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Summary Microeconomics, 1st year

Micro/Macro Economics year 1 (Maastricht University)

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Microeconomics EBC1010 Summary

Author: Ferdinand Kraemer

Chapter 1 - Introduction
1.1 Microeconomics: the study of the allocation of scare resources
Society faces three key trade-offs:
- Which goods and services to produce
- How to produce
- Who gets the goods and services
Markets: exchange mechanism that allows buyers to trade with sellers

1.2
Model: description of relationship between two or more economic variables.
Positive statement: testable hypothesis about cause and effect.
- What will happen?
Normative statements: conclusion as to whether something is good or bad.
- What should happen?

1.3 Microeconomic models: explain why economic decision are made and allows
making predictions.
- Individuals: to make purchasing and other decisions

Chapter 2 – Supply and Demand

Supply & Demand model: describes how consumers and suppliers interact to
determine Q of a good or service and P.

2.1 Demand
Potential consumers decide how much of a good or service to buy on the basis of its
price and:
- Tastes
- Information
- Prices of other goods
- Substitute – product that you see as similar or identical.
- Complement – product that you like to consume at the same time.
- Income
- Government rules and regulations

Quantity demanded: amount of a good that consumers are willing to buy at a given
price, holding other factors that influence purchases constant.

Demand curve: quantity demanded at each possible price, holding other factors that
influence purchases constant

Law of demand: Consumers demand more of a good the lower the price, other
factors holding constant. => Demand curves slope downward

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Change in any factor other than price of good: causes a shift of demand curve
Change in price: causes a movement along the demand curve

2.2. Supply
Firms determine how much of a good to supply on the basis of the price of that good
and other factors:
- Costs
- Government rules and regulations

Quantity supplied: amount of a good that firms want to sell at a given price, holding
other factors constant.

Supply curve: shows Q supplied at each possible price, holding other factors
constant.

Change in any factor other than price of good: causes a shift of supply curve
Change in price: causes a movement along the supply curve

Summing supply curves: the total supply curve is the horizontal sum of the
domestic and foreign supply curve.

Quota: limit a government sets on Q of a foreign-produced good that may be

imported.

2.3. Market Equilibrium

Equilibrium: situation in which no one wants to change his or her behavior.
- Equilibrium quantity
- Equilibrium price

Excess demand: amount by which Q demanded exceeds Q supplied at a specific

price.

Excess supply: amount by which Q supplied exceeds Q demanded at a specific

price.

2.4 Shocking the Equilibrium

Equilibrium changes only if a shock occurs that shifts demand or supply curve.

2.5. Effects of Government Interventions

Price ceiling at p: e price at which goods are sold may not be higher than p. Price
ceilings have no effect if they are set above the equilibrium price.
Price floors at p: the price at which goods are sold may not be fall below p. Price
floors have no effect if they are set below the equilibrium price.
Shortage: persistent excess demand

2.6 When to Use the Supply and Demand Model

Markets are:
- Everyone is a price taker
- Firms sell identical products
- Everyone has full information about the price and quality of goods
- Costs of trading are low
 perfectly competitive markets

Transaction costs: expenses of finding a trading partner.

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Chapter 3- Applying Supply and Demand Model

3.1 How shapes of Supply and Demand Curves Matter
- Shape of demand and supply curves determine by how much a shock affects the
equilibrium price and quantity.
- The amount consumers spend rises by more when the demand curve is vertical
instead of downward sloping.

3.2 Sensitivity of Quantity demanded to price

Elasticity: percentage change in one variable in response to a given percentage
change in another variable.

Price Elasticity of demand, : percentage change in Q demanded, in response to a

given percentage change in P, at a particular point on the demand curve.

 = (Q/Q) / (p/p)

- The elasticity of demand answers the question: “How much does quantity
demanded fall (in percent) in response to a 1% increase in price.”

The demand curve is:

- perfectly inelastic if ε=0
- inelastic if 0>ε>-1 (if ε is between 0 and –1)
- unitary elastic if ε=-1
- elastic if ε<-1
- perfectly elastic if ε approaches negative infinity

A vertical demand curve is perfectly inelastic at every price

A horizontal demand curve is perfectly elastic.

