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MicroeconomicsInternational-Busi...
Laga02
Microeconomía
1º Grado en Empresa Internacional
Facultad de Economía y Empresa

Universidad de Barcelona
Reservados todos los derechos.

No se permite la explotación económica ni la transformación de esta obra. Queda permitida la impresión en su totalidad.
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MICROECONOMICS
INTERNATIONAL BUSINESS UB

NOTES
si lees esto me debes un besito

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08/10/2020
BLOCK 1: INTRODUCTION TO ECONOMICS
Economics: social science that studies the product, and consumption of goods and services; and
the income distribution
It comes from the Greek word oikonomos: oikos “house” + nomos “managing”.
It can also be defined as the science which studies human behaviour as a relationship between
ends and scarce means which have alternative uses.
Without scarcity and alternative uses, there is no economic problem. The main problem of
economics is the scarcity, that’s why it’s needed to find alternative uses (MIRAR WEB)
Market: is any mechanism/structure that allows buyers and sellers to exchange any type of
goods, services and information. The market equilibrium occurs at the price at which quantity
demanded and quantity supplied are equal (when the producer and the consumer make an
agreement (price and quantity: euros/kilo)).
Social science is an academic discipline concerned with society and the relationship among
individuals within a society,

Economics is a social science that seeks to analyse and describe the production, consumption
and distribution of wealth.
Microeconomics: branch of economics concerned with how people make decisions and how
these decisions interact. Analyse the behaviour of different economic agents (households,
firms/companies and states/administration/public sector = consumers and producers).
Macroeconomics: brunch of economics concerned with the overall economy.
Economic growth: growing ability of the economy to produce goods and services.
Difference between positive economics and normative economics
- Positive economics: is the branch of economic analysis that describes the way the
economy actually works (statement of fact = “what is”).
A positive statement is one that is objective and can be backed up by evidence (EX: If
carbon emissions were cut by 25%, air quality would improve and the number of people
diagnosed with asthma would decrease significantly).
- Normative economics: makes prescriptions about the way the economy should work
(statement of opinion = “what ought to be”).

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A normative statement is a value judgment and states what someone thinks “ought to
be”. Normative statements are subjective and influences by personal biases,
backgrounds, personal politics… (EX: To clean up air quality and cut down carbon
emissions by 25%, 4 x 4 vehicles should only be sold to farmers and
those living in rough terrain areas).
(A forecast is a simple prediction of the future)
Model: is a simplified representation of real situations used to better understand real-life
situations. They play a crucial role in economics due to they are used t study a real but simplified
economy and also used to simulate an economy on a computer.
The “other things equal” (ceteris paribus) assumptions means that all other relevant factors
remain unchanged (constant).
Factors of production

Inputs:
- K: capital (there’s the financial capital and the physical capital such as machines,
factories, properties, tools, software, hardware…
- L: labour or human capital (physical workers and their intellectual
- NR&E: Natural resources and energy
- Φ (phi): technology
- Entrepreneurship
The price of the capital is the interest rate of the loan (i), the price of labour is the salary/wages
(w), the price of the natural resources and energy is usually the price of the oil and the price of
technology is complicated to define but are the copy rights, patterns…
Difference between short run and long run
- Short run: less than the maturity period (less than a year).
- Long run: more than one maturity period (more than a year).
Maturity period: which is the period of time from the moment that you decided to invest one
euro until the moment that you receive this euro.

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Short run: Y = f ( k̅ , L) . Capital and technology are fixed. Variable labour (you can change the
number of workers and the number of hors the have to work)
Long run: Y = f ( K , L) . Everything is variable.
ECONOMIC SYSTEMS
Capitalism: is an economic system in which a country’s trade and industry are controlled by
private owners for profit, rather than by the state.
(A. Smith, Thomas Malthus, David Ricardo)

ADAM SMITH (An inquiry into the nature and causes of wealth of nations 1776)
- Invisible hand: refers to the idea that individual pursuit of self-interest can lead to good
results for society as a whole.
- Laissez-faire: He was the founder of free market economics. It is an economic system in

which transactions between private parties are absent of any form of economic
interventionism such as regulations and subsidies. It is a policy of minimum
governmental interference in the economic affairs of individuals and society.
- Limited government: no government intervention. It is a governing or controlling body

whose power exist only within pre-defined limits that are established by a constitution
or other source of authority.
- Free market: is an economic system that allows supply and demand to regulate prices,
wages, etc., rather than government policy (very small governmental control)
- Production function: relationship between the quantity of inputs a firm uses and the
quantity of outputs it produces.
- Division of labour: the separation of a work process into a number of tasks, with each
task performed by a separate person or group of persons (workers can focus on specefici
tasks).
- K accumulation (capital accumulation): is the dynamic that motivates the pursuit of

profit, involving the investment of money or any financial asset with the goal of
increasing the initial monetary value if said asset as a financial return, whether in the
form of profit, rent, interest, royalties or capital gains.
- Free Trade: is an international trade left to its natural course without tariffs, quotas or
other restrictions. Under a free trade policy, goods and services can be bought and sold
across international borders with little or no governmental tariffs, quotas, subsidies, or
prohibitions to inhibit their exchange.
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The capitalism failed in 1929 for the first time (NY crash) and the second in 2007.
Socialism/communism: any of various economic and political theories advocating collective or

governmental ownership and administration of the means of production and distribution of
goods.
KARL MARX (The Communist manifesto, 1848), Das Kapital (1867-1894) WATCH VIDEOS
- Conflict of classes: conflict between different classes in a community resulting from
different social or economic positions and reflecting opposed interests.
- Working class’ conquest of political power

- Theory of value: use-value, exchange-value (price), surplus-value. It is a term used in
economics which covers all the theories included in economics that explain price of
goods and services or exchange value. The basic and most important questions of the
theories of economics are why the price of goods and services are priced as they are,
how the price of goods and services are considered and how the correct price of goods
and services can be calculated.
- Extraction of surplus value or surplus profit

- Minimum wage to reproduce the proletariat
- Economic organization: is the way in which the means of production and distribution of
goods are organized, such as capitalism or socialism.
The communist system failed when Berlins wall fall in 1989.
Price: is the result of the market. Where producer and consumers reach an agreement
Cost: is the addition of the price of the inputs that we have used in the production.
Tc = K· i + L·w
Value: there’s subjective and objective value. The subjective value is your point of view. The
objective value is when we create/add value, when we produce. It is created thanks to the
capital, the labour, natural resources and energy and technology.
Mixed economy: is an economic system in which both the state and private sector direct the
economy, reflecting characteristics of both market economies and planned economies.
JOHN MAYNARD KEYNES (The General theory of employment, interest and money, 1936):
appeared after the crash of 1929.
- Mixed economy: is an economic system in which both the state and private sector direct
the economy, reflecting characteristics of both market economies and planned
economies. It protects private property and allows a level of economic freedom in the

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use of capital, but also allows for governments to interfere in economic activities in
order to achieve social aims.
- Economic intervention by public sector: it is the regulatory action taken by governments

that seek to change the decision made by individuals, groups and organization about
social and economic matters.
- Aggregate demand: it is an economic measurement of the total amount of demand for

all finished goods and services produced in an economy. It is expresses as the total
amount of money exchanged for those goods and services at a specific price level and
point in time.
- Stabilization function
- Public deficit: it is the gap between revenues and expenditures for a government (over
a given period of time), often referred to as an internal deficit or fiscal deficit.
- Public debt: total amount of money borrowed by the government of a country, including
individuals, businesses and other governments.

- Macroeconomic equilibrium with unemployment
- Animal spirits: represent the future expectation. Term coined by John Maynard Keynes,
that describes how people arrive at financial decisions, including buying and selling
securities, in times of economic stress or uncertainty.
I = f ( i ; animal spirits). When the interest rate increases the private investments (I)
decreases and otherwise, when the interest rate decreases, the private investments
increases.
- Liquidity paradox: when the variation of interest rate doesn’t affect the ……. (MIN 46 O
AIXI CLASSE)
ECONOMIC AGENTS
- Households: basic unit of consumption (EX: families, adults sharing a home, person
living alone…). Households buy goods and services to satisfy their basic needs (food and
water, accommodation and clothes) and be happy. In economic terms: to maximise
happiness and utility.
- State/administration: public management
- Firms/companies/enterprises typologies: basic unit of production.

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ACCOUNTING: Balance Sheet

Difference between efficacy and efficiency
- Efficacy (or effectiveness): is the capacity to produce an effect. It is the ability of an

intervention/action/product to produce a desired effect. (the cost is not a important)
- Efficiency (economic efficiency): refers to the use of resources so as to maximize the

production of goods and services. Production proceeds at the lowest possible per-unit
cost (minimization) = OPTIMIZATION. The property of society getting the most it can
from its scarce resources.
Pareto efficiency: no one can improve without damaging someone else.
An economy is efficient, according to Pareto, if it takes all opportunities to make some people
better off without making other people worse off.

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Equity: means that everyone gets his or her fair share. Since people can disagree about what’s
“fair”, equity isn’t as well-defined a concept as efficiency. (ex: if you have low incomes, you pay
less than the ones who have larger incomes)
When we increase the efficiency, we have to scarify equity. If we increase the equity, probably
we will not be as efficient as we could be.
Conflict between: equity, making life “fairer”, or efficiency, making sure that all opportunities
to make people better off have been fully exploited.
Markets usually lead to efficiency. The incentives built into markets economy already ensure
that resources are usually put to good use. Opportunities to make people better off are not
wasted. But there are some exceptions: market failure, the individual pursuit of self-interest
found in markets makes society worse off = the market outcome is inefficient.

The circular-flow diagram:
It is a representation of the economy.
Trade takes the form of barter when people directly exchange goods and services they have
for goods or services they want.
The circular-flow diagram is a model that represents the transactions in an economy by flows
around a circle.
- Households buy goods and services from firms.

- Firms buy factors of production from households
- Inner flow = goods and services
- Outer flow = money
Households offer labour
Circular flow of economic activities:
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- A household or a person or a group of people that share their income.
- A firm is an organization that produces goods and services for sale.
- The markets for goods and services is where firms sell goods and services that they
produce to households.
- The factor markets are where firms buy the resources they need to produce (factors of
production)
Business pay’s company taxes and individuals pays income taxes and the VAT (value added tax
= IVA) through the consumption.
Security (seguredad social) is paid one part for the households and another is paid by the
company.

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Ultimately. Factor markets determine the economy’s income distribution: how total income is
divided among the owners of the various factors of production-
Macroeconomic identity: Income = Production = Expenditure

OPPORTUNITY COST
Opportunity cost: sources are limit (scarcity), so we have to choose. The opportunity cost is the
lost option, what you must to give up in order to get it. (ex: the cost of attending to economics
class is what you must give up to be in the classroom during the lecture = sleeping, watching
TV…).
Opportunity cost is about what you have to forgo to obtain your choice. It is also defined as the
value of the next best alternative.
The production possibility frontier (PPF):
It’s the maximum quantity that we can produce in an economy with the scarcity of resources.
The efficient quantity that we can produce.
- Illustrates trade-offs facing an economy that produces only two goods.

- It shows the maximum quantity of one good that can be produced for any given
production of the other. (taking into account of a concrete amount of resources)
- The PPF improves our understanding of trade-offs by considering a simplified economy
that produces only two goods by showing this trade-off graphically.
Opportunity cost and slope of PPF
- If the tradeoff remains constant along the PPF then we say they face a Constant
Opportunity Cost and the PPF has a linear slope.

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- If the tradeoff increases along the PPF than we say they face an Increasing Opportunity
Cost and the PPF has a nonlinear slope.
All the options around the PPF are efficient!!!
Application of the opportunity cost in the graphic PPF with constant opportunity cost (OC): If we
want to produce one leather jacket we have to scarify 2 units of computers.

