1

Economics
Microeconomics analysis:
Demand & supply analysis
Introduction
Microeconomics classifies private economics into two groups; consumers & firms

- The theory of consumer deals with demand by utility-maximizing

- The theory of firm deals with supply by profit-maximizing

Types of markets:

1- Factor markets: markets for factors of production

2- Goods market: markets for the output of production or final products
3- Intermediate markets: markets for products that used in finalizing another products

Market interaction are voluntary. Firms offer products when they believe that payment will exceed their cost
of production & consumers willing to buy when they believe that the value they expect to receive exceeds
the payment

Demand: the willingness and ability of consumers to purchase a given amount of good or service at a given
price

Supply: the willingness of sellers to offer a given quantity of a good or service at a given price

Demand function & curve:

The quantity that consumers are willing to purchase depends on several variables such as price, income,
price of other goods (substitutes or complementary)

Demand function: Q d = f (P x, I, P y...)

Price causes a movement along the demand curve & change in quantity demanded while any other variables
changing will cause a shift in demand curve

Supply function & curve

The quantity that firms are willing to offer is depending on several variables such as price, cost of additional
inputs of production as well as cost of production of an additional unit of good

Supply function: Q s = f (P x, W…)

Price causes a movement along the supply curve & change in quantity supplied while any other variables
changing will cause a shift in supply curve
2
Market equilibrium

Defined as the condition in which the quantity willingly offered for sale by sellers at a given price is just
equal to the quantity willingly demanded by buyers at that same price.

An alternative and equivalent condition of equilibrium occurs at that quantity at which the highest price a
buyer is willing to pay is just equal to the lowest price a seller is willing to accept for that same quantity.

It is the intersection of demand and supply curves

Equilibrium condition: is simply Q d =Q s

Endogenous variables: are variables whose equilibrium values within the model being considered like price
and quantity

Exogenous variables: are variables whose equilibrium values outside the model being considered like all
other variables: I, P substitute, and W

Partial equilibrium analysis is using endogenous variables and given exogenous variables only while general
equilibrium analysis is using endogenous and exogenous variables

Market mechanism: to reach equilibrium, price must adjust until there is no excess supply nor excess
demand, in case of excess demand price will rise, in case of excess supply price will fall until market reach
equilibrium

Stable equilibrium is when supply demand is positively sloped and demand negatively sloped and whenever
price is disturbed away from equilibrium it tends to converge back to equilibrium while

Unstable equilibrium if price can’t converge back to equilibrium for whatever is the reason

Auctions is a way to find equilibria and it is divided into common value auctions & private value auctions

Types of determining the price and buyer of the auction:

1- Ascending price auction: single item sold to the higher price

2- second price sealed bid (Vickery auctions): highest price win but pay second highest price
3- Descending price auction (Dutch auctions): price starts high and go lower until someone purchase
4- Modified Dutch auctions:
5- Single price auctions: used by US treasury securities

Marginal value: the added value from an additional unit of good

Marginal value curve: a curve described the highest price consumers are willing to pay for each additional
unit of good

Consumer surplus: which is the measure of how much net benefit buyers enjoy from the ability to participate
in a particular market, is the difference between the total value to consumers of the unites of goods that they
buy and the actual amount of money to buy them, it’s the area beneath the demand curve and above the price
paid

Producer surplus: which is the measure of how much net profit sellers enjoy from the ability to participate in
a particular market, is the difference between total revenue from selling a given amount and total variable
cost of producing that amount, it’s the area above the supply curve and above the cost
3
Total society’s surplus: is a measure of society’s gain from the voluntary exchange of goods and services,
it’s the sum of consumer surplus and producer surplus

An important result of equilibrium is maximizing total surplus

Division of the total surplus between consumer and producer is depending on the steepness of the curves, the
more steepened curve enjoys high share of surplus

Free markets maximize total surplus while market interference has a negative impact on total surplus

Dead weight loss: is the loss of total society’s surplus due to market interference like price ceiling, price
floor, taxes, subsidies & quotas

Demand elasticity

Is to measure just how sensitive quantity is to changes in the independent variables that affect them

Elasticity: is the ratio of percentage change

Own-price elasticity of demand: is defined as the percentage change in quantity demanded divided by the
percentage change in own-price, holding all other things constant

