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Summary microeconomics
Chapter 1: Preliminaries

Microeconomics is the branch of economics that deals with the behavior of individual economic
units ranging from consumers, to firms, to workers and as well investors. Microeconomics describes
and analyses the trade-offs that are faced by these different entities and investigates the role of
prices as well as how they are determined.

Microeconomics analysis instruments:

- Theories: Used to explain observed phenomena in terms of a group of basic rules and
assumptions.
- Models: Mathematical representations of economic theories that are used to make
predictions.

Positive analysis is analysis that describes cause and effect relationships.

What will happen to the price, the production and to the sales of cars if the US government
imposes an importing quota on foreign cars. (no opinion)

Normative analysis is an analysis that examines questions of what ought to be.

What is the best mix of different sized cars that should be produced to maximize profits
when the tax on gasoline is imposed. (opinion)

A market is the collection of different buyers and sellers that determine the price as well as the
allocation of a product or set of products through actual/potential interactions.

- On the markets for goods/products, firms and industries are considered to form the supply
side whereas consumers are considered to form the demand side.

Market definition refers to the determination of which buyers and sellers are to be included within a
particular market. Furthermore, it also refers to which products should be included in a particular
market.

The extent of a market refers to the geographical boundaries as well as boundaries in terms of
product range that are to be produced or sold within the market.

Market definition is important for the following three reasons:

- A company must define whom its actual and/or possible customers are in order to know
which products and/or potential products to sell in the future.
- A company must know the product boundaries as well as geographical boundaries of its
market so that it can set a price, determine budgets for advertising, and make investment
decisions.
- Market definition is important for public policy decisions as it impacts various policies on
future competition and prices.

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Arbitrage is the practice of buying something at a low price in one location and then selling it at a
much higher price in a different location.

Perfect competitive markets are markets with many buyers and sellers, thus no single buyer or seller
can have a significant impact on price. In other words, in a competitive market a single price (market
price) will prevail.

Noncompetitive markets are markets where many firms exist each affecting the price of a product.

Chapter 2: The basics of supply and demand

Supply curves show the relationship between the quantity of a good that producers are willing to sell
at a certain price. The relationship can be expressed in the following format: Qs = Cs(p)

- Upward sloping, therefore the higher the price, the more the firms are able to and willing to
produce and sell.

Change in price and other variables: impact on supply curve:

- A change in price, and therefore Qs i.e. quantity supplied, is represented by a movement

along the supply curve.
- A change in any other supply determining variable, such as lower material costs, result in a
shift of the supply curve itself.

Importance of supply and demand analysis:

- Supply and demand analysis enables us to understand and predict the effects of changing
market conditions.
- It allows us to analyze the effects of economic policy.
- It allows us to carry out an equilibrium analysis, i.e. to find out when the supply and demand
are in balance, and to find out how exogenous changes in the economic conditions affect the
equilibrium.

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The demand curve is a curve that represents the relationship between the quantity of a good that
consumers are happy to buy as price per unit changes. The relationship is presented by the following
equation: Qd=Qd(p)

Change in price and other variables: impact on demand curve

- An increase in price, as well as income levels, causes a shift on the demand curve to the right.
This is referred to as a change in demand.
- A change in any other demand-determining variable causes a change in the quantity
demanded. This is referred to as a movement along the demand curve.

Substitute goods: An increase in the price of good 1 causes an increase in the quantity demanded for
good 2.

Complementary goods: An increase in the price of good 1 causes a decrease in the quantity
demanded for good 2.

The market mechanism is the tendency, in a free market, for the price to change until the market
clears. The term market clears refers to the price that equates the quantity supplied to the quantity
demanded. This is known as the equilibrium price or the market-clearing price.

A condition where the quantity supplied exceeds the quantity demanded is referred to as a surplus.

A condition where the opposite happens, i.e. the quantity demanded exceeds the quantity supplied,
is referred to as a shortage.

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Supply-demand model assumptions

- At any given price, a given quantity will be produced as well as sold.

- A market must be at least roughly competitive.

A shift in the supply curve will induce a price drop which will cause an increase in quantity produces
and an increase in sales (due to the price drop).

A shift in the demand curve will increase price, which will cause an increase in quantity produced.

Price elasticity of demand and supply

Ep= P/Q x Q/P

- The price elasticity of demand: use Qd

- The price elasticity of supply: use Qs
- Price elasticity shows the percent change that will occur in supply (or demand) in response to
a percentage increase in price.

Price elasticity of supply is usually positive:

- As price increases, the suppliers have an incentive to increase output

Price elasticity of demand is usually negative:

- As price increases, quantity demanded decreases.

Infinitely elastic demand means that consumers will buy as much as they can at one particular price.

Completely inelastic demand means that consumers will buy a fixed quantity, regardless of the price.

In the presence of close substitutes: a price increase causes consumers to buy more of the
substitute instead, hence demand is highly price elastic (Epd > 1).
In the absence of close substitutes: a price increase would not result in consumers buying
different goods, hence demand will be price inelastic (Epd < 1)

Price elasticity of demand changes as we move along a curve.

Epd is measured at a particular point on the demand curve, and even though Q/P might be
constant, the ratio P/Q would change as we move along the curve, which is what causes the
change in Epd as we move along the curve.

Income elasticity of demand refers to the percentage change in quantity demanded resulting from a
percentage increase in income.

- Eid = I/Q x Q/I

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Cross price elasticity of demand refers to the percentage change in quantity demanded for a good
that results from a one-percent price increase in another good.

