Microeconomics — Supply, Demand & Market Structures

Supply & Demand

The law of demand : as price rises, quantity demanded falls (negative slope, ceteris paribus). The law of supply : as price rises, quantity supplied rises (positive slope). Market equilibrium : where supply and demand curves intersect (P*, Q*). At prices above equilibrium: surplus (excess supply). Below equilibrium: shortage (excess demand). Shifts : demand shifts with income, preferences, prices of related goods (substitutes/complements), expectations, and population. Supply shifts with input costs, technology, government policy, and number of sellers. Price controls : price ceilings (rent control → shortages) and price floors (minimum wage → surplus labor/unemployment debate).

Elasticity

Price elasticity of demand (PED) = %ΔQᵈ / %ΔP. |PED| > 1: elastic (luxury goods, many substitutes). |PED| < 1: inelastic (necessities, few substitutes, addictive goods). |PED| = 1: unit elastic. Along a linear demand curve, elasticity varies (elastic at high prices, inelastic at low). Income elasticity : normal goods (positive), inferior goods (negative), luxury goods (>1). Cross-price elasticity : substitutes (positive), complements (negative). Price elasticity of supply : depends on production flexibility and time horizon (more elastic in long run). Tax incidence : the more inelastic side bears more of the tax burden (why cigarette taxes mostly fall on consumers).

Consumer & Producer Theory

Utility theory : consumers maximize utility subject to budget constraint. Marginal utility diminishes (law of diminishing MU). Optimal consumption: MUₐ/Pₐ = MUᵇ/Pᵇ (equal marginal utility per dollar). Indifference curves (convex to origin) + budget line → optimal bundle at tangency point. Producer theory : firms maximize profit (π = TR – TC). Short-run costs: fixed (FC) + variable (VC). Marginal cost (MC) = ΔTC/ΔQ, intersects ATC at its minimum. Profit maximization : produce where MR = MC. Economies of scale (decreasing ATC), diseconomies of scale (increasing ATC). Consumer surplus : area between demand curve and price. Producer surplus : area between price and supply curve.

Market Structures

Perfect competition : many sellers, identical products, free entry/exit, price takers. P = MR = MC in long run, zero economic profit. Monopoly : single seller, unique product, barriers to entry. P > MC, deadweight loss, may price discriminate (1st, 2nd, 3rd degree). Natural monopoly: declining ATC (utilities). Monopolistic competition : many sellers, differentiated products, free entry (restaurants, clothing). Short-run: possible profits; long-run: zero economic profit. Oligopoly : few large firms, interdependent pricing. Models: Cournot (quantity), Bertrand (price), Stackelberg (leader-follower). Collusion risk (cartels like OPEC). Game theory : Prisoner’s Dilemma, Nash equilibrium (each player’s strategy is best response to others).

Market Failures & Government

Externalities : costs/benefits not reflected in market prices. Negative: pollution (Pigouvian tax, cap-and-trade — EU ETS). Positive: education, vaccination (subsidies). Public goods : non-excludable, non-rivalrous (national defense, street lighting). Free-rider problem → government provision. Common resources : rivalrous but non-excludable (overfishing, tragedy of the commons). Information asymmetry : adverse selection (lemons problem, Akerlof 1970), moral hazard (insurance). Solutions: signaling (education), screening (deductibles). Government intervention : taxes, subsidies, regulation, antitrust enforcement. Deadweight loss from taxation; efficiency vs. equity trade-offs.

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❓ Frequently Asked Questions

What is supply and demand?

Supply and demand is the fundamental model of how prices are determined in a market. Demand shows how much buyers want at each price (downward-sloping). Supply shows how much sellers offer (upward-sloping). The intersection sets the market equilibrium price and quantity. Changes in factors like income, costs, or preferences shift these curves.

What is price elasticity?

Price elasticity of demand measures how responsive quantity demanded is to a price change: PED = %ΔQ/%ΔP. Elastic (|PED|>1): demand changes significantly with price (luxury goods). Inelastic (|PED|<1): demand barely changes (necessities like insulin). This determines whether raising prices increases or decreases total revenue.

What is a Nash equilibrium?

A Nash equilibrium (John Nash, 1950) is a situation in a game where no player can improve their payoff by unilaterally changing their strategy, given the other players’ strategies remain fixed. It’s not necessarily optimal (Prisoner’s Dilemma: both confess is Nash but both staying silent is better for both). Applications: pricing wars, arms races, auction design.

Why do monopolies cause inefficiency?

Monopolists set P > MC to maximize profit, producing less than the socially optimal quantity. This creates deadweight loss — transactions that would benefit both buyer and seller don’t occur. Additionally, monopolists may have less incentive to innovate and can extract consumer surplus through market power. Antitrust laws (Sherman Act, EU competition policy) address this.

What is an externality?

An externality is a cost or benefit of a transaction that affects third parties not involved in it. Negative: factory pollution harms nearby residents (cost not in the product’s price). Positive: your neighbor’s garden raises your property value. Without intervention, markets overproduce negative externalities and underproduce positive ones. Solutions: Pigouvian taxes/subsidies, Coase theorem (property rights bargaining), regulation.

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