Download Microeconomics 1 for ECO Guideline

Microeconomics
1 for ECO
Guideline
Microeconomics, David Besanko and Ronald R. Braeutigam
Chapter 1
Analyzing economic problems
Exogenous variable: its value is taken as given in a model.
Endogenous variable: its value is determined within the model being studied.
Marginal impact: the incremental impact of the last unit of the exogenous variable on the endogenous
variable (marginal utility, marginal cost, marginal revenue).
Microeconomics uses three analytical tools:
- Constrained optimization: making the best (optimal) choice, taking into account any possible limitations
or restrictions on the choice. There are two parts: an objective function (the relationship that a decision
maker seeks to maximize or minimize) and a set of constraints (restrictions/limits imposed on a decision
maker in a constrained optimization problem).
- Equilibrium analysis: an equilibrium is a state or condition that will continue indefinitely as long as
factors exogenous to the system remain unchanged. The market clears at a price at which the quantity
offered for sale just equals the quantity demanded by customers.
- Comparative statistics: examine how a change in some exogenous variable will affect the level of some
endogenous variable in an economic system.
Positive analysis: explain how an economic system works or predicts how it will change over time (‘what
has been done?’, ‘what will be done?’).
Normative analysis: focuses typically on issues of social welfare, examining what will enhance or detract
from the common good (‘what should be done?’.
Objective function: specifies what the agent cares about.
Constraints: whatever limits are placed on the resources available to the agent.
Alternatives: specify what an agent could do. Set of feasible alternatives is determined by constraints.
Each alternative has consequences for the agent.
Opportunity cost of a resource: the value of that resource in its best alternative use.
Economic benefit = revenue – opportunity cost
Chapter 2
Demand and supply analysis
Market demand curve: shows the quantity of goods that customers are willing to buy at different prices.
Derived demand: demand for a good that is derived from the production and sale of other goods.
Direct demand: comes from the desire of buyers to directly consume the good itself.
Law of demand: inverse relationship between the price and the quantity demanded, when all other
factors that influence demand are held fixed.
Market supply curve: shows the quantity of goods that suppliers are willing to sell at different prices.
Law of supply: positive relationship between the price and the quantity supplied, when all other factors
that influence supply are held fixed.
Market equilibrium: there is no tendency for the market price to change (as long as exogenous variables
remain unchanged).
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Excess supply: the quantity supplied at a given price exceeds the quantity demanded.
Excess demand: the quantity demanded at a given price exceeds the quantity supplied.
Increase in demand, unchanged supply curve  higher equilibrium price, larger equilibrium quantity.
Decrease in demand, unchanged supply curve  lower equilibrium price, smaller equilibrium quantity.
Increase in supply, unchanged demand curve  lower equilibrium price, larger equilibrium quantity.
Decrease in supply, unchanged demand curve  higher equilibrium price, smaller equilibrium quantity.
A shift in a supply/demand curve is always caused by an exogenous variable.
A movement along the supply/demand curve is always caused by an endogenous variable (price).
Competitive market: sellers and buyers are small and numerous enough that they take the market price
as given.
Price elasticity of demand
Ԑ Q, P
= percentage change in quantity / percentage change in price
= ΔQ / ΔP * P / Q
Arc elasticity
=dQd/dP*P/Q
Point elasticity
The flatter the demand curve, the more price elastic the demand.
Value of Ԑ Q, P
0
0 < Ԑ Q, P < -1
-1
Classification
Perfectly inelastic demand
Inelastic demand
Unitary elastic demand
-1 < Ԑ Q, P < ∞
-∞
Elastic demand
Perfectly elastic demand
Meaning
Quantity demanded is completely insensitive to price
Quantity demanded is relatively insensitive to price
Percentage increase in quantity demanded is equal to
percentage decrease in price
Quantity demanded is relatively sensitive to price
Increase in price  quantity demanded falls to zero.
Decrease in price  quantity demanded rises to infinity
Linear demand curve: Q = a – b P
(a and b are positive constants)
Constant a embodies the effect of all factors other than the price that affect the demand for the good.
Coefficient b is the slope and reflects how the price of the good affects the quantity demanded.
Inverse demand curve: expresses price as a function of quantity  P = a/b – 1/b Q
a/b: choke price at which quantity demanded falls to 0. -1/b: slope.
The elasticity is –b P / (a – b P)
Constant elasticity demand curve: Q = a P –b (a and b are positive constants)
The price elasticity here is always equal to the exponent –b.
Inverse: P = a -1/b Q 1/b
Products are more price elastic if:
- The consumer’s expenditure on the product is large.
- There are good substitutes for a product.
Products are less price elastic if:
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- The product is seen by customers as being a necessity.
If demand is inelastic at the market, it can be highly elastic at individual brand level.
