Introduction & Supply and Demand (chapters 1 – 4)

 Competitive markets:
o Many buyers + many sellers => individual actions do not affect price.

The supply and demand model

Demand curve

 Relationship between demand and price.

 Change in quantity demanded at any price (constant) => shift in demand curve. Caused by
o Change in taste.
o Change in price related to goods.
 Substitutes: increase in substitute price => increase in demand of good
 Complements: increase in their price => decrease in demand of good
o Changes in income
 Normal goods: rise in income increases demand.
 Inferior goods: rise in income decreases demand (e.g., Fast food)
o Changes in expectation (e.g., stock market)
o Other factors: e.g., consumers, whether all factors affecting willingness to pay of consumer
(see table 3.1 book)
 Movement along demand curve: a change in quantity demanded due to change in price.
 Movement of the demand curve: changes in things other than price.
 Demand curves is always downwards sloped.
Supply curve (model de producer side)

 Supply curve: Relationship quantity supplied and price.

 Always upwards slopped.
 Shift in supply curve: change in the quantity supplied at any given price (keeping price constant).
Causes:
o Changes in taste
o Changes in input prices (less costly = more supply)
 Input: good that is used to produce another good
o Changes in technology (more efficient)
o Changes in expectations: expect stock price to rise = less supplied
o Other: weather/ climate: number of producers: factors
 Movement along the curve: change in the quantity supplied because of change in the price.
 Shift of the curve: change in other factors besides price (e.g., technology)
Meaning of consumer and producer surplus

 Total welfare: consumer + producer surplus

Consumer surplus

 Individual consumer surplus = price one was willing to pay – price one paid.
 Total consumer surplus: sum of the individual consumer surpluses of a good
o Equal the area below the demand curve but above the price line.
o Fall in price => higher consumer surplus.

Producer surplus

 How much to sellers on a market gain from the existence of the market (welfare)
 Individual producer surplus = Price received – seller cost (how low they were willing to go)
 Opportunity costs: costs of any activity measures in terms of the value of the best alternative
that was not chosen.
 Total producer surplus: sum of the individual producer surpluses.
o Area above the supply curve up to the price line.
 Producer surplus if prices go up.
o Increase in producer surplus to original sellers.
o Producer surplus gained by new sellers.

Consumer Surplus, Producer Surplus and Efficiency of markets

 Market failure happens when there is an inefficiency in the market => government intervenes.
o By the invisible hand logic, market is always efficient but that is not true. Thus,
government has to intervene.
 Market equilibrium: Supply = demand.
 Excessive supply => incentive to decrease price so market price moves towards equilibrium
price.
 Excessive demand: incentive to increase the price.
 Can’t improve welfare by relocating (logic of the invisible hand by Adam Smith assures market
efficiency)
o Relocating consumptions lowers consumer surplus.
 If you relocate the good from A, who is willing to pay more (higher in the
demand curve) from B, you give it to someone who values the good less.
o Relocating production lower producer surplus
 Giving it to someone whose costs will not be covered by selling (costs are
higher than profit)
 Relocating increases opportunity costs decreasing welfare.
 Relocating to someone who is less willing to sell (less costs)
o So, the market ensures that:
 Those who value it the most consume and sell it.
 Consumer values good more than the seller (transaction are mutually benefit)
 Every potential buyer who does not make a purchase value the good less than
the seller who doesn’t make a sale.
 Market inefficiency happens when a seller that is willing to sell above the equilibrium price still
manages to sell => makes it impossible to achieve the highest possible total surplus.

Total surplus (of the real market )

Market efficiency =
highest possible total surplus (one found ∈the deman∧suply model)
Equilibrium and shifts of the demand curve

 Demand increases => quantity rises and price rises.

 Supply increases => prices lowers but quantity rises.
o Movement along the demand curve.
o Shift of supply curve.
 When demand increases and supply decreases: price rises but change in quantity is ambiguous.
Both times both curves shift. To know which happens the direction of the shift is important but so
is the magnitude of the shift.
o Price rises and quantity rises.
o Price rises and quantity falls.
 Chapter 5: Price controls and Quotas: meddling with Markets
Why governments control prices

 Market can be perfectly efficient but not necessarily equitable/fair => Possible solution: price
controls.
 Price controls: legal restriction on how high or low a market price may go.
o Price ceiling: max price allowed (e.g., rent control)
 Why: E.g., equilibrium is higher than average wage + good/service is essential.
 Mainly imposed during crisis (cause sudden price increases) such as war.
o Price floor: minimum price required.
 Why: Equilibrium price is bellow working salary, making it impossible to receive
profit.
 Assumptions in this chapter: Market is efficient before price control are imposed (legislations
=> predictable and unpleasant side effects)
o Legislation can make an inefficient market more efficient.

Price ceilings

 Modelling a price ceiling:

