ECON1101

ECON1101 Notes

Chapter 1: Comparative Advantage and the Basis for Trade

● A ​model​ is a simplified representation of reality

ONE AGENT ECONOMY

● The ​Production Possibility Curve ​represents all maximum output

possibilities for two (or more) goods, given a set of inputs if these inputs
are used efficiently
● The curves & scenarios below represent a ​one agent economy

● The blue line is the PPC

○ The example above assumes that a day provides 16 working hours
(8 hours of sleep) and 1 kg of bananas are obtained in 1 hour and 1
kg of rabbits are obtained in 2 hours
● There are 4 steps to construct a PPC
○ Draw the axis and define them

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○ Point out the extreme examples - the maximum output in efficiently

producing just ​one​ good (note that this point will either be on the x or
y axis)
○ Plot the points which combines the production of ​two ​goods
○ Connect the dots

● An ​Efficient Production Point ​represents a combination of goods for

which currently available inputs do not allow for an increase in production
without a reduction in the production of another (all points ON the PPC as
illustrated below)

● An ​Inefficient Production Point ​represents a combination of goods for

which currently available inputs allow the increase of production in one
good without a reduction in the production of another (all points BELOW
and TO THE LEFT of the PPC)

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● An ​Attainable Production Point ​represents any combination of goods

that CAN be produced with currently available inputs (all points ON the
PPC, BELOW and LEFT of the PPC)

● An ​Unattainable Production Point ​represents any combination of goods

that cannot be produced with the currently available inputs (all points
ABOVE or TO THE RIGHT of the PPC)

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TWO AGENT ECONOMY

● Now assume that there are two people in the economy

● The PPC of this second person is 4 kg of bananas in a day (16 hrs) and 4
kg of rabbits in a day (4 hrs for 1 banana or rabbit)

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● An agent (or economy) has an ​absolute advantage​ in a productive activity

when they can carry this activity with less inputs than another agency (in
the example above, Alberto has an absolute advantage over Leo because
he can carry out the same activity with less inputs, being time)
● The ​opportunity cost ​of a given action is the value of the next best
alternative to this particular action (for Alberto, collecting 16 bananas
means not being able to collect 8 rabbits. As such, the opportunity cost of
1 kg of banana is 0.5 kg of rabbits and the opportunity cost of 1 kg of rabbit
is 2 kg of bananas) (see diagram below)
○ The opportunity cost can also be calculated using the PPC. To do
so, simply find the slope (gradient) by dividing the rise by the run

● An agent has a ​comparative advantage​ in a productive activity when they

have a lower opportunity cost of carrying out the activity than another
agent
○ Leo has a comparative advantage in producing rabbits
● Principle of Comparative Advantage: ​The Principle of Comparative
Advantage states that everyone is better off if each agent specialises in the
activities for which they have a comparative advantage

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TRADING IN A TWO AGENT ECONOMY

● When purchasing a product, it will be worthwhile to buy as long as the

price of the product is less than the opportunity cost of producing that
product
○ E.g. Leo is buying bananas since he specialises in rabbits (see
diagram above for context of scenario)
○ OC of 1 kg of rabbit is 1 kg of banana
○ Therefore, Leo will want to buy 1 kg of bananas for no more than 1
kg of rabbits
● When selling a product, it will be worthwhile to sell at a price that is more
than the opportunity cost for producing that product
○ E.g. Alberto is selling bananas since he specialises in this (see
diagram above for context of scenario)
○ OC of 1 kg of bananas is 0.5 kg of rabbits
○ Therefore, Alberto will want to sell 1 kg of bananas for ​at least ​0.5
kg of rabbits
● The cost of a product should be greater than or equal to the opportunity
cost of buyer and less than or equal to opportunity cost of seller

ECONOMY WIDE PPC IN A TWO AGENT ECONOMY

● To find out how to derive an economy-wide PPC, look at the steps in the
following link: ​http://lionsheartstudios-publishing.com/unsw/ch_1_pg_3/
● Any combination of goods that lies on this economy-wide PPC will result in
the use of ALL inputs
● Any combination of goods that lies below/to the left of this economy-wide
PPC indicates an underutilisation or inefficient use of resources

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● Looking at the diagram above, we see that the opportunity cost of bananas
increases (the gradient of the blue slope becomes steeper).
○ This is due to the fact that resources are ​scarce
● The Low-Hanging Fruit Principle (or increasing Opportunity Cost):
This principle states that in the process of increasing production of any
good, one first employs those resources with the lowest opportunity cost.
Once these resources are exhausted, it is then viable to turn to resources
with a higher opportunity cost
● The main factors driving economic growth (pushing the economy-wide
PPC out and to the right) come from an increase in inputs. This can come
in the form of:
○ an increase in infrastructure such as factories, equipment, etc
○ an increase in the population, such so in the labour force
○ advancements in knowledge and technology (education, R&D, IT
and communications technologies)

TRADING BETWEEN ECONOMIES: INTERNATIONAL TRADE

http://lionsheartstudios-publishing.com/unsw/ch_1_pg_66/

● A country’s economic welfare does not depend on what it produces (PPC)

but what it consumes (CPC, Consumption Possibility Curve)

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● The ​Consumption Possibility Curve ​represents all possible combinations

of two goods that the agents in the economy can consume
○ Different definition when it is open to international trade: The
Consumption Possibility Curve ​represents all possible
combinations of two goods that the economy can feasibly consume
when it is open to international trade
● If a country is a closed economy (doesn’t trade internationally), the PPC
and CPC are the same because the agents must consume whatever they
produce
● If a country is an open economy (trades on an international scale), the
CPC is usually greater than the PPC because part of what domestic
agents produce can be traded for other goods which relieves restrictions
on consumption
● Changes in the international price can change the CPC
● Since PPC is always below CPC, we can conclude that consumption
opportunities in an open economy are always wider than in a closed one
● What should an economy consume? This depends on needs and wants
(economic term is ​preferences)