Income elasticity of demand:
Ԑ Q, I = d Q / d I * I / Q
Cross-price elasticity of demand:
Ԑ Q i, P j = d Q i / d P j * P j / Q i
Ԑ Q i, P j > 0
a higher price for good j increases the demand for good i. These goods are demand
substitutes.
Ԑ Q i, P j < 0
a higher price for good j decreases the demand for good i. These goods are demand
complements.
Price elasticity of supply:
Ԑ Q s, P = d Qs / d P * P / Qs
Long-run demand curve: pertains to the period of time in which consumers can fully adjust their
purchase decisions to the changes in price. More price-elastic than short-run (for durable goods less).
Short-run demand curve: pertains to the period of time in which consumers cannot fully adjust their
purchase decisions to the changes in price.
For durable goods, long-run demand can be less elastic than short-run, because these goods provide
valuable services over many years and you can delay the purchase of it. For some goods though, the
long-run supply can be less elastic than short-run supply, especially for goods that can be recycled and
resold in the secondary market.
Chapter 3
Consumer preferences and the concept of utility
Basket: combination of goods and services that an individual might consume.
Consumer preferences: indicators of how a consumer would rank any two possible baskets, assuming
that these baskets were available to the consumer at no cost. Rankings:
-A
B: consumer prefers A to B.
- A ≈ B: consumer is indifferent between A and B.
-A
B: consumer prefers B to A.
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The basic assumptions of the theory of consumption choice:
- Completeness: a consumer can rank bundles of goods (prefers 1st to 2nd, prefers 2nd to 1st, indifferent).
- Transitivity: if the consumers prefers bundle Z to bundle Y and prefers bundle Y to bundle X, then the
consumer also prefers bundle Z to bundle X.
- More is better: more of a commodity is better than less of it (monotonic). If A contains B plus
something more than A
B.
Ordinal ranking: indicates whether a consumer prefers one basket to another, but does not contain
quantitative information about the intensity of that preference.
Cardinal ranking: quantitative measure of the intensity of a preference for one basket over the other.
Utility function: measures the level of satisfaction a consumer receives from any basket.
Marginal utility: MU, the rate at which total utility changes as the level of consumption rises (holding
constant the utility of all other goods).
- Total utility and marginal utility cannot be plotted on the same graph.
- The marginal utility is the slope of the utility function.
Diminishing marginal utility: after some point, as consumption of a good increases, marginal utility will
begin to fall (then more is not better)  utility curve is concave.
Indifference curve: connects all set of consumption baskets that yield the same level of utility /
satisfaction to the consumer. An indifference map shows a set of indifference curves.
Properties of indifference curves on an indifference map:
- When the consumer likes both goods (MUx and MUy are both positive)  indifference curves have a
negative slope.
- Indifference curves cannot intersect.
- Every consumption basket lies on only one indifference curve.
- Indifference curves are not “thick”.
Marginal rate of substitution: the rate at which the consumer will give up one good to get more of
another, holding the level of utility constant:
MRS x, y = MU x / MU y = - Δ y / Δ x
MRS is the slope of the indifference curve. Diminishing marginal rate of substitution: for many (not all)
goods, MRS x, y diminishes as the amount of x increases along an indifference curve.
Special utility functions:
- Perfect substitutes: the MRS is constant  the indifference curves are straight lines. U(x, y) = Ax + By
- Perfect complements: two goods that the consumer always wants to consume in fixed proportion to
each other. U(x, y) = A * min(x, y)
- Cobb-Douglas utility: U = A x α y β.
- Quasi-linear utility: is linear in at least one of the goods consumed, but may be nonlinear for the other
goods. The indifference curves are parallel. U(x, y) = v(x) + By
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Chapter 4
Consumer choice
Budget constraint: set of baskets that a consumer can purchase with a limited amount of income:
PX X + PY Y ≤ I
Budget line: set of baskets that a consumer can purchase when spending all of the available income:
PX X + PY Y = I
Slope of the budget line: Δ y / Δ x = - PX / PY. It tells us how many units of good y a consumer must give up
to obtain an additional unit of good x.
Increase in income  budget line shifts outward (expands the set of possible baskets).
Increase in price of one good  moves the intercepts on that good’s axis toward the origin. The slope
change, so there is a new trade-off between the two goods.
Optimal choice for a consumer is a basket of goods that:
- Maximizes utility.
- While live within the budget constraint.
max(x, y) U(x, y)
subject to: PX X + PY Y ≤ I
Optimum occurs at the point where the budget line is tangent to the indifference curve:
MUX / MUY
=
PX / P Y
MUX / PX
=
MUY / PY
MUX / PX
>
MUY / PY  spend all of X and none of Y.
Interior optimum: the extra utility per dollar spent on good x is equal to the extra utility per dollar spent
on good y.
