
• expected value
• certain value
• risk premium

Short-Run Output
shut-down rule - firms may continue to produce even when losing money
• firm could expect to earn a profit in the future
• shutting down might be costlier than operating in the red
• product price > average economic cost of production >> firm makes a profit by producing
o assuming no sunk costs, firm should shut down when price of product falls below
average total cost
o w/ sunk costs, firm should only shut down when price of product falls below average
variable cost
firm short-run supply curve - shows how much firm will produce for each price
• supply curve
• part of marginal curve greater than average cost curve
• price changes >> firm changes output so that marginal cost equals price
• higher market price or higher prices for inputs may lead to upward shifts in marginal cost and
market short-run supply curve - sum of all firm supply curves in the market
• overall prices changes can make adding firm supply curves more difficult
o higher prices >> firms expand output >> demand of inputs increase >> prices of inputs
could increase >> firms would then decrease output
o market supply curve might not be as responsive
• Es = (∆ Q/Q) / (∆ P/P)
• perfectly inelastic supply - greater output only possible by building new plants
• perfectly elastic supply - when marginal costs are constant
• producer surplus - difference between revenue and variable cost
o surplus = R - VC = profit + FC

Short-Run, Long-Run Cost

short-run cost - remember that certain inputs are fixed in the short-run

• marginal (incremental) cost - increase in cost from producing another unit of output
o no need to consider fixed cost (just a function added on)
o MC = ∆ (VC)/∆ Q = ∆ C/∆ Q
• average total cost (ATC) - divided into average fixed and variable cost
o average fixed cost = FC/Q, decreases as output increases
o average variable cost = VC/Q
o difference between average total cost and average variable cost decreases as output
increases (since their difference is equal to the average fixed cost)
• MC = w/MPL
o eventually increases as output increases
• marginal cost curve crosses average variable cost and average total cost at their minimum points
long-run cost - firm now allowed to change all its inputs
• costs/prices sometimes amortized (allocated) across the life of the use of the equipment (ie. plane
bought for $200 million but since it's used for 40 years, it's at a cost of $5 million per year)
o also means that the economic value of the plane decreases by $5 million every year (has 0
value after 40 years)
o also note that w/o buying the plane, the firm would've had $150 million that could've
gained money through interest (opportunity cost)
• user cost of capital = economic depreciation + (interest)(value of capital)
o value of capital decreases w/ time
• long-run marginal cost curve intersects long-run average cost at its minimum, just like w/ short-
run equivalents

Short-run vs Long-run, Price Controls

short-run versus long-run
• long run lets consumers/producers fully adjust to price change
• demand - more price elastic in long run
o consumers adjust habits over time
o linked to another good that changes over time, more substitutes available later (knock-
offs, competition)
o short term - durable goods >> consumers hold onto >> no need to replace >> less demand
o no new purchases >> less consumption in short run
o over long term, will still need to be replaced >> more elastic
• supply - percentage change in quantity supplied due to price change
o same concept as demand elasticity
o materials shortage >> bottlenecked production >> low elasticity (capacity constraint)
o easy to get capital/labor/materials >> high elasticity (long run pattern)
o durable goods >> can be refabricated >> smaller long-run elasticity
price controls - price ceiling/minimum set by organization (usually gov’t)
• ceiling below equilibrium >> excess demand
o normally, suppliers would raise money, but can’t in this situation
o could drive price above market price (ceiling) through auction, bribes
• minimum (floor) below equilibrium >> no effect
• ceiling above equilibrium >> no effect
• minimum (floor) above equilibrium >> excess supply
• excess demand - difference in quantity of demand and quantity of supply, calculated at the price
ceiling
 • price ceiling
• equilibrium can't be reached
• at price ceiling, quantity demanded exceeds quantity supplied
• suppliers not allowed to raise prices (legally)

• price floor
• equilibrium can't be reached
• at price floor, quantity supplied exceeds quantity demanded
• suppliers can't lower prices

Single Factor Demand (Labor)

factor market - shows how much the firm demands units of labor (or other factor)
• combines utility, isoquants, and market
• marginal revenue product of labor (MPRL) - additional revenue from the extra output that
would result from hiring another unit of labor
o MPRL = (MR)(MPL)
o in competitive market, MR=P >> MPRL = (P)(MPL)
o will hire more if extra revenue exceeds the cost
o cost = wage = w >> usually constant
 • cost function
• MPRL
• lower cost >> wage shift >> increased demand in labor