ECONOMY WIDE PPC IN A MANY-AGENTS ECONOMY

● There are now millions of agents

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● The principles of the two agent economy applies in this scenario as well
● Start by considering the two scenarios in which all workers collect bananas
or catch rabbits. This gives you the points on the x & y axis
● With just two agents, the curve started to arc from its origin. With millions
of agents, this will translate to a smooth arc
● Remember that this slope reflects the opportunity cost of 1 kg of bananas
in terms of forgone rabbits
○ As we increase the quantity of bananas produced, the PPC slope
also increases, meaning the opportunity cost rises
○ As in the two-agent case, if we need more bananas, we will assign
the task to the agent with the lowest opportunity cost at picking
bananas in the economy. If society wants even more bananas, it will
be necessary to employ another agent that has a higher opportunity
cost than the first agent

CRITIQUES TO THE MODEL

1. No psychological cost: ​Human beings enjoy variety and performing the

same activity can result in dissatisfaction
2. No transaction cost: ​Did not account for transaction costs associated with
trading (negotiation costs, transportation costs) as well as tariffs and
quotas
3. No change in preferences: ​Demand for goods which an economy
specialises in can change and furthermore, social norms (political,
religious) can also prevent trade

General Notes

● For the chapter 1 question 2, the answer is $79 because she has spent
$19 for the movie and lost $60 in terms of the opportunity to babysit ($60 is
the second best option)
● To calculate OC, the formula is loss OVER gain (loss is the whatever the
question wants in terms of and gain is the item which you are calculating
the opportunity cost for. For example, let’s say one person produces 24

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bananas and 8 rabbits. To find the opportunity cost of producing 1 banana,

this will be equal to 8 (loss) / 24 (gain), giving us an answer of ⅓.

Chapter 2: Supply in Perfectly Competitive Markets

● Market: ​The market for a given good or service is the set of ​all the
consumers and suppliers who are willing to buy and sell ​that good or
service at a given price
● Market Equilibrium: ​Market equilibrium occurs when the price and the
quantity sold of a given good is stable
○ The equilibrium price is such that the quantity that consumers want
today is the same as the quantity that suppliers want to sell

Characteristics of a Perfectly Competitive Market

1) Consumers and Suppliers are price takers: ​Both suppliers and

consumers are not willing/able to affect the equilibrium price (if suppliers
increased price, consumers will buy from competitor and suppliers will lose
profits if they reduced prices. If consumers try to ask for lower price,
supplier will just serve another customer and there is no incentive for
customer to pay a higher price)
2) Homogenous goods: ​all suppliers sell exactly the same product
3) No externality: ​an externality is a cost or benefit that is incurred by
someone who is not involved in the production or consumption of a certain
good
4) Goods are excludable and rival: ​suppliers can prevent consumers from
consuming a certain good (excludability) and once consumed, that good
becomes unavailable to other customers (rivalry)
5) Full information: ​the suppliers and the consumers are perfectly informed
regarding the characteristics of the good (price and quality of good)
6) Free entry and exit: ​there is no cost to entry and no penalty for leaving

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Supply Curve for an Individual

● Marginal benefit: ​The marginal benefit of producing a certain unit of a

given good is the extra benefit accrued by producing that unit (i.e. if it takes
1 hr to harvest a bushel of Apples which sell for $1.90, the marginal benefit
is $1.90)
● Marginal cost: ​The opportunity cost of producing a certain unit of a good
(using the example above, if the same person can produce 2 units of fish
in 1 hr and sell it for $1.00 (50c each), the marginal cost is $1.00)
● Cost benefit principle: ​The cost benefit principle states an action should
be taken if the marginal benefit is greater than ​or equal to​ the marginal
cost
● Economic surplus: ​The economic surplus of a certain action is the
difference between the marginal benefit and the marginal cost of taking an
action (in the case above, this will be 90c ($1.90 - $1)
● Quantity supplied: ​The quantity supplied by a supplier represents the
quantity of a given good or service that maximises the profit of the supplier
(quantity of supply until the marginal benefit < marginal cost)
● Supply curve: ​The supply curve represents the relationship between the
price of a good or service and the quantity supplied of that good or service
● Law of supply: ​The Law of Supply describes the tendency for a producer
to offer more of a certain good or service when the price of that good or
service increases (if the price of Apples now sell for $2.10, the quantity
supplied will raise to 3 units of Apples (alternative is $2.00 of producing
Fish)

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● Horizontal interpretation of the supply curve: ​start from a certain price

and then use the supply curve to derive how many units of the good will be
supplied at this price (easier)
● Vertical interpretation of supply curve: ​start from a certain quantity then
find the associated price on the supply curve (more difficult)
○ This price is the minimum amount of money a producer is willing to
accept to offer a certain quantity of goods/services (​aka Producer
Reservation Price)

Supply Curve for Firms

● Sunk Cost: ​this is a cost that once paid cannot be recovered

● Fixed cost: ​A fixed cost is associated with a fixed factor of production
○ Fixed Factor of Production: ​The cost associated with it does not
vary with the quantity produced (daily repayments of machinery - it
doesn’t matter if we use the machine more or less the repayments
remain constant)
● Variable cost: ​A cost that is associated with a variable factor or production
○ Variable Factor of Production: ​the cost associated with it directly
varies with the number of units produced
● Short Run: ​This denotes a period of time during which at least one factor
of production is fixed
● Long Run: ​This denotes a period of time during which all factors of
production are variable

● Let’s consider an entrepreneur producing soft drinks that sell at $1.20 per
unit (data in table below)
○ Requires machinery with a daily repayment of $100
○ Each employee costs him $12

