Advanced Microeconomic Theory: Key Concepts

Advanced Microeconomic Theory: Key Concepts

• Utility Maximization and Consumer Choice:
  • Consumers seek to maximize their utility (satisfaction) given their budget constraint.
  • Utility functions represent preferences, often assumed to be continuous, monotonic (more is preferred to less), and convex (diminishing marginal rate of substitution).
  • Indifference curves graphically depict these preferences. They slope downward and are convex to the origin.
  • The budget constraint represents all possible bundles of goods that the consumer can afford.
  • Equilibrium occurs where the highest attainable indifference curve is tangent to the budget constraint. This tangency point represents the optimal consumption bundle.
  • Marginal rate of substitution (MRS) measures the rate at which a consumer is willing to trade one good for another while maintaining the same level of utility.
  • Income and substitution effects explain how changes in price affect consumer demand.
  • Consumer surplus is the difference between the total amount a consumer is willing to pay for a given quantity and the amount actually paid.

Production Theory and Cost Minimization

• Production Functions:

  • Production functions show the relationship between inputs (e.g., labor, capital) and output.
  • Short-run production functions assume one or more inputs are fixed, while long-run functions allow all inputs to vary.
  • Key concepts like marginal product and average product of inputs describe the production process's efficiency.
  • Diminishing marginal returns describes how the marginal product of a variable input eventually declines as more of it is used with fixed inputs.

• Cost Minimization:

  • Firms aim to minimize their costs for a given level of output.
  • Isoquants depict the various input combinations that can produce a specific output level.
  • Isocost lines illustrate different combinations of inputs that cost the same.
  • Cost minimization occurs where the isoquant is tangent to the lowest isocost line. The slope of the isoquant (MRTS) equals the ratio of input prices.
  • Long-run cost curves are derived from minimizing costs at various output levels. Short-run cost curves include fixed costs.

Market Structures and Firm Behavior

• Perfect Competition:

  • Many buyers and sellers, homogeneous products, free entry and exit.
  • Firms are price takers. Demand curve is perfectly elastic.
  • Firms maximize profit by producing where marginal cost equals price.

• Monopoly:

  • Single seller, unique product, significant barriers to entry.
  • Firms are price makers. Demand curve is downward sloping.
  • Firms maximize profit by producing where marginal cost equals marginal revenue. This often leads to higher prices and less output than in perfect competition. Deadweight loss represents inefficiency.

• Monopolistic Competition:

  • Many sellers, differentiated products, low barriers to entry.
  • Firms have some price-setting power due to product differentiation, but the market is relatively competitive.
  • Downward-sloping demand curves exist. Short-run profit maximization occurs at the point where marginal revenue equates marginal cost.

• Oligopoly:

  • Few large sellers, significant interdependence among firms.
  • Firms' decisions affect each other, making game theory a critical tool for understanding pricing and output decisions.
  • Possible outcomes include collusion (forming cartels), price wars, and tacit coordination.

Game Theory

• Game theory: Models strategic interactions between rational agents.
• Normal form games: Represent strategies and payoffs in tabular form.
• Nash equilibrium: A stable state where no player can improve their payoff by unilaterally changing their strategy.
• Prisoner's Dilemma: Illustrates the conflict between individual and collective rationality.
• Repeated games: Consider the possibility of future interaction between players.
• Applications of game theory: Used in various fields, including economics, politics, and biology, to understand strategic interactions between agents.

Market Failures

• Externalities: Occur when a transaction impacts a third party not directly involved.

  • Positive externalities (e.g., education) lead to underproduction, necessitating government subsidies.
  • Negative externalities (e.g., pollution) result in overproduction, requiring government intervention such as taxes or regulations.

• Public Goods: Goods that are non-excludable and non-rivalrous (e.g., national defense).

  • Private providers cannot effectively supply public goods due to the free-rider problem.
  • Typically require government provision.

• Information Asymmetry: One party has more information than another in a transaction.

  • Can lead to market inefficiencies and adverse selection.

General Equilibrium

• General equilibrium analysis examines the interaction of all markets within an economy.
• Walrasian equilibrium: A state where supply equals demand in all markets simultaneously, and all markets clear.
• Pareto efficiency: A state where it is impossible to make any individual better off without making at least one individual worse off.

Welfare Economics

• Welfare economics studies how different market structures and policies affect overall economic well-being.
• Consumer and producer surplus measures the gains from trade.
• Deadweight loss arises from market distortions like taxes or monopolies.
• Welfare theorems relate competitive equilibrium to Pareto efficiency.