Intermediate Microeconomics: Programme

1. Profit Maximization and competitive supply.

2. Competitive markets.

3. Monopoly.

4. Price discrimination.

5. Monopolistic competition.

6. Game theory.

7. Oligopoly.

8. Asymmetric information.

1. Profit maximization: a dual problem

1.1. The profit maximization assumption.

Do firms maximize profits?

Profit maximization is a basic assumption in microeconomics. It predicts business behavior

reasonably accurately and avoids analytical complications.

However, this assumption is controversial. Managers in large firms may pursue other goals (such as
revenue maximization, revenue growth of the payment of dividends). These managers may also
be more concerned with short-run profits at the expense of long-run profits. The lack of
information might lead managers to use rules of thumb.

Anyway, a manager’s freedom to have aims other than long-run profit maximization is limited.
Firms that do not come close to maximize profits are not likely to survive in competitive markets.
Moreover, it is the market value of the firm what is of direct interest to stockholders.

Alternative forms of organizations.

Some forms of organizations have objectives that are different from the profit maximization, for
example a cooperative. A cooperative is an association of businesses or people jointly owned and
operated by members for mutual benefit. Cooperative agreements are common in agricultural
markets: small producers who jointly distribute their product under a common marketing brand.
Other recent examples of such agreements are food cooperatives or housing cooperatives.

There also exist not-for-profit organizations, for example firms that do not look for profits. These
firms do not pay dividends to their owners.

The firm maximization problem.

Profits
The firm’s profit is defined as the difference between revenue
and cost:
∏(q) = R(q) – C(q)
Where q is the firm’s output. Then, ∏, R and C depend on output

Duality: The profit maximization problem has two parts, for example in a first step the firm
minimizes costs and in a second step it chooses the output quantity that maximizes the difference
between total revenue and the minimum cost function.

1.2. Production.

The technology of production.

In the production process, firms turn inputs into outputs (or products).

Inputs, also called factors of production, include anything that the firm must use in order to
produce output (labor, materials and capital).

We can describe the relationship between the inputs into the production process and the
resulting output by a production function.

In order to simplify the analysis, we will consider a two-input production function. We can write
it as q = F(K,L) where L denotes labor and K denotes capital.

Definition: A production function indicates the highest output q that a firm can produce for
every specified combination of inputs.

Definition

A production function indicates the highest output q that a firm can produce for every
specified combination of inputs.

The production function applies to a given technology, for example to a given state of knowledge
about the various methods that might be used to transform inputs into outputs.

As defined above, production functions assume that firms are always technically efficient.

The Cobb-Douglas production function

A production function widely used in microeconomic theory is the
Cobb-Douglas production function. It is a function of the form:
q = AKαLβ
Where A, α and β are positive constants.

The Cobb-Douglas production function is frequently encountered in economics and can be used to
model many kinds of productions. It can also account for technological change through changes in
the value of A.

Production with one variable input.

Definition
The average product is the output per unit of a particular input:
 APL= APK=

Definition
The marginal product is the additional output produced as an input is increased by one
unit. Mathematically, we will express it as a partial derivative:

MPL= MPK=

Example: Let’s calculate the AP and the MP of both inputs for the following production function:

q = 2K1/2L1/2

APL = = = -1== 2K1/2L-1/2 = 2 = 2

APK = = = -1== 2K-1/2L1/2 = 2 = 2

MPL = = 2k1/2L-1/2 = k1/2L-1/2 = =

MPK = = 2k-1/2L1/2 = k-1/2L1/2 = =

The law of diminishing marginal returns
The law of diminishing marginal returns states that as the use of an input increases with other
inputs fixed, a point will eventually be reached at which the resulting additions to output
decrease.

Mathematically, it means that the marginal product of any input will be decreasing from a certain
point.
Example: Given q = 2K1/2L1/2, we had . The diminishing marginal returns holds for every level of
labor.

Production with two variable inputs

Definition
An isoquant is a curve that shows all the possible combinations of inputs that yield the same
output

When a number of isoquants are combined in a single graph, we call the graph an isoquant map.