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● For the first worker, marginal benefit is simply the price where you can sell
the cans at ($1.20)
● The marginal cost is (change in total cost divided by change in quantity
produced):
○ Using formula below, the marginal cost of first employee will be
$0.30. Using the cost benefit principle, the firm should hire the first
worker because the marginal benefit is greater than the marginal
cost

ΔT C
ΔQ

● The 2nd, 3rd and 4th employee will all be worth it

○ The 5th employee is not worth it since the marginal cost of $2.40 is
greater than the marginal benefit
● Hence, the optimal number of employees is 4
● Shut Down Condition (short run): ​In the short run, the entrepreneur
should shut down production if the profit/loss from production is ​less than
the fixed cost
○ Otherwise, the firm should continue production at the optimal
number of workers
○ If the profit/loss from production is the same as the fixed cost, we
assume that the firm will continue to produce
● Exit Condition (Long run): ​In the long run, the entrepreneur should exit
the industry if it is making a loss
○ By exiting, it loses nothing and gains nothing (there are no more
fixed costs in the long run), therefore it wants a return of more than 0
From Discrete to Continuous Model

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● The above graph plots the average variable cost (AVC), average total cost
(ATC) and Marginal Cost (MC)
○ This is a discrete model

● The above graph is the same as the first graph but it is using a continuous
model (labour supply was more flexible and employees were hired for as
many hours as the entrepreneur wants)
● The above graph allows you to easily find the optimal quantity

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○ At a certain price (marginal revenue), simply extend that line until it

intersects the marginal cost curve and see what quantity it
corresponds to (see diagram below)

● We can also use this graph to verify whether the entrepreneur should shut
down in the short run (shut down condition in the short run) by seeing if the
price line is below the ​minimum point o
​ n the AVC (Average Variable Cost
Curve) (see diagram below)

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● To verify whether entrepreneur should shut down in the long run, they
should shut down if the price is lower than the minimum of the ATC
(average total cost) curve (see diagram below)

● The supply curve for a firm is equal to the Marginal Cost (MC) curve
○ Only for values that are higher than the minimum AVC (in the short
run)
○ Only for values that are higher than the minimum ATC (in the long
run)
● The MC curve eventually increases with quantity produced (subject to
increasing marginal costs) due to productivity losses
● The MC curve cuts the AVC curve and ATC curve at their minimum points
● In the long run, the AVC curve would become identical to the ATC curve
(this is not shown in the diagram above) because all costs become variable
(fixed costs don’t exist)

Shifting the Supply Curve

● A change in the market price determines a movement ​along ​the supply

curve
● A change in some factor other than the price will shift the entire supply
curve. Factors include:
○ Technology: ​more advanced technology reduces the cost of
production, shifting the supply curve to the right

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○ Input prices
○ Expectations: ​If sellers expect the demand for a product to rise,
they might reduce supply until the price rises due to this increase in
demand
○ Changes in the pricing of other products: ​if a seller sells more
than one good and a particular good experiences a surge in
demand, the seller will shift its productive focus to the high demand
good (= supply curve shifts to the right)
○ Number of suppliers: ​the higher the number of suppliers entering a
market, the larger the shift to the right in the aggregate supply curve

Price Elasticity of Supply

● This denotes the percentage change in the quantity supplied resulting from
a change in price

Formula for calculating elasticity:

P ercentage change in quantity

percentage change in price
OR

1
P rice
Quantity x Slope

● Law of Supply: ​Supply curves have the tendency of being upward sloping
○ This is why the price elasticity of supply is usually positive (when
price increases, supply increases as well)
● Supply is ​elastic ​when the price elasticity of supply is greater than 1
● Supply is ​unit elastic ​when price elasticity of supply is equal to 1
● Supply is ​inelastic ​when the price elasticity of supply is less than 1
● Elasticity is not the same at each point

Determinants of Price Elasticity of Supply

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● Availability of Raw Material: ​Large availability = elastic supply and vice

versa
● Factors mobility: ​the more mobile factors of production are, the higher the
elasticity
● Inventories/excess capacity: ​the larger amount of inventories, the higher
the elasticity
● Time horizon: ​Time horizon is the length of time in which a producer has
to respond to a change in price. A longer time horizon leads to a higher
elasticity because they can search for more efficient inputs and revise
production plans

Special Note

● In the example above, the first total cost of $10 for 0 quantity is a fixed cost
○ This is how we can easily identify the fixed cost if it is not given

Chapter 3: Demand in Perfectly Competitive Markets

● Utility: ​This denotes the satisfaction that an individual derives from

consuming a given good or taking a certain action. It is measured in ​utils
per unit of time

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● Decreasing Marginal Utility: ​Decreasing Marginal Utility implies that the

utility from consuming an extra unit of a given good decreases with the
number of units that have previously been consumed
● Quantity Demanded: ​This represents the quantity of a given good or
service that maximises the utility experienced by the individual consuming
it
● Substitution Effect: ​This captures the change in quantity demanded of a
given good following a change in its relative price
● Income Effect: ​This captures the change in the quantity demanded of a
given good following the reduction or increase in the consumer’s
purchasing power
○ For a ​normal ​good, a reduction in income reduces the quantity
consumed and vice versa
○ For an ​inferior ​good, a reduction in income increases the quantity
consumed and vice versa
● Due to the substitution effect, price and quantity tends to move in opposite
directions
○ The implication of this is the ​law of demand ​which simply states that
demand curves have a tendency to be downward sloping
○ The exception to the law of demand is a ​giffen good ​where with an
increase in price, there is an increase in the quantity demanded
● Demand Curve: ​This represents the relationship between the price of a
product and the quantity demanded of this product
● Horizontal interpretation of demand curve: ​start from a certain price and
find the associated quantity
● Vertical interpretation of demand curve: ​start from a certain quantity
and find the associated price
● Consumer Reservation Price (Willingness to Pay): ​This denotes the
maximum amount of money an individual is willing to pay for a g/s

