MICROECONOMICS

Vietnam Economics Olympiad

16-19/6/2022
TOPIC 1: INTRODUCTION TO
ECONOMICS
The Foundations of Economics
• A fundamental problem provides a foundation for
economics:
Unlimited economic wants >< Limited economic resources
• Society’s economic wants: the economic wants of its
citizens and institutions.
• Economic resources: the means of producing goods
and services (labour, capital, natural resources…)
What is Economics?
• Economics is the study of how a society manages its
scarce resources to fulfill the needs and wants of its
people.
• It is concerned with the efficient use of scarce resources
to achieve the maximum satisfaction of economic wants.
Scarcity and Choice
• Scarcity: There is not enough resources to
produce all the goods and services that people
want.
• Choice: We “can’t have it all”, we must decide
what we will have and what we must forgo.
• Opportunity cost: The opportunity cost of an item
is what you give up to obtain that item. It is the
next best alternative forgone.
Three Basic Economic Questions
• What to produce?
• What types of goods and services the society chooses
to produce?
• How to produce?
• What sort of technology can be used to produce the
goods and services?
• For whom to produce?
• How the goods and services are distributed among
people?
Economic Systems
• An economic system is a particular set of institutional
arrangements and a coordinating mechanism.
• Economic systems differ as to
• Who owns the factors of production
• The method used to coordinate and direct economic
activities
Economic Systems
• Market economy: an economy which is characterized
by the private ownership of resources and the use of
market and prices to coordinate and direct economic
activities.
• Command economy: an economy in which resources
are owned by government and economic decision
making occurs through a central economic plan.
• Mixed economy: an economy which has the
combination of features of market and command
economies. The government and the private sector
jointly solve economic problems.
Microeconomics and
Macroeconomics
• Microeconomics looks at specific economic units. It
studies the behavior of individual economic units such as
consumers, firms, investors, workers … as well as
individual markets.
• Macroeconomics studies the aggregate behavior of the
economy. Macroeconomics seeks to obtain an overview
or general outline of the structure of the economy and the
relationships of its major aggregates.
Tools of Economics
• Models are simplification of the fact that omits many
details to allow us to see what is truly important.
• Economic models are composed of diagrams and
equations that show relationships among economic
variables.