Income Elasticity of demand, : percentage change in Q in response to a given

percentage change in income.

= DQ/Q = DQ * Y
ΔY/Y ΔY * Q

Cross-price Elasticity of demand: percentage change in Q in response to a given

percentage change in the price of another good.

CPE= DQ/Q = DQ * p(o)

Δp(o)/p(o) Δp(o) * Q

 When negative, goods are complements

 When positive, goods are substitutes

3.3 Sensitivity of Quantity Supplied to price

Price elasticity of Supply, : percentage change in Q supplied in response to a
given percentage change in the price.

= DQ/Q = DQ * p
Δp/p Δp * Q

Analogous (except for the minus of the demand elasticity), the supply curve is:

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- perfectly inelastic if η=0

- inelastic if 0<η<1 (if η is between 0 and 1)
- unitary elastic if η=1
- elastic if η>1
- perfectly elastic if η approaches positive infinity

3.4. Long Run vs. Short Run

- The shape of the demand and supply curves depend on the relevant time period.
Often one can substitute between products in the long run, but not in the short run.
- For good that can be stored easily, short-run demand curves may be more elastic
than long- run curves.
- If producers can increase output at lower extra cost in the long run than the short
run, the long run elasticity of supply is greater than the short run elasticity.

3.5. Effects of a Sales Tax

- Most common tax is the ad valorem tax by economists and the sales tax by
real people. For every dollar the consumer spends, the government keeps a
fraction, , which is the ad valorem tax rate
- Other types of sales tax is specific or unit tax, where a specific dollar amount,
, is collected per unit of output.
- Specific tax causes the equilibrium price consumers pay to rise, the equilibrium
quantity to fall and tax revenue to rise.
- Effect of a specific tax on the equilibrium price and the quantity depends on the
elasticity of supply and demand.

η * Dt
D=
h-ε

For a given supply elasticity, the more elastic demand is, the less the equilibrium
price rises when a tax is imposed.
For a given demand elasticity, the greater supply elasticity, the larger the increase in
the equilibrium price consumers pay when a tax is imposed.

Incidence of a tax on consumers: share of the tax that falls on consumers.

p /  

The more elastic the demand at the equilibrium, holding supply elasticity constant,
the lower the burden of the tax on consumers.
The greater the supply elasticity, holding the demand elasticity constant the greater
the burden on consumers.

- Firms can pass along the full cost of a specific tax only when the demand or supply
elasticity takes on certain extreme values.
- When a demand curve becomes relatively inelastic (ε approaches zero) or the
supply curve becomes relatively elastic (η becomes very large) the incidence of the
tax falls mainly on consumers.
- Sales tax harms consumers and producers by reducing the equilibrium quantity.
- A specific tax, regardless of whether the tax is collected from consumers or
producers, creates a wedge equal to the per-unit tax of τ between the price
consumers pay, p, and the price suppliers receive, p-τ.
- An ad valorem tax also shifts either the supply or the demand curve, but as it is not
a unit tax, the tax rate is lower at low prices and higher at higher prices. Therefore,
we do not encounter a parallel shift, but a move along one point.

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In short, regardless of whether firms or consumers pay the tax to the

government, you can solve tax problems by shifting the supply curve, shifting
the demand curve, or using a wedge. All three approaches give the same
answer.

Chapter 4- Consumer Choice

Consumer behavior is based on following premises:
- Individual tastes or preferences
- Consumers face constraints on their choices
- Consumers maximize their well-being or pleasure from consumption.

4.1 . Preferences
Consumer must allocate his money to by a bundle (combination) of goods.

Critical assumptions about properties of consumers’ preferences:

1. Completeness: consumer prefers the first bundle to the second, prefers
the second to the first or is indifferent between them
2. Transitivity: consumer prefers bundle a to bundle b and prefers bundle b
to bundle c => he prefers bundle a to bundle c.
3. More is better
Good: commodity for which more is preferred to less
Bad: something for which less I preferred to more (pollution)

Indifference curve: set of all bundles of goods that a consumer views as being
equally desirable.

Indifference map: complete set of indifference curves that summarize a consumer’s

taste.