o Price ceiling below equilibrium price => higher demand + less supply => shortages.
o Price ceiling above equilibrium price => no effect (not binding).
 Shortage => Inefficiencies (gains from trade that go unrealized):
o Inefficient low quantity: e.g., reduces quantity of apartments bellow efficient level.
 Deadweight loss: policy reduces quantity transacted => loss of total surplus (not
transfer of surplus, just loss)
 Deadweight loss of Policy X = Maximum possible attainable total profit before
policy X – maximum possible attainable total profit after policy X
 Deadweight loss triangle: area in supply and demand model that represent
deadweight loss (total surplus lost).
o Inefficient allocation to consumers: good does not go to those who value it the most.
 Efficient allocation: those who value the good the most (willing to pay more) will get
it. Those who are less urgent won’t.
 E.g., people get apartments through luck or personal connection under rent control =>
inefficient allocation to consumers.
 Way of fixing it: sublease. Issue: it is illegal under rent control (but increasingly
happens => increase in illegal behaviour)
o Wasted resources: wasted time, money and effort and time to cope with shortages.
 Increase in opportunity costs (resources could be used elsewhere)
o Inefficiently low quality: sellers offer low-quality goods at low prices but are still able to
find clients easily despite people wanting better quality products and being willing to pay
more for them. Landlords maintain apartments in inefficiently low quality or condition.
 Rise in illegal behaviour (people try to circumvent them): Black markets.
o E.g., Illegal subletting by tenants. Issue: worsens position of those who are honest.
 Why do price ceilings still exist:
o Still benefit some (hurt majority but give a small, more vocal minority cheaper products +
benefits influential buyers).
o People aren’t aware of what would happen without them (e.g., don’t know black market
prices are higher than in an unregulated market)
 o Government officials often don’t understand supply and demand analysis.

Price floors

 Widely legislated for agricultural products (support farmer’s income)

 Minimum wage: legal floor of the wage rate (market price of labour).
o Involuntary unemployment: willing to work for minimum wage.
o Voluntary unemployment: unwilling to work for minimum wage.
 Modelling a price floor:
o Price floor above equilibrium price: increase in quantity above demand => surplus
 What happens to unwanted surplus depends on government regulation
 Government is not prepared to buy unwanted surplus: sellers can’t find buyers
=> e.g., people can’t find jobs.
o Price floor below equilibrium price: no effect.
 Effects of price floors:
o Inefficiently low quantity: less willing to buy => less quantity sold => deadweight loss
(same effect of price ceiling).
o Inefficient allocation of sales among sellers: low price sellers can’t sell while high price
sellers do => shift to the black market or other illegal means + emigration (permanent
reduction in future economic performance)
o Wasted resources: e.g., government purchasing surpluses to destroy them.
o Inefficiently high quality: sellers offer high-quality goods at a high price, even though
buyers would prefer lower quality at a lower price.
 Illegal activity:
o Black labour: employment that is concealed from the government or bribe the government
inspectors (paid below minimum wage)
 Why do we still have price floors:
o Government officials disregard warning of its consequences (believe relevant market is
poorly described by supply and demand model or because they don’t understand it)
o Benefit influential sellers.

Controlling quantities

 Quantity control or quota: regulations on the upper limit of the quantity of a good.
o Quota limit: total amount of good that can be legally transacted.
o Done by the government through a limited number of licenses (gives owner right to supply
good).
 E.g., taxi medallion.
 Usually issued due to a temporary problem
Anatomy of Quantity Controls

 Demand price of a given quantity: price at which consumers will demand that quantity.
 Supply price: price of a given quantity to which producers will supply it.
 Quantity control or quota is smaller than equilibrium quantity => wedge between demand price
and supply price of a good at a quota limit
o Wedge: price paid by buyers end up being higher than that received by sellers (demand
price higher than supply price). This is called the quota rent.
o Quota rent: demand price – supply price. Equals market price of the license at time of
trading (price of the license)
 If quota is set above equilibrium quantity in an unregulated market => no effect (not binding).
 Costs of quality control
o Quantity below equilibrium => deadweight loss (beneficial transaction don’t occur)
o Incentives for illegal activities.

Chapter 6: Elasticity
 Price of elasticity allows to know if it is possible to earn significant profits in a business by
predicting a significant rise in its price.
Calculating the price of elasticity of demand

 Price of elasticity of demand: percent change in quantity demanded divided by percent change
in price.

o Attention: when calculating if percent change in quantity demanded comes out negative
=> drop the sight
 Law of demand: demand curves are downward sloping => price and quantity
demanded are always moving in opposite direction.
 E.g., Negative change in demand => positive change in price
 But minus is inconvenient, and economists use the absolute value of price
elasticity of demand.
Alternative way to calculate elasticities: the midpoint method.

 While calculating price elasticity of demand 1:

o Same weather we go from curve A to B than from curve B to A (no minus sign, just
absolute value) => can use a more general formula for price elasticity of demand
 Midpoint method: technique for calculating the percent change by calculating changes in a
variable compared with the average or midpoint of the starting values.
o Attention: drop minus signs and use absolute values

Interpreting the Price elasticity of demand

How elastic is elastic

 Extreme cases
o Price elasticity of demand = 0: Perfect inelastic demand
 Demand is not responsive to changes in price. Perfectly vertical demand curve.
o Price elasticity is infinite: Perfectly elastic demand.
  Demand is highly responsive. Buy any quantity at a certain price. Horizontal
demand curve.
 Types of elasticity
o Unit-elastic: price elasticity of demand is exactly 1.
o Inelastic: less than 1
o Elastic: greater than 1
 Types of elasticity help predict how changes in price of a good will affect the total revenue (total
value of sales of a good or service multiplied by the quantity sold.
Total revenue = Price * quantity sold

 Countervailing effects of raising price (except for perfectly elastic/inelastic demand):

o Price effect: price increase => each unit sold sells at a higher price => raise in revenue
o Quantity effect: price increase => fewer units are sold => lower revenue.
 Effects of changing price depending on price elasticity of demand:
o Uni-elastic demand (=1):
 Raise in price: quantity effect and price effect offset each other (nothing
happens)
 Lowering price: no effect.
o Inelastic demand (<1):
 Raise in price: price effect (price increase => increase in total revenue)
 Lowering price: price effect (fall in price => less total revenue)
o Elastic demand (>1):
 Raise in price: quantity effect (less quantity sold => less total revenue)
 Lowering price: quantity effect (more quantity sold => more revenue)
Price elasticity along the demand curve:

 Price elasticity of demand changes along the demand curve.