Slope is -2. Negative because when I decided to increase the quantity of leather jackets (X) I have
to decrease computers (Y), the result will be negative.
The production possibility frontier with constant opoortunity cost:
The opportunity cost of one unit of fish is 6/8 = 0’75 coconuts. And the o.c of one coconut is 8/6
= 4/5 = 1’3 units of fish.
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The opportunity cost is increasing. When
this happens the slope is concave
Technological development? *

The production possibility frontier with increasing opportunity cost:
Economic growth: is the growing ability of the economy to produce goods and services.
Economic growth can come from two sources:
- Increase in Factors of production: resources used to produce goods and services (Land,
Labour and Capital).
- Technological improvement: improvement in the technical means of production goods

and services.
Economic growth results in an outward shift

of the PPf because production possibilites are
expanded. The economy can now produce
more of everything
Production is initally at point A (20 fish and 25

coconuts), it can move to point E (25 fish and
30 coconuts)
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EXAMPLE: Production possibilities for two castaways
Tom has an opportunity cost of 4/3 units of fish for one coconut. And the OC of one unit of fish
is ¾ coconuts. While, Hank’s opportunity cost of one coconut is ½ units of fish and the OC of one
unit of fish is 2 coconuts.
Specialize and trade
Both castaways are better off when they each specialize

in what they are good at and trade. It’s a good idea for
Tom to catch fish for both of them, because his
opportunity costs of a fish in temps of coconuts not
gathered is only ¾ of a coconut, versus 2 coconuts for
Hank. Correspondingly, it’s a good idea for Hank to
gather coconuts for both of them because his
opportunity costs are less, only 1/2 of a fish (4/3 for
Tom).
Operations: the opportunity cost of 40 units of fish = 30 units of coconuts. So, if we divide both
by 40, we get that the o.c of 1 unit of fish is ¾ coconuts.
Comparative advantage and gains from trade
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(To calculate the gains from trade we have to compare the production without trade and the consumption with trade,
de difference is the gains from trade)
Both Tom and Hank experience gains from trade:
- Tom’s consumption of fish increases by two and his consumption of coconuts increases
by one.
- Hank’s consumption of fish increases by four and his consumption of coconuts increases
by two.
For this reason, is important to specialise and trade because both finally experience gains. Only
if the opportunity costs of both parts are equal, there’s no possible trade between the two parts.

Tom vs Hank – Absolute vs Comparative advantage
Tom has an absolute advantage in both activities, he can produce more output with a given
amount of input (in this case, his time) than Hank. But tom can indeed benefit from a deal with
Hank because comparative advantage is the basis for mutual gain. So Hank, despite his absolute
disadvantage, has a comparative advantage in coconut gathering
Comparative advantage vs Absolute advantage
Comparative advantage: is an evolution of absolute advantage. This concept was improved by

Ricardo. Is taking into account the opportunity cost. An individual has a comparative advantage
in producing a good or a service if the opportunity cost of producing the goods is lower for that
individual than for other people.
Absolute advantage: (adam smith) who can produce more in absolute terms. Was created by
Adam Smith. An individual has an absolute advantage ……. (in tom and Hanks example, Tom has
absolute advantage in collecting coconuts and fishing because he has more quantity of fish and
coconuts)
Having an absolute advantage is not the same thing as having a comparative advantage. You can
have an absolute advantage in both goods and still benefit from trade.
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ANOTHER EXAMPLE: Comparative advantage and international trade
Just like the example of Tom and Hank, the US and Canada can both achieve mutual gains from
a trade.

If the US concentrates on producing pork and ships some of its outputs to Canada, while Canada
concentrates on aircraft and ships some of its outputs to the US, both countries can consume
more than If they insisted on being self-sufficient.
Basic principles of Choice Interaction Gains from trade
In a market economy, individuals engage in trade, that happens when individuals prove goods
and services to others and receive goods and services in return.
There are gains from trade, which means people can get more of what they want through trade
than they could if they tried to be self-sufficient.
Specialization: when each person specializes in the task that he/she is good at performing. The
economy, as a whole, can produce more when each person specializes in a task and trades with
others.
In order to stablish the price of the trade, we have to consider a price between the two
opportunity costs.
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BLOCK 2 DEMAND, SUPPLY AND MARKET EQUILIBRIUM
2.1 DEMAND AND SUPPLY
The demand function
Partial equilibrium (Alfred Marshall) vs General equilibrium (Leon Walras)
Partial equilibrium: method that analyses the relationship between two variables, other
variables must remain constant.
We have some human needs (food, accommodation and clothes). In order to satisfy this human
needs we need goods and services.
Utility: in economics means the capacity/ability of the goods and services to satisfy the human

needs. It’s the value of use and it is different for every individual
Demand: is the action where we buy/use goods and services that they have a specific utility to
satisfy human needs.
Total utility: total amount in terms of utility that we receive when we buy a specific number of
goods and services. The satisfaction you get from having a good or service.
Average total utility = total utility /quantity
Marginal Utility = variation in total utility / variation of quantity
Decreasing marginal utility: when your willing to pay is lower
Variables:
Q1D = (P1 (price of the good), P2 (price of related goods), income (m), tastes, quality, design,
#population, law, expectations, …)
Q1D = f (P1) Price demand

Q1D = f (P2) Cross-demand
Q1D = f (m) Income demand or Engel’s function
When de price increases the demand quantity decreases, when the price decreases the demand
increases. The relationship between the price and the demand is negative.
Demand function: quantity demand as a function of the independent variables that influence
the quantity demanded.
Direct demand: the direct relationship between the quantity demanded and the price (other
independent variables held constant).
Inverse demand: the direct relationship between price and quantity demanded P1 = f (Q1D).
Price- demand function: normal and Giffen goods
Normal goods: majority of goods and services are

normal goods. When the price increases the demand
quantity decreases, and when the price decreases the
demand quantity increases. The relationship is
negative.
Giffen goods (Robert Giffen): strange case when the
price increases the demand quantity increases
(Ex: potatoes in Ireland case, unique case in history).

Relationship between demand quantity and price is
positive.
Cross-demand Function: substitutes and complementary goods

Related goods: they have some relationship
▪ Substitutes goods: are goods that satisfy the same need. The relationship is positive
and then, the cross-demand has positive slope. (Ex: coffee or tea, caffeine or sugar,
iPhone or Samsung, butter or margarine, car or motorbike, bus or metro, Coca-Cola
or Pepsi, etc.). When the price of Coca-Cola decreases, demand quantity for Pepsi
will decrease (they will buy more Coca-Cola because it’s cheaper).
▪ Complementary goods: goods that we have to consume together, because they only
satisfy the need together (car and oil, charger and a smartphone, etc.). When the
price of oil increases, people will use less their cars.
Independent goods: two goods without relationship. (it would be drawn as a vertical line

Microeconomics
Income-demand function: normal and inferior goods
Normal goods: are those goods that when the income

increases the demand quantity increases too (Ex: Iberian
ham, salmon, shellfish, etc.)
Inferior goods: are those goods when the income

increases, the demand quantity decreases (sardines,
legumes…)
If your income increases, you’ll buy more Iberian ham than mortadella, for example, you’ll buy
goods that with a lower income you’ll not buy because you would not be able to. When you
become poorer, you are going to buy inferior goods
The demand schedule and the demand curve
When the price of the ticket

decreases, the quantity of
tickets demanded increases,

and vice versa. When the price
of the ticket decreases we are
moving along the demand
function.
Price movement along the demand curve vs shift of the demand curve
The movement from A to B is only when we change

the variable, in this case when the price of the ticket
decreases. When we analyse the price-demand and
we observe a variation in the price of the good, the
demand quantity is going to change.
If the price increases, the demand quantity is going

to decrease and vice versa, if the price decreases,
the demand quantity increases.

But if there is a variation in the other variables, we can observe a shift of the demand curve.
Shifts happen when the demand change without changing the price. When we observe a
change on the price of the related goods, a change in the income, in the tastes, in quality, in
design, in the number of population, on the law, etc., the demand is shift.
An increase in the demand is a shift rightwards and a decrease in the demand is a shift leftwards.
There’s an increase in demand when:
- The price of the substitute increases.
- The price of the complementary goods decreases.
- The income in the case of normal goods increases.
- The income in the case of inferior goods decreases.
- Variation on tastes (good unfashion).
- Good expectations of future.
- Increase in population.
A decrease in demand:
- Decreasing the price of related goods in case of substitutes

- An increase in the case of complementary goods
- A decreasing income in the case of normal goods and services

- An increasing income in the case of inferior goods and services
- Out fashioned
- Decrease in the number of population
- Bad expectations
A change in the quantity demanded occurs when only the price changes (demand remains in the
same place) = MOVEMENT ALONG DE CURVE
A change in demand occurs when one of the other variables changes = DEMAND CURVE SHIFTS
A variation in the demand quantity DOESN’T imply a variation in the demand, while a variation
in the demand always IMPLY a variation in the demand quantity.
Individual and market demand
Individual demand: demand for a good or service by an individual.

Microeconomics
Market demand: we have to aggregate the individual demand in order to get the market
demand. in the case of private goods and services the market demand is the horizontal addition
of the individual demands. Only in the case of private goods we add the quantities of individuals.
In the example we don’t add the prices of the clams, the price is the same, we only add the
quantity of clams of the individual demands (horizontal).
Example:
- First group: 20 people ---- Q1D = 15 – p

- Second group: 30 people ---- Q2D = 40 - 2p
- Third group: 10 people ---- Q3D = 120 – 3p
Q1D = 20 · Q1D = 20 · (15 – p) = 300 – 20p

Q2D = 30 · Q2D = 30 · (40- 2p) = 1200 – 60p
Q3D = 10 · Q3D = 10 · (120 – 3p) = 1200 – 30p

To calculate the market demand:
Supply function
Q1S = f (P1 (price of the good), P2 (price of the related goods), PINPUTS, technology,
expectations, …)
Q1S = f (P1)
The relationship between the supply quantity

and the price is that when price increases,
quantity supplied increases and when the price
decreases the supply quantity decreases too
because they can’t cover costs.
Behind the demand function we have defined the willingness to pay, your willingness to pay
depends on your marginal utility (ex: you don’t appreciate the same way a meat ball when you
are hungry than when you have already eaten 5, so your willingness to pay a meat ball will be
lower in your 5th meat ball than in your 1st one).
Behind the supply function we have to observe the cost of production. If the price increases
more firms can produce at a lower cost than the price and if you can do that you can get benefits.
When the price increases, more firms see that they are capable to produce at a lower costs of
production. When the price increases, more firms enter to the market, more firms produce and
consequently, the supply quantity is higher.
When the price decreases, the firms that can’t produce at a lower cost (if they produce at lower
costs they have losses) they decide to go out from the market. Then, when the price decreases,
the supply quantity decreases too.
Two goods or services are substitutes in consumption if these two goods separately can satisfy
the same need
Two goods are substitutes in production if the producer can produce these two goods and the
producer has to decide which of these two products is going to produce.

Assume that the costs of production are similar, if the price of the substitutes in production (P2)
increases I’m going to produce more P2 and decrease the production for P1 (Q1S) (it depends on
the one that will provide you higher benefits).
If P2 increases, I’m going to decrease the supply quantity of P1.
When the price of the inputs, or the wages, or the price of the oil, or the interest rate decreases,
the supply quantity (level of production) increases. Then, the relationship between the supply
quantity and the input price is negative. If the technology improves, there are good
expectations, the supply quantity increases.
The relationship between supply quantity and price is positive. The relationship between the
price of substitutes in production and the supply quantity is negative. The relationship between
the price of the inputs and supply quantity is also negative. And finally the relationship between
the good expectations or the improvement of the technology with the supply quantity is
positive.
Price movement along the supply curve vs shift of the supply curve
As in the demand function, a movement along the curve is

not the same as a shift of the curve. In a movement along
the curve, the price changes, while a shift means a change in
the other variables except the price.
A change in the supply quantity is when we change the price,

while a change in the supply is when we change in other
variables.