Properties of indifference curves:

1. Indifference curves farther from the origin are preferred to those closer to the
origin.
2. There is a indifference curve through every possible bundle
3. Indifference curves cannot cross
4. Indifference curves slope downward.

Marginal rate of substitution, MRS: maximum amount to one good a consumer will
sacrifice to obtain one more unit of another good. => Willingness to trade

MRS = B / Z

Marginal rate of substitution is the slope of indifference curve.

Diminishing marginal rate of substitution: marginal rate of substitution

approaches to zero as we move down and to the right along an indifference curve.

Perfect substitutes: goods that a consumer is completely indifferent as to which to

consume. => Straight indifference curves.

Perfect complements: goods that a consumer is interested in consuming only in

fixed proportions. => Rectangular indifference curves.

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4.2 Utility
Utility: set of numerical values that reflect the relative rankings of various bundles of
goods.

Utility function: relationship between utility measures and every possible bundle of
goods.

Ordinal measures: tells us the relative ranking of two things bur not how much more
one is rank than another.

Cardinal measure: absolute comparisons between ranks may be made.

Marginal utility: extra utility that you get from consuming the last unit of a good.
Slope of the utility function, as we hold the other factors constant.

MU = U / Z

MRS = U / Z = - MU (Z) / MU (B)

HORIZONTAL AXIS / VERTICAL AXIS!!!!

4.3 Budget Constraint

p(B)*B + p(Z)*Z = Y

Budget line (budget constraint): bundles of goods that can be bought if the entire
budget is spent on those goods at given prices.

Opportunity set: all bundles a consumer can buy, including all the bundles inside
the budget constraint and on the budget constraint.

Marginal rate of transformation (MRT): trade-off the market imposes on the

consumer in terms of the amount of one good the consumer must give up to obtain
more of the other good.
slope of the budget line

DB p(z)
MRT = = -
DZ p(B)

HORIZONTAL AXIS / VERTICAL AXIS!!!!

Changes in income only affect the position and not the slope of the budget line

4.4 Constrained Consumer Choice

Consumers choose combination of bundle that maximize their utility

Consumers’ optimum: optimal bundle must lie on the budget constraint and be on
an indifference curve that does not cross it.

Interior solution: optimal bundle has positive quantities of both goods.

MU(Z) p(Z)
MRS = - = - = MRT
MU(B) p(B)

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MU(B) MU(B)
=> =
p(Z) p(B)
Corner solution: optimal bundle is at the one end or the other end of the budget
line: it is at a corner with one of the axes.

4.5 Behavioral Economics

Behavioral economics: adds insight from psychology and empirical research on
human cognition and emotional biases to the rational economic model to better
predict economic decision-making.

Endowment Effect: people place a higher value on a good if they own it than they
do if they are considering buying it.

Salience: people are more likely to consider information if it is presented in a way

that grabs attention or if it takes relatively little thought or calculation to understand.

Bounded rationality: people have a limited capacity to anticipate, solve complex

problems or enumerate all options.

Chapter 5: Applying Consumer Theory

5.1 Deriving Demand Curves: see p. 113
Demand curves can be found by using the information about tastes from indifference
curves. Therefore, we estimate a set of indifference curves for to goods and draw
them into a panel with the amount of each product on both axes.. Then we hold all
variables (e.g. budget, tastes and variable of the good on the y-axis) constant
EXCEPT the price of the good on the x-axis. From this information, we can draw the
curves that measure the possible choices of amounts to consume for various price
levels (this can be viewed as finding the “budget constraint” vertical lines), as with
differing prices of one commodity more can be bought. Then we find the single
intersection with an indifference curve (as with the optimal bundle in the consumer
choice), on which the optimal bundle is consumed. Through all these points we can
draw a curve, which is called the price-consumption curve (PCC). To get to our
demand curve, we now have to read off the quantities for the good on the x-axis from
this curve at all prices. Finally, given these two information (namely price and
observed quantity), we can construct a new panel (price on the y-axis, quantity on
the x-axis ⇒ see Chapter 2), that gives us the demand curve for all prices.

Price – consumption curve: line through the equilibrium bundles that a person
would consume at each price beer, when the price of wine and the persons budget
are held constant.