 Measuring a good’s elasticity = measuring a particular point or section of the good’s demand
curve.
What factors determine the price elasticity of demand?
o Whether good is a necessity or a luxury: Luxury goods tend to have a high price
elasticity (not necessary)
o Availability of close substitutes: no close substitutes = low price elasticity.
o Share of income spent on the good: high share = high price elasticity of demand.
o Time since price change: price elasticity of demand tends to increase with time.

Other demand elasticities

 Attention: don’t drop the minus sign. Other demand elasticities (don’t drop the minus sign)
Cross-price elasticity of demand

 Cross-price elasticity: between two goods measures the effects of the price of B on the quantity
demanded of A.

 Cross-price elasticity of:

 o Substitute goods: positive- rise in price of B => increase of demand of A (shift of
demand curve to the right)
 Size of cross-price elasticity demands on how close of substitutes they are
(higher number = closer substitutes)
o Complementary goods: negative – rise in price of B => decrease of demand of A (shift
of demand curve to the left).
 Size depends on how strongly complementary they are (stronger = lower
number)
 Minus sign tells us if they are substitutes or complementary => cannot be dropped.
Income elasticity of demand

 Income elasticity of demand: measure of how much changes in income affects the quantity
demanded of the good
o Inferior goods: negative (income increases => demand Decreases).
o Normal goods: positive (income increases => demand increases).
 Income-elastic: income elasticity > 1
 Income-inelastic: income elasticity is positive but < 1.
Price elasticity of supply

 Price elasticity of supply: measure of responsiveness of the quantity of a good supplied to the
price of that good. Ration of percent change in quantity supplied to the percent change in the price
as we move along the supply curve.

 Extreme cases
o Perfectly inelastic supply (elasticity = 0): quantity supplied is always the same no matter
the price (vertical curve)
o Perfectly elastic supply (infinite elasticity): produce any quantity at a given price. If it
rises above it they will supply an extremely large quantity (horizontal curve).
 Factors that determine it:
o Availability of inputs: more inputs available = larger elasticity of supply
o Time: elasticity tends to grow with time (long-run elasticity > short-run)

Chapter 7: Taxes
The economics of Taxes: A preliminary view

 Excise tax: tax charged on each unit of a good or service that is sold. Simple type of tax
o Effects apply to other types of more complex taxes.

Effect of excise tax on quantities and prices

 The supply curve shifts up by the amount of the tax.

 Tax does the same as quotas=> wedge between price paid by the consumers and the price receive
by producers (consumers pay more than the producers receive less).
o + creates missed opportunities:
  raises in price lead to the loss of people who were willing to pay the equilibrium price,
but not the new price with taxes.
 Decrease of profit makes suppliers less willing to supply.
o Results are the same no matter who pays the tax (deadweight loss + missed opportunities)

Price elasticities and tax incidence

 Tax incident: who really pays for the tax.

o Depends on the price elasticity of supply and the price elasticity of demand.

Excise tax is paid mainly by...

 Excise tax wedge = difference in price paid by consumers + difference in price received by
producers.
 Incident and elasticities
o Price elasticity of demand is low and price elasticity of supply is high: burden of tax falls
mainly on consumers.
o Price elasticity of demand is high and price elasticity of supply is low: burden of tax falls
mainly on producers.
 So, whoever has the most elasticity takes less of the burden of the tax. Elasticity determines the
incident of an excise tax. Not who officially pays for it.
Benefits and costs of taxation

 Benefit of a tax: revenue for the government to pay for these services. Comes at a cost (usually
bigger than the among paid)
Tax rates and revenue

 Tax revenue = area of the rectangle whose height is the tax wedge between supply and the
demand curves and width is quantity transacted under tax.
 Tax rate: amount of tax people is required to pay per unit of what is being taxed.
 The relationship between revenue and rate is not one to one (bigger rate reduces quantity sold).
o Sometimes it’s not positive: increasing tax rate reduces the amount of revenue collected.
 Can’t set a rate so high it deters a significant number of transaction (causes fall in tax
revenue)
 Effects of increase of tax rate in tax revenue
o Two things happen (at the same time)
 The government raises revenue per unit.
 Reduces quantity of sales.
o Effect and supply and demand elasticities
 Low price elasticities: tax increase won’t reduce quantity of good sold very much =>
increase in revenue
 High price elasticities: less certain results
 High enough => reduce in quantity sold => less revenue
o Initial tax
 Is low: not much revenue is lost by the decrease in quantity sold.
 Is high: less certain results. Revenue likely to fall or rise verry little (only with high
price elasticities)
 So, tax revenue can be increased both by decreasing and increasing tax rate.
Costs of taxation
 Costs are over and above tax revenue in the form of inefficiencies (transactions that would have
occurred without the tax, don’t occur): loss of mutual beneficial transactions, i.e., deadweight
loss.
 Producer and consumer loss (total surplus lost) is not offset by the government's gain
 The larger the tax wedge => larger reduction in quantity transacted => greater inefficiency from
tax.
 Tax also produces administrative costs: resources used for collection, method of payment and
any attempts to evade a tax.
 So: Total inefficiency of tax = deadweight loss it caused + administrative costs.
Elasticities and deadweight loss of tax

 The larger the number of transactions that are prevented by the tax, the larger the deadweight loss.
o High elasticity of demand/supply => relatively large decrease in quantity
o Inelastic => quantity is relatively unresponsive to changes in price => relatively small
decrease in quantity transacted => relatively small deadweight loss.
 So, to minimize efficiency costs of taxation: tax good with relatively inelastic
demand/supply/both.
o Perfectly inelastic demand: quantity demanded unchanged => no deadweight loss.
o Perfectly inelastic supply: quantity supplied unchanged => no deadweight loss.
 Or, if tax is made to decrease harmful activity: activity should be high elastically demanded or
supplied.

