ECON1101 Summary Notes

ECON1101: Microeconomics
Chapter 1: Thinking as an Economist

1.1
Economics: The Study of Choice in a World of Scarcity
Economics - study of how people make choices under conditions of scarcity and of the results of those choices
for society
o Microeconomics - the study of individual consumer, firm and market behaviour
o Macroeconomics - the study of the aggregate economy
Scarcity Principle (no-free-lunch principle) - unlimited wants and limited resources forces us to make
economic decisions that involve trade-offs or competing interests
o Economic Decisions - any decision where securing something of value means going without some
other thing of value
o Choice - involves compromise between competing interests; which wants we satisfy first using our
limited resources comes down to the relative importance of competing interests
o 4 kinds of limited resources - labour (human effort and time), land (natural resources, including
physical space), capital (something produced that is long-lasting and used for other productions) and
entrepreneurship (ability and willingness to combine other resources into productive enterprise)
Cost-Benefit Principle - an entity (individual, firm or society) should take an action if, and only if, the extra
benefits from taking the action are at least as great as the extra costs
o Benefit - the largest dollar amount the person would be willing to pay in order to take the action
o Cost - the dollar value of everything the person must give up in order to take the action
o Rationality Assumption - in studying choice under scarcity, people are assumed to be rational in the
sense that they compare the costs and benefits of alternative actions in pursuing their goals
Ceteris Paribus (all else equal) - the assumption that everything that could affect a variable of interest,
other than the thing being studied, stays the same.
1.2
Learning to Think as an Economist
Economic Naturalist - someone who uses basic economic concepts to make sense of observations about all
aspects of everyday life. Economists need to consider all costs and benefits when making decisions.
Economic Surplus - the gain that results from taking an action when the benefits outweigh the costs
o Rational people will choose actions that generate the largest economic surplus (but at least positive)
Opportunity Cost - the value or benefit of the next-best alternative that must be given up or sacrificed to take
a particular action (which becomes a cost of taking that particular action)
o Sum of explicit costs (paid to someone else) and implicit costs (cost for yourself)
o Eg. You have time to either: go shopping with friends and spend $10 or study for a test and improve
your mark by 10. The opportunity cost of going shopping is the $10 (explicit cost) plus the largest dollar
value youd be willing to pay for the extra 10 marks in the test (implicit cost).
The Role of Economic Models
Model - an abstract representation of reality (in words, diagrams and mathematical statements) to help explain
and predict something. Economics relies heavily on modelling.
o Eg. Economists use the cost-benefit principle as an abstract model of how an idealised rational individual
would choose among competing alternatives.
They recognise that people usually dont consciously assess costs and benefits when they make
simple decisions; all the cost-benefit principle really says is that a rational decision is one that is
explicitly or implicitly based on a weighing of costs and benefits.
Nonetheless, people still make sensible decisions most of the time, without being consciously
aware that they are weighing costs and benefits. This is mainly due to trial and error which
gradually allows people to learn what kinds of choices tend to work best in different contexts.
1.3
Four Important Decision Pitfalls
1. Measure costs and benefits as absolute dollars rather than as proportions

2. Account for all opportunity costs
3. Ignore sunk costs
Sunk Costs - a cost that cannot be recovered at the moment a decision is made
o Since sunk costs must be borne whether or not an action is taken, they are irrelevant to the decision of
whether to take the action.
o Eg. Regardless of what you paid to enter an all-you-can-eat restaurant, you should eat same amount
4. Know when to use average costs and benefits and when to use marginal costs and benefits
Marginal Benefit / Cost - increase in benefit / cost associated with a small increase in the level of an activity
Average Benefit / Cost - total benefit / cost of undertaking n units of an activity divided by n
o In many situations, the issue is not whether to pursue the activity at all, but rather the extent to which
it should be pursued. The cost-benefit rule is to keep increasing the level of activity as long as the
marginal benefit of the activity exceeds the marginal cost.
Not-all-costs-and-benefits-matter-equally principle - some costs and benefits (eg. Opportunity cost and
marginal costs and benefits) matter in making decisions, whereas others (eg. Sunk costs and average costs and
benefits) dont.
Chapter 2: Comparative Advantage: the Basis for Trade

2.1
Opportunity Cost and Specialisation
Absolute Advantage - when one person is able to produce a G+S with less resources than another person
Comparative Advantage - when one persons opportunity cost of producing a G+S is lower than another
persons opportunity cost
Specialization - to concentrate on the activities for which opportunity cost is lowest (ie. Most efficient)
o Economic systems based on specialization and the exchange of G+S are generally far more productive
than those with less specialization
2.2
The Principle of Comparative Advantage
Principle of Comparative Advantage - states that when people specialize in the activities for which their
opportunity is lowest (ie. Most efficient, comparative advantage) and then trade to get the G+S they do not
produce themselves, the total value of G+S produced can be maximized and everyone can be better off
Mathematically: consider example of 2, 1 person economies (6 hours per day), value of 1 bread = 1 pizza:
Time to bake pizza
Time to bake bread
Jon
20 mins
10 mins
James
30 mins
30 mins
O.C to bake pizza
O.C to bake bread
Jon
2 bread
pizza
James
1 bread
1 pizza
o Jon has AA and CA in bread, James has CA in pizza
o Jon should, according to Principle of CA, specialise in bread, and James should specialise in pizza
Without Specialisation
Jon (3 hours each)
James (1 hour pizza, rest bread)
Total
With Specialisation
Jon
James
Total
Sources of Comparative Advantage
Individual Level
o Inborn talent
o Education and training
Pizzas baked
Breads baked
9
2
18
10
11
28
Pizzas baked
Bread baked
0
12
36
0
12
36
National Level
o Uneven distribution of natural resources
o Infrastructure
o
Experience
Cultural institutions
Comparative Advantage is Dynamic - it can change over time

o The process of specialization helps build comparative advantage: as you focus more and more on one
production, you become better at that production and relatively not as good on other productions,
increasing the differences between opportunity costs
o Countries can attempt to build comparative advantage in particular industries by adopting strategic
trade policies such as subsidizing domestic firms and government investments in research
2.3
Illustrating Comparative Advantage Graphically
Production Possibilities Curve (PPC) - a graph that describes the maximum amount of one good that can
be produced for every possible level of production of the other good.
o PPC is a graphical representation of opportunity cost.
o Attainable - any combination of goods that can be
produced using currently available resources
Any point on the PPC or below and to the left

o Unattainable - vice versa of attainable
Any point to the right and above

o Efficient - any combination of goods for which
currently available resources do not allow an increase
in the production of one good without a reduction in the
production of the other
Any point on the PPC

o Inefficient - vice versa of efficient
Any point to the left and below
2.4
A Production Possibilities Curve for a ManyPerson Economy
PPC can take on two shapes:

o
Straight Line - one person economy
o Outward Bow Shape - many-worker economy.
Principle of Increasing Opportunity Cost (low-hanging-fruit principle) - states that in expanding the
production of any good, first employ those resources with the lowest opportunity cost, and only afterwards turn
to resources with higher opportunity costs
o Explains the outward bow shape of PPC of multi-worker economy
Opportunity cost of increasing production of good X (ie. forgone production of good Y) is equal
to the slope of the tangent at any point ( OC = more negatively sloped tangent)
Principle of increasing opportunity cost suggests that the more of good X that is already being
produced, the greater the opportunity cost of further increasing the production of good X
Thus the slope of tangents becomes more negative as production of good X increases, giving
the outward bow shape of the PPC
o Based on the fact that economic resources are not completely adaptable to alternative uses imperfect
substitutes cause a lack of flexibility or ability to be interchanged
Factors that Shift the Economys PPC Outwards
1. Increasing productive resources - investment in new factories and equipment, population growth
2.
Improvements in knowledge and technology - investment in education, research and development and
information communication technologies, gains from specialisation
Reasons for slow specialisation: population density and geographical isolation, laws and customs that
restrict the freedom to exchange G+S
2.5
Can we have too much specialisation?
It is possible to have too much specialization; when the marginal benefits of an increase in specialization is less
than the marginal costs of achieving that increase in specialization
o Eg. Due to economic costs, costs to the mental and physical health of workers
8.1
Comparative Advantage as a Basis for Trade
Countries have different resources - population size and density, labour skills, fertility of soil, climate,
natural resources, technology, culture, etc.
o Such differences in national resources provide countries with comparative advantages in the production
of different G+S (ie. They can produce certain G+S at a lower opportunity cost than other countries)
o Principle of comparative advantage states that we can all enjoy more G+S when each country produces
according to its comparative advantage, and then trade with other countries by using export revenue to
import goods in which they do not have a comparative advantage
o Market will ensure that goods will be produced where opportunity cost is lowest
8.2
Production and Consumption Possibilities and the Benefits of Trade
Consumption Possibilities Curve (CPC) - graph that shows combination of G+S that a countrys citizens
might feasibly consume
o Closed Economy - an economy that does not trade with other economies; CPC = PPC
o Open Economy - an economy that trades with other economies; CPC > PPC thus illustrating gains to
be made from trade in terms of higher consumption and welfare
Open Economy CPC - is graphically a downward line that just touches the PPC at one point.
o Slope of straight-line CPC equals the amount of the good on the vertical axis that must be traded on the
international market to obtain 1 unit of good on the horizontal axis.
o A country maximises its consumption possibilities by producing at the point where the CPC and PPC
intersect and trade
Chapter 3: Supply and Demand: an Introduction

