Business Economics Notes

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BS0815'
Business'Economics'
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Dr!Ralf!Martin!
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BPES!2014!!2015!
Business!for!Professional!Engineers!and!Scientists!
BUSINESS FOR PROFESSIONAL ENGINEERS AND SCIENTISTS

UNDERGRADUATE STUDIES
The purpose of our Business for Professional Engineers and Scientists (BPES) Programme is to
provide engineering and science students with the opportunity to learn about business and
management. Many of the modules we offer are provided for the engineering departments and
have been jointly developed to enhance specific programmes of study. Additionally we offer a
number of options or electives which are open to students from all the engineering and science
disciplines. As Programme Director for Undergraduate Studies, I welcome you to our modules. I
believe what we offer will stimulate your interest and enhance your capacity to succeed in our
ever more competitive world.
Jeremy Fernando
Director of Undergraduate Studies
j.fernando@imperial.ac.uk
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Rose Brown
Undergraduate Programme Coordinator
bpes.registration@imperial.ac.uk
IMPORTANT NOTICES REGARDING ALL BPES MODULES

KEY DATES
Autumn term: Monday 6th October 2014 Friday 19th December 2014
NB: All BPES modules begin in Week 2, Monday 13th October 2014
**Autumn Exams: 12th January 2015 16th January 2015
NB: Your exam timetable will be made available as soon as it is finalised.
**Subject to change. Exams may also be later in January depending on home departments
exam timetable.
Spring term: Monday 12th January 2015 27th March 2015
NB: All BPES modules will begin in Week 16, Monday 19th January 2015.
**Spring Exams: Monday 27th April 2015 Friday 1st May 2015
**Subject to change. Exams may also be later in May depending on home departments exam
timetable.
COMMUNICATION
Please ensure you check your college e-mail regularly as this is how any important notices or
last minute details will be communicated to you. All important notices will also be put up on the
module area on Blackboard.
BLACKBOARD
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modules as well as being an important space for students to access any module materials.
Website: http://learn.imperial.ac.uk
Login: with your regular college user ID and password
If you cant see the BPES module for which you are registered, please contact
bpes.registration@imperial.ac.uk with your user ID, full name and the module you are registered
for. We can then give you access to the module immediately.
All module materials will be available on Blackboard. This will include lecture slides, readings
and anything else your lecturer believes is important for your module.
Submitting assignments via Blackboard

Please note:
1. All assignments at Imperial College Business School must be submitted via Blackboard.
Submissions by hand or by e-mail will not be accepted.
2. Electronic submission for an assignment will close at the cut-off deadline.
3. If you are late in submitting an assignment, you need to contact your administrator. Note
the College procedure that in cases where an assignment is submitted late, a reduction
of 5% per day (per week for part-time programmes), will apply.
4. Note that it is your responsibility to ensure that an assignment has been submitted.
5. Assignment submissions must be accompanied by a completed plagiarism form.
6. If you experience technical problems when submitting an assignment, click on the Help
link in the Blackboard menu bar for detailed help and instructions. You can also contact
the Imperial help desk at: service.desk@imperial.ac.uk. For all other problems contact
your BPES coordinator.
Procedure'for'submitting'assignments!
Assignments!are!submitted!via!the!relevant!Module'Area.!From!the!Home%Page!click!on!Assessment'in!
the!left!hand!navigation!menu
On!the!following!Assessment%page,!you!will!see!the!assessment!options!available.!In!order!to!submit!
you!must!complete!the!Pre=Submission'checklist'and!fill!in!the!plagiarism!form.!Then!click!on!the!
Assignment'submission'icon!
The!Preview%Upload%Assignment%Submission%screen!will!then!appear.!Click!Browse'My'Computer'
and!Add'Attachment'
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Under!Submission'click!Browse'My'Computer'
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In!the!following!dialogue!browse!to!your!assignment!file!on!your!computer!and!click!Open!
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You!will!now!see!that!the!attachment!is!displayed!under!the!Submission'area'box!!
Add!any!relevant!text!comment!for!your!submission!if!requested.!
!
Click!the!Submit'button!at!the!bottom!of!the!page!
The!Review'Submission'History'page!will!appear!asking!whether!you!are!sure!that!you!want!to!
submit!this!assignment.!Click!OK.
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You!will!now!be!taken!back!to!the!Home%Page.!
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Your'assignment'has'been'submitted'successfully.'
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PLAGIARISM FORMS
EVERY STUDENT must submit their own plagiarism form via Blackboard. If you do not
personally submit a plagiarism form by the coursework due date, you will score zero for the
coursework. The form is in Blackboard, under Assessment and then Plagiarism Form. This will
take you to a new web link where you can complete the form. By submitting this form you are
agreeing that you have not plagiarised any part of the submitted coursework. Details of how to
correctly reference can be found on the Library website using the following link:
http://www3.imperial.ac.uk/library/subjectsandsupport/referencemanagement You should keep
an audit trail of who contributed to each part of any group coursework. If you do not do this and
the work is judged to contain plagiarism, the whole group could be penalised.
The plagiarism form allows you to give each member of your group a mark out of 5 for effort. If
you believe that someone has not done as much work as the rest of the group you can mark
them accordingly. All forms with a mark lower than 5 for any student will be reviewed and a
decision made by the Programme Director as to whether their coursework mark should be
adjusted.
If you are having trouble with the group dynamics during the term, please do not hesitate to
contact either your lecturer or the programme co-ordinator Rose Brown and they will try to sort
out any issues before the coursework is completed.
FORMING GROUPS ON BLACKBOARD
You will need to form your own groups for the coursework by the end of Week 3 (Friday
1st November 2014) and there should be 4 students per group.
If you make a mistake with the group you have chosen, please contact Rose on the above email address to make changes. If you have not joined a group by the stated date, Rose will
allocate you into a group and No changes will be permitted after this date.
You will need to go to the module in Blackboard and click on Assessment. Then select
Entrepreneurship group sign-up sheet. There will be a selection of numbered groups which you
can allocate yourself to. It is best if one person in your group, (perhaps the nominated group
leader) chooses a group number and then lets the rest of you know which group number they
have chosen so you can all allocate yourselves to that group.
Module Notes Business Economics - Page 1 of 81. Ralf Martin
BPES:&BUSINESS&ECONOMICS&
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Module Notes
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By!Ralf!Martin!
r.martin@imperial.ac.uk!!
http://www3.imperial.ac.uk/people/r.martin!!
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Aims
Economics! provides! us! with! a! set! of! tools! for! analysing! the! world! and! aiding! decision=
making!by!managers!and!policy=makers.!!This!course!aims!to!give!students!an!overview!of!
many! of! these! tools! and! of! the! insights! that! can! be! obtained! with! them,! concentrating! on!
those! most! relevant! to! business! managers.!! This! means! that! most! of! the! lectures! are! on!
microeconomic! topics,! looking! at! the! actions! of! firms! and! of! individuals,! but! the! course!
concludes! with! some! coverage! of! macroeconomic! problems! and! policies,! looking! at! the!
economy! as! a! whole! and! its! international! context.!! Students! who! complete! this! course!
should!be!able!to!read!the!business!and!economics!pages!of!a!quality!paper!and!assess!the!
arguments!they!contain.!
Module Format
The!course!consists!of!7!lectures!and!online!material!to!be!studied!and!worked!through!by!
students.! The! online! material! consists! of! written! material,! online! lectures,! exercises,! tasks!
and! group! experiments.! Assessment! is! based! on! a! final! multiple! choice! exam! (70%)! and! a!
smaller!online!half!time!quiz!(30%)!
Module Schedule
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Week1&
Introduction!
Demand!and!Supply!
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Week&2&
Consumer!Choice!
Firms!
Competition!&!Monopoly!
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Week&3&
Welfare!and!Market!Failure!
Government!Regulation!
Material!up!to!here!is!
examined!in!the!half!time!test!
in!week!5!
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Week&4&
Uncertainty!and!Information!
Investment!
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Week&5&
Study!week!and!half&time&test!(30%&of&grade!)!
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Week&6&
Pricing!strategies!
Emissions!trading!game!
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Week&7&
Games!and!Oligopoly!
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Week&8&
Macroeconomics!
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Week&9&
Loose!ends!
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Week&10&
Revision!Week!!
How to study for this course
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Come!to!lecture!
Read!through!these!course!notes,!which!provide!you!with!the!core!knowledge.!
Read! through! the! lecture! slides! which! are! provided! online! shortly! before! or! after!
every!lecture!
Work!through!online!materials!and!video!lectures!
Do!all!exercises!in!the!suggested!week!(and!not!only!in!the!evening!before!the!exam)!
Participate!in!group!simulations!
If!things!are!unclear!read!up!in!the!suggested!further!reading!reference!
And/or!ask!me!via!the!blackboard!forum/email!or!after!lectures!about!things!that!are!
unclear!
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Only reading these notes is not sufficient for a good

grade. The lectures and online material will contain
additional topics that are also part of the exam
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Course Etiquette
To!get!the!most!out!of!this!course!you!should!study!the!material!and!do!the!exercises!as!we!
go! along.! We! will! also! do! some! group! exercises,! which! can! only! work! if! everybody!
participates!and!has!the!knowledge!to!do!so.!Hence!keeping!up!is!also!a!matter!of!fairness!to!
your!fellow!students.!
Often!many!students!have!similar!questions.!Thats!why!asking!me!on!the!public!forum!is!
best.!In!case!you!want!to!remain!anonymous!ask!me!via!email.!Unless!you!ask!me!otherwise!
I!will!still!post!your!anonymised!questions!in!the!forum.!
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Recommended Literature
To!deepen!your!understanding!it!will!help!to!read!up!on!topics!you!are!unsure!about!in!a!
textbook.!The!following!are!recommended!textbooks.!!
Pindyck!R.S.!&!Rubinfeld!D.L.!Microeconomics,!Prentice!Hall!!!
Begg,!D.!and!D.!Ward!Economics!for!Business!!
There! are! several! copies! of! these! in! the! library! and! at! the! end! of! every! chapter! there! are!
references!to!specific!chapters!in!these.!
The! following! are! somewhat! quirky! books! that! are! very! useful! to! get! into! thinking! like! an!
economist:!
The!Undercover!Economist!by!Tim!Hardford!
(http://timharford.com/books/undercovereconomist/)!
Freakonomics!(http://www.freakonomics.com/!)!
1 Introduction What is Economics about?
More!than!ever!economic!issues!are!debated!in!the!public!discourse.!To!make!good!decisions!
as!managers,!consumers!or!voters!an!understanding!of!economic!issues!is!central.!
But! how! to! make! sense! of! it! all?! ! Some! might! argue! that! it! is! important! to! keep! on! top! of!
events,! and! have! a! good! knowledge! of! economic! history.! This! will! certainly! be! useful,!
however! there! is! another! important! aspect! of! how! economists! approach! economic! issues,!
which! is! very! different.! They! behave! more! like! physicists! in! that! they! build! models! of! the!
economy!before!they!look!at!data.!!
These!models!can!be!in!the!shape!of!graphs!and!diagrams,!mathematical!formulas!or!indeed!
cupboards!(see!Figure!1).!
In!these!models!the!basic!unit!of!analysis!is!a!decision!maker!such!as!a!manager,!a!consumer,!
an!investor!or!the!government.!Hence!what!we!are!building!are!models!of!decision=making.!
This!can!at!times!be!tricky!because!decision!makers!dont!behaviour!as!regularly!as!natural!
phenomena,!say.!However,!the!modelling!approach!provides!economists!with!some!unique!
advantages!possibilities!such!as!being!able!to!
Structure!facts!and!data!
Analyse!hypothetical!situations!
Forecasting!
Coming!up!with!quantitative!assessments!
Discovering!unexpected!(counterintuitive)!implications!!
Understanding!clearly!the!conditions!necessary!to!get!certain!outcomes!
This!module!will!give!you!a!basic!introduction!how!economists!do!this!modelling.!!
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If!it!hurts,!its!working.!
In!other!words!the!module!will!give!you!an!introduction!in!how!to!think!like!an!economist.!
This! means! that! unless! you! are! already! an! economist! then! its! likely! that! studying! for! the!
module!will!lead!to!the!formation!of!new!wiring!in!your!brain.!Like!going!to!the!gym,!this!
can!feel!painful!or!exhausting!initially.!But!if!you!keep!on!doing!your!exercises!you!will!be!
rewarded!eventually!by!more!powerful!thinking!muscles.!
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Figure&1:&The&Philips&Machine&
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Notes: The Phillips Machine is a model of the economy built by the economist Bill Phillips (1914-1975). You
can admire it in the Science Museum on Exhibition Road.
http://www.youtube.com/watch?v=k_-uGHWz_k0
2 Demand and supply

2.1 Your(first(model:(The(demand(curve(
Consider!the!following!situation:!you!are!the!manager!of!the!campus!caf!and!you!wonder!
about!how!set!the!prices!for!a!cup!of!coffee.!You!ask!the!Business!School!students!for!advice,!
as! they! should! know.! One! tells! you! to! increase! prices! because! you! make! more! money! this!
way.! Another! student! tells! you! that! if! you! drop! your! prices! you! will! make! more! money:!
while! you! make! less! for! every! cup! you! sell,! you! gain! because! a! lower! price! will! increase!
your!sales.!
Its!obvious!you!cannot!rely!on!these!students!so!what!are!you!going!to!do?!
Our! first! model! is! a! tool! that! can! help! you! with! that.! Its! called! a! demand! curve! and! it!
summarises!the!behaviour!of!consumers!in!a!market.!Figure!2!shows!an!example.!
Whats!important!about!the!demand!curve?!
On!the!y=axis!we!have!the!price!of!a!good!and!on!the!x=axis!the!quantity!
It! shows! how! many! units! of! the! good! will! be! demanded! by! all! consumers! in! the!
market!for!a!given!price!
Its!a!downward!sloping,!which!reflects!that!consumers!typically!want!less!of!a!good!
if!it!is!more!expensive.!
Its! called! a! curve! but! we! often! draw! it! as! a! line,! simply! because! that! is! the! easiest!
curve!one!can!think!of.!
&
Figure&2:&A&generic&demand&curve&
Price
Demand Curve
(it doesnt have to
be a line)
Quantity
!
Where! do! we! get! the! demand! curve! from?! One! approach! could! be! to! ask! all! =! or! a!
representative!sample!of!!consumers!how!much!of!a!product!they!would!buy!at!different!
price! points.! Table! 1! has! a! fictitious! example.! From! this! data! we! get! a! number! of! points! in!
the! price! quantity! space,! which! can! be! seen! in!Figure! 3.! To! get! from! the! dots! to! a! demand!
curve!we!simply!draw!the!line!that!fits!the!point!cloud!best.!Of!course!in!reality!it!is!often!
the! case! that! the! points! are! not! laying! so! neatly! on! a! line.! We! might! then! consider! fitting!
some!kind!of!other!function.!Also,!rather!than!drawing!the!line!by!hand!we!typically!use!an!
algorithm!that!tells!us!the!best!fitting!line.1!There!is!a!whole!branch!of!economics!that!deals!
with!the!best!ways!to!fit!models!to!data,!which!is!called!Econometrics.!
Once!we!have!an!estimate!of!a!demand!curve!we!can!use!it!in!various!ways.!For!instance!we!
can!make!predictions!about!the!demand!for!prices!we!havent!asked!anybody!about;!e.g.!the!
graph!would!suggest!that!at!a!price!of!2!demand!is!about!162!thousand!cups.!
To!get!a!feel!for!demand!curves!its!a!good!idea!to!ask!how!the!shape!of!the!demand!curve!
might! be! affected! by! various! scenarios.! For! instance,! suppose! all! consumers! that! make! up!
the! demand! side! of! the! market! become! richer.! How! would! it! affect! demand?! You! might!
expect!that!at!every!price!a!richer!person!would!buy!more!of!the!same.!As!a!consequence!the!
demand!curve!would!shift!outwards,!as!in!Figure!4.!However,!this!might!not!be!true!for!all!
types! of! goods.! Consider! goods! that! tend! to! be! consumed! more! by! poorer! people! such! as!
public!transport!or!rental!flats.!Consumption!of!such!inferior!goods!might!fall!as!people!get!
richer.! However,! consumption! of! most! goods! will! increase! with! income,! which! is! why! we!
call!such!goods!normal!goods.!
Figure!5!illustrates!what!factors!might!affect!the!slope!of!a!demand!curve.!A!demand!curve!
that! is! flatter! implies! that! for! a! given! price! change! demand! changes! are! larger.! We! would!
expect! this! to! be! the! case,! if! there! are! easily! available! substitutes! for! the! good;! e.g.! before!
there! were! DVDs! and! video=tapes! (not! mention! online! videos),! consumers! had! little!
alternative! but! watch! a! movie! in! the! cinema.! Consequently,! after! the! introduction! of! these!
alternatives!we!would!expect!the!demand!curve!for!cinema!tickets!to!become!flatter.!
!
While!we!can!do!quite!some!analysis!with!a!graphical!representation!of!a!demand!curve!we!
need! a! mathematical! representation! to! make! quantitative! precise! statements.! A! general!
representation!of!a!linear!demand!curve!is!
P = a bQ !
where!a!represents!the!intercept!and!b!the!slope!of!the!curve!(see!Figure!6).!
!!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!Many!software!packages!contain!functions!that!compute!such!lines.!For!a!simple!example!in!Excel!
!!
1
Table&1:&Demand&for&Cappuccino&
Price&per&cappucino&(say)0
1.50
2.50
Student/Sta*
0.50
10
30
3.50
40
1*
2*
3*
3*
9*
12*
0*
10*
12*
0*
7*
11*
0*
6*
5*
0*
4*
7*
0*
1*
3*
0*
0*
3*
4*
5*
9*
14*
6*
12*
4*
13*
2*
9*
0*
6*
0*
8*
0*
4*
6*
7*
8*
11*
14*
10*
10*
9*
12*
8*
8*
7*
5*
6*
7*
4*
3*
3*
1*
5*
3*
0*
0*
1*
9*
17*
17*
15*
12*
10*
10*
9*
10*
10*
11*
9*
4*
5*
4*
3*
Cups8of8coee8per8
108students/sta8per8
week*
109*
99*
82*
56*
42*
35*
20*
218000*
198000*
164000*
112000*
84000*
70000*
40000*
Total8demand8
(assume820,0008
students8&8sta)*
!
!
Figure&3:&Plotting&demand&data&
Cups&of&coee&per&week&
4.5"
4"
Price&per&cup&&
3.5"
3"
2.5"
2"
1.5"
1"
0.5"
0"
0"
50000"
100000"
150000"
200000"
250000"
Cups&of&coee&
!
!
!
!
Figure&4:&An&increase&in&income&for&a&normal&good&
Increase in income is likely to
increase the demand for the
good (Normal Good)
However there are goods
where this is different
(Inferior Goods); e.g. tube
tickets, richer people tend to
use cabs more
Price
Inc
om
e
Quantity
!
!
!
Figure&5:&Determinants&of&the&slope&of&demand&
e.g. DVDs vs
cinema tickets
Price
Before DVDs
where around
For a good with many close