- Elasticity of demand of good A with respect to price of good B:

Pb/Qa x Qa/Pb

- It is positive when the goods are substitutes (a rise in price of good 1 will make good 2
cheaper relative to good 1 so customers will demand more of good 2).
- It is negative when goods are complements (the two goods tend to be used together).

Arc elasticity of demand is price elasticity of demand, but it is over a range of prices rather than a
particular point on the demand curve.

- Ep = P./Q. x Q/P
Where, P. is the average of the initial and final prices in the range and Q. is the average of the
corresponding quantity.

Difference between short-run and long-run elasticities

- Short-run: allowing only a year or less to pass by before measuring changes in quantity
demanded of supplied.
- Long-run: allowing enough time for consumers/producers to fully adjust to the price change
before measuring the changes in quantity demanded or supplied.

Elastic demand refers to the increase in demand for a certain good that results from a price change.

- The change in quantity demanded is bigger than the change in price, Qd > P, which results
in EpD having a magnitude greater than 1, i.e. the demand is elastic.

Inelastic demand refers to the decrease in demand for a certain good that results from a price
change.

- The change in quantity demanded is smaller than the change in price, Qd < P, which
results in EpD having a magnitude less than 1 i.e. the demand is inelastic.

Short-run demand

- Demand, e.g. for coffee, is less price elastic because habits change gradually
- Demand for durable goods is more price elastic

Long-run demand

- Demand, e.g. for coffee, is more price elastic because consumers have had enough time to
change their habits
- Demand for durable goods is less price elastic

Short-run supply

- Supply is less price elastic because firms face capacity constraints

- Supply of durable goods is more price elastic (because goods can be recycled as part of
supply if price increases)

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Long-run supply

- Supply is much more price elastic

- Supply of durable goods is less price elastic (due to the contraction of secondary supply i.e.
the supply from recycling).

Chapter 3: Producers, consumers, and competitive markets

The three basic preferences assumptions

- Completeness: consumers can compare and rank all baskets.

- Transitivity: if a consumer prefers A to B and B to C, then we can conclude that the consumer
prefers A to C.
- More is better than less: more is always better, even if it is only a little better.

Market basket refers to a list of quantities of one or more goods. Also referred to as a bundle.

An indifference curve is a graphical illustration of all market basket combinations that provide a
consumer with the same level of utility (satisfaction).

- Indifference curves are always downward sloping (convex) because of the assumption more
is better.

An indifference map graphically presents a set of indifference curves among which a consumer is
indifferent. Indifference curves cannot intersect on the map due to the transitivity and more is better
assumptions.

In a case like this, you would focus on the utility curve

that is the highest and the basket on that utility curve
would be the basket that generates the highest utility
level.

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Marginal rate of substitution refers to the maximum amount of a good that a consumer is willing to
give up in order to obtain one additional unit of another good.

- MRS = - A (vertical axis) / B (horizontal axis)

- A is negative, so the negative sign in from of the equation ensures that MRS is positive.

Bads are goods for which having less is preferred to having more. Examples include air pollution,
where less of it is preferred to more.

Utility is a number that represents the level of satisfaction/happiness that a consumer gets from a
certain market basket.

Utility function is a formula that assigns a level of utility to individual market baskets. It is a way of
ranking different baskets.

- Ordinal utility functions rank different market baskets from most to least preferred, but the
magnitude does not say much because we do not know by how much one casket is preferred
over another.
- Cardinal utility functions tell by how much one market basket is preferred to another, but it
is ignored because we cannot make such measurements.

Budget constraints are the second element of consumer theory. They refer to constraints that
consumers face due to having a limited income.

A budget line is a line that indicates all combinations of goods for which the total amount of money
spent is equal to income.

Effect of changing income on the budget line:

- Slope remains the same

- I increases: budget line moves outward
- I decreases: budget line moves inward

Effect of price changes on the budget line:

- Price of one good (on y axis) decreases, budget line rotates outward
- Price of one good (on y axis) increases, budget line rotates inward.

Goods are chosen to maximize satisfaction given the limited budget that is available.

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The necessary conditions to maximize a basket:

- The basket must be located on the budget line (more specifically, it must be located on the
highest indifference curve that touches the budget line, i.e. that it is tangent to it).
- The basket must give consumers the most preferred combination of goods.

When is satisfaction maximized?

When:

- Marginal Rate of Substitution = Ratio of the prices

In other words:
- Marginal benefit = marginal cost

Where marginal benefit is the benefit associated with consuming one additional unit of the good and
marginal cost is the cost of the additional unit of the good.

The satisfaction maximizing equation indicates:

- It tells the value of each consumers MRS

- It does not inform us of the quantity of goods that a consumer buys:
This depends on individual preferences, so quantity purchased by two customers can differ
even though their MRS is the same.

A corner solution arises when a customers marginal rate of substitution does not equal the price
ratio for all levels of consumption. The customer, therefore, maximizes their satisfaction by only
buying one of the numerous goods available for purchase.

The revealed preferences approach

- The revealed preferences approach checks whether individual choices are consistent with
the consumer theory assumptions.

Marginal utility measures the additional satisfaction that is obtained from consuming one additional
unit of a particular good.

Marginal utility that yields less and less satisfaction as more and more of a good is consumed is
referred to as diminishing marginal utility.

The equal marginal principle states that utility is maximized when a consumers marginal utility per
dollar of expenditure across all goods is equalized.

- MRS= MUa/Mub
- We also know that utility is maximized when:
MRS = Pa/Pb
We can conclude that MUa/MUb=Pa/Pb, equivalently, MUa/Pa=MUb/Pb

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The cost of living index is a ratio of the present cost of a typical bundle of goods compared to the
cost of an identical bundle during a base period.