Corner point: some good is not being consumed at all, the optimal basket lies on an axis. The budget line
may not be tangent to an indifference curve and the slope of the budget line and the indifference curve
may not be equal.
Composite good: a good that represents the collective expenditures on every other good except the
commodity being considered.
Expenditure minimization problem:
min(x, y) Expenditure = PXX + PYY
subject to U(x, y) = U2
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Determine an optimal basket of goods:
1. Tangency condition:
MUX / MUY = PX / PY
 Y* as a function of X*
2. Budget constraint:
Substitute Y*(X*) in the budget constraint.
 you get a solution for X*, substitute in Y* (X*)
The government can intervene on the market in two ways:
- Cash subsidy: available income rises  budget line shifts to the right  a higher utility level can be
reached.
- Voucher subsidy: budget line gets a kink, higher utility level can be reached.
Lending and borrowing:
A consumer gets an income in period 1 and 2 (I1, I2) and consumes in period 1 and 2 (C1, C2).
- The consumer can shift consumption from period 1 to period 2 by lending money to the bank:
~ C1 = I1 – l
~ C2 = I2 + (1+r)l
- The consumer can shift income from period 2 to period 1 by borrowing:
~ C1 = I1 + (1/(1+r)) b
~ C2 = I2 - b
Chapter 5
The theory of demand
Price consumption curve: connects the set of utility maximizing baskets as the price of one good varies
(holding income and the prices of other goods constant).
Income consumption curve: set of utility maximizing baskets as income varies (prices are held constant).
Engel curve: a graph relating the amount of the good consumed to the level of income.
Normal good: a consumer purchases more of this as income rises (Engel curve has a positive slope).
Inferior good: a consumer purchases less of this as income rises (Engel curve has a negative slope).
Giffen good: so strongly inferior that the income effect outweighs the substitution effect (see below),
resulting in an upward-sloping demand curve over some region of prices.
The overall effect of a change in the price of a good consists of two parts:
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- Substitution effect: that part of the change in the demand for X that is explained by the change in the
relative prices P x / P y.
- Income effect: that part of the change in the demand for X that is explained by the change in the
purchasing power.
When prices decrease:
- Normal good (see above): SE >0, IE>0.
- Inferior good: SE > 0, IE <0.
When the prices increase:
- Normal good: SE < 0, IE < 0.
- Inferior good: SE < 0, IE > 0
Follow three steps:
1. Find the initial optimal basket:
- Tangency condition.
- Budget constraint.
 you find Y*a and X*a.
2. Find the final basket (after the price falls to PX2. The budget line rotates outwards if the price falls.
- Tangency condition.
- Budget constraint.
3. Find an intermediate decomposition basket that will enable us to identify the portion of the change in
quantity due to the substitution effect.
- On the same utility curve as A. Fill in U(X*a, Y*a) and you get Yb as a function of Xb.
- Optimality at new price ratio. Fill in budget constraint with new prices and you get
Xb as a function of Yb  fill in function of step 3.1.
SE = XB –XA
IE = XC – XB
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A quasi linear utility function has no income effect.
Consumer surplus: the difference between the maximum amount a consumer is willing to pay for a good
and the amount he or she must actually pay when purchasing it. It can be a useful tool for representing
the impact of a price change on consumer well-being. It is the area below the demand curve and above
the price that the consumer must pay for the good. Without income effects, consumer surplus provides a
monetary measure of how much better off the consumer will be when he purchases a good.
Market demand curve: the horizontal sum of the demands of the individual consumers.
Chapter 6
Inputs and production functions
Production function: the maximum amount of output that can be produced for any given amount of
inputs. Q = f(L, K).
Production set: set of technically feasible combinations of inputs and outputs (area on and under the
production curve). Technically efficient production is on the production function.
Labor requirements function: indicates the minimum amount of labor needed to produce a given
amount of output. It’s the inverse of the production function for labor.
Single-output function: how total output depends on the level of the input. Properties:
- When L = 0, Q = 0.
- Output can rise with increasing marginal returns to labor. It’s the region along the total output function
(= single-output function) where output rises with additional labor at an increasing rate.
- Output can rise with diminishing returns to labor. It’s the region along the total production function in
which output rises with additional labor but at a decreasing rate.
- Output can decrease with diminishing total returns to labor. It’s the region along the total product
function where output decreases with additional labor.
Average product: average amount of output per unit of labor/capital.
. Graphically
it’s the slope of a ray drawn from the origin to the point along the single-input production function.
Marginal product: rate at which total output changes as the amount of the input is changed.
and
. Graphically it’s the slope of the line tangent to the single-input production function.
Law of diminishing marginal returns: the marginal product of an input eventually decreases as its usage is
increased, holding all other inputs constant.