substitutes demand will react
more sensitively to an
increase in price; e.g. if
cinema tickets get too
expensive people will watch a
movie on DVD rather than
pay the high price so demand
for the movie goes down if it
is available on DVD.
After DVDs
Quantity
!
Figure&6:&From&figure&to&formula&
b
1
Q
2.2 Elasticity(
An!important!concept!to!describe!demand!curves!is!price!elasticity.!It!tells!us!by!how!much!
demand!reacts!(in!%)!to!a!1%!change!in!price.!The!elasticity!is!particularly!useful!because!it!
is!unit=free,!hence!it!is!a!number!we!can!meaningfully!compare!between!different!markets.!
Formally!price!elasticity!is!defined!as!
!
ED,P =
QD
QD
PD
PD
!
Notice!that!because!the!demand!curve!is!downward!sloping!the!elasticity!must!be!negative.!
We!say!that!demand!is!!
that is to say that demand will not change
that much for a large (or any) change
Elastic!if!the!elasticity!is!less!than!=1!(that!is,!=2!or!=3)! in price.
Inelastic!if!the!elasticity!is!between!=1!and!0!
!
To! understand! the! meaning! of! this! distinction! lets! consider! the! impact! on! revenue! ! i.e.!
price! times! quantity! sold! =! of! a! 1%! reduction! of! price.! Notice,! that! because! revenue! is!
R = Q P ! the! growth! of! revenue! is! (approximately)! the! growth! of! Q! plus! the! growth! of!
prices;!i.e.!
!
R P Q
=
+
R
P
Q !
!
Hence!if!we!know!that!prices!grow!(shrink)!by!=1%!then!we!can!use!the!elasticity!formula!to!
work!out!the!growth!of!revenue!as!!!
R
= 1% 1% ED,P
R
!
!
Note!that!if!demand!is!elastic!
R
!is!positive,!whereas!it!is!negative!if!demand!is!inelastic,!
R
finally!it!is!zero!if!elasticity!is!equal!to!1.!Coming!back!to!our!question!from!the!beginning!of!
section!1:!whether!revenue!increases!or!reduces!if!we!reduce!the!price!of!coffee!depends!on!
the!elasticity!of!demand.!!
We!can!re=arrange!the!elasticity!formula!in!the!following!way!
!!
E D,P =
QD
QD
PD
PD
QD P QD P
P Q P Q
!
!
In! words:! The! price! elasticity! of! demand! can! be! computed! as! the! derivative! of! the! inverse!
demand!function!times!the!price!over!quantity.!
We! can! use! this! to! get! the! elasticity! whenever! we! have! a! specific! formula! for! the! demand!
function.! For! instance! with! the! linear! demand! function! we! have! introduced! before! we! can!
now!derive:!
!
The!inverse!demand!function:! Q =
The!derivative:!
Elasticity:! E D,P
a 1
P !!
b b
Q
1
= !!
P
b
1P
=
!!
bQ
!
Notice!that!this!implies!that!the!elasticity!is!not!constant!as!we!go!along!the!demand!curve!
(see! Figure! 8).! However! this! depends! on! the! specific! shape! of! the! demand! function.!
Consider!for!instance!the!hyperbolically!shaped!demand!function!shown!in!Figure!9,!which!
in!formal!terms!is!defined!as!
P = aQ !
Hence!we!can!derive!the!elasticity!as!
P
Q =
a
ED,P =
Q P
= !
P Q
Thus!for!this!particular!demand!function!the!elasticity!is!constant!everywhere.!
!
Figure&7:&Elasticities&
Price(
Which/demand/curve/has/
a/higher/price/elasticity/of/
demand?(
Quantity( !
!
!
!
!
!
Figure&8:&Elasticity&of&a&linear&demand&curve&
!
!
Price
10
15
Figure&9:&A&constant&elasticity&demand&function&
10
Quantity
2.3 Supply(
The! supply! side! of! the! market! is! represented! by! an! upward! sloping! curve.! It! tells! us! for! a!
given!price!how!much!all!suppliers!together!are!willing!to!provide.!It!is!upward!sloping!if!
we!think!that!unit!costs!increase!as!the!market!has!to!supply!more.!There!could!be!various!
reasons!for!this.!For!instance!the!cheapest!production!methods!might!have!only!available!at!
a! limited! capacity.! To! increase! output! beyond! that! capacity! might! require! more! costly!
methods.!
&
Figure&10:&The&supply&curve&
Price
P = c + dQ
Quantity
2.4 Demand(and(supply((A(simple(example(
By! combining! demand! and! supply! we! can! work! out! the! market! equilibrium.! To! fully!
understand!the!market!equilibrium!and!its!implications!lets!look!at!a!very!simple!example.!
Lets!consider!the!market!for!chocolate!bars!in!Southpark.!In!Table!2!we!see!the!willingness!
to! pay! of! the! only! three! consumers:! Butters,! Cartman! and! Stan.! Table! 3! reports! the!
production! costs! of! different! producers.! Ritter! and! Hirshey! have! only! enough! capacity! to!
produce! one! bar,! thats! why! their! costs! go! to! infinity! for! the! second! bar.! Cadbury! on! the!
other! hand! can! produce! one! bar! at! cost! of! $3! and! a! second! bar! at! a! cost! of! $5.! Using! the!
information!in!the!tables!we!can!draw!a!demand!and!supply!curve!in!Figure!11!and!Figure!
12.!By!combining!demand!and!supply!we!can!work!out!the!market!equilibrium!in!Figure!13;!
i.e.!where!the!supply!and!demand!curve!intersect.!!
There!are!a!number!of!things!worth!pointing!out!about!the!market!equilibrium!
1. It!tells!us!how!much!chocolate!is!going!to!be!produced,!at!what!price!it!is!being!sold!
and!who!is!going!to!produce!and!consume!it;!i.e.!a!price!of!6!and!a!quantity!of!3!with!
Butters! and! Cartman! buying! chocolate! and! Stan! abstaining.! Note! that! the! price! is!
equivalent!to!the!production!cost!of!the!last!bar!of!chocolate!that!is!being!produced.!
2. It!is!the!only!point!where!all!economically!sensible!options!are!exploited.!Suppose!we!
would! be! producing! more! than! 3! bars! so! that! Stan! could! have! one! too:! this! would!
cost!an!extra!$8!in!terms!of!production!cost.!However,!Stan!is!only!willing!to!pay!$2,!
so!this!would!clearly!be!a!waste!of!resources.!
3. No!market!participant!has!any!incentive!to!deviate!from!this!point!and!if!we!are!at!
any!other!point!the!incentives!of!the!market!participants!will!bring!the!market!back!
into! equilibrium.! This! is! called! the! market! mechanism;! e.g.! say! the! price! is! higher!
than!$6.!Only!Cartman!would!buy!chocolate,!which!means!that!Ritter!might!not!be!
able! to! sell! any! chocolate! even! though! it! would! be! profitable! for! them.! Hence! they!
would!have!every!incentive!to!reduce!the!price!to!ensure!a!sale.!
!
Table&2:&Preferences&for&chocolate&in&Southpark&
Butters
Cartman
Stan
Willingness to pay for

first bar of chocolate
$6
$ 10
$2

2nd bar of chocolate
$0
$7
$0

3rd bar of chocolate
$0
$0
$0
A way of representing
a consumers interests
=preferences
!
!
Table&3:&Chocolate&production&costs&in&Southpark&
Cadbury
Ritter
Hersheys
Production cost for first

of chocolate bar
$3
$6
$8
Production cost for

second bar
$5
Production Cost for 3rd

bar
&
Figure&11:&Chocolate&demand&curve&
!
!
Figure&12:&Chocolate&supply&curve&
!
!
Figure&13:&Chocolate&market&equilibrium&
!
!
2.5 Key(concepts(in(this(chapter(
Demand!Curve!
Supply!Curve!
Market!Mechanism!
Market!Equilibrium!
Elasticity!
Further(reading(
Pindyck!&!Rubinfeld!Chapters!1!and!2!
!
!
3 Consumer choice
We!discussed!how!the!demand!curve!is!driven!by!decision!making!by!consumers.!Here!we!
discuss!how!we!can!model!this!consumer!decision=making!better.!
The!starting!point!for!economists!is!the!idea!that!people!behave!rationally!(at!least!some!of!
the!time).!
In! its! most! general! this! means! that! people! look! at! all! possible! options! and! trade=offs! and!
pursue!the!one!that!make!them!happiest.!
Does! this! mean! that! economists! think! people! are! selfish?! Not! necessarily:! if! it! makes! you!
happy! to! sacrifice! yourself! for! others! that! can! be! accommodated! with! the! rational! choice!
model.!Rather:!economists!dont!judge!the!preferences!of!people!but!take!them!as!given.!
They!then!work!out!what!is!going!to!happen!if!everybody!pursues!their!own!preferences!
!
To!model!rational!choice!we!need!three!elements:!
1. Consumer!preferences:!ranking!of!all!possible!options!
2. Constraints:!restrictions!that!people!face!(e.g.!limited!funds)!
3. Combine!the!two!to!determine!consumer!choices.!
!!
3.1 Preferences((
We! think! of! preferences! as! a! ranking! of! all! possible! scenarios! the! consumer! has! to! decide!
about.!For!instance!Table!4!shows!different!scenarios!(i.e.!bundles!of!good!combinations)!for!
two!types!of!product:!gummy!bears!and!kitkats!
!
!
Table&4:&Preferences&
Option' Number.gummy.
bears'
A"
B"
C"
50"
1"
20"
Number.of.
kitkat'
Utility'
1"
50"
20"
1"
1"
2"
!
!!!
!
The! number! in! the! column! Utility! is! a! measure! of! how! much! the! consumer! likes! these!
different!options.!Thus!this!particular!consumer!likes!option!C!more!than!options!A!and!B,!
which! she! likes! in! equal! measure! (another! way! of! saying! this! is! that! the! consumer! is!
indifferent!between!options!A!and!B).!
!
In!formal!terms!we!can!summarise!preferences!with!a!utility!function:!
U = U ( Good1 ,Good2 , Bad1 ,....)
i.e.! for! every! combination! of! goods! (as! well! as! bads;! i.e.! things! the! consumer! dislikes)! it!
assigns!a!number!that!allows!to!rank!all!of!these!options.!
!
We! can! represent! preferences! in! a! diagram! as! well.! Figure! 14! represents! the! preferences!
from!Table!4!in!a!Kitkat=gummy!bear!diagram.!
!
Figure&14:&Preferences&for&KitKat&and&gummy&bears&
Kitkat (K)
50
40
30
20
10
10
20
30
40
50
A
Gummy
Bears
(G)
3.2 Indifference(Curves(
Indifference!curves!describe!combinations!of!consumer!options!delivering!the!same!amount!
of!utility.!Figure!15!shows!an!example.!Note!that!option!A!and!B!are!on!the!same!curve,!but!
option!C!is!on!higher!curve.!
Indifference! curves! can! come! in! various! shapes! or! forms.! However,! the! ones! plotted! in!
Figure! 15! are! characteristic! of! a! particular! type! of! preferences,! which! imply! that! there! is!
declining&marginal&utility.!This!means!that!consuming!more!of!a!good!will!always!increase!
the first unit of consumption of a good or service yields
more utility than the second and subsequent units, with
a continuing reduction for greater amounts
your! utility.! However,! the! additional! utility! you! get! out! of! a! given! unit! declines! as! you!
consume! more;! e.g.! think! of! the! first! beer! you! drink! on! a! Friday! night! in! the! pub.! It! feels!
great! in! particular! after! a! hot! day.! Compare! that! to! the! last! beer! you! will! drink! that! same!
night.! Indeed! for! some! people! the! additional! utility! will! be! negative.! Note! that! a! rational!
consumer!would!never!consume!an!additional!unit!that!delivers!a!negative!utility.!But!some!
of!us!are!clearly!not!so!rational!any!more!late!on!a!Friday!night.!
!
Figure&15:&Indifference&curves&
Kitkat (K)
50
40
30
20
Utility is constant along

an isoquant
10
10
20
30
40
A
Gummy
50 Bears
(G)
!
In! Figure! 16! we! plot! a! utility! function! with! declining! marginal! utility! in! a! diagram! with!
utility!on!the!y!and!the!amount!of!good!consumed!(e.g.!gummy!bears)!on!the!x=axis;!i.e.!the!
gradient!is!becoming!flatter!and!flatter.!
!
Figure!17!illustrates!how!we!can!spot!declining!marginal!utility!in!the!2!good!diagram.!Look!
at! the! 2! triangles! drawn! in! the! diagram.! They! illustrate! the! following! thought! experiment:!
suppose!I!reduce!my!consumption!of!kitkat!by!a!certain!amount.!How!many!gummy!bears!
more!do!I!need!to!consume!to!leave!my!utility!un=affected.!Notice!that!for!case!one!with! K1 !
the!amount!of!gummy!bears! G1 is!much!smaller!than!in!case!2.!!
&
Figure&16:&A&utility&function&with&declining&marginal&utility&
!
!
!
Figure&17:&Declining&marginal&utility&in&kitkatXgummyXbearXspace&&
When we have fewer Kitkats they
become more valuable.we have
to give up fewer KitKats per
Gummy Bears to remain equally
well off
Kitkat (K)
50
40
K1
G1
K1
K1 K 2
<
G1 G2
30
20
G1
K 2
10
10
20
30
K 2
G2
G2
40
50
Gummy
Bears
(G)
!
!
3.3 Marginal(rate(of(substitution(
Notice! that! our! thought! experiment! ! i.e.! the! ratio! between! kitkats! and! gummy! bears! to!
leave!utility!unaffected!!is!the!gradient!of!the!indifference!curve.!We!also!refer!to!it!as!the!
Marginal!Rate!of!Substitution!(MRS)!
Figure&18:&Marginal&rate&of&substitution&
Kitkat (K)
50
40
30
K
= MRS
G
10
20
20
10
30
40
50
Gummy
Bears
(G)
3.4 Budget(constraint(
To! make! her! consumption! decision! the! consumer! has! to! take! into! account! her! available!
budget;!i.e.!she!cannot!spend!more!than!her!income.!We!can!summarise!this!in!the!budget!
constraint:!
PK K + PG G I
where! PK !and! PG !are!the!prices!for!kitkats!and!gummy!bears!and! I !is!the!available!income.!

