Self Notes – Micro Economics

Economics :
• Study of human action how people make choices and how they make choices under scarcity.
• Economics proceeds by developing models of social phenomena
• An economic model describe every aspect of reality (simplified representation of reality).
• Here Economists are guided by 2 principles
 Optimization : People try to choose what’s best for them (consuming best patterns which they can afford)
 Equilibrium: Prices will adjust until demand and supply are equal

• Economic models may include multiple types of variables. Two common types are endogenous and exogenous variables.
• microeconomics Branch of economics that deals with the behavior of individual economic units
—consumers, firms, workers, and investors—as well as the markets that these units comprise.

• macroeconomics Branch of economics that deals with aggregate economic variables, such as
the level and growth rate of national output, interest rates, unemployment, and inflation.
Exogenous variable
• An exogenous variable is one that exists outside of the model.
• Factors outside of the economic model determine the value of exogenous variables.
• Factors within the economic model don't affect exogenous variables, meaning that they're similar to independent variables.
Examples:
• External factors in agriculture
Consider that you're modeling a farm's corn production. There are variables that can affect your crops, but that your crops cannot affect.
External factors like crop-eating pests and the weather would be exogenous variables. This is because other variables in the model can 't
affect these variables. They can cause more or fewer crops to grow, but the crops can't affect them in return.
• Tax Rates
A company made a net income of $200,000 last year. Its net income depends on a variety of factors, including tax rate. Because other
variables can 't impact the tax rate in the model, the tax rate is an exogenous variable.
Endogenous variable
• An endogenous variable is a variable in an economic model
• The values of this variables are determined by the model.
• The endogenous variable is the dependent variable, meaning its value depends on other variables within the model.
• Because the endogenous variable exists within the economic model, the model can predict the value of the endogenous variable.

Examples:

• Cookies sold by a Bakery

You're modeling how many cookies a bakery produces each day. In this case, the endogenous variable would be how many
cookies the bakery sells. The endogenous variable—the number of cookies sold—depends on other variables in the model,
including the number of employees working and the price of cookie ingredients..
• Lamp produced by a manufacturer
Imagine that a lighting manufacturer is modeling how many lamps it produces. The number of lamps produced depends on
other variables in the model, including the price of lamp parts. The endogenous variable, in this case, is the number of lamps
produced.
Reservation Price

Reservation (or reserve) Price

• A reservation (or reserve) price is a limit on the price of a good or a service.
• On the demand side, it is the highest price that a buyer is willing to pay;
• on the supply side, it is the lowest price a seller is willing to accept for a good or service.
Pareto Efficency

• we can find a way to make some people better off without making anybody else worse off, we have a Pareto improvement.
• If an allocation allows for a Pareto improvement, it is called Pareto inefficient;
• if an allocation is such that no Pareto improvements are possible, it is called Pareto efficient.
• A Pareto inefficient allocation has the undesirable feature that there is some way to make somebody better off without hurting anyone else.
Budget

• Economists assume that consumers choose the best bundle of goods they can afford
• Suppose that there is some set of goods from which the consumer can choose. It is convenient to consider only the case of two goods, since
we can then depict the consumer’s choice behavior graphically.
• We will indicate the consumer’s consumption bundle by (x1, x2). This is simply a list of two numbers that tells us how much the consumer is
choosing to consume of good 1, x1, and how much the consumer is choosing to consume of good 2, x2. Sometimes it is convenient to
denote the consumer’s bundle by a single symbol like X, where X is simply an abbreviation for the list of two numbers (x1, x2).
• Then the budget constraint of the consumer can be written as :

p1x1 + p2x2 ≤ m
 p1x1 is the amount of money the consumer is spending on good 1,
 p2x2 is the amount of money the consumer is spending on good 2.

• The consumer’s affordable consumption bundles are those that don’t cost any more than m.
• We call this set of affordable consumption bundles at prices (p1, p2) and income m the budget set of the consumer.
Why 2 Goods ?

