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# ECONS 301 - INTERMEDIATE MICROECONOMICS

LECTURE NOTES

Felix Munoz-Garcia
1

School of Economic Sciences
Washington State University

This document contains a set of partial lecture notes that are intended to serve as a
starting point when coming to class, so every student can complement them with
additional examples, exercises and applications discussed in class. (Do not quote).

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103G Hulbert Hall, School of Economic Sciences, Washington State University, Pullman, WA 99164-6210.
e-mail: fmunoz@wsu.edu. Tel. +1-509-335-8402.
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## EconS 301 Intermediate Microeconomics

Chapter 2 Demand and Supply Lecture notes
In chapter 2 we deal with demand and supply analysis in perfectly competitive markets. Perfectly
competitive markets consist of a large number of buyers and sellers. In competitive markets, the
transactions of any individual buyer or seller are so small in comparison to the overall volume of the good
or the service traded in the market that the buyer or seller essentially takes the price set by the market.
Therefore, we consider this the perfect competition model as a model of price-taking behavior.
Demand Curve:
Market Demand Curve: A curve that shows us the quantity of good that consumers are willing to buy at
different prices.
For instance, in the graph below, the demand curve shows us the amount of corn a buyer would
be willing to buy at different prices.

This illustration brings us to a crucial law in economics, the Law of Demand
Law of Demand: The inverse relationship between the price of a good and the quantity demanded, when
all other factors that influence demand are held fixed. This law is intuitive, as a higher price will make
consumers less willing to purchase that good. With almost all goods, the consumer will behave in this
manner, treating price and quantity demanded as inversely related.
A demand curve will take the form . . .
Q = a bP where a = vertical intercept, and b = slope
Rearranging and solving for P, we get
2

P = (a/b) (Q/b)
This is the Inverse Demand Curve, which is simply the demand curve where P = some function of Q
Example:
Demand: Q = 100 -2P
Inverse Demand: P = 50 (Q/2)
The vertical intercept is therefore 50 and represents the Choke Price, or the price at which
consumers of the product will not desire any of the good.
The horizontal intercept is therefore 100, and represents the amount of the good the consumer
would want to purchase at a price of 0.

Or more generally
Demand: Q = a bP
Inverse Demand: P = (a/b) (Q/b

ChokePrice
3

Supply Curve
Market Supply Curve: A curve that shows us the total quantity of goods that their suppliers are willing
to sell at different prices.

Example:
Supply Curve: Q
S
= 0.15 + P
a) Supply of wheat if P = \$2 Q
S
= .15 (2) = 2.15
P = \$3 Q
S
= .15 (3) = 3.15

b) Sketch the supply curve
Q
S
= 0.15 + P and solving for P, we get P = Q
S
0.15
So the slope = 1 (coefficient of Q
S
)
Intercept = -0.15

4

Equilibrium
As you might guess, the market equilibrium in a perfectly competitive market is the intersection of the
supply and demand curves. That is, in equilibrium, a perfectly competitive market will set a price and
quantity such that there is no excess supply and no excess demand, hence demand equals supply.
Example:
Demand Curve: Q
d
= 500 4P
Supply Curve: Q
S
= -100 + 2P
a) Let us sketch these curves on the same graph with quantity on the horizontal axis and price on the
vertical axis.

Inverse Demand Curve P = (500/4) (Q
d
/4)
Inverse Supply Curve P = (Q
S
/2) + 50

b) At what price and quantity do you reach equilibrium?
Q
S
= Q
d

500 4P = -100 + 2P
600 = 6P
100 = P
And then take this p=100 and plug it into either the demand or supply curve to find the
equilibrium quantity
Q
S
= 500 4(100) = 100

And so, equilibrium occurs at p=100 and Q=100
An Increase in Demand, for any given price

WhenP=0,Q
d
=5004.0=500
5

An increase in demand as the one depicted about can originate from an increase in income, or in
consumers preference for the good. For any given price, the quantity that consumers demand has now
gone up. You can visually see that by extending a long horizontal dotted line which maintains your focus
on a given (fixed price). The point where the dotted line crosses each demand curve represents the
quantity demanded.

A decrease in supply, for any given price

6

A decrease in supply might originate from an increase in production costs, which lead producers of the
good to supply lower amounts of the good at any given price. [Follow similar graphical representation as
above]

Example: Market for Aluminum
Q
d
= 500 50P + 10I where P=price and I=income
Q
S
= -400 + 50P
a) Equilibrium when I = 10
Plug in I=10 into Q
d
to get Q
d
= 500 50P + 10(10) = 600 50P

Now equate Q
d
to Q
S
,
600 50P = -400 + 50P
1000 = 100P
10=P
Q
S
= -400 + 50(10) = 100
b) Equilibrium when I = 5
Plug I = 5 into Q
d
to get Q
d
= 500 50P +10(5) = 550 50P

Now equate Q
d
to Q
S
,
550 50P = -400 + 50P
950 + 100P
9.5 = P
Q
S
= -400 + 50(9.5) = 75

Summarize

Supply
P=10
P=9.5
100 75
P
Q
7

## A change in both the demand and supply curve

A decrease in demand and an increase in supply:
Unambiguously produce a reduction in the equilibrium price; but

the effect on the equilibrium quantity is more ambiguous. In the figure, the outward shift in the
supply curve dominates the inward shift in the demand curve, producing an overall increase in the
equilibrium quantity. Otherwise, the equilibrium quantity would decrease.

Price Elasticity of Demand
The price elasticity of demand measures the sensitivity of the quantity demanded to price changes.
Price Elasticity of Demand: A measure of the rate of percentage change of quantity demanded with
respect to price, holding all other determinants of demand constant. Or, it is the percentage change in
quantity demanded (Q) brought about by a 1% change in the price.
e
,P
=
% cbongc in
% cbongc in P
=

P
P
=

Example:
When P=10, quantity is Q=50
When P=12, quantity is Q=45 (So Q = -5)
e
,P
=

=
-S
2

1u
Su
= -u.S
Remember, (P/Q) represents the initial price and quantity
8

Why is the elasticity of demand always negative? Because (Q/P) is the slope of the demand curve,
which is negative by the law of demand and (P/Q) is always positive because neither P nor Q can ever be
negative.

Example
Lets find the elasticities for different prices along the demand curve Q = 100 2(P), first when
o A) P=40, so Q= 20
o B) P=25, so Q= 50
o C) P=10, so Q= 80
Remember, the demand curve is in the form Q = a bP, so the elasticity equation is
d
= -b (P/Q)
A)
d
= -2 (40/20) = -4
B)
d
= -2 (25/50) = -1
C)
d
= -2 (10/80) = -(1/4)
Vertical Intercept:

d
= -2 (50/0) = -
Horizontal Intercept:

d
= -2 (0/100) = 0

Elasticity of demand in the linear demand curve, Q = a-bP

9

Usual mistake: say that the price-elasticity of demand is equal to the slope of the demand curve. NO!
We just saw that a demand curve with a constant slope (-b) can have different price-elasticities of
demand, depending on the price at which the elasticity is evaluated.
Why do we make things so difficult? Wouldnt it be easier to simply talk about the slope of the demand
curve, rather than the price-elasticity? The reason we use price elasticity of demand (and not simply the
slope of the demand curve) is because by using the former we can produce a unit-free measure of how
sensitive is the demand curve to changes in prices. Indeed, note that units cancel out when you use the
formula of price-elasticity of demand, but they wouldnt if you were simply using the slope of the demand
curve.

Different Types of Elasticities of Demand
As we have seen, elasticities show us how one component of a demand equation changes with another
component. So far we have only compared how quantity demanded varies with price, in order to see how
price sensitive certain commodities are. This analysis, however, can be extended to compare more than
just quantity with price. As we will show, we can compare changes in quantity with changes in income, or
even with the price of other goods.
Constant Elasticity Demand Curve: A demand curve of the form Q = aP
-b
where a and b are
positive constants. The term b is the price elasticity of demand along this curve.
If we take the derivative of Q with respect to P, we can see that the elasticity is simply the b
exponent
Income Elasticity of Demand: The ratio of the percentage change in quantity demanded to the
percentage change in income, holding price and all other determinants of demand constant.
e
,I
=

I
I
onJ rcorronging e
,I
=

I
I

Cross-Price Elasticity of Demand: The ratio of the percentage change of the quantity of one good
demanded with respect to the percentage change in the price of another good.
e

i
P
]
=

P
]
P
]
onJ rcorronging =

P
]
P
]

For example, research shows that a 1% increase in the price of the Nissan Seutra cause a 0.454%
change in the quantity demanded of the Ford Escort
Coke vs. Pepsi
10

Coke Pepsi
Price Elasticity of Demand
Q,P
-1.47 -1.55
Cross-Price Elasticity of Demand 0.52 0.64
Income Elasticity of Demand 0.58 1.38

SO a 1% in the price of Coke causes a 1.47% drop in the Q
d
of coke, but a 0.52% increase in the Q
d
of
pepsi. This shows us that they are substitutes, so as the price of one rises consumers will demand less of
that product and more of its substitute.

Price Elasticity of Supply
This is a very similar analysis to price elasticity of demand, except we are seeing how supply reacts to a
1% increase in the price. Simply, this elasticity will tell us how sensitive quantity supplied is to the price
of that good.
e

S
,P
=

S
P
P

S

Fitting Linear Demand Curves
Now that we know how a demand curve is constructed and how to use its various parts to analysis the
relationship between quantity demand, quantity supplied, and price, we can work backwards to actually
construct a demand curve. More simply, if we know the prevailing market Q and P and
Q,P
, we can have
all the components we need to construct the actual demand curve equation of Q
d
= a - bP
1)
Q,P
= -b(P/Q) So b = -
Q,P
(Q/P)

2) Q = a bP So

a = Q + bP
a = Q + (-
Q,P
(Q/P))P
a = Q + (-
Q,P
(Q))
a = (1 -
Q,P
) Q

1

## CHAPTER 3 - Consumer Preferences and Utility

Bundle (food, clothing)- each bundle/basket is represented by a point on the graph below.
There are three assumptions that must hold true in consumer preference theory.

Consumer preferences: These three preferences must hold true and
1. Complete ability to compare, either A >B or B >A, or A~B (in other
words the consumer has to state their preferences. Whether they prefer A over B, or B
over A or if they both make them equally happy.)

2. Transitive if A >B and B >C, then A >C (the choices that the consumer
makes must be consistent with each other. Explaining the symbols above, the consumer
prefers A over B, and B over C, such that the consumer should prefer A over C)
Example of non-transitive preferences: I would rather have two cookies than a glass of
milk. And I would rather have a glass of milk than a slice of pizza. However (puzzlingly)
I would rather have a slice of pizza than two cookies.
3. Nonsatiated (more is better)- a fairly easy concept to understand because a consumer
should prefer two hot dogs to one, and three hot dogs to two. As consumers we want
more.
Ranking Systems:
There are two type of ranking systems that the book references.
Rationality
2

1) Ordinal Ranking: allows us to gather information about the order in which a consumer
ranks a bundle. We can know that a consumer prefers basket A to B but not how much more
they prefer it.
2) Cardinal Ranking: allows us to answer the intensity at which a consumer prefers one
bundle to another. For example, I like basket A twice as much as basket B. It is usually hard
for consumers to articulate their intensity but both ranking systems are important to recognize.
Utility Function: measures the level of satisfaction from consuming different bundles. It
represents the consumers preferences. The unit of measurement is Utils, which does not have
a real life translation. Instead of considering the absolute or numerical value for the level of
satisfaction we compare relative values. For example, the consumer receives more utility from
consuming an orange than from consuming an apple. Different consumers may have different
utility functions. Thus knowing that John receives 5 Utils from consuming an apple and Jill
receives 6 Utils does not give us any useful information. If we knew John received 7 Utils
from consuming an orange we could say that John would prefer to consume an orange more
than an apple. But again we can only compare relative values. We can think of Utils as a
consumers level of happiness in consuming one good.
Lets begin with just one good, u(y)=(y)
1/2
. This utility function represents consumer
preferences that satisfy:
1) Completeness
For any A, B we have u(A) or u(B) that indicates either A >B, A <B, or A ~B.
2) Transitive
For example what if:
A=1, B=4, C=5, then u(A) = (1)
1/2
= 1
u(B) = (4)
1/2
= 2
u(C) = (3)
1/2
> 2
Thus if u(A) > u(B) and u(B) > u(C), then we have that u(A) > u(C).
Therefore the preferences are transitive because
if A >B and B >C then A >C
3) Non-satiation (more is better)
Indeed is satisfied since u(C) > u(B) > u(A)

3

Marginal utility: rate at which utility changes as consumption increases. Often thought of as, how
much better off we would be if we received one more of something. In mathematical terms as
you will see below, the marginal utility is the first derivative of the utility function.

MU
y
= du/dy = change in u/change in y
Each representation is equivalent.
MU
y
= u/y = U(y)/y

Example:
If u(y)=(y)
1/2
, then u/y = y
1/2-1
= y
-1/2
= (1/y
1/2
) = 1/(2 y
1/2
)

MU
y
(aty=4)=slopeofUaty=4

Diminishing marginal utility: additional units add less utility (U smaller and smaller) but we
will assume that U > 0 always. That is, more is always better, although it is not as good as the
last unit consumed.
There are three important points in mind when drawing total and marginal utility curves.
1) Total Utility and marginal utility cannot be plotted on the same graph, because the Y-axis
variable differs on each graph.
2) The marginal utility function is the slope of the total utility function.
3) The relationship between total and marginal utility holds for other measures in economics that
will be discussed later on.
For example: copies of the same DVD movie. When you get the first one youre very excited and
value the DVD movie greatly. When you get a second one youre not as happy because you
already own a copy of the DVD. The property that you receive less utility from the 2
nd
copy of
the DVD than the 1
st
copy and less utility from the 3
rd
copy than from the 2
nd
copy is called
diminishing marginal utility.

Is more always better?
More than one good
Example Utility function: U(x,y) = (xy)
1/2
= x
1/2
y
1/2

If x = 2, y = 8 then we plug into the utility function to find (28)
1/2
= (16)
1/2
= 4 utils.
In the 3D graph below points A, B, and C all represent the same level of utility
x = 4, y = 4 4 utils
x = 8, y = 2 4 utils
x = 2, y = 8 4 utils

5

MU
x
=U/x
y is held constant
= U(x,y)/x
y is held constant

MU
y
=U/y
x is held constant
= U(x,y)/y
x is held constant
This notation represents partial derivatives. When we take a derivative with respect to x we must hold y constant. For example if x is apples and y
is oranges. We would take a partial derivative with respect to x in order to find out how much utility increases from consuming one more apple.
We must hold the number of oranges consumed constant because consuming more oranges would also cause utility to increase.

Calculus example: Then
MU
x
=U(x,y)/x = x
-1/2
y
1/2
= 1/(2x
1/2
) y
1/2
MU
y
=U(x,y)/y = x
1/2
y
-1/2
= 1/(2y
1/2
) x
1/2
Learning-by-doing 3.1

U(x,y) = (xy)
1/2

1. Satisfies more is better?
2. Satisfies diminishing marginal utility?

1. More is better can be checked in two different ways:
a) Increase in x increase in U and increase in y increase in U
b) MU
x
> 0 and MU
y
> 0 for any x,y > 0
2. Diminishing marginal utility just tells us that the additional utility we get from
consuming amount of goods is smaller and smaller. The additional utility we get from
x
and MU
y
. So we notice that:
6

MU
x
is decreasing in x (x is in the denominator)
MU
y
is decreasing in y (y is in the denominator)
Mathematically we may take a derivative twice to check for diminishing marginal utility.
a) MU
xx
< 0 and MU
yy
< 0 for any x,y > 0

Indifference curves: curves connecting consumption bundles that yield the same level of utility.

Properties:
1) When the consumer likes both goods (MU
x
>0, MU
y
>0), indifference curves are
negatively sloped (Figure)
2) Indifference curves cannot intercept. They cannot intersect because if they did, then a
bundle could creat two different levels of utility which would destroy rational thinking.
In the Figure the ICs increase to the Northeast (upper right)
3) Every consumption bundle lies on one and only one IC (Figure)
4) ICs are not thick They are not thick because then it would violate the more is better
assumption if a bundle with more of one good and a constant amount of the other would
create the same utils.

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## MRS (marginal rate of substitution)

The rate at which a consumer will give up one good to get one additional unit of another
good, keeping his or her utility level constant. In our earlier example the consumer gets the same
utility from 4x and 4y as she does from 8x and 2y. This in the second situation shed be exactly
indifferent between a trade of 4x for 2y. In this situation we would say the MRS of x for y is 4 for
2, or 2 for 1, or just 2.

Graph depicting MRS

Moving along the curve we see if the consumer has a lot of good x she will trade a lot of good x
for a single unit of good y. In the same way if the consumer has a lot of good y she will trade a
lot of good y for a single unit of good x. This is known as diminishing MRS.
y/x is the rate at which the consumer is giving up y in order to get an additional unit of x.
MRS
x,y
= - slope of I.C. = MU
x
/MU
y

Totally differentiating

Diminishing MRS
Initially you are willing to give up many glasses of lemonade (y) for m additional
hamburgers (x). When you have few glasses of lemonade and many hamburgers you will not be
willing to give up as many (or none) glasses of lemonade in order to get an additional
hamburger.
8

Totally differentially x and y (since I am lowering y in order to get more of x), we obtain

-MRS=slope of Ind. Curve
MRS= -slope of Ind. Curve

ICs are bowed in toward the origin.

Application 3.2. Demand for attributes in cars
U(x,y) = (xy)
1/2
where x is horsepower
y is gas mileage
MRS
x,y
represents how a typical consumer will be willing to forgo horsepower x in order
to get an additional mile per gallon (y).
In 1969, MRS
x,y
= 3.79
u = MU
x
x + MU
y
y
MU
x
x = MU
y
y
MU
x
MU
y
=
y
x
9

In 1986, MRS
x,y
= 0.71
The decrease means that people became more willing to give up horsepower in order to
get an additional mile per gallon (y).

Learning-by-doing 3.3
U(x,y) = xy
MU
x
= U(x,y)/x = y
MU
y
= U(x,y)/y = x
a)
Draw the IC correspondingly to U
1
= 128
xy = 128 in many of its combinations
For example, G: x = 8 , y = 16
H: x = 16, y = 8
I: x = 32, y = 4

Does I.C. intersect either axis?
No, if IC intersects x-axis, then y = 0, U
1
= 0 128
y-axis, then x = 0, U
1
= 0 128
Does IC indicate that MRSx,y is diminishing?
Yes, since IC is bowed in toward the origin.
andconnectthem
10

Note that
MRS
x,y
= MU
x
/MU
y
= y/x so we more from left to the right (x), we get
smaller ratios, smaller MRS
x,y
(diminishing).
b) Similar, but for U
2
= 200
Not graded: Learning-by-doing 3.4. Increasing MRS
x,y

U = Ax
2
+ By
2
MU
x
= 2Ax
MU
y
= 2By

Special Utility Functions-There are certain goods that will create unique utility functions.
These functions are important to recognize because they will not always have diminishing
MRS, and it is important to check what type of utility function your working with.
Perfect Substitutes: Aquafina versus Dasani bottled water or Kingston versus Scandisk
memory sticks. Close substitutes: butter versus margarine or coffee versus black tea.
MRS
B,M
= MRS
M,B
= 1 but it can be any constant
Example
MRS=2Ax/2By=Ax/By,whichincreasesinx
MRS
x,y
=
MU
x
MU
y
=
2Ax
2Ay
=
Ax
By
, which increases in x
11

U = aB + aM, then MU
B
= a and MU
M
= a
Hence, MRS
B,M
= MU
B
/MU
M
= a/a = 1
Then , slope of IC = -1
Example: Pancakes and Waffles
U = P + 2W, MUp = 1 and MU
W
= 2
The consumer is always willing to trade 2 pancakes for 1 waffle.
MRS
P,W
= MUP/MU
W
= slope of IC = -1/2

Constant slope of IC- perfect substitutes will always have a linear indifference curve and
are the simplest to sketch.
Constant MRS (not diminishing as in previous examples)

Similarly, U = ax + by, MRS
x,y
= a/b

Perfect compliments left shoe and right shoe (consumer wants them in fixed proportions), or
two scoops of peanut butter to one scoop of jelly for the perfect PB&J sandwhich.
Example:
U = 10min(R,L)
12

G R = 2 and L = 2, then U
2
= 102 = 20
H R = 3 and L = 2, then U
2
= 102 = 20
(consumption choices should be at the kink)
Slope of IC (MRS) is:
Zero at the flat segment of the IC
Infinity at the vertical segment of the IC
Undefined at the kink of the IC (infinitely many slopes
Cobb-Douglas
U = (xy)
1/2
and U = xy are examples of Cobb-Douglas utility functions
Generally, U = Ax

y

if = = , then U = Ax
1/2
y
1/2
= A(xy)
1/2
if = = 1 and A =1, then U = xy

Properties:
1) MU
x
> 0 and MU
y
> 0. That is, more is better is satisfied
MU
x
= U(x,y)/x = Ax
-1
y

> 0 for any x
MU
y
= U(x,y)/y = Ax

y
-1
> 0 for any y
2) Since MU
x
> 0 and MU
y
> 0, then IC is downward slopping (recall property 1 of ICs)
[what about the case in which the consumer dislikes some goods, MU
x
< 0? Review
Session]
13

3) Diminishing MRS
x,y
:
MRS
x,y
= Ax
-1
y

/ Ax

y
-1
= / x
-1-
y
-(-1)
= / 1/x y = / y/x
The movements from left to right (x) will shrink this ratio, and reduce MRS
x,y

Diminishing MRS
x,y

Quasi-Linear preferences
Used in economic applications for situations in which the amount of a commodity (such as
toothpaste or garlic) doesnt change very much to income.
ICs are parallel displacements to each other

General form
U(x,y) = (x) + by (linear in y, but not generally linear in x)
where (x) is a function that increases in x, such as (x) = (x)
1/2
or (x) = x
2
.
where b > 0.
For example you make \$400 dollars and spend \$5 on toothpaste and \$395 on pizza. With quasi-
linear preferences if got a better job and made \$500 dollars you would still spend \$5 on
toothpaste and increase pizza purchases to \$495.