We! can! draw! the! budget! constraint! in! the! 2! goods! space.! It! will! be! a! line! with! slope!
and!intercept!
PG
!
PK
I
!as!shown!in!Figure!19.!
PK
Figure!20!and!Figure!21!illustrate!how!the!budget!constraint!moves!if!either!income!or!prices!
change.!
!
Figure&19:&The&budget&constraint&
KitKat
(I/PK) = 40
PK = 0.20
PG = 0.1
I = 8
A
B
30
10
20
Slope = K / G = -
D
20
1
= - PG / PK
2
10
G
0
20
40
60
80 = (I/PG)
!
!
Figure&20:&Varying&income&
!
Kitkat
A"increase"in*
income"shifts*
the"budget"line*
outward*
80
60
A"decrease"in*
income"shifts*
the"budget"line*
inward*
40
20
(I =
4)
!
!
!
!
!
40
(I = 16)
(I = 8)
80
120
160
Gummy Bears
Figure&21:&Varying&prices&
KitKat
40
(PG = 0.1)
(PG = 0.2)
40
80
(PG = 0.05)
120
160
Gummy Bears
3.5 Optimal(choice(
The! optimal! choice! maximises! the! consumers! utility! while! being! within! her! budget!
constraint.! Figure! 22! and! Figure! 23! figure! illustrate! this! in! the! 2! goods! diagram.! Note! that!
the! highest! utility! indifference! curve! the! consumer! can! afford! is! the! one! that! just! about!
touches!the!budget!line.!This!implies!that!at!the!optimum!consumption!point!we!have!that!
the!price!ratio!is!equal!to!the!MRS;!i.e.!
PG
= MRS
PK
!
!
Figure&22:&Optimal&choice&
KitKat
PK= 0.2
PG= 0.1
I = 80
At market basket A
the budget line and the
indifference curve are
tangent and no higher
level of satisfaction
can be attained.
40
30
A
At A: MRS =PG/PK = 0.5
20
U2
Budget Line
0
20
40
80
Gummy Bears
Figure&23:&Non&Optimal&choice&
KitKat
40
C
30
B
A
20
20
40
80
Gummy Bears
Key(concepts(in(this(chapter(
Rational!choice!
Preferences!
Utility!function!
Budget!Constraint!
Optimal!consumption!
Normal!and!Inferior!goods!
Further(Reading(
!
!
4 Firms
Firms!have!to!make!many!choices.!Like!for!consumers!we!use!as!a!starting!point!a!rational!
firm.! This! means! that! all! possible! choices! are! made! to! serve! one! goal:! to! maximise! profits.!
Our! first! model! of! a! firm! considers! a! firm! that! has! to! decide! about! only! two! things:! how!
much!it!produces!and!what!price!it!charges.!
We!can!write!down!the!profit!of!this!firm!as!
! =! ! !! ! !
where!! ! is!a!function!telling!us!how!prices!are!affected!by!the!firms!production!choices!
and! ! ! ! ! is! a! function! telling! us! how! production! costs! evolve! in! response! to! production!
choices.!
Before! we! discuss! actual! profit! maximisation! we! discuss! these! two! components.! Costs! are!
primarily! determined! by! the! firms! production! technology.! Therefore,! before! discussing!
costs!we!look!at!production!technology.!
4.1 Production(technology(
The! production! technology! determines! how! firms! can! translate! production! inputs! such! as!
labour,!intermediate!inputs!and!capital!into!final!output.!
In! most! cases! we! will! have! many! different! types! of! inputs.! There! is! a! range! of! different!
classes!and!sub=classes!of!production!factors.!For!instance!in!any!given!firm!there!is!bound!
to!be!a!very!wide!range!of!different!types!of!jobs!and!hence!types!of!labour.!
Similarly!there!will!be!many!different!types!of!capital:!machines,!buildings,!
vehicles!etc..!The!most!important!distinction!is!between!production!factors!
that!are!variable!and!those!that!are!fixed.!What!is!fixed!and!what!is!variable!
depends! to! a! large! extent! on! the! time! horizon! we! are! considering.! The!
longer!the!time!horizon,!the!less!will!be!fixed!and!the!more!will!be!variable;!
e.g.!in!short!run!things!like!the!machines!and!the!factory!building!cannot!be!changed.!!
To! develop! ideas! lets! consider! an! extremely! simple! example:! ! Suppose! that! the! firm!
consists! of! a! street! sweeper! with! a! broom.! Suppose! that! we! are! considering! a! short! run!
horizon!where!both!the!brooms!and!the!number!of!sweepers!are!fixed.!In!fact,!just!consider!
that!the!firm!owns!one!broom.!So!the!only!thing!that!is!variable!is!the!number!of!hours!the!
sweeper! puts! in.! The! key! tool! in! the! economics! tool=box! to! describe! the! production!
technology! is! the! production! function.! The! production! function! is! a! mapping! from!
production! inputs! to! production! outputs;! i.e.! for! any! number! (and! if! we! have! several!
production! inputs! any! combination! of! inputs)! the! production! function! tells! us! how! much!
output!we!can!get.!
The! following! table! has! a! simple! example! for! the! street! sweeper.!
Suppose!that!if!we!starts!cleaning!in!the!morning!it!takes!him!1!hour!
to!clean!the!first!street.!However,!once!he!warmed!up!he!get!much!
faster.! If! he! cleans! for! 2! hours! he! manages! to! clean! almost!4! streets!
(3.9).! Note! that! this! means! that! while! in! the! first! hour! he! cleaned! 1!
street!in!the!2nd!hour!he!must!have!cleaned!2.9!streets.!If!he!carries!on,!in!his!third!hour!he!
manages! to! clean! more! than! 4! streets! bringing! his! total! to! more! than! 8.! Not! entirely!
surprisingly,!we!call!this!change!in!the!amount!that!is!being!produced!the!marginal!product.!
Note!that!while!the!marginal!product!is!initially!increasing!eventually!it!reduces!(after!the!5th!
hour).!Hence!the!total!amount!produced!still!increases,!however!the!amount!added!during!
the!6th!hour!is!less!than!the!amount!added!during!the!5th!hour.!Its!easy!to!understand!what!
is! causing! this! in! the! case! of! the! street! sweep.! He! is! probably! getting! tired.! However,! we!
think!that!this!is!very!general!feature!of!almost!any!production!process!that!we!can!think!of;!
i.e.! as! we! increase! production! inputs,! output! increases.! Learning! effects! can! imply! that!
initially! for! every! additional! unit! of! input! we! get! an! increasing! number! unit! of! outputs.!
However,! sooner! or! later! adding! more! inputs! does! lead! to! marginally! less! output.! Indeed,!
we!can!easily!imagine!cases!where!adding!more!inputs!reduces!the!total!number!of!outputs.!
The!proverbial!broth!that!is!ruined!by!too!many!cooks!is!a!case!in!point.2!Another!example!is!
sometimes! expressed! as! Brooksps! law:!Adding0 manpower0 to0 a0 late0 software0 project0 makes0 it0
later. !
Different! industries! and! types! of! firm! will! differ! in! the! exact! shape! of! the! production!
function.! The! production! function! will! also! look! different! depending! on! the! time! horizon!
and!the!level!of!aggregation.!Oil!exploration!for!instance!will!in!the!short!run!be!constrained!
by! the! installed! equipment! and! the! known! reserves.! Hiring! more! workers! will! do! little! to!
increase! output! if! we! hit! the! capacity! constraints! of! the! equipment! they! are! using.! In! the!
longer! run! it! is! possible! to! install! more! pumps! and! pipelines! and! invest! in! further!
exploration.!However,!we!know!that!there!is!limited!amount!of!oil!in!the!ground!and!easy!to!
access!oil!is!even!more!limited.!Hence!even!in!the!very!long!run!and!at!the!aggregate!world!
level,!as!we!expand!output!(cumulative!amount!of!oil!extracted)!we!have!to!put!ever!more!
resources! in! to! get! the! same! amount! of! oil.! Or! put! differently:! adding! the! same! amount! of!
additional!inputs!we!get!less!and!less!extra!(marginal)!output.!
Hence,! the! crucial! takeaway! here! is! that! eventually! a! production! function! is! exhibiting!
decreasing!marginal!returns.!Decreasing!returns!are!important!as!they!imply!that!there!is!a!
well!defined!optimal!amount!of!input!for!a!given!production!activity!as!we!shall!see!later.!
As! with! demand! and! supply! curves,! it! is! often! convenient! to! work! with! continuous!
functions! describing! the! production! function.! Probably! the! simplest! such! function! exhibit!
decreasing!returns!is!of!the!following!form!
! ! = !! ! !
where!!!is!the!amount!being!produced!(e.g.!number!streets!cleaned!in!the!example!above)!
and!X!is!the!amount!of!input!(e.g.!hours!of!sweeping).!!!is!that!just!a!shift!factor.!The!higher!
A,! the! more! productive! the! production! process! described! here! is.! !! is! a! parameter! that!
controls!the!shape!of!this!production!function.!Note!that!this!implies!that!marginal!return!or!
marginal!product!becomes!!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
! Although! perhaps! technology! has! found! a! solution! to! that! particular! problem.! See!!
http://www.wired.co.uk/magazine/archive/2014/09/play/bot=pot!
2
!"
= !"! !!! !
!"
Hence!to!have!decreasing!returns!we!need!0 < ! < 1.!
!
&
Table&5:&A&simple&production&function&
Hours
1
2
3
4
5
6
7
8
9
Number*Streets
1
3.9
8.2
13.3
18.6
23.5
27.4
29.7
29.8
Marginal*product
1
2.9
4.3
5.1
5.3
4.9
3.9
2.3
0.1
Figure&24:&The&production&function&
Number&Street&cleaned&
35"
30"
25"
20"
Number"Streets"
15"
Marginal"product"
10"
5"
0"
0"
2"
4"
6"
8"
10"
Hours&
&
!
4.2 Costs(
To!summarise!costs!we!use!a!cost!function.!The!cost!function!is!a!mapping!from!production!
quantity!!!to!costs.!Once!we!have!a!production!function!we!can!derive!a!cost!function.!!
For!instance!consider!the!case!of!the!street!sweeper!firm.!!We!can!find!the!cost!function!by!
inverting! the! production! function! ! which! gives! us! the! hours! worked! for! a! given! unit! of!
output!!and!multiply!it!by!the!cost!of!an!hour!of!work;!i.e.!the!hourly!wage.!The!resulting!
cost!function!is!plotted!in!Figure!25.!!
Notice! that! if! we! have! a! production! function! with! first! increasing! and! then! decreasing!
marginal!returns,!then!we!get!a!cost!function!with!decreasing!and!then!increasing!Marginal&
Costs&(MC);!i.e.!in!!Figure!25!marginal!costs!decrease!when!the!cost!curve!is!becoming!flatter!
and!increase!as!the!cost!curve!is!becoming!steeper.!!
!
Table&6:&From&production&to&cost&(assume&wage=10)&
Hours
1
2
3
4
5
6
7
8
9
Number*of*Streets
1
3.9
8.2
13.3
18.6
23.5
27.4
29.7
29.8
Cost
10
20
30
40
50
60
70
80
90
Figure&25:&The&Cost&function&
100"
90"
80"
70"
60"
50"
40"
30"
20"
10"
0"
0"
!
!
5"
10"
15"
20"
25"
30"
35"
If!the!production!function!is!simple!enough!we!can!derive!an!explicit!cost!function!from!the!
production!function.!For!instance,!consider!the!simple!production!function!discussed!earlier.!
The!cost!function!would!simply!be!
!
! ! =!
!
!
!
(1)!
where!!!!is!the!price!for!a!unit!of!production!factor!X!(e.g.!in!the!sweeper!case!the!wage!for!
one!hour!of!sweeping.)!
Note! that! because! the! simple! production! function! always! has! decreasing! returns,! its!
associated!cost!function!has!increasing!marginal!costs.!
Intuitively,!and!staying!with!the!sweeper!example:!the!reason!marginal!costs!are!increasing!
is!because!a!given!increase!in!roads!swept!will!take!the!sweeper!an!ever!longer!amount!of!
hours!because!she!is!getting!ever!more!tired.!
Figure!26!illustrates!this!for!the!case!where!! = 10,!! = 1!and!! = 0.8.!!
Figure&26:&Simple&cost&function&
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40"
30"
20"
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0"
0"
1"
2"
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C(Q)"
4"
MC(Q)"
5"
6"
!
!
When! discussing! production! functions! we! stressed! the! distinction! between! fixed! and!
variable! factors.! A! similar! distinction! applies! for! costs.! So! far! we! have! only! considered! the!
costs! associated! with! variable! factors.! Naturally,! these! are! called! Variable& Costs& (VC);& i.e.!
costs!that!change!as!we!change!the!number!of!units!of!output.!!
Costs! associated! with! factors! that! are! fixed! are! not! surprisingly! called! Fixed& Costs& (FC).&
When!summing!over!all!variable!and!fixed!costs!we!get!Total&Costs&(TC).&
Hence,! suppose! the! sweeper! firm! has! to! pay! 30! every! day! for! the! sweeping! equipment!
(e.g.! they! might! have! to! pay! that! to! a! firm! renting! out! sweeping! equipment)! and! variable!
costs!are!described!by!equation!(1)!then!total!costs!become!
fixed cost
!" ! = 30 + 10!!.!" !
An!interesting!further!kind!of!costs!are!average!costs.!They!come!in!two!flavours:!Average!
Variable!Costs!(AVC)!and!Average!Total!Costs!(ATC).!They!are!defined!as!the!costs!divided!
by!quantity;!i.e.!if!total!costs!are!as!above!then!we!can!write!
30
!"# ! =
+ 10! !.!" !
!
Average Total Costs = TC(Q)/Q
Notice!that!marginal!costs!in!this!case!become!
!" ! = 12.5! !.!" !
Marginal Costs = dTC/dQ