From Discrete to Continuous Model

● Under a continuous model, the demand curve would be a smooth line

● Factors that can shift the demand curve to the right: ​(a shift to the left is
generated by opposite effects of what is set out below)

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○ Effective Marketing Campaign - this might increase the marginal

utility experienced from each unit of consumption
○ Decrease in the price of ​complements
○ Increase in the price of ​substitutes
○ An increase in income for a normal good (demand will rise)
○ A decrease in income for an inferior good (demand will rise)
○ A positive shift in consumer preferences towards a certain good
○ Expectations of rising prices (this pushes buyers to try to purchase
early)
○ Population growth

Price Elasticity of Demand

● This captures the percentage change in quantity demanded resulting from

a
● very small percentage change in price
P ercentage change in quantity
percentage change in price

OR
P rice 1
Quantity x Slope

● Note that the price elasticity of demand is almost always negative. This is
due to the fact that price and quantity tend to move in opposite directions
○ For simplicity, we will ignore the negative sign and consider the
absolute value of price elasticity
● Demand is ​elastic ​if the price elasticity is greater than 1
● Demand is ​unit elastic ​if price elasticity = 1
● Demand is ​inelastic ​if price elasticity is lower than 1
● Even for a straight line with a constant gradient, the elasticity is different at
different points on the line

Determinants of Price Elasticity of Demand

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1) Availability of substitutes: ​the larger the number of substitutes, the more

elastic demand tends to be (consumers can easily switch to other
products)
2) Definition of a good: ​this depends on how you define a certain good. If
you take a good as a whole category, then this broad category will be likely
to have no substitutes (i.e. salt) and thus, demand will be inelastic.
However if you consider a certain ​brand ​of salt, then the elasticity for that
particular brand is likely to be high as there are many substitutes
3) Income share: ​the larger the share of income required to purchase a
good, the higher the elasticity
4) Time horizon: ​the longer the time horizon, the higher the elasticity
because this provides time for buyers to find alternative substitutes

Chapter 4: Perfectly Competitive Markets (Demand and Supply - An

equilibrium analysis)

Demand and Supply Aggregation

● Let’s say we have two producers of Apple juice. Each of them have
different supply curves due to differences in their respective production
processes. To find the aggregate supply curve (total supply for the
economy), simply take a price, check how much each producer supplies at
this price and then sum up these quantities

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● For the aggregate demand curve, the same concept applies (see diagram
below)

● The aggregate demand and supply is the horizontal sum of the individual
demand and supply curves

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Market Equilibrium

● Excess Supply: ​This depicts a situation where the quantity supplied is

larger than the quantity demanded
○ In this case, it is clear that suppliers are left without a buyer and
thus, will lower the price to attract one
● Excess Demand: ​This depicts a situation where the quantity demanded is
larger than the quantity supplied
○ In this case, buyers are left without a seller and thus, some will pay a
higher price to get the good

● If there is an excess supply or demand, the adjustment process will

continue until we reach the equilibrium price or equilibrium quantity
● Note that in order for a market to be perfectly competitive, buyers and
sellers need to be ​equilibrium​ price takers ​(no one change or is willing to
change the equilibrium price)
○ This is an important condition of a perfectly competitive market -
buyers and sellers are price takers in the sense that if they were to
change the price away from the equilibrium level, they would be
unable to sell or buy anything. Thus, they take the equilibrium price
● Recall these concepts:

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○ The reservation price of a buyer is the highest price a buyer is willing

to pay for a good
○ The reservation price of a seller is the lowest price a seller is willing
to accept for a given good
● Rationing Rule: ​The buyer with the highest reservation price moves first
and decides which seller to approach, where the price requested by each
seller is ​common knowledge
○ The buyer with the second highest reservation price moves and so
on
● Consumer Surplus: ​This represents the difference between what a
consumer is willing to pay for a good or service (buyer reservation price)
and what they actually pay for that good or service
○ If the reservation price of a consumer is $6 and they pay $5, they’ve
paid less than what they were willing to pay, thus gaining a
consumer surplus of $1 ($6 - $5)
● Producer Surplus: ​This represents the difference between the price a
seller receives for a good and the price that they were willing to receive for
that good or service (seller reservation price)
○ If the reservation price of a seller is $1 but they sell for $5, they’ve
gained more than what they w1ere willing to sell, thus gaining
producer surplus of $4 ($5 - $1)

Consumer and Producer Surplus

● Note that on a graph, consumer surplus will simply be the area of

reservation price - equilibrium price (this is the yellow area in the picture
below)
● The producer surplus is the green area (see picture below)
● Total Consumer Surplus: ​This represents the sum of the economic
surplus of all consumers
● Total Producer Surplus: ​This represents the sum of the economic surplus
of all producers
● Total Surplus: ​This is the sum of the Total Consumer Surplus and Total
Producer Surplus

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● Total surplus is maximised at the equilibrium price

● The graph below simply shows the total consumer surplus and total
producer surplus for smooth demand and supply curves

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Pareto Efficiency (Short Run)

● Pareto Efficiency: ​This is a situation where it is impossible to make any

individual better off without making at least one individual worse off
● Pareto Improving Transaction: ​This is a transaction where all parties
involved are better off
● The perfectly competitive market equilibrium is ​Pareto Efficient
● Note that Pareto efficiency should not be an ideal situation
○ If we take $10 from a rich man and give it to a poor man, this
violates Pareto efficiency (it is not a Pareto Improving Transaction
because the rich man is worse off)
○ Other important objectives exist such as equity

The Invisible Hand (Long Run)

● The Invisible Hand Principle: ​The invisible hand principle states that
individuals’ independent efforts to maximise their gains (profits for sellers
and utility for buyers) will generally be beneficial for society and result in
the socially optimal allocation of resources
● If firms in a market are making positive profits, there is an incentive for new
ones to enter the market. This will cause the supply curve to shift to the
right and which in turn, reduces the equilibrium price