Microeconomics
A variation in the supply quantity DOESN’T imply a variation in the supply. But a variation in the
supply IMPLIES a variation in the supply quantity (same as in the demand quantity).
A shift leftwards means a decrease in supply, while a shift rightwards means an increase in
supply (forget the variable price).
We can find an increase in supply:
- Price of the substitutes in production decreases

- Price of the inputs decreases
- Improve in technology
- Good expectations
- Number of firms increases
We can find a decrease in supply:
- Price of the substitutes in production increases

- Price of inputs increases
- Technological problem
- Bad expectations
- Number of firms decreases

Individual supply curve and the market supply curve
In order to calculate the market

supply curve, we have to do the
same as in the market demand
curve: a horizontal addition.
Market equilibrium (“Law of supply and demand”)
Market: structure where suppliers and consumer

make economic transactions and they reach an
agreement. This agreement is called market
equilibrium and has two elements: equilibrium
price and equilibrium quantity.
Equilibrium: supply quantity = demand quantity

Known as the “INVISIBLE HAND” (Adam Smith)
Law of supply and demand (scissors model) “Partial equilibrium”- Alfred Marshall

Microeconomics
2.2 WELFARE AND EFFICIENCY
Consumer surplus
Behind the demand, we have to consider the willingness to pay and this depends on the marginal
utility.

Consumer Surplus (CS) = willingness to pay – price
If your willingness to pay is lower than the equilibrium price you are not going to buy the
product.
When the price decreases, the consumer surplus is going to increase. And vice versa, if the price
increases, the consumer surplus is going to decrease.
Producer surplus
Behind the supply we have to consider the cost of production.
Production Surplus (PS) = price – cost of production

If the producer is going to receive a higher price, then the producer surplus increases, and vice
versa.
Total surplus
If the price increases, the consumer is going to lose

and the producer is going to win. And vice versa, if
the price decreases, consumers are going to win and
producers are going to lose.
Total Surplus (TS) = PS + CS

Microeconomics
Market equilibrium and efficiency
In a competitive market the total surplus is maximized

and then we can conclude the allocation of the resources
is efficient (the market equilibrium is efficient and the
total surplus is maximized (maximal))
If in the market equilibrium is efficient and the total

surplus is maximized, out of equilibrium allocations are
inefficient.
Households demand
good and services
and at the same time
supply labour.
While, firms supply

goods and services
and at the same

time, demand factors
of production.
Efficiency vs equity
▪ An economy is efficient if it takes all opportunities to make some people better off
without making other people worse off (Pareto Efficiency).
▪ Equity means that everyone gets his or her fair share. Since people can disagree about
what’s fair, equity isn’t as well-defined a concept as efficiency.
When we try to increase the equity we must scarify some degrees of efficiency. We have to
reach an equilibrium between efficiency and equity, but it’s really hard to find this point.
In addition to efficiency, it is desirable that the allocation of resources is equitable anc

economically just.
The measurement of equity has to do with income distribution.
Measures of the income distribution
If the income distribution is fair, then the equity is higher.

- Lorenz curve
50% of the population have the 20% of the total

income. Or in other words, 50% of the population
has the 80% of the total income.
If the red curve is near the straight line, then the

equality is higher. If the red curve is far from the
straight line, the level of inequality is very high.
Thanks to the Lorenz curve, another economist, Corrado Gini, develop the Gini
coefficient.
Gini coefficient:

If the gini coefficient is near 0, then complete equality (the area of A if the Lorenz curve
is near the line of equality will be really small, which means near 0) and if the gini
coefficient is near 1, complete the inequality.
Sometimes you can find the gini coefficient between 0 and 100, in this case you have to
multiply the gini coefficient by 100.
- The Rawls’ criterion (John Rawls):

The Rawls’ criterion is the criterion of maximin (short for “Maximum minimorum”).
The main idea is to maximize the minimorum, which means improve the income of the
lowest levels of income, the people with the lowest level of income. The emphasis is on
the most disadvantage. When we decide to increase the minimum wage, the maximin
is trying to maximize the welfare of the most disadvantage people.
The contrary would be minimax, that would be decrease the income of the richest. But
in terms of welfare you are going to increase it more by increasing the lowest incomes.

Microeconomics
- Utilitarianism (Jeremy Bentham):
The goal is to maximize the total welfare. If the total utility increases, the social
inequality is going to decrease.
Utilitarianism is not in favour of egalitarianism (equalize all the different levels of

incomes).
Income redistributive policies
- Fiscal policies instruments

▪ Via revenue (taxes)
▪ Principle of ability to pay: who has more income, have to pay more. The

ones who have less income, has to pay less.
▪ Principle of profit: you have to pay if you are going to use it.
▪ Via expenses/transfers
▪ The Welfare State (4 legs of the Welfare State): guarantee public system
of health, education, pensions and to take care of disadvantage people.
- Equality of opportunities
2.3 ELASTICITIES
Price elasticity of demand
εpD = sensibility of the demand quantity when the price changes
∆Q
𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 % 𝑄𝐷 · 100 𝑃 ∆Q
ε p
D =-
𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 % 𝑝𝑟𝑖𝑐𝑒
= - 𝑄
∆P
· 100
= - ·
𝑄 ∆P
>0
𝑃
𝑄1 − 𝑄0
In order to calculate the variation we have to: 𝑄0
· 100
εpD > 1 ------ elastic demand
If the
If the εpD = 1 ------ unit-elastic demand
If the εpD < 1 ------ inelastic demand
εpD ≥ 0 → This is the case of normal goods and services

Microeconomics
Extreme cases:
Mid-point price demand elasticity
If the demand is stepper the demand will be inelastic.

This happens when the price changes a lot, but the
demand changes really small.
Example: demand of oil. When there is a huge change

in the price of the oil, the change in the demand
quantity is really small because we depend of it.

When the price increases a 20%, the quantity

decreases a 20%, and vice versa. If the price
decreases a 20%, the quantity increases a 20%.

Microeconomics
Why is so important the elastic concept? It helps us to know when the total revenue is
maximized.

p Q TR = p · Q 𝑻𝑹 𝒑·𝑸 ∆𝐓𝐑
∆𝐓𝐑 = = =𝒑 𝑴𝑹 =
𝑸 𝑸 ∆𝐐
12 0 12 · 0 = 0 0
11 1 1 · 11 = 11 11 11 – 0 = 11
10 2 10 · 2 = 20 10 20 – 11 = 9
9 3 9 · 3 = 27 9 27 – 20 = 7
8 4 8 · 4 = 32 8 32 – 27 = 5
7 5 7 · 5 = 35 7 35 – 32 = 3
6 6 6 · 6 = 36 MAX. 6 36 – 35 = 1
5 7 5 · 7 = 35 5 35 – 36 = -1
4 8 4 · 8 = 32 4 32 – 35 = -3
3 9 3 · 9 = 27 3 27 – 32 = -5
2 10 2 · 10 = 20 2 20 – 27 = -7
1 11 1 · 11 = 11 1 11 – 20 = -9
0 12 0 · 12 = 0 0 0 – 11 = -11
Marginal revenue (MR): variation in the total revenue when we change the quantity sold.
𝑃 ∆Q
TR maximized when εpD = 1 → - ·
𝑄 ∆P
=1

Microeconomics
Summary:

- If we want to maximize the total revenues, we have to choose the point where the price
elasticity is equal to 1.
- If we can’t reach the point where the price elasticity is equal to 1 and we want increase
the total revenue:
▪ If we have an inelastic demand, we must increase the price,
▪ If we have an elastic demand, then we have to decrease the price.
When the seller decides to increase the price, if the area of C is higher than the area of A, then
the total revenue is going to increase. But if the area A is higher than the are C, it has no sense
to increase the price.

Income elastic of demand
The relationship is +/-.
𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 % 𝑄 𝐷 𝑚 ∂Q
εmD = 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 % 𝑖𝑛𝑐𝑜𝑚𝑒
=
𝑄
·
∂m
εmD < 0 ----- Inferior goods
εmD > 0 ----- Normal goods
- 0 < εmD < 1 ----- Necessary goods
- εmD = 1 ----- Normal goods strictus sensus
- 1 < εmD < ∞ ----- Luxury goods
Cross-price elasticity of demand: we consider the price of the related goods.

𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 % 𝑄1𝐷 𝑃2 ∂Q1
εcD = 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 % 𝑃2
= ·
𝑄1 ∂P2
εcD > 0 ----- Substitute goods

εcD < 0 ----- Complementary goods
εcD = 0 ----- Independent goods
Price elasticity of supply
𝑆
∂𝑄1 𝑆
εpS = 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 % 𝑄1
𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛 % 𝑃
=
𝑃1
𝑄1 𝑆 · ∂𝑃1
Q1S = f(P1)
1

Microeconomics
Factors affecting the price elasticity of demand:
The number of close substitutes for a good or the uniqueness of the product: the availability of
alternatives goods can affect the demand elasticity. The demand of goods or services with many
substitutes is highly elastic because a small increase in the price levels of goods causes
consumers to buy its substitutes.
If we can only choose one product the demand will be more inelastic. If we can choose among
different products the demand will be more elastic
Degree of complementarity of goods/services: with a high degree of complementary, the price

demand will be more inelastic (low PED), because you have to buy this two goods in order to
use one, so even if one has an increase in their price, you will buy both of them. Ex: iPhone and
iTunes
Cost of switching between different products: if the costs involved in switching between

different goods and services are significant, the demand tends to be more inelastic. And with
small costs of switching, the demand is more elastic because a small rise in the price could make
many consumers switch easily. Ex: change from Movistar to Vodafone.
Nature of commodity (necessity, comfort or luxury): certain goods by their nature tend to have
an elastic or inelastic demand. By nature, goods may be classified into luxury, comforts or
necessary goods. In general, demand for luxuries and comforts is relatively elastic (consumers
can live without them when their budgets are stretched), while for necessaries is relatively
inelastic.
Time period: the longer the time period, the greater the elasticity, as consumers have more time
to adapt and find more substitutes. In short run, the demand will be more inelastic (compulsive
buy), while in the long run the demand will be more elastic (conscious buy).
Consumer’s income level: goods and services that take a high proportion of household’s income
will tend to have a more elastic demand than products where large price changes make little or
no difference to someone’s ability to purchase the product. Ex: anyone can afford a box of
matches so a change in their price will not make a huge variation in the demand, while a change
in the price of a car could make people with lower income levels not be able to purchase it.
Habits: commodities, which have become habitual necessities for the consumer, have less
elastic demand. It happens because such a commodity becomes a necessity for the consumer
and he continues to purchase it even if its price rises. (ex: tobacco, alcohol, cigarettes…).
Peak and off-peak demand: demand tends to be price inelastic at peak times, a feature that
suppliers can take advantage of when setting higher prices (in peak times purchases are
compulsive, consumers will buy at any price). Demand is more elastic at off-peak times, leading
to lower prices for consumers (in off-peak hours, the atmosphere is more relaxed, and
consumers can decide better and are more sensible to price changes).
Advertising and brand loyalty: the price demand elasticity for a particular brand of smartphone
such as iPhone is usually greater than smartphones itself because different brand have
substitutes (iPhone, Samsung, Huawei, etc), whereas smartphones it self does not (anyone need
a smartphone, it does not matter the brand). For this reason, producers try to convince us their
brand has no suitable substitutes, and they spend lot of money on marketing campaigns trying
to increase brand loyalty, which means decrease the PED for their particular product. Ex: freaks
of iPhones will make the demand more inelastic because they will always buy iPhones, at any
price (they will never buy a Samsung, for example).
Factors affecting the price elasticity of supply:
Spare production capacity: if there is plenty of spare capacity, a business should be able to
increase its outputs in response to increased prices without a rise in costs and therefore supply
will be elastic in response to a change in demand (will be able to produce much more). While, if
you are producing near your full capacity, the price elasticity of supply will be lower, more
inelastic.
Stocks of finished products and components: if stocks of raw materials and finished products are
it a high level, then a firm is able to respond to a change in demand quickly by supplying these
stocks onto the market (the supply will be more elastic). Conversely, when stocks are low our
capacity to react to the variation to the price is lower, then the supply will be inelastic.
The ease and cost of factor substitution: if both capital and labour resources are occupationally
mobile, then the elasticity of supply for a product is higher than if capital and labour cannot
easily and quickly be switched. So, if there can be factor substitution, the supply function will be
elastic, but if there is no factor substitution, the supply function is inelastic.