In other words, rate of change of total costs
wrt change in demand
Figure!27!plots!these!curves.!A!number!of!things!are!worth!pointing!out.!
The! ATC! curve! initially! decreases,! has! a! minimum! and! then! increases! again.! The!
reason! that! it! decreases! is! because! the! fixed! costs! being! spread! over! more! units.!
However,!with!increasing!marginal!costs!this!cannot!go!on!forever!and!at!some!point!
average!costs!increase.!
Notice! that! marginal! costs! intersect! with! average! costs! at! the! minimum! of! average!
costs.! This! is! not! just! a! co=incidence,! but! a! general! result.! Why?! Average! costs! can!
only!increase!if!we!add!units!that!are!larger!than!the!average!to!an!existing!average!
calculation.!The!marginal!cost!curve!shows!the!size!of!the!units!we!add.!To!the!left!of!
the!minimum!this!is!smaller!than!the!average!so!the!average!decreases.!To!the!right!
of! the! minimum! this! is! larger! than! the! average! hence! the! average! cost! curve!
increases.!Hence,!at!the!minimum!the!average!costs!are!just!equal!to!marginal!costs.!
We!will!be!using!this!property!of!average!and!marginal!costs!below.!
!
Figure&27:&Marginal&vs&Average&Costs&
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20"
15"
10"
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0"
5"
10"
15"
MC(Q)"
20"
25"
ATC(Q)"
Profit!
Production!function!
Marginal!Product!
Cost!function!
Marginal!Costs,!Average!Cost,!Fixed!Costs,!Variable!Costs!
Further(Reading(
!
5 Competition and Monopoly
How!prices!respond!to!output!changes!by!a!specific!firm!depends!on!the!market&structure.!
By!market!structure!we!mean!how!many!firms!are!active!in!a!market!and!how!they!interact!
with!each!other.!!
5.1 Perfect(competition(
We!start!with!an!extreme!case:!perfect!competition.!What!this!means!is!that!there!is!a!large!
number!of!relatively!small!firms!so!that!none!dominates!the!market.!Moreover,!there!are!no&
entry&barriers,!so!that!firms!can!freely!enter!and!exit!the!market.!
To! help! with! the! discussion! of! individual! firms! actions! and! whole! market! outcomes! lets!
have!the!following!convention:!Lets!index!variables!that!refer!to!an!individual!firms!with!!;!
e.g.!the!output!of!a!firm!!!we!refer!to!as!!! .!Lets!use!the!same!letter!without!subscript!!!to!
refer! to! aggregate! figures;! i.e.! aggregate! output! is! the! sum! of! output! in! all! firms! in! the!
market:!
!! !
!=
!
!
An!implication!of!a!market!structure!with!many!small!firms!is!that!an!individual!firm!cannot!
influence!prices!but!takes!them!as!given.!Hence!we!can!write!down!the!profit!functions!for!
an!individual!firm!as!
!! = !!! !" !! !
To! make! matters! simple! suppose! all! firms! have! a! cost! function! of! the! shape! we! discussed!
earlier!!
!" !! = 10 + !!! !
(2)!
!
i.e.!fixed!costs!are!10!and!marginal!costs!are!increase.!Note!that!this!particular!case!is!nice!as!
they!are!increasing!linearly!since!
!" !! = 2!! !
The!firm!level!profit!function!consequently!becomes!
!! = !!! 10 !!! !
Notice!that!this!is!an!inverted!u!shape.!Figure!28!plots!this!(blue!line).!The!intuition!for!this!
is! as! follows:! As! the! firm! increases! output! it! can! sell! more! which! is! good! for! profits.!
However,!because!costs!increase!there!comes!the!point!where!the!additional!costs!from!one!
more!unit!sold!are!larger!than!the!additional!revenue!made!by!selling!it.!Thats!when!profits!
start!declining.!!
Figure! 28! contains! a! number! of! additional! ways! of! representing! this.! ! For! instance! we! can!
plot!revenue!R,!which!is!linear!along!with!costs!C.!Profits!can!be!read!off!as!the!difference!
between!these!two!lines.!!
So!what!do!we!expect!a!firm!with!such!profit,!revenue!and!cost!functions!to!do?!As!we!said!
before!they!will!maximise!profits.!Clearly!profits!are!maximised!at!the!top!of!the!inverted!u!
shape.!The!graph!also!makes!clear!that!this!is!happening!when!the!slope!of!the!revenue!line!
and!the!slope!of!the!cost!curve!are!equal.!Another!way!of!expressing!this!is!that!the!marginal!
revenue!MR!has!to!be!equal!to!the!marginal!cost!MC.!Or!expressed!more!intuitively:!in!order!
to! maximise! profits,! we! should! expand! production! until! the! point! where! the! last! unit!
produced!costs!no!more!(and!also!no!less)!than!the!amount!we!make!when!selling!this!last!
unit.!Figure!28!illustrates!this!as!well!by!plotting!the!marginal!revenue!!notice!that!marginal!
revenue! in! this! case! is! a! constant! equal! to! P! =! and! marginal! cost! curves.! Note! that! they!
intersect!where!profits!are!highest.!Finally,!if!we!want!spell!out!this!condition!formally!it!is!
that!the!optimal!production!point!!! !satisfies:!
! = !" !! !
i.e.! the! price! is! equal! to! marginal! costs.! With! the! cost! function! we! have! been! using! in! this!
section!this!simply!becomes:!
! = 2!! !
(3)!
!
Notice,!that!while!this!condition!gives!us!a!profit!maximising!production!point,!there!is!no!
guarantee! that! the! firm! will! actually! make! a! positive0 profit.! Why! is! this?! Note! in! the! above!
reasoning!we!have!at!no!point!taken!fixed!costs!into!account.!Hence,!while!!! !might!be!the!
highest! profit! the! firm! is! able! to! make! it! could! still! not! be! enough! to! recover! all! the! fixed!
costs.!Of!course!this!also!depends!on!the!price.!The!higher!the!price!in!the!market!that!the!
firm!can!charge!the!more!likely!it!is!that!overall!profits!are!positive.!
Hence!we!have!to!examine!the!relation!between!market!price,!optimal!production!point!and!
fixed!costs.!A!good!way!to!do!this!is!using!average!costs!and!by!drawing!graphs!such!as!in!
Figure!27.!Notice!that!unlike!marginal!costs,!average!(total)!costs!take!into!account!the!level!
of! fixed! costs.! Also! note! that! the! average! cost! is! obviously! the! cost! per! unit! of! output.! The!
price!on!the!other!hand!is!the!revenue!per!unit!of!output.!Hence!as!long!as!
! > !"# !! !
the!firm!is!making!a!profit.!With!a!diagram!such!as!in!Figure!27!we!can!immediately!see!if!
this! is! the! case! for! a! given! price.! Figure! 29! contains! several! examples! for! the! specific! cost!
function!used!in!this!sections!(i.e.!the!cost!function!in!equation!(2)).!In!the!left!panel!the!price!
is! higher! than! the! minimum! of! the! average! cost! function.! Hence,! it! is! possible! to! make! a!
profit.!How!much!profit!exactly!we!can!work!out!by!locating!the!optimal!production!point!
using! the! marginal! cost! curve! (the! red! curve);! i.e.! in! the! left! panel! this! would! be! !! = 6.!
Hence,!revenue!will!be!equal!to!!! !times!the!price,!which!is!equal!to!the!surface!area!of!the!
green!and!grey!shaded!rectangle.!Costs!will!be!equal!to!the!level!of!the!average!cost!curve!at!
!! !times!!! ;!i.e.!the!grey!shaded!rectangle.!Profits!are!the!difference!between!the!two,!which!
is!the!greenish!rectangle.!!
We!can!look!at!the!same!areas!in!the!right!panel!where!the!price!is!much!lower.!Now!it!turns!
out!that!the!revenue!is!smaller!than!costs!and!the!firm!would!make!a!loss!equivalent!to!the!
red!rectangle.!
When! discussing! demand! and! supply! we! were! stressing! that! prices! adjust! to! achieve! a!
market!equilibrium.!In!this!section!we!have!taken!the!price!as!given!until!now.!How!can!we!
figure!out!what!the!equilibrium!price!is!going!to!be!here?!
What! we! have! been! discussing! so! far! is! all! related! to! the! supply! side.! However,! we! have!
only! ever! been! discussing! an! individual! firm.! However,! the! supply! curve! represents! the!
combined!decisions!of!all!firms.!It!is!easy!to!get!from!individual!firms!to!the!supply!curve.!
From!Equation!(3)!we!can!work!out!how!much!an!individual!firm!will!supply!given!a!price!
P;!i.e.!!
!
!! = !
2
Suppose!now!that!we!have!!!identical!firms.!Then!the!market!supply!curve!is!simply!
!=
!"
!
2
!=
2!
!
!
Or!in!the!usual!inverse!notation:!
!
Hence,!together!with!a!demand!curve!we!can!find!the!market!equilibrium.!Suppose!we!have!
again!the!simple!linear!(inverse)!demand!curve:!
! = ! !"!
We!can!compute!the!market!equilibrium!price!from!! ! !
!! ! ! 1 !
= ! !
2
! !
hence!
! 1 ! !
+ ! = !
2 !
!
!! =
and!!
! ! 1
+
! 2 !
!!
2!
!
!" + 2
!! =
!
!+
2
!
!
Notice!how!the!market!equilibrium!is!related!to!the!number!of!firms!in!the!market:!the!more!
firms! there! are! (the! higher! !),! the! lower! the! equilibrium! price! and! the! higher! equilibrium!
output.!This!makes!intuitive!sense:!more!firms!mean!more!competition!for!the!same!number!
of! consumers.! As! a! consequence! prices! go! down! and! total! amount! sold! in! the! market!
increases.! But! of! course! if! prices! go! down! each! individual! firm! is! selling! less! while! the!
market!as!a!whole!is!selling!more;!i.e.!!
!!! =
!!
!
=
!
2
!" + 2
Hence,! as! more! firms! enter! the! profits! of! an! individual! business! are! shrinking! for! two!
reasons:!Firstly,!because!they!sell!less!and!secondly!at!a!lower!price.!This!implies,!that!as!the!
number!of!firms!goes!up!more!and!more!firms!will!find!themselves!in!a!situation!such!as!the!
right!panel!in!Figure!29;!i.e.!the!profit!they!make!is!not!enough!to!cover!their!fixed!costs.!Of!
course!no!business!in!their!right!mind!will!carry!on!like!that!for!very!long.!Rather,!they!will!
be!exiting!the!market.!This!of!course!means!that!the!number!of!firms!in!the!market!
!! comes! down.! Hence,! for! the! remaining! businesses! profits! will! go! up.! In! other!
words! this! exit! mechanism! balances! the! market! so! that! when! starting! from! a!
situation! where! businesses! make! losses! we! slowly! end! up! with! businesses! making! profits!
again.!!
Equally,!if!a!market!is!characterised!by!high!profits!we!expect!that!more!firms!enter!to!get!a!
share!of!the!pie.!This!will!bring!prices!down!along!with!lower!quantities!so!that!
the!high!profits!erode.!!
Hence,! this! exit! and! entry! process! leads! to! a! long! run! equilibrium! where! firms!
make!neither!profits!nor!losses.!Note!that!we!can!use!this!property!to!work!out!!
within!the!context!of!our!simple!model!=!how!many!firms!will!be!in!the!market!in!this!long!
run! equilibrium.! For! that! notice! that! a! firm! will! make! zero! profits! if! the! market! price! is!
exactly! equal! to! its! average! costs.! Now,! if! firms! are! profit! maximisers! we! know! that! their!
production!point!is!determined!by!the!marginal!cost!curve.!Hence,!the!only!point!where!we!
are!both!on!the!MC!and!AC!curve!is!the!intersection!between!the!two.!!Hence,!using!the!cost!
function!from!earlier!we!would!get!
!"# !!! =
10
+ !!! = 2!!! = !" !!! !
!!!
Implying!that!!
!!! = 10!
So!lets!recap!what!have!just!calculated.!!!! !is!the!output!quantity!of!an!individual!firm!!!in!
the!long!run!equilibrium!where!profits!are!zero!so!that!no!firms!wants!to!either!enter!or!exit!
(i.e.!the!L!stands!for!long!run!equilibrium).!
What!is!the!price!in!this!long!run!equilibrium?!We!can!work!that!out!by!sticking!!!! !into!the!
MC!curve!(or!the!ATC!curve!for!that!matter):!!
! ! = 2!" !!! = 210!
From!this!we!can!work!out!the!aggregate!demand!using!the!demand!function!
! ! = ! !! ! !
!! =
! 1 ! ! 2 10
! =
!
! !
!
!
Its!now!easy!to!work!out!the!number!of!firms!in!the!long!run!equilibrium!from!
!! =
!!
!
2
!
=
!!
10! !
Does!this!expression!make!intuitive!sense?!Notice!that!the!number!of!firms!will!be!higher!if!
!! is! higher.! A! higher! !!simply! means! that! customer! demand! is! higher! and! the! market! is!
larger.!Clearly!it!makes!sense!to!have!more!firms!in!a!larger!market.!Also!note!that!10!is!the!
square! root! of! fixed! costs! (Compare! equation! (2)).! Hence,! what! this! suggest! is! that! with!
larger! fixed! costs! we! have! less! firms.! Again! this! makes! sense:! firms! can! only! recover! the!
larger!amount!of!fixed!costs!if!prices!are!higher!and!each!firm!produces!a!larger!amount!of!
output,!which!happens!with!less!firms!in!the!market.!
Another!way!of!thinking!about!this!is!that!fixed!costs!imply!a!kind!of!entry!barrier!to!certain!
markets.!There!are!a!number!of!different!categories!of!fixed!costs.!These!include!
Plants! and! machinery:! in! many! industries! you! have! to! build! a! costly! factory! first!
before!you!can!even!begin!to!sell!a!single!unit!of!output.!Examples:!steel!plants,!car!
plants!
R&D:!There!are!many!industries!where!you!have!to!invest!heavily!in!research!before!
it!is!possible!to!sell!anything.!Examples:!pharmaceuticals!
Marketing:! Production! costs! in! many! industries! pale! compared! to! marketing!
expenditure,! which! is! required! to! make! any! sales! at! all.! Examples:! fashion,!
newspapers.!
Figure&28:&Profit&maximisation&of&price&takers&
!
!
Figure&29:&Entry&and&Exit&
!! !
!! !
5.2 Monopoly(
Under!perfect!competition!firms!consider!the!market!price!as!given.!At!the!other!end!of!the!
spectrum!we!have!monopoly:!there!is!only!one!firm!in!the!market.!How!will!prices!respond!
to!output!decisions!by!this!firm?!As!they!are!the!only!firm!the!price!response!is!driven!by!the!
demand!function.!
To! find! the! profit! maximising! production! point! we! still! need! to! equalise! marginal! revenue!
with!marginal!costs.!However!now!marginal!revenue!is!no!longer!simply!the!market!price,!
rather,!since!
R = PQ = ( a bQ ) Q = aQ bQ 2 !!
we!have!that!
MR = a 2bQ !!
!
Notice! that! this! marginal! revenue! curve! is! similar! to! the! demand! curve:! it! has! the! same!
intercept! but! twice! the! steepness! of! the! demand! curve.! Its! therefore! easy! to! draw! in! the!
price!quantity!diagram!(See!Figure!30).!We!can!see!that!output!is!lower!and!the!equilibrium!
price!higher!(above!marginal!costs)!than!in!the!perfect!competition!case.!
!
Figure&30:&Profit&maximisation&of&a&monopoly&
Price
MC
ATC
P1
MR
MC=MR
Q1
D = AR
Output
!
!
!
5.3 Market(power(and(elasticity(
A!way!of!assessing!how!bad!market!power!is!concerns!the!gap!between!prices!and!marginal!
cost.! The! bigger! it! is! ! i.e.! the! higher! the! mark=up! over! marginal! cost! that! the! monopolist!
charges!!the!more!concerned!we!should!be.!
We!can!link!this!back!to!the!concept!of!elasticity.!Intuitively,!if!demand!is!less!elastic!!i.e.!if!
customers! are! more! inclined! to! buy! the! product! whatever! its! price! ! then! monopolists! can!
charge! a! higher! mark=up.! We! can! show! this! somewhat! more! formally.! Using! the! product!
rule!for!taking!derivatives!we!re=write!marginal!revenue!as!follows:!
MR = P +
dP
dP Q
Q = P 1+
dQ
dQ P !
If!you!compare!this!with!the!formula!for!the!price!elasticity!of!demand!we!discussed!earlier!
you!can!see!that!we!can!re=write!this!as:!
MR = P +
dP
1
Q = P 1+
dQ
E D,P
Combining!this!with!the!MR=MC!condition!yields!
! = !"#!
where!! =
!
!!
!
!!,!
!is!the!mark=up!over!marginal!costs.!Notice!that!the!closer!the!elasticity!is!to!
0!(i.e.!the!less!elastic)!the!larger!the!mark=up!will!be!(recall!that!the!elasticity!is!negative)!
!
Price!taking!
Profit!maximisation!
P=MC!
Market!Entry!and!Exit!
Perfect!Competition!
Monopoly!
MR=MC!
Further(Reading(
!
!
6 Welfare & Market Failure

6.1 Producer(and(consumer(surplus(
How! can! we! assess! the! value! of! a! market! or! compare! different! markets! and! as! well! as!
different!market!outcomes?!For!that!we!need!so!called!welfare&measures.!
Journalists! and! commentators! often! assess! markets! on! the! basis! of! the! turnover;! i.e.! how!
much! money! changes! hand! in! a! market.! However,! this! might! be! entirely! misleading! in!
assessing! the! true! value! of! a! market.! To! immediately! see! why! consider! a! market! where!
prices!are!zero!such!as!the!market!for!air!to!breathe.!There!is!clearly!a!demand!for!such!air!
judging! from! the! amount! of! air! people! breathe! all! the! time! and! hence! there! must! be! some!
value!attached!to!breathing!air.!However,!as!the!price!is!zero!judging!by!the!turnover!does!
not!get!us!very!far.!
Economists!deal!with!the!matter!using!the!concept!of!surplus.!There!are!at!least!two!types!of!
surplus!that!are!of!interest:!
Consumer!surplus!
Producer!surplus!
Lets!first!examine!consumer!surplus,!which!is!easily!grasped!by!looking!at!a!demand!curve!
such! as! in! Figure! 31.! Suppose! this! is! the! demand! for! concert! tickets! to! see! the! band! The!
Economists.! We! see! that! there! are! 100! consumers! willing! to! pay! 90! to! see! the! band.! 100!
consumers! are! willing! to! pay! 80! and! so! on.! Suppose! the! price! for! a! concert! ticket! in! the!
market!is!actually!40.!!Hence!the!people!who!were!willing!to!pay!90!have!their!happiness!
improved! by! a! value! equivalent! to! 90=40=40.! The! people! who! were! willing! to! pay! 80!
have!their!happiness!improved!by!30!and!so!on!until!the!people!who!are!willing!to!pay!40!
who! are! indifferent! about! this! market.! The! consumer! surplus! is! the! sum! of! all! happiness!
improvements!!in!money!terms!!for!all!consumers!in!the!market;!i.e.!it!is!equivalent!to!the!
area!under!the!demand!curve!and!above!the!price!line.!
Another!way!to!think!about!the!consumer!surplus!is!the!following!thought!experiment:!how!
much! would! we! have! to! pay! all! consumers! to! make! them! just! indifferent! between! buying!
the!good!in!the!market!and!not!buying!it?!
!
Figure&31:&Consumer&Surplus&
90
80
70
Price
60
50
Market Price
40
30
20
10
100
200
300
400
500
600
700
800
900
Concert Tickets
!
!
Consumer!surplus!can!easily!be!computed!with!any!kind!of!demand!function;!e.g.!in!Figure!
32!with!a!linear!demand!function!it!is!also!the!area!between!the!demand!curve!and!the!price!
line.!Note!that!this!area!is!a!rectangular!triangle!so!we!can!compute!it!as!
!!"#$%&'($')*$# =
1
!"#$%&$'# !"#$% !"#$%&%' = 0.550600 = 15,600!
2
!!
"
Figure&32:&Consumer&surplus&with&linear&demand&
90
80
70
Price
60
50
Market Price
40
30
20
10
100
200
300
400
500
Concert Tickets
600
700
800
900
!
We! can! analogously! derive! the! producer! surplus! as! the! total! amount! required! to! make! all!
producers! indifferent! between! selling! and! not! selling! in! the! market.! Or! in! graphical! terms!
we! can! compute! the! producer! surplus! as! the! areas! between! the! price! line! and! the! supply!
curve.!
Figure&33:&Producer&surplus&with&linear&supply&
90
80
70
Price
60
50
Market Price
40
Producer Surplus
30
ly
Supp
20
10
100
200
300
400
500
600
700
800
Concert Tickets
900
!
Hence!for!the!supply!curve!shown!in!Figure!33!
!"#$%&'"(%")*%+ =
1
!"#$% !"#$%&$'# !"#$%&%' = 0.520600 = 6,000!
2
Note!that!the!producer!surplus!is!equivalent!to!the!profit!of!all!producers.!
6.2 Government(intervention(in(the(market(
An!important!application!of!the!concept!of!consumer!and!producer!surplus!is!the!analysis!of!
government! interventions! in! a! market.! For! instance! in! Figure! 34! we! look! at! a! tax! on! the!
producer! equal! to! the! amount! t! for! sales! of! a! good.! There! are! many! goods! where! the!
government!imposes!taxes!such!as!petrol!or!cigarettes.!Note!that!this!is!a!tax!on!the!quantity!
sold!not!the!value!!like!a!value!added!tax.!
Without! the! tax! the! market! equilibrium! is! at! Q0 ! with! price! P0 ! .! The! consumer! surplus! is!
equal!to!areas!A+B+E.!The!producer!surplus!is!equal!to!D+C+F.!
!
With!a!tax!the!market!equilibrium!is!at! Q1 !with!price! Pb !for!consumers!whereas!producers!
receive!only!a!price!of! Ps .!!Notice!that!the!consumer!surplus!is!reduced!to!area!E!whereas!
the! producer! surplus! is! reduced! to! area! F.! The! surplus! lost! consists! consequently! of! areas!
A+B+D+C.! Note! that! A+B! corresponds! to! the! amount! the! government! is! raising! in! taxes.!
Hence,! this! is! not! really! lost! surplus! but! rather! surplus! that! has! been! transferred! to!
government.!The!areas!B+C,!however,!constitute!surplus!that!is!lost.!It!is!often!referred!to!as!
deadweight0loss.0It!happens!because!the!tax!distorts!the!price!signal.!
!
Figure&34:&A&tax&on&sales&of&a&good&
Pb is the price (including
the tax) paid by buyers.
PS is the price sellers receive,
net of the tax. The burden
of the tax is split evenly.
Price
Pb
P0
D
Buyers lose A + B, and