5.2 How changes in Income Shift Demand Curve, see p.114

A similar technique is used to illustrate the shifts in demand curve created by income
shifts. We again keep all variable constant except income. A change in income will
create a parallel shift of the budget constraint. We therefore look at the intersections
(optimal bundles) of the indifference curves at changing income levels. The curve
through these is called income- consumption curve (ICC). As we have changed
income levels, quantity responded to it, while prices stayed constant. Therefore, in
our new panel showing the demand function (price on the y-axis, quantity on the x-
axis ⇒ see Chapter 2), we have a fixed price but observe a change of quantity
because of our income change. The only conclusion possible is that our demand
function from before shifts.

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Engel Curve: shows the relationship between Q demanded of a single good and
income, holding prices constant. This means that we now have income on the
vertical axis (instead of price for demand curves) and the quantity on the horizontal
axis. The technique (as explained above) stays the same though, as we can read off
demanded quantities of one good in response to income and construct a curve from
this information.

Normal good: if much or more is demanded as income rises

Inferior good: if less is demanded as income rises.

5.3 Effect of a price change

Total Effect: Substitution Effect + Income Effect

Substitution effect: change in Q of a good that a consumer demands when the

goods price rises, holding other prices and the consumer’s utility constant.
This means, we express a consumer’s changed consumption behavior while staying
on the same indifference curve. We find this effect by drawing a parallel line to our
new budget line (after the price change) that intersects our old indifference curve.
The change in quantity as a number is then the substitution effect.
Unambiguous: More of a good is demanded as the price falls and vice versa.

Income Effect: change in Q of a good a consumer demands because of a change in

income, holding prices constant. This new income is in fact the budget line after the
price change. The change in quantity here is the difference between the new
equilibrium quantity and the equilibrium quantity we observed by shifting the budget
line.

Ambiguous: Direction of the income effect (the sign of it) elasticity (whether a good
is normal or inferior).
- Case 1: The good is a normal good, therefore the total effect is positive (for
price decreases) or negative (for price increases). Both substitution and
income effect have the same direction.
- Case 2: If the good is an inferior good, the we have two cases again:
1. Income effect < Substitution effect ⇒ Total effect moves into the same
direction as the substitution effect.
2. Income effect > Substitution effect ⇒ Total effect moves into the
opposite direction of the substitution effect.
- A good is called a Giffen good if a decrease in its price causes the quantity
demanded to fall. The contradiction of this definition with the Law of Demand is
solved by the fact that the LOD is an empirical regularity and that hardly any, if
no, giffen goods actually exist.

Chapter 6: Firms and Production

6.1. Ownership and Management of Firms
Firm: organization that converts inputs such as labor, materials, and capital into
outputs, the goods and services that it sells.

- Sole proprietorships: firms owned and run by a single individual

- Partnership: business jointly owned and controlled by two or more people

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- Corporations: owned by shareholders in proportion to the number of shares of

stock they hold.

Sole proprietors and partners are personally responsible for the debts of their
firms. All of an owner’s personal wealth is at risk if the business becomes bankrupt.
In contrast, owners of corporations have limited liability: the most that shareholders
can lose if the firm goes bankrupt is the amount they paid for their stock.

Firms’ owners try to maximize profit, :

=R–C (R = p x q)

To maximize , firm must produce as efficiently as possible.

Efficient production (achieves technological efficiency): if it cannot produce its
current level of output with fewer inputs, given existing knowledge about technology
and the organization of production.

6.2. Production
Inputs can be grouped into following groups:
- Capital (K)
- Labor (L)
- Materials (M)

Production function: relationship between Q of inputs used and the maximum Q of

output that can be produced, given current knowledge about technology and
organization.

Short run: period of time so brief that at least one factor of production cannot be
varied. => Fixed input, variable input

Long run: lengthy period of time that all inputs can be varied.

6.3 Short-run Production

Capital is fixed input and labor is variable.
q= f(L,K) K is fixed =>K bar

Marginal product of labor, (MPL): change in total output, q, resulting from using
an extra unit of labor, L, holding other factors constant.