Sameslope,sameMRS
betweengoodsevenif
incomeincreases
14

Application 3.4

## Pet Rock Fad is not completely over

For more practice on derivatives see: APP. A3 and A4, pp. 690-695

Another way to find MRS
U = MU
x
x + MU
y
y
0 = MU
x
x + MU
y
y
-MU
x
x = MU
y
y
-MU
x
/ MU
y
= y/x
-MRS = slope of IC
or
MRS = - slope of IC

1

CHAPTER 4 Consumer Choice

Chapter 4 introduces us to consumer choice. That is, we are introduced to how consumers
choose between different bundles of goods in order to maximize their utility. As we will see,
this requires that we know not only consumer preferences but also the constraints that any
consumer is bound by, the budget constraint. Using both preferences and constraints we can
deduct which baskets a utility-maximizing will choose in a given situation between various
goods.

Preferences

Preferences tell us how a consumer ranks some bundle compared to another bundle, and the
utility function representation tells us how much utility a consumer derives from different
bundles. Remember also that from a utility function we can create our indifference map,
which will later be crucial in choosing an optimal bundle.

However, the bundles are not equally costly, and some may be unavailable at the
current prices and income.

Hence, in order to understand how a consumer chooses among different goods we need to
take into account both consumer preferences and budget constraint. Simply put, given that
a consumer faces a certain budget constraint (i.e. he or she only has so many resources by
which to attain goods), what bundle is the affordable and utility maximizing?

Budget constraint

The budget constraint defines the set of baskets that a consumer can purchase with a limited
amount of income. Graphically, the budget constraint will be represented by a specific region
on the graph where all bundles in that region are affordable.

To find the limit (outermost edge) of our budget constraint we must construct a budget line
(B.L.). The B.L. indicates all of the combinations of a given set of goods that a consumer can
afford to consume if she spends all of her money.

x food, p
x

y clothing, p
y

I income

Example: Lets use the example from the book where Eric is faced with the decision of
purchasing some combination of food and clothing. Let p
x
=price of food, p
y
=price of
clothing, and I=Erics income over the period.

Budget Line:
p
x
x + p
y
y = I
where
p
x
x total expenditure on food
p
y
y total expenditure on clothing
Combination of x and y
that the consumer can
entire income
2

p
x
= 20 , p
y
= 40 , I = 800

p
x
x + p
y
y I meaning the you can only spend as much money as you have
this is called the budget constraint (B.C.). Notice that both the x and y intercepts are simply
Erics income divided by the price of the good on that respective axis. Each intercept
therefore represents how much food or clothing Eric could consume if he were to spend his
entire income on that one good.

Slope of Budget Line (B.L.)

p
x
x + p
y
y = I

p
y
y = I - p
x
x

y = I/p
y
(p
x
/p
y
) x

Notice that this equation resembles the general equation of a straight line y = b + mx, where
b = vertical intercept , m = slope

Hence, the slope of the B.L. = (p
x
/p
y
) and indicates, when moving from left to right along
the budget line, how many units of y the consumer must give up to increase his consumption
of x in one unit. An easy way to remember the slope is simply as the negative of the price
ratio. But why is the slope negative? Because to get more of good x while staying on the
same budget line you must give up some of good y. If the slope were positive, you would be
getting more of good x by also getting more of good y, which intuitively doesnt make sense
when we are constrained by a budget.

Example
(p
x
/p
y
) = - 20/40 = -1/2, and the consumer must give up units of clothing (y) in order to
obtain an additional unit of food (x). This ratio is constant because prices are constant.

Income is the symbol for change in

Budget line
Unattainable at the current prices and income
p
x
x + p
y
y = 2020 + 4015 = \$1,000 > \$ 800
3

Unchanged slope since (p
x
/p
y
) = - 20/40 = -1/2
Hence, new B.L. is parallel to old B.L., but shifted outward. The set of available choices
increases with the increases in Income. Why is the B.L. still parallel after an increase or
decrease in income? Remember that the slope of the B.L. is the negative of the price ratio
between food and clothing. A shift in income has no effect on the prices of the two goods and
thus leaves the slope of the line unchanged.

p
x
What if the price of good x increases from 20 to 25?

The consumer must give up 5/8 units of y to obtain one more unit of x.

New slope = (p
x
/p
y
) = -25/40 = -5/8 since |-5/8 | > |-1/2 | , BL
2
is steeper than BL
1
. In this
case where prices are changed, the slope of the B.L. is inevitably changed as well, as shown
in the above graph. Now, to stay on the budget line as Eric moves from left to right, his
tradeoff between clothing and food is now occurring in a different ration than before the
change in the price of food.

4

What if both income and all prices are doubled? Intuitively it would seem that if both prices
and income double, the two effects would cancel each other out and Eric would be left no
better or worse off than before the change. Mathematically, this proves to be the case
Vertical intercept 2I/2p
y
= I/p
y

Horizontal intercept 2I/2p
x
= I/p
x

Slope = - 2p
x
/2p
y
= - p
x
/p
y

PUTTING PREFERENCES AND B.L. TOGETHER:

Having now identified what a consumer is constrained by when making a choice between
bundles, we can put together both his preferences and constraint to find the optimal bundle.
This process is central to intermediate micro and will come up time and time again
throughout the course, so lets learn it well

Optimal choice
Consumer choice of a basket of goods that 1) maximizes utility
2) is affordable (in the B.C.)

No points inside B.L. (utility could be increased)
No points outside B.L. (unaffordable)

Intuitively, an optimal consumption bundle will not only maximize a consumers utility, but
it will also be affordable. These very simple conditions are what we translate into
mathematical condition by which to discover the optimal bundle. Also note that a consumer
would not choose any bundle inside or outside of the budget line as his optimal bundle. Any
point outside the line would be unaffordable for the consumer, and any point inside the line
will not maximize utility because it would leave income to be spent which would further
increase his utility (remember that this consumer spends all of his income to maximize his
utility).

Here is our mathematical expression of the two conditions for optimization

Max U(x,y) reaches the highest I.C. max U(x,y) means x and y are the choice variables
x,y x,y
subject to p
x
x + p
y
y = I that still belongs to the set of affordable baskets(on or inside B.L.)

The 2s cancel out, thus no
element of B.L. changes
5

Looking at the above graph, why are other baskets not optimal?
D unaffordable (outside of B.L.)
C money unspent could increase our utility by spending it (generally, it could be
future consumption of the good, or savings)
B lower I.C. than at A (less utility at same cost)

Tangency condition at the optimum, A

We refer to the condition for the optimal bundle as a tangency condition. This is because at
the optimum bundle A the I.C. and the B.L. are tangent, that is, they have the same slope.
Knowing this allows us to simply express that optimum condition as

Slope of B.L. = slope of I.C. at A
(p
x
/p
y
) = - MU
x
/MU
y
= MRS
x,y
(remember MRS is the slope of I.C.)
p
x
/p
y
= MU
x
/MU
y

MU
y
/ p
y
= MU
x
/ p
x

Extra utility per dollar spent on y = Extra utility per dollar spent on x
Same BANG FOR THE BUCK spent across different goods.

The expression MU
y
/ p
y
= MU
x
/ p
x
tells us that at the optimum bundle A both the
marginal utility per dollar of good x and the marginal utility of good y are equal. So,
at this bundle each dollar spent on each good result in the same level of utility
received from consuming that good. If these marginal utilities per dollar were
different this bundle would not be optimal. Why is this the case? Because if one good
had a higher MU per dollar than it wouldnt make sense to consume that bundle. It
would make sense to consume more of the good with the higher MU per dollar, thus
increasing your utility, and thus changing the bundle.

6

Example

U(x,y) = xy
MU
x
= y, MU
y
= x
I = 800, p
x
= 20, p
y
= 40

B.L. 1) p
x
x + p
y
y = I 20x + 40y = 800
Tangency Condition 2) MU
x
/MU
y
= p
x
/p
y
y/x = 20/40 2y = x
Plug (2y=x) back into the B.L. equation so that we only have one
variable

NOTE: In an optimization problem where the MUs are both positive, the optimal bundle we
find at the point of tangency is referred to as an interior optimum. An interior optimum is
simply an optimal basket at which the consumer will be purchasing positive amounts of all
commodities.

Point B in the graph was not optimal since:
MU
y
/ p
y
= MU
x
/ p
x
y/20 x/40 16/20 8/40 0.8 0.2
In particular,
MU
y
/ p
y
> MU
x
/ p
x

x
Thus, spending less Money on y and more Money on x increases total utility (different
marginal utilities per dollar).

USING THE LAGRANGE MULTIPLIER METHOD OF CONSTRAINT
MAXIMIZATION IN THE CONSUMER CHOICE PROBLEM

Using the Lagrange method, we can mathematically show this tangency condition as the
optimal bundle. Here we again see that the optimal bundle is where MU
x
/P
x
=MU
y
/P
y
.

Max U(x,y)
x,y

subject to p
x
x + p
y
y = I

(x,y;l) = U(x,y) + l [I - p
x
x - p
y
y]

F.O.C.s:

/x = U(x,y)/x - lp
x
= 0 MU
x
/ p
x
= l (1)

MU
x

20(2y) + 40y = 800
80y = 800
y = 10
x = 2y = 210 = 20
7

/y = U(x,y)/y - lp
y
= 0 MU
y
/ p
y
= l (2)

MU
y

/l = I - p
x
x - p
y
y

= 0 (3)

From (1) and (2), we have MU
y
/ p
y
= MU
x
/ p
x
(same bang for the buck), and from
(3) we have the B.L.
These are the same two conditions we use to find optimal consumption choice for the
consumer.

More on maximization problems: APP.A5 pp.695-697
constrained optimization: APP.A7 pp.701-702
and Lagrange multipliers: APP.A.8 pp. 702-704

Example: Cobb-Douglas Utility

Here we use the Lagrange method with a Cobb-Douglas Utility Function.

U(x,y) = x
a
y
1-a

subject to p
x
x + p
y
y = I

(x,y;l) = x
a
y
1-a
+ l [I - p
x
x - p
y
y]

F.O.C.s:

/x = ax
a-1
y
1-a
- lp
x
= 0 ax
a-1
y
1-a

(1/x) = lp
x

MU
x
U(x,y)

aU(x,y) / xp
x
= l (1)

/y = (1-a)x
a
y
1-a-1
- lp
y
= 0 (1-a)x
a
y
-a
(1/y) = lp
y

MU
y
U(x,y)
(1-a)U(x,y) / yp
y
= l (2)
/l = I - p
x
x - p
y
y

= 0 p
x
x + p
y
y = I (3)

From (1) and (2) we have
aU(x,y) / xp
x
= (1-a)U(x,y) / yp
y
xp
x
/ yp
y
= a/1-a

Or alternatively, p
x
x = (a/1-a ) p
y
y

Substituting this result into (3),
8

(a/1-a ) p
y
y + p
y
y = I (1+ a/1-a ) p
y
y = I (1 - a + a/1-a ) p
y
y = I y = (1 - a) I/p
y

And similarly for x. Starting with p
y
y = (1-a/a ) p
x
x , and plugging it into (3),

(1-a/a ) p
x
x + p
x
x = I (1+ 1-a/a ) p
x
x = I (a+ 1-a/a ) p
x
x = I x = (I/p
x
) a

Budget shares
The proportion of total income spent on each good.

Budget share of x: p
x
x/I = p
x
(I/ p
x
a) / I = Ia / I = a
Budget share of y: p
y
y/I = p
y
(I/ p
y
(1-a)) / I = I(1-a) / I = (1-a)

Notice from an empirical point of view: if you observe a consumer spending a % of his
wealth on x and (1-a) % on y, you know his utility preferences function from consuming
these two goods.

Expenditure minimization problem (EMP) alternative way to think about optimality

This is simply another way to look at the optimization conditions. Whereas before we were
maximizing utility given a certain budget constraint, here we approach optimization by
minimizing expenditure subject to a certain utility level. This shows that the answer you
reach through the tangency condition is the cheapest bundle at a certain utility level. As you
can see with bundle A above, it is the least expensive and in fact the only affordable bundle
that reaches the utility level of U
2
. This approach is mathematically expressed as

Min Expenditure = p
x
x + p
y
y
(x,y)

Subject to U(x,y) = U(x,y) (given level of utility)

U(x,y) = x
a
y
1-a

Budget p
x
x + p
y
y
9

Min p
x
x + p
y
y
x,y
subject to U(x,y) = x
a
y
1-a

(x,y;l) = p
x
x + p
y
y + l [ - x
a
y
1-a
]

F.O.C.s:
/x = p
x
- l

ax
a-1
y
1-a
= 0 p
x
= lax
a-1
y
1-a

(1/x) =

U(x,y)

p
x
x

/ aU(x,y) = l (1)

/y = p
y
- l (1-a)x
a
y
1-a-1

= 0 p
y
= l (1-a)x
a
y
-a
(1/y)

U(x,y)
p
y
y/

(1-a)U(x,y) = l (2)
/l = - x
a
y
1-a
= 0 (3)

From (1) and (2) we have
p
x
x

/ aU(x,y) = p
y
y/

(1-a)U(x,y) (1-a)p
x
x = a p
y
y xp
x
/ yp
y
= a/1-a

Hence,
p
y
y= p
x
x (1-a)/a, or

y = (p
x
x/ p
y
) ((1-a)/a)

Substituting this result into (3), we obtain,

= x
a
[(p
x
x/ p
y
) ((1-a)/a)]
1-a
= x
a
x
1-a
[(p
x
/ p
y
) ((1-a)/a)]
1-a

Solving for x,

x = / [(p
x
/ p
y
) ((1-a)/a)]
1-a
= [(p
x
/ p
y
) ((1-a)/a)]
a-1

And similarly for y, we start from x = (a/1-a)( p
y
/ p
x
)y. Substituting it into (3). We have

= [(a/1-a)( p
y
/ p
x
)y]
a
y
1-a
= [(a/1-a)( p
y
/ p
x
)]
a
y
a
y
1-a

Solving for y,

y = / [(a/1-a)( p
y
/ p
x
)]
a
= [(a/1-a)( p
y
/ p
x
)]
-a

10

p
y
y = (1-a/a ) p
x
x , and plugging it into (3),

(1-a/a ) p
x
x + p
x
x = I (1+ 1-a/a ) p
x
x = I (a+ 1-a/a ) p
x
x = I x = (I/p
x
) a

Corner Points Solutions

So far we have been dealing with optimal bundles where the consumer purchases positive
amounts of all commodities (interior optimum). However, in the real world this is not always
the case. Many times a consumer will not consume a good at all, and thus, we need a way to
find optimal bundles in these situations. This search will take us to what we refer to as corner
point solutions: a solution to the consumers optimal choice problem at which some good is
not being consumed at all, in which case the optimal basket lies on an axis.

Example:

U(x,y) = xy + 10x
MU
x
= y + 10
MU
y
= x
I = 10, p
x
= 1, p
y
= 2

1) x + 2y = 10
2) MU
x
/ MU
y
= p
x
/ p
y
(y+10)/x = 2y + 20 = x

Attempting to find the optimal bundle via the tangency condition gives us a negative amount
consumed of good clothing. Since we can obviously not consume negative clothing, this
simply informs us that our optimal bundle is going to be where we consume 0 units of
clothing. This is a corner point.

Then, consumer wants to increase his consumption of x as much as possible. That is, the
consumer spends all his income in x, I/ p
x
= 10/1 = 10 , and no income in y.

(2y+20) + 2y = 10
4y = -10
y = -2.5 (NO!! y cannot be
negative, thus we have a corner
solution where y = 0)
x = 2y + 20 = - 5 + 10 = 5
11

The graph shows our corner solution where all income is spent on good x. In this situation,
the MU per dollar of food is always higher than the MU per dollar of clothing, so you will
this consumer will continually substitute clothing for more food until he reaches 0 units of
clothing (i.e. all his income is spent on food at bundle R).

Corner Points with Perfect Substitutes
What if a consumer is always willing to substitute clothing for food, but in a constant ratio?
This is a case of perfect substitutes. Instead of a curved I.C., the I.C.s will be straight line,
since the slope is constant.

MRS
choc.,vanilla
= MU
c
/MU
v
= 2 (constant MRS because of Perfect substitutes)
p
c
/p
v
> MU
c
/MU
v
MU
v
/p
v
> MU
c
/p
c
and as a consequence the consumer should

Once again, the MU per dollar for both goods is never equal, which will in turn lead the
optimal bundle to a corner point where 0 units of the less preferred good is consumed. In
other words, the consumer only likes chocolate ice cream twice as much as vanilla ice cream,
but vanilla ice cream is three times cheaper than chocolate ice cream.
p
c
/p
v
= 3

Dont confuse this Indifference
curve with B.L.
[What if price ratio was lower than
MRS? Then BL becomes flatter than
I.C., and the consumer buys only
chocolate]
12

Coupons vs cash subsidies

Occasionally governments and other institutions want to increase the consumption of a
particular good. They can do this by issuing coupons, which can only be spent on the good of
interest, or through cash subsidies, which are lump sum payments that can be spent on any
good (but which the issuer hopes will be spent on the good of interest).

To isolate the good of interest, say housing, we lump all other goods into a variable we refer
to as a composite good. A composite good is simple a good which represents the collective
expenditures on every other good except the commodity being considered.

Cash subsidies: B.L. moves from KJ to EG
Vouchers (coupon): B.L. moves from KJ to KFG

In the above graph, both methods of either issuing a coupon or a subsidy push the
consumer from I.C. U
1
to U
2
. Thus, both achieve the desired effect of raising housing
consumption to h
B
. However, this is not always the case. Notice that if the U
2
I.C.
was tangent to the segment EF, the coupon would not allow the consumer to move to
a higher I.C. while the subsidy would.

Joining a Club

You pay a lower price if you are a club member, however you must pay to join the club. Is
this trade off worth joining the club? Lets look at an example
I = 300
p
x
= \$20
p
y
= \$1

13

I = 300 100 (fee) = \$200
p
x
= \$10
p
y
= \$1

Before joining: I= 300, p
x
= \$20 I/ p
x
= 300/20 = 15 units
p
y
= \$1 I/ p
y
= 300/1 = 300 units

After joining: I = 300 100 (fee) = \$200, p
x
= \$10 I/ p
x
= 200/10 = 20 units
p
y
= \$1 I/ p
y
= 200/1 = 200 units
Flatter BL, and the consumer selects basket B.

Basket B is on a higher I.C. than basket A, and therefore this consumer is better off
after joining the club.

A similar analysis is applicable for
1) cell phone service (higher monthly subscription charge in order to have lower price
per minute in calls)
2) gym, golf club
Example:
Sprint Cellular in 2006
Plan A: \$ 30 monthly charge, 200 minutes, and \$0.10 beyond these minutes.
Plan B: \$60 monthly charge, 1,000 minutes, and \$0.10 beyond these minutes.

Drawing Plan A: income is \$120, but the consumer pays \$30 on monthly charge
200 first minutes are free, then the slope of BL is 0.1
If he didnt get free minutes, the highest amount of minutes he could
consume is 90/0.1 = 900, but he gets 200 min.for free = 1,100
MRT is the BL
A

14

Drawing Plan B: income is \$120, but the consumer pays \$60 on monthly charge
1,000 first minutes are free, then the slope of BL is 0.1
If he didnt get free minutes, the highest amount of minutes he could
consume is 60/0.1 = 600, but he gets 1,000 min.for free = 1,600
MRT is the BL
B

If the consumer were to spend all income on cell phone minutes he would choose Plan B to

Borrowing and Lending

So far we have considered the consumers income as fixed within a time period. However,
this is not always the case in the real world. As we well know as college students, consumers
can both borrow and lend money. Borrowing and lending is really a tradeoff in consumption.
In borrowing you consuming more today by consuming less tomorrow. In lending you are
consuming less today so that you can consume more tomorrow. But how does this affect our
optimization problem?

Without borrowing and lending consume I
1
today and I
2
tomorrow (as we have considered
thus far)
With borrow and lending
(allowing for)
If you dont consume anything today, then you have I
2
+ I
1
(1+r) tomorrow because
you lent some consumption today to be paid back with interest (1+r) tomorrow,
where r=interest rate earned by loaning the money
If you dont consume anything tomorrow, then you can consume:
I
1
+ I
2
/(1+r) today by borrowing

How to find a slope?
Our x-axis here will be consumption today while the y-axis will represent
consumption tomorrow
Intuitively, the price of giving up one unit of consumption tomorrow (y axis) in order
to gain one more unit of consumption today (x axis) is measured by the opportunity
costs of every dollar, (1+r).
How to prove it more formally?
We know that the B.L. is y = a + mx
y = I
2
+ I
1
(1+r) + mx

a
and, in addition, y = 0 and x = I
1
+ I
2
/(1+r) ,
Then ,
0 = I
2
+ I
1
(1+r)+ m( I
1
+ I
2
/(1+r))

m = [I
2
+ I
1
(1+r)]/-[ I
1
+ I
2
/(1+r)] = [I
2
+ I
1
(1+r)]/-[ (I
1
(1+r)+ I
2
)/(1+r)]

= - (1+r)[I
2
+ I
1
(1+r)]/ [I
2
+ I
1
(1+r)] = - (1+r)

15

A consumer with these preferences chooses to :
o Borrow today if C1B > I1
o Repay the loan tomorrow if C2B<I2

How can we draw the ind. curve of an individual that prefers to:
o Save today?
o Get the returns of his savings tomorrow?

