Ten lessons on choice, demand and supply, elasticity, surplus, taxes, costs, competition, monopoly, externalities and game theory, with sliders and worked examples.
A study guide to an introductory college microeconomics course, not a full course. Topics follow standard principles-of-microeconomics sequencing used by open textbooks. Practice values in the labs are invented. For AP-specific exam skills use the AP Microeconomics guide.
['Basic algebra']
Course outline
Scarcity, opportunity cost and the production possibilities frontier
Use opportunity cost and trade-offs to reason about choices.
Demand, supply and equilibrium
Solve for equilibrium and predict shifts.
Elasticity
Measure how responsive quantity is to price and income.
Consumer surplus, producer surplus and price controls
Measure gains from trade and effects of price floors and ceilings.
Taxes and deadweight loss
Find who bears a tax and how big the loss is.
Costs of production
Separate fixed, variable, marginal and average costs.
Perfect competition
Find the profit-maximizing output and the long-run outcome.
Monopoly
Solve for the monopoly price and quantity.
Monopolistic competition and oligopoly
Compare market structures and measure concentration.
Externalities, public goods and game theory
Handle spillovers, free riders and strategic choices.
Read every lesson below. The interactive reader above contains the same explanations, with visual tools and quizzes.
1. Scarcity, opportunity cost and the production possibilities frontier
Learning goal: Use opportunity cost and trade-offs to reason about choices.
Economics studies how people choose when resources are scarce. Every choice has an opportunity cost: the value of the best alternative given up. Money price is only part of the cost; time counts too.
A production possibilities frontier shows the most of two goods an economy can produce with its resources. Points on it are efficient, points inside it waste resources, and points outside it cannot be reached now. If you can make 10 pizzas or 20 sodas, one pizza costs 2 sodas.
A bowed-out frontier reflects rising opportunity cost: resources are not equally good at both tasks. Growth in resources or technology shifts the frontier out.
Comparative advantage is the ability to produce at a lower opportunity cost. Two parties gain from trade by specializing where their opportunity cost is lower, even if one is better at everything.
Worked example
Find the opportunity cost of a pizza.
10 pizzas or 20 sodas
Giving up 20 sodas gets 10 pizzas
20 divided by 10 = 2 sodas per pizza
Practice problem and solution
A farmer can make 10 pizzas or 20 sodas. How many sodas does one pizza cost? Enter a number.
20 divided by 10.
Mental model: Every choice has an opportunity cost.
Common trap: Ignoring the value of time and alternatives.
2. Demand, supply and equilibrium
Learning goal: Solve for equilibrium and predict shifts.
The law of demand: at higher prices people buy less. The law of supply: at higher prices firms offer more. A change in price moves you along a curve; a change in income, tastes, related prices, expectations or number of buyers or sellers shifts the curve.
Equilibrium is the price where quantity demanded equals quantity supplied. With demand Qd = 100 - 2P and supply Qs = -20 + 4P, set them equal: 100 - 2P = -20 + 4P, so P = 20 and Q = 60.
Above equilibrium there is a surplus, so price falls. Below it there is a shortage, so price rises. If demand increases, both price and quantity rise. If supply increases, price falls and quantity rises.
For a double shift predict the one direction that is certain and say the other is ambiguous.
Worked example
Solve for equilibrium.
100 - 2P = -20 + 4P
120 = 6P
P = 20
Q = 100 - 40 = 60
Practice problem and solution
Demand is Qd = 100 - 2P and supply is Qs = -20 + 4P. What is the equilibrium price? Enter a number.
120 = 6P, so P = 20.
Mental model: Equilibrium is where the quantities match.
Common trap: Treating a price change as a shift of the curve.
3. Elasticity
Learning goal: Measure how responsive quantity is to price and income.
Price elasticity of demand is the percentage change in quantity demanded divided by the percentage change in price, read as an absolute value. Above 1 is elastic (quantity responds a lot), below 1 is inelastic, exactly 1 is unit elastic.
If price rises 5% and quantity falls 10% the elasticity is 2. The midpoint method uses the average of the two values as the base so the answer is the same whichever direction you move.
Elasticity predicts revenue. If demand is elastic, a price increase lowers total revenue. If inelastic, a price increase raises it. Necessities, short time horizons and few substitutes make demand more inelastic.
