MICROECONOMICS

SUMMERS PREPARATORY MATERIAL 2015-16

SUPPLY AND DEMAND

In a free market the equilibrium price and quantity occur where
the supply and demand curves intersect.

The Law of Demand

Buyers of a product will purchase more of the product if its price is lower and
vice versa, assuming all other things remain constant (ceteris paribus).

The Law of Supply

At higher prices, producers are willing to offer more products for sale than at
lower prices

Two Reasons Why Buyers Buy More at Lower Prices and Less at
Higher Prices

The Substitution Effect - When the price of a product decreases, ceteris

paribus, the product becomes cheaper. It is, therefore, more attractive relative to
other products (and vice versa).

The Income Effect

- When the price of a product decreases, ceteris paribus,

consumers have more relative income. They can, therefore, purchase additional
products (and vice versa)

DEMAND CURVE SHIFT

The following changes will shift the demand curve to the right or to the left.

A change in real incomes or wealth (normal and inferior products).

A change in tastes or preferences.

A change in the prices of related products (substitute and complementary

products).

A change in the expectation of the products future price or buyers future

incomes.

A change in the number of buyers (population)

SUPPLY CURVE SHIFT

The following changes will shift the supply curve to the right or to the left.

An advance in technology.

A change in input prices.

A change in taxes, subsidies, or regulations.

A change in the number of firms selling the product.

ELASTIC AND INELASTIC SUPPLY CURVE

SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand
(a) Gasoline: Short-Run and Long-Run
Demand Curves

In the short run, an increase in price

has only a small effect on the quantity
of gasoline demanded. Motorists may
drive less, but they will not change the
kinds of cars they are driving
overnight.
In the longer run, however, because
they will shift to smaller and more fuelefficient cars, the effect of the price
increase will be larger. Demand,
therefore, is more elastic in the long
run than in the short run.

SHORT-RUN VERSUS LONG-RUN ELASTICITIES

Demand and Durability
(b) Automobiles: Short-Run and Long-Run
Demand Curves

The opposite is true for automobile

demand. If price increases,
consumers initially defer buying new
cars; thus annual quantity demanded
falls sharply.

In the longer run, however, old cars

wear out and must be replaced; thus
annual quantity demanded picks up.
Demand, therefore, is less elastic in
the long run than in the short run.

INDIFFERENCE CURVE
The optimum consumption point

An indifference curve is a line that

shows all the possible combinations
of two goods between which a
person is indifferent. In other
words, it is a line that shows the
consumption
of
different
combinations of two goods that will
give the same utility (satisfaction) to
the person.

A rational, maximizing consumer would prefer to be on the highest possible

indifference curve given their budget constraint.

CONSUMER ,PRODUCER SURPLUS

AND MARGINAL UTILITY

CONSUMER AND PRODUCER SURPLUS

Consumer Surplus is the difference in what consumers are willing to
pay for the price of the product and what they are actually paying for
it in the market.

Producer Surplus is the difference in what suppliers are willing to

sell the product for and what they are actually receiving for it in the
market.

CONSUMER AND PRODUCER SURPLUS

MARGINAL UTILITY

Marginal Utility
Marginal utility is the increase in satisfaction (as measured in utils) per
additional item consumed.

The Law of Diminishing Marginal Utility

As consumers purchase more of a product, the value (satisfaction) of
additional items purchased declines.

AVERAGE AND MARGINAL PRODUCT

Amount of input for which average product is maximized, marginal product is equal
to average product.

At input levels where marginal product is above average product, the average
product is rising (the curve slopes up as more input is used).

At input levels where marginal product is below average product, average product
is falling (the curve slopes down)

AVERAGE AND MARGINAL PRODUCT

TYPES OF COST

FIXED, VARIABLE AND SUNK COST

Fixed costs are costs that are independent of output. These remain constant
throughout the relevant range and are usually considered sunk for the
relevant range (not relevant to output decisions). Fixed costs often include
rent, buildings, machinery, etc.

Variable costs are costs that vary with output. Generally variable costs
increase at a constant rate relative to labor and capital. Variable costs may
include wages, utilities, materials used in production, etc.