By drawing ind.curve where the tangency point (optimal consumption) is above the
point of no-borrowing or lending (A)

WHAT IF THE INTEREST RATE FOR BORROWING AND LENDING DO NOT
COINCIDE?
Assume I
1
= 10,000
I
2
= 13,200

16

Example:

Lending, r
L
= 0.05
Next year he will have 13,200 from tomorrows income = 13,200
10,000 (1+0.05) from savings = 10,500
-----------------
23,700
(Vertical intercept, all of consumers income was consumed next year)

Borrowing, r
B
= 0.10
Today I can have : 10,000 from todays income = 10,000
13,200/1+0.10 = 12,000 = 12,000
--------------
22,000

Where is the I.C. of a saver? Tangency point at segment AE
Where is the I.C. of a borrower? Tangency point at segment AG

Quantity Discounts

Firms can also incentivize the consumption of a product by offering quantity discounts (i.e.
discounts after you purchase over a given number of units). In this case, the budget line for a
consumer will have a kink where the discounted price kicks in. Lets look at an example

p
y
= \$1
p
x
= \$11 for the first 9 units

How to find the vertical and horizontal intercepts in this case?
Vertical Intercept =

Slope = - p
x
/ p
y
= - 5.5/1
= -5.5
Slope = - p
x
/ p
y
= - 11/1 = -11
I
P
y
=
\$440
\$1
= 440
I
P
x
=
440
11
= 40
17

Horizontal intercept of BL
1
(no discounts) =

Horizontal intercept of BL
2
(with discounts) =

Notice that this consumer is better off with the quantity discount, and that she is
consuming 7 more units than before.
Frequent flyer programs are another example of quantity discounts.

Revealed Preferences

We have learned how to find optimal baskets for a consumer if we know her preferences and budget
line. But, what if we dont know the consumers preferences? Her choices in different
settings will help us infer her preferences. That is, by looking at how she chooses bundles in
different situation, we can infer which bundles she prefers to others.

Note that the dark shaded region represents that the area to the northeast of any
bundle will always be preferred to that bundle.

Through revealed preferences we can establish if a consumer weakly prefers a bundle to
another (i.e. prefers it at least as much as the other bundle when both choices are affordable),
or if he strongly prefers one bundle to another (i.e. prefers the bundle more when both
choices are affordable).

1) When facing BL
1
, consumer chose A instead of any point inside BL
1
, such as B. Then
A B
2) A and C were equally costly, but he chose A. Hence A C
3) Since C lies to the northwest of B, then C >B

Choices:
A >B
440 9.11
5.5
= 62
18

Failing to max utility

I= \$24
( p
x
, p
y
) = (\$4, \$2)
(x
1
, y
1
) = (5, 2) A

( p
x
, p
y
) = (\$3, \$3)
(x
2
, y
2
) = (2, 6) B

Here the consumer fails to maximize utility. Lets see why

BL
1
:
1) when facing BL
1
, the consumer chose A instead of C, in spite of being available (affordable)
AC
2) Since C is to the northwest of B, C>B

BL
2
:
1) when facing B in spite of D was available
BD
2) Since D is to the northwest of A, D>A

Contradiction occurs because under both budget lines A and B were affordable. If A were
chosen over B under BL
1
then it

should always be chosen over B whenever both are
affordable consumer wasnt maximizing utility when
24/3=8
24/4=6
24/2=12
24/3=8
A >B
B >A
19

Choosing A within BL
1

Choosing B within BL
2

Alternative approach
BL
1
: Consumer prefers basket A. Thus A >B
Cost of basket A, \$45 + \$22 = \$24
Cost of basket B, \$42 + \$26 = \$20
BL
2
: Consumer prefers basket B. Thus B >A
Cost of basket B, \$32 + \$36 = \$24
Cost of basket A, \$35 + \$32 = \$21
Case 1.

Any point on B.L. is strongly preferred to points inside B.L.

BL
2

C>A since it is to the northwest of A
B C since B was chosen when C was affordable

Case 2

An example of choices that are inconsistent with utility-maximizing behavior

BL
2
: From above, we know that B >A since A is inside BL
2

BL
1
: Additionally, A B since both were affordable when facing BL
1

Hence, consumer is NOT maximizing utility

Case 3:
BL
1
: the consumer chose A when both A and B were affordable, A B
BL
2
: the consumer chose B when A wasnt affordable

Case 4
BL
1
: chose A but B wasnt affordable
B >A
We cant infer anything from these
choices because we dont know which
bundle the consumer would choose if
both were affordable
20

BL
2
: chose B but A wasnt affordable

The theory of revealed preference:
1) Allows us to infer how a consumer ranks one basket of goods over others her
preferences
2) We can discover when a consumer is not maximizing his utility

1

## EconS 301 Intermediate Microeconomics

Chapter 5

Optimal Choice and Demand
It is important to realize that given the consumers preferences, income, and price of all goods we
could determine how much they will buy. That is simply one point on their demand curve for
that good. We can find more point by repeating the process by changing the price of that one
good for example ice cream.
Figure 5.1 Does a good job of explaining how to use indifference curves and budget lines to find
the demand curve.

2

The curve used to find the demand curve is known as the price consumption curve (the set of
utility maximizing baskets as the price of one good varies while holding constant income and the
prices of the other goods).

Effects of a change in Income:

We can also change the income of the consumer and observe how their demand shifts based on
income. Figure 5.2 displays how we use an income consumption curve to see shifting demands.

From the picture above we can see the Income Consumption Curve is the set of utility
maximizing baskets as income varies while prices are held constant!

There is one last way of showing how a consumers choice of a particular good varies with
income and that is to draw an Engle curve (a curve that relates the amount of commodity
purchased to the level of income, holding constant the prices of all goods).

It is important to remember there are more than one type of good, and an Engle curve can
help you distinguish which type of good the consumer is dealing with. A normal good is a good
that a consumer purchases more of as income rises and an inferior good is a good that a
consumer purchases less of as income rises.

3

The next page contains algebraically how to find the demand curve as well as the engle curve
with visual representation.

Finding a demand curve (Learning by doing 5.2):

A consumer purchase two goods X and Y where the utility function is represented by

*
*
and
1)
2) plug into 1
2 plug into y
2
2
2
x y
x y
x x x x
y y y y
x
x y x
y x
x
x
y y
U xy MU y MU x
p x p y I
MU p y p p x
MRS y
MU p x p p
p x I
p x p I p x I x
p p
I
p
p I
y
p p
= = =
+ =
= = = =

+ = = =

= =

The last equations
( )
* *
x and y represent the demand curve. Given any value for Income and for
prices of goods, we can find the quantity of good the consumer will purchase.

Demand with corner point solution:

Using the same goods from previous example but here we change the utility function such that
( )
( )
( )
10 10 and
Suppose that 100 and 1 then
1) 1 100 100
10 1
2) 10 plug into 1
100 10
10 100 2 10 100
2
100 10
2
x y
x y
x y y
x x
y
y y y
y
y y y y
y
y
U xy x MU y MU x
I p p unknow
p x p y x p y
MU p y
MRS x y p
MU p x p
p
y p p y p y p y
p
p
p
= + = + =
= = =
= + = + =
+
= = = = +

+ + = + = =

## 0 only if 100-10 0 100 10 10

100 10
if <10
2
0 otherwise

y y y
y
y
y
y
p p p
p
p
p y

Only the consumer demand positive quantities of normal goods.
4

## What happens if >10

y
p ? The consumer will be at a the corner point because
y
x
x y
MU
MU
P P
>

Engel Curve in corner solution:
Recall that Engel curve relate the amount of good consumed to the level of income, then the
Engel Curve will be the same like axis X, depends where is the corner solution.

[Figures]

Engel Curve for non corner solution:

When the Engel curve have positive slope then the good will be normal

Normal goods,

, ,
0
Q I Q I
x I
I x

+

> =

When consumer buy less of one good when
income increase then the good will inferior
Inferior goods,

, ,
0
Q I Q I
x I
I x

< =

5

Note that some good must be normal, not all can be inferior. To show this using elasticities,
1 1 2 2
...
n n
p x p x p x I + + + =
Differentiate w.r.t. I,
( )
1 2
1 2 1 2
... 1 since , ,..., ,
n
n i n
dx dx dx
p p p x p p p I
dI dI dI
+ + + =
Multiply and divide by
i
x I ,

1 2
,
, , 1
2
1 2
1 1 2 2
1 2
1 2
1 1 1 2 2 2
1 2
1 , 2 , ,
... 1
... 1
... 1
n
Q I
Q I Q I
n
n
n n
n
n
n n n
n
Q I Q I n Q I
x I dx x I dx x I dx
p p p
x I dI x I dI x I dI
p x dx p x dx p x dx I I I
I dI x I dI x I dI x

+ + + =
+ + + =
+ + + =
_ _

Since
1 2
, ,..., 0
n
, you cannot have
,
0
Q I
< for all goods and still have the expression be
equal to one.

6

Example:
Food / all other goods in China
[ ]
0,1 , but ?
f o

We know that:

( )
1
1 1
1
f
f o o
food other

+ = =

_

If 0
f
= , then
1
1
o

If 1
f
= , then
1
1
1
o

= =

## , which is the lower bound.

According to the data, foods share of total expenditure in 1983 was 0.6 = , and in 2005
0.37 = .
Then our upper bound was
1 1
2.5
1 1 0.6
o

= = =

in 1983, and
1 1
1.59
1 1 0.37
o

= = =

in
2005. Hence you know that in 1983
[ ]
1, 2.5
o
, and in 2005
[ ]
1,1.59
o
.

7

## Change in the Price of a Good: Substitution Effect and Income Effect

Substituion effect: The change in the amount of a good that would be consumed as the price as
that good changes holding all other prices and the level of utility constant.

Income Effect: The change in the amount of a good that a consumer would buy as purchasing
power changes holding all other prices constant.

The following figure does a nice job of showing step by step how to find both the substitution
and Income effect graphically.

8

## Decomposition Budget Line:

After define what good is what, we can observe the effects after the price of one good change.
One will be the substitution effect and the other will be the income effect, both conform the
decomposition budget line, how? Well the SE will be in the same curve and the IE will shift the
curve (up or down).
1) Parallel to the BL
2
(since prices are the same)
2) Tangent to IC
1

Substitution Effect Income Effect Total Effect
Normal + + +
Inferior + (>) - +
Giffen + (<) - -
Here are some pictures of different possibilities, the one above was x being a normal good.

Case 2: X is neither a normal good nor an inferior good-

Case 3: X is an inferior good-

9

## Case 4: X is a giffen good-

IE & SE for a price decrease (Learning by doing 5.4):
( )
1 2
and
Suppose that 72 and the initial 9 then decrese to 4, 1
:
1) 9 72
9
2) 9 plug into 1
1
9 9 72 18 72 4 plug into y
9(4) 36
(4, 36)
x y
x x y
y
x x
y y
U xy MU y MU x
I p p p
x p y
MU p y
MRS y x
MU p x
x x x x
y
A
Ba
= = =
= = = =
+ =
= = = =
+ = = =
= =
=
( )
C:
1) 4 72
4
2) 4 plug into 1
1
4 4 72 8 72 9 plug into y
9(4) 36
(9, 36)
y
x x
y y
sket
x p y
MU p y
MRS y x
MU p x
x x x x
y
C
+ =
= = = =
+ = = =
= =
=

1) B must give the same utility level as the initial basket A, Hence, from (4, 36) A = we
know
1
4(36) 144 U xy = = = . Then the (x,y) of basket B must satisfy xy=144.
10

2) BL
d
must be tangent to IC
1
. Since the slope of BL
d
is the same as BL
2
, then
4
1
x
y
p
p
= .
Then,

d 1
slope of BL slope of IC
4
1
4 4
x
y
MU
MU
y
y x
x
=
=
= =

3) Then we have,

( )
( )
( )
2
144
4 144 4 144 6
4
4 6 24
6, 24
xy
x x x x
y x
y
B
=
= = =

=

= =
=

Where,

6 4 2
3
B A
C B
SE x x
IE x x
= = =
= =

Summary: As price of good Y decrease the SE leads us to an increase in consumption of good Y
(normal good) from 4 to 6. The IE will measure the consumption from decomposition basket B

Note: When you confront SE you are in the same Utility but when you confront IE you are in the
same sloperemember is just a trick

IE & SE for a price increase: Do Learning by doing 5.5 yourself.

Learning by Doing 5.6 IE & SE for a Quasilinear Utility:

Recall that the distinguish characteristic for Quasi-linear utility function is that as we move due
north on the indifference map, the marginal rate of substitution of x for y remains the same, so be
careful with IE.

11

( )
( )
1 2
1
2 and 1
10, 0.5, 0.2, 1
:
1) 0.5 10
1
0.5 1 1
2) 4
1 1 2
0.5 4 10 8
(4, 8)
C:
1) 0.2 10
1
0.2 1 1
2) 25
1 1 5
0.2 25 10
x y
x x y
x x
y y
x x
y y
U x y MU MU
x
I p p p
x y
MU p
x
MRS x
MU p x
y y
A
x y
MU p
x
MRS x
MU p x
y
= + = =
= = = =
+ =
= = = = =
+ = =
=
+ =
= = = = =
+ = 5
(25, 5)
y
C
=
=

1) Same utility level as basket A=(4,8), so
1
2 2 4 8 12 U x y = + = + = . Thus we know,
2 12 x y + = .

2) BL
d
must be tangent to IC
1
and parallel to BL
2
.

( )
1 2
d
slope of IC slope of BL
(and BL )
1
0.2 1 1
25
1 1 5
2 25 12 2
25, 2
25 4 21
25 25 0
x x
y y
B A
C B
MU p
x
x
MU p x
y y
B
SE x x
IE x x
= = = =
+ = =
=
= = =
= = =

Notice there is no IE because she or he consumes the same amount of good at B and C.

12

13

## Compensated Demand Curve:

[Figures]

In our exercise from last Tuesday, if =0.6,
( )
0.4 0.4
1 2
0.6
, , 1.18
0.4
y y
x x
p p
h p p U U U
p p

= =

Using
( )
1 2
, , h p p U we obtain the minimal expenditure,

( ) ( ) ( )
1 2 1 1 1 2 2 2 1 2
, , , , , , E p p U p h p p U p h p p U = +
Hence,

( )
1 1 2 1
1
, ,
E
h p p U q
p

=

Slutsky Equation:
We know that
( ) ( )
1 2 1 2 1 2
minimal expenditure
to reach
, , , , , ,
U
h p p U D p p E p p U

=

_

Differentiating w.r.t. p
1
,

1
1 1 1
1
1 1
q
h D D E
p p E p
h D D
q
p p E

= +
= +

Multiplying all terms by
1
1
p
q
and the last by
E
E
,

1 1
1
,
1 1 1
1
1 1 1 1 1
*
Q I
p q D E
E q E
p p p h D D E
q
p q p q E q E

= +
_
_ _ _

Rearranging,

,
,
*
*
Q I
Q I
TE SE
IE

= +
=

14

Examples:
1) Garlic: If 0 = , then

*
TE SE
= or the TE = SE.
2) If 0.76 = ,
,
0.88
Q I
= , 0.76 = and * 0.09 = , then
,
0.6688
Q I
= and we have,
0.76 0.09 0.6688 =
3) Housing: If 0.4 = ,
,
1.38
Q I
= , and 0.6 = , then we have
,
* 0.6 (0.4)1.38) 0.04
Q I
= + = + =
For an inferior good, >0, but

, ,
0 *
Q I Q I

+

< =
_
_

For a giffen good, <0 because
,
0
Q I
< and

,
*
Q I

+
+
=
_
_

The Concept of Consumer Surplus:

CS= maximum willingness to pay for a good price paid for good.

i.e. how much better off the consumer will be when he purchases the good.
The area under a demand curve measure net benefits for a consumer only if the consumer
experiences no income effect over the range of price change.

Learning by doing: Q=# of gallons of milk purchased at P dollars
Q=40-4p > but we want p to be in the y-axis, the rewrite p=10-Q/4

1) Point A is the crossing of p=10-Q/4 and p=3. Then,
3 10 7 28
4 4
Q Q
Q = = =
2) CS is the shaded blue (G) triangle
15

1
(28)(10 3) 98
2
CS = =

Consumer Surplus with a Cobb-Douglas utility function:
0.6 0.4
15 20 300
x x
U x y p p I = = = =
1) Find the consumers demand curve,
0.6 0.6(300) 180
x x x
I
x
p p p
= = =
2) [Figure]

[ ] [ ]
20
20
15
15
180
180 ln 180 ln 20 ln15 51.79
x x
x
CS d p p
p
= = = =

3) What if we were assuming linear demand:
Area of A=(20-15)9=45
Area of B=(20-15)3=15
Total loss in CS =60

Welfare changes resulting from variations in prices CV and EV:
CV: A measure of how much money a consumer would be willing to give up after a reduction
in the price of a good to be just as well off as before the price decrease.
If prices increase, then I need more income to maintain the same level of utility. How much
money would I need? CV
If prices decrease, then I dont need all my original income to remain at original utility. How
much money would I be willing to give up in order remaining at the original utility? CV

EV:A measure of how much additional money a consumer would need before a price reduction
to be as well off as after the price decrease.
If prices are going to decrease, then after the decrease, consumers are going to be better off
because they can purchase more. How much income should we give them today, before the
price increase, to make them just as well-off as they will be tomorrow after the price decrease?
EV
If prices are going to increase, then after the increase, consumers are going to be worse off. How
much money would we need to take from the consumer today, before the price increase, in order
for him to be just as worse-off as he is going to be tomorrow? EV

16

0K consumers income
0L income needed to purchase basket B at the new prices of x

0K-0L=KL is the CV
The amount of money that the consumer will be willing to give up, after the price change,
in order to maintain the original utility that he had before the price change.

0J income needed to buy basket E at the old prices of x.

0J-0K=JK is the EV
The amount of money that we need to give to the consumer, before the price change, in
order to make him just as well-off as he will be after the price change.

CV EV, except with quasilinear utilities (CV = EV).

CV and EV with no income effect (Based on Learning by Doing 5.6):
Recall in this case the IE was zero
1 2
2
10, 0.5, 0.2, 1
x x y
U x y
I p p p
= +
= = = =

a) CV= Cost of initial basket A (\$10) less cost of decomposition basket B (0.2(25)+2=\$7)
CV= 10-7=\$3

1) We know E must reach a utility of U
2
=15, hence 2 15 x y + =
2) We also know that at E, the slope of U
2
= slope of BL
1

1
0.5 1 1
4
1 1 2
x
x
x
= = =
Hence, 2 4 15 11 (4,11) y y E + = = =
EV=13-10=\$3
17

Hence the CV=EV when the IE is absent (which occurs when we have a quasilinear utility)

What if we measure the change in welfare by using CS?
You can easily check that when,

1 2
2
10, 0.5, 0.2, 1
x x y
U x y
I p p p
= +
= = = =

The demand for x is,
2
1
x
x
p
= . Then,

18

0.2
0.2
2
0.5
0.5
1 1 1 1
3
0.2 0.5
x
x x
CS d p
p p

= = = =

## which is exactly the same as the CV and EV when we

have a quasilinear utility function.

What if IE>0?

1 2
72, 9, 4, 1
x x y
U xy
I p p p
=
= = = =

((4)6+24=448)
CV=72-48=24
What is E?
1) We know basket E must reach U
2
, so 4(36) 324 xy = =
2) We also know that at E, the slope of U
2
= slope of BL
1

( )
9
9
1
9 324 6
9(6) 54
(6, 54)
y
y x
x
x x x
y
E
= =
= =
= =
=

EV=108-72=36
c) CV EV

What if we measure the change in welfare using CS?
Given,
72, 1
y
U xy
I p
=
= =

It is straight forward to find the demand
72 36
2 2
x x x
I
x
p p p
= = =
19

[ ] [ ]
9
9
4
4
,
36
36 ln 36 ln9 ln 4 29.20
29.2
24 different, but is this usual? Not so much since and are low.
36
x x
x
Q I
CS d p p
p
CS
CV
EV

= = = =
=

Application: Automobile export restrictions for Japanese cars in 1984.
Prices went up about 20% for Japanese cars, and CV = \$14 billion. That is the additional
income needed after the price change (due to export restrictions). Since in 1984 there were 2
million new cars bought, the CV per car buyer was \$14,000/2 = \$8,000.

Market Demand:
If we have three demand curves, which two are fro two kinds of consumers and the last one
the market demand.

15 3 if 5
( )
0 if 5
6 2 if 3
( )
0 if 3
The market demand will be
21 5 if 3 (Both)
( ) 15 3 if 3 5 (Only h consumes)
0 if 5 (Neither
h
c
M
p p
Q p
p
p p
Q p
p
p p
Q p p p
p
<
=

<
=

<
=
consumes)

Graphically we can represent this
20

21

Network Externality:
Bandwagon effect: A positive network externality that refers to the increase in consumer
demand for a good as more consumers buy the good. (ie online games)

Snob effect: A negative network externality that refers to the decrease in consumer demand for a
good as more consumers buy the good.

Perloff: Ch.4 pp. 111-116, Ch.5 pp. 136-141 and 152-164.