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Isoquant: shows all the combinations of inputs that produce the same level of output.
Uneconomic region of production: region of upward-sloping/backward-bending isoquants. At least one
input has a negative marginal product. Economic region is where the isoquants are downward-sloping
(because it’s a trade-off between inputs), both MPL and MPK are positive.
Marginal rate of technical substitution of labor for capital: MRTSL, K, the rate at which the capital input K
must be decreased (increased) to keep output level constant after the labor input L is increased
(decreased) by one unit.
.
Diminishing marginal rate of technical substitution: the more labor L is used, the smaller the amount of
capital K that is necessary to replace a unit L in order to get the same amount of output.
- Limited input substitution: MRTSL, K changes substantially as we move along an isoquant. The isoquants
are nearly L-shaped. Elasticity of substitution is close to 0.
- Abundant input substitution: MRTSL, K changes gradually as we move along an isoquant. The isoquants
are nearly straight lines. Elasticity of substitution is large.
Elasticity of substitution (σ): how easy it is for a firm to substitute labor for capital (how quickly MRTS
changes along the isoquant) It is equal to the percentage change in capital-labor ratio for every one
percent change in the MRTSL, K.
⁄
σ=0
σ=
.
 perfect complements.
 perfect substitutes.
. All inputs are scaled up by the same proportionate amount λ
and the resulting proportionate increase in quantity of output Q is Ø.
Ø > λ: increasing returns to scale (cost advantage for large firms)

α+β>1
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

Ø = λ: constant returns to scale
Ø < λ: decreasing returns to scale
Production function
Linear production function
Q = aL + bK
Elasticity of substitution (σ)
Fixed-proportions production
function
Q = min(aL, bK)
σ=0
Cobb-Douglas production function
Q = ALαKβ
σ=1
CES production function
[
]
⁄
α+β=1
α+β<1
Other characteristics
- Inputs are perfect substitutes
- Isoquants are straight lines
- MRTSL,K is constant
- Constant returns to scale
- Inputs are perfect complements
- Isoquants are L-shaped
- MRTSL,K is 0, or undefined
- Constant returns to scale
- Smooth convex isoquants
- MRTSL,K drops along isoquants
- Returns to scale depends on the
sum of α + β.
- Includes other three production
functions as special cases.
- Shape of isoquants varies.
Technological progress: change in a production function that enables a firm to achieve more output from
a given combination of inputs. The isoquants of all output levels shift inwards. Three categories:
- Neutral: MRTSL, K remains unchanged.
- Labor-saving: MPK increases relative to MPL, MRTSL,K decreases  less K is tradable per unit L.
- Capital-saving: MPL increases relative to MPK, MRTSL,K increases  more K tradable per unit L.
Chapter 7
Costs and cost minimization
Explicit costs: involve a direct monetary outlay.
Implicit costs: do not involve outlays of cash (opportunity cost).
Opportunity cost: the value of the next best alternative that is forgone when another option is chosen.
Economic costs: the sum of the firm’s explicit and implicit costs.
Accounting costs: the total explicit costs.
Sunk costs: costs that have already been incurred and cannot be recovered.
Non-sunk costs: cost that are incurred only if a particular decision is made.
In the long run, a firm is able to vary the quantities of all its inputs as much as it desires (no constraints).
In the short run, a firm will not be able to adjust the quantities of some of its inputs (facing constraints).
Isocost line: the set of combinations of labor and capital that yield the same total cost for the firm.
Graphically,
. The slope is –w/r. Intercepts:
- K = 0  L = TC0 / w.
- L = 0  K = TC0 / r.
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Long-run cost minimization problem: given a technology Q = f(L, K) and a given desired amount of output
Q0, minimize the total cost
.
Interior solution:
(1)
MPL/MPK
=
w/r
Write L* as a function of K*.
(2)
Production function, substitute L for L*(K*) in Q = f(L, K).
This implies bang for the buck from each output.
Corner point solution: the isocost line is flatter than the isoquant:
- MPL/w > MPK/r

K* = 0.
- MPL/w < MPK/r

L* = 0.
An increase in output level moves the isoquant outwards.
Normal input: cost-minimizing quantity increases as the firm produces more output.
Inferior input: cost-minimizing quantity decreases as the firm produces more output.
If a firm only uses two inputs, at least one must be normal.
Expansion path: connects all cost-minimizing input combinations as the output level is varied. If both
inputs are normal, it is upward sloping. If one of the inputs is inferior, it is downward sloping.
A change in the relative prices of input changes the slope of the isocost line (slope = w/r).
The cost-minimizing quantity of the input that has become more expensive (L), cannot increase:
- It must decrease if the cost-minimizing input basket was an interior solution.
- When the inputs are perfect complements, a price change results in no change in the
cost-minimizing input combination.
