Microeconomics

This deck offers a solid introduction to the core ideas of microeconomics, the branch of economics that looks at how individuals and businesses make decisions in specific markets. The flashcards walk through foundational concepts such as the laws of supply and demand, how equilibrium prices are set, and what causes curves to shift. From there, the deck moves into related territory, including price controls, consumer and producer surplus, deadweight loss, and the basics of price elasticity of demand.

It is well suited for students taking a first course in economics, learners preparing for an exam or quiz, or anyone who wants to refresh the building blocks of how markets work. Because the questions are framed as straightforward definitions and short explanations, the deck works just as well for a quick review as it does for a first pass through the material.

To get the most out of these cards, try to connect each term to a real-world example as you study, since microeconomic ideas really click when you see them in action at a market, a store, or even in everyday decisions. Spreading your review across several short sessions rather than cramming will also help these definitions stick for the long term. When you come across a concept that feels tricky, like elasticity or deadweight loss, try drawing a simple supply and demand diagram alongside the card to reinforce the idea visually.

Microeconomics begins with two fundamental laws that describe how buyers and sellers behave in a market. The law of demand states that, ceteris paribus, as the price of a good rises, the quantity demanded falls, and vice versa. The law of supply states the opposite relationship: as the price of a good rises, the quantity supplied rises, and vice versa. When these two forces meet, the market reaches its equilibrium price, the price at which the quantity demanded exactly equals the quantity supplied. The market demand curve itself is obtained by horizontally summing all individual consumers' demand curves at each price level, while the market supply curve aggregates the behavior of all producers.

While movements along a curve represent responses to the good's own price, shifts of the entire curve reflect changes in underlying conditions. The demand curve shifts when factors such as income, tastes, prices of related goods, expectations, or the number of buyers change. The supply curve shifts when input prices, technology, expectations, the number of sellers, or government policies change. A useful framework for measuring the welfare consequences of market outcomes relies on consumer surplus, the area below the demand curve and above the price, and producer surplus, the area above the supply curve and below the price. Together, total surplus is maximized at the competitive equilibrium.

Governments sometimes intervene with price controls. A price ceiling is a legal maximum price; if set below the equilibrium price, it creates a shortage because quantity demanded exceeds quantity supplied. A price floor, such as a minimum wage, is a legal minimum price; if set above equilibrium, it creates a surplus. Both types of controls typically generate deadweight loss, the reduction in total surplus that results from a market distortion, because mutually beneficial trades between buyers and sellers go unrealized.

Elasticity measures how strongly one variable responds to another, and it is one of the most important tools in applied microeconomics. Price elasticity of demand (PED) is defined as the percentage change in quantity demanded divided by the percentage change in price: \( \text{PED} = \%\Delta Q_d / \%\Delta P \). When PED exceeds one, demand is elastic and consumers are highly responsive to price; when PED is less than one, demand is inelastic and consumers are relatively unresponsive. The special case PED equals one is called unit elastic, where quantity and price change by the same percentage. At the extremes, perfectly inelastic demand (PED = 0) gives a vertical demand curve (quantity is fixed regardless of price), while perfectly elastic demand (PED = \(\infty\)) gives a horizontal demand curve (any price increase drives quantity to zero).

Several factors shape elasticity. Demand tends to be more elastic when close substitutes are available, when the good is a luxury rather than a necessity, when it represents a large share of the consumer's budget, and when consumers have more time to adjust. To calculate elasticity consistently regardless of the direction of change, economists often use the midpoint method, which averages the initial and final values in both numerator and denominator. Elasticity also directly affects total revenue \( TR = P \times Q \). When demand is elastic, a price decrease raises total revenue; when demand is inelastic, a price decrease reduces total revenue.

Beyond own-price elasticity, two related measures are important. Cross-price elasticity of demand (XED) is the percentage change in quantity demanded of good A divided by the percentage change in the price of good B. A positive XED indicates substitute goods, while a negative XED indicates complementary goods. Income elasticity of demand (YED) is the percentage change in quantity demanded divided by the percentage change in income. A positive YED characterizes normal goods (and YED greater than one indicates a luxury), while a negative YED identifies inferior goods, for which demand falls as income rises. A particularly unusual case is the Giffen good, an inferior good in which the income effect from a price increase is so strong that quantity demanded actually rises.

