Difficulty: Intermediate | Prerequisites: Basic algebra, supply and demand
This set of notes covers how consumers make choices (budget constraints, indifference curves, income and substitution effects), how firms decide what to produce (profit maximisation, cost curves), and how markets respond to price changes and government interventions (elasticity, price controls, taxes). These are foundational tools you will use throughout the rest of the course. Make sure you are comfortable with plotting graphs and interpreting slopes before working through this material.
TL;DR: Consumers maximise utility by finding the point where their budget line is tangent to the highest attainable indifference curve. Firms maximise profit by producing where MR = MC. Markets respond to interventions like price ceilings, floors, and taxes in predictable ways, and elasticity determines who bears the burden.
Budget constraint
The set of all combinations of goods a consumer can afford given their income and the prices of goods. Think of it as the boundary of what you can buy.
Indifference curve
A curve showing all combinations of two goods that give a consumer the same level of satisfaction (utility). In simple terms, every point on the same curve makes the consumer equally happy.
Marginal rate of substitution (MRS)
The slope of the indifference curve at any point. It measures how much of one good a consumer is willing to give up to get one more unit of the other, while staying equally satisfied.
Substitution effect
The change in consumption that results from a price change making one good relatively cheaper, holding real income constant. Consumers buy more of the cheaper good and less of the now-relatively-expensive one.
Income effect
The change in consumption that results from a price change altering the consumer's real purchasing power. A price drop effectively makes you richer.
Normal good
A good whose consumption increases when income rises. Most goods are normal goods.
Inferior good
A good whose consumption decreases when income rises. Think instant noodles: you buy fewer when you can afford better food.
Demand curve
A graph showing the quantity of a good consumers are willing to buy at each price. It slopes downward because of the law of demand.
Price elasticity of demand
A measure of how responsive quantity demanded is to a change in price. Elastic means quantity changes a lot; inelastic means it changes little.
Cross-price elasticity of demand
A measure of how the quantity demanded of one good responds to a change in the price of another. Positive = substitutes; negative = complements.
Marginal revenue (MR)
The additional revenue from selling one more unit of output.
Marginal cost (MC)
The additional cost of producing one more unit of output.
Average total cost (ATC)
Total cost divided by quantity produced. It is U-shaped because of the interplay between spreading fixed costs and diminishing returns.
Returns to scale
How average costs change as a firm scales up production in the long run. Increasing returns = costs fall; constant returns = costs stay flat; decreasing returns = costs rise.
Price ceiling
A legal maximum price, set below equilibrium. Creates shortages. Rent control is the classic example.
Price floor
A legal minimum price, set above equilibrium. Creates surpluses. The minimum wage is the classic example.
Tax incidence
How the burden of a tax is divided between buyers and sellers. It depends on the relative elasticities of supply and demand, not on who physically pays the tax.
Willingness to pay
The maximum price a consumer would pay for a good. If the market price is below willingness to pay, the consumer buys and earns consumer surplus.
Deadweight loss
The reduction in total surplus caused by a market distortion (tax, price control, monopoly). It represents lost gains from trade.
A budget constraint shows all the combinations of two goods a consumer can afford given their income and prices.
Equation: Income = (Price of Good A x Quantity of A) + (Price of Good B x Quantity of B).
Example: with $300 income, pizza at $15 and movies at $10, the consumer can buy any combination where 15P + 10M does not exceed 300.
The slope of the budget line equals the negative ratio of the two prices (-P_A / P_B). It tells you the rate at which the market allows you to trade one good for the other.
Points on the line: the consumer spends their entire budget. Points inside: some income is unspent. Points outside: not affordable.
A change in income shifts the budget line in or out (parallel). A change in the price of one good pivots it.
Indifference curves show combinations of two goods that give the consumer the same level of utility.
Properties:
Downward-sloping: to stay equally happy, getting more of one good means giving up some of the other.
Convex to the origin: reflects diminishing marginal rate of substitution. The more you have of one good, the less you are willing to give up of the other to get still more.
Higher curves = higher utility. The consumer aims to reach the highest indifference curve that their budget allows.
Indifference curves cannot cross.
Special shapes:
Perfect substitutes: straight-line indifference curves (constant MRS).
Perfect complements: L-shaped (right-angle) indifference curves. The consumer always wants goods in a fixed ratio.
Optimal choice: the point where the budget line is tangent to the highest attainable indifference curve. At this point, MRS = price ratio.
When the price of a good changes, two effects work simultaneously:
Substitution effect: the price change makes one good relatively cheaper. Consumers substitute toward the cheaper good and away from the relatively more expensive one. This effect always moves consumption in the opposite direction to the price change.