- If the input was not used in the cost-minimizing input basket so far (corner-solution), it
must remain zero (corner solutions can change due to input price changes!).
Input demand curve: show’s how the cost minimizing quantity of an input varies with the inputs own
price. If the relative price changes, there is a movement along the line. If the desired output level
changes, there is a shift of the input demand curve (to the right for normal, to the left for inferior). These
curves are downward sloping. The lower the elasticity of substitution, the more inelastic the input
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demand curve.
Price elasticity of demand for labor: percentage change in cost-minimizing quantity of labor with respect
to a 1 percent change in the price of labor.
⁄
.
⁄
Price elasticity of demand for capital: percentage change in the cost-minimizing quantity of capital with
respect to a 1 percent change in the price of capital.
⁄
⁄
.
Short run costs can be variable and non-sunk, fixed and non-sunk or fixed and sunk.
Capital costs will not go up or down as the firm produces more or less output. Labor costs will go up or
down as the firm produces more or less output, because in the short run firms are not able to adjust the
quantities of some of its inputs (facing constraints).
Suppose K is fixed in the short run. TC = TVC + TFC = wL + rK0.
Minimize TC = rK0 + wL
L
s.t. Q0 = f(L, K0)
To reach a specific output level there is only one technological efficient input level:
- The expansion path is horizontal.
- L* is independent of input prices w and r.
- The short-run demand for labor is perfectly inelastic.
The short-run cost minimization input combinations are not necessarily optimal in the long-run.
Chapter 8
Cost curves
Long-run total cost function: relates minimized total cost to output Q and factor prices w and r.
With L* and K* as long-run input demand functions.
Long-run total cost curve: shows minimized total costs as output Q varies, holding input prices w and r
constant. Sometimes referred to as the envelope curve.
Shephard’s dilemma: the rate of change of a total cost function with respect to an input price is equal to
the corresponding input demand function (
).
A given percentage increase in both input prices leaves the cost-minimizing input combination
unchanged. The total cost curve will shift up by exactly the same percentage as the increase in prices.
Long-run average cost:
Long-run marginal cost:
.
.
- MC(Q) < AC(Q) AC(Q) decreases in Q, the next unit is cheaper than the average so far.
- MC(Q) > AC(Q) AC(Q) increases in Q, the next unit is more expensive than the average so far.
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- MC(Q) = AC(Q) AC(Q) is flat with respect to Q. The next unit is just as expensive as the average so far.
Economies of scale: average cost decreases as output goes up due to specialization and indivisible inputs.
Diseconomies of scale: the average cost increases as output goes up due to managerial diseconomies.
Indivisible input: only available at a certain minimum size. Its quantity cannot be scaled down as the
firm’s output goes to zero.
Managerial diseconomies: a given percentage increase in output forces the firm to increase its spending
on the services of managers by more than this percentage.
Minimum efficient scale: smallest quantity at which the long-run average cost curve has its minimum.
Output elasticity of total cost:
⁄
.
⁄
- >1 and MC > AC: diseconomies of scale (decreasing returns to scale).
- <1 and MC < AC: economies of scale (increasing returns to scale).
Short-run total cost curve: shows the minimized total cost of producing a given quantity of output when
at least one output is fixed. Short-run total cost is the sum of total variable cost and total fixed cost.
, since STC(Q) = wL*(Q, w, r) + rK0 (see below).
 With K0 is the fixed input and L is the variable input, then:
- TVC(Q) = wL*(Q, w, r)
- TFC = rK0
- STC(Q) = wL*(Q, w, r) + rK0
The short-run total cost curve,
can never be below the long-run
total cost curve.
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Economies of scope: the total cost of producing given quantities of two goods in the same firm is less
than the total cost of producing those quantities in two single-product firms. Variety is more efficient
than specialization, due to common inputs (factory, marketing etc.).
TC(Q1, Q2) < TC(Q1, 0) + TC(0, Q2).
Stand-alone cost: the cost of producing a good in a single-producing firm.
Economies of experience: cost advantages that result from accumulated experience, learning-by-doing.
AVC(Q t = 5) < AVC(Q t = 1).
The experience curve plots the relationship between AVC and cumulative production.
Chapter 9
Perfectly competitive markets
Perfectly competitive markets, characteristics:
- The industry is fragmented: so many buyers and sellers that the action of a single agent has no
perceptible effect on the market price.
- Firms produce undifferentiated products (identical products and uniformity of output quality).
- Consumers have perfect information about prices.
- The industry is characterized by equal access to resources.
How perfectly competitive markets work, implications:
- Sellers and buyers act as price takers.
- Law of one price.
- Free entry and exit.