“All models are wrong, but

some models are useful.”
TOPIC 2: MARKET ANALYSIS
DEMAND
 Demand is the amount of some good or service
consumers are willing and able to purchase at each price
 Demand schedule is a table that shows the relationship
between the price of the good and the quantity demanded.
 Demand curve is a graphical presentation of the relationship
between the price of the good and the quantity demanded.
A Buyer’s Demand For Apples
Price per kg Quantity Demanded (kg)
$5 1
$4 2
$3 4
$2 7
$1 10
Law of Demand
• The law of demand: All else equal, as price falls the
quantity demanded rises and as price rises the quantity
demanded falls.
Demand and Quantity Demanded
• Demand describes the behavior of a buyer at every price
(i.e. the demand curve).
• Quantity demanded is a particular quantity that is
demanded at a particular price.
Demand and Quantity Demanded
• A movement along the demand curve: a change in
quantity demanded caused by a change in the price of the
product.
Demand and Quantity Demanded
• A shift of the demand curve: a change in demand.
• Increase in demand: The demand curve shifts to the right.
• Decrease in demand: The demand curve shifts to the left.
Determinants of Demand
• Determinants of demand are factors that cause the
demand curve to shift. They are also called the demand
shifters. They are:
• Consumers’ tastes and preferences
• Consumers’ income
• The prices of related goods
• Expectation
• Number of buyers
• Weather
• ….
Income
• Normal goods: products whose demand varies directly
with income.
• As income increases (decrease) the demand for a normal
good will increase (decrease).
• Inferior goods: products whose demand varies inversely
with income.
• As income increases (decrease) the demand for an inferior
good will decrease (increase).
Prices of Related Goods
• Substitute goods are goods that are similar to one another
and can be consumed in place of one another.
• When the price of a good falls (rises), the demand for its
substitute good decreases (increases).
• Complementary goods are goods that are consumed in
conjunction with one another.
• When the price of a good falls (rises), the demand for its
complementary good increases (decreases).
SUPPLY
• Supply is the amount of a product that producers are
willing and able to sell at each price.
• Supply schedule is a table that shows the relationship
between the price of the good and the quantity supplied.
• Supply curve is a graphical presentation of the relationship
between the price of the product and the quantity supplied.
A Producer’s Supply of Apples
Price per kg Quantity Supplied (kg)
$5 60
$4 50
$3 35
$2 20
$1 5
Law of Supply
• The law of supply: All else equal, as price rises the
quantity supplied rises and as price falls the quantity
supplied falls.
• There is a positive or direct relationship between price
and quantity supplied.
Supply and Quantity Supplied
• Supply describes the behavior of a seller at every
price (i.e. the supply curve).
• Quantity supplied is a particular quantity that is
supplied at a particular price.
Supply and Quantity Supplied
• A movement along the supply curve: a change in
quantity supplied caused by a change in the price of
the product.
Supply and Quantity Supplied
• A shift in the supply curve: a change in supply.
• Increase in supply: The supply curve shifts to the right.
• Decrease in supply: The supply curve shifts to the left.
Determinants of Supply
• Determinants of supply are factors that cause the supply
curve to shift. They are also called the supply shifters.
They are:
• Resource prices
• Technology
• Taxes and subsidies
• Prices of other goods
• Expectations
• Number of sellers
• Weather
• …
MARKET EQUILIBRIUM
• Market equilibrium is achieved at the price at which
quantities demanded and supplied are equal.
• It is established at the intersection of demand and
supply curves.
MARKET EQUILIBRIUM
• Market equilibrium determines
• Equilibrium price P*
• Equilibrium quantity Q*
Exercises
• Demand and supply in a market can be described by the
following functions:
QD = 120 – 2P
QS = 20 + 3P
• Calculate the equilibrium price and equilibrium quantity in
this market.
Market Analysis
 Market analysis: study the fluctuations in market price
and quantity as a result of changes in market conditions.
 Market equilibrium changes when there is a change in
market conditions.
 Change in supply
 Change in demand
 Change in supply and demand
Market Analysis
• Change in demand
Market Analysis
• Change in supply
Market Analysis
• Change in demand and supply
• Increase in demand and decrease in supply
• Increase in demand and increase in supply
• Decrease in demand and increase in supply
• Decrease in demand and decrease in supply
GOVERNMENT CONTROLS ON
PRICES
• In a free, unregulated market system, market forces
establish equilibrium prices and equilibrium quantities.
• Sometimes government believes that the market price is
unfair to buyers or sellers, so government may place legal
limits on prices.
• The result is government-created price ceilings and floors.
Price Ceilings and Price Floors
• Price ceiling: A legal maximum on the price at which a
good can be sold.
• Price floor creates a shortage.
• Price floor: A legal minimum on the price at which a good
can be sold.
• Consequences of price floor
• Price floor creates a surplus.
Exercises
• Demand and supply in a market can be described by the
following functions:
QD = 120 – 2P
QS = 20 + 3P
• If the government imposes a price ceiling of 18, what will
happen?
ELASTICITY
• Elasticity allows us to analyze supply and demand
with greater precision.
• Elasticity is a measure of how much buyers and
sellers respond to changes in market conditions.
Price Elasticity of Demand
• The price elasticity of demand measures the
responsiveness of quantity demanded to changes in
price.
Price Elasticity of Demand
• The price elasticity of demand measures the
responsiveness of quantity demanded to changes in
price.
• The price elasticity of demand is computed as the
percentage change in the quantity demanded divided by
the percentage change in price.
• Formula for price elasticity of demand

%Q Q2  Q1 ( P1  P2 ) / 2
EP   
%P (Q1  Q2 ) / 2 P2  P1
Price Elasticity of Demand
• Formula for price elasticity of demand