Tax Revenue and Labor Supply:
TaxRevenue ( )
where ( ) is the number of hours worked when wage net of taxes is (1- )
wh
h w

=
=

2
positive effect on T
from higher rate negative effect on T
from fewer hours worked
( )
T dh
wh w
d

+
=

_
_

For 0
T

## < so a decrease in tax causes an increase in revenue, we need,

2
1
( )
( )
dh dh w
wh w
d d h

< <
Multiply both sides by 1-,
( )
elasticity of
supply of labor
1
1
( )
1
( )
w
dh
d h
dh
d h

<

<

_

Hence, for T to raise from a small fall in the tax rate, we need

supply,
1

>
Example:
supply,
1 0.25
3
0.25

> = which is unlikely. (ie Bush, Reagan)

In Sweden 90% = ,
supply,
1 0.9
.111
0.9

> = which is very likely. (ie Japan, Sweden, Kennedy)

22

Labor Supply:

( )
( )
1
from work
from leisure
1 1
1 1
1
( ) (24 )
( ) (24 ) ( ) 1 (24 ) 0
( ) (24 ) ( ) 1 (24 )
( ) (24 ) 1
(24 ) 1
24
24
U wh h
FOCs
U
w wh h wh h
h
w wh h wh h
w wh h
h
h
h h h
h

=
= =
=
=
=
=
=
_

If, for example, alpha was one third, then hours worked would be eight, regardless of wage.

1

EconS 301 Intermediate Microeconomics
Chapter 6

Inputs and Production Function
In order for a firm to produce output, either products or services, the firm must use a
certain function of inputs to create their output. Inputs (factors of production) are
resources, such as labor, capital equipment, and raw materials, that are combined to
produce finished goods.

A firm must decide how to use these inputs to produce a given output level. For instance,
they may use a lot of labor and very little capital (machines, etc.) or they may use a lot of
capital and very little labor. This is called a firms production function: a mathematical
representation that shows the maximum quantity of output a firm can produce given the
quantities of inputs that it might employ.

( ) , Q f L K =

The production function tells us the maximum amount of production, Q, for a given
amount of inputs L and K. (analogous to utility function). Note: we could include any
number of inputs in the production function but L and K are the two inputs most firms
face and L and K allow us to develop the main ideas of production theory.

Example: Technical Inefficiency among U.S Manufacturers

(63% of efficiency)
(39% of inefficiency)

2

( ) / , 0.63 Q f K L = but much closer to the frontier if the firm:
faces competition
not a major player in its industry

We can also invert the production function to get L=g(Q), which tells us the minimum
amount of labor needed to get a specific quantity of output. This approach is called the
Labor Requirements Function.

Marginal and Average Products

We now want to characterize the productivity of the firms labor input. Looking at the
production function we can derive two distinct types of productivity for a given input: the
average productivity and the marginal productivity of a certain input. In the cases below,
we are looking at these two distinctions for labor

The first is the Average Product of Labor, which tells us the average output per worker,
which we write as the AP
L
.
/
L
AP Q L = Labor productivity
Looking above at the Total Product graph, the Average Product of Labor is the
slope of the ray between any point on the curve and the origin (for instance, the
ray from point A to the origin).

The second is the Marginal Product of Labor, which tells us the rate at which total
output rises as the firm increases its quantity of labor. We write this as MP
L
.
3

/
L
MP Q L = (analogous to Marginal Utility in Consumer Choice Theory)
Looking above at the Total Product graph, the Marginal Product of Labor is the
slope of any line tangent to any point on the graph (for instance, the line BC is
tangent to L
1
).

Before we continue we need to focus on Law of diminishing Marginal Returns

Relationship between AP and MP: the relationship between MR and AR can be
illustrated with the simple example of adding one more test score to a collection of
scores. If the added test score (marginal effect) is greater than the current average, it will
bring up the overall average. If the added score is lower than current average, it will bring
down the average score.
average grade its marginal effect was positive
average grade its marginal effect was negative

AP is increasing MP
L
> AP
L

AP is decreasing MP
L
< AP
L

AP is flat MP
L
= AP
L

2 INPUTS: When we consider a production function with two inputs, the associated
graph is three-dimensional. On the two horizontal axiss are the two inputs, and on the
vertical axis is the quantity produced. We refer to this graph as the Total Product Hill.

If the production output is ( ) , Q f K L =

( )
L K cte
K L cte
MP Q/ L |
Slopes
MP ( Q/ K) |
=

They are the slopes of the hill for labor and capital when the other inputs are fixed.

We can therefore derive the Total Product Function for one input from a two input
production function by holding either K or L constant and following the hill as the
other input increases.

4

Example:
24, K and L = (eastward), we move from A to B to C (peak).
Given the green line is our TP when ( ) Q f L = because we were fixing K (in particular,
fixing it at K = 24).
( )
( )
tan
tan
/ / |
/ / |
L K is held cons t
K L is held cons t
MP change in Q change in L Q L
MP change in Q change in K Q K
= =
= =

MP
L
is the steepness of the green line, when we hold K fixed at 24 K = .

ISOQUANTS: To show the economic trade-offs in production, it is helpful to flatten the
three dimensional Total Product Hill to two dimensions. By taking a fixed level of Q
from the Total Product Hill and then dropping those fixed levels to the same level, we
can graph a contour plot very similar to the indifference plot we constructed in consumer
choice. We call these fixed levels of production given various combinations of two inputs
Isoquants. As stated in the book, an isoquant is a curve that shows all the combinations
of labor and capital that can produce a given level of output.
Level curves, representing all the points of the mountain with the same heights (Q).

Downward slopping: a firm can substitute K for L, keeping Q unchanged.

Isoquant as a line in topographical map (Mount Hood) oregon.
5

Example:
( ) ( )
( )
1/ 2 1/ 2
1/ 2
2 2
20 400 400 /
, /
Q KL KL KL K L
Generally Q KL Q KL K Q L
= = = =
= => = =

Economic/Uneconomic Regions
But why dont we include the full circle of the isoquant (think of topographic map) on the
actual plot of isoquants? This is because of economic and uneconomic regions. The
upward slope and backward bending regions correspond to a situation where an input has
a negative marginal product (i.e. diminishing total return), but a normal firm that wants to
minimize its production cost will never operate in this regions. In other words, in the
upward and backward sloping regions of the isoquant that firm would be producing a
certain output level at an unnecessarily high cost. They could produce the same level of
output by using far fewer inputs.

Marginal Rate of Technical Substitution

By measuring the slope of the isoquant, we can see the trade-off a firm must make
between inputs in order to maintain a certain level of output. This is referred to as the
Marginal Rate of Technical Substitution. Or as stated in the book, the MRTS is the rate
at which the quantity of capital can be reduced for every one unit of increase in the
quantity of labor, holding the quantity of output constant.
Measure how steep an Isoquant(IQ) is.
Slope of IQ (analog to MRS being slope of IC)
6

Rate at which the quantity of one input could or for every one unit or
in the quantity of the other input, holding Output constant.

Diminishing MRTS
L,K
(isoquants are bowed in towards the origin)

Example

( )
2 3
, 0.1 3 0.1 q f L K LK L K L K = = +
Assume
__
10 K = , so that ( )
2 3 2 3
,10 0.1 10 3 10 0.1 10 30 f L L L L L L L = + = +

1)
2
/ 1 60 3
L
MP dq qL L L = = +
Where does it reach a max?

( )
2
1 60 3 / 60 6 0 60 6 10 d L L dL L L L + = = = =

2) ( ) ( )
2 3 2
,10 / 30 / 1 30
L
AP f L L L L L L L L = = + = +
Where does it reach a max?

( )
2
1 30 / 30 2 0 30 2 15 d L L dL L L L + = = = =

Is this point L = 15 the crossing point between AP
L
and MP
L
?
2 2
2
1 60 3 1 30
30 2
30 2
15
L L L L
L L
L
L
+ = +
=
=
=

Generally, why do AP
L
and MP
L
cross each other at the max of AP
L
?
If ( ) /
L
AP f L L = , then it reaches its Max at

7

( ) ( ) ( ) ( )
( ) ( ) ( ) ( )
( )
( )
2 2
/ 1 / / / 0
/ 0

,
( , /
L
L L
L L
dAP dL f L L f L L f L L f L L
f L f L L L MP AP L
MP AP
Q f K L
Q f K L
= = =

= =
=
=
=
8
( )
,
) ( , / )

0

/ /
/
K L
K L
L K
L K
L K L K
K K f K L L L
Q MP K MP L
MP K MP L
MP L MP K
MP MP K L slope of IQ
MP MP MRTS
+
= +
= +
=
= =
=

Intuitively, the MP
L
and the AP
L
will always cross at the maximum of the AP
L
because,
at that point, the MP
L
is not putting any upward or downward pressure on the AP
L
.
Remember the relationship between the AP
L
and MP
L
. If the MP is above or below the
AP, it will force the AP up or down, respectively. So they will cross where they two are
equal.

Example Learning-by-Doing 6.1

The production function is
,
The marginal products are

Where
/
L
K
L K
Q KL
MP K
MP L
MRTS K L
=
=
=
=

Diminishes as L increases and K falls as we move along an Isoquant so MRTS of Labor
for Capital is diminishing, why? Because MRTS is a measure of slope of tangency of one
point on Isoquant and compared with the slope of other points in the same Isoquant (see
points B and D). When L increases the MRTS will reduce. (Slope of point B is more
vertical than slope in point D)

MRTS is analogous to MRS from consumer theory.
8

Example
MRTS between low and high tech workers 6 in US

ELASTICITY OF SUBSTITUTION

( ) ( )
( )
L, K
% K / L

% MRTS

This elasticity shows how easy it is to substitute L for K.

Where K/L is the slope of the rays from origin to a given point on the isoquant
MRTS is the slope of the isoquant at the given point.

Example

9

( ) ( )
( )
( ) ( ) ( )
L, K
% K / L
1- 4 / 4 / 1- 4 / 4 - 0.75 / -0.75 1
% MRTS

= = = =

If s is close to zero, then MRTS changes drastically, as in Figure 6.11 (a)
If s is large, then K/L changes drastically while MRTS is almost constant, as in Figure
6.11 (b)

Application Industries like Chemicals, Motor vehicles, Foodetc.

10

SPECIAL PRODUCTION FUNCTIONS

1) Linear: MRTS is constant
The MRTS is constant because the lines are straight. That is, the two
inputs in this production process can always be substituted in perfect
ratios. Think of a manufacturing process that requires oil or gas. That
firm can always substitute a certain amount of oil for a certain amount
of gas to achieve the same level of output.
Example: 20 10 Q H L = + (always additive). This is an example of High
vs. Low productivity computers.

( )
,
200 20 10
10
10
1/ 2
L H
H L
H L
H L equation of isoquant
MRTS for all L
= +
= +
=
=

Case for Linear: Perfect Substitutes
As example before, two low capacity workers are as productive as a one high
capacity worker
( )
,
1/ 2
L H
MRTS for all L = .Since the denominator is zero, the
elasticity is infinity, which implies that it is perfectly easy for the firm to substitute
between these two inputs while maintaining the same level of output.

( ) ( )
( )
( ) ( )
L,
% / L % / L

0 % MRTS
H
H H

= = =

If L = 0 then 200=20H
H =10
If H = 0 then Q=10L
200=10L L=20
Since the slope of the
Isoquant is constant
11

2) Fixed proportion or Perfect Complement
In the case of Fixed Proportions, think of the Perfect Complements in Consumer
Choice. Here, adding more of one input given the other input is fixed will not change
the total Output. That is the reason you are going to use the minimum value (going to
the corner point).

As the inputs are combined in fixed proportions what happens with the elasticity of
substitution? Well, is clear that will be zero, why? Because the numerator of is zero
(not change in the ratio
K
L
).

Example:
{ } { } min / 2, min , 2 Q L K L K = = i.e. 2 units of labor for each unit of K. Note
that in the equation every L value is twice the quantity of every K value, thus the K
value is multiplied by 2.

{ }
{ }
3 min 6 / 2, 3
3 min 10 / 2, 3
=
=

s = 0 since MRTS goes from to 0.

ApplicationElasticity of substitution in German industry

Chemicals 0.37
Iron 0.50
Motor vehicles 0.10 low substitutes between L and K
Food 0.66 high substitutes between L and K

12

3) Cobb- Douglas
This production function is an intermediate between the previous ones. The elasticity
of substitution for a Cobb-Douglas production function is always equal to 1 and the
isoquants are downward sloping curves bowed in toward the origin. The general form
for a Cobb-Douglas is

] [
1 1
,

/ [ / ] /
L K L K
Q AL K
MRTS MP MP AL K AL K K L

=
= = =

(decreasing in L, therefore flatter isoquant)

(FROM CHAPTER 6 APPENDIX)

Rearranging,

,
/ /
L K
MRTS K L = (1)
Hence,

( )
( )
L, K
L, K
K / L ( / ) MRTS
K / L / MRTS ( / )

=
=
(2)

We also know from (1)

( )
,
,
( / ) /
/ / /
L K
L K
MRTS K L
MRTS K L

=
=
(3)

Hence,
( ) ( )
( )
( ) ( ) ( )
( )
( ) ( ) ( ) ( )
L, K , ,
, ,
% K / L / / /

% MRTS /
/ / / / ( / ) ( / ) 1
L K L K
L K L K
K L K L
MRTS MRTS
K L MRTS MRTS K L

= = =

= = = =

This means that the elasticity of substitution along a Cobb-Douglas production
function is always equal to 1.

Example: if a = b = 0.5
1) ( ) ( ) , 12, 3 0.5 12 / 0.5 3 4 K L = =
2) ( ) ( ) K, L 6, 6 0.5 6 / 0.5 6 1 = =
3) ( ) ( ) , 3,12 0.5 3 / 0.5 12 1/ 4 K L = =

13

3) CES

All the previous ones are derived from it/the other three production functions above
are special cases of the constant elasticity production function.

1/ 1/ / 1
[ ] Q aL bK

= +

where s is the elasticity

s = (linear) substitutes
s = 0 (fixed proportions) Compliments
s = 1 Cobb-Douglas

Now that we know how to define how a firm substitutes one input for another, we
will now see how output changes given a certain increase in all inputs. Remember
that from our analysis of the marginal product of inputs we can figure out whether
output will increase given an increase in inputs, but what we do not know is by HOW
MUCH output will increase. Returns to Scale tell us the percentage increase in output
given a certain percentage increase in inputs. This is generally expressed as

( )
( )
% quantity of output
.
% quantity of ALL input
R S

=

Here, this firm increases or scales up production by . That is, they multiply both
inputs L and K by . The resulting change in output will be measured by .
( ) ,
( , )
% Q
% in all inputs
Q f L K
Q f L K

=
=

Then, if
f > l increasing (i.e. output rises by a higher percentage than the percentage increase
in inputs) Fig.(A)
14

f = l cte (i.e. output rises by the same percentage as the percentage increase in
inputs) Fig.(B)
f < l decreasing (i.e. output rises by a smaller percentage than the percentage
increase in inputs) Fig.(C)

Example:
Let
1 2
& Q Q two different Output levels, both have the same quantity of inputs.
( )( )
1
2 1
Q AL K
Q A L K AL K Q

+ +
=
= = =

If l
a+b
>l

, (a+b >1) then Q
2
> Q
1
increasing
if l
a+b
=l

, (a+b =1) then Q
2
= Q
1
cte
if l
a+b
<l

, (a+b <1) then Q
2
< Q
1
decreasing

Difference between diminish marginal returns and returns to scale Fig.6.19

15

More examples on Returns to Scale
Example

Decreasing a+b
Tobacco 0.51 example:
0.51
2 1 1 1
2 1.42 Q Q Q Q

+
= = =

Food 0.91
Transportation equipment 0.92

Constant a+b
Apparel and textiles 1.01
Furniture 1.02
Electronics 1.02

Increasing a+b
Paper products 1.09
Petroleum and coal 1.18
Primary metal 1.24 example: doubling
1.24
2 1 1 1
2 2.36 Q Q Q Q

+
= = =

y But why is the understanding of Returns to Scale important for economic decision
making? Because if a firm exhibits increasing Returns to Scale, there are cost
advantages to large scale production. That is, the firm will be able to produce at a
lower cost per unit. On the contrary, a firm can turn away from large scale
production to save unduly harsh costs at large levels of production. That is, they
could have a lower cost per unit at a smaller scale of production.

16

Technological progress
Here, the production function can shift over time, why? Because a firm can achieve
equal or more out of output from a given combination of inputs (less or equal quantity
of inputs). This can occur because of increased skill by managers from experience,
the payoff of previous investment in research and develop, and from new technology.
Essentially, this means that as time goes on the firm can produce more with less.

Categories of Technological Progress

1) Neutral combination of L and K are fixed (shift inward of the isoquant )
Neutral Technological Progess decreases the amount of inputs needed to achieve
a certain level of production without affecting the firms marginal rate of
technical substitution. Graphically, the isoquants will shift inward while
maintaining the same slope.
( i.e. shift in parallel along the ray
____
0A )

2) Labor-Saving MP
K
relative to MP
L
(i.e. MP
K
increase faster than MP
L
) and
the Isoquant shift inward too
Intuitively this means that the capital becomes more effective and
therefore less labor is needed to maintain a given level of production.

flatter isoquant
MRTS goes down for any given ray from the origin
Since MRTS = MP
L
/ MP
K
, then MP
K
more than MP
L

17

3) Capital-Saving MP
L
relative to MP
K
and Isoquant shift inward too. Here,
labor becomes more effective and thus this firm will require less capital to
maintain a certain level of output. Thus the curve becomes steeper, showing that
less capital can maintain the same production levels. This type of progress could
occur from increased skill of workers or increased education of workers.

MRTS is steeper
MRTS goes up
MP
L
more than MP
K

Example 6.4
In this example, we want to see if the change in the production function represents
technological progress, and if so, what kind of technological progress.
( ) ( )
( ) ( )
( )
( )
0.5 0.5
1 2
0.5 0.5
0.5
0.5
where over time this change to
1
0.5 0.5
0.5
K K
L L
Q KL Q L K
L
MP MP L
K K
K
MP MP K
L
= =
= =
= =

a) Tech.progress? Yes!!

1 2
< 0 Q Q for any K and L >

b) capital savings since
( )
( )
( )
( )
1 2
0.5
0.5
L, K L, K 0.5 0.5
0.5
K 2K
MRTS MRTS
L
1
0.5 0.5
Q Q
K
K
L
L
L
L
K K

= = < = =

18

The isoquant becomes steeper after the tech. progress, as in Fig 6.22

1

EconS 301 Cost Theory
Chapter 7

Before we get into using cost concepts for decision making, we need to define some
important concepts. The first two are explicit and implicit costs.
Explicit Costs: Costs that involve a direct monetary outlay.
Implicit Costs: Costs that do not involve outlays of cash.

Another important economic concept that should be familiar is the idea of opportunity
costs.
Opportunity Costs: The value of the next best alternative that is forgone when
another alternative is chosen
Ex: You are giving up potential salary while going to college so trading
the potential salary for an education.

Closely related to explicit and implicit costs are economic and accounting costs.
Economic Costs: The sum of the firms explicit costs and implicit costs.
Accounting Costs: The total of explicit costs that have been incurred in the past.

There are two more important costs that any firm must recognize when making economic
decisions. Those are sunk and nonsunk costs.
Sunk Costs: Costs that have already been incurred and cannot be recovered.
Nonsunk Costs: Costs that are incurred only if a particular decision is made.

The Cost Minimization Problem:
The main idea behind the cost minimization problem is finding the input combination
that minimizes a firms total cost of producing a particular level of output. There are two
important time scales to remember when dealing with these types of problems.
Long Run: The period of time that is long enough for the firm to vary the
quantities of all its inputs as much as it desires.
Short Run: The period of time in which at least one of the firms quantities cannot
be changed.

In the utility maximizing problems there was a budget line, in cost minizing problems we
will be using an Isocost line.
Isocost line: The set of combinations of labor and capital that yield the same total
cost for the firm.

To find the tangency point it is very similar to the utility maximizing problem.
Slope of isoquant=slope of isocost line

-MRTS
L,K
= -w/r

Below is a graphical representation:

2

Corner Point

Here, the optimal solution doesnt have a tangency between an isocost line and an
isoquant curve.

The next example (perfect substitution) uses the follow information:

Production function: 10 2
where 10 and 2
Price of labor: 5 per unit
Price of capital: 2 per unit
Firm wish produce: 200 units
= +
= =
=
=
=
L K
Q L K
MP MP
w
r
Q

Using the previous figure we observed that the optimal combination is a corner solution. Why?
Because
,
10 5
>
2 2

= = =

L
L K
K
MP w
MRTS
MP r

So there is no point that can satisfy =
L
K
MP w
MP r
. This tells us that we cannot have an
interior solution.
The next question will be where and what is my solution?
10 2

5
2 1
2

= = > = =

L K
MP MP
w r

The marginal product per dollar of labor exceeds the marginal product per dollar of
capital ( ) 2 1 > , then the firm will substitute labor per capital until it uses no capital
(K=0).

Another fact here is that the slope of Isoquant is bigger that the slope of Isocost (5 > 2.5).

Then, the quantity of labor satisfy 10 2 will be: = + Q L K
( )
200
200 10 2 0 200=10 =20
10
= + = = L K L L L .

3

Comparative Strategies of Changes in Input Prices

w

An increase in the price of labor w makes the slopes of the isocost steeper for the same
Q=100, then the cost-minimizing amount of labor must go down and the cost-minimizing
quantity of capital must go up.

Comparative Strategies of Changes in Output

For the first case, we hold the input prices fixed and increased the quantity of output, this
move the firm to Isoquants to North East. When this quantity of output increases, the
cost-minimizing quantities of L and K also increase.

Expansion Path: A line that connects the cost-minimizing input combinations as the
quantity of output, Q varies, holding input prices constant.

4

Normal output: An input whose cost-minimizing quantity increases as the firm produces
more output.
Inferior output: An input whose cost-minimizing quantity decreases as the firm produces
more output.
The second case show us when the quantity of output increase but this change decrease
the cost minimizing quantity of labor and increase the cost minimizing of capital.

Example: Burke Mills Revisited.

Labor Demand Curve : A curve that shows how the firms cost minimizing
quantity of labor varies with the price of labor.