E DPX = % Δ Q d / % Δ P

1. Elastic: coefficient of elasticity > 1

2. Inelastic: coefficient of elasticity < 1
3. Unitary: coefficient of elasticity = 1

Characteristics of all negatively sloped linear demand curves:

 above midpoint of the curve, demand is elastic

 below midpoint of the curve, demand is inelastic

A vertical demand has zero elasticity and called perfectly inelastic

A horizontal demand has infinite elasticity and called perfectly elastic

Impact on total expenditure:

 Demand is elastic: price and expenditures moving in opposite directions

 Demand is inelastic: price and expenditures moving in same direction
 Demand is unitary elastic: changes in price associate no changes in total expenditures

Income elasticity of demand: is defined as the percentage change in quantity demanded divided by the
percentage change in income (I), holding all other things constant

E Income = % Δ Q d / % Δ I

 Normal goods: is good that consumed in greater quantities as income increases

 Inferior goods: is goods that consumed in lower quantities as income increases

Cross-price elasticity of demand: define an elasticity with respect to the other price
4
E cross price = % Δ Q d / % Δ cross price

 Substitute: tow goods that if price of one increases, demand on the other increases & curve shift
upward to the right
 Complements: tow good that if price of one increases, demand on the other decreases & curve shift
downward to the left
5

Demand and Supply analysis

Consumer demand
1- Consumer Theory

Consumer choice theory: can be defined as a branch of microeconomics that relates consumer demand
curves to consumer preferences

Budget constraints: the ability to purchase a various combinations of goods and services constrained by a
given income, it’s a constraint on spending or investing by income or wealth

2- Utility theory

Axioms of the consumer choice theory:

Consumption bundle or basket: specific combination of goods and services that consumer would like to
consume

 Complete preferences: the assumption that a consumer is able to make a comparison between any
two bundles of goods
 Transitive preferences: the assumption that when comparing any three bundles A, B & C, if A is
preferred than B & B is preferred than C, then A is preferred than C is a must
 Non station (more is better): assumption that consumer could never have so much of a preferred
good that she would refuse any more, even it were free

The utility function: represents the preferences of a consumer, it’s a mathematical representation of the
satisfaction derived from a consumption basket, and it’s measured in utils which is the quantities of
happiness, or well-being or satisfaction, U = f (Qx1, Qx2 ... Qxn)

Indifference curve: a curve representing all the combinations of two goods or attributes such that the
consumer is entirely indifferent among them, it is negatively sloped, convex and cannot cross

Marginal rate of substitution: the slope of indifference curve at any point is referred to marginal rate of
substitute, the rate of which consumer is willing to give up one good to obtain more of another

Indifference curve map: a group or family of indifference curves representing a consumer’s entire utility
function

3- The opportunity set

Simply there is no enough of everything to satisfy everyone at a given time, so we examine how to represent
the set of choices from which to choose

Income (Budget) constraint: means consumer has the freedom to spend his income anyway he chooses as
long as the total expenditures is below income

PB QB + PW QW = I

A simple algebraic budget constraint in terms of intercept and slope will be

6
QW = (I / PW) – (PB / PW) QB

 If price of horizontal axis rise, budget constraint become more steeper

 If price of vertical axis rise, budget constraint become less steeper
 If income were to rise, budget constraint shifts to the right

Production opportunity set: Companies face constraints on their production opportunities simply like
consumer budget constraints

Production opportunity frontier: Curve describe the maximum number of units of one good a company can
produce, for any given number of the other good that it chooses to manufacture

Opportunity cost: the value that investors forgo by choosing a particular course of action, the value of
something in its best alternative use

Investment opportunity set: We can structure her investment opportunities as a frontier that shows the
highest expected return consistent with any given level of risk

4- Consumer equilibrium, maximizing utility subject to budget constraint

It would be wonderful if could have as much of everything as we wanted, but we can’t have, we now
superimpose the budget constraints onto the preferences map to model the actual choice of consumer

Consumer equilibrium: This is a constrained optimization problem consists of maximizing utility subject to
budget constraint

Equilibrium point: represents the tangency between the highest indifference curve and the budget constraint

Tangency point: where the two curves have the same slope, MRS is equal to price ratio, maximizing
consumer surplus

Consumer response to changes in income: as income increase, budget constraints shift outward, and vice
versa

 Normal goods where the income effect is positive

 Inferior goods where income effect is negative
 Geffen goods are inferior where income effect is negative and weights the positive substitute effect
 Veblen goods where the higher price make it more desirable like Gucci bag

5- Revisiting consumer’s demand function

Consumer demand curve from preferences and budget constraints

Substitution and income effects on normal goods: as price falls, demanded quantity increases due to
substitute and income effects

An important thing to notice is that the pure substitution effect must always be in the direction of purchasing
more when the price falls and purchasing less when the price rises, this is because of the diminishing
marginal rate of substitution, or the convexity of the indifference curve.