Substitution among inputs

Definition
The marginal rate of technical substitution (MRTS) of labor capital is the amount by which the
quantity of capital can be reduced when one extra unit of labor is used, so that output remains
constant.

Graphically, the marginal rate of technical substitution is the slope of an isoquant (with positive
sign).

The MRTS formula

The marginal rate of technical substitution between two inputs is equal to the ratio of the
marginal products of the inputs, MRTS =

MRTS = = KL-1 =

Diminishing MRTS: the MRTS falls as we move down along an isoquant.

Definition
Returns to scale is the rate at which output increases as inputs are increased proportionately.
Three cases:
• Increasing returns to scale: output more than doubles when all inputs are doubled.
• Constant returns to scale: output doubles when all inputs are doubled.
• Decreasing returns to scale: output less than doubles when all inputs are doubles.

Note: A production function can exhibit different kinds of returns to scale according to the output
level.

Returns to scale and the Cobb-Douglas production function

Recalling the general formula of a Cobb-Douglas
q = AKαLβ

We have that,
• If α + β > 1 ! increasing returns to scale.
• If α + β = 1 ! constant returns to scale.
• If α + β < 1 !decreasing returns to scale.

Example: Let’s calculate the AP and the MP of both inputs for the following production function: q
= 2K1/2L1/2

1.3. The cost of production

Concepts of costs

Economic cost versus accounting cost

Definition
Economic cost is the cost to a firm of utilizing economic resources in production.

Economic cost is different from accounting cost. That is because economic cost includes the
opportunity cost while accounting cost does not.

Definition
Opportunity cost is the cost associated with opportunities that are forgone by not putting the
firm’s resources to their best alternative use.

Sunk cost

Definition
A sunk cost is an expenditure that has been made and cannot be recovered.

After it has been incurred a sunk cost should always be ignored when making future economic
decisions.
Kinds of costs

The Total cost (C) is divided into two components:

• Fixed cost (FC): is a cost that does not vary with the level of output and that can be
eliminated only by going out of business.

• Variable cost (VC): a cost that varies as output varies.

Fixed costs and sunk costs should not be confused: fixed costs can be eliminated but not sunk
costs.

Marginal cost is the increase in cost that results from producing one extra unit of output.
Mathematically, it is the derivative of the total cost:

MC=dC/dq.

Average total cost (AC) is the firm’s total cost divided by its level of output:

AC=

It has two components: Average fixed cost (AFC)= and Average variable cost (AVC)= .

Costs in the short run

The short run is a period of time in which quantities of one or more production factors cannot be
changed.

We usually consider capital as the fixed input in the short run and we will examine the shape of
the short-run cost functions graphically.

Costs in the long run

The long run is the amount of time needed to make all production factors variable.

It follows that in the long run all costs are variable and there are no fixed costs the firm’s
problems as how to select the amount of inputs to produce a given output at minimum cost.

Prices of inputs

We assume that there are competitive markets for both inputs so that firms cannot influence
their prices

• Price of labour: the wage rate, w.

• Price of capital: the user cost of capital, r. It includes the economic depreciation and the
opportunity cost of capital, r=Depreciation rate + Interest rate.

The isocost line

An isocost line shows all possible combinations of labour and capital that can be purchased for
given total cost.
The total cost of production is given by: C=wL+rK

Arranging terms, we get: K=(C/r)-((w/r).L)

Cost minimization problem

The problem of the firm can be expressed as follows:

Min C=wL+rK

Subject to F (K, L)=q0

We will solve this problem graphically instead of mathematically.

The solution of the previous problem yields to the following optimization condition:

In the optimal point the slope of the isoquant and the slope of the isocost are equal.

Definition
The expansion path describes the combinations of labor and capital that the firm will chose to
minimize costs at each output level.

Then, the expansion path is the curve passing through points of tangency between a firm’s isocost
and its isoquants.

Practical note: how to calculate the long-run cost function

In order to calculate the firm’s cost function in the long run we have to follow three steps:

1. Calculate the combinations of capital K and labor L that minimize the total cost applying
the optimality condition:

Thus, we obtain the firm’s expansion path.

