How individuals, households, and firms make decisions and interact in markets.
Consumer Choice
Utility and Satisfaction
Utility = Satisfaction or benefit from consuming goods and services.
| Concept | Definition | Example |
|---|
| Total utility | Total satisfaction from all units consumed | Satisfaction from eating 3 slices of pizza |
| Marginal utility | Additional satisfaction from one more unit | How much the 4th slice adds |
| Diminishing marginal utility | Each additional unit adds less satisfaction | 1st slice great, 4th slice okay, 7th slice regretted |
The Rational Consumer
Consumers maximize utility given their budget constraint.
| Decision Rule | Meaning |
|---|
| Budget constraint | Income limits what you can buy |
| Equimarginal principle | Allocate spending so last dollar on each good gives equal utility |
| Optimal choice | Can't improve by switching spending between goods |
Budget Constraint Example
Income: $100 Price of movies: $20 Price of meals: $10
| Movies | Meals | Total Spent |
|---|
| 5 | 0 | $100 |
| 4 | 2 | $100 |
| 3 | 4 | $100 |
| 2 | 6 | $100 |
| 1 | 8 | $100 |
| 0 | 10 | $100 |
Trade-off: Every movie costs 2 meals (opportunity cost).
Consumer Surplus
The difference between what you're willing to pay and what you actually pay.
| Your Willingness to Pay | Market Price | Consumer Surplus |
|---|
| $50 | $30 | $20 (you gained value) |
| $30 | $30 | $0 (break even) |
| $20 | $30 | Don't buy (would lose value) |
Markets create value: Consumer surplus represents gains from trade.
Producer Theory
Costs of Production
| Cost Type | Definition | Example |
|---|
| Fixed costs | Don't change with output | Rent, equipment, salaries |
| Variable costs | Change with output | Materials, hourly labor, utilities |
| Total cost | Fixed + Variable | All costs combined |
| Average cost | Total cost / Quantity | Cost per unit |
| Marginal cost | Cost of one more unit | Additional cost of next item |
Cost Curves
| Output | Fixed Cost | Variable Cost | Total Cost | Average Cost | Marginal Cost |
|---|
| 0 | $100 | $0 | $100 | - | - |
| 1 | $100 | $30 | $130 | $130 | $30 |
| 2 | $100 | $50 | $150 | $75 | $20 |
| 3 | $100 | $80 | $180 | $60 | $30 |
| 4 | $100 | $120 | $220 | $55 | $40 |
| 5 | $100 | $180 | $280 | $56 | $60 |
Notice: Average cost first falls (spreading fixed costs) then rises (diminishing returns).
Economies of Scale
| Concept | Definition | Example |
|---|
| Economies of scale | Average cost falls as output increases | Large factory more efficient |
| Diseconomies of scale | Average cost rises as output increases | Organization becomes unwieldy |
| Minimum efficient scale | Output where economies exhausted | Optimal plant size |
Producer Surplus
The difference between the price received and the minimum acceptable price.
| Minimum Acceptable | Market Price | Producer Surplus |
|---|
| $20 | $30 | $10 (profit on marginal unit) |
| $30 | $30 | $0 (break even) |
| $40 | $30 | Don't produce (would lose money) |
Profit Maximization
The Profit-Maximizing Rule
Produce where Marginal Revenue = Marginal Cost (MR = MC)
| Output | Price (MR) | Marginal Cost | Decision |
|---|
| 1 | $50 | $20 | Produce (MR > MC) |
| 2 | $50 | $30 | Produce (MR > MC) |
| 3 | $50 | $50 | Produce (MR = MC) |
| 4 | $50 | $70 | Don't produce (MR < MC) |
Optimal output: 3 units (where MR = MC)
Short-Run vs. Long-Run Decisions
| Time Horizon | Fixed Factors | Decision |
|---|
| Short run | Some factors fixed (plant size) | Adjust variable inputs |
| Long run | All factors variable | Adjust everything, entry/exit |
Shutdown Decision
| Situation | Rule | Reason |
|---|
| Price > Average Total Cost | Stay open, making profit | Covering all costs plus some |
| Average Variable Cost < Price < ATC | Stay open short-run | Covering variable costs, losing less than shutting |
| Price < Average Variable Cost | Shut down | Losing more than just fixed costs |
Market Structures
Types of Markets
| Structure | Number of Firms | Product | Barriers to Entry | Price Power |
|---|
| Perfect competition | Many | Identical | None | None (price taker) |
| Monopolistic competition | Many | Differentiated | Low | Some |
| Oligopoly | Few | Either | High | Significant |
| Monopoly | One | Unique | Very high | Full |
Perfect Competition
| Characteristic | Implication |
|---|
| Many small firms | No single firm affects price |
| Identical products | Consumers don't care who sells |
| Free entry/exit | Profits attract entrants |
| Perfect information | Everyone knows prices |
Long-run outcome: Zero economic profit (accounting profit covers opportunity cost only).