Sunk cost
recovered.
face, such
happened.

- A cost that has already been incurred and thus cannot be

A sunk cost differs from other, future costs that a business may
as inventory costs or R&D expenses, because it has already
Sunk costs are independent of any event that may occur in the
future.

AVERAGE AND MARGINAL COST

Marginal cost is the change in total cost that arises when the quantity produced
changes by one unit. That is, it is the cost of producing one more unit of a good
marginal cost is the change in total cost that arises when the quantity produced
changes by one unit. That is, it is the cost of producing one more unit of a good

Average cost or unit cost is equal to total cost divided by the number of goods
produced (the output quantity, Q). It is also equal to the sum of average
variable costs (total variable costs divided by Q) plus average fixed costs
(total fixed costs divided by Q)

MC = VCq

AC =TCq

MC = AC + (AC/q)q.

AVERAGE AND MARGINAL COST

With cost, if the marginal cost (of a particular unit of output) is greater than
the average variable cost, the average variable cost will go up when that output
is produced

ACCOUNTING, ECONOMIC AND OTHER

COSTS,
Economic cost of a decision depends on both the cost of the alternative chosen and the
benefit that the best alternative would have provided if chosen. Economic cost differs
from accounting cost because it includes opportunity cost.

Opportunity cost is the cost of any activity measured in terms of the value of the next
best alternative forgone (that is not chosen). It is the sacrifice related to the second
best choice available to someone, or group, who has picked among several mutually
exclusive choices
Accounting Cost - The total amount of money or goods expended in an endeavour. It is
money paid out at some time in the past and recorded in journal entries and ledgers.
Eg: If attending college has a direct cost of $20,000 dollars a year for four years, and
the lost wages from not working during that period equals $25,000 dollars a year,
then the total economic cost of going to college would be $180,000 dollars ($20,000
x 4 years + the interest of $20,000 for 4 years + $25,000 x 4 years

SHORT RUN AND LONG RUN COST

The SMC goes through the minimum of the SAC and the LMC goes
through the minimum of the LAC.
When SAC = LAC we must have SMC = LMC (since slopes of total cost
functions are the same there).

SHORT RUN AND LONG RUN COST

SHORT RUN AND LONG RUN COST

In the long run, costs are all variable. This means that even capital can be altered.
Output can be changed by changing both capital and labour.We say that
changing the amount of capital that a producer uses is changing its "scale"
By changing scale in the long run, a firm can pick which short run average total
cost curve it wants to have

The long run average total cost curve slopes down (indicating lower average costs)
if the scale is increased from a very small scale to a little larger scale.

These declining average costs as scale is increased are called "economies of

scale" or "increasing returns to scale.

As output and scale are increased, a point is reached at which greater scale no
longer decreases average costs. This begins the range of output for which we say
there are "constant returns to scale;" average costs neither rise nor fall as scale is
increased.

Eventually, larger scale will lead to average costs getting larger. This is referred to
as "diseconomies of scale," or "decreasing returns to scale."

ECONOMIES OF SCOPE

Economies of scale' for a firm primarily refers to reductions in average

cost (cost per unit) associated with increasing the scale of production for
a single product type, Economies of scope' refers to lowering average
cost for a firm in producing two or more products

Eg: Proctor & Gamble, which produces hundreds of products from razors
to toothpaste. They can afford to hire expensive graphic designers and
marketing experts who will use their skills across the product lines. At
some point, additional advertising expenditure on new products may start
to be less effective (an example of diseconomies of scope).

LEARNING CURVE

There is a simple rationalisation behind

this: the more units produced by a given
worker, the less time this same worker
will need to produce the following units,
because he will learn how to do it faster
and better.

LEARNING CURVE

The average costs of production decline in real terms as a result of

production experience as businesses cut waste and find the most
productive means of producing output on a bigger scale.

Firms produce goods and services

with the assumed goal of maximizing
profits.
Total revenue (TR): (Price per unit)
times (quantity sold).
Total costs: variable costs plus fixed
costs.

