Course Notes — Principles of Microeconomics, Fall 2023 (MIT)

1. What is Microeconomics?

Microeconomics is the study of how individuals and firms make themselves as well off as possible in a world of scarcity. The core focus is on constrained optimization—making the best possible choices given limited resources and trade-offs. Scarcity is fundamental: every decision involves an opportunity cost, as resources are limited and choices must be made.

2. Opportunity Cost

Opportunity cost is the value of the next best alternative forgone when making a choice. Every action or inaction has a cost in terms of what you could have done instead. This principle is central to economic reasoning and recurs throughout the course.

3. Trade-Offs and Decision Making

Microeconomics is fundamentally about trade-offs. Since one cannot have everything, individuals and firms must decide how to allocate their limited resources most effectively. For example, spending money on a shirt means forgoing the opportunity to buy pants; spending time studying means not attending a concert.

4. The Role of Economic Models

Economists use simplified models to represent and analyze complex realities. Models are abstractions that describe relationships between variables, constructed with simplifying assumptions to balance explanatory power and clarity. As the statistician George Box said, "All models are wrong, but some are useful."

5. The Supply and Demand Model

• Demand Curve: Illustrates the relationship between price and quantity from the consumer's perspective. As the price increases, quantity demanded decreases (downward sloping), due to higher opportunity costs. Example: q = 1800 - 400p
• Supply Curve: Shows the relationship from the supplier's perspective. As the price increases, quantity supplied increases (upward sloping), because producing the good becomes more attractive relative to alternatives. Example: q = 200p
• Equilibrium: The intersection of supply and demand curves, where both buyers and sellers are satisfied at a particular price and quantity. Example: q* = 600, p* = 3

6. Positive vs. Normative Economics

• Positive Economics: Describes "what is"—objective statements about facts and causal relationships (e.g., why did the price of a kidney on eBay get so high? High demand, low supply).
• Normative Economics: Concerns "what should be"—value judgments and policy recommendations (e.g., should people be allowed to sell organs?).

7. Market Failures and Equity

• Market Failures: Occur when the free market does not yield efficient or desirable outcomes (e.g., information asymmetry, coercion, externalities).
• Equity: Relates to fairness—markets may deliver efficient outcomes but not necessarily equitable ones (e.g., only the wealthy can afford life-saving organs). The course focuses primarily on efficiency, with equity discussed later.

8. Economic Systems: Capitalist vs. Command

• Capitalist (Market) Economy: Decisions are made by individuals with minimal government intervention. In practice, all economies are subject to some constraints (regulations, taxes, social norms).
• Command Economy: The government makes all production and allocation decisions. While theoretically this can ensure fairness, in practice it faces problems of information overload and corruption.
• Real-World Application: Most countries are mixed economies, with varying degrees of government intervention. The U.S. is highly market-driven but has significant inequality; European countries have more intervention and greater equality.

9. The Invisible Hand

Adam Smith's "invisible hand" describes how markets coordinate decentralized decision-making, often leading to efficient outcomes. However, this process can also result in inequality, as goods go to those willing to pay the most, not necessarily those who need them most.

💡 Takeaways:

This lecture introduces microeconomics as the study of decision-making under scarcity, focusing on opportunity cost, trade-offs, and the foundational supply-demand model. It distinguishes between positive and normative economics, discusses market failures and equity, and compares capitalist and command economies. The course aims to develop both theoretical understanding and practical analytical skills, with a strong emphasis on both efficiency and fairness in economic outcomes.

This lecture begins building the foundation for the demand curve by understanding consumer preferences. The goal is to describe what consumers want, separate from what they can afford, and translate those wants into a mathematical formula.

1. Assumptions of Preferences

The core assumptions about consumer preferences are:

• Completeness: When faced with choices, consumers can always make a decision; they either prefer one to the other or are indifferent, but they never say "I don't know".
• Transitivity: If a consumer prefers A to B, and B to C, then they must prefer A to C. This is a standard logical assumption.
• Non-satiation: More is always better. This doesn't mean the 10th unit makes you as happy as the 9th, just that having the 10th unit is better than not having it.

2. Indifference Curves

From these assumptions, we construct Indifference Curves, which are maps of a consumer's preferences. Indifference curves have four key properties:

1. Consumers prefer higher indifference curves: A curve further from the origin is always preferred, which follows from non-satiation.
2. Indifference curves are downward sloping: This also follows from non-satiation. If a curve were upward sloping, it would imply being indifferent between having less of something and more of something, which violates the "more is better" rule.
3. Indifference curves never cross: If they did, it would violate both transitivity and non-satiation.
4. Only one indifference curve passes through any given point: This reflects the completeness of choices.