Pure income effect is in the same direction of substitute effect for normal goods
7
Substitution and income effects on inferior goods: Pure income effect is in opposite direction for substitute
effect

Negative income effect larger than substitution effect for Giffen goods: Pure income effect is in opposite
direction and long magnitude for substitute effect

Veblen goods:
8

Demand and Supply analysis

The Firm
It’s the study of supply of goods and services by profit-maximizing

Profit is the difference between revenue and cost

Objectives of the firm:

Finance experts reconcile profitability and risk objectives by stating that the objective of the firm is to
maximize shareholders wealth, and generally can be describe as profit maximization

Types of profit measures:

Accounting profit = economic profit + normal profit

1. Accounting profit = Total revenue – explicit costs

Accounting profit: defined as net income reported on the income statement

Explicit costs: payments to third parties for services and resources they supply to the firm

2. Economic profit = accounting profit – implicit opportunity cost

3. Normal profit = implicit opportunity costs

Economic profit can be defined in publicly traded corporations as accounting profit minus the required
return on equity capital

Economic profit for a firm can originate from sources such as:
 Competitive advantage
 Exceptional managerial efficiency or skill
 Difficult to copy technology or innovation (e.g., patents, trademarks, and copyrights)
 Exclusive access to less-expensive inputs
 Fixed supply of an output, commodity, or resource
 Preferential treatment under governmental policy
 Large increases in demand where supply is unable to respond fully over time
 Exertion of monopoly power (price control) in the market
 Market barriers to entry that limit competition

As accounting and economic profits are variable in the long & short run, Normal profit is the minimum for a
firm to continue operating in the long run

Economic rent: is the surplus value that results from inelastic supply and higher market price than what is
required to bring the resource or good

Comparison of profit measures:

 Accounting profit > normal profit, Economic profit > 0, positive effect
 Accounting profit = normal profit, economic profit = 0, no effect
 Accounting profit < normal profit, economic < 0 implies economic loss, negative effect
9

Analysis of revenue, costs and profits:

Summary of profit, revenue and cost terms:

 Profit
1. Economic profit = Total revenue minus total economic cost; (TR – TC)
2. Economic costs = implicit + explicit
 Revenue
1. Total revenue (TR) = P x Q
2. Average revenue (AR) = TR / Q = P
3. Marginal revenue (MR) = ∆ in TR for the last unit sold
 Costs
1. Total costs (TC) = TFC + TVC
2. Total fixed cost (TFC) = Sum of all fixed expenses include opportunity costs
3. Total variable cost (TVC) = per unit VC × Q
4. Average total cost (ATC) = TC / Q = AFC + AVC
5. Average fixed cost (AFC) = TFC / Q
6. Average variable cost (AVC) = TVC / Q
7. Marginal cost (MC) = ∆TC / ∆Q

Profit maximization:

Function of profit is as follows:

 Rewards entrepreneurs for risk taking when pursuing business ventures to satisfy consumer demand.
 Allocates resources to their most-efficient use
 Spurs innovation and the development of new technology.
 Stimulates business investment and economic growth.