MP(L) = q / L

Average product of labor, APL: ratio of output, q, to the number of workers, L,

used to produce that output.

AP(L) = q / L

Total product of labor: output that can be produced by a given amount of labor.

Relationship between the product curves:

- Slope of line from origin to point on the total product curve is the APL.
- MPL is the slope of the tangent that touches on point on the produce curve
- APL curve slopes upwards where MPL curve is above it and slopes downward
where MPL curve is below it.
- APL reaches its peak where the MPL curve crosses it. => the most efficient
production point is at the peak of the APL, as each extra worker adds less

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output.

Law of diminishing returns: of a firm keeps adding one more unit of an input, the
extra output it gets becomes smaller and smaller.

6.4. Long run production

Isoquant: curve that shows the efficient combinations of labor and Capital that can
produce a single level of output.

q = f(L;K) => q Bar, because L & C can be varied.

Properties of isoquants:
1. Isoquant farther from origin, the greater the level of input
2. Isoquants do not cross
3. Isoquants slope downward

Curvature of an isoquant shows how readily a firm can substitute one input for
another
- Straight line isoquant: inputs are perfect substitutes
- Rectangular isoquant: they cannot be substituted for each other

Marginal Rate of substitution, MRTS: number of extra units of one input needed to
replace one unit of another input, by holding output constant

Δ K MPL
MRTS = = -
Δ L MPK

6.5. Returns to scale

Constant returns to scale: when all inputs are increased by a certain percentage,
output increases by that same percentage
Hochzahlen addiert ergeben 1

Increasing returns to scale: when output rises more than in proportion to an equal
increase in inputs
Hochzahlen addiert ergeben > 1

Decreasing returns to scale: when output rises less than in proportion to an equal
increase in inputs.
Hochzahlen addiert ergeben < 1

6.6 Productivity and Technical Change

We can measure the relative productivity of a firm by expressing the firms actual
output, q, as a percentage of the output that the most productive firm in the industry
could have produced, q*, from the same amount of inputs: 100q/q*

Technical Progress: advance in knowledge that allows more output to be produced

with the same level of inputs.
- Neutral technical change: The firm can produce more output using the same
ratio of inputs.
- Non-neutral technical change: Innovations that alter the proportion in which
inputs are use, e.g. labor saving methods - the ratio of labor to other inputs used
to produce a given level of output falls after the innovation.

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Organizational change: May also alter the production function and increase the
amount of output produced by a given amount of inputs (e.g. assembly lines).

Chapter 7 - Costs
Economically efficient: Minimizing the cost of producing a specified amount of
output.

7.1 Measuring Costs

Explicit costs: firms direct, out of pocket payments for inputs to its production
process during a given time period, such as a year.

Implicit costs: inputs that may not have a explicit price.

Economic costs (opportunity costs): value of the best alternative use of a

resource; includes explicit and implicit costs.

Durable goods: a product that is usable for years.

Options to allocate opportunity costs of capital for a company:

- Rent: rental payment is the relevant opportunity cost
- Buy: The opportunity cost is the amount the firm receives if it rents the
commodity to others at the going rental rate.

Sunk costs: Expenditure that cannot be recovered, the opportunity costs of the
capital is zero.

7.2. Short-Run costs

Fixed costs, F: a production expenses that does not vary with output.

Variable Costs, VS: production expenses that vary with the quantity of output
produced.

Cost (total cost), C: Sum of firms variable cost and fixed cost
C = VC + F

Marginal Costs (MC): amount by which a firms cost changes if the firm produces
one more unit of output.

D C D VC
MC = =
D q D q

Average fixed costs, AFC: fixed costs divided by the units of output produced
AFC = F / q
falls as output increases because the fixed costs is spread over more units.

Average variable costs, AVC: variable costs divided by the units of output
produced.
AVC = VC / q
AVC may either increase or decrease as output rises

Average costs, AC: total cost divided by the units of output produced.