Time period: the amount of time it takes producers to respond to price changes is extremely
important to the elasticity of supply. Supply is more elastic in the long run than in the short run.
The longer the time period the easier it is to shift resources among products, following a change
in their relative prices.
Mixing the last two points: in the short run, factor substitution is really low and for this reason,
the supply function is more inelastic. But in the long run, we can change capital and labour and
then the level of factor substitution is very high, so the supply function is more elastic.

Microeconomics
BLOCK 2: EXTENSIONS AND APPLICATIONS

2.4 GOVERNMENT POLICIES
Price ceiling: when the government decide to fix the maximum legal price.
For a binding price ceiling: PMAX below the PE
Price floor: government decide to set a minimum legal price
For a binding price floor: PMIN above the PE
We can justify the government intervention in the market when the equilibrium price is too high.
Then the government fix this new equilibrium price, which in this case is 800 euros.

If the new price is 800, at this price the demand quantity will be 2,2 millions of apartments, in
this price the quantity of apartments supplied will be 1,8 millions of apartments.
Another example:
Price floor must be higher than the equilibrium price. The government decide to stablish a
minimum price in order to protect the farmers. Now, the minimum price will be 1.20$. At this
price the supplied quantity will be 12.0 millions of pounds of butter and the demand will be of
9.0 millions of pounds. They will sell less but a higher price.
Any intervention of the government will always cause a reduction in the total surplus, which
means that will always produce inefficiency.

Microeconomics

Example of price floor:
Example of price ceiling:
Microeconomics

Microeconomics
Consequences of price controls
- In the case of price floor, it transfers some of the Consumer Surplus to Producer Surplus
and in the case of price ceiling, it transfers some of the Producer Surplus to Consumer
Surplus, while creating in both cases an inefficiency or deadweight loss (DWL).
- Price ceiling creates a shortage and price floor creates a surplus. In both cases the black
market will appear.
Excise tax on consumers and producers
Excise tax on producers
We are talking about the VAT (IVA), for example, a specific tax on gasoline.
In this case we must focus our attention on the supply

function.
The excise tax on producers will shift the supply function

leftwards. We, as consumers, are going to pay PE’. On the
other hand, producers are going to receive the PE’ paid by

consumers minus the tax.
PE’ – T
Example:
Excise tax on consumers
We are talking about the ITP and the ATD, for example, we pay the ITP when we buy a house.
Here, as consumers, we are going to pay twice: the price to the seller and the tax to the
government. → PE’ + T

Microeconomics
In this case, we must focus our attention on the demand function.
Exercise:
To sum up, when the tax is on producers, the supply function shifts leftward. While, if the tax is
on consumers, the demand function will shift leftwards. The economic effects of tax on

producers and tax on consumers are the same, inefficiency.
Deadweight loss and elasticities
Taxes are paid by consumers are producers. In the examples, the tax was 1 and the consumers
pay 0.5 and the producers 0.5. But, usually, the consumers and the producers do not pay the
same quantity of tax (the burden tax is not equal)
The key point is in elasticity.

Microeconomics
The one that is more inelastic will always pay more. While the one who is more elastic, will
always pay less.
The demand function for gasoline is very inelastic,

then 0.95 cents of the tax is going to be paid mainly
by consumers. While the supply function is very

elastic, so the producers/sellers are going to pay
only 0,05 cents of the tax.
The deadweight loss of a subsidy
A subsidy is the contrary of a tax, the opposite case.
Subsidy on producers Subsidy on consumers
Here we are going to focus our attention Here, we are going to focus our attention on
on the supply function. the demand function. We will pay the price
to the producers and afterward we will
PE’ + S
receive the subsidy. PE’ - S

Subsidy on producers
Subsidy on consumers
Microeconomics

Microeconomics
International trade
Here, we will compare the domestic price (PDOM) with the world price (PW). We can have 3
different cases:

a) PDOM = PW → the domestic market does not change
b) PW > PDOM → the production is really competitive (export)
c) PW < PDOM → import
PW > PDOM
If the consumers of the rest of the world want to pay a higher price for my domestic production,
then I am going to export.

Microeconomics
In this case, producers are winning because they are very competitive, they can produce at a
lower price than other producers of the world.
However, the domestic consumers lose because they have to pay higher prices.

PW < PDOM
If the world price is lower than the domestic price, like consumers, we would want to buy the
products produced in the rest of the world, which leads to import these products.

Microeconomics
In this case, consumers are going to win because they are going to pay lower prices. On the other
hand, only the more competitive domestic producers will survive, that means that many of them

won’t and consequently they will lose.
Free trade (≠protectionism) has no neutral economic effects. In products where you are
competitive, you are going to increase your production, you are going to promote the more
competitive producers. But you will scarify the production of the producers/firms with lower
competitiveness. In both cases, free trade always increases the total welfare.
Tariffs
Tariffs are taxes in imports, which means the

world price is lower than the domestic price.
Non-competitive producers organize

themselves and ask the government
protection as they cannot compete with the
foreign producers. The government accept
giving them this protection and set up a
tariff.
In this case, the government and the

domestic producers are going to win, but
foreign producers and consumers are going
to lose.

Microeconomics
Topology of goods and services
Goods can be classified according to two attributes:
- Whether they are excludable or nonexcludable

- Whether they are rival or nonrival in consumption
A good is excludable if the supplier of that good can prevent people who do not pay from
consuming it (positive price).
When a good is nonexcludable the supplier cannot prevent consumption by people who do not
pay for it (price is equal to 0).
Microeconomics
A goof is rival in consumption if the same unit of the good cannot be consumed by more than
one person at the same time. Ex: a coffee.
A good is nonrival in consumption if more than one person can consume the same unit of the
good at the same time. Ex: public TV channels.
PRIVATE GOODS (goods that are both excludable and rival in consumption) can be efficiently
produced and consumed in a competitive market.
Goods that are nonexcludable suffer from the free-rider problem: individuals have no incentive
to pay for their own consumption and instead will take a free ride on anyone who does pay.

When goods are nonrival in consumption, the efficient price for consumption is zero.
If a positive price is charged to compensate producers for the cost of production, the result is
inefficiently low consumption.
A PUBLIC GOOD is the exact opposite of a private good: it is a good that is bot nonexcludable
and nonrival in consumption.
How to calculate the market demand for public goods and services
We know that the market demand for a private good is calculated through horizontal addition
(at each price we have to add the individual demand quantities). But, public goods and services
the market demand is calculated through vertical addition (at each quantity you have to add
the different prices of individuals, willingness to pay of each individual).

Microeconomics
Market demand for private goods (horizontal addition):

Market demand for public goods (vertical addition):

Microeconomics
Providing public goods
No individual has an incentive to pay for providing the efficient quantity of a public good because
each individual’s marginal benefit is less than the marginal social benefit.
MgBi < MgBsociety
The marginal society benefit of an additional unit of a public good is equal to the sum of each
consumer’s individual marginal benefit from that unit.
∑ MgBi = MgBsociety
At the efficient quantity, the marginal social benefit equals the marginal cost
MgBsociety = MgC
This is a primary justification for the existence of PUBLIC SECTOR (government).
Public goods and services
- Public goods generate positive externalities.
- Problems of public goods and services:

▪ Congestion: everybody can access to them and then de demand is very high (we
can find problems of congestion). EX: public parks are filled with kids, you
cannot exclude them.
▪ Free riders: when you decide to use a public good and service without paying
anything. They willingness to pay for everything is 0 although they enjoy of
those goods and services.
- Merit G&S: generate positive externalities. EX: education
- Demerit G&S: private goods create negative externalities. EX: tobacco, alcohol, drugs,
junk food
Examples of public goods and services
Lighthouses, wheatgerm forecasting, fireworks service, street lightning, national security,

justice, national defence, information, knowledge, peaches, roads and motorways, public
water supplies, sewer system, clean air, public health and public sanitation, scenic views…
Communal goods (common resources): non excludable and rival in consumption
Garret James Hardin (1915-2003): “The tragedy of the commons”: the damage that innocent
actions by individuals can inflict on the environment.
A common resource is nonexcludable and rival in consumption: you can’t stop me from
consuming the good and more consumption by me means less of the good available for you

Microeconomics
Examples: fisheries, forests (mushrooms collection).
In each of these cases, the fact that the good, through viral in consumption, is nonexcludable
poses a serious problem. The problem of overuse (renewable resource over exploitation).
The problem of overuse
Common resources left to the free market suffer from overuse
Overuse occurs when a user depletes the amount of the common

resource available to others but does not take this cost into
account when deciding how much to use the common resource.
In the case of a common resource, the marginal social cost of my

use of that resource is higher than the individual marginal cost or

the cost to me of using an additional unit of the good,
MgCi < MgCsociety
The efficient use and maintenance of a common resource
To ensure efficient use of a common resource: “society must find a way of getting individual
users of the resource to take into account the (unwitting) costs they impose on other users”.
Like negative externalities, a common resource can be efficiently managed by:
- A tax or regulation imposed on the use of the common resource.

- Making it excludable and assigning property rights to it.
- Creating a system of tradable licenses for the right to use the common resource.
Collective goods or artificially scare goods
A collective good or artificially scare good is excludable

but nonrival in consumption.
Because the good is nonrival in consumption, the

efficient price to consumers is zero. A good is made
artificially scarce because producers charge a positive
price which leads to inefficiently low consumption.
The marginal cost of allowing one more person to

consume the good is zero.
The problems of artificially scarce goods are similar to

those posed by a natural monopoly. Ex: medicine
patents.
Microeconomics
Externalities = side effects
An external cost is an uncompensated or collateral cost that an individual (consumption) or a

firm (production) imposes on others → negative externalities (pollution, smoking…)
An external benefit is a benefit or side effect that an individual (consumption) or a firm

(production) confers on others without receiving compensation → Positive statements
(technology spillovers, vaccines…)
Costs and benefits of pollution
- The marginal social cost of pollution is the additional cost imposed on society as a whole
by an additional unit of pollution.
- The marginal social benefit of pollution is the additional gain of society as a whole from
an additional unit of production.
- The social optimal quantity of pollution is the quantity of pollution that society would
choose if all the costs and benefits of pollution were fully accounted for.
Left to itself, a market economy will typically generate too much pollution because polluters
have no incentive to take into account the costs they impose on others.