How can we fix it? First, this curve generally is downward slopping and will be
affected by changes in price of labor or by increase in output or mixed both. This curve
will show how the firms cost-minimizing amount of labor varies as price or output
varies.
2 1

= =
w
w w

When increasing output to Q=200 the shift to Labor demand curve will be
Shift to the right is labor demand normal
Shift to the left if is an inferior

5

Labor Demand Algebraically

Suppose that the production function is 50 = Q LK we want to find the demand curves
for labor and capital:
First, tangency condition
( )( )( )
( )( )( )
0.5
0.5
0.5 50
0.5 50

=

L
K
L
K
MP w
MP r
dQ
LK K
MP K
dL
dQ
MP L
LK L
dK

Then,

= =

K w r
L K
L r w
, this equation represent our expansion path.

Second, replace into the production function, to find the demand curve for capital first
1 1 1
2 2 2
2
50
50 50 50

= = = =

r Q r Q r Q w
Q K K K K K
w w w r

Now we will replace the previous result into our expansion path equation to find our
demand curve for labor
1 1
0.5
2 2
0.5
50 50 50

= = =

r Q w r w Q Q r
L L L
w r r w w

Price of inputs:

is decreasing in
is increasing in

r
K
w

is decreasing in
is increasing in

w
L
r

6

Output: Note that if Q, then the demand for both K and L increase. Hence, both K and
L are normal inputs.

7

Price Elasticity of Demand for Labor: The percentage change in the cost-
minimizing quantity of capital with respect to a 1 percent change in the price
of capital.

Represent the percentage change in the cost-minimizing quantity of labor with respect to
one percent change in the price of labor.
,
*100%
.
*100%

= = =

L w
L L
L w
L L
w w
w L
w w

It really depends on the substitution between two inputs,
,

K L

Low implies that a change in w has almost no effect in L, which is the first graph.
High implies that the same change in w induces a great change in L, the right graph.

8

Short-run Costs

There exist 3 types where the components of total cost differ from each other.

1. Variable and Nonsunk
0 0
&
= =

If Q then Costs
Labor Materials
Q Costs

2. Fixed and Nonsunk
0 0

= =

If Q then Costs
heating
Q not change Costs

3. Fixed and Sunk

0 0

= >

## Q not change Costs

Mortgage payments
If Q then Costs

Cost Minimization Short-run

Total Variable Cost: The sum of the expenditures on variable inputs, such as labor and
materials, at the short run cost-minimizing input combinations.

Total Fixed Costs: The cost of fixed inputs; it does not vary with output.

_
K
0
Q Isoquant

Example:
Suppose that the production function is 50 = Q LK but
__
K (i.e. capital is fixed) where
the only unknown is L.
Solving for L:
( )
2
2
__ __ __
2
2
__
50 50 2500
2500

= = = =

Q
Q LK Q LK Q LK L
K

The last result represents the demand for labor in the short run when the capital amount is
fixed.
9

Other example is Learning by doing which is considering more than one variable input
__
= + + TC wL mM r K
(Solve this exercise for yourself)

But, What happen if we reduce the price of labor (w) from \$2 to \$1 (i.e. 50% drop)
Then we are going to increase in labor.

5 4.6
8% increase in labor in (a)
4.6
5 2.2
127% increase in labor in (e)
2.2

=

if
f

Empirical evidence
Industries: textile, paper, chemical, metals in Alabama 1976-1991

1

EconS 301 Chapter 8

Long-Run Total Cost

The long run total cost curve shows the total cost of a firms optimal choice combinations for
labor and capital as the firms total output increases. So, each point on the long run total cost
curve represents one optimal basket at a specific level of output. Note that the total cost curve will
always be zero when Q=0 because in the long run a firm is free to vary all of its inputs.

0 0

= =
Q TC
Q TC

The upper graph shows a change in output and the minimized total cost increase. The
below graph shows the long run total cost curve. Remember that the total cost curve is
just the aggregation of the total costs of optimal bundles as output (isoquants) increases.

Example:
Suppose that the production function is 50 = Q LK

We know from chapter 7 that
1 1
2 2
&
50 50

= =

Q r Q w
L K
w r
and
2

( ) ( ) ( )
( )
( ) ( )
1 1
2 2
0.5 0.5 0.5
0.5
0.5
2
50 50 50 50 50
25
If we are told that 25 & 100, then:
25*100 50 2
25 25

= + + +

=
= =

=

Q r Q w Q Q Q
TC wL rK w r rw rw rw
w r
Q
TC rw
w r
Q Q
TC Q Q

(The L and K that we used to plug into our total cost function are the cost-minimization
equations for both inputs L and K. The cost minimization equation for either input can
generally be stated as K=TC/r (w/r)L for capital or L=TC/w (w/r)K for labor).

What happens when just one input price change?
0
Q

r forces
1
C to pivot to left (flatter) since K is more expensive, but TC remain
constant between
1
C and
2
C because the isoquant doesnt change.
However
0
Q
output level must remain unchanged, then
2
C
shifts outward up to
3
C
, so this firm incurs a higher total cost to maintain the Q
0
level of output.
Hence r forces a ( ) TC Q
3

Example: Trucking firms
Then implies r
When = r w then
K
L
doesnt change because the tradeoff between the two inputs
doesnt change, but ( ) = = TC Q r w

Long-run Average and Marginal Cost
( ) ( )
= =
TC Q dTC Q
LRAC LRMC
Q dQ

The LRAC is equivalent to the slope of any ray from the origin to a point on the TC
curve. The LRMC is equal to the slope of a line tangent to the TC curve. The LRMC
tells us how the total cost changes as a firm increases output by one unit.

4

50
50
Slope of =30 30
Slope of tangent at =10 10
=
=
=
=
Q
Q
OA AC
A MC
RELATIONSHIP
AC > MC producing a marginal and
reduces AC
AC<MC producing a marginal and
raises AC

Note: the MC curve will always cross the AC curve at the minimum of the AC curve
because of the relationship between the marginal of anything and the average of anything
that we discussed in detail with consumer choice.

Application: US Universities
Q=Students
195 U.S. universities from 1990 to 1991
The study divides universities in 4 categories, according to the site of grant proposal.
Here we only show the group of 66 units with the largest graduated programs.
( ) AC Q decreases until Q=30,000 undergraduates students.
The effect of an additional student is positive!! AC .
25, 000 WSU students

Example:
Given the production function ( ) 50 and =25 100 we have 2 = = = Q LK w r TC Q Q

5

2
2
2
= = =
= =
TC Q
AC
Q Q
dTC
MC
dQ

Economies of Scale
Here, with economies and diseconomies of scale, we want to see whether a firm should expand
their production based on the extra cost of doing so. Put differently, is the extra cost worth the
extra production?

E
c
o
n
o
m
i
e
s
d
i
s
e
c
o
n
o
m
i
e
s

Economies of scale: They arise from specialization, but also from indivisible inputs: an
input that is available only in a certain minimum size. Its quantity cannot be scaled down
as the firms output goes to zero, or where the cost of producing a very small amount of
output is very similar to the cost of producing a very high output level (satellites for
providing cell phone service).
Example: minimum-scale packing line for breakfast cereal is equally costly
for any firm producing from 0 to 14 million pounds of cereal / year
Diseconomies of scale: usually arise from managerial diseconomies: a given %Q forces
the firm to largely increase its spending on managers by more than this percentage.

Minimum efficient scale: minimum Q for which ( ) AC Q attains its minimum point (on
the above graph), the leftward most point on the straight line of the AC.
6

High for breakfst cereal and cane sugar

MSE
Q

Output Elasticity to Total Cost
Its the percentage change in total cost per 1 percent change in output (the same concept
behind all elasticities).
,
1
. .

= = = =

TC Q
TC
TC Q MC
TC
MC
Q
Q TC AC AC
Q

,
1
Economies of scale
Examples:
Iron, Stela
Electricity
Gas
<
TC Q ,
1
Diseconomies of scale
Examples:
Textile,
Cement
>
TC Q

Short run TC
One or more inputs are fixed at given level. Relate this to LRTC where all inputs can
vary so the firm is left with complete freedom in choosing between inputs.
7

7TFC
7TFC
7 TFC

In the short run, we can split the cost between the cost that varies (Total Variable Cost)
and the cost that is fixed, Total Fixed Cost (hence short run). This is depicted in the graph
above where the slope of the Short Run Cost Curve is determined by the TVC, but is
vertically higher than the TVC by precisely the amount of the TFC.

Example: Short run ( ) TC Q
Suppose that the production function is 50 = Q LK but
__
K (i.e. capital is fixed) where
25 and 100 = = w r .
Solving for L:
( )
2
2
__ __ __
2
2
__
50 50 2500
2500

= = = =

Q
Q LK Q LK Q LK L
K

This is the cost miniminizing amount of labor.
Plugging it into the TC
( )
N
__
2 2
__ __
__ __
100
25 100
2500 100
= + + +

TFC TVC
Q Q
K
STC Q wL r K K
K K

Short-run Total Cost vs. Long-run Total Cost
When the firm is free to vary the quantity of capital in the long run, it can attain lower
total cost than it can when its capital is fixed.
8

1
Q
2
Q

Short-run Average Cost
(Notice that the MCs still intersect the AC curves at their minimum in the short run)
( ) STC Q
VC FC VC FC
SAC AVC AFC
Q Q Q Q
+
= = = + = +

9

Long-run Average Cost as an Envelope Curve ( ) ( )
. . i e LRAC Q

(Note that the AC is the summation of the minimums of the SAC curves)

Example:
Production function is 50 = Q LK

a) What is the SAC for a fixed
__
K when 25 and 100 w r = =
?

From the previous examples we know that
( )
( )
2
__
__
__
__
100
100
Thus,
100
100
Q
STC Q K
K
Q K
SAC Q
Q
K
= +
= +

b) Sketch ( ) SAC Q for { }
__
1, 2, 4 K =

( )
( )
( )
__
__
__
100
1
100
200
2
200
400
4
400
Q
K SAC Q
Q
Q
K SAC Q
Q
Q
K SAC Q
Q
= = +
= = +
= = +

10

An increase in K (track mileage) can benefit the railroad company and reduce the cost

11

Economies of Scope
Here, the firm produces two products,
1 2
& Q Q and the total cost of one single firm
that produce these two goods is less than the total cost of producing those quantities
in two single product firms. In essence, there are cost advantages to merging the
production of two products to one single firm.
( ) ( ) ( )
1 2 1 2
, , 0 0, TC Q Q TC Q TC Q < +
Then, the variety is better than specialization.
( ) ( ) ( ) ( )
1 2 1 2
2
1
firm was only producing Q
0

, , 0 0, 0, 0 TC Q Q TC Q TC Q TC <
0

2
itional cost of producing Q when
firm was not producing anything

Example:
Cost of Coca Cola to
add a new product of Cost to a new company to
Cherry Cola to its live start producing Cherry Cola
of products

<

Example:

Cost of adding one more channel to a satellite < Cost of the satellite
Shares Eurotunel between Cars and Train < Two Tun
XXXXX
nels

Economies of Experience
We have two processes. One is a dynamic process which produces a reduction in
costs that results from accumulated experience.
The other process is static like economies of scale.

The economies of experience are described by the experience curve which show a
relationship between average variable cost and cumulative production volume. How
does accumulated experience affect costs?
( ) ( )
AVC N
( ) [ ]
. where >0 and 1, 0
B
AVC N A N A B =
Where A is the AVC of the first out and B represent the experience elasticity
( )
( )
1
. .
1% in is the % in
B
B
dAVC N
N N
BAN
dN AVC N AN
N B AVC

=

12

Economies of Experience vs. Economies of Scale
What is the relationship between economies of experience and economies of scale?
( )
( )

Typical for the production of new products, after some results or years the production process
gets more efficient.

Typical fro mature industries
N AVC Experience
Q AVC Scale

Econ of Scale, no experience: mature industries
Econ of experience, no scale: handmade products e.g. watches

Slope of experience curve:
How much does the average variable cost go down as a percentage of an initial level
when cumulative output N doubles.

( )
( )
( ) 2 2 2
Slope of experience curve 2
B
B B
B
B B
A N AVC N N
AVC N AN N
= = = =

13

The smaller the slope the steeper the experience curve the more rapidly AVC goes
down as cumulative output increases. Slope of 100% only occurs if B=0 (no Econ of
experience)

1

EconS 301 Chapter 9
Perfectly Competitive Markets

What are we going to do in this chapter?

Characteristics of P.C. markets
Determining P in P.C. markets
Economic surplus and welfare analysis

Characteristics of P.C. markets

1. Fragmented many buyers and sellers (each one is to small to affect the prices)
2. Undifferentiated products-products that consumers perceive as being identical.
3. Perfect information about prices-full awareness by consumers of the prices charged by all
sellers in the market.

But what are the implications of this characteristics?, see the next point

How PCM work

1. Price takers this come from of the industry is Fragmented
2. Law of one pricefrom the 2 and 3 characteristic of P.C
3. Free entry in the market From the last characteristic of P.C

Now, what Im going to do with this theory? Well, know we need to find how this P.C. Market is
going to facilitate the allocation of resources and the creation of economic value.

Economic profit vs Accounting profit

Economic Profit = Sales Revenue Economic Costs (including opportunity costs)
Accounting Profit = Sales Revenue Accounting Costs

Firm

Market
2

Q that maximizes Economic Profits

Marginal Revenue: The rate at which total revenue changes with respect to output.

TR TC =
Where TR = QP and given price taking behavior P constant

&
TR TC
MR MC
Q Q

= =

Where MR > MC (P > MC), we have Q
MR < MC (P < MC), we have Q
But when both are equal, what happen?

A price taking firm maximizes when P = MC.
MC must be increasing.

(i.e. the price taking firm Max. profit when produce some Q at which MC equal market price) in
roses example this Max profit was in 300.
But, is Q = 60 another profit maximizing Q? No! The is minimized.

So, the question is how could I know when is Max or Min my profit? Easy fellas, first when
P=MC and when MC is decreasing then we have a Profit Maximization.

3

Now we are going to construct a supply curve for a firm in the short-run. Well, first we need a
Price, so I need made assumptions to find this price.

Determination of market price in the short-run

Short-run: K is fixed for all firms.
Number of firms is also fixed in the market.

Case: when all fixed costs are sunk

Sunk fixed costs: A fixed cost that the firm cannot avoid if it shuts down and produces zero
output.

Nonsunk fixed costs: A fixed cost that must be incurred for a firm to produce any output
but that does not have to be incurred if the firm produces no output.

1. The profit-maximizing condition P = MC makes the supply decisions of the firm (Supply
Curve) to coincide with the SMC curve (red line).

2. If P < AVC, then we have that, apart from the Sunk Fixed Cost, the firm is making losses
for TFC+[Q(AVC P)], the shaded rectangle.

3. This explains Supply Curve concentrated at Q=0 for all p < min AVC.

4. Note, finally, that there are points where p (AVC, SAC) where the firm is not
compensated for its fixed costs, although it is for its variable costs.

5. Short Run supply curve: The supply curve that shows how the firms profit-maximizing
output decision changes as the market price changes, assuming that the firm cannot adjust
all of its inputs.

4

Example:

STC = 100 + 20Q + Q
2
, then MC = 20 + 2Q

FC TVC

a) AVC = (20Q + Q
2
)/Q = 20 + Q
b) Min AVC
We know that this minimum occurs where MC = AVC. Then,
20 + 2Q = 20 + Q
2Q = Q
Q = 0
Then min AVC = 20 + 0 = 20.
c)
a. Short-run Supply Curve
For p < 20, we have Q = 0
For p 20, we have p = MC. That is p = 20 + 2Q. Then p 20 = 2Q

Supply (P) =

Case: determining Supply with Sunk Costs

In the previous case (all fixed cost are sunk) you could only avoid losing money by Q = 0 when
p AVC < since there is no fixed costs which were non-sunk (all your FC were sunk). Now, you
can set Q = 0 and avoid paying FC since some of them are non-sunk.

p/2 10 = Q
0 if p < 20

p/2 10 if p 20
5

In this case you will never produce when p ANSC <
Shut down price: The price below which a firm supplies zero output in the short run.

Example

STC = 100 + 20Q + Q
2

SMC = 20 + 2Q

a) Assume SFC = 36 and NSFC = 64. What is ANSC?

NSC = TC Sunk Costs

= NSFC + Sunk Fixed Costs + VC Sunk Costs
= NSFC + VC

Then ANSC = NSFC/Q + VC/Q = 64/Q + (20Q + Q
2
)/Q = 64/Q + 20 + Q

Min ANSC
It happens where ANSC = MC

64/Q + 20 + Q = 20 + 2Q 64/Q = Q 64 = Q
2
Q = 64^(1/2) = 8

Then min ANSC = 64/8 + 20 + 8 = \$36

b) Supply Curve
If p < 36 then Q = 0
If p 36 then Q is determined from p = MC, p = 20 + 2Q. Hence Q = p/2 10.

Supply (P) =

0 if p < 36

p/2 10 if p 36
6

Now, we need to find the supply curve for the entire industry (recall that previous was just only
one price-taking firm).

Short-Run Market Supply

Horizontal summation of supply curves.

Be careful: if we are adding up Supply 1, 2 for each price, we want Supply 1, 2 in terms of
20 2 p Q = + . Secondly, we will differentiate for different price intervals.
Suggestion: exercise 9.10.

Dont worries is easier that you expect, but dont forget the number of types of firm per each
supply curve.

Short-run market supply curve: The supply curve that shows the quantity supplied in the
aggregate by all firms in the market for each possible market price when the number of firms in
the industry is fixed.

Competitive Equilibrium in the Short-run

Market Demand = Market Supply

Example

D(p) = 60 p
STC = 0.1 + 150Q
2
N=300
SMC = 300Q and AVC = 150Q

7

Where from SMC the N=300 are the number of firms.

a) Firms supply
Min AVC occurs at Q = 0, what implies min AVC = 0. Then, for any p > 0 we
have p = MC, p = 300Q, Q = p/300.
Firm Supply curve is Q = p/300 for all p > 0.

b) Market Supply
300 p/300 = p

c) Competitive market
p = 60 p 2p = 60

Competitive Statics
N makes p and Q

Increases in Demand

Very elastic supply Very inelastic supply

Long-run
p* = \$30
Q* = 30
Application ST. Valentine
8

Supply curve in the long-run should be use the long-run cost functions.

Similar to short-run, but now there are no fixed or sunk costs: now all costs are avoidable, since
the size of the plant, K, act like variable.

Long-run P.C. markets

Long-run competitive equilibrium: The market price and quantity at which supply equals
demand, established firms have no incentive to exit the industry, and prospective firms have no
incentive to enter the industry.

At the price at which Market Demand = Market Supply we have that

1) No entry, no exit
2) Each firm maximizes long-run changing Q and K decisions
3) Economics profits is zero, since p = min AC
4) Market Demand = Market Supply

Example

AC(Q) = 40 Q + 0.01Q
2

MC(Q) = 40 2Q + 0.03Q
2

D(p) = 25,000 1,000p

P.C.

We know that in a P.C. market the following 3 conditions must hold:
p* = MC(Q*) = 40 2Q* + 0.03(Q*)
2
(profit maximizing)
p* = AC(Q*) = 40 Q* + 0.01(Q*)
2
(zero profit)
D(p*) = n*Q* 25,000 1,000p* = nQ* (market demand = market supply)
9

1) From the first two equations
40 2Q* + 0.03(Q*)
2
= 40 Q* + 0.01(Q*)
2

0.02 (Q*)
2
= 2Q* - Q*
0.02 (Q*)
2
= Q*
0.02 Q* = 1

Individual supply in equilibrium

2) p* = 40 2Q* + 0.03(Q*)
2
= 40 - 250 + 0.03(50)
2
= 50 equilibrium price
3) plugging p* into the Demand function
D(p) = 25,000 1,00015 = 10,000
4) Then, 10,000 = n50 n = 10,000/50 = 200 firms in equilibrium

Long-run Supply Curve

1) If shift from D
0
to D
1

from p
0
to p
1

2) Large profits, since p
1
> SRAC in the LHS
3) This induces the entrance of firms, from SS
0
to SS
1

4) Equilibrium, in the long run, happens to be at
p
0
= min AC
No entry or exit of additional firms
5) Long-run supply curve is a flat line at p = min AC

But how the long-run supply curve will work with respect to the cost?

There is the case of constant cost industry: Q from new firms doesnt change costs.
Increasing cost-industry: an industry in which increases in industry output increases the prices of
inputs

Decreasing cost industry: An industry in which increases in industry output decrease the prices
of some or all inputs.

Long-Run Supply when we have increasing costs Q from entering firms p inputs (costs)
Q* = 1/0.02 = 50
Application of n*
10

Long-run supply curve with decreasing costs Q from entering firms p inputs (costs).
Example: an industry which uses chips extensively.

After understand how the supply curve works; now we need to learn how firms and input owners
profit from their activities in perfectly competitive markets, for that reason will use the concept
of Economic rent and Producer surplus.

Economic Rent: The economic return that is attributable to extraordinarily productive inputs
whose supply is scarce.

Reservation value: The return that the owner of an input could get by deploying the input in its
best alternative use outside the industry.

Maximum amount that a firm is willing to pay for services of an input inputs reservation value
where reservation value return of the best possible alternative

Economic rent Economic profit

11

1) AC` and MC` in left-hand side due to extraordinary master grower who receives a low
salary as regular master grower
2) MC and AC in right-hand side since they use run-of-the-mill master grower who receives
a low salary as regular master grower, their costs are higher.
3) If P.C. p* = 0.25, then firm 1 profits are larger
4) Competition for such a valuable (talented) extraordinary master grower makes firm 2
offer up to 70,000 to 105,000, as well for Firm 1. Finally, the economic rent will be 105-
70 thousand=35 thousand which is entirely captured by the extraordinary master grower.

