Key Microeconomic Models

Why This Matters

Every AP Microeconomics question ultimately tests whether you understand how markets work—and that understanding comes from mastering these foundational models. The supply and demand model explains price determination, consumer choice theory reveals why people buy what they buy, and market structure models show how competition (or lack of it) shapes outcomes. These aren't isolated concepts; they build on each other. You'll need to connect cost curves to firm behavior, link game theory to oligopoly decisions, and explain why externalities cause markets to fail.

Here's the key insight: the exam doesn't just ask you to define these models—it asks you to apply them. You're being tested on your ability to predict what happens when conditions change, compare outcomes across market structures, and evaluate efficiency. Don't just memorize that monopolies charge higher prices; know why (downward-sloping demand plus price-setting power) and what it costs society (deadweight loss). Each model below illustrates a core principle about how rational actors make decisions under constraints.

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Foundational Market Models

These models establish the basic mechanics of how prices emerge and how buyers and sellers interact. The core principle: prices coordinate decentralized decisions by transmitting information about scarcity and value.

Supply and Demand Model

• Equilibrium occurs where quantity demanded equals quantity supplied—this intersection determines both market price and quantity, serving as the reference point for all market analysis
• The laws of demand and supply describe inverse and direct relationships with price, respectively; all else being equal (ceteris paribus) is the critical qualifier
• Shifts vs. movements distinguish between changes in determinants (shifting curves) and responses to price changes (movements along curves)—a distinction the AP exam tests repeatedly

Consumer Choice Theory

• Utility maximization under budget constraints explains how rational consumers allocate income; the rule is to equalize marginal utility per dollar across all goods ($\frac{MU_x}{P_x} = \frac{MU_y}{P_y}$)
• Indifference curves and budget lines graphically represent preferences and constraints; optimal choice occurs at the tangency point
• Substitution and income effects decompose how price changes alter consumption—substitution effect always moves opposite to price change, while income effect depends on whether the good is normal or inferior

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Production and Cost Models

These models explain the firm's side of the market—how inputs become outputs and what it costs. The core principle: firms face trade-offs between inputs, and costs shape every production and pricing decision.

Production Theory

• The production function relates inputs (labor $L$, capital $K$) to output ($Q$); understanding this relationship is foundational to cost analysis
• Diminishing marginal returns states that adding more of one input while holding others constant eventually yields smaller output gains—this explains why cost curves slope upward
• Short-run vs. long-run distinctions matter: in the short run at least one input is fixed; in the long run all inputs are variable, allowing firms to achieve economies of scale

Cost Theory

• Marginal cost (MC) is the cost of producing one more unit and is the key decision-making variable for profit maximization; firms produce where $MC = MR$
• Average total cost (ATC) determines profitability: if $P > ATC$, the firm earns economic profit; if $P < ATC$, it incurs losses
• The relationship between MC and ATC follows a predictable pattern—MC intersects ATC at its minimum point, which represents productive efficiency

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Market Structure Models

These models show how the number of firms and product differentiation affect prices, output, and efficiency. The core principle: market power allows firms to charge above marginal cost, creating inefficiency.

Perfect Competition Model

• Firms are price takers facing a horizontal demand curve at the market price; they maximize profit by producing where $P = MC$
• Long-run equilibrium features zero economic profit because free entry and exit drive price to minimum ATC; this achieves both allocative efficiency ($P = MC$) and productive efficiency (production at minimum ATC)
• The model serves as a benchmark for evaluating other market structures—any deviation from perfect competition creates some inefficiency

Monopoly Model

• A single seller with no close substitutes faces the entire market demand curve, giving the firm price-setting power
• Profit maximization occurs where $MR = MC$, but price is set on the demand curve above that quantity—this gap between $P$ and $MC$ represents market power
• Deadweight loss results because monopolists restrict output below the competitive level; society loses trades that would have been mutually beneficial

Monopolistic Competition Model

• Many firms sell differentiated products, giving each firm a downward-sloping demand curve but limited market power due to close substitutes
• Long-run equilibrium features zero economic profit (like perfect competition) but excess capacity—firms produce below minimum ATC
• Non-price competition through advertising, branding, and product features is a defining characteristic; firms compete on differentiation rather than price alone

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Strategic Interaction Models

These models analyze situations where one firm's optimal choice depends on what other firms do. The core principle: interdependence creates strategic behavior that simple supply-and-demand analysis cannot capture.

Oligopoly Models (Cournot and Bertrand)

• Interdependence defines oligopoly—each firm's profit depends on competitors' actions, requiring strategic thinking rather than simple optimization
• The Cournot model assumes firms compete on quantity simultaneously, reaching a Nash equilibrium with output between monopoly and competitive levels
• The Bertrand model assumes price competition with homogeneous goods, often driving prices down to marginal cost—demonstrating how the form of competition dramatically affects outcomes

Game Theory

• Nash equilibrium occurs when no player can improve their payoff by unilaterally changing strategy—this is the solution concept for most strategic situations
• The prisoner's dilemma illustrates why rational self-interest can lead to collectively suboptimal outcomes; it explains why cartels are unstable and why firms might engage in price wars
• Dominant strategies (best regardless of opponent's choice) simplify analysis when they exist; look for them first when solving game theory problems

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Market Failure Models

These models explain when and why free markets fail to achieve efficient outcomes. The core principle: when private costs or benefits diverge from social costs or benefits, markets produce the wrong quantity.

Externalities and Public Goods Model

• Externalities create a wedge between private and social costs/benefits; negative externalities (pollution) cause overproduction, while positive externalities (education) cause underproduction
• The efficient solution requires internalizing the externality—through Pigouvian taxes (negative) or subsidies (positive) equal to the marginal external cost or benefit
• Public goods are non-excludable and non-rivalrous, leading to the free-rider problem; private markets underprovide because firms cannot capture full benefits

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Quick Reference Table

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Self-Check Questions

1. Both monopoly and monopolistic competition feature downward-sloping demand curves. What key structural difference explains why monopolists can earn long-run economic profit while monopolistic competitors cannot?

2. How does the concept of diminishing marginal returns in production theory directly explain the shape of the marginal cost curve in cost theory?

3. Compare the outcomes of Cournot and Bertrand competition. Why does the mode of competition (quantity vs. price) lead to such different equilibrium prices in oligopoly markets?

4. A factory emits pollution that harms nearby residents. Using the externalities model, explain whether the market produces too much or too little output, and describe one policy intervention that could achieve the efficient outcome.

5. In what sense is perfect competition the "benchmark" model? Identify two specific efficiency conditions it achieves that monopoly does not, and explain the welfare implications of each deviation.