2. Substitute the result into the production function q = F(K,L). thus, we obtain the
constrained factor demands for labor and capital.

3. Finally, we substitute results obtained in step 2 into the equation C = wL + rK.

Long run versus short run cost

When a firm operates in the short run, its costs may not be minimized. That is because of the
inflexibility of capital. The implication is that the short-run expansion path is different from the
long-run expansion path.

Long-run average and marginal cost

In the long run, we define two cost curves:

• The long-run average cost curve (LAC): Average cost of production to output when all
inputs are variable.

• The long-run marginal cost curve (LMC): It shows the change in long-run total cost as
output is increased by one unit. In the long run we do not have fixed costs.

1.4. Competitive supply

Perfectly competitive markets

The model of perfect competition rests on three basic assumptions:

• Price taking: The companies accept the prices that are given by the market; they cannot
sell at the price they want.

• Product homogeneity: All the units produced in that markets are the same.

• Free entry and exit.

Profit maximization and competitive supply

The supply curve of a competitive firm is a derived from the profit maximization
problem.

As the competitive firm is a price taker, marginal revenue equals price so:

Output choice in the short run

Shutting down threshold
In the short run, the firm produce a positive output if price is greater than the average variable
cost (AVC)

Note that the firm may incur losses in the short run if price is below the average total cost (AC).

To see why the minimum of the AVC is the shutting down threshold considers the following
equation:
Output choice in the long run
Shutting down threshold
In the long run, the firm will produce a positive output if price is greater than
the long run average cost (LAC).
As in the long run all costs are variable, the competitive firm will try to avoid
losses.

2. Competitive markets
2.1. The short-run market supply curve
2.1.1. Definition and derivation

How the short-run market supply curve is obtained:

Definition
The short-run market supply curve is the amount of output that the industry will produce in
the short run for every possible price.

It can be obtained by adding the quantities supplied by all firms in the market.

Graphically, it is the horizontal sum of the supply curve of each of those firms.

2.1.2. Elasticity of market supply

Definition
The price elasticity of market supply ES is the percentage change in the quantity supplied Q in
response to one percent change in price P:

The short-run elasticity of supply is always positive.

Two extreme cases:

• Perfectly inelastic supply: greater output can be achieved only if new plans are built.

• Perfectly elastic supply: marginal cost is constant.

2.2. The long-run competitive equilibrium

2.2.1. Profitability, entry and equilibrium

Profits and entry of firms:

• In the long run there is entry of firms into the market.

• At the same time, some firms may leave the market.

• What makes a firm enter or leave the market?

In a market with entry and exit, a firm enters when it can earn a positive long-run profit and exits
when it faces the prospect of a long-run loss.

Long-run competitive equilibrium:

Definition
A long-run competitive equilibrium occurs when three conditions hold:
• All firms in the industry are maximizing profit.
• No firm has an incentive either to enter or exit in the industry because all firms earn
zero economic profit.
• The price of the product is such that the quantity supplied is equal to the quantity
demanded.

2.2.2. Meaning of zero economic profit

Economic profit

Economic profit π equals revenues R minus total cost:

π = R – wL – rK

Recall that the cost of capital r includes annual depreciation and the opportunity cost of capital.

Zero economic profit:

Definition
A zero economic profit means that the firm is earning a normal return on investment – i.e., it
is doing as well as it could by investing its money elsewhere.

In a perfectly competitive industry a firm will earn a return on investment that is equal to the
opportunity cost of capital.

2.3. The industry’s long-run supply curve

2.3.1. Derivation

We cannot analyze long-run supply in the same way we did with short-run supply.

In the long run firms enter and exit the market so it is impossible to sum up their supplies.

To determine long-run supply, we assume that:

• Output is increased by using more inputs, not by invention.

• Conditions underlying the market for inputs do not change when the industry expands or
contracts.

The shape of the long-run supply curve depends on what happens with input prices when output
changes.

We distinguish three types of industries:

• Constant cost.

• Increasing cost.

• Decreasing cost.