%Q Q P Q P
EP   :  
%P Q P P Q

%Q Q2  Q1 ( P1  P2 ) / 2
EP   
%P (Q1  Q2 ) / 2 P2  P1

P
EP  Q '
P
Q
Price Elasticity of Demand
• Example: If the price of an ice cream cone increases from
$2.00 to $2.20 and the amount you buy falls from 10 to 8
cones, then what would be your elasticity of demand?
Price Elasticity of Demand
• Elastic Demand: EP  1
• Percentage change in quantity demanded is greater than percentage
change in price.
• Inelastic Demand: EP  1
• Percentage change in quantity demanded is less than percentage
change in price.
• Unit Elastic: EP  1
• Percentage change in quantity demanded is equal to percentage
change in price.
• Perfectly inelastic: EP  0
• Quantity demanded does not change as price changes.
• Perfectly elastic: EP  
• A small percentage change in price causes an extremely large
percentage change in quantity demanded.
 Price Elasticity of Demand and the
Shape of the Demand Curve

P P P P P

Q Q Q Q Q

Ep = 0 |Ep|< 1 |Ep|= 1 |Ep| > 1 |Ep|= ∞

Price Elasticity and Total Revenue
• Total revenue is the amount that a seller receives from the
sale of a good.
• Total revenue is computed as the price of the good times
the quantity sold.

TR = P × Q
Price Elasticity and Total Revenue
• When demand is elastic:
• An increase in price results in a decrease in total revenue.
• A decrease in price results in an increase in total revenue.
• When demand is inelastic:
• An increase in price results in an increase in total revenue.
• A decrease in price results in a decrease in total revenue.
• When demand is unit elastic:
• A change in price results in no change in total revenue.
Cross Price Elasticity of Demand
• Cross price elasticity of demand is a measure of the
responsiveness in quantity demanded of one good to
changes in the price of another good.
• It is computed as the percentage change in quantity
demanded of one good (X) divided by the percentage
change in the price of another good (Y).
Cross Price Elasticity of Demand
• Substitute goods: If the cross price elasticity of demand is
positive then X and Y are substitute goods.
• If EX,Y > 0 → Goods are substitutes.
• Complementary goods: If the cross price elasticity of
demand is negative then X and Y are complementary
goods.
• If EX,Y < 0 → Goods are complement.
• Unrelated goods: If the cross price elasticity of demand is
zero then X and Y are unrelated.
• If EX,Y = 0 → Goods are unrelated.
Income Elasticity of Demand
• Income elasticity of demand is a measure of the
responsiveness in quantity demanded to changes in
income.
• It is computed as the percentage change in the quantity
demanded divided by the percentage change in income.
Income Elasticity of Demand
• Normal goods: Those goods that have positive income
elasticity of demand.
• Higher income raises the quantity demanded for normal
goods.
• Inferior goods: Those goods that have negative income
elasticity of demand.
• Higher income lower the quantity demanded for inferior
goods.
Income Elasticity of Demand
• Goods consumers regard as necessities tend to be
income inelastic: EI <1
• Examples include food, fuel, clothing, utilities, and medical
services.
• Goods consumers regard as luxuries tend to be income
elastic: EI >1
• Examples include sports cars, furs, and expensive foods.
Price Elasticity of Supply
• Price elasticity of supply is a measure of the
responsiveness of quantity supplied to changes in price.
• The price elasticity of supply is computed as the
percentage change in the quantity supplied divided by the
percentage change in price.
Price Elasticity of Supply
• Elastic supply: The price elasticity coefficient is greater
than 1.
• Inelastic supply: The price elasticity coefficient is less than
1.
• Unit elastic supply: The price elasticity coefficient is 1.
• Perfectly inelastic supply: The price elasticity coefficient is
zero.
• Perfectly elastic supply: The price elasticity coefficient is
infinite.
TOPIC 3: THE THEORY OF
CONSUMER CHOICE
Theory of Consumer Behavior
• Theory of consumer behavior: description of how
consumers allocate incomes among different goods
and services to maximize their well-being.
• Consumer behavior is best understood in three
distinct steps:
• Budget constraints
• Consumer preferences
• Consumer choices
Budget Constraints
• Budget constraint: what the consumer can afford.
• Budget constraint is the constraint that the
consumers faces as a result of limited incomes.

