Introductory Microeconomics Lectures

✅ Lecture 1 - February 27: Subject overview

Week 1A Basic economic problem: Human wants are unlimited, means to satisfy are limited

✅ Lecture 2 - March 1: Introduction to key concepts

Week 1B
What is economics all about?
• About human well-being (the consumption of goods and services)
• Resources to make good & services
Natural resources, physical capital, human capital, time
• Basic/Fundamental problem individuals/societies face: Scarcity of resources
• Scarcity of resources means we need to make decisions how to use/allocate limited
resources => decisions made will affect individual & society’s well-beings

Economics use scientific methods:

• Develop theories to describe & understand economic activity
• Gather data to test predictions of those theories
• Verify those theories based on results of empirical tests

A theory has 2 elements:

• Model of the situation
o Mini world of the real world we’re studying so we are taking essential
features of the situation
o Goal of model: To simplify reality in order to understand better
• Hypotheses/predictions derived from that model

Underlying assumption of economic theory: Rationality

• Decision-makers (model varies: consumer, firms, or government) are rational, they
have well-defined objectives, make consistent choices (actions) to achieve
objectives
o Firms: Take actions that are consistent to maximise profit

Decision theory in economics

• Every action comes with benefits and cost
• Objective function:
Net benefit (NB) = Total benefits (TB) – Total cost (TC)
• Best (optimal) action a rational decision-maker makes is:
Maximise net benefit

How to measure cost?

• When decision-makes takes an action,
the resources used to take that action becomes unavailable for alternative use
• Cost of an action is measure in terms of those resources
• Value of these resources = consider the next best alternative use
Opportunity cost of an action reflects the value of resources used in taking that action to
their next best alternative use

What about resources that were used before making the decision?
• Do not include in decision – money you already spent
• At the time a decision-maker chooses an action,
resources that were already used should not matter in the decision-making
• Therefore, the value of those resources that were already used should not be
considered opportunity cost

Sunk cost reflect the value of resources that were used before making a decision about
which action to take

Examples
(1) Attending Commerce Student Society Ball
• Ball cost $150, 3 hours
• Part time job: You have schedule to work over those 3 hours at wage $20 an hour

What is your opportunity cost for going to the ball?

• Cost of ticket $150 + cost of 3 hours ($60) = $210

(2) Going to a football match, supposing you already own a season ticket
• Already paid $150 per game for tickets
• Part time job: You have schedule to work over those 3 hours at wage $20 an
hour

What is your opportunity cost for going to the ball?

• Ticket: Sunk cost, not affecting your decision
• Opportunity cost = 3 hours of work = $60

(3) Both
• Ball tickets = $150
• You paid $150 for footy tickets you can’t resell
• The game & the ball are at the same time
• You are scheduled to work over those 3 hours at wage of $20 an hour
• You value going to the ball at $240

What is your opportunity cost of going to the footy game?

If I go to the footy game: 2 alternatives

1. Go to work = 3 hours of income = $60
2. Go to the ball = (Value at S240 - $150 for ticket) - $60 for work = $30 net benefit

Time value = $60 + $30 = $90

How to measure benefits?
 • Benefits sit at the core of the objective function of a decision-maker

• Firms objective: To maximise profit,

since Profit = Revenue – Cost (benefit would be the revenue_

• Suppose a firm needs to decide whether to open a new branch, then the benefits
that need to be accounted would include expected revenue from having the new
branch

Rational decision-makers think at margin what happens if I change a little bit

Increment in total benefits by taking an action/

Marginal benefit (MB)
increasing the level of activity by 1 unit

Increment in total cost by taking an action/

Marginal cost (MC)
increasing the level of activity by 1 unit

• To maximise net benefit,

one would take an action/ increase in level of activity as long MB >/ MC

• If an action/ increase in level of activity confers MB < MC,

it must no longer be optimal = Net benefit is decreasing

Algebraic:
• Suppose 𝑁𝐵(𝑥) = 𝑇𝐵(𝑥) – 𝑇𝐶(𝑥)

• To maximise net benefit 𝑵𝑩(𝒙), differentiate 𝑵𝑩(𝒙) & set to 0

• Optimal quantity x* is one that satisfies 𝑴𝑩(𝒙) ∗ = 𝑴𝑪(𝒙 ∗)

Example
• 𝑇𝐵(𝑥) = 10𝑥
• 𝑇𝐶(𝑥) = 𝑥 2
• 𝑁𝐵(𝑥 ) = 𝑇𝐵(𝑥 ) − 𝑇𝐶(𝑥 ) = 10𝑥 – 𝑥 2

To maximise net benefit 𝑵𝑩(𝒙),

• 𝑁𝐵(𝑥) = 10𝑥 – 𝑥 2
𝑑𝑁𝐵(𝑥)
• 𝑑𝑥
= 10 − 2𝑥
Hiring workers for a computer store
• Matt Manager must decide how many workers to hire for his new computer store
• Suppose:
o Hourly wages $20 per worker marginal cost
o 1st worker is expected to help increase sales by $60 per hour
o Any new workers will diminish $15 per hour for every 1 new worker until
they make no more contribution marginal benefit

How many workers should Matt hire?

No. of workers Total benefit Marginal benefit Total cost Marginal cost Net benefit
0 - -
1 60 60 20 20 40
2 105 45 40 20 65
3 135 30 60 20 75
4 150 15 80 20 70

People respond to incentives

• In economic theories, individual make decisions based on relative costs &
benefits of alternative actions

• When these costs/benefits change, we expect rational decision-makers to

change their actions accordingly we switch to maximise our valuation

• Setting these incentives right is critical especially for policy making

B. Perfectly competitive market

✅ Lecture 3 - 6 March: Demand and supply
Week 2A - Perfectly Competitive Markets

Demand and supply

What is a market?
• Where buyers & sellers trade a particular good/service
• Buyers on demand side & sellers on supply side of the market
• Both agents decide to transact by considering MB and MC
• Trade occurs when MB ≥ MC for both buyers and sellers
• Buyers: MB – Valuation >/ MC – Price
• Seller: MB – Price >/ MC – Opportunity cost (cost of production)
• Trade: Valuation >/ Price >/ Opportunity cost (cost of production)

Types of markets
Perfectly competitive markets
• Have many buyers & sellers + trading identical goods
• Such markets are competitive because buyers know that there are many sellers to
choose from because there is no product differentiation identical
• Individual sellers have no market power, they are price-takers

Demand
Demand curve
• Maps out no. of units “demanded” by buyers in market given a price
• Demand curve downward sloping

• When price ⬆ quantity demanded ⬇

• Demand is influenced by factors:

o Price
o Tastes
o Price and quality of alternative goods
o Income

• For example, 𝑄𝐷 = 𝑎 − 𝑏𝑃 + 𝑐𝑋
,
Law of demand
• Price & quantity demanded are inversely related, other things being equal

Movement in demand curve Price determinant

• Quantity demanded by buyers decrease when unit price of a good increases
(and vice-versa), holding other factors constant
• When price changes, there is a movement along the demand curve

Shifts in demand curve – Non-price determinants

Income
• Normal good = positively related
When income ⬆, normal good demand ⬆

• Inferior good = inversely related

When income ⬆ inferior good demand ⬇

Price of other goods

• Substitute goods = positively related to demand for other good
Price Good A price ⬆, Good A demand ⬇
(Substitute goods) Quantity demanded Good B ⬆

• Complement goods: = inversely related to demand for other good

Price Good A price ⬆, Good A demand ⬇
(Complement goods) Good B demand ⬇

Other factors
• Consumer tastes
• Opportunity costs
• Price expectations
• No. of buyers

Supply
• Market supply = Sum of all supplies of sellers
• Supply is potentially influenced by many factors (price, technology, etc.)
• For example, 𝑄𝑠 = 𝑎′ + 𝑏′𝑃 + 𝑐′𝑋

Law of supply
• Price & quantity supplied are positively related, other things being equal

Movement in supply curve Price determinant

• Quantity supplied by sellers increases when unit price of a good increases
(and vice-versa)
• When price changes, there is movement along the supply curve

Shifts in supply curve Non-price determinant

• Technology COP ⬇, quantity supply ⬆, shift rightwards
 • Input prices
• Price expectations
• Cost of production

Market equilibrium
• Situation in which demand & supply have brought into balance
• Quantity demanded (supplied) represents the willingness and ability of buyers
(sellers) to buy (sell) at each price
• Trade occurs where both sides of market “agree” on a price and quantity
• The market “clears” in the sense that buyers (sellers) have bought (sold) all they
wanted
• Graphically, market clears at intersection of market demand & supply curves

Equilibrium

Algebraically
𝑄𝐷 = 120 − 20𝑃
𝑄𝑠 = 20𝑃

Solve for equilibrium point {P∗, Q∗} using condition 𝑄𝐷 = 𝑄𝑆 = 𝑄 ∗

✅Lecture 4 - 8 March: Market equilibrium and comparative statics

Week 2B

How do we know that the outcome in a perfectly competitive market is the pair {P∗ , Q∗}?
What happens at other prices?