Economic profit
=
Sales revenue Economic cost
Π = TR(Q) – TC(Q)
TR(Q) = P * Q
Equilibrium criteria:
- First order criterion (FOC): for price taking firms, MR(Q) = P. For profit maximization, P = MC MR=MC.
- Second order criterion (SOC):
. MC must be increasing in q*.
- Extra condition: π(q) > π(0)  p > AVC or p > ANSC. Otherwise, don’t produce.
At any price p < pS the firm shuts down, because it loses (AVC – p or ANSC – p) on every unit that is sold
on top of the sunk fixed costs. PS is the minimum of the AVC or ANSC curve.
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- When all fixed costs are sunk, NSFC = 0 and thus TFC = SFC.
- Firms produce where P = SMC (short-run marginal cost).
- Firms never produce when:
~ No non-sunk costs: P < AVC (average variable cost).
~ Some non-sunk costs: P < ANSC (average non-sunk cost = AVC + NSFC/Q).
Short-run supply curve: shows how the firm’s profit maximizing output decision changes as the market
price changes (assuming that the number of firms in the market is fixed and that a firm cannot adjust all
of its inputs). The short-run supply curve is the increasing part of the SMC function, where p > pS.
In a perfect competitive market, a firm can choose to operate while it earns negative economic profits (p
< ASC). If this pertains, the firms will exit or reduce capacity in the long-run.
Short-run market supply curve: gives the quantity supplied by the aggregate of all firms in the market for
each possible market price  horizontal summation of the individual short-run supply curves.
Short-run competitive market equilibrium: the market quantity demanded equals the market quantity
supplied. The typical firm can earn positive or negative economic profits.
Long-run: all costs are avoidable (no sunk fixed costs). Profit maximization:
- P = MC(q*).
- Increasing MC(q*),
- p > pS. Shutdown price is at the minimum of AC(q), where AC(q) = MC(q).
There can be entry and exit, zero profit condition. At the equilibrium, established firms have no incentive
to exit the industry and prospective firms have no incentive to enter the industry.
Three conditions for a long-run perfectly competitive equilibrium (market price P*, number of firms n*
and output per firm q*):
- Each firm maximizes its long-run profit with respect to output and plant size.
P* = MC(q*)
- Each firm’s economic profit is zero.
P* = AC(q*)
- Market demand equals market supply.
QD(P*) = n*q* 
n* = QD(P*) / q*
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This implies that in the long-run equilibrium MC(P*) = AC(P*), which means that q* is the minimum
efficiency scale (smallest quantity at which the long-run average cost curve has its minimum).
Long-run market supply curve: gives the quantity that will be supplied in the market for each possible
market price, assuming that all long-run adjustments take place (plant size, new entry etc.). It’s not
simply the summation of individual firms’ long run supply, because the number of firms may change.
We can derive the long-run market supply curve by studying the change in the long-run equilibrium
when a shock occurs = new long-run perfect competitive equilibrium.
The long-run market supply is flat (perfectly price elastic)  the prices of the inputs do not change due
to extra demand = constant-cost industry.
Increasing-cost industry: the long-run market supply is increasing.
~ When the price of an industry-specific input increases as the total industry’s output increases.
~ The average cost curve shifts up and the minimum average cost increases leading to a long-run
increase in the equilibrium price.
Decreasing-cost industry: the long-run market supply is decreasing.
~ When the price of a specialized input decreases as the total industry output increases.
~ The average cost curve shifts downwards and the minimum average cost decreases leading to
a long-run decrease in the equilibrium price.
Economic rent attributable to a scarce input: difference between a firm’s maximum willingness to pay for
the input and the input’s reservation value.
Reservation value: the return that the input owner would get by deploying the input in its best
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alternative use outside the industry.
Producer surplus: monetary measure of the benefit that producers derive from producing and selling a
good at a particular price. It’s the area between the supply curve and the market price. In the short-run,
a firm’s PS and its economic profit are not equal, but differ in the extent of the firm’s sunk costs. The
long-run PS is equal to economic profit.
Chapter 10
Competitive markets: applications
Market welfare = consumer welfare (CS) + producer welfare (PS).
In the perfect competitive equilibrium, resources are allocated efficiently, which implies that:
- Everyone who is willing to buy for a price higher or equal to the market price, can buy the resource.
- Everyone that is willing to sell for a price lower or equal to the market price, can sell the resource.
Total welfare in the market cannot be increased by decreasing or increasing the number of trades.
The invisible hand: the output produced in a perfectly competitive market is the one that maximizes net
economic benefit (= the sum of consumer and producer surplus).
Deadweight loss: reduction in net economic benefits resulting from an inefficient allocation of resources.
The government often intervenes in perfectly competitive markets for various reasons. The instruments
are taxes/subsidies, price ceilings/floors, production quotas or purchase programs, import quotas/tariffs.
As a result, there is a deviation of the economic efficient outcome  deadweight loss.
