AEB

Lecture 1
Chap 1
1.1 Why study microeconomics?
Economics is the science that deals with the allocation of limited resources to satisfy
unlimited human wants. Resources are said to be scarce because their supply is limited.
The scarcity of resources means that we are constrained in the choices we can make
about the goods and services we produce, and thus also about which human wants
we will ultimately satisfy. That is why economics is often described as the science of
constrained choice.
Microeconomics studies the economic behavior of individual economic decision
makers, such as a consumer, a worker, a firm, or a manager. It also analyzes the
behavior of individual households, industries, markets, labor unions, or trade
associations. Macroeconomics analyzes how an entire national economy performs. A
course in macroeconomics would examine aggregate levels of income and
employment, the levels of interest rates and prices, the rate of inflation, and the
nature of business cycles in a national economy.
1.2 Three key analytical tools
An exogenous variable is one whose value is taken as given in a model. In other words,
the value of an exogenous variable is determined by some process outside the model
being examined.
An endogenous variable is a variable whose value is determined within the model
being studied.
- Constrained optimization
The tool of constrained optimization is used when a decision maker seeks to make the
best choice, taking into account any possible limitations or restriction on the choices.
We can think about constrained optimization problems as having 2 parts, an objective
function and a set of constraints. An objective function is the relationship that the
decision maker seeks to ‘optimize’, that is, either maximize or minimize.
Decision makers must also recognize that there are often restrictions on the choices
they may actually select. These restrictions reflect the fact that resources are scarce,
or that for some other reason only certain choices can be made. The constraints in a
constrained optimization problem represent restriction or limits that are imposed on
the decision maker.
- Equilibrium analysis
An equilibrium in a system is a state or condition that will continue indefinitely as long
as exogenous factors remain unchanged – that is, as long as no outside factor upsets
the equilibrium.
- Comparative statics
Comparative statics analysis is used to examine how a change in an exogenous variable
will affect the level of an endogenous variable in an economic model.
1.3 Positive and normative analysis
Positive analysis: analysis that attempts to explain how an economic system works or
to predict how it will change over time.
Normative analysis: analysis that typically focuses on issues of social welfare,
examining what will enhance or detract from the common good. --- ‘What should be
done?’

Chap 2 Demand and supply analysis

2.1 Demand, supply, and market equilibrium
in this chapter, we analyze perfectly competitive markets.
Perfectly competitive markets comprise large numbers of buyers and sellers. The
transactions of any individual buyer or seller are so small in comparison to the overall
volume of the good or service traded in the market that each buyer or seller takes the
market price as given when purchase or production decisions. The model of perfect
competition is cited as a model of price-taking behavior.
- Demand curves
Market demand curve: a curve that shows us the quantity of goods that consumers
are willing to buy at different prices.
Derived demand: demand for a good that is derived from the production and sale of
other goods.
Direct demand: demand for a good that comes from the desire of buyers to directly
consume the good itself.
Law of demand: The inverse relationship b/t the price of a good and the quantity
demanded, when all other factors that influence demand are held fixed.
- Supply curves
Market supply curve: A curve that shows us the total quantity of goods that their
suppliers are willing to sell at different prices.
Law of supply: The positive relationship b/t price and quantity supplied, when all other
factors that influence supply are held fixed.
As with demand, other factors besides price affect the quantity of a good that
producers will supply to the market. For example, the prices of factors of production
– resources such as labor and raw materials that are used to produce the good – will
affect the quantity of the good that sellers are willing to supply.
- Market equilibrium
A point at which there is no tendency for the market price to change as long as
exogenous variables remain unchanged.
- Shifts in supply and demand
 Shifts in either supply or demand
The demand and supply curves discussed so far in this chapter were drawn under the
assumption that all factors, except for price, that influence the quantity demanded
and quantity supplied are fixed.
To do a comparative statics analysis of the market equilibrium, you first must
determine how a particular exogenous variable affects demand or supply or both.
2.2 Price elasticity of demand
The price elasticity of demand measures the sensitivity of the quantity demanded to
price. The price elasticity of demand is the percentage change in quantity demanded
brought about by 1 percent change in price.

𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 ∆𝑄 𝑃

PED = / PED = *
𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑐ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 ∆𝑃 𝑄
The value of PED must always be negative, reflecting the fact that demand curves slope
downward because of the inverse relationship of price and quantity.
- Linear demand curves
Q = a – b*P
Inverse demand curve: an equation for the demand curve that expresses price as a
𝑎 1
function of quantity. P = - 𝑏*Q
𝑏
a/b is called the choke price, the price at which the quantity demanded falls to 0.

The formula tells us that for a linear demand curve, the PED varies as we move along
the curve. B/t the choke price a/b (where Q=0) and a price of a/2b at the midpoint M
of the demand curve, the PED is between -∞ and -1. This is known as the elastic region
of the demand curve. For prices b/t a/2b and 0, the PED is b/t -1 and 0. This is the
inelastic region of the demand curve.
The slope measures the absolute change in quantity demanded brought about by a
one-unit change in price. By contrast, the PED measures the percentage change in
quantity demanded brought about by a 1 percent change in price.
- Determinants of PED
 Demand tends to be more price elastic when there are good substitutes for a
product.
 Demand tends to be more price elastic when a consumer’s expenditure on the
product is large.
 Demand tends to be less price elastic when the product is seen by consumers as
being a necessity.
- PED and total revenue
If the demand is elastic, the quantity reduction will outweigh the benefit of the higher
price, and total revenue will fall. If the demand is inelastic, the quantity reduction will
not be too severe, and total revenue will go up.
- Market level V.S. brand-level PED
A common mistake in the use of PED is to suppose that just because the demand for a
product is inelastic, the demand each seller of that product faces is also inelastic. For
example, the demand for cigarettes is not especially sensitive to price: an increase in
the price of all brands of cigars would only modestly affect overall cigarette demand.
However, if the price of only a single brand of cigarettes went up, the demand for that
brand would probably drop substantially because consumers would switch to the low-
priced brands whose prices did not change. Thus, even if demand is inelastic at the
market level, it can be highly elastic at the individual brand level.
2.3 Other elasticities
- Income elasticity of demand
Income elasticity of demand is the ratio of the percentage change of quantity
demanded to the percentage change of income, holding price and all other
determinants of demand constant.

