Microeconomics For Dummies Cheat Sheet

Although micro means small, microeconomics covers a wide set of topics. These include how consumers and businesses make choices and how those choices interact through the forces of supply and demand in the marketplace; when market outcomes might be considered good and why monopoly power and information problems can make those outcomes less good; problems of risk and insurance; and the gains from international trade. So, a microeconomics textbook can seem long. This cheat sheet provides a very brief description of some key microeconomic concepts.  

Recognizing some key definitions in microeconomics

Microeconomics comes complete with its own vocabulary, which can sometimes be confusing. To get a true feel for microeconomics, some key terms must be defined and understood:  

• Utility: Utility is the value people get from making a choice. You can find out how much utility a consumer gains by working it out based on the choices they make. Consumers optimize — get the best level of utility they can given that they have to do so within a budget constraint.
• Profits: Profits are what’s left over from a firm’s revenue after all relevant costs have been accounted for. Costs include the return to shareholders that they could earn on similar investments elsewhere. These aren’t usually included in accounting profit. So, zero economic profit means that the bottom line of the firm’s income statement is just large enough to pay shareholders this opportunity cost. Firms try to make as much profit as they can, and they do so by producing until marginal revenue — the revenue gained from adding an extra unit — equals marginal cost – the cost of producing that extra unit.
• ‍Markets: Markets are places where consumers and firms trade. In any market, consumers optimize their utility and firms try to maximize their profits. The price and quantity in the market will be affected by lots of things — from the number of firms in the market to the income and valuations of consumers.

Understanding the Prisoner's Dilemma in microeconomics

The Prisoner’s Dilemma refers to a standard issue in settings of strategic interaction where each agent’s actions affect the outcome of the other agents. Such settings are usually called games, and the Nash equilibrium is the outcome of the game when the players pursue their own interests. A Nash equilibrium is the condition where each player is doing the best they can, given the choices of all other players. So, in a Nash equilibrium, no player has an incentive to change their behavior unilaterally. However, because a Nash Equilibrium is noncooperative, it’s quite possible that even though each player is doing the best they can do given the other players’ choices, there’s an alternative outcome that could potentially make every player better off.  

For example, two people are arrested for a crime and put in separate rooms so that they can’t communicate. The authorities offer each separately a deal whereby confession leads to charges being dropped for the player who confesses but only if the other prisoner holds out, in which case the holdout gets a very harsh sentence. If neither confesses, the authorities will drum up some minor charge that will have a fairly mild punishment. If both confess, the punishment is serious but not as harsh as that meted out to the holdout if only one confesses. The Nash equilibrium in this game is for both to confess even though both prisoners would be better off if they cooperated and neither confessed. This example is the source of the Prisoner’s Dilemma name that now generally applies to all strategic settings where cooperation is potentially better for all the players, but the non-cooperative Nash equilibrium is the one that prevails.  

Here are some important definition of the two:  

• ‍Imperfect competition: Imperfect competition characterizes any market where firms are large enough to affect the conditions facing all the rival firms. From the firms’ perspective, cooperation could raise the profits for all but, because such cooperation is illegal, the Nash equilibrium is a noncooperative equilibrium.  
• ‍Cooperative behavior: When the firms meet on the corporate battlefield year in and year out with no definitive end in sight, the repetition of the game may permit a Nash equilibrium in which cooperation emerges. This is why cartels sometime arise even though they’re technically illegal. It’s also why long-term contracts may enable management and labor or employees from different divisions within a firm to be able to establish cooperative relations.

Classifying types of markets in microeconomics

Microeconomists compare different types of markets depending on the number of firms in the market, the ease of entering the market and the degree to which products sold are similar. The four main types are as follows:  

• Perfect competition: Perfect competition is when a large number of firms sell to a large number of consumers. Firms make an identical product, and consumers are perfectly informed about prices and quantities. An example might be a fruit and veggie market.
• ‍Pure monopoly: A pure monopoly is the only firm selling in a market, and there may be high entry or exit costs. Monopolies will produce less for a higher price. Consumers will get worse welfare under monopoly, and society as a whole will take some part of the loss — a deadweight loss.
• ‍Oligopoly: Oligopolies are markets where there are only a few competitors, and probably high entry costs. Oligopolies tend to produce more than monopolies but less than firms in perfect competition —the result depends on how firms compete with each other.
• ‍Monopolistic competition: In a monopolistically competitive market firms make different products from each other. As a result, they behave like monopolies in the short run and competitive firms in the long run. Firms in monopolistic competition have to consistently invest in their product to keep themselves making economics profit by retaining their unique brand identities.

Identifying five reasons why markets fail

Understanding why markets fail is a key element in understanding microeconomics. Markets can fail for a number of different reasons, but the two most common are when a market doesn’t provide enough of something that society does wants or when it provides too much of something society doesn’t want. Here is a more complete list of the sources of market failure:

• Market power: Settings of imperfect competition, especially situations where one firm truly dominates or even monopolizes the market, can allow the dominant firm to exploit that power by holding back output and pushing the price up. Early examples like the firm Standard Oil, which controlled 90 percent of oil refining capacity from the 1870s to the 1890s, led to the passage of the antitrust laws as a way of combating excessive market power.  
• ‍Externality: An externality is a cost or benefit that falls on a third party. For instance, if you buy land and build a factory but those  nearby suffer damages from  your emissions society gets more polluted air and water than it wants because those costs aren’t reflected in the price you sell your product at.
• ‍Information asymmetries: If firms know something that consumers don’t or consumers know something that firms don’t, then information is asymmetric. A lemon market — a market where there are lots of low quality products and you can’t tell before buying what the product quality is — is one example.
• ‍Too few property rights: If no property rights are assigned then the good is called a common good and individuals will have an incentive to over-use it — as no one is paying for that use. The Tragedy of the Commons is an extreme example of this situation.
• ‍Public goods: Public goods are not excludable, which means you can’t exclude anyone who hasn’t paid for the good from using and benefitting from it. An example is street lighting. Markets find it hard to price these goods, so they tend to be produced collectively or through philanthropy

Appreciating the sources and gains from international trade

Why trade happens between countries and the potential gains from such trade are some of the most profound insights of microeconomics. The costs and benefits of impeding trade are also important. Here are some key concepts:

• Comparative advantage: Trade is based on comparative not absolute advantage. A labor-rich country like India where wages are low will often find it advantageous to exploit that advantage by exporting labor-intensive goods such as textiles, apparel, and leather goods because it is relatively good at these activities. Exporting such labor-intensive production allows India to import semiconductors, consumer electronics, military equipment, and energy on much better terms than if it tried to produce these goods itself. Capital- and knowledge-rich countries like the United States and many European nations find it best to export goods and services that exploit these advantages and import labor-intensive goods.
• ‍Costs and benefits from trade: When a country exploits its comparative advantage, consumers in general gain as do producers in the export sector. Producers in the import-competing sector often lose. But the gains to the “winners” are more than enough to compensate the “losers.”