Chapter 16: Externalities

External costs and Benefits

 Externalities: external costs (negative externalities) + external benefits (positive

externalities).
o Definition: actions of agents affect welfare of agents outside the market mechanism.
 External cost: uncompensated cost that an individual or firm imposes on others (e.g., pollution)
 External benefits: benefit that an individual or firm confers on other without receiving
compensation. (E.g., beekeepers create benefits for a nearby orchards)
Pollution as an external cost

 Goods things can be harmful (e.g., energy generators, chemicals that help farmers) => need to
accept a certain cost of pollution for a good life.
o Marginal social cost of pollution: additional cost imposed on society by an additional unit
of pollution. Tends to increase.
o Marginal social benefit of pollution: benefit to society from an additional unit of
pollution. Tends to decrease.
 Methods to reduce pollution have an opportunity cost (e.g., reducing production)
 Socially optimal quantity of pollution: quantity of population society would choose if all
social costs and benefits were fully accounted for.
o Shown is marginal social cost and benefit curve.
 MSC: upwards slopping
 MSB: downwards slopping
 Market produces above socially optimal quantity => need government intervention (e.g., tax of
value of pollution).
o Why: polluters have no incentive to consider external cost (focus on profit) => creates
inefficient market
Private solution to externalities

 Coase theorem: economy with externalities can reach efficient solution regardless of property
rights if transaction costs (individual costs of making a deal) are sufficiently low.
o But: transaction costs are often significant (e.g., costs of communication, making legally
binding agreements, etc).
 So:
o Transaction costs aren’t too high => individual reach a deal to internalize the externality
(taking external costs or benefits into account).
o Transaction costs are too high => need for government intervention
 Experiment on Coase:
o I’m linked with a non-controller but can’t talk with each other (no negotiation) => choose
the outcome that is best for myself
o I’m linked but we can negotiate => choose the outcome that is better for both (together, we
get the most amount of money that we can then split)
Policies towards Pollution

 Environmental standards: rules that protect the environment by specifying actions by

producers and consumers.
 Emission taxes (Pigouvian): emission tax equal to the MSC at the socially optimal quantity of
pollution (MSC = MSB). Taxes that depend on the amount of pollution a firm emits.
o Induces polluters to internalize the externality (consider true cost of their actions to society)
o Impose tax on activity => reducing activity
o Pigouvian taxes: taxes designed to reduce external costs.
o Issue: not clear how high tax should be
 Too low: won’t sufficiently reduce pollution.
 Too high: emissions will be reduced more than is efficient.
 Uncertainty can’t be eliminated but nature of risks can be changed by using an alternative:
issuing tradable emissions permits.
 Tradable pollution permits: licenses to emit limited quantities of pollutants. Can be bought
and sold by polluters.
o Firms with different costs of reducing pollution can engage in mutually beneficial
transactions.
 Flexible: allocate more pollution reduction to those who can do it more cheaply =>
market outcome is socially efficient.
o Motivate polluters to adopt new pollution reducing technology.
o Fixed tax (same tax no matter who gets them)
o Issue: how many permits should be issued?

Negative externalities and production

 Pollution is not directly observable/measurable/taxable => regulate good that is causing the
pollution
 Marginal social cost of good or activity = marginal private costs + marginal external costs
 Optimal Pigouvian tax = marginal external costs at the socially optimal quantity
Positive externalities

 Marginal social benefit: marginal private benefit + marginal external benefit.

o E.g., preserved farmland.
Preserved farmland as an external benefit

 Without government intervention: farmer who wishes to sell their land suffers all the costs of
preservation (e.g., forgone profit to be made from selling the farmland to a developer).
o Bear all the costs of preservation but gain none of the benefits => inefficiently low quantity
will be preserved.
 How to induce the market to preserve acres at a socially optimal level: Pigouvian subsidy
(payment desired to encourage activities that yield external benefits).
o Optimal Pigouvian subsidy = marginal external benefit at the socially optimal quantity.

Chapter 17: Public goods and common resources

Private goods-and others
Characteristics of goods

 Framework:
o Excludable: suppliers of the good can prevent people who don’t pay from consuming it
o Rival in consumption: same unit of the good cannot be consumer by more than one person
at the same time.

 Types of goods
o Private goods = Excludable + rival in consumption (e.g., ice cream)
o Public goods = non-excludable and non-rival in consumption (e.g., public sanitation and
national defence)
 Often used to correct consequences of negative externalities. E.g.:
 negative externality of littering => public good of street cleaning.
 negative externality of crime => public good of police.
o Common resources = nonexcludable + rival (e.g., clean water in a river)
o Artificially scarce resources = excludable but non rival (e.g., on demand movies on
Netflix)
Public goods

 Non-excludable => free-rider problem => no private firm is willing to produce them.
 Non-rival: inefficient to charge consumption => need to find nonmarket methods for providing
them
Why markets can supply only private goods efficiently.