3. Utility Function

A Utility Function is the mathematical representation of the graphical indifference curves. It serves to rank choices (ordinal) rather than measure happiness in absolute terms (cardinal). For example, a utility function could be U = √(S * C), where S is slices of pizza and C is cookies.

• Diminishing Marginal Utility: This is a fundamental assumption that drives consumer decisions. It states that while more is better, each additional unit of a good provides less satisfaction than the previous one. This is why utility functions often take a power form of less than 1 (like a square root). Companies like Starbucks and McDonald's use this principle when pricing larger sizes only slightly more expensively, knowing customers get diminishing utility from the extra quantity.

4. Marginal Rate of Substitution (MRS)

The Marginal Rate of Substitution (MRS) is the slope of the indifference curve.

• Definition: The MRS is the rate at which a consumer is willing to trade the good on the Y-axis for the good on the X-axis. In a world with a budget, buying one good is effectively trading away the money that could have bought another good.
• Formula: MRS = - (Marginal Utility of X) / (Marginal Utility of Y) or MRS = -MUc / MUs.
• Diminishing MRS: As you get more cookies and fewer pizzas, your willingness to give up pizza for another cookie decreases. This is what gives indifference curves their characteristic convex shape (bowed toward the origin).

💡 Takeaways:

Consumer preferences are modeled with three core assumptions: completeness, transitivity, and non-satiation. These axioms give rise to indifference curves, which map preferences. Diminishing marginal utility is a key principle, meaning each additional unit of a good is less satisfying. The Marginal Rate of Substitution (MRS) is the slope of the indifference curve and represents the trade-off a consumer is willing to make between two goods.

This lecture introduces the budget constraint, which reflects the reality that consumers have limited resources when making decisions. It then combines this constraint with preferences to find the consumer's optimal choice.

1. The Budget Constraint

The budget constraint represents all combinations of goods a consumer can afford with their income.

• Formula: Income (Y) = P_c * C + P_s * S, where P is price and C and S are quantities of cookies and pizza.
• Graph: It is a straight line. The x-intercept shows the maximum amount of cookies one can buy (Y / P_c), and the y-intercept shows the maximum amount of pizza (Y / P_s).
• Slope: The slope of the budget constraint is the negative price ratio: -P_c / P_s. This slope is called the Marginal Rate of Transformation (MRT) and represents the market's trade-off or opportunity cost: to get one more cookie, you must give up a certain amount of pizza.

2. Changes to the Budget Constraint

• Price Change: If the price of one good (e.g., pizza) increases, the budget constraint pivots inward. The opportunity set (the area under the line) shrinks, making the consumer worse off.
• Income Change: If income decreases, the budget constraint makes a parallel shift inward. The slope (MRT) doesn't change because the price ratio is the same, but the opportunity set still shrinks.

3. Constrained Optimal Choice

Consumers maximize their utility by choosing the point where their highest possible indifference curve is tangent to their budget constraint.

• Tangency Condition: At the optimal point, the slope of the indifference curve (MRS) is equal to the slope of the budget constraint (MRT).
• Optimization Formula: MRS = MRT, which translates to MU_c / MU_s = P_c / P_s.
• "Bang for the buck" Interpretation: The formula can be rearranged to MU_c / P_c = MU_s / P_s. This means that at the optimum, the "utility per dollar spent" should be equal for all goods. If it's not equal (e.g., at point A in figure 3.4), the consumer can increase their total utility by shifting spending from the good with a low "bang for the buck" to the one with a high one.

4. Real-World Example - SNAP (Food Stamps)

• In-kind vs. Cash Benefits: The analysis shows that providing food vouchers (an in-kind benefit) instead of cash can alter a consumer's choice and potentially make them worse off (on a lower indifference curve) if they would have preferred to spend less on food than the value of the voucher.
• Fungibility of Money: However, if a consumer already intended to spend more on food than the voucher's value, receiving a voucher or cash makes no difference to their behavior because money is fungible. Governments use in-kind benefits like SNAP out of a concern that cash might be spent on non-essentials like "cocaine".

💡 Takeaways:

The budget constraint limits consumer choices based on income and prices. Its slope, the MRT, represents the market's opportunity cost. The optimal choice occurs at the point of tangency between the indifference curve and the budget constraint, where MRS = MRT. This ensures that the "bang for the buck" (MU/P) is equal across all goods purchased.