Income effect: the price change alters the consumer's real purchasing power. A price decrease effectively makes you richer (your income buys more). For normal goods, the income effect reinforces the substitution effect (you buy more). For inferior goods, the income effect works against it (you buy less of the inferior good as your real income rises).
The total change in consumption = substitution effect + income effect.
For normal goods, both effects push in the same direction, so the demand curve definitely slopes downward.
For inferior goods, the effects push in opposite directions. In the rare case where the income effect dominates (a Giffen good), the demand curve slopes upward.
Demand curves
A demand curve shows the quantity demanded at each price. It slopes downward (law of demand).
Movement along the curve = a change in price causes a change in quantity demanded.
A shift of the entire curve = a change in a non-price determinant (income, preferences, prices of related goods, expectations, seasonality).
Price elasticity of demand
Measures how responsive quantity demanded is to price changes.
Perfectly inelastic (elasticity = 0): quantity does not respond at all. Vertical demand curve.
Inelastic (elasticity between 0 and 1): quantity responds less than proportionally.
Elastic (elasticity greater than 1): quantity responds more than proportionally.
Revenue link: for inelastic demand, raising the price increases total revenue. For elastic demand, raising the price decreases total revenue. Unit elastic is the turning point.
Cross-price elasticity
Positive cross-price elasticity = substitutes (e.g. quilts and comforters: when the price of one rises, demand for the other increases).
Negative cross-price elasticity = complements (e.g. printers and ink).
Profit maximisation rule
Firms maximise profit by producing the quantity where marginal revenue (MR) equals marginal cost (MC).
If MR > MC, the firm should increase output (each extra unit adds more revenue than cost).
If MR < MC, the firm should decrease output (each extra unit costs more than it earns).
At MR = MC, profit is maximised.
Monopoly pricing
A monopolist faces the entire market demand curve and must lower its price to sell additional units.
Because of this, marginal revenue falls faster than price. The MR curve lies below the demand curve.
The monopolist sets MR = MC, finds the corresponding quantity, then reads the price off the demand curve. This results in higher prices and lower output than under perfect competition, creating deadweight loss.
Average total cost (ATC)
ATC is U-shaped. When MC is below ATC, ATC falls. When MC is above ATC, ATC rises. MC crosses ATC at its minimum point.
The minimum of ATC indicates the most efficient scale of production.
Long-run supply and returns to scale
Constant returns to scale: long-run ATC stays flat as output grows. If all firms are identical, the long-run market supply curve is horizontal.
Increasing returns to scale: long-run ATC falls with output.
Decreasing returns to scale: long-run ATC rises with output.
If firms have different cost structures, the long-run supply curve slopes upward.
Supply and demand shifts
A change in price causes movement along the existing curve (change in quantity demanded or supplied).
A shift of the curve comes from a non-price determinant:
Demand shifters: income, preferences, expectations, prices of related goods, seasonality.
Supply shifters: technology, input prices, regulations, number of firms.
Price ceilings
A price ceiling set below the equilibrium price creates a shortage (excess demand). Rent control is the textbook example, leading to housing shortages.
Price floors
A price floor set above equilibrium creates a surplus (excess supply). It reduces consumer surplus because prices are higher and quantity demanded falls, leading to deadweight loss and wasted resources.
Tax incidence
When a per-unit tax is imposed, the price buyers pay rises and the price sellers receive falls. The difference between the two is the tax.
Example: if buyers pay $2.50 and sellers receive $1.75, the tax per unit is $0.75.
Who bears more of the tax burden depends on relative elasticities. The more inelastic side bears the larger share.
Willingness to pay and market participation
A consumer buys only if their willingness to pay meets or exceeds the market price. If Tessa's willingness to pay is $750 and the price is $700, she buys and earns $50 of consumer surplus.
Budget constraint:
I = P_A \cdot Q_A + P_B \cdot Q_BSlope of the budget line = -P_A / P_B
Optimal consumer choice: MRS = P_A / P_B (the slope of the indifference curve equals the slope of the budget line at the tangency point).
Profit maximisation: produce where MR = MC.
Price elasticity of demand:
E_d = \frac{\% \Delta Q_d}{\% \Delta P}Tax incidence: Tax per unit = Price paid by buyers - Price received by sellers.
Key diagrams to practise: budget constraint with indifference curves; supply and demand with a tax wedge; monopoly pricing (demand, MR, MC); price ceiling causing a shortage; price floor causing a surplus.
Budget constraints and indifference curves explain everyday choices: how you allocate your monthly spending between necessities and luxuries, or why a sale changes what you buy (substitution effect) and how much you buy overall (income effect).