In other words, both are going to offer until observe
1
=
2
= 0

Producer Surplus: A measure of monetary benefit that produces derive from producing a good
at a particular price.

Difference between what a producer actually receive for selling one unit and the minimum price
he must receive in order to be willing to supply that unit.

Both in the case of institutional firms and market supply
Note that with the usual supply curves

12

Example

Market supply Q = 60p
p = 2.5

with p = 2.5, Q = 60 2.5 = 150

Area:
(A) = 150,000 2.5 = 187,500
(B) = (4 2.5) 150,000 = 225,000
(C) = (4 2.5)(240-150) = 67,500
Increase in Production Supply
with p = \$4, then Q=604 = 240

Producer surplus in the long-run

Here the Producer surplus in the long run will be equal to zero, why? Because in the long-run the
producer surplus=economic profit which, as we know, in the long run is zero.

(B) + (C) = 292,500
13

How can we have (+) PS if it is supposed to be zero profits in the LR? This PS reflects the
economic rent captured by the owners of those inputs which are scarce.

Application
Roses and Valentines Day

Constant cost Increasing cost
1

EconS 301 Chapter 11
Monopoly

Unlike firms who face perfect competition and therefore have no choice over what
quantity and price to set for their product, monopolies set the market price for their good.
What keeps them from setting an infinitely high price? Monopolists must still take into
account a downward sloping market demand curve, as consumers will buy less as the
price rises.

Recall:
Perfect competition one firm has no consequence on the market price (price taker)
Monopolist one firm has total impact on price (set the market price of his product)

Then, why the monopolist does not set price = ? Because he faces the market demand
curve (i.e. higher prices reduces demand and vice verse).

So, how (where on graph) does the monopolist maximize his profit?
MR=MC Monopolist profit max condition where MR equals Marginal Revenue and
MC equals the Marginal Cost
Note that since P>(MC=MR) , Profits >0

So monopolists can make a positive profit, unlike perfect competition firms.

2

Why MR is below Demand?

1) Firstly, the marginal revenue is below the demand curve because the second part
of the marginal revenue equation (highlighted region), MR = (pq)/q = p +
qp/q, is negative because the change in P is negative. Since this negative
number is subtracted from P, MR is below P.
2) Change in monopolist revenue III I, where area I is the revenue lost from
decreasing the price of some of the sold product and area III is the revenue gained
from selling more units than before.

Area I = Q p = Q (-p) = - \$6(loss)
Area III = Qp = \$21
Then, TR = III I = Qp +Qp = \$15

Therefore, we can derive the MR by simply deriving the TR equation with respect to
Q
MR = TR/Q = [Qp +Qp] / Q = p + Q(p/Q)

At Q=0, MR= p (i.e. MR = Demand)
Q>0, since p/Q <0, then we have that [p + Q(p/Q)] < p
MR<Demand (the same conclusion we came to up above)

3

Average Revenue vs. Marginal Revenue
Why is this so important in monopoly theory? Because
TR PQ
AR P
Q Q
= = = ,but in
monopoly theory the firm can decide the price of the product, then this price is
determined by the demand curve, well what does this means? It means that
( ) ( ) AR Q P Q =

Example
p = a bQ is our market demand curve.
AR = p = a bQ (remember that AR equals P in the case of a monopoly)

MR = p + Q(p/Q) = a bQ + Q (-b) = a 2bQ

P p/Q
Alternatively, TR = pQ = (a-bQ)Q = aQ bQ
2

MR = TR/Q = a 2bQ
So graphically this implies that the MR has the
Same vertical intercept as Demand
Twice the slope of Demand

When the average of a variable is
falling, it must be because
average.
4

Example
Another example, where the market demand is given by
p= 12 Q
MC = Q

1) MR
TR = pQ = (12-Q) = 12Q Q
2
MR = 12 2Q
2) MR=MC (This is the profit maximizing condition for a monopoly)
12 2Q = Q 12=3Q Q
m
= 4
p = 12-4 = 8
So, this monopoly will set its price at 8 and sell a quantity of 4 units.

Lesson: p>MC for the last unit supplied, indeed 12-4 >4 8>4
So therefore this firm has positive profits of B+E = \$12
CS>0, area A = (12-8)4 = \$8, note that these consumers still have a positive
consumer surplus, contrary to what we may have suspected under a monopoly

The monopolist doesnt have a supply curve

Perfect competition Firm observes a market price (exogenous and fixed) and
determines how much to produce, q. There is a specific relationship between p and q
where one forces a certain shift in the other.

Monopolist Firm determines simultaneously the market output and price without
taking into account anybody else.
For different demand curves a monopolist can produce the same output at different
prices:

5

No unique correspondence between p and Q, so no supply curve.

Hence, no unique supply of produced output can be depicted for the monopolist, as the
monopoly is the determiner of both price and quantity.

Monopoly Supply Conclusions:
MR < P
Since AR = P, therefore MR<AR
Since AR curve coincides with demand curve, MR curve must be below
demand curve
Price Elasticity and Mark-up Prices

Elastic Inelastic
p
A
MC small p
B
MC large

These graphs show us that the price elasticity of demand plays an important role in
determining by how much a monopolist can raise his price over marginal cost. In graph a,
the demand is elastic and thus this monopolist can only set price slightly higher than
marginal cost. In graph b, the monopolist can set his price much higher than marginal
cost.
Then, what is the relation between price elasticity and marginal cost?

MR = p + Q (p/Q) factoring the p out, we get
MR = p [1+(Q/p) (p/Q) ]= p (1+1/e
Q,p
)

And since the monopolist set MC = MR, then MC = p(1+1/e
Q,p
)
Existence/Non-
existence of close
substitutes
6

MC p = p(1/e
Q,p
) (MC-p)/p = 1/e
Q,p

Inverse Elasticity Pricing Rule (IEPR)

The left side of the IEPR equation is the monopolists optimal price markup expressed in
percentage terms. So for this monopolist to optimize the price she can charge, she would
use the IEPR. The monopolists optimal mark-up of p above MC, as a % of price, is equal
to minus the inverse of the price elasticity of demand. So

|e
Q,p
| |1/e
Q,p
| (close to 0) (p-MC)
The higher the price elasticity of demand, the smaller the price markup

Example

Demand is Q=aP
-b
So price elasticity of demand equals

e
Q,p
= (P/Q) (Q/P) = (P/Q) (-baP
-b-1
) = P/aP
-b
(-b)(aP
-b
)P
-1
= P(-b) P
-1
= -b

Here, we consider a case where MC = 50 and the demand equations are given below

a) p* if Demand is Q = 100p
-2
, then e
Q,p
=-2
Using IEPR, (p-MC)/p = - 1/-2 (p-50)/p = 2p-100 = p, p = 100

b) p* if Demand is Q = 100p
-5
, then e
Q,p
=-5
Using IEPR, (p-MC)/p = - 1/-5 (p-50)/p =1/5 5p-250 = p, 4p = 250 p=62.50

Note that when demand is more elastic (as in -5) we have that the monopolist markup
is smaller.

Application

Chewing gum (low elasticity, high mark-up) impulse purchase items
Baby goods (high elasticity, low mark-up) non-impulse purchase items

Example
MC = \$50
p=100 Q/2 Q = 200 -2p

p-MC/p = - 1/e
Q,p

e
Q,p
= (q/p)(p/q) = - 2(p/200-2p) = -2p/(200-2p)

Then,
(p-MC)/p = - 1/e
Q,p

7

p-50/p = -1/[-2p/200-2p] = (200 2p)/ 2p

Multiplying both sides by 2p,
2p (p-50/p) = 2p [200-2p /2p] 2p-100 = 200-2p 4p=300 p=\$75

Q = 200 - 275 = 50 units supplied at a price of \$75

So to find the profit maximizing price we first find the Price Elasticity of Demand and
then set up the IEPR and solve for P. We then plug in that P to the demand function and
solve for Q.

Elastic Region
The monopolist always produces in the elastic region of the Demand curve. Why?
Because MC is positive then from the relation MC= MR = p (1+1/e
Q,p
) the only way that
will be positive is if
[ )
Q, p
1, , means demand is price elastic. That is, the
monopolist could always decrease his production (raise his price) and increase profits.
Graphically, the I region is larger (which is the profit lost if quantity increases from B to
A) than the II region (profit gained from increasing Q from B to A).

Going from A to B we have an TR = I II >0

Lerner Index of market power
Learner Index is a measure of the Market Power. In the real world, firms can be in
between perfect competition and monopoly. For instance, Coca Cola is not a
monopoly because brands like Pepsi are important competitors, but it also faces a
8

downward sloping demand curve and thus has some market power (i.e. not a price
taker). The learner index helps us measure that market power.

p-MC/p 0 for perfect competition, where p=MC
1 (100%) for monopolists

Collusive Cereal 65%
41%

Lerner index will be - HIGH for inelastic Demands
LOW for elastic Demands (existence of close substitues)

Comparative Statics
How a shift in demand curve affects monopolist profit maximization? Or, how a shift
in MC affects profit maximization?

1) Demand will lead to p and Q as long as MC constant or increasing
Demand will lead to p and Q as long as MC decreasing
So, quantity follows shifts in demand and price changes are dependent on whether
MC is increasing or decreasing.
2) MC will lead to p and Q

3) TR as a consequence of MC (e.g., taxes)

if we observe this for a group of firms, they are acting as a monopolist (collusion)
if we dont, then they are not acting collusively.

9

Example with Linear Demand

p = a-bQ
MC=c
MR = a-2bq = c = MC
q=(a-c)/2b p = a-b[(a-c)/2b] = a (a-c)/2 = (2a-a+c)/2 = (a+c)/2

Monopoly pricing as the MIDPOINT RULE, in between the choke price, a, and the
MC, c (or the vertical intercept of MC, but the MC is a straight line here).
For monopolies facing linear demand curves and constant marginal cost, the
optimal price will always be the midpoint between the choke price (intercept of
demand curve) and the MC curve.
Multiplant Monopoly
When there exists two plants for the same monopolist you need to answer:
How much to produce in overall, well where MR=MC total
in each plant

High MC firm produces less. The MC total is a horizontal sum of the individuals MC.

To profit maximize, a monopoly will never want to produce quantities in plants when
their respective marginal costs are different because they could reallocate production to
the plant with a lower MC and reduce total cost. THUS, to maximize profits a multiplant
monopolist will always produce at quantities where the plants have the same MC.

10

Example
p = 120-3Q MR = 120 -6Q
MC
1
= 10+20Q
1
MC
2
= 60+5Q
2

1) MC
T
(We first solve for MC
T
by summing separate MCs)
MC
T
is the horizontal sum of MC
1
and MC
2

Firstly, (MC
1
-10)/20 = Q
1
and (MC
2
-60)/5 = Q
2

1
+ Q
2
= (MC
T
-10)/20+(MC
T
-60)/5= 0.25MC
T
-2.5
2) Q=0.25MC
T
-2.5
Solve for MC
T
= 50+4Q
3) MR = MC
T

120-6Q = 50+4Q
70=10Q Q=7 Total units produced by monopoly
p = 120 3Q = 120-21 = 99
4) Q
1
,Q
2
(No we solve for the quantity produced in each firm)
MC
T
(Q=7) = 50+47 = 78
From inverted MC
1
and MC
2
curves,
Q
1
=(78-10)/20 = 3.4
Q
1
=(78-60)/5 = 3.6

Example. Output choice with two markets.
Same price (later on we will analyze how to price discriminate). First, we want to
aggregate the individual market demands so that we can determine the aggregate
marginal revenue for this firm. We then set aggregate MR equal to the MC to find
optimal price. We then find Q by using the aggregate demand curve.

1
(p) = 180-p
Vacation Q
2
(p) = 120-p
MC(Q) = 30
where p e [120,180], demand is Q=180-p, so inverse demand is p = 180 Q,
MR=180 2Q
when p<120, aggregate demand is
Q=(120-p)+(180-p) = 300-2p
Hence, inverse demand is
p=150-1/2 Q
MR = 150-Q
1) Can p>120?
Lets assume thats the case
Then MR = MC implies
180-2Q = 30 Q=75
p=180-75 = 105 X p is NOT >120
2) Can p<120?
Lets assume thats the case
Then MR=MC implies 150-Q=30 Q=120
p=150-1/2120 = 90 YES! p<120
Q
1
(p) = 180-90 = 90 and Q
2
(p) = 120-90 = 30
11

CARTEL
Cooperation by individual entities in order to max joint profits, example OPEC
Analysis: same as the one in a multiplant monopoly. That is, we can determine the
optimal price and production for the cartel by the same process we used for multiplant
monopolists.

QT, Q1, Q2
OPEC production is not consistent with this
So, A monopolist could have done better. OPEC is not allocating
production as to equate MCs of each member and could thus make more
profit.

Welfare analysis of Monopoly
How is the consumer benefitted or harmed in the monopolistic market versus a perfectly
competitive market? Related to deadweight loss (net economic benefit of Perfect
Competition and Monopoly are different)

Deadweight loss may be understated because of the existence of rent-seeking activities
Upper-bound of DWL of monopoly = (B+E+H) + (F+G)
monopoly
12

Why do monopoly markets exist?
1) Because they are a natural monopoly (decreasing AC that makes one firm has
smaller costs that many firms). That is, it makes more sense in regards to cost for
one firm to supply the market versus many firms. Total cost for one firm is less
than the total cost of many firms.

TC
one firm
= \$19,000 = 9,000
TC
two firms
= [\$1.204,500] 2= \$10,800

2) Barriers to entry:
Structural (e.g., cost advantage over other firms)
Legal (e.g., government regulation protecting the market, patents, ect.
Strategic (e.g., regulation of fighting any new comer, incumbent purposefully
attempts to differ other firms from entering)

Exercises: Chapters 6, 7, 8, 9, 11, not about 10
Chapter 6: 6.16, 6.11, 6.8, 6.20
Chapter 7: 7.7, 7.8, 7.17
Chapter 8: 8.10, 8.14
Chapter 9: 9.6, 9.10, 9.18, 9.25
Chapter 11: 11.7, 11.12, 11.16

Effects of a specific tax on monopoly - Perloff pp.376-378

The monopolist must pay t per unit produced, so that TC(Q) = c(Q)+ tQ

p(Q)= TR(Q)- TC(Q)p(Q)= TR(Q)-c(Q)- tQ

FOCs: (derive with respect to Q)

[TR(Q)/ Q] [ c(Q)/ Q] - t = 0

SOCs: (second derivative)

[
2
TR(Q)/ Q
2
][
2
c(Q)/ Q
2
] 0, which we know that holds from
our standard analysis of monopolist

If the monopolist sells Q(t) as a fraction of the tax, what is the effect of rising the tax?

1) TR(Q(t))/ Q(t) - c(Q(t))/ Q(t) - t = 0
2) Differentiate with respect to (t),

[
2
TR(Q(t))/ Q(t)
2
][ Q(t)/t] - [
2
c(Q(t))/ Q(t)
2
][ Q(t)/t]-1= 0,

13

Or alternatively,
[
2
TR(Q)/ Q
2
-
2
c(Q)/ Q
2
] Q/t = 1

Q/t = 1/ [
2
TR(Q)/ Q
2
-
2
c(Q)/ Q
2
]
from SOC its negative

Hence, Q/t <0, and as t Q. So taxes reduce quantity produced.

Tax incidence on consumers
Can the imposition of a \$1 tax to a monopolist lead to an increase in the price consumers
pay of more than \$1? YES

1) Inverse demand function p(Q) = Q
1/e

TR(Q) = pQ = Q Q
1/e
= Q
1+1/e

MR(Q) = [1+1/e] Q
1/e

2) MC(Q)=c, but after the tax they become c+t
3) Making MR=MC we obtain
[1+1/e] Q
1/e
= c+t
Solving for Q we have
Q = [m+t]/[1+1/e]e
and plugging back this into the inverse demand function, p(Q)= Q
1/e

p = [m+t]/[1+1/e]

4) How does p change in t? Lets derive it so that dp/dt equals

dp/dt = 1/[1+1/e]
But we know that e<-1 for the monopolist, e.g., -2 dp/dt = 1/[1-0.5] = 1/0.5 = 2.
So the imposition of the tax increases price by more than the tax.

Example
Lets look at an example where a tax is imposed on a monopolist. What happens to price
and quantity after tax?
p = 24-Q
MR=24-2Q
MC=2Q, where t =8

1) No tax
MR=MC
24-2Q = 2Q Q=6
P=24-6=\$18
2) Tax
MR=MC
24-2Q = 2Q + 8 Q=4
P = 24 -4 = \$20
14

p=\$2 and the consumer is clearly worse off as demand has not changed, but quantity
produced has gone down and price has increased.

Tax incidence out of \$8 of the tax \$2 are passed on the consumer
\$6 are absorbed by the monopolist

Monopsony

Definition: A market of a single buyer and many firms (sellers). Example: Major
League Baseball in 70s where one team was the buyer of many players (sellers). To
profit maximize, a monopsonist. To profit maximize, this firm will want to find a
level of production where MRP
L
=ME
L
(Marginal revenue product of labor = marginal
expenditure of labor).

Example:
Production function Q=f(L)
Firm in perfect competition is the market of coal, p is given. However, firm is the
only buyer of labor in this region so it is a monopsonist.

TR = pf(L)
Marginal Rev.Product of Labor MRP
L
: additional revenue that the firm gets when it
employs an additional unit of labor.

MRP
L
= pf(L) = pQ/L (draw it)
Supply of labor is given by w(L) (draw it)

Marginal Expenditure on Labor: the rate at which a firms total cost goes up, per unit
of labor, as it hires more labor.

ME
L
= TC/L
where TC = I+II, where I = wL(extra cost from hiring more workers) and
( ) II w L = (extra cost that comes from raise the wage for all initial workers)

Hence, ME
L
= [wL+wL]/L = w+(w/L) L
And since L w, then

ME
L
= [w+(w/L) L] >w = Supply curve
ME
L
lies above supply.

15

Profits = pf(L) wL, where pf(L) is the revenue from labor and wL =TC from
labor monopolist maximizes its profits when MRP
L
=ME
L

if L>3,000 the firm does not maximize profits since MRP
L
<ME
L
if L<3,000 the firm does maximize profits since MRP
L
>ME
L

Example
Q=5L (demand), p=\$10 and w=2+2L
1) We want to find L such that MRP
L
=ME
L
2) ME
L
= w+(w/L) L= (2+2L)+2L = 2+4L
MRP
L
= pQ/L = \$105 = 50
3) MRP
L
=ME
L
2+4L = 50
4L= 48
L=48/4 = 12 units of labor purchased
Hence, w=2+2L =2+212=2+24=\$26 wage for workers.

DWL of Monopsony

1

## EconS 301 Intermediate Microeconomics

CHAPTER 12 CAPTURING SURPLUS

Monopolist would like to capture CS and DWL
In order to capture all of this surplus, the producer will try to charge different prices (i.e., price
discriminate among consumers).

Price Discrimination: The practice of charging consumers different prices for the same good or
service. There are 3 different degrees of price discrimination.

1
st
degree
1
p

= willingness to pay
i
(reservation price: the consumers maximum willingness
to pay for that unit.)
2
nd
degree Different prices to different amounts of units bought: quality desired

\$10 0 10 units
\$5 10-20 units
p
p
= =
=

3
rd
degree Different prices to different consumer groups who have different demand curves

1 1
2 2
D MR MC
D MR MC
=
=

Example Airlines \$500 per business class ticket
\$200 per economy class ticket

Requirements
Some market power to determine prices (not price taken). Downward sloping demand
curve
No arbitrage (cannot resell the good to a new consumer)

1
st
degree price discrimination

Demand curve as a willingness-to-pay schedule

E F
G H J
P
DWL
MC
Q
P
CS
TR
D
Q
P
2

Uniform monopoly proxy 1
st
degree
CS E + F Zero
PS G + H (E + F) + (G + H) + J
DWL J Zero

It is ideal (perfect) for the producer!!

Check? of thee Requirements:
1) Same kind of marked power (Demand B downward energy)
2) Perfect information about willingness to pay, imperfect information is better than none.
3) No arbitrage otherwise p MC can sell to the consumers with the ??? willingness to
pay.

Ex. P = 20 Q
MC = 2

a) Monopolist MR = 20 2Q = 2 = MC 18 = 2Q Q = 9
Price p = 20 9 = 11.
Producer Surplus = TR TC = pQ MC Q = 11.9 2.9 = 81

b) 1
st
Degree Dem = MC 20 Q = 2 18 = Q
Price p = 20 18 = 2
Producer Surplus = TR TC = (20-2) 18 = 162 ( wrt
Monopoly)

MR = Dem. Curve in 1
st
degree price discrimination

With each additional unit sold, the producer gets p from that corner.
However, he doesnt need to reduce the price of all the previous units.

Application College Education

1) Downward sloppy demand curve (Qp)
2) Info about willingness to pay?
3) No arbitrage: I cant sell you my education

But if they ask your family may data about their finances when you apply for financial aid based
on the financial need of your faculty, colleges can get a very good approximation of .2.

3

## Second Degree Price Discrimination Quantity Discount

Block tariff two part tariff a form of 2
nd
degree price discrimination

A form of 2
nd
degree price discrimination in which we consider
0 Q - pays one price for units consumed in the first block of output (up to Q)
Q - pays a different price for any additional units consumed on the second block

Optimal block pricing

MC = 2
P 20 Q

1) Blue segment twice slop of demand curve
Starts at P
1

Crosses MC always at the half point between
Q
1
and 18. Then
1
2
18 6 18 24
. . 12
2 2 2
Q
Q e g
+ +
= = =

where to set Q
1
.
After that everything is OK.

