Microeconomics ll

Chapter one
understand and analyze profit maximizig behaviour of monopolistically compettive firms

In a monopolistically competitive market, firms have some degree of market power as they differentiate
their products from competitors. This allows them to have some control over the price they charge. The
profit-maximizing behavior of these firms can be analyzed using the following steps:

1. Differentiation: Monopolistically competitive firms differentiate their products through various means
such as branding, packaging, quality, or location. This differentiation creates a perceived uniqueness in
their product, which enables them to charge a higher price.

2. Demand and Revenue: Due to product differentiation, the demand curve for each firm is downward
sloping but relatively elastic. This means that firms can increase their quantity sold by lowering their
price, but they cannot charge an arbitrarily high price without losing customers. The revenue of a
monopolistically competitive firm is maximized when marginal revenue (MR) equals marginal cost (MC).

3. Markup Pricing: Since monopolistically competitive firms have some market power, they can set their
prices above marginal cost. They determine their price by adding a markup to their marginal cost. The
size of the markup depends on the degree of product differentiation and the elasticity of demand.

4. Long-Run Profits: In the long run, new firms can enter the market, attracted by the potential profits.
This entry increases competition and reduces the market share of existing firms. As a result, the demand
curve for each firm becomes more elastic, and the ability to charge a higher price diminishes. In the long
run, monopolistically competitive firms earn zero economic profit, as new entrants erode any excess
profits.

Overall, the profit-maximizing behavior of monopolistically competitive firms involves balancing the
trade-off between charging a higher price due to product differentiation and the need to remain
competitive in the market.

Chapter two

Compare and analyze different models and strategies of oligopoly market structure
1. Cournot Model: In the Cournot model, firms in an oligopoly independently decide their quantity of
output to maximize profits. They assume that competitors' quantities are fixed when making their
decisions. This leads to a Nash equilibrium where firms produce less than perfect competition but more
than a monopoly. The Cournot model highlights the interdependence of firms' decisions and the impact
on market outcomes.

2. Bertrand Model: The Bertrand model assumes that firms in an oligopoly compete based on prices.
Each firm sets its price assuming that competitors' prices remain fixed. If a firm's price is lower than its
competitors, it captures the entire market share. This model predicts that prices will be driven down to
marginal cost, resembling perfect competition. However, if firms have differentiated products or
capacity constraints, this model may not hold.

3. Stackelberg Model: The Stackelberg model introduces a leader-follower dynamic in an oligopoly. One
firm acts as the leader and determines its quantity or price first, considering the reactions of other firms.
The follower firms then adjust their strategies accordingly. This model emphasizes the advantage of
being the first mover in an oligopoly and the ability to set prices or quantities strategically.

4. Collusion: Collusion occurs when firms in an oligopoly cooperate to maximize joint profits. Cartels are
a form of collusion where firms explicitly agree to coordinate their actions, such as fixing prices or
dividing markets. Collusion can lead to higher prices and reduced competition, but it is often difficult to
sustain due to enforcement issues and the temptation for individual firms to cheat.

5. Game Theory: Game theory is widely used to analyze oligopoly situations. It allows for the study of
strategic interactions between firms and helps predict their behavior in different scenarios. Game theory
models, such as the Prisoner's Dilemma or the repeated game, provide insights into the incentives and
outcomes of oligopoly situations.

Analyzing these models and strategies helps understand the dynamics and complexities of the oligopoly
market structure. Each model provides different insights into how firms behave, compete, and collude in
such markets. The choice of strategy depends on factors like market conditions, competitive advantages,
and the behavior of other firms in the industry.

Chapter three

Understand and apply game theory in firms decsion making

Game theory is a branch of economics that studies strategic decision-making in situations where the
outcome of one person's decision depends on the decisions made by others. It provides a framework for
analyzing and understanding the strategic interactions between firms, individuals, or countries.

In the context of firm decision-making, game theory can be applied to various scenarios such as pricing
decisions, entry and exit decisions, advertising strategies, and negotiations with suppliers or
competitors. By understanding and applying game theory, firms can make more informed decisions and
anticipate the actions and reactions of their competitors.

Here are some key concepts and applications of game theory in firm decision-making:

1. Nash equilibrium: A Nash equilibrium is a situation where each player in a game chooses their best
strategy given the strategies chosen by others. Firms can use game theory to identify Nash equilibria and
determine the optimal strategies to maximize their own payoffs.

2. Prisoner's dilemma: The prisoner's dilemma is a classic game theory scenario where two individuals or
firms face a choice between cooperating or defecting. Firms can analyze this scenario to understand the
trade-offs between short-term gains and long-term cooperation with competitors.

3. Dominant strategies: A dominant strategy is a strategy that yields the highest payoff regardless of the
actions taken by other players. By identifying dominant strategies, firms can make decisions that are
robust against the actions of their competitors.

4. Sequential games: In sequential games, players take turns making decisions, and each player's
decision depends on the actions of previous players. Firms can use game theory to analyze these
sequential interactions and determine the optimal timing and sequencing of their decisions.

5. Collusion and competition: Game theory can help firms analyze situations where collusion
(cooperative behavior) may be beneficial, such as forming cartels or strategic alliances. It can also help
firms understand competitive dynamics and devise strategies to gain a competitive advantage.
6. Bargaining and negotiation: Game theory provides insights into bargaining and negotiation situations,
where firms can analyze the strategies and outcomes of negotiations with suppliers, customers, or other
stakeholders.

Overall, game theory provides a powerful tool for firms to understand and navigate complex decision-
making scenarios. By applying game theory concepts and models, firms can make more strategic and
informed decisions that take into account the actions and reactions of other players in the market.

Chapter four

Understand how resources are valued under different market structures.