sellers lose D + C, and
the government earns A + D
in revenue. The deadweight
loss is B + C.
B
C
PS
F
D
Q1
Q0
Quantity
6.3 (Market(Failure(
Any! government! intervention! in! the! market! affecting! marginal! costs! or! benefits! of! market!
participants! will! lead! to! deadweight! loss! ! unless! the! market! is! subject! to! a! market0 failure.0
What!this!means!is!that!even!in!the!absence!of!government!regulation!the!market!is!not!fully!
efficient;! i.e.! the! market! has! an! equilibrium! that! leaves! opportunities! to! generate! value! un=
exploited.!
There!are!three!types!of!reasons!why!this!could!be!happening:!
1. Externalities:!As!a!result!of!a!market!transaction!costs!or!benefits!arise!to!people!not!part!
of!the!market!transaction.!An!example!of!a!cost!is!pollution.!An!example!of!a!benefit!is!
innovation.!
2. Imperfect! Information:! if! market! participants! have! imperfect! information! about! the!
things!that!are!being!traded!in!the!market.!
3. Market!Power;!e.g.!as!in!the!case!of!a!monopoly!
We!will!explore!these!issues!in!more!detail!in!the!following!sections.!
Producer!surplus!
Consumer!surplus!
Market!failure!
Further(Reading(
Pindyck!&!Rubinfeld!Chapter!!9!
!
7 Government regulation
7.1 Pollution(Externality(
Consider! once! more! the! Southpark! chocolate! market! discussed! earlier.! Suppose! that! the!
wrapping! from! the! chocolate! leads! to! litter! that! has! to! be! cleaned! up! by! Southpark! city!
council.! Table! 7! suggests! a! cost! schedule.! Note! that! we! assume! that! marginal! costs! are!
increasing.!Of!course!this!doesnt!have!to!be!the!case!but!it!is!a!more!interesting!case.!!
!
Table&7:&Litter&cleanXup&costs&
Number of wrappings
to be disposed
Total Cost
Marginal
Cost
$1
$1
$3
$2
$6
$3
$9
$3
!
To!analyse!the!implications!of!this!we!add!these!costs!to!the!supply!curve!in!Figure!35!(recall!
that! the! supply! curve! represented! the! increasing! marginal! costs! suppliers! are! facing).! The!
clean=up!costs!are!an!additional!cost!that!is!associated!with!the!consumption!of!chocolate!so!
it!makes!sense!to!add!them!to!the!supply!curve.!!
We!have!seen!before!that!an!efficient!allocation!is!achieved!when!marginal!costs!are!equal!to!
marginal!willingness!to!pay.!Hence,!because!the!full!social!costs!are!now!higher!we!see!that!
the!efficient!allocation!is!now!lower!than!before!with!only!two!chocolate!bars!sold.!However,!
because!the!market!participants!of!the!chocolate!market!dont!have!to!pay!for!the!clean=up!
costs! themselves! the! market! equilibrium! will! be! as! before! at! a! chocolate! consumption! of!
three.!Thus,!the!external!clean=up!costs!drive!a!wedge!between!the!efficient!market!outcome!
and!the!actual!market!equilibrium.!!
Figure&35:&External&costs&in&a&supply&and&demand&diagram&
!
!
So! what! can! or! should! be! done! about! this?! Before! we! discuss! possible! policy! options,! lets!
first!introduce!an!alternative!way!of!representing!the!externality!shown!in!Figure!36.!
On!the!left!hand!side!we!reproduce!the!normal!market!diagram.!On!the!right!hand!side!we!
look!at!the!externality!in!terms!of!a!diagram!where!units!of!pollution!(i.e.!in!this!chocolate!
wrappers)! are! on! the! x=axis.! Moreover! rather! drawing! the! complete! supply! and! demand!
picture! we! focus! on! only! the! marginal! benefit! as! well! as! the! marginal! cost! from! pollution.!
Note! that! the! marginal! benefit! combines! both! the! producer! and! consumer! surplus! with!
every!unit!of!pollution.!!
Note! that! sometimes! we! look! at! these! curves! starting! from! the! status! quo;! i.e.! the!
equilibrium!that!arises!when!the!market!is!left!to!its!own!devices,!which!in!the!current!case!
is! at! an! output! level! of! 3.! We! then! consider! the! effect! of! reducing! pollution.! From! this!
perspective!the!marginal!cost!of!abating!emissions!is!what!we!have!to!give!up!as!pollution!
falls! from! 3! wrappers! to! 2! to! 1.! ! In! some! settings,! this! is! the! cost! of! fitting! clean=up!
equipment!to!a!polluting!plant;!in!this!example,!it!is!the!net!benefit!of!consumption.!!X!was!
willing!to!pay!more!for!chocolate!bar!number!2!than!it!cost!to!produce,!and!if!he!doesnt!get!
to! eat! it,! his! welfare! goes! down.! ! Since! we! normally! have! to! give! up! more,! the! more! we!
reduce!pollution,!this!curve!slopes!up!as!we!abate!the!emissions!and!move!from!right!to!left.!
The! marginal! benefit! of! abating! emissions,! on! the! other! hand,! is! the! curve! showing! the!
marginal!external!cost,!and!this!one!slopes!down!as!we!move!from!right!to!left.!
&
Figure&36:&An&alternative&way&of&representing&externalities&
!
!
Debates!around!pollution!can!often!be!very!polarised.!On!the!one!hand!there!are!those!who!
suffer! from! pollution! and! they! would! often! suggest! that! any! amount! of! pollution! is! un=
acceptable.! On! the! other! hand! there! are! polluters! ! perhaps! big! businesses! ! who! all! too!
often! want! us! to! believe! that! efforts! to! curtail! pollution! will! have! dire! economic!
consequences.!Figure!36!=!reproduced!in!Figure!37!=!offers!a!more!nuanced!view.!We!have!to!
balance!costs!and!benefits!of!pollution!by!equating!marginal!costs!and!marginal!benefits!of!
pollution.!This!provides!a!theoretically!clear!notion!of!a!pollution!level!that!is!desirable;!i.e.!
good!pollution!in!Figure!37.!!
Figure&37:&Good&and&bad&pollution&
!
!
As! in! the! case! of! the! supply! and! demand! diagram! we! typically! work! with! simple! smooth!
functions!to!describe!the!abatements!costs!and!benefits!as!illustrated!in!Figure!38.!
(Marginal) Costs/Benefits
Figure&38:&Abatement&and&benefit&curves&
Pollution/Emissions: E
7.2 (Emission(taxing(
Earlier! we! discussed,! how! a! tax! would! imply! that! the! economy! is! subject! to! a! deadweight!
loss,!where!economic!value!is!below!its!optimal!value.!However,!when!the!equilibrium!the!
economy!reaches!is!not!(socially)!optimal!because!of!the!presence!of!an!externality,!a!tax!on!
polluters!can!improve!things.!Figure!39!illustrates!how.!Suppose!polluters!face!a!tax!that!is!
exactly! equal! to! the! marginal! cost! of! emissions! at! the! intersection! between! emission!
marginal! cost! and! benefit! curves.! Faced! with! such! a! tax,! polluters! would! not! want! to!
increase!pollution!beyond!E*,!the!optimal!emission!point.!
!
Figure&39:&A&pollution&tax&
!
!
7.3 (Tax(versus(direct(regulation(
Instead! of! imposing! an! emission! tax! the! government! might! consider! simply! imposing! the!
regulation!that!emissions!should!not!be!higher!than!E*.!This!can!be!problematic!if!there!are!
many! different! polluters! with! different! abatement! cost! schedules.! Figure! 40! suggests! the!
example!of!two!firms.!Firm!1!has!a!steeper!marginal!abatement!cost!curve!meaning!that!she!
finds!it!harder!to!reduce!emissions!than!firm!2.!Suppose!now!the!regulator!wants!to!ensure!
that! emissions! are! no! higher! than! E*! and! to! be! fair! and! imposes! that! either! firm! is! only!
allowed!to!emit!E*/2!units!of!pollution.!We!can!see!that!at!this!point!marginal!costs!are!much!
higher! than! for! firm! 1! than! for! firm! 2.! This! means! that! we! can! reduce! the! total! costs! of!
achieving! emission! level! E*! by! reducing! emissions! of! firm! 2! further! than! E*/2! whereas!
increasing!them!for!firm!1.!To!minimise!costs!we!should!increase!firm!1!and!reduce!firm!2!
emissions!until!marginal!abatement!costs!are!exactly!equal,!which!happens!in!the!figure!at!
E1! and! E2.! ! Note! that! firms! would! respond! with! exactly! the! same! level! of! emissions! if! we!
simply!imposed!a!tax!of!T!!rather!than!micro!regulating!the!amount!of!emissions!required!
for!every!firm.!
This! has! an! important! implication:! even! if! the! government! does! not! know! the! marginal!
abatement! cost! schedule! of! every! firm! by! imposing! a! tax! the! government! can! be! sure! that!
that!the!resulting!level!of!emissions!is!achieved!in!an!optimal!manner.!
!
Figure&40:&Tax&vs&regulation&
Firm%1'
Firm%2'
E*/2%E1%
E2% E*/2%
T%
7.4 (Emission(trading(
Instead!of!imposing!a!tax!to!reduce!emission!efficiently!the!government!could!alternatively!
allow!for!emission!trading.!
Consider! again! the! case! where! the! government! imposes! that! each! firm! is! only! allowed! to!
pollute!E*/2.!However,!suppose!the!government!implements!this!by!giving!each!firm!a!set!of!
pollution! permits! equivalent! to! E*/2! and! allows! firms! to! trade! these! permits! freely! among!
themselves.!At!point!E*/2!firm!1!would!happily!by!permits!for!any!price!that!is!lower!than!
her! marginal! abatement! cost! at! E*/2.! ! At! this! price! firm! 2! is! happy! to! sell! some! of! her!
permits.! This! will! continue! until! firm! 1! pollutes! at! E1! whereas! firm! 2! pollutes! at! E2.! The!
price!of!the!last!permit!traded!will!be!equal!to!the!tax!in!Figure!40.!
7.5 (Monopoly(and(welfare(
We!can!use!welfare!analysis!to!examine!the!impact!of!a!monopoly.!Figure!41!shows!a!similar!
diagram! as! we! have! seen! in! Figure! 30! but! compares! welfare! changes! between! the! perfect!
competition! and! monopoly! case.! Recall! that! in! the! perfect! competition! case! the! market!
equilibrium!is!at!the!intersection!between!marginal!cost!curve!and!demand!curve!(which!is!
also! the! average! revenue! curve).! The! market! equilibrium! under! monopoly! occurs! at! the!
point! where! marginal! revenue! and! marginal! cost! curve! intersect.! How! is! welfare! affected?!
The! consumer! surplus! reduces! by! A+B.! Producers! lose! C! but! they! gain! A.! Hence! this! is!
clearly! good! for! the! monopolist! as! A>C.! However,! the! economy! as! whole! is! losing! the!
deadweight!loss!of!B+C.!
!
Figure&41:&Welfare&loss&and&Monopoly&
$/Q
Lost Consumer Surplus
Deadweight
Loss
Pm
A
Because of the higher

price, consumers lose
A+B and producer
gains A-C.
MC
B
C
PC
AR
MR
Qm
QC
Quantity
7.6 (Regulating(market(power(
What!is!a!sensible!way!to!deal!with!market!power?!One!thing!the!government!could!do!is!
impose! a! price! ceiling! as! illustrated! in! Figure! 42.! Unlike! in! a! competitive! market,! where! a!
binding!price!ceiling!would!reduce!total!welfare,!in!this!case!the!price!ceiling!moves!us!to!a!
point!with!higher!welfare.!!
Notice!that!the!net!welfare!increase!emerges!!once!the!price!ceiling!is!in!place!!because!the!
monopoly! has! now! an! incentive! to! increase! its! output! from! !! ! to! !! .! Without! the! price!
ceiling! the! monopoly! looses! A! and! gains! C! when! doing! that.! However,! now! it! would! no!
longer!loose!A!but!gain!C!so!its!a!no!brainer!to!increase!output!which!leads!to!a!social!gain!
of!C+B.!
There! is! one! big! problem! with! this,! however.! In! order! to! set! such! a! ceiling! effectively! the!
government!needs!to!have!good!idea!about!the!cost!structure!of!the!regulated!company.!!
This! can! be! challenging! in! particular! because! the! people! who! have! the! best! information!
about! this! ! i.e.! the! regulated! firms! ! have! also! strong! incentives! to! exaggerate! the! real!
numbers.!!
An! alternative! to! out=right! price! regulation! are! efforts! to! prevent! the! emergence! of!
monopolies!or!the!break=up!of!any!monopolies!that!might!have!arisen.!
Most!governments!have!a!number!of!different!policy!options!for!that!purpose.!In!the!UK!this!
falls!under!the!remit!of!the!Office!of!Fair!Trading!and!the!Competition!Commission.3!The!EU!
competition!authorities!can!also!pursue!firms!operating!in!the!UK.!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!In!the!future!these!will!merge!themselves!into!a!new!authority!called!the!Competition!and!Markets!
Authority!(http://en.wikipedia.org/wiki/Competition_and_Markets_Authority!).!
3
These! institutions! have! the! power! to! fine! companies! that! are! found! to! engage! in! anti=
competitive! practices.! A! recent! famous! example! for! this! are! the! cases! brought! against!
Microsoft! by! both! the! EU! and! the! American! competition! authorities.4! Microsoft! was! found!
guilty!of!using!their!dominant!position!for!operating!systems!as!an!entry!barrier!for!smaller!
competitors!in!other!markets!such!as!media!players!or!Internet!browsers.5!
They! can! also! prevent! companies! from! merging! if! the! merger! threatens! to! reduce!
competition.! Finally,! they! can! order! the! break=up! of! companies! in! an! effort! to! increase!
competition.! For! instance,! a! couple! of! years! ago! BAA! who! still! owns! airport! such! as!
Heathrow!and!Stansted,!was!ordered!to!sell!Gatwick!in!an!effort!to!improve!competition!in!
airports!near!London.6!
There! are! also! still! many! instances! where! monopolies! are! the! consequence! of! government!
policies;7!e.g.!in!many!cities!the!number!of!taxi!firms!is!regulated!by!law.!Hence!government!
policy! creates! an! out=right! entry! barrier! for! new! companies.! To! encourage! competition!
governments!can!then!simply!remove!such!barriers.!
Figure&42:&A&price&ceiling&and&monopoly&
$/Q
Regained Consumer Surplus
MC
Regained Deadweight
Loss
Pm
A
B
C
PC
Price ceiling
AR
MR
Qm
QC
Quantity
7.7 Barriers(to(entry(
To!determine!if!government!action!in!a!market!is!required!it!is!important!to!examine!if!there!
are!barriers!to!entry!which!prevent!competing!firms!from!entering!the!market.!An!obvious!
example!for!barriers!to!entry!are!legal!barriers;!e.g.!in!many!cities!the!number!of!taxi!firms!is!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!See!http://en.wikipedia.org/wiki/European_Union_Microsoft_competition_case!and!
http://en.wikipedia.org/wiki/United_States_v._Microsoft_Corporation!
5! Similar! charges! are! now! being! drawn! up! against! Goolge:! http://www.ft.com/cms/s/0/e4e9f1f8=42ff=
11e4=9a58=00144feabdc0.html#axzz3E8neTAJv!!
6!http://news.bbc.co.uk/1/hi/8317662.stm!
7!E.g.!in!many!cities!the!number!of!taxi!firms!is!regulated!by!law.!
4
regulated! by! law.! Hence! government! policy! creates! an! out=right! entry! barrier! for! new!
companies.!To!encourage!competition!governments!can!then!simply!remove!such!barriers.!!
In!the!case!of!Microsoft!the!barriers!was!implied!by!Microsofts!dominance!in!the!operating!
system! market.! They! could! then! leverage! this! dominance! into! other! markets;! e.g.! by!
automatically!installing!the!Microsoft!media!player!along!with!the!operating!system.!
Price!dumping!can!be!another!barrier:!an!incumbent!might!lower!prices!to!an!extent!where!a!
potential!entrant!will!make!losses!if!she!were!to!enter.!Of!course!this!might!also!imply!that!
the!incumbent!is!making!losses.!However,!if!this!is!only!temporary!and!the!incumbent!can!
rise! prices! in! the! future! such! a! move! can! make! sense.! Moreover,! it! might! sometimes! be!
enough! to! threaten! price! dumping! and! a! price! war! to! keep! competitors! away.! We! shall!
examine!this!in!greater!detail!when!looking!at!Game!Theory.!
7.8 Natural(monopoly(
We!have!seen!earlier,!that!a!major!determinant!of!the!number!of!firms!in!a!market!are!fixed!
costs.! The! higher! the! fixed! costs,! the! lower! the! number! of! firms.! In! the! extreme! case! ! i.e.!
when!fixed!costs!are!very!high!=!this!means!that!only!one!firm!can!profitably!operate!in!the!
market.!!
Examples! of! such! markets! include! the! railways,! electricity! provision,! water! supply,! etc.! In!
these!industries!large!amounts!of!investment!are!needed!to!provide!a!useful!service.!!
Because!the!presence!of!such!fixed!costs!prevents!more!than!one!firm!from!entering!we!can!
think!of!them!as!an!entry!barrier!as!well.!However,!unlike!with!other!entry!barriers,!it!would!
not! be! wise! nor! feasible! for! the! government! to! increase! the! number! firms.! It! would! not! be!
wise,! because! incurring! the! fixed! costs! several! times! would! create! more! waste! =! and! thus!
destroy! economic! value! ! than! could! be! gained! by! removing! monopoly! power;! e.g.! in!
principle! we! could! have! two! or! more! train! tracks! going! everywhere! for! different! firms! to!
compete.! However,! the! costs! would! be! absurd! for! this! ! not! to! mention! the! impact! on! the!
landscape!!and!given!that!existing!customers!would!be!split!between!these!companies,!they!
would!not!be!able!to!recover!these!fixed!costs.!!
Some! authors! therefore! advocate! not! to! consider! fixed! costs! that! apply! to! both! incumbents!
and! entrants! as! an! entry! barrier.! Rather:! an! entry! barrier! is! a! factor! that! prevents! a! more!
competitive!market!structure!with!a!larger!number!of!firms!in!a!situation!where!this!market!
structure!would!be!welfare!improving.8!
In! industries! where! we! are! dealing! with! natural! monopolies,! governments! often! have!
specialised! agencies! regulating! the! market.! These! typically! have! the! power! to! set! price!
targets.!For!instance!in!the!UK!this!includes!government!agencies!such!as!the!Office!of!Gas!
and! Electricity! Markets! (OFGEM),! the! Office! of! Rail! Regulation! (ORR)! or! the! Office! of!
Communications!(OFCOM).!
!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!See!McAfee!(2004),!http://www.jstor.org/stable/3592928!for!a!discussion!of!this!point.!
!
Also! note! that! even! in! those! industries! it! is! often! only! a! subset! of! the! value! chains! that! is!
characterised!by!a!natural!monopoly.!Hence,!what!government!are!trying!to!do!is!allow!for!
competitive! markets! in! the! sub! activities! of! these! industries! where! this! is! possible.! For!
instance!for!electricity!market!this!implies!that!we!have!a!highly!regulated!national!grid!but!
competitive! markets! for! power! generation! and! power! retailing.! For! the! railways,! the! large!
fixed! cost! arises! because! of! the! network! of! tracks.! Hence,! the! government! has! created!
Network! Rail,! a! company! that! owns! the! track.! It! sells! track! usage! services! with! regulated!
prices!and!contracts!to!a!wide!range!of!train!operating!companies!that!compete.!
Notice! that! if! a! regulator! wants! to! set! the! price! of! a! monopoly! that! is! dealing! with! a!
substantial! fixed! costs! the! target! price! cannot! be! the! marginal! cost! as! in! Figure! 42.! Rather,!
the!regulator!has!to!aim!to!set!the!price!close!to!average!costs!as!illustrated!in!Figure!43.!
Figure&43:&Regulating&a&natural&monopoly&
$/Q
Unregulated, the monopolist

would produce Qm and
charge Pm.
If the price were regulate to be PC,
the firm would lose money
and go out of business.
Pm
Setting the price at Pr

yields the largest possible
output;excess profit is zero.
AC
Pr
MC
PC
AR
MR
Qm
Qr
QC
Quantity
Market!failure!
Deadweight!loss!
Natural!monopoly!
Barriers!to!entry!
Externality!
Pollution!tax!
Pollution!trading!
Further(Reading(
Pindyck!and!Rubinfeld!Chapters!17,!18!
Begg!and!Ward!Chapter!8!
8 Uncertainty and Information

