Microeconomics Lecture Notes 2014

ECON1001
Foundations of Microeconomics
Lecture Notes
Maksymilian Kwiek
30th September 2014
University
of Southampton
Contents
1 Introduction - positive statements
1.1 A warm-up: social interaction . . . . . . . . . . . .
1.2 Examples (using simple game-theoretic setup) . . .
1.2.1 Prisoners Dilemma . . . . . . . . . . . . . .
1.2.2 Standards . . . . . . . . . . . . . . . . . . .
1.2.3 Entry game . . . . . . . . . . . . . . . . . .
1.3 Do economists think that free markets are the best?
1.4 Economics . . . . . . . . . . . . . . . . . . . . . . .
1.5 Scientific method in economics . . . . . . . . . . . .
1.5.1 Economic model . . . . . . . . . . . . . . .
1.5.2 How are models used? . . . . . . . . . . . .
2 Introduction - normative statements
2.1 Basic assumptions . . . . . . . . . .
2.2 Ordinal utility and Pareto efficiency
2.3 Utility Possibility Frontier . . . . .
2.4 Utilitarianism . . . . . . . . . . . .
2.5 Equity . . . . . . . . . . . . . . . .
2.5.1 Equity of utilities . . . . . .
2.5.2 Equity of outcomes . . . . .
2.5.3 Equity of opportunities . . .
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3 Preferences, constraints, choices.

3.1 Preferences . . . . . . . . . . . . . . . . . . . . . . .
3.1.1 Preferences: Basic definitions and assumptions
3.1.2 Indifference curve . . . . . . . . . . . . . . . .
3.1.3 Utility . . . . . . . . . . . . . . . . . . . . . .
3.1.4 Marginal utility . . . . . . . . . . . . . . . . .
3.2 Budget constraint . . . . . . . . . . . . . . . . . . . .
3.3 Choice . . . . . . . . . . . . . . . . . . . . . . . . . .
3.4 Comparative statics . . . . . . . . . . . . . . . . . . .
3.4.1 Change of income - Engel curve . . . . . . . .
3.4.2 Change of price - individual demand . . . . .
3.4.3 Income and substitution effect . . . . . . . . .
3.4.4 Incentives in general . . . . . . . . . . . . . .
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Contents
4 Firm (one variable input)
4.1 Production function with one variable input
4.2 Cost functions . . . . . . . . . . . . . . . . .
4.2.1 Shape . . . . . . . . . . . . . . . . .
4.2.2 Cost curves . . . . . . . . . . . . . .
4.3 Profit . . . . . . . . . . . . . . . . . . . . .
4.3.1 Output decision . . . . . . . . . . . .
4.3.2 Shutdown decision . . . . . . . . . .
4.4 Supply . . . . . . . . . . . . . . . . . . . . .
4.4.1 Supply of an individual firm . . . . .
4.4.2 Market supply . . . . . . . . . . . . .
4.4.3 Example continued . . . . . . . . . .
4.4.4 Comparative statics . . . . . . . . . .
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5 Market equilibrium. Exogenous shocks and comparative statics.

5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.1.1 Assumptions of perfect competition . . . . . . . . . . .
5.1.2 Definition of competitive equilibrium . . . . . . . . . .
5.1.3 Why we study competitive equilibria? . . . . . . . . . .
5.1.4 Types . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.2 Examples . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.2.1 Price control . . . . . . . . . . . . . . . . . . . . . . . .
5.2.2 Unit tax . . . . . . . . . . . . . . . . . . . . . . . . . .
5.2.3 Short-run and long-run . . . . . . . . . . . . . . . . . .
5.3 Short-run competitive equilibrium . . . . . . . . . . . . . . . .
5.4 Long-run competitive equilibrium . . . . . . . . . . . . . . . .
5.5 Exogenous shock; comparative statics . . . . . . . . . . . . . .
5.5.1 Short-run adjustments . . . . . . . . . . . . . . . . . .
5.5.2 Long-run adjustments . . . . . . . . . . . . . . . . . .
5.6 Elasticity . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.6.1 Expenditures/Revenue and elasticity . . . . . . . . . .
5.6.2 Tax incidence and elasticity . . . . . . . . . . . . . . .
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7 General equilibrium trade and comparative advantage.

7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
7.2 Bilateral trade without production . . . . . . . . . . . . . . . . . . .
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6 Normative properties of competitive equilibria

6.1 Measure of agents welfare . . . . . . . . . . . . . .
6.2 Competitive equilibrium and maximization of social
6.3 Welfare Theorems . . . . . . . . . . . . . . . . . . .
6.4 Applications . . . . . . . . . . . . . . . . . . . . . .
6.4.1 Price floor . . . . . . . . . . . . . . . . . . .
6.4.2 Price support . . . . . . . . . . . . . . . . .
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welfare.
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Contents
7.3
7.4
Trade in the economy with production. Comparative advantage . . .

Example of general equilibrium analysis . . . . . . . . . . . . . . . . .
8 Public goods, externalities, asymmetric information

8.1 Public goods . . . . . . . . . . . . . . . . . . . . .
8.1.1 Types of goods. . . . . . . . . . . . . . . .
8.1.2 Government and public goods. . . . . . . .
8.2 Externality . . . . . . . . . . . . . . . . . . . . .
8.2.1 Examples: . . . . . . . . . . . . . . . . . .
8.2.2 Government and externalities . . . . . . .
8.3 Asymmetric information . . . . . . . . . . . . . .
9 Monopoly
9.1 Setup . . . . . . . . . . . . . . . . .
9.2 Profit maximization . . . . . . . . .
9.3 Marginal Revenue of the monopoly
9.4 Graphical illustration . . . . . . . .
9.5 Welfare properties of the monopoly.
9.6 Price discrimination. . . . . . . . .
9.7 Why monopolies exist? . . . . . . .
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10 Oligopoly
10.1 Market structures . . . . . . . . . . . . . . . . . . . .
10.2 Strategic behavior . . . . . . . . . . . . . . . . . . . .
10.3 Application: Cournot model of quantity competition.
10.4 Application: Bertrand model of price competition. . .
10.5 Cartel . . . . . . . . . . . . . . . . . . . . . . . . . .
10.6 Summary . . . . . . . . . . . . . . . . . . . . . . . .
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12 Costs (many variable inputs)

12.1 Short-run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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11 Production (many variable inputs)

11.1 Introduction to firms problem .
11.1.1 Goal . . . . . . . . . . .
11.1.2 Assumptions . . . . . . .
11.1.3 The problem . . . . . . .
11.1.4 Approach . . . . . . . .
11.2 Production function . . . . . . .
11.2.1 One input (Short-run) .
11.2.2 Two inputs (Long-run) .
11.2.3 Marginal returns . . . .
11.2.4 Returns to scale . . . . .
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iii
Contents
12.2 Long-run . . . . . . . . . . . . . . . . . . .
12.2.1 Short-run and long-run comparison
12.2.2 Economies of scale . . . . . . . . .
12.3 Equilibrium conditions revisited . . . . . .
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80

1.1 A warm-up: social interaction
Each of N students Enters or Stays Out. Staying out generates net payoff of
zero virtual pounds. As far as entering is concerned, there is a benefit and a cost.
The cost is equal to the number of students who selected Enter. Benefit is equal
to some pre-announced value V . What is the number of students who enter, n?
A different experiment: let there be an entry fee of F pounds. Otherwise, the
procedure is the same.
1.2 Examples (using simple game-theoretic setup)

There are many classes of economic models and you will become experts in using
many of them. One class is called normal-form games.
1. What is it for? A normal-form game is a model appropriate to analyze situations
in which independent agents interact in a single simultaneous-move encounter.
2. What is it? A normal-form game is a list of
agents, i.e. independent decision makers
strategies (choices available to each agent), i.e. expressions of scarcity and
trade-offs
payoff functions, i.e. expressions of desires/incentives
3. How is it solved? Solution concept is Nash equilibrium: a list of agents choices,
with the property that no agent can improve their payoff by switching to a
different choice, while other agents choices are kept the same.
1.2.1 Prisoners Dilemma

Each of two suspects held by the police can either confess the alleged serious crime
involving both, or stay silent. If at least one suspect confesses then the serious crime
can be proven in court. If none confesses, then the serious crime cannot be proven, but
there is a minor offense that can still be proven against the suspects. The detectives
tell the suspects that they are going to be sentenced according to this matrix:
Prisoner 1
Confess
Silent
Prisoner 2
Confess
Silent
6
6 0
9
9
0 1
1
Table 1.1: Prisoners Dilemma (years in prison)
Confess-Confess is a Nash equilibrium.

Remark: Note that Silent-Silent is a better outcome for the suspects, but it is not
an equilibrium.
1.2.2 Standards
Robinson Crusoe and Friday live on an island. They can purchase mobile phones, but
there are two standards to choose from. If they select incompatible standards, they
will not be able to communicate with each other and will receive payoff zero. If they
both choose standard 1 then they will get payoffs (2, 3). Standard 2 is objectively
inferior; if they both select it then they will get payoffs (1, 2).
Friday
S1
Crusoe
S1
S2
2
0
S2
3
0
0
1
0
2
Table 1.2: Standards
(S1,S1) is a Nash equilibrium, because if everybody is expected to select S1, then

no player has any incentives to switch to S2 unilaterally. (S2,S2) is a Nash equilibrium
too.
Remark: Sometimes, there may be more than one equilibrium.
1.2.3 Entry game

Let there be N = 140 students in the room and let V = 70.01.
V , N and F are exogenous variables, F being possibly a policy variable. Variable
n, total number of entrants, is endogenous (see the explanation in section 1.5.1).
1. Suppose there is no fee, F = 0. Only if there is n = 70 entrants we have a Nash
equilibrium. Proof: Consider the incentives of an entrant: by entering, they get
V n = 0.01. By staying out they get zero. Thus, they should enter. Consider
the incentives of an abstainer: by staying out they get zero, by entering they
get V (n + 1) = 0.99. Thus they should stay out. We have an equilibrium.
1.3 Do economists think that free markets are the best?

2. Let F = 30. Claim: there is n = 40 entrants in equilibrium. Proof: Consider
the incentives of an entrant: by entering, they get V F n = 0.01. By
staying out they get zero. Thus enter. Consider the incentives of an abstainer:
by staying out they get zero, by entering they get V F (n + 1) = 0.99.
Thus stay out. We have an equilibrium.
Comparative statics: comparing outcomes for two situations, F = 0 and F =
30. Maybe interpret as if the fee goes up from 0 to 30 then the number of
entrants goes down from 70 to 40
Note also that with F = 0 the total payoff in the economy is close to zero (70
entrants, each getting a penny, that is a total of 0.70). When F = 30 then
the society collects total of 40 30 = 1200 pounds in taxes and all entrants go
home with a penny. The total gain of the economy is therefore 1200.40.
1.3 Do economists think that free markets are the

best?
These examples suggest an important observation: even if every individual is the best
judge of what is best for her/him
social outcomes are not necessarily socially the best.
This statement justifies the existence of governments as forces of coercion, applying
policies and interventions that are capable of moving equilibrium outcomes closer to
what is socially best. However, first we have to define what we mean by the best
outcome; see next week.
1.4 Economics
Economics social science that studies human behavior as an outcome of an interplay
of two factors
scarcity (of food, time, production factors, other resources etc) and
desires/incentives (of economic agents such as individuals, firms, institutions,
associations etc).
1.5 Scientific method in economics

Positive question - what is? Positive analysis should be free of ethical, religious,
political, or value judgments.
Normative approach - what ought to be? Norms have to be defined.