Composite good
• The two-good assumption is more general. we can often interpret one of the goods as representing everything else the consumer might
want to consume.
• if we are interested in studying a consumer’s demand for milk, we might let x1 measure his or her consumption of milk in quarts per month.
We can then let x2 stand for everything else the consumer might want to consume.
• We say that good 2 represents a composite good that stands for everything else that the consumer might want to consume other than good
1.
 Properties of the Budget Set
• The budget line is the set of bundles that cost exactly m:
p1x1 + p2x2 = m.
• These are the bundles of goods that just exhaust the consumer’s income.
• The heavy line is the budget line
• the bundles that cost exactly m
• the bundles below this line are those that cost strictly less than m.
• We can rearrange the budget line in equation to give us the formula

• This is the formula for a straight line with :

• a vertical intercept of m/p2
• a slope of −p1/p2.
• The formula tells us how many units of good 2 the consumer needs to consume in order to
just satisfy the budget constraint if she is consuming x1 units of good 1.
• The slope of the budget line has a nice economic interpretation. It measures the rate at
which the market is willing to “substitute” good 1 for good 2.
• Suppose for example that the consumer is going to increase her consumption of good 1 by Δx1. Let us use Δx2 to indicate her change in the
consumption of good 2.

• if customer satisfies her budget constraint before and after making the change she must satisfy both:
p1x1 + p2x2 = m
p1(x1 +Δx1) + p2(x2 +Δx2) = m.
• Subtracting the first equation from the second gives
p1Δx1 + p2Δx2 = 0.
• This says that the total value of the change in her consumption must be zero.
• Solving for Δx2/Δx1, the rate at which good 2 can be substituted for good 1 while still satisfying the budget constraint, gives
Δx2 / Δx1 = −p1/p2

• This is just the slope of the budget line. The negative sign is there since Δx1 and Δx2 must always have opposite signs. i.e.; If you consume
more of good 1, you have to consume less of good 2 and vice versa if you continue to satisfy the budget constraint.
• Economists sometimes say that the slope of the budget line measures the opportunity cost of consuming good 1. In order to consume more
of good 1 you have to give up some consumption of good 2.
• Giving up the opportunity to consume good 2 is the true economic cost of more good 1 consumption; and that cost is measured by the
slope of the budget line.
Change in Income - Effect on Budget Line
• When prices and incomes change, the set of goods that a consumer can afford changes as well.

Income Changes
• An increase in income will result in a parallel shift
outward of the budget line. Similarly, a decrease in
income will cause a parallel shift inward.
Change in Price of Goods – Effect on Budget Line – to be updated
 Factors Affecting Budget Constraint – Tax , Subsidies and Rationing
https://www.youtube.com/watch?v=9CYe6-VdX3Y

1. Quantity Tax 2. Value Tax (Ad Valoren Tax)

• $t if the tax per unit good sold at price p1, the new price of good • If p1 is the price of good and T is the tax to be paid ; customer
will be (p1+t) needs to pay total p1+ T to get the good
• The BL x1p1+x2p2=m will now change to x1(p1+t) + x2p2=m • The total price spend by customer = P1+TP1 or (1+T)P1
• P to seller
• BL gets steeper
• TP1 to Government