• When 𝑷 ≠ 𝑷 ∗, competitive process will drive price to converge to P∗

∗
• Only when 𝑷 = 𝑷 ∗ price is stable (equilibrium)
Inequilibrium
Excess supply Price is higher
Suppose 𝐏 = 𝐏  > 𝐏∗
• There’s a mismatch between quantity demanded & quantity supplied
𝑄𝐷 (𝑃) < 𝑸 ∗ < 𝑄𝑠 (𝑃)

At given 
𝐏,
• Quantity traded is @ 𝑸𝑫 (𝑷) because there are no more buyers who are willing to
buy @ that price
• Some sellers are rationed out of the market:
Sellers would like to sell @  
𝐏 but there is no more quantity demanded @ 𝐏

• Thus, sellers are willing to lower their asking price in order to sell their products

•  (𝑃 < 𝑃 < 𝑃 )
When 1 seller lowers his price to 𝑷
then additional buyers will be willing to trade

• But all existing buyers will rather buy @ 

𝑷,
so market price will be forced down to 𝑷 

• By the same argument,

sellers will continue to lower asking price until there are no more gains from trade
Excess demand When price is lower

< 𝐏∗
Suppose if 𝐏 = 𝐏
• There’s a mismatch between quantity demanded & quantity supplied
𝑄𝐷 (𝑃) > 𝑸 ∗> 𝑄𝑠 (𝑃)

At given 
𝐏,
• Quantity traded is @ 𝑸𝒔 (𝑷) because there are no more sellers who are willing to
sell at that price

• Some buyers are rationed out of the market:

Buyers would like to buy @ 𝐏 but there is no more quantity supplied @ 
𝐏

• By the same argument as before, buyers will increase price offer

• Market price will converge to 𝐏 ∗

Market equilibrium & comparative statics

Comparative statics
• Factors that are exogenous to price/quantity (non-price determinants) shift
demand/supply

• Comparison 2 different equilibria (changes in demand/supply)

Demand shocks

• Suppose there is increase in demand @ every price, quantity demanded ⬆

• This creates excess demand @ old equilibrium price 𝐏 ∗

• Competition from buyers will push price up to higher equilibrium price 𝐏**
(Conversely, when there is decrease in demand)

Supply shocks

• Suppose there is increase in supply @ every price, quantity supplied ⬆

• This creates excess supply @ old equilibrium price 𝐏 ∗

• Excess supply will push price down to lower equilibrium price 𝐏**
(Conversely when there is decrease in supply)
Combinations AMBIGUOUS

Positive demand shock & negative supply shock

When lobster was fertiliser?
• A meal that cost $4 (in today’s money) in the 1870s cost $30 or more a century later.
• What was once a manure substitute is now a prized delicacy.
• What the lowliest servant once refused, the swankiest restaurateur now offers with
pride.
• Overharvesting and increased status as a restaurant food help explain the steep rise
in lobster price

✅ Lecture 5 - 13 March: Elasticity & applications

Week 3A
Elasticity
• Measures responsiveness of quantity demanded (or supplied) to their determinants
• To analyse how buyers & sellers respond to market conditions
• Magnitude changes in market prices & quantities
• Units free measure: allows us to make comparisons across products with different
attributes
Price elasticity of demand
• Measures responsiveness of quantity demanded to change in price
• Percentage change in quantity demanded per percent change in price
• Positive number by convention

𝑑𝑄𝐷 𝑃
𝐸𝐷 = | × |
𝑑𝑃 𝑄𝐷
Point-price elasticity of demand

𝑑𝑄𝐷 𝑃
𝐸𝐷 = | × |
𝑑𝑃 𝑄𝐷
Example Demand curve = 𝑄𝐷 = 120 − 20𝑃
Calculate price elasticity of demand @ 𝑸𝑫 = 𝟐𝟎

When 𝑸𝑫 = 𝟐𝟎

Find price
𝑄𝐷 = 120 − 20𝑃
𝟐𝟎 = 120 − 20𝑃
𝐏=𝟓

𝒅𝑸
Find slope 𝑫
𝒅𝑷
𝑄𝐷 = 120 − 20𝑃
𝑑𝑄𝐷
= −20
𝑑𝑃

𝑑𝑄𝐷 𝐏
𝐸𝐷 = | × |
𝑑𝑃 𝑄𝐷
5
𝐸𝐷 = |−20 × |
20

𝐸𝐷 = 5

Calculate price elasticity of demand @ 𝑸𝑫 = 𝟏𝟎𝟎

When 𝑸𝑫 = 𝟏𝟎𝟎

Find price
𝑄𝐷 = 120 − 20𝑃
𝟏𝟎𝟎 = 120 − 20𝑃
𝐏=𝟏
 𝒅𝑸
Find slope 𝒅𝑷𝑫
𝑄𝐷 = 120 − 20𝑃
𝑑𝑄𝐷
= −20
𝑑𝑃

𝑑𝑄𝐷 𝐏
𝐸𝐷 = | × |
𝑑𝑃 𝑄𝐷
1
𝐸𝐷 = |−20 × |
100

𝐸𝐷 = 0.2

Range of price elasticities of demand

Perfectly inelastic 𝐸𝐷 = 0
Inelastic 0 < 𝐸𝐷 < 1
Unit elastic 𝐸𝐷 = 1
Elastic 1 < 𝐸𝐷 < ∞
Perfectly elastic 𝐸𝐷 = ∞

Factors affecting price elasticity of demand

Degree of necessity Necessity more elastic

Availability of substitutes Substitute good more elastic
Time horizon Longer time horizon more elastic
Share of household budget
Elasticity & total revenue
• Total revenue TR = Price × Quantity
• By law
Price change Quantity change
Increase Decrease
Decrease Increase

• Price change ⇒ Opposite direction quantity

demanded change

• Effect on TR depends on relative

∆%Price size and ∆%Quantity
(own-price elasticity of demand)

Funding a highway extension

• Ker Ching Consultants are advising Premier on how to fund a proposed extension of
the highway

• Proposal = Have extension fully funded by additional revenue raised from toll
increment (marginal revenue MR) pay money by increasing toll price

Is proposal likely to work @ price elasticity of demand for toll roads = -0.8 𝐸𝐷 < 1
Is proposal likely to work @ price elasticity of demand for toll roads = -1.8 𝐸𝐷 > 1

TR = P × Q

Use product rule

d(TR) dQ dP
=𝑃 +𝑄
dP dP dP

d(TR) dQ
=𝑃 + 𝑄(1)
dP dP

d(TR) 𝑄 dQ
= 𝑃 +𝑄
dP 𝑄 dP

d(TR) dQ 𝑃
=𝑄( + 1)
dP dP 𝑄

d(TR) Consumers not responsive

= 𝑄 ( −0.8 + 1)
dQ P dP to change in price
Inelastic × = −0.8
dP 𝑄
d(TR) Company will end up
= 0.2𝑄 > 0
dP making high TR
 d(TR) Consumers very responsive
= 𝑄 ( −1.8 + 1)
dQ P dP to change in price
Elastic × = −1.8
dP 𝑄 d(TR) Company will end up not
= −0.8𝑄 < 0
dP making high TR

Conclusion:
d(TR) d(TR)
Whether additional tolls on raised money depends on dP
> 0 or <0
dP
Which depends on price elasticity of demand

When does the company make the most money where tolls are raised?
• When the total revenue is maximised when 𝐄𝐃 = 𝟏 unit elastic

𝐝(𝐓𝐑)
When = 𝟎 total revenue maximised
𝐝𝐏

d(TR)
= 𝑄 ( −1 + 1)
Unit dQ P dP
× = −𝟏 Total revenue maximised
elastic dP 𝑄
d(TR)
=0
dP

Price elasticity of supply

• Measures responsiveness of quantity supplied change in price

Point-price elasticity of supply

𝑑𝑄𝑆 𝑃
𝐸𝐷 = | × |
𝑑𝑃 𝑄𝑆
Range of price elasticities of supply

Perfectly inelastic 𝐸𝑆 = 0
Inelastic 0 < 𝐸𝑆 < 1
Unit elastic 𝐸𝑆 = 1
Elastic 1 < 𝐸𝑆 < ∞
 Perfectly elastic 𝐸𝑆 = ∞

Other types of demand elasticities

Income 𝑬𝒀
• Measures responsiveness of quantity demanded to change in income

∆% Quantity demanded
𝑬𝒀 =
∆% Change in income

Normal goods 𝑬𝒀 > 𝟎

Inferior goods 𝑬𝒀 < 𝟎
Necessary goods 𝟏 > 𝑬𝒀 > 𝟎
Luxury goods 𝟏 > 𝑬𝒀

Cross price elasticity𝑬𝑨𝑩

• Measures responsiveness of quantity demanded of one good to change in price of
another good

∆% Quantity demanded 𝐆𝐨𝐨𝐝 𝐀

𝑬𝑨𝑩 =
∆% Price change 𝐆𝐨𝐨𝐝 𝐁

Substitute goods 𝑬𝑨𝑩 > 𝟎 Positive

Complementary goods 𝑬𝑨𝑩 < 𝟎 Negative

Other types of supply elasticities

Influenced by many factors (price, technology, climate, etc.)