2.3.2. Constant-cost industry

Property

The long-run supply curve for a constant-cost industry is a horizontal straight line.

Supply is horizontal at a price that is equal to the long-run minimum average cost of production.

We will analyze it graphically.

2.3.3. Increasing-cost industry

Property

In an increasing-cost industry, the long-run industry supply curve is upward sloping.

2.3.4. Decreasing-cost industry

Property

In a decreasing-cost industry, the long-run supply curve for the industry is downward sloping.

In this case, forms’ long-run average cost curves shift downward.

2.4. Analysis of competitive markets

2.4.1. Market demand

The market demand curve

Definition
The market demand curve relates the quantity of a good that all consumers in a market will
buy to its price.

Individuals demands a certain amount of a good for a given price so their utility or “satisfaction”
is maximized.

The demand curve is the sum of the individual curves of all consumers in a particular market.

The demand curve is usually downward sloping.

Elasticity of demand

Definition
The price elasticity of demand is the percentage change in quantity demanded of a good
resulting from a 1-percent increase in its price: Ed =

Price elasticity of demand is usually negative.

The slope of a linear demand curve is constant but not its elasticity. We distinguish two cases:

• Inelastic demand: Ed < -1

• Elastic demand: Ed > -1

2.4.2. Equilibrium

Competitive market equilibrium

Definition
The equilibrium (or market clearing) price is the price at which quantity supplied and
demanded are just equal.

The market mechanism guarantees that the equilibrium point will be reached.

Market equilibrium: interpretation

Competitive market equilibrium interpretation

The equilibrium price is the only point at which both consumers’ and producers’ plans coincide.

2.4.3. Welfare

Welfare analysis

If prices freely change in a competitive market then it will get to the equilibrium point.

However, the competitive market price and quantity might not always be achieved.

Possible reasons:

• A government intervention prevents demand and supply from being in equilibrium – e.g.
price controls.

• Competitive conditions do not prevail in the market – e.g. a monopoly.

Should this happen, are consumers better off or worse off? And producers? What is the effect on
the whole?

Consumer surplus

Definition
Consumer surplus is the difference between what consumers are willing to pay for a good and
what they actually pay when buying it.

Consumer surplus is the total benefit or value that consumers receive beyond what they pay for
the good.

Producer surplus

Definition
Producer surplus is the difference between the market price of the good and the marginal cost
of its production.
Producer surplus is the benefit that lower-cost producers enjoy by selling at the market price.

Application: the minimum wage law

• Suppose that the government imposes a minimum price in the labor market.

• The wage is set at wmin, a level higher than the market-clearing wage w*.

• Firms are not allowed to pay less than wmin.

• This results in unemployment of an amount L2 – L1.

• There is a deadweight loss given by triangles B and C.

3. Monopoly
3.1. Market power

3.1.1. Concept and cases

What is market power?

Definition

Market power is the ability of a seller or a buyer to affect the price of a certain good.

Market power derives from a reduced number of either sellers or buyers in the market.

It may also derive from product differentiation.

In these situations, the assumption that those agents will behave like price takers does not hold
anymore.

Forms of market power

Market power on the supply side

Market structures:
• Monopoly: Market with only one seller.
• Monopolistic competition: Market in which firms sell differentiated products.
• Oligopoly: Market in which only few firms compete with one another.
Market power on the buyer side
Market structures:
• Monopsony: Market with only one buyer.
• Oligopsony: Market with only few buyers.

3.2. Monopoly

3.2.1. The monopolist’s output decision

Profit maximization

The monopolist solves the following profit maximization problem:

max π(Q) = R(Q) – C(Q)

= MR(Q) – MC(Q) = 0

MR(Q) = MC(Q)

As the monopolist is the only seller, it is not a price taker:

R(Q) = P(Q)Q

Where P(Q) is the market demand curve and the average revenue (AR):

AR(Q) = = = P(Q)

We can calculate the marginal revenue (MR):

R(Q) = P(Q)Q

MR(Q) = P(Q) + Q

Therefore, the monopoly equilibrium is:

P(Q) + Q = MC(Q)

We will analyze it graphically.