Profits: Total revenue minus total

costs.

PROFIT MAXIMIZATION

Profit is maximized where the slope

of the total revenue curve (marginal
revenue) equals the slope of the total
cost curve (marginal cost).

TYPES OF MARKET
1. PERFECT COMPETITION

PERFECT COMPETITION

A market structure in which the following five criteria are met:

1. All firms sell an identical product.
2. All firms are price takers.
3. All firms have a relatively small market share.
4. Buyers know the nature of the product being sold and the prices
charged by each firm.
5. The industry is characterized by freedom of entry and exit.
Sometimes referred to as "pure competition".

PERFECT COMPETITION

In contrast to a monopoly or oligopoly, it is impossible for a firm in perfect

competition to earn economic profit in the long run, which is to say that a firm
cannot make any more money than is necessary to cover its economic costs.

In a perfectly competitive market, a firm's demand curve is perfectly elastic

Because markets are competitive, average and marginal revenues for each firm
should be equal to the market price of the good.

In the short run, it is possible for an individual firm to make an economic

profit. However, in the long period, economic profit cannot be sustained
MC(q)=MR=Price

PERFECT COMPETITION
Short Run

Long Run

2. MONOPOLISTIC
COMPETITION

CHARACTERISTICS

Differentiated products that are highly substitutable but not perfect substitutes

Free entry and exit

Downward sloping demand curve because of differentiated products implying

some monopoly power

In short-run, firms may earn profits but in the long run profits drop to
competitive levels as more and more firms enter the industry

ECONOMIC EFFICIENCY:

Inefficiency due to:

There is deadweight loss like in monopoly

Average cost is greater than minimum which is obtained in perfect

competition

But still efficient because:

Due to free entry large number of firms compete and monopoly power is
small resulting in average cost close to minimum

Product diversity gains outweigh inefficiencies

3. OLIGOPOLY

CHARACTERISTICS:

Only few firms compete

Barriers to entry

Products may or may not be differentiated

Strategic planning necessary as each firm must make

decisions on price etc. considering the reactions of its rivals

Eg: automobile, steel, aluminum, petrochemicals

ALTERNATIVE FORMS OF ORGANIZATION

Cooperative
is
an
autonomous
association
of
persons
who voluntarily cooperate for their mutual, social, economic, and
cultural benefit.

Cooperatives include non-profit community organizations and

businesses that are owned and managed by the people who use its
services (a consumer cooperative) or by the people who work there (a
worker cooperative) or by the people who live there (a housing
cooperative).

PRICE CONTROL MECHANISMS

PRICE CEILING
A price ceiling is a legal
restriction that prohibits
exchanges at prices greater
than a designated price - the
ceiling price

PRICE CONTROL

A deadweight loss (also

known as excess
burden or allocative
inefficiency) is a loss
of economic efficiency that
can occur when equilibrium
for a good or service is
not Pareto optimal = Net Loss

PRICE FLOOR

A price floor is a governmentor group-imposed limit on

how low a price can be
charged for a product.

A price floor must be greater

than the equilibrium price in
order to be effective.

SUBSIDY

TAX

EFFECT OF TAX AND SUBSIDY

A marginal tax on the sellers of a good will shift the supply curve to the left
until the vertical distance between the two supply curves is equal to the per
unit tax; when other things remain equal, this will increase the price paid by
the consumers (which is equal to the new market price), and decrease the
price received by the sellers

Marginal subsidies on production will shift the supply curve to the right until
the vertical distance between the two supply curves is equal to the per unit
subsidy; when other things remain equal, this will decrease price paid by the
consumers (which is equal to the new market price) and increase the price
received by the producers. Similarly, a marginal subsidy on consumption will
shift the demand curve to the right.

Without a tax, the equilibrium price will

be at Pe and the equilibrium quantity
will be at Qe.
After a tax is imposed, the price
consumers pay will shift to Pc and the
price producers receive will shift to Pp.
The consumers' price will be equal to
the producers' price plus the cost of the
tax.
Since consumers will buy less at the
higher consumer price (Pc) and
producers will sell less at a lower
producer price (Pp), the quantity sold
will fall from Qe to Qt.

