Microeconomics: consumer and firm behaviour
Microeconomics: consumer and firm behaviour
This domain tests the neoclassical toolkit behind demand curves and supply decisions, and the informational frictions that complicate them.
Consumer theory
- Preferences need completeness, transitivity and monotonicity. Utility is ordinal, not cardinal - comparisons of level are meaningless.
- Indifference curves are convex to the origin; their slope is the marginal rate of substitution (MRS).
- The budget constraint has slope −Px/Py. The optimum is where MRS = Px/Py, i.e. the curves are tangent.
- A price change splits into a substitution effect (always negative for the good whose price rose) and an income effect. Inferior goods have a negative income effect; Giffen goods are inferior and so strongly income-dominated that demand rises with price.
- Consumer surplus is the area between the demand curve and price.
Firm theory
- Q = f(K, L). In the short run some factors are fixed, so marginal returns diminish.
- Cost minimisation requires MPL/w = MPK/r. Returns to scale are a long-run property and are distinct from diminishing returns.
- MC cuts AC at its minimum. Profit is maximised where MR = MC with MC rising; shut down in the short run if P falls below minimum average variable cost.
- Asymmetric information creates adverse selection (before contracting), moral hazard (after) and principal–agent slack.
Worked example
A firm faces P = 90 − 3Q and MC = 6Q. Total revenue is 90Q − 3Q², so MR = 90 − 6Q. Setting MR = MC gives 90 − 6Q = 6Q, hence Q = 7.5 and P = 67.5. Notice MR has twice the slope of demand - a frequent source of lost marks.
Traps
- Treating utility as measurable across people.
- Confusing diminishing returns (short run) with diseconomies of scale (long run).
- Equating inferior with Giffen.
- Solving MR = MC without checking that MC is rising.