• The BL x1p1 + x2p2 = m will now change to x1(1 +T)P1 + x2p2=m

• BL gets steeper
Quantity Subsidy 4. Lumpsum tax / subsidy
• $s if the subsidy per unit good sold at price p1, the new price of • Govt takes / gives a fixed amount regardless of customer behavior
good will be (p1-s)
• Lumpsum tax BL shift inwards
• The BL x1p1+x2p2=m will now change to x1(p1-s) + x2p2=m
• BL gets flatter
5. Lumpsum tax / subsidy
• Governments also sometimes impose rationing constraints. This means
that the level of consumption of some good is fixed to be no larger than
some amount.
• Suppose good 1 were rationed so that no more than x`1 could be
consumed by a given consumer.
• it would be the old budget set with a piece lopped off.
• The lopped-off piece consists of all the consumption bundles that are
affordable but have x1 > x`1.
6. Combining Tax & Rationing
• Consumer can buy a good x1 at a price p1 till a given quantity x`1 , beyond which he need to pay a tax t on all extra quantities
• If x1 < x`1 ; slope of BL : -p1/p2
• If x1>= x`1 ; slope of BL : -(p1+t)/p
Preferences
• In economics and other social sciences, preference refers to the order in which an
agent ranks alternatives based on their relative utility.
• The process results in an "optimal choice"
• An individual's preferences are determined purely by a person's tastes as opposed to
the good's prices, personal income, and the availability of goods.
 Indifference Curve & Properties
An indifference curve is a line drawn between different consumption
bundles, on a graph charting the quantity of good A consumed versus
the quantity of good B consumed. At each of the consumption bundles,
the individual is said to be indifferent.
Note:
• If a good satisfies all the four properties of indifference curves, the
goods are referred to as ordinary goods.
• They can be summarized as the consumer requires more of one
good to compensate for less consumption of another good, and the
consumer experiences a diminishing marginal rate of substitution
when deciding between two goods
Properties of Indifference Curves

• Indifference curves never cross. T

• he farther out an indifference curve lies, the farther it is from the origin, and the higher the level of utility it
indicates.
• Indifference curves slope downwards. (this means that: The only way an individual can increase consumption
in one good without gaining utility is to consume another good and generate the same amount of utility.
Therefore, the slope is downwards sloping).
• Indifference curves assume a convex shape (it means that: It illustrates that all individuals experience
diminishing marginal utility, where additional consumption of another good will generate a lesser amount of
utility than the prior).
Is ID Curve always convex to orgin?
No
• An indifference curve concave to the origin would represent increasing marginal rate of
substitution.
• An indifference curve will be straight line in case of perfect substitutes.
• An indifference curve will be L shape line in case of perfect compliments.
Concept of Utility

• Utility, in economics, refers to the usefulness or enjoyment a consumer can get from a service or good.

• More specifically, utility is the total satisfaction or benefit derived from consuming a good or service.
 "Ordinal" utility refers to the concept of one good being more useful or desirable than another.

 "Cardinal" utility is the idea of measuring economic value through imaginary units, known as "utils."

 Marginal utility is the utility gained by consuming an additional unit of a service or good.
Cardinal Utility Ordinal Utility
Definition It explains that the satisfaction level after It explains that the satisfaction level after consuming
consuming any goods or services can be scaled any goods or services cannot be scaled in numbers.
in terms of countable numbers. However, these things can be arranged in the order of
preference.
Example Pizza gives Sam 60 utils of satisfaction, whereas Sam gets more satisfaction from a pizza as compared to
burger gives him only 40 utils. that of a burger.

Measurement Utility is measured based on utils. Utility is ranked based on satisfaction.

Realistic It is less practical. It is more practical and sensible.

Examination Marginal Utility analysis Indifference Curve Analysis
Total Utility
• If utility in economics is cardinal and measurable, the total utility (TU) is defined as the sum of the satisfaction that a person can receive
from the consumption of all units of a specific product or service.1
If a person can only consume three slices of pizza and the first slice of pizza consumed yields ten utils, the second slice of pizza consumed
yields eight utils, and the third slice yields two utils, the total utility of pizza would be twenty utils.

Marginal Utility
• Marginal utility is the added satisfaction that a consumer gets from having one more unit of a good or service.

• The concept of marginal utility is used by economists to determine how much of an item consumers are willing to purchase.

• Marginal utility can be positive, zero, or negative.

• Positive marginal utility occurs when the consumption of an additional item increases the total utility. That is when having more of an item
brings additional happiness.
Suppose you like eating a slice of cake, but a second slice would bring you some extra joy. Then, your marginal utility from consuming
cake is positive.
• Zero marginal utility is what happens when consuming more of an item brings no extra measure of satisfaction.
For example, you might feel fairly full after two slices of cake and wouldn't really feel any better after having a third slice. In this case,
your marginal utility from eating cake is zero
• Negative marginal utility occurs when the consumption of one more unit decreases the overall utility. That is where you have too much of
an item, so consuming more is actually harmful.
For instance, the fourth slice of cake might even make you sick after eating three pieces of cake
Marginal Utility vs. Total Utility
• Marginal utility measures the change in satisfaction from consuming one additional unit.