✅ Lecture 6 - 15 March: Government intervention

Week 3B
Welfare & markets

Welfare in perfectly competitive markets

How do we measure society’s well-being from their transactions in markets?
Consumer surplus

• Sum of individual benefits from

buyers’ willingness-to-pay marginal benefit – amount buyers actually pay
consumer expenditure

• Market demand curve = Marginal benefit = prices @ which buyers are willing to pay

• Net benefit = area under demand curve & above price

• Measures buyers’ willingness-to-pay, net of the amount they actually pay

Producer surplus

• Sum of all net benefits from the

difference between seller’s opportunity costs of production marginal cost – price
sellers received

• Market supply curve = marginal cost = Prices @ which sellers are willing to sell

• Producers’ collective gains from trade

Amount they receive (P1) (Q1) total revenue of firm – area below supply curve

• Measures the amount sellers receive, net of their willingness-to-sell

Total surplus

• Sum of consumer surplus & producer surpluses

• Society’s well-being from trade between buyers and sellers

Efficiency
• Market outcome is efficient when total surplus is maximised

Dead weight loss

• Decrease in total surplus relative to efficient benchmark

Is equilibrium quantity Q∗ (quantity demanded = quantity supplied) the efficient

arrangement?
• Deviations away from Q∗ generates total surpluses lower than under market
equilibrium
• These deviations either (i) create possibilities for mutually-beneficial trade or (ii)
indicate the presence of mutually-harmful trade, so none of them could provide as
much welfare to the society as the market equilibrium
• Therefore, equilibrium quantity Q∗ is efficient

At 𝑷 ∗, 𝑸 ∗
Society’s MB (for buyers) = MC (for sellers)
At 𝑸𝟏,
Total surplus is less that Q*
• Dead weight loss = B
• Any deviations away from Q*is inefficient

At 𝑸𝟐
• Negative surplus
• MC > MB
• There is cost to society
• Society bought more units than it should
• Hence a deadweight loss
• Total surplus = A+B minus C

Anti-marijuana lobby
• Marijuana legalization has been a major issue in many countries
• In Arizona, anti-marijuana lobby is composed of a very strange collection of firms:
o Pharmaceutical Companies (Insys): Recreational marijuana legal can make
synthetic marijuana un-favoured
o Liquor Distributors
o Prison Guard Unions 
 • Using what you know about supply & demand, what self-interested motives do each
of these groups have?

Government intervention

Indirect intervention • Taxes

(Demand or supply) • Subsidies

• Price ceiling
Direct control
• Price floor
(Price or quantity)
• Quota

Indirect intervention (demand or supply)

1. Taxes
• Payment to government on each unit good transacted
• Used by governments to raise revenue
• Creates tax wedge

Tax wedge
• Price paid by buyers – price received by sellers
𝑡 = 𝑃𝐷 – 𝑃𝑠
• Difference = Tax revenue for government

Tax imposed on sellers

• At every quantity supplied,
sellers are only willing to sell if price they receive is $𝒕 higher
• Sellers are collecting agents of tax
• Tax will shift supply curve to the left = Supply curve + 𝒕

Tax imposed on buyers

• Demand curve will shift to the left = Demand curve + 𝒕
Example
Solve for equilibrium (𝑃 ∗∗, 𝑄 ∗∗) using condition 𝑸𝑫 = 𝑸𝒔 = 𝑸 ∗∗

𝑄𝐷 = 120 − 20 𝑃𝐷
𝑄𝑆 = 20𝑃𝑠

𝑄𝐷 = 𝑄𝑠
120 – 20𝑃𝐷 = 20𝑃𝑆

𝑡 = 0 no tax therefore, 𝑷𝑫 = 𝑷𝑺

120 – 20𝑃 = 20𝑃

120 = 40𝑃
𝑃 = $3

When 𝑃 ∗∗= $3 => 𝑄 ∗∗= 60

How does equilibrium change if $2 per unit tax is imposed on sellers?

Tax on sellers
𝑄𝑆 = 20𝑷𝒔
𝑄𝑆 = 20(𝑷𝑫 – 𝒕) REMEMBER

Tax equilibrium
𝑄𝐷 = 𝑄𝑆
120 – 20𝑃𝐷 = 20(𝑷𝑫 – 𝒕)
120 – 20𝑃𝐷 = 20(𝑷𝑫 – 𝟐) 𝑡 = $2
𝑷𝑫 = $4

When 𝑷𝑫 = $4 Q∗∗ = 4 𝑃𝑠 = $2
How does equilibrium change if $2 per unit tax is imposed on buyers?

Tax on buyers
𝑄𝐷 = 120 − 20𝑷𝑫
𝑄𝐷 = 120 – 20(𝑷𝒔 + 𝒕)

Tax equilibrium
𝑄𝑑 = 𝑄𝑠
120 – 20(𝑷𝒔 + 𝒕) = 20𝑃𝑠
120 – 20(𝑷𝒔 + 𝟐) = 20𝑃𝑠 𝑡 = $2
𝑷𝒔 = $2

𝑊ℎ𝑒𝑛 𝑷𝒔 = $2 𝑄 ∗∗ = 40 𝑃𝐷 = 4

Tax policies & welfare

• Taxes may result inefficient outcomes
• Create deadweight loss hurt total surplus
• Supply and demand will bear a part of tax burden

Tax incidence
Tax impose on sellers
 Before tax Surplus after tax Difference
Consumer surplus A+B+C A -B -C
Producer surplus D+E+F F -D -E
Tax revenue 0 B+D B+D
Deadweight loss -C -E

Tax incidence from price elasticity

• Tax burden depends on relative price elasticity of supply and demand
• Tax burden falls more on price inelastic (more responsive to price)
• Tax burden is not determined by who pays the tax
Price elasticity @ P*Q*
𝑑𝑄𝐷 𝑃
Demand 𝐸𝐷 = | × | Small Relatively elastic
𝑑𝑃 𝑄𝐷

• Producers end up paying

𝑑𝑄𝑆 𝑃 more tax burden
Supply 𝐸𝑆 = × Large Relatively inelastic
𝑑𝑃 𝑄𝑆 • More responsive to
price

Price elasticity @ P*Q*

• Producers end up paying

𝑑𝑄𝐷 𝑃 more tax burden
Demand 𝐸𝐷 = | × | Large Relatively inelastic
𝑑𝑃 𝑄𝐷 • More responsive to
price
𝑑𝑄𝑆 𝑃
Supply 𝐸𝑆 = × Small Relatively elastic
𝑑𝑃 𝑄𝑆
Example: Alcopop tax
• In April 2008, Australian Government increased tax rate on pre-mixed alcopop
drinks by 70% to tackle binge drinking among teenagers
• Effectiveness of tax policy depends on its impact on the quantity of pre-mixed drinks
sold, which relies on (i) size of the tax, and (ii) relative price elasticities of demand
and supply
• Consumption of pre-mixed drinks fell by 26.1%
• Who likely bore more of tax burden: consumers or producers?

2. Subsidies
• Payment from government to consumers/producers for each unit of a good
transacted
• To encourage consumption/production

Negative tax
𝒔 = 𝑷𝑺 – 𝑷𝑫
𝑡 = 𝑃𝑑 – 𝑃𝑠 Recall tax!
𝑡 = −𝑠

Subsidy incidence

• Depends on relative price elasticities of demand and supply

• Subsidy increase supply, supply curve shift to the right
• Q* increase to Q**
Direct control intervention (price or quantity)
Price controls Used by government to correct market outcome deem unfair

1.Price floor Imposes minimum price 📢 LETAK ATAS

• Set above equilibrium price
• Create excess supply surplus

Before After price floor Difference

Consumer surplus A+B+C A -B –C worse off
Producer surplus D+E B+D B-E better off
Deadweight loss -C -E

2.Price ceiling Imposes maximum price 📢 LETAK BAWAH

• Set below equilibrium price
• Create excess demand shortage
Example: Price floor on organ donations
• The Australian Organ Donor Register is a registry list authorizing the use of organs
and tissue after death for the purposes of transplants. There is no compensation
• Suppose that we are considering whether to give cash bonuses to families of organ
donors for funeral expenses:
• The bonus is paid for the government from taxes
• For fairness reasons, all donor organs must be given the
• same bonus regardless of when an individual opts into the
• register
• The organ transplant list has perfect rationing
• Question: Why might we want to maintain the current no compensation policy?

3. Quotas Impose maximum quantity traded

Kinked supply curve

Before Q** Relative elastic
Kinked supply curve
After Q** Perfectly inelastic straight line
Lecture 8 - 22 March: International trade
Week 4B

Comparative advantage
Ability to produce good/service at lower opportunity cost than another producer
292929292929
Absolute advantage
Ability to produce good/service using fewer inputs than another producer

International trade

Trade on global market to get gains from trade

• Import good where they have comparative disadvantage
• Export good where they have comparative advantage

How do we measure society’s well-being from international trade?