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● As illustrated in the diagram above, there is profit and thus, more firms will
enter the market. The resulting effect is shown in the picture below:

● Profits will reduce since the equilibrium price has decreased

● Entry into the market will continue in this fashion until all firms in the market
are making exactly zero profit (we also assume that the cost curves are
identical for all firms (they have the same productive technology))
○ Note that price will reduce to the point where the equilibrium price
will equal the minimum ATC ​(this should make sense because
there will be zero profit if the price is at the minimum ATC)
● A similar process would occur whenever firms make negative profits
○ Firms would exit the market, supply curve will shift to the left and
equilibrium price will increase. This process will continue until all
firms remaining make zero profit (or zero loss in this case)

The Long Run Supply Curve

● As set out above, the long run supply curve will be a horizontal line that is
equal to the minimum average total cost

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● In the short run, an increase in the quantity demanded (push demand

curve to the right) raises the price and quantity, whereas in the long run,
the price is more likely to be stable and what changes is the quantity
○ This is due to the fact that new suppliers enter the market which will
offset the increase in price
● In other words, we can say that ​supply is more elastic in the long run​ (it
becomes a horizontal line)
● Note that the long run supply curve is only horizontal if all firms have the
same productive technology

Chapter 5: Perfectly Competitive Markets (Government Intervention: The

cost of interfering with Market Forces)

● Any government intervention that prevents a market from reaching its

equilibrium price must have a negative effect on total surplus

Price Ceiling

● The price ceiling represents a maximum allowable price imposed by the

government
● Let’s say equilibrium price is $100. If the price ceiling was set to $80, the
price won’t be able to rise above the ceiling (note that any price ceiling set
above equilibrium would have no effect)

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● The price ceiling forces the price down, creating excess demand
● The buyers with the highest willingness to pay can acquire the good at a
lower cost price, thus the surplus increases (area A’) compared to their
surplus before the price ceiling (area A)

● However, a certain group of consumers will be left unserved after the price
ceiling is introduced since the reduction in price results in a decrease in the
quantity supplied. The amount of surplus lost is area B (the pink area in
picture below)

● Furthermore, producers are also worse off as their initial surplus (area C) is
larger than the final one (area C’) (see picture below)

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● Deadweight loss: ​This is the loss in economic surplus due to the market
being prevented from reaching the equilibrium price and quantity where
marginal benefit equals marginal cost

● As such, tinkering with the market reduces total surplus

● The winners from this policy are consumers with a high willingness to pay -
therefore this policy is likely to transfer surplus from the poor to rich instead
of improving equity

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Price Floor

● The price floor represents a minimum allowable price imposed by the

government
● A price floor is essentially the opposite of a price ceiling
○ If price floor is set below the market price, it will have no effect
whatsoever
● Price floors generate excess supply (not enough buyers)
● The producers that manage to sell the good benefit from this higher price
● Producers that don’t manage to sell off their goods experience a reduction
in surplus

● Consumers are also worse off since some won’t be able to afford the
higher price
● In this case, the losers are the consumers that can’t buy and producers
that don’t sell
○ Another loser are consumers that currently buy and have to pay a
higher price
● The only winners are the producers that manage to sell their product

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Taxation

● For simplicity, we assume that tax is levied on producers (although the

same results would apply even if we levied the tax on consumers)
● From the POV of the producer, a tax is similar to an increase in production
cost by exactly the amount of the tax
○ The marginal cost increases by exactly the tax amount
● Hence, introduction of tax shifts the supply curve to the left, ​where the
vertical distance between the original and shifted supply curve is equal to
the tax amount

● By introducing the tax, consumer surplus will decline due to the increase in
price
● Now let’s say that there is a $1 tax (levied on per unit of good produced)
and as a result of this $1 tax, the price increase is $0.5
○ Hence, the consumers bear a fraction of the tax burden (they would
bear the full amount if the price rose by $1)
● The remaining part of the tax burden is borne by producers (in this case,
$0.5 would be borne by the producers since the other $0.5 was borne by
consumers)
● To determine the government tax revenue, this should be the tax amount
(in our case, $1) multiplied by the quantity supplied after the tax (this is the
red area in the diagram)

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● Also note that a deadweight loss occurs in this situation

○ Whilst there is a deadweight loss, it is important to remember that
tax is vital to society as the government provides a range of public
services and goods
● We also need to determine what is the most efficient way of collecting of
collecting tax revenue
○ This will depend on the responsiveness of demand and supply with
respect to tax changes
● The more elastic demand and supply are at the initial equilibrium price, the
bigger the deadweight loss
○ If supply and demand are highly elastic, even a small tax will lead to
a large reduction in the quantity demanded and supplied
● Thus if the government needs to impose a tax, the most effective way of
doing it is to apply it to the less responsive market

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Subsidy

● A subsidy is essentially the opposite of a tax

● Assume that a per-unit $1 subsidy is applied to sellers
○ As such, the marginal cost decreases by $1
● Supply curve shifts to the right
● Note that a subsidy is a cost for the government (area is set out in diagram
below)

● Also note that the total surplus after a subsidy is C’ + P’ - S

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● Also in the diagram above, the red area is the deadweight loss
● A better option than a subsidy would be to lump-sum transfer from the rich
to the poor

Chapter 6: Perfectly Competitive Markets (International Trade)

● Domestic Price: ​Domestic price represents the equilibrium price that

would occur in a country if no international trade is allowed
● World Price: ​World price represents the equilibrium price on the
international market
● Small Open Economy: ​A small open economy is an economy that
participates in international markets for goods and services, but its
production or consumption is small enough to the rest of the world that its
supply or demand does not affect the world price
○ These economies take the world price as given (price-takers)