Scientific method is a collections of rules that allow us to provide a relatively reliable
answer to the positive question. Postulate a hypothesis and investigate how much
confidence there is that the hypothesis is true:
Theory - what are the necessary implications of the hypothesis?
Empirics - finding evidence and testing if the implications of the hypothesis
hold in reality by controlled field or lab experiments, natural experiments, case
studies etc.
Theory is deductive and so the implications are totally reliable. Empirical investigation is inductive, thus it is not totally reliable.
1.5.1 Economic model

How do we perceive reality? Since the reality is too difficult to understand, we use
models of reality to represent some of its aspects in a simplified way. You cannot
avoid being a theorist!
We can talk about two types of errors
a model contains an internal logical mistake
a model, being logically correct, is not an adequate representation of the reality.
By studying models we can learn to avoid the first type of error. Deductive methods
(i.e. logic) are used to infer the implications from the assumptions. This logic can
be represented algebraically, graphically, or verbally. Empirics helps us to avoid the
second one, and teaches us that models (a) are contextual and (b) constantly evolve
(i.e. hopefully improve).
A microeconomic model attempts to draw conclusion about how the whole system
works (like organisations, households, firms, markets, entire economy etc) from the
analysis of incentives of the decision makers in these systems (like consumers, workers,
sellers, buyers, managers, owners, etc). An economic model is a set of assumptions
about how various elements of an economic system relate to and depend on each
other. In practice, any economic model will
1. define a list of variables and
2. assume relationships between them.
Types of variables
1. Exogenous parameters (external, independent, explanatory) - these are parameters that the model is not trying to explain. They are given. We can distinguish
unchangeable parameters of nature,
policy variables - potentially changeable, e.g. by some authority.
1.5 Scientific method in economics

2. Endogenous variables - these are variables which are not known at the outset.
We can say that the model explains these variables. Among endogenous
variables we can distinguish
decision variables - there is an agent in the economic model, who has this
variable under their control.
non-decision variables - an endogenous variable that nobody actually chooses;
it is determined by some other force that the model must postulate.
Among the assumed relationships there are equilibrium conditions. There are many
types of equilibria, but the basic idea is always the same.
An equilibrium is a list of the values of all endogenous variables, such that if these
values are realized then there are no reasons in the model that push the endogenous
variables away from the supposed equilibrium.
Typically, the equilibrium conditions are:
an agent should have no incentives to change the decision variable under their
control, and
the forces that control non-decision variables (if any) exactly cancel out.
1.5.2 How are models used?

We study equilibria because we believe that if the endogenous variables in the model
are in equilibrium, then the variables that they represent in reality would remain in
its vicinity most of the time.
The ultimate purpose of the model is to deliver a testable/falsifiable hypothesis,
i.e. a prediction.
Comparative statics is a thought experiment - calculate an equilibrium for one set
of exogenous variables and the second one for another set. Interpret the first situation
as before the change of exogenous variables and the second as after the change. Or
interpret these equilibria as representing two different locations.
2 Introduction - normative
statements
Economists often find themselves in debates involving value judgments. Normative
question is what ought to be? Normative ethics provides framework for this discussion.
E.g.:
Should income tax be increased? If yes, then which income bracket? Should
the tax be progressive?
Who should pay for public goods, such as roads - those who use them, or those
who can afford it more?
Should we subsidize, tax, ban, price-control etc. certain goods, such as petrol,
housing, drugs, nappies, electricity, alcohol, gambling?
Who should pay for old-age care, baby-boomers or their children?
Where should public resources go in health service? I.e. given that someone
will die, who should it be?
2.1 Basic assumptions

At the outset, we often assume
Consequentialism - only consequences are the basis for a judgment of what is
right and wrong (as opposed to adherence to rules, virtues, etc).
Non-paternalism - only preferences of the individuals are the basis for a judgment of which social outcome is right or wrong (as opposed to someone eases
preferences, e.g. mine).
Need to define preferences. Utility is a measure of satisfaction/happiness of an individual from a given outcome. It could be the same as monetary payoff, but it could
also be a description of subjective desires or preferences unrelated to money.
Ordinal utility - captures only ranking (and not intensity) of preferences.
Cardinal utility - its level is treated as an ethically or behaviorally significant
quantity.

Examples:
1. Suppose raspberry ice-cream gives me utility 2 and chocolate ice-cream gives
me utility 3. The meaning of this in ordinal approach is that I prefer chocolate
ice-cream to raspberry. In cardinal approach numbers 2 and 3 are meaningful,
e.g. these could be the maximal prices I am willing to pay for the ice-creams.
2. Consider Standards game. Ordinal utility approach states that Robinson is
indifferent between (S1,S2) and (S2,S1), and (S2,S2) is strictly better, while
(S1,S1) is better still; beyond that, these payoffs are meaningless. Cardinal
utility approach makes the following statement meaningful: Robinson prefers
(S1,S1) twice as much as (S2,S2), or his payoff is the same in (S1,S1) as Fridays
payoff in (S2,S2).
2.2 Ordinal utility and Pareto efficiency

Pareto improvement - a change from one allocation/outcome to a different one that
makes at least one agent strictly better off and nobody worse off. An allocation/outcome
is Pareto efficient if no Pareto improvement is possible. I.e. if any change makes at
least one agent worse off.
Example. There are five possible outcomes and three agents.
Outcome
A
B
C
D
E
(Ordinal) utility of
Agent 1 Agent 2 Agent 3
10
20
30
10
10
10
10
20
80
30
35
30
40
40
20
Is this outcome Pareto Efficient?

Not PE (e.g. A C)
Not PE (e.g. B A)
PE (agent 3 suffers in any change)
PE (either agent 1 or 3 suffers)
PE (agent 1 suffers in any change)
Table 2.1: Pareto efficiency
Pareto efficiency is a minimal requirement on what we would think is a right

outcome. It just says that there is no unnecessary waste.
Remark: There may be many Pareto efficient allocations (and typically there are
many)
Remark: Pareto efficiency has nothing to do with equality or fairness. For instance,
allocation C is very unequal but Pareto efficient, while B is equal but not
Pareto efficient.
2.3 Utility Possibility Frontier

U2
C
A
B
U1
Figure 2.1: Utility Possibility Sets and Frontiers
2.3 Utility Possibility Frontier

Assume cardinal utility. Utility Possibility Set is the set of all utility levels that are
feasible. Utility Possibility Frontier are those utility levels that come from Pareto
efficient outcomes (North-East frontier of the U P S). Figure 2.1 shows a hypothetical
Utility Possibility Set for two agents. Point A shows feasible but Pareto inefficient
situation, point B (being on the Utility Possibility Frontier) shows Pareto efficient
outcome, and finally point C shows a configuration of utilities that is not feasible.
2.4 Utilitarianism
Utilitarianism proposes that we ought to maximize the sum of utilities.
Example. According to utilitarianism, the best allocation in Table 2.1 is C because
it maximizes utilitarian social welfare, 10 + 20 + 80 = 110. For instance, D is no
longer justifiable, because going from D to C generates higher utilitarian welfare.
Social Welfare function is a way to aggregate individual utilities - from a list,
u1 , . . . , uN , to a single measure of welfare, W . The utilitarian welfare function
is W = u1 + . . . + uN .
Obviously, the best outcome according to this criterion is Pareto efficient, but
not every PE outcome is the best according to this criterion.
Utilitarianism is particularly justified if utility is transferable. Then the issue
of welfare distribution (cutting the cake) is separate from welfare maximization
(baking the cake). E.g. with transferable utilities, C is the only Pareto efficient
outcome, i.e. the maximal surplus can be distributed among the agents so that
everyone is happier in C than in any of the remaining outcomes.

Cost-benefit analysis of a proposed change - sum all the payoffs to all the agents
in the economy and subtract all the costs to all the agents and see whether
the result is positive; if yes, then proposed change is an improvement in the
utilitarian sense (again: Pareto improvement if utility is transferable).
2.5 Equity
2.5.1 Equity of utilities
The utilitarian welfare criterion puts equal weight on all agents. One can use different
welfare functions. Consider welfare functions that put more weight on lower utilities.
Maximin (Rawlsian) welfare function has the strongest concern for equity, W =
min {u1 , ..., uI }; i.e. the right outcome is the one that selects the greatest benefit
of the least advantaged.
According to Maximin criterion, the best allocation in Table 2.1 is D because
welfare in this case is the highest possible, min {30, 35, 30} = 30.
The best outcome according to any such Welfare function is Pareto efficient,
but not every PE outcome is the best according to this criterion.
2.5.2 Equity of outcomes

A practical approach when thinking about equality is to pick a criterion, calculate a
measure of dispersion and declare it important. For example, one can pick income,
or wealth and use Gini coefficient (value of zero for perfect equality, value of one for
perfect inequality).
Note that minimizing such measures of dispersion may generate silly results,
e.g. if nobody has anything then perfect equality is achieved.
More to the point, income is not the same as utility, e.g. some individuals
prefer to work less and enjoy life.
2.5.3 Equity of opportunities

An allocation is envy-free if no agent would like to exchange her position for that
of another agent. Envy-freeness is a notion of equity. Note that envy-freeness is
not necessarily Pareto efficient (say destroy everything gives us envy-free outcome),
neither Pareto efficiency is necessarily envy-free. We want both.
Equity of opportunities proposes that initially (i) all agents are given the same
endowment (equal division) and face the same choice opportunities, then (ii) they
are allowed to make life choices according to their heterogeneous preferences, so the
outcomes and even resulting utilities do not have to be the same.
10
2.5 Equity
Equity concern: Observe that the allocation of equal division of endowment is
trivially envy-free. Moreover, the outcome after agents choices is also envyfree.
Efficiency concern: The outcome of equal division is not necessarily Pareto
efficient. We will see later (trust me) that in some circumstances the outcome
after agents choices will be Pareto efficient.
Equity of opportunities approach seem to achieve a similar fairness postulate as
equity of utilities, except that it does not require cardinal notion of utility. It uses
ordinal utility approach. Note however, that equity of endowments may be difficult
to achieve in case of talents, abilities, etc.
11

Consumer preferences
(define better)
Choose the best option from
those that are affordable
Budget constraint
(define affordable)
Comparative static: How does
this choice vary when best or
affordable is altered?
Figure 3.1: Plan
3.1 Preferences
3.1.1 Preferences: Basic definitions and assumptions
A B means A is at least as good as B (or weakly better).
A B means A and B are equally good.
A B means A is strictly better than B.
Assumption 1. Preferences are rational. I.e. they are
complete - any two alternatives A and B can be compared and either A B or
B A.
transitive - if A B and B C, then A C.
Remark: rational preferences does not mean that they are
conscious - e.g., I may honestly claim that I prefer a safer car rather than a
faster one, but my actions may reveal the opposite
typical - I may have rational, yet completely abnormal preferences.
objectively correct - e.g., I may be rational and still derive preference from the
assertion that flying is more dangerous that driving.
egoistic - I may care about others; i.e. altruism is not assumed away (nor is
snobbery, status-seeking etc.)
13
Food
AB
Nonmonotonic
preferences
Food
Water
Water
Food
better
Water
Figure 3.2: Indifference curves, A B
3.1.2 Indifference curve

Indifference curve - a set of bundles that the consumer views as equally good.
For convenience we assume
Assumption 2. Monotonicity - more is better.
Assumptions made so far give us a few observations (see Figure 3.2):
1. Indifference curves are downward sloping. If not, then monotonicity is violated.
2. Indifference curves farther from the origin depict better bundles, by monotonicity.
3. Distinct indifference curves cannot cross. If they did, the intersection point
would be indifferent to any point on these two indifference curves.
4. For any point, there is an indifference curve going through it.
14
3.1 Preferences

Food
Food
B
f
D w
Water
Water
Figure 3.3: Shape of indifference curves
Subjective substitution between goods. Consider a change depicted on Figure 3.3:

move from A to B to C. Left - get more and more water, give up food; water becomes
valued more in terms of food. Right - Get more and more water, give up food; water
becomes valued less in terms of food.
The indifference curve on the right seems to describe our typical preferences better.
The Marginal Rate of Substitution of water for food M RSf w says how much food
has to be given up when the consumer gets one more unit of water, so that he/she
is as well off as before. M RSf w = f /w and approximates the slope of a smooth
indifference curve.
Assumption 3. M RS is diminishing (along a smooth indifference curve, moving to
the right, in absolute terms)
3.1.3 Utility
Utility can be interpreted as satisfaction, happiness. A B translates to A yields
a strictly higher utility than B. Suppose one has utility u (x1 , x2 ) = x1 + x2 ,

where x1 is quantity of the first good, etc. Then e.g. (16, 1) (4, 4).
It is a mathematical fact, that if preferences are rational (plus some minor technical
assumptions) then there is some utility function that captures these preferences.
From now on we are going to spell out preferences in terms of utility functions.
3.1.4 Marginal utility