Social Costs of Monopoly

demand shifts - will only change price

• quantity produced by monopoly still stays the same
• intersection of MR=MC stays the same
tax effect - increases price by less than tax in a competitive market
• in monopoly, price can sometimes rise higher than the tax
• MC' = MC + tax
o basically, the marginal cost shifts up by a constant

• demand
• marginal revenue
• marginal cost
• marginal cost plus tax
 • p = price before tax
• p* = price after tax, increased by more than the tax
deadweight loss - occurs along w/ consumer surplus loss w/ change to monopoly
• normally in competitive market, price found at intersection of marginal cost and market demand
o price set higher than this in monopoly >> loss of consumer surplus
o less quantity produced >> deadweight loss
• price regulation can get rid of deadweight loss in a monopoly
o sets price minimum in competitive market, sets price maximum in a monopoly market
natural monopoly - has a much more efficient production than other firms
• makes it unprofitable for other firms to even continue production
• possible w/ large economies of scale

Special Cases, Returns to Scale

perfect substitutes - linear isoquants

• isoquants
• constant MRTS
• diminishing MRTS doesn't apply
• not necessarily a one to one exchange though
fixed-proportions production function - like perfect complements in consumer theory

• isoquants
• impossible to make substitutions among inputs (ie. recipes)
• each output requires a specific combo of inputs
• both inputs must be increased to increase output >> limited methods of production
returns to scale - shows how output is increased by input
• increasing returns to scale - output more than doubles when inputs doubled
o for example, Q = KL >> (2K)(2L) = 4KL = 4Q
o common in large scale operations (w/ very specialized operations)
 • constant returns to scale - output doubled when inputs doubled
o for example, Q = K+L >> (2K)+(2L) = 2(K+L) = 2Q
o size of firm doesn't affect productivity
• decreasing returns to scale - output less than doubled when inputs doubled
o for example, Q = (KL)1/3 >> (2K x 2L)1/3 = 41/3Q

Specific Taxes
tax - on a per-unit basis, cost divided between consumer and producer
• subsidy - essentially a negative tax
• treated as an increased cost, this will lead to lower consumption/production

• pb = price that consumers pay

• ps = price that producers receive
• pb - ps = tax
• gov't revenue = A+B
• deadweight loss = C+D
• consumer surplus decreases by A+C
• producer surplus decreases by B+D

subsidies - moves to the other side of the graph (scandalous!)

• ps - pb = subsidy
• note that the ps and pb have switched locations from before
• costs the gov't A+B+C+D+E+F
• consumer surplus increases by D+E
• producer surplus increases by A+B
• net deadweight welfare loss of C+F
Supply and Demand
supply curve - relationship between how much producers willing to sell and price
• price (x) vs quantity (y) graph, axes can be reversed
• what price necessary to get designated quantity? what quantity necessary to get designated price?
• higher price >> firm able/willing to produce more >> slopes upward
• variables affecting supply curves - labor, capital, raw materials
o lower cost of production >> higher profits >> expand output
o supply curve shifts as variables change
o shift not caused by change in price (already part of calculated curve)
o price only changes mov’t up and down the existing curve
demand curve - relationship between how much consumers willing to buy and price
• price decreases >> consumers more willing to buy >> slopes downward
• variables affecting demand curves - income, consumer tastes, price of related/similar goods
o more income >> more willing to buy
o substitutes (knock-offs) - increasing price of one >> increasing consumption of other
o complements - used together >> increasing price of one >> decreasing consumption of
other
• demand curve shifts as w/ supply curve
o income increases >> more quantity bought overall (regardless of price)
o competition lowers prices >> cheaper substitutes >> shifts inward >> less bought

• demand curve
• supply curve
• equilibrium point
• all changes made to move towards equilibrium point
• move towards equilibrium point >> move along curve

• changes in demand curve

 • increased income
• substitutes got more expensive
• complements come free or at reduced price
• decreased income
• substitutes got cheaper
• complements got more expensive

• changes in supply curve

• cost of production (labor/materials/tariffs) increase
• cost of production decrea