Elasticity matters for business pricing. Pharmaceutical companies can raise prices on inelastic drugs (few substitutes, essential need) without losing many customers. Airlines use elasticity to price-discriminate between business travellers (inelastic) and leisure travellers (elastic).
Price ceilings like rent control are debated in cities worldwide. The economic prediction (shortages, reduced housing quality) matches observed outcomes in New York, San Francisco, and Berlin.
Students often confuse a shift of the demand curve with movement along it. A price change causes movement along the curve. A change in income, preferences, or the price of a related good shifts the entire curve.
A common error is thinking that if MR > MC, the firm is already maximising profit. It means the firm should produce more. Profit is maximised only at MR = MC.
Students sometimes assume a price ceiling always causes a shortage. It only causes a shortage if set below the equilibrium price. A ceiling set above equilibrium has no effect.
Another frequent mistake: assuming the person who physically pays the tax bears the full burden. Tax incidence depends on elasticities. Even if the tax is levied on sellers, buyers share the burden through higher prices.
The MRS is often confused with the price ratio. At the optimum they are equal, but they measure different things: MRS is the consumer's willingness to trade, while the price ratio is the market's rate of exchange.
⚠️ Drawing budget constraints, indifference curves, and finding the tangency point is a staple exam question. Practise graphing these and identifying how a price or income change shifts the optimum.
⚠️ The MR = MC rule for profit maximisation appears in nearly every exam that covers firm theory. Be ready to apply it for both competitive firms and monopolists.
⚠️ Elasticity calculations and the revenue-elasticity link are high-frequency exam topics. Know when raising a price raises or lowers total revenue.
⚠️ Price ceiling and price floor diagrams, including identifying deadweight loss and surplus/shortage areas, are commonly tested.
⚠️ Tax incidence questions often ask you to split the burden between buyers and sellers given different elasticity scenarios.
True or false: the slope of the budget constraint equals the ratio of income to the price of Good A. (False, it equals the negative ratio of the two prices, -P_A / P_B.)
Fill in the blank: at the consumer's optimal choice, the MRS equals the ______. (Price ratio.)
True or false: for an inferior good, the income effect reinforces the substitution effect. (False, they work in opposite directions.)
Fill in the blank: a firm maximises profit where MR = ______. (MC.)
True or false: if demand is inelastic, a price increase reduces total revenue. (False, it increases total revenue.)
Q: A consumer has $300, pizza costs $15, and movies cost $10. What is the maximum number of pizzas they can buy? What is the slope of the budget line?
A: Maximum pizzas = $300 / $15 = 20. Slope of the budget line = -15/10 = -1.5. For every pizza gained, the consumer gives up 1.5 movies.
Q: If the price of pizza falls, explain the substitution and income effects on pizza consumption for a consumer who treats pizza as a normal good.
A: Substitution effect: pizza is now relatively cheaper, so the consumer buys more pizza and fewer movies. Income effect: the price drop raises real income, and since pizza is a normal good, the consumer buys still more pizza. Both effects increase pizza consumption.
Q: A monopolist faces a demand curve P = 100 - 2Q and has MC = 20. What quantity maximises profit?
A: MR = 100 - 4Q (for a linear demand curve, MR has the same intercept and twice the slope). Set MR = MC: 100 - 4Q = 20, so Q = 20. The profit-maximising price is P = 100 - 2(20) = $60.
Q: A $0.75 per-unit tax is imposed. Buyers pay $2.50 and sellers receive $1.75. How is the tax burden split?
A: Buyers bear $0.50 of the tax (their price rose by $0.50 from the no-tax equilibrium). Sellers bear $0.25 (their received price fell by $0.25). The more inelastic side bears the larger share.
Consumer theory connects to the trade notes: consumer and producer surplus (from the trade material) are built on the same willingness-to-pay and demand-curve tools covered here. Elasticity is central to tax incidence and tariff analysis. The profit maximisation rule (MR = MC) reappears in monopoly, oligopoly, and game theory. Cost curves and returns to scale feed into long-run market structure and industrial organisation.
Budget constraint, budget line, indifference curve, utility, marginal rate of substitution, MRS, substitution effect, income effect, normal good, inferior good, Giffen good, demand curve, law of demand, price elasticity of demand, elastic, inelastic, unit elastic, cross-price elasticity, substitutes, complements, marginal revenue, marginal cost, MR = MC, profit maximisation, monopoly pricing, average total cost, ATC, U-shaped cost curve, returns to scale, economies of scale, long-run supply, price ceiling, rent control, price floor, minimum wage, surplus, shortage, tax incidence, tax burden, willingness to pay, consumer surplus, deadweight loss, ECO 101, microeconomics, managerial economics