Total welfare: W = CS + PS + G.
Economic benefit: CS + PS.
Excise tax: tax on a specific commodity, such that the producer pays a fixed amount per unit sold to the
government. This creates a tax wedge between producer price and consumer price. The consumer pays
PD = PD*. The supplier receives PS = PS* = PD* - T. The producers marginal cost of production has
increased by T.
Effects of introducing excise tax:
- The market under produces relative to competitive equilibrium.
- Total market welfare decreases:
Deadweight loss
~ Higher consumer price  CS decreases.
~ Lower producer price  PS decreases.
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~ Government income  G increases.
Tax incidence of customers: measure of the effects of an excise tax on the prices consumers pay.
Measures the extent to which the producers are able to put the burden of the tax on the customers.
, determines to which extend the consumers (producers) carry the burden of the tax.
 The party that is the most price elastic (steeper curve), carries the largest burden.
Subsidy: negative tax, the producer receives a fixed amount per unit sold from the government. This
creates a subsidy wedge between the consumer price and the producer price. The consumer pays
PD = PD*. The supplier receives PS = PS* = PD* + T. The producers marginal cost of production has
decreased by T.
Effects of introducing producer subsidies:
- The market overproduces relative to competitive equilibrium.
- Total market welfare decreases:
Dead weight loss
~ Lower consumer price  CS increases.
~ Higher producer price  PS increases.
~ Government spending  G decreases.
Price ceilings: restricts the price in the market to a maximum. The government finds the market
equilibrium price too high. The market will result as not clearing. At the maximum price, there occurs an
excess demand. Effects of price ceilings:
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- The market will under produce relative to competitive market equilibrium.
- A deadweight loss exists.
- Always lower PS.
Price floors: restricts the price in the market to a minimum. The government finds the market
equilibrium price too low. The market will result as not clear. At the maximum price, there occurs an
excess supply. Effects of price floors:
- Consumers will buy less goods relative to competitive equilibrium.
- A deadweight loss exists.
- Always lower CS.
Production quota: restricts the quantity that producers can supply in the market (number of providers of
amount of production). The market price will increase due to the production quota. The market will not
clear, because of excess supply. Effects of production quotas:
- Consumers will buy less goods relative to competitive equilibrium.
- Deadweight loss.
- Always lower CS.
Free trade: the domestic market equilibrium is driven by the supply of domestic and foreign producers
and the demand of (only) domestic consumers. Foreign producers are assumed to sell any quantity at
the world price. Effects of free trade:
- Price decreases  consumer surplus increases.
- Market clears thanks to foreign producers.
- Domestic producer surplus decreases.
Import quota: restricts the quantity that foreign producers can supply on the domestic market.
Import tariff: excise tax for foreign producers.
Both measures increase the price on the domestic market and aim to increase the domestic producer
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surplus. Trade prohibition: no foreign supply allowed (quota = 0) or very high import tariffs (higher than
the domestic market price). Trade prohibition and partial restrictions on trade create a dead weight loss,
although domestic producers can be better off.
Chapter 11
Monopoly and monopsony
Monopolist: only firm producing and selling a good. Price is not fixed, but depends on the quantity the
monopolist supplies, the price is endogenous and depends on the inverse market demand curve P(Q) 
monopolist is a price setter. TR = P(Q)Q.
Monopolist’s profit maximization:
1)
Produce QM such that MR(QM) = MC(QM).
2)
Price according to the demand curve, PM = P(QM). Optimizing price exceeds MC.
3)
Shut down if the price is below average variable cost.
4)
The monopolist will only be active in the market if he makes a positive profit.
TR = QMP(QM); TC = QMAC(QM);
πM = QM[PM(QM) – AC(QM)]
The monopolist always prices on the elastic part of the demand curve, where MR is positive and a
quantity increase would yield higher TR. Short-run and long-run are the same (no entry or exit). There is
no supply curve, because the producer chooses both P and Q simultaneously.
A monopolist prices above marginal costs and is able to make a positive economic profit. The ability to
price above marginal costs is determined by the price sensitivity of the demand  the more elastic a
demand, the lower the price-cost margin of the monopolist.
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(
)
and
.
(
)
Lerner index: gives a measure of market power exerted (by the monopolist). It is defined as the
percentage markup over the marginal costs.
.
An increase in demand, results in an increase of the monopoly quantity and price.
An increase in marginal costs, results in a decrease of the monopoly quantity and an increase in price.
Monopoly deadweight loss:
- Monopoly outputs are lower than in perfect competition.
- Monopoly prices (P > MC) are higher than in perfect competition (P = MC).