PX X  PY Y  I
Budget Constraints
• Budget line shows all combinations of goods that
can be consumed within the budget limit.

Y
The Effects of Changes in Income and
Prices
• Income changes: Shift in the budget line.
• Price changes: Change in the slope of the budget
line.
Consumer Preferences
• Consumer preferences: what the consumer wants
• Basic assumptions about preferences:
• Completeness: Consumers can compare and rank all
possible market baskets (bundles) of goods.
• Transitivity: Preferences are transitive.
• More is better than less: More of any good is preferred
to less.
Utility
• The satisfaction or pleasure one gets from
consuming a good or service is called utility.
• Total utility (U) is the total amount of satisfaction a
person receives from consuming a particular
quantity of a good.
U = U(Q)
• Marginal utility (MU) is the additional utility a person
receives from consuming one more unit of a good.
MU = ∆U / ∆Q
Total Utility and Marginal Utility
Quantity of Total utility Marginal utility
the product Q U MU

0 0 -
1 10
2 18
3 24
4 28
5 30
6 30
Law of Diminishing Marginal Utility
• The law of diminishing marginal utility: the marginal utility
gained by consuming additional unit of a good will decline
as more of the good is consumed.
• As Q increases, MU decreases.
Indifference Curves
• The consumer’s preferences are represented with
indifference curves.
• Indifference curve: a curve that shows all
combinations of goods that provide a consumer with
the same level of satisfaction.
Indifference Curves
• Indifference map: a graph that contains a set of
indifference curves.
The Shapes of Indifference Curves
• Marginal rate of substitution (MRS): amount of a
good that a consumer is willing to give up in order to
obtain one additional unit of another good (while
remaining the same level of satisfaction).
• MRS is the slope of the indifference curve.
Properties of Indifference Curves
• Higher indifference curves are preferred to lower ones.
• Indifference curves are downward sloping.
• Indifference curves do not cross.
• Indifference curve are bowed inward (convex).
Consumer’s Optimal Choice
• Optimization: what the consumer chooses.
• How do consumers allocate their money incomes
among different goods and services to achieve the
highest level of satisfaction?
Consumer’s Optimal Choice
• Consumer’s optimal choice occurs at the tangency
point of the budget constraint and the highest possible
indifference curve.

U3
U2
U1
B Y
Consumer’s Optimal Choice
• At the consumer’s optimal choice, the slope of the
indifference curve is equal to the slope of the budget
constraint.
MRS = Price ratio of the two goods
or
MU X / MU Y  PX / PY
Utility Maximization

• Utility maximizing combination of goods

MU X / PX  MUY / PY
How Changes in Income Affect the
Consumer’s Choices
• When income changes, the budget constraint shifts.
• Normal good: a good for which an increase in
income raises the quantity demanded.
• Inferior good: a good for which an increase in
income reduces the quantity demanded.
How Changes in Prices Affect the
Consumer’s Choices
• A fall in the price of a good has two effects:
• Substitution effect: Consumers tend to buy more of the
good that has become cheaper and less of the good
that is relatively more expensive.
• Change in consumption of a good associated with a
change in its price, with the level of utility held constant.
• Income effect: Because one of the goods is now
cheaper, consumers enjoy an increase in real
purchasing power.
• Change in consumption of a good resulting from an
increase in purchasing power, with relative price held
constant.
TOPIC 4: THE THEORY OF FIRM:
PRODUCTION AND COSTS
What is a Firm?
• Business firm is an entity that employs factors of
production (resources) to produce goods and services to
be sold to consumers, other firms or the government.
The Objective of the Firm
• There are two sides to a business firm: a revenue side
(total revenue) and a cost side (total cost).
• Total revenue is amount of money the firm receives from the
sale of its product.
• Total cost is the costs that the firm incurs for the use of
inputs.
• Profit is the difference between total revenue and total
cost.
π = TR – TC
• The firm’s objective is to maximize its profit.
Production Function
• Production is a process of transforming inputs into
output.
• Production function shows the maximum quantity of
output that can be produced from a given amount of
various inputs.
𝑄 = 𝐹(𝐾, 𝐿)
Short Run Production Relationships
• Total product (Q) is the quantity or total output of a
particular good produced.
• Marginal product of labor (MPL) is the additional
output that the firm can produce when it employs
one more unit of labor.
MPL = ∆Q / ∆L
• Average product of labor (APL) is output per unit of
labor input. It is also called labor productivity.
APL = Q / L
Short Run Production Relationships
Amount of Amount of Total output Average Marginal
labor capital (Q) product of product of
(L) (K) labour labour
(APL) (MPL)
0 10 0 - -
1 10 10
2 10 30
3 10 60
4 10 80
5 10 95
6 10 108
7 10 112
8 10 113
Short Run Production Costs