M U - extra utility generated by extra unit of a commodity.
15

Number of apples
0
1
2
3
4
5
Utility
101
110
114
116
117
116
Marginal Utility, M Uapple

9
4
2
1
1
Table 3.1: Marginal utility

Consider again Figure 3.3. Slope of a smooth indifference curve is M RSf w =
f /w (such that we stay on the same i.c.). But also, the move from A to B can
be decomposed into two steps, A D B.
1. If A D, then utility goes down roughly by f M Uf .
2. If D B, then utility goes up roughly by w M Uw .
3. In order to stay on the same indifference curve the total utility must not change,
hence these two changes must cancel each other, f M Uf = w M Uw ,
or
!
f
M Uw
= M RSf w =
w
M Uf
Conclusion: The M RS can be easily expressed in terms of M U s.
3.2 Budget constraint

Expenditures Income. Let pw , pf and Y be prices and income. Then pw w + pf f
Y . Budget line is where this condition holds with equality and can be written as
f = (Y /pf ) (pw /pf ) w. One can see that this is a straight line with a slope pw /pf
and an intercept of Y /pf . Bundles P and R are affordable, S is not. R requires all
the income.
Food
Slope pw/pf
S
Intercept
Y/pf
R
P
Y/pw
Water
Figure 3.4: Budget constraint
16
3.3 Choice
3.3 Choice
Take the best bundle from these that are affordable. Preferences are given (either
M Uf and M Uw , or indifference curves, or utility, or M RS), market conditions are
given too (pw , pf and Y ). Optimal choice of a consumer is represented by point
D. Points like A, B and C are affordable but still, there are better affordable options; point E is not affordable. An interior point like D must satisfy the tangency
condition:
Slope of indifference curve = Slope of budget line
M RSf w =
pw
pf
In other words, consumer does not rest in adjusting her bundle until her subjective rate of substitution between two goods (M RS) is equal to the market rate of
substitution (price ratio).
Food
A
C
B
Y/pw
Water
Figure 3.5: Optimal choice

Alternatively, this can be written as
M Uw
M Uf
=
.
pw
pf
3.4 Comparative statics

3.4.1 Change of income - Engel curve
E.g., suppose that the initial income is 9 and that it falls to 6; graphically, this does
not affect the slope of the budget line; parallel shift of budget line inward. Engel
17

Food
Food
Water is normal
9/py
9/py
6/py
6/py
6/pw
Income
Water is inferior
9/pw Water
6/pw
9/pw Water
Income
Engel curve for

normal goods
Engel curve for

inferior goods
Water
Water
Figure 3.6: Derivation of Engel curve

curve - How does the quantity demanded change if income varies? Two possible
cases depicted on Figure 3.6: normal goods and inferior goods.
3.4.2 Change of price - individual demand

E.g., suppose that the initial price of water is 8 and that it falls to 6. Graphically, this
does not affect the vertical intercept Y /py ; the budget line rotates around this point
outward. How does the quantity demanded changes? Two possible cases: Picture
on the left of Figure 3.7 depicts an ordinary situation, where quantity demanded
increases when price falls. But the picture on the right shows that this does not
have to hold: we may have a rational consumer who has preferences satisfying all
the assumptions above, but with a bizarre comparative static: quantity demanded
goes up as the price goes up (while income, preferences and everything else stays
unchanged). A good with such property is called a Giffen good.
Ordinary situation the lower price, the higher quantity demanded (negative
slope).
Remark: Demand (function, or curve) is the relationship between price and quantity
(the entire curve), quantity demanded is a number of units demanded for
one price (point on the curve).
Remark: Quantity demanded not the same as quantity needed (needs are not
defined in economics). Quantity demanded not the same as quantity purchased.
Effect of a change of price of this good change of quantity demanded, movement
along the curve. Effect of a change of other factors (income, prices of related goods,
18
3.4 Comparative statics
Food
Law of demand
Giffen paradox
Y/py
Y/py
Y/8
Price
of
water
Food
Y/8
Y/6 Water
Y/6 Water
Price
of
water
Water
Water
Figure 3.7: Derivation of demand
Price
of
apples
Quantity of apples
Price
of
apples
Quantity of apples
Figure 3.8: Demand curve and its shift
19

tastes, expectations, etc) change of demand, movement of the curve itself, shifts.
Example income increases, then the demand shifts (maybe to the right so that
quantity demanded is greater for all prices). See Figure 3.8.
3.4.3 Income and substitution effect

Income effect - the change in quantity demanded caused by the change of income, while keeping prices constant.
Substitution effect - the change of quantity demanded caused by the change of
price, while keeping the real wealth constant.
When income changes then the only effect is income effect. But when the price
changes, then both income and substitution effects are present. Firstly - if price
decreases the consumer becomes richer exactly like when income decreases: this
is the income effect of the change of the price. Secondly - the consumer shifts her
purchases towards the cheaper product: this is the substitution effect of the change of
price. The isolation of income effect from substitution effect when the price changes
hinges on the fact how we define real wealth to be kept constant.
3.4.4 Incentives in general

How do individuals react to the environment? Demand and Engel functions could
be called more generally behavior functions; they show the behavior intended by a
decision maker as a function of some factor external to the decision maker - a factor
which could be called an incentive or an incentive. E.g. the demand curve shows
how the quantity demanded reacts to the change of the unit price. One may consider
other behavioral functions: quantity demanded changes with other prices, desired
size of meals changes with content of fat, speed of driving changes with safety of a
car, students enrollment changes with the difficulty of the exam, etc.
20

This section considers production decisions of firms, but focuses on a simpler version
(more complicated will be discussed later).
4.1 Production function with one variable input

Production function is a way to describe technology. It tells how many units of output
(production) can be produced at most, for given inputs (factors of production).
Assumption about technology in this section: production of the final product requires one piece of equipment and one variable input. We will call them Capital (fixed
= 1) and Labor (variable L).
K
Production function maps labor into output, q = f (L). For instance, production
function may be
Labor L
0
1
2
3
4
5
6
Production q = f (L)
0
10
30
45
55
60
60
Marginal Product of Labor, M PL
10
20
15
10
5
0
Table 4.1: Production function and Marginal Product
Marginal Product of labor, M PL = q/L is an extra product generated by an

extra unit of labor. It approximates the slope of the production function.
Fundamental assumption: Law of diminishing marginal returns (or product) to
an input.
Figure 4.1 shows a typical production function for one variable input. Only the
middle section is interesting, and from now on we are going to assume that the
production function satisfies M Pinput is positive and decreasing.
21

q
L
MPL
MPL
L
of diminishing
MPL law
marginal returns
MPL > 0, or q
MPL < 0, or q
Figure 4.1: Production function graphically
22
4.2 Cost functions
4.2 Cost functions

Cost function describes the minimal cost of producing q units of final output. Denoted
C (q). It conveniently summarizes technology and input prices.
+wL, where the capital K
= 1 is fixed
In general, cost can be written as Cost = rK
at one unit, and the only variable is labor, L, and parameters r and w are market
prices of a unit of capital and labor, respectively. This, however, is not the cost
function. The cost function depends only on q and other exogenous parameters but
not on endogenous variable inputs such as L.
As one wants to change q, one must adjust L, according to the production function
q = f (L). Let L (q) be an inverse of this function, telling us the required L, if q is
+ wL (q).
to be produced. Then, the cost function is C (q) = rK
One can see that the total cost consists of Fixed Cost plus Variable Cost, C (q) =
F C + V C (q).
Required labour,
L = L(q)
C(q)
C(q)
Production function
q = f(L)
FC
VC(q)
Figure 4.2: From production function to cost function
4.2.1 Shape
The cost function becomes steeper eventually, by law of diminishing marginal returns
to a variable input (labor). Note that the V C (q) = wL (q) has exactly the same shape
as the production function, except that it is inverted
and multiplied by w.
Example: Let the production function be q = L. Therefore, required labor is
L = q 2 . Conclusion: the cost function is C (q) = r + wq 2 . E.g. if wage is w = 2,
rental price of capital is 800, then our cost function becomes C (q) = 800+2q 2 . Fixed
Cost is F C = 800 and Variable Cost is V C (q) = 2q 2 .
4.2.2 Cost curves

The above costs C (q), F C, V C (q) are total; but one can talk about unit costs:
23

Cost curves in
the short-run
MC
AC
AFC
AVC
q
Figure 4.3: Shape of unit cost functions
Average costs:
Average cost, AC (q) = C (q) /q.
Average Fixed Cost, AF C (q) = F C/q.
Average Variable Cost, AV C (q) = V C (q) /q.
Obviously AC (q) = AF C (q) + AV C (q).
Marginal Cost: M C (q) = C (q) /q, extra cost required to produce an additional unit of output. It is roughly the slope of the cost function.
Important observations about cost curves so far:
1. M C is eventually increasing, because the cost function becomes steeper eventually, by law of diminishing marginal returns to a variable input.
2. If AC > M C then AC &, if AC < M C then AC %, if AC = M C then AC is
constant. In particular, if AC reaches its minimum then AC = M C. Similarly,
for AV C.
3. If F C > 0:
q0
q
AF C
AV C
some positive number
increasing by law of diminishing marginal
returns to variable input
Table 4.2: Shape of Average Cost curves
24
4.3 Profit
MC
AC
80
AVC
20

Figure 4.4: Cost curves in the example
Hence, AC has a U-shape; AF C are overwhelmingly important for small
productions; AV C are overwhelmingly important for large productions.
4. AV C = M C in the limit as q &.
Figure 4.4 illustrates the example (continued): AC (q) = 800/q + 2q, AF C (q) =
800/q, AV C (q) = 2q. Marginal Cost is M C (q) = 4q, if q is small.
4.3 Profit
Three ways to write profit conveniently
1. (q) = pq C (q), by definition.
2. (q) = (p AC (q)) q, as per unit profit multiplied by the number of units.
3. (q) = (p AV C (q)) q F C. This is taking Fixed Costs aside and writing
profit as operational profit (a.k.a. quasi-profit, quasi-rent, or producer surplus) minus Fixed Cost. Operational profit itself is per unit operational profit
multiplied by the number of units.
Plan: find out what level of production is optimal. There are two sub-problems:
1. Output decision if produce, then how much?
2. Shutdown decision whether to produce at all or to shut down to avoid avoidable losses.
25

Operational Profit
Profit
MC
AC
AVC
Quantity
Figure 4.5: Representing profit
4.3.1 Output decision

Suppose that the firm wants to produce a positive quantity what is the optimal
level of production? Profit is (q) = pq C (q), where
p is the exogenous price of the final product
C () is the cost function summarizing the technology and input prices.
If production increases by one unit then the revenue goes up by p, and cost goes up
by M C (q). Whether production should or should not be increased depends on the
comparison between these two forces, p and M C (q). Lets compare them on Figure
4.6.
1. Suppose q1 is proposed. Note that M C (q1 ) < p and increasing production by
a small unit will increase profit, so original q1 is not optimal.
2. Suppose q2 . Then M C (q2 ) > p and decreasing production by a small unit will
increase profit, so original q2 is not optimal.
3. Suppose q . Then M C (q ) = p and changing production a little will change
revenue and cost at the same rate and hence will not change profit, so this q
may be optimal.
Hence, to get a candidate for optimal production level, q , set M C (q ) = p.
4.3.2 Shutdown decision

Is the above positive q indeed optimal? Consider three cases illustrated on Figure
4.7.
26
4.4 Supply
Profit from last

unit, when q1 is
produced.
Loss from last

unit, when q2 is
produced.
MC
AC
AVC
q1 q*
q2
Figure 4.6: Output decision

(a)
Suppose that p > min AC. Then profit is positive and q is definitely
optimal, because shutting down gives profit of (0) = F C.
(b)
Suppose that price is lower, but not too much, so that min AV C < p <
min AC. The profit is negative, but operational profit is still positive. This
operational profit can be used to cover some of the Fixed Cost. Hence, the
firm should keep producing q in the short-run to minimize losses.
(c)
Suppose that price falls even more, so that p < min AV C. Then not
only profit is negative, but operational profit is negative too. Instead of
producing q , the firm should rather shut down the operations immediately,
avoid this operational loss and suffer losses equal only to unavoidable fixed
costs, (0) = F C.
Conclusion: Shut down only if operational profit is negative, or if p < min AV C.