 Free-rider problem: with goods that are nonexcludable many people are unwilling to pay for
their own consumption and instead will take a “free ride” on anyone who does pay.
o Leads to negative externalities.
  When goods are nonrival in consumption: efficient price for consumption is 0.
o Positive price is charged to compensate producers for cost of production => inefficiently
low consumption.
 Game theory: framework for modelling and predicting behaviour in situations in which the
outcomes of decisions are not only depending on own decision but on decision made by others.
 Nash equilibrium: equilibrium that results when all players choose the action that maximizes
their payoffs given the actions of other players.
o Combinations of strategies in which both players respond to the strategy of the other player.
o Can be the opposite of what is socially optimal.
 Prisoner’s dilemma: game based on two premises:
o Each players had an incentive to choose an action that benefits themselves at the other
player’s expense and
o Both players are worse off than if they had acted cooperatively.
 Public goods are not provided at efficient levels when left to the market due to free rider
problem.
 Providing public goods
o Voluntary contributions
o Supplied by self-interested individuals or firms (make money in an indirect way)
 E.g., broadcast television which makes money through advertising.
 Downside: skews nature and quantity of public goods supplied
o Usually Government (paid by taxes)

How much of a public good should be provided?

 Marginal analysis: finds efficient quantity of the public good (marginal social benefit of the
good = marginal cost of producing it).
o Marginal social benefit: willingness to pay of all consumers per each additional unit.
 Individual marginal benefit < marginal social benefit of final unit => No one will provide at
efficient quantity.
 Like positive externality MSB > MPB => under provision in competitive market.
o Marginal social benefit of all consumers of another unit Is greater than the price that the
producer receives for that unit => market produces too little of the good => need for
government intervention.
Common resources

 Common resources: goods that is nonexcludable but rival in consumption.

o Can’t stop others from consuming, but consumption of it means less of the good is
available for you. E.g., clean air and water, fish in the sea.
Problem of overuse

 When common resources are left to the market they suffer from overuse
 Overuse: individuals ignore the fact that their use depletes the amount of the resource
remaining for others.
o Individuals consume until MPB = MPC (cost of me using an additional unit of the good),
ignoring the costs on society as a whole.
 Inducing people who use common resources to internalize the costs they impose on others (like
negative externalities):
o Tax or regulate use.
o Create system of tradable licenses for the right to use the common resources.
 o Make the common resource excludable by assigning property rights to some individuals.
 Issue: e.g., nobody owns the fish in the sea

Chapter 13: Monopoly

Types of Market structures

 Four principal models of market structure:

o Perfect competition: many producers, standardized or homogeneous products.
o Monopoly: single producer, single undifferentiated product.
o Oligopoly: few producers, with identical/differentiated products.
o Monopolistic competition: many producers with differentiated products.
 System of market structure us based on:
o Number of producers (one, few or many): determined by conditions that deter entering the
market.
 One firm=> no competition
 Few => in between
 Many => much competition.
o Goods are identical or differentiated (somewhat substitutable, e.g., Coke vs Pepsi)

Meaning of monopoly

 Monopolist: firm that is the only producer of a good that has no close substitutes. An industry
controlled by a monopolist is known as a monopoly.
 Hard to find in the modern economy due to obstacles (e.g., antitrust laws that intend to prevent
monopolies form emerging)
o Oligopolies are much more common (most goods are supplied by them).
o Still important in some sectors (e.g., pharmaceuticals).
 Market power: ability of a firm to raise prices. The main purpose of a creating a monopoly.
Why do monopolies exist: Barrier to entry

 Barrier to entry: for a profitable monopoly to persist they need a barrier to entry, something
that keeps other from going into the same business
1. Control of a scarce resource or input prevents others from entering the market.
2. Increasing returns to scale: total average cost falls as output increases => firms tend to grow
larger => drive out smaller ones (less profitable).
a. Gives rise and sustains a natural monopoly (when increasing returns to scale
provides a large cost advantage to a single firm that produces all an industry’s
output).
b. E.g., local utilities (e.g., water, gas and sometimes electricity)
3. Technological superiority: typically, not a barrier of entry for the long term (over time
people invest in upgrading their technology to match that of the leader)
4. Network externality: value of a good or service to an individual is greater when many other
uses the same good or service (e.g., internet). Value comes from enabling users to participate
in a network of other users.
5. Government-created barrier: justification is based on incentives (do they expect a profit or
not?). Sources of temporary monopolies (want to compensate inventor but also want
consumer surplus and greater efficiency).
6. Patents: gives an inventor temporary monopoly in the use or sale of an invention
7. Copyright: gives creator of a literary or artistic work sole rights to profit from that work.
How to monopolies maximize profit

 Firm with market power vs firm in a perfectly competitive market:

o Perfectly competitive market: price-takers, face horizontal demand curves (cannot
affect market price of good
 Perfectly elastic demand.
o Monopoly (complete market power): price-makers, faces a downward-sloping demand
curve (can affect prices, so to sell more output need to lower prices. Raises price by raising
output)
 Higher price => less quantity sold.
 Effects of increase in production by a monopolists
o Quantity effect: one more unit is sold => increase in total revenue by the price at which
the unit was sold. Stronger in low levels of output.
o Price effect: to sell the last unit, monopolist needs to cut the market price of all units =>
decrease in total revenue. Stronger in higher levels of output.
 Increasing quantity to increase profit => trade-off between quantity effect and price effect.
o To sell more items need to decrease price per unit.
 Monopolist marginal revenue curve: always below the demand curve (price effect => wedge
between monopolist’s marginal revenue curve and the demand curve)
o Wedge exists for any firm with market power => faces downward-slopping demand curve
=> always has price effect from an increase in output.