3.2.2. Monopoly power

Markup equation

Recalling the monopolist profit maximization condition:

P + Q = MC
Thus,
P + = MC
P + P = MC
Finally,

The left side of the equation is called Lerner Index and is a measure of monopoly power:

• If P=MC (perfect competition) then monopoly power is zero.

• The maximum value of the index is one.

Some properties of monopoly can be derived from the markup equation:

• Monopoly power depends inversely on the elasticity of demand.

• The monopolist will never produce a quantity of output on the inelastic portion of the
demand curve.

3.2.3. The social costs of monopoly power

Deadweight loss from monopoly power

In order to analyze the welfare effects of monopoly power we make two assumptions:

• The competitive market and the monopolist have the same cost curves.

• The technology of production exhibits constant returns to scale.

We will analyze it graphically.

The highlighted triangle is the deadweight loss from monopoly power.

Therefore, monopoly results in economic inefficiency (net loss of total surplus).

Profit and monopoly

Recall that in long run a competitive firm earns a normal economic profit:

π = R – wL – rK = 0

This means that the firm has a return on investment equal to the opportunity cost of capital.

The cost of capital is:

R=d+i

where d is depreciation and I is the interest rate (opportunity cost).

R – wL – (d+i)K = 0

Then,
 R – wL – dK = iK

Monopolist’s profit

Unlike a competitive firm, the monopolist may obtain a positive profit even in the long run.

We say that the monopolist obtains an extraordinary profit – i.e., a profit greater than the
opportunity cost of capital.

3.3. Monopsony

3.3.1. The monopsonist’s purchase decision

Monopsonist buyer

The monopsonist is interested in the value that it gets from the purchased units of the good.

It also takes into account the expenditure it must incur to purchase them.

Therefore, the net benefit from the purchase is:

NB(Q) = V(Q) – E(Q)

Maximizing NB,

= MV(Q) – ME(Q) = 0

MV(Q) = ME(Q)
As the monopsonist is the only buyer, it is not a Price taker:

E(Q) = P(Q)Q

where P(Q) is the supply curve. Thus,

ME(Q) = P(Q) + · Q

Because the supply curve P(Q) is upward sloping,

>0

Then, marginal expenditure is greater than P(Q) or average expenditure.

The less elastic supply is, the greater monopoly power is.

3.3.3. The social costs of monopsony

Deadweight loss from monopsony power

Monopsony power results in lower prices and lower quantities purchased.

Then, we would expect it to make the buyer better off and sellers worse off.

But how is aggregate welfare affected by monopsony power?

3.3.4. Bilateral monopoly

Pure bilateral monopoly

Definition

A bilateral monopoly is a market or industry with only one seller and one buyer.

In this case, both the buyer and the seller are in a bargaining situation.

The final result will depend on the relative negotiation or bargaining power of each party.

3.4. Market power in practice

3.4.1. Monopoly: causes and regulation

How can a monopoly appear?

There are several causes of a monopoly:

• Control of production factors.

• Licensing.

• Patent and copyright laws.

• Economies of scale (natural monopoly).

Price regulation

A monopoly harms consumers and produces a deadweight loss.

However, sometimes a monopoly may be desirable.

e.g., a pharmaceutical company that invents a new life-saving drug.

In this instances, goverments usually apply price regulation.

Price regulation consists in the imposition of a price ceiling.

If the government wishes to completely eliminate the deadweight loss, then it should apply the
following rule:

pr = MC

Natural monopoly and regulation

Definition
A natural monopoly is a firm that can produce the entire output of the market at a cost lower
than it would be if there were several firms.

Traditional forms of intervention:

• Public provision.

• Price regulation; in this case it should apply the AC rule:

pr = AC

Otherwise, the monopolist would lose money.

Modern form of regulation:

• In some instances, governments can introduce competition in the market – e.g. the phone
market.

Technical change allows other firms to use the monopolist’s network.