The key observation is that only F C is unavoidable. Operational profit (positive)
can cover part or whole of the F C. If there is operational loss then it is not going to
help in covering F C, but this operational loss can be avoided by shutting down.
4.4 Supply
We would like to know how firms respond to market prices.
4.4.1 Supply of an individual firm

The firm supplies zero if price is below the shutdown price of min AV C. If the price
is above this shutdown price, then the firm should supply according to the M C (q)
curve, like on Figure 4.8. Conclusion: for this technology, the supply of an individual
firm is upward sloping, essentially by the law of diminishing marginal returns.
27
Case (a)
MC
AC
AVC
minAC
Case (b)
MC
AC
p
minAC
AVC
p
minAVC
minAVC
q*
q*
Case (c)
MC
AC
AVC
minAC
minAVC
p
q*
Figure 4.7: Shutdown decision
SR Supply
AC
AVC
Shutdown
price
MC
q
Figure 4.8: Individual supply
4.4.2 Market supply

It is the sum of individual supplies. For instance, let firm 1 supply q1 and firm 2
supply q2 at price p0 . Then market supply (if only these two firms are on the market)
at this price is q1 + q2 .
28
4.4 Supply
Firm 1
Firm 2
Market Supply
p
q
q1
q2
q1 + q2
Figure 4.9: Market supply
4.4.3 Example continued

Recall that the short-run cost function is C (q) = 800 + 2q 2 , so that AC (q) =
800/q+2q, AF C (q) = 800/q, AV C (q) = 2q, and M C (q) = 4q. Hence, the shutdown
price is zero and the short-run supply function of the individual firm is obtained from
condition p = 4q, which results in individual supply function q (p) = p/4. If there
are n identical firms like this one the market supply is Qs (p) = np/4. (Parameter n
is exogenous for now).
4.4.4 Comparative statics

Quantity supplied - the amount of the good that the firm intends to sell at a given
price, holding other factors constant. Supply curve - quantity supplied at each price.
See Figure 4.10. How do the following changes can be depicted graphically
Increase of the price of the good produced by this firm
Increase of the price of the fixed input
Increase of the price of the variable input
change in technology (various forms)
29
Price
Price
of
corn
of
corn
Quantity of corn
Figure 4.10: Supply curve and its shifts
30
Quantity of corn
5 Market equilibrium. Exogenous

shocks and comparative statics.
5.1 Introduction
5.1.1 Assumptions of perfect competition
Perfect competition will always mean that
1. Goods are private and homogeneous (like corn, but not necessarily cars, and
surely not like public security)
2. No market power (such as monopoly, oligopoly or cartel); we say that all agents
are price-takers. In particular, goods must be traded and have prices.
3. No transaction costs (like search cost, legal fees, transportation etc.)
4. No externalities (like pollution, congestion, or making discoveries that benefit
others)
5. No asymmetric information (i.e. qualities and abilities are known etc.)
Assumptions made here for simplicity: all firms are identical and all input prices and
technology are constant, even if the entire industry expands or contracts. Note that:
1. Strictly speaking we do not assume that there are many firms and individuals.
But since many assumptions above are justified only if there are many agents,
me may as well make that de facto assumption.
2. We do not automatically assume that entry to an industry and exit from it is
free. Usually, we will assume free entry/exit in the long-run, but not in the
short-run.
5.1.2 Definition of competitive equilibrium

So far we only illustrated how an external factor affects agents behavior. E.g. the
price of corn affects buying and selling intentions of corn consumers and producers.
Now we will hypothesize that causality also goes in the other direction: collective
behavior affects the price.
Draw supply and demand on one picture.
31
Price
of
corn
Excess
supply
Supply
13
12
10
Demand
Excess demand
Quantity of corn
Figure 5.1: Competitive equilibrium
If price is, say, 10 then quantity demanded is much larger than quantity supplied. There is excess demand. Imagine a queue of potential buyers chasing
sellers. We expect that buyers bid up price, i.e. this price cannot be a part of
equilibrium.
If price is 13 then there is excess supply, sellers chase few buyers, and price is
pushed down.
If price is 12, then quantity demanded is equal to quantity supplied. Neither
sellers nor buyers have an advantage; there is no pressure on price.
Thus, in a competitive equilibrium, optimal behavior of consumers (demand) and
optimal behavior of firms (supply) interact in a process determining the prices which
is called market clearing.
Competitive equilibrium is a price and quantity such that:
1. Given prices, every decision maker is behaving optimally and
2. Prices are such that markets clear (quantity supplied is equal quantity demanded)
Remark: The story motivating this definition refers to a dynamic process of price
adjustments and bargaining, but strictly speaking the concept is static
(price & quantity such that. . . ).
Remark: Price is endogenous (for the first time) but it is not a decision variable.
32
5.2 Examples
5.1.3 Why we study competitive equilibria?

As in any equilibrium two types of questions are usually asked:
1. How does this equilibrium change when exogenous parameters change? This
is a positive question that leads us to a comparative statics exercises. (See
week 1)
2. What are the welfare properties of equilibria; do they lead to good outcomes?
This is a normative question. (See week 2)
5.1.4 Types
There are many versions of competitive equilibrium, e.g.
1. Long-run versus short-run. In our presentation below the difference is the
following:
a) In long-run, firms can enter and exit from the market. In the short-run
entry/exit is not possible.
b) (to be considered later, when there are multiple inputs: in the long-run
all inputs can be changed. In the short-run, some may be fixed)
2. Partial equilibrium versus general equilibrium.
a) Partial equilibrium examine one market in isolation if it affects and is
affected by other markets in a negligible way.
b) General equilibrium if interactions between markets are non-negligible
then one has to close a few partial equilibrium models together to capture these cross-market effects. Microeconomics versus macroeconomics
traditional and contemporary sense.
5.2 Examples
5.2.1 Price control
Consider housing market represented on Figure 5.2. If market is unregulated, then r0
is equilibrium rent and q0 is the quantity of flats rented in equilibrium. Suppose that
the gov introduces rent control: the maximum rent is r1 . Under this regulation
the rent would like to go above r1 to eliminate the excess demand, but it cannot.
Excess demand of q1 q2 is a permanent feature on this market (if black market can
be eliminated). However, the actual drop in number flats rented is smaller, q0 q2 .
5.2.2 Unit tax

Read on your own.
33

rent
Demand
Supply
r0
r1
q2
q0
q1
Quantity of flats
Figure 5.2: Rent control

rent
Demand
(initial)
rent
Supply SR
Demand
(initial)
Demand
(after army
moves in)
r1
Demand
(after army
moves in)
Supply LR
r0
r0
q0
Quantity of flats
q0
q1
Quantity of flats
Figure 5.3: Shape of behavioral functions
5.2.3 Short-run and long-run

Suppose that the army builds a new base in a town. Hundreds of new families move
in. This shock is depicted on Fig 5.3 as a demand shift.
1. Short-run: it is impossible to add new flats and houses right away; supply is
fixed at q0 , and initial rent is r0 . Higher demand changes only prices (left panel
on Figure 5.3).
2. Long-run: this is a town where land and permits for new developments are
waiting for investors, so any number of new flats can and will be built as long
as the rent just covers costs equal r0 . Higher demand triggers more investments
only quantity changes (right panel).
Conclusion: the same change (the army moves in) can have different effects depending
on the shape of the demand & supply curves (supply in this case).
34
5.3 Short-run competitive equilibrium
Individual Firm
Market
MC
D
S
pe
AC
00000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000
00000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000
000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000
00000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000
00000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000
qe
AVC
Firms
output
Qe = nqe
Market
output
Figure 5.4: Short-run equilibrium
5.3 Short-run competitive equilibrium

1. Givens:
a) Market demand, D (p), from week 3.
b) Supply in the form of cost curves, M C (q) , AC (q), from week 4.
c) Number of firms, n.
2. Conditions that determine the market equilibrium (price pe , individual level of
production q e ) are :
a) For any market price pe , firms supply function is given by the optimal
production choice: pe = M C (q e ) pSD , where pSD is the shutdown price.
b) Market clears, i.e. quantity supplied equals quantity demanded, i.e. nq e =
D (pe )
5.4 Long-run competitive equilibrium

Entry and exit is free, so the number of firms, n, is endogenous too.
1. Given:
a) Market demand, D (p).
b) Supply in the form of cost curves, M C (q) , AC (q),
2. Conditions
35
Individual Firm
Market
MC
Old S (Short-run)
New S (Short-run)
AC
AVC
pe
S (Long-run)
qe
Firms
output
Qe = neqe
Market
output
Figure 5.5: Long-run equilibrium

a) pe = M C (q e ) pSD
b) Market clears, nq e = D (pe ).
c) Zero profit condition, pe = AC (q e ), so that there is no incentive to exit or
enter this market.
3. Short-run equilibrium above is not a long-run equilibrium. Given the price, the
profit can be made by an investor, hence fresh entry occurs. Entry increases
(shifts) the short-run supply. This pushes the price down and ultimately eliminates profits.
4. So what is the long-run equilibrium? Note that the conditions tell us that
AC (q e ) = M C (q e ) = pe . In other words: There is only one price that does not
give any opportunity for firms to compete by lowering the cost, i.e. min AC.
Otherwise, either losses are made or profits could be made. This gives us a
simple algorithm to find the long-run equilibrium (see Figure 5.5):
a) Set price pe = min AC.
b) Set the individual quantity, q e , so that AC (q e ) = pe .
c) See how much quantity will be demanded for price pe , i.e. find D (pe ).
d) Determine how many firms ne must be active on the market so that quantity demanded equals quantity supplied, D (pe ) = ne q e .
Remark: In the long-run, the prevailing price is the lowest conceivable, by free entry.
Remark: One may consider a market where entry/exit is restricted. It could still be
called competitive, because the agents are price-takers.
36
5.5 Exogenous shock; comparative statics
Individual Firm
Market
MC
S (Short-run)
AC
p*
AVC
pe
qe q*
Firms
output
Qe = neqe neq* Market

output
Figure 5.6: Exogenous shock and short-run adjustments

Remark: Firms may not be identical. If some firms have an access to better technologies or to cheaper resources (lower AC curves) than others (or if entry
is restricted) then these firms may have positive profit permanently. In
such a case, the profit would often be called economic rent rather than
economic profit, and would be attributed to access to better resources,
technology or to industry with limited entry.
Remark: More to come later, when we consider firms with more than one variable
input.
5.5 Exogenous shock; comparative statics

Consider Figure 5.6, which shows a market in LR equilibrium. The price is pe ,
individual quantity is q e , and number of firms is ne . Suppose that a close substitute
becomes more expensive so that the demand for this good increases.
5.5.1 Short-run adjustments

There is an excess demand at price pe , thus the price is bid up. Higher price does
two things:
it induces firms to increase the quantity supplied according to their supply
function M C (), so that the total quantity supplied increases,
it convinces consumers to reduce the level of quantity demanded.
Eventually, price p equilibrates the market, firms produce q .
37
Individual Firm
Market
MC
S (Short-run)
AC
p*
AVC
pe
qe q*
Firms
output
neqe neq*
n*qe
Figure 5.7: Long-run adjustments
5.5.2 Long-run adjustments

