Microeconomics

Microeconomics studies how individual agents -- consumers, firms, and governments -- make decisions under scarcity and how those decisions interact through markets. Where macroeconomics examines aggregate outcomes, microeconomics examines the mechanisms that produce them: why prices move, why firms enter or exit industries, why some markets work well and others fail. This skill covers supply and demand, elasticity, market structures, game theory, and welfare analysis with worked examples and decision heuristics.

Agent affinity: smith (market coordination, invisible hand), robinson (imperfect competition, monopsony), varian (pedagogical exposition)

Concept IDs: econ-supply-demand, econ-price-mechanism, econ-market-structures, econ-marginal-thinking, econ-opportunity-cost

The Microeconomics Toolbox at a Glance

Topic 1 -- Supply and Demand

The fundamental model. Supply and demand is the workhorse of microeconomics. A demand curve shows the quantity buyers are willing to purchase at each price. A supply curve shows the quantity sellers are willing to offer at each price. The intersection is the equilibrium -- the price at which quantity demanded equals quantity supplied.

Why it works. Prices coordinate information. When price is above equilibrium, surplus accumulates and sellers compete the price down. When price is below equilibrium, shortage emerges and buyers bid the price up. No central planner is needed -- Smith's "invisible hand" operates through price adjustment.

Worked example. Suppose demand is Q_d = 100 - 2P and supply is Q_s = 3P - 25. Setting Q_d = Q_s: 100 - 2P = 3P - 25, so 125 = 5P, giving P* = 25 and Q* = 50. At any price above 25, quantity supplied exceeds quantity demanded (surplus); at any price below 25, quantity demanded exceeds quantity supplied (shortage).

Shifts vs. movements. A change in the good's own price causes movement along a curve. A change in anything else (income, preferences, input costs, technology) shifts the entire curve. Confusing these is the single most common error in introductory economics.

Applications. Price ceilings (rent control), price floors (minimum wage), tax incidence, subsidy analysis, import quotas.

Tax incidence worked example. A $1 per-unit tax is imposed on sellers. Supply shifts up by $1 (from Q_s = 3P - 25 to Q_s = 3(P-1) - 25 = 3P - 28). New equilibrium: 100 - 2P = 3P - 28, so 128 = 5P, giving P* = 25.60. Consumers pay $25.60 (up $0.60), producers receive $24.60 after tax (down $0.40). The burden is split roughly 60/40 because demand (slope -2) is more inelastic than supply (slope 3) at this equilibrium. The tax raises $1 * 48.80 = $48.80 in revenue, but total surplus falls -- the deadweight loss triangle equals 0.5 * $1 * 1.20 = $0.60.

Price ceiling worked example. A rent ceiling of $20 in the market above yields Q_d = 100 - 2(20) = 60 and Q_s = 3(20) - 25 = 35. Shortage: 60 - 35 = 25 units. Twenty-five people who want housing at the controlled price cannot find it. The visible effect is "affordable rent"; the invisible effect is 25 unhoused people, reduced housing quality (landlords underinvest), and black markets.

Topic 2 -- Elasticity

Definition. Price elasticity of demand measures the responsiveness of quantity demanded to a change in price: E_d = (% change in Q_d) / (% change in P). Analogous elasticities exist for supply, income, and cross-price relationships.

Classification. |E_d| > 1 is elastic (quantity responds more than proportionally to price). |E_d| < 1 is inelastic (quantity responds less than proportionally). |E_d| = 1 is unit elastic.

Why it matters. Elasticity determines who bears a tax. When demand is inelastic relative to supply, consumers bear most of the burden. When supply is inelastic relative to demand, producers bear most. Elasticity also determines whether a price increase raises or lowers total revenue: if demand is elastic, raising price reduces revenue because the quantity drop dominates.

Determinants of elasticity. Availability of substitutes (more substitutes = more elastic), time horizon (longer run = more elastic), necessity vs. luxury (necessities are more inelastic), share of budget (larger share = more elastic).

Worked example. If a 10% increase in the price of coffee leads to a 20% decrease in quantity demanded, E_d = -20%/10% = -2.0. Demand is elastic. A coffee shop raising prices by 10% would see revenue fall because the 20% drop in quantity more than offsets the higher price per unit.

Topic 3 -- Consumer Choice

The framework. Consumers have preferences (represented by utility functions or indifference curves) and face budget constraints. Optimal choice occurs where the budget line is tangent to the highest achievable indifference curve -- equivalently, where the marginal rate of substitution equals the price ratio.

Marginal utility. The additional satisfaction from one more unit of a good. The law of diminishing marginal utility states that each successive unit provides less additional satisfaction, which is why demand curves slope downward.

Income and substitution effects. When the price of a good falls, two things happen: the good becomes relatively cheaper (substitution effect, always increases quantity demanded) and the consumer's real purchasing power increases (income effect, direction depends on whether the good is normal or inferior).

Giffen goods. The theoretical edge case where the income effect is so strong and negative that it overwhelms the substitution effect, causing quantity demanded to rise when price rises. Empirically rare but theoretically important for understanding the decomposition. Jensen and Miller (2008) found evidence of Giffen behavior for rice in Hunan, China -- extremely poor households that spent most of their budget on rice increased rice consumption when its price rose because the price increase reduced their real income so much that they could no longer afford more expensive foods and substituted toward more rice.

Revealed preference. Samuelson's alternative to utility theory: instead of assuming consumers maximize an unobservable utility function, infer preferences from observed choices. If a consumer chooses bundle A when bundle B was affordable, then A is revealed preferred to B. The Weak Axiom of Revealed Preference (WARP) states that if A is revealed preferred to B, then B is never revealed preferred to A. Violations of WARP indicate either irrational behavior or changing preferences -- which is where behavioral economics enters.

Behavioral departures. Standard consumer theory assumes rational, consistent preferences. Behavioral economics documents systematic departures: the endowment effect (people value what they own more than what they don't), framing effects (choices depend on how options are described), and present bias (people overweight immediate gratification). These departures matter for policy design -- see the behavioral-economics skill for the full treatment.

Topic 4 -- Producer Theory

Production functions. A firm transforms inputs (labor, capital, materials) into outputs. The production function Q = f(L, K)