8.1 The(market(for(lemons(
Another!issue!that!can!lead!to!market!failure!is!uncertainty!and!lack!or!limited!information!
about!the!product!being!traded.!Clearly,!to!participate!in!market!as!either!buyers!or!sellers!
people! need! to! know! something! about! the! product! that! is! being! traded.!
The! perfect! competition! model! formally! assumes! perfect! information!
which!is!another!way!of!saying!that!everybody!knows!everything.!This!is!
a!rather!strong!assumption!and!it!can!be!relaxed!to!some!extent.!In!fact!it!
turns! out! what! is! particularly! problematic! is! not! so! much! uncertainty! as!
such!but!if!some!market!participants!are!more!uncertain!than!others.!This!
is! called! asymmetric! information.! The! most! famous! example! to! illustrate!
this! has! to! do! with! lemons.! Lemons! refers! in! this! case! to! used! cars! that! regularly! fail!
leading!to!high!repair!costs!without!this!being!immediately!apparent!by!visual!inspection!or!
a!short!test!drive.!We!examine!the!implications!of!lemons!for!a!used!car!market.!
Suppose!we!have!a!used!car!market!where!we!have!two!types!of!sellers:!
1. Good!car!sellers!want!at!least!3000!for!their!car.!
2. Lemon!sellers!who!just!want!to!get!rid!of!their!car!for!whatever!they!can!get.!
Potential!buyers!are!willing!to!pay!5000!for!a!good!car!and!nothing!for!a!lemon.!!
Suppose! there! is! information! asymmetry! so! that! only! sellers! know! the! quality! of! the! cars.!
However,!they!know!approximately!how!many!sellers!of!either!type!operate!in!the!market.!!
Suppose!initially!10%!of!sellers!sell!lemons.!Buyers!will!make!the!following!calculation:!the!
expected!value!they!will!derive!from!buying!on!this!market!is!
90%!x!5000!+!10%x!0!=!4500!
Hence! this! is! the! maximum! price! they! would! be! willing! to! pay! for! such! a! purchase.! As!
sellers!of!good!cars!are!willing!to!let!go!of!their!car!for!3000!trading!will!take!place!on!this!
market.!!
Now! consider! what! happens! if! the! share! of! lemon! car! sellers! operating! in! this! market!
increases;!e.g.!suppose!the!share!increases!to!50%.!Buyers!willingness!to!pay!would!drop!to!!
50%!x!5000!+!50%x!0!=!2500!
At! this! price! good! car! sellers! would! no! longer! be! interested!in! participating! in! the! market.!
Buyers!would!realise!this!and!as!a!consequence!we!have!a!complete!collapse!of!the!market.!
To!address!this,!good!car!sellers!could!engage!in!some!form!of!signalling.!There!are!credible!
and!non=credible!signals.!An!example!of!a!non=credible!signal!would!be!a!flashy!sign!saying!
No! Lemon.! An! example! of! a! credible! signal! would! be! the! provision! of! a! warranty! ! a!
promise! to! pay! any! repair! costs.! What! makes! a! warranty! more! credible! is! the! fact! that! it!
would!be!more!costly!for!the!lemon!seller!to!provide!such!a!warranty!than!for!the!good!car!
seller.!
8.2 Insurance(
While! uncertainty! can! destroy! markets! it! doesnt! have! to.! Indeed! some! markets! only! exist!
because! of! uncertainty:! the! market! for! insurance! products.! The! product! insurance! markets!
sell!is!a!reduction!in!uncertainty.!And!people!are!willing!to!pay!for!that!because!they!are!risk!
averse.! We! can! describe! this! with! a! utility! function! that! exhibits! diminishing! marginal!
returns!in!wealth.!To!make!things!clearer!consider!the!risk!that!your!bike!is!stolen.!Figure!44!
illustrates!this.!On!the!x=axis!we!measure!wealth!and!on!the!y=axis!utility.!The!shape!of!the!
concave! utility! function! implies! that! we! always! like! to! be! richer.! However,! if! we! are! very!
rich!already!an!additional!unit!of!wealth!doesnt!make!that!big!a!difference!as!when!we!are!
poor.! Now! suppose! that! the! theft! of! our! bike! sets! us! back! by! the! amount! shown! in! the!
diagram;! e.g.! to! make! matters! concrete! suppose! that! our! wealth! is! 10,000! with! bike! and!
8100! without.! Suppose! there! is! 50%! chance! that! the! bike! is! being! stolen.! Our! expected!
wealth!is!consequently!!
50% 10,000+50%! 8,100!=!9050!
Suppose!our!utility!function!can!be!written!as!U(Wealth).!Then!the!expected!utility!is!!
50% U(10,000)+50%! !U(8,100)!
The!exact!value!of!this!depends!of!course!on!the!precise!utility!function!we!think!is!relevant.!
However,!it!is!easy!to!draw!it!qualitatively!in!Figure!44!where!it!is!indicated!by!the!red!dot.!
Notice! that! at! the! same! point! the! consumer! would! get! more! utility! from! receiving! the!
expected!wealth!for!certain!as!indicated!by!the!blue!dot!right!above!the!red.!It!turns!out!an!
insurance!company!can!deliver!this!level!of!utility!to!the!consumer!by!charging!a!premium!
of!
10,000=9050=950!(labelled!fair!premium!in!Figure!44)!
and! transferring! the! value! of! the! bike! (1900)! in! case! of! a! theft.! The! expected! profit! of! the!
insurance!will!consequently!be!!
=50%!x!1900+950=0!
This! is! bad! news! if! the! insurance! company! ! besides! receiving! premiums! and! paying! out!
damages!=!has!to!cover!some!overheads;!e.g.!for!staff.!However!note,!that!the!premium!can!
actually!be!higher!than!the!fair!premium.!The!blue!point!to!the!left!of!the!red!identifies!the!
level!of!premium!that!would!make!consumers!exactly!as!well!off!as!they!would!be!without!
insurance.!Hence!the!insurance!could!charge!a!premium!up!to!this!level!and!the!consumers!
would!still!accept!it,!thereby!making!a!profit!that!could!cover!overheads.!
!
Figure&44:&Insurance&markets&
As good as no
insurance
Utility
Utility when expected

outcome is certain
Bike stolen
Expected wealth
without insurance
Your%expected%
utility%is%a%weighted%
average%of%the%two%
No losses
Expected
possible%outcomes%
outcome
(known%as%states%of%
the%world)>
You%care%much%more%
about%the%big%loss%if%
your%bike%is%stolen%
than%the%smaller%loss%
of%paying%the%
premium>
Fair premium
Maximum acceptable
premium
Uncertainty!
Asymmetric!Information!
Risk!averse!
Further(Reading(
Pindyck!&!Rubinfeld!Chapter!17!
!
Expected utility
without insurance
Wealth
9 Investment
Investment! is! about! comparing! economic! values! across! time.! How! can! this! be! done! in! a!
systematic!way?!!
9.1 Present(discounted(value((PDV)(
Suppose! somebody! promises! to! give! you! 100! pounds! next! year.! What! is! the! value! of! this!
for! you! today?! This! future! payment! is! worth! nothing! today! if! you! cannot! find! somebody!
who!is!willing!to!lend!you!something!today!in!exchange!for!paying!her!tomorrow.!Hence!in!
considering! the! value! of! the! future! payment! we! have! to! take! into! account! the! interest! this!
lender! is! going! to! charge.! Suppose! the! annual! interest! rate! is! R=25%.! Hence! if! we! get! 100!
next!year!it!means!we!can!spend!at!most!100/(1+25%)=80!today.!Hence!80!is!the!value!of!
100!next!year.!
What!if!a!payment!occurs!in!two!years!and!annual!interest!rates!are!R=25%?!Then!it!is!next!
year!like!we!like!getting!only!80!next!year.!Hence!the!value!of!100!in!two!years!is!!
100
1 + 25%
= 64!
We!call!this!the!present!discounted!value!(PDV)!of!our!future!payment;!i.e.!its!value!in!the!
present.!
In!general,!the!present!discounted!value!(PDV)!of!a!payment!!or!indeed!a!cost!=!of!M!in!t!
years!with!interest!R!is!
!
PDV=
M
!
1+R !
Using!the!PDV!concept!we!can!compare!disparate!streams!of!payments!at!various!points!of!
the!future.!
For!instance!consider!the!two!payment!streams!in!Table!8!over!two!years?!Which!one!would!
you!prefer?!
!!
Table&8:&Payment&streams&&2&examples&
Time
Year 0
Year 1
Year 2
Payment Stream A
$100
$100
Payment Stream B
$20
$100
$100
Which payment stream is more

valuable for us right now?
!
If!you!are!rational!then!answer!depends!on!the!interest!rate.!We!can!calculate!the!PDV!for!
both!streams!as!
!
PDV of Stream A = 100 +
PDV of Stream B = 20 +
100
(1+ R)
100
100
+
(1+ R) (1+ R)2 !
!
Table! 9! shows! the! PDV! values! for! different! interest! rates.! Note! that! stream! A! is! better! for!
higher!interest!rates!as!payments!are!made!earlier.!
!!
Table&9:&PDV&calculations&for&different&interest&rates&
Interest Rate
5%
10%
15%
20%
Payment
Stream A
195.24
190.90
186.96
183.33
Payment
Stream B
205.95
193.54
182.57
172.77
The higher R,
the lower the value of both
but the value of stream B
declines faster
9.2 Annuity(
Suppose!we!have!a!payment!N!that!is!repeated!over!several!periods;!e.g.!for!10!years.!The!
present!value!will!be.!
PDV =
N
N
N
+
+ ...+
2
(1+ R) (1+ R)
(1+ R)10 !
!
Such!a!payment!stream!is!called!an!annuity.!If!the!number!of!periods!is!very!long!computing!
the!PDV!in!this!way!can!easily!become!exhausting.!Luckily!in!the!case!of!the!annuity!there!is!
a!simplification!at!hand.!To!see!notice!that!we!can!write!the!PDV!as!
PDV = Ns where s= ( + 2 + ...+ 10 ) and =
1
1+ R !
Note!that!we!can!use!s!to!write!
s - s =
+ 2 .... + 10
2
... 10
11 = 11
If!we!solve!this!equation!for!s!
s=
11
1 !
Generalising!this!to!an!arbitrary!number!of!periods!suggests!that!the!PDV!of!an!annuity!can!
be!computed!as!
!"# !, ! =
! ! ! !!!
!
1!
Notice! that! this! expression! allows! us! to! examine! what! happens! if! t! goes! to! infinity.! An!
annuity!of!this!kind!is!known!as!perpetuity.!Because!! < 1!we!have!that!
!"# !, ! =
!"
!
= !
1! !
9.3 Net(present(value(
Typically!an!investment!project!involves!a!negative!payment!stream!in!the!present!with!the!
promise! of! a! series! of! positive! payment! streams! in! the! future! as! reward.! The! net! present!
value!(NPV)!is!simply!the!PDV!of!all!those!payment!streams.!!
We! can! use! the! NPV! to! decide! about! investment! project.! An! investment! project! is!
worthwhile! doing! if! the! NPV! is! positive.! If! we! have! several! investment! projects! that! are!
mutually!exclusive!e.g.!the!particular!building!project!we!could!undertake!on!a!given!plot!
of!land!!it!is!rationale!to!undertake!the!one!project!that!generates!the!highest!NPV.!
!
9.4 Internal(rate(of(return(
For!any!investment!project!we!can!calculate!the!internal!rate!of!return!(IRR).!It!is!the!interest!
rate! that! makes! the! NPV! of! the! project! equal! to! zero.! For! instance,! if! we! have! to! pay! 100!
today!to!get!150!tomorrow!we!can!work!out!the!IRR!as!
!
!100+
150
=0!
1+IRR
!
!
!
1+IRR=
150
=1.5!
100
For!investment!streams!that!extent!over!more!than!1!period!it!is!mostly!impossible!to!derive!
an! explicit! expression! for! the! IRR.! However,! many! software! packages! such! as! Excel! have!
built!in!functions!to!compute!the!IRR.!
!
Note!that!a!common!mistake!is!to!use!the!IRR!as!a!means!to!compare!investment!projects.!As!
we!have!seen!from!the!example!in!Table!,!the!ranking!of!PDVs!(and!equally!NPVs)!depends!
on!the!interest!rate!that!is!prevailing.!Hence,!depending!on!the!actual!interest!rate!a!project!
with!a!higher!IRR!might!become!less!favourable!than!one!with!a!lower!IRR.!!!
Discounting!
Present!discounted!value!
Net!present!value!
Annuity!
Internal!rate!of!return!
Further(Reading(
Pindyck!&!Rubinfeld!Chapters!15!
!
!
10 Pricing strategies
10.1 Price(discrimination(
We! have! seen! before! how! monopoly! power! leads! to! inefficiently! low! levels! of! output! and!
transfer!of!surplus!from!consumers!to!monopolists.!While!this!is!good!news!for!monopolists!
they!often!can!do!much!better!than!that.!Have!a!look!at!Figure!45,!which!repeats!the!familiar!
monopoly! diagram.! While! the! monopolist! gains! area! A! he! misses! out! on! the! red! triangles.!
Note!that!if!the!monopolist!would!charge!every!consumer!a!price!that!is!exactly!equal!to!his!
or!her!willingness!to!pay,!then!she!could!unlock!these!triangles!of!opportunity!and!reap!all!
the! surplus! that! the! market! has! to! offer.! Also! note! that! while! consumers! would! be! even!
worse!off,!the!total!surplus!in!such!a!market!is!higher!than!under!normal!monopoly.!There!
is! just! one! problem:! the! willingness! to! pay! of! a! consumer! is! in! most! cases! entirely! private!
information!of!the!consumer!and!consumers!have!an!interest!to!make!it!appear!lower!than!it!
really! is.! Nevertheless,! companies! have! found! a! number! of! ingenious! ways! to! learn! about!
the!willingness!to!pay!of!different!consumers.!
!
Figure&45:&Lost&opportunities&
Triangles of (lost)
Opportunity
P*
A!
MC!
Q*
Quantity
10.2 Direct(price(discrimination(
To!experience!direct!price!discrimination!you!dont!have!to!go!far.!In!particular!on!campus!it!
is! happening! all! the! time.! ! All! campus! restaurants! and! cafs! charge! separate! prices! for!
students! and! staff.! Staff! pay! more! as! their! willingness! to! pay! is! higher.! It! is! possible! to!
discriminate!as!everybody!has!a!college!card!that!clearly!identifies!who!is!who.!
Direct!price!discrimination!is!common!more!widely:!senior!citizens!have!special!tariffs,!there!
are!sometimes!different!prices!for!locals!and!tourists!etc!Many!companies!also!charge!very!
different! prices! at! different! locations.! Sometimes! this! reflects! real! differences! in! costs! ! e.g.!
transportation! costs! might! differ.! More! often! it! reflects! price! discrimination;! e.g.! coffee! on!
motorways!is!typically!more!expensive,!simply!because!the!average!consumer!going!there!is!
desperate!for!coffee!and!has!little!alternative!but!to!pay!the!high!price!at!the!service!station.!
10.3 Indirect(price(discrimination(
More!frequent!than!direct!price!discrimination!is!indirect!price!discrimination.!This!is!when!
companies!set!up!elaborate!schemes!so!that!consumers!effectively!reveal!their!willingness!to!
pay.!
10.4 Bundling(
By! bundling! their! product! with! various! auxiliary! goods! ! or! indeed! bads! such! as! time!
wasting!!companies!can!differentiate!customers!in!various!willingness!to!pay!groups.!
Examples!of!this!include:!
The! price! gap! between! business! class! and! economy:! business! class! customers! are!
willing! to! pay! so! much! more! because! they! value! the! perks! of! business! class! vastly!
more!than!economy!class!customers!
Discount! vouchers;! i.e.! getting! the! discount! requires! collecting! and! sending! in! of!
vouchers,! which! requires! time! that! users! with! higher! willingness! to! pay! might! not!
have!or!value!more.!
!
The!challenge!in!pricing!such!bundles!of!goods!is!to!ensure!that!the!higher!paying!customers!
dont!find!it!profitable!to!the!lower!price.!Lets!examine!this!issue!with!a!particular!example!
of!an!action!cam.!Suppose!there!are!two!types!of!customers:!!
Consumer!1!(Rich)!WTP!200!pounds!
Consumer!2!(Poor)!WTP!150!pounds!
The!types!differ!also!w.r.t!their!valuation!of!the!time!it!takes!to!deal!with!discount!vouchers.!
Consumer!1!(Rich)!value!time!at!50!
Consumer!2!(Poor)!value!time!at!20!
Suppose!that!there!500!customers!of!either!type.!
!
Consider!the!following!pricing:!!
Pricing!without!voucher!180.!!
Pricing!with!voucher!130.!
!
The! poor! customers! will! buy! for! the! low! price! and! rich!
customers!for!the!high!price.!Why!would!the!firm!not!charge!
200! to! rich! customers?! After! all! that! is! their! willingness! to!
pay.!However!note!that!the!willingness!to!pay!of!rich!people!
for!the!camera!combined!with!the!time!wasting!of!sending!in!
voucher! is! 200=50=150.! Hence! at! a! price! of! 130! for! this!
option! rich! customers! would! get! a! net! benefit! of! 20! whereas! a! price! of! 200! without!
voucher!would!leave!them!with!a!net!benefit!of!0.!!
!
Price!discrimination!
Bundling!
Further(Reading(
Pindyck!&!Rubinfeld!Chapters!11!
(
!
11 Games and Oligopoly
We! discussed! perfect! competition! and! monopoly.! They! are! two! extremes! of! a! spectrum! of!
market!structures.!In!many!industries!we!have!a!few!firms!all!with!some!degree!of!market!
power.! What! determines! the! structure! of! an! industry?! In! some! industries! the! number! of!
firms!might!be!regulated!by!law.9!However!in!most!industries!there!is!in!principle!free!entry.!
We!still!might!only!have!a!relatively!small!number!of!firms!for!the!same!reason!that!some!
industries!have!a!natural!monopoly:!fixed!costs.!For!instance!to!be!a!car!firm!you!need!a!big!
factory!before!selling!a!single!car.!If!fixed!costs!are!important!but!not!as!dramatic!as!in!the!
case!of!a!natural!monopoly!we!might!see!an!industry!with!only!a!few!firms.!!
Firms!in!such!a!market!structure!do!not!only!have!to!take!into!account!how!consumers!are!
going!to!react!to!their!actions!but!also!the!response!of!competing!firms.!Game!theory,!which!
is!the!systematic!study!of!strategic!interactions,!can!help!us!with!that.!
11.1 Nash(Equilibrium(
As!always!we!are!interested!in!equilibrium!outcomes.!The!Nash!Equilibrium!!named!after!
John!Nash!!is!a!general!equilibrium!concept!in!strategic!situations.!We!say!that!players!of!a!
game!(e.g.!strategically!interacting!firms)!are!in!a!Nash!equilibrium!if!every!player!is!doing!
what!is!best!for!her!given!whatever!other!player!is!doing.!
11.2 The(Cournot(model(
The! Cournot! model! describes! a! situation! where! a! small! number! of! firms! ! at! least! two! !
compete!in!output!quantities.!It!was!developed!by!the!French!economist!Augustin!Cournot!
who!died!well!before!John!Nash!was!born.!It!turns!out!however!that!it!is!a!good!example!of!
a!Nash!equilibrium.!In!its!simplest!form!it!describes!a!market!with!two!competing!firms!that!
both!produce!a!homogenous!product.!!
How! can! we! approach! this?! Following! on! from! the! idea! of! a! Nash! equilibrium,! lets! think!
about!how!one!of!the!firms!!say!firm!1!!is!behaving!given!what!the!other!firm!is!doing.!It!
turns! out! the! problem! is! very! similar! to! the! pure! monopoly! problem.! The! firm! maximises!
profits!taking!into!account!the!demand!curve.!The!only!difference!is!now!that!firm!1!has!to!
add!the!(given)!output!of!firm!2!to!its!own!output!to!figure!out!the!price!response!they!are!
going!to!get.!To!make!things!concrete!suppose!that!demand!is!
! = 30 !!
where!! = !! + !! .!Also!suppose!!for!simplicity!!that!marginal!costs!are!0!for!both!firms.!
Profits!for!firm!1!are!therefore!
!! = !!! = 30!! !! !! !!! !
which!is!equal!to!revenue!as!marginal!costs!are!0.!
As!before!we!can!find!the!optimal!production!point!by!setting!first!derivatives!equal!to!zero:!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
! e.g.! in! many! cities! in! the! UK! the! number! of! taxis! is! regulated! by! the! government!
(http://www.oft.gov.uk/shared_oft/investigations/taxi.pdf).!
9
!!!
= 30 !! 2!! = 0!
!!!
Implying!that!the!optimal!output!for!firm!1!given!the!output!of!firm!2!is!
!! =
30 !!
!
2
Notice!that!the!more!of!the!market!has!already!been!grabbed!by!firm!2!(i.e.!the!larger!!! )!the!
lower!will!be!the!output!of!firm!1.!We!call!this!expression!a!reaction!curve!for!firm!1.!It!tells!
us!how!firm!2!would!react!to!different!behaviours!(i.e.!in!this!case!only!output!choices)!by!
firm!2.!
Notice!that!there!is!nothing!particular!about!firm!1.!We!could!just!as!well!have!started!this!
argument!by!looking!at!firm!2.!Indeed!if!firm!2!is!exactly!the!same!kind!of!firm!as!firm!1!then!
we!can!derive!the!reaction!function!for!firm!2!by!symmetry:!
!! =
30 !!
!
2
Figure!46!shows!how!these!reaction!curves!look!if!we!draw!them!in!a!!! =!!! =!diagram.!Note,!

