Microeconomics
Microeconomics tests price formation, elasticity, consumer and firm optimization, market structures, and market failure. Expect numerical items on equilibrium, elasticity, and profit maximization, plus conceptual items on why competitive and monopolized markets produce different quantities and prices.
Core rules
- Demand slopes downward and supply slopes upward; equilibrium sets Qd = Qs. A price change moves along a curve; income, tastes, related-good prices, expectations, technology, and the number of buyers or sellers shift curves.
- Price elasticity of demand = percent change in Qd divided by percent change in price; the midpoint formula averages the starting and ending values. Demand is elastic when |E| > 1 and inelastic when |E| < 1. More substitutes, a larger budget share, and longer time horizons make demand more elastic.
- Utility is maximized where MUx/Px = MUy/Py. Profit is maximized where MR = MC; shut down in the short run if P < AVC.
- Perfect competition: P = MR, long-run zero economic profit, allocative efficiency. Monopoly: MR < P, restricted output, deadweight loss. Monopolistic competition: differentiated products, long-run zero profit. Oligopoly: strategic interdependence; cartels are unstable because of the prisoner's dilemma.
- Market failure: negative externalities cause overproduction, positive externalities underproduction; public goods are nonrival and nonexcludable; common resources are rival but nonexcludable. Pigouvian taxes, subsidies, and tradable permits internalize externalities.
- Price ceilings create shortages and price floors create surpluses. A tax burden falls more heavily on the more inelastic side.
Worked example
Price falls from $10 to $8 and quantity rises from 50 to 70. Midpoint percent change in Q = 20/60 = 33.3%; midpoint percent change in P = -2/9 = -22.2%; E = 1.5, elastic. Revenue rises from $500 to $560, exactly what elastic demand predicts when price falls.
Traps
Shifting demand when only price changes (that is movement along the curve); treating elasticity as slope; counting fixed costs in shutdown decisions; assuming a monopolist charges the highest possible price; assuming sellers legally bear a tax.