Behind every demand curve lies a model of how individual consumers make choices. The starting point is the concept of utility, the satisfaction a consumer derives from goods. A utility function assigns a numerical value to each consumption bundle, allowing us to rank preferences. Marginal utility is the additional satisfaction from consuming one more unit of a good, and the law of diminishing marginal utility says that, holding consumption of other goods constant, marginal utility eventually declines as more of a good is consumed. This tendency explains, at a basic level, why consumers are willing to pay less and less for successive units.

Consumers are constrained by income and prices. The budget constraint expresses the combinations of two goods that a consumer can afford: \( P_1 Q_1 + P_2 Q_2 = \text{Income} \). Within this affordable set, the consumer's preferences are represented by indifference curves, each of which shows all bundles of two goods that yield the same utility. Indifference curves are typically downward-sloping and convex, and the marginal rate of substitution (MRS) is the rate at which the consumer is willing to trade one good for another while staying on the same indifference curve, equal to the absolute slope of the curve. The consumer's optimal choice occurs where the budget constraint is tangent to the highest attainable indifference curve, where \( \text{MRS} = P_1/P_2 \).

When a price changes, the consumer's response can be decomposed into two effects. The substitution effect is the change in quantity demanded that comes from the altered relative prices, holding utility constant; consumers substitute toward the good that has become relatively cheaper. The income effect is the change in quantity demanded that comes from the change in purchasing power, real income, induced by the price change. Together these effects determine the slope of the demand curve and explain unusual cases like Giffen goods. Underpinning all of consumer theory is the concept of opportunity cost, the value of the next best alternative forgone when a choice is made.

On the production side of the economy, firms combine inputs to produce output, and their decisions hinge on the costs of doing so. Costs come in two forms. Explicit costs are direct monetary outlays such as wages and rent, while implicit costs are the opportunity costs of using owner-supplied resources, such as the salary a business owner gives up by working for themselves. Accounting profit subtracts only explicit costs from total revenue, but economic profit subtracts both explicit and implicit costs: \( \text{Economic profit} = TR - (\text{Explicit} + \text{Implicit costs}) \). A firm earning zero economic profit is doing just as well as it could in its next-best use of its resources; it is earning a normal return.

Costs are also classified by how they respond to output. Fixed costs (FC) do not change with output, such as rent on a building, while variable costs (VC) do change with output, such as raw materials and hourly labor. Total cost is \( TC = FC + VC \). The average total cost is \( ATC = TC / Q = AFC + AVC \), where AFC and AVC are the average fixed and variable costs. Marginal cost (MC) is the additional cost of producing one more unit, \( MC = \Delta TC / \Delta Q \). A key graphical result is that the MC curve intersects the ATC curve at its minimum point: when MC is below ATC, ATC is falling; when MC is above ATC, ATC is rising. Marginal cost is also the foundation of the firm's profit-maximizing rule, namely that a firm maximizes profit where marginal revenue (MR) equals marginal cost, \( MR = MC \).

The shape of cost curves reflects the underlying production technology. In the short run, at least one input is fixed, and the law of diminishing marginal returns says that as more of a variable input is added to a fixed input, the marginal product of that input eventually decreases. The marginal product of labor (MPL) is the additional output from one more unit of labor, \( MPL = \Delta Q / \Delta L \). In the long run, all inputs are variable and firms can enter or exit the market. Economies of scale occur when long-run average total cost falls as output increases, due to specialization, bulk purchasing, or the spreading of fixed costs; diseconomies of scale occur when long-run average total cost rises with output, often because of coordination problems and bureaucracy.

How firms compete depends on the structure of the market in which they operate. In perfect competition, there are many buyers and sellers, products are homogeneous, entry and exit are free, information is perfect, and individual firms are price takers. The firm's supply curve in the short run is the portion of its MC curve lying above the AVC curve, and the firm shuts down if price falls below AVC. In long-run equilibrium, free entry and exit drive economic profit to zero, so \( P = MC = \text{minimum ATC} \), and there is no incentive for entry or exit. This outcome is both allocatively efficient (P = MC) and productively efficient (production at minimum ATC).

At the opposite extreme, a monopoly is a market with a single seller, no close substitutes, and significant barriers to entry such as patents, control of key resources, government licenses, high startup costs, or economies of scale. When economies of scale are so strong that one firm can supply the entire market at lower average cost than two or more firms, the result is a natural monopoly. A monopolist maximizes profit at \( MR = MC \) and then charges the price on the demand curve corresponding to that quantity. Because the monopolist must lower the price on all units to sell one more, MR lies below the demand curve, so the monopoly price exceeds MC. This creates a deadweight loss relative to perfect competition, since the monopolist produces less than the socially efficient quantity.