Monopoly
| Source of Monopoly | Example |
|---|
| Control of resource | De Beers diamonds (historical) |
| Government license | Utilities, patents |
| Natural monopoly | High fixed costs (one firm more efficient) |
| Network effects | Platform dominance |
Monopoly pricing:
| Aspect | Competition | Monopoly |
|---|
| Price | Lower | Higher |
| Quantity | Higher | Lower |
| Consumer surplus | Higher | Lower |
| Producer surplus | Normal | Higher |
| Total welfare | Maximum | Deadweight loss |
Oligopoly
| Behavior | Description |
|---|
| Strategic interaction | Each firm considers rivals' reactions |
| Game theory applies | Nash equilibrium, prisoner's dilemma |
| Possible collusion | Firms may coordinate to act like monopoly |
| Kinked demand curve | Prices sticky (rivals match cuts, not raises) |
Monopolistic Competition
| Feature | Effect |
|---|
| Product differentiation | Firms have some price power |
| Free entry | Zero long-run economic profit |
| Advertising important | Creates brand loyalty |
| Excess capacity | Firms produce below minimum cost |
| Examples | Restaurants, clothing, services |
Strategic Behavior
Game Theory Basics
| Concept | Definition |
|---|
| Players | Decision makers |
| Strategies | Possible actions |
| Payoffs | Outcomes for each combination |
| Nash equilibrium | No player can improve by changing alone |
| Dominant strategy | Best choice regardless of others |
Prisoner's Dilemma
| Partner Silent | Partner Confesses |
|---|
| You Silent | Both: 1 year | You: 10 years, Partner: Free |
| You Confess | You: Free, Partner: 10 years | Both: 5 years |
Nash equilibrium: Both confess (5 years each) even though both silent (1 year each) is better collectively.
Business parallel: Price wars - cutting prices is rational individually but harmful collectively.
Overcoming the Dilemma
| Mechanism | How It Works | Example |
|---|
| Repeated games | Fear of retaliation | Ongoing business relationships |
| Reputation | Future dealings matter | Brand protection |
| Contracts | Legal enforcement | Explicit agreements |
| Collusion | Coordinate decisions | Cartels (often illegal) |
| Signaling | Communicate intentions | Industry announcements |
Pricing Strategies
Price Discrimination
Charging different prices to different customers for the same product.
| Degree | Description | Example |
|---|
| First degree | Individual prices | Negotiated sales, auctions |
| Second degree | Quantity discounts | Bulk pricing, packages |
| Third degree | Group pricing | Student discounts, regional pricing |
Requirements for Price Discrimination
| Requirement | Reason |
|---|
| Market power | Must be able to set price |
| Identify groups | Different willingness to pay |
| Prevent resale | Can't arbitrage between groups |
Other Pricing Tactics
| Strategy | Description | Example |
|---|
| Bundling | Sell products together | Cable packages |
| Two-part pricing | Entry fee + per-unit price | Costco membership + purchases |
| Versioning | Different quality levels | Basic vs. premium software |
| Peak pricing | Higher price at peak demand | Uber surge, airline pricing |
| Penetration pricing | Low initial price to gain share | New subscription services |
| Loss leaders | Sell below cost to attract | Grocery store sales |
Factor Markets
Labor Market
| Concept | Meaning |
|---|
| Marginal product of labor | Additional output from one more worker |
| Marginal revenue product | Marginal product x price of output |
| Wage = MRP | Firm hires until wage equals value of worker |
| Labor demand | Derived from product demand |
Wage Determination
| Factor | Effect on Wages |
|---|
| Skill/education | Higher skills = higher wages |
| Risk/difficulty | Compensating differential |
| Unions | Collective bargaining power |
| Minimum wage | Floor on wages |
| Discrimination | Wage gaps not explained by productivity |
| Monopsony | Single buyer depresses wages |
Capital and Interest
| Concept | Meaning |
|---|
| Physical capital | Machines, buildings, equipment |
| Interest rate | Price of borrowing capital |
| Present value | Today's value of future payments |
| Investment decision | Invest if return > interest rate |
PV = Future Value / (1 + r)^n
| Future Value | Interest Rate | Years | Present Value |
|---|
| $1,000 | 5% | 1 | $952 |
| $1,000 | 5% | 5 | $784 |
| $1,000 | 5% | 10 | $614 |
| $1,000 | 10% | 10 | $386 |
Key insight: Money today is worth more than money later.
Market Efficiency
Conditions for Efficiency
| Condition | Meaning |
|---|
| Perfect competition | No market power |
| No externalities | All costs/benefits are private |
| Perfect information | Everyone knows everything relevant |
| Complete markets | Markets exist for all goods |
| No transaction costs | Exchange is costless |
When Markets Fail
| Failure | Problem | Solution |
|---|
| Market power | Too little output, too high price | Antitrust, regulation |
| Externalities | Wrong amount produced | Tax, subsidize, regulate |
| Public goods | Underproduction | Government provision |
| Asymmetric info | Adverse selection, moral hazard | Disclosure, insurance reform |
| Transaction costs | Trade doesn't happen | Reduce barriers |
Key Takeaways
Consumers maximize utility - Given budget constraints, people allocate spending to equalize marginal utility per dollar
Firms maximize profit - Produce where marginal revenue equals marginal cost; shut down if price falls below average variable cost
Market structure determines behavior - Competition drives profits to zero; monopoly extracts rents; oligopolies play strategic games
Strategic interaction matters - Game theory helps predict behavior when decisions are interdependent
Price discrimination captures surplus - Firms charge different prices to extract more value from customers
Factor markets are derived - Demand for labor and capital comes from demand for products
Efficiency requires many conditions - Market failures justify intervention but interventions can also fail