Price p cannot be a part of long-run equilibrium because it is higher than min AC,
so that profit can be made by new entrants. New firms enter and the market supply
increases, n goes up. Price goes down and individual quantity decreases according to
the M C (). Eventually, the price is pe , each firm produces q e . New number of firms
is n .
5.6 Elasticity
It is important to know how much quantity responds to a change of price for both
demand and supply. Thus we need a measure of responsiveness of demand and supply.
Consider Figure 5.8. The (inverse of) slope of demand could be one measure,
q/p. But much better measure is price elasticity of demand - the percentage
change of quantity demanded related to the percentage change of price,
=
%q
q/q
q/p
=
=
%p
p/p
q/p
Example: suppose that if the price goes up from 1000 to 1010, then the quantity
demanded falls from 50 to 47.5. Then %p = 10/1000 = 1%, while %q =
2.5/50 = 5%. Therefore, the elasticity is 5%/1% = 5.
Observation: elasticity has no units, as opposed to slope. Hence, it is irrelevant
whether one uses versus , or liters versus pints (which is not the case for the
slope).
Perfectly elastic demand = ,
38
5.6 Elasticity
price
Demand
p
p
Quantity
Figure 5.8: Elasticity

Elastic demand < 1,
Unit elasticity demand = 1,
Inelastic demand > 1,
Perfectly inelastic = 0.
Elasticity can be defined for any behavioral function.
5.6.1 Expenditures/Revenue and elasticity

Total consumers expenditure (and firms revenue) is E = pq. If the price goes up,
then there are two offsetting effects, p and q . Fact: if demand is inelastic > 1
then total E goes up (as price increases), otherwise it goes down. Graphically, E is
the shaded rectangle on Figure 5.9
5.6.2 Tax incidence and elasticity

How does it depend on price elasticity of demand/supply?
39

price
price
Demand
(inelastic)
Demand (elastic)
Quantity
Figure 5.9: Expenditure
40
Quantity
6 Normative properties of
competitive equilibria
6.1 Measure of agents welfare
In this presentation we will use the utilitarian criterion (Pareto efficiency with transfers), see week 2.
1. Consumer surplus (CS) the difference between what a consumer is willing

to pay and what she actually pays. This CS is a measure of consumers (and
consumers) welfare. Remark: Our original measure of consumers happiness is
some abstract utility. Consumer surplus is exactly the same as utility if utility
is measured in monetary units comparable across agents.
2. Producer surplus (P S) the difference between the price that the firm actually
gets and the minimum that the firm is must receiver just to cover the cost. P S
is our old friend operational profit.
3. Social Welfare or surplus (W ) the total of all surpluses in the economy, W =

CS + P S (+Gov Rev + all other surpluses other costs).
CS
p1
p1
Supply
PS
Demand
q
Figure 6.1: Measure of agents welfare
41
p
Supply
CS
pe
Demand
PS
qe
Figure 6.2: Social Welfare in competitive equilibrium

DWL
p
Demand
Supply
Supply
W
Demand
qe
qe
Units that should be

produced but were not.
Units that should not be

produced, but were.
Figure 6.3: Deadweight Loss
6.2 Competitive equilibrium and maximization of

social welfare.
Consider Figure 6.3 and suppose that the production is lower than in competitive
equilibrium q e . Then some units are not produced, even if they should, since they are
worth more to the consumers than the minimal amount needed to cover the variable
cost.
Suppose that the production is more than q e . Then some units are produced, even
if they should not, since they are worth less than the minimal amount needed to cover
the variable cost. Loss of social welfare relative to the maximum is called Deadweight
Loss (DW L)
42
6.3 Welfare Theorems
6.3 Welfare Theorems

This leads us to the observation that the competitive quantity maximizes social welfare. This is an example of one of the most celebrated results in all economics. The
First Theorem of Welfare Economics
Competitive equilibrium is Pareto efficient.
Competitive price plays a dual role here.
1. Firstly, it tells each consumer how much to demand and each firm how much
to produce. This informative role of prices is fundamental for welfare maximization.
2. Secondly, they divide social welfare into parts (CS and P S, in this case).
However, we know that there are many Pareto efficient allocations; some may be
more desirable than others. It turns out that, even if you do not like this division
of social welfare, you may still use prices in their first role, at least theoretically.
The Second Theorem of Welfare Economics states that, if the assumptions of perfect
competition are satisfied and the economy is convex, then
Any Pareto efficient outcome can be achieved by competitive prices, given the
appropriate initial transfers of surplus.
Remark: Transfer here is a theoretical possibility. For all practical reasons, transfers involve distortionary taxes and hence result in some DW L. But still,
DW L from a well-designed tax system may be lower than the loss associated with price manipulation.
Remark: The term invisible hand, coined by Adam Smith in XVIII century, is
interpreted today as a prequel to the First Welfare Theorem. But formally,
both theorems were proven in their full versions barely 60 years ago.
Remark: There have been attempts to replace price system with a central planner (Soviet Union, Eastern Europe and other places). There are two big
failures of a central planner.
1. Is the government benevolent? It may be autocratic. Even if not, the
central planner - like any bureaucracy - is corruptible.
2. Is the government omniscient, and then is it omnipotent? The problem of allocation is fabulously complex.
And this attempt was just to replicate the working of a price system that
solves for Pareto efficient allocations automatically and instantly.
43

p
Supply
Min p
pe
A
B
D
C
E
Demand
q1
qe
Figure 6.4: Price floor

Lets recall the definitions
Pareto efficient outcome
Some social/central planner dictates
the quantities in order to maximize
the utilitarian social welfare. She must
be benevolent, omniscient and
omnipotent
Competitive outcome
Nobody dictates anything.
Price-taking economic agents behave
egoistically according to their
individual incentives (and according to
the postulates of perfect competition)
6.4 Applications
Assessment of policies. Two examples
6.4.1 Price floor

Prices lower than a certain minimum price are declared illegal. See Figure 6.4.
No price floor: CS = A + B + C, P S = D + E, W = A + B + C + D + E.
Price floor: CS = A, P S = B + D, W = A + B + D. DW L = C + E.
Remark: whenever there is excess supply or demand, in principle we need to specify
a rationing rule. Here we assume that the rationing rule says that the
goods go to those who value them most from these who can produce them
the cheapest. With alternative assumptions we would obtain even bigger
DW L. E.g. if there is a queue, time is lost, or if the firm with higher cost
gets to sell before the firm with lower cost.
44
6.4 Applications
p
Supply
p`
pe
A
B
E
C D
F
G
q1
qe
Demand
q2
Figure 6.5: Price support

Remark: if B > E then producers gain from the price floor relative to no intervention. However, by the Second Welfare Theorem, we can still improve the
situation of the producers without creating DW L. Just take the sum of B
from consumers and transfer it to the producers, and then let the prices
work in an unrestricted way. As the result CS = A + C, P S = B + D + E,
and both producers and consumers are happier than with price floor. Prices
still play an informative role, but not a distributive role.
6.4.2 Price support

Consider Figure 6.5. Suppose that the Gov wants to support price p0 > pe by buying
excess supply q2 q1 from the producers (and then dumping it to the Ocean).
No price support: CS = A + B + C, P S = E + F , W = A + B + C + E + F .
Price support: CS = A, P S = B + C + D + E + F , Gov exp = C + D + F + G.
W = A + B + E G. DW L = C + F + G.
45
7 General equilibrium trade and

comparative advantage.
7.1 Introduction
So far we ignored the fact that changes on one market may influence other markets.
But such link may be relevant, because the changes on other markets may hit back
our original market. It is more correct to consider equilibrium on all markets simultaneously (general equilibrium). If one considers trade selling one thing in order
to buy another then general equilibrium approach is essential. This approach is a
workhorse of such disciplines as macroeconomics, finance, international trade, etc.
Circular model of economy (Figure 7.1) reveals the two-sided nature of every transaction.
People do not work to earn money, but to buy consumption goods
Likewise, investors do not invest to have profit
Countries do not export to have hard currency or gold, but to finance imports
Wage, profit, hard currency is only an intermediary

Market for
factors of
production
Factors of
production
(labour, capital,
land, etc)
Income versus Expenditures

Objective: according to preferences
Constraint: budget
Households
(Consumers)
Supply
Demand
Payments
for goods
and services
Payments (wage,
rental price of
capital, etc.)
Demand
Firms
Market for
final product
Goods
and
sevices
Supply
Cost versus Revenue

Objective: max profit
Constraint: technology
Figure 7.1: Circular model of economy
47
oranges
oranges
Robinson
50
50
10
10
90 apples
10
Friday
90 apples
10
Figure 7.2: Preferences and endowments

oranges
50
10
10
90 apples
Figure 7.3: Edgeworth box
7.2 Bilateral trade without production

Example: Suppose that initially Robinson has an endowment of 40 oranges and 10
apples, while Friday has an endowment of 10 oranges and 90 apples. Robinsons and
Fridays preferences are expressed in terms of indifference curves. See Figure 7.2.
1. Why trade may be beneficial?
Key observation: Robinson values apples a lot in terms of oranges (high
M RS), while Friday values apples a little in terms of oranges (low M RS).
Maybe, if Robinson gives up some of his oranges in exchange for some of
Fridays apples, then both would be happier. . .
Pareto improving redistribution and Edgeworth box. Any point in the
Edgeworth box shows a possible distribution of total endowment of 100
apples and 50 oranges. The gray area shows all combinations in which both
Robinson and Friday are better off than in initial endowment. Hence, a
Pareto improvement exists.
Conclusion: If at certain allocation the M RS are not equal across agents then
there exists mutually beneficial redistribution. M RS equal across agents a
necessary condition for Pareto efficiency.
48
7.2 Bilateral trade without production
oranges
Robinson
50
y
10
10
90 apples
Figure 7.4: Trading away from the endowment

2. Trade in competitive equilibrium.
The price as terms-of-trade, expressed not in money but in terms of other
goods. Consider Robinson: without trade he can consume everything
South-West of the endowment.
But suppose that he can sell y oranges in exchange for x apples.
Then he can consume everything on or below the blue line. In particular, he can reach a bundle on a higher indifference curve. The rate
y/x is a price of an apple in terms of oranges graphically this is a
slope of a budget line. Let p = y/x denote this prevailing market
exchange rate.
If this slope is steeper than Robinsons M RS at endowment (rather
than flatter), then Robinson would also trade to reach higher indifference curve, but now selling apples to buy oranges.
The only case when Robinson does not take advantage of trade is
when the slope of the budget line is exactly equal to M RS, where he
is already in optimal point.
As always in perfect competition, the price of apples, p, is taken by agents
as given, but it is endogenous in the model. Suppose it is too high, i.e.
budget constraint is too steep, then Robinson does not want to sell as many
oranges as Friday wants to buy shortage on orange market, oversupply on
apple market (see left panel on Figure 7.5). However, if the price is correct
then there is market clearing and thus the price-quantity configuration
forms a competitive equilibrium (right panel on Figure 7.5)
Remark: Observe that in equilibrium we have M RSR = p and M RSF = p.
But this implies that M RSR = M RSF . Hence, we have a decentralized trade that leads to a Pareto efficient allocation; this is a
general-equilibrium version of the First Welfare Theorem (competitive equilibrium implies Pareto efficiency).
49

oranges
oranges
50
50
10
10
10
90 apples
10
90 apples
Figure 7.5: Competitive equilibrium

Remark: This is still perfect competition, as both Robinson and Friday are
price-takers. The fact that we assume two agents is for convenience
only; there should be more for price-taking behavior to be justified.
Remark: This is general equilibrium - all markets are solved together.
We are only touching big issues here. Things to remember:
Pareto improvement generically possible.
Voluntary trade (leading to competitive equilibrium) possible.
This equilibrium picks up one Pareto efficient allocation.
All the above holds in a general equilibrium model of an arbitrarily big and
complex economy, under some mild assumptions.
7.3 Trade in the economy with production.