3.2
Buyers and Sellers in Markets
Market - the market for any G+S consists of all the buyers and sellers of that G+S. Consists of 2 forces known
as demand (all the buyers) and supply (all the sellers).
The Demand Curve
Demand - amount of G+S consumers are willing and able to purchase at various prices per point in time
o Demand Curve - graphical representation of the relationship between the quantity of a particular G+S
that buyers want to purchase in a given time period and the price of the G+S
Law of Demand - states that as the price of G+S falls, quantity demanded increases and vice versa (ie. An
negative relationship between the price of a G+S and quantity demanded)
o Ceteris paribus - all other variables other than the price of the G+S that might influence how much of
the G+S people buy at various prices are held constant
Demand curve for almost all goods is negatively sloped due to three main reasons:
1. Substitution Effect - higher the price of the product, the better value substitute products become and
thus more consumers switch to substitute products
2. Income Effect - as people have limited income, consumers simply cant afford to buy as much of a product
at higher prices as at lower prices
3. Cost-Benefit Principle (Buyers Reservation Price) - people will only buy the good if the anticipated
benefits are greater than the cost. The benefit of the product is equal to the buyers reservation price
(the largest dollar amount the buyer would be willing to pay for a product). As the price of the product rises
and exceeds the reservation price, less of the product will be demanded.
The Supply Curve
Supply - amount of G+S producers are willing to sell at various prices per point in time.
o Supply Curve - graphical representation of the relationship between the quantity of a particular G+S
that sellers want to supply in a given time period and the price of the G+S
Law of Supply - states that as the price of G+S falls, quantity supplied falls and vice versa (ie. A positive
relationship between the price of a G+S and quantity supplied).
Sellers Reservation Price - the smallest dollar amount for which a seller would be willing to sell an additional
unit, generally equal to marginal cost
o Sellers are willing to sell additional units if the price (revenue per unit, or the marginal benefit) is at
least as great as the opportunity cost (marginal cost) of supplying that extra unit
o As price increases, producers are able to cover the higher opportunity cost of further production
(principle of increasing opportunity cost)
3.3
Market Equilibrium
Market Equilibrium - situation in market where no participant in the market has any
reason to alter their behaviour (ie. No tendency to change, in terms of both price and
quantity demanded and supplied)
o Is price and quantity at which demand and supply curve intersect
There are two situations in which forces known as market forces will move a market
towards its equilibrium:
1. Excess Supply - price of good exceeds equilibrium price, causing quantity supplied
> quantity demanded
o Unsold stock -> suppliers price. As price , quantity demanded and
quantity supplied . This proceeds until market returns to equilibrium
2. Excess Demand - price of good below equilibrium price, causing quantity
demanded > quantity supplied
o Shortage of stock -> bidding -> price. As price , quantity demanded and
quantity supplied . This proceeds until market returns to equilibrium
Regulated Market
Price Ceiling - a maximum allowable price, specified by law (to help low-income
producers) -> excess demand
Price Floor - a minimum allowable price, specified by law (to help producers) ->
excess supply
Black market - an illegal market in which the price exceeds the legally imposed ceiling
3.4
Predicting and Explaining Changes in Price and Quantities
Changes in the Quantity Demanded / Supplied (Expansion or Contract in Demand / Supply) - a

movement along the demand / supply curve that occurs in response to a change in price
Changes in Demand / Supply - a shift of the entire demand / supply curve (ie. change in the quantity of
G+S demanded or supplied at each price level)
Shifts in the Demand Curve
Price of related goods

o Substitute Goods (used in place of each other) - direct relationship between the price of one good and
demand for another
o Complimentary Goods (used together) - inverse relationship between the price of one good and
demand for another
Income
o Normal (superior) Good - demand varies directly with income
o Inferior Good - demand varies inversely with income
Tastes or preferences - increased preference by buyers for G+S -> D
Number of buyers - increase in the population of potential buyers -> D
Future expectations - consumers expect higher prices in the future -> D

Shifts in the Supply Curve
Costs of inputs - decrease in cost of inputs -> S
Technology - improvement in technology that reduces cost of production -> S
Number of firms in industry - increase in number of suppliers -> S
Future expectations - expectation of lower prices in future -> S
Nature - eg. Improvement in weather -> S of agricultural products
3.5
Markets and Social Welfare
Consumer Surplus - the difference between the consumers

reservation price (marginal benefit) and the price they actually pay
(equilibrium price)
Producer Surplus - the difference between the price received by
the supplier and their reservation price
Economic Surplus - the sum of the consumer and producer
surplus
o Maximized at market equilibrium
o Cash on the table - a metaphor used by economists to
describe unexploited gains from exchange (ie. the market
can still increase its economic surplus by moving to
equilibrium position)
Socially Optimal Quantity - quantity of a G+S that results in the
maximum possible difference between the total benefits and total
costs from producing and consuming the G+S
o Is the level where MB = MC of the G+S
o Market equilibrium is where MB = MC for all private
participants in the market
Efficiency - occurs when all G+S are produced and consumed at
their respective socially optimum levels
Market equilibrium quantity is socially optimal if all costs of
producing the good are borne by private sellers and if all benefits
from consuming the good accrue directly to private buyers (ie. No
externalities). In such situations, the private market equilibrium is efficient.
But factors such as pollution are social costs that dont fall to the producers, and is thus unaccounted for by the
market (ie. At market equilibrium, social MC > private MC = private MB and is thus not socially optimal)
Negative Externalities - market equilibrium quantity is larger than socially optimal quantity
Positive Externalities - market equilibrium quantity is smaller than socially optimal quantity
Equilibrium Principle - a market in equilibrium leaves no unexploited opportunities for individuals, but may
not exploit all gains achievable through collective action.
Deadweight Loss - the decrease in consumer and producer surplus that results from an inefficient allocation
of resources
Chapter 4: Elasticity
4.2
Price Elasticity of Demand
Price Elasticity of Demand - percentage change in quantity demanded that results from a 1% change in price
o D = Percentage change in quantity demanded = QD / QD
Percentage change in price
P / P
o Ignore the minus sign (ie. Absolute value of percentages are used in equation)
Elastic Demand - D > 1 (a given % change in P larger % change in quantity demanded)
Inelastic Demand - D < 1 (a given % change in P smaller % change in quantity demanded)
Unit Elastic Demand - D = 1 (a given % change in P same % change in quantity demanded)
Determinants of Price Elasticity of Demand
1. Substitution Possibilities - the more close substitutes the product has, D
2. Budget Share - the higher the proportion of income spent on a good, D
3. Time - the longer the period after price change (short run vs. long run), D
4.3
Graphical Interpretation of Price Elasticity
Price Elasticity at A (point formula) - D = P x 1__

Q slope
2 Exceptions to the Rule
1. Perfectly Elastic Demand (horizontal) - D =
2. Perfectly Inelastic Demand (vertical) - D = 0
4.4
Elasticity and Total Expenditure
Total Expenditure (what consumers spend) = Total

Revenue (what producers receive) = P x Q
For a straight-line demand curve, at point where it is:
o Unit elastic (D = 1) (midpoint) - TE is max
o Elastic (D > 1) - P and TE opposite directions
o Inelastic (D < 1) - P and TE same direction
4.5
Income Elasticity and Cross-Price

Elasticity of Demand
Cross-Price Elasticity of Demand - percentage by which the quantity demanded of a good changes in
response to a 1% change in the price of a second good
o Substitute goods - positive cross-price elasticity of demand
o Complimentary goods - negative cross-price elasticity of demand
Income Elasticity of Demand - percentage by which the quantity demanded of a good changes in response
to a 1% change in income
o Normal goods - positive income elasticity of demand
o Inferior goods - negative income elasticity of demand
4.6
Price Elasticity of Supply
Price Elasticity of Supply - percentage change in quantity supplied that results from a 1% change in price
o S = Percentage change in quantity supplied = QS / QS = P x 1__
Percentage change in price
P / P
Q slope
Same method as demand to determine whether supply is inelastic or inelastic (S>1, S=1, S<1)
Perfectly Elastic Supply - S = at any pt (ie. Supply curve is horizontal)
Perfectly Inelastic Supply - S = 0 at any pt (ie. Supply curve is vertical)
Determinants of Price Elasticity of Supply
1. Flexibility of inputs - extent that production of a good requires inputs that are also useful for production
of other goods. Easier it is to lure additional inputs away from their current uses, S
2. Mobility of inputs - easier it is for producers to transport compatible inputs from other markets, S
3. Ability to produce substitute inputs - products which can produce substitute inputs will have S
4. Time - since it takes time for producers to switch from one activity to another (build new capital and train
additional workers), the S will be higher for most goods in the long run than in the short run
Chapter 5: Demand: The Benefit Side of the Market

5.1
The Law of Demand
The Law of Demand - the quantity demanded of a G+S in a given time period declines as its price rises and
increases as its price falls, ceteris paribus.
o Needs - bare material levels of consumption (food, shelter, clothing) required to maintain our health
o Wants - any consumption that exceeds needs
5.2
Translating Wants into Demand
Utility - the satisfaction people derive from their consumption activities

o Utility maximization assumption - people try to allocate their incomes so as to maximise their
satisfaction or total utility
Marginal Utility - additional utility gained from consuming an additional unit of good in a given period of time
o Law of Diminishing Marginal Utility - the tendency for the marginal utility to diminish as
consumption increases beyond some point
o Suggests that spending all of our income on one good is not a good strategy to maximise utility
Optimal Combination of Goods - the affordable combination of G+S that yields the highest total utility
o Rational Spending Rules - spending should be allocated across G+S so that marginal utility per dollar
is the same for each good
5.3
If the ratio of marginal utility to price is higher for good X than good Y, the consumer can
increase their total utility by purchasing more of good X and less of good Y
Applying the Rational Spending Rule
Real Price - the dollar price of a good relative to the average dollar price of all other goods
Nominal Price - the absolute price of a good in dollar terms
o Even when price of a good increases in nominal terms, consumption of that good may increase because
the price of the good has actually decreased in real terms
5.4
Individual and Market Demand Curves
The market demand curve for a G+S is the horizontal summation of all individual demand curves for that G+S
(ie. at each price level, add all the individual quantity demanded).
5.5
Demand and Consumer Surplus
Consumer Surplus - the difference between the consumers reservation price (marginal benefit) and the price
they actually pay (equilibrium price) for a product
o Aggregate consumer surplus in the market (ie. Summation of marginal benefit minus price for
every good consumed) = area between the demand curve and the equilibrium price line
o The benefit or total welfare consumers receive from participating in the market as they perceive it
Chapter 6: Perfectly Competitive Supply: the Cost Side of the Market