Calculate the point of profit maximization:

 Maximum profit occurs at output level where difference between TR & TC is the greatest
 Profit maximization takes place at the point where last per-unit revenue break even with per-unit cost
 Profit contribution occurs when revenue of an input unit exceeds its cost

Revenue – Total, average and marginal:

1- Perfect competition: a market structure where the individual firm has virtually no impact on market
price, because it is assumed to be a very small seller among a very large number of firms selling
essentially identical products

In perfect competition: Firms face a perfectly elastic demand curve and all units are sold at the same price

Price = AR = MR

2- Imperfect competition: is where an individual firm has enough share of the market or can control a
certain segment of the market and is therefore able to exert some influence over price

In imperfect competition: firm face a downward demand curve, to sell one more unit company must
decrease price, as price decline, AR & MR will decline and
 Price = AR ≠ MR
 MR declines with greater percentage that AR
 TR peaks when MR equals zero
10
Factors of production: land, labor, capital and material

Production function: provides the quantitative link between production output and the inputs used in
production process

Q = f (K, L) where K: capital, L: labor

Total product: the aggregate sum of production units for the firm during a period

Production function has 3 distinct regions:

 TP is increasing fast because of specialization

 TP is increasing in lower rate because labor experienced diminishing marginal productivity
 TP is declining

Costs – total, average, marginal, fixed and variable:

Total cost: are the summation of all costs, fixed or variable. The rate of increase in total costs declines up to
a certain output level and, thereafter, accelerates as the firm gets closer to full utilization of capacity

Total fixed cost: is the summation of all expenses that do not change when production varies

Quasi-fixed cost: a cost that stays the same over a range of production but can change to another constant
level when production moves outside of that range

Total variable cost: which is the summation of all variable expenses, has a direct relationship with quantity.
When quantity increases, total variable cost increases; total variable cost declines when quantity decreases

Relationship between TC, TVC and TFC is as follows:

 The curve for total costs is a parallel outward shift of the total variable cost curve by the amount of
total fixed cost
 At zero production, total costs are equal to total fixed cost because total variable cost at this output
level is zero.
 Fixed cost is horizontal line

Relationship between ATC, AVC and AFC:

 ATC and AVC take on a bowl shape pattern in which each curve initially declines
 Difference between ATC and AVC equals AFC
 When output increases, AFC decline as approaches the horizontal axis
 In the long run all costs are variable

Relation between ATC, AVC and MC:

 Marginal cost curve decreasing until some point it begins to increase in reflection of increasing total
cost due to producing more outputs
 MC intersects ATC & AVC at their respective minimum points

Short-run supply curve: is the section on MC curve that lies above intersection of the minimum point of
AVC curve

 Shutdown point: If the firm is operating below this point

 Breakeven point: if the firm is operating above intersection point between MR curve & ATC curve
 any point between two above points, firm will still operate in the short run and shutdown in long run
11
Breakeven point: is the point where net income = zero, in perfect competition it is Q where price = average
revenue = marginal revenue = average total cost

Output optimization & profit maximization:

 TR – TC is at maximum, firm should estimate TR & TC for various outputs

 Increase producing until MR = MC, firm should estimate MR & MC

Summary of profit maximization and loss minimization under perfect competition:

 TR = TC and MR > MC: Firm is operating at lower breakeven point; increase Q to enter profit
territory.
 TR ≥ TC and MR = MC: Firm is at maximum profit level
 TR < TC and TR ≥ TVC but (TR – TVC) < TFC (covering TVC but not TFC): Find level of Q that
minimizes loss in the short run; work toward finding a profitable Q in the long run; exit market if
losses continue in the long run.
 TR < TVC (not covering TVC in full): Shut down in the short run; exit market in the long run.
 TR = TC and MR < MC: Firm is operating at upper breakeven point; decrease Q to enter profit
territory

Economies of scale & diseconomies of scale:

Planning horizon: is the long run period in which all factors of production are variable including technology,
physical capital and plant size

SRATC - Short-run average total cost curve: the curve describes average total cost when some costs are
considered fixed

LRATC - Long-run average total cost curve: the curve describes average total cost when no costs are
considered fixed, which is derived from the short-run average total cost curves that are available to the firm
to choose from

Economies of scale: reduction in cost per unit resulting from increased production as a business expands
output, it can utilize more efficient technology and physical capital and take advantage of other factors to
lower the costs of production

Diseconomies of scale: increasing in cost per unit resulting from increasing production, the opposite effect
can result after a certain volume level at which the business faces higher costs as it expands in size

Both economies and diseconomies of scale can occur at the same time; the impact on long-run average total
cost depends on which dominates. If economies of scale dominate, Long Run ATC decreases with increases
in output; the reverse holds true when diseconomies of scale prevail.