EFFECT OF ELASTICITY
Depending on the price elasticities of demand and supply, who bears more of the
tax or who receives more of the subsidy may differ.

Where the supply curve is more inelastic than the demand curve, producers bear
more of the tax and receive more of the subsidy than consumers as the difference
between the price producers receive and the initial market price is greater than the
difference borne by consumers.
Where the demand curve is more inelastic than the supply curve, the consumers
bear more of the tax and receive more of the subsidy as the difference between the
price consumers pay and the initial market price is greater than the difference borne
by producers

MARKET FAILURE

Market failure is a concept within economic theory describing when the

allocation of goods and services by a free market is not efficient. That is, there
exists another conceivable outcome where a market participant may be made
better-off without making someone else worse-off. Important Instances in which
market failure occur are

Externalities - A good or service could also have

significant externalities, where gains or losses associated with the
product are borne by people who did not sell or purchase the
product eg: Traffic congestion, Pollution

Nature of Exchange Markets may have significant transaction

costs, agency problems, or informational asymmetry.

Nature of the goods being exchanged - For instance, goods can

display the attributes of public goods or common goods, wherein
sellers are unable to exclude non-buyers from using a product

MODELS: HOMOGENOUS GOODS

Cournot Model:(Quantity)

Each firm considers the quantity of competitors as fixed and all firms
decide simultaneously their quantity

Stackelberg Model: (Quantity) First mover advantage

One firm sets its output before other firms do to gain advantage

Bertrand Model: (price)

Each firm considers the price of competitors as fixed and all firms
decide simultaneously their price

The Nash equilibrium in this case is the competitive outcome

DIFFERENTIATED PRODUCTS:

Price Competition: (price)

Each firm considers the price of competitors as fixed and all firms decide
simultaneously their price

Unlike the Stackelberg model, here the second mover has an advantage as
it can undercut slightly and gain a larger market share

KINKED DEMAND CURVE

Each firm believes that if it raises

price above current price p2,none
of its competitors will follow suit
and it will lose all sales

It also believes that if it lowers

price, everyone will follow suit and
its sales will increase only to the
extent that market demand
increases

As a result, its demand curve is

kinked at point p2 and its MR
curve is discontinuous at that point

Even if marginal cost increases

from MC1 to MC2, the firm will
produce initial quantity Q2 and
maintain price p2

PRICING WITH
MARKET POWER

PRICE DISCRIMINATION

Practice of charging different prices to different customers for similar

goods

First degree perfect

First degree imperfect

Second degree

Third degree

FIRST DEGREE

First degree: Practice of charging each customer her reservation price i.e.
the maximum price the customer is willing to pay for a good

Perfect price discrimination: Every customer is charged exactly its reserve

price & all the consumer surplus is captured by the firm

Eg: Auction

Imperfect Price Discrimination: Here exact reservation price is not charged

Eg: A doctor, lawyer, accountant may charge different prices as they know
their clients reasonably well

Eg: College tuition fee is charged differently by providing scholarships to

economically weak students

SECOND DEGREE

Second degree: Practice of charging different prices per unit for different
quantities of the same good or service

Eg: Block pricing by electric power companies, natural gas utilities

Eg: Quantity Discounts

THIRD DEGREE

Third Degree: Practice of dividing consumers into groups and with separate
demand curves and charging different prices to each group

Eg: Premium v/s non-premium brands of liqour, discounts to students and senior
citizens etc.

IN A NUT SHELL

First Degree
Perfect

First Degree
Imperfect

Second
Degree

Third Degree

Basis

Reservation
Price

Reservation
Price

Quantity

Elasticity

Price

Maximum

Slabs

Quantity
Discount

Multiple

Consumer
Surplus

Nil

Low

Low

High in
respective
categories

Multiple
Prices

Quantity
Discount

Branding

COMPARISON

Main Tool

Auction

PRICING WITH TIME AS A BASIS

Intertemporal Price Discrimination:

Eg: Charging a high price for a first run movie and then charging a low
price when the movie has been out a year
Peak Load Pricing:
Eg: Charging a high price for evening movie shows and a low price for
matinee shows
The difference between this and 3rd degree is that in 3rd degree,

EXTERNALITY AND
PUBLIC GOODS

WHY MARKETS FAIL?