6.1
Thinking about Supply: the Importance of Opportunity Cost
Additional units of a product should be supplied until the marginal revenue (price) is equal to the opportunity
cost (marginal cost).
Eg. Harry can either wash dishes for $6/hour or collect containers.
o Opportunity cost of collecting cans is $6/hour
Lowest
o
o
o
refund to induce Harry to spend at least:

1 hour/day recycling: $6 / 600 = 1 cent
2 hour /day recycling: $6 / 400 = 1.5 cent
3 hour/day recycling: $6 / 300 = 2 cent
To cover opportunity cost under conditions of diminishing marginal returns (or output), price must rise to give
incentive for suppliers to supply more.
Individual and Market Supply Curves
The quantity that corresponds to a given price on the market supply curve is the sum of the quantities supplied
at that price by all individual sellers (ie. Same as demand).
6.2
Supply in Perfectly Competitive Markets
Profit - the total revenue a firm receives from the sale of its product minus all costs (explicit and implicit)
incurred in producing it
o Primary goal of most firms is to maximise its profit (total revenue - total cost)
Perfectly Competitive Markets
The supply curve assumes that goods are sold by profit-maximizing firms in:
Perfectly Competitive Markets - a market in which no individual supplier has any influence on the market
price of the product
o Price Takers - a firm that has no influence over the price at which it sells its product
Four conditions or characteristics of perfectly competitive markets:
1. All firms sell the same standardized product (homogenous)
2. The market has many buyers and sellers, each of which buys or sells only a small fraction of the
total quantity exchanged
3. Sellers are able to enter and leave a market as they like
4. Buyers and sellers are well informed
Imperfectly Competitive Markets - a market in which individual suppliers have at least some ability to set
their own price
o Price Setters - a firm that has at least some control over the market price of its product
Production in the Short Run
Factor of Production - inputs used in the production of a G+S
o Fixed - an input whose quantity does not change as the output of a particular G+S changes
o Variable - an input whose quantity varies as the output of a particular G+S changes
Short Run - a period of time sufficiently short that at least one of the firms factors of production are fixed
Long Run - a period of time of sufficient length that all the firms factors of production are variable
Law of Diminishing Returns - in the short run, when at least one factor of production is fixed, successive
increases in variable inputs will eventually yield smaller and smaller increments in output
o Ie. Raising output will eventually require ever-larger increases in variable inputs
o Occurs because of congestion of fixed inputs
Costs in the Short Run
Explicit (economic cost) - payments made to outsiders for inputs used by the firm
Implicit (opportunity cost) - the potential earnings of the firms resources had they been used in some other
production
Total Cost - the sum of all payments made to the firms fixed
and variable factors of production
o Total Fixed Costs (TFC) - sum of all payments
made to the firms fixed factors of production
o Total Variable Costs (TVC) - sum of all payments
made to the firms variable factors of production
Average Fixed Cost (AFC) = TFC / Q
Average Variable Cost (AVC) = TVC / Q
Average Total Cost (ATC) = AFC + AVC
o Falls at first: fixed costs are being spread and the
effect of specialization
o Eventually rises: due to law of diminishing returns,
AVC rises (ie. To increase output, firm needs to use
and pay for more and more variable inputs)
Marginal Cost (MC) - additional cost of producing one more unit of output
o MC = TC / Q
o MC declines at first due to increasing returns, then increases due to diminishing returns
o MC curve will intersect the minimum points of AVC and ATC
Profit-Maximizing Output
In perfect competition, each firm is a price taker; they are too small to have an influence over the market price.
As such, each firm faces a perfectly elastic demand for its output at the market price (ie. At the market price,
firms can sell as many units as they can produce), causing P=MR under perfect competition. Due to the law of
diminishing marginal returns, firms will face MC as its output increases beyond a certain point.
Profit-Maximising Condition (perfect competition) - when a firm produces at the quantity of output where
the marginal cost of the last product produced is equal to the price of the product on the market (ie. P = MC)
o Condition applies because of the cost-benefit principle - an action should be taken only if the marginal
benefits associated with that action is at least as great as its marginal cost (P=MR=MC)
o At any production level above (eg. At Q1), the firm will suffer a marginal loss as MC > MR. Vice versa
Three Possible Short Run Outcomes
Producing at the profit-maximizing output does not always lead to a positive economic profit (ie. TR - TC > 0).
To determine this, we compare the firms ATC, at the profit-maximizing output with the market price.
o Economic Profit = (P - ATC) x Q
1.
2.
3.
Normal Profit - economic profit = 0 - price is at level where MC intersects with ATC
Economic Profit - economic profit > 0 - price is above level where MC intersects with ATC
Economic Loss - economic profit < 0 - price is below level where MC intersects with ATC
o Temporary Shutdown Condition - a firm should shut down and produce nothing in the short run if
P<AVC at the profit-maximizing (or loss-minimizing) level of output.
Ie. The firms revenue from operating is not enough to cover its variable costs of production
The Law of Supply
Law of demand -> consumers buy less of a product when its price rises
Law of supply -> producers offer more of a product when its price rises
o This is because supply curves are essentially marginal cost curves, and because of the law of
diminishing returns, marginal cost curves are upward-sloping in the short run
o For every price-quantity pair along the market supply curve, price will be equal to each sellers marginal
cost of production
Thus, supply curves represent the cost side of the market while demand curves represent the benefit side of
the market.
6.3
1.
2.
3.
4.
Determinants of Supply Revisited

Technology - introduction of technology which increases productivity leads to an outward shift in the
market supply curve. Rational producers will only adopt technological changes if they reduce cost of
production.
Input Prices - changes in the price of variable inputs can cause large and quick shifts in the supply curve.
Changes in fixed input prices would not affect the profit-maximizing level of output since increases in fixed
costs dont increase marginal cost, and thus has no impact on supply.
Expectations - if prices were expected to increase, suppliers would withhold the product from the market
in order to sell it at a higher price at a later point in time, decreasing supplying the short term.
Changes in prices of other products - if the price of other productions increases, sellers in other
markets may be tempted to shift production to that higher priced good
5.
6.5
Number of suppliers - since market supply is the horizontal aggregation of individual supply curves,
market supply will shift to the right as the number of individual suppliers increase and vice versa.
Supply and Producer Surplus
Producer Surplus - the difference between the amount actually received by the seller (equilibrium price) and
the sellers reservation price (marginal cost)
o = area between the equilibrium price line and the supply curve
Chapter 7: Efficiency and Exchange

7.1
Market Equilibrium and Efficiency
Efficient (Pareto Efficient) - a situation is efficient if there is no opportunity for exchange or trade that will
make at least one person better off without harming others (ie. economic surplus is maximised)
Pareto-improving transaction - a transaction that leaves at least one person better off without harming
others (ie. a transaction that creates additional economic surplus)
Only the equilibrium will maximise economic surplus (ie. Efficient) - the market price is the only price
at which buyers and sellers cannot design a surplus-enhancing or Pareto-improving transaction
o When the price is above or below the equilibrium, the quantity exchanged will be below the equilibrium
o The marginal benefit of an extra unit (price on D curve) is greater than the marginal cost of producing
that unit (price on S curve), and thus there is still opportunity to increase economic surplus by
increasing quantity traded up (until equilibrium quantity)
o However, this is only true if buyers are well informed, markets are perfectly competitive, supply
measures all relevant costs and demand measures all relevant benefits.
Efficiency: the First but not the Only Goal
Being efficient does not mean the same as desirable:
o All markets can be in equilibrium, yet many people may lack sufficient income to buy even basic G+S
o Markets are not necessarily equitable
Nonetheless, permitting markets to reach equilibrium is important, because it means:
o No resources are being wasted
o When economic surplus is maximized, it is possible to pursue other goals more fully
7.2
The Cost of Preventing Price Adjustments
Price Ceiling - a maximum legally allowable price for a G+S

established below the market equilibrium
o Causes a loss in economic surplus (wastage)
If aim of price ceiling is to protect low-income earners, it cannot be
said that it achieves this aim.
o Although the price is lower, the quantity available in the
market is lower and there is no guarantee that low-income
earners are the ones buying the cheaper product
o Same objective can be accomplished in a much less-costly
way (eg. Income transfer)
Price Subsidies - form of financial assistance to either sellers (to reduce production cost) or buyers (to reduce
price) of a good.
o Causes an overall loss in economic surplus (wastage)
Eg. Government subsidizes an import (perfectly elastic supply
as we can import as much as we want at world price).
o Overall loss in economic surplus since the cost of the
subsidy (borne by taxpayers) is greater than the
increase in consumer surplus.
First come, first served policies -
o
o
7.3
Gives little weight to the interests of consumers with a greater marginal benefit for (or greater
opportunity cost for not) taking an action
A better alternative is a compensation policy, which allows a more efficient allocation of G+S since the
G+S are provided to those who value them the most (minimizes the loss in economic surplus)
Marginal Cost Pricing of Public Services
To achieve the largest possible total economic surplus:
In private markets - goods are exchanged at equilibrium prices (where value of the last unit to the buyer
is exactly equal to the sellers marginal cost of producing it).
Government as sole provider of G+S - charge each customer exactly the marginal cost of providing the
G+S
o If there are multiple marginal costs for providing a G+S (eg. Acquiring water from different sources), a
government should share every household the highest marginal cost
7.4
Taxes and Efficiency
Incidence of Tax - division of the tax burden between the increase in price paid by the consumer and
decrease in revenue received by the producer.
o Relative incidence is shaped by the relative price elasticity of demand and supply; the burden of the
tax will be borne by the side of the market that is more inelastic
How a Tax Collected from a Seller Affects Economic Surplus
A tax levied on the seller of a product has the same effect on equilibrium as a rise in MC equal to the amount of
the tax (ie. Decrease in supply by the size of the tax).
o Causes total economic surplus to shrink (to area of triangle bounded by Y-axis, demand curve and new
supply curve. However, consumers receive a reduction other taxes paid by an amount equal to the
additional tax revenue and this adds to consumer surplus.
o Nonetheless, the tax still leads to an overall loss in economic surplus equal to half the value of
the tax per unit multiplied by the decrease in quantity between the equilibrium points before and after
the tax. This is known as a deadweight loss.
To minimise deadweight loss, tax goods that have more inelastic demand and/or supply
Deadweight Loss - the reduction in total economic surplus that arises when a market operates at some price
and output combination other than the one at which marginal benefit equals marginal cost (ie. Equilibrium).
Chapter 8: International Trade and Trade Policy