The ideal cost-of-living index is the cost of attaining a given level of utility at current prices
relative to the cost of attaining the same utility at base-year prices.
- It requires information about prices, expenditures, as well as preferences (which differ
between individuals).

The two cost-of-living indexes:

- Laspeyres price index: is the amount of money (at current prices) that a customer needs to
purchase a bundle chosen in the base year divided by the cost of purchasing the same bundle
at base year prices.

PA current price x Abase year quantity + PB current price x B base year quantity
PA base year price x A base year quantity + PB base year price x B base year quantity

Laspeyres price index is greater than the ideal cost-of-living index

Laspeyres price index always overstates the true cost-of-living index
The Laspeyres price index assumes that consumption patterns are not altered as prices
change.

- Paasche index: is the amount of money (at current prices) that a customer needs to purchase
a bundle chosen in the current year divided by the cost of purchasing the same bundle at
base year prices.

PA current price x A current quantity + PB current price x B current quantity

PA base year price x A current quantity + PB base year price x B current quantity

Paasche index is lower than the ideal cost-of-living index

Paasche index always understates the true cost-of-living index
This is due to the assumption that customers will buy the current year bundle in the base
period.

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Chapter 4: Individual and market demand

A price-consumption curve is a curve that traces all utility maximizing combinations of two goods as
the price of one of the goods changes.

An individual demand curve is a curve that relates the quantity of a good that a single consumer will
buy to its price.

- Individual demand can be derived using the price-consumption.

The properties of an individual demand curve are:

- The level of utility that can be attained changes along the curve.
- At every point on the curve the consumer maximizes their utility (because at every point on
the curve, MRS= the reatio of the prices of the goods condition is satisfied).

An income-consumption curve traces all combinations of goods that maximize utility as the income
of a consumer changes. As income changes, demand curve shifts to the left or the right.

Normal goods are goods that consumers want to buy more of as their income increases.

Inferior goods are goods that consumers want to buy less of as their income increases.

Engel curves are curves that relate the quantity of a good consumed to income.

- Upward sloping Engle curve applied to normal goods.

The effects of a price decrease:

- Consumers buy more of the good that has become cheaper, and less of the good that is now
relatively more expensive.
- Consumers enjoy greater real purchasing power due to one of the goods becoming cheaper.

A situation where a change in consumption of a good results from a change in its price, while utility
remains constant, is referred to as the substitution effect.

A situation where relative prices are constant, and a change in consumption of a good is a result of
an increase in purchasing power is referred to as the income effect.

When added together they make up the total effect.

The market demand curve represents the relationship between the quantity of a good that all
customers in a market will buy related to its price.

The market demand curve can be derived by adding up the individual curves of all of the
customers in the market

Demand curves reaction when more consumers enter the market

- The market demand curve shifts further to the right as more customers enter the market
Factors that influence the consumer demand will also affect market demand.

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The building blocks of market demand

Consumer Budget Constraints

Preferences

Consumer Choice

Individual Demand

Market Demand

An isoelastic demand curve is a demand curve that has a price elasticity that is constant.

Consumer surplus is a measure of how much better off individuals are in the market. It is the
difference between how much consumers are willing to pay for a good and how much they actually
pay.

Network externalities are situations in which a consumers demand depends on the purchases of
others. These externalities can be negative, if the externality leads to a decrease in demand in
response to growth in purchases by others, or positive, in the case of an increase in demand in
response to a growth in purchases by others.

Situations where the quantity of a good demanded by a consumer increases because others possess
that good is referred to as the bandwagon effect -> the bandwagon effect is a positive network
externality.

A situation where the quantity of a good demanded by a consumer decreases because others
possess that good is referred to as the snob effect.

- A situation in which a consumer would prefer to own exclusive or unique goods, rather than
goods similar to those owned by others
The snob effect is a negative network externality.

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Chapter 6: Production

The three steps of production decisions:

- Production technology: practical ways of converting inputs into outputs.

- Cost constraints: taking into account prices of labor, capital and other inputs.
- Input choices: how much of each input to use in producing the output.

The three categories that production factors can be divided into:

- Labor (L): skilled and unskilled workers.

- Capital (K): any goods that can be transformed into final products.
- Materials: land, buildings, machinery, inventories etc.

A production function is an equation that indicates the highest level of output that a firm can
produce for every combination of inputs. It describes what is technically feasible when the firm
operates efficiently.

- Q= F(K,L)

Returns to scale is the rate at which output increases as inputs increase proportionately.

- Increasing returns to scale

- Constant returns to scale
- Decreasing returns to scale

There are two ways of looking at a firms benefits and costs:

- On an incremental basis (Q / factor of input)

- On an average basis (Q / factor of input)
The incremental basis refers to firms focusing on the additional output that results from an
incremental addition to an input i.e. marginal basis.

Marginal product and average product relation:

- Maximum when MP=AP (additional labor would be unprofitable).

- When MP > AP the AP so average output increases with an additional worker.
- When MP < AP the AP so additional workers do not contribute much to output.

The law of diminishing marginal returns is a principle, which states that as the use of an input
increases, with other inputs remaining constant, the additional output produced will eventually
decrease.

The law of diminishing marginal returns:

- Describes a declining marginal product, so it is not necessary that the returns are negative.
- Applies to a given production technology, so inventions or technological improvements can
shift the total product curve upwards.

With respect to labor productivity:

- Assumed that labor input is of the same quality, so diminishing marginal returns would be
due to limitations in fixed inputs such as machinery and not worker quality.

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Productivity growth sources:

- Stock of capital: the total amount of capital available for production.

- Technological change: technological development allows factors of production to be used
efficiently.

