MICROECONOMICS
KU Leuven – Business Administration
1
,Contents
1. Ten principles of economics
2. Thinking like an economist
3. The market forces of supply and demand
4. Elasticity and its applications
5. Background to demand: the theory of consumer choice
6. The cost of production
7. Consumers, producers and the efficiency of markets
8. Supply, demand and government policies
9. The tax system and the costs of taxation
10. Public goods, common resources and merit goods
11. Externalities and market failure
13. Firm's production decisions
14. Market structures I: Monopoly
15. Market structures II: Monopolistic competition
16. Market structures III: Oligopoly
Game theory
2
,1. Ten principles of economics
Source: notes A
• "Economy" comes from the Greek word "oikonomos", which means "one who manages a
household".
• Economies are similar to households, because as societies, households must make decisions: who
cooks dinner, who does the laundry, who chooses activities/food.
• Societies must make decisions like how many farmers/engineers/doctors we need, who should
become a farmer/engineer/doctor, who will drive a Porsche and who will take the bus.
• Like households, societies need to manage their scarce resources. Resources may be land, oil,
labor, physical capital (ex: computers), human capital (ex: doctors, engineers), …
• Resources are used to produce goods and services, consumed by people. The amount of
interactions between households and firms, the amount of buying and selling, represents the level
of economic activity. The more people buy and sell, the higher the economic activity. Households
and firms in a particular geographic region are together referred to as the economy.
• There is a tension between:
– People's/societies' desires for goods and services, which are unlimited
– The available resources (land, labor, capital, skills), which are limited
• Resources are insufficient to produce the goods and services that satisfy all the needs/desires (=
scarcity). Given the scarcity of resources, it is important to manage them well.
• Economics can be defined as the study of how society manages its scarce resources. It is divided in
two main subfields: microeconomics and macroeconomics.
Microeconomics, macroeconomics and managerial economics
• Microeconomics is the study of how consumers and firms make decisions and how they interact in
specific markets (+ impact of governments on their choices and interaction).
– Examples: how consumers decide on the quantity of coffee to buy, depending on the price of
coffee, the price of substitute goods, and their revenue. What will be the effect of a rise in
cigarette taxation on cigarette consumption by the young? What is the effect of an increase in
airlines competition on ticket prices?
• Macroeconomics is the study of the effect on the aggregate economy of choices made by
individuals, firms and government.
– Examples: Which factors affect gross domestic product (GDP) growth? How does the
unemployment allowance affect unemployment rate/labor market efficiency in the long term
and in the short term? How does printing money affect inflation and interest rates?
• Managerial economics applies microeconomic theory to management decisions.
– Examples of management decisions: Enter a market or not? How much of a good to produce?
Which inputs to use in production? At which price to sell the good?
– An optimal decision is one that leads to a maximal profit.
– In order to take optimal decisions, a manager should be aware of macroeconomic trends in
the economy. For example: if the economy is in recession, the demand for a particular product
is likely to be low, so it may not be a good time to hire new employees or buy new machinery.
– → Managerial economics is closest to microeconomics but uses some concepts from
macroeconomics.
• Some principles are common to all fields of economics (microeconomics, macroeconomics,
managerial economics, public economics, finance, etc.).
The principles
Important principles of economics can be divided into two subcategories:
• How people make decisions:
3
, – People face trade-offs.
– The cost of something is what you give up getting it.
– Rational people think at the margin.
– People respond to incentives.
• How people interact with each other:
– Trade can make everyone better off.
– Markets are usually a good way to organize economic activity.
– Governments can sometimes improve economic outcomes.
Principle 1: People face trade-offs
• Households and firms are faced with making decisions and in doing so have to consider the
benefits gained from choosing one course of action. To get one thing that we like, we usually have
to give up another. Making decisions requires trading off the benefits of one action against those
of another.
• Efficiency deals with ways in which society gets the most it can (depending on how this is defined)
from its scarce resources.
• Equity looks at the extent to which the benefits of outcomes are distributed fairly among society's
members. In other words, it refers to how the cake is divided.
• It is argued by some economists that there is a trade-off between efficiency and equity. To increase
equity, society may need to give up on efficiency to some extent, and vice versa.
Principle 2: The cost of something is what you give up getting it
• Because people face trade-offs and make choices, they must compare the costs and benefits of
each action. Sometimes the cost of an action is not as obvious as it might appear.
• The opportunity cost is the highest valued alternative that must be given up to obtain something.
• Opportunity cost ≠ direct monetary cost.
• Good choice: Value of the choice > Opportunity cost of the choice.
Principle 3: People think at the margin
• In economics it is generally assumed that consumers and producers behave rationally:
– Consumers maximize their utility
– Producers maximize their profit
• Rational behavior leads (generally) to efficient market outcomes. The rationality assumption has its
boundaries.
• Marginal changes describe small incremental adjustments to an existing plan of action. Marginal
analysis is based around the assumption that economic agents (individual, firm or organization that
has an impact in some way in the economy) are seeking to maximize or minimize outcomes when
making decisions.
• In many situations, decision makers will make the best decision by thinking at the margin (=
"edge"). A rational decision maker takes an action if the marginal benefit of the action exceeds its
marginal cost.
Principle 4: People respond to incentives
• People make decisions by comparing costs and benefits → their behavior may change when costs
and/or benefits change.