8.3
A Supply and Demand Perspective on Trade
World price - the price at which a G+S is traded on international markets

o Assumes that the economys market for the good is too small to affect the world price of the good
o World price is essentially fixed and the supply curve of imported goods is perfectly elastic
If domestic equilibrium price > world price,

economy -> net importer of that G+S
If domestic equilibrium price < world price,
economy -> net exporter of that G+S
Winners and Losers from Trade
Losers: domestic producers of imported goods
Winners: consumers, domestic producers of

exported goods
But gains > losses - free trade benefits the economy as a whole (bigger economic surplus)
Protectionist Policies: Tariffs and Quotas
Protectionism - use of policies that give domestic producers an artificial advantage over foreign competition
Import Tariff - a tax imposed on an imported good
Import Quotas - a legal limit on the quantity of a good that may be imported
o Tariffs and quotas both result in P, quantity demanded ( domestic production, imports)
o But while tariff generates government revenue, quotas generates revenue for import licensees
8.4
The Inefficiency of Protectionism

Free trade is efficient because it ensures that goods will be produced where opportunity cost is
lowest (ie. By countries who have a comparative advantage), maximizing consumption possibilities
Trade barriers are inefficient and reduce the size of the total economic surplus - loss in consumer
surplus > increases producer surplus and government revenue / revenue for import licensees
Gains from trade could be used to assist groups that have been hurt by trade
Much of the income loss arising from barriers to trade is absorbed by poor, developing economies
Chapter 9: The Quest for Profit and the Invisible Hand

9.1
The Central Role of Economic Profit
Explicit Costs - the opportunity costs of resources that the firm uses that are supplied from outside the firm.
Calculated as the actual payments the firm makes to its factors of production and other suppliers.
Implicit Costs - the value of the best opportunity forgone by the firm when it uses resources supplied by the
firms owners
Three Types of Profit
1. Economic Profit - difference between a firms total revenue and the sum of its explicit and implicit costs
o = total revenue - (explicit costs + implicit costs)
2.
3.
9.2
Accounting Profit - difference between a firms total revenue and explicit costs
o = total revenue - explicit costs
Normal Profit - level of accounting profit that a firm earns when economic profit is zero
o = implicit costs
o At normal profit, total revenue is just sufficient to offset the opportunity cost of all the resources that it
uses and thus there is no incentive for firms to leave the industry or for new firms to enter the industry
o Is where AR = MR = P = AC
T
h
e
Invisible Hand Theory

Invisible Hand Theory - Adam Smiths theory that the actions of self-interested buyers and sellers, all acting
independently, will often result in the socially optimal allocation of resources
Two Functions of Price
1. Rationing Function - distribute scarce goods to those consumers who value them most highly
2. Allocative Function - direct resources away from overcrowded markets and towards underserved markets
How Firms Respond to Profits and Losses
Invisible hand in a market where firms are earning a positive economic profit:
o Initially, producers earn positive economic profit
because equilibrium P > ATC at their profitmaximising output (P=MC)
o Attracts new firms into market
o Supply increases, reducing equilibrium P
o This continues until P falls to the level where MC
intersects ATC at its minimum point
o At this point, producers are making normal profit or
no economic profit, and there is no longer an
incentive for new firms to enter the market
Invisible hand in a market where firms are earning a negative economic profit (ie. economic loss):
o
o
o
o
o
Despite economic loss, if P > AVC (the shutdown

condition), firms will temporarily continue to supply
at their profit-minimising output (P=MC)
But eventually, current firms will exit market
Supply decreases, increasing equilibrium P
This continues until P rises to the level where MC
intersects ATC at its minimumiuo point
At this level, producers are making normal profit or
no economic profit, and there is no longer an
incentive for current firms to leave the market
Long-Run Supply in a Competitive Market

Short-run supply curve for a profit-maximising firm in a competitive market is its MC curve
Long-run supply curve is perfectly elastic at the price corresponding to the minimum point on the short-run
ATC curve (ie. where MC = ATC, and all firms are making normal profit in long-run)
o Due to invisible hand, any higher price would stimulate additional entry until price fell again to that
level, and any lower price would stimulate exit until price rose again to that level
Perfectly competitive long-run market equilibrium - 2
attractive features:
1. Market outcome is efficient - long-run equilibrium occurs
in a competitive market where P=MC=ATC. This implies that
the value of the last unit produced to buyers is equal to its
marginal cost of production, leaving no possibility for
mutually beneficial transactions.
2. Goods are produced at the lowest cost possible given
the technology existing at the time - shown by the fact
that all firms produce the level of output corresponding to
the minimum point on their ATC curve.
2 assumptions required for perfectly elastic long-run supply curve:
1. Adjustments in the LR - may entail not just entry and exist of standardised firms, but also the ability of
firms to alter their mix of capital equipment and other fixed inputs they employ
2. Producers are able to buy additional inputs at fixed costs - ruling out possibility of LMC increasing as
market output increases and giving rise to an upward-sloping long-run supply curve
The Importance of Free Entry and Exit
Invisible hand works effectively in perfectly competitive markets because firms can enter new markets and
leave existing ones at will. If new firms could not enter a market, the invisible hand will not function; there
would be fewer / no forces that would lead economic profit to fall to zero in the long-run.
Barriers to Entry - any force that prevents firms from entering a new market (eg. Copyrights, patents)
o Barriers to exit are also barriers to entry - if firms believe that a market, once entered, is difficult or
impossible to leave, they become reluctant to enter that market
9.3
Economic Rent versus Economic Profit
Economic Rent - the part of the payment for a factor of production that exceeds the owners reservation price
o Economic profit is like economic rent in that it, too, may be seen as the difference between what a firm
is paid (total revenue) and the firms reservation price for remaining in business (total costs)
o But while competition pushes economic profit towards zero, it has no such effect on the economic rent
for inputs that cannot be replicated easily (eg. Talented chef, singer, land, etc)
The economic profit associated with a very productive resource (eg. Talent chef) would create an incentive for
other producers to bid that resource away ( economic rent from the productive resources perspective).
o Equilibrium will be reached only when the resources price has been bid up to the point that no further
economic profit remains (ie. extra TR the resource brings = economic rent of having the resource)
9.5
Smart for One, Dumb for the Group Revisited
Equilibrium / no cash on the table principle doesnt mean there are never any valuable opportunities to exploit,
but that there are none when the market is in equilibrium. Equilibrium will not be socially optimal when the
costs or benefits to individual participants in the market differ from those experienced by society as a whole.
Chapter 10: Monopoly and Other Forms of Imperfect Competition

10.1
Imperfect Competition and Price-Setting
Imperfectly Competitive Market - a market in which firms have at least some ability to set their own price.
Three different forms include:
o Pure Monopoly - a market in which a single firm is the only supplier of a product for which there are
no close substitutes
o Oligopoly - a market in which only a few rival firms produce goods that are close substitutes
o Monopolistic Competition - a market in which a large number of firms produce slightly differentiated
products that are reasonably close substitutes for one another.
Market Power and the Firms Demand Curve
Perfectly Competitive Firm - faces a perfectly elastic
demand curve at the goods market price.
o Each firm is a price taker
o At that price, the perfectly competitive firm can
sell as many units as it wishes.
o It has no incentive to charge more (wont sell
anything if it does so) or less
Imperfectly Competitive Firm - faces a negatively sloping demand curve
o Each firm is a price setter
o If it increases its price, some (but not all) customers may desert it.
o In the case of the monopoly, the demand curve that the firm faces will be the market demand
curve
Market Power - a firms ability to raise the price of a good without losing all its sales
o A firm with market power cannot sell any quantity at any price it wishes. All it can do is pick a pricequantity combination along its demand curve (raising price = reduced quantity of sales).
10.2
Barriers to Entry
Barriers to entry - legal or natural constraints that protect a firm from potential competitors by restricting the
free entry and exit of firms to and from the market. Factors include:
1.
Exclusive control over important inputs - if a single firm controls an input essential to the production
of a given product, that firm will have market power
2.
Government-created monopolies - governments can confer market power on firms by the use of
patents, copyright protection and the grant of licenses and franchises
3. Economies of Scale (more important barrier)