Monopolists Profit-maximizing output and price

 Monopolies produce to the point of Profit maximization: produce quantity where MR

(marginal revenue) = MC (marginal cost)
o Monopoly price follows the demand curve => produce less at higher price than in a
perfectly competitive industry would => earns higher profits (short and long run).
  How to see best quantity: Total revenue – total cost = Total profit
Welfare effects of a monopoly

 Perfectly competitive: P = MC => no profit => no Producer surplus => TS = CS

 Monopoly: decreases output but charges at the price in the demand curve => loss of beneficial
transactions => TS decreases + deadweight loss.
 Ways to prevent deadweight loss:
o Competition policy: forbids single firm to have a too large market share.
 Forbids abuse of a dominant position,
o Public ownership: having the good be supplied by the government or by a firm owned by
the government (e.g., rail services in the US)
o Price regulation: limit the price that a monopolist is allowed to charge (price ceilings)

Understanding oligopoly

 Dominant firms: Gaining market power due to network externalities and potentially becoming a
monopolist (or a very close one).
Price discrimination

 Single-seller monopolist offers its products to all consumers at the same price.
 Monopolists engages in price discrimination when it charges different prices to different
consumers for the same good (e.g., airlines with business vs first class)
o Increases the part of the CS that is surplus.
 The higher the price discrimination (different amount of prices) the larger the amount
of CS becomes profit.
 Perfect price discrimination: CS = Profit
o Does not cause any inefficiencies since all potential transactions are made: no deadweight
loss.
o Price = willingness to pay of each consumer.

Oligopoly

 Oligopoly: only a small number of producers. Industry is known as an oligopolist.

o Duopoly: there are only two firms. Industry is duopolist.
 Arises due to the same forces that lead to the monopoly but in a weaker form.
 Imperfect competition: competing firms can affect market prices.
 Oligopolist outcomes:
o Cooperative outcome => split the market for the higher amount of revenue (gather to act
as a monopoly=> illegal and unstable (not in equilibrium => both firms have an incentive
to produce more and have a negative relationship).
 A increases quantity => increases A’s profit + decreases profit of B.
o Cournot Nash Equilibrium: Both want to produce more => reach a new equilibrium
(stable) where both have an incentive to stay (individually best outcome).
Repeated interaction

 Games played by oligopolists are not one-time events and tend to be continuous.
 Another strategic element: attempt to influence the future behaviour of other firms.
 Tit for tat: playing cooperatively at first, then doing whatever the other player did in the
previously period.
 o Creates two Nash equilibria (not a prisoners’ dilemma but a coordination game): trying to
coordinate which of them to end up in (there can be more than one stable outcome)
o Tacit collision: both produce at the social optimal outcome.

Bottom line of Oligopoly:

 Two possible outcomes:

o Close of that of monopoly (coordinate to reach a cooperative outcome). Due to:
 few firms in the market
 no market power on the part of buyers
 demand easily predictable
 transparent product and pricing strategy
o Close of that of perfect competition (competitive outcome)

Chapter 21: Macroeconomic- The Big Picture

The nature of macroeconomics
Why are some countries richer than others?

 Technology: efficiency
 Human capital: education, health
 Physical capital: infrastructure, machines, capital intensity
 Geography: natural resources, climate
 Institutions: colonization, exploitations, government, rule of law
 Culture: entrepreneurship
Macroeconomic questions

 Microeconomics: how decisions are made by individuals and firms and the consequences of those
decisions
 Macroeconomics: overall behaviour of the economy. How all individual firms interact and the
economy-wide level of economic performance. => need too keep track of performance => done
through GDP and CPI
o E.g., general prices in the economy and compare them to the year before.
 How much richer are we (on average) compared to fifty years ago?
 Why are there income differences across countries?
 Consumer Price Index (CPI): measures price level and can be used to evaluate whether prices
have increased (inflation) or decreased (deflation)
Macroeconomics: the whole is greater than the sum of its parts

 All individual actions => outcome higher than more than the sum of those actions.
 Combined effect of individual actions might not lead to individuals intentions.
Macroeconomics: Theory and Policy

 Concerns about policy and how the government can increase macroeconomic performance.
o Strongly shaped history (e.g., during the great depression of the 30s)
 Before 30s: self-regulating (invisible hand), no government.
 Keynesian economics: depressed economy is a result of inadequate spending.
o Government intervention can help a depressed economy through:
 Monetary policy: uses change in quantity of money to alter interest rates and
affect overall spending.
  Fiscal policy: uses changes in taxes and government spending to affect overall
spending.
o Established the idea that managing the economy is the responsibility of the government.

The business cycles.

 Government policies lead to an improvement of the economy, but that improvement is not stead
(rate of change shows stumbles after policies)
 Uneven progress of economy is one of the main preoccupations of macroeconomics.
Charting the business cycle

 Real gross domestic product (real GPD): measure of economy’s overall output.
 Business cycle: alternation between short-term downturns and upturns (recessions and
expansions)
o Recession: or contraction, periods of economic downturn when output and employment are
falling.
o Expansion: or recoveries, periods of economic upturn when output and employment are
rising.
o Business-cycle through point at which the economy turns from recession to expansion.
o Business-cycle peak: point where economy turns from expansion to recession.

The pain of recession

 Decrease in ability to find and hold jobs

o Unemployment rate: one of the most used indicators to see conditions in the labour
market.
o Many lose their jobs + it’s harder to find a new one => hurst standard of living of many
families.
 Effects of recession-caused unemployment
o Rise in people living below the poverty line.
o Increase in people losing houses (can’t afford mortgage payments)
o Decrease in people with health insurance.
 Firms: decrease in employment, wages, profits => failure of many small companies.
Long-run Economic Growth

 Long-turn economic growth: sustained rise in the quantity of goods and services the economy
produces (sustained upward trend in the economy’s output over time)
o Fundamental to many of the most pressing economic questions today (determines partly
responses to key policy questions)
 Public’s sense of a country’s progress depends highly on long-turn economic growth:
o Long-term growth per capita: sustained upward trend in output per person. Key to higher
wages and a rising of standard living.
 More urgent in poorer, less developed countries => need to accelerate long-run growth through
economic policy.
o Main issue: how?

Inflation and deflation

 Inflation: rise in the overall level of prices.