that! at! the! point! where! both! curves! intersect,! we! have! a! Nash! equilibrium:! both! firms! are!
doing!the!best!they!can!do!!i.e.!we!are!on!both!reaction!curves!!given!what!the!other!firm!is!
doing.!
Note!that!if!we!had!only!one!firm!in!this!market!the!equilibrium!output!would!be!Q=15.!This!
is! lower! than! aggregate! equilibrium! output! in! two! firm! oligopoly! (duopoly)! case,! which! is!
!! + !! = 20.! Hence! having! two! firms! makes! the! market! power! problem! somewhat! less!
severe.!
!
!
Figure&46:&Lost&opportunities&
Q1
30
Firm 2 s
Reaction Curve
The demand curve is P = 30 - Q and

both firms have 0 marginal cost.
Cournot Equilibrium
15
10
Firm 1 s
Reaction Curve
10
15
30
Q2
11.3 The(Stackelberg(model(
An! implicit! assumption! of! the! Cournot! model! is! the! simultaneity! of! the! players! decision!
making.! Things! are! slightly! different! if! decision=making! happens! sequentially.! In! this! case!
the! first! firm! to! make! a! decision! (the! leader)! will! take! into! account! the! response! of! the!
follower.!
Suppose!firm!1!is!the!leader.!Her!profit!function!will!become!
1
! = 30!! !!! 15 !! !! !
2
i.e.!firm!1!rather!than!taking!!! !as!given!will!replace!it!with!firm!2s!reaction!function!to!her!
own!(firm!1)!behaviour.!The!usual!optimisation!leads!to!the!condition!
MR1 = 30 - 2 Q1 -15 + Q1 = MC = 0
Hence!!! = 15!and!!! = 7.5.!This!implies!that!the!leader!is!making!a!higher!profit!than!the!

follower.!Note!that!not!in!all!strategic!situations!it!is!better!to!be!the!leader.!Often!it!might!be!
good!to!know!for!sure!what!your!rival!is!doing!before!taking!your!action.!Being!the!leader!is!
good!if!your!first!move!allows!you!to!somehow!restrict!the!options!of!the!follower!and!if!you!
can!credibly!commit!to!your!choice.!In!the!Stackelberg!case!the!leader!excludes!the!follower!
from!certain!price!and!output!combination!choices.!
11.4 Competing(in(prices((The(Bertrand(Model(
You!might!think!that!competing!in!prices!is!not!so!different!from!competing!over!quantities.!
After!all!the!demand!function!seems!to!map!from!one!to!the!other!so!isnt!it!just!a!different!
way! of! looking! at! the! same! thing?! Turns! out! no.! To! see! why! lets! look! again! at! a! simple!
example.!Assume!again!we!have!a!homogenous!good!and!market!demand!!
! = 30 !!
where!!! = ! !! ! + ! !! .!Also!assume!that!marginal!costs!for!both!firms!are!!MC!=!$3.!
Note!that!the!Cournot=Nash!equilibrium!in!this!case!is!!! = !! = 9!and!!P=12.!
However,! consider! what! happens! if! the! firms! compete! in! prices.! If! the! goods! produced! by!
both! firms! are! indeed! homogenous! ! i.e.! identical! ! then! we! would! expect! that! consumers!
buy!from!whichever!firm!turns!out!to!be!cheaper.!Hence,!whichever!firm!has!a!lower!price!
will!have!sales!of!Q=30=P!(i.e.!the!inverse!of!the!demand!curve)!whereas!the!other!firm!will!
sell! nothing.! Hence,! the! reaction! function! in! this! case! given! the! price! of! the! competitor!
would! be! to! charge! a! slightly! lower! price! ! except! that! is! if! the! price! of! the! competitor! is!
already! equal! to! marginal! costs.! Lowering! the! price! even! further! at! this! point! would! only!
mean!losing!money.!Consequently,!the!only!possible!Nash!Equilibrium!is!
!! = !! = !"!
Note! that! this! equilibrium! is! equal! to! the! perfect! competition! case! in! terms! of! aggregate!
output,!surplus!generated,!how!surplus!is!divided!between!producers!and!producers!as!well!
as!regarding!prices.!This!is!of!course!very!interesting.!It!implies!that!we!might!need!only!two!
firms! to! get! the! perfect! competition! outcome! ! which! most! economists! generally! regard! as!
the!best!outcome!available.!!
There! are! a! number! of! issues! worth! discussing! with! this! model.! Firstly,! the! model! doesnt!
give! us! any! prediction! regarding! the! distribution! of! output! between! the! two! companies! in!
equilibrium.! Secondly,! it! makes! an! implicit! assumption:! firms! can! only! then! compete! in!
prices! and! threaten! rivals! with! taking! the! whole! market! if! they! dont! face! any! binding!
capacity!constraints.!
This!last!point!gives!us!an!indication!as!to!when!the!Bertrand!model!is!likely!to!apply!and!
when!not:!if!firms!dont!face!capacity!constraints!they!are!more!likely!to!compete!in!prices.!
11.5 Collusion(
Lets!look!again!at!the!Cournot!example!from!Section!11.2.!Each!firm!produces!10!for!a!price!
of! P=30=20=10.! Hence! each! firm! makes! a! profit! of! 100.! Note! that! monopoly! in! the! same!
situation! would! produce! 15! for! a! price! of! 15! at! a! profit! of! 225.! So! why! dont! the! firms!
create!a!virtual!monopoly;!i.e.!collude?!Splitting!the!monopoly!profit!will!give!each!a!profit!
higher!than!100!!i.e.!112.50!for!each.!
Firstly,! collusion! is! an! illegal! practice! in! most! countries! and! industries.! However,! even! if!
there! are! no! legal! barriers! here! are! reasons! why! collusion! might! fail.! To! see! why! suppose!
that! firm! 2! sticks! to! an! output! level! consistent! with! collusion! i.e.! 7.5! units! of! output.! From!
the!reaction!curve!for!firm!1!we!know!that!the!best!firm!1!can!do!in!this!case!is!produce!
!
30 7.5
= 11.25!
2
with!profits!for!firm!1!of!!more!than!126!and!profits!for!firm!2!of!less!than!85.!
In! other! words! it! makes! sense! for! firm! 1! to! deviate! from! the! collusion! output! level.!
Moreover,!if!firm!2!sticks!faithfully!to!the!collusion!price!they!are!worse!off!than!they!would!
have!been!in!the!Cournot!case.!Of!course!firm!1!being!aware!of!this!would!probably!not!stick!
to!the!collusion!price!either,!so!we!end!up!in!the!only!Nash=Equilibrium!in!this!case!which!is!
at!an!output!of!10!for!each!firm.!
The!strategic!dilemma!the!two!firms!find!themselves!in!is!a!classic!problem!in!Game!Theory!
referred!to!as!a!Prisoners!Dilemma.!A!common!way!of!representing!things!in!game!theory!
is!in!a!2!by!2!table!as!shown!in!Figure!47!!
Figure&47:&Collusion&dilemma&
!
!
i.e.!every!cell!reports!the!pay=offs!for!both!firms!under!different!choices.!Its!called!prisoners!
dilemma,!as!its!payoff!pattern!is!equivalent!to!the!following!scenario:!suppose!two!criminals!
who! jointly! have! committed! an! offense! are! being! separately! questioned! by! the! police.! The!
police! have! only! evidence! to! convict! them! for! a! lesser! crime! (i.e.! they! will! serve! 1! year! of!
prison! time)! so! they! hope! that! at! least! one! of! them! snitches! on! the! other! in! exchange! for!
getting!off.!However!if!both!snitch!on!each!other!the!time!for!each!will!be!3!years!(see!Figure!
48)!So!what!is!going!to!happen?!Clearly,!not!confessing!or!snitching!would!lead!to!the!best!
outcome!for!both!overall.!However,!this!is!not!a!stable!equilibrium!as!either!criminal!would!
be! trying! to! reduce! their! sentence! to! 0! years! ! or! they! might! suspect! that! their! accomplice!
might! be! doing! it.! Either! way,! there! is! a! strong! incentive! for! both! to! snitch! and! the! only!
stable!outcome!leads!to!a!3!year!prison!sentence!for!both.!
Figure&48:&Prisoners&dilemma&
11.6 Repeated(games(
So!can!we!conclude!from!the!Prisoners!dilemma!story!that!collusion!is!something!we!dont!
have!to!worry!about?!Evidently!not.!There!is!plenty!of!evidence!that!firms!collude,!even!if!
this!is!illegal!and!can!!when!discovered!!lead!to!hefty!fines.!So!how!can!we!explain!this?!A!
crucial! element! of! the! market! structures! we! looked! at! so! far! is! that! they! were! one=shot!
games;!i.e.!the!strategic!interaction!took!place!only!once.!In!practice!most!firms!operate!in!an!
environment!where!they!interact!repeatedly!with!their!competitors.!This!means!that!players!
can! potentially! be! coerced! into! collusion! for! fear! of! retaliation! in! later! periods.! What!
determines!if!this!is!going!to!work?!
Lets!consider!again!the!payoff!structure!from!Figure!47.!However,!suppose!both!firms!are!
playing! this! game! infinitely! many! periods! using! a! tit! for! tat! strategy;! i.e.! they! stick! to!
collusion! until! the! other! party! deviates! from! collusion.! After! a! deviation! they! punish! the!
other! party! by! not! colluding! either! forever! after.! Using! the! formulas! for! perpetuities! we!
derived!earlier,!we!can!examine!if!this!is!a!stable!equilibrium!strategy.!For!that!we!have!to!
check!that!in!the!perpetual!collusion!pay=off!for!both!players!is!higher!than!the!one!off!non=
collusion!payoff!when!the!other!party!colludes!followed!by!perpetual!non!collusion!by!both!
players;!i.e.!for!an!equilibrium!we!need!that!!
112 +
112
100
> 126 +
!
!
!
where! R! is! the! interest! rate.! Note! that! an! increase! in! interest! rate! has! a! stronger! impact! on!
the! LHS! (i.e.! the! payoff! for! never! cheating)! than! on! the! RHS.! Hence,! what! the! equation!
shows! makes! a! lot! of! sense:! if! we! value! the! future! less! sustaining! collusion! will! not! be!
feasible.! Equally! if! the! payoff! from! cheating! were! very! high! ! e.g.! if! it! were! much! higher!
than!126!!then!collusion!would!not!work.!
Key(concepts(in(this(section(
Oligopoly!
Cournot!Model!
Nash!Equilibrium!
Betrand!Model!
Stackelberg!Model!
Further(Reading(
12 Macroeconomics
If! we! focus! on! whole! countries! rather! than! particular! markets! and! try! to! get! to! grips! with!
emergent!phenomena!such!as!business!cycles!or!economic!growth.!
12.1 The(whole(economy(as(one(market(
A!lot!of!modelling!in!macroeconomics!is!done!by!treating!the!economy!of!a!whole!country!in!
much! the! same! way! as! we! were! treating! until! now! specific! markets.! This! is! done! by!
constructing!a!virtual!good!by!dividing!the!value!added!of!products!and!services!by!a!price!
index;!i.e.!
Macro Output (Y) =
Value (Added) of all goods produced in a country