Autarky world closed economy
• Every country produces domestically
• Best welfare equilibrium (domestic) = P*Q* using total
surpl

World market 𝑷𝑾 predetermined

If 𝑷𝑾 > 𝑷∗ Excess domestic supply satisfied by exports

• 𝑄𝐷 (𝑃𝑊 ) < 𝑄𝑆 (𝑃𝑊 )
• Domestic sellers will sell (export) to rest of the world
• Comparative advantage
• Welfare improves because of international trade
• Total surplus increase gains from trade
• Domestic producers are better off
• Consumers are worse off consume less

Autarky Trade Difference

Consumer surplus A+B A –B
Producer surplus C B+C+D B+D
Total surplus A+B+C A+B+C+D + D increase total surplus
If 𝑷𝑾 < 𝑷∗ Excess domestic demand satisfied by imports
• 𝑄𝐷 (𝑃𝑊 ) > 𝑄𝑆 (𝑃𝑊 )
• Domestic consumers will buy (import) from rest of the world
• Comparative disadvantage
• Welfare improves because of international trade
• Total surplus increase gains from trade
• Domestic sellers are worse off produce less
• Consumers are better off consume more

Autarky Trade Difference

Consumer surplus A A+B+D B+D
Producer surplus B+C C –B
Total surplus A+B+C A+B+C+D + D increase total surplus
𝑷𝑾 to 𝑷𝑾+𝒕 Effects of import tariff

• Price will increase from 𝑷𝑾 to 𝑷𝑾+𝒕

• This moves market closer to autarky equilibirum

Imports decrease
• Quantity supplied by domestic sellers increases
But supplying more than at world price opportunity cost > 𝑷𝑾
• Quantity demanded by domestic buyers decreases
Potential consumption benefit gone marginal benefit > 𝑷𝑾

Conclusion: Made gains from international trade small but still better off rather than
without international trade (autarky) aka nothing at all

✅ Lecture 9 - 27 March: Market failure 1 - Externalities

Market failure
• Market efficient outcome = maximise total surplus
• Market inefficient outcomes = lower well-being for society than efficient level =
market failures

Sources of market failure

• Externalities
• Public goods
• Imperfect competition
• Asymmetric information
1. Externalities
• Arises when a decision-maker’s action causes costs for others that is not borne by
decision-maker

• Arises when a decision-maker’s action causes benefits for others that is not received
by decision-maker

• Because decision-maker does not bear costs or receive benefits,

spill over consequences for others not considered when decision is made

• Externalities can be positive (benefits for others) or negative (costs for others)

New interpretation of demand/supply

Private market competitive market

Demand Private marginal benefits (PMB)

Supply Private marginal costs (PMC)

Market equilibrium
PMB = PMC, outcome Q ∗ maximises private net benefits

Society perspective efficient social outcome

• Social marginal benefits (SMB)
• Social marginal costs (SMC)
• Generates socially optimum outcome Q ∗∗
• If PMB = SMB and PMC = SMC, then private market
equilibrium is socially efficient

Q** = society optimum outcome (quantity)

(insert diagram)

Government intervention
• Pigouvian tax/subsidy
• Direct regulation (quota)
• Coasian bargaining
• Tradeable permits
Negative externality in production
River pollution
2 producers located on river
• Paper mill (upstream) emits pollution into river as part of its production process
Brewery (downstream) uses water from river in production
• Neither producer has ownership of the river

For paper mill, suppose:

PMB = SMB = 100 − Q
PMC = Q
SMC = Q + 20

Compute market outcome Q ∗ & socially efficient outcome Q ∗∗

Market outcome Q*
PMB = PMC
PMB = 100 – Q
PMC = Q
100 – Q = Q
Q* = 50

Social efficient outcome Q**

SMB = SMC
100 – Q = Q + 20
Q**= 40

Implement

(i) Pigouvian tax match tax to externality

to internalise
Put tax on paper mill $20 per unit
Opportunity cost to paper mill = PMC + tax

(ii) Quota to achieve Q**

Direct regulation
Kinked supply curve
✅ Lecture 10 - March 29: Market failure 2 - Public goods

Government intervention

Coase Theorem private solution

• If property rights for an externality are established,

private parties can trade externality @ sufficiently-low transaction cost, private
bargaining will lead to efficient outcome

• Coasian bargaining can lead to efficient outcomes regardless of initial allocation of

property rights

Tradeable permits hybrid solution

• Have a quota split into coupons, sell/allocate coupons to different firms

Example
• Suppose there’s 2 paper mills instead of 1 paper mill
• Both PMC and SMC are as before, so Q ∗∗ = 40

But, how should we allocate quota to 2 mills?

• If both papers mills have different marginal costs to reduce pollution,
an equal reduction scheme may not be efficient

• Set some initial distribution of pollution permits (say, 50/50 split) and allow two mills
to trade
• Because mills have different willingness-to-pay for each level of pollution, there are
gains from trade

• Mill A finds it more expensive to reduce pollution

• Any initial level of permit distribution will work
• Mill A is willing to buy permits from Mill B @ price between PA and PB
• They will continue to trade until both marginal costs to reduce pollution are equal

• Society is better off since less resources is used to achieve same total reduction in
pollution
• Tradeable permits is effectively a hybrid solution
• Promotes efficient distribution to reduce pollution across 2 mills
2. Public goods (market failure)

Consider 2 characteristics of a goo

• Excludable? Can a consumer be prevented from using the good?
• Rivalrous? Does one consumer’s use diminish another consumer’s use?

Public goods
• Non-excludable Consumer is not prevented from using good/services
• Non-rivalrous One consumer’s use does not diminish another consumer’s use

“Under-provided” in competitive markets

• Non-rivalry implies a positive externality in production
Q**>Q*
• Non-excludability leads to free-rider problem
P=0
Qs = 0

Free rider A person who receives benefit of good/service but avoids paying for it

Government interventions

1. Undertake public production of public good

Assign property rights to create excludability (hence providing incentives for private
production)

The under-production of knowledge

Research and development of a chemical formula is required to manufacture a vaccine
Costs of producing “knowledge” (PMC = SMC) is $50
Four members of society have the following willingness-to-pay (PMB):
Abbie = $10
Ben = $20
Carly = $30
Dan = $40
Should the knowledge be produced?
Would any of the four members produce the knowledge?

Public production:
Suppose the government knows all private valuations (PMB) of the knowledge
It computes SMC and SMB (= ∑PMB) to determine the socially-efficient level of production •
It then acts as a collective agent for society to produce the knowledge, and finances
production via taxation • For example, it imposes Lindahl taxes onto each member of
society (effectively a cost-sharing arrangement whereby each member pays a share that is
equal to PMB SMB )
2. Ownership assignment: Patent
Suppose the government assigns ownership of the knowledge to whoever produces it • If
Abbey produces the knowledge, she then receives a patent/copyright for the vaccine and
can legally exclude other members from using the vaccine • Knowing the private valuations
of the other members, Abbey’s optimal decision is to produce the knowledge

✅ Lecture 11 - April 10: Markets: A review

What does a firm do?

• Production of goods/services the “supply side”
• Use input in a production to deliver outputs
• Firms offer a means of coordinating work:
o Eliminates need to negotiate over every task a worker does
o Internalizes externalities in different layers of production
• Many types of firms e.g. sole proprietor, partnership, limited liability company etc.

• Most basic primitive of a firm is technology

• A technology is a way of describing how inputs are turned into an output
• Types of Inputs
o Labour (L)
o Capital (K)
o Raw Materials

Bob’s Book Binding Assembly Line

• Bob owns a company that binds hardback books
• Books are bound with Book Binder 2000 technology
• Each machine has maximum output of 36 books per minute with a crew
of 6.
(1xLoader, 3x Gluer, 2x Packer)
• Lower output is possible with less people by having people double up
jobs

Production function
• Describe what is technically feasible when a firm uses inputs
efficiently
• A production function describes the highest output Q that a firm
can produce for every specified combination of inputs
• While firms use a variety of inputs, we will keep things simple by
thinking about only 2 input: labour (L) and capital (K) machine=1
• We write production function as Q = F (K, L)
Productivity
Total product (TP)
• Total quantity of outputs given the level of inputs
• F(K, L) gives us the total productivity of K units of capital and L units of labour

Marginal product (MP)

• Increase in output from an additional unit of inpu
• Hold capital fixed @ K
• Consider what happens when we increase L by smallest amount possible
• Partial derivative

Law of diminishing returns

• As use of input increases in equal increments (with other inputs fixed),

a point will eventually be reached where the resulting additions to output decrease
• Flatter slops of production function when labour increase

Profit maximization
• Firm’s profit = Total revenue minus total cost
• Firm’s objective is to maximise profits

Profits in terms of inputs

• Suppose that firm gets p for each unit of output, it must pay w for each unit of
labour and r for each unit of capital
• To maximize profit: pF(K, L) revenue − wL – rK cost
• Profit maximization problem with multiple inputs is hard to solve
Profits in terms of outputs

• Differentiate π(Q) = TR(Q) − TC(Q) to maximise profit

• Optimal level of production Q ∗ satisfy MR(Q ∗ ) = MC(Q ∗ )

Total cost function

• Cost function = finds cheapest way of producing a
certain amount of output given input prices

Suppose
• Cost of labour = $40,000 for 1 unit
• Rental cost of machine = $50,000

How should we produce 72 units?

• Cost of 12 workers and 2 machines: $580,000

• Cost of 9 workers and 3 machines: $510,000
• Cost of 8 workers and 4 machines: $520,000
• TC (72) = $510,000 cheapest option = minimising cost

Importance of minimizing costs

• Firms perform better when they can operate with lower costs, without
compromising other aspects of output e.g. quality
• Even public sector & non-profit organisations are increasingly judged on their ability
to deliver services at minimum possible cost
Reminder on cost
• Economic profits consider
opportunity costs (explicit &
implicit costs) of all resources
used in production

Time & cost

Time horizon
• At any given point in time,
inputs are either variable (can adjust) or fixed (cannot adjust)
• Time horizon = whether firm can adjust level of inputs

Short run Period during which at least 1 fixed input

Long run Period needed for all variable inputs

Fixed costs Costs do not vary with level of output

Variable costs Costs that vary with level of output

Short run costs

• SRTC(Q) = FC + VC(Q)
• FC = need to pay fixed cost regardless of Q (cannot adjust level of fixed input)
• VC = need more of variable input to produce higher Q, hence higher (variable) cost

Bob’s Short Run Costs

• Suppose Bob has 2 machines (must rent on
yearly contracts)
• Contract can be reversed by shutting down,
but no. of machines cannot be adjusted
• Capital is fixed short run k = 2
• Regardless of the amount produced, 2
machines cost $100,000 does not change
with Q
• Bob can adjust his labour as he sees fit.
Shape of production function & cost function
• K=2 fixed F(2, L) tells us how much labour we need to produce a given amount of Q
• We can use this to calculate VC(Q)
• Both curves shapes are connected

Short run costs vs. long run costs

• Short run = fixed capital
• Short run and long run costs will coincide only
when it is efficient to use exactly 2 units of
capital in the production function
Agenda
• Firms operate in environments that can change rapidly with production decisions of
their competitors and the whims of their consumers.
• To stay competitive, firms must constantly assess whether their production
processes are optimal

On the production side, decisions often revolve around 3 issues:

• What technology should a firm use?
• How much should a firm produce? MR = MC
• When should a firm exit market?