 Deflation: fall in the overall level of prices.
Causes of inflation and deflation
 Supply and demand only explain why a good or service becomes more expensive relative to other
goods and services. Doesn’t explain, e.g., why chickens have increased in price over time, despite
a more efficient production.
 Short run: movements in inflation are closely related to business cycle:
o Economy is depressed => harder to find jobs => inflation falls
o Economy is booming => inflation tends to rise.
 Long run: overall level of prices is determined by changes in the money supply (total quantity of
assets that can be readily used to make purchases).
o Hyperinflation (prices rise by thousands/hundreds of thousands of percent): occurs when
governments print money to pay a large part of their bills.
The pain of inflation and deflation

 Inflation downsides: Cash loses value (can buy less with the same amount) => people less
concerned to holding on to cash
 Deflation: cash increases value (can buy more for the same) => people are more concerned in
holding on to cash => less investments => recession can deepen.
 Price stability: overall price changes slowly or not at all. Goal of economists.
International imbalances

 Open economy: economy that trades goods and services with other countries.
o Trade deficit: value of goods and services bought from abroad outweighs value of goods
and services sold.
 Does not mean something is wrong with the economy
o Trade surplus: value of goods and services sold > value of goods and services bought
 Trade deficit and surplus:
o Macroeconomic phenomena. Result of situations in which the whole is very different from
the sum of its parts.
o No simple relationship successful economy and having a surplus or deficit.
 Whether a country has a deficit, or a surplus is determined by savings and investment spending
o High investment spending relative to savings => deficit
o Low investment spending relative to savings => surplus

Chapter 22: GDP and the CPI – Tracking the Macroeconomy

The national accounts

 National income and product accounts: or national accounts. Keep track of flows of money
between different sectors of the economy (spending of consumers, sales of producers, business
investment spendings, government purchases, etc).
o Reliable indicators of its state of economic development
o The more reliable the accounts => the more economically advanced the country.

The circular-flow diagram, revisited and expanded

 Expanded circular-flow diagram: shows money + elements that allow to show key concepts
behind the national accounts.
 o Principle: inflow of money into each market/sector = outflow of money coming from that
market/sector.

 Households:
o Engage in Consumer spending: buying goods and services from domestic firms and from
firms around the world.
o Own factors of production: labour, land, physical capital, human capital and financial
capital.
o Can get indirect income from indirect ownership of physical capital owned by firms: stocks
(share in the ownership of a company held by a shareholder), shares, bonds (borrowing in
the form of an IOC that pays interest).
o Total rent: wages + profit + interest payments + rent
 Don’t get to keep it all => need to give part to the government (taxes)
 + some receive government transfers (payments by the government to individuals
for which no good or service is provided in return)
 What is left after paying taxes and receiving government transfers: disposable
income.
o Disposable income = Income + government transfers – taxes.
 Not usually all spent on goods and services but set aside as private savings
(disposable income not spent on consumption).
 Private savings go into financial markets (market that channels private savings
and foreign lending into investment spending, government borrowing and foreign
borrowing)
 Government:
o Returns portion of the money from taxes to households as government transfer. But part
o Government borrowing: total amount of funds borrowed by the federal, state and local
government in the financial market.
o Government purchases of goods and services: their total expenditure on goods and
services.
 Rest of the world:
o Exports: goods and services sold to other countries
o Imports: goods and services purchased from other countries.
o Foreigners can participate in another countries financial market by making transactions
  Foreign lending: lending by foreigners to borrowers in the country
 Foreign borrowing
 Firms:
o Accumulate inventories (stocks of goods and raw materials that hold to facilitate their
operation)
 National accounts count this as: Investment spending (spending on productive
physical capital, e.g., machinery and construction of buildings, as a part of total
spendings on goods and services).
Gross Domestic Product

 Final goods and services: goods and services sold to the final, or end, user.
 Intermediate goods and services: inputs for production of final goods and services (the other
firm does not count as a final user)
 Gross domestic product (GDP): total value of all final goods and services produced in an
economy during a given period, usually a year.
o Goods: physical products you buy
 Final goods: food that is sold to the final user (when it is not => intermediate input
in production)
o Services: intangible things you buy (e.g., haircut, surgery, education, bank account)
 GDP Calculated by three different ways:
o Production approach: Adding up the total value of production of final goods and services
 Value added: of a producer is the value of its sales minus the values of its
purchases of intermediate goods and services. Used to avoid double counting when
calculating GDP.
 Value added = Revenue – intermediate inputs
o Expenditure approach: See the flow of funds received by firms from sales in final goods
and services market
 GDP = total spending of economy in domestically produced final goods and
services in the economy
 Aggregate spending: sum of consumer spending, investment spending,
government purchases of goods and services, and exports minus imports. Total
spending on domestically produced final goods and services in the economy (in the
diagram it is the total flow of funds into the market for goods and services).
 Net exports (NX): difference between the value of exports and the value of
imports (X – IM). Demand from abroad.
 GDP = C (consumption of households) + I (investments) + G (government
purchases) + NX
 G does not include social welfare transfers.
o Income approach: Based on total income earned in the economy
 Flows out of firms to households needs to be equal to the flow into firms from the
markets => total value of production in the economy (GDP)
 So, sum the total factor income earned by households from firms in the economy.
What GDP tells us

 Most important use: as a measure of the size of the economy. Provides a scale against which to
measure the economic performance of other years or to compare the economic performance of
other countries.
Real GDP: A measure of Aggregate Output
 To measure economy’s growth need a measure of aggregate output (total quantity of final goods
and services the economy produced) => real GDP
 Tracking real GDP over time: avoid changes in price distorting the value of changes in production
of goods and services over time.
Calculating Real GDP

 Nominal GDP: number that has not been adjusted for changes in prices. Calculated using the
prices in the year in which the output is produce (it’s the GDP).
 Chained dollars: methods of calculating changes in real GDP using the average between the
growth rate calculated using an early base year and the growth rate calculated using a late base
year.
nominal GDP
 Real GDP =
price level
 So, real GDP corrects for changes in the price level
o Nominal GDP can double but real GDP only increase 40% for example.
 How to measure price level?
o Basket of products: an hypothetical aggregate of products households often use
o CPI

Market Baskets and Price Indexes

 Market basket: hypothetical set of consumer purchases of goods and services.