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AC = C / q or AC = AFC + AVC

Relationships between the different cost curves:

- VC curve and C curve are parallel
- AC is vertical sum of AFC and AVC curves
- AC at particular output level is slope of a line from origin ti the corresponding
point in the cost curve
- MC is the slope of either the C or the VC curve at a given output level.
- MC intersects the AC curve where the slope of AC equals the slope of the MC
- Where MC is above AC the AC curve rises with output, where MC is below AC,
the AC curve declines with output.
- Where MC = AC, the AC curve has a minimum.
- Where MC = AVC, the AVC curve has a minimum

Production function: determines the shape of a firms cost curves.

In the short run: VC = wL

In the short run the only way to increase output is to use more labor, if a firm
increases labor enough, it reaches the point of diminishing marginal return to
labor, at which each extra worker increases output by a smaller amount.

Total product curve has the y-axis: q, and on the horizontal axis: L. By using the
variable cost labels (VC = wL) on the horizontal axis the total product of labor curve
becomes the variable cost curve.

In the short run, capital is fixed, so the only way the firm can produce more output is
to use more labor.
MC D VC D L
= w
MC => = D q D q

=> MPL = q / L

=> MC = w / MPL

VC L
AC => AVC = = w
q q

=> APL = q / L

=> AVC = w / APL

These two equations leas us to the important conclusion that costs and production
are inversely related.
- If the AVC curve is U-shaped adding the strictly falling AFC curve makes the AC
curve fall more steeply than the AVC curve at low output levels.
- The AC and the AVC differ by ever smaller amounts, as FC approaches zero at
high output levels.

7.3 Long-Run costs

In the long run, the firm adjusts all its inputs so that its cost of production is as low as
possible.
C = wL + rC (r = rent; C is constant)

Isocost line: all combinations of inputs that require the same total expenditure.

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Properties:
1. Where isocost lines hit the C and L axes depends on the firms cost, C, and on
the input prices.
2. Isocost lines farther from the origin have higher costs than those that are close
to the origin.
3. Slope of each isocost line is the same: w *
D K = - D L
r

Firm chooses the lowest-cost way by combining the isocost lines with the
isoquants.
Three approaches:
- Lowest-cost rule: Pick the bundle where the lowest isocost line touches the
isoquant
- Tangency rule: Pick the bundle of inputs where the isoquant is tangent to the
isocost line
- Last-Dollar rule: Pick the bundle where the last Dollar spent on one input gives
as much extra output as the last dollar spent on any other input.

To minimize its cost of producing a given level of output, firm chooses its inputs so
that the marginal rate of technical substitution equals the negative of the
relative input prices:

MRTS = - w/r => MPL / w = MPK /r

By determination of the cost of the cost levels for different output levels the firm can
determine cost varies with output. Therefore, the input prices are held constant and a
curve is drawn through the tangency points.
Expansion path: cost minimizing combination of L and C for each output level.

Long run cost function C(Q): shows the relationship between the cost of
production and output.
Shape:
- MC = AC curve, where AC has its minimum
- When MC is above AC, the AC curve rises with output, when MC is below AC,
the AC curve declines with output.

Economies of scale: IF the AC or production falls as output expands.

No economies of scale: if the AC curve is flat, an increase in output has no effect

on average cost

Diseconomies of scale: if the AC rises when output increases.

Chapter 8 – Competitive firms and Markets

Market structure: The number of firms in the market, the ease with which firms can
enter and leave the market and the ability of firms to differentiate their products form
those of their rivals.

8.1. Competition
Price taker: A firm that cannot significantly affect the market price for its output or
the prices at which it buys its inputs.

Perfectly competitive market: A market in which each firm in the market is a price

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taker. The firm has to be a price taker if it faces a demand curve that is horizontal at
the market price.

Properties for a perfectly competitive market:

- Consumers believe that all firms in the market sell identical products.
- Firms freely enter and exit the market.
- Buyers and sellers know the prices charged by firms.
- Transaction costs are low.

Residual demand curve: The market demand that is not met by other sellers at any
given price. Therefore, a residual demand curve is the demand curve a single firm
faces.
- Residual demand function equals the market demand function, D(p), minus the
supply function of all other firms.

D^r(p) = D(p) – S°(p)

If there are n identical firms in the market, the elasticity of demand, , facing firm, i, is:

 = n - (n – 1) x (o)

firms residual demand curve is more elastic the more firms, n, in the market,
the more elastic the market demand, , and the larger the elasticity of supply
of the other firms, (o)

8.2 Profit Maximization

Economic cost: Includes both explicit and implicit costs. Economic cost is the
opportunity cost.