• In the short run, some resources (inputs) are fixed

and other resources (inputs) are variable.
• Short run costs may be divided into fixed costs and
variable costs.
• Fixed costs are the costs incurred for the use of fixed
inputs.
• Variable costs are the costs incurred for the use of
variable inputs.
Fixed, Variable and Total Costs
• Total fixed costs (TFC) are those costs that do not
vary with the level of output produced.
• Examples are rental payment, interest on firm’s debt,
insurance premium.
• Total variable costs (TVC) are those costs that
change with the level of output produced.
• Examples are payments for materials, fuel, power,
labor …
• Total costs (TC) is the sum of fixed costs and
variable costs at each level of output.
TC = TFC + TVC
Fixed, Variable and Total Costs
Amount Amount Total Fixed Variable Total cost
of labor of capital output cost cost (TC)
(L) (K) (Q) (FC) (VC)

0 10 0
1 10 10
2 10 30
3 10 60
4 10 80
5 10 95
6 10 108
7 10 112
8 10 115
Average and Marginal Costs
 Average fixed cost (AFC) is fixed cost per unit of output
AFC = TFC / Q
• Average variable cost (AVC) is variable cost per unit of
output
AVC = TVC / Q
• Average total cost (ATC) is total cost per unit of output
ATC = TC / Q
ATC = AFC + AVC
 Marginal Cost (MC) is additional cost that the firm incurs
when it produces one more unit of output.
MC = ∆TC / ∆Q
 Average and Marginal Costs
Amount Amount Total Average Average Average Marginal
of labor of capital output fixed cost variable total cost cost (MC)
(L) (K) (Q) (AFC) cost (ATC)
(AVC)
0 10 0 - - - -
1 10 10
2 10 30
3 10 60
4 10 80
5 10 95
6 10 108
7 10 112
8 10 115
Cost Curves
Relation of MC to AVC and ATC
• The MC curve intersects the ATC curves at its
minimum point.
• When MC is less than ATC then if Q increases ATC will
fall.
• When MC is higher than ATC then if Q increases ATC
will rise.
• The MC curve intersects the AVC curve at its
minimum point.
• When MC is less than AVC then if Q increases AVC will
fall.
• When MC is higher than AVC then if Q increases AVC
will rise.
Shifts of Cost Curves
• Cost curves will shift when there is a change in
• Taxes and subsidies
• Input prices
• Technology
Long Run Production Costs

• In the long run, a firm can adjust all its resources: all
inputs are variable.
• In the long run, there are no fixed costs. All costs are
variable costs.
• Total costs = Total variable costs
The Long Run Cost Curve
• The long run ATC curve - the firm’s planning curve -
shows the lowest average total cost at any level of
output produced.
• It is the envelope of all possible short run ATC
curves.
Long Run Average Costs
Economies of Scale, Constant Economies
of Scale and Diseconomies of Scale
• The long run average cost curve displays 3 regions:
• Economies of scale: long run average total cost falls as
quantity of output increases.
• Constant returns to scale: long run average total cost
is unchanged as quantity of output increases.
• Diseconomies of scale: long run average total cost
rises as quantity of output increases.
• The minimum efficient scale (MES) is the level of
output at which a firm can minimize its long run
average total cost.
TOPIC 5: MARKET STRUCTURES
Market Structures
• Market structure is a set of market characteristics that
determines the economic environment in which a firm
operates.
• It describes the competitive environment of the market.
• Market structure depends on
• The number and relative size of firms in the industry.
• The degree of product similarity or differentiation.
• Conditions of entry and exit.
Market Structure