An isoquant is a curve that shows all possible combinations of inputs that would yield the same
output.

An isoquant map is a graph that combines numerous isoquants that can then be used to describe
production functions.

When and why do firms use isoquants?

- Firms can use isoquants when making production decisions as they show how much flexibility
firms have.
- Isoquants allow managers to choose the ideal input combinations that would minimize costs
and maximize profits.

The marginal rate of technical substitution is the amount by which the quantity of one input can be
reduced when one extra unit of another input is used, so that output remains constant. It is also
equal to the ratio of the marginal products of the inputs involved.

- MRTS of labor for capital, in other words, is the amount by which capital can be reduced
when one additional unit of labor is used, so that output remains constant.
- MRTS = - K/L = MPL / MPK

MRTS= - A / B

- MRTS is diminishing, i.e. it falls as we move down along an isoquant.

- This is because productivity of inputs is limited. Adding more of input A, in place of input B
will result in a decrease in the productivity of A because production requires a balanced mix
of both inputs.

A fixed-proportions production function describes situations where the method of production is

limited just like in the case of car production.

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Chapter 7: The Cost of Production

Accounting costs include actual expenses together with depreciation charges for capital equipment.

Economic costs are the costs that a firm faces for utilizing economic resources in production, and it
includes opportunity costs.

Opportunity costs are costs associated with opportunities that have been forgone due to a
firms resources not being put to their best alternative use.

Sunk costs are costs that have been incurred and cannot be recovered.

Prospective sunk costs are considered to be an investment.

- A firm contemplating whether to buy a specialized piece of equipment faces prospective

sunk costs, i.e. they face an investment and should analyze whether this investment would
be economical (would it generate large revenues?). if the specialized equipment is bought,
then it would become a sunk cost as the equipment would not be used for anything other
than what it was made to be used for (its opportunity cost would be zero).

Total costs = Fixed costs + Variable costs

- Where:

Fixed costs refers to any costs that do not vary with output level and can be eliminated only
by shutting down the production process.

Variable costs refers to costs that vary with output level.

Fixed costs impact future decisions.

Sunk costs do not impact future decisions.

Amortization is a policy of treating a one-time expenditure as an annual cost that can be spread out
over time.

- Sunk costs can be treated as fixed costs by amortizing them and the expenditure over a
number of years.

Marginal costs are increase in costs due to the production of one additional unit of output.

- Marginal Cost = Variable cost / Quantity

Average costs refer to a firms total costs divided by its level of output. Average (total) costs
constitute of average fixed costs and average variable costs.

- Average costs = Total Cost / Quantity

The determinants of short run costs

- The rate at which variable and total costs increase in the short-run depends on
- The production processes
- The extent to which diminishing marginal returns to variable costs is involved

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The impact of diminishing marginal returns on marginal costs

- Diminishing marginal returns implies that the marginal product of one of the production
factors declines as the quantity of input of that factor increases.
So, marginal costs increase as output increases.

User cost of capital is the annual cost of owning and using a capital asset rather than selling it or
never buying it in the first place.

- User cost of capital = Economic depreciation + (Interest Rate)(Value of Capital)

Interest is part of the user cost of capital because a firm could be earning interest by
investing capital elsewhere.

Expressing capital expenditure as a flow

- By amortizing the expenditure i.e. spreading it over the lifetime of the capital
- Forgone interest must be taken into consideration
This is exactly what is done through the user cost of capital calculation.

Rental rate is the rate per year of renting one unit of capital.

- Rental rate is equal to the user cost because firms expect to earn a competitive return when
renting capital that they own (we assume this is the case when the market is competitive).

An isocost line is a graphical illustration of all possible combinations of labor and capital that can be
purchased for a given total cost.

- Total cost = Labor (wage) + Capital (rental rate)

- The minimum cost for producing a certain output can be found at the point where an
isoquant (for that level of output) touches the isocost line.

Relation between isocost line and a firms production process

- We know that the amount by which capital can be reduced with the use of an additional unit
of labor, while keeping quantity constant is :

MRTS = -K / L = MPl / MPk

- From the isoquant line we know that, in terms of capital and labor, the slope of K/L is
- wage / rental rate , so firms can minimize costs by

MPl / MPk = wage / rental rate

- Equivalently, MPl / wage = MPk / rental rate

The expansion path describes the cost minimizing combinations when output levels vary.

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Economies of scale refers to a situation in which output can be doubled for less than double the cost
(input proportions vary).

When workers specialize in activities that they are most productive in.

Diseconomies of scale refers to a situation where the doubling of output requires more than double
the cost.

The advantage of buying in bulk may disappear once certain quantities are reached because
at some point supplies of essential inputs will be limited and hence their costs will rise. So,
when doubling output, the costs would be more than double.

Measuring economies of scale

- Economies of scale are measured in terms of a cost-output elasticity, Ec:

Ec = C/C x Q/Q

- Equivalently: Ec = MC/AC

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Chapter 8: Profit maximization and competitive supply

The perfect competition model relies on the following assumptions:

- Price taking
A firm is a price taker if it has no influence over the market price. Hence, it takes the price as
it is given.
This is the case when a market is made up of several small firms, each of which satisfies a
small proportion of the total market demand. Therefore, their decisions do not impact the
market price.
- Product homogeneity
Products in a market are homogeneous if they are perfectly substitutable. In other words,
these products are identical, or nearly identical, to each other.
- Free entry (or exit) is a condition that states that firms wanting to enter or exit a market/an
industry can do so without incurring any special cost.

A market is highly competitive when the firms within the market face demand curves that are highly
elastic (with rather easy entry and exit)

Remember: competitive behavior does not necessarily indicate that the market is highly
competitive. Analysis of the firms and their strategic interactions would be necessary.