Exporting Country

● Let’s say the price of rabbits domestically is $10 and the world price is $15.
Without trade, the price will obviously remain at $10 (equilibrium). However
with trade (assuming there are no trade restrictions), domestic suppliers
are willing to sell to overseas producers at $15

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● If the domestic price is ​smaller than t​ he world price, a country has a

comparative advantage in producing a good and will become an ​exporter
upon opening up to international trade
● Opening up to trade leads to an increase in total surplus
○ Look at diagram above
○ At the world price, consumer surplus will decrease to A (this was A +
B + C at the domestic price)
○ However, producer surplus will grow to B+C+D+E+F (it was only
E+F) at the domestic price
○ As such, total surplus is now A+B+C+D+E+F (previously, it was only
(A+B+C+E+F)
● Closed Economy: ​A closed economy is an economy that does not
engage in international trade. AKA ‘autarky’
● Open Economy: ​An open economy is an economy that engages in
international trade
● Gains from trade: ​The gains from trade capture the extra total surplus
available in an open economy situation compared to a closed economy

Importing Country

● Suppose the price of bananas is $3 without trade (domestic price) but it is

only $2 on the international market

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● Before imports, total surplus was A+B+E

● After imports, total surplus is A+B+C+D+E (Producer surplus declines to E
but consumer surplus grows to A+B+C+D

Winners and Losers from International Trade

● Total surplus is always higher with trade than without (assuming that there
are no trade restrictions like tariffs or quotas)
○ However, domestic consumers lose surplus when producers export
and sell goods at the higher world price
○ Domestic producers lose surplus when the country starts to import
cheaper goods
○ This is what leads to trade restrictions by lobbying the government

Other benefits include:

● Consumers get access to a wider variety of goods

● Producers may take advantage of economies of scale by selling to a larger
market
● Domestic monopolies or oligopolies might face international competition,
thus reducing their market share
● The flow of ideas and technology is faster and easier

Trade Restrictions

● Import Tariff: ​This is a tax on imported goods or services

● Import Quota: ​This represents a quantity limit on
● Let’s look at tariffs first

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● Due to the tariff of $10 (which increases the price from $15 to $25),
consumers will lose the surplus of H, I, J and K
● Domestic producers gain H through the increase in price
● The government gains J through tariff revenue
● I and K become deadweight loss

● Another policy is an import quota which directly changes the quantity of

imports
● Using the same figures from the previous graph, let’s say the government
restricts imports to 2,000 units
● To find the equilibrium with the quota, we take the supply from domestic
producers and add the 2000 units in the quota of imported goods

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● Price will be $25 and consumers will buy 6,000 books in total (4,000
domestically, 2,000 in imports)
● The impact on consumer surplus is the same as the tariff; it falls by
H+I+J+K
● Surplus of producers will rise by H again
● The area J will go to importing agents (they buy at $15 and sell at $25)
○ If the government charges a fee to importing agents, then
government revenue would be the same as tariff revenue
● Deadweight loss is also I + K

Chapter 7: Imperfectly Competitive Markets

● Refer back to the characteristics of perfectly competitive markets. An

imperfectly competitive market fails to satisfy at least one of those
categories
● Market Power: ​A firm has market power if it has the ability to set its own
price
● Firms with market power are said to be ​price makers ​or price setters, in
that they have the ability to set their own prices

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○ If a price-setting firm increases prices, it does not lose all its

customers (just some)
○ This is in contrast to a price taker where if they raise prices, they
lose ​all ​customers

● A market composed of firms that are price-setters is said to be an

imperfectly competitive market. There are three main forms of imperfectly
competitive markets:
○ Monopoly: ​There is only one firm in the market. Hence, the
individual’s demand curve coincides with the market’s demand curve
○ Monopolistic competition: ​There is a large number of firms, each
producing a slightly differentiated product.
○ Oligopolistic Competition: ​There is a small number of firms that
sell goods that are close substitutes

Determinants of Market Power

● As soon as there are barriers to entry, market power is likely to arise. A list
of barriers to entry include:
○ Control over scarce resources: ​If a firm has exclusive control over
key inputs of production, it might be impossible for other firms to
enter the market
○ Government-Created Barriers to Entry: ​This is through issuing
patents, offering copyright protection or granting licenses. If a

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company holds a patent for a drug, no other company can produce

that product
○ Increasing Returns to Scale: ​AKA Economies of scale, the ATC of
producing a good decreases with the amount of the good produced.
In this case, a firm producing a large quantity of a good can do so
more efficiently than other firms
■ Natural Monopoly: ​This denotes a monopoly that occurs
because of economies of scale
○ Network Economies: ​This emerges when customer satisfaction
with a given product increases with the number of users (E.g.
Facebook). This is similar to economies of scale because in both
cases, a company’s position gets stronger and stronger as it
expands production.

Monopoly

● Monopoly is a market structure where there is only one firm operating in

the market
● Firms operating in a monopoly are called a ​monopolist
● The demand curve for a monopolist is the same as the demand curve for
the entire market and this demand curve is unlikely to be horizontal
○ A monopolist faces a downwards sloping demand curve - they need
to reduce price to increase the quantity sold
● We compute marginal revenue in the following way:

ΔR
Marginal Revenue = ΔQ

● Now that we know this, we know how to maximize the monopolist’s profit.
Simply expand production until the marginal revenue equals the marginal
cost

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● In the case above, the monopolist maximises its profit by hiring 3

employees and selling 600 units per day at $0.45 each

Monopoly and the Invisible Hand

● Remember that the demand curve represents the marginal benefit or

reservation price
● Under the cost benefit principle, a firm should continue to produce until
marginal benefit is greater than or equal to the marginal cost (in the case
above, the firm would produce 5 units)
● However as set out before, the firm is at its most profitable point when
producing 3 units (note that marginal revenue and marginal benefit are
very different things)
● As such, the price or quantity that maximises profitability does not
maximise the surplus for society