To answer these questions, it will be useful to think about not just SRTC and LRTC, but also a
variety of alternative cost measures that allow the firm to evaluate the firm’s position
Short run marginal cost

Increase in short run total costs to produce 1 additional unit of output

Short run average total cost

𝑆𝑅𝑻𝑪(𝑄) 𝑭𝑪 + 𝑽𝑪(𝑄)
𝑆𝑅𝑨𝑻𝑪(𝑄) = = = 𝑨𝑭𝑪(𝑄) + 𝑨𝑽𝑪(𝑄)
𝑄 𝑄

𝑨𝑭𝑪(𝑄)
• Since FC is constant, AFC(Q) must decline throughout
AFC(Q) Falling over large spread of quantity

𝑨𝑽𝑪(𝑄)
• AVC(Q) depends on AVC(Q) ≶ SRMC(Q)
• SRATC(Q) shape depend on share of FC & shape of SRMC(Q)

Trade-offs in technology

Car wash business Consider 2 technologies for washing cars

Short run costs Method 1 bucket & hose

No large physical capital required but capacity constraint affects marginal product

• Low FC must decline throughout

• Diminishing MP of labour

• Given diminishing MP of labour,

SRMC(Q) and AVC(Q) are rising over output

• SRATC = U-shaped over output because

o At low output, larger share of FC AFC(Q) falling
o At high output, larger share of VC(Q) AVC(Q) rising

• SRMC(Q) must intersect min AVC(Q) & min SRATC(Q)

Short run costs Method 2 automation
Large investment machinery FC constant marginal product electricity VC

• High FC because of production method

• Constant MP electricity

• Given constant MP electricity,

SRMC(Q) and AVC(Q) are constant over output

• SRATC is declining over output because

o AFC(Q) is declining throughout
o AVC(Q) is constant throughout

Long run costs

• Recall long run = all inputs become variable (fixed costs become variable inputs)
• Firms can therefore select any short run production method
• Since costs differ across short run production methods, for a given level of output,
firms should choose cheapest production method
• Hence, for a given production level Q,
LRATC(Q) should reflect ATC of the production method with minimum SRATC(Q)

Technology & scale

• For example, in car wash business,
firms would choose between method 1 and
method 2, depending on which is cheaper at
given production level

• At lower production level,

cheaper method method 1

• At higher production level,

cheaper method method 2

• Graphically, LRATC(Q) should envelope all SRATC(Q)

• Thus, LRATC(Q) ≤ SRATC(Q)
Shape of LRATC(Q) shows important info about technology of production

Economies of scale LRATC falling over output range

Diseconomies of scale LRATC rising over output range
Efficient scale Lowest level of production that minimise LRATC

D. Firm and managerial economics

✅ Lecture 12 - April 12: Key decisions and concepts

• We saw firms choose technologies to minimize costs in long run

• Today we will think how firms behave in short run & long run when prices change
• How much should a firm produce? Q*
• When should a firm enter/exit the market?
• We will concentrate on cases where firm is too small to influence prices

Profit maximisation
• Recall firm’s objective is to maximise economic profit differentiate, think at margin
π(Q) = TR(Q) − TC(Q)

• A profit maximizing firm would

o Produce Q ∗ that maximises π(Q)
o Only want to operate when π(Q ∗ ) is positive
Profit maximisation: perfectly competitive markets

Perfectly competitive markets

• Firms are price-takers = perfectly elastic demand curve = market price P ∗

𝜕𝑻𝑹(𝑄)
𝑀𝑅(𝑄) =
𝜕𝑄
𝜕𝐏 ∗ × 𝐐(𝑄)
𝑀𝑅(𝑄) =
𝜕𝑄
𝐏 ∗ × 𝐐(𝑄)
𝑀𝑅(𝑄) =
𝜕𝑄
𝑀𝑅(𝑄) = 𝐏 ∗

• Firm’s demand curve = average revenue AR(Q) & marginal

revenue MR(Q)
𝐓𝐑(𝑄)
𝐴𝑅(𝑄) =
𝜕𝑄
𝐴𝑅(𝑄) = 𝐏 ∗

• Profit-maximising firm chooses to produce Q ∗

MR(Q ∗ ) = P ∗ = MC(Q ∗)

Firm’s profits
Entry and exit: perfectly competitive markets

When should a firm operate?

• To be willing to operate in market,

firm need to have total revenue that at least covers total costs
(must make positive profits from producing Q ∗)

TR (Q ∗) ≥ TC (Q ∗ )

• Total costs = opportunity costs not sunk costs

Matt’s computer store

• Profit maximising to sell 5 computers a day
• Supplying that quantity generates revenue of $2,500
• Requires variable costs (labour) of $600 a day
• Rent has been paid for the next month and amounts to $2,000 a day

Should the store operate (i) tomorrow, and (ii) in a month?

Tomorrow
• TC = $600 (The rent is sunk)
• TR = $2500 > TC = $600
• Thus, the store should operate today

In a month
• TC = $600 + $2000 (The rent is now part of opp. costs)
• TR = $2500 < TC = $2600
• Thus, the store should shut down in a month

Supply perfectly competitive markets

• Given market price P ∗
firm will choose Q ∗ such that MR(Q ∗ ) = P ∗ = MC(Q ∗ )

• At any given price, profit-maximising Q ∗ is depicted by

MC(Q ∗ )

• Recall firm’s total revenue must at least cover total

opportunity costs not including sunk cost & MC cuts ATC
at minimum

AR (Q ∗) = P ∗ ≥ ATC (Q ∗)

• Firm’s supply curve = MC curve above minimum ATC

Short run perfectly competitive markets

1. Entry/exit (short run)

• No. of firms is fixed in short run
• No exit/entry
• Even firms that prefer to shutdown in long run may “stay” in short run as many of
their costs are sunk
• For n firms indexed by i,
short-run industry supply = sum of firm short-run supply
QS = ∑n i Q ∗ i
• Firms upward-sloping short-run supply = industry supply also upward-sloping

2. Firm profits (short run) ****

• Each firm i chooses its profit-maximising level of production Q ∗ i
• Whether firm makes profits or not will depend on P ∗ ≶ SRATC(Q ∗ i )
• Firms that decide to shut down (i.e. zero production) will incur losses equal to its
sunk costs

3. Market outcomes (short run)

• In equilibrium, market price = P ∗
• Market supply = QS = ∑n i Q ∗ i ,
with each firm supplying respective profit-maximising quantity
• Market supply QS will match market demand QD
Long run perfectly competitive markets

1. Entry/exit (long run)

• Firms can enter & exit freely in long run

Suppose firms earn positive profits in short run

• This will attract new firms to enter industry
• In turn, market supply will shift right & equilibrium price will fall
• This process will continue until all firms make zero profit in long run

Suppose firms earn negative profits in short run

• Some firms will exit until all remaining firms make zero profit in long run

2. Firm profits (long run)

• The analysis before implies last firm to enter must make zero profit in long run
• If not,
firms will continue to enter/exit until the market adjusts price until there is no
more entry/exit

3. Market outcomes (long run)

• In equilibrium, market price = P ∗
• Market supply = QS = ∑n i Q ∗ i
with each firm supplying respective profit-maximising quantity
• All firms must supply positive quantities & earn positive profits
• Market supply QS will match market demand QD

Long run industry supply market

Suppose industry is initially in long run

During positive demand shock

Short-run

• No of firms fixed no entry/exit

• Price rise
• Make positive profits for each firm
Long run
1. Constant cost industry

• More firms enter

• Market supply increases
• Price fall back
• Make zero profit for last firm that enters

Price fall back Constant cost industry

• New firms & incumbent firms have same cost structure
• Prices should fall back to same level as initial long run
• Hence LR market supply = perfectly elastic

Long run
2. Increasing cost industry

• More firms enter

• Market supply increases
• Price does not fall back
• Make zero profit for last firm that enters

Price fall back Increasing cost industry

• If new firms have higher LRATC than incumbent firms
 • Prices will not fall back to initial level
• Long-run market supply will be upward sloping
• New firms may have higher costs because
o Some resources used in production may be available only in limited
quantities
o Firms may have different cost structures

Lecture 15 - April 24: Price/quantity decision

Perfect competitive markets sellers & buyers = price-takers cannot influence prices
Imperfect competitive markets where firms may be able to influence prices

Market structure Determines how much market power firm possesses

Types of market structure

Market power
• Ability of a firm to raise prices above level that would exist in perfect competitive
market

Ability of firm to set price above marginal cost

1. Barriers to entry
• Constraints that makes it hard for other firms to enter
• Barriers to entry determine no. of competitors
2. Product differentiation
 • Producers have market power if consumers are not willing to switch to another
product
• Market power inversely related to degree of competition