Some managers deviate from profit maximization behavior:

- To satisfy shareholders
- To maximize short-run profits at the expense of long-run profit in order to earn a bonus or a
promotion.
- Because it requires technical and marketing information which is costly to acquire.
Firms with such managers are not likely to survive in competitive industries

Firms that do survive in competitive industries make long-run profit maximization their priority
(otherwise they can be replaced by shareholders or board of directors, or a new management could
take over the entire firm).

A cooperative organization is an association of businesses or people that is jointly owned and

operated by members for mutual benefit.

Profit is the difference between the total revenues and total costs of a firm

- =RC
Where revenue is R = PxQ

Marginal revenue refers to the change in revenue that results from output increasing by one unit.

- MR = R / Q

Profit maximization

- Profit is maximized when MC(q) = MR = P, alternatively we can say that profit is maximized
when MR MC = 0
- If the firm is perfectly competitive, to maximize its profits it should ensure that P = MR = MC
i.e., the price it charges should be equal to the firms marginal costs.

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Shut-down condition:

- If the price of the good is less than the average variable cost of production at the profit
maximizing output, it should shut down.

The short-run supply curve is given by the portion of the marginal cost curve for which MC > AVC.

Short-run supply curve

The price elasticity of market supply measures the industrys sensitivity to market price. It is the
percentage change in quantity supplied in response to a one-percentage change in price:

- Es = (Q/Q ) / (P/P)
- Always positive in the short-run, as MC curves are upward sloping
- Elasticity of supply is perfectly inelastic when firms are capacity constrained due to all
equipment being completely utilized.
- Elasticity of supply is perfectly elastic when marginal cost is constant.

Producer surplus is the sum (over all units produced) of the differences between a goods market
price and the marginal cost of production. Alternatively, it is the difference between a firms revenue
and its total variable cost.

- It measures the area above the supply curve (of the producer) and below the market price:
PS = R VC
Remember: = R C, where C = VC + FC

The profit maximizing output in the long-run is found at the point where long-run marginal cost is
equal to price (LMC = P).

Zero economic profit means that the firm is earning a normal return on its investment and is doing
as well as it would if it had invested its money elsewhere.

If a market has free entry and exit, when would a firm choose to enter or exit the market?

- Entry: a firm would enter when it can earn a positive long-run profit, this would occur if the
price charged for a good exceeds the minimum long-run average cost of producing it (min
LAC < P).
- Exit: a firm would exit when it faces a prospect of making a long-run loss, this would occur if
the minimum long-run average cost is greater than the market price (minLAC > P).

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The three conditions of long-run competitive equilibrium:

- All firms in the industry are maximizing their profits.

- All firms are earning zero economic profit, so there is no incentive to enter or exit the
industry.
- The price of a good is such that the quantity supplied is equal to the quantity demanded.

Economic rent is a term used for the amount that a firm is willing to pay for an input minus the
minimum amount necessary to buy it.

In competitive markets this is often positive, both in the short-run as well as the long-run,
even though profit is zero.

The long run producer surplus of a firm in a competitive market consists of the economic rent from
all its scarce inputs.

The three different cost industries:

- Constant-cost industry: long-run supply curve is horizontal at P = (minimum) LAC

- Increasing-cost industry: long-run supply curve is upward sloping. (Higher prices are needed
to cover the increasing cost).
- Decreasing-cost industry: long-run supply curve is downward sloping.

Responses to output tax:

An output tax:

- Raises a firms marginal cost

- Raises a firms average variable cost curve
o F a single firm is taxed: as long as it can still earn a positive/zero economic profit, it
will choose output level at which MC + t = P
If a firms cost are too high, it will exit the industry
o If every firm in the industry is taxed: marginal costs will increase due to the tax, firms
will reduce their output at the current market price
This will reduce the total output supplied by the industry and firms will raise their prices.

Long-run elasticity of supply for constant-cost and increasing-cost industries:

- Constant-cost industry
o Long-run supply curve is horizontal so the long-run Es is infinitely large
- Increasing-cost industry
o Long-run Es is large (positive) but finite

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Chapter 10: Market power: Monopoly and Monopsony

A monopoly is a market where there is only one seller and numerous buyers.

A monopsony is a market where there are numerous sellers but only one buyer.

Market power refers to the ability of a seller or a buyer to affect the overall price of a good.

Marginal revenue (MR) is the change in revenue due to an increase in output by one unit.

- First, find the revenue which is :

Revenue = Price x Quantity
- Then, differentiate in terms of Q if dealing with a demand function to find the marginal
revenue:
MR = R/Q
- If you have only numbers, the MR is the difference between the initial and the subsequent
revenue.

Practical rule of thumb for pricing and why it is used:

- A firms profit function is :

= Revenues (Q) Costs (Q)
- The profit maximizing quantity is found by using derivatives:
/Q = R/Q - C/Q = 0
- Equivalently:
/Q = MR MC = 0
- Finally, solve for Q

Managers use a rule of thumb for pricing as it can be applied in practice much more easily due to it
requiring a lot less information

P = MC / (1 + (1/Ed))
o Where Ed is the elasticity of demand for the firm

Output decisions depend on MC and the demand curve, there is no supply curve in a monopolistic
market.