Comparative advantage
Example: If Robinson works only fishing, then he can catch 20 kilograms of fish
per day. Alternatively, if he works only collecting bananas, then he can collect 10
baskets of them. Obviously, he can split his day between these activities to get any
combination of these two. Friday is far more experienced. He can catch 30 kilograms
of fish or collect 30 baskets of bananas, or get any combination of the two. In addition
to these productivity, assume some preferences; Robinson and Friday want to consume
fish and banana in fixed 1 : 1 proportion.
Production Possibility Frontier (P P F ) describes what bundles can be produced.
Slope of the P P F is called Marginal Rate of Transformation (M RT ) because it says
how fish can be transformed into bananas. For instance, Robinson needs to give
up two kilograms of fish to get one more
of bananas. Without trade, Robin basket
son produces and consumes (bR , fR ) = 6 23 , 6 32 and Friday produces and consumes
(bR , fR ) = (15, 15). See Figure 7.6.
50
7.3 Trade in the economy with production. Comparative advantage

Fish
Robinsons PPF
1:1
Fridays PPF
Fish
1:1
30
20
MRT = 1
MRT = 2
10
30 Bananas
Bananas
Figure 7.6: Individual P P F
Joint PPF
Fish
50 MRT = 1
(25,25)
(30,20)
(21,21)
MRT = 2
40 Bananas
Figure 7.7: Joint P P F
1. Why trade may be beneficial? Suppose that Robinson
do not trade

and Friday
initially. Total production is (bR + bF , fR + fF ) = 21 23 , 21 23 . Question: Can
we Pareto improve? Consider the following maneuver:
a) Robinson gives up one basket of bananas, which allows him to produce 2
additional kilos of fish, i.e. (bR 1, fR + 2),
b) Friday produces one and a half baskets of bananas more by giving up one
and a half kilo of fish, (bF + 1.5, fF 1.5).
In total their production of bananas and fish increases by 0.5 unit each, so they
end up with (bR + bF + 0.5, fR + fF + 0.5). This is an authentic free lunch!
Formally, this is a Pareto improvement.
Terminology: Robinson has comparative advantage over Friday (but not absolute) in fish and Friday has comparative advantage over Robinson in bananas.
A fundamental observation is that generically everyone has comparative advantage in something!
51
Fish
Robinson
Fish
Robinson
produces
fish
30
Robinson wants
to sell fish for
bananas
20
2 1.5
10
1.5
Bananas
Friday wants to
sell bananas
for fish
Friday
produces
bananas
30 Bananas
Figure 7.8: Markets do not clear at price p = 1.5
2. Trade in competitive equilibrium. Question: Can Friday and Robinson trade

with each other, even if Robinson is less productive in both industries? Answer:
Yes.
Let us verify that the following is equilibrium. Let the price be p = 1. Given
this price, Robinson is producing only Fish (20 kilograms) and intends to sell
10 kilograms to Friday in exchange for 10 baskets of bananas. Hence, his
consumption is (10, 10). Given this price, Friday is indifferent among various
quantities of trade (His marginal rate of transformation is equal to the market
marginal rate of transformation, M RT = p). So he may as well produce 25
baskets of bananas and 5 kilos of fish and sell 10 baskets for 10 kilos of fish. He
ends up with consumption bundle (15, 15). To sum up: everyone is behaving
optimally given prices and markets clear.
Total production is (25, 25), which is the best point on the joint P P F .
Remark: we are only touching big issues here. Things to remember:
Pareto improvement generally possible even if one party is less productive
than others in all industries. It is the comparative advantage that matters.
Everyone has comparative advantage in something.
Voluntary trade at equilibrium price possible.
This equilibrium picks up a Pareto efficient allocation.
This is a general equilibrium analysis (even if the economy is tiny) because
markets of bananas and fish are interrelated; one cannot exist without the
other. This also shows that buying is just another side of selling; imports
are another side of exports, e.g. preventing imports hurts exporters, etc.
52
7.4 Example of general equilibrium analysis
7.4 Example of general equilibrium analysis

Figure 7.9 shows an example of trade-off. Draw in some indifference curves in the
top-right panel to see what is the best outcome. Suppose that fish industry becomes
more productive for every level of employment. What happens with the production
plan? Is water industry affected?
Production
function in the
fish industry
Fish
Production
Possibility
Frontier
(baskets
per capita)
100
50
50
100 80
Labour in
fish industry
Distribution of
labour between fish
and water industry
20
100
100
Labour in
water industry
Water
(barrels
per capita)
Production
function in the
water industry
Figure 7.9: Production function and Production Possibility Frontier
53
8 Public goods, externalities,

asymmetric information
The model of perfect competition is relatively tractable and in many cases reliable as
an initial approximation. We obtained a number of testable hypotheses. Now lets
discuss some of the situations where we cannot count on perfect competition. Goal
is as always two-fold: positive question how the system works, normative question
is the outcome good and can it be improved?
We will discuss:
1. Public goods, commons, free riding,
2. Externalities,
3. Imperfect information,
4. Market power of a monopoly,
5. Market power in imperfect competition, game theory.
8.1 Public goods

8.1.1 Types of goods.
Private goods discussed so far have the properties of rivalry and exclusion.
Rivalry one unit of a good cannot be consumed by more than one consumer.
Exclusion consumption of a good can be prevented by an owner.
A public good - one unit of this commodity can be consumed by many agents simultaneously, i.e. there is no rivalry. Pure public good - non-rivalrous and non-excludable.
A congestible common property is a good that is accessible to all, i.e. non-excludable,
but is not too public, i.e. there is some rivalry, thus congestible.
55
Rivalry
No rivalry
Exclusion
Private goods: apples,
flats, consulting your
GP, toll bridge (if
capacity is an issue).
Public goods with
exclusion: cable TV,
concert (if capacity is
not exhausted,
non-congestible)
No exclusion
Commons: public
roads, fishery, public
park. (if congestible)
Pure public goods:
national defense, law
enforcement, clean
air, lighthouse,
prevention of
infectious diseases
Table 8.1: Types of goods
8.1.2 Government and public goods.

Two ways to supply public goods in without governments involvement:
1. Paying before production, i.e. voluntary contribution (chipping in). But free
riding among contributors.
2. Paying after production. The good has to be at least excludable. Otherwise,
free riding of consumers on the supplier would be rife and it is possible that a
good is not provided by a private entrepreneur at all. But obviously excludability alone does not guarantee that the good will be provided by a perfectly
competitive market in efficient quantities (see natural monopoly, etc).
The question of public goods gives the classical explanation why governments, as a
force of coercion, are needed. Without forced taxation to finance public good - in
particular, pure public goods such as security - the society would have to do without
it.
8.2 Externality
An externality is present whenever an action of an agent (or a voluntary transaction
between a group of agents) affects another agents utility or profit, and the effect is
not mediated by prices. External effect is this extra benefit/cost and contrasts to
internal benefits/costs of agents who are voluntary participants of the transaction.
Competitive model incorporates effects mediated by prices.
8.2.0.1 Types of externality
One can talk about consumption externality (consumption generates externality)
versus production externality (production generates externality).
56
8.2 Externality
price
Positive externality
Private
Demand
Social
Valuation
price
Negative externality
Demand
MC
Social MC
External
cost
Private MC
External
benefit
qe
qW
q-ty
qW
qe
q-ty
Figure 8.1: Positive and negative externality

More importantly
Positive externality: effect is beneficial. True social valuation is the sum of two
components, private valuation, i.e. inverse demand, and external benefit. This
is illustrated on Figure 8.1. Competitive market quantity is qe , but socially
optimal level is qW > qe . Conclusion: goods with positive externality are
under-supplied by competitive markets.
Negative externality: effect is harmful. True social M C consists of two components, private M C and external M C, i.e. marginal damage. Competitive
market quantity is qe , but socially optimal level is qW < qe . Conclusion: goods
with negative externality are oversupplied by competitive markets.
8.2.1 Examples:
Positive: beekeeping, keeping garden tidy and house painted, education, R&D,
knowledge, charity (i.e. decreasing poverty), network externalities (such as
phone, face book, software standard, language), taking a flu jab, common
project, teamwork,...
Negative: pollution, CO2 emissions, chatter during class, deforestation, road
congestion, overfishing, overgrazing, unlicensed radio spectrum, crime (and
drugs that lead to crime), war, voting while not interested or informed, going out while having a flu, sneezing, unprotected casual sex.
Remark: Socially optimal level of pollution typically is not zero! It is just lower
than the competitive one.
57

Remark: Public good creates a positive externality say, if someone builds a lighthouse then all benefit from it. A person who uses public good without
paying is free riding.
8.2.2 Government and externalities

1. Direct controls such as quotas, industry standards, bans and price controls
2. Pigouvian approach - manipulating incentives. E.g. taxes (Pigouvian tax),
subsidies, tariffs. In fact, all policies that affect competitive quantities can be
used to bring competitive quantities closer to social optimum.
Remark: the Government does not often have enough information.
3. Coasian approach. The government may try to create ownership and markets
for externalities, to internalize them in prices. Coase Theorem property rights
and frictionless negotiations will bring the efficient quantities, regardless of
initial distribution of property rights.
For instance, suppose Robinson values smoking at +10 and Friday values
passive smoking caused by Robinson at 7 (negative externality); Pareto
efficient outcome (with transfers) is to allow Robinson to smoke. If we
establish property over air and guarantee unhindered negotiations then
this efficient outcome will be achieved for any distribution of property
rights. Consider two options:
Option 1: give air to Robinson; the outcome is that Robinson
smokes.
Option 2: give air to Friday; then Robinson buys the right to smoke
from Robinson for a price between 7 and 10 (say 8) and smokes. The
price is acceptable to both.
If Robinson valued smoking at +10 and Friday at 15, so that smoking
is not Pareto efficient, then again we would face two options and again
regardless of the option the outcome is efficient:
Option 1: give air to Robinson; then Friday buys the air from
Robinson for a price between 10 and 15 and enjoys breathing.
Option 2: give air to Friday; then Robinson dont smoke.
Remark: in real life, negotiations are not frictionless and often Friday and
Robinson would not come to a Pareto improving agreement. But, anyway,
maybe we should try to create markets for pollution and other externalities
and give up only if this is too cumbersome.
4. An example of a hybrid method: cup-and-trade (total quota with trading) etc
58
8.3 Asymmetric information
8.3 Asymmetric information

Broadly speaking there are two types of problems.
1. Unknown quality (unobserved type, adverse selection, pre-contractual asymmetric information). Some examples:
a) A seller knows the quality of the object for sale (say, a used car). A buyer
does not know it.
b) A job applicant knows her abilities, but the employer does not.
c) A buyer knows how much he is willing to pay; a seller does not know how
much she can ask for.
d) A mechanic knows if the car needs an engine replacement or just oil change,
but the owner may not know this.
e) A person knows her health, an insurer does not.
This is called adverse selection. Attempts to alleviate these problems: Signaling, screening, external expert, warranty, disclosure policy/requirements,
reputation. . .
2. Unobservable actions (moral hazard, contract theory, post-contractual asymmetric information). Some examples:
a) Employer can only partially observe the level of his employees effort. Employee can shirk. How to design the optimal contract?
b) Insurer cannot observe the lifestyle of an insured person, but this person
can engage in risky behavior after purchasing health or life insurance.
What is the optimal contract?
c) Managers actions are not fully observed by stock owners. Managers could
spend money on expensive jets or offices, and stock owners have no chances
of seeing if these expenditures are indeed profit-generating.
d) Firms collusion not fully observable by market regulating agency.
Attempts to alleviate moral hazard problems: profit-sharing and various other
incentive schemes (in the context of employment), co-payment and deductibles
(in the context of insurance), better monitoring, screening, reputation. . .
The central challenge: incentive compatibility (truth telling). A contract (mechanism, institution) is incentive compatible (induces truth telling) if all participants
have sufficient incentives to follow the provisions of the contract. Some examples of
mechanism that are not incentive compatible:
Centrally planned economies of former Soviet Union and Eastern Europe. Nobody had incentives to do what they are supposed to do: workers do not have
incentives to work, managers do not have incentives to lower the costs, etc.
59