Monopoly rent-seeking (Posner): when expected monopoly profits (“rents”) are high, firms often engage
in rent-seeking activities. E.g.: political lobbying for acquiring or preserving a monopoly. Rent-seeking
expenditures incur an additional social cost. This can be because the incentive to engage in rent-seeking
activities gets stronger the greater the potential monopoly profit is.
Market efficiency: efficient when total welfare is as large as possible (no DWL).
- Perfect competition: 100%.
- Monopoly:
.
Natural monopoly: total cost incurred by a single firm producing a relevant level of output is less than
the combined total cost of two or more firms producing the same level of output. Depends on:
- Technology: the average cost of production must be falling for any relevant level of output
(economies of scale).
- Demand: the relevant level of output depends on demand. A market may be a natural
monopoly only because the demand is very low compared to the minimum efficient scale.
Multi-plant monopoly: monopolists can increase profits by reallocating production towards the lower
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marginal cost plant.
Optimal multi-plant behavior:
- Optimal total production:
MCT(QM) = MRT(QM).
- Choice between two plants: MC1 = MC2 (the cost of producing the last unit at plant 1 has to be equal
to the cost of producing the last unit at plant 2).
Multi-plant marginal cost curve: derived by adding the individual plants’ marginal cost curves (MC1 and
MC2) horizontally. So:
1)
MC1(Q1)  Q1(MC1) and MC2(Q2)  Q2(MC2).
2)
Total quantity: QT = Q1 + Q2  QT(MCT).
3)
QT(MCT)  MCT(QT).
Cartel: group of firms that collusively determine the price and output in a market. The firms cooperate,
so a cartel is similar to a multi-plant monopoly (where each member of the cartel represents one or
more production plants).
- A cartel maximizes its profit by choosing a total output level that equates multi-plant marginal costs to
the cartel’s marginal revenue. MCC(QC) = MR(QC).
- The optimal production allocation is as in the multi-plant monopoly, which means that the production
is typically not divided equally amongst cartel members.
When an increase/decrease in MC leads to an increase/decrease in TR, the firms are not colluding in a
production cartel.
Barriers to entry: factors that allow an incumbent firm to earn positive economic profits while making it
unprofitable for newcomers to enter the Industry.
Structural barriers to entry: incumbent firms have cost or demand advantages that would make it
unattractive for a new firm to enter the industry.
Legal barriers to entry: an incumbent firm is legally protected against competition.
Strategic barriers to entry: an incumbent firm takes explicit steps to deter entry.
Chapter 12
Capturing surplus
When a monopolist charges a uniform price, he cannot capture the entire consumer surplus.
Price discrimination: the practice of charging consumers different prices for the same good/service or
consumers pay different prices according to the quantity of the product that they consume.
1) First-degree or perfect price discrimination: attempting to price each unit at the consumer’s
reservation price (maximum willingness to pay). Conditions:
- Market power: firm’s demand curve is downward sloping.
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- The monopolist has perfect information on the demand curve and uses a mechanism such that
the willingness to pay of consumers are somewhat revealed (such as auctions).
- No arbitrage.
Price = reservation price of individual customer
Quantity: sell as long as P > MC
PS = AFD
and
CS =0
Economically efficient output
2) Second degree or indirect price discrimination: offering consumers a menu of prices such that the
consumers self-select and therefore reveal information about their willingness to pay. Conditions:
- Not possible to observe the type of consumer.
- Not possible to prevent arbitrage.
- The firm has market power, it can let consumers self-select into consumer groups.
Block pricing: charging one price per unit in the first block of output and a different (usually lower) price
for any additional units you buy. E.g.: quantity discount  change in the price for the consumer 
change in the optimal consumption pattern  change in the demand for the product. This leads to
higher producer surplus.
Optimal block pricing, profit maximization:
1)
Uniform optimum: MR(Q1) = MC(Q).
2)
Optimal setting:
- Q res = (Q2 – Q1).
- Determine residual demand: P(Q) = a – bQ, P res(Q) = a – b(Q1 + Qres).
- MR(Q res) = MC(Q res).
Two-part tariffs: charges a per unit fee p, plus a lump sum fee F (paid whether or not a positive number
of units is consumed). Effectively charges demanders of a low quantity different average prices than
demanders of a high quantity. Like hook-up charge plus usage fee for a telephone. Two types:
- There is only 1 type of consumer.
- There are different types of consumers and the monopolist cannot distinguish between them.
3) Third degree or direct price discrimination: charging different uniform prices to different consumer
groups or segments in the market. Conditions:
- Market power: firm’s demand curve is downward sloping.
- No arbitrage.
- No perfect information. Instead, observe the type of consumer and have information about the
type’s willingness to pay.
MR1(Q1) = MR2(Q2) = MC(Q1 + Q2). I.e. sell the product in the market where it gives the highest revenues.
The profits are higher compared to uniform pricing. The most price inelastic will pay the highest price.
.
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