In the context of firm decision-making, understanding how resources are valued under different market
structures is crucial for determining the optimal pricing of factors of production and achieving a fair
income distribution. Here are some key concepts related to resource valuation in different market
structures:

1. Perfect competition: In a perfectly competitive market, resources are valued based on their marginal
productivity. The price of a factor of production, such as labor or capital, is determined by the
intersection of the market demand and supply curves. Each firm takes the market price as given and
hires resources up to the point where the marginal revenue product equals the resource's price.

2. Monopoly: In a monopoly market, the monopolist has the power to set the price of its product and
determine the value of resources. The monopolist will hire resources up to the point where the marginal
cost of the resource equals its marginal revenue product. However, due to its market power, a
monopolist may restrict output and pay lower prices for resources compared to a perfectly competitive
market.

3. Monopsony: In a monopsony market, there is a single buyer of a resource or a small number of

dominant buyers. The monopsonist has the power to set the price it is willing to pay for the resource
and determine its value. The monopsonist will hire resources up to the point where the marginal cost of
the resource equals its marginal revenue product. Due to its market power, a monopsonist may pay
lower prices for resources compared to a perfectly competitive market.

4. Oligopoly: In an oligopoly market, a few large firms dominate the industry. Resource valuation in an
oligopoly depends on the strategic interactions between firms. Each firm considers the potential
reactions of its competitors when determining how much to pay for resources. This can result in higher
or lower resource prices compared to perfect competition, depending on the specific dynamics of the
oligopoly.

5. Monopolistic competition: In a monopolistic competition market, firms have some degree of market
power due to product differentiation. Each firm faces a downward-sloping demand curve for its product,
which affects the value it places on resources. Firms in monopolistic competition will hire resources up
to the point where the marginal revenue product equals the resource's price, similar to perfect
competition.

Understanding how resources are valued under different market structures is essential for firms to make
informed decisions about factor pricing and income distribution. By analyzing the market structure and
considering the strategic interactions with other firms, firms can determine the optimal pricing of factors
of production and ensure a fair distribution of income among resource owners.

Chapter five

Analyze general equilibrium and welfare

General equilibrium refers to a state in which all markets in an economy are simultaneously in
equilibrium, meaning that the quantity demanded equals the quantity supplied for every good and
service. In general equilibrium analysis, the interactions between different markets and economic agents
are taken into account to understand the overall functioning of the economy.

Welfare economics, on the other hand, focuses on evaluating and comparing different economic
outcomes in terms of their impact on societal well-being or welfare. It aims to determine whether an
economic allocation is efficient and equitable. Efficiency refers to the allocation of resources that
maximizes total societal welfare, while equity refers to a fair distribution of resources and income.

In general equilibrium analysis, welfare economics plays a crucial role in assessing the overall impact of
market structures on societal welfare. It allows economists to compare different market structures and
determine which one leads to the most desirable outcomes in terms of efficiency and equity.

For example, under perfect competition, it is often argued that resources are allocated efficiently, as
firms produce at the point where marginal cost equals marginal revenue. This leads to productive
efficiency, where resources are used in the most cost-effective way. Additionally, perfect competition is
often associated with allocative efficiency, where goods and services are produced at the quantities that
maximize consumer satisfaction.

In contrast, under monopoly or monopsony market structures, there may be a misallocation of

resources due to market power. Monopolists may restrict output and charge higher prices, leading to a
loss of consumer surplus and potentially reducing overall welfare. Similarly, monopsonists may pay
lower prices for resources, leading to a decrease in producer surplus and potentially reducing overall
welfare.

Analyzing general equilibrium and welfare in different market structures allows policymakers and
economists to understand the trade-offs involved in different economic arrangements. It helps identify
potential inefficiencies or inequities and provides insights into potential policy interventions that can
improve overall welfare.

chapter six

understand the effect of asymmetric information on decision making

Asymmetric information refers to a situation where one party in a transaction has more information
than the other party. This can have significant effects on decision making in various economic contexts.

In the context of markets, asymmetric information can lead to adverse selection and moral hazard
problems. Adverse selection occurs when the party with more information uses that information to their
advantage, leading to a market failure. For example, in the market for used cars, sellers may have more
information about the quality of the car than buyers. This can lead to a situation where only low-quality
cars are sold, as buyers are hesitant to purchase without knowing the true quality.

Moral hazard, on the other hand, occurs when one party takes more risks or behaves in a way that is
detrimental to the other party due to asymmetric information. For example, in the insurance market, if
policyholders have more information about their risk profile than insurers, they may engage in riskier
behavior, knowing that the insurer will bear the cost. This can lead to higher premiums for all
policyholders and an overall inefficient allocation of resources.

Asymmetric information can also affect decision making in other areas, such as labor markets and
financial markets. In labor markets, employers may not have perfect information about the abilities or
work ethic of potential employees. This can lead to suboptimal hiring decisions and lower productivity.
In financial markets, investors may not have access to all relevant information about a company, leading
to mispricing of securities and potential investment losses.
To address the effects of asymmetric information, various mechanisms can be employed. One approach
is to reduce information asymmetry through disclosure requirements and regulations. For example,
companies may be required to provide accurate and timely information to investors to ensure
transparency in financial markets. Another approach is to rely on signaling and screening mechanisms.
Signaling involves parties with more favorable information voluntarily revealing it to build trust, such as
obtaining a college degree to signal one's ability. Screening involves the party with less information
designing mechanisms to gather more information, such as job interviews or credit scoring in lending.

Overall, understanding the effects of asymmetric information on decision making is crucial in designing
policies and mechanisms that can mitigate its negative impacts and promote efficient and equitable
outcomes in various economic contexts.