Constant returns to scale - a production process is said to have constant returns to scale if, when all inputs
are changed by a given proportion, output changes by the same proportion
Increasing returns to scale (economies of scale) - a production process is said to have increasing returns
to scale if, when all inputs are changed by a given proportion, output changes by more than that proportion
Natural Monopoly - a monopoly that results from economies of scale, because a single firm can serve the
whole market at a lower cost than can two or more firms (due to cost advantage of larger output)
4. Network Economies (more important barrier)
The effect of network economies is that as the number of people using a certain product increases, the
consumers perception of its quality and value increases (eg. Networking between Microsoft software). Firmly
entrenched network economies can be as persistent as a source of monopoly as economies of scale.
10.3
Economies of Scale and the Importance of Fixed Costs
Total Cost (TC) = Fixed cost (F) + Marginal Cost x Quantity (MCxQ)
Average Total Cost (ATC) = TC / Q = F / Q + MC
Since fixed costs or start-up costs dont increase as output
increases, the ATC of production for goods will decrease as
output increases. Though ATC is always higher than MC, the
difference between the two diminishes as output grows.
At extremely high levels of output, ATC becomes very close to
marginal cost, because the firm is spreading out its fixed
costs over an extremely large volume of output (such that
fixed cost per unit or F/Q becomes almost insignificant).
This economies of scale effect on reducing ATC is most significant for goods whose production entrails large
fixed (start-up) costs and low variable (reproduction) costs. This explains why many industries such as software
and drugs are dominated by either a single firm or a small number of firms.
10.4
Profit Maximisation for Firms that are Price Setters
Marginal Revenue - change in a firms total revenue that results from a one-unit change in output (TC / Q)
Marginal Revenue for the Single-Price, Price-Setting Firm
MR of selling an additional unit is strictly less than the market price due to a downward-sloping D curve, a price setter will only sell an additional
unit if it cuts the price. If it must sell all its output at a single price, it must cut
the price of the additional unit and of all units it is currently selling.
For this reason, it can be derived that the MR curve of a price setting firm
intercepts the horizontal axis at the midpoint of the origin and where the
demand curve intersects (ie. below demand curve).
The Monopolists Profit-Maximising Decision Rule
Both the perfectly competitive firm and the monopolist have profitmaximising level of output at MR = MC
o Perfectly competitive firm: P = MR
o Monopolist: P > MR
o Thus, monopolist will set P > equilibrium P
Having Market Power doesnt Guarantee an Economic Profit
Economic profit if P > ATC at the profit-maximising

level of output.
Economic loss if P < ATC at the profit-maximising
level of output
o Monopolist will do best by shutting down
and produce nothing in the short run if P
< AVC at profit-maximising level of output.
o Monopolist will leave the market in the long
run in face of economic losses
But unlike perfect competition, monopolist dont earn normal profit in the long run - if they are earning an
economic profit, more firms will not (or cannot) enter the market and split the economic profit.
10.5
Why the Invisible Hand Breaks Down Under Monopoly
Social efficiency is achieved at the output level where market demand curve
(marginal benefit to society) intersects with the monopolists marginal cost
curve (marginal cost to society).
o Social efficient output level is when the firm is producing at D=MC
o But since the monopolist produces at MR = MC and D>MR, the
monopolists profit-maximising output can never be socially efficient.
There is economic surplus that is not realised or unexploited

opportunities, represented by the deadweight loss
But the invisible hand is completely idle in monopoly markets:
o Individual self-interest still leads people to respond to the incentive of unexploited opportunities (eg.
Develop substitute goods or production methods that do not rely on owning a unique resource)
o Even the monopolist itself has an incentive to expand output - if only there was some way to maintain
the price of existing units and cut the price of only the extra units.
Monopolists constantly struggle to find ways of serving buyers with low reservation prices
without spoiling the price at which they sell to high reservation price buyers
10.6
Using Discounts to Expand the Market
Inefficiency occurs in monopoly markets where the firm is a single-price price-setter because the firm is
reluctant to cut price to equilibrium price and increase quantity to equilibrium quantity - in the firms point of
view, the price reduction the firm must grant existing buyers to expand output is a loss.
Price Discrimination
Price Discrimination - practice of charging different buyers different prices for essentially the same G+S,
where differences do not simply reflect differences in cost of supplying different buyers.
o Transfers consumer surplus to producer.
o Only effective if:
Firms have some price-setting ability
Firms must be able to separate buyers into groups, either directly or indirectly, on the basis of
their willingness to pay for the good (buyers reservation price)
How Price Discrimination Affects Output and Profit
Perfect Price Discrimination - when a firm that charges each buyer exactly their reservation price for each
unit purchased (ie. monopolists marginal revenue curve is the same as market demand curve)
o With a perfectly discriminating monopoly, there is no loss of efficiency - all buyers who are willing to
pay a price high enough to cover the monopolists marginal cost will be served
o But while total economic surplus is maximised this way, all economic surplus is producer surplus or
consumer surplus = 0
eg. Opportunity cost of each paper edited = $29
If single-price:
A-C, 3 papers will be edited (MR>MC)
Economic profit = 108 (3x36) - 3x29 = $21
Socially efficient output:
A-F, 6 papers edited (D=MC)
Economic profit = 180 (6x30) - 6x29 = $6
If perfectly price discriminate (D=MR):
A-F, 6 papers edited (MR>MC)
Economic profit = 210 (40+38+30) - 6x29 = $36
Imperfect Price Discrimination - price discrimination in which at least some buyers are charged less than
their reservation prices. 2 problems that make perfect price discrimination impractical / impossible for sellers:
1. Sellers need to find out every consumers reservation price
2. Sellers need some means of excluding those with high reservation price from buying at a low price
Group Pricing - a form of price discrimination where different discounts are offered in different sub-markets,
while members of a particular sub-market all receive the same discount
o Sub-markets use observable characteristics of buyers (eg. Age or employment status) to make a
generalisation of reservation prices of buyers possessing those characteristics
Hurdle Method of Price Discrimination (Versioning) - the practice by which a seller offers a discount to all
buyers who overcome some obstacle
o Eg. Discounted printer if bought in bundle with a keyboard and mouse, temporary sales period (those
with low reservation prices are more likely to reorganise shopping schedule to buy during sale periods)
o Hurdle method solves both the sellers problem:
1. People will self-select into groups according to their reservation prices
2. Buyers with low reservation price are more willing than others to jump the hurdle
o Perfect Hurdle - a hurdle that completely segregates buyers whose reservation prices lie above it from
others whose reservation prices lie below it, imposing no cost on those who jump the hurdle.
Realistically impossible.
Is Price Discrimination a Desirable Thing
Price discrimination gives the monopolist a practical method of cutting prices for additional output only,
especially hurdle method of price discrimination
o Use of imperfect price discrimination is still more efficient than charging a single price to all buyers
Through the use of price discrimination, monopolists become willing to increase their quantity supplied to
the socially efficient level (ie. equilibrium)
o Price discrimination can increase economic surplus and the number of buyers served in the market
o May be socially desirable because it reduces the deadweight loss
10.7
Public Policy Towards Competition
Governments regulate extreme cases of market power such as monopoly because of a potential loss in
efficiency, restricted output and economic profit at the buyers expense.
Regulations to change how firms use their market power and promote competitive market structures include:
1. National Competition Policy (NCP) 1995
o Based on assumption competitive markets will generally serve the interests of consumers and the
wider community by providing strong incentives for suppliers to operate efficiently and be price
competitive and innovate
o NCP covered, for example, reforms to government businesses to make them more commercially
focused, guard against overcharging by monopoly service providers (eg. Infrastructure), review and
amending of legislation which restricted competition
2.
Trade Practices Act (TPA) 1974 and Australian Competition and Consumer Commission (ACCC)
o Acts purpose is to enhance the welfare of consumers through promotion of competition and fair
trading, and provision of consumer protection
o Act covers unfair market practices, industry codes, product safety, product labelling, price monitoring
o Compliance to act is administered by ACCC
Regulating Natural Monopolies

Despite structural reform and privatisation + corporatisation, natural monopolies still exist in industries such as
telecom, transport, water and gas. This has urged some government regulation of monopoly power.
Efficient regulation: marginal cost pricing rule (socially optimum price)
o P = where D=MC
o Causes monopoly to have economic loss - they can never recover
the cost of their start-up fixed costs, and forces them to go
bankrupt in the long run
Average cost pricing: average cost pricing rule (fair return price)
o P = where D=ATC
o Eliminates any positive economic profits since P=ATC
o But regulators must estimate average costs, and regulation limits
the firms incentive to adopt cost-saving innovations (firm
gets to keep its cost savings in current period but not in future
periods).
Price Cap - a moving price ceiling that is adjusted upwards at a slower rate than inflation
o Most commonly adopted approach in Australia
o Price caps force regulated firms to strive for increased productivity, since firms that fall behind in the
productivity race will experience smaller profits or even a loss, while firms that beat the productivity
race will enjoy above-normal returns
Chapter 11: Thinking Strategically

