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About the book
In this textbook you can read about how to develop models that describes how an economy works. The book provides a comprehensive overview of all facets from Microeconomics.
Starting with the market, consumers and producers followed by demand and production. You can also read about Monopoly, Price discrimination and Game theory.
Download the exercise book and test what you have learned.
Economics is often defined as something along the lines of “the study of how society manages its scarce resources.” The starting point of most such studies is that individuals allocate their resources such that they themselves will get the highest possible level of utility. An individual has an idea of what the con-sequences of different actions will be, and she chooses that action she believes will produce the best result for her. She is, in other words, selfish and rational. Note that she is also forward-looking. She acts so that she in the future will get the highest possible level of utility, independently of what she has already done. That she is selfish does not have to mean that she is an egoist. However, it does mean that she will only voluntarily share with others if she believes that she thereby will maximize her own utility. We often call this simplification of human beings Homo Economicus.
Economics: The study of how society manages its scarce resources
Homo Economicus: A model of human beings. She is assumed to maximize her own utility.
The resources that we are talking about here could be labor, capital (such as machines), and raw materials. That they are scarce means there are not enough resources to produce everything we want. That, in turn, means that one has to weight different things against each other. To get more of one thing, one has to give up something else. If you, e.g., want to sleep an extra hour, it is impossible to do so without giving up something else, such as an hour of studying. There is, consequently, a sort of a hidden cost to sleeping longer. This type of cost is called opportunity cost (or alternative cost). A classical saying in economics is that “there is no such thing as a free lunch.” This means that, even if you do not actually pay for the lunch, you always have to give up at least the time when you could have done something else. That is, you always have to pay the opportunity cost.
Resources: Labor, capital and raw materials. The things we use to produce goods and services.
Opportunity/alternative cost: The (hidden) cost of choosing one alternative instead of another.
When we study microeconomics, it is primarily individual human beings and individual firms, agents, that we study. This is in contrast to macroeconomics, where one studies whole economies, and questions such as unemployment and inflation.
Microeconomics: The study of the economic behavior of individual human beings and firms.
Agent: An entity that is capable of making a deci-sion, e.g. a human being or a firm.
Macroeconomics: The study of whole economies.
Roughly speaking, there are three types of decisions that need to be made in an economy: Which goods and services to produce, how to produce them, and who should get them. Often in economic models, the prices of goods (or ser-vices, labor, capital, etc.) automatically coordinate these decisions in a market. A market is any mechanism where buyers and sellers meet. That could be, for example, a market square, a stock exchange, or a computer network where one can buy and sell things.
Market: Meeting place where buyers and sellers are able to trade with each other.
Microeconomics if often based on models. We try to describe a real phenome-non as simply as possible by only highlighting a few central features. Many economic models can be used for predictions and can therefore be tested against reality. Such models are called positive. The opposite kind of models, models that are about values, is called normative. For example, to decide about an economic policy one would first use positive economics to make as-sessments about the consequences of different alternatives. Then one would use one’s opinions about what is desirable and what is not to choose between the different alternatives. That is then a normative decision.
Model: A simplified description of reality.
Positive economics: A testable economic model.
Normative economics: An economic model that includes values (and therefore is not testable).