If we increase the quantity of pollution, the marginal social benefit decreases and the marginal
social costs of this pollution increases.
The social optimal quantity of pollution is not zero, is the quantity where the marginal social cost
is equal to the marginal social benefit.
The marginal private cost and the marginal social costs are not the same. Then, usually, when a
producer pollutes the clean air, the producer is damaging the society. The costs of production
don’t include the pollution of the clean air. The social cost is higher than the private cost.
MPC: marginal private cost; MSC: marginal social cost; MEC: marginal environmental cost

Microeconomics
Private solutions of externalities
The economist Ronald Case pointed out that, in an ideal world, the private sector could indeed
deal with all externalities. When individuals or firms do take externalities into account, the
internalize the externality through government regulations, the Pigouvian tax, the permits
markets, etc.
According to the Coase theorem, even in the presence of externalities, an economy can always
reach an efficient solution once property rights have been defined and when the transaction
costs (costs of making a deal) are sufficiently low.
For example, the air is of everyone. Companies have the right to pollute. Once the rights are
stablished, Coase creates a market, the market of pollution permits. Imagine we have several
plants with a level of SO2 emissions as shown in the table, and for the following year they must
reduce a 10% these emissions.
Year 1 Year 2 Plant 2 must invest in new clean technology so they can
P1 10 tn. 9 tn. reduce the 10%. Thanks to this new technology they cannot
only produce with 45 tn. of emissions but with only 40 tn. of
P2 50 tn. 45 tn.
SO2 emission. This plant will then sell these 5 pollution
3 20 tn. 18 tn.
permits (the money they will obtain will be used in the
… … investment of the new clean technology).

100 tn. 90 tn.
If the first plant wants to produce with the same amount of pollution that the first year, they
would buy a pollution permit.
The idea is that at last, all companies will have changed their dirty technology to clean
technology
The Pigouvian tax

Microeconomics
We have to correct the level of production and the way to pass from the market equilibrium to
the optimal equilibrium is moving the supply leftwards. We can do that by applying taxes, in this
case the Pigouvian tax.
An emission tax is a form of Pigouvian tax, a tax designed to reduce external costs (Arthur Cecil
Pigou).
The effect of a Pigouvian tax is to make the private marginal cost plus this tax equals the marginal
social cost.
The Pigouvian tax does not generate any efficiency loss of markets, as internalize the externality
costs for producers and consumers, rather than changing them.
Policies towards pollution
Environmental standards are rules that protect the environment by specifying actions by
producers and consumers. Generally, such standards are inefficient because they are inflexible.
An emission tax is a tac that depends on the amount of pollution a firm produces.
Tradable emissions permits are licenses to emit limited quantities of pollutants than can be
bough and sold by polluters.

Taxes designed to reduce external costs are known as Pigouvian taxes.

Microeconomics
30/11/2020
BLOCK 3 FIRM THEORY AND PERFECT COMPETITION
3.1 FIRM THEORY
The production function
Production is the name given to the

transformation of factors of production into
goods and /or services. This is the role of firms.
The production process can be divided into the long run and the short run. The difference
between the short run and the long run is that, in the short run the capital is fixed, while in the
long run all inputs are variable.

Short run: Long run:
In the short run we are going to analyse the productivity and in the long run we are going to
analyse the concept of returns to scale or economies of scale: increasing returns to scale (IRS),
constant returns to scale (CRS) and decreasing returns to scale (DRS).
The total product (TP or Y or Q) curve shoes how the quantity of output depends on the quantity
of the variable input (L), for a given quantity of the fixed input (K).
Marginal product of labour (MPL or MP) is the additional output (TP) that will be forthcoming
from an additional worker (L), other inputs remaining constant (K). Quantity of output generated
by one additional unit of labour.
Average product of labour (APL or AP) is calculated by dividing the total output by the quantity
of the output.
𝑌 ∂Y 𝑛𝑜 𝑜𝑢𝑡𝑝𝑢𝑡𝑠
𝐴𝑃𝐿 = = = 𝑜
𝐿 ∂L 𝑛 𝑤𝑜𝑟𝑘𝑒𝑟𝑠
The law of diminishing marginal productivity “David Ricardo”
The production function for most outputs has three stages:
Stage 1: The production function exhibits increasing marginal returns. Each additional unit of
input yields more output than the previous unit, thanks to the division of labour.
Stage 1: Initially, the production function exhibits increasing Marginal Productivity of Labour
(MPL) and increasing Average Productivity of Labour (APL).
Stage 2: The production function exhibits diminishing (but positive) marginal returns. Therefore,
total production increases with each additional unit of input

(labour) but total production does not increase as much as the
last additional unit of input. Here, we can identifiy the
maximum Average Productivity of Labour (APL).
Stage 2: The, the production function exhibits diminishing
Marginal productivity of labour (MPL) and, firstly, a increasing
Average Porducitivity of Labour, and afterwards, a decreasing
Average producitivity of labout (APL).
Stage 3: The production function exhibits negative marginal returns. As the variable input used
exceeds the capacity of the fixed inputs, the output may actually begin to decline.
Stage3: Finally, the Production Function exhibits negative marginal prosuctivity of Labour (MPL)
and decreasing average producitivty of labour (APL).
There are three ways to maximize the Average

Producitivity of Labour (the number of goods per
worker):
- Increase the level of production. Try to produce

more using the same quantity of workers.
- Decrease the amount of workers. Try to

produce the same quantity of output using a
lower quanitity of workers.
- Increase the level of production and decrease

the quanitty of workers at the same time.
The division of labour is finite because you can divide the process of production in limited fases.
The “Law of diminishing returns” states that adding additional amounts of labour (L) to a fixed
amount of capital (K) will eventually reduce the Marginal Product of Labour (MPL).
We focus our analysis at the level of production in which the Marginal Product of Labour (MPL)
decreases as the number of workers increase and where the Average Product of Labour (APL)
reach the maximum.
Also called the “flowerpot law”

Microeconomics
A production table
*Marginal production = 10-4 = 6; 17-10 =7 ------ Average product = 10/2= 5; 17/3 = 5.7

The production function in the short run
̅ · Lβ
Y= 𝐾
β > 1 Increasing returns

(unrealistic)
β = 1 Constant returns
β > 1 Decreasing returns
(usual case, realistic)
The production function in the long run
In the long run all the inputs are variable. Y = f (K, L) outputs = f (inputs)
Economies of scale and scope
Y = A · Kα · Lβ *A corresponds to technological parameters
- α + β > 1 ----- Increasing returns to scale (IRS) = economies to scale

- α + β = 1 Constant returns to scale (CRS)
- α + β < 1 Decreasing returns to scale (DRS) = diseconomies of scale
When there’s an increase of the inputs, we have to analyse the variation in the outputs (%
outputs).
Examples of each case:
+ 100% input → + 200% output ----- Increasing Returns of Scale (IRS)
+ 100% input → + 100% output ----- Constant Returns of Scale (CRS)
+ 100% input → + 50% output ----- Decreasing Returns of Scale (DRS)
Relationship between production and costs
- The structure of costs of a company is a reflection of the production process.

- The production process is defined by the production function.

Concepts and measures of costs
̅ · L)
In the short run: Y = f ( K
̅·r+L·w
TC = 𝐾
*where r corresponds to the price of the capital (interest rate) and w to the price of the labour (wages)
- Fixed costs: is a cost that is constant, regardless of the number of units produced (ex: natural
gas, electricity…).
Average fixed costs: calculated by dividing the total fixed cost by the number of units
produced (always decreasing, tending to zero).

Microeconomics
AFC = FC/Q
- Variable costs: is a cost that is incurred with each unit of production.
Average variable costs: calculated by dividing the total variable costs by the number of units
produced.
AVC = VC / Q
- Total cost: is the sum of fixed costs and variable costs. The variation in the total cost will be
the variation in the variable costs because fixed costs are constant. (sometimes we don’t
know the fixed costs, but we know the total costs when the level of production is 0, then we
know the fixed costs because they are independent from production).
TC = FC + VC

Average total cost (unitary costs): is calculated by dividing the total cost by the number of units
produced. Costs per unit produced
𝑇𝐶 𝐹𝐶+𝑉𝐶 𝐹𝐶 𝑉𝐶
ATC = 𝑄
= 𝑄
= 𝑄
+ 𝑄
= 𝐴𝐹𝐶 + 𝐴𝑉𝐶
Marginal cost: is the variation of the total costs when we change the production. Is the cost of
producing one additional unit of output.
𝜕𝑇𝐶 Δ (𝐹𝐶+𝑉𝐶) ΔF𝐶 Δ𝑉𝐶 𝜕𝑉𝐶

MC = 𝜕𝑄
= Δ𝑄
= Δ𝑄
+ Δ𝑄
= 𝜕𝑄
*the derivative of FC respect to Q is 0 because the fixed costs are independent from the production.
*Variation in the total costs is calculated dividing TC1-TC0 and the variation in the quantity is
q1-q0.
Example:
The average variable cost is minimized when the average productivity of labour is maximized.
But the average total cost is not minimized at the same point because we have to consider the
average fixed costs. When we analyse the productivity, we do not use the fixed capital.
The marginal cost is minimized when the marginal productivity of labour is maximized.
The relationship between productivity and costs is an inverse relationship.
Q3 is the optimal level of production. We don’t want to minimize only the AVC, as in Q2, we
want to minimize the ATC, so we must take into account the AFC.
Average total cost curve
Increasing output, therefore, has two opposing effect on average total cost:
- The spreading effect: the larger the output, the greater the quantity of output over
which fixed cost is spread, leading to lower the average fixed cost.
- The diminishing returns effect: the larger the output the greater the amount of variable
input required to produce additional units leading to higher average variable cost.
Some conclusions about cost curves:
▪ Marginal cost is upward sloping to due to diminishing returns.

▪ Average variable cost also is upwards sloping but is flatter than the marginal cost curve.
▪ Average fixed cost is downward slopping because of the spreading effect. The
numerator is constant, so when we increase the level of production the average fixed
costs is going to decrease. We are going to distribute the fixed costs among the number
of outputs, the production and that is the spreading effect, how are the fixed costs
spread in the production.
▪ The marginal cost curve intersects the average total cost curve from below, crossing it
at its lowest point.
▪ The minimum-cost output is the quantity of output at which average total cost is lowest
(the bottom of the U-shaped average total cost curve).
- At the minimum-cost output, average total cost is equal to marginal cost.

- At output less than the minimum-cost output, marginal cost is less than average
total cost and average total cost is failing.
- And at output greater than the minimum-cost output, marginal cost is greater
than de average total cost and average total cost is rising.

Microeconomics
*point M optimal quantity. The marginal costs cross the average total costs at its minimum.
Marginal cost curve
In practice, marginal cost curves often slope downward as a firm increases its production from
zero up to some low level, sloping upward only at higher levels of production.

This initial downward slope occurs because a firm that employs only a few workers often cannot
reap the benefits of specialization of labour.
This specialization can lead to increasing returns at first, and so to a downward-sloping marginal
cost curve.
Once there are enough workers to permit specialization, however, diminishing returns set in.
Behind the marginal cost we have to thing in the marginal productivity of labour. The same for
the average costs, behind the ATV we have to think of the APL.

More conclusions about cost curves
▪ U-shaped average total cost curves are typical

because average total cost consists of two parts:
average fixed cost, which falls when output increases
(the spreading effect) and average variable cost
which rises with output (diminishing returns effect).
▪ When average total cost is U-shaped, the bottom of
the U is the level of output at which average total
cost is minimized, the point of minimum-cost output.
This is also the point at which the marginal cost curve
crosses the average total cost curve from below.
The break-even point vs the shutdown point
▪ The shutdown point is the minimum

point in AVC curve, where AVC curve and
MC curve intersect.