Inverse demand curve Price in terms of Q

• Represent market power
• Represents maximum price a firm could set if it chooses to sell Q units

The firm: price/quantity decision

Imperfectly competitive markets

• Firms with market power can set prices
• Have downward-sloping demand curve
• Have to lower the price (of all units) to be able to
sell an additional unit,
• Thus, total revenue TR(Q) = P(Q) × Q

Inverse demand curve is price in terms of Q

Inverse demand curve = P(Q) which is also AR
𝑇𝑅(𝑄) 𝑃(𝑄) × 𝑄
𝑨𝑹(𝑸) = = = 𝑷(𝑸)
𝑄 𝑄
Firm marginal revenue (MR)
• MR = extra revenue from selling additional unit net of reduction in revenue from
selling all previous units at lower price

Profit maximisation Monopoly

Monopoly
• Firm has downward-sloping demand
curve

To maximise profit, MR = MC

Rearranging this
Trade-off when increasing Q by a small amount

Marginal gain
• I get another customer
• P(Q) − MC(Q) Profit of this customer

Inframarginal loss
• To sell to one more customer,
𝒅𝑷(𝑸)
I need to reduce price by 𝒅𝑸
for all Q units already selling

Where marginal gain and inframarginal loss exactly equal = production level QM that
maximises profits

Profit maximisation Monopoly *Algebraic

Monopolies best action is pinned down by price elasticity of demand
• Despite having freedom to choose any price,
monopolies best action is pinned down by price elasticity of demand

• Despite monopoly being “big”, consumers being “small”

consumer’s tastes fully determine monopolists decision

• Since price & quantity supplied are both set by firm, we do not speak of the “supply
curve” when analyzing monopoly problem

Starting from
Marginal gain = Inframarginal lost
𝑑𝑃(𝑄)
𝑃(𝑄) − 𝑀𝐶(𝑄) = − 𝑄
𝑑𝑄

Divide both by P(Q)

𝒅𝑷(𝑸)
𝑃(𝑄) − 𝑀𝐶 (𝑄) 𝒅𝑸 𝑸 𝟏
=−
𝑃 𝑷 𝑬𝒅

Recall P(Q) = inverse of Q(P)

Thus, we could rewrite this as

𝑃(𝑄) − 𝑀𝐶 (𝑄) 1 𝟏
= =
𝑃 𝒅𝑷(𝑸) 𝑬𝒅
𝒅𝑸 𝑸
− 𝑷

THUS, SMART TANK

If consumers are so responsive
Tip if we see Ed perfectly elastic = P(Q) = MC(Q) like PC
Market failure: monopoly
• Despite monopolist’s profit maximising choices being pinned down by consumers Ed,
monopolist’s objective is to maximise its surplus, not social surplus

• When price > MC = deadweight loss

Why do monopolies arise?

Barriers to entry
• Exclusive ownership of resources
o Endowment
o Government-granted
• Large economies of scale
o Natural monopoly

Addressing monopoly market failure

Pro-competition policy Promote competition in the industry

Direct regulation Constrain behaviour of monopolist
Public ownership Convert monopolies into public enterprises
Pharmaceutical Benefits Scheme

• Patents protect monopolies over sale of new pharmaceutical drugs

• Apart from efficiency concerns, these drugs are an important component for
treating many illnesses but are expensive

• PBS = a direct regulation on drug price by

o Set a producer price below monopoly price but above consumer price
o Pay a subsidy to producers to make up for the difference between producer
and consumer price

• Consider market for one drug, with constant MC & zero FC

• Monopolist drug manufacturer sets price Pm above MC & quantity Qm,
creating a deadweight loss

• Monopolist drug manufacturer understands listing the drug on PBS will yield a large
increase in sales (since doctors are more likely to prescribe PBS-listed drugs)

• Of course, if drug is on PBS, it will have to settle for a lower price & regulated

• To address market failure, government

o Sets consumer price Pc = MC to achieve he efficient quantity Q ∗

o Sets producer price Pa (between PM and PC) such that drug manufacturer
will make exactly the monopoly profit & therefore willing to join PBS
Lecture 16 - April 26: Perfectly competitive markets

The firm: price discrimination

What if firms can sell same product @ different prices to different consumers?
Would price discrimination increase their profits?

Readalot Publishing Co. Third degree price discrimination

• Readalot’s best-selling author has just written her latest novel & has sold her
publishing rights for $2 million

Market research says

• 10,000 hard-core fans are willing to pay $40 for a book
• 100,000 fans are willing to pay $30 for a book
• 400,000 other readers are willing to pay up to $5 dead weight loss

Suppose marginal cost = 0, what price should it set?

Calculating profits
Book price $40 Profit = 10 000 × $40 = $400 000
Book price $30 Profit = (100 000 + 10 000) × $30 = $3 300 000
Book price $5 Profit = (400 000 + 100 000 + 10 000) × $5 = $2 550 000

Readalots optimal decision sell 110 000 copies (100 000 + 10 000) @ $30

This decision creates monopoly deadweight loss of $2 million (400 000 readers willing to
pay at $5, zero marginal cost)

Readalot then discovers

• All hard-core fans live in New Zealand
• All loyal fans live in Australia
• Other readers live in U.S

Novel now sells in

• New Zealand = $40
• Australia = $30
• US = $5

This substantially increase profits = No deadweight loss

4 lessons from Readalot

1. Price-discrimination increases profits (firms must have market power to set prices)
2. Firms must have info on consumers’ willingness-to-pay & able to “separate” while
at the same time preventing arbitrage
3. Price discrimination can increase welfare increase total surplus TS=PS
4. Price discrimination erodes consumer surplus!!!
Ability of firm to price discriminate depends on what he knows about his consumers

• Monopolist knows exact willingness-to-pay of all consumers

First-degree
• Can prevent arbitrage

• Monopolist has no observable signals.

Second-degree • By selecting a product that is best for them, consumers reveal
their type

• Monopolist can discriminate based on observable

Third-degree
characteristic

First degree
• Perfect price discrimination
• Each unit of product sold to consumer who values it most @ maximum price
consumer is willing to pay
• Firm will appropriate entire consumer surplus
• Efficient quantity is achieved = no deadweight loss
• Infeasible is it
Pharmaceutical incentives (drugs vs vaccines)

• Investment in medicine continues to be one of biggest challenges in regulation

• Incentives for research, development, infrastructure are important
o Vaccines & drugs involve huge fixed costs + low variable costs
o Academic research is useful for early stages of drug development but not for
clinical trials and deployment
o Positive externalities in production

• On the other hand, patents can have large distortionary effects property rights
• Lobbying is rampant
• High investments in direct to consumer and doctor advertisement
• Skewed incentives for pharmaceutical research

• Development of drugs for developing countries is particularly skewed

o Property rights aren’t always maintained across borders
o Poverty implies low margins

• Incentives have led to extremely low expenditures in R&D on diseases specific to

developing countries

• Between 1995-1997 there were 1223 patents for new drugs

• 13 of these were for tropical diseases.
Only 4 of these 13 were a result of explicit research

In developing countries, vaccines have proven to be far more effective than drugs in
eradicating disease
• 75% of children are given a standard set of cheap, off-patent vaccines
• Vaccines are easier to administer – doctors don’t need to administer them

However, vaccines are under-provided

• Global marketplace for drugs exceeds $300 billion, whereas worldwide vaccine sales
were only about $5 billion
• Why? There are lots of answers, but a striking one emerges when thinking about
first-degree price discrimination

Example 1 Homogeneous population

• Suppose population = 1000 people.
• Each has 50% chance of catching the flu
• If 1 person catches the flu, they would be willing to pay $100 to take a drug to
eliminate symptoms
• A pharmaceutical company can make a drug or vaccine
• Each involve same variable cost of $0 per dose constant MC = 0

Which should firm choose?

Profit from drug:
• 50% of 1000 = 500 people will get sick on average = Each will pay $100
• Revenue =500 × $100 = $50 000

Profit from vaccine:

• Each person would pay up to $50 for vaccine
• At this price all 1000 people will pay for $50 vaccine
• Revenue = 1000 people × $50 = $50 000

In this example, future economic profit is same. So, company can choose whichever has
lowest expected R&D cost

Example 2 Heterogeneous population

• Suppose population = 1000 people
• Different people have different chance of getting the flu
• 100 people have a 10% chance
• 100 people have a 20% chance
• ...
• 100 people have a 100% chance

Firm does not know who is whom, thus can only set a uniform price

Should firm produce a vaccine or a drug?

Profit from drug

• (10% × 100 people) + (20% × 100 people) + . . . (100% × 100 people) = 550 people will
get sick
• Each will pay $100
• Revenue = 550 people × $100 = $55 000

Profit from vaccine charge uniform price

• For any price only people with flu probability p with price below 100p will buy
• Best price = $50
• Revenue = $30,000

• In case of the drug, everyone who gets sick is the same.

o This is just like first-degree price discrimination

• In the case of the vaccine, everyone is different and the firm is unable to tell the
difference

• Based on this simple concept, drugs can better extract surplus from consumers i.e.
the potential revenue generated by a drug is higher than that by a vaccine
Third-degree price discrimination
• Firm identifies different groups of consumers from observable differences in
demand
• Firm sells same product to different groups @ different prices
• For example, consumers have different willingness-to-pay by age, gender, location
• Firm must be able to prevent arbitrage (resale from low-price to high-price market)

Second-degree price discrimination

• Per unit price of product will depend on quantity/quality of product sold

• Because consumer with high WTP can always pretend to be the low WTP consumer
• Firm must design a suite of prices that gives consumers an incentive to self-select
accordingly
• Firm must reduce quantity/quality offered to low WTP consumers so as not to
cannabalise sales at the high end
• An example of adverse selection or screening model

Revelation principle
• Pricing scheme must be designed => consumers self-select quality & price package
designed for them
• Choice of bundle reveals true type of each individual in market
Trade off
To design optimal bundle, seller has to compromise, trading off gains in high WTP
market with losses in low WTP market
Different classes of air travel

Suppose 500 leisure passengers and 100 business passengers

Uniform price
If airline offers single class of travel at one price which option is profit-maximising?