4. Price discrimination

4.1. Pricing with market power

4.1.1. Capturing consumer surplus

Consumer surplus capture and price discrimination

Firms with market power apply pricing strategies in order to increase their profits.

There pricing strategies are means of capturing consumer surplus and transferring it to the
producer.

Capturing consumer surplus is the basis of price discrimination.

Definition
Price discrimination is a practice of charging different prices to different consumers for similar
goods.

The problem is to identify the different consumers and to get them to pay different prices.

4.2. Types of price discrimination

Price discrimination can take three broad forms:

• First-degree price discrimination.

• Second-degree price discrimination.

• Third-degree price discrimination.

4.2.1. First-degree price discrimination

Definition
First-degree price discrimination is the practice of charging each consumer their reservation
price.

The reservation price is the maximum price that a consumer is willing to pay for a good.

This strategy is also called perfect price discrimination.

• Reservation price can be identified for each consumer.

• Each consumer is charged exactly what he or she is willing to pay.

• The producer captures the entire consumer surplus.

We will analyze it graphically.

In practice, firms can only apply imperfect price discrimination.

Firms discriminate imperfectly by charging a few different prices based on estimates of

consumers’ reservation prices.

This practice is often used by professionals such as doctors, lawyers, accountants or architects.

4.2.2. Second-degree price discrimination

Definition
Second-degree price discrimination is the practice of charging different prices per unit for
different quantities of the same good or service.

This practice is based on the fact that in some markets the reservation price declines with the
number of consumers. e.g.,, water, electricity or gas.

In these cases, a firm can discriminate according to the quantity purchased.

BUNDLING consists in selling different products that can be sold separately all together.

TYING is when the seller puts in the market a certain product that you have to buy with another
one.

Two-part tariff

Definition
A two-part tariff is a form of pricing in which consumers are charged both an entry and a usage
fee.
The general formula is:

Tariff = T + pq

Where T is the entry fee and p is the usage fee.

We distinguish two cases:

• One type of consumers: The optimal tariff is to set the entry fee T equal to the total
consumer surplus and the usage fee p equal to the marginal cost.

• Two types of consumers: The optimal tariff is to set the entry fee T equal to the surplus of
the consumers with the smaller demand and the usage fee p that maximizes profit.

4.2.3. Third-degree price discrimination

Definition
Third-degree price discrimination is the practice of dividing consumers into two or more
groups with separate demand curves and charging different prices to each group.

Some characteristic is used to divide consumers into distinct groups.

Sometimes consumers separate themselves when choosing the product.

Analysis

Total profit (two groups):

π = P1Q1 + P2Q2 – C(QT)

where QT = Q1 + Q2.

The maximum profit condition for sales to the first group is

 = MR(Q1) – MC = 0

Thus, we have

MR1 = MC

Similarly for the second group, we have

MR2 = MC

Putting these relations together:

MR1 = MR2 = MC

Property

The higher price will be charged to consumers with the lower demand elasticity.

Individuals that are less sensitive to price changes will be charged a higher price.

For instance, if Ed1 < Ed2 then P1 > P2.

This property is derived from the following relationship:

Which is the same as MR1 = MR2.

Other examples

Other examples of third-degree price discrimination include:

• Intertemporal price discrimination.

• Coupons.
5. Monopolistic competition
5.1. Monopolistic competition analysis

5.1.1. Characteristics

The makings of monopolistic competition

A monopolistically competitive market has two main characteristics:

• Firms compete by selling differentiated products (not perfect substitutes).

• There is free entry and exit.

Equilibrium price and output

As with monopoly…

• In monopolistic competition, firms have some degree of monopoly power.

• It means that they face downward-sloping demand curves

As with perfect competition…

• In the short-run may have positive economic profits.

• However, in the long-run entry drives economic profits down to zero.

5.2. The Hotelling model

Setting the model: the beach location example

Consider the following situation:

 • Two vendors (a and b) plan to sell soft drinks on a beach this summer.

• The beach is 1km long and swimmers are spread evenly across its length.

• Both vendors sell soft drinks at the same prices.

• Then, consumers will walk to the closest vendor.

Where on the beach will the two vendors locate?