2) Constructing PS
st
block = P
1
Q
1
and from Demand, (20 Q
1
)Q
1

nd
block = P
2
(Q
2
Q
1
) and from Demand, (20 Q
2
) (Q
2
Q
1
)
Total cost = MC Q
2
= 2Q
2

Therefore, PS = (20 Q
1
)Q
1
+ (20 Q
2
)(Q
2
Q
1
) 2 Q
2

= 20Q
1
Q
1
2
+ 20Q
2
20Q
1
Q
2
2
+ Q
2
Q
1
2Q
2

3) Optimal Q
1
and Q
2

\$11 for each of the first 9 units
(in this case, the consumer only
MC
Q
P

D
9 12
11
8
1
st
block 2
nd
block
MC
Q
P
D
Q
1
Q
2
18
P
1
P
2

2
4

1
1 2
1
2 1 1 2
2
2 2
20 2 20 0
20 2 2 0 2 18
20 2 2 18 20 0
Q
PS
Q Q
Q
PS
Q Q Q Q
Q
Q Q

= + =

= + = =

+ =

20
2
4 36 20 Q +
2 2
2
0 30 36
12
Q
Q
+ = =
=

Pay

1 2
1
2 2
2 18 24 18 6
20 20 6 14 1st block (\$4 for all units up to 6 units)
20 20 12 8 2nd block (\$8 for all additonal units in excess of 6)
Q Q
P Q
P Q
= = =
= = =
= = =

Subscription and Usage Charges

Example: Telephone company charges \$20 on subscription fee
\$0.10 per call (usage charge)

How can a producer use Sub. + Usage charges in order to capture more surplus

P = MC
F = Consumer Surplus

It is really so easy? No, different consumers may have different demand curves for the good. If
the producer sets F = CS high demand consumers then all low demand consumers will refrain.

MC
Q
P
D
0.05
CS
\$20 of subscription fee
5

As we will see, in the observations, the producer will prefer to offer a new of phone plans. Each
consumer picks the one he likes the best.

Nonlinear Outlay Schedule: An expenditure schedule in which the average outlay(expenditure)
changes with the number of units purchased.

Third Degree Price Discrimination

Different prices to different consumer groups who have different demand curves.

Ex.
1 1
2 2
38
14 0.25
10
P Q
P Q
MC
=
=
=

1)
1 1
1 1 1
1
1 1
38 2
1 38 2 2 38 1 28
14
38 38 14 24
MR Q
MC MR Q Q Q Q
Q
P Q
=
= = =
=
= = =

MC
Q
P
MR
2
D
2

Q
2
P
2
Q
P
MR
1
D
1
Q
1

P
1

MC
MC=MR
1
=MR
2
6

2)
2 2
2 2 2
2
2
14 0.5
10 14 0.5 0.5 14 10 4
8
14 0.25 8 14 2 12
MR Q
MC MR Q Q
Q
P
=
= =
=
= = = i

Ex.
,
,
1.52 (Vacation travelers)
MC=10
B B
V V
Q P
Q P

=
=
,
1 1
10
1.15
B B
Q P
p MC
p p
P E

= = i
2) IEPR for Vacation travelers
,
1 1
10
1.52
V V
Q P
p MC
p p
p

= = i
B V
p p >

Is it so easy to change different prices to different consumers?
The answer will need to truthfully reveal the demand for the good with the consumer
demanding high do so?

Solution: Screening commonly used in practice in order to do 3
rd
degree price discrimination.

Screening: A process for sorting consumers based on a consumer characteristic that (1) the firm
can see (such as age or status) and (2) is strongly related to a consumer characteristic that the
firm cannot see but would like to observe (such as willingness to pay or elasticity of demand.)

Sort the consumers according to a perfectly observable character age
student
- - -
This characteristic must be tightly correlated with the willingness to pay
for the good. (which the price couldnt observe).

Application: Screening in the travel industry.

Perfectly reasonable characteristic:

a vacation traveler books the ticket months in advance

a business traveler books the ticket but one day in advance (or same day)

or

7

a vacation traveler doesnt care about staying at the destination over Saturday night

then

high prices to couples who book their flight in the last week
didnt stay Saturday night

low prices to couples who book their flight months in advance
stay Saturday night

Other applications:

Day/night phone call prices
New/old i-pod or computer

Coupon and rebates as a screening device

TYING (TIE-IN-SALES)

A sales practice that allows a customer to buy one product (the tying product) only if that
consumer also agrees to buy another product (the tied product).

A firm with a patent in a photocopy machine would like to price discriminate, by setting

highnumber low number
of photocopies of photocopies
consumed consumed
P P >

How to know how many copies is the firm doing? By tying the photocopies with the purchase of
paper.

BUNDLING (type of tie-in-sales): a type of tie-in sale in which a firm requires customers who
buy one of its products also to simultaneously buy another of it products.

The firm requires customers who buy one of its products also to simultaneously by other of its
products.

3 types of bundling:
Option 1: No bundling. The manufacturer does not bundle any goods.
Option 2: Pure bundling. The manufacturer only offers bundled goods.
Option 3: Mixed bundling. The manufacturer offers customers different prices for
bundled and non-bundled goods.

Examples: Computer and monitor
Disney World ticket and all rides at the park
True p
8

Reservation Price
Computer Monitor Comp & Monitor
negatively
correlated
demands
Customer 1 1,200
600
1,800
Customer 2 1,500 400 1,900
MC 1,000 200 1,300

No bundling Bundling
Computer: 1,200 200 profit 2 = 400 Comp & Monitor: 1,800 500 2 = 1,000
profit
1,500 500 profit 1,900 600

Monitor: 400 100 profit 2 = 200
600 300 profit Clearly:
Profits Bundling > Profits No Bundling
Take profits = 500 + 300 = 800 (1,000) (800)

9

## Positive (Twohead of Negative) Correlation in Demands

Reservation Price
Computer Monitor Comp & Monitor

Customer 1 1,200 400 1,600
Customer 2 1,500 600 2,100
MC 1,000 300 1,300

No bundling Bundling
Computer: 1,200 200 profit 2 = 400 Comp & Monitor: 1,600 300 2 = 600 profit
1,500 500 profit 2,100 800

Monitor: 400 100 profit 2 = 200
600 300 profit Therefore, bundling does not increase the firms
profits when ??? are positively correlated.
Take profits = 500 + 300 = 800

No Mixed Bundling

ADVERTISING non-price strategy to capture surplus.

Advertising Demand, but it is costly to what extent it is profitable to spend on advertising

1) Demand
0
and MR
0

2) MC constant and AC
0

3) P
0
and Q
0

4) Profits
initial
= I+II
1
and MR
1

6) MC constant, but AC
1
shifts upwards
MC
Q
P
P
1

Q
0
Q
1

P
1

P
0

AC
1
MR
0
MR
1

AC
0
D
0
II
I
III
10

7) P
1
and Q
1

8) Profits
fixed
= I+II

If I+III A > I + III
III A > II then you will keep on advertising
In other words

III II
A A
MR MC
A > +
You will stop when MR
A
= MC
A

For a monopolist to be profit ????, we need MR
Q
= MC
A

to be spending the right amount on A, we need MR
A
= MC
A

It can be shown that these two conditions lead to

,
,
Q A
Q P
A
PQ

=

Ratio of negative of the ratio of the advertising
Expenditures to sales elasticity of demand to the own price
elasticity of demand

Ex. What
A
PQ
be in two markets with the same
, Q P

With different
, Q A
higher in market 1
Lower in market 2

A
PQ
should be longer in the first market, since consumer are more sensible to

Ex.
,
,
1.5
0.1
Q P
Q A

=
=

a) Interpretation of
,
0.1
1% in 0.1% in quantity demanded
Q A
A
=

b) IEPR:
,
1 1 2
1.5 3
3 3 2 3
Q Q Q
Q P
Q p Q
p MC p MC p MC
P P P
p MC p MC

= = =
= =

11

0.1
0.067
1.5
A
PQ
= =

1

## EconS 301 Intermediate Microeconomics

Chapter 13. Market Structure and Competition

Chapter 13 explores different types of market structures. Markets differ on two important dimensions: the
number of firms and the nature of product of differentiation. We will analyze competitive markets (many
sellers), oligopoly markets (few sellers), and monopoly markets (just one seller).

OLIGOPOLY MARKET
- A small number of firms sell products that have virtually the same attributes, performance
characteristics, image, and price. Think of the U.S. salt industry where Morton Salt, Cargill, and IMC sell
virtually the same product at the same price.

Oligopoly Cournot
Bertrand no product differentiation (homogenous)
Stackelberg

Dominant firm markets
Oligopoly with differentiated products differentiated products
Many firms Monopolistic competition

Oligopoly Cournot- refers to a homogenous products oligopoly. In the Cournot model, firms act as
quantity takers because they set the quantity they produce by first making assumptions about what the
other firm in the market will produce. The market price adjusts to equilibrium after each firm sets the
quantity it will produce.
1) N-2
2) Firms compete in quantities
3) They both simultaneously submit their quantities

Residual demand:

The residual demand curve illustrates the relationship between the market price and a firms quantity
when rival firms hold their outputs fixed. This demand curve is simply the market demand curve shifted
inward by what the exact amount the rival produces.

Since that my rival has already sold 50 units, the demand I face has been reduced. Taking into account
this reduced demand I act as a monopolist MR
50
= MC. That is, I set my Marginal Revenue curve (twice
the slope of the residual demand curve) equal to the Marginal Cost (a constant).

Profit inventory quantity given that my rival produced 50
40
2

60
5
;
Best response function: q
1
(q
2
) A firms best response is the quantity where MR
residual
=MC. The
best response, or reaction function, function is the function that gives us a firms best response
given any quantity the rival firm produces.
(Reaction function)

Equilibrium in Cournot Occurs where each firms output is the best response to the other firms output.
Thus, neither firm has any after-the-fact reason to regret its output choice. This occurs where the reaction
functions cross.

Ex. Market demand
1 2
100 100
10
= =
=
p Q p q q
MC

a) optimal q
1
where q
2
= 50.
Firm 1s residual demand is
1 1
100 50 50 p q q = =
MR associated to demand is
1
MR 50 2q =

1 1 1
50 2 10 40 2 20 q q q = =

b) optimal q
1
for any arbitrary q
2

Firm 1s residual demand is ( )
2 1
100 p q q =
MR =
( )
( )
2 1
2 2
2 1 1
100 2 \$10
90
90 2 45
2 2
q q
q q
q q q
=

= = =

c) optimal q
2
for any arbitrary q
1

Given ???
3

## Practice, but by symmetry

1
2
45
2
q
q =
d) Cournot equilibrium is where Best Response functions cross each other

2
1
1 2
1
2
45
2
: Th symmetry diopotis
45
2
q
q
Trick q q q
q
q

= =

3
45 45
2 2
30
100 30 30 40
q
q q
q
p
= =
=
= =

e) What are the monopoly price and Q?

1
2
22.5
MR 100 2 \$10 90 2 45
22.5
100 100 45 55
q
Q Q Q
q
p Q
=
= = = =
=
= = =

Monopoly vs Cournot
P
monop
>P
cournot

Q
monop
<Q(q
1
+q
2
)
cournot

Profits
monop
>Profits
1
+Profits
2

Revenues
Reviews of my competitors
q
p

Cournot with N firms
Here, we want to analyze the Cournot model with any number of firms

N firms, , MC \$ p a bQ c = =
Residual demand for firm 1 ( ) ( )
1 1
p a b q X p a bX bg = + =

( )
1
1 1
MR 2
1
2 2 2
a bX bq c
a bX c a c
q q X
b b
= =

= =

By symmetry
( )
( )
1 2 2 3 1
1
1 1
... , what makes that ... 1
1
1
2 2
N N
N
q q q X q q q N q
a c
q N q
b

= = = = + + + =

Manipulating
Overall production
2 3
...
n
q q q + + +
4

( )
( )
( )
1 1
1 1
1 1
1
1
1
1
2 2
2 1
2 2
1
2 2
1
1
a c
q N q
b
q N q
a c
b
q Nq a c a c
q N
b b
a c
q
N b

+ =
+

=
+
= + =

=
+
(A firms optimal quantity given N firms)

Market quantity

1
1
1 1 1
a c a c
Q N
N b b
N a c a N
p a b c c
N b N N

=
+

= = +
+ + +
i
i

Note: As the number of firms in a Cournot model increases to infinity, the firm and industry profits are
zero, like a perfectly competitive market. Note that Cournot markets do not maximize industry profit
because the firms do not act collusively, but individually. This self-interest erodes industry profits.

IEPR in the Cournot model

1 1
MC 1 MC 1 1
market up ( market power)
Q P Q P
p p
p p N
N

= =

i

Therefore, the more firms there are, the less market power each firm has. Note that this IEPR is the same
as the Monopoly IEPR, except (1/N) is added to the right-hand side.

Bertrand Model Competition in prices, and not competition in quantity as in the Cournot model.
Let us assume that firm 2 sets a price p=\$40, what price will firm 1 set?

5

The process can be infinitely repeated until p=MC. That is, each firm can set a lower and lower
price until they cannot set a lower price.
So, the Bertrand model even with N=2 firms we have competitive industry prices

Cournot vs. Bertrand

The Cournot and Bertrand models show drastically different conclusions within oligopolistic markets.
1) Capacity constraints:
Cournot capacity is set firstly, then competition (LR capacity competition)
Bertrand enough capacity to satisfy all market demand if necessary (SR price comp.)

2) Firms beliefs about the reaction of its competitor:
Cournot model competitors cannot adjust their production very much
Bertrand model all my competitors have enough production capacity to steal my
customers.

Stackelberg Sequential competition in quantities where one firm acts as a quantity leader, choosing its
quantity first ,with other firms acting as followers.
2) The leader measures profits taken as given the followers BR (Reaction) function

Ex. We first find the followers BR function, and then plug that into the leaders BR function.
Follower
1
2 2
45
2
q
F q =
1
s residual demand:

1 1
1 2 1
1
1
1
1
100 100 45 55
2 2
55 10
MR 55 2 55
2
MC \$10
q q
p q q q
q
q
q
q

= = =

=
= =

=

i

Follower:

2
55
45 22.5 Follower
2
q = =
Price:
Conclusions:
Stackelberg Cournot
1 1
Stackelberg Cournot
2 2
Stackelberg Cournot
Stackelberg Cournot
1 1
Stackelberg Cournot
2 2
100 55 22.5
Profits Profits
Profits Profits
p
q q
q q
Q Q
=
>
<
>
>
>

6

Dominant Firm Markets

Composition:
1) One dominate firm with a large market store dominates the market (has a significant market
share compared to others)
2) Many small firms (Market competitive fringe)

1) D
M
and S
Fringe
, and MC for everybody is equal.
2) Residual demand for the dominant firm = D
M
-S
Fringe

When D
M
=S
Fringe
D
R
=0
When S
Fringe
= 0 D
R
converges with D
M

3) MR
R
associated to D
R

MR
R
= MC determines the equilibrium Q for the dominant form
4) Market price: from D
R
, not from D
M

5) Profit = ( ) ( ) MC 50 25 50 \$1, 250
R
p Q = =
6) Fringe firms supply an output of 25 units when p = \$50

Product Differentiation

Vertical differentiation: two products with differences in their quality
Duracell vs. Store-brand batteries

Horizontal differentiation: two products with differences in some attributes, a matter of
substitutability. For instance, some consumers may consider Diet Pepsi a poor substitute for Diet
Coke, and therefore will still purchase Diet Coke even if Diet Pepsi is a lower price. Firms selling
horizontally differentiated products exhibit downward sloping demand curves.

7

Weak HD: firm demand is very flat and therefore is very sensitive to its own prices
rivals prices

pq along D
0

price q price the leftward
shift in the demand curve

Strong HD: firm demand is much less sensitive to own prices
rivals prices

p slight q D
0

price slight leftward shift in the demand curve (q).

Bertrand Competition with HD EXAMPLE:
1) Given HD, the demand functions are different for coke and pepsi

Coke
1 1 2
64 4 2 Q p p = + each firm wants to produce ???
Pepsi
2 2 1
50 Q p p = + Its profits given pure competition

Procedure
1
st
) Find Cokes profit maximizing price for any arbitrary price of Pepsi, p
2

BRF coke p
1
(p
2
)
2
nd
) Substitute one BRF into another, and find given prices

Ex.
1
2
MC \$5
MC \$4
=
=

a) What is Coca-Cola profit maximizing price when p
2
= \$8?

( )
1 1 1 1 1 1
1 1 1
1
2
64 4 2.8 64 16 4 48 4 20 0.25
MR 20 0.50 \$5 15 0.50 30
Price: 20 0.25 30 \$12.50
\$8
Q p p p p q
q q q
p
p
= + = = =
= = = =
= =
=

b) What is Coca-Cola profit maximizing price for any arbitrary p
2
?
8

1 1
1 1 2 1 2 1 1
2 1
1
64 2
64 4 2 2 64 4
4
16
2 4
p Q
Q p p Q p p p
p Q
p
+
= + = =
+ =

2 1
2 1 2
1
MR 16 2 5 MC
2 4
14 22
2 2 4
p Q
p Q p
Q

= + = =

+ = = +

Substituting back in the demand function, we obtain

2
2 2
1 1
22
4 1
16 10.5
2 4 4
p
Q
p p
p p
+

+ = +

Coca-Cola Price Reaction ???

Doing the same for Pepsi, we obtain
1
2
7
10
p
p = +
Then,

( ) ( )
( ) ( )
2 2
1
2 2
1
2
1
1
2
10.5 10.5
4 4
7 \$8.26
10
7
10
8.26
10.5 \$12.56
4
64 4 12.56 2 8.26 30.28 units
50 5 8.26 12.56 21.26 units
p p
p
p p
p
p
p
Q
Q

+ = +

= + =

= +

= + =
= + =
= + =

Application: pricing the Channel Tunnel (Real-world example)

87 channel
150 ferries

9

Page1

## EconS 301 Intermediate Microeconomics

Chapter 14: Game Theory

Definitions
Game Theory: The branch of microeconomics concerned with the analysis of optimal decision making in
competitive situations.
Strategy: a detailed plan of action under any possible state that the player might face (know as a complete
contingent plan).
Nash Equilibrium (NE): a situation in which each player is choosing his Best Response given the strategy
chosen by the other player.
Best Responses for the Honda and Toyota game:
Column Row
Fix column in Build (meaning consider only the
upper left box and the lower left box)
Will Honda Build?
Yes, because 16>15
( )
H
BR B B =
(meaning Hondas best response
given that Toyota Builds is to Build also)
3. Fix row in Build
Will Toyota Build?
Yes, because 16>15

( )
T
BR B B =

Fix column in Not Build
Will Honda Build?
Yes, because 20>18
( )
H
BR NB B =

4.Fix row in Not Build
Will Toyota Build?
Yes, because 20>18
( )
T
BR NB B =
Page2

## Row Player Column Player

(Honda) (Toyota)
NE ( Build , Build )

Prisoners Dilemma

A game where there exists a tension between the self-interests of the player and the collective interest.
The players strategies do not result in the outcome that is best for everyone.
The story: Ron and David steal a car and drive it off a cliff destroying most of the evidence. The police
have a suspicion that they committed the crime but cant prove it. Nonetheless they arrest both Ron and
David and interview them in separate rooms. If neither of them confess to the crime a judge will give
them both a year in jail on suspicion. The police make a deal with Ron by saying if you tell us David did
it and he keeps quite we will let you free and put him in jail for 10 years. They make the same deal with
David; if he confesses and Ron keeps quite he will be completely free and Ron will receive 10 years in
jail. Lastly if they both turn each other in then the judge will have evidence and will convict them both to
5 years in jail. Lets examine the interesting equilibrium of this game.

We find that, even though Ron and David would be much better off if they both said nothing to the
police, such an outcome is not a Nash Equilibrium.
Ron
( )
( )
NE ( , )
David
( )
( )
R
R
D
D
BR C C
BR NC C
C C
BR C C
BR NC C

=

=

Page3

Dominant Strategy: A strategy that is better than any other a player might choose, no matter what strategy
the other player follows.
Dominated Strategy: A strategy such that the player has another strategy that gives a higher payoff no
matter what the other player does.
Summary:
Whenever both players have a dominant strategy, those strategies will constitute the Nash
Equilibrium in the game.
If just one player has a dominant strategy, that strategy will be the players Nash equilibrium
strategy. We can find the other players Nash equilibrium strategy by identifying that players best
response to the first players dominant strategy.
If neither player has a dominant strategy, but both have dominated strategies, we can often
deduce the Nash equilibrium by eliminating the dominated strategies and thereby simplifying the
analysis of the game.
Learning By Doing 14.1

Games with more than one Nash Equilibrium
Game of Chicken. Two players drive their cars toward each other. If they both swerve to avoid an
accident they walk away unharmed and with no good story to tell. If one player doesnt swerve while the
other does the swerving player suffers embarrassment while the other player gets to tell a good story. If
neither player swerves the cars crash and both players suffer greatly.
A similar result is found in games modeling the Cold War between the USA and the USSR. The game
can also be used to model an industry with room for just one firm to make a profit.

Page4

Luke
( )
( ) Two NEs ( , ) and ( , )
Slick the players do not cordinate
( )
( )
L
L
S
S
BR Swerve Stay
BR Stay Swerve Stay Swerve Swerve Stay
BR Swerve Stay
BR Stay Swerve

=

=

Example
The game of chicken between XM and Sirius satellite radio.

Bank Run Game
The equilibriums of this game are coordination. Both players withdraw or both players dont withdraw.

Mixed Strategies
Pure strategy: a specific choice of a strategy, with 100% probability.
Mixed strategy: the choice among two or more strategies according to a specified probability.
Page5

1999 Final match of the Womens World Cup
The game was between the USA and China. The game was tied 0-0 so the winner would be decided by
penalty kicks. p is the probability that the Chinese Goalie plays dive right. q is the probability that the US
Kicker plays aim right.