Income elasticity is positive for normal goods and negative for inferior goods. Cross-price elasticity is positive for substitutes and negative for complements.
Worked example
Compute elasticity for a 5% price rise and a 10% quantity fall.
% change in quantity: 10
% change in price: 5
10 divided by 5 = 2
Elastic
Practice problem and solution
Price rises 5% and quantity falls 10%. What is the elasticity (absolute value)? Enter a number.
10 divided by 5.
Mental model: Elastic above 1, inelastic below 1.
Common trap: Using the slope of the curve as the elasticity.
4. Consumer surplus, producer surplus and price controls
Learning goal: Measure gains from trade and effects of price floors and ceilings.
Consumer surplus is the gap between what buyers are willing to pay and what they pay. Producer surplus is the gap between the price sellers receive and their cost. At a linear demand curve with maximum willingness to pay 100, price 40 and quantity 60, consumer surplus is half times 60 times 60 = 1800.
Total surplus is the gains from trade. A competitive market maximizes it.
A price ceiling set below equilibrium creates a shortage. A price floor set above equilibrium creates a surplus. Both block trades that would have benefited buyer and seller, creating deadweight loss.
Ceilings also invite waiting lines, quality cuts and black markets. Floors, such as a minimum wage above equilibrium, create unsold goods or unemployment.
Worked example
Compute consumer surplus at price 40.
Q = 100 - 40 = 60
Triangle area half base height
1/2 x 60 x 60
1800
Practice problem and solution
Demand is P = 100 - Q. At price 40 buyers purchase 60. What is consumer surplus? Enter a number.
1/2 times 60 times 60.
Mental model: Surplus is the area between curve and price.
Common trap: Calling a non-binding control harmful.
5. Taxes and deadweight loss
Learning goal: Find who bears a tax and how big the loss is.
A per-unit tax drives a wedge between the price buyers pay and the price sellers keep. It reduces the quantity traded. Who pays the tax does not depend on who the law says pays.
Incidence depends on elasticity: the less elastic side bears more of the tax. If demand is more inelastic than supply, buyers carry most of it.
Deadweight loss is the lost surplus from trades that no longer happen. For a small tax it is about half times the tax times the fall in quantity. A 4 per unit tax that cuts quantity by 10 units gives 1/2 times 4 times 10 = 20.
Larger taxes cause more than proportionately more deadweight loss, because the loss grows with the square of the tax.
Worked example
Find the deadweight loss of a 4 tax cutting quantity by 10.
Triangle: half base times height
Height: 4
Base: 10
1/2 x 4 x 10 = 20
Practice problem and solution
A tax of 4 per unit reduces quantity by 10 units. What is the deadweight loss? Enter a number.
1/2 times 4 times 10.
Mental model: Incidence follows elasticity; loss is a triangle.
Common trap: Assuming the legal payer bears the tax.
6. Costs of production
Learning goal: Separate fixed, variable, marginal and average costs.
Total cost splits into fixed cost (does not change with output) and variable cost (does). Marginal cost is the extra cost of one more unit: the change in total cost divided by the change in quantity. If total cost is 200 at 10 units and 215 at 11, marginal cost is 15.
Average total cost is total cost divided by quantity. The marginal cost curve crosses the minimum of the average total cost curve: when marginal cost is below average, the average falls; when above, it rises.
Diminishing marginal returns in the short run make marginal cost rise. Economies of scale in the long run lower average cost as the firm grows; diseconomies raise it.
Sunk costs, already paid and unrecoverable, should not affect forward-looking decisions.
Worked example
Compute marginal cost.
TC(10) = 200
TC(11) = 215
Change in TC is 15
Change in Q is 1
MC = 15
Practice problem and solution
Total cost is 200 at 10 units and 215 at 11 units. What is the marginal cost of the 11th unit? Enter a number.
215 - 200 = 15.
Mental model: Marginal pulls the average toward itself.
Common trap: Including sunk costs in a decision.
7. Perfect competition
Learning goal: Find the profit-maximizing output and the long-run outcome.
A perfectly competitive firm is a price taker: many sellers, identical goods, free entry. It maximizes profit where price equals marginal cost, because producing a unit adds revenue P and cost MC.
Profit equals (P - ATC) times quantity. With P = 12, ATC = 10 and Q = 50, profit is 2 times 50 = 100. If P is below ATC but above average variable cost, the firm loses money but should keep operating in the short run. Below AVC, shut down.