Monopolistic
Oligopoly Perfect
Monopoly competition
Airlines competition
Tap water Restaurants
Cars Agricultural
Railways Books
Computers products
Movies
PERFECT COMPETITION
• Characteristics of perfect competition
• Numerous number of small firms: There are many firms and
each firm is relatively small in size.
• Standardized product: Product is identical or homogenous.
• Free entry and exit: There is no barriers to entry or exit the
market.
• Perfect information: Sellers and buyers have full access to
information regarding the product.
• Price taker: Each firm is a price taker. It can sell as much
product as it wants at the market price. Each firm has no
market power.
Demand as Seen by a Perfectly
Competitive Firm
• The firm is a price taker so it can sell as much
product as it wants at the market price.
• No matter how many product the firm can sell, it still
receives the market price. Thus the demand for a
perfectly competitive firm is perfectly elastic.
Total Revenue, Average Revenue
and Marginal Revenue
• Total revenue (TR) is the amount of money that a
firm receives from selling its output.
TR = P x Q
• Average revenue (AR) is the revenue per unit of
output sold.
AR = TR / Q = P
• Marginal revenue (MR) is the additional revenue
that the firm receives when it sells one more unit of
output.
MR = ∆TR / ∆Q = P
Output Decision in the Short Run
• Because a perfectly competitive firm is a price taker,
it can sell as many output as it wants at the market
price.
• How many output that the firm will choose to
produce and sell to maximize its profit?
 Profit Maximization Rule
• Marginal revenue (MR) is the revenue that the additional unit
of output would add to total revenue.
• Marginal cost (MC) is the cost that the additional unit of
output would add to total cost.
• If MR > MC, firm should increase the level of output
• If MR < MC, firm should reduce the level of output
• If MR = MC, firm produces output level that maximizes its profit.
• Profit maximizing condition
MR = MC
• For a perfectly competitive firm, profit is maximized when
P = MR = MC
Long Run Equilibrium
• Entry eliminates economic profits.
• Exit eliminates losses.
• Long run equilibrium is where firms earn zero
economic profits
Why Do Competitive Firms Stay in
Business If They Make Zero Profit?
• Total cost includes all the opportunity costs of the
firm.
• In particular, total cost includes the time and money that the
firm owners devote to the business.
• In the zero-profit equilibrium, the firm’s revenue
must compensate the owners for these opportunity
costs.
• Economic profit is zero, but accounting profit is
positive.
MONOPOLY
• Characteristics of monopoly
• Single seller: There is only one firm supplies a product
for the whole market.
• Unique product: There are no close substitutes for the
product.
• Blocked entry: strong barriers to prevent other firms to
enter the market.
• Price maker: The monopolist has the entire market
power to set the price for its product.
Why Monopolies Arise
• Barriers to entry are the factors that prohibit firms
from entering an industry.
• Three main sources of barriers to entry:
• Monopoly resources: A key resource required for production
is owned by a single firm
• Government regulation: The government gives a single firm
the exclusive right to produce some good or service.
• Economies of scale: A single firm can produce output at a
lower cost than can a larger number of firms.
Monopoly’s Demand and Marginal
Revenue
• Total Revenue

TR = P  Q
• Average Revenue

AR =TR / Q = P
• Marginal Revenue

MR = ∆TR / ∆Q
Monopoly’s Demand and Marginal
Revenue
• Because a monopoly is the sole producer in the market,
its demand curve is the market demand curve.
• The monopolist faces a downward-sloping demand curve.
• The monopolist’s demand and marginal revenue curves
are not the same.
• At any level of output, price is higher than marginal revenue
P > MR.
• The monopolist’s marginal revenue curve lies below its
demand curve.
Monopoly’s Demand and Marginal
Revenue