Two Variable Inputs

long run - allows for 2 (or more) variable inputs
• diminishing marginal returns shown by drawing horizontal or vertical line through isoquant map
o shows that each increased unit of capital or labor adds less and less to the total output
marginal rate of technical substitution (MRTS) - like MRS for consumers
• amount of capital that can be decreased by an extra unit of labor, for a given output level
• MRTS = -∆ K/∆ L = MPL/MPK
o MP = marginal product (partial derivatives of the production function w/ respect to either
labor L or capital K)
• units of labor decrease the required capital less and less >> diminishing MRTS
o isoquants are convex >> magnitude of the slope decreases (gets more flat) >> ratio of
capital (vertical axis) to labor (horizontal) falls

• isoquant
• equivalent changes in labor lead to less and less change in capital >> diminishing MRTS
Two-part Tariff
entry/usage - consumers charged both an entry fee and a usage fee
• ie. amusement parks, golf course, resorts
• will use entry fee to try to capture as much consumer surplus as possible
• for just 1 consumer, will set usage fee at marginal cost and entry fee to capture all of the
consumer surplus
• for more than 1 consumer:
o will set usage fee higher than marginal cost
o will set entry fee to capture all of consumer surplus of consumer w/ the least demand

Types of Cost
accounting cost - actual expenses, plus depreciation
• more concerned with past performance
• depreciation expenses calculated for capital equipment
• more connected to the IRS than economic cost
economic cost - cost of utilizing all resources in production
• more forward-looking view of the firm
• concerned w/ what cost will be in the future
• associated w/ forgone opportunities, includes opportunity cost
• talks about all the costs/resources that the firm can control/change
opportunity cost - sometimes synonymous w/ economic cost
• unused opportunities treated as costs (since firms not using resources in the most efficient way)
• monetary transaction may be absent, but opportunity still there
o for example, company owns a building or space that it doesn't use. since they could've
have rented it out or sold it, this is an opportunity cost
o for example, store owner doesn't pay herself, but could have or worked for money
elsewhere, so this becomes an opportunity cost
• hidden, but need to be considered in economic decisions
sunk cost - shouldn't be taken into account in economic decisions
• expense that has been made and can't be recovered
o visible and recorded, but shouldn't be considered for decisions
• certain specialized equipment can't be converted to do any other tasks >> sunk cost when unused
o has opportunity cost of 0 since you can't use them for anything else
• prospective sunk cost - hasn't been made yet
o considered an investment, economical if it can generate enough profit to cover its
expense
total cost - made up of fixed and variable cost
• fixed cost (FC) - cost that doesn't vary w/ output
o paid even when output is 0
o only removed when firm goes out of business
o different from sunks costs since sunk costs can't be recovered even when the firm goes
out of business
• variable cost (VC) - varies w/ output, dependent on Q
Types of Markets
market - exchange center, central economic unit
• place where buyers/sellers come together to exchange product/good
o retail market - buyers = consumers, sellers = retail stores
o wholesale markets - buyers = retail stores, sellers = goods producers
o factor markets - buyers = goods producers, sellers = workers/capital suppliers
• contains different range of products w/ different geographies (extent of market)
o used to find actual/potential competitors
• arbitrage - buying low, selling high in another market
o determines extent of market, due to significant differences in price
o complete market (perfectly competitive) - consumers/producers can’t determine/change
price
o impossible in real life
o large number of buyers/sellers >> hard to influence price
o competition keeps different markets’ prices even
o no need for market to pay attention to single consumer
o no influence from either side on price (fast food is closest real example)
• incomplete market (noncompetitive) - either demand or supply affects price
o balance between demand and supply
o not just one decision marker (economic agent), may be based on brand loyalty/price
o producers influence the price individually (w/ monopoly) or cartel (ie OPEC)
o oligopoly - sellers combine forces (OPEC, railways, etc)
o monopoly - only 1 choice, source >> seller has all power
• commodity market - many units of same goods (supermarket)
o consumers decide how much to buy
• product differentiated markets - buyers purchase fixed number of units
o units differ in quality, specifications (ie cereal, cars)
o monopolistic competition - ie Mac vs PC >> specialty brands
o producers have limited ability to influence price (due to competition from other brands)
o new/different brands >> competitive force
market operation - live auctions, sealed bids
• live auctions -
o sellers starts low, raises price until 1 buyer left
o seller starts high, lowers until 1st buyer emerges
o buyers place max price orders (allowance), sellers place minimum price requests
• sealed bids -
o seller says what’s for sale, buyers submit a single bid >> highest bid wins
o buyer says what’s needed, buyers submit a single bid >> lowest bid wins
• posted prices - difference prices for different quality
o compare prices/quality >> look for best trade off
o unsold units >> seller cuts prices (w/ sales, discounts)