Market power: monopoly or minimum wage laws

Information Asymetry: adverse selection and moral hazard

Externalities: Positive and Negative

Public Goods: Non-exclusive, non-rival good

EXTERNALITIES

Externality-The effects of production and consumption activities not directly

reflected in the market

Positive externality: Action of one party benefits another Eg: I plant a garden
which benefits my neighbours

Negative externality: Action of one party costs another Eg: Steel plant dumps
waste in river that fishermen depend on for their catch

INEFFICIENCY DUE TO NEGATIVE

EXTERNALITY

Marginal Social Cost(MSC) =

MPC(Marginal Product
Cost)+MEC(Marginal External Cost)

MEC is not reflected in market pricing

thus a higher quantity Q1 is produced
instead of efficient level Q1

Similarly, in case of positive externality since the marginal external benefit is

not reflected in the market the quantity produced is less than the socially
efficient quantity

REMEDY:

Efficiency is reached when marginal cost of abatement is equal to marginal external

cost. This is ensured by imposing :

Emission Standard: Legal limit on amount of pollutants that a firm can emit

Emission Fee: Charge levied on each unit of a firms emissions

Tradeable Emission Permits:

Property Rights: Coase Theorem

EMISSION STANDARD V/S FEE

STANDARD

Provide greater control on

emissions in case of uncertainty
Apt when MEC is steep and MCA
is flat

FEE

Fees are more cost efficient

Fees provide further incentive to

install equipment to lower
emissions

TRADABLE EMISSION PERMITS

A permit specifies no. of units of emissions firm can put out

Firms whose MCA is high will purchase permits as it is cheaper to buy them
than reduce emissions

Firms whose MCA is low will sell permits and reduce emissions as it is
profitable to do so

Thus the overall level of emissions will not exceed that permitted while retaining
economic efficiency

PROPERTY RIGHTS AND COASE THEOREM

Coase Theorem states that: When parties can bargain without cost and to
their mutual advantage, the resulting outcome will be efficient, regardless of
how property rights are specified

PUBLIC GOODS
NONRIVAL GOOD
For which the marginal cost of its provision to an additional consumer
is zero
NON-EXCLUSIVE GOOD
That people cannot be excluded from consuming, so that it is difficult
or impossible to charge for its use.
rival

Non-rival

excludable

Private Goods
Food
clothes

Club Goods
Movies
music

Non-excludable

Common Pool Resources

R&D
Forest

Public Goods
National Defense
Clean Air

For public goods, the presence of free riders makes it impossible for markets to provide
Goods efficiently

INFORMATION ASYMMETRY

Adverse Selection: Lemons Market

Moral Hazard

Principal-Agent Problem: Problems arising when agents(eg: firms managers)

pursue their own goals rather than the goals of the principals(eg: the firms
owners)

ADVERSE SELECTION: LEMONS PROBLEM

The Lemons Problem: Due to Info asymmetry, low quality goods drive out
high quality goods

Eg: In a sale of second-hand car, the buyer has less info about the car then the
seller. Thus, buyer is willing to pay the average price of the cars in the market
which is less than high quality cars price but greater than that of low quality
car. As a result, the high quality cars are pushed out of the market by the low
quality cars

ADVERSE SELECTION(AS)

Eg: Insurance People who buy insurance know better about their health than
insurance companies causing AS problem

As unhealthy people are more likely to want insurance their proportion in pool
of insured people is high

This forces to raise premium which further pushes the healthy people to avoid
buying an insurance and this pattern continues

REMEDY FOR AS

Signaling: It is easier for a high quality product to signal its high quality than
for a low quality product to signal high quality

Warranty is a signal that can be given to show high quality. It is more difficult
for low quality products to provide warranties as the cost of repairs and
returns will far exceed the premium charged for perceived high quality

Reputation: You go to a restaurant that is reputed for its fresh preparations

Standardization: On a highway you go to McDonalds rather than a dhaba

because the knowledge that McD has the same quality and ingredients across
all outlets provides comfort

MORAL HAZARD

After automobile Insurance you tend to drive a little more rash. This causes
moral Hazard for the insurance company

Remedy:

Screening

Monitoring

Penalty

Short-term Contracts

GAME THEORY

GAME THEORY

Interactive decision theory: used when there is potential for conflict or

cooperation.

Objective: Finding equilibrium (combination of strategies chosen by all the

players)

Assumptions:
Rationality: players are interested in maximizing their pay off.
Common knowledge: All players know the structure of the game and their
opponents are rational.

1.
2.

NON-COOPERATIVE VERSUS
COOPERATIVE GAMES

Cooperative Game

Players negotiate binding contracts that allow them to plan joint strategies
Example: Buyer and seller negotiating the price of a good or service or a joint
venture by two firms (i.e. Microsoft and Apple)
Noncooperative Game

Negotiation and enforcement of a binding contract are not possible

Example: Two competing firms assuming the others behavior determine,
independently, pricing and advertising strategy to gain market share.

DOMINANT STRATEGY

Dominant Strategy: The strategy one player will choose (highest pay off) no
matter what the other player chooses.

Regardless of what B does A is better off with advertising. same holds true for
B. Hence advertising is the dominant strategy for both A and B.
Firm B

Advertise

Advertise

Dont
Advertise

10, 5

15, 0

6, 8

10, 2

Firm A
Dont
Advertise

DOMINANT STRATEGIES

The optimal decision of a

player without a dominant
strategy will depend on what
the other player does.

Firm B
Advertise

Advertise

Since A has no dominant

strategy its decision would
depend on the choice mad
by B.

Dont
Advertise

10, 5

15, 0

6, 8

20, 2

Firm A

Dont
Advertise

MAXIMIN/ MINIMAX STRATEGY

The Maximin solution/strategy is

the strategy that maximizes a
player's minimum gain.
Alternatively, the Minimax
solution/strategy is the strategy
that minimizes a player's
maximum loss.
Dominant strategy Firm 2:
Invest
If Firm 2 does not invest, Firm
1 incurs significant losses. Firm
1 might play dont invest and
minimize losses to 10 -maximin strategy

Firm 2
Dont invest

Dont invest

Invest

0, 0

-10, 10

-100, 0

20, 10

Firm 1

Invest

DOMINATED STRATEGY

A strategy is dominated
when the player has
another strategy that gives
it a higher pay off no
matter what the other
player does.
For firm 2 dont build a
plant is the dominated
strategy as building a plant
will always give it a higher
pay off.

Build a
plant

Build a
plant

Firm 2

Dont
Build a
plant

12, 4

20, 3

15, 6

18, 5

Firm 1
Dont
Build a
plant

BEST RESPONSE STRATEGY AND NASH

EQUILIBRIUM

Best response strategy is the strategy with highest pay off given the strategy of
the opponent. Nash equilibrium is the strategy profile which exhibits mutual
best response strategies.

If player 1 does his best by playing strategy A, when player 2 plays strategy a,
and similarly if player 2 does his best by playing strategy a against player 1s
play of strategy A, then the pair of strategies (A,a) is a Nash equilibrium.

PRODUCT CHOICE PROBLEM

Firm 2

If firm 1 produces crispy firm

2 would be better off
producing sweet and vice
versa.
The two scenarios where the
firms
produce
different
products
are both Nash
Equilibrium conditions.

Crispy

Crispy

Sweet

-5, -5

10, 10

10, 10

-5, -5

Firm 1
Sweet

PRISONERS DILEMMA
Conflict

between
individual incentive
and joint incentives .

In

a market
environment, each
agent pursuing only
his own interest leads
to a socially desirable
outcome.

Prisoner B
Confess

Confess

Dont Confess

-5, -5

-1, -10

-10, -1

-2, -2

Prisoner A
Dont
Confess

THANK YOU

GOOD LUCK !