Q P MR

1 10

2 9

3 8

4 7

5 6

6 5
Monopoly’s Output and Pricing Decision
• What specific price-quantity combination will the
monopolist choose to maximize its profit?
• The monopolist will choose the level of output where
its marginal revenue equals its marginal cost.
MR = MC
Monopoly’s Output and Pricing Decision
• A monopolist firm has no supply curve.
• There is only one combination of price and quantity
that the monopolist chooses to supply to maximize
its profit.
• At the optimal level of output
• MR = MC
• P > MC: The price that the monopolist charges for its
product is higher than its marginal cost.
Possibility of Losses by Monopolist
• Pure monopoly does not guarantee profit.
• If demand is week and costs are high then the pure
monopolist may incur loss.
Price Discrimination
• Price discrimination: a pricing practice that charges
different prices for the same product.
Conditions for Price Discrimination
• Monopoly power: The seller must have the ability to
control output and price.
• Market segregation: The seller must be able to
segregate buyers into distinct classes, each of
which has a different willingness or ability to pay for
the product.
• No resale: Buyers cannot resell the product among
themselves.
MONOPOLISTIC COMPETITION
• Characteristics of monopolistic competition
• Many sellers
• Differentiated products
• Easy entry to and exit from the market
• Each firm is a price maker
The Firm’s Demand Curve
• Each monopolistically competitive firm faces a
downward-sloping demand curve.
• The price elasticity of demand faced by each firm
depends on the number of rivals and the degree of
product differentiation.
• The larger the number of rivals and the weaker the
product differentiation, the greater the price elasticity of
each firm’s demand.
Monopolistic Competition in the Short Run
• The monopolistically competitive firm
maximizes its profit or minimizes its loss by
producing at the level of output where
MR = MC
• In the short run, the monopolistically
competitive firm can either earn economic
profit or loss.
Monopolistic Competition in the
Long Run
• In the long run, firms will enter the market if it is
profitable and leave the market if it is unfavorable.
• Profits → Firms enter: Economic profits attract new firms to enter
the market, demand for existing firms’ product fall and their
profits decline. Economic profits are eventually driven to zero.
• Losses → Firms leave: Losses cause some firms to leave the
market, demand for existing firms’ product rise and their losses
are reduced. Eventually the losses will be eliminated.
• In the long run, firms earn zero economic profit.
OLIGOPOLY
Characteristics of oligopoly
 A few large firms dominate the market.
 Homogeneous or differentiated products
 Mutual interdependence: each firm’s outcome depends
not only on its own decision but also on decisions of other
firms. When each firm makes decision, it has to consider
the actions and reactions of other firms.
 Significant barriers to entry
 Each firm is a price maker
The Cartel Theory
 In a given industry, oligopolist firms will be best off if they
cooperate and act as one firm. They form a cartel to act
just like a monopolist to capture the maximum level of
profit.
 Cartel is an organization of firms that reduces output and
increases price in an effort to increase joint profits.
The Cartel Theory
• Problems with cartels
• Costly to form a cartel.
• Difficult to reach agreement in formulating cartel policy.
• Potential of new firms entering the industry.
• Problem of cheating among cartel members.
Game Theory
• In oligopoly market, mutual interdependence exists
among firms.
• Each firm must make strategic choice based on the
consideration of actions and reactions of other firms.
• Game theory is a mathematical technique used to
analyze the behavior of decision makers who try to
reach an optimal position for themselves in strategic
situations.
The Prisoners’ Dilemma

Bob
Don’t confess Confess

Don’t confess
A: 2 years A: 10 years
B: 2 years B: 6 months
Anna
Confess A: 6 months A: 5 years
B: 10 years B: 5 years
Nash Equilibrium
• Nash equilibrium: a set of actions for which all
players are choosing their best strategies given the
strategies chosen by their rivals.
Dominant Strategy
• Dominant strategy is a strategy that is best for a player
in a game regardless of the strategies chosen by the
other players
• Dominant strategy equilibrium is the outcome when
both players have dominant strategies and play them.
• In prisoners’ dilemma, Anna and Bob both choose to confess.
• When there is no dominant strategy, each player’s
strategy depends on other player’s strategy.
Business Application