Economic profit: Revenue minus economic cost:  = R(q) – C(q)

To maximize firms’ profit, any firm must answer two questions:

- Output decision: If the firm produces, what output level, q*, maximizes its profit
or minimizes its loss?
- Shutdown decision: Is it more profitable to produce q* or to shut down and
produce no output?

Marginal profit, MP: change in the profit the firm gets form selling one more unit of
output: MP =  / q or MR - MC

Marginal revenue, MR: change in revenue it gets from selling one more unit of
output: MR = R / q

Output Rules:
- The firm sets its output where its profit is maximized
- A firm sets its output where its MP is zero
- A firm sets its output where its MR = MC

Shutdown Rules:
- The firm shuts down only of it can reduce its loss doing so
- The firm shuts down if its revenue is less than its avoidable cost.

Chapter 9 – Applying the competitive model

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Welfare: refers to the well being of various groups such as consumers and
producers.

9.1. Consumer welfare

Consumer welfare: benefit a consumer gets form consuming that good minus what
the consumer paid to buy the good.

Consumers’ marginal willingness to pay: Maximum amount a consumer will

spend for an extra unit of that good.

Marginal Value: marginal willingness to pay the consumer places on the last unit of
output.

Consumer surplus, CS: monetary difference between what a consumer is willing to

pay for the quantity of the good purchases and what the good actually costs.
 Area under the demand curve and above the market price up to the quantity
the consumer buys.

In general as the price increases, consumer surplus falls more:

- the greater the initial revenues spent on the good.
- The less elastic the demand curve

9.2. Producer Surplus

Producer surplus, PS: difference between the amount for which a good sells and
the minimum amount necessary for the seller to be willing to produce the good.
 area above the supply curve and below the market price up to the quantity
actually produced.

PS = R – VC

Difference between producer surplus and profit is fixed costs.

9.3. Competition Maximizes Welfare

Social welfare, W: sum of consumer surplus and producer surplus

W = PS + CS

Deadweight loss: net reduction in welfare from a loss of surplus by one group that is
not offset by a gain to another group from an action that alters a market equilibrium.

Competition maximizes welfare because price = marginal cost at the competitive

equilibrium.

Market failure: inefficient production or consumption, often because a price exceeds

marginal cost.

9.4 Policies that shift supply curve

Two government actions affect the competitive equilibrium.
- Limits on the number of firms in a market shift the supply or demand curves
- Sales taxes, quotas and trade barriers create a wedge between price and
marginal cost so that they are not equal, as they were in the original
competitive equilibrium.

Limit on the number of firms causes a shift of the supply curve to the left, which
raises the equilibrium price and reduces the equilibrium quantity.

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Barriers to entry: explicit restriction or a cost that applies only to potential firms.
Large sunk costs can be barriers to entry if:
- If capital markets do not work well ⇒ new firms have difficulties raising money.
- If a firm must incur large sunk costs.

9.5. Policies that create a Wedge between Supply and Demand

Most common government policies that create a wedge between supply and demand
curves are sales taxes (or subsidies) and price controls.

If government does something useful with the tax revenue:

W = CS + PS + T (tax revenue)

=> change in welfare: W = CS + PS + T

Price floors (the lowest price a consumer can legally pay for a good): result in two
distortions of the market:
- Excess production: More output is produced than consumed. The rest is
destroyed or shipped abroad.
- Inefficiency in consumption: At the quantity they actually buy consumers are
willing to pay more than the marginal cost of producing that good.
⇒ Some of the consumer surplus is transferred to the producer.

Price ceilings ( the highest price that a firm can legally charge) result in:
- Less supply, consumers can only buy less (Excess demand).
- Prices are lower.
⇒ Some of the producer surplus is transferred to consumers, the rest is deadweight
loss.

Chapter 11 – Monopoly
Monopoly: only supplier of a good for which there is no close substitute.

Patent: exclusive right to sell the lasts for a limited time period
Monopoly is a price setter.