A mechanism that says that we clean our kitchen just because we share it.
Nobody has incentives to stick to this contract. Rather, everyone would prefer
to free ride.
A mechanism that says that we give you insurance premium discount if you
declare that you do not smoke (without actual medical examination). Everyone
would say that they do not smoke.
Consider a scheme in which a student may study for free in exchange for a
fixed fraction of her future income (higher income tax). The hope is that high
earners will pay more to cover insufficient contributions of low earners. This is
not incentive compatible: those who are likely to earn a lot will not participate,
because they will prefer to take a standard loan and repay fixed interest and
principal later, rather than pay high income tax. But if the system attracts
only low income graduates, then it is not able to pay for itself.
Whoever designs a contract, scheme or creates an institution, must take this incentive compatibility constraint into account. That is, one must make sure that all
participants receive enough incentives to act as assumed in the contract.
60
9 Monopoly
9.1 Setup
Monopoly is a single firm producing a particular commodity. It can affect the market
price by changing the quantity; via the (inverse) demand function p (q). The tradeoff: either sell a lot cheaply, or sell little for a high price. This is the only thing that
is different from the previous analysis of a perfectly competitive firm in particular,
cost curves are not affected. That is, the firm is still perfectly competitive on the
input markets and derives its cost function in the same way as previously.
Market structures - monopoly and perfect competition as polar cases:
One firm
Monopoly
A few firms
Imperfect Competition
Oligopoly
Many firms
Perfect
Competition
Figure 9.1: Market structures
9.2 Profit maximization

The monopolist follows the same general rules as perfectly competitive firm. First
(i) output decision by the comparison of Marginal Revenue (M R) and M C.
M C < M R then q increases the profit
M C > M R then q increases the profit
M C = M R then a small change of q will not affect the profit: a candidate for
optimal production level.
Then (ii) shutdown decision shutdown if operational profit is not positive.
The twist is in Marginal Revenue. In the case of a perfectly competitive firm, M R
is equal to price. Not for the monopoly.
9.3 Marginal Revenue of the monopoly

As always, Marginal Revenue is a change of the revenue caused by a unit production
increase, M R = R/q. But now R = p (q)q. That is, the price that the monopoly
61
9 Monopoly
price
p(q1)
Initial Revenue
B
Demand
q1
q
q-ty
Figure 9.2: Marginal Revenue of the monopoly
can select, depends on the quantity that the monopolist desires to sell. Figure 9.2
presents the trade-off of the monopolist. If quantity increases from q1 by q, then
initial revenue goes up by area A because the monopolist sells more, but also goes
down by area B because the price must be lowered from initial price p (q1 ) by p < 0.
Rectangles A = q (p (q1 ) + p) and B = p q1 . Since R = A B, we have
M R = p (q1 ) + p + (p/q) q1 . If the change of production is small then p is
essentially zero and we ultimately have p (q1 ) + (p/q) q1 .
Comparison with perfect competition:
Change of the price

induced by the firms
increase of production
Area B
Marginal Revenue
Monopoly
Negative, p/q < 0
Competitive Firm
None, p = 0
There is one
M R < p (q1 )
There is none
MR = p
Table 9.1: Monopoly versus perfect competition
Table 9.2 presents a numerical example: First two columns describe the demand,
the third column describes total cost. The optimal production level is q m = 3 units
(where (i) M R is (almost) equal to M C and (ii) operational profit is not negative,
p (q m ) > AV C)
62
9.4 Graphical illustration

p
10
9
8
7
6
5
4
3
2
q
0
1
2
3
4
5
6
7
8
C
10
14
18
22
26
30
34
38
42
R
0
9
16
21
24
25
24
21
16
MR
9
7
5
3
3
-1
-3
-5
MC
4
4
4
4
4
4
4
4
AV C
4
4
4
4
4
4
4
4
Table 9.2: Numerical example
9.4 Graphical illustration

Choice: (i) Output decision find a candidate q m from M C = M R, then use demand
to see what price pm is acceptable to consumers. (ii) Shutdown decision verify that
operational profit is not negative, pm AV C.
price
MC
pm
AVC
Demand
qm
q-ty
MR
Figure 9.3: Monopoly decision graphically
9.5 Welfare properties of the monopoly.

1. The optimal behavior of the monopoly involves M C = M R < pm . That is, q m
is less than competitive outcome q e with the same cost structure. Hence, there
is DW L. Moreover, Consumer Surplus is lower than if the product is delivered
by perfect competition, because the price is higher.
63
9 Monopoly
2. The above social loss can in fact be greater, if firms actively spend resources
to become monopolies (for instance, lobbying). Such behavior is called rent
seeking.
price
pm
DWL relative to perf comp

Social Welfare of monopoly
MC
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00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000
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00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
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00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
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000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000
000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
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00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000 000
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00 00
AVC
Demand
qm
q
q-ty
MR
Figure 9.4: Welfare properties of the monopoly
9.6 Price discrimination.

Implicit assumption above: monopolist has to charge a single price for all delivered
units. It may be justified sometimes maybe in real world there is arbitrage: consumes who buy cheaper may resell to those who would be charged more. But if such
resale is impossible then the monopolist may be able to charge different prices to
different consumers or for different units. This is called price discrimination. Perfect
price discrimination is when the monopolist knows exactly how much each consumer
is willing to pay for each unit. Monopolist may then sell precisely q e units for the
price of the entire Social Welfare (first unit for a very high price, second for slightly
lower, etc. until the consumers valuation equals M C). Two consequences of such
perfect price discrimination:
Socially optimal production level is delivered q e , resulting in no DW L. . .
. . . but Consumer Surplus is zero, captured entirely by the monopolist via perfectly tailored prices.
9.7 Why monopolies exist?

Not only monopolies, but all firms with market power.
1. Cost Advantage. Consider the following exercise: Imagine a perfectly competitive market with free exit and entry, with AC that has Minimum Efficient Scale
roughly of the size of the market. Lets try to find the competitive equilibrium
64
9.7 Why monopolies exist?

according to our notes from week 5: we find that in the long-run the price must
be pe , because this is where AC has its minimum, and individual production
is equal to M ES. Then we proceed to find the equilibrium number of firms,
but this is where we realize that total quantity demanded is actually equal to
production of a single firm and we conclude that equilibrium number of firms
is ne = 1. This however contradicts our assumption that the number of firms
is so great that they all should take prices as given.
Conclusion: If M ES is large relative to the size of the demand, i.e. if firm
has economies of scale for all relevant production levels, then we have a natural monopoly. If the industry is characterized by economies of scale then the
structure with many firms will not be permanent the bigger one firm becomes
the more cost-efficient it gets, gaining advantage over competitors. Ultimately,
only one firm would survive. Examples:
power plants (say nuclear)
networks such as electricity, gas, water, rail,
intellectual property such as software, movies, music, books, new drugs
etc.
price
MC
AC
pe
Demand
MES
q-ty
Figure 9.5: Natural Monopoly

2. Government actions:
Patents or copyrights introduced to encourage scientific development and
artistic creativity.
As a result of barriers to entry to assure quality or standards medical
professionals, architects, academic titles, solicitors etc.
As a result of government procurement contracts, or to assure reliability
of deliveries national security, defense industry, energy supplies, food or
medicine stock, etc. (but here the demand side is not a price taker)
65
9 Monopoly
Selling licenses or rights to operate to obtain budget revenue.
Licensing, cartels or other less explicit methods due to lobbying, to protect
interests of some political/professional groups or outright corruption.
66
10 Oligopoly
10.1 Market structures
Monopoly and perfect competition are polar cases, but Imperfect Competition is the
most interesting.
One firm
Monopoly
A few firms
Imperfect Competition
Oligopoly
Many firms
Perfect
Competition
Figure 10.1: Market structures

Consider an industry with 2 firms, qi is the production level of firm i, and Q = q1 +q2
is the market quantity. Inverse demand is p (Q) = 2 Q = 2 q1 q2 , and cost is 1
per unit for both firms. Two polar cases (check yourself):
1. Monopoly (cartel) outcome: Qm = 0.5 and pm = 1.5,
2. perfectly competitive outcome: Qe = 1 and pe = 1.
10.2 Strategic behavior

If firm 1 increases its quantity q1 , then this affects
1. Her costs
2. Her revenue, in particular:
a) One more unit brings an additional revenue equal to the price of this unit,
b) In order to sell this unit, price may have changed and this affects the
revenue from all other units sold,
c) With the different behavior of firm 1, firm 2 may need to adjust its behavior, and this hits back firm 1. That is, a change in q1 changes market
quantity, price and then the problem that firm 2 faces. This may trigger
some change of q2 , and this affects back the market price that ultimately
affects firm 1.
67
10 Oligopoly
Effects (1) and (2a) are present in Perfect Competition. In addition to this,
the monopolist has to tackle effect (2b). Effect (2c) is only present in the
situation of Imperfect Competition. Notice that effect (2c) is very difficult to
crack conceptually. If the change of behavior of firm 1 triggers the change of the
optimal behavior of firm 2, then the same force works in the opposite direction.
Optimal behavior depends on beliefs that firms have about the behavior of their
competitors. But how about beliefs about beliefs that firms have about each
other, etc?
Question: Can we predict that some types of behavior will occur systematically?
Strategic situations like the above one are analyzed by non-cooperative game
theory. Recall the normal-form games from the first lecture.
10.3 Application: Cournot model of quantity

competition.
Problem of firm 2 is to maximize profit given behavior of firm 1, i.e. to let M C
equal to M R2 . Marginal Cost is equal one. Marginal Revenue of firm 2, given the
production level of firm 1, is M R2 = (2 q1 ) 2q2 . Hence optimality condition
M C = M R2 translates into 1 = (2 q1 ) 2q2 , so that the best response of firm 2 to
the given production level of firm 1 is q2 = 0.5 (1 q1 ). This is called best response
because it says what firm 2 should do if it believes that firm 1 chooses q1 .
Problem of firm 1 is entirely symmetric and its
best response to behavior of form
C C
2 is q1 = 0.5 (1 q2 ). Production profile q1 , q2 is a Nash equilibrium (or Cournot
equilibrium) if it satisfies both these conditions. Solution is q1C = q2C = 1/3. Total
market quantity is QC = 2/3 and market price is pC = 4/3.
We can see how market power gradually increases price, Producer Surplus and
Deadweight Loss and decreases market quantity, Consumer Surplus and Social Welfare.
10.4 Application: Bertrand model of price

competition.
Suppose that firms choose prices, and all consumers buy from less expensive supplier.
If prices are equal then they buy from randomly chosen supplier. Demand and cost
are like above.
Both firms choosing price 1 forms a Nash equilibrium (Bertrand-Nash), because:
Obeying the plan: profit is zero;
Deviation: choosing price lower than 1 will attract all consumers but the firm
will sell below costs; choosing price higher than 1 means that all consumers will
go to the competitor and nobody will buy from this firm.
68
10.5 Cartel
There is no profitable deviation if everybody is expected to stick to this plan.
10.5 Cartel
Cartel may be explicit when a number of producers sign a binding contract to restrict
production (like OPEC). Very often illegal in most developed countries. More interesting case is tacit collusion, where there is no communication or contract. Producers
understand and obey the rules of the cartel without explicit agreement. Cartels
are difficult to maintain because
1. each member of such cartel has incentives to cheat (play a best response), or
2. a new firm may try to enter.
But if firms interact repeatedly, then they may stick to the rules of collusion to avoid
future punishments (say, price wars). Tacit collusion is more difficult to sustain if
1. there is a threat of new entry,
2. there is a problem with detection of a player who cheats his partners in the
cartel (monitoring)
3. decision are infrequent or firms are impatient
10.6 Summary
While there is one model of Perfect Competition and one model of Monopoly, there
are a few different market forms of Imperfect Competition between these two polar
cases. Cournot, Bertrand and Cartel are three examples.
p
1
4/3
Monopoly, Cartel
Cournot
Perfect Competition, Bertrand
MC
Demand
2/3
Figure 10.2: Competition between two firms may lead to a range of outcomes
69

The last two sections are an elaboration on the firms problem in week 4.
11.1 Introduction to firms problem