Pepsi

Discount Price Regular Price

Discount
C: $4 C: $8
Price
P: $3 P: $1
Coca-Cola
Regular C: $2 C: $6
Price P: $5 P: $4
TOPIC 6: MARKET FAILURES AND
THE ROLE OF GOVERNMENT
Market Failures
• Market failure is a circumstance in which private
markets do not bring about the allocation of
resources that best satisfies society’s wants.
• Three kinds of market failures:
• Public goods
• Externalities
• Information asymmetries
Externalities
• Externality is a cost or a benefit accruing to a third
party (bystander) that is external to a market
transaction.
• Negative externalities: impact on the third party is
adverse.
• Positive externalities: impact on the third party is
beneficial.
Negative Externalities
P

MSC

S = MPC

D = MPB

Q
Negative Externalities
• Negative externality creates costs to the third party which
is called external costs
• Social costs will be higher than private costs
MSC = MPC + MEC
• MSC: social marginal costs
• MPC: private marginal costs (market supply)
• MEC: marginal external costs
• The market equilibrium output is the output at which
MPC = MPB
• The socially optimal output is the output at which
MSC = MPB
Negative Externalities
• Consequences of negative externalities
• Overproduction: The equilibrium market output QE is
greater than the socially optimal output QO
• This creates deadweight loss
Positive Externalities

P
Deadweight S = MPC
F loss
0

MSB

D = MPB
Q
QE QO
Positive Externalities
• Positive externality creates benefit to the third party
which is called external benefit.
• Social benefits will be higher than private benefits
MSB = MPB + MEB
• MSB: social marginal benefit
• MPB: private marginal benefit (market demand)
• MEB: marginal external benefit
• The market equilibrium output is the output at which
MPB = MPC
• The socially optimal output is the output at which
MSB = MPC
Positive Externalities
• Consequences of positive externalities
• Underproduction: the market equilibrium output QE
is less than the socially optimal output QO
• This creates deadweight loss
Private Solutions
• Property rights
• Moral codes and social sanctions
• Charities
• Contracts
Government Role in Externality
Problem
• Solutions to positive externalities
• Subsidies to buyers: increase demand
• Subsidies to producers: increase supply
• Public provision: government provides the good as a
public good.
• Solutions to negative externalities
• Regulation
• Corrective taxes (Pigovian taxes)
• Market for externality right
A Market for Externality Rights
• The government creates a market for externality
rights.
• A pollution-control agency determines the amount of
pollutants that firms can discharge into the air while
maintaining the air quality at some acceptable level.
The supply of pollution rights is fixed.
• The demand for pollution rights is downward
sloping.
• The market determines the price for pollution rights.
Private Goods
• Private good characteristics
• Rivalry (in consumption): one person’s use of the good
diminishes other people’s use of it
• Excludability: some people can be prevented from
using the good
Public Goods
• Public good characteristics
• Nonrivalry (in consumption): one person’s consumption of
a good does not preclude consumption of the good by
others.
• Nonexcludability: there is no effective way to exclude
individuals from the benefit of the good.
• Free-rider problem: Once the good is provided
everyone can obtain the benefit without payment.
 Private and Public Goods
COMMON RESOURCES PRIVATE GOODS

Fisheries Food
Biodiversity Clothes
Rivalry

Houses

PUBLIC GOODS CLUB GOODS

National defense Cable TV

Firework displays Computer softwares
Lighthouses

Excludability
Government Role in Public Goods
Problem
• Since public goods have no market, they cannot be
supplied privately.
• The government should provide the public goods and tax
people to finance its spending.
Information Failures
• Asymmetric information: unequal knowledge
possessed by the parties to a market transaction.
• Buyers and sellers do not have identical information
about price, quality or some other aspects of the
good or service.
Information Failures
• Moral hazard: the tendency of one party to a
contract or agreement to alter his or her behavior
after the contract is signed in a way that could be
costly to the other party.
• Adverse selection: a situation in which the
information known by the first party to a contract or
agreement is not known by the second and thus the
second party incurs major costs.