- Cross-price elasticity of demand

The cross-price elasticity of demand for good i with respect to the price of good j is the
ratio of the percentage change of the quantity of good i demanded to the percentage
change of the price of good j.
Cross-price elasticity can be positive or negative. If 𝜀𝑄𝑖𝑃𝑗 >0, a higher price for good
j increases the Q of good I demanded. In this case, these two goods are demand
substitutes. If 𝜀𝑄𝑖𝑃𝑗 <0, they are demand complements.

- Price elasticity of supply

The price elasticity of supply measures the sensitivity of Q supplied 𝑄 𝑠 to price. It

tells us the percentage change in quantity supplied for each percent change in price.

Lecture 2 Chap 3 Consumer preferences and the concept

3.1 Representations of preferences

We consider a market basket (bundle), defined as a collection of goods and services

that an individual might consume.

Consumer preferences tell us how an individual would rank any two baskets, assuming
the baskets were available at no cost.

- Assumptions about consumer preferences

1. Preferences are complete. That is, the consumer is able to rank any two baskets.
For baskets A and B, for example, the consumer can state her preferences
according to one of the following possibilities:

She prefers basket A to B. / She prefers basket B to A. / She is indifferent b/t A

and B.

2. Preferences are transitive. By this we mean that the consumer makes choices
that are consistent with each other. Suppose that a consumer tells us that she
prefers A to B, and B to E. we can expect her to prefer A to E. using the notation
 we have just introduced to describe preferences, we represent transitivity as
follows: if A>B and if B>E, then A>E.

3. More is better.

- Ordinal and cardinal ranking

Ordinal ranking: ranking that indicates whether a consumer prefers one basket to
another, but does not contain quantitative information about the intensity of that
preference.

Cardinal ranking: a quantitative measure of the intensity of a preference for one

basket over another.

A cardinal ranking contains more information than an ordinal ranking.

3.2 Utility functions

The 3 assumptions – preferences are complete, they are transitive, and more is better
– allow us to represent preferences with a utility function. A utility function measures
the level of satisfaction that a consumer receives from any basket of goods and services.

- Preferences with a single good: the concept of marginal utility

Marginal utility: the rate at which total utility changes as the level of consumption
rises.

∆𝑈
M𝑈𝑦 = . Graphically, the marginal utility at a particular point is represented by the
∆𝑦

slope of a line that is tangent to the utility function at that point.

Since the slopes of the tangents change as we move along the utility function U(y), the
marginal utility will depend on the Q of goods she has already purchased. The
additional satisfaction she receives from consuming more of a good depends on how
much of the good she has already consumed.
 Principle of diminishing marginal utility

Key point:

 Total utility and marginal utility cannot be plotted on the same graph.

 The marginal utility is the slope of the total utility function.

 The relationship b/t total and marginal functions holds for other measures in
economics.

Principle of diminishing marginal utility: after some point, as consumption of a good

increases, the marginal utility of that good will begin to fall.

- Preferences with multiple goods

The marginal utility of any one good is the rate at which total utility changes as the
level of consumption of that good rises, holding constant the levels of consumption of
all other goods.

For example, in the case in which only two goods are consumed and the utility function
is U(x, y), the marginal utility of food (M𝑈𝑥 ) measures how the level of satisfaction will
change (∆𝑈) in response to a change in the consumption of food (∆𝑥), holind the level
of y constant:

- Indifference curves

A curve connecting a set of consumption baskets that yield the same level of
satisfaction to the consumer.

1. When the consumer likes both goods (MU x & y are both positive), all the
indifference curves will have a negative slope. --- monotonicity

2. Indifference curves cannot intersect. --- transitivity

3. Every consumption basket lies on one and only one indifference curve. --- each
basket lies on only one indifference curve.

Marginal rate of substitution is the maximum rate at which the consumer would be
willing to substitute a little more of good x for a little less of good y. it is the increase
in good x that the consumer would require in exchange for a small decrease in good y
in order to leave the consumer just indifferent b/t consuming the old basket or the
new basket. It is the rate of exchange b/t x & y that does not affect the consumer’s
welfare.

- Perfect substitutes (in consumption)

Two goods such that the marginal rate of substitution of one good for the other is
constant, therefore, the indifference curves are straight lines.

- Perfect complements

Two goods that the consumer always wants to consume in fixed proportion to each
other. The indifference curve comprises straight-line segments at right angles.

Lecture 3

Budget constraint: the set of baskets that a consumer can purchase with a limited
amount of income.

Budget line: the set of baskets that a consumer can purchase when spending all of his
available income.

Consumer surplus: the net economic benefit to the consumer due to a purchase (i.e.
the willingness to pay of the consumer net of the actual expenditure on the good).

The area under an ordinary demand curve and above the market price provides a
measure of the consumer surplus.