Oligopoly is a market structure in which:
o Small number of firms, each of which has a large share of the market (a four-firm concentration ratio
where share of total revenue >60% = oligopoly)
o Natural or legal barriers prevent the entry of new firms
o Mutual interdependence - where each firm anticipates the behaviour of its rivals when making
decisions, recognising that the outcome of its decision depends entirely on what their rivals do
o Eg. Banking sector, airlines
To analyse behaviour in oligopoly markets (where payoffs of different actions depend on the actions their
opponents take) and to describe and predict their likely outcomes, we use:
Game Theory - a tool for studying strategic behaviour, which is behaviour that takes into account the expected
behaviour of others and the mutual recognition of interdependence
11.1
Theory of Games
3 Basic elements of a game - players, the strategies (or possible actions) available to each player, and the
payoffs the players receive from each combination of strategies
Payoff Matrix - table that describes the payoffs to each player in a game for each possible combination of
strategies
Dominant Strategy - a strategy that yields a player a higher payoff no matter what the other players in a
game choose. Not all games involve a dominant strategy
Dominated Strategy - any other strategy available to a player who has a dominant strategy
Nash Equilibrium - a set of strategies, one for each player, in which each players strategy is his or her best
choice, given the other players strategies
o When a game is in equilibrium, no player has any incentive to deviate from his or her current strategy
If Mountain Springs charges $1, Aquapure
gets higher payoff by charging $0.90
If Mountain Springs charges $0.9, Aquapure
gets higher payoff by charging $0.90
If Aquapure charges $1 etc
Mountain Springs dominant strategy is to
charge $0.90; Aquapures dominant strategy
is to charge $0.90
Nash equilibrium is bottom right cell
11.2
The Prisoners Dilemma Game
Prisoners Dilemma - a game in which each player has a dominant strategy, and when each plays their
dominant strategy, the resulting payoffs are smaller than if each had played a dominated strategy
Prisoners Dilemmas Confronting Imperfectly Competitive Firms
Firms in an oligopoly market often play a price-fixing game, as many decisions faced by firms in oligopoly
markets turn out to be prisoners dilemma.
Eg. If both firms play their dominant strategy, they will both charge $0.90. The resulting payoffs are smaller
than if both firms had played their dominated strategy and charge $1. This gives them an incentive to make an
agreement to both charge $1.
Cartel - any group of firms that conspires to coordinate production and pricing decisions in an industry for the
purpose of earning an economic profit
o Cartels collude by selling products at a price higher than they would as competitors
o Are often unstable as firms have an incentive to cheat and sell below the agreed price, capturing the
market and increasing economic profit (but only in short run - other firms will follow the price cut)
Price war - where firms continually undercut each others price to capture the market and earn a higher
economic profit in the short run
o Price can fall all the way to the marginal cost\
Tit-for-Tat and the Repeated Prisoners Dilemma
When all players cooperate in a prisoners dilemma, each gets a higher payoff than when all defect. Thus, they
need some way to penalise players who defect.
Repeated Prisoners Dilemma - a game in which the same pair of players play out a prisoners dilemma
repeatedly, with the outcome of all previous players observed before the next play begins.
o In such games, a strategy known as tit-for-tat is effective at limiting defection
Tit-for-Tat - a strategy for playing the repeated prisoners dilemma game in which a player cooperates on the
first move, then mimics their partners last move on each successive move
o To be effective in limiting defection, tit-for-tat strategy requires that players have a significant stake in
what happens in the future, for it is the fear of retaliation that deters people from defecting
o Tit-for-tats effectiveness depends on there being only 2 players - because other firms may enter the
industry, either firm may decide to defect now to reap at least some economic advantage in short run.
11.3
Games in Which Timing Matters
Decision Tree (Game Tree) - a diagram that describes the possible moves in a game in sequence and lists
the payoffs that correspond to each possible combination of moves
Ultimate Bargaining Game - a game in which the first player has the power to confront the second player
with a take-it-or-leave-it offer
Credible Threat - a threat to take an action that is in the threateners interest to carry out
Credible Promise - a promise to take an action that is in the promisers interest to keep
Commitment Problem - a situation in which people cannot achieve their goals because of an inability to make
credible threats or promises
Chapter 12: Externalities, Common Resources and Property Rights

Three major sources of market failure:
1. Produces the wrong amount of G+S that have externalities or spillover effects
2. Fails to allocate sufficient resources to the production of certain goods known as public or social goods
3. Buyers and sellers may have different and imperfect information with which they make decisions
12.1
Externalities and Resource Allocation
Externalities - an external cost or benefit of an activity
1. Negative Externality (external cost) - a cost of an activity that falls on people other than those who
pursue the activity (additional marginal cost unaccounted for by market supply)
2. Positive Externality (external benefit) - a benefit of an activity received by people other than those
who pursue the activity (additional marginal benefit unaccounted for by market demand)
In either case, the externalities
cause the competitive equilibrium
to result in a loss of economic
surplus equal to the area of the
shaded triangle.
When all relevant costs

and benefits of an activity accrue directly to the people who produce and consume it (ie. no externalities),
the level of the activity that is best for the individual will also be the best for society
When an activity generates externalities (negative or positive), individual self-interest will not result in the
best allocation of resources for society (in other words, goods will not be produced at their socially optimal
levels which, by definition, is inefficiency).
o Individuals and firms who consider their own costs and benefits will tend to engage too much in
activities with negative externalities and too little in activities with positive externalities
Coase Theorem
Coase Theorem - if at no cost people negotiate the purchase and sale of the right to perform activities that
cause externalities, they can always arrive at efficient solutions to the problems caused by externalities.
o Informal rules and social norms often take care of reciprocal social costs without the need for either
Coasian deals or formal rules
If negotiation is costless, the task of adjustment generally falls on the party who can accomplish it at the lowest
cost, hence being efficient even if it may not be in accordance with societal norms.
Eg. Ruth operates a factory that dumps toxins into lake, negative externality to Hugh who operates a fishery
Total daily surplus without filter (220) > with filter (200) more efficient to operate without filter
Hugh should adjust - Hughs cost of putting up with
toxin (30) < Ruths cost of installing filter (50)
Ruth could pay Hugh $31 and both are still better off
operating without a filter than with a filter
Legal Remedies To Externalities
When negotiation is costly or impractical, legal remedies can address the problems of externalities.
o Many laws are made to address the problems caused by externalities - they help people achieve the
solutions they might have reached had they been able to negotiate with one another.
Putting Markets to Work to Solve the Problem of Externalities
Internalise the externality - making markets account for the costs or benefits of externalities they produce
Market-based Instruments (MBIs) - policies that use a range of approaches to positively influence the
behaviour of people in markets to achieve targeted outcomes.
Price-based MBIs - Taxes and Subsidies
Subsidies - to encourage activities with positive externalities)
Taxes - to discourage activities with negative externalities
Pigouvian Taxes - taxes to control externality problems
o Advantage is that it concentrates externality abatement in the hands of the firms that can accomplish it
at the least cost
o Requires detailed knowledge about each firms cost of reducing pollution (too low tax too much
o
pollution, too law tax too little pollution)

Tax paid by firm do not constitute a cost of pollution reduction - money can be used to reduce whatever
taxies would otherwise need to be levied on citizens
eg. Each firm emits 4 tonnes of pollution/day.
Government wants to half total emissions. 2 options:
1. Require each firm to curtail its emissions by half total cost = 500 + 80 = $580
2. Set a tax of $T per tonne of pollution/day (if MC of
cutting a tonne < $T, either firm will cut 1 tonne
than pay tax of $T) - $T = $101 to get Sludge Oil to cut 1 tonne (AB=$100 MC) and Northwest Timber to
cut 3 tonnes (CD=$100 MC), total cost = 100 + 180 = $280
Quantity-Based MBIs
Marketable permit system - also known as cap and trade, involves the creation of a market to facilitate the
trade of environmental goods (eg. Water, pollutant)
o In the case of a negative externality, establishing such a system involves 3 steps:
1. Set a quantity cap
2. Define entitlements (property rights) and distribute these among users
3. Create a market to enable the trading of entitlements
Like taxes, it reduces pollution by concentrating on firms that can do it at lowest cost. But unlike taxes, it:
Does not induce firms to make costly investments that they will have to abandon if the clean-up falls short
of the target level
Private citizens can buy the permits, giving them control over where the emission level will be set
Eg. In above example, the government auctions off 4 permits (entitles bearer to emit 1 tonne of pollution/day)
o If savings from increasing pollution by a tonne (MB) > price of permit (MC), either firm will rather buy
the permit to increase pollution by a tonne
o Therefore, when P auctions up to $101, Sludge Oil will demand 3 permits and Northwest Timer will
demand 1 permit. Total cost = 100 + 180 = $280
The Optimal Amount of Negative Externalities is not Zero
Curbing negative externalities entails both costs and benefits.
o Following the low-hanging-fruit-principle, polluters use the cheapest clean-up methods first and then
turn to more expensive ones (ie. MC increases)
o The intersection of the MC and MB curves marks the socially optimal level of reduction in negative
externalities which in turn implies an optimal level of negative externalities
o MC and MB curves often intersect at less than the maximum amount of reduction (ie. where amount of
negative externalities is 0)
o Best policy is to curtail pollution until the cost of further abatement is just equal to the marginal benefit
12.2
Property Rights, Common Resources and Open Access
Common Resource - a resource from which it is difficult to exclude people and for which each unit consumed
by one person means one fewer unit available for others
Tragedy of the Commons - the tendency for a common resource that is open access to be used until its
marginal benefit falls to zero
o When peoples use of a common resource is not subject to some control, it means that no one has an
incentive to take the opportunity cost of using it into account
o Cause of the tragedy is not that the resource is a common resource, but that open access is allowed
Open Access - a situation where no one has the ability to restrict access or to regulate use of a resource,
meaning that the resource is exploited on a first-come, first-served basis
Eg. Village has 5 residents, each of whom has
accumulated savings of $100. Can either:
Buy government bond for 13% interest pa
Buy year-old cattle, send it onto the commons to

graze, and sell it after one year. Its value after one
year depends on weight it gains, which depends on
the number of cows sent onto the commons.
If villagers make their investment decisions individually:
For self-interest - will send cow onto commons if income per cow > $13
Expect 4 villagers to send a cow onto the commons (4th villager indifferent between buying cow or bond)
Total villager income = 13 (bond) + 4x13 (cow) = $65 - not most efficient allocation of villagers resources
because they could have earnt that same amount by all buying bonds
If villagers make their investment decisions collectively (behaving as one entity or private owner):
For group-interest - will send cow onto commons if its marginal contribution to village income > $13
Expect a single cow to be sent onto the commons (socially optimal number)
Total villager income = 26 (cow) + 4x13 (bond) = $78