2 Supply, Demand, and Market Equilibrium
2.1.1 The Demand Curve
2.1.2 When do We Move along the Demand Curve, and When Does It Shift?
2.2.1 The Supply Curve
2.3.1 How to Find the Equilibrium Point Mathematically
2.4 Price and Quantity Regulations
2.4.1 Minimum Prices
2.4.2 Maximum Prices
2.4.3 Quantity Regulations
3 Consumer Theory
3.1 Baskets of Goods and the Budget Line
3.3 Indifference Curves
3.4 Indifference Maps
3.5 The Marginal Rate of Substitution
3.6 Indifference Curves for Perfect Substitutes and Complementary Goods
3.7 Utility Maximization: Optimal Consumer Choice
3.8 More than Two Goods
4.1 Individual Demand
4.1.1 The Individual Demand Curve
4.1.2 The Engel Curve
4.2 Market Demand
4.3.1 Price Elasticity
4.3.2 Income Elasticity
4.3.3 Cross-Price Elasticity
5 Income and Substitution Effects
5.1 Normal Good
5.2 Inferior Good
6 Choice under Uncertainty
6.1 Expected Value
6.2 Expected Utility
6.3 Risk Preferences
6.4 Certainty Equivalence and the Risk Premium
6.5 Risk Reduction
7.1 The Profit Function
7.2 The Production Function
7.2.1 Average and Marginal Product
7.2.2 The Law of Diminishing Marginal Returns
7.3 Production in the Short Run
7.3.1 The Product Curve in the Short Run
7.4 Production in the Long Run
7.4.1 The Marginal Rate of Technical Substitution
7.4.2 The Marginal Rate of Technical Substitution and the Marginal Products
7.4.3 Returns to Scale
8.1 Production Costs in the Short Run
8.2 Production Cost in the Long Run
8.3 The Relation between Long-Run and Short-Run Average Costs
9 Perfect Competition
9.2 Conditions for Perfect Competition
9.3 Profit Maximizing Production in the Short Run
9.3.1 Strategy to Find the Optimal Short-Run Quantity
9.3.2 The Firm’s Short-Run Supply Curve
9.3.3 The Market’s Short-Run Supply Curve
9.4 Short-Run Equilibrium
9.5 Long-Run Production
9.6 The Long-Run Supply Curve
9.7 Properties of the Equilibrium of a Perfectly Competitive Market
10 Market Interventions and Welfare Effects
10.1 Welfare Analysis
11.1 Barriers to Entry
11.2 Demand and Marginal Revenue
11.3 Profit Maximum
11.4 The Deadweight Loss of a Monopoly
11.5 Ways to Reduce Market Power
12 Price Discrimination
12.1 First Degree Price Discrimination
12.2 Second Degree Price Discrimination
12.3 Third Degree Price Discrimination
13 Game Theory
13.1 The Basics of Game Theory
13.2 The Prisoner’s Dilemma
13.3 Nash Equilibrium
13.3.1 Finding the Nash Equilibrium in a Game in Matrix Form
13.4 A Monopoly with No Barriers to Entry
13.4.1 Finding the Nash Equilibrium for a Game Tree
13.5 Backward Induction
14.1 Kinked Demand Curve
14.1.1 How does the Price in the Kinked Demand Curve Arise?
14.2 Cournot Duopoly
14.3 Stackelberg Duopoly
14.4 Bertrand Duopoly
15 Monopolistic Competition
15.1 Conditions for Monopolistic Competition
15.2 Market Equilibrium
15.2.1 Short Run
15.2.2 Long Run
16.1 The Supply of Labor
16.2 The Marginal Revenue Product of Labor
16.3 The Firm’s Short-Run Demand for Labor
16.3.1 Perfect Competition in both the Input and Output Market
16.3.2 Monopoly in the Output Market
16.3.3 Monopsony in the Input Market
16.3.4 Bilateral Monopoly
17.1 Present Value
17.2 Correction for Risk
17.2.1 Diversifiable and Nondiversifiable Risk
17.3 CAPM: Pricing Assets
17.4 Pricing Business Projects
18 General Equilibrium
18.1 A “Robinson Crusoe” Economy
18.3 The Edgeworth Box
18.4 Efficient Consumption in an Exchange Economy
18.5 The Two Theorems of Welfare Economics
18.6 Efficient Production
18.7 The Transformation Curve
18.8 Pareto Optimal Welfare
18.8.1 A Definition of Pareto Optimal Welfare
19.2 The Effect of a Negative Externality
19.3 Regulations of Markets with Externalities
20 Public Goods
20.1 Definition of Public and Private Goods
20.2 The Aggregate Willingness to Pay
20.3 Free Riding
21 Asymmetric Information
21.1 Adverse selection
21.1.2 Used Cars
21.1.3 Signaling and How to Reduce Problems with Adverse Selection
21.2 Moral hazard
21.2.1 How to Reduce Problems with Moral Hazard
22 Key Words
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