Price Index
!
!
For!an!individual!firm,!the!value!added!is!the!value!of!its!sales!minus!the!value!of!payments!
for!intermediate!products;!i.e.!if!we!denote!the!price!a!firm!!!charges!by!!
!! !
!!! = !!
!
where! !! ! is! the! firms! revenue! in! a! given! period! and! !! ! is! the! firms! expenditure! on! an!
intermediate! product! M.! Hence! the! macro/aggregate! value! added! is! simply! the! sum! over!
those!firm!level!added!values:!
!!! !
!" =
!
At!the!level!of!the!individual!firm!the!value!added!must!equal!to!the!sum!of!wage!payments,!
interest!payments,!dividend!payments!and!re=invested!assets.!The!same!must!be!true!at!the!
level!of!the!aggregate!economy.!This!gives!rise!to!a!basic!accounting!identity!which!we!shall!
use! below.! Note! that! if! we! would! not! subtract! the! value! of/expenditure! on! intermediate!
products! this! would! not! be! true! as! we! would! be! double! counting! the! actual! value! that! is!
being!created!in!the!economy.!
The!price!index!is!a!weighted!average!of!all!(most)!prices!in!the!economy.!There!are!a!variety!
of! methods! of! how! to! do! this! exactly! (i.e.! which! weights! to! use,! arithmetic! or! geometric!
averages! etc.).10! For! the! purpose! of! this! module! we! dont! have! to! worry! about! different!
methodologies.!!
Once! we! have! this! virtual! good! we! can! work! again! with! supply! and! demand! curves! as!
before!using!the!price!index!as!the!price!level!on!the!y=axis.!
!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!For!details!on!the!price!indices!used!by!UK!institutions!see!the!ONS!Webpage.!
10
Figure&49:&Aggregate&supply&and&Demand&
Price level
Aggregate Supply
Aggregate Demand
Aggregate Output (Y)
12.2 Shocks(and(sticky(prices(
In! most! of! this! module! so! far! we! didnt! give! much! attention! to! price!
adjustment.! We! almost! exclusively! focused! on! various! equilibria! that!
emerge! once! prices! had! time! to! adjust.! To! the! contrary,! a! large! part! of!
macroeconomics! is! concerned! with! the! fact! that! it! might! take! quite! a!
while! until! all! prices! have! adjusted.! This! is! referred! to! as! sticky! prices.!
There!are!a!number!of!reasons!why!prices!might!be!sticky.!While!in!some!markets!prices!can!
vary!easily!!e.g.!many!financial!markets!are!no!working!at!time!resolutions!of!fractions!of!a!
second! ! in! most! market! this! is! not! practical.! Often! prices! are! changed! or! reviewed! at!
seasonal!or!yearly!intervals.!Whats!more!if!comes!to!markets!such!as!the!labour!market!and!
wages! ! which! are! prices! as! well! ! there! are! many! different! drivers! for! wage! changes! that!
have! little! to! do! with! efforts! to! balance! demand! and! supply.! For! instance,! in! many! cases!
wages!might!simply!increase!according!to!fixed!rates;!e.g.!because!of!seniority!or!because!of!
wage!paths!that!have!been!negotiated!between!unions!and!employers!several!years!before.!
Particularly,!if!different!sectors!of!the!economy!are!hit!by!the!same!kind!of!shock!at!the!same!
time.! For! instance! most! recently,! the! world! economy! has! been! hit! by! the! sub=prime!
mortgage! crisis! which! lead! to! a! wider! banking! crisis.! This! depressed! investment! and!
demand!in!a!most!sectors!of!the!economy.!Back!in!the!70s!and!80s!the!world!economy!was!
subject! to! massive! oil! price! shocks,! which! meant! that! energy! and! transport! costs! in! all!
sectors!of!the!economy!suddenly!went!up.!
What!makes!such!shock!particularly!bad!is!not!necessarily!the!initial!shock,!but!the!time!it!
takes!prices!to!adjust!to!them!and!the!fact!that!all/many!markets!are!out!of!equilibrium!in!a!
similar!way.!!
Any!market!that!is!out!of!equilibrium!is!wasting!resources:!the!economic!value!generated!is!
not!as!high!as!it!could!be!and!resources!such!as!production!factors!are!not!allocated!in!the!
right!way!throughout!the!economy.!!
Most!markets!will!be!a!bit!out!of!equilibrium!most!of!the!time.!In!some!cases!this!means!that!
prices!and!output!are!higher!than!they!should!be!in!equilibrium!in!other!cases!the!opposite!
is! happening.! Most! of! the! time! this! is! due! to! factors! (shocks)! that! are! very! specific! to! the!
individual! markets! (e.g.! the! aspirin! market! in! South! Kensington! might! well! be! a! bit! out! of!
equilibrium!on!a!day!after!students!had!a!particularly!wild!party.)!and!so!on!average!this!
has!little!effect!because!these!shock!cancel!each!other!out!to!some!extent.!
However!with!a!macro!shock!all/many!markets!are!off!equilibrium!in!the!same!way.!Hence!
as!a!consequence!output!(macro!output)!in!the!economy!as!a!whole!might!be!too!low!which!
can!lead!to!increases!in!country!wide!unemployment!rates.!Or!indeed!output!might!be!too!
high!which!can!be!a!problem!as!well!as!we!see!below.!!
12.3 Runs(
What! determines! the! shape! of! the! macro! supply! and! demand! curves?! Lets! start! with! the!
supply!curve.!It!turns!out!that!we!think!there!are!actually!several!different!supply!functions,!
according! to! the! time! horizon! we! are! talking! about.! Specifically,! macroeconomics!
distinguishes!between!at!least!three!different!time!horizons:!the!short!run,!medium!run!and!
long!run.!
1. The! very! short! run! is! defined! as! a! time! period! in! which! shocks! might! have! hit! the!
economy!but!initially!prices!dont!respond!at!all.!
2. The!medium!run!is!defined!by!the!time!it!takes!for!some!prices!to!adjust!while!others!
are! still! fixed.! For! instance! goods! prices! might! have! adjusted! while! wages! are! still!
fixed.!
3. The!long!run!when!all!price!have!adjusted!and!the!economy!has!a!new!equilibrium.!
In!practice!it!is!hard!to!pin!point!exactly!when!these!runs!start!and!end.!Also!the!economy!
might!be!hit!by!more!shocks!before!all!prices!have!fully!adjusted.!Nevertheless!it!is!useful!to!
make!these!distinctions.!
So!how!would!these!time!horizons!affect!the!shape!of!the!supply!curve?!Lets!start!with!the!
long!run!supply!curve.!It!is!typically!represented!as!being!vertical!as!shown!in!Figure!50.!It!
is! vertical! because! we! think! that! in! the! long! run! output! is! determined! by! the! resources!
available!to!an!economy!and!not!by!the!prices.!
To! understand! better! what! this! means! lets! go! back! to! the! basic! theory! of! the! firm.! What!
macroeconomist!do!a!lot!is!that!they!talk!about!a!representative&firm!(they!also!talk!about!
representative! consumers);! by! that! they! mean! we! pretend! that! the! aggregate! output! of! the!
whole!economy!is!produced!by!one!firm!(or!by!many!firms!that!are!exactly!the!same).!!
So!suppose!that!our!representative!firm!is!a!price!taker,!uses!labour!as!its!only!input!with!
decreasing!marginal!returns;!e.g.!we!might!have!a!production!function!such!as!!
! = !!.! !
So!that!the!cost!function!becomes!
! ! = !! ! !
where!W!are!wages!paid.!
Note! that! we! use! Y! instead! of! Q! as! we! are! talking! about! the! macro! output.! Earlier! in! the!
module!we!discussed!that!the!profit!maximising!condition!of!such!a!firm!would!be!
! = 2!"!
Now! if! wages! are! constant! this! describes! an! upward! sloping! curve! in! P=Y! space;! i.e.! if! the!
firm!can!charge!a!higher!price!for!the!same!cost!it!happily!produces!more.!However!if!wages!
change! in! the! same! way! as! prices! (e.g.! price! double! and! wage! double),! then! the!
representative!firm!will!just!keep!producing!the!same!amount!of!output!Y.!Hence,!whatever!
the! price! we! would! always! have! the! same! amount! of! output! !.! Consequently,! the! supply!
curve!would!simply!be!a!vertical!line.!
But!how!could!we!motivate!that!wages!would!always!keep!up!with!prices?!A!simple!way!of!
modelling!this!is!the!following,!using!a!wage!bargaining!process.!Suppose,!L!represents!total!
hours! worked.! If! the! amount! of! workers! in! the! economy! is! fixed,! there! restrictions! on! L.!
There!will!be!total!amount!of!hours!that!is!available!per!year!give!or!take!a!certain!amount!of!
over=time!hours.!Lets!call!the!this!amount!!;!!
! = !"#$%#!"#$%&!!"#$%&'(")#*!""#$%!!"#$%&'!!"#$!
Suppose! that! whenever! actual! employment! (hour! worked)! fall! short! (! i.e.! ! < !! )! of! this!
normal!hours!budget,!workers!and/or!unions!on!behalf!of!them!are!willing!to!accept!wage!
cuts! because! they! fear! being! made! redundant! otherwise.! Although! these! wage! cuts! dont!
happen! over! night! because! wages! might! not! be! re=nogiated! for! a! while! and! also! workers!
might!find!it!hard!to!accept!nominal!wage!reductions.!Of!course!as!wages!are!cut!employers!
are!willing!to!increase!L!bringing!it!closer!to!!.!
On!the!other!hand!if!! > !,!workers!are!working!more!than!full!time;!i.e.!they!will!be!asked!
to!do!overtime!or!come!in!weekends.!They!are!in!a!good!bargaining!position!and!can!easily!
ask!for!a!rise!because!employers!will!find!it!hard!to!find!somebody!else!to!fill!any!existing!
job.! Of! course! the! wage! increase! means! that! that! employers! will! employ! a! bit! less.!
Consequently!L!moves!closer!to!!.!
Hence! this! creates! a! negative! feedback! mechanism! where! over! time! employment! will!
gravitate!towards!!.!It!also!defines!the!level!of!the!vertical!long!run!supply!curve!as!!
! = !! !
Figure! 51! illustrates! how! this! adjustment! process! works! for! a! drop! in! the! price! level! P.!
Suppose!prices!are!initially!at!P0!and!then!suddenly!drop!to!P1!while!wages!remain!fixed,!
initially.!Hence!we!have!a!positively!sloped!medium!run!aggregate!supply!curve.!Telling!us!
that! output! would! go! down! to! Y1.! Hence,! because! this! is! below! the! long! run! aggregate!
supply!and!hence!some!people!are!starting!to!be!un=!and!under=employed!wages!will!come!
down,!with!time.!As!wages!come!down!employment!and!output!nudge!back!to!the!long!run!
equilibrium.!!
!
Figure&50:&Long&and&medium&run&aggregate&supply&
!! !
!
!
Figure&51:&Adjustment&of&aggregate&supply&to&change&in&price&level&
!
!
12.4 Aggregate(Demand(
As!far!as!demand!is!concerned!we!distinguish!between!four!broad!sources!of!demand:!
1.
2.
3.
4.
Households!consumption!:!C!
Investment!by!companies:!I!
Government!spending!on!goods!and!services:!G!
Net!exports!(Exports!!Imports):!N!
Like!all!other!demand!curves!the!aggregate!demand!curve!is!downward!sloping.!However,!
the! reason! why! is! actually! slightly! different! from! the! usual! one.! It! has! to! do! with! the!
relationship! between! the! amount! of! money! that! goes! around! in! the! economy! and! the!
number! of! transactions! that! are! required.! We! assume! that! there! is! a! fixed! relationship!
between!the!amount!of!goods!and!the!amount!of!money!as!long!as!prices!are!fixed.!The!idea!
is!that!every!good!that!is!produced!has!to!be!sold.!Hence,!you!fixed!amount!of!money!in!the!
economy,!there!are!only!so!many!goods!that!you!can!sell.! Moreover,!if!you!increase!prices!
but!keep!the!nominal!amount!of!money!the!same,!then!the!number!of!goods!you!can!sell!in!a!
given! period! is! lower.! To! fully! appreciate! this! we! need! to! discuss! the! money! market! in!
greater! detail,! which! we! will! do! in! class.! For! now! just! think! of! it! like! any! other! demand!
curve.!In!particular!when!thinking!about!which!factors!might!shift!the!curve.!We!start!with!
two:!changes!in!government!spending!and!expectations!about!wealth.!We!discussed!earlier!
in!the!module!that!a!decline!in!income!will!reduce!(shift!downwards)!the!demand!curve!for!
a! normal! good.! We! find! something! similar! here! as! far! is! wealth! is! concerned.! Hence,!
consider!what!happened!when!the!mortgage!crisis!struck:!it!was!the!sudden!realisation!that!
many! assets! that! companies! and! individuals! where! holding,! werent! quite! as! valuable! as!
people!thought.!Hence,!we!can!represent!this!as!shift!of!the!aggregate!demand!curve!to!the!
left.!On!the!other!hand,!what!will!be!the!effect!of!an!increase!in!government!spending!on!the!
demand!curve?!It!will!be!a!shift!to!the!right.!
Figure&52:&Shifts&in&aggregate&demand&
12.5 A((great)(recession(
During! the! module! we! will! study! the! foundations! for! aggregated! demand! and! supply! in!
more!detail.!Before!that,!lets!use!the!theory!developed!so!far!to!apply!it!to!the!recession!we!
have! been! experiencing! in! recent! years.! Figure! 53! illustrates! how.! The! drop! wealth! as!
consequence! of! the! mortgage! crisis! in! 2007/08! led! to! a! leftward! shift! of! AD.! Because! it! is! a!
shift!of!the!aggregate!demand!curve!we!also!call!this!a!negative&demand&shock.11!
!Suppose!the!economy!starts!out!in!point!A.!Then,!in!the!very!short!run!all!prices!were!fixed!
so! the! economy! moves! to! point! B! with! output! dropping! below! the! long! run! level! which!
corresponds!to!the!full!potential!where!all!resources!are!used!adequately.!Initially!only!some!
prices! such! as! output! price! levels! will! adjust.! As! they! reduce,! demand! picks! up! and! the!
economy!moves!to!point!C.!When!finally!wages!start!to!adjust!as!well!(they!have!to!reduce),!
output!moves!back!to!its!full!potential!!!.!All!through!the!recession!we!have!what!we!call!a!
negative!output!gap.!Also!note!that!for!the!economy!to!move!back!to!its!full!potential!prices!
had!to!come!down;!i.e.!we!had!deflation!(as!opposed!to!inflation)!of!prices.!
!
!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
!During!the!module!we!will!also!discuss!supply!shocks,!which!are!shifts!of!the!supply!curve.!
11
Figure&53:&A&recession&
!
!
12.6 Stabilisation(policy(
Similar! to! the! market! failure! discussion! we! had! earlier! in! the! module,! when! faced! with! a!
recession! there! is! potentially! a! role! to! play! for! government! to! improve! upon! market!
outcomes.!There!are!two!main!instruments:!
1. Fiscal!policy!
2. Monetary!policy!
To!fully!understand!monetary!policy!we!have!to!look!more!closely!into!the!money!market,!
which!we!will!do!during!the!module.!!
Lets! focus! on! fiscal! policy! now.! Fiscal! policy! is! essentially! net! spending! spending! by! the!
government.! A! so! called! fiscal& expansion! corresponds! to! an! increase! of! government!
spending! or! a! decrease! of! taxes! or! both.! A! fiscal& contraction! is! the! opposite.! Figure! 54!
illustrates!how!this!would!amount!to!a!stabilisation!policy.!Suppose!that!after!the!economy!
is! hit! by! a! negative! supply! shock! which! means! that! it! moves! from! point! A! to! B,! the!
government!launches!a!massive!public!spending!programme!(i.e.!a!fiscal!expansion).!As!we!
have!discussed!earlier!this!would!imply,!that!the!demand!curve!shifts!outward.!Hence,!if!the!
government!designs!this!well!it!might!just!shift!the!demand!curve!back!to!(close!to)!where!it!
was!before!the!negative!demand!shock!hit!the!economy.!As!a!consequence!there!is!no!need!
for!prices!to!adjust!and!there!wont!be!a!period!where!output!is!below!its!potential.!
Of!course,!there!is!no!guarantee!that!the!government!designs!this!well.!Things!can!go!wrong!
in!two!ways.!
Firstly,! far! from! counterbalancing! the! negative! demand! shock,! governments! might! make!
things! worse.! Many! have! criticised! the! current! UK! government! for! precisely! that.! Rather!
than! expanding! spending! in! the! recession! Tory! government! embarked! on! a! programme! of!
austerity!which!basically!means!a!fiscal!contraction.!They!justified!that!by!the!high!level!of!
debt! the! UK! government! had! been! accumulating.! Nobody! argued! with! the! need! to! reduce!
the! debt! in! the! long! run! but! many! suggested! that! right! after! a! big! negative! demand! shock!
was!not!the!right!time,!because!that!will!lead!the!economy!to!an!even!deeper!recession;!e.g.!it!
might!shift!to!a!point!such!as!D!in!!Figure!54.!
Secondly,! many! worry! that! governments! might! overdo! stabilisation! policy.! Figure! 55!
illustrates! this.! Suppose! starting! from! a! point! A! the! government! embarks! on! a! fiscal!
expansion.! Initially,! this! increases! output! and! the! economy! grows.! However,! soon! prices!
will! have! to! increase! because! the! economy! is! essentially! overheating.! This! means! we! will!
have! inflation! and! also! at! some! point! the! economy! will! have! negative! growth! rates! as! the!
move!back!to!the!long!run!equilibrium.!This!is!sometimes!referred!to!as!boom!and!bust.!This!
entails! the! idea! that! rather! than! recessions! being! the! consequence! of! some! external! shock!
that! is! hitting! the! economy,! they! are! essentially! created! by! the! government! who! tried! to!
increase!output!and!growth!beyond!what!was!feasible.!!
Figure&54:&Stabilisation&policy&
!
!
Figure&55:&Overdoing&stabilisation&policy&
(
Aggregate!Demand!
Sticky!prices/wages!
Long/Short!run!
Aggregate!Supply!
Stabilisation!policy!
Further(Reading(
Begg!and!Ward!Chapters!9,!10,!11!
!
!

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BUSINESS FOR PROFESSIONAL ENGINEERS AND SCIENTISTS

IMPORTANT NOTICES REGARDING ALL BPES MODULES

Submitting assignments via Blackboard

Module Notes Business Economics - Page 1 of 81. Ralf Martin

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How to study for this course

Only reading these notes is not sufficient for a good

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1 Introduction What is Economics about?

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2 Demand and supply

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For a good with many close

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that much for a large (or any) change

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Willingness to pay for

Willingness to pay for

Willingness to pay for

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Production cost for first

Production cost for

Production Cost for 3rd

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U = U ( Good1 ,Good2 , Bad1 ,....)

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Utility is constant along

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where! PK !and! PG !are!the!prices!for!kitkats!and!gummy!bears!and! I !is!the!available!income.!

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At A: MRS =PG/PK = 0.5

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Average Total Costs = TC(Q)/Q

Marginal Costs = dTC/dQ

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5 Competition and Monopoly

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