Principle 5: Trade can make anyone better off
• Trade is not like a sports competition where one side wins and the other side loses; trade allows
each person/company/country to specialize in the activities they do best. By trading with others,
4
KU Leuven – Business Administration
1
,Contents
1. Ten principles of economics
2. Thinking like an economist
3. The market forces of supply and demand
4. Elasticity and its applications
5. Background to demand: the theory of consumer choice
6. The cost of production
7. Consumers, producers and the efficiency of markets
8. Supply, demand and government policies
9. The tax system and the costs of taxation
10. Public goods, common resources and merit goods
11. Externalities and market failure
13. Firm's production decisions
14. Market structures I: Monopoly
15. Market structures II: Monopolistic competition
16. Market structures III: Oligopoly
Game theory
2
,1. Ten principles of economics
Source: notes A
• "Economy" comes from the Greek word "oikonomos", which means "one who manages a
household".
• Economies are similar to households, because as societies, households must make decisions: who
cooks dinner, who does the laundry, who chooses activities/food.
• Societies must make decisions like how many farmers/engineers/doctors we need, who should
become a farmer/engineer/doctor, who will drive a Porsche and who will take the bus.
• Like households, societies need to manage their scarce resources. Resources may be land, oil,
labor, physical capital (ex: computers), human capital (ex: doctors, engineers), …
• Resources are used to produce goods and services, consumed by people. The amount of
interactions between households and firms, the amount of buying and selling, represents the level
of economic activity. The more people buy and sell, the higher the economic activity. Households
and firms in a particular geographic region are together referred to as the economy.
• There is a tension between:
– People's/societies' desires for goods and services, which are unlimited
– The available resources (land, labor, capital, skills), which are limited
• Resources are insufficient to produce the goods and services that satisfy all the needs/desires (=
scarcity). Given the scarcity of resources, it is important to manage them well.
• Economics can be defined as the study of how society manages its scarce resources. It is divided in
two main subfields: microeconomics and macroeconomics.
Microeconomics, macroeconomics and managerial economics
• Microeconomics is the study of how consumers and firms make decisions and how they interact in
specific markets (+ impact of governments on their choices and interaction).
– Examples: how consumers decide on the quantity of coffee to buy, depending on the price of
coffee, the price of substitute goods, and their revenue. What will be the effect of a rise in
cigarette taxation on cigarette consumption by the young? What is the effect of an increase in
airlines competition on ticket prices?
• Macroeconomics is the study of the effect on the aggregate economy of choices made by
individuals, firms and government.
– Examples: Which factors affect gross domestic product (GDP) growth? How does the
unemployment allowance affect unemployment rate/labor market efficiency in the long term
and in the short term? How does printing money affect inflation and interest rates?
• Managerial economics applies microeconomic theory to management decisions.
– Examples of management decisions: Enter a market or not? How much of a good to produce?
Which inputs to use in production? At which price to sell the good?
– An optimal decision is one that leads to a maximal profit.
– In order to take optimal decisions, a manager should be aware of macroeconomic trends in
the economy. For example: if the economy is in recession, the demand for a particular product
is likely to be low, so it may not be a good time to hire new employees or buy new machinery.
– → Managerial economics is closest to microeconomics but uses some concepts from
macroeconomics.
• Some principles are common to all fields of economics (microeconomics, macroeconomics,
managerial economics, public economics, finance, etc.).
The principles
Important principles of economics can be divided into two subcategories:
• How people make decisions:
3
, – People face trade-offs.
– The cost of something is what you give up getting it.
– Rational people think at the margin.
– People respond to incentives.
• How people interact with each other:
– Trade can make everyone better off.
– Markets are usually a good way to organize economic activity.
– Governments can sometimes improve economic outcomes.
Principle 1: People face trade-offs
• Households and firms are faced with making decisions and in doing so have to consider the
benefits gained from choosing one course of action. To get one thing that we like, we usually have
to give up another. Making decisions requires trading off the benefits of one action against those
of another.
• Efficiency deals with ways in which society gets the most it can (depending on how this is defined)
from its scarce resources.
• Equity looks at the extent to which the benefits of outcomes are distributed fairly among society's
members. In other words, it refers to how the cake is divided.
• It is argued by some economists that there is a trade-off between efficiency and equity. To increase
equity, society may need to give up on efficiency to some extent, and vice versa.
Principle 2: The cost of something is what you give up getting it
• Because people face trade-offs and make choices, they must compare the costs and benefits of
each action. Sometimes the cost of an action is not as obvious as it might appear.
• The opportunity cost is the highest valued alternative that must be given up to obtain something.
• Opportunity cost ≠ direct monetary cost.
• Good choice: Value of the choice > Opportunity cost of the choice.
Principle 3: People think at the margin
• In economics it is generally assumed that consumers and producers behave rationally:
– Consumers maximize their utility
– Producers maximize their profit
• Rational behavior leads (generally) to efficient market outcomes. The rationality assumption has its
boundaries.
• Marginal changes describe small incremental adjustments to an existing plan of action. Marginal
analysis is based around the assumption that economic agents (individual, firm or organization that
has an impact in some way in the economy) are seeking to maximize or minimize outcomes when
making decisions.
• In many situations, decision makers will make the best decision by thinking at the margin (=
"edge"). A rational decision maker takes an action if the marginal benefit of the action exceeds its
marginal cost.
Principle 4: People respond to incentives
• People make decisions by comparing costs and benefits → their behavior may change when costs
and/or benefits change.
Principle 5: Trade can make anyone better off
• Trade is not like a sports competition where one side wins and the other side loses; trade allows
each person/company/country to specialize in the activities they do best. By trading with others,
4
