Microeconomics Study Guide

1. Supply and Demand

Supply and demand is the most fundamental model in economics, explaining how prices are determined and resources allocated in market economies. It consists of two forces: the demand side (buyers' behavior) and the supply side (sellers' behavior), whose interaction determines market outcomes.

The Law of Demand states that, all else equal, as the price of a good rises, consumers will demand less of it — and as price falls, they demand more. This inverse relationship holds because of two effects: the substitution effect (as something becomes more expensive, consumers shift to cheaper alternatives) and the income effect (higher prices reduce purchasing power, making consumers effectively poorer). Graphically, the demand curve slopes downward from left to right.

The Law of Supply states that, all else equal, as price rises, producers are willing to supply more — and as price falls, they supply less. Higher prices make production more profitable, incentivizing greater output. The supply curve slopes upward. Crucially, supply and demand curves can shift (the entire curve moves) due to factors other than the good's price, or show movements along the curve (in response to price changes). Demand shifters include: income changes, prices of related goods, consumer tastes, expectations, and number of buyers. Supply shifters include: input costs, technology, number of sellers, taxes/subsidies, and future price expectations.

2. Market Equilibrium

Market equilibrium is the state in which quantity supplied equals quantity demanded — the market "clears" with no persistent surplus or shortage. At the equilibrium price (market-clearing price), all goods offered for sale find willing buyers, and all buyers willing to pay the price find sellers. This is the outcome the market naturally tends toward in the absence of external intervention.

When price is above equilibrium, a surplus (excess supply) develops: more is produced than consumers want at that price. Unsold inventory accumulates, putting downward pressure on price as sellers compete for buyers. When price is below equilibrium, a shortage (excess demand) develops: consumers want more than is produced at that price. Buyers compete for scarce goods, bidding prices upward. Both forces push markets toward equilibrium.

Comparative statics analyzes how equilibrium changes when supply or demand shifts. If demand increases (curve shifts right) while supply is unchanged, equilibrium price rises and equilibrium quantity rises. If supply decreases (curve shifts left) while demand is unchanged, equilibrium price rises and equilibrium quantity falls. Analyzing the direction and magnitude of these shifts is the core analytical method of microeconomics.

Price controls prevent markets from reaching equilibrium. A price ceiling (maximum price, e.g., rent control) set below equilibrium creates a shortage. A price floor (minimum price, e.g., minimum wage) set above equilibrium creates a surplus. Both generate deadweight loss — a reduction in total economic welfare, as mutually beneficial trades that would have occurred at the equilibrium price no longer happen.

3. Price Elasticity

Price elasticity of demand (PED) measures how sensitive consumer demand is to price changes. It is calculated as the percentage change in quantity demanded divided by the percentage change in price. A PED greater than 1 in absolute value means demand is elastic — quantity changes proportionally more than price. A PED less than 1 means demand is inelastic — quantity barely responds to price changes.

Determinants of elasticity: goods with many close substitutes are more elastic (if one brand raises prices, consumers easily switch). Necessities are inelastic (people must buy insulin regardless of price); luxuries are elastic (vacations are postponed when prices rise). A larger budget share makes demand more elastic (a 10% price rise on expensive items prompts more careful shopping). A longer time horizon makes demand more elastic (consumers can adjust habits and find substitutes over time).

Elasticity has important implications for business revenue: for elastic demand, a price cut increases total revenue (quantity rises proportionally more than price falls); for inelastic demand, a price increase raises revenue (quantity falls proportionally less than price rises). This explains why airlines lower prices on flexible leisure routes (elastic demand) but charge high prices for last-minute business tickets (inelastic demand). Price elasticity of supply similarly measures how quantity supplied responds to price — more elastic when producers can easily expand production.

4. Market Structures

Market structure describes the competitive environment in which firms operate, determining their pricing power, profit levels, and efficiency outcomes. Four main structures are analyzed in microeconomics.

Perfect competition is the theoretical ideal: many buyers and sellers, identical (homogeneous) products, free entry and exit, and perfect information. Each firm is a price taker — too small to influence the market price. In the long run, economic profits are competed away as new entrants join, and output is produced at minimum average cost — achieving both allocative efficiency (P = MC) and productive efficiency. Agricultural commodity markets approximate this ideal.

Monopoly has a single seller with no close substitutes, giving it significant market power to set price. The monopolist maximizes profit by producing where MR = MC — but since MR < P for a monopolist, it produces less and charges more than the competitive outcome, creating deadweight loss. Monopolies persist through barriers to entry: patents, natural scale advantages, resource control, or legal franchise. Monopolistic competition features many firms selling differentiated products, each with some pricing power — restaurants, clothing brands, and hair salons are examples. Oligopoly is dominated by a few large firms with interdependent decisions — game theory is the key analytical tool. The airline industry, smartphone market, and commercial aircraft manufacturing are oligopolies.

5. Market Failure

Market failure occurs when the free market, left to itself, produces an allocatively inefficient outcome — too much of some goods, too little of others. The four main types each have distinct policy implications.

Externalities occur when production or consumption imposes costs or benefits on third parties. Negative externalities (pollution, traffic congestion, secondhand smoke) cause markets to overproduce the good — the private cost is below the full social cost. Positive externalities (education, vaccination, basic research) cause markets to underproduce — the private benefit to the buyer is below the full social benefit. Policy tools: Pigouvian taxes on negative externalities (carbon tax), subsidies for positive externalities (vaccine vouchers, education grants), regulations (emissions standards).

Public goods are non-excludable (impossible to prevent non-payers from using) and non-rival (one person's use doesn't reduce availability for others). Markets underprovide them due to the free-rider problem — individuals have incentive to use without paying. National defense, street lighting, and basic scientific research are public goods typically provided by government. Information asymmetry — when buyers and sellers have different information — leads to adverse selection (the "market for lemons") and moral hazard. Insurance markets, healthcare, and used car markets are classic examples. Market power (monopoly and oligopoly) causes underproduction and above-competitive pricing, justifying antitrust policy.

6. Production and Costs

Firms make production decisions based on costs and revenues. The key distinction is between fixed costs (don't change with output — rent, machinery depreciation, salaries of permanent staff) and variable costs (change with output — raw materials, hourly labor, utilities). In the short run, at least one input is fixed; in the long run, all inputs can be varied.

Key cost concepts: Average total cost (ATC) = total cost / quantity; the minimum point of the ATC curve is where productive efficiency is achieved. Marginal cost (MC) = the change in total cost from producing one more unit; the MC curve intersects the ATC curve at its minimum. The profit-maximization rule: produce where MR = MC. If MR > MC, produce more; if MR < MC, reduce output. Economies of scale — falling average costs as output expands — explain why large firms often dominate capital-intensive industries. Sunk costs — already incurred and unrecoverable — should never influence future decisions; only marginal costs and benefits are relevant.

Key Microeconomics Terms