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● For the monopolist, there is an implicit cost in increasing the quantity sold
(to increase quantity, they need to reduce price to attract more customers)
● Thus, equilibrium production level is lower than the socially optimal one
(600 units as opposed to 1000 units)
● The deadweight loss in this situation is the red area (due to the fact that
the monopolist does not select the socially optimal quantity)
● It is clear that the ​invisible hand principle ​does not apply in this case (the
principle says that individual’s independent efforts to maximise their gains
(profits for sellers and utility for buyers) will generally be beneficial for
society and result in a socially optimal allocation of resources

Government Regulation

● A simple way of solving these inefficiencies is to stimulate competition by

encouraging new firms to enter the market
○ This is through competition laws
● Competition Law: ​Competition law denotes laws intended to foster market
competition by regulating the anti-competitive conduct of firms
○ The main objective of these laws is to ensure that consumers are
charged the lowest possible prices
● However in the case of a natural monopoly, government intervention might
create inefficiencies since a single firm producing a large quantity can do
so much more efficiently than a large number of firms each producing a
small quantity
● To regulate against natural monopolies, governments can regulate the
price at which the monopolist is allowed to sell its products
● Average Cost Pricing: ​This denotes a policy through which the
government forces the monopolist to set the price and quantity at the
intersection of the ATC and the demand curve - this eliminates any positive
profit accrued to the monopolist
● However, average cost pricing is hard to implement because:

1) The government can only estimate the ATC (it does not know actual, exact
figures)

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2) Once this policy is in place, firms have no incentive to invest in new

technology to lower their production costs - they make zero profit either
way
3) By using average cost pricing, the firm’s output is ​allocatively inefficient.
This is due to the fact that price usually exceeds the marginal cost

First Degree Price Discrimination

● One of the reasons as to why a monopolist does not produce enough -

produce less than what is socially optimal - is that it needs to set the same
price for all consumers
● First Degree Price Discrimination: ​This describes a situation where the
producer knows the reservation price of each consumer and is able to
charge each consumer their reservation price
● Let’s go back to our previous table and see how the monopolist’s decision
changes when first degree price discrimination is allowed

● Note that this changes marginal revenue

● In this case, the optimal quantity becomes 5 units (they sell at the socially
optimal quantity)
● However, note that the issue with this is that consumers get zero surplus
(they are charged at their reservation price) whereas the supplier accrues
all the surplus

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Other Forms of Price Discrimination

● First degree price discrimination can fail for a range of reason:

○ Existing laws
○ The inability of a monopolist’s ability to learn the different reservation
prices of different customers
○ There is the risk that consumers can buy at the lower price and sell
at a higher price to those with a higher reservation price
● Other forms of price discrimination include:
● Second Degree Price Discrimination: ​the monopolist charges different
prices based on the quantity demanded by each consumer. If a consumer
buys a larger quantity, they will be charged a lower amount per unit (bulk
discount)
● Third Degree Price Discrimination: ​the monopolist charges different
prices depending on observable consumer attributes such as location
○ (this leads to a shift in surplus from the monopolist to the consumer)

● Note that marginal benefit = demand = price

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Chapter 8: Imperfectly Competitive Markets (Oligopoly)

● An oligopoly is market structure that features a small number of

dominant firms
○ Australian media outlet industry (news corp, time warner &
fairfax media)
● A ​Simultaneous Game ​is a game where players move
simultaneously or, alternatively, they are unaware of the other
player’s actions

Simple Entry Game

● A ​dominant strategy ​represents a strategy that is preferred by a

player irrespective of the strategy selected by the other player

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● This solution concept is called ​iterated elimination of dominated

strategies ​and involves iteratively removing strategies that are not
dominant

Prisoner’s Dilemma Game

● The prisoner’s dilemma game is a type of game where firms or

individuals fail to cooperate even though doing so would be beneficial
to both of them
● Note that by introducing strategic interactions, this violates the
Invisible Hand Principle where the individual quest for profit might not
translate into socially optimal allocation of resources

● Essentially, both parties face negative effects by taking on their

respective dominant strategies in a Prisoner’s Dilemma game

Cartel Game

● Cartels ​represent private agreements aimed at increasing the profit

of the cartel members by reducing competition in the market
○ A Cartel Game is the same as a prisoner’s dilemma game - the
only difference is that it translates to benefits for society

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○ Collusion is much more likely in an oligopoly since there are

only a small number of firms
● This is done by controlling prices or preventing new competitors from
entering the market
● This is the purpose of competition laws - to ensure that firms do not
engage in cartel conduct and that consumers are charged the lowest
possible prices

The Coordination Game

● These are a type of game where the players benefit from coordinating
their decisions
● A ​strategy profile ​denote a set of strategies, one for each player.
● Nash Equilibrium - ​a strategy profile is a Nash Equilibrium if no
player can benefit from ​unilaterally ​changing their strategy

Chapter 9: Imperfectly Competitive Markets (Externalities)

Positive Consumption Externality

● A positive consumption externality represents a benefit accrued to

someone who is not involved in the consumption of the given good

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● In the diagram above, the red curve represents the social demand
curve
● The marginal external benefit is $2 (see the horizontal red line at the
bottom)
○ As such, we get the red lines by shifting the blue line upwards
by $2 (vertical distance is marginal external benefit)
● Looking at the graph above, assume the market price is $8
● If you only considered your own marginal benefit, you would consume
4 units of the good (marginal benefit would be = $8 and this is equal
to the marginal cost)
● However, the socially optimal quantity is 6 units (the social demand
curve is $8 when you consume 6 units)
● By making consumption decisions without accounting for external
benefits, you are not maximising social surplus. This results in a
deadweight loss (see diagram below)