• Total utility, instead, measures the total amount of satisfaction of you get from all the units you consume of a good or service.

Note:
 Marginal utility affects total utility.
 Positive marginal utility causes total utility to increase
 Negative marginal utility decreases total utility.

For example, if you go to five sessions with a personal trainer, you might get the highest level of satisfaction from the novelty and excitement of the first
session. With each additional session, the marginal utility decreases because you are less excited and doing more strenuous work. But the marginal utility
of each is positive, so your total utility is still increasing.

• We can calculate marginal utility by dividing the change in total utility (TU) by the change in number of units (Q):

• Change in total utility is found by subtracting the previous total utility from the current total utility (TU2-TU1).

• Change in number of units is found by subtracting the previous number of units from the current number of units (Q2-Q1).

Law of Diminishing Marginal Utility

The law of diminishing marginal utility is a law of economics that states that as your consumption increases, the satisfaction you
derive from each individual unit decreases.
The principle of diminishing marginal utility is illustrated here
as the total utility increases at a diminishing rate with
additional consumption. It is evidenced by figures D, E, and F
having decreased marginal utility. Therefore, the
principle of diminishing marginal utility indicates that each
additional unit of consumption adds less to the cumulative
utility than the previous unit.
Types of Marginal Rate of Substitution
Diminishing
• The marginal rate of substitution is diminishing. One can obtain it if the consumer is willing to give up less and less unit of good Y for every
additional unit of good X.
Constant
• The marginal rate of substitution is constant also. One can obtain this if, for one more unit of Y, only one unit of X is given up. It is constant
for perfect substitution.
Increasing
• Suppose a consumer substitutes a commodity X for the other commodity Y at an increasing rate to maintain the same level of satisfaction.
In this case, one can obtain an increasing marginal rate of substitution.
 Perfect Substitutes & Compliments
• Two goods are perfect substitutes if the consumer is Perfect complements are goods that are always
willing to substitute one good for the other at a constant consumed together in fixed proportions. In some sense
rate. The simplest case of perfect substitutes occurs when the goods “complement” each other. A nice example is
the consumer is willing to substitute the goods on a one-
that of right shoes and left shoes.
to-one basis.
• Perfect substitutes have the property that, instead of The consumer likes shoes, but always wears right and left
decreasing marginal rate of substitution (MRS), they have shoes together. Having only one out of a pair of shoes
constant marginal rate of substitution (MRS). This means doesn’t do the consumer a bit of good.
that they have the same slope everywhere, i.e. they are
straight lines sloping downwards to the right.
Demand Curve

Demand Curve
• Relates Quantity Demanded to Price. Describes the quantity Demanded at
each possible prices
• Case 1: Reduced prices of the Good
• High & Low values uses treated alike
• Case 2 : Higher price of the good
• Customer prefer to have High value uses
• Low value uses can get substituted. (Benefit of purchasing them are
not justifiable at higher price )
• However for high value uses , outweigh the increase in price
Supply Curve

Demand Curve
• Relates Quantity Supplied to Price. Describes the quantity Supplied at each
possible prices
• Case 1: Reduced prices of the Good
• Less suppliers in the market
• One who can produce good more cheaply will meet the demand
• Case 2 : Higher price of the good
• More suppliers enter in the market
• Profit / the high price that can be charged on the good can outweigh
the Production cost
Income Effect & Substitution Effect
Marchalian & Hicksian Demand
Substitutes & Complements
Elasticity of Demands
Demand Curve –Mathematical
Derivation
Supply Curve –Mathematical
Derivation
General Equilibrium
Welfare Theorem
Edgeworth Box
Information Asymmetry
Market Structure and Competetion
Perfect Monopoly Duopoly
Competion
Hoteling Model
Types of Market