Intermediate Microeconomic

Theory
Tools and Step-by-Step Examples

Chapter 1:
Introduction
 What is Microeconomics?
• Microeconomics seeks to understand “individual” behavior.
• Consumers. Purchasing decisions.
• If your favorite singer is coming to town, would you buy one
ticket at price $45?
• Firms. Input decisions.
• How many workers to hire and computer to purchase?
• Regulators. Public officials can anticipate how firms and
consumers behave in different markets.
• Can some policy tools, such as taxes or quotas on consumers
or firms, be beneficial?

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 What is Microeconomics?
• The behavior of economic agents is investigated under the
assumption of rationality:
• Each agent seeks to maximize her payoff (i.e., utility of the
consumer, or profits for the firm), given her resources, and the
information to which she has access.
• Two contexts:
• When an agent seeks to maximize her own material payoff.
• When she maximizes a combination of her own and other
agents’ payoffs (allowing her to be selfish or altruistic).

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 Comparative Statics
• “Comparative statics”, to measure how an individual's behavior
changes when one, and only one, variable varies (e.g., the
price of the item).
• If your favorite singer is coming to town, would you buy one
ticket at price $45?
• Yes
• Would you make a different choice if the ticket price increases to
$55?

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 Overview of the Book
• Consumer Theory (chapters 2-6)
• Chapter 2: A model to represent a consumer.
• Notion of consumption bundle (i.e., a list of goods and
services).
• How a consumer’s preferences rank different bundles.
• How to represent these preferences in a utility function,
measuring the consumer’s well-being from each bundle.
• Properties that utility functions can satisfy.

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 Overview of the Book
• Consumer Theory (chapters 2-6)
• Chapter 3: The consumer’s optimal purchasing decision.
• Budget constraints, which are dictated by good prices and
available income.
• Consumer’s purchasing decision (“demand” for a good):
• Buy the bundle that increases my utility as much as possible
but … without breaking the bank!

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 Overview of the Book
• Consumer Theory (chapters 2-6)
• Chapter 4: Changes in a consumer’s demand for a good.
• When her income increases by a small amount.
• After winning the lotto, you may increase purchases for most
goods (e.g., a nicer car), and yet may decrease purchases of
some goods (e.g., fast food).
• When the price of the good experiences a small increase.

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 Overview of the Book
• Consumer Theory (chapters 2-6)
• Chapter 5: Welfare loss due to a price increase.
• Three measures to evaluate this welfare loss:
• Change in consumer surplus.
• Compensating variation.
• Equivalent variation.
• Similarities and differences, and applications to different
contexts.

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 Overview of the Book
• Consumer Theory (chapters 2-6)
• Chapter 6: Choice under uncertainty.
• Situations where the consumer faces uncertainty about
some elements that affect her utility.
• E.g., Accept a job paying $60,000/year with certainty
(100% probability), or work for a star-up company that will
pay $95,000 if it makes it to the New York Stock Exchange
(30% probability) or $15,000 if it does not (70% probability).
• “Expected utility”.
• Risk attitudes.
• Measures of risk aversion.

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 Overview of the Book
• Production Theory (chapters 7-8)
• Chapter 7: The firm’s optimal production decision.
• Use of inputs (how many workers to hire or machines to
purchase).
• Technological constraints, indicating the output levels the
firm can produce given its technology.

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 Overview of the Book
• Production Theory (chapters 7-8)
• Chapter 8: The firm’s costs from its output decision.
• Units of each input that the firm hires.
• Average cost (i.e., cost per unit of output).
• Marginal cost (i.e., increase in cost when the firm increases
its output by one unit).
• How the firm’s average cost is affected when:
• Its scale expands (economies of scale).
• It offers more product lines (economies of scope).

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 Overview of the Book
• Markets (chapters 9-11)
• Chapter 9: Perfectly competitive market.
• Many firms, each producing a small share of industry output.
• Firms are “price takers.” When choosing to produce a larger
output, every firm can anticipate that is decision will not
affect market prices.

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 Overview of the Book
• Markets (chapters 9-11)
• Chapter 10: Monopoly.
• A single firm operates choosing the optimal output to
maximize profits.
• The monopolist is a “price setter.” His output decision
uniquely determines market price.
• Multiplant monopolies, a firm is the only seller of a product,
which is made at two or more plants.
• Welfare loss under a monopolized industry.

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 Overview of the Book
• Markets (chapters 9-11)
• Chapter 11: Price discrimination.
• Monopolists can further increase their profits.
• Three forms of price discrimination, charging different prices
to different consumers.
• Advertising, which makes the firm’s product known to a
larger pool of customers.
• Bundling, the firm offers customers a “bundle product” (e.g.,
PC tower and monitor).

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 Overview of the Book
• Strategy–Let’s Play Games (chapters 12-13)
• Chapter 12-13: Game Theory.
• The branch of economics studying strategic behavior.
• Interactions among “players” (firms, consumers, or
governments), when the action of one player affects the
payoffs of other players.
• Games in which all players (e.g., firms) choose their actions
(e.g., output levels) simultaneously (chapter 12).
• Games in which player act sequentially (chapter 13).
• “Equilibrium behavior” (how player behave) in each game.

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 Overview of the Book
• Putting Game Theory to Work (chapters 14-15)
• Chapter 14: Imperfectly competitive markets.
• Application of game theory tools to industries with a limited
number of firms.
• Markets in which firms simultaneously choose their actions,
either competing in price or quantity.
• Industries where firms act sequentially.
• Settings where firms sell products that consumers regards as
close (but not perfect) substitutes.

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 Overview of the Book
• Putting Game Theory to Work (chapters 14-15)
• Chapter 15: Incomplete information.
• Contexts where one player has more information than its
rivals.
• A firm observing its production cost, but its rivals cannot
perfectly observe it.
• Auctions, where each bidder knows how much she is willing
to pay for an object but she does not know how much other
bidders are willing to pay.
• First-price, second-price, and all-pay auction formats.
• Optimal bidding strategy (i.e., how much money you should
bid).

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 Overview of the Book
• More Market Failures–When Markets Work Well and
When They Don’t (chapters 16-17)
• Chapter 16: Contracts.
• One party is better informed that the other.

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 Overview of the Book
• More Market Failures–When Markets Work Well and
When They Don’t (chapters 16-17)
• Chapter 17: Externalities and public goods.
• Situations where actions of one agent produce external
effects on another agent’s well-being.
• Sustainability issues in common-pool resources (e.g., fishing
ground).
• In the short-run, when agents ignore the long-term effects,
they may exploit the resource intensively.
• When considering long-run effects, their optimal behavior
dictates a less intense exploitation.

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