Second degree price discrimination

Economy class + Business class

• Business traveller for

economy seat has surplus
($4500 - $2000) $2500

• Reduce business traveller for

business seat for ($10000-
$2500 surplus) at $7500 so
they are indifferent
Suppose now airline can change economy class to misery class by shrinking seat space,
slowing down check-in, reducing airline miles, and making working in economy difficult

Will airline offer economy or misery class?

Second degree price discrimination

Misery class + Business class

• Business traveller for misery seat has

surplus ($3000 - $1800) $1200 surplus

• Reduce business traveller for

business seat for ($10000- $1200
surplus) at $8800 so they are
indifferent

Information rents
• Ability of business class flyers pretend to be a different “type” ensures that they
receive positive rents •
• Monopolist needs to “bribe” consumers to induce them to reveal private
information about type
• Info is main weapon consumers have in maintaining consumer surplus
• Firms do many things to try to extract info about type & information rents
o Product and menu design
o Frequent shopper cards
o Browser and Facebook scraping

When a menu of goods are offered, we usually see following

• Products intended for buyers with low WTP will often be designed to be inferior to
reduce temptation of high-value buyers from purchasing them

• Products intended for buyers with high WTP will have to perfectly match
characteristics these consumers desire

• Buyers with low WTP receive no surplus from trade fully appropriated

• Buyers with high WTP will receive information rents’

E. Game theory
Lecture 19 - May 08: Introduction to game theory

Game Theory Study of decision-making in strategic situations interrelated actions

In strategic games,
players’ actions have cross-effects on other players given mutual awareness of these cross-
effects, players will respond to actions of others

Cooperative Game Theory Used extensively in understanding bargaining & matching

✅Non-Cooperative Game Theory Assumes each agent tries to do what’s best for them

Examples of strategic situations

• Auctions
• Bargaining
• Markets (oligopoly)
• Politics (domestic and international)
• Sports

Some lessons
• Strategic situations involve inter-dependencies among actions taken by decision-
makers
• Strategic interactions can be complex and may involve psychological considerations

Games category

• Static situation where all individuals make their decision once

Simultaneous at the beginning of game without observing any other action
• Example: Rock-Paper-Scissors

• Dynamic situation where games have sequence of moves with

Sequential new info transmitted about past actions
• Example: Chess

Strategy
• Complete set of actions in response to other players’ decisions in every contingency
• Pure strategies When players choose actions with certainty
• Mixed strategies When players choose actions with some randomness

Equilibrium
• When each player chooses a strategy that is a “best response” to other players’
strategy
Simultaneous games

Prisoners’ dilemma
• 2 prisoners are being asked separately
• 2 prisoners have to confess/not confess to a crime

Game mechanism
• If both confess,
they will be convicted & sentenced to 10 years in
prison

• If both do not confess,

they will be charged with less offence & receive 3
years in prison

• If one confesses & other player does not confess,

confessor receive 1-year in prison
non-confessor receives 25-year sentences
(Each suspect wants to betray other player because of the attractiveness of the
reduced prison sentence)

Player A (row)
If Player B (column) chose confess, A picks confess (-10)
If Player B (column) chose not confess, A picks confess (-1)
Best response action = Player A picks confess

Player B (column)
If Player A (row) chose confess, B picks confess (-10)
If Player A (row) chose not confess, B picks confess (-1)
Best response action = Player B picks confess

Strictly dominant strategy

• Strategy that provides player with a strictly higher payoff than all other strategies
• Rational players will always pick strictly dominant strategy if it exists as best
response
• When all players have strictly dominant strategy, equilibrium should contain strictly
dominant strategies

• In prisoner’s dilemma game,

both prisoners have strictly dominant strategy => “confess”
so we predict equilibrium= both prisoners receive 10-year sentence

Weakly dominant strategy

• Strategy that provides player with no lower payoff than all other strategies
• Rational players will always pick a weakly dominant strategy, if it exists as best
response
• When all players have weakly dominant strategy, equilibrium should contain
weakly dominant strategies
Battle of sexes 3x3 game
Husband & wife need to coordinate how to spend their day without observing each other

Dominated strategy NEVER PICK

• Strategy that provides player with lower payoff than any other strategy
• Rational players will never pick dominated strategy

• If strictly dominant strategy exists, all other strategies must be strictly dominated
• If weakly dominant strategy exists, all other strategies must be weakly dominated

• Even when there are no strictly/weakly dominant strategies,

a player could still have dominated strategies

• In battle of the sexes,

o “Wedding” = dominated
strategy because both player
never played

o Given remaining possibilities,

“Opera” = weakly dominant
strategy for both players
hence, predicted equilibrium

Sometimes, eliminating dominated strategies may not be enough to determine the

equilibrium
Tennis
• 2 players in a game of tennis
• To begin each point,
server chooses one of “Left, Centre, Right” and receiver prepares to return with one
of “Left, Centre, Right”

Nash equilibrium
• A set of strategies such that, when all other players use these strategies, no player
can obtain a higher payoff by choosing a different strategy
• If all players have dominant strategies, there is Nash equilibrium
• Dominated strategies can never be part of a Nash equilibrium
• Even when 1 (or more) player does not have a dominant strategy,
Nash equilibrium could still exist

In tennis game,
• No player has a dominant strategy
• We can eliminate server’s dominated strategy “C” but this does not show any
dominant strategy for either player given remaining possibilities
• While {L, C} are not dominant strategies, no player can do better by switching
strategies
• So, {L, C} is a Nash equilibrium, thus predicted equilibrium

How to use Nash equilibrium (NE) as a solution concept

• If all players have dominant strategies,
they cannot do better than playing these strategies => there’s NE

• When some players have dominant strategies & some not,

do the latter have best responses to formers’ dominant strategies? => If so, then NE

• When no player has a dominant strategy,

can we eliminate dominated strategies to find dominant strategies? If so, then NE
Can have multiple predicted outcomes in a game when we use Nash equilibrium
• No dominant strategy
• No dominated strategy

Look at intersection of best responses

 All 3 are NE

Extra considerations (refinement)

• Psychology & role of fairness: make 50/50 a “focal point”

Sequential games
We could specify a new Normal Form to find all the NE

• The Normal Form approach has some issues: • The normal form doesn’t give us any
sense of timing. We have a hard time reconstructing the original game. • A bigger
issue is that some of the NE of the game are strange. • If P1 chooses T, P2 using
strategy {V, V} will be getting 0. • She could do better if she changed her strategy
after P1’s initial choice and switched to T,V • Thus, the Nash Equilibrium V, {V, V}
exists in part because P2 is not switching strategies when it is in his interest. • We
can this type of equilibrium “non-credible” because the equilibrium is based on a
strategy profile that the individual would like to change when they arrive at a future
decision.

Game tree/ extensive form

Subgame
• A game comprising a portion of a longer game, starting from a non-initial node of
the larger game

Backward induction
• Start at final subgames, to find Nash equilibrium for these subgames
• Move up the tree using these choices as predicted actions of later subgames.

Subgame perfect nash equilibrium SPNE

• An equilibrium found through backward induction
• A set of strategies that is Nash equilibrium at every single the games’ subgame
 • Solution predicts stable outcomes because no player wants to deviate from her
equilibrium strategies.

Airbus versus Boeing

• CEOs of Airbus and Boeing are in a strategic situation whether to introduce a new
passenger jet

Scenario 1: Airbus first mover

• Airbus’s strategy is {Introduce}

• Boeing’s strategy is {Not
Introduce, Introduce}
• In this SPNE, payoffs are {50, 100}
• Even decision nodes that are
never reached are important for
understanding player’s
observable actions

Scenario 2: Boeing first mover

• Boing’s strategy is {Introduce}

• Airbus’s strategy is {Introduce,
Not Introduce}
• Payoff is 50,100
• Notice how SPNE & payoffs
change when the ordering of
moves changes.