The Effect of Private Ownership
Private ownership is one solution to overcoming the tragic overuse of common resources. Since the owner has
the exclusive right to the resource, it will be in their own interest to use the resource efficiently.
o In example above, if grazing land was made private property of one villager, it will provide the owner of
the grazing land with the incentive to send only the efficient number of cows onto the grazing land (1)
Using Common and State Property to Manage Common Resources
Common Property - a type of property rights regime where resources are controlled by an identifiable
community of users, and rules governing use are made and enforced locally
State Property - a type of property regime where government has sole jurisdiction over the resource and
where regulatory controls are centralised
o Laws and rules dont always provide an ideal resolution to problems of externalities and the tragedy of
the commons - enforcement of these property rights entails cost, and sometimes costs > benefits.
Managing the Global Commons
Global Commons - refers to resources that form common heritage of mankind (eg. Atmosphere, oceans,
space, Antarctica, high sea fisheries).
o As world population grows, pressures on the global commons increase
o Many nations do not have the economic incentive to consider the negative effects it has on other
countries, making international agreements to manage these resources to be difficult to implement
o Resources economically valuable to humans but are not privately owned/effectively regulated by anyone
tend to be overused (eg. This is why extinction is a problem for whales but not chickens)
Treaties dealing with common resource problems (eg. Environmental) are generally too weak from a global
cost-benefit perspective:
o A country does not have to sign an agreement at all (commit to any costs), but would still benefit from
the efforts of other nations who sign the agreement (unless no-one commits to it, then it collapses)
o Once signed, each country faces a prisoners dilemma - because it can enjoy the benefits of agreement
without honouring their commitment to it, cheating is the dominant strategy
12.3
Positional Externalities
Positional Externality - occurs when a change in one persons performance changes the expected reward of
another in situations in which reward depends on relative performance
o Eg. How big an impression a firms advertisement campaign creates depends on the amount spent on
advertisement by the firm as well as by its competitors
o Invisible hand of the market is weakened by both standard and positional externalities
o Competitors have incentive to invest (often excessively) in actions that increase their odds of winning
Positional Arms Race - a series of mutually offsetting investments in performance enhancement that is
stimulated by a positional externality
o Eg. Firms often become drawn into costly positional arms races with rivals, spending more and more on
advertising and product branding that become matched and offset by rivals
Positional Arms Control Agreements - agreement in which contestants attempt to limit mutually offsetting
investments in performance enhancement in situations in which reward depends on relative performance
o Made because positional arms races produce inefficient outcomes
o Often achieved by the imposition of formal rules or signing of legal contracts
Eg. Laws against the use of steroids in professional sport, restrictions on shop trading hours
Social Norms as Positional Arms Control Agreements
Eg. Labelling of students who study too much as a social misfit or nerd prevents a positional arms race - when
students are graded on the basis of ranking, a positional arms race ensues because if all students were to
double the amount of time they studied, the distribution of grades would remain essentially the same.
However, social norms tend to change in order to accommodate the progressively more excessive behaviour
and spending patterns that are characteristic of such races.
Chapter 13: Public Goods and their Financing

13.1
Four Different Types of Goods
Rivalry - the extent to which consumption of a G+S by one person diminishes its availability for others
Excludability - the extent to which non-payers can be excluded from consuming a G+S
Private Goods - G+S that are both excludable and rivalrous in consumption
o All previous use of demand, supply and market equilibrium assumed that goods were private goods
Common Goods - G+S (or resources) that are rivalrous in consumption and are non-excludable
o Common resources belong in this category -> tragedy of the commons without regulation
Collective Goods - G+S that are non-rivalrous but excludable
o Eg. Pay TV - since the marginal cost to society to society of their tuning is literally zero, excluding nonpaying users is wasteful
Public Goods - G+S that are both non-excludable and non-rivalrous
Rethinking the Public Good / Private Good Divide
Whether goods are best provided publicly or privately (market) is determined not solely by their basic
properties, but also by policy choice (influenced by its interest for society as a whole and their externalities).
o Eg. Based on its basic properties, education is both rivalrous and excludable, with some positive
externalities. Yet, most societies choose to make it non-rivalrous and non-excludable.
o Eg. By issuing exclusive licenses to fish, such goods are moved out of the public domain
13.2
Government Provision of Public Goods
Free-Rider Problem - inventive that arises to not contribute to the provision of a G+S in situations in which
individuals are able to enjoy the benefits of a G+S without contributing to its cost
2 arguments for why government provision of public goods is necessary:
1. Free-rider problem - given the inability to exclude non-payers, private companies will have difficulty
recovering their cost of production
2. MC=0 to serve additional users once the good has been produced makes charging for good inefficient
However, the government should only provide public goods whose benefits > costs
o Cost of a public good is simply the sum of all explicit and implicit costs incurred to provide it
o Benefit of an additional unit of a public good is the sum of the reservation prices of all people who value
that additional unit
o Cost-benefit principle: if benefit does not exceed costs, we are better off without it, and vice versa
Paying for Public Goods
Not everyone benefits equally from the provision of a given public good
Most equitable way to finance public good -> tax people according to their willingness to pay (WTP)
In practice, government lacks WTP information for specific public goods
Joint purchases and sharing facilities are difficult in practice because of:
o
o
o
Significant communication costs (insignificant between 2 people, but significant between thousands)
Free-rider problems
Difficulty in reaching an agreement on fair sharing of costs
4 types of tax to fund public goods

1. Head tax - tax that collects the same amount from every taxpayer
2. Regressive tax - tax under which the proportion of income paid in taxes declines as income rises
3. Proportional income tax - tax under which all taxpayers pay the same proportion of their income in taxes
4. Progressive tax - tax in which the proportion of income paid in taxes rises as income rises
Eg. Neighbours A and B, cost of septic tank filtration system for joint consumption = $1000
As WTP=$800 and Bs WTP=$400 (As income double Bs)
o Individually - because the two together value the filter at $1200, sharing its sue would be socially
efficient (total economic surplus would be $200 higher than if they did not buy the filter)
o Head Tax - each must pay $500. Since device is only worth $400 to B, B will vote against this project,
thus denying it a majority vote and the good will not be provided.
o Proportional Tax - as As income double Bs, A would have to pay $667 while B would have to pay
$333. As both are below their WTP, the vote will pass and the good will be provided.
Different individuals are free to consume whatever quantity and quality of most private goods they buy
o But public goods that are jointly consumed, once provided, are available in the same quantity and
quality for all persons
Wealth individuals tend to assign greater value to public goods than low-income people do
o Head tax -> high-income people getting smaller amounts of public good than they want
o Progressive tax makes possible a better outcome
o However, progressive and proportional taxation have been criticised as being unfair to wealth
Local, State, Federal or Global
Benefits of some public goods are clearly local (eg. Street lights, fireworks), and thus local governments are
in best place to govern these public goods as different communities have different preferences.
Economies of scale argue for provision of defence at the national level
Externalities that transcend local boundaries provide additional rationale for national and international
agreements (eg. Carbon dioxide emissions)
13.3
Optimal Quantity of a Public Good
Demand Curve for a Public Good
Market demand curve is required to calculate the socially optimal quantity of any good
Demand curve for private good is calculated by the horizontal summation of individual demand curves
o This is because for a private good, one unit of quantity gives MB once
Demand curve for public good is calculated by the vertical summation of individual demand curves
o This is because for a public good, all buyers consume the same quantity and thus gives MB multiple
times, although each may differ in terms of willingness to pay for additional units of the good
o
o
The efficient quantity of a public good is the quantity that maximises net benefit (total benefit - total cost)
which is the same as the quantity at which marginal benefits equals marginal cost.
13.4
1.
2.
3.
4.
Private Provision of Public Goods
Government provision of public good has disadvantages - many people have to pay for public goods they
dont want
Many social institutions have evolved to provide public goods outside the government sector o The challenge is to devise a scheme for raising the required revenues to provide the public good
Funding by donation - private charities, volunteering, etc (Eg. Wikipedia)
Development of new means to exclude non-payers - scrambling TV signals to non-payers, electronic
toll charges for urban roads
Private contracting - gated private communities
Sale of by-products - radio and TV programming costs are paid by the sale of advertising, not-for-profit
groups selling calendars, books and bumper stickers, etc
By how much is economic surplus reduced by a pay-to-view charge?
13.5
Sources of Inefficiency in the

Political Process
Government does much to help the economy function more efficiently, but it can also be a source of waste:
Pork Barrelling - enacting legislation which do not satisfy the cost-benefit criterion (total costs > total benefit)
but which benefit constituents by more than their share of the extra taxes required to pay for the projects.
o Eg. A public project delivers benefits of $100 million for an electoral district which contains 1% of the
countrys taxpayers, but costs the federal government $150 million. Since the districts share of the tax
bill will be only $1.5 million, the residents are $98.5 million better off.
Rent Seeking - the socially unproductive efforts of people / firms to win a prize (eg. when individuals or firms
use real resources in an effort to win favours from the government)
13.6
What should we Tax?
Primary purpose of tax system - generate revenue to fund public goods

Tax also affects distribution of real purchasing power in the economy
When government run deficit budgets to fund goods, they borrow from capital markets
o Crowding Out - the extent to which government borrowing leads to higher interest rates, causing
private firms to cancel planned investment projects
Tax affects incentives and causes deadweight loss
Tax may help achieve socially optimal output levels in externality situations
Chapter 14: Economics of Information

The invisible hand theory assumes that buyers and sellers are fully informed.
Given that consumers are not fully informed, they must employ strategies for gathering information.
14.1
How the Middleman Adds Value
Peoples perceptions differ regarding the role of manufacturer and the role played by wholesalers, retailers and
sales agents.
o It is generally viewed that the production worker is the ultimate source of economic valueadded
Economic role of sales agents is essentially the same as that of production workers o Middlemen add economic value by providing better information which increases the extent to which
G+S find their way to the consumers who value them the most
o Creates a real increase in economic surplus
14.2
Optimal Amount of Information
As additional information is acquired, MB and MC

(people tend to gather information from the cheapest or
easiest sources first before turning to more costly ones,
as per the low-hanging-fruit principle)
Apply the cost-benefit test - rational consumer will
continue to gather information as long as MB > MC
Two Guidelines for Rational Search

In practice, the exact value of additional information is difficult to know. The cost-benefit principle provides a
strong conceptual framework for this problem:
1. Spending additional search time is more likely to be worthwhile for expensive items than for cheap ones
2. When search becomes more costly, expect to do less of it
The Free-Rider Problem

Just as buyers must decide how much information to gather, sellers must also decide how much information to
provide to prospective buyers.
The invisible hand does not ensure that the optimal amount of advice will be made available to customers
Free-rider problem:
o
o
o
Sellers that provide information will have P (hiring more salesperson)

But such sellers cannot charge directly for information
Customers are free to just come in, obtain advice and then leave to purchase elsewhere where P
because they dont provide as much information
The Gamble Inherent in Search