- A shift in demand can lead to:

o Change in price, no change in quantity
o Change in quantity, no change in price
o Change in both price and quantity

Effect of tax on a monopolist

- MR= MC + tax
- The marginal cost curve shifts upwards by an amount t and intersects marginal revenue at a
different point
o This causes a decrease in Q and an increase in P (this increase can be by more than t)

Output decision: for a firm with multiple plants

- Divide the total output between the plants so that marginal cost of each plant is equal to
each other
- Since profit is maximized when MR=MC and marginal cost must be equal for all plants, profits
will be maximized when MR=MC of each plant

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For measuring monopoly power, we use the Lerner index:

- L = (P MC)/P which, can also be expressed in terms of the firms elasticity of demand i.e.,
L= -1 / Ed

There are three determinants of monopoly power:

- The elasticity of market demand: a pure monopolists demand curve is the market demand
curve
- The number of firms in the market: monopoly power decreases as more firms enter the
market due to increased competition
- The interaction between firms: firms might compete aggressively or not compete much or
they might collude and agree to limit output while raising prices

The social costs of monopoly power:

- In a monopolistic market, price exceed marginal costs (P>MC), which decreases consumer
surplus and increases producer surplus
This reduces total social welfare

Rent seeking refers to the amount of money that firms spend on unproductive efforts to either
acquire, maintain or exercise monopoly.

Ways for governments in preventing firms from acquiring large monopoly power:

- Price regulation (by setting a price cap) -> can eliminate the dead weight loss
- Rate-of-return regulation
The maximum price allowed is based on the (expected) rate of return that the firm will earn

A natural monopoly is a firm that can meet the demand of the entire market at a cost that is lower
than what it would be if there were several firms. It arises from strong economies of scale.

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Chapter 11: Pricing with Market Power

Different ways of capturing consumer surplus:

- Price discrimination
o First-degree
o Second degree
o Third-degree
- Two-part tariff
- Intertemporal price discrimination
- Peak-load pricing

Price discrimination refers to the practice of charging different prices to various customers for
similar goods.

First-degree price discrimination is the practice of charging customers a reservation price, which is
essentially the maximum price that they would be wanting to pay.

Such practices lead to firms having a variable profit as they can charge each customer a
different price (because different people have different preferences and would be willing to
pay different prices for a similar good).
- Perfect first-degree price discrimination:
o Each person is charged exactly what they are willing to pay
o MR curve becomes irrelevant
o Additional profit from selling an incremental unit: D MC
- Imperfect first-degree price discrimination:
o Reservation price of individuals in unknown, so several different prices are charged
based on estimates of customers reservation prices.

Second-degree price discrimination refers to the practice of charging different prices per unit for
different quantities of the same good. E.g., a single Kinder Bueno bar might cost 0.60, yet a pack of
3 Kinder Bueno bars might cost 1.50 i.e., each bar costs 0.50

Second-degree price discrimination includes block pricing where customers are charged
different prices in blocks of a good, as is done by electric power companies and water
municipal companies.

Third-degree price discrimination refers to the practice of dividing consumers into several groups
and charging each group a different price. E.g., public transport concessions for students and senior
citizens.

Formula for determining relative prices:

- P1/P2 = (1 + 1/E2)/(1 + 1/E1)

Intertemporal price discrimination is a practice that involves separating consumers with different
demand functions into different groups by charging different prices at different points in time.

- The goal is to separate high-demand consumers from low-demand consumers by charging a

price that is high at first which falls later on
For example, Apples iPhone 6 will start off at a high price attracting consumers that value
the product highly, with time (and when a newer version is released) the price will begin to
fall and will attract consumer who did not value the product as highly

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Peak-load pricing is a practice that involves charging consumers different prices at different points in
time.

- The aim is to increase economic efficiency by charging prices close to marginal cost
For example, amusement parks charge higher fees on weekends compared to during
weekdays

Two-part tariff is a form of pricing in which consumers are charged an entry fee as well as a usage
fee.

For example, at a tennis club, members pay an annual membership fee as well as a fee for
each use of a court

Setting entry and usage fees:

- Information required:
o Marginal cost
o Demand functions
o Profit as a function of usage fee and entry fee, this will allow the firm to choose the
prices that maximize the profit function
- The firm should do the following:
o Usage fee > MC
o Entry fee = remaining consumer surplus of the consumer with the smaller demand

Entry and usage fees if there are many consumers:

- Carry out trial-and-error to find the optimal two-part tariff

Decision makers must keep in mind the following trade-off:

- If entry fee is low there will be more entrants, hence more profit from sales
- If entry fee is too low and the entrants are too many then profits derived from entry fee will
fall

Chapter 12: Monopolistic Competition and Oligopoly

Monopolistic competition refers to a market in which firms can enter, and exit freely, each
producing and selling their own brand or version of a differentiated product.

For example, different toothpaste companies offer toothpaste that is differentiated in taste,
color, or consistency.

An oligopoly is a market that consists of only a few firms that compete with each other. Entry by new
firms ins impeded in a market like this.

Short and long-run profits of a monopolist:

- For monopolistic firms: P > MC

In the short-run:
- P > AC, this allows the firm to earn a nice profit
In the long-run:
- New entrants become attracted due to the high profits. This reduces the firms market share
and pushes the demand curve downwards. P = AV so profits become zero, even though the
firm still has monopoly power

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Two sources of inefficiency in monopolistically competitive industry:

- P > MC, so the value (to customers) of additional units of output is greater than the costs
involved in producing those units.
- New entrants drive profits to zero. Since the demand curve for a monopolistically
competitive market in downward sloping, the point at which profits are zero is lower than
the point at which average cost is minimum. So, excess capacity is inefficient because the
average cost would be lower with fewer firms.