Key lessons for sequential games

• Look ahead to anticipate what other players would do, and use that
Backward induction information to work out a best-response strategy
• Use these best-response strategies to find the SPNE
• Moving first allows a player to commit to a strategy, which can be
valuable in terms of forcing other players to change their decisions
Ordering matters • Moving second allows a player to discover information about the
other players’ strategies, which can be valuable for working out own
best-response
• In some games, it is optimal to let other players know one’s strategy
(i.e. coordinate to obtain higher payoffs)
Strategy relevation
• In other games, it is optimal to prevent other players from knowing
one’s strategy (zero-sum payoffs)
Oligopoly
• Oligopolistic markets ideal for studying strategic behaviour
• Oligopolistic markets comprise just a few firms
• Oligopolists are best off collectively when they cooperate & act like a monopolist
• In absence of a binding agreement, however, firms face incentives to deviate from
cooperation

1. Quantity competition (simultaneous game)

Airbus vs. Boeing
Suppose Airbus and Boeing are the only 2 firms (duopoly) in passenger jet industry

• Market supply = QS = QA + QB
• Market demand = QD = 800 – P
• Inverse demand = P = 800 – QD
• Both firms FC = 0
• MC = $100 million same cost structure

Monopoly outcome What is monopoly outcome? Monopoly seek MC=MR

𝑻𝑹 = 𝑷 × 𝑸
1. TR 𝑇𝑅 = (800 − 𝑄) × 𝑄 sub inverse demand (Price in terms of Q)
𝑇𝑅 = 800𝑄 − 𝑄2

𝒅𝑻𝑹 𝒅(800𝑄 − 𝑄2 )
=
2. MR 𝒅𝑸 𝒅𝑸
𝑑𝑻𝑹
= 800 − 2Q
𝑑𝑄

𝐌𝐑 = 𝐌𝐂
800 − 2Q = 100
Set MR = MC
𝑸𝑴 = 𝟑𝟓𝟎
When 𝑸𝑴 = 𝟑𝟓𝟎 => 𝑷𝑴 = 𝟖𝟎𝟎 – (𝟑𝟓𝟎) = $𝟒𝟓𝟎

𝜫𝑴 = (𝑷𝑴 − 𝑨𝑻𝑪) × 𝑸𝑴
𝑽𝑪
Profits 𝑨𝑻𝑪 = 𝑽𝑪 because no FC => 𝑨𝑻𝑪 = = 𝑴𝑪
𝑸
𝜫𝑴 = ($𝟒𝟓𝟎 − 𝟏𝟎𝟎) × 𝟑𝟓𝟎 = 1 225 00
Cartel outcome What quantities would firms choose if they choose to collude?
Keep price at $450 monopoly to maximise profit

𝑸𝑴
𝑸𝑨 = 𝑸𝑩 =
𝟐
𝟑𝟓𝟎
1. Split quantity
𝑸𝑴
= = 𝟏𝟕𝟓
𝟐 𝟐

𝜫𝑴
𝜫 𝑨 = 𝜫𝑩 = 𝟐
2. Shared profits 𝜫𝑴
𝟐
= $61250

Would cartel be sustainable? Incentives to deviate away from Cartel

Airbus

𝑻𝑹𝑨 = 𝑷 × 𝑸𝑨
𝑻𝑹𝑨 = (𝟖𝟎𝟎 − 𝑸𝑺 )(𝑸𝑨 ) knowing that 𝑸𝒔 = 𝑸𝑨 + 𝑸𝑩
TR
𝑻𝑹𝑨 = (𝟖𝟎𝟎 − (𝑸𝑨 + 𝑸𝑩 ))(𝑸𝑨 )
𝑻𝑹𝑨 = (𝟖𝟎𝟎 − 𝑸𝑨 − 𝑸𝑩 )(𝑸𝑨 )

TC 𝑻𝑪𝑨 = 𝟏𝟎𝟎(𝑸𝑨 )

𝜫𝑨 = 𝑻𝑹𝑨 − 𝑻𝑪𝑨
𝜫𝑨 = (𝟖𝟎𝟎 − 𝑸𝑨 − 𝑸𝑩 )(𝑸𝑨 ) − 𝟏𝟎𝟎(𝑸𝑨 )
= 𝟖𝟎𝟎𝑸𝑨 − 𝑸𝑨 𝟐 − 𝑸𝑩 𝑸𝑨 − 𝟏𝟎𝟎𝑸𝑨
Profits
𝜫𝑨
𝜫𝑨 = 𝟕𝟎𝟎𝑸𝑨 − 𝑸𝑨 𝟐 − 𝑸𝑩 𝑸𝑨

𝒅𝜫𝑨 𝒅(𝟕𝟎𝟎𝑸𝑨 − 𝑸𝑨 𝟐 − 𝑸𝑩 𝑸𝑨 )
=
𝒅𝑸𝑨 𝒅𝑸𝑨

𝒅𝜫𝑨
= 𝟕𝟎𝟎 − 𝟐𝑸𝑨 − 𝑸𝑩
𝒅𝑸𝑨
𝒅𝜫𝑨
= 𝟕𝟎𝟎 − 𝟐(𝟏𝟕𝟓) − 𝟏𝟕𝟓
𝒅𝑸𝑨

𝒅𝜫𝑨
= 𝟏𝟕𝟓
At cartel quantity 175 𝒅𝑸𝑨
𝒅𝜫𝑨
is positive Marginal gain > Inframarginal loss
𝒅𝑸𝑨

Cartel unsustainable as NE, Airbus has incentive to cheat

So, what can be a NE?

Best response function (reaction function)

Airbus

𝑻𝑹𝑨 = 𝑷 × 𝑸𝑨
𝑻𝑹𝑨 = (𝟖𝟎𝟎 − 𝑸𝑺 )(𝑸𝑨 ) knowing that 𝑸𝒔 = 𝑸𝑨 + 𝑸𝑩
𝐓𝐑𝐀
𝑻𝑹𝑨 = (𝟖𝟎𝟎 − (𝑸𝑨 + 𝑸𝑩 ))(𝑸𝑨 )
𝑻𝑹𝑨 = (𝟖𝟎𝟎 − 𝑸𝑨 − 𝑸𝑩 )(𝑸𝑨 )

𝒅𝑻𝑹𝑨
= −𝟖𝟎𝟎 − 𝟐𝑸𝑨 − 𝑸𝑩
𝐌𝐑𝐀 𝒅𝑸
𝐌𝐑𝐀 = −𝟖𝟎𝟎 − 𝟐𝑸𝑨 − 𝑸𝑩

𝐌𝐂𝐀 𝐌𝐂𝐀 = $𝟏𝟎𝟎

𝐌𝐑𝐀 = 𝐌𝐂𝐀
−𝟖𝟎𝟎 − 𝟐𝑸𝑨 − 𝑸𝑩 = 𝟏𝟎𝟎
Set 𝐌𝐑𝐀 = 𝐌𝐂𝐀
𝟕𝟎𝟎 − 𝑸𝑩
𝑸𝑨 =
𝟐

Boeing
𝟕𝟎𝟎 − 𝑸𝑩
𝑸𝑨 =
𝟐

𝟕𝟎𝟎 − 𝑸𝑨
𝑸𝑩 =
𝟐

Symmetric game Under symmetry (identical firm) = identical best response strategy
𝑸𝑨 = 𝑸𝑩

𝟕𝟎𝟎 − 𝑸𝑨
𝑸𝑩 =
𝟐

𝟕𝟎𝟎 − 𝑸𝑩
𝑸𝑩 = 𝒔𝒖𝒃 𝑸𝑩
𝟐
𝟏
𝑸𝑨 = 𝑸𝑩 = 𝟐𝟑𝟑
𝟑
Perfect competition outcome What would outcome be if industry was PC?

Demand = Supply
AR = MC
Inverse demand = AR

Inverse demand = P = 800 – QD

MC=100

800 – QD = 100
QPC = 700

Best response function

How much more of competition to move from strategic setting to PC outcome

𝒏
𝑸𝒔 = (𝑷𝑪)
𝒏+𝟏

n approach infinity = Qs = 700

2. Quantity competition (sequential game)
Airbus vs. Boeing
• Suppose again that Airbus and Boeing operate as a duopoly, but 1 firm gets to move
first
• Is it better to go first or second?
• Recall: moving first allows a player to commit to a strategy, ,thus force other players
to react accordingly, while moving second allows a player to learn about other
players’ strategies from earlier moves

Airbus moves first … SPNE

Backward induction

𝟕𝟎𝟎−𝑸𝑨
Boeing’s best response 𝑸𝑩 = 𝟐

1st stage
Airbus TR
𝑻𝑹𝑨 = 𝑷 × 𝑸𝑨 sub inverse demand

𝑻𝑹𝑨 = (𝟖𝟎𝟎 − 𝑸𝑨 − 𝑸𝑩 ) × 𝑸𝑨

𝟕𝟎𝟎 − 𝑸𝑨
𝑻𝑹𝑨 = (𝟖𝟎𝟎 − 𝑸𝑨 − )(𝑸𝑨 )
𝟐

𝑸𝑨
𝑻𝑹𝑨 = (𝟒𝟓𝟎 − )𝑸
𝟐 𝑨

𝒅𝑻𝑹𝑨
𝑴𝑹𝑨 =
𝒅𝑸𝑨

𝑴𝑹𝑨 = 𝟒𝟓𝟎 − 𝑸𝑨

𝑴𝑪𝑨 = 𝟏𝟎𝟎

𝑴𝑹𝑨 = 𝑴𝑪𝑨

𝟒𝟓𝟎 − 𝑸𝑨 = 𝟏𝟎𝟎

𝑸𝑨 = 𝟑𝟓𝟎 what Airbus is going to do FIRST MOVER ADVANTAGE!!!!!

𝟕𝟎𝟎−𝟑𝟓𝟎
Boeing’s best response 𝑸𝑩 = = 𝟏𝟕𝟓
𝟐

Sequential game SPNE moves to a better society outcome (175 + 350) =

• In this example, best-response functions are negatively-sloped (inverse relation =

“strategic substitutes”) From perspective of Airbu, larger QA and smaller QB both
enhances profit, so there is clearly a first-mover advantage