In general, someone who engages in further search must accept certain costs in return for unknown benefits.
Thus further search invariable carries an element of risk.
Expect Value of a Gamble - the average amount you would win (or lose) if you played that gamble an infinite
number of times. It is calculated as the sum of the possible outcomes multiplied by their respective probabilities
Fair gamble - a gamble whose expected value is zero
Better-than-fair gamble - a gamble whose expected value is positive
Risk-neutral person - someone who would accept any gamble that is fair or better
Risk-averse person - someone who would refuse any fair gamble
Eg. Two kinds of apartments - one which rents for $360 (20%) and remaining which rents for $400 (80%). The
only way you can discover the rent for a vacant apartment is to visit it in person, which costs $6. The first
apartment you visit is one that rents for $400.
o Visiting another apartment is a gamble with a 20% chance to win $40-$6=$34 and an 80% chance of
losing $6 (ie. -$6).
o Expected value of gamble = (0.2)(34) + (0.8)(-6) = $2
o Visiting another apartment is a better-than-fair gamble
The Commitment Problem When Search is Costly
When search costs are high, examining every possible action is impossible and irrational.
o But if more attractive options come along after the search has ceased, people are tempted to switch
o Most people solve this problem by signing an agreement for a specific period to remain committed
eg. Landlords and tenant signing a lease agreement - landlords wont lease to tenants who
leave once they find something cheaper, and tenants wont want to commit to an apartment
who would kick them out once a person who would pay higher comes along
14.3
Asymmetric Information
Asymmetric Information - situations in which people on different sides of an economic exchange are not
equally well informed about a particular aspect of the transaction that will affect the outcome for them
o Scope for opportunistic behaviour - one party can exploit their monopoly information to the
disadvantage of the other
Eg. Tom will offer Jane $21,000 because there is no way
of assuring that the car is in excellent condition.
$21000 < Janes reservation price of $22000
Therefore no trade
Had Jane been able to transfer information to Tom
(balance the asymmetric information), they could have
made sale and make potential surplus of $3000 (car
would have traded for anything between $22000-$25000).
The Lemons Model

Lemons Model - George Akerlofs explanation of how asymmetric information about the characteristics of
goods tends to reduce the average quality of goods offered for sale.
o People who have below average (lemon) products are more likely to want to sell them
o Buyers know that below average products are more likely to be on the market and lower their
reservation prices
o Thus, the owners of products that are in good condition have an even stronger incentive to hold onto
them, causing the quality of the product offered for sale on the market to decline even further
Eg. Assume there are only 2 types of used cars: good cars and lemons
o Only seller knows quality, the buyer is uncertain
o Market value of good cars = $10,000; market value of lemons = $5000
o P(good car) < 1
o Rational buyer who is uncertain of quality will pay $10,000xP(good car) which is <$10,000
o Seller who is certain of quality will not accept less than $10,000 for a good car and $5000 for a
lemon
o Only lemons will be bought and sold
Principal-Agent Problem
Principal - someone who contracts or hires another party to perform some service or provide some good on
their behalf
Agent - someone who is contracted or hired by another party to perform some service or provide some good
on their behalf
Principal-Agent Problem - a situation where an agent, whose actions are costly to monitor and whose
objectives are not aligned with those of the principal, takes actions that do not result in the best outcome
for the principal
Overcoming the principle-agent problem
Agents concern for reputation and pride mitigate the problem to a certain extent
Aligning interests of agent with those of the principal (eg. Allowing customer tipping to induce waiters to
provide good service)
Written quotes, seeking price estimates from many potential agents, getting 2 nd opinions
Designing incentive-compatible reward schemes

The Credibility Problem in Trading
Buyers and sellers interests tend to conflict
People tend to interpret ambiguous information in their favour or interest
However, parties to a potential exchange can often gain if they find some means to communicate truthfully
o Eg. How can a used car seller signal high-quality credibly? Offering warranty.
Costly-To-Fake Principle
Costly-to-fake principle - the idea that to communicate information credibly to a potential rival, a signal must
be costly or difficult to fake
o Eg. Warranty (entail costs that are significantly higher for defective cars than good cars, hence it is
credible as a signal of product quality), million-dollar worth advertising campaign
o Companies care about elite educational credentials as this signifies that the person is hardworking and
diligent enough to be able to attain these credentials
Conspicuous Consumption as a Signal of Ability
People with the most abilities tend to receive the highest salaries
The more someone earns, the more likely he/she will spend on high quality G+S
o Eg. Why do clients seem to prefer lawyers who wear expensive suits? Because if they have no other
information about their ability, they rely on the correlation between salaries/wealth and ability
However, the resulting spending pattern may be inefficient, for the same reason that other positional arms
races are inefficient
Statistical Discrimination
Statistical Discrimination - the practice of making judgement about the quality of people and G+S based on
the characteristics of the groups to which they belong (demographics)
o Eg. Why do males <25 years of age pay more than others for comprehensive car insurance? They
statistically have more car accidents.
In a competitive market with perfect information, the price the buyer of a G+S would pay equals the sellers
cost of providing that G+S.
However, in many markets (eg. Insurance) the seller does not know the exact cost of serving each buyer.
In such cases, the missing information has economic value
o If seller can come up with a rough estimate of missing information, they can improve their position
o Thus firms engage in statistical discrimination
Adverse Selection and Moral Hazard

Adverse Selection - a pattern which emerges in markets where those on the informed side of the market selfselect in a way that tends to reduce the average quality of the G+S sold
o Eg. High-risk individuals are more likely to buy insurance than low-risk individuals, P and value
Moral Hazard - the tendency of people to change their behaviour once they become party to a contract
o Eg. People who have insured cars may take less care to prevent it from being damaged or stolen
Solution - insurances with excess to make high-risk people pay more and to give additional incentives for
people to maintain their behaviour after they become party to a contract.
14.4
Disappearing Political Discourse
The theory that people who support a position may remain silent, because speaking out would
create a risk of being misclassified on the basis of their membership of a statistical group
o Eg. Why might proponents of safe injecting rooms often remain silent? Because they could be
misinterpreted of supporting the use of drugs.
Information and health care delivery

First dollar insurance coverage: Insurance that pays all expenses associated with claims
generated by the insured activity.
Example: If hospital care is completed covered by insurance, the marginal cost to a patient
would be zero, otherwise they might only stay for one day. This change in behaviour is an
example of moral hazard, because the patient has more incentives to stay at hospital than
when he was directly responsible for the cost of the hospital stay himself. This also causes
waste and inefficiency, as there is lost economic surplus for staying the extra days.
Solution: Cash payment to the patient to let them decide the amount of days they want to
stay, noting that the cash payment only covers for a bit less than two days worth of hospital
stay hence only able to fully cover one day of hospital stay. In this way, economic loss is
reduced, and both the patient AND the insurance company have a more balanced
distribution of economic surplus (instead of the patient using all the economic benefits
provided by the insurance company).
Private health care insurance: Attempts to encourage private health insurance are often
frustrated by adverse selection. Mounting insurance premiums have caused many people in
good health to do without health coverage, resulting in higher premiums for those who
remain insured.
Oligopoly Two models: Kinked demand curve and the collusive oligopoly
The kinked demand curve model of oligopoly is based on the assumption that each firm
believes that if it raises its price, others will not follow, but if it cuts its price, other firms will
cut theirs.
If they act as one firm (collusive oligopoly), it will closely resemble a monopoly.

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ECON1101: Microeconomics

Chapter 1: Thinking as an Economist

Economics: The Study of Choice in a World of Scarcity

Learning to Think as an Economist

Four Important Decision Pitfalls

1. Measure costs and benefits as absolute dollars rather than as proportions

Chapter 2: Comparative Advantage: the Basis for Trade

Opportunity Cost and Specialisation

The Principle of Comparative Advantage

Comparative Advantage is Dynamic - it can change over time

Illustrating Comparative Advantage Graphically

Any point on the PPC or below and to the left

Any point to the right and above

Any point on the PPC

Any point to the left and below

A Production Possibilities Curve for a ManyPerson Economy

PPC can take on two shapes:

Can we have too much specialisation?

Comparative Advantage as a Basis for Trade

Production and Consumption Possibilities and the Benefits of Trade

Chapter 3: Supply and Demand: an Introduction

Buyers and Sellers in Markets

Predicting and Explaining Changes in Price and Quantities

Changes in the Quantity Demanded / Supplied (Expansion or Contract in Demand / Supply) - a

Price of related goods

Tastes or preferences - increased preference by buyers for G+S -> D

Number of buyers - increase in the population of potential buyers -> D

Future expectations - consumers expect higher prices in the future -> D

Costs of inputs - decrease in cost of inputs -> S

Technology - improvement in technology that reduces cost of production -> S

Number of firms in industry - increase in number of suppliers -> S

Future expectations - expectation of lower prices in future -> S

Nature - eg. Improvement in weather -> S of agricultural products

Markets and Social Welfare

Consumer Surplus - the difference between the consumers

Price Elasticity of Demand

Graphical Interpretation of Price Elasticity

Price Elasticity at A (point formula) - D = P x 1__

Elasticity and Total Expenditure

Total Expenditure (what consumers spend) = Total

Income Elasticity and Cross-Price

Price Elasticity of Supply

Chapter 5: Demand: The Benefit Side of the Market

The Law of Demand

Translating Wants into Demand

Utility - the satisfaction people derive from their consumption activities

Applying the Rational Spending Rule

Individual and Market Demand Curves

Demand and Consumer Surplus

Chapter 6: Perfectly Competitive Supply: the Cost Side of the Market

Thinking about Supply: the Importance of Opportunity Cost

refund to induce Harry to spend at least:

Supply in Perfectly Competitive Markets

Determinants of Supply Revisited

Supply and Producer Surplus

Chapter 7: Efficiency and Exchange

Market Equilibrium and Efficiency

The Cost of Preventing Price Adjustments

Price Ceiling - a maximum legally allowable price for a G+S

Marginal Cost Pricing of Public Services

To achieve the largest possible total economic surplus:

Taxes and Efficiency

Chapter 8: International Trade and Trade Policy

A Supply and Demand Perspective on Trade