Since there is no overlap of the two countrys players best responses there is no Pure Strategy Nash
Equilibrium (PSNE).
However there still may be Mixed Strategy Nash Equilibrium (MSNE). Lets check:
1
2
(aim right) (aim left) where is Expected Utility
0( ) 10(1 ) 10 0(1 )
10 10 10
10 20
the US Kicker is indifferent between playing aim right or aim left when the

USA USA
EU EU EU
p p p p
p p
p
p
=
+ = +
=
=
=
Chinese Goalie plays dive right with 50% probability

1
2
(Dive right) (Dive left)
0 ( 10)(1 ) 10 0(1 )
10 10 10
20 10
the Chinese Goalie is indifferent between playing dive right or dive left when the
USA Kicker pl
China China
EU EU
q q q q
q q
q
q
=
+ = +
+ =
=
=
ays aim right with 50% probability

Now the Best Responses of each player do overlap and we have an equilibrium.
Page6

1 1 1 1
2 2 2 2
Chinese Goalie US Kicker
: ( , ) MSNE R L R L + +

Another popular example of a MSNE is the Battle of the Sexes game. The couple gets an extra benefit if
they go somewhere together, but the man wants to go to one place and the woman wants to go to a
different place.

Repeated Prisoners Dilemma

In the Grim Trigger Strategy the players cooperate until either player is caught cheating and then neither
player will ever cooperate again. If a player is caught cheating in the first period, then players receive, the
lower, not cooperating payoff in every remaining period.
Page7

Tit-for-tat: A strategy in which you do to your opponent in this period what your opponent did to you in
the last period.
Cooperation is more likely if:
Beliefs from cheating are small
The game is repeated enough periods of time
We care about the future periods (we are not too impatient)
Cheating is easy to detect

Sequential Move Games
A game in which one player takes an action before the other player.
Game tree: a diagram that shows the different strategies of each player and when these strategies become
available to play.
Sequential-moves games: Games in which one player (the first mover) takes an action before another
player (the second mover). The second mover observes the action taken by the first mover before
deciding what action it should take.
Game tree: A diagram that shows the different strategies that each player can follow in a game and the
order in which those strategies get chosen.
Backward induction: A procedure for solving a sequential-move game by starting at the end of the game
tree and finding the optimal decision for the player at each decision point.
Example
Honda decides whether to build a large factory (BL), build a small factory (BS), or to not build a factory
(NB). Toyota then observes Hondas choice and makes its own choice about what factory to build.

Page8

We may use backwards induction to find that the equilibrium of this sequential game is (BL, NB).

Entry to an industry
Say for example Quiznos is thinking of opening a sandwich shop on campus to compete with Subway. In
order to fight against Quiznos Subway may drop its prices drastically. Lower prices would hurt Subway
but they might do it because it would also hurt Quiznos. Well call this action Fight. Subway could also
choose to accommodate Quiznos by keeping their prices the same and losing some business to Quiznos.
Well call this action Accommodate. Of course Quiznos would rather open a sandwich shop if Subway
would accommodate them. Subway receives its greatest payoff if Quiznos does not enter (open a shop).
0
2

3
1

2
1

We may also represent the game in Normal Form:

In the normal form game gives us the two equilibriums:
(Out, Fight if In)
(In, Accom if In)
Page9

Using the game tree we narrow this down to the unique equilibrium that survives backwards induction:
(In, Accom if In)

Example
2
0
1

1
5
6

3
1
2

5
4
4

0
1
7

0
1
7

Entry Game
Consider the game where you decide on what size factory to build. Then your competitor decides whether
to start a price war or accommodate you.

We may use backwards induction to find that the equilibrium of this sequential game is (small, accom).
1

## EconS301 Intermediate Microeconomics

Chapter 15 Risk and Uncertainty
This chapter deals with the role of risk and uncertainty in an economy. For instance, say you were to
make a decision over whether or not to buy stock in a certain company. You know that this stock has
gone both up and down in the past, and has had various payoffs. However, you cannot predict perfectly
what the stock might be worth tomorrow, a month, or a year down the road. Because of this uncertainty,
buying the stock caries a certain risk, the risk of losing money if the value of the stock drops. However,
there is also a chance that this stocks return will be positive and you will earn money. Analyzing these
types of decisions is crucial in economics, and so, we will deal with it here.
LOTTERY
Lottery A lottery is simply any event in which the outcome is uncertain, much like our example above
or the outcome of a college football game. Probability is the likelihood that any specific outcome will
occur (i.e. the likelihood of earning a positive return on the stock you purchased). Furthermore, the
probability distribution is a graph that depicts all possible outcomes and their associated probabilities,
as depicted below.
The probability of any particular outcome has to be between 0 and 1
The sum of the probabilities of all possible outcomes must equal 1
Where do probabilities and prob. distributions come from? Some probabilities result from the laws of
nature, as in flipping a coin. We know that there is exactly a 50% chance of flipping heads and a 50%
chance of flipping tails. This is referred to as Objective Probability.
On the other hand, deducing probabilities can be much harder (as in buying stock), as there is no clear
probability associated with a certain event. These are referred to as Subjective Probabilities:
probabilities that reflect subjective beliefs about risky events.
2

Expected Value the Expected Value is the measure of the average payoff that the lottery will generate.
That is, it is the weighted average of possible outcome, meaning that it takes into account the probability
of each potential outcome in calculating the average.
For instance, using our example from the probability distribution above
EV = (Prob
A
Poyo
A
) +(Prob
B
Poyo
B
) +(Prob
C
Poyo
C
)
EV = .30(120) + .40(100) + .30(80) = 100

But, what if some lotteries have the same EV, but one is much more volatile than the other? How do we
describe this occurrence? We use a measure of variability called variance.

Each of these probability distributions has an EV = 100, but the one on the left is clearly more risky, as
the probabilities are distributed more evenly, versus the graph on the right where we can be quite sure the
payoff will be 100.
Variance The sum of the probability-weighted squared deviations of the possible outcomes of the
lottery. That is, the variance gives us a measure of how the potential outcomes (taking into account their
associated probabilities) deviate from the expected value we calculated above.
From the example above
For the internet company
Var = Prob
A
(Poyo
A
- EI)
2
+ (or cocb c:cnt)
Var = 120 + 0 + 120
Variance = 240
3

## For the public utilities company

EV = 100
Var = same process as above
Var = 40 + 0 + 40
Variance = 80
As we can see, this affirms what the graph shows us. The internet company is a riskier investment
because the chance of receiving a payoff different than the EV is greater, that is, the variance is greater
than the variance for the public utilities company.
NOTE: Another common measure of riskiness (chance of payoff different than the EV) is the standard
deviation. It simply the square root of the variance.
StonJorJ c:iotion = :orioncc
Utility Functions and Risk Preferences
Now that we know how to describe risk and uncertainty through the method above, we can now look at
how a decision-maker might evaluate and compare alternates whose payoffs have different probability
distributions and therefore different degrees of risk.
Lets consider an example . . .
Say a graduate is offered two jobs upon graduation. One job is from a large and well-established
corporation who guarantees the graduate a salary of \$54,000 for the coming year. The other offer is from
a new start-up company who has been operating at a loss and therefore offers the graduate a \$4000 token
salary. However, the company also offers the possibility of a \$100,000 bonus if the company earns a
profit in the ensuing year. What offer should/will this consumer take?
EI
wok 1
= 1 S4uuu = \$S4,uuu
EI
wok 2
= .Su \$4,uuu + .Su \$1u4,uuu = \$S4,uuu
But, even though these two options have the same EV, the graduate will probably not look at them the
same way, because of risk. We can evaluate this more formally by using a utility function
4

Increasing (more is better) in income
Diminishing marginal utility
That is, even if EV
work 1
= EV
work 2
, this shows that EU
work 1
= EU
work 2
. That is, your expected utility
at the established company is higher than your utility at the start-up company.
Expected Utility it is simply the expected value of the utility levels that the decision maker receives
from the payoffs in the lottery.
Risk Preferences
Risk Adverse A characteristic of a decision maker who prefers a sure thing to a lottery of equal
expected value. That is, the decision maker above is clearly risk adverse. This is represented in the
utility function.
EX) u(I) = 1uuI

5

EU of internet stock:
= .S1uu 8u + .41uu 1uu +.S1uu 12u = 99.7
EU of Public Utility
= .11uu 8u + .81uu 1uu +.11uu 12u = 99.9

Sincc Eu
pubIc utIt
> Eu
ntcnct
, then the risk adverse agent will prefer the Public Utility

Risk Neutral A characteristic of a decision maker who compares lotteries according to their
expected value and is therefore indifferent between a sure thing and a lottery with the same expected
value.
This is characterized by a linear utility function u = o + bI,
o so Eu = p(o + bI
1
) + (1 - p)(o +bI
2
)

EX) a=0, b=100
EU of internet stock
= .S(1uu 8u) + .4(1uu 1uu) + .S(1uu 12u) = 1u,uuu
EU of Public Utility
= .1(1uu 8u) + .8(1uu 1uu) + .1(1uu 12u) = 1u,uuu
As wc con scc, tbis pcrson is inJicrcnt bctwccn tbc two options onJ is tbcrcorc risk ncutrol
6

Risk Loving - A characteristic of a decision maker who prefers a lottery to a sure thing that is equal to the
expected value of the lottery. In the job offer example, a risk-loving person would prefer the start-up
company to the established company.
This is characterized by increasing marginal utility

TRY similar example from above two

Bearing and Eliminating Risk
Now that we can describe lotteries and can calculate expected utilities to determine a consumers
preferences amongst different lotteries, we will now move into analyzing when an agent will choose to
bear risk and when they will choose to eliminate it. This analysis is based on the assumption that most
people are risk-adverse, at least for important decision like whether or not to insure a car or whether to
purchase a home, but also, that people still choose to bear risk.
An agent might chose to take the riskier offer if the expected payoff from the gamble is sufficiently larger
than that of the sure thing. The graph below illustrates this...
7

The exact difference in payoff that would invoke this agent to decide on the riskier choice is referred
to as the risk premium or the necessary difference between the expected value of the lottery and
the payoff of a sure thing to make the decision maker indifferent between the lottery and the sure
thing.
In a lottery of two payoffs, I
1
and I
2
, with the probabilities p and (1-p), respectively, we can find the
risk premium using the following formula:
pu(I
1
) + (1 - p)u(I
2
) = u(pI
1
+ (1 - p)I
2
-RP)
EX) A) U = I, Find the risk premium associated with the risky start-up company.
pu(I
1
) +(1 -p)u(I
2
) = u(EI - RP)
WhereI
1
= 104,000 I
2
= 4,000 p=.5 EV=54,000
. S1u4,uuu +.S4,uuu = S4,uuu - RP
192.87 = S4,uuu -RP
8

## S7,199 = S4,uuu -RP

RP = 16,8u1
B) If the wage offer of the start-up company changes to I
1
= 0, I
2
= 108,000, then what is the RP?
EI = .S u +.S 1u8,uuu = S4,uuu
. Su +.S1u8,uuu = S4,uuu - RP
164.S2 = S4,uuu -RP
27,uuu = S4,uuu -RP
RP = 27,uuu
So, as the variance of the lottery increases, the RP also increases. This makes sense, as the riskier the
option the higher you would need the payoff to entice you to choose that option.
Fairly Priced Insurance
The logic of risk aversion also sheds light on the circumstances under which a risk-averse person would
chose to eliminate risk by buying insurance. When the insurance policy has a premium equal to the
expected value of the promised insurance payment, we call this Fairly Priced Insurance.
Insuroncc Prcmium = EI o tbc promiscJ insuroncc poymcnt
Lets consider an example where a person has to decide whether or not to purchase insurance.
Insurance Coverage (if accident occurs) = \$10,000 (full coverage)
Prob of accident = .05
Prob of no accident = .95
500 = .05(10,000) + .95(0)
500=500
Insurance:
No accident: 50,000-500 = 49,500 So 49,500 is a sure thing, no matter what happens
Accident: 50,000-500 -10,000 + 10,000 = 49,500
Without Insurance:
No Accident: 50,000-500 = 49,500 EV = .5(40,000) + .95(50,000) = 49,500
9

## Accident: 50,000-500-10,000 = 40,000

So, EI
bung nsuuncc
= EI
not bung nsuuncc
=>

And so, a risk averse person will therefore pick the
Practice this with Learning-by-Doing 15.4

Asymmetric Information
Often in economics, one party in a deal knows more than the other party, and therefore has bartering
power. This is referred to as Asymmetric Information and is basically a situation in which one party
knows more about its own actions or characteristics than another party. For instance, you know more
about your driving than a car insurance company. For this, car insurance companies charge a premium to
safeguard against their lack of information (or think of health insurance deductibles). There are a few
types of asymmetric information.
Hidden Action: Moral Hazard
Suppose your car is fully insured. How careful would you be? Probably not as careful as you would be
without insurance. That is, insurance in a way incentivized less careful driving. This is a form of moral
hazard or otherwise, a phenomenon whereby an insured party exercises less care than he or she would
in the absence of insurance. The insurance company cannot perfectly monitor the actions of their
customers (hidden action problem), and therefore charges a deductible to induce customers to be more
cautious. That is, a deductible places some of the responsibility of an accident on the driver, and
therefore helps to reverse the moral hazard of insurance.
Another reason insurance companies do not provide full coverage is adverse selection a phenomenon
whereby an increase in the premium increases the overall riskiness of the pool of individuals who buy an
insurance policy. That is, the higher the premium the insurance company charges, the more likely that
only people truly in need of insurance (unhealthy) will buy the policy, and it is exactly these people who
will cost the insurance company the most money (obviously something the companies do not desire).

10

Decision Trees
Lets now use a tool called a Decision Tree to analyze how a decision maker might choose a plan of
action in the face of risk. A Decision Tree is a diagram that describes the options available to a decision
maker as well as the risky events that can occur at each point in time.

In a decision tree, you always start from the end (far right hand options) and work your way back to the
beginning.

Auctions
Auctions are a large part of the economic landscape (i.e. governments auctioning off their air waves,
eBay, etc.). Auctions typically involve relatively few decision makers who make decision under
uncertainty.
Private Values vs Common Values
Private value auctions are auctions where each buyer has his own personal valuation of the auctioned
item. You know the value of the item to yourself, but not the value of the item to others (art, antiques). On
the contrary, common value auctions are a situation where the item being auctioned has the same
intrinsic value to all buyers, but no buyer knows exactly what that value is (oil leases, U.S. Treasury
Bills).

11

Types of Auctions: Private value Auctions
English Auction an auction in which participants cry out their bids and each participant can
increase his or her bid until the auction ends with the highest bidder winning the object being
sold.
First-Price Sealed Bid Auctions an auction in which each bidder submits one bid, not knowing
the other bids. The highest bidder wins the object but pays a price equal to his or her bid.
Second-Priced Sealed-Bid Auction An auction in which each bidder submits one bid, not
knowing the other bids. The highest bidder wins the object but pays an amount equal to the
second-highest bid.
Dutch Descending Auction An auction in which the seller of the object announces a price which
is then lowered until a buyer announces a desire to buy the item at that price.
Common Value Auctions
When bidders have common values, a complication arises that does not occur when bidders have private
values, the winners curse: The winning bidder might bid an amount that exceeds the items intrinsic
value.
As in the example below, the winning bid is 100 but the intrinsic value of item is only 80.
1

EconS301IntermediateMicroeconomics
Chapter17ExternalitiesandPublicGoods

There is more than one type of market. Some markets have externalities and markets with
public goods. These markets are unlikely to allocate resources efficiently.

Externality: The effect that an action of any decision maker has on the well-being of
other consumers or producers, beyond the effects transmitted by changes in prices.

Public Good: A good, such as national defense, that has two defining features: first, one
persons consumption does not reduces the quantity that can be consumed by any other

Externalities
Vaccination Positive Consumption
BandwagonEffect Positive Consumption
Developmentoflaser
technology
Positive Production
ManufacturerPollutingin
Rive
Negative Production
Highwaycongestion Negative Consumption
ComputerNetwork Negative Consumption
SnobEffect Negative Consumption

Negative Externality:

Equilibrium
(price=p
1
)
Social Optimum
(price=p
*
)
Difference
Consumer Surplus A+B+G+K A -B-G-K
Private Producer
Surplus
E+F+R+H+N B+E+F+R+H+G B+G-N
-Cost of
Externality
-R-H-N-G-K-M -R-G-H M+N+K (external
savings cost)
Net Social Benefit A+B+E+F-M A+B+E+F M
2

## Is Zero pollution socially efficient?

No. At Q=0 Mg Benefit> Mg Cost
Q
*
is efficient amount of production and pollution

There are two main ways to reduce pollution externalities:
1) Emission standards
A governmental limit on the amount of pollution that can be emitted, since MPC
and MSC may be difficult to calculate the government may set an optimal Q
*
and allow
firms to decide if they really want to pollute or not.
Tradable emissions standards: low cost firms sell them to high cost firms
( i.e. cap and trade system)

2) Emission fees
Tax imposed on pollution the firm releases to the environment.

Equilibrium (with tax)
Consumer Surplus A
Private Producer Surplus F+R
-Cost of Externality -R-H-G
Government receipts from emissions tax B+G+E+H
Net Social Benefit A+B+E+F

Learning By Doing 17.2
Inverse Demand Curve: P
d
=24-Q
Inverse Supply Curve: MPC=2+Q
Industry emits one unit of pollutant for each ton of chemical it produces. As long as
fewer than 2 million units of pollutant emitted each year, the external cost is zero. But
when pollution exceeds 2 million units the marginal external cost is positive.

3

MEC: =
0, when Q 2
2 +Q whenQ > 2

Suppose the government wants to use an emission fee of \$T that will induce the market to
produce the economically efficient amount of the chemical.

a) Construct a graph and table comparing the equilibria with and without the
emission fee.

No Emissions Fee Emissions Fee of \$6 a unit
Consumer Surplus AJH (60.5 mil) ABM (32 mil)
Private Producer Surplus FJH (60.5 mil) FEN (32 mil)
-Cost of Externality -VLH=-GUI (-40.5 mil) -VNM=-GKR (-18 mil)
Govt Earnings from fee Zero ENMB (48 mil)
Net Social Benefit AMVF-MLH (80.5 mil) AMVF (94 mil)

In order to find the values above you have to remember your geometric equations.

Triangle: 1/2Base*Height
Square: Base*Height

Example AJH .5{(24-13)(11)}=60.5

Repeat for all other sections of the graph above.

b) Why is the sum of CS + PPS EC+GOVT+DWL the same without or without
the fee?

The figures in the table show that the sum is going to be 94 million both ways because
the figure represents the potential net benefit in the market whether or not there is a fee.
When there is no fee the market performs inefficiently because of the negative externality
4

and there is a DWL. When there is a fee the market performs efficiently and the entire
potential is captured.

Common Property
A resource, such as a public park, a highway, or the internet, that anyone can access.

Q1= no congestion
Peak: Too much Q
5
B-E is the toll
Off Peak: Too much Q
3
..M-N is the toll

Positive Externalities and Under Production

Equilibrium Social Optimum Difference
Private Consumer
Surplus
B+E+F B+E+F+G+K+L G+K+L
Producer Surplus G+R F+G+R+J+M F+J+M
Benefit from
Externality
A+H+J A+H+J+M+N+T M+N+T
Govt Cost Zero -F-G-J-K-L-M-T -F-G-J-K-L-M-T
Net Social Beneifts A+B+E+F+G+H+J+R A+B+E+F+G+H+J+M+N+R M+N

Solution: Subsidy
5

## Property Rights and the Coase Theorem

Property Rights: The exclusive control over the use of an asset or resource.
Why are we not applying property rights and allowing firms to work?

Coase Theorem: Regardless of how property rights are assigned with an externality, the
allocation of resources will be efficient when the parties can costlessly bargain with each
other.

Example: Fishery vs. Steel Firm (who owns the river)

SPECIAL CLASS ON ENVIRONMENTAL ECONOMICS NEXT FALL EconS 330

Public Goods
Examples: National Defense, Clean Air, Your neighbors Internet Connection
(unprotected).

Two Features of a Public Good:
Non-Rival: When consumption of a good by one person does not reduce the quantity that
can be consumed by others.
National Defense (yes)
Highway (not so much)
Clothing (not at all)

Non-Exclusive: A good that, once produced, is accessible to all consumers; no one can be
excluded from consuming such a good after it is produced.
National Defense (yes)
Clean air (yes)
Highway (not so much)

Rival Non-Rival
Excludable Clothing/Food Pay-TV Channels
Non-Excludable Hunting National Defense/Clean Air

Note: Not every publicly provided good is a truly public good.

6

## Efficient Provision of a Public Good - Learning by doing 17.4

if MC= 400 it is efficient to provide zero of the public good
if MC= 240 it is efficient to provide Q=30 of the public good
if MC= 50 it is efficient to provide Q=150 of the public good

Example:
P
1
=100-Q Individual 1
P
2
=200-Q Individual 2

a) MC =240 Efficient amount of Q?

## Start by adding the equations vertically

MSB= P
1
+P
2
= (100-Q) + (200-Q) = 300-2Q

MSB =
300 2Q for Q100
200 Q for Q >100
0 Q > 200

Set MSB=MC
300-2Q=240
60=2Q
Q=30

b) MC=50

MC=MSB
200-Q=50
150=Q

7

c) MC=400

300-2Q=400
2Q=-100
Q=-50?

The marginal social benefit of this public good is not high enough for any of it to be provided so
the Q=0.

Free Rider
A consumer who doesnt pay for a non-excludable good, expecting that others pay.

Examples:
PBS (100 Million viewers, 4 million contributors)
National Public Radio (22 million listeners, 3 million contributors)

Additional Examples that can be worked out:
17.1, 17.6, 17,16