▪ The Breakeven point is the minimum
point on AC curve, where the Ac curve
and MC intersect.
At last, the MC will be the supply curve of the firm from the shutdown point. If we consider the
market supply, we have to add the individual marginal costs of the individual firms.
Short run vs long run costs
In the short run, fixed cost is completely outside the control of a firm. But all inputs are variable
in the long run. This means that in the long run fixed cost may also be varied.
In the long run, in other words, a firm’s fixed cost becomes a variable it can be choose.
The firm will choose its fixed cost in the long run based on the level of output it expects to
produce.
Long run average total cost curves and returns to scale
Economies of scale:
- Increasing returns to scale (IRS) or economies of scale: when long run average total cost
declines as output increases (decreasing ATC). When we change the quantity of inputs
the change in the output is higher.

Microeconomics
- Constant returns to scale (CRS): when long-run average total cost is constant as output
increases (constant ATC).
- Decreasing Returns to Scale (DRS) or diseconomies of scale: when long-run average total
cost increases as output increases (increasing ATC).

LRATC: long run average total costs
We are going to be in the ATC3. The LRATC doesn’t exist, is fictitious.
ENVELOPE THEOREM: the average total cost in the long run compresses all the average total
cost in the short run at a different level of production.
Business profits
- Accounting profit: the business’s revenue minus the explicit costs and depreciation
(benefits)
- Normal profit: typically equals to opportunity cost (in freelance case is the wage). The
normal profit is often called the break-even point. Normal profits are positive when the
price is the minimum ATC. Usually used to pay to the shareholders, the owners of the
capital (dividends). Is the value of your work.
- Economic profit: business’s revenue minus the opportunity cost of its resources. It is
often less than the accounting profit
In accounting profits, we, usually, analysed in Limited Companies. We analyse the benefits,
which are higher than 0. You have to pay to shareholders (dividends which are normal profits).
Once we have paid them, we get the economic profits, which we put to reserves.
Explicit costs: they involve a direct payment of cash.
Implicit costs: they involve no outlay of money. The implicit cost of capital is the opportunity

cost of the capital used by a company.
So, companies should base decision on economic profit, which takes into account implicit costs
such as the opportunity cost of the owner’s time (=normal profit) and the implicit cost of capital.
The accounting profit, which companies calculate for the purposes of taxes and public reporting,
is often considerably larger than the economic profit because it includes only explicit costs and
depreciation, not implicit costs.
The normal profit is the amount the owners would have received in their next best alternative.
*Economic profits are profits above normal profits
Economic profit = Total revenue (TR) – Explicit costs – Implicit costs
Accounting profit = Total revenue (TR) – Explicit costs
Examples:
1. Total Benefit = 40.000€

Wage (w) = 30.000€
What is the normal profit and the economic profit?
Normal profit (opportunity cost) = 30.000€

Economic profit = Business revenue – opportunity cost = 40.000 – 30.000 = 10.000€
2. Total benefit = 100.000€ ----- Accounting profit

Pay benefits to the shareholders (dividends) = 60.000€ ----- Normal profits
Which are the economic profits?
Economic profits = 100.000 – 60.000 = 40.000€ (we will put this money in reserves)-

Microeconomics
Profit maximization rule
Profit maximization occurs when marginal revenue is equal to marginal cost.

∂TB ∂TR ∂TC
𝑀𝑎𝑥. 𝑇𝐵 = = − =0
∂Q ∂Q ∂Q
MR – MC = 0
MR = MC
*Total Benefit = Total revenue – Total costs
- If MR > MC, we are going to increase the level of production.

- If MR < MC, we are going to decrease the level of production. In this case what we are
going to receive (MR) is less than the costs (MC).
When:
TB = 0 - Normal profit > 0 (positive) = opportunity cost

- Economic profit = 0
TB > 0 - Normal profit > 0 (opportunity cost)

- Economic profit > 0
TB < 0 = losses
In this perfectly competitive market, producers should produce where the marginal cost of one
unit of output is equal to the market price
Inputs should be used until their marginal cost is equal to their marginal product value.
THE MARKET STRUCTURE
Concurrency: We analyse the number of producers and the number of consumers

If we consider one producer and many consumers. Monopoly (Ex: we can find many energetic
drinks but perhaps the 90% of the consumption is Redbull, so it is really near to a monopoly.
RENFE could be considered as well a monopoly)
Two producers and many consumers: duopoly (ex: NASA and ESA).
Many consumers and many producers:
- Perfect competition
- Monopolistic competition: is very near to perfect competition and far from monopoly.
Between the two extremes we have oligopoly, few producers and many consumers (Ex: mobile
phone platforms, airplanes agencies, gas stations, tobacco). Sometimes oligopoly is nearer
monopoly than perfect competition.
Market intervention
Free market: without governmental intervention. Companies try to maximize profits;

households try to maximize utility. Then, in the market equilibrium we have the break-even
price, when the welfare and efficiency is maximized.
Regulated market (interventionism): price ceiling, price floor, taxes, subsidies, tariffs and other

administrative regulations (laws).
Degree of market opening
Open markets: firms are completely free to enter or leave the industry.
Closed market: there are barriers to entry and barriers to exit an industry. Some barriers to
entry, for instance, are high start-up costs, economies of scale (advantage in costs), government
regulations (licence to produce, for example), control of resources, vertical integration,
horizontal integration, technological barriers (R&D+i), advertising, intellectual property and
patents… When these barriers are applied, the competitiveness of future competitors is
reduced.
If the barriers to enter are important, the level of competitiveness will be lower (not many firms
competing in the same market).
Market power
The market power is the ability to affect price to its benefit without losing all the costumers and
is infinite. For instance, raising the market price of a good or service without losing all the
costumers.
Governmental intervention is justified because they reduce the market power of the
monopolists.
When the industry is made up of a very large number of firms, then the market is atomized. If in
a market power we can identify many producers and their market share is 1-2%, then we can
conclude that the market power of these firms is very low, near 0.

Microeconomics
A firm cannot affect the supply chain of the industry and so cannot affect the price of the
product. So, the individual firms are “price takers”. This price takers are inside an atomized
market.
The conclusion is, when there is power market, the firm can modify the price market without
losing all the costumers.
Product differentiation
The way to apply the market power is the price discrimination. There are different degrees of
price discrimination:
- The third-degree price discrimination: prices varies by the individual or collective

costumer’s identity. For instance, the payment in discotheques, female don’t pay and
male pay (gender discrimination)

- Second degree price discrimination: price varies according to quantity demanded. For
example, in discotheques one drink is 10 euros and three drinks 20 euros
- First degree price discrimination or perfect price discrimination: requires knowing the
absolute maximum price that every consumer is willing to pay. A possible example
would be the price of flights: every passenger pays a different price for the same flight.
Depending on the degree of market power:
No market power:
- Firms (many) are “price takers”
Small amount of Market power:
- Monopolistic competition
- Firms (many) are “price setters”
Large amount of Market power:
- Oligopoly
- Firms (few) are “price searchers”
Complete market power:
- Monopoly
- Single firm is “price maker”
Difference between Identical products and Product differentiation
Identical products
The firms that all produce exactly identical products. The goods or services are homogeneous
(commodities). It is not possible to distinguish between a good produced in one firm and good
produced in another. There are no brand names and there is no marketing to attempt to make
goods different from each other. That’s why the price is really important, consumers are going
to buy the cheaper (they are not going to pay more for the same).
They standardized processes and products.
Example: the market of eggs, we can find different sizes (M, L, XL) and 4 categories (0,1,2 and 3)
according to the level of freedom of the hens but all the eggs are identical products).
Process of distinguish a product from others offered, to make it more attractive to a particular
target market.
- Differences in quality and/or differences in price.

- Differences in functional features and/or design.
- Sales promotion activities of sellers, in particular, and advertising, in general.
- Differences in availability (e.g., limiting and locating).
- Ignorance of buyers regarding the essential characteristics and qualities of goods they
are purchasing
- “Human touch”

The difference between perfect competition and
monopolistic competition are the products. In perfect
competitions the products are not differentiated, while
there exists a difference of products in monopolistic
competition (the product is different depending on the
producers).
Level of information
Complete information: all producers and consumers have perfect knowledge of the market
(prices, products and available technology).
Incomplete information, for example, asymmetric information. Asymmetric information is

found when the level of information is different for the seller and the buyer. This is very common
in the second-hand market, for instance, in the car market; the seller in order to sell the
automobile, he will defend the best features of the car and is not going to say all the real
information, the real state of the car.
The government try to fight against this asymmetric information by putting 2 years guarantees.
The difference is the uncertainty. Here we can identify different behaviours: risk averse (concern
about the future), risk lovers and risk neutral. In order to fight against this uncertainty, risk
averse buy more sand more insurances, while risk lovers will not buy them.

Microeconomics
Economic benefits “Firms are profit maximisers”
To maximize profits (total profit, not profit per unit), a firm should produce where marginal cost
equals marginal revenue.
Typology of Profits:
- Normal profits or ordinary profits.

- Economic profits or extraordinary profits.
Normal profits are included as a cost and are not included in economic profits. Economic profits
are profits above normal profits.
Even though economic profit is zero, all resources/inputs, including entrepreneurs, are being
paid their opportunity costs.
3.2 PERFECT COMPETITION
Introduction to perfect competition
Perfect competition is a model used as the starting point to explain how firms operate. It is a
theoretical model based upon same very precise assumptions (it doesn’t exists but is our goal).

It is very important, because once we understand the theoretical assumptions it makes easier
to move towards models of markets that are more realistic
Perfect competition in the real world
Although we generally say the perfect competition is completely theoretical, there are some
industries in the world that get close to be perfectly competitive markets. Industries that are
often used as examples by economists are usually agricultural markets
Characteristics of perfect competition
- Concurrency: many producers and many consumers.

- Free market: no government intervention
- Open market: no barriers to entry
- No market power: “price takers” in an atomized market
- Commodity: homogenous product.
- Complete Information
- Existence of normal profits in short-run and long-run
- Existence of economic profits in short run but no existence of economic profits in the
long run (equal to 0)
- Efficient equilibrium and maximum welfare.

The price-taking firm’s profit-maximizing quantity of output
In the profit maximization rule, the marginal revenue has to be

equal to the marginal cost. In this case this happens in Q=5,
which will be the optimal production (output).
When we produce 4, the price is higher than the marginal costs

and then we are going to increase the level of production in
order to maximize profits. On the other hand, if we produce 6
or 7 the marginal cost is higher than the marginal revenue or
the price, when this happens, we reduce the level of production.
*Optimal output: total profits are maximized
Remember:
- IF TR > TC, the company has Economic Profits (and normal profits)
- If TR = TC, the company has Normal Benefits (economic profits equal to 0).
- If TR < TC, the company has losses.
The price-taking firm faces a horizontal demand

P = ATR = MR only in perfect competition
Short-run average costs + production and profits
Here, the lowest ATC is 14 (4 units of tomatoes). But if we

produce 4 units of tomatoes the profit is 16. The maximum
profit is 18 (5 units of tomatoes. So, it is important to know
that the idea of all firms is to maximize profits (using the
profit maximization rule), not to produce at the minimum
average total cost.

Microeconomics
Costs and production in the short run
The marginal cost (MC) equal to the price in point
C. In this point, the ATC is minimized, and the
total benefit will be 0 and the economic profit
also 0. But we have to take into account that the
normal profit is positive
Profitability and the market price
Profit Maximization rule: P = MC → point E, then

I’m going to produce 5 units.