 Price index: measures the cost of purchasing a given market basket in a given year, where the
cost is normalizes that it is equal to 100 in the selected year.
o Used to summarize the prices of all goods and services.

 Price indexes are also the base for measuring inflation.

 Inflation rate: percent change per year in a price index (typically the consumer price index)

 Consumer price index (CPI): one of the most used measures of prices. Measures the costs of the
market basket (basket of products) of a typical urban family.
o We assume this basket is constant throughout the years (so quantity remains constant)
o CPI goes up => inflation
 But did life really become more expensive: probably not (people change their
consumption basket and the assumption of CPI is that they don’t)
 Increase in price => decrease in demand (find substitutes too)
o CPI goes down => deflation.

What real GDP doesn’t measure?

 Nominal or real GDP are a country’s aggregate output => more people working = higher GDP
 To eliminate effect of differences in size of population => GDP per capita (GDP divided by the
size of the population).
 Real GDP per capita: e.g., useful for comparison of labour productivity between countries. But it
is a rough measure of the average real output per person.
o Limitations: Country’s standard of living (GDP can improve but if prices also increase
there is actually no improvement in standard of living)
 Not a sufficient measure of human welfare in that country. Growth in real GDP per capita is not
an appropriate policy goal in itself.
o Increase in real GDP => expansion of economy’s production possibility frontier (increase in
productive capacity => society can achieve more)
o But it’s only potential (needs to be put into used)
o Real GDP measure what an economy can do, so real GDP =/= quality of life

GDP vs welfare

 GDP is used since it is relatively easy to measure => interest is in well-being (not how rich people
are) => GDP is a decent measure (positive relation between GDP and well-being)
o Relatively easy to use = easier to interpret (Increase in GDP by 2% is easier to understand
than well-being increased 2%)
 Positive correlation between GDP several well-being factors
o Life expectancy
o Sanitation levels
o Self-reported life satisfaction.
 Attention
o Maximizing GDP should never be the final goal for policy makers (increase in GDP
does not always increase quality of life)
o Correlation does not always mean causality (just because GDP is correlated with some
dimensions of well-being it does not mean there is causality between them).
Price indexes and the Aggregate Price Level (don’t think this is needed)

 Aggregate price level: measure of the overall level or prices in the economy.
Other price measures

 Producer price index (PPI): measures the cost of a typical basket of goods and services,
containing raw commodities such as stell, electricity, coal and so on, purchased by producers.
o Commodity producer are relatively quick to change prices when they receive a change in
demand => PPI responds to inflationary or deflationary pressures more quickly than CPI
=> seen as an early warning signal.
 GDP deflator: not really a price index, but serves the same purpose. Equal to 100 times the ratio
of nominal GDP for that year to real GDP for that year.
 The three price measures tend to behave similarly.
Chapter 24: Long-run Economic Growth
Comparing economies across Time and space
Growth rates

 Economic growth is measured using real GDP per capita.

 Increase in real GDP => increase in living standards.
 Long-term rise in Real GDP per capita is the result of gradual growth
o Rule 70: tells us how many years at a given annual rate of growth it takes to double real
GDP per capita (relationship between annual growth rate of the real GDP per capita and the
long-run change in real GDP per capita)
  Can only be applied to a positive growth rate.
 So, time it takes a variable to double over time is approximately 70 divided by that
variable’s annual growth rate.
 Growth rate of 1% => it takes 70 years to double GDP.
 Growth rate of 2% => it takes 35 years to double GDP.
 Growth rates of real GDP per capita differ substantially among nations.
The sources of Long-run Growth

 Economic growth depends mainly on rising productivity. Yet it is also affected by other factors.
The crucial importance of productivity

 Sustained economic growth occurs only when the amount of output produced by the average
worker increases steadily.
 Labour productivity (or just productivity): output per worker, or in some cases output per hour.
 Why did productivity grow?
o Moder worker has more physical capital (human-made resources such as buildings and
machines)
o Modern worker is much better educated, i.e., has more human capital (improvement in
labour created by the education and knowledge embodied in the workforce)
o Modern firms have century’s accumulation of technical advancements reflecting a great
deal of technological progress (advance in technical means of the production of goods and
services)
Accounting for growth: The aggregate production function

 Aggregate production function shows how productivity (real GDP per worker) depends on
quantities of physical capital per worker and human capital per worker + state of technology.
 When analysing historical economic growth, economists discovered a crucial fact about the
estimated aggregate production function: exhibits diminishing returns to capital (amount og
human capital per worker and state of technology are fixed: each successive increase in physical
capital per worker => smaller increase in productivity.

 Growth accounting: used to disentangle all the factors that contribute to higher productivity rise
during the economic growth. Estimates the contribution of each major factor in the aggregate
production function to economic growth.
 Total factor productivity: amount of output that can be produced with given amount of factor
inputs.
 o So, total productivity increases => economy can produce more output with the same
quantity of physical capital, human capital, and labour.
 Natural resources are less important today than physical and human capital as sources of
productivity growth in most economies.