Minimum efficient scale: the output that a firm can produce such that LARTC is minimized

Economies of scale and lower ATC can result from:

 Specialization and professionalism

 Able to afford more expensive and more efficient equipment
 Effectively reducing waste and lowering costs
 Better use of market information and knowledge for more-effective managerial decision making.
 Discounted prices on resources when buying in larger quantities.

Diseconomies of scale and higher TAC can result from:

12
 So large companies that it cannot be properly managed.
 Overlap and duplication of business functions and product lines.
 Higher resource prices because of supply constraints when buying inputs in large quantities.

Long-run industry supply curve: a curve describing relationship between quantities supplied and output
prices when no costs are considered fixed

Increasing-cost industry: productive inputs prices increase as industry expands, long run curve for the
industry is upward sloping. Example is oil industry, as demand increases, costs of finding oil & prices
increases

Decreasing-cost industry: resource prices fall as industry expand, long run supply curve is downward
sloping. Example is flat-panel television industry, as demand increases, costs & prices decreases

Constant- cost industry: resource prices stay constant as industry expand, long rum supply curve is flat
(perfectly elastic) at minimum average cost

Productivity:

Productivity is defined as: the amount of output produced by workers in a given time period, common
practice is to measure productivity of labor in form of number of workers or number of worked hours

Benefits from increasing productivity:

 Lower business costs, which translate into increased profitability

 An increase in worker rewards, which motivates further productivity increases from labor.

Total product of labor is the output for a specific amount of labor

Average product of labor per worker is total product of labor divided by number of workers

Marginal product of labor is the addition to total product of labor from employing on more worker

Marginal product is a better measure than average and total product, however average is useful when it is
difficult to determine productivity of any one worker

Increasing marginal returns: where the marginal product increases as additional input increases

Law of diminishing returns: where the marginal product decreases as additional input increases

Actually in the short run; AP & MP are respective mirrors for AC & MC, in turn, productivity significantly
influences total, marginal, and average costs to the firm, and costs directly impact profit. Obviously, what
happens at the production level in terms of productivity impacts the cost level and profitability

The firm always wants to maximize output per monetary unit of input cost.

Addition output from employing one more unit = Price of input / MP of input

Output per additional dollar spent = MP of input / Price of input

Cost minimization:

At quantities of input where MP Labor / P Labor = MP capital / P capital

13
Profit maximization

Marginal revenue product: it is the monetary value of marginal product of an input, MRP is the increase in
firm’s total revenue from selling the additional output from employing one more unit of labor or capital

It is calculated by multiplying MP of an input by marginal revenue of the additional output

This term measures the value of the input to the firm in terms of what the additional input contributes to TR.
It is also defined as the change in TR divided by the change in the quantity of the resource employed

MRP = MP input x MR output

Profit maximization occurs when the MRP equates to the price or cost of the input for each type of resource
that is used in the production process.

Finally we can estate that cost minimization or profit maximization, a firm must employ inputs in
quantities that:

MPR1/P1 = MPR2/P2 = MPRN / PN

Market structures
14
Analysis of market structures:

Factors that determine market structure:

 The number and relative size of firms supplying the product

 The degree of product differentiation
 The power of the seller over pricing decisions
 The relative strength of the barriers to market entry and exit
 The degree of non-price competition

Economists’ four types of market structures:

Characteristics of market structure:

Degree of product
Market structure Number of sellers Barriers to entry Pricing power Non price competition
differentiation
Perfect competition Many Standardized Very low None None
Advertising and product
Monopolistic competition Many Differentiated Low Some
differentiation
Some or Advertising and product
Oligopoly Few Standardized High
Considerable differentiation
Monopoly One Unique Very high considerable advertising

Porter’s five forces: presented a systematic analysis of the practice of market strategy:

 Threat of substitutes
 Threat of entry
 Intensity of competition
 Bargaining power of customers
 Bargaining power of suppliers

Perfect competition:
Demand analysis:
Firms are price takers, individual firm’s demand curve is horizontal, perfectly elastic

A profit maximization firm will produce Q when P = AR = MR = MC and

 P > ATC – economic profit

 P = ATC – normal profit, long run equilibrium
 P Between ATC & AVC – economic loss
 P Below AVC - shutdown

Long run equilibrium for the industry is same price with higher quantity due to increase in demand
continued by increase in supply