In order to calculate the total profit:
TB = TR – TC // TB = (P-ATC) · Q
TR = P · Q
TC = ATC · Q
TB = (18-14.40) · 5 = 18
If we analyse how is going to be the future of this case, we observe that when there’s an
economic profit, more farmers will decide to produce tomatoes. When this happens, the supply
of tomatoes will increase, i.e., the supply function will shift rightwards, and the market
equilibrium price will decrease.
Here the market equilibrium is 10, and then you are

going to maximize profits. When you are maximizing
profits at the same time you are minimizing losses
(Losses minimization rule).
Price equals to the marginal cost at point A, so we

are going to produce 3 units of tomatoes. Point Y is
the average total cost. We can observe that there
are losses we can conclude that this firm will stop
the production of tomatoes (shut down).
The short-run individual supply curve: here, we have added the AVC.
If the market price is 18$, applying the profit maximization rule, we know that point E is p = MC
and we are going to produce 5 units.
If we focus our attention on the ATC, all the painted surface will represent economic profits. If
we are producing tomatoes and we are getting economic profits, more farmers will decide to
produce tomatoes as well (we are wining economic profits, why will not they do the same?).
More farmers will produce more tomatoes and the supply will shift rightwards, consequently
the market equilibrium will decrease.
When the equilibrium price is 14, Point C is the profit maximization rule, and we are going to
produce 4 units. In this point the total benefit is 0 and then the farmer can survive only with the
normal profit. More farmers will produce tomatoes and the equilibrium price keep decreasing.
*Point C is the break-even point (p = min ATC) and point A is the shutdown point.
As a result of this decrease, the price is 12$ and we are at point B with a production of 3.5 units
of tomatoes. When the price is between C and A (between break-even point and shutdown
point) the total benefit is negative. Then, as a farmer we would have to decide whether we
continue producing tomatoes or we change our product. The most common reaction is continue
producing tomatoes because we don’t know the future we will get if we produce another
product.
If we cover the variable cost, which means we are able to pay our workers, then we can decide
to produce in the short run with negative profits (losses). But once we are in the point A we are
in a critical point because we only cover the VC and then usually in the shut-down price we
decide to finish the production of tomatoes. The problem is that once you decide to close your
business, you have to also pay your fixed costs and most of the times you are not able to do that,
so that’s why usually people try to maintain the business until you are not able to cover the VC.
Break-even point vs shut-down point
Shut-down point: minimum point on AVC curve,

where AVC curve and MC curve intersect.
Break-even point: minimum point on ATC curve,

where AC curve and MC curve intersect.
The MC is the supply function of the individual firm.

From the shut-down point to the break-even point,
the supply function is in the short run and above the
break-even point the supply function is in the long run
(in the long run you cannot operate with losses).

Microeconomics
Perfectly competitive firm’s profitability and production conditions in the short run
Production condition
(minimum AVC = shut-down price)
- If P < minimum AVC, then the firm shuts down in the short run because it does not cover
the variable costs.
- If P = minimum AVC, then the firm is indifferent between producing in the short run or
not (it just covers the variable costs).
- If P > minimum AVC, the firm produces in the short run but can be in different scenarios.
▪ If P < minimum ATC, firm covers variable costs and some but not all of fixed
costs (you are producing with losses).
▪ If P > minimum ATC, the firm covers all variable costs and fixed costs.
Perfectly competitive firm’s profitability and production conditions in the long run

Profitability condition
(minimum ATC = break-even point)
- If P < minimum ATC, then the firm is unprofitable. The firm can still produce if P < min
AVC but only in the short run. If in the long run you still not cover the ATC, you will have
to shut down.
- If P = minimum ATC, firms breaks even (there’s no economic profits although you are
getting normal profits) which means that no entry into or exit from industry is possible
in the long run.
- If P > minimum ATC, the firm is profitable and the entry into the industry in the long run
is possible.
Industry supply curve
The industry supply curve shows the relationship

between the price of a good and the total output
of the industry as a whole.
The short-run industry supply shows how the

quantity supplied by an industry depends on the
market price given a fixed number of producers.
There is a short-run market equilibrium when

the quantity supplied equal the quantity
demanded, taking the number of producers as
given.

The long-run industry supply curve
A market is in long-run market equilibrium when the quantity supplied equals the quantity
demanded, given that sufficient time has elapsed for entry into and exit form the industry to
occur.
In the long run, the equilibrium price in

perfect competition is equal to the
minimum ATC of the efficient technology
of production (break-even point) = point C
Comparing the short-run and long-run industry supply curve
The speed of reaction in the long run is higher (more

elastic) than in the short run because in the short
run we can’t modify the capital nor the production,

we can only modify labour. For this reason, when
the price increases, in the short-run we can produce
more but only by changing the number of workers
not the capital. But, in the long run I can modify the
dimension of the factory. The variation of the supply
quantity is higher in the long tun than in the short
run
The effect of an increase in demand in the short-run and the long-run

Microeconomics
If we are in point X and the demand increases (shift rightwards), we move to point Y. In this
point, we get economic profits, and more firms decide to produce. Then, the supply function will
shift rightwards to point Z (more firms enter to the market). Consequently, the price will
decrease from 18$ to 14$ and we will change from point Y to Z.
When we observe economic profits, more firms will enter to this market and the equilibrium
price and equilibrium market will change from point Y to point Z. For this reason, in perfect
competition, in the long run the economic profits disappear.
Shape of the supply curve
The shape of the supply curve of the industry, in short terms, has positive slope.
The shape of the supply curve in the long term can be:

- Horizontal if we assume constant costs.
- Positive slope in the case of rising costs. In this case, the supply curve is more elastic
than the short-run supply curve and the price of factors of production, given that
resources are scarce, rise with increasing production industry.
Some conclusions about the cost of production and efficiency in the long-run equilibrium of a
perfectly competitive industry:
1. In a perfectly competitive industry in equilibrium, the value of marginal cost is the same
for all firms.
2. Best use of the economies of scale (minimum ATC in the long run) and the equilibrium
price is the lowest possible.
3. In a perfectly competitive industry with free entry and exit, each firm will have zero
economic profits in the long-run equilibrium. As many competitors will entry to the
market, innovation is needed to obtain profits.
4. The long-run market equilibrium of a perfectly competitive industry is efficient (in the
short run is not)
BLOCK 4: IMPERFECT COMPETITION
Types of market structure
Principal models of market structures:
- Imperfect competition
▪ Monopoly
▪ Oligopoly
▪ Monopolistic competition
Imperfect competitions: situations where producers/sellers have some market power to

influence the market price. It implies one or more of the following characteristics:
- Relatively small numbers of companies

- A differentiated product (not homogeneous)
- Limited entry to the market (barriers to entry or exit the market)
Features of the monopoly
A monopolist is a firm that is the only producers of a good that has no close substitutes (unique
product). An industry controlled by a monopolist know as a monopoly.

The ability of a monopolist to raise its price above the competitive level by reduction output is
known as market power → price-maker
If a monopoly has a complete market power, government have to regulate the market in order
to avoid it.
A monopolist has market power, and as a result will charge higher prices and produce less output
than a competitive industry. This generates profit for the monopolist in the short run and long
run.
Profits will not persist in the long run unless there’s a barrier to entry. This can take the form of:
- Control of natural resources or inputs

- Increasing returns to scale
- Technological superiority
- Government-created barriers
▪ Patents and copyrights
▪ state concessions
- Elimination of competition (try to become a monopolist)
▪ Mergers and/or acquisitions
▪ Holdings & trusts
▪ Tacit or explicit collusion (cartel)
Characteristics of monopoly
- Concurrency: many consumers and only one producer (the monopolist) ≠ monopsony
- Free Market, regulation is recommended in order to decrease the market power of the
monopolists.
- Closed Market, i.e., no existence of barriers to entry.

- Existence of a market power → “price-maker” and price discrimination (way to apply
market power)
- Unique product (no substitutes). The way to fight against monopoly is creating closed
substitutes.
- Complete information.
- Existence of normal profits and economic profits both in short-run run and long-run. The
government intervention reducing the market power is reducing at the same time the
economic profits.
Economies of scale and natural monopoly
A natural monopoly exists when increasing returns to scale provide a large cost advantage to a
single firm that produces all of an industry’s output (then it can be justified)
It arises when increasing returns to scale (economies to scale) provide a large cost advantage to
having all of an industry’s output produced by a single firm. One producer can produce at a lower
ATC (ATC is decreasing) if this monopolist is the unique producer. Is better to have one producer
when producing the quantity needed requires more ATC when there’s many companies than
only one.
Under such circumstances, average total cost is declining over the output range relevant for the
industry.

This creates a barrier to entry because an established monopolist has lower average total cost
than any smaller firm.
To produce quantity Q of output in a monopolist we will have X costs, but if we use two different
companies to produce the same quantity, costs are clearly higher. So, ATC > if we have two firms
than 1.
Examples: networks (airports, ports, water, natural gas, electricity, metro…)
Natural monopoly
An industry in which the production level, whatever that may be produced cheaper by one
company that by two or more firms.
The cause is the economics of scale and scope that have decrease ATC. We are going to identify
decrease ATC in the case of high fixed costs or high initial investments. In this case, only
governments can do these high initial investments, for instance, build all the metro network.

There are different regulations options:
*the effects vary in monopolies and natural monopolies due to cost structure (change in the order of the letters)
1. Apply the perfect competition criteria, where P=MC. Here we will be in point A of both
graphs.
Under this regulation, monopolies will still have profits due toe the ATC is below the MC.
However, for natural monopolies, as the MC is higher than the ATC, the government has
to subsidy this monopoly, as it is impossible to produce with losses in the long run.
2. P=ATC, which will represent the second option in point B.
In this case, monopolies will not have economic profits, only normal benefits.
As consumers, we want point B of monopolies and point A in natural monopolies, although here
we would have to pay the price + the subsidy (more taxes to pay).

Comparing demand curves

*In point A the MC = ATC, optimal
quantity of production. But point A
is not the market equilibrium of the
monopoly, the market equilibrium
is point B (we have to project point
A in the demand).
Monopoly profit: we are in the case of a monopoly and not a natural
monopoly because the ATC is not decreasing.
Persistence of long-term economic benefits of the monopolist:

- Closed market → existence of barriers to entry such as:
▪ Control of natural resources or inputs

▪ Increasing returns to scale (decreasing ATC)
▪ Technological superiority
▪ Government-created barriers including patents and copyrights
- Intervention and/or government regulation on monopoly (to limit the market power of
monopolist and defend the interest of the consumers).
Existence of scale and scope in natural monopolies
The ATC is decreasing in the range of the demand and that’s why is a
natural monopoly. When production is divided among more firms, each
firm produces less and average fixed costs arises.
Measurement of monopoly power
1. Lerner index (abba Lerner)
IL = (P-MC) / P
If IL = 0 then, the firms is perfectly competitive
If IL > 0 then, there is a market power (monopoly power)
Herfindhal index (Orris Herfindhal)
IH = ∑ si2, (I = 1,2,…,n)

Where n is the number of firms in the industry and si the maret share of each firm
Then, 1/n ≤ IH ≤ 1
IH high indicates monopoly power (result near 1, market power is high).
IH lows indicates competitive levels
Perfect competition vs monopoly
- Rule of profit maximization:

In perfect competition: P = MR = MC
In monopoly: P > MR = MC
- Market equilibrium
The equilibrium quantity in monopoly is lower than the equilibrium quantity in perfect
competition: QM < QPC
And the equilibrium price in monopoly is higher than the equilibrium price in perfect
competition: PM > PPC
- Loss of efficiency in the monopoly (existence of a DWL)

- Determining the level of production in a different way:
- Economic benefits:

- Efficiency and total welfare: In perfect competition the market equilibrium is efficient,
and the welfare is maximized (there’s not DWL). In monopoly there’s always a DWL. We
will produce MC=MR, we won’t produce more because then our MR will be less than
our MC. There’s a quantity not produced in monopoly that would be produced in a
perfect competition situation, which cause a DWL.
*The orange area is the PS and the blue area is the CS. In monopoly consumers have losses and producer (monopolist) clearly win.
The most important difference between perfect competition and monopoly in terms of
welfare is that the consumer surplus is reduced.