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● This highlights the limitations of the invisible hand principle where the
action which maximises personal satisfaction does not translate to
the optimal amount of consumption for society as a whole
● To solve this problem, parties can undergo a ​private negotiation
○ The person gaining the marginal external benefits can pay $2 to
get the consumer to consume 2 more units of the good
● Coase Theorem: ​this theorem states that if trade in an externality is
possible and there are no transaction costs, bargaining will lead to an
efficient outcome regardless of the initial allocation of property rights
○ This is also the idea that inefficiency arising from externalities
can be solved without government intervention
● Other examples of positive consumption externalities include:
○ Fitness activities - reduces health care for society
○ Vaccinations - by being vaccinated, an individual reduces the
likelihood that others get infected

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○ Education - by acquiring an education, an individual has a

positive impact on society
○ Social networking - by participating in social networks, an
individual has the potential to enrich the experience for other
members of the network
Negative Production Externality

● A negative production externality represents a cost incurred by

someone who is not involved in the production of a given good

● The private marginal cost is illustrated in the left panel

● However, the marginal external cost is $1 (blue horizontal line). As
such, this external cost needs to be accounted for in the price of the
good
● Let’s assume that the market price of this good is $3
● When you produce 3 units of the good, your personal marginal
benefit ($3) is equal to the marginal cost ($3)
● However in the presence of negative externalities, when you produce
3 units, the social marginal cost ($4) is greater than the marginal
benefit ($3) (leading to a negative surplus of $1)

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● The socially optimal quantity occurs when you produce 2 units (the
social marginal cost will be $3 which is equal to the benefit you gain)
● Similarly, this problem can also be solved by private bargaining.
Someone could offer you $1 to decrease production by one unit
● Examples of negative production externalities include:
○ Harmful production activities - increase water, noise and air
pollution
○ Excessive risk taking - banks can kickstart global financial
crises
○ Overfishing - depletes stock of fish in the ocean

Externalities in Large Markets

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● Now let’s consider a market with many buyers and sellers (smooth
demand and supply curves)

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● Note that panel A shows the social demand curve in a market with
positive consumption externalities. Panel B shows the social supply
curve in a market with negative production externalities
● It is important to note that in this a market with a large number of
buyers and sellers, the Coase theorem no longer applies since the
sheer number of buyers and sellers creates high transaction costs
● As such, government intervention is necessary to fix what the market
cannot handle (subsidies and taxes)
● We know that subsidies can stimulate consumption by shifting the
demand curve to the right
● A tax equal to the marginal external cost would shift the private
supply curve to the left

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Negative Consumption Externality

● A negative consumption externality represents a cost incurred by

someone who is not involved in the consumption of a given good
● Examples of a negative consumption externalities include:
○ Smoking - second hand smoke
○ Alcohol abuse - increases health care costs for society
○ Driving - increases traffic congestion and pollution

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Chapter 10: Imperfectly Competitive Markets (Public Goods)

Non-Rivalry and Non-Excludability

● Private goods are rivalrous and excludable

○ A good is rivalrous if its consumption prevents someone else
from consuming it
○ A good is excludable if you can exclude someone else for
consuming it
● Public goods are neither rivalrous or excludable
○ Non rivalry - ​one individual’s consumption of the good does not
impede another individual from consuming it as well: the
marginal cost of providing the public good to an additional
individual is equal to zero
○ Non-excludability - ​no one can be excluded from consuming
the good
● Goods that are ​perfectly ​non rivalrous and non excludable are called
pure public goods
● Goods that are non rivalrous and non excludable up to a point are
called ​impure public goods
○ Some goods are non rivalrous but are excludable - a typical
example is pay TV where unless you pay a subscription, you
can be excluded. However, it is not rivalrous because your
consumption doesn’t stop someone else from consuming it
○ Some goods are non excludable but are rivalrous. An example
is a motorway where anyone can access it (assuming there are
no tolls) but as you consume it, you stop others from doing the
same (congestion)
● Typically, most public goods are only pure up to a point (very rare for
a good to be perfectly public)

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Aggregating Individual Demands: Marginal Social Benefit and

Efficiency

● Remember to construct the aggregate demand for a private good,

you sum up the individual demands horizontally
○ The same concept does not apply to a public good
○ For a public good, we sum the demands ​vertically
● Marginal Social Benefit - ​The marginal social benefit is the vertical
sum of the individual marginal benefits (demand curves)
● Suppose the marginal cost of cleaning is $30/hr (see horizontal line
below)

● As long as the marginal social benefit (gray curve) is greater than the
marginal cost, you should hire the cleaner
● When setting marginal social benefit equal to the marginal cost, what
we’re really doing is setting the sum of the individual marginal
benefits equal to the marginal cost
● The ​Samuelson Condition ​states that the efficient quantity of a
public good is found by setting the sum of the individual marginal
benefits equal to the marginal cost

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Market Provision and Free Riding

http://lionsheartstudios-publishing.com/unsw/ch_10_pg_3/

(read everything in here)

Public Goods and Externalities

● A public good is an extreme case of positive externalities

● A similarity between positive externalities and public goods are that
they are both under-provided by the market

Market, Government and Taxation

● Markets are not well equipped to provide public goods

○ One of the main reasons are free riders
● This is why governments interfere with free markets and impose
taxation to provide public goods such as national defence, education
and infrastructure
● Governments could tax people respectively on their Lindahl prices
○ This possible if each person’s marginal were common
knowledge
○ However in reality, the willingness to pay is private information
and people would have an incentive to understate their true
valuations, hoping to free ride on the provision of others
● As a result, taxation tends to follow two fairness principles
○ Richer people pay more (progressive taxation)
○ They tend to tax on a pay-as-you-go principle, imposing a
higher burden on those who use it more often (tolls on bridges
and tunnels)

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