Schumpeter pointed out that technical change in economics can happen in two main ways:
1. Innovation of process: a new, more efficient way to produce an existing good or service.
2. Innovation of product: a new product altogether or an innovation upon an existing product

Monopolistic competition:
15
Firms are price searchers that faces downward sloping demand curve, individual supply curve are highly
elastic because competing products are close substitutes

Profit maximization in short run is to produce quantity where MR = MC and charge price of demand curve
which is above ATC

In long run more firms enter the industry, shifts individual firm’s demand curve where to equal ATC but not
in its minimum point and only normal profit will be earned, the firm will still produce at profit maximization
point where MC = MR

Note that in monopolistic competition P = ATC above MC = MR due to cost of advertising and
differentiating products

Oligopoly:
The key difference between oligopoly and monopolistic competition is that firms are interdepended, so a
price change by one firm can be expected to be met with a price change by competitors

Because of the complicated relationship between competitors, four models to describe pricing and profits:

1- Kinked demand curve model:

Demand curve in elastic above the kink and inelastic below the kink, at the kink is the quantity of profit
maximization

2- Cournot model:

2 identical firms knows the amount supplied by the other in the previous period and assumes that this will
not change in the next period, by subtracting this quantity from market demand curve, the firm can construct
its own demand curve and production which maximize its profit, quantities between the 2 firms will change
until they are equal and achieve stable equilibrium. Stable price will be between monopolist and perfect
competition prices. As number of firms increase, price will fall towards perfect competition price

3- Nash equilibrium

Nash equilibrium is reached when the choices of all firms are such there is no other choice that make any
firm better off (increases profits or decreases losses)

Nash equilibrium is presented by Prisoner’s dilemma type game

4- Dominant firm model

There is a single dominant firm with significantly large market share because of greater scale and lower cost
structure which determine the price and other competitors follow it

Monopoly:
16
Firm is a price searcher that facing a downward demand curve, the firm must determine what price to charge by
experiment different prices hoping to find the right combination of price and quantity that maximizing profit

Two pricing strategies are:

1- Single price: single price for all customers

Monopolists will expand production to the quantity that MR = MC, due to barriers to enter, positive
economic profit can last for the long run

2- Price discrimination: charging different prices for different customers based upon that product is
non-resalable, its motivation to do so is to capture more consumer surplus as economic profit

Types of price discrimination:

 First degree price discrimination: where a monopolist is able to charge each customer the highest
price the consumer is willing to pay
 Second degree price discrimination: where monopolist charges different per unit prices using the
quantity purchased as an indicator of how highly the customer values the product
 Third degree price discrimination: where monopolist segregates customers into groups based on
demographic or other characteristics and offer different prices to each group

For price discrimination to work, the seller must:

 Face downward demand curve

 Have at least two different groups with different elasticities of demand
 Be able to prevent reselling product from the low price buyer to the higher ones

With perfect price discrimination, all consumer surplus will by captured by the monopolist

Under monopoly, the firm will produce lower Q with higher P

Because monopolists produce less than the optimal quantity, government aimed to improve resources
allocation by regulating monopolists’ prices by either ways:

1- Average cost pricing: force monopolists to reduce prices where D = ATC which will increase output,
decrease price, increase social welfare and ensure normal profit for the firm
2- Marginal cost pricing: force monopolist to reduce prices where D = MC which will increase output,
decrease price, increase social welfare but economic losses for the firm which requires government
subsidy equal to normal profit to prevent the firm from exiting

Supply finctions under each market structure:

Under perfect competition supple curve is MC curve above its AVC curve, under monopolistic competition,
oligopoly and monopoly, there is no well-defined supply function because firms face downward demand
curve and quantity supplied in determined by MR = MC and price charged determined by demand curve

How should one measure market power?

17
The theoretical answer is to estimate the elasticity of demand. If demand is very elastic, the market must be very close
to perfect competition. If demand is rigid (inelastic), companies may have market power, however it is very difficult to
be measured

The simplest measure is the concentration ratio:

N-firm concentration ratio: it is calculated as the sum of share percentage of the largest N-firms in the
market, the main advantage is that it is simple to compute, the disadvantage is that it does not directly quantify market
power and it may be relatively insensitive to mergers

HHI (Herfindahl-Hirschman index): it is calculated as the sum of squares of the largest firms in the market

Main disadvantage for both is that barriers does not considered in either ratios