Inefficiency of monopoly
The loss of efficiency or inefficiency is due to the production level of monopoly is lower than
under competitive conditions (irretrievable loss of efficiency).
In addition, the economic benefits of monopoly meant a cut in consumer surplus and an increase
in producer surplus.
*Profits are included in the PS
Consequences of monopolies
- The power of monopoly implies that the price is higher than marginal cost, so this causes
a worsening consumer welfare and enterprises don’t improve.
- There is also an efficiency loss when the monopolist must devote resources to maintain
their position of power, monitor the emergence of possible competitors, get legal
franchises…
- The social costs that cause monopolies implies to move on governments to act to try to
remove them → liberalisation of markets which means eliminate the barriers to entry

or try to find the way to avoid them (≠privatization of public monopolies which means
that only the owner is changed, from public to private).
- “Monopolies are a major engine of economic growth because due to the great economic
benefits, the attraction to enter the market makes no one monopoly lasts forever”
(Joseph Schumpeter)
Price discrimination
Price discrimination means selling a product at a different price depending on the consumer
and/or depending on the number of units sold. Requirements:
- Typology of consumers must be identifiable and separable

- The resale must be difficult
These price differences are not caused by differences in production costs.

The logic of price discrimination
In fact, monopolies find that they can increase their profits by charging different customers
different prices for the same good. For instance, a discount applied for students.
Price discrimination is profitable when consumers differ in their sensitivity to the price (different
price elasticity). It is profit-maximizing to charge higher prices to low-elasticity consumers and
lower prices to high-elasticity consumers.
The form to implement market power (degrees of price discrimination):

*All degrees are legal
The third-degree price discrimination: price varies by the individual or collective customer’s
identity. is based on the willingness to pay. The seller distinguishes the different consumer
groups and set a different price for each group or collective. Examples: discounts for students,
young card, old-age pensioner, students UB…
*In price discrimination D=MR as you charge a different price for each consumer.
The second-degree price discrimination: prices varies according to quantity demanded and not
on the identity of the consumer. We are talking about volume discounts. For instance, 1 drink 5
euros 3 drinks 10 euros; printing 10 photos costs 2 euros, printing 30 photos 4,5 euros and over
50 only 7 euros; or buy 1 get the 2nd free.
The first-degree price discrimination or perfect price discrimination: it takes place when a
monopolist charges each consumer according to his or her willingness to pay, the maximum that
the consumer is willing to pay. This degree requires to apply the first-degree and second-degree
price discrimination. Perfect price discrimination is probably never possible in practice; however,
nowadays is possible thanks to internet because is easier to know the willingness to pay of each
individual based on what they search.
The seller sets different prices for each consumer and for each unit purchased, extracting all
consumer surplus (all the area shown in the graph corresponds to PS).
There is no deadweight loss. From the point of view of efficiency, when a monopoly practices
such discrimination has the same result as perfect competition.
Public policy about monopolies
- Doing nothing (unregulated): market deregulation and/or introduction of competition.

- Antitrust policies (antitrust laws): To prevent or eliminate monopolies and to reduce
market power: maximize market shares, forced disinvestments, forbidden
concentrations, fines or financial penalties…)
- Public ownership (nationalization): nationalization is the contrary to privatization.
Nationalization means change the owner, the property from private to public
ownership.
- Price regulation (price ceiling): price ceiling on a monopolist, as opposed to a perfectly
competitive industry, need to cause shortages and can increase total surplus. Price
ceiling creates deadweight loss.
Regulation options:
- Unregulated
- Price efficiency: Price = MC (lowest price as possible)
- Production efficiency: highest quantity possible (P=ATC)
- Profit regulation: try to decrease the economic profits of monopoly.
Options:
Point A: Unregulated
Point B: marginal cost pricing (P=MC)
Point C: Average Cost pricing (P=ATC) → deadweight loss
If we leave monopolies alone, they will always maximize their

profits (unregulated: point A).
If we apply the perfect competition criterium (P=MC), then we will be in point B. The new
equilibrium price will be lower, and the new equilibrium quantity will be higher. The monopolist
here continues getting economic profits.

Another option is P = ATC, which is point C. This is the best option for consumers because we
pay the lowest price and get the largest quantity, but here the economic profits of monopolies
are eliminated, are equal to 0.
Natural monopoly regulation
If the ATC is decreasing in the range of the demand, we are in the range of a natural monopoly.
Case b shows P=ATC. This type of regulation is applied when government don’t want to spend
money on subsidies for natural monopolist. If we apply P=MC, the price will be lower to the ATC
and in the long run it’s impossible to produce in these conditions, so the government have to

subsidy natural monopolist.
Oligopoly
Market structure where most of the production and/or sales are made by few companies and
each one is able to influence on the market price (market power).
There exists an interdependence between these companies, which means that the actions and
decisions of a company affect and are affected by the actions and decisions of other firms.
Features of oligopoly
- Oligopoly is a common market structure:
▪ It is a weaker form of monopoly.

▪ It is an industry with only a small number of producers (oligopolists).
▪ An oligopoly consisting of only two firms is a duopoly. Each firm is a duopolist.
- In oligopolies, firms compete but posses market power. Oligopolies are “price searchers”.
- Few sellers offering similar or identical products but differentiated via advertising, brands,
design…
- The key feature of oligopoly is the tension between cooperation and self-interest. If these
few companies cooperate and act as a one firm, we are in a monopoly case again.
Examples: mobile operators we only have few operators (Movistar, Vodafone, Orange…),
gasoline (Respol, Cepsa and British Petrolium), etc.

Characteristics:
- Concurrency: many consumers and few producers (oligopolists).

- Free market
- Closed market, existence of barriers to entry.
- Existence of market power → “price-searchers”
- Differential product
- Interdependence and strategic behaviours
- Complete information
- Existence of normal profits and economic profits in the short-run and in the long-run
but lower than monopolies.
Interdependence
Cooperative behaviour: it is forbidden
- Informal collusion or tacit collusion (without a formal agreement)

- Formal collusion: Cartel
Noncooperative behaviour = competition
- Nonprice competition:
▪ Quantity competition (Cournot model)

▪ Advertising competition.
- Price competition (price war or tacit collusion):
▪ Price competition (Bertrand model)
▪ Price leadership (differentiated products)
Interdependence
The key feature of oligopoly is the tension between cooperation and self-interest. The study of
behaviour in situations of interdependence is known as the game theory.
A Nash equilibrium is a situation In which economic actors interacting with one another each
choose their best strategy given the strategies that all the others have chosen.
The games theory
“The Prisoner’s dilemma”
“Two robbers, Blake and Reid, are caught robbing a bank, a crime that had been committed
many times before. Locked in two separate cells from prison, they are made the same proposal
to both "two years in prison for the robbery that you did last night. But if one of you confesses
all robberies that have made, reduced the sentence to one year, while another eight years in
prison. If both confess, the sentence shall be five years each. You have one hour to decide”

The dominant strategy is the egoist strategy. An action is a dominant strategy when it is a
player’s best action regardless of the action taken by other players. Choose the option which
gives me the best result without taking into account the decision of the others.
*In the case: the best results in absolute terms would be not confessing.
The Nash equilibrium, also known as a noncooperative equilibrium, is the result when each
player in a game chooses the action that maximizes his or her payoff given the actions of other
players, ignoring the effects of his or her action on the payoffs received by those other players.
Maximize my results taking into account the different possibilities than other competitors can
chose.
In oligopoly as few companies compete, we can imagine that equilibrium price can change very
fast or every day, but this is not true because in oligopoly is a very important stability of prices

This stability of prices is guaranteed by the asymmetrical behaviour: if one firm decide to
decrease the price, other firms will decrease prices as well: but if they increase the price, the
rest of the firms will not follow this behaviour.
If all firms decide to increase prices at the same time, then probability are making a collusion.
Oligopoly conclusions:
If oligopoly firms pursue their own self-interests (without collusion):
1. Joint output is greater than the monopoly quantity but less than the competitive
industry quantity.
2. Market prices are lower than monopoly price but greater than competitive prie.
3. Total profits are less than the monopoly profits.
Monopolistic competition
Monopolistic competition is a market structure near perfect competition but with product
differentiation. There are many competing producers in an industry, each producer sells a
differentiated product and there is free entry into and exit from the industry in the long run.
Product differentiation is the only way monopolistic competitive firms can acquire some market
power (elastic demand, near to be horizontal but not horizontal).
Characteristics:
- Concurrency: many producers and many consumers

- Free market
- Open market, no existence of barriers to entry
- Light market power → elastic demand function
- Differentiated product
- Existence of normal profits and economic profits in the short run
- Existence of normal profits in the long run but not of economic profits (if I get economic
profits economic profits in the s/r, more firms will enter to the industry).
- Each firm produces a product that is at least slightly different from those of other firms.
- Rather than being a price taker, each firm faces a downward sloping demand curve. They
are price setters.
- Value in diversity
- Forms of Product differentiation:
▪ Differentiation by style or type
▪ Differentiation by location
▪ Differentiation by quality
▪ Some firms create brand names
Example: hair salons (you are going to pay more for a hair cut if you go to one hair salon or
another).

In monopolistic competition they produce less than the output at which average total cost is
minimized → P=ATC; not P=min ATC as it happens in perfect competition.
Entry and exit shift existing firms demand curve and marginal revenue curvre
The long-run zero profit equilibrium

Monopolistic competition vs perfect competition
- In the long-run equilibrium of monopolistically competitive industry, there are many

firms, all earning zero profit.
- P > MC; price exceeds marginal cost, so some mutually beneficial trades are unexploited.
(see last minute)
- Firms in a monopolistically competitive industry have excess capacity: they produce less
than the output at which average total cost is minimized. P = ATC but, P ≠ min ATC.
- This is actually a source of inefficiency, but we assume this in order to get a
differentiated product.
Comparing long-run equilibrium in perfect competition and monopolistic competition

SUMMARY


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MicroeconomicsInternational-Busi...

1º Grado en Empresa Internacional

Facultad de Economía y Empresa

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BLOCK 1: INTRODUCTION TO ECONOMICS

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Macroeconomics: brunch of economics concerned with the overall economy.

Difference between positive economics and normative economics

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(A forecast is a simple prediction of the future)

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Difference between short run and long run

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Long run: Y = f ( K , L) . Everything is variable.

(A. Smith, Thomas Malthus, David Ricardo)

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- Laissez-faire: He was the founder of free market economics. It is an economic system in

- Limited government: no government intervention. It is a governing or controlling body

- K accumulation (capital accumulation): is the dynamic that motivates the pursuit of

Socialism/communism: any of various economic and political theories advocating collective or

- Working class’ conquest of political power

- Extraction of surplus value or surplus profit

Reservados todos los derechos.

The communist system failed when Berlins wall fall in 1989.

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- Economic intervention by public sector: it is the regulatory action taken by governments

- Aggregate demand: it is an economic measurement of the total amount of demand for

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- State/administration: public management

- Firms/companies/enterprises typologies: basic unit of production.

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- Efficacy (or effectiveness): is the capacity to produce an effect. It is the ability of an

- Efficiency (economic efficiency): refers to the use of resources so as to maximize the

Pareto efficiency: no one can improve without damaging someone else.

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It is a representation of the economy.

- Households buy goods and services from firms.

Households offer labour

Circular flow of economic activities:

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Macroeconomic identity: Income = Production = Expenditure

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The production possibility frontier (PPF):

- Illustrates trade-offs facing an economy that produces only two goods.

Opportunity cost and slope of PPF

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All the options around the PPF are efficient!!!

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The production possibility frontier with constant opoortunity cost:

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Economic growth can come from two sources:

- Technological improvement: improvement in the technical means of production goods

Economic growth results in an outward shift

Production is initally at point A (20 fish and 25

Specialize and trade

Both castaways are better off when they each specialize

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Comparative advantage and gains from trade

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