Microeconomics: resource allocation and market behaviour
This domain examines how demand and supply allocate resources, how elasticities shape responses, when equilibrium is efficient, why markets fail, and how government interventions change outcomes.
Core rules
- Demand is downward sloping. Supply shifts with input costs, technology, taxes or subsidies, expectations and the number of sellers.
- Elasticity measures responsiveness. Price elasticity of demand = %ΔQd ÷ %ΔP. Demand is more elastic when close substitutes exist, the good is a large share of income, and the time horizon is longer. With inelastic demand, a price rise raises total revenue.
- Efficiency: competitive equilibrium maximises total surplus (consumer plus producer surplus) unless externalities, public goods, common resources or market power exist.
- Market failure: a negative externality means marginal social cost exceeds marginal private cost; a positive externality means marginal social benefit exceeds marginal private benefit. The free market over- or under-produces relative to the social optimum.
- Interventions change incentives: a tax equal to marginal external cost internalises the externality; a subsidy can raise output of a merit good; a price ceiling below equilibrium creates a shortage.
Worked example
Dairy runoff imposes an external cost. The private supply curve (MPC) lies below the social supply curve (MSC) by the marginal external cost. The free-market equilibrium has a higher quantity and lower price than the social optimum. A per-unit tax equal to the marginal external cost shifts supply up to MSC, reducing quantity and raising price. Deadweight loss falls, although consumers pay more and producers receive less.
Traps
- Confusing a shift of a curve with a movement along it.
- Treating elasticity as slope.
- Assuming any tax corrects an externality - the tax must match marginal external cost.
- Saying a price ceiling causes a surplus; a binding ceiling causes a shortage.