Between these extremes lie oligopoly and monopolistic competition. An oligopoly has a few large firms whose decisions are interdependent; each firm considers rivals' reactions. Cartels such as OPEC involve explicit collusion to restrict output and raise prices, acting as a collective monopoly. The kinked demand curve model explains why oligopoly prices tend to be rigid: rivals are assumed to match price cuts but not price increases, producing a kink in the demand curve and a discontinuity in MR at the prevailing price. Monopolistic competition features many firms selling differentiated products with free entry and exit. In the long run, firms earn zero economic profit but produce with excess capacity, at a quantity below the minimum of the ATC curve. Two common measures of market power are the Herfindahl-Hirschman Index (HHI), the sum of squared market shares, and the Lerner Index, \( L = (P - MC)/P \), which ranges from 0 in perfect competition toward 1 for extreme market power.

When a market contains only a few significant competitors, each firm's profit depends on what its rivals do, and the natural framework is game theory, the study of strategic decision-making in which each player's payoff depends on the actions of all. A central solution concept is the Nash equilibrium, a set of strategies in which no player can improve their payoff by unilaterally changing strategy. Some games have a dominant strategy, one that yields the highest payoff regardless of what the other players do, which simplifies equilibrium analysis. When no pure-strategy equilibrium exists, players may use a mixed strategy, randomizing over actions with specific probabilities to keep opponents indifferent.

The most famous illustration is the Prisoner's Dilemma, in which two players pursuing their own self-interest reach an outcome that is worse for both than mutual cooperation would have been. In oligopoly, the Prisoner's Dilemma explains why firms have an incentive to cheat on collusive agreements: individual profit maximization leads to a Nash equilibrium that delivers lower joint profits than cooperation. Cooperation can sometimes be sustained in a repeated game, where the same interaction occurs many times and players value future payoffs. Strategies like tit-for-tat, cooperating when the other cooperates and punishing defection, can support cooperative equilibria over the long horizon.

Strategic considerations also shape pricing. In a sequential game, players move in turn, and such games are analyzed using a game tree and solved by backward induction, starting from the final decision nodes and reasoning back to the beginning. A credible threat is one that the threatener would actually find it in their interest to carry out; non-credible threats are dismissed in equilibrium. Firms with market power may practice price discrimination to extract more surplus. First-degree (perfect) price discrimination charges each consumer their maximum willingness to pay, capturing all consumer surplus. Second-degree price discrimination uses quantity or product-version discounts, such as bulk pricing or tiered menus. Third-degree price discrimination charges different prices to identifiable groups with different elasticities, like student or senior discounts. For any price discrimination to be viable, the firm must have market power, must be able to identify groups with different elasticities, and must prevent resale or arbitrage between groups.

Competitive markets are remarkably efficient, but they do not always produce socially desirable outcomes. A market failure occurs when the market equilibrium does not maximize total surplus, and the most common source is externalities, costs or benefits that fall on third parties who are not part of the transaction. A negative externality, such as pollution from a factory, means that the social cost of production exceeds the private cost borne by the producer. As a result, the market produces more than the socially optimal quantity and creates deadweight loss. A positive externality, such as education or vaccinations, means that the social benefit exceeds the private benefit received by the consumer, so the market produces less than the socially optimal quantity.

Public policy can address these gaps. A Pigovian tax is a per-unit tax equal to the external cost of a negative externality, designed to internalize the externality and bring private decisions in line with the social optimum. Symmetrically, a Pigovian subsidy, a per-unit payment equal to the external benefit, can be used to encourage activities with positive externalities. An alternative, articulated by the Coase Theorem, holds that if property rights are well defined and transaction costs are low, the affected parties can bargain privately to reach an efficient outcome regardless of who initially holds the rights.

Some goods are particularly prone to market failure because of their special properties. A public good is both non-excludable, meaning no one can be effectively prevented from using it, and non-rivalrous, meaning one person's use does not diminish availability for others. National defense is the classic example. Because people cannot be excluded, individuals have an incentive to free ride, benefiting without paying, which leads to under-provision by private markets. A common resource, such as fish in the ocean, is rivalrous but non-excludable, and overuse leads to the tragedy of the commons, in which individuals deplete the shared resource because they do not bear the full social cost of their consumption. A club good sits in between: it is excludable but non-rivalrous up to a point, as with cable television or uncongested toll roads. Understanding these categories helps explain why certain goods are best provided by governments, while others can be efficiently managed through markets, bargaining, or collective action.