Monopolistically competitive market structure is socially desirable because:

- Generally, market power is small because enough firms compete with sufficiently
substitutable brands
- Product diversity balances against inefficiencies because consumers value the ability to
choose from a variety of products (it outweighs the inefficiencies)

Entry barriers in an oligopoly, how they work:

- Coexistence might be unprofitable (due to economies of scale)

- A patent is an entry barrier that works by discouraging entry because it makes it necessary
for competitors to spend money (for name recognition or market reputation) to enter the
market

Setting prices and output in an oligopolistic market;

- Based on strategic consideration regarding competitors

- Based on the firms decision
o Firms choose the price and output that allows them to do the best they can, given
the actions of their competitors. This is also known as the Nash equilibrium.

In the Cournot model, oligopolistic firms decide how much they will produce (homogeneous
product) simultaneously.

Each firm treats the output of its competitors as fixed.

Cournot equilibrium:

The market demand function, in terms of Q, can be used to calculate the quantity that each firm will
produce:

- Q = Q1 + Q2
- R1= P x Q1, MR1 = R1/Q1 (Derivative)
Rearranging would give firm 1s reaction curve. The same can be done for firm 2.
- In cournot equilibrium is assumed that Q1=Q2
- So Q2 in the reaction curve for firm 1 can be replaced by Q1 and a quantity for Q1 can be
derived. Both firms will produce this output.
- Q= Q1 + Q2, and since Q1=Q2, Q=2Q1. This can be substituted into the demand function to
find the market price.

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Why collude rather than cooperate?

- Firms collude in order to increase their profits (the profits obtained from producing at the
Nash equilibrium are lower)
- Firms do not cooperate without explicitly colluding because they expect that the competitors
would deviate from the collusive price level in order to get a higher payoff.

A non-cooperative game is a game in which it is not possible to negotiate or enforce a binding

contract.

The prisoners dilemma is an example in which two prisoners decide separately whether or not to
confess to their crime. The one who confesses will receive a lighter sentence (higher payoff), but if
neither confesses, their sentences will be lighter compared to both confessing.

Prisoner 2
Refuse Admit
Prisoner 1 Refuse 4,4 0,5
5,0 1,1
Admit

A payoff matrix shows the profit to each player, given his/her decision and the competitors decision.

A kinked demand curve model is an oligopoly model in which firms face a demand curve that is
kinked at the currently prevailing price. If price is any higher, then the demand is very elastic; if
lower, then demand is inelastic.

Kinked demand curve model

Can oligopolistic coordination and cooperation prevail?

Yes it can, as firms repeatedly interact and therefore can develop trust:

- Each firms manager know that if they deviate from the collusive price during one
interaction, then the opponents will punish them during the next interaction by choosing a
Nash equilibrium price which would yield lower profits in the long run compared to collusive
cooperation (hence, cooperation would be encouraged).

Price signaling is a form of implicit collusion in an oligopoly during which firms announce a price
increase with the hope that other firms will follow suit

This behavior helps in solving the problem of coordinating price.

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Price leadership is a pricing pattern in which one firm regularly announces price changes, which are
then matched by other firms.

This behavior solves the problem of coordinating price as everyone charges at the same price
as the leader.

A dominant firm is a firm with a large share of total sales that sets price to maximize profits, taking
into account the supply response of smaller firms.

Chapter 13: Game Theory and Competitive Strategy

A game is any situation in which players/participants make strategic decisions, that take into account
other players actions and responses. These strategic decisions result in payoffs for each player i.e.,
they result in rewards or benefits.

The goal of game theory:

- Game theory aims to find the optimal strategy for each player i.e. the rule or plan of action
for playing the game, which would lead to maximum expected payoff.

Cooperative game is a game in which players negotiate binding contracts that allow them to plan
joint strategies.

Non-cooperative game is a game in which negotiation is not possible, and neither is the enforcement
of a binding contract.

A dominant strategy is a strategy that is a players optimal strategy, regardless of what the opponent
chooses to do.

Dominant strategies are stable

An equilibrium in dominant strategies refers to the outcome of a game in which each firm is doing
its best regardless of its competitors actions.

Nash equilibrium compared to equilibrium in dominant strategies:

- Dominant strategies
o I am doing my best, regardless of what you do
o You are doing your best, regardless of what I do
- Nash equilibrium
o I am doing my best given your actions
o You are doing your best given my actions

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Chapter 16: General Equilibrium and Economic Efficiency

Partial equilibrium analysis involves determination of equilibrium prices and quantities assuming
that one markets activity has little or no effect on other markets.

General equilibrium analysis on the other hand, involves determination of equilibrium price and
quantities in all markets simultaneously, taking feedback effects into account.

A feedback effect is a price or quantity adjustment in one market caused by price and
quantity adjustments in related markets.

Technical efficiency is a condition under which firms combine inputs to produce a given output at a
cost that is as low as possible. An input allocation is said to be technically efficient if the output of one
good cannot be increased without decreasing the output of another.

A production possibilities frontier is a curve that shows the combination of two goods that can be
produced with fixed quantities of inputs, and while holding technology constant.

- This curve is downward sloping because in order to produce more of good A efficiently, a
firm must switch inputs from the production of B, which then lowers the production level of
B
- The slope of the curve measures the marginal cost of producing one good relation to the
marginal cost of producing another (MC1 / MC2)

Marginal rate of transformation refers to the amount of a good that must be given up in order to
produce one additional unit of another good.

MRT = MCA / MCB

What makes an economy efficient?

- Goods produced at minimum cost only

- Goods produced in combinations that match peoples willingness to pay for them
MRS = MCx/MCy = Px / Py = MRT

A comparative advantage occurs when company 1 has an advantage over company 2 in producing a
good because the cost of producing the good in 1 is lower than the cost of producing the good in 2,
relative to the cost of producing other goods in 2.