Positive profit attracts entry, which shifts supply right and lowers the price. Losses cause exit. In the long run price falls to the minimum of ATC and economic profit is zero.
The long-run outcome is efficient: P = MC (allocative efficiency) at minimum ATC (productive efficiency).
Worked example
Compute profit at P = 12, ATC = 10, Q = 50.
Profit per unit: 12 - 10 = 2
Times 50 units
Profit 100
Practice problem and solution
P = 12, ATC = 10 and Q = 50. What is the profit? Enter a number.
(12 - 10) times 50.
Mental model: Price taker: P = MC; entry erases profit.
Common trap: Using average rather than marginal cost to choose output.
8. Monopoly
Learning goal: Solve for the monopoly price and quantity.
A monopolist is the only seller, so it faces the whole demand curve. To sell more it must cut price on all units, so marginal revenue is below price.
With demand P = 20 - Q, revenue is 20Q - Q squared and marginal revenue is 20 - 2Q. If marginal cost is 4, set MR = MC: 20 - 2Q = 4, so Q = 8. Read the price from demand: P = 20 - 8 = 12.
The monopoly price is above marginal cost and output is below the competitive level (Q = 16 where P = MC), so some mutually beneficial trades do not happen: deadweight loss.
Price discrimination, charging different prices to different groups, can capture more surplus. Regulation or antitrust can reduce the loss.
Worked example
Solve demand P = 20 - Q with MC = 4.
MR = 20 - 2Q
20 - 2Q = 4
Q = 8
Price from demand: 12
Practice problem and solution
Demand is P = 20 - Q and MC = 4. What is the monopoly price? Enter a number.
Q = 8, so P = 20 - 8 = 12.
Mental model: Set MR = MC, then read the price off demand.
Common trap: Reading price off the MR curve.
9. Monopolistic competition and oligopoly
Learning goal: Compare market structures and measure concentration.
Monopolistic competition has many firms selling differentiated products with free entry, such as restaurants. Each has some pricing power, so price exceeds marginal cost, but entry drives long-run economic profit to zero. Firms end up with excess capacity.
Oligopoly has a few large firms whose choices depend on each other. Barriers to entry such as scale, patents and control of inputs keep rivals out. Firms may collude, but cartels are unstable because each member gains by cheating.
The Herfindahl-Hirschman Index sums the squares of market shares in percent. Four equal firms each with 25 percent give 4 times 625 = 2500. A single monopolist is 10,000. Regulators treat higher values as more concentrated.
Compare structures by four features: number of firms, product type, entry barriers and pricing power. Competition has the least pricing power and monopoly the most.
Worked example
Compute the HHI for four equal firms.
Each share is 25 percent
Square: 625
Sum over 4 firms
2500
Practice problem and solution
Four firms each hold 25 percent of a market. What is the Herfindahl-Hirschman Index? Enter a number.
4 times 25 squared = 4 times 625.
Mental model: Differentiation gives some power; oligopoly depends on rivals.
Common trap: Treating the HHI as a count of firms.
10. Externalities, public goods and game theory
Learning goal: Handle spillovers, free riders and strategic choices.
An externality is a cost or benefit that falls on a third party. With a negative externality the market produces too much. A tax equal to the marginal external cost makes the producer pay it (a Pigouvian tax). If each unit imposes 3 on others, the efficient tax is 3 per unit.
Public goods are non-excludable and non-rival, so people free ride and markets under-provide them. Common resources are rival but non-excludable, leading to overuse.
Game theory studies strategic choices. A Nash equilibrium is a pair of strategies where neither player gains by changing alone. In the prisoner's dilemma each player's best reply is to defect whatever the other does, so mutual defection is the unique Nash equilibrium even though both would be better off cooperating.
Repeated play, reputation and enforceable agreements can sustain cooperation, as in cartels that tend to break down for the same reason.
Worked example
Find the efficient tax for an external cost of 3 per unit.
Marginal external cost: 3
Tax equal to it makes the firm internalize it
Tax = 3
Practice problem and solution
Each unit of production imposes an external cost of 3. What per-unit tax makes the market efficient? Enter a number.
Tax equal to the marginal external cost.
Mental model: Fix spillovers with prices; expect free riding on public goods.
Common trap: Assuming cooperation is a stable equilibrium in a one-shot dilemma.