11.1.1 Goal
Questions: how do competitive firms operate and make economic decisions? How do
their decisions depend on long-run and short-run perspective? Ultimately, we want
to derive producers supply.
11.1.2 Assumptions
Firms may be enormous in size and complexity, but we are going to assume that
1. They maximize profits, Profit = revenues costs, = R C.
2. The technology is given. For simplicity assume that the firm produces q units
of a single good or service, but uses two inputs, K units of capital, L units of
labor. Production function f , such that q = f (K, L), tells us what level of q is
created by the firm employing K and L units of inputs.
3. The firm is perfectly competitive, takes all prices as given: p price of final good,
r rental price of capital, w wage or price of labor.
11.1.3 The problem

Thus the firms decision problem may be written as Knowing all prices (that is p,
w and r), choose the level of production and employment (that is q, L and K) so
that the profit = pq (rK + wL) is the highest, given that inputs and output are
related through q = f (K, L).
11.1.4 Approach
This problem is complex, it involves finding three variables: q, L and K. Therefore,
we are going to divide it into two simpler steps.
71

1. Step 1 (cost minimization). Suppose that there is some desired level of final
output q. What is the cheapest way to produce this q and how much does it
cost? That is, what should K and L be to produce this desired q? This gives
us the correct composition of inputs, K (q) versus L (q), and the cost function
C (q) = rK (q) + wL (q).
Here is a new perspective on what is the short-run and long-run:
a) in the short-run (SR) capital is fixed, the only variable input is labor.
Hence, this step is trivial there is no substitution between K and L.
b) in the long-run (LR) both inputs are variable. This is where this problem
bites.
2. Step 2. (profit maximization). Step 1 tells us what the cheapest way to
produce any desired level of final product q is. But what should q be? As
previously this problem consists of two sub-steps: output decision and shutdown decision.
Remark: Confusingly, we use two notions of short-run/long-run. Previously, longrun meant only that firms could enter and exit freely, which was not allowed
in the short-run. The second meaning introduced in this section is that in
the long-run firms can change capital in additional to labor, while in the
short-run capital is fixed. Please do not confuse the two meanings. Generally speaking, the meaning of short-run/long-run has to be understood
from the context.
11.2 Production function

First, however, one has to introduce production function f .
11.2.1 One input (Short-run)

This is exactly the problem in week 4.
11.2.2 Two inputs (Long-run)

Two inputs capital is no longer fixed.
Isoquant is a set of all combinations of inputs that lead to the same level of output.
Shows flexibility that the firm has in substituting one input for another without giving
up output. Properties:
1. Isoquants slope down
2. Isoquants to the north-east represent higher output
3. Isoquants cannot cross
72
K
A, q = 100
K
D
q < 100
B, q = 100
L

Figure 11.1: Isoquants
4. For every point there is an isoquant that goes through it.
Slope of an isoquant - also known as the marginal rate of technical substitution of
labor for capital, M RT SKL = K/L, such that production is unaltered. Consider
a change A B as shown on Figure 11.1. This move can be divided into two steps,
ADB
If go A D then production goes down by around K M PK .
If go D B then production goes up by around L M PL .
Since total change of production is zero, then K M PK = L M PL . Or
M RT SKL =
M PL
M PK
Observation: If go A B then M PL goes down, and M PK goes up, both by the law
of diminishing marginal returns. Hence M RT S becomes flatter (as one moves to the
right along an isoquant).
11.2.3 Marginal returns

Recall the law of diminishing marginal returns. It is assumed to hold for all inputs
now.
11.2.4 Returns to scale

Increase K and L proportionately by a factor a > 1, and see what happens with the
product. If the product goes up by...
73

Marginal
returns to
labour
q = 10
q = 20
q = 10
q = 20 q = 30
Returns to
scale
q = 30
Fixed capital,
increase labour
Increase labour
and capital
proportionately
Figure 11.2: Comparing the two returns

... a exactly, then constant returns to scale,
... less than a, then decreasing returns to scale,
... more than a, then increasing returns to scale.
Note the difference between returns to scale and marginal returns to an input.
Remark: One may have a technology that has diminishing marginal returns to all
factors of production (as always assumed), but increasing returns to scale! Consider
so-called Cobb-Douglas production function q = AK a Lb where parameters a and b
are positive and less than 1 and parameter A is positive. Figure 11.3 shows such
function for A = 1/7, a = b = 0.75.
Diminishing marginal returns as indicated by a parallel slice for a fixed capital
= 20,
K
Increasing returns to scale, as indicated by a diagonal slice, where K = L.
74
Marginal returns to an
input
What is the extra product
generated by an extra unit
of one factor of production,
keeping all other factors
constant.
Law of diminishing
marginal returns always
satisfied by assumption
Returns to scale
How much output changes
if all inputs increased
proportionately
Depends on technology
one may have decreasing /
constant / increasing
returns to scale
Table 11.1: Comparing the two returns
Figure 11.3: Cobb-Douglas production function with increasing returns to scale
75

12.1 Short-run
Recall the cost curves in the short-run. Finding the cost function was easy, we had
to invert the production function. The law of diminishing marginal returns implies
increasing M C and AC.
12.2 Long-run
The question is: given q, what should the composition of K and L be, so that
Cost = rK + wL is minimal?
Isocost line - all combinations of inputs that are equally expensive: Cost = rK +
wL. Can be written as K = Cost/r (w/r) L. This is a line with vertical intercept
Cost/r and slope (w/r).
Optimality condition. Let us superimpose isocosts on isoquants (Figure 12.1).
Given isoquant q lets minimize cost. Point A is clearly not optimal because q units
can be delivered cheaper, by employing more capital and less labor. Point B is
optimal. Tangency, where the slope of an isoquant equals to the slope of an isocost,
or M RT SKL = w/r, or M PK /r = M PL /w.
Figure 12.2 shows graphically how the cost function emerges from the production
function.
Example continued
K
Lower
cost
K(q)
B
A
L(q)
Given q
L
Figure 12.1: Optimality in the long-run
77
K
C(q3)/r
C(q2)/r
Cost function
Expansion path
(correct composition
of capital and labour)
C(q3)
C(q1)/r
C(q2)
q3
C(q1)
q2
q1
L
q1
q2
q3
Figure 12.2: Cost minimization and the cost function

1. Now the production function has both
capital
and
labor
variable,
q
=
K L.
Believe it or not, but the M PK = L/2 K and M PL = K/2 L. This
means that the M RT S for this production function is K/L. Hence, the above
optimality condition gives us K/L = w/r, describing the correct composition
of factors of production (the expansion path).
2. To get optimal employment K (q) and L (q), one has to solve the system of two
equations (isoquant and q
tangency condition) q
with two unknowns (L and K).
This solution is L (q) = q r/w and K (q) = q w/r.
3. To get the cost function just check how
much the above solution costs C (q) =
rK (q) + wL (q); we obtain C (q) = (2 rw) q. Recall that w = 2 and r = 800,
so that C (q) = 80q.
12.2.1 Short-run and long-run comparison

be the optimal capital for output q , and let this K
be fixed in the short-run.
Let K
in the subscript to indicate that this is the short-run for this level
Notation: put K
of capital; add SR or LR to make clear which cost is which.
Observation 1: Average Costs, LRAC (q ) = SRACK (q ) and LRAC (q) SRACK (q).
Observation 2: Marginal Costs, LRM C (q ) = SRM CK (q ) and LRM C (q) is flatter
around q than SRM CK (q) .
12.2.2 Economies of scale

As we said before, SRAC is ultimately increasing, by law of diminishing marginal
returns to a variable input. But in the long-run, all input can change, so there are no
78
12.2 Long-run
K
q1
SRAC
q* q2
SRMC
LR path
LRMC
SR path
LRAC
q1
q*
q2
Figure 12.3: Short-run and long-run cost curves
a priori reasons for LRAC to be increasing. LRAC decreasing economies of scale,

LRAC increasing diseconomies of scale, LRAC constant no economies of scale.
This concept is related to returns to scale (but not equivalent) increasing returns
to scale in the production function imply economies of scale in the cost function, but
are not implied by.
Summary:
Short-run: SRACK and SRM CK are upward sloping eventually (by law of diminishing marginal returns to a variable input, labor in this example). Subscript
K denotes level of capital that is fixed in this short-run sometimes
called scale of operations or plant size. Figure 12.4 shows only three
examples of short-run costs, for capital levels 1, 2 and 3. There are many
more in between.
Long-run: LRAC may slope upward, downward, be constant, or change its slope.
However, U-shaped LRAC is typical for competitive firms. The minimum
quantity at which LRAC reaches its minimum is called the Minimum Efficient Scale, M ES, or full capacity.
79

U-shaped LRAC
SRAC1
SRMC1
SRAC2
SRMC3
LRAC
SRAC3
SRMC2
Firms output
Economies of scale MES
Diseconomies of scale
Figure 12.4: Cost curves
12.3 Equilibrium conditions revisited
All the previous equilibrium conditions hold, but there are new ones. In the sort-run,
for some fixed K, it is possible to have LRAC < SRACK . But in the long-run,
we must also have LRAC = SRACK , for if not, the firm would adjust K to reach
a lower average cost. Likewise, at the equilibrium price p = LRM C = SRM CK .
Observation 2 now leads to an important implication: individual supply curve of the
firm is flatter in the long-run.
80
12.3 Equilibrium conditions revisited
SRMCK
pe
SRACK
LRAC
LRMC
qe
Figure 12.5: Long-run equilibrium (with restricted entry)
81

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ECON1001

3 Preferences, constraints, choices.

5 Market equilibrium. Exogenous shocks and comparative statics.

7 General equilibrium trade and comparative advantage.

6 Normative properties of competitive equilibria

Trade in the economy with production. Comparative advantage . . .

8 Public goods, externalities, asymmetric information

12 Costs (many variable inputs)

11 Production (many variable inputs)

1 Introduction - positive statements

1.2 Examples (using simple game-theoretic setup)

1.2.1 Prisoners Dilemma

1 Introduction - positive statements

Table 1.1: Prisoners Dilemma (years in prison)

Confess-Confess is a Nash equilibrium.

Table 1.2: Standards

(S1,S1) is a Nash equilibrium, because if everybody is expected to select S1, then

1.2.3 Entry game

1.3 Do economists think that free markets are the best?

1.3 Do economists think that free markets are the

1.5 Scientific method in economics

1 Introduction - positive statements

1.5.1 Economic model

1.5 Scientific method in economics

1.5.2 How are models used?

2.1 Basic assumptions

2 Introduction - normative statements

2.2 Ordinal utility and Pareto efficiency

Is this outcome Pareto Efficient?

Table 2.1: Pareto efficiency

Pareto efficiency is a minimal requirement on what we would think is a right

2.3 Utility Possibility Frontier

Figure 2.1: Utility Possibility Sets and Frontiers

2.3 Utility Possibility Frontier

2 Introduction - normative statements

2.5.2 Equity of outcomes

2.5.3 Equity of opportunities

3 Preferences, constraints, choices.

Figure 3.1: Plan

3 Preferences, constraints, choices.

Figure 3.2: Indifference curves, A B

3.1.2 Indifference curve

Figure 3.3: Shape of indifference curves

Subjective substitution between goods. Consider a change depicted on Figure 3.3:

a strictly higher utility than B. Suppose one has utility u (x1 , x2 ) = x1 + x2 ,

3.1.4 Marginal utility

3 Preferences, constraints, choices.

Marginal Utility, M Uapple

Table 3.1: Marginal utility

3.2 Budget constraint

Figure 3.4: Budget constraint

Figure 3.5: Optimal choice

3.4 Comparative statics

3 Preferences, constraints, choices.

Engel curve for

Engel curve for

Figure 3.6: Derivation of Engel curve

3.4.2 Change of price - individual demand

3.4 Comparative statics

Figure 3.7: Derivation of demand

Figure 3.8: Demand curve and its shift

3 Preferences, constraints, choices.

3.4.3 Income and substitution effect

3.4.4 Incentives in general