A monopoly’s output is the market output, and the demand curve a monopoly faces
is the market demand curve, which is downward sloping (thus, a monopoly doesn’t
lose all its sales if it raises the price). As a consequence, the monopoly sets its
price above marginal cost to maximize its profit.

11.1 Monopoly profit maximization

Maximize profit: MR = MC

Marginal Revenue, MR: change in its revenue from selling one more unit.
MR = R / q

For all linear demand curves:

Marginal revenue curve is a straight line that starts at the same point on the vertical
price-axis as the demand curve but has twice the slope of the demand curve.

For non linear demand curve:

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D p
MR= p + Q
D Q

 because the slope of the monopoly’s demand curve, R / Q, is negative, the
last term is negative.

MR at any given quantity depends on the demand curves height (price) and shape:

1
MR= p ( 1 + )
e

 marginal revenue is closer to price as demand becomes more elastic.

Where the demand curve hits the price axis, the demand curve is perfectly elastic, so
MR = p. Where the demand elasticity is unitary, ε= -1, MR is zero. MR is negative
Where the demand curve is inelastic.

Monopoly’s maximizes profit in the elastic part of the demand curve

- NEVER IN THE INELASTIC PART

In the short-run, the monopoly shuts down if the monopoly-optimal price is less than
its average variable cost.

In the long run, a monopoly shuts down to avoid making a loss if the monopoly-
optimal price is below its average cost.

11.3 Market Power

Market power: ability of a firm to charge a price above marginal cost and earn a
positive profit.

The degree to which the monopoly raises its price above its marginal cost depends
on the shape of the demand curve at the profit-maximizing quantity.

The ratio of the price to marginal cost depends only on the elasticity of demand at the
profit-maximizing quantity:

1
MR= p ( 1 + ) = MC
e

p / MC = 1 / (1 + (1 / )

Monopoly that faces horizontal, perfect elastic demand curve sets its price equal to
its marginal cost – just like a price-taking, competitive firm.

Lerner Index (price markup): ratio of the difference between price and marginal
cost to the price: (p – MC) / p

If firm is maximizing profit:

P – MC / p = - 1/ 

Demand curve a firm faces becomes more elastic:

- Better substitutes for the firms product are introduced

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- More firms enter the market selling the same product

- Firms provide the same service locate closer to this firm

11.4 Welfare effect of Monopoly

Welfare, W: is lower under monopoly than under competition.

By setting its price above its marginal cost, a monopoly causes consumers to buy
less than the competitive level of the good, so a deadweight loss to society.

Specific tax on a monopoly: provides tax revenue but reduces welfare below even
the monopoly level. Governments prefer ad valorem taxes because have the same
(equilibrium) effects, but raise more tax revenue when applied to a monopoly.

11.5. Government Actions that create Monopolies.

Governments create monopolies in one of three ways:
- By making it difficult for new firms to obtain a license to operate.
- By granting a firm the rights to be a monopoly
- By auctioning the rights to be a monopoly.

Patent: An exclusive right granted to the inventor to sell a new and useful product,
process, substance, or design for a fixed period of time.

Natural Monopoly: one firm can produce the total output of the market at lower
costs than several firms could.

11.7 Government Actions that reduce Market Power

One method governments use to limit the harms of monopoly is to place a ceiling on
the price that a monopoly charges, which is usually the presumed competitive price.

Governments face several problems in regulating monopolies:

- As they do not know the actual demand and marginal cost curves,
governments may set the price at the wrong level.
- Many governments use regulations that are less efficient than price regulation.
- Regulated firms may bribe or otherwise influence government regulators to
help the firms rather than society as a whole.

The monopoly would threaten to shut down:

If the price ceiling was at a price equal to a natural monopoly’s marginal cost, the
price would be below the firm’s average cost. ⇒ Call for subsidies.

11.8. Network externalities, behavioral Economics and Monopoly decision over

time.

Network Externality: if one person demand depends on the consumption of a good

by others.
- positive network externality: value a consumer grows as the number of units
sold increases (telephone)

Bandwagon Effect: person places greater value on a good as more and more other
people possess it.

Snob effect: person places greater value on a good as fewer and fewer other people
possess it.

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