Microeconomics: Prices, Elasticity and Welfare
Microeconomics tests whether you can model price formation, consumer and firm choice, and the welfare consequences of market structure and intervention. Questions usually ask you to derive an equilibrium, compute an elasticity or surplus, and then interpret the number rather than just state it.
Core rules
- Elasticity: point elasticity is ε = (dQ/dP)(P/Q). On a linear demand curve its magnitude falls as you move down the curve and equals 1 at the midpoint. Revenue rises with price when |ε| < 1.
- Consumer choice: at an interior optimum the marginal rate of substitution equals the price ratio, MRS = Px/Py. A price change splits into substitution and income effects; for a normal good both push quantity the same way.
- Costs: MC passes through minimum ATC. Short-run fixed costs do not affect the profit-maximizing quantity; sunk costs are irrelevant to marginal decisions.
- Market power: a monopolist sets MR = MC, giving the Lerner markup (P − MC)/P = 1/|ε|. Perfect competition drives P = MC, and the welfare loss is the triangle between demand and MC over the restricted quantity.
Worked example
Demand Qd = 100 − 2P, supply Qs = 3P. Setting them equal gives 100 − 2P = 3P, so P = 20 and Q = 60. Elasticity at equilibrium: (−2)(20/60) = −0.67, so demand is inelastic there and a small price rise raises revenue. Consumer surplus is the triangle above price and below demand: the demand choke price is 50 (where Q = 0), so CS = ½ × 60 × (50 − 20) = 900.
Traps
- Confusing a movement along a curve with a shift of the curve.
- Assuming elasticity is constant along a linear demand curve.
- Forgetting to check which side of the market binds under a price ceiling; a ceiling set above equilibrium has no effect.
- Reporting a deadweight loss without checking that the intervention actually changes quantity.