In a situation where company 1 has an advantage over company 2 when producing a good because
the cost of producing the good at 1 is lower than the cost of producing it at 2. This advantage is
known as an absolute advantage.

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Chapter 17: Markets with Asymmetric Information

Asymmetric information is a situation where either the buyer or the seller possess different
information regarding the transaction.

For example, an owner selling his/her car will know much more about the car and its quality
than a buyer, or a mechanic, because the owner has had experience driving the car.

The lemons problem is a situation with asymmetric information, where a low-quality good can drive
high-quality goods out of the market.

Adverse selection is a form of market failure that occurs when different quality products are sold at a
single price due to asymmetric information, so that too much of the low-quality and too little of the
high-quality goods are sold.

Market signaling refer to the process used by sellers to signal conveying information about product
quality to its buyers.

For example, in the labor market it is only the workers who know their true levels of
productivity. Firms do not have this information (asymmetric information), so they rely on
signals from the works about their productivity when hiring. A strong signal of high
productivity would be education.

Why do firms offer guarantees and warranties?

- Guarantees and warranties can convince customers that the firm is offering higher-quality,
more dependable products.
- They signal product quality because an extensive warranty is more costly for low-quality
product producers than for higher-quality producers.
- Standardization and reputation are also ways to deal with adverse selection.

Moral hazard occurs when a group of people, whose actions are unobserved, can affect the
probability or the magnitude of a payment associated with an event.

For example, people with complete medical coverage insurance will visit their doctors more
often (an action that is unobserved by the insurance providers) and make more claims.
Hence, the insurance companys payments will be greater than expected and the company
may be forced to increase premiums for everyone.

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Chapter 18: Externalities and Public Goods

Externalities are actions, taken by a producer or a consumer, which affect other producers or
consumers but are not accounted for in the market price.

- Externalities can be negative: a steel plant dumping waste into a river that fishermen depend
on for fish. The more waste the plant dumps, the fewer the fish in the river. Yet the firm has
no incentive to account for such an external cost.
- Externalities can be positive: a home owner repaints their house and renovates their garden,
the neighborhood benefits from this (as it looks more attractive) even though the home
owner did not take such an external benefit into account.

Marginal external cost measures the additional cost of an externality that is associated with each
additional unit of output, (MEC)

Marginal social cost refers to the sum of the marginal cost of production and the marginal external
cost, (MSC = MC + MEC)

Marginal external benefit refers to the additional benefit that other people/firms obtain as a firm
produces one extra unit of output, (MEB)

Marginal social benefit is the sum of the marginal private benefit (given by the marginal benefit
curve) and the marginal external benefit, (MSB = D + MEB)

The cost of abatement is represented by the cost of abatement curve, which measures the
additional cost that a firm faces for installing pollution-control equipment.

- The MCA curve is downward sloping because:

o The MC of reducing emissions is low when the reductions have been slight
o The MC of reducing emissions is high when reductions have been substantial

Correcting market failures:

- Emission standards: legal limit of how much pollutant firms can emit
- Emissions fee: a charge for each unit of a firms emission
- Tradable emissions permits: a system of marketable permits that specify the maximum level
of emissions that can be generated
- Recycling

Advantages of setting standards and fees:

- Advantages depend on the information that the policymakers hold and the cost of
controlling emissions
- Fees reduce emissions by the same amount as standards, at a lower cost
- Fees give firms a stronger incentive to install new equipment which can further reduce
emissions
- Standards offer certainty about reduction of emissions levels (when information is
incomplete) but they leave abatement costs uncertain: the cost of not reducing emissions is
high when MEC curve is quite steep and MC of abatement is rather flat.

Tradable emissions permits are marketable permits that can be bought and sold, which specify the
maximum level of emissions that a firm can generate. If a firm produces emissions greater than what
the permit allows then they are subject to substantial monetary sanctions.

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A policy to encourage recycling:

- The efficient amount of recycling is at the point where marginal cost of recycling (MCR) and
the marginal social cost of disposal (MSC) are equal.
- Marginal social cost of disposal includes environmental harm from littering: it increases
partly due to the marginal private costs increasing and partly because environmental costs
are likely to increase as disposal increases.
- Recycling can be encouraged by:
o Refundable deposits
The policy works by store owners charging an initial deposit for glass
containers, the deposit is refunded when consumers return the container to
the store or a recycling center
A per-unit refund will encourage households and firms to recycle more

Inefficiencies can be eliminated via:

- Well specified property rights: legal rules stating what people/firms can do with their
property
- Suing for damages: victim can recover monetary damages equal to the harm suffered
- Using the Coase theorem: bargaining without cost and to mutual advantage

Common property recourses are resources to which anyone has free access

- Such resources are externalities because of the fact that they do not require a payment,
which means that they become over utilized.
o What is the solution?
A single owner should be allowed to manage the resource. The owner can
set a fee for using the resource which will be equal to the MC of depletion of
the resource

Public goods are goods that are nonexclusive, so people cannot be excluded from consuming the
goods, and nonrival, the marginal cost of provision to an additional consumer is zero.

E.g. the national defense or the lighthouse: in both cases the MC of providing a benefit to an
additional person is zero and both are nonexclusive

Efficiency among public goods:

- Efficient level of providing a public good is determined by the comparison of marginal benefit
of an additional unit to the marginal cost of producing that unit (MB = M)
- MB is measured in terms of how much consumers value the additional unit of output

How public goods lead to market failure:

- Some consumers understate how valuable a good is to them. They act as free riders as they
are not willing to pay for a nonexclusive